Analysis of Sequoia Fund
analysis, mutual fund

Today’s column in MarketWatch describes the downfall of the Sequoia Fund (SEQUX). The fund sports an exceptional long-term record:

Over 45 years through the end of 2015, Sequoia Fund has returned 14.0% per annum versus 10.8% for the S&P 500 index, with $10,000 invested at Sequoia’s inception worth $3.9 million, versus $1.0 million for the same amount invested in the index. Over the last twenty years, we have returned 10.2% per annum, versus 8.2% per annum for the index.

However, over the past eight months this non-diversified fund was undone by an excessive position in just one stock, Valeant Pharmaceuticals International Inc. (VRX). How did the fund fare overall from the perspective of Alpholio™’s patented methodology?

For each analyzed fund, Alpholio™ constructs a reference portfolio of ETFs that mostly closely tracks periodic returns of the fund, thus adjusting for the fund’s volatility (to learn more, please visit our FAQ). Let’s start with the simplest variant of the methodology, in which both ETF membership and weights in the reference portfolio are fixed over the evaluation period. Here is a chart and related statistics of the cumulative RealAlpha™ for the Sequoia Fund in this analysis mode:

Cumulative RealAlpha™ for Sequoia Fund (SEQUX) - Regular Fit

From late 2004 through 2010, the fund generated hardly any RealAlpha™ over its fixed reference ETF portfolio. While the cumulative RealAlpha™ peaked at almost 82% in July 2015, it has since declined to less than 21% in February 2016. Consequently, the fund produced only about 1.5% of annualized discounted RealAlpha™ over the entire period. The standard deviation (a measure of volatility of returns) of the fund was significantly higher than that of the reference portfolio; this is consistent with the concentrated nature of the fund’s holdings.

In a more elaborate variant of Alpholio™’s methodology, the membership of the reference portfolio is fixed but the weights can fluctuate to more accurately track the fund’s returns over time. The following chart and statistics illustrate this outcome:

Cumulative RealAlpha™ for Sequoia Fund (SEQUX) - Fine Fit

In this analysis mode, the fund added only about 1% of annualized discounted RealAlpha™. The standard deviation of the reference portfolio increased to about 12.5%, closer to 13.7% of the fund. (Note that in this analysis, the first data point was in February 2005, i.e. three months after the start of input data. This lag stems from the sliding time-window aspect of Alpholio™’’s methodology.)

Finally, in the most advanced variant of Alpholio™’s methodology, both the ETF membership and weights in the reference portfolio may change over the analysis period. Here is the resulting chart with accompanying statistics:

Cumulative RealAlpha™ for Sequoia Fund (SEQUX) - Detailed Fit

Compared to this reference portfolio, the fund produced a negative annualized discounted RealAlpha™. This means that many of the substantial bets the fund made on its holdings did not really add value when fully adjusted for risk. After the fund’s cumulative RealAlpha™ peaked in September 2015 at about 4%, it subsequently slumped to below minus 21% in February 2016. The lag cumulative RealAlpha™, which simulates a substitution of the fund with a reference ETF portfolio with a one-month lag, shows that at the end of the entire evaluation period the fund added only 3% of value through security selection (as of this writing, the fund returned an additional negative 7.5% in March 2016). It is also worth noting that in this analysis mode, the top equivalent position of the fund, in Market Vectors Pharmaceutical ETF (PPH), peaked at at a weight of almost 58%. This underscored the non-diversified nature of the fund with its inordinate exposure to just one industry.

The prospectus benchmark for Sequoia Fund is the S&P 500® Index. One of the long-lived and low-cost implementations of this index is the SPDR® S&P 500® ETF (SPY). Alpholio™’s calculations show that from December 2004 through February 2016, the fund returned more than the ETF in approximately 86% of all rolling 36-month periods, with a median cumulative (i.e. not annualized) outperformance of 34.6%. Similarly, the fund returned more than the ETF in 69% of all rolling 24-month and 60% of 12-month periods. However, as the above analysis clearly demonstrated, merely comparing fund and single-benchmark returns paints a vastly incomplete picture of the fund’s performance.

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


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Analysis of American Century Equity Income Fund
analysis, mutual fund

Today’s profile in Barron’s features the American Century Equity Income Fund (TWEIX; Investor Class shares). This $9.2 billion no-load, large-cap value fund sports a reasonable 0.93% expense ratio and a 56% turnover. According to the article

The fund has delivered an average annual return of 7.5% over the past 15 years, better than 98% of large value funds tracked by Morningstar. While the market and its peer group have lost money over the past 12 months, this fund is up 4.2%.

The prospectus benchmark for the fund is the Russell 3000® Value Index. One of the long-lived and low-cost implementations of this index is the iShares Core U.S. Value ETF (IUSV). Alpholio™’s calculations show that since September 2000, the fund returned more than the ETF in about 41% of all rolling 36-month periods, with a median cumulative (non-annualized) return difference of minus 9.7%. Similarly, the fund outperformed the ETF in only 38% of all rolling 24-month periods and 39% of 12-month periods over the same analysis interval.

Instead of just comparing periodic returns, let’s employ Alpholio™’s patented methodology that adjusts for the fund’s risk. The simplest variant of this approach constructs a reference portfolio of ETFs with both fixed membership and weights. This portfolio is designed to most closely tracks periodic returns of the analyzed fund. Here is the resulting chart of cumulative RealAlpha™ for the American Century Equity Income Fund since late 2004:

Cumulative RealAlpha™ for American Century Equity Income Fund (TWEIX)

Over the last 11 years, the fund produced approximately minus 1.4% of the regular and minus 1.3% of the lag annualized discounted RealAlpha™ (to learn more about this and other performance measures, please consult our FAQ). In practice, this means that an investor in the fund would realize an over 22% lower cumulative return than an investor in the reference ETF portfolio. The fund performed on par with its reference ETF porfolio until the trough of the equity market in March 2009, and underperformed on a cumulative basis afterward until mid-2015. At 10%, the fund’s standard deviation was about 0.2% higher than that of its reference ETF portfolio. The fund’s RealBeta™ was 0.64.

The following chart shows constant weights of ETFs in the reference portfolio for the fund over the same analysis period:

Reference Weights for American Century Equity Income Fund (TWEIX)

The fund had major equivalent positions in the iShares Morningstar Large-Cap Value ETF (JKF; fixed weight of 24.8%), iShares 1-3 Year Treasury Bond ETF (SHY; 13%), First Trust Value Line® Dividend Index Fund (FVD; 12.5%), iShares Core U.S. Aggregate Bond ETF (AGG; 9.5%), Vanguard Consumer Staples ETF (VDC; 8.8%), and SPDR® S&P® 500 Value ETF (SPYV; 7.7%). The Other component in the chart collectively represents additional six ETFs with smaller weights.

Over the past 11 years, the American Century Equity Income Fund subtracted value when compared to its fixed-weight ETF reference portfolio of similar volatility. At times, the fund had large capital gain distributions, such as the one close to 7.9% of the NAV in 2015. This made the fund less suitable for taxable accounts.

To learn more about the American Century Equity Income and other mutual funds, please register on our website.


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Analysis of Seafarer Overseas Growth and Income Fund
analysis, foreign equity, mutual fund

A recent piece in Barron’s features the Seafarer Overseas Growth and Income Fund (SFGIX; Investor Class shares). This $876 million (at the end of February 2016) no-load fund has a 1.15% expense ratio (after a fee waiver/reimbursement through August 2017) and 28% turnover. According to the article:

Seafarer’s only fund […] is down an average of 1% a year over the past three years, far better than its peers, which are down an average of 7%. Last year, the MSCI Emerging Markets index fell 14.9%, and the category sank 13.8%. Seafarer lost 4.3%.

Smaller losses are hardly a consolation to investors. Nevertheless, the fund has clearly exhibited some defensive qualities in a challenged asset class, by focusing on dividend-paying equities and fixed-income securities.

The fund’s benchmark is the MSCI Emerging Markets Index. One of accessible implementations of this index is the iShares MSCI Emerging Markets ETF (EEM). Alpholio™’s calculations indicate that since inception the fund returned more than the ETF in about 89% of all rolling 12-month periods, and 100% of 24- and 36-month periods. The median outperformance over a rolling 12-month period was 7.4%. It has to be noted, though, that the fund only has a four-year history.

To gain insight into risk-adjusted returns of the Seafarer Overseas Growth and Income Fund, let’s employ a variant of Alpholio™’s patented analysis methodology. In this approach, a reference portfolio of ETFs with a fixed membership but variable weights is constructed for each analyzed fund. The difference of returns of the fund and its reference portfolio constitutes the cumulative RealAlpha™, which is shown in the following chart:

Cumulative RealAlpha™ for Seafarer Overseas Growth and Income Fund (SFGIX)

The fund generated approximately 2.5% of the regular and 3.1% of the lag annualized discounted RealAlpha™ (to learn more about this and other performance measures, please visit our FAQ). However, most of this outperformance was produced in just a four-month period at the beginning of 2015. At 13%, the fund’s standard deviation exceeded that of the reference portfolio by 3%. The fund’s RealBeta™, measured against a broad-based US stock market ETF, was 0.74.

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

Reference Weights for Seafarer Overseas Growth and Income Fund (SFGIX)

The fund had major equivalent positions in the iShares 7-10 Year Treasury Bond ETF (IEF; average weight of 28.8%), iShares MSCI Emerging Markets ETF (EEM; 16.6%), iShares MSCI Hong Kong ETF (EWH; 10.4%), iShares MSCI Singapore ETF (EWS; 9.3%), PowerShares Dynamic Market Portfolio (PWC; 7.7%), and iShares Latin America 40 ETF (ILF; 6.3%). The Other component in the chart collectively represents additional six ETFs with smaller average weights.

The IEF position represents fixed-income holdings of the fund:

Nearly a quarter of the fund’s assets are in preferred stock, convertibles, and debt.

Over its lifespan, the Seafarer Overseas Growth and Income Fund added a considerable amount of value. However, this outperformance was achieved over a relatively short sub-period of time and at the expense of an elevated volatility as compared to that of the fund’s reference ETF portfolio. The fund’s historical distributions were modest except for a surprising 2.2% short-term capital gain in 2013. Only time will tell if the fund is suitable for taxable accounts.

To learn more about the Seafarer Overseas Growth and Income and other mutual funds, please register on our website.


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Substituting Liquid Alternative Funds
alternatives, analysis, asset allocation, exchange-traded fund, hedge fund, mutual fund, portfolio

A recent cover story in Barron’s features liquid alternative funds from AQR. According to the article

The liquid-alt pitch is that individuals can access the same types of investments as university endowments and other big institutions, to diversify equity-heavy portfolios, typically with a 10% to 20% allocation to liquid alts… The advantage of the [AQR Managed Futures] strategy […] is that it is uncorrelated with other asset classes, and “has the most consistently strong performance in equity bear markets.” That is when diversification matters most, as was the case in the third quarter of last year and the early part of this year.

Ideally, returns of a liquid-alt fund should not only be uncorrelated with those of both stocks and bonds but also significantly positive over a long evaluation period. Let’s take a look at the performance of three AQR funds with a sufficiently long history.

The following chart shows rolling return correlation of the AQR Managed Futures Strategy Fund (AQMIX) with the Vanguard Total Stock Market ETF (VTI) and the Vanguard Total Bond Market ETF (BND):

Correlation of Rolling 36 Monthly Returns for VTI and BND with AQMIX

Please note that AQMIX had the first full month of returns in February 2010. Consequently, the first rolling 36-month return became available at the end of January 2013. As could be expected, the fund had lower correlation to stocks than to fixed income, although both coefficients were quite low (generally, correlation below 0.6 provides diversification benefits).

Here is a similar chart with related statistics for the AQR Multi-Strategy Alternative Fund (ASAIX):

Correlation of Rolling 36 Monthly Returns for VTI and BND with ASAIX

Compared to AQMIX, this strategy had a higher correlation to bonds.

Here is a similar chart with statistics for the AQR Diversified Arbitrage Fund (ADAIX):

Correlation of Rolling 36 Monthly Returns for VTI and BND with ADAIX

In contrast to AQMIX and ASAIX, this strategy had a higher correlation to equities than bonds; however, both coefficients were still pretty low.

The problem with any of these strategies is the lack of accessibility for most individual investors:

AQR’s approach can be hard to understand. Because of this—and to deter hot money—the firm sells its liquid-alt funds almost entirely through financial advisors. Retail buyers can access the funds directly through fund supermarkets like Fidelity, but direct investments involve a minimum of $1 million. Investments through advisors and 401(k) plans have no minimum.

Is there a way to substitute these liquid-alt funds with readily available ETFs? Let’s explore this possibility using Alpholio™’s patent-based analysis service for mutual funds. One variant of this methodology constructs a reference portfolio of ETFs with fixed both membership and weights. Here is the resulting cumulative RealAlpha™ chart for the AQR Managed Futures Strategy Fund (to learn more about this and other performance measures, please visit our FAQ):

Cumulative RealAlpha™ and Statistics for AQR Managed Futures Strategy Fund (AQMIX)

As the statistics section below the chart shows, since its inception the fund had a smaller return and a much higher volatility (measured by standard deviation) than those of the reference portfolio. The following chart illustrates the constant composition of the reference ETF portfolio in this analysis:

Reference Weights for AQR Managed Futures Strategy Fund (AQMIX)

The major positions in the reference portfolio were the PowerShares DB US Dollar Index Bullish Fund (UUP; fixed weight of 38.1%), iShares 20+ Year Treasury Bond ETF (TLT; 22.9%), iShares MSCI Netherlands ETF (EWN; 9.3%), Guggenheim CurrencyShares® Swiss Franc Trust (FXF; 6.0%), Consumer Staples Select Sector SPDR® Fund (XLP; 5.5%), and Utilities Select Sector SPDR® Fund (XLU; 4.7%). The Other component in the chart collectively represents addition five ETFs with smaller fixed weights.

The return correlation of the reference ETF portfolio over the entire evaluation period was 0.16 with VTI and 0.58 with BND. Given that these figures for AQMIX were approximately -0.07 and 0.21, respectively, the reference portfolio was not as good a diversifier for stocks and bonds as the fund was. However, the reference portfolio only had long positions in non-leveraged ETFs. It also returned about 8% more than the fund on a cumulative basis and with a 59% lower volatility. Similar analyses can be conducted for ASAIX and ADAIX. In the end, it is up to the investor to weigh the pros and cons of using reference ETF portfolios as substitutes for these funds in the context of the overall portfolio.

We hope that our Investment Toolkit™ will provide useful services for investors who want to construct well-diversified portfolios. If you would like to use it, please register on our website.


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