Increasing Correlations of Asset Classes
analysis, asset allocation, correlation, portfolio

A recent column from Bloomberg Gadfly discusses increasing correlations of asset classes. The correlation coefficient of periodic returns is a measure of the extent to which these returns move in the same direction. Contrary to a common misconception, a high correlation does not imply that the two assets or classes are identical. Ideally, to diversify a portfolio, long-term correlations among portfolio components should low.

This correlation shift has a major impact on portfolio construction following the Modern Portfolio Theory. The article uses ten-trailing-year correlations of various indices:

Ten-year trailing correlations of asset classes in 1997

Ten-year trailing correlations of asset classes today

While a point-in-time analysis of ten-year correlations between indices is instructive, it is of little practical value to investors. Luckily, Alpholio™ has just introduced a new Multi-Correlation service, which provides an interactive analysis of rolling correlations.

In a typical analysis, monthly returns are used because they are less “noisy” than weekly or daily returns. A span of 36 months (three years) of returns is usually sufficient to approximate the long-term correlation and, at the same time, to nimbly react to rapid correlation changes. A rolling-period approach provides insights on how the correlation coefficient evolved over time. It can also facilitate calculation of useful statistics. Finally, instead of artificial indices that cannot be bought or sold, Alpholio™ uses ETFs.

To demonstrate the Multi-Correlation service in action, here is a chart of rolling correlations between each of several analyzed ETFs and one reference ETF:

Correlation of Rolling 36 Monthly Returns for IVV, EFA, EEM, ICF with GSG

In the above chart, the analyzed ETFs are the iShares Core S&P 500 ETF (IVV), iShares MSCI EAFE ETF (EFA), iShares MSCI Emerging Markets ETF (EEM), and iShares Cohen & Steers REIT ETF (ICF). The reference ETF is the iShares S&P GSCI Commodity-Indexed Trust (GSG).

Please note that the youngest of these ETFs (GSG) determines the common time frame of this analysis: the first full month of GSG returns was August 2006, so the first 36-month rolling return became available at the end of July 2009. The Multi-Correlation service determines the longest possible analysis interval automatically.

The following table contains statics of rolling correlations between each analyzed ETF and the reference ETF:

Statistics of Correlation of Rolling 36 Monthly Returns for IVV, EFA, EEM, ICF with GSG

By default, the statistics are ordered in the ascending order of median value, but can be reordered in any ascending/descending order by clicking on the header of the respective column. In conjunction with the chart, these statistics show that each of the equity ETFs had a substantial (above 0.6) correlation to commodities, while the REIT ETF had the lowest correlation. The correlation of all four analyzed ETFs to the reference ETF declined from the second half of 2014 onward, with the REIT ETF showing the strongest decoupling. The Forecast statistic is the expected value of the rolling correlation one month forward, or in February 2016 in this example.

We hope that the Multi-Correlation service will become a useful tool for investors who want to construct well-diversified portfolios. If you would like to use this and other Alpholio™ services, please register on our website.


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Analysis of Hennessy Cornerstone Mid Cap 30 Fund
analysis, mutual fund

This weekend’s profile in Barron’s features the Hennessy Cornerstone Mid Cap 30 Fund (HFMDX; Investor Class shares). This $930 million no-load fund has a 1.32% gross expense ratio and 5% turnover. According to the article

Over 10 years, mid-caps delivered 6.7% annually, versus 6.4% for large companies, and 4.7% for small. The Cornerstone Mid Cap fund returned 6.8%, beating 86% of its peers.

Alpholio™ agrees that mid-cap equities are a compelling asset class.

The primary prospectus benchmark for the fund is the Russell Mid Cap Index. One of the accessible implementations of this index is the iShares Russell Mid-Cap ETF (IWR). Alpholio™’s calculations show that since late 2004 the fund returned more than the ETF in approximately 61% of all rolling 36-month periods with a median cumulative (non-annualized) outperformance of 1.3%. Similarly, the fund outperformed the ETF in 59% of all rolling 24-month periods and 62% of 12-month periods.

The secondary prospectus benchmark for the fund is the S&P 500® Index. One of the low-cost implementations of this index is the iShares Core S&P 500 ETF (IVV). Over the same evaluation interval, the fund returned more than the ETF is about 78% of all rolling 36-month periods (with a median cumulative outperformance of 5%), 72% of 24-month periods and 60% of 12-month periods.

While comparisons of rolling returns provide a valuable insight, they do not take the fund’s risk into account. To do so, let’s employ Alpholio™’s patented methodology. One variant of this approach constructs a custom and dynamic reference portfolio of ETFs for each analyzed fund. This portfolio has a fixed ETF membership but variable weights, which enables it to more accurately track the fund’s composition over time. Here is a resulting chart of the cumulative RealAlpha™ for Hennessy Cornerstone Mid Cap 30:

Cumulative RealAlpha™ for Hennessy Cornerstone Mid Cap 30 Fund (HFMDX)

Over the last 11 years, the fund produced around 3.1% of annualized discounted RealAlpha™ (to learn more about this and other performance measures, please visit out FAQ). However, the fund achieved this commendable result at the expense of elevated volatility: standard deviation of 18.3% compared to 16.9% of the reference ETF portfolio. This was underscored by considerable declines of the cumulative RealAlpha™ in September 2008 and from the second half of 2015 through January 2016. The fund’s RealBeta™, measured against a broad-market equity ETF, was 1.04.

The following chart illustrates changes of ETF weights in the reference portfolio over the same analysis period:

Reference Weights for Hennessy Cornerstone Mid Cap 30 Fund (HFMDX)

The fund had top equivalent positions in the iShares S&P Mid-Cap 400 Growth ETF (IJK; average weight of 37.3%), iShares Morningstar Small-Cap ETF (JKJ; 17.7%), PowerShares Dynamic Market Portfolio (PWC; 11.3%), iShares Transportation Average ETF (IYT; 10%), iShares Morningstar Mid-Cap Growth ETF (JKH; 8.3%), and Vanguard Energy ETF (VDE; 8%). The Other component in the chart collectively represents additional two ETFs with smaller average weights.

The Hennessy Cornerstone Mid Cap 30 Fund added a substantial amount of value on a truly risk-adjusted basis. However, the cost of this performance was a significant volatility that stemmed from a concentrated nature of the fund’s holdings (30 equally-weighted positions, constructed annually). Although turnover was very low, the fund produced relatively big distributions which made it largely unsuitable for taxable accounts.

To learn more about the Hennessy Cornerstone Mid Cap 30 and other mutual funds, please register on our website.


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Analysis of Hartford Core Equity Fund
analysis, mutual fund

Today’s profile in Barron’s features the Hartford Core Equity Fund (HAIAX; Class A shares). This $1.1 billion fund has a 5.5% maximum sales charge, 0.79% net expense ratio (subject to an upcoming renewal of the contractual reimbursement) and 33% turnover. According to the article

[The current manager] has managed the fund since its inception in 1998, and in the past 10 years, its 6% annualized return has beaten 92% of its peers and the Standard & Poor’s 500 index. Over the past three and five years, the large-blend fund produced an annualized total return of more than 10%, beating 99% of its peers and the S&P 500… Over the trailing three and five years, the fund fell only 80% to 90% as much as the S&P did, and exceeded the market’s gains by 2% to 4%.

Comparing Returns

First, with the front load taken into account, the fund did not beat its benchmark, the S&P 500® Index, over the 10 years through January 2016. Without the sales charge, the fund returned about 0.6% more than the index on an annualized basis over the same interval:

Historical Performance of Hartford Core Equity Fund (HAIAX)

One of the long-lived and low-cost implementations of the index is the SPDR® S&P 500® ETF (SPY). Alpholio™’s calculations indicate that since late 2004 the fund returned more than the ETF in about 50% of all rolling 36-month periods, 47% of 24-month periods and 55% of 12-month periods. The median outperformance in a rolling 36-month period (not annualized) was zero and the mean one 0.76%:

Rolling Returns for Hartford Core Equity Fund (HAIAX)

Adjusting for Risk

While a comparison of periodic returns provide a simple measure of performance, it does not adjust for the fund’s risk. To gain a deeper insight, let’s apply Alpholio™’s patented methodology. In a simplest variant of this methodology, a reference portfolio of ETFs with fixed membership and weights is constructed for each analyzed fund. Here is the resulting chart of cumulative RealAlpha™ for the Hartford Core Equity (to learn more about RealAlpha™ and other performance measures, please visit our FAQ):

Cumulative RealAlpha™ for Hartford Core Equity Fund (HAIAX)

The fund produced a negative 0.8% of annualized discounted RealAlpha™. That outcome would have been much worse were it not for a strong rebound in the second half of 2014 and in 2015. At 14.2%, the fund’s standard deviation (a measure of volatility of returns) was approximately 0.25% higher than that of the reference portfolio. The fund’s RealBeta™ was 0.93.

Reference ETF Portfolio

The following chart illustrates weights of ETFs in the reference portfolio for the fund:

Reference Weights for Hartford Core Equity Fund (HAIAX)

The fund had major equivalent positions in the iShares Morningstar Large-Cap Growth ETF (JKE; constant weight of 15.1%), Health Care Select Sector SPDR® Fund (XLV; 14.8%), iShares Morningstar Large-Cap Value ETF (JKF; 13.6%), PowerShares Dynamic Market Portfolio (PWC; 11.3%), SPDR Russell 3000® ETF (THRK; 10.9%), and Vanguard Mid-Cap ETF (VO; 9.7%). The Other component in the above chart collectively represents additional six ETFs with smaller fixed weights.

Conclusion

Over the past 11 years, the Hartford Core Equity Fund did not add value on a truly risk-adjusted basis. The fund could have been easily substituted by a collection of readily accessible ETFs. Such an ETF portfolio would offer a higher return and slightly lower volatility. The fund’s steep front load further detracts from it appeal.

Currently, the fund is fairly well diversified, with top-10 of its 68 holdings constituting less than 23% of assets. Historically, the fund had reasonably low distributions, which may haven made it suitable even for taxable accounts.

To learn more about the Hartford Core Equity and other mutual funds, please register on our website.


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Investing in ‘Sin Stocks’
analysis, mutual fund

An article in the Wall Street Journal’s recent Wealth Report covers investing in the so-called “sin stocks,” i.e. shares of companies in the alcohol, tobacco, gambling and weapons industries. The article features the USA Mutuals Barrier Fund (with an apt ticker VICEX; Investor Class shares), which specializes in such investments. This $200 million fund has a 1.44% expense ratio and 78% turnover. According to the article

The fund saw a total return of minus 5.7% for the year ended Jan. 25 […] compared with a decline of 6.5% for S&P 500 Total Return Index. Over the past five years, the index is up about 10%, while VICEX has grown by around 11%.

The prospectus benchmark for the fund is the S&P 500® Index. One of the long-lived and low-cost implementations of this index is the iShares Core S&P 500 ETF (IVV). Alpholio™’s calculations show that since inception the fund returned more than the ETF in about 65% of all rolling 36-month periods, 71% of 24-month periods and 66% of 12-month periods. The median 36-month (non-annualized) outperformance was 6.4%.

While the comparison of periodic returns is instructive, it does not take the fund’s risk into account. To accomplish the latter, let’s employ Alpholio™ patented methodology. One variant of this methodology constructs a reference portfolio of ETFs with fixed membership but variable weights. This allows the portfolio to more closely track the fund’s return than if the weights were constant. Here is the resulting chart of cumulative RealAlpha™ for the USA Mutuals Barrier Fund from late 2004 through 2015:

Cumulative RealAlpha™ for USA Mutuals Barrier Fund (VICEX)

The fund produced 0.45% of the regular and minus 0.06% of the lag annualized discounted RealAlpha™ (to learn more about this performance measure, please visit our FAQ). In 2015, the lag cumulative RealAlpha™ curve was below the regular one, which indicates that not all new investment ideas in the fund performed as well as expected. At 15.1%, the fund’s standard deviation, a measure of volatility of returns, was about 2.4% higher than that of the reference ETF portfolio. The fund’s RealBeta™ was 0.84. The median rolling 36-month correlation of the fund’s returns to those of IVV was approximately 0.9.

The following chart illustrates changes of ETF weights in the reference portfolio for the fund over the same analysis period:

Reference Weights for USA Mutuals Barrier Fund (VICEX)

The fund had major equivalent positions in the Vanguard Consumer Staples ETF (VDC; average weight of 32.2%), Vanguard Consumer Discretionary ETF (VCR; 9.7%), iShares Select Dividend ETF (DVY; 9.2%), iShares MSCI Hong Kong ETF (EWH; 7.7%), iShares MSCI United Kingdom ETF (EWU; 7.6%), and PowerShares Dynamic Market Portfolio (PWC; 6.2%). The Other component in the chart collectively represents additional six ETFs with smaller average weights.

Overall, the USA Mutuals Barrier Fund added little value on a truly risk-adjusted basis. From the cumulative RealAlpha™ chart, it follows that, despite the “defensive” nature of its holdings, the fund may not always outperform during market downturns, such as in 2008-09. In addition, its significant exposure to particular industries can lead to a substantial underperformance, as was the case with gambling in Macau in 2014. Despite a relatively high turnover, in recent years the fund did not produce any capital gains, which made is suitable even for taxable accounts.

To learn more about the USA Mutuals Barrier and other mutual funds, please register on our website.


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