Put Cash to Use
July 31, 2013
An article on Bloomberg describes major market timing efforts by “value” managers who currently cannot find underpriced stocks and therefore have large cash positions in their mutual funds:
This problem was already addressed in a previous post. While the managers are attempting to generate returns superior to those of their funds’ benchmarks and to reduce fund volatility, they are also distorting asset allocation in their investors’ portfolios. It should be up to an investor to decide what specific percentage of cash he/she wants in the portfolio, and not up to a manager of the equity portion of the portfolio.
So, how to solve this problem to the satisfaction of both parties? The manager should keep only a minimal amount of cash at hand, and temporarily invest the rest of it in an index instrument, such as an exchange-traded fund (ETF), that follows the fund’s benchmark. This way, the fund would be almost fully invested in equities, and there would be not forgone gains if the market kept going up. (The managers’ argument for keeping cash is not that a collapse of the equity market is imminent; it is that no sufficiently deep value stocks are available.)
This proposal certainly sounds like a blasphemy — after all, these managers want to show off their skill in picking individual stocks, instead of becoming “index huggers.” However, it does keep the best interest of investors in mind — to at least keep up with the market. Since most market timing efforts backfire, staying close to fully invested is the only prudent thing to do.
July 30, 2013
Persistence Is Futile
A recent article from InvestmentNews describes the popularity of Dimensional Fund Advisors (DFA) mutual funds with financial advisers:
For the third time in four years, Dimensional Fund Advisors tops the list of mutual fund companies best positioned to increase its share of assets with financial advisers… The Austin, Texas-based mutual fund company, best known for its factor-based investing philosophy and high barriers to entry (for the mutual fund world, at least), scored 25% higher than bond megashop Pacific Investment Management Co. LLC, which came in second. The Vanguard Group Inc., the world’s largest mutual fund company, finished third.
Why do advisers prefer DFA funds? Three reasons come to mind: exclusive access, smart beta, and superior performance. The first reason is the same as the “high barriers to entry” mentioned in the above quote — the DFA funds cannot be purchased directly by individual investors, but only through qualified advisers. This means advisers can position themselves between inexpensive index-like vehicles and investors’ assets, thus improving the justification for an advisory fee.
The second reason emphasizes characteristics that make DFA funds supposedly different from regular index funds. For example, DFA Core Equity funds skew towards small-cap and value stocks:
Increased exposure to small and value companies may be achieved by decreasing the allocation of the portfolio’s assets in large growth companies relative to their weight in the US universe. Securities are considered value stocks primarily because a company’s shares have a high book value in relation to their market value (BtM).
However, this tilt is well known through Fama-French research and can be achieved through other means, including specialized factor exchange-traded funds (ETFs).
The third reason requires more scrutiny. While it is true that most DFA funds earn above-average ratings in their respective categories according to Morningstar, how does the performance of these funds look like from the Alpholio™ perspective? Let’s analyze the first DFA fund on the US Core Equity list, the US Core Equity 1 Portfolio (DFEOX). Here is the cumulative RealAlpha™ chart for the fund:
The chart clearly shows that on a truly risk-adjusted basis, the fund did not generate any alpha in the past seven years. This is further supported by performance statistics:
Similar results are observed for all of the DFA US Core Equity funds since their inception:
These data indicate that an individual investor would realize better risk-adjusted returns from substitute portfolios of ETFs than from these DFA funds, while in the process gaining intra-day liquidity and full control of investments. Alpholio™ provides composition of such substitute portfolios on an ongoing basis. Thus, the three reasons for preference of DFA funds, in particular the exclusive access, no longer hold.
July 26, 2013
Active Share Is No Guarantee of Superior Performance
The latest semi-annual S&P Persistence Scorecard study again demonstrates that the quest for performance persistence of actively-managed mutual funds is as futile as the famous resistance to the Borg in Star Trek. The majority of well-performing funds will be “assimilated” from the top quartile into the lower quartiles or from the top half into the bottom half of the fund population after both three and five years. The percentage of funds remaining in the top quartile or half after either period is much smaller than that implied by random expectations (chance), which indicates that active management skills are very fleeting.
While the study certainly brings value, it would be better if it compared actively-managed mutual funds not against each other but against an independent market benchmark specific to each fund category. Since an average fund underperforms such a benchmark by slightly more than the average expense ratio, fewer than half of the funds would beat it. In other words, if the performance bar were raised from a “relative” to an “absolute” level (as Alpholio™ does in its analyses), the distribution of funds would be much more skewed to the left, i.e. below the benchmark. However, such a distribution would truly reflect all the investment vehicles available to the investor, including index funds and exchange-traded products (ETPs). Chances are that in that case performance persistence would be even worse than the one shown in the study.
The findings of the study are corroborated by Morningstar in the analysis of its fund rating system:
“Fifteen years previously, the seminal paper on the topic, Mark Carhart’s ‘On Persistence in Mutual Fund Performance,’ offered this as its first and main conclusion: ‘Avoid funds with persistently poor performance.’
Morningstar’s research on the predictive power of its Morningstar Rating for funds (aka the star rating) further supports the notion. For most time periods, the star ratings do show mild persistence across the ratings bands, with the higher-rated funds in aggregate scoring better total returns over the next time period than the lower-rated funds. The finding is at its strongest, though, at the bottom.”
Since the statistical evidence shows that there is little long-term persistence of outperformance, the only solution is to focus on a shorter time frame. Because risk profiles in a given category vary widely across both funds and in time, a custom and dynamic benchmark has to be devised for each fund. This is exactly the methodology Alpholio™ uses. While no analytical approach based on historical data can guarantee a perfect prediction of future performance, smoothed cumulative RealAlpha™ curves do exhibit a certain degree of momentum for most funds. An investor can use this information to capitalize on fund outperformance trends, while avoiding periods of underperformance on a truly risk-adjusted basis.
July 26, 2013
Comparing Fund Companies
Recent articles from InvestmentNews discuss the concept of active share and how it helps explain a superior performance of Fidelity® Contrafund® (FCNTX) vs. that of the S&P 500 index.
Active share is a measure of the degree by which the weights (percentages) of fund holdings differ from those of the index. In mathematical terms, it is simply half the sum of absolute values of weight differences. If the active share of a fund is close to zero, then the fund is effectively a replica of the index, hence the term “closet indexer.” Conversely, if the active share is 100%, the fund and index have no overlap. A large active share is a necessary but not a sufficient condition for a fund to add value over the index.
Active share of a fund is typically calculated based on its holdings reported in periodic filings. This leads to inaccuracies because such filings only contain point-in-time snapshots of the fund’s portfolio, are published with a delay, and are subject to a potential manipulation. There is also a problem of which benchmark is chosen to calculate the active share, as frequently the one chosen by the fund’s management does not precisely reflect the actual portfolio.
FCNTX is a case in point. While its stated benchmark is the S&P 500® index, in reality its best-fit benchmark is the Morningstar US Growth index. This is illustrated by the following reference weights chart for the fund:
Currently, the fund’s equivalent positions with the highest weights are iShares Morningstar Large-Cap Growth ETF (JKE), PowerShares Dynamic Market Portfolio (PWC), and iShares Morningstar Mid-Cap Growth ETF (JKH), collectively accounting for 74%. Therefore, the use of S&P 500® index as the benchmark for the fund is misleading — it is clearly a “growth” fund with a significant mid-cap component. It is not then surprising that the active share of the fund measured against the S&P 500® index is a high 72%, as the stated in the second article.
When compared against the dynamic reference portfolio of exchange-traded products (ETPs) calculated by Alpholio™, the fund’s performance has been unimpressive:
Despite a substantial reduction of the underperforming position in Apple (AAPL), the fund’s cumulative RealAlpha™ in the past year remained largely flat. A high active share does not guarantee a superior performance of a fund on a truly risk-adjusted basis, as clearly demonstrated by this Alpholio™ analysis.
Disclaimer: Due to a multitude of random factors, perfect prediction of performance of an investment vehicle is nearly impossible. Therefore, the above analysis should be treated as merely one of the many inputs to an investment decision, and not as a definitive recommendation to buy or sell any securities. While Alpholio™ strives to provide original and useful insights into fund and portfolio performance, the ultimate investment decision belongs to you, the investor.
For a detailed explanation of the patent-pending Alpholio™ analysis methodology, please refer to the FAQ.
July 26, 2013
How Long Will This Comeback Last?
A recent three-part article from Morningstar compares American Funds with Vanguard. The first part claims many similarities between the two firms with respect to:
- Long employee tenure
- Staid funds
- Low portfolio turnover
- Multiple investment managers
- High diversification
- Risk aversion
- Strong market correlations
This is despite all major differences — unlike American Funds, Vanguard
- Focuses on indexing
- Sells funds directly to retail investors
- Has plenty of bonds funds
- Offers ETFs
- Services 401(k) plans
- Is prominently featured in the media
The second part proposes several explanations why, despite those similarities, US equity American Funds have collectively suffered net outflows of $110B, while a single Vanguard Total Stock Market Index (VTSMX) fund gained $45B in net inflows over the trailing three years. Apparently, the main reasons were poor distribution and marketing decisions, and not a poor average fund performance, despite the latter being deficient by an annualized 0.5% vs. VTSMX over the last five years. This indicates that despite a roughly equal performance over the last ten years, and a superior performance over a fifteen-year period, the glory days of American Funds may be over.
The third part delves more into performance and tries to massage the numbers to support the thesis of equality. First, a 25-year time frame of analysis is picked. This is convenient because, as part two shows, the more recent performance of American Funds has been deficient.
Next, seven unidentified American Funds and ten unspecified index funds are chosen for performance comparison. Index funds from firms other than Vanguard are used, apparently to alleviate a low-cost advantage the latter have. Given that the analysis period starts in 1988, only three existing Vanguard index funds are applicable: 500 Index (VFINX), Extended Market Index (VEXMX), and Small Cap Index (NAESX). All these are Investor share class, which means the comparison does not take advantage of even lower cost Admiral shares that were introduced in 2000 (switching between share classes of the same fund is a non-taxable event). With all that, the selection of funds for the comparison is questionable.
Subsequently, a maximum 8.5% front load is applied to American funds. This is fair because an investor could not have purchased these funds without such a load 25 years ago. However, then an “industry standard” 1% fee is charged annually to index funds. This is ostensibly done to account for the lack of “financial advice” with index funds. This “equalization” approach makes no sense because the front load is paid only once, while the financial advice fee is charged annually and thus has a compounding effect. A one-time financial “advice” provided 25 years ago (i.e. “I recommend that you should buy this great fund [on which I get a commission]”) is not the same as continuous advice on asset allocation (typical with passive investments) provided over the 25 year period. Apples to oranges.
Next comes a simplified accounting for taxes, which, for the lack of data, extends the average annual performance penalty for American Funds recorded in the last 15 years to the entire 25-year period. It is unclear if this analysis takes into account the reinvestment of residual after-tax distributions into each fund (this is what an investor would do, absent any external funds to pay taxes). Nevertheless, it is at least an attempt to take an important performance factor into account.
In the end, were it not for the recurring management fee penalty, index funds would have clearly come on top. In addition, this performance comparison does not take into account the volatility of each fund. At a minimum, what were the ex-post Sharpe Ratios for each fund calculated over the entire 25-year period? The article does not say.
In sum, it looks like the article started with a thesis of an apparent equality between the two fund firms, and then concocted a cryptic and incorrect performance analysis to support this thesis. That is regrettable.
July 26, 2013
Specialty Products No More
A couple of recent articles from The Wall Street Journal and MarketWatch declare a comeback of Bill Miller as a co-manager of the Legg Mason Opportunity Trust fund.
According to the first article
“For the third straight quarter, Legg Mason Opportunity Trust finished first in The Wall Street Journal’s ranking of diversified U.S.-stock mutual funds with more than $50 million in assets and at least a three-year record.”
This performance is attributed to the fund’s investment in stocks such as BestBuy, Netflix and Groupon. The second article gives a bit more of historical background of the fund:
“Legg Mason Opportunity was in the bottom 10% of its Morningstar peer group in 2007, 2008 and 2010, before finishing dead last in 2011. In 2012, it was up nearly 40%, ranking in the top 2% of large-cap value category; that was good, but it could be looked at as an anomaly because Miller had managed one good year (2009) amid his miseries. But the fund has gained nearly 40% again already this year, putting Miller close enough to the top that investors are thinking this hot streak might be the start of something big.
To put the fund’s performance in perspective, let’s take a look at the results of the Alpholio™ analysis of class C shares:
As the chart shows, the general trend of the fund’s cumulative RealAlpha™ in the past eight years has been downward, resulting in an aggregate alpha loss of about 75%. A pattern emerges: after each of the 2005-07 and 2009-11 plateau periods, RealAlpha™ decreased further. If history is any guide, the most recent period of relatively flat RealAlpha™ performance from the beginning of 2012 till present might be followed by another slide.
Alpholio statistics for the fund clearly demonstrate the amount of value the fund destroyed on a truly risk-adjusted basis:
Of note here is also the high volatility of the fund’s monthly returns, which approached almost 30%, or approx. twice that of the S&P 500® index, in the analysis period. Fund’s returns did not justify this elevated volatility, as its Sharpe Ratio was about half that of the index, according to Morningstar’s figures.
Moreover, while Morningstar currently classifies the fund in the US OE Mid-Cap Value category, its two equivalent exchange-traded product (ETP) positions with the highest weights are currently Vanguard Small-Cap Growth ETF (VBK, 57.3%) and Vanguard Financials ETF (VFH, 40.5%). The latter is a reflection of the 36.1% of holdings in financials as of March 31, 2013 stated in the latest quarterly report. At 27.7%, the second biggest subset of the fund’s holdings was in consumer discretionary sector, followed by 13.2% in information technology.
While investors might be tempted to draw conclusions only from the most recent performance, they should instead look at the longer-term record of the fund, which is not as encouraging.
July 26, 2013
Alternatives vs. Bonds
A recent article in The Wall Street Journal comments on the findings of an annual study of the investment management industry conducted by The Boston Consulting Group. The study provides interesting statistics of this industry:
- Global assets under management (AuM) rose to $62.4 trillion in 2012, surpassing the 2007 record of $57.2 trillion.
- Operating margins rose to 37 percent of net revenues and profit increased to $80 billion, although it remained roughly 15 percent below precrisis highs [of ~$94B].
- The increase in new asset flows remained relatively modest, totaling just 1.2 percent of global AuM in 2012. Most of those new flows moved to solutions, specialties, and passive asset classes rather than to the actively managed core assets of traditional players.
- A full quarter of traditional managers actually experienced significant erosion of their traditional actively managed core-asset base in 2012.
The study goes on to say that
The most successful managers are either specialists or traditional providers who have become “ambidextrous.” That is, they have maintained their active core-asset businesses while developing capabilities to capture new faster-growth assets, including solutions and specialties. While traditional players saw their profits decrease by 2 percent a year since 2010, specialists and ambidextrous players saw their profits increase by 10 percent a year.
So, what are those “solutions” and “specialties”? The article explains:
Specialty products include small-cap, mid-cap and sector stock investments as well as fixed-income products, such as high-yield bond and convertible investments among others. Solutions-based products are those that customize a solution for a client, such as target-date, absolute-return, volatility and flexible investments.
While the custom nature of solutions makes sense (after all, this is exactly what an investor would expect as a value added by a professional asset manager), the definition of specialties is surprising — it essentially implies that only large-cap equity and regular bond investments are “not special.” Given the current variety and accessibility of exchange-traded products (ETPs) that cover all of the above asset classes, it is hard to consider these “specialty products” really special. This approach will certainly not be able to sustain the high level of operating margins, which would not be attainable in most other industries.
Alpholio™ clearly demonstrates that most of active asset management strategies do not add value on a truly risk-adjusted basis, i.e. are deficient when compared to a dynamic portfolio of ETPs. The “burning platform” analogy the study uses in regard to 25% of active managers certainly applies to a much larger percentage of firms.
July 26, 2013
Lies about Active Investment Management
In light of a recent downturn in bonds caused by a perception of the Fed’s upcoming actions, a Barron’s blog post and a Morningstar article explore alternative investments with “bond-like” returns. However, it turns out that these alternatives behave mostly like stocks with poor return-to-risk characteristics, and thus do not provide diversification to a broader portfolio.
To illustrate, here are correlations to stocks and Sharpe Ratios derived from Morningstar’s statistics for mutual funds and ETFs mentioned in the post and article:
These three-year statistics indicate a high positive correlation to stocks coupled with sub-par risk-adjusted returns. This observation is corroborated by a new study from the Leuthold Group cited in The Wall Street Journal article that states:
“From 1994 through May, it found that hedge-fund correlations have slowly been inching up to 0.75, almost 36% higher than earlier levels. Since a measure of 1.00 represents lock-step movements, hedge fund returns are generally following the tendencies of stocks about three-quarters of the time… Funds with correlations to stocks of 0.6 or less are prized by investors since they can significantly reduce portfolio volatility and limit risks over full-market cycles.”
In the past month or so, these alternative funds held their value well relative to bond investments. This is supported by their negative or low positive three-year correlations to iShares Core Total U.S. Bond Market ETF (AGG), as estimated by Alpholio™:
|IQ Merger Arbitrage ETF
|IQ Alpha Hedge Strategy
For reference, the correlation of SPDR® S&P 500® ETF (SPY) to AGG over the same period is -0.33. Therefore, these alternatives do not provide a significant amount of diversification to a balanced equity-and-bond portfolio, but could be marginally helpful if the portfolio contains only bonds. However, even in the latter case they could be a drag on the risk-adjusted performance of the portfolio: at 1.31, the Sharpe Ratio of SPY is higher than that of any of the above funds.
July 26, 2013
A recent article from Index Universe takes on a white paper from American Century (AC), trying to expose “lies” from the paper. In doing so, the article starts with a comparison of returns of sample AC funds to those of DFA and Vanguard funds in nine “asset classes.” The article says that
“For each asset class, we used all funds fitting a particular category and chose the lowest-cost version of each fund, as long as it had a record of 10 years or more.”
First, there is a problem with assigning AC funds to these asset classes. For example, four “Large Growth” and one “Large Blend” AC funds are assigned to a US Large class, for which the references are “Large Blend” funds from DFA and Vanguard (all quoted categories from Morningstar). Strangely, the next class, US Large Value, differentiates between value and growth types of AC funds.
Similarly, two “Small Growth” and one “Small Blend” AC funds are in a common US Small class, for which the references are “Small Blend” DFA and Vanguard funds. In the International Large class, a “Foreign Large Growth” AC fund is compared to “Foreign Large Blend” references. Comparisons of AC funds to wrong benchmark funds are inaccurate, even though the conclusions might be the same otherwise.
Second, in some asset classes the Investor instead of Admiral or Institutional shares are used for Vanguard reference funds, even though the latter have been available over the past ten years and have lower expenses. Therefore, the choice of Vanguard reference funds is inconsistent with that of AC funds.
Third, the DFA funds used as references are not available to retail investors, and some are even closed to new investors. Therefore, the comparison is less meaningful for those individual investors who are not served by financial advisors offering DFA funds.
Finally, the single-fund DFA and Vanguard benchmarks do not necessarily exhibit the same volatility characteristics as the equal-weighted portfolios of AC funds in each respective asset class.
All that aside, only one of the representative AC funds, American Century Equity Income (ACIIX), currently carries the highest five-star rating from Morningstar; the rest of the AC funds are rated two to four stars. Let’s take a look at this fund from the Alpholio™ perspective:
In the past eight years, with the exception of a short period at the onset of the recent market downturn, the cumulative RealAlpha™ for this fund was essentially flat. As the AC paper states:
“Active managers vary in skill and competency, so it is essential to engage a manager that outperforms on a consistent basis.”
Investors should heed that advice also in the case of AC funds.
July 26, 2013
A couple of articles in InvestmentNews and The Wall Street Journal discuss the recent underperformance of risk parity funds. To recap what such funds do:
“Risk parity funds operate under the notion that the majority of risk in a portfolio comes from stocks. So instead of investing 60% of a portfolio in stocks, the funds lower the stock allocation and use leverage to boost the returns of the safer side of portfolio, e.g. bonds, to achieve the same returns with less risk.”
“Risk-parity funds use leverage to try to increase returns on bond investments so they more closely resemble returns of stocks. The basic idea of the strategy is that by equally distributing risks among stocks, bonds and commodities, the portfolio can weather huge price swings without sacrificing returns.”
The benchmark for these funds is typically a classic balanced portfolio of 60% stocks (e.g. represented by the S&P 500® index) and bonds (e.g. Barclays Capital Aggregate Bond Index). As indicated by a performance chart for one of the funds mentioned in the articles, AQR Risk Parity Fund (AQRIX), it is not easy to beat that benchmark even over a period of several years:
Lately, risk-parity strategies underperformed:
“That is mostly because stocks have tumbled along with bonds after the Federal Reserve hinted at a reduction in its stimulus program last month. Making things worse, commodities and inflation-protected securities, which are widely used by risk-parity managers as a hedge against inflation, also suffered heavy losses because of receding inflationary expectations.”
To see why, let’s consider the long-term and short-term correlation coefficients between returns of stocks, bonds and commodities, represented by SPDR® S&P 500® ETF (SPY), iShares Core Total U.S. Bond Market ETF (AGG), and PowerShares DB Commodity Index Tracking Fund (DBC), and iShares TIPS Bond ETF (TIP):
||7 Years (Monthly)
||1 Month (Daily)
|SPY – AGG
|SPY – DBC
|AGG – DBC
|SPY – TIP
|AGG – TIP
|DBC – TIP
The above figures clearly illustrate a significant increase in correlations between SPY and AGG, AGG and DBC, SPY and TIP, and AGG and TIP, in the last month. This explains losses suffered by risk parity strategies: stocks, bonds, and commodities all moved down in unison, and leverage exacerbated the bond downfall caused by rising interest rates. Thus, the basic premise of equalizing the risk contributed by uncorrelated components was broken, and risk parity turned to “risk disparity.”