Today’s profile in Barron’s features the Hotchkis & Wiley Value Opportunities Fund (HWAAX, Class A shares; HWACX, Class C shares; HWAIX, Class I shares). Class A shares of this $538 million fund have a front-end sales charge of up to 5.25%, expense ratio of 1.25% and turnover ratio of 45%.

According to the article:

This go-anywhere, highly concentrated style can produce above-average performance, as well as above-average volatility—such as in 2011, when it was down 7%. Over the longer term, however, the fund has beaten the market and its peers (Morningstar puts it in the mid-value category), with average annual returns of 10% over the past decade, and nearly 20% over the past five years, better than 98% of its peers.

There is a clear problem with the fund’s classification. The fund “seeks to own companies, regardless of market capitalization” and “may also own preferred stock, fixed income securities.” Morningstar currently shows that about half of the fund’s portfolio is in “giant-cap” equities, totally absent from the Russell Midcap® Value Index, an analyst-assigned benchmark. Nevertheless, if this benchmark were to be used, its accessible realization is the iShares Russell Mid-Cap Value ETF (IWS). Alpholio™ calculates that since late 2004, the fund returned more than the ETF in about 50% of all rolling 12-month periods, with a median outperformance of only 0.14%.

The fund’s prospectus benchmark is the S&P 500® index. One of practical implementations of the index is the SPDR® S&P 500® ETF (SPY). Alpholio™ estimates that over ten years the fund beat that ETF in almost 55% of all rolling 12-month period by a median of about 1.2%.

Alpholio™’s methodology is much-better suited to the analysis of a multi-cap, go-anywhere fund because it does not attempt to shoehorn the fund into a narrow category. Instead, without any preconception Alpholio™ finds a collection of ETFs that best match a given fund.

In the simplest approach, both membership and weights of ETFs in the reference portfolio are fixed. Such an analysis indicates that the fund had a significant exposure to the finance sector: a 29.3% weight of the iShares U.S. Financial Services ETF (IYG). This exposure, well in excess of approximately 16% sector’s weighting in the S&P 500® index, is corroborated by a further analysis (see below).

In a more elaborate Alpholio™ approach, ETF membership in the reference portfolio is fixed, but ETF weights can fluctuate over time to better match the analyzed fund’s holdings. Here is the resulting chart of cumulative RealAlpha™ for Hotchkis & Wiley Value Opportunities:

Cumulative RealAlpha™ for HWAAX

In the three years from early 2005, the fund generated about minus 30% of cumulative RealAlpha™. After that, the cumulative RealAlpha™ strongly rebounded, with an exception of a brief pullback in the second half of 2011. However, it took about five years for the cumulative RealAlpha™ to recover to the initial level. Overall, the fund generated only about 2% of annualized discounted RealAlpha™ over the entire analysis period. That is because early losses were weighted more than subsequent gains (to learn more, please visit our FAQ).

The fund was quite volatile: At almost 21%, its standard deviation was about 4% higher than that of the reference ETF portfolio. This indicates that the reference portfolio was unable to fully track the fund, which could be expected given the fund’s concentrated holdings. (For example, at present top-ten positions account for almost 51% of assets.) A RealBeta™ of 1.15 also underscores the risk of the fund.

The following chart shows the composition of the reference ETF portfolio in the same analysis period as above:

Reference Weights for HWAAX

The fund’s top equivalent positions were in the iShares S&P 100 ETF (OEF; average weight of 24.4%), Vanguard Financials ETF (VFH; 21.4%), iShares Morningstar Small-Cap Value ETF (JKL; 14.7%), Guggenheim S&P 500® Equal Weight ETF (RSP; 12.2%), iShares Transportation Average ETF (IYT; 7.4%), and iShares Morningstar Mid-Cap Growth ETF (JKH; 5.9%). The Other component in the chart collectively represents four additional ETFs with smaller average weights.

The fund continues to have a heavy exposure to financials. As of the end of August 2014, it had over 32% of assets in the insurance and banks industries. The fund’s top position of 11.5% in a single financial stock (AIG) is worrisome, despite management’s assurance that it is not as risky as it would seem.

Over the past ten years, the Hotchkis & Wiley Value Opportunities Fund has added value for its shareholders but at the expense of elevated volatility of returns. The fund’s concentrated portfolio as well as substantial sector and single equity bets can potentially backfire. In addition, in each of the past two calendar years the fund generated total distributions of about 6-7% of the net asset value, and with a large portion in short-term capital gains. This diminished the fund’s appeal for taxable accounts.

To learn more about the Hotchkis & Wiley Value Opportunities and other mutual funds, please register on our website.


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