November 29, 2013
Selective Disclosure of Holdings
As the end of the year approaches, the investment industry is gearing up for the annual portfolio rebalancing act. An article in InvestmentNews gives the following example:
Still, advisers’ plan to stick to their long-term asset allocation was likely thrown out of whack this year by the divergence of stocks and bonds. For example, a client who started the year with a simple 60/40 portfolio comprised of the $287 billion Vanguard Total Stock Market Fund (VTSMX) and the $247 billion Pimco Total Return Fund (PTTAX), the two largest mutual funds in the world, would now have 66.3% invested in stocks and just 33.7% invested in bonds, pushing beyond the typical 5% leeway most advisers give their asset allocation.
To illustrate the divergence from asset allocation historical averages, here is a chart from a Vanguard blog post:
While the collective allocation of mutual funds and ETFs to equities has recently reached 57%, the biggest divergence from the historical median is in international equities. Allocation to bonds is also relatively high, while the proportion in domestic equities is close to the 20-year median.
The higher allocations to international equities and bonds are at the expense of cash. Assets in money market funds are at a historical minimum of about 18% in the observation period. This has undoubtedly been caused by the low interest rate policy of the Fed, which depressed returns of such funds. The danger is that when interest rates eventually rise, bond prices will suffer:
So in an intermediate-term bond fund, with an average duration of four to five years, the loss would be about 4% to 5%.
This means that it may actually be prudent for an average investor to shorten the duration by moving a part of investment in bonds to money market funds.
Historically, the proportion of international equities in the total equity allocation has been about 19%; currently, it is about 27%. The argument for keeping it high is a relatively low valuation of foreign stocks compared to domestic ones:
When rebalancing portfolios, it is also important that investors understand the true exposure of their mutual fund holdings to various asset classes. The recurring problem, which Alpholio™ addressed in several prior posts, is that managers in some equity funds (especially value strategies) hold a large percentage of assets in cash. As a result, asset allocation in the overall portfolio can be distorted unbeknownst to the investor.
Alpholio™ provides current information on the exposure of mutual funds to various asset classes. This information is not obtained from the regulatory filings or selective disclosures of fund holdings, which suffer from a number of problems.
In sum, when rebalancing a portfolio either on a fixed schedule or as a result of divergence from prior allocations, investors should take into account a broader market and interest rate context, rather than just follow rigid rules.
November 25, 2013
Return of Irrational Exuberance
A trio of MarketWatch articles lament a more frequent disclosure of mutual fund holdings to select institutional clients and business affiliates than to individual shareholders.
The first article states that
First and foremost, as a shareholder, you should recognize that a fund’s trading record is your intellectual property.
As a result, you most likely believe that the funds you own report their holdings—which easily can be reverse engineered to show transaction trends—every quarter, as required for nearly a decade now by the Securities and Exchange Commission. But many funds report their holdings more frequently than that, often giving their details—with active investment themes redacted—to data firms like Morningstar and Lipper on a monthly basis. The purported benefit to more-regular disclosures is that it helps research firms evaluate and categorize funds, which is good for shareholders.
The funds also typically give those updated portfolios to their top clients, pension funds and institutional money managers.
The problem is that data collecting firms resell this information
In describing a product called “full holdings data for institutional investors,” for example, Morningstar documents say the research “provides the most up-to-date portfolios available and makes waiting for SEC filings from EDGAR [the commission’s online document depository] unnecessary.”
although the second article indicates that this particular product has received little interest from hedge funds. While there is no evidence of “front running” individual fund trades based on that information, knowledge of collective trends in funds is apparently valuable:
In short, if you can tell where managers, on the aggregate, are going, you can ride the crest of the waves they create.
The second article gives an example of American Funds having recently broadened the scope of additional disclosures:
Under the disclosure rules, the firm releases its portfolio quarterly, but then makes more frequent and regular disclosures to the fund’s “custodian, outside counsel, auditor, financial printers, proxy voting service providers, pricing information vendors, co-litigants (such as in connection with a bankruptcy proceeding related to a fund holding) and certain other third parties … each of which requires portfolio holdings information for legitimate business and fund oversight purposes.”
More than half of all mutual funds disclose their holdings more frequently than required by the SEC. (To be precise, at a minimum the disclosure has to be made within 60 days from the end of the first and third quarter in the fiscal year of a fund.) In fairness, some funds publicly post such information on their websites, which also benefits individual investors. On the other hand, firms like AthenaInvest™ mine funds’ data to run a family of Global Tactical ETFs.
The third article realizes that allowing funds to only make quarterly disclosures or forcing them to make monthly disclosures is not practical. Hence, a compromise solution:
If funds exercise the option to disclose their holdings more often than required, they should be required to give that extra information candy to everyone, or to no one at all.
Any such regulatory change, if undertaken at all, will undoubtedly take time. Meanwhile, Alpholio™ can help level the playing field for underprivileged investors.
Even a more frequent (monthly) disclosure of holdings suffers from a number of problems, which we outlined in one of the previous posts. This is especially true for funds with high turnover ratios, in which portfolio composition changes rapidly. While not showing individual securities, the Alpholio™ analysis demonstrates an effective exposure of each fund to major investment factors modeled by exchange-traded products (ETPs).
The analysis is updated monthly with a significantly shorter lag than that of the regulatory disclosure. The results of the analysis are much more comprehensible than a long listing of individual holdings. They are also less susceptible to portfolio manipulation at the end of the reporting period.
Finally, Alpholio™ also helps investors to easily navigate the actual regulatory disclosures of fund holdings published on EDGAR. To access this information, all a subscriber has to do is to select the fund by its ticker or name, click View Filings, and click Quarterly Schedule of Portfolio Holdings. For convenience, the list of all N-Q filings is arranged in reverse chronological order.
November 23, 2013
Searching for Consistent Outperformance
A host of industry articles have recently raised an alarm about a possible return of irrational exuberance in the stock market, much like the one at the end of the 1990s. Bloomberg reports that investors have poured the most money into stock funds in 13 years:
Stock funds won $172 billion in the year’s first 10 months, the largest amount since they got $272 billion in all of 2000, according to Morningstar Inc. (MORN) estimates. Even with most of the cash going to international funds, domestic equity deposits are the highest since 2004.
In addition, investors currently have a high proportion of stocks in their portfolios:
The market run-up has left investors as a group with an unusually high allocation to equities, at 57 percent. Equity allocations were higher only twice in the past 20 years: in the late 1990s leading up to the technology stock crash of 2000, and prior to the 2007-2009 global financial crisis.
The most often quoted signal of overvaluation is Robert Shiller’s cyclically-adjusted price-to-earnings ratio (CAPE).
The numerator of the ratio is the real value of the S&P 500® index, i.e. a nominal value adjusted for inflation by the consumer price index (CPI). The purpose of this adjustment is to bring the value of the index to an equivalent present level. Assuming a rising CPI, i.e. inflation as opposed to deflation, historical values of the index are adjusted upwards. The intuition for this adjustment is that the nominal return of the index can be modeled as a sum of the real return and inflation. In the presence of inflation, the real return is smaller than the nominal one, hence a higher adjusted historical value of the index.
Similarly, the denominator of the ratio is a 10-year average of real trailing earnings of the index. A longer-term average removes the effects of market cycles. Nominal historical earnings are adjusted for inflation the same way as the index value.
The result is that, as reported by a Wall Street Journal article, the current CAPE of 25.2 is well above its historical average of 16.5:
Most industry articles therefore conclude that the market is in a bubble (although perhaps not as bad as in early 2000 when the CAPE was approximately twice as high). However, as the chart shows, the CAPE is currently still well inside the “yellow zone” and not in the “red zone” of 28.8 or higher.
Moreover, the current CAPE value in the chart is just an estimate. As of this writing, the actual data used to calculate the metric are incomplete. The most recent trailing four months of earnings (July through October) are missing and thus their adjusted counterparts are not included in the historical average. The November CPI is estimated from the values of just two previous months that indicated deflation.
When the missing earnings are estimated from the previous 12-month trend, the CAPE comes out closer to 24.8. The current 10-year earnings average starts in November 2003 when real profits were just rebounding from the nadir in March 2002. Therefore, in the next few years the denominator of CAPE should get larger. It is also worth noting that even with the current incomplete data, the CAPE was as high as 23.5 in February 2011, which at that time did not seem to raise many concerns.
In an interview with BusinessInsider in January 2013, Shiller stated the following:
John Campbell, who’s now a professor at Harvard, and I presented our findings first to the Federal Reserve Board in 1996, and we had a regression, showing how the P/E ratio predicts returns. And we had scatter diagrams, showing 10-year subsequent returns against the CAPE, what we call the cyclically adjusted price earnings ratio. And that had a pretty good fit. So I think the bottom line that we were giving – and maybe we didn’t stress or emphasize it enough – was that it’s continual. It’s not a timing mechanism, it doesn’t tell you – and I had the same mistake in my mind, to some extent. Wait until it goes all the way down to a P/E of 7, or something.
…the lesson there is that if you combine that with a good market diversification algorithm, the important thing is that you never get completely in or completely out of stocks. The lower CAPE is, as it gradually gets lower, you gradually move more and more in. So taking that lesson now, CAPE is high, but it’s not super high. I think it looks like stocks should be a substantial part of a portfolio.
I think predicting something like 4 percent real for the stock market, as opposed to 7 or 8 percent historically.
So, the CAPE should not be used as a timing mechanism but rather as an estimator of the future 10-year real returns. Even with the market reaching new highs, perhaps some rational exuberance is due after all.
November 20, 2013
Exchange-Traded Product Statistics
Two studies from Vanguard underscore how difficult it is to identify actively-managed mutual funds that not only survive and but also consistently outperform their benchmarks.
The first study shows that the majority of funds across all asset classes failed to outperform their prospectus benchmarks over the past 15 years through 2012:
The chart demonstrates that when assessing long-term performance, it is important to take into account liquidated and merged (“dead”) funds. Otherwise, statistics suffer from a “survivorship bias” that benefits funds still in existence. In addition, in most categories a median surviving fund exhibited a negative annualized excess return vs. the benchmark.
Statistics get worse when style benchmarks, assigned to fund categories, are used:
This is because many funds choose an inappropriate prospectus benchmark that does not reflect the fund’s actual investment style. In a majority of categories the survivors’ excess returns were even lower.
Finally, what are the chances that a fund ranked in the top quintile (20%) of U.S. actively-managed funds in terms of five-year returns through 2007 persisted in the same quintile in the next five years? About 15%, which is less than the 20% expected by chance:
As a matter of fact, about a quarter of such funds wound up in the lowest quintile, and about one-sixth disappeared altogether. Of all the funds available, only about 3% persisted in the top quintile in both five-year periods.
The second study shows that of the 1,540 U.S. domestic equity funds in the 15-year period through 2012, only about 18% survived and outperformed their respective style benchmarks:
However, almost all of these successful funds had five or more years of underperformance within the 15 years of analysis:
Moreover, about two-thirds of outperforming funds experienced at least three consecutive years of underperformance. In many cases, investors would have divested such funds and therefore not realize a full 15-year benefit.
All these findings underscore the need for a close monitoring of mutual fund performance. Outperforming funds are rare and do not persist in their winning streaks. Therefore, a dynamic analysis with a true adjustment for risk is required. Alpholio™ analyzes funds with a monthly frequency and provides buy-sell signals derived from the smoothed cumulative RealAlpha™ curves. These signals, among other inputs, can help investors make informed investment decisions. For more information about the Alpholio™ methodology, please visit our FAQ.
November 16, 2013
High Stakes in Small Caps
A paper from PwC provides interesting statistics on exchange-traded funds (ETFs) and products (ETPs). [Alpholio™ uses the latter term to encompass ETFs, exchange-traded notes (ETNs), and other similar investment vehicles.]
As of 3Q2013, about $2.2T was invested in almost 5,000 ETPs globally:
Thanks to a large single market, an average ETP had much more AUM in the US than elsewhere (however, this does not take into account the typical right skew of the AUM distribution, whereby a small number of funds hold the majority of assets):
Unlike elsewhere, in the US the majority of ETP AUM belong to retail investors:
The percentage of AUM in active ETFs, whose launch began only in 2008, is still small but growing:
ETFs enable the shift from individual security selection to asset allocation, especially in liquid markets:
ETFs now cover a broad spectrum of asset classes:
All these findings strongly support the Alpholio™ thesis: the growing number, breadth and variety of ETPs enable more and more accurate assessment and substitution of actively-managed mutual funds and arbitrary investment portfolios for the benefit of investors.
November 12, 2013
Sharpe Ratio of Smart Beta
A trio of articles covers high year-to-date returns, valuations and, consequently, increased risk of small-cap equities, especially those with growth characteristics and in the technology sector.
An article in Bloomberg indicates that the rise of small-cap stocks has historically signaled an economic improvement:
Shares of companies … in the Russell 2000 Index (RTY) have advanced 32 percent in 2013, compared with 19 percent for the Dow Jones Industrial Average. The spread is the widest for any year since 2003, according to data compiled by Bloomberg. Three of the last four times small-caps outperformed by this much, the economy grew faster the next year and stocks stayed in a bull market for another year or more, based on data from the past 34 years.
While small-cap earnings are growing fast, valuation of these stocks has also increased:
Russell 2000 companies are beating analyst earnings estimates by 11 percent, more than twice the rate for companies in the Dow, according to data compiled by Bloomberg.
The Russell 2000’s price-earnings ratio increased 52 percent this year to 27.5 times estimated operating earnings, compared with 14.7 for the Dow, according to data compiled by Bloomberg.
The first article of the two from The Wall Street Journal brings up an issue of high stakes in the technology sector in many small-cap growth mutual funds:
The second article in The Wall Street Journal worries about small-cap returns:
Small-capitalization growth funds are up an average of 33.1% in 2013 through October, according to Morningstar Inc. That compares with average gains of 28.7% for small-cap value funds and 26.3% for large-cap growth funds. Within the small-cap growth category, many funds have gains approaching, or even topping, 40%.
However, the article states several factors propelling small-cap stocks:
- A more direct exposure to the U.S. economy compared to large-cap stocks (per the Bloomberg article, 84% of an average Russell 2000 company sales vs. only 55% of an average DJIA company are domestic)
- A higher rate of organic earnings growth thanks to profit reinvestment
- A continuing low interest rate policy of the Federal Reserve that encourages investors to seek higher returns in riskier assets.
So, have investors been compensated for the increased risk of small-cap stocks? One way to determine that is to compare historical Sharpe Ratios of small-cap ETFs to those of the S&P 500® ETF (all figures to October 31, 2013 from Morningstar):
The above data show that small-cap growth stocks have indeed provided higher risk-adjusted returns than large-cap equities did. However, the same cannot be said about the broader small-cap sector or its value component in the last three- and five-year periods.
November 6, 2013
Wide Range of Emerging Market Returns
A post in Barron’s and an article in GlobeAdvisor cover a report by strategists at Pavilion Global Markets on historical performance of “smart beta” strategies.
The report analyzed a number of monthly-rebalanced portfolios consisting of equities in the S&P 500® index since 1991. The conclusion stated in the post was that
All the methods beat the no-frills S&P 500. But the group found that only one strategy — screening for stocks exhibiting low volatility over three months — beat the index with reduced risk.
In particular, the article says that
One strategy draws from the same index, but weights stocks equally rather than by market capitalization. Since 1991, this approach turned a $100 investment into $892, or about 70 per cent more than the benchmark index. The divergence between the two approaches picked up noticeably after 2001.
An index that weighted stocks based on sales outperformed the benchmark by 53 per cent, an index that weighted stocks based on earnings outperformed by 77 per cent and an index that weighted stocks based on return-on-equity outperformed by 114 per cent – an astounding difference when you consider that it still draws from the same 500 stocks as the benchmark index.
This is further illustrated in the following chart:
Since “smart beta” strategies exhibit both higher returns and elevated volatility compared to the index, naturally a question arises: What is the incremental return per unit of risk of these strategies compared to that of the index? This is where the ex-post Sharpe ratio (SR) comes in.
To estimate the SR for each strategy and the index, we can
- Read the annualized return and volatility figures from the chart. While the annualized (geometric average) return is different from the arithmetic average required in the SR calculation, it should suffice as a rough equivalent.
- Obtain an average risk-free rate (RF) in the analysis period. As a proxy for the risk-free rate, many SR calculations use a three-month Treasury bill rate; because each strategy was rebalanced monthly, we could also use a four-week bill rate.
- Assume that the volatility of Treasury bill returns is negligibly small compared to that of the strategy. Further assume that the correlation of these returns to strategy returns is close to zero. This means that the denominator in the SR effectively becomes the risk of the strategy.
The rate on three-month Treasury bills since 1991 can be obtained from the FRED® service of the Federal Reserve Bank of St. Louis. (Data on four-week Treasury bill rates are only available from July 2001.) It turns out that the average annualized rate in that period was about 3%.
The following table shows the estimated SRs:
||Return – RF
|Profit Margins Weighted
All of the fundamental indexing strategies exhibited a higher SR than that of the traditional market-cap index. In addition, the return-on-equity strategy beat the low-volatility strategy on a risk-adjusted basis. No wonder that, according to the article, fundamental indexing is gaining momentum:
Whatever you prefer to call them, there are now 326 U.S. ETFs that fit the description in one way or another, according to IndexUniverse, and this number doesn’t include leveraged and inverse strategies. These funds account for 40 per cent of all U.S.-listed ETFs and about 14 per cent of ETF assets. This year alone, nearly $46-billion (U.S.) has flowed in.
November 4, 2013
Investors Leave Money on the Table
An article in The Wall Street Journal indicates that emerging market mutual funds have a wide range of year-to-date (YTD) returns:
The average diversified mutual fund focused on emerging markets is up 1.2% in 2013 through October, according to researcher Morningstar Inc. But the range of returns is wide, from a gain of more than 24% to losses of more than 7%.
One of the strongest performers described in the article is the Thornburg Developing World Fund (THDAX, class A shares) with a YTD return of approx. 14%. With its inception in mid-December 2009, the fund has a relatively short history, yet Morningstar already rates it Five Stars / Bronze in the Diversified Emerging Markets category. Similarly, Lipper rates the fund a Five in the Total Return, Consistent Return and Tax Efficiency categories in the Emerging Markets asset class.
Let’s take a closer look at the fund’s performance from the Alpholio™ perspective. Here is the cumulative RealAlpha™ chart for the fund, starting three full months after the fund’s inception:
Following three years of a largely unimpressive performance on a truly risk-adjusted basis, the fund has generated a substantial amount of RealAlpha™ earlier in 2013. However, as the chart shows, this outperformance peaked in May and has been on a decline since then. This may be a sign of reversion to the long-term historical pattern.
The following chart shows the percentage weights of exchange-traded products (ETPs) in the reference portfolio for the fund over the same analysis period:
The top-three equivalent ETP positions for the fund in emerging markets were in the iShares MSCI Hong Kong ETF (EWH; average weight of 17.1%), iShares MSCI Malaysia ETF (EWM; 15.9%), and iShares MSCI Singapore ETF (EWS; 11.7%).
It is worth noting that, as a proxy for foreign holdings, the fund also invests in domestic stocks with a substantial exposure to emerging markets. For example, according to the most recent holdings report, the fund held positions in Qualcomm (QCOM; 2.5%), Yum! Brands (YUM; 1.9%), First Cash Financial Services (FCFS; 1.9%), and Colgate Palmolive (CL; 1.9%).
According to the article
The $1.5 billion fund is positioned to capitalize on growing consumption in developing nations, says manager Lewis Kaufman. It has about half its portfolio in consumer-facing businesses…
This investment tilt is reflected in an equivalent position in the Vanguard Consumer Discretionary ETF (VCR; average weight of 11.1%).
As the following chart from the article depicts, returns of emerging market stock funds have been quite volatile this year:
The big decline in May-June was caused by an indication by the Federal Reserve that it may begin tapering its quantitative easing strategy by year’s end, which caused the domestic interest rates to rise and emerging market currencies to fall against the dollar. As a result, there was a huge outflow of capital from emerging markets — investors saw a better reward-to-risk opportunity at home.
When in September-October it became clear that the Fed will continue with its policy at least in the near term, emerging markets rebounded. However, since the Fed’s bond purchases will not last forever, the emerging markets will undoubtedly be again affected. This underscores the wide range of returns of foreign investments caused by changes in the domestic monetary policy.
November 2, 2013
An article in The Wall Street Journal claims that many investors earn lower returns than their investments do. This is caused by buying and selling mutual fund shares at a wrong time. The author cites an example of the PIMCO Total Return Fund:
In the year ended Sept. 30, its largest share class lost 0.74% — a respectable result, considering that the bond benchmark the fund seeks to beat, the Barclays U.S. Aggregate index, lost 1.89%.
According to people familiar with the fund, its investors incurred an average loss of 1.4% over this period, nearly double the loss of the fund itself. That is because investors bought high and sold low, locking in the fund’s interim losses and missing its later gains.
First, the largest share class of the fund, returning -0.74% in one year to September 30, is institutional (PTTRX). This share class requires a minimum initial investment of $1 million, which is impractical for most individual investors. Therefore, for further analysis this post will use the class A shares (PTTAX) with a minimum initial investment of $1,000.
Second, the problem with this assessment is that it is solely based on the general cash inflows and outflows of the fund, and not the analysis of circumstances of individual investors. This subject was already covered in a previous Alpholio™ post, which found a problem with
…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).
To illustrate that point, let’s analyze a situation of a hypothetical market timing investor who invested into PTTAX on September 28, 2012 (the last trading day of that month) and did not pay the front load of the fund. In May 2013, the investor was observing rising interest rates, which caused the NAV of the fund to fall, and decided to terminate the investment on May 31, 2013, i.e. in the middle of the May/June massive withdrawal period quoted by the article. According to Morningstar’s “growth of $10,000” figures, which assume reinvestment of all fund distributions, the investor realized a return of +0.502% in that period. Had the investor instead retained the investment in the fund until September 30, 2013, the total return would have been -1.128%. This clearly shows why doing an “average investor” return calculation solely based on fund inflows and outflows is misleading.
Furthermore, the above scenario does not take into account what the investor did with the proceeds from the May 31 sale. If the investor kept the proceeds in a money market fund with a typical annual yield of a few basis points, then the return through September 30 would be only slightly higher than the +0.502% calculated above. However, the investor certainly had many other investment possibilities, both in fixed income and in equities.
For example, let’s assume that in the face of rising rates (the duration of PTTAX is approx. five years) the fixed-income investor decided to invest the proceeds in a short-term taxable bond fund, such as the PIMCO Short-Term Fund (PSHAX, class A shares), again without paying a front load. From June 3, 2013 to September 30, 2013, the total return of PSHAX was -0.057%. Therefore, this hypothetical market-timing investor would have realized a total return of (1 + 0.502%) x (1 – 0.057%) – 1 = +0.445%, still better than the -1.128% for PTTAX alone. This again illustrates that estimating fund investors’ returns without taking into account follow-up investments (into which an analyst may not have visibility) is misguided.
In sum, while a buy-and-hold strategy can certainly produce good long-term results for most investors, in a case of prolonged rock-bottom interest rates, some market timing may be warranted.