Hedge Fund Stats
correlation, hedge fund

An article in Barron’s points out a disconnect between assets and returns of hedge funds:

As of Sept. 30, the industry managed a record $2.51 trillion in assets, according to the analysts at Hedge Fund Research. That’s also a huge recovery from the depths of the financial crisis, when the funds’ $1.87 trillion in assets fell by $400 billion.

The HFRI Fund Weighted Composite Index, which covers a wide range of strategies, was up only 5.5% from Jan. 1 to Sept. 30, while the S&P 500 rose 19.79%. The poor showing was no better than during the 10 years ended on Sept. 30, when the index, compiled by Hedge Fund Research, was up only 5.92% on an annualized basis.

Annualized returns for other periods to September 30 compiled by Hedge Fund Research (HFR) are also unimpressive:

Index 1-Year 3-Year 5-Year
HFRI Fund Weighted Composite Index 7.05% 3.85% 5.01%
HFRI Equity Hedge [EH] (Total) Index 11.08% 4.61% 5.22%
HFRI Event-Driven (Total) Index 12.32% 6.22% 6.85%
HFRI Macro (Total) Index -2.92% -0.60% 1.83%
HFRI Relative Value [RV] (Total) Index 7.18% 6.13% 7.70%
HFRI Emerging Markets (Total) Index 6.66% 0.22% 4.28%
HFRI Fund of Funds Composite Index 6.58% 2.50% 1.95%
HFRI EH: Short Bias Index [lowest] -17.06% -13.02% -12.79%
HFRI RV: Fixed Income-Asset Backed Index [highest] 10.19% 10.60% 12.01%

Not surprisingly, in the environment of low interest rates and modest economic recovery, the short-biased funds had the worst and the fixed income funds had the best performance in the past five years.

Meanwhile, the compensation of hedge fund personnel increased more in line with assets under management rather than performance. Per a Barron’s blog post, the 2014 Glocap Hedge Fund Compensation Report states the following figures:

A new study contends an entry-level analyst at a middling large hedge fund is taking home $353,000 this year. The figure, which includes salary and bonus, rises to $2.2 million for the average portfolio manager of a large fund. Overall, average compensation in the industry gained between 5% and 10% for the year.

This surely contributed to the huge increase in the number of hedge funds: from 2,392 in 1996 to 8,201 at present (567 more than before the financial crisis).

The influx of money into hedge funds is caused by institutional investors that, according to the 2013 Glocap Report, account for 77% of capital compared to only 12% contributed by high-net-worth individuals and family offices. The main reason is that after the financial crisis institutions want to minimize losses during market downturns, while sacrificing the upside during market rebounds (in 2008, the HFRI composite index fell 19.03%, while the S&P 500® lost 37.0%).

Also, hedge fund returns are supposed to exhibit low correlation with those of the market, which leads to improvement of return-to-risk characteristics of the investment portfolio. However, as the following chart from the HFR presentation to the US Dept. of Labor shows, historical correlation of the HFRI composite index to the S&P 500® has been quite high:

HFRI Correlation to S&P 500® (12-Month Rolling Window)

Furthermore, the correlation of the equity hedge fund index to the S&P 500® has been on the rise for a long time, which makes it very difficult for such funds to beat that benchmark:

Correlation of HFRI Equity Hedge Index with S&P 500&reg (Rolling 60 Months) Jan 1990 - Oct 2011

In sum, while some, especially smaller, hedge funds have attractive characteristics, performance of the overall industry leaves a lot to be desired.

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Value in Technology
mutual fund, value investing

According to an InvestmentNews article, Oakmark Funds, managed by the value investment firm Harris Associates, are increasingly holding technology stocks traditionally preferred by growth strategies:

The Oakmark Select [OAKLX] Fund has a 24% weighting to technology, and the flagship $11 billion Oakmark Fund (OAKMX) has a 19% weighting.

The reason is that prices of traditional value equities have increased to the point where the technology sector is more attractive. To illustrate that, here are some statistics from a recent edition of S&P’s The Outlook:

S&P 500 GICS Sector Performance

At 12.9, the price to estimated 2014 earnings ratio of the information technology sector is lower than that of classic value sectors, such as consumer staples (15.9) or utilities (14.7). In addition, the 13.1% year-to-date return of the sector trails that of the overall S&P 500® (19.1%). Finally, the price-to-earnings-growth (PEG) ratio of 1.0 for the sector matches that of consumer discretionary for the lowest value of all sectors. In a low-interest-rate environment maintained by the Fed, investors in search of dividend income have pushed the PEG of the consumer staples sector to 1.7 and telecom services to 1.6.

While the emphasis on technology stocks may improve the funds’ performance, as shown in a previous Alpholio™ post, past selection of securities in OAKMX did not lead to spectacular results when measured on a truly risk-adjusted basis. Therefore, investors should view the latest attempts with caution.

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Sector ETFs from Fidelity
exchange-traded fund

Fidelity Investments is about to introduce a set of ten sector ETFs that will compete with similar products from State Street (Select Sector SPDR), BlackRock (iShares) and Vanguard (sector-specific ETFs).

NYSE - Upcoming Fidelity Sector ETFs

The new ETFs will undoubtedly complement the current offering of 65 iShares ETFs that can be traded commission-free in Fidelity accounts if held for more than 30 days. The expense ratio of these ETFs will be 0.12%, lower than the average of 0.18% for SPDRs, 0.45% for iShares and 0.14% for most of Vanguard ETFs.

However, in addition to reported expense ratios, investors should also take into account trading costs, including bid/ask spreads and premium/discount to the net asset value (NAV) of each ETFs. With the highest trading volumes, SPDR ETFs are leaders in that respect.

The following table summarizes the existing U.S. sector ETFs from major issuers:

Sector SPDR iShares Vanguard
Consumer Discretionary XLY IYC VCR
Consumer Staples XLP IYK VDC
Financials XLF IYF VFH
Health Care XLV IYH VHT
Industrials XLI IYJ VIS
Information Technology XLK IYW VGT
Materials XLB IYM VAW
Telecommunication Services XTL* IYZ VOX
Utilities XLU IDU VPU

*The SPDR® S&P® Telecom ETF (XTL) is not part of the original Sector SPDRs; its expense ratio is 0.35%.
The new Fidelity sector ETFs will track MSCI IMI sector indices. In contrast, the nine SPDR ETFs track S&P sector indices that collectively represent all stocks in the S&P 500® index. iShares ETFs track the Dow Jones U.S. sector indices. As of February 2013, Vanguard ETFs track MSCI 25/50 indices that cap each fund’s exposure to stocks dominant in a given sector.

From Alpholio™’s perspective, these sector ETFs should benefit investors by expanding the pool of securities that can be used to build substitution portfolios for actively-managed mutual funds in a cost-effective manner (low expense ratio, commission-free trading).

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Cash Cushion in Equity Funds
mutual fund, valuation

An article in The New York Times describes a recent build-up of cash positions in equity mutual funds:

Many fund managers have quietly been raising their cash positions. In their latest reporting periods, according to Morningstar, the average equity mutual fund held 9.7 percent in cash, up from 8.8 percent in the previous three-month period.

The article discusses the following funds with high cash positions:

Name Ticker % of Cash
Pinnacle Value PVFIX 44
Fairholme Allocation FAAFX 14.8
Tweedy, Browne Global Value TBGVX 17
FirstEagle Overseas SGOVX 23.1

Managers of these funds cite several reasons for keeping substantial cash cushions:

  • Inability to find sufficiently undervalued stocks
  • Paramount need for capital preservation in market downturns
  • Ability to get in on best buying opportunities during market sell-offs
  • Global markets currently being fully valued.

The argument of a full- or over-valuation of stocks backfires when applied to the existing equity holdings of a fund: If at present the manager does not want to use the surplus cash to add to these positions, this implies that they have a limited appreciation potential, are fully valued or even over-valued. With that diminished reward-to-risk ratio, the fund should sell these equity holdings and increase its cash position even further.

The other arguments hinge on an assumption that a major market downturn is imminent and will have a significant magnitude, which justifies a high cash position. This leads to market timing, at which, statistically, most managers fail. Meanwhile, such funds do not realize their full potential in a rising market. Investors end up paying the price both ways.

As Alpholio™ stated in previous posts, the decision about the percentage of cash should really be left to the investor at the portfolio level rather than to a manager of each mutual fund. Otherwise, the investor is forced to constantly monitor cash positions in funds and make offsetting portfolio adjustments to stay on the overall asset allocation track. Alpholio™ helps with that by providing a visibility into the equivalent exchange-traded product (ETP) positions of a fund in between its periodic regulatory filings.

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Long Tenure Is No Guarantee of Outstanding Results
mutual fund

An article in Barron’s covers the ClearBridge Aggressive Growth (SHRAX) mutual fund whose manager is about to celebrate a 30th anniversary at the helm. While this is certainly a very long tenure, has it produced outstanding results? The author thinks so:

Freeman, 60 years old, has compiled superb long-term numbers. Since the fund’s inception in October 1983—when he launched it with his mentor and friend, Eliot Fried—the fund has averaged an annual return of 12.1%, versus 10.7% for the S&P 500. It has also beaten the S&P based on one-, three-, five-, 10- and 20-year returns, a testament to its consistency. There have been some volatile stretches, however, such as in 2008, when the fund lost 42%, trailing the Standard & Poor’s 500 index by 5.4 percentage points.

Since, as its name suggests, the fund pursues a growth strategy, it may not be appropriate to compare its returns to those of a large-cap blend index. Figures from Morningstar indicate that in the past 15 years the fund’s beta vs. the S&P 500® total return index ranged from 1.11 to 1.24 and its volatility was higher than that of the index as well. So, the fund’s performance may not be as good on a risk-adjusted basis.

Here is a cumulative RealAlpha™ chart for the fund produced by the Alpholio™ methodology:

Cumulative RealAlpha™ for SHRAX

The chart shows that the fund started to underperform on a risk-adjusted basis long before the onset of the financial crisis. Since 2008, the cumulative RealAlpha™ for the fund has been largely flat.

The following chart illustrates how the reference exchange-traded product (ETP) portfolio for the fund evolved since early 2005:

Reference Weights for SHRAX

Recently, the fund’s three largest equivalent positions were in the iShares Russell Mid-Cap Growth ETF (IWP; weight of about 41%), iShares Nasdaq Biotechnology ETF (IBB; 24%), and Vanguard Energy ETF (VDE; 23.6%). This is consistent with the current top ten holdings of the fund:

Security % of Investments
Biogen Idec Inc. 10.83
UnitedHealth Group Inc. 7.46
Anadarko Petroleum Corp. 5.93
Amgen Inc. 5.65
Comcast Corp. 5.57
Weatherford International Ltd. 3.38
Core Laboratories NV 3.22
Sandisk Corp. 3.09
Forest Laboratories 3.02
Cree Inc. 2.51
Total 50.66

With about 48% of holdings in stocks with market capitalization below $25B and a tilt toward growth, the fund hardly falls into a pure large-cap blend category. Therefore, comparing the fund’s returns to those of the S&P 500® index is misleading.

The Alpholio™ analysis demonstrates that the fund’s performance on a truly risk-adjusted basis in the past eight years has been unimpressive. Just as past performance of an investment is not a guarantee of future outcomes, a long management tenure is no guarantee of outstanding results, especially when a proper benchmark is used.

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Is Index Investing Extinct?
active management, exchange-traded product

An article in Forbes laments a recent change of focus in ETF industry conferences from traditional “market-tracking” products to active investment strategies. By “market-tracking,” the author clearly means the classic market-cap weighted indexing that is prevalent in ETFs.

This brings up two questions. The first one: What really qualifies as active management? A one-time decision to invest in the entire stock market, such as through the Vanguard Total Stock Market ETF (VTI), is arguably an act of active management. So is a decision to split the investment portfolio between 60% VTI and 40% iShares Core Total U.S. Bond Market ETF (AGG). Likewise, a decision to adopt

“a fixed asset allocation to various asset classes based on an investor’s long-term needs.”

Periodic portfolio rebalancing to such a fixed allocation is also a form of active management, if not market timing, even if conducted on a fixed schedule. That is because one of its attributes is to “buy low, sell high,” i.e. lock in the gains in appreciated assets to cheaply purchase other assets in anticipation of a reversal to the mean.

Similarly, any modification of a “fixed” asset allocation in response to a change in the investor’s age or life circumstances also qualifies as active management.

Finally, it is worth noting that indices tracked by passive ETFs are also actively managed. Over time, the membership of securities in the index will change, and frequently so due to an arbitrary decision from a management committee rather than as a result of an explicit formula. A recent recomposition of the Dow Jones Industrial Average is one case in point. Another example is a recent switch of the Vanguard Emerging Markets ETF’s (VWO) underlying index from MSCI to FTSE, which caused all South Korean stocks to be removed from the fund.

Active management inevitably takes place at all stages of the investment process, even one based on passive instruments.

The second question that arises: Where is the ETF industry heading? The first wave of ETFs was about attaining economies of scale while implementing traditional market indices. It created a few dominant providers but resulted in a race to the bottom in management fees.

The second wave was about spreading horizontally to all niches of the market. Many of such exotic strategies failed to garner minimum assets of $50-100M that are typically required for an ETF to survive.

The third wave is about non-market-cap indexing, whether equal-weighted or fundamentally-weighted (“smart beta“). Such funds are a blasphemy to market-cap indexing purists who spend a lot of time poking holes in these strategies.

The next wave, pending regulatory approval of infrequent reporting of fund holdings, will be about active management. The ETF structure is attractive to actively-managed mutual fund vendors because it allows them to lower fees and survive the onslaught of cheap market-cap indexed ETFs.

All this makes traditional fee-based advisers nervous:

In the end, most advisers continue to do what’s in their clients’ best interest; they create a long-term asset allocation, buy low-cost index fund, and then stay the course!

The problem is that in many cases investors pay a recurring annual fee of anywhere from 0.2% to 1.5% of assets for a one-time setup of a portfolio pie-chart (frequently with small variations from the adviser’s “moderate” allocation template), followed by periodic rebalancing and reports. That enables a typical adviser to spend only about 11% of time on investment research, while devoting about 18% to client acquisition and prospecting, and 48% to client management.

In the end, the market will rightly decide what type of financial products survive and flourish. Marketing gimmicks aside, innovation in the ETF industry is a good thing because it gives investors more financial instruments to choose from at an ever-decreasing cost. Alpholio™ can use these new products to form reference ETF portfolios that better explain the performance of actively-managed mutual funds and arbitrary portfolios.

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Active ETFs Slow to Catch On
active management, exchange-traded fund

An article in The New York Times points out that actively-managed exchange-traded funds (ETFs) have not become hugely popular in over five years since they were first introduced.

Alpholio™ identified only 18 active ETFs, each with current assets of at least $100M (generally considered a minimum for a long-term viability of a fund), listed here in the descending order of assets:

Name Ticker Assets ($M) Expense Ratio (%)
PIMCO Enhanced Short Maturity MINT 4,192 0.35
PIMCO Total Return BOND 3,927 0.55
WisdomTree Emerging Markets Local Debt ELD 1,412 0.55
SPDR Blackstone/GSO Senior Loan SRLN 525 0.90
WisdomTree Asia Local Debt ALD 509 0.55
Guggenheim Enhanced Short Duration Bond GSY 476 0.28
First Trust North American Energy Infrastructure EMLP 422 0.95
AdvisorShares Peritus High Yield HYLD 388 1.35
WisdomTree Chinese Yuan CYB 216 0.45
WisdomTree Emerging Currency CEW 196 0.55
PIMCO Intermediate Municipal Bond MUNI 194 0.35
AdvisorShares Ranger Equity Bear HDGE 185 1.93
WisdomTree Managed Futures WDTI 145 0.96
SPDR SSgA Multi-Asset Real Return RLY 138 0.70
Cambria Shareholder Yield SYLD 125 0.59
WisdomTree Emerging Markets Corporate Bond EMCB 112 0.60
PIMCO Global Advantage Inflation-Linked Bond ILB 111 0.60
SPDR SSgA Income Allocation INKM 105 0.70
Total 13,378
Average 0.72
Asset-Weighted 0.55

For this group of ETFs, the asset-weighted expense ratio is smaller than the average expense ratio. This is largely caused by relatively low expense ratios of the three largest ETFs that invest in bonds and hold approx. 71% of the group’s assets.

In contrast, currently there are about 636 passive ETFs, each with assets of at least $100M totaling about $1.53T. The asset-weighted expense ratio of these ETFs is 0.29% and the average expense ratio is 0.49%.

Active ETFs still have less than half of expense ratios of actively-managed mutual funds. This is because ETF shares are mostly traded among investors, and not between investors and the issuer, which decreases operating costs.

A major obstacle for managers of active ETFs is the requirement to publish fund holdings daily, which can enable other parties to front-run or shadow (emulate) their portfolios. This is especially a problem for those ETFs that are clones of actively-managed equity mutual funds.

Several issuers are currently seeking regulatory approval for a quarterly reporting of portfolio holdings by active ETFs, same as for traditional mutual funds. The industry has also devised patented workarounds, incl. the publication of indicative values every 15 seconds together with the stated benchmark for the ETF, and using blind trusts for authorized participants to preserve tax efficiency.

If the SEC approves such “non-transparent” active ETFs, the number and assets of these products will likely rise. Alpholio™ can effectively analyze active ETFs regardless of the frequency of holding disclosure, applying the same return-based methodology as for traditional mutual funds. In addition, Alpholio™ can also include active ETFs in reference portfolios for mutual funds if that improves the accuracy of fund analyses.

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Winner Again, But for How Long?
mutual fund

An article in The Wall Street Journal recaps the results of the quarterly Winners’ Circle, a ranking of mutual funds according to their returns in the most recent 12 months.

The Winners’ Circle contest looks at diversified U.S.-stock mutual funds with more than $50 million in assets and at least a three-year record, based on preliminary data from Morningstar. It excludes index funds, leveraged index funds and inverse leveraged index funds.

For the fourth quarter in a row, the winner is Legg Mason Opportunity Trust (LMOPX, class C shares):

Legg Mason Opportunity returned 63.25% over the 12 months through September, according to Morningstar Inc. Nine stocks of about 60 in the $1.4 billion portfolio doubled in the past year, its managers calculate, while fewer than 1% of companies in the S&P 500 did so.

As a follow-up to a previous post, let’s again take a closer look at this fund from the Alpholio™ perspective. Here is an updated cumulative RealAlpha™ chart for the fund:

Cumulative RealAlpha™ for LMOPX

As the chart indicates, in the 12 months through August 2013 the cumulative RealAlpha™ for the fund was relatively flat. How is that possible, given that the fund had such a stellar return in that period?

The chart shows the cumulative RealAlpha™ since early 2005. The fund severely underperformed in 2008 (return of -65.5%) and 2011 (-34.9%), so despite its recent rebound and other years of outstanding returns, it has not yet started to generate a substantial RealAlpha™ on a cumulative basis. In other words, the penalty of poor past performance is factored into the cumulative RealAlpha™, similarly to how investment returns, both positive and negative, are compounded over time.

Although it is tempting to focus on short-term returns, Alpholio™ takes a longer view of the fund’s performance. As Bill Miller, the manager of the fund, states:

“there is no money manager that never has had a bad period.” He says “a streak creates a set of expectations that don’t make any sense and that it’s hard to live up to. If it’s positive, people are likely to end up disappointed.”

Consistent, long-term excess returns on a truly risk-adjusted basis are key to adding value for the fund’s investors.

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Low-Vol Rises
exchange-traded fund, mutual fund

An article in The Wall Street Journal brings up an increasing popularity of low-volatility strategies in both mutual funds and exchange-traded funds (ETFs). The article states that

Currently, Morningstar tracks 33 low-volatility mutual funds with $7.23 billion in assets, at least six of which were launched this year.

But assets in low-volatility mutual funds still pale in comparison to those of low-volatility ETFs. Morningstar tracks 12 such ETFs with $11.26 billion in assets. Partly, that’s because ETF providers were first to market.

Alpholio™ identified the following low-volatility ETFs in the decreasing order of assets as of 10/3/2013:

Name Ticker Inception Date Assets ($M)
PowerShares S&P 500 Low Volatility Portfolio SPLV 5/5/2011 4,203.7
iShares MSCI Emerging Markets Minimum Volatility EEMV 10/18/2011 2,706.4
iShares MSCI USA Minimum Volatility USMV 10/18/2011 2,019.6
iShares MSCI All Country World Minimum Volatility ACWV 10/18/2011 1,013.5
iShares MSCI EAFE Minimum Volatility EFAV 10/18/2011 810.7
PowerShares S&P Emerging Markets Low Volatility Portfolio EELV 1/13/2012 204.4
PowerShares S&P International Developed Low Volatility Portfolio IDLV 1/13/2012 125.2
EGShares Low Volatility Emerging Markets Dividend HILO 8/4/2011 100.6
PowerShares S&P SmallCap Low Volatility Portfolio XSLV 2/15/2013 28.4
PowerShares S&P MidCap Low Volatility Portfolio XMLV 2/15/2013 18.8
SPDR Russell 2000® Low Volatility SMLV 2/20/2013 9.9
SPDR Russell 1000® Low Volatility LGLV 2/20/2013 9.5

Since the oldest of these ETFs, SPLV, has been around for only 29 months, volatility and Sharpe Ratio measures are not yet available from Morningstar or other providers that require at least three years of a fund’s history. Alpholio™ published Sharpe Ratios through March 2013 for some of these ETFs in a previous post.

Low-volatility strategies typically have a high allocation to utilities, healthcare and consumer staples stocks, or to “deep value” equities. One example of low-volatility mutual funds mentioned in the article is the Invesco Low Volatility Equity Yield Class A (SCAUX).

Measure SCAUX S&P 500
3-Year Standard Deviation 13.33 12.41
3-Year Sharpe Ratio 1.10 1.28
5-Year Standard Deviation 18.61 18.08
5-Year Sharpe Ratio 0.51 0.61

The above historical performance figures from Morningstar indicate that the fund had a higher volatility (expressed as a standard deviation of returns) and underperformed the S&P 500® index, its best-fit benchmark, on a risk-adjusted basis (Sharpe Ratio) in both the three- and five-year trailing periods.

In July, Invesco restructured its U.S. Quantitative Core and Global Quantitative Core funds and renamed them Invesco Low Volatility Equity Yield and Invesco Global Low Volatility Equity Yield. The change was made to respond to investors’ growing demand for income with the potential for downside protection, says Donna Wilson, the firm’s director of portfolio management.

It is uncertain whether the recent restructuring of the fund will result in different results going forward.

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