Under the Hood of Tactical Allocation Funds
September 29, 2013
Funds Again Outperformed by Benchmarks
An article from The Wall Street Journal describes a new wave of “tactical allocation” mutual funds:
There are 41 mutual funds with “tactical” in their names that are tracked by investment-research firm Morningstar Inc., including 18 that were launched since the beginning of 2012. Total assets in this fund category have risen to $4.92 billion from $1.10 billion in December 2007, according to Morningstar.
Successors to the so-called market-timing funds of the past, tactical allocation funds attempt to shift between asset classes
…with the idea of exploiting the stock market’s strong points and dodging its weaker corners over time.
One of such funds mentioned in the article is Leuthold Core Investment Fund (LCORX):
Douglas Ramsey, one of the managers of the Leuthold Core Investment Fund, says the fund’s goal is to match the performance of the stock market over the full cycle with substantially less risk, which it has done.
The fund can shift its stock exposure from 30% to 70%, and now holds 60%, Mr. Ramsey says. While it was originally conceived as a core portfolio holding, it’s now often used by registered investment advisers as a part of their alternatives allocation, Mr. Ramsey says.
Let’s take a look at the fund’s performance from the Alpholio™ perspective. The cumulative RealAlpha™ chart shows that the fund did not add value on a truly risk-adjusted basis, i.e. vs. a dynamic reference portfolio of exchange-traded products (ETPs):
The fund’s statistics demonstrate that despite a low TrueBeta™, the volatility of the fund’s returns was higher than that of the reference portfolio, and the annualized RealAlpha™ was negative:
The reference weights chart depicts how the fund’s asset allocation changed over time:
An equivalent fixed-income position of the fund is represented by the iShares 1-3 Year Treasury Bond ETF (SHY). In 2008, this position was insufficient to cushion equity declines and, as a result, the fund returned about -27.4%. From mid-2009 to mid-2010, in an attempt to capitalize on the stock market’s rebound, the fund started to decrease this position. However, the decrease was too gradual and ultimately reversed in the second half of 2010. Consequently, in 2010 the fund returned only 3.5% compared to about 12% of its peers. This illustrates the difficulties tactical allocation managers have with market timing.
September 27, 2013
Average Investor Return
The semi-annual report from S&P Indices Versus Active (SPIVA®) once again demonstrates that the majority of mutual funds were outperformed by their benchmarks over the one-, three-, and five-year periods to June 30, 2013. Here are the statistics for the US equity funds
and global/international funds
The only category where active management prevailed was international small-cap.
The situation was similar in fixed income:
Over the five-year period, the investment-grade intermediate and, to a lesser extent, global income were the only two categories in which, on average, active management provided superior returns.
While valid, the above results paint only a partial picture of funds’ performance: the returns but not the risk. In contrast, Alpholio™, through its RealAlpha™ measure, clearly demonstrates how much value each fund added or subtracted on a truly risk-adjusted basis, i.e. with respect to a dynamic reference portfolio of exchange-traded products (ETPs).
September 24, 2013
Capital Group Defends Active Management
An article in InvestmentNews discusses how “average investors” in some of the top ten large-cap mutual funds failed to beat the market over a recent five-year period due to market timing:
Over the five-year period ended Aug. 31, which includes the collapse of Lehman Brothers Holdings Inc. in 2008, the S&P 500’s 42% free fall to the bear market’s bottom and its subsequent 130% rally, five of the 10 biggest large-cap-stock funds posted better annualized returns than the benchmark.
These five funds are:
According to the article
The average investor return, which takes into account buying and selling behavior, for all but one of the funds was much lower because investors were busy selling, according to Morningstar Inc.
Only investors in the T. Rowe Price Growth Fund enjoyed the full market cycle’s outperformance. The average investor return over the past five years in the fund was 8.85%, beating the fund’s 8.63% return.
So, what’s wrong with the article’s thesis? First, a simplified proposition of looking at just the fund’s returns without taking the fund’s risk into account. Second, the use of a single performance benchmark (the S&P 500® index, a proxy for “the market”) that cannot fully adjust for that risk. Third, a notion that there exists an “average investor” whose investments into and withdrawals from the fund precisely mimicked the inflows and outflows generated by all of the fund’s investors in both time and relative scale (for one, there is no proof that these same investors who cashed out later reinvested into the fund). Fourth, a surprising indication that market timing may actually work in some cases (e.g. PRGFX). Fifth, looking at just one specific time period for a very small number of funds to derive the following speculation:
After all, five years from now, it may be funds such as the American Funds Growth Fund of America (AGTHX) or the American Funds Investment Co. of America Fund (AIVSX) that are sporting the best 10-year annualized returns, even though both have underperformed these past five years.
How would a truly risk-adjusted performance of the five funds look like over an extended period of time, which includes the interval used in the article? Here is one example, as a continuation of a previous Alpholio post on Fidelity® Contrafund®:
The chart clearly shows that on a cumulative RealAlpha™ basis, the fund started to underperform its reference portfolio in late 2007, i.e. well before the onset of the financial crisis. Therefore, the following five-year period was largely irrelevant to those investors who practiced “market timing” based on the above information.
September 19, 2013
Calamos Active ETF
Capital Group (CG), the owner of American Funds, held a very rare meeting with the media, as reported by Bloomberg, Reuters and The Financial Times. What undoubtedly prompted the meeting:
The firm’s American Funds have lost $242 billion to withdrawals since the end of 2007, while Vanguard Group Inc., the largest index-fund provider, has attracted $607 billion, according to Morningstar Inc.
One way to counteract this shrinkage of AUM is to go on the offensive and promote an apparent dominance of active management over indexing. To that end:
Capital Group, based in Los Angeles, in a study released today, argued that its stock-picking mutual funds outperformed their benchmark indexes in the majority of almost 30,000 periods examined over the past 80 years. That included 57 percent of one-year stretches, 67 percent of 5-year periods and 83 percent of 20-year ranges.
The Capital Group study examined 17 of the company’s mutual funds that invest in equities or both equities and bonds. It measured their performance over every one-, three-, five-, 10-, 20- and 30-year period, on a rolling monthly basis, from Dec. 31, 1933, through Dec. 31, 2012.
Should investors care? Not really, because over such a long period of time, and especially in the last 15-20 years, the nature of investing has changed dramatically. There is more information available about both stocks and bonds, and this information is propagated with higher speed to a much broader investment audience, which makes markets more efficient and the job of an active manager more difficult. In addition, composite investment vehicles other than mutual funds — exchange-traded products (ETPs), tracking an ever-expanding spectrum of indices — have become readily available.
Finally, comparing just the returns of a mutual fund against those of its benchmark is largely meaningless because it does not fully adjust for the fund’s risk. Alpholio™’s methodology seeks to overcome this limitation by providing a dynamic, custom reference portfolio of ETPs for each analyzed mutual fund. Only the excess return of the fund over that of its reference portfolio, i.e. the RealAlpha™, counts.
According to the Bloomerg article:
Capital Group’s largest offering, the $123 billion Growth Fund of America, has seen its assets drop 31 percent in the five years ended Aug. 31. During that time the fund returned an annual average of 6.4 percent, compared with 7.3 percent for the S&P 500.
As an update to an earlier Alpholio™ post, here is how the risk-adjusted performance of this fund looked like since early 2005:
Despite a recent improvement, the fund’s performance in the last five years has been unimpressive. Small wonder many investors voted by withdrawing their assets.
September 18, 2013
Analysis of Invesco Balanced-Risk Retirement Fund
Calamos Investments recently filed a registration statement for an actively-managed Select Growth ETF. Should investors care? To answer that, let’s take a closer look at the Principal Investment Strategies section of the statement:
The Fund invests primarily in equity securities issued by U.S. companies. Under normal market conditions, the Fund invests primarily in companies with market capitalizations of greater than $1 billion that the Adviser believes offer the best opportunities for growth. The Fund may invest up to 25% of its net assets in foreign securities.
When buying and selling growth-oriented securities, the Adviser focuses on the company’s growth potential coupled with financial strength and stability. When selecting specific growth-oriented securities, the Adviser incorporates the firm’s top-down macro-economic views and focuses on individual security selections (referred to as a “bottom-up approach”) based on qualitative and quantitative research.
In seeking to meet the Fund’s investment objective, the Fund’s investment Adviser utilizes a disciplined investment process designed to help enhance investment returns while managing risk. As part of these strategies, an in-depth proprietary analysis is employed on an issuing company and its securities. At the portfolio level, risk management tools are also used, such as diversification across companies, sectors and industries to achieve a risk-reward profile suitable for the Fund’s objectives.
For comparison purposes, here are Principal Investment Strategies in the summary prospectus of the Calamos Growth Fund:
The Fund invests primarily in equity securities issued by U.S. companies. The Fund currently anticipates that substantially all of its portfolio will consist of securities of companies with large and mid-sized market capitalizations. The Fund’s investment adviser generally defines a large cap company to have a market capitalization in excess of $25 billion and a mid-sized company to have a market capitalization greater than $1 billion, up to $25 billion. The Fund may invest up to 25% of its net assets in foreign securities.
In pursuing its investment objective, the Fund seeks out securities that, in the investment adviser’s opinion, offer the best opportunities for growth. The Fund’s investment adviser typically considers the company’s financial soundness, earnings and cash flow forecast and quality of management. The Fund’s investment adviser seeks to lower the risks of investing in stocks by using a “top-down approach” of diversification by company, industry, sector, country and currency and focusing on macro-level investment themes.
In addition, these documents show the same nine managers for both funds. Therefore, it would be reasonable to assume that both funds will pursue very similar investment strategies, although the “select” in the ETF’s name would suggest a more concentrated portfolio than that of the Growth Fund.
To get an idea of what the performance of the upcoming ETF may look like, let’s review the historical performance of the Growth Fund:
Since early 2005, the fund exhibited a decisively downward trend in its cumulative RealAlpha™. This is further demonstrated by performance statistics:
Unless the forthcoming active ETF adopts a drastically different investment strategy, the historical risk-adjusted performance of its sibling mutual fund does not bode well for the future of this new product.
September 18, 2013
Doubling Returns in No Time
An article in The Wall Street Journal discusses the recent performance of Invesco Balanced-Risk Retirement 2030 Fund (TNAAX, class A shares). In the fall of 2009, the fund started adopted a risk parity investment strategy, which distributes the risk evenly between stocks, bonds and commodities. To increase bonds’ contribution to the overall risk, the fund uses leverage. Consequently, when interest rates started to rise in May 2013, the fund’s performance took a hit:
Nevertheless, the chart shows that from the beginning of 2010 through August 2013, the total return of the fund was still higher than that of its average peer in the Target Date 2026-2030 category. Morningstar also reports a three-year (to August 31, 2013) Sharpe Ratio of 1.14 and 0.97 for the fund and its category, respectively. While the return of the fund was lower than the category’s average, its volatility was even more so thanks to the relatively high bond position.
Let’s take a look at the fund’s performance from Alpholio™’s perspective. First, the cumulative RealAlpha™ chart:
The chart shows three distinct periods in the fund’s performance:
- From early 2007 through 2009, the cumulative RealAlpha™ was trending down
- In 2010 and 2011, the cumulative RealAlpha™ was largely flat
- In 2012, the cumulative RealAlpha™ started slowly increasing.
Therefore, the switch to a risk parity strategy generally benefited the fund’s shareholders, esp. when compared to the first two years of operation. The next chart shows the reference portfolio weights for the fund:
Currently, the fund has top three equivalent positions in iShares Core Total U.S. Bond Market ETF (AGG; 46.4%), PowerShares QQQ™ ETF (QQQ; 24.5%), and iShares MSCI Singapore ETF (EWS; 12.8%).
As a previous Alpholio post indicated, when interest rates rise, correlations among stock, bond and commodity returns increase; hence, risk parity strategies tend to underperform. This negatively affected the fund in mid-2013. However, longer-term performance of the fund since its adoption of the risk parity approach is moderately encouraging.
September 13, 2013
Betting on Manager’s Past Performance
An article from MarketWatch points out that thanks to the financial crisis of late 2008, five-year annualized returns of mutual funds are about to roughly double, even if incremental returns through the end of 2013 are nil:
This will undoubtedly lead to a marketing promotion from fund companies and advisers touting the five-year “performance” of funds in absolute terms. Moreover, absent a major downturn, numbers will look even better in about six months from now, when the trailing five-year period starts at the market’s bottom in early 2009 (re: S&P 500®’s close at 676.53 on March 9 that year).
Investors focusing solely on fund returns in isolation of relevant benchmarks make a classic mistake. Luckily, Alpholio™ can help: not only does it provide a custom benchmark for each analyzed fund, but it also makes this reference portfolio dynamic, truly adjusting for an ever-changing risk taken on by the fund over the analysis period. Therefore, from Alpholio™’s perspective, the passage of fifth anniversary of the onset of the financial crisis is irrelevant.
September 10, 2013
Are ETF Fees Increasing?
A research paper from Gerstein Fisher echoes recurring findings from SPIVA® — there is very little persistence of performance in mutual funds, even highly-ranked ones:
Unlike the Performance Scorecard that uses consecutive one-year returns, the study focused on rolling three-year trailing returns in each fund category. This multi-year approach had a smoothing effect, so percentages of the top quartile persistence were higher than those found by SPIVA®. However, it is clear that after a few years, a very small percentage of funds remained in the top quartile.
As depicted above, the study also found that
…in the rolling 3-year periods between 2002 and 2012, the likelihood that a top performer would descend to the bottom quartile of returns turns out to be exactly the same (27%) [47% in the chart?], on average, as the chance that a “dog” of a fund ends up ascending to the top quartile in the following three years.
In short, statistically speaking, an investor would have been just as well off picking a professional manager with an abysmal record of returns as he would have been with a star manager.
So, what is an investor to do? Alpholio™ provides one possible recommendation: investigate a smoothed cumulative RealAlpha™ curve to determine whether the fund will continue to add value on a truly risk-adjusted basis. To learn more, please visit the FAQ and take a look at the analyses of sample mutual funds in this blog.
September 4, 2013
An article in Forbes indicates that an average expense ratio (ER) of exchange-traded products (ETPs) increased from 0.61% to 0.62% over the 12 months to June 2013. The emphasis should be on average, as opposed to asset-weighted. That is because
Driving the fee increase is the cost of newly issued funds. Since 2010, the average net ER of a newly issued fund is 0.70%, according to Morningstar data.
Not surprisingly, as the ETP space becomes more crowded and basic indexing is increasingly well covered, more niche products with a small amount of assets under management (AUM) and, consequently, higher ERs are introduced. However, a straight ER average is less indicative of what a typical investor would pay compared to an asset-weighted average.
So, was there also an increase in asset-weighted fees? The 2012 and 2013 Lipper’s Quick Guides to OE [open-ended] Fund Expenses provide at least a partial answer. Here are the average asset-weighted fees for ETFs with “institutional” load types:
For all ETF types, the ER decreased or stayed the same between 2011 and 2012, with an overall decline by about 7.3%. Therefore, on an asset-weighted basis, ETF fees exhibited an opposite trend to that on a straight average basis. That is great news for both ETF investors and Alpholio™, as the fund expense component of the (negative) excess return became smaller.