Are Stocks Cheap Now?

A recent post on Liberty Street Economics (a blog of the Federal Reserve Bank of New York) attempts to answer that question. The post focuses on statistical analysis of the equity risk premium (ERP). As the following chart illustrates, the ERP is recently at an all-time high of 5.4%, compared to the long-term average of about 3%:

To arrive at this conclusion, the authors of the post analyzed 29 different ERP models and weighted them so that the cross-section R-squared was maximized. The authors further concluded that the high level of the ERP is currently driven no so much by dividends (roughly, at the historical average) or dividend growth (anticipated to be slightly above average), but rather by the exceptionally low Treasury yields that result from the Fed’s actions. In other words, while in the traditional CAPM

Re = Rf + β * ERP
where Re = expected return on equity
Rf = risk-free rate
β = beta coefficient, by definition equal to 1 for the equity market

also

ERP = f(Rf)
i.e. the equity risk premium is a function of the risk-free rate, so Re is doubly so.

By various accounts, a long-term average return of the equity market is just over 10%. Subtracting the average ERP of 3%, this would imply a risk-free rate of about 7%. In today’s low-rate environment, the risk-free rate is in the 0.03% to 2.8% range, depending on which Treasury instrument with a maturity from one month to 30 years is used (while many models use three-month T-bills, others may use T-notes or T-bonds depending on the duration of the analysis period).

The following chart shows that the currently expected ERP falls only slightly from the one-month ahead value of 5.4% when the forecast period is extended:

Let’s assume that the ERP in the next two years is expected to be about 5% and use a corresponding two-year Treasury note yield of 0.2% as a proxy for the risk-free rate. Adding the two, the expected annualized return of the equity market in that period is about 5.2%, which is significantly below the aforementioned historical average.

So, while the ERP rose to a historically high level, it is still insufficient to compensate for the decline in the risk-free rate. In addition, at 14.3-times estimated next-twelve-month earnings, the price-to-earnings ratio of the S&P 500® is only slightly below the historical average. Therefore, based on the ERP measure alone, one cannot conclude that stocks are cheap now.

Strong Returns But at What Risk?

A recent blog post on Barron’s refers to a Dow Jones Newswires analysis of the Amana Income mutual fund. The post states that

“The returns have reflected the blockbuster success of staid sectors over the last 15 or so years. Per Nish, the Amana Income fund is up 12.48% on a 10-year annualized basis, far outstripping the S&P 500. The prohibition on financial stocks was a big boost during the financial crisis, although it hurt during that sector’s steep rise during 2009-10.”

Let’s take a look at the fund’s performance through the Alpholio™ lens. Here is a cumulative RealAlpha™ chart for the fund:

The chart shows three distinct phases in the fund’s performance in the past eight years:

• From early 2005 to early 2008, the fund generated positive increments of RealAlpha™
• In 2008 and 2009, the fund exhibited a substantial decline in cumulative RealAlpha™, followed by a recovery to approximately the previous peak level
• From 2010 onwards, the fund’s cumulative RealAlpha™ stayed roughly flat.

Interestingly enough, in the first phase, the lag cumulative RealAlpha™ of the fund was below the regular one. This implies that in the fund’s management attempted new investment ideas that substantially differed from those in the prior sub-periods; however, these attempts were largely unsuccessful in generating more RealAlpha™.

The overall Alpholio™ statistics of the fund are unimpressive:

The annualized volatility of fund’s returns in the entire analysis period was much lower than that of the market, which was also reflected in the commendable RealBeta™ of about 0.77. However, in the last three years, the fund’s returns mostly failed to beat the returns of a reference portfolio of exchange-traded products (ETPs) that also had a slightly lower risk level. While this flat cumulative RealAlpha™ trend may not continue in the future, so far there is no strong indication that it will be broken. If it happens, Alpholio™ methodology will generate a buy signal on the fund.

Willing to Wait… But for How Long?

A recent article on Barron’s profiles Chuck Royce, the manager of the Royce Pennsylvania Mutual Fund for over 40 years. According to the article:

“The senior fund manager, 73 years old and regarded as a top small-cap investor, blames the Federal Reserve and its quantitative-easing program for distorting values in the stock market… For New York-based Royce, investing has always been about following a discipline. Those investors so eager to bolt for funds posting better returns should consider whether their new portfolio managers can match Royce’s 30-year record of 11.54% a year as of the end of the first quarter, versus 9.39% for the Russell 2000, or the 11.18% a year he’s managed over the past 10 years through May 8, better than 80% of all small-cap funds… In the short term, Royce hasn’t done as well. For the year through May 8, the fund’s 11.22% gain is worse than 81% of the small-cap funds tracked by Morningstar. Year over year, Royce posted a 19.75% rise, well behind the Russell 2000’s 24.17% gain.”

With that, how does the fund’s performance in the past eight years look from the Alpholio™’s perspective?

The chart reveals two distinct phases in that period:

• From early 2005 through late 2009, the fund largely did not generate any RealAlpha™
• From 2010 onwards, the fund exhibited a negative trend in cumulative RealAlpha™.

In its analysis of the fund titled “Royce’s flagship fund is a contender,” which was published in November 2012, Morningstar states that:

“The past few years have been uninspiring, but Royce Pennsylvania Mutual still has what it takes to succeed in the long term.”

The questions are: How long will the fund take to recover? Will it ever outperform its reference exchange-traded product (ETP) portfolio? The above chart does not offer an encouraging answer to either question.

Does”Going Active”Matter?

A recent article in Barron’s contains an interview with industry experts about the pros and cons of a growing trend of actively-managed exchange-traded funds (ETFs). In that context, the discussion covered one of the most prominent mutual funds, The Fairholme Fund. One of the experts, Ben Johnson, global director of passive-funds research at Morningstar, stated that:

Q: Are there any strategies not suited for the ETF structure?

“Some of the most successful strategies on the equity side may never end up in this format. Look at Bruce Berkowitz, manager of the Fairholme fund (FAIRX). He is Morningstar’s equity manager of the decade. And yet he is pretty much running from something as liquid as a traditional mutual fund, to say nothing of ETFs.”

The counterpoint to that statement was posted by AdvisorShares:

“Lastly, the prominent mutual fund (Fairholme Fund) cited by Morningstar’s Ben Johnson is a poor example of the type of strategy that wouldn’t be a good fit for the liquidity of an ETF. In fact, the mentioned fund is the perfect example of the inefficiency of the mutual fund structure. In the Fairholme example, a lot of hot money comes in which is more wear and tear on the portfolio manager to put the cash to work. There is a cost to do that: spreads and settlement costs that impact both the new investors and your long-time shareholders. Then something happens: the fund falls out of favor, all the hot money is flying out, the PM is now selling what he can to meet redemption requests with those costs again impacting the departing shareholders, but also being born by the long-term shareholders. In reality, it is the long-term shareholders that will suffer the most by the tax inefficiency of the capital gain generating transactions.”

Luckily, from the Alpholio™’s perspective, it does not matter whether Fairholme is constructed as a mutual fund or an ETF. What really counts is how much value active management by Mr. Berkowitz adds or subtracts on a truly risk-adjusted basis (RealAlpha™). In the past eight years, the results have been mixed.

Comparison of Dividend-Oriented ETFs

A recent article in The Wall Street Journal attempts to compare the Vanguard Dividend Appreciation ETF (VIG) to iShares Select Dividend ETF (DVY) and other “peer dividend ETFs.” As is typical for such cursory analyses, the article lumps together ETFs with the word “dividend” in their name, and focuses on short-term (up to three years) returns to draw conclusions about the funds’ performance. The article only briefly touches on the difference of holdings of the two funds.

So, what are the proper ways to compare these funds? Here is one alternative comparison based on Sharpe Ratios (all figures calculated and published by Morningstar):

ETF Ticker Category 3-Year SR 5-Year SR
Vanguard Dividend Appreciation VIG Large Blend 0.99 0.46
iShares Select Dividend Index DVY Mid-Cap Value 1.31 0.40
PowerShares FTSE RAFI US 1000 PRF Large Value 0.83 0.42
WisdomTree LargeCap Dividend DLN Large Value 1.20 0.36
SPDR S&P Dividend SDY Large Value 1.10 0.53
iShares High Dividend Equity HDV Large Value N/A N/A

In the longer 5-year period, which spanned a major market downturn, the Vanguard ETF exhibited a return/risk characteristic superior to that of the iShares ETF. However, the SPDR S&P Dividend ETF beat both according to that measure.

Another way to compare the first two of these ETFs is to use the dividend discount model to arrive at the expected rate of return. According to the article, the Vanguard ETF’s holdings currently yield about 2% in dividends and are expected to generate over 9% of earnings growth in the next three to five years. Assuming that the current dividend payout ratios and earnings growth rates stay approximately constant in the future, the ETF should return about 11% per year in total. For the iShares ETF, these figures are 7%, 4%, and also 11%, respectively. However, these identical results stem from vastly simplifying assumptions.

Finally, the two ETFs address different segments of the equity market. According to Morningstar, in the last three years the Vanguard ETF was most closely matched by the US Core Total Return index, while the iShares ETF’s best fit index was the Dow Jones Industrial Average Price Return index. This indicates that since the iShares ETF effectively tracked a much more narrowly focused index, it should not necessarily be compared to the more broadly-oriented Vanguard ETF. Indeed, Morningstar classifies the Vanguard ETF into the Large Blend category, while it puts the iShares ETF in the Mid-Cap Value category. Hence, the two ETFs are not really peers. Only the rest of the above dividend ETFs could be considered peers by virtue of the common, Large Value, category.

Rebound at Third Avenue Value Fund?

A recent article in The Wall Street Journal describes a “rebound” in the performance of the Third Avenue Value mutual fund. Let’s take a look at this fund from the Alpholio™ perspective. To do so, we will use the institutional (TAVFX) instead of investor (TVFVX) class of shares, which, thanks to a lower expense ratio, should give the fund’s management greater credit for any generated alpha.

First, a cumulative RealAlpha™ chart for the fund:

The chart clearly shows that the only rebound the fund had was in a short period of outperformance in the second half of 2008. Otherwise, the fund exhibited a persistent downward trend in the cumulative RealAlpha™.

The following chart illustrates the major equivalent holdings of the fund in the entire analysis period:

From 2009 to 2012, the fund was predominantly invested in securities driven by the Hong Kong market — see the equivalent position in EWH (iShares MSCI Hong Kong ETF). The weight of this ETF peaked at over 73% in November 2009, and even most recently it was higher than 25%. Investors in this fund effectively had a foreign single-country fund in their portfolios. Such concentration is not something that most investors would expect. Alpholio™ provides a current analysis of all major funds, which gives investors an early warning on major directional bets their fund managers are making.

Yacktman vs. Yacktman

A recent article from Morningstar compares two sibling funds, Yacktman Focused (YAFFX) and Yacktman (YACKX). The thesis of the article is that:

“… the former’s unnecessarily high expenses dim its appeal relative to its cheaper sibling.”

The article goes on to say that:

“Since its 1997 inception, Focused has an R-squared, a measure of correlation, of 95.2 relative to Yacktman. Granted, Focused’s gross return since its 1997 inception edges Yacktman’s, an encouraging sign that management’s greater conviction has led to better results. But any incremental outperformance gross of fees has been more than absorbed by the fund’s higher expenses. Focused’s 9.65% annualized return net of fees during that same stretch trails Yacktman’s 9.87%. Based on how they’re investing their own money, though, the management team of Don Yacktman, Stephen Yacktman, and Jason Subotky believes Focused will ultimately trump Yacktman. None of them invests a dime in the Yacktman fund, but all three maintain positions of more than \$1 million in Focused.

…and, rightly so! Here are the Alpholio™ statistics for both funds from February 2005 through March 2013:

This analysis takes into account only the after-fee returns of both funds and their respective reference portfolios. Clearly, YAFFX performance on a truly risk-adjusted basis has been superior to that of YACKX: The discounted cumulative RealAlpha™ figures speak for themselves. In addition, the volatility of YAFFX was only slightly higher than that of YACKX. The managers are right by voting with their own money in favor of the former fund.

This is further corroborated by the trailing Sharpe Ratios for both funds calculated by… Morningstar itself:

Fund Ticker 3-Year 5-Year 10-Year 15-Year
Yacktman Focused YAFFX 1.08 0.74 0.69 0.42
Yacktman YACKX 1.05 0.72 0.69 0.46

In the 3-, 5- and 10-year periods to present, the Sharpe Ratio of YAFFX was greater or equal to that of YACKX. The latter fund had a higher Sharpe Ratio only in the 15-year period, which indicates that any advantage of risk-adjusted performance it had over the former fund was confined to the 5-year period that ended 10 years ago. So much for a superficial observation that YACKX had a higher net return than YAFFX since the 1997 inception. Yacktman Focused’s markup is not “needless,” it is actually warranted by its risk-adjusted performance in the last 10 years, even if such an adjustment is made with a relatively crude measure of the Sharpe Ratio.

What’s in Your Wallet? (Part II)

Building upon the previous post, here are more indications of how some mutual fund managers attempt substantial market timing, of which investors may not be aware.

A recent article from The Wall Street Journal describes several funds with large cash positions. One of these funds, FPA Capital, was a topic of Alpholio™ analysis published in a prior post. According to the article, the fund held 33% in cash at some date from year-end 2012 to March 31, 2013. Indeed, the fund reported 32.9% in cash and equivalents as of the latter date.

An investor could reasonably expect that a fund with the following investment objective and strategy would be almost solely invested in equities rather than cash:

“The Fund’s primary investment objective is long-term growth of capital. Current income is a secondary consideration. FPA Capital Fund seeks to fulfill this objective through investing primarily in small and medium-sized public companies.”

The Alpholio™ analysis clearly demonstrated that at times the fund’s equivalent cash position was as high as 52%, and that such market timing efforts did not result in generation of any meaningful RealAlpha™ in the analysis period. Caveat emptor!

…or, to paraphrase the slogan from Capital One’s credit card commercial, what’s in your portfolio? This important question came up in the context of a recent Wall Street Journal article, which stated that:

The number of bond funds that own stocks has surged to its highest point in at least 18 years, another sign that typically conservative investors are taking bigger risks to boost returns.

In particular, the article mentioned the Loomis Sayles Strategic Income mutual fund (ticker NEFZX, Class A shares) that lately increased common and preferred stock holdings to 19% of its portfolio. Per the prospectus, the stock allocation in this fund can be as high as 35%. Is that what an average investor would reasonably expect? Is monitoring stock allocation in quarterly filings sufficient? Certainly not.

According to the Alpholio™ analysis, at the end of March 2013, the fund’s equivalent positions in equity exchange-traded products (ETPs) totaled over 40% (in part, this reflects the fact that the fund can invest in convertibles and foreign debt):

The fund had a significant exposure to the healthcare sector (VHT, Vanguard Health Care ETF, weight of 10%), technology sector (MTK, SPDR® Morgan Stanley Technology ETF, 5.6%), and gold miners (GLD, SPDR® Gold Shares, 4.1%).

A recent Morningstar analyst report on the fund stated that

“Since mid-2011, the team has grown increasingly concerned about the potential for rising rates and the limited opportunity for upside in most fixed-income investments. That’s led it to take increasing advantage of the fund’s broad flexibility to invest up to 35% of the portfolio in stocks… This portfolio’s flexibility may hold appeal for those who share the team’s concerns about bond valuations. However, the fund’s large equity stake adds risk to the portfolio, which, with large positions in high-yield (20%) and non-U.S. dollar denominated bonds (30%), is already one of the multisector category’s most volatile.”

Alpholio™ provides a month-by-month or even more frequent insight into the equivalent ETP holdings of mutual funds. Investors can take advantage of this information to determine a true exposure of their portfolios to various types of securities.

Analysis of Heartland Value Fund

Heartland Value (ticker symbol HRTVX) is a mutual fund with approx. \$1.2 billion in total assets managed by Bill Nasgovitz and associates. Currently, Morningstar rates the fund Two Stars / Bronze in the US OE Small Value category. The latest Morningstar analyst report on the fund titled “The fund has plenty of positive attributes working in its favor” was published in May 2012. At present, this no-load fund has an total expense ratio of 1.1% and charges a 2% redemption fee on shares redeemed or exchanged within 10 days of purchase. Let’s assess the fund’s performance using the Alpholio™ methodology.

First, the total return chart, which assumes reinvestment of all distributions into the fund and each member of the reference portfolio, respectively:

The chart shows that in the analysis period the fund generally underperformed its reference portfolio.

This is further illustrated by the cumulative RealAlpha™ chart:

In the chart, the lag cumulative RealAlpha™ curve is, for the most part, below the regular RealAlpha™ curve. Typically, this is an indication that the fund manager made major directional bets that significantly departed from the fund’s holdings in the immediately preceding time window. Unfortunately, these actions did not contribute RealAlpha™; on the contrary, an investor would be better off sticking with the lag reference portfolio (see the FAQ). With respect to cumulative RealAlpha™, the analyzed period can be divided into four distinct sub-periods:

• From early 2005 to early 2007, the cumulative RealAlpha™ of the fund was largely flat
• In 2007 (well before the market downturn), the fund lost approx. 25% of cumulative RealAlpha™
• In 2008-09, the fund’s cumulative RealAlpha™ rebounded but did not reach its peak level from early 2007
• From early 2010 onward, the fund had a negative trend in cumulative RealAlpha™.

The overall statistics further underscore the unimpressive performance of the fund:

At close to 21%, the fund’s volatility, measured by an annualized standard deviation of monthly returns in the entire analysis period, was significantly higher than that of the overall stock market. The volatility of the reference portfolio was about 2% lower than that of the fund. The discounted annualized RealAlpha™ of the fund was approximately minus 2%, which was mostly caused by the substantial loss of alpha in the in the second sub-period described above. At about 1.06, the fund’s RealBeta™ was slightly higher than that of the market, which was also reflected in the higher volatility.

The following chart demonstrates the use of smoothed RealAlpha™ to automatically generate a hypothetical trading signal for the fund:

The analysis starts with an assumption that the investor initially bought the fund in early 2005 and intended to hold this investment indefinitely, i.e. at least through early 2013. The blue curve depicts the cumulative RealAlpha™ in that entire period. Since there is some degree of high-frequency oscillation in that curve, its longer-term trend can be elicited from its smoothed approximation with an exponential moving average (EMA), depicted by the green curve. Subsequently, a simple decision criterion is applied to determine whether the investment in the fund should be retained. As long as the fund generates positive monthly increments to cumulative RealAlpha™, the investment in the fund is considered beneficial. Conversely, if the fund’s cumulative RealAlpha™ begins to consistently decrease, the investment is no longer considered attractive.

The signal would allow an investor to avoid the significant periods of the fund’s underperformance according to the smoothed RealAlpha™ measure, while capturing a couple of periods of outperformance in 2006-07 and 2009-10.

The following chart shows the major investment “themes” of the fund over time:

In the analysis period, the fund held equivalent equity positions in IWM (iShares Russell 2000 ETF; average weight of 24.4%), VBK (Vanguard Small-Cap Growth ETF; 20.4%), JKJ (iShares Morningstar Small-Cap ETF; 8.5%), VPU (Vanguard Utilities ETF; 8.2%), and EWC (iShares MSCI Canada ETF; 7.4%).

For clarity, smaller reference positions are collectively represented by the Other category in the chart. For example, this category includes an equivalent cash position in IWO (iShares Russell 2000 Growth ETF; average weight of 4.5%).

As indicated by a recent MarketWatch article, the fund also had a significant recent exposure to gold, which is illustrated by an equivalent position in GLD (SPDR® Gold Shares ETF; most recent weight of 17.7%, which was in increase from 12.9% in the previous month of the analysis). This increased exposure to stocks of gold miners had a negative impact on the fund’s performance in light of a recent significant decline in the price of gold.

Morningstar’s analyst report on the fund stated that:

“Experience and execution are this fund’s strong suits… Nasgovitz and his team employ a valuation-conscious approach to small-cap investing… While the process is sound, execution has been spotty.”

This analysis clearly demonstrates that the strategy of the fund could easily be replicated using a relatively small number of exchange-traded products (ETPs), and with a better performance (higher return with smaller volatility). As a matter of fact, in the last month of the analysis just three ETPs, with collective weights of 98.2%, accounted for almost all returns of the fund. Investors could use the results of the ongoing Alpholio™ analysis to construct a substitute portfolio of liquid, low-cost instruments that provide a higher diversification (as of 3/31/2013, the fund’s top ten holdings accounted for over 21% of its assets).