January 17, 2017
Increasing Correlations of Asset Classes
A recent piece in Barron’s proposes an investment into seven actively-managed mutual funds. This recommendation is motivated by the following observation:
A long, humiliating period for professional stockpickers might be giving way to something different. Stocks that have moved in near unison in recent years are beginning to chart more distinct paths. Data points that haven’t mattered in a decade, like the relationship between prices and fundamental measures of value, are starting to have more sway on returns. The divide between cheap stocks and expensive ones remains exceptionally wide, which could mean last year’s shift in favor of value investing is just the beginning.
Supposedly, were on the verge of entering the “stockpicker’s market,” as shown in this chart:
The myth that low correlations between stock returns lead to active manager’s outperformance has long been debunked. Similarly, a high active share is cited as one of the reasons actively-managed funds will outperform their passive peers. Please refer to our earlier post for a discussion of this topic.
So, this post will instead focus on the long-term performance of the funds featured in the article:
The following charts with related statistics show the cumulative RealAlpha™ for each fund that has at least ten years of history through 2016 (to learn more about this and other patent-based performance measures Alpholio™ uses, please consult our FAQ). In all analyses, the number of ETFs in the reference portfolio was limited to no more than seven. The ETF membership and weights in each reference portfolio were constant throughout the entire evaluation period.
Here is a chart with statistics for the AllianzGI NFJ Dividend Value Fund (PNEAX; Class A shares):
The fund cumulatively returned over 20.5% less than its reference ETF portfolio of lower volatility.
Here is a chart with statistics for the DFA US Large Cap Value Portfolio (DFLVX; Class I shares):
The fund cumulatively returned about 8.5% more than its reference ETF portfolio of lower volatility.
Here is a chart for the Dodge & Cox Stock Fund (DODGX):
While the fund produced a 14% higher cumulative return than its reference ETF portfolio, by early 2016 it also lost virtually all of its cumulative RealAlpha™ generated since 2007.
The following chart is for the Sound Shore Fund (SSHFX):
On a cumulative return basis, the fund underperformed its reference ETF portfolio by over 7.7%; most of that loss occurred over the past two years.
This chart is for the T. Rowe Price Equity Income Fund (PRFDX):
The fund’s cumulative return was over 23.3% lower than that of its reference ETF portfolio of a slightly higher volatility.
The final chart is for the Vanguard U.S. Value Fund (VUVLX; Investor Class shares):
The fund cumulatively returned about 9.1% more than its reference ETF portfolio of a slightly lower volatility. However, as recently as at the end of October 2016, the cumulative RealAlpha™ was only 4.4%.
In conclusion, only three out of the six funds analyzed above added some value when compared to their respective reference ETF portfolios. The rest of the funds underperformed, and in some cases quite significantly. It remains to be seen whether a combination of the expected low stock correlations in the market and a high active share of these funds leads to their significant outperformance in 2017.
To learn more about these and other mutual funds, incl. the composition of their reference ETF portfolios, please register on our website.
To learn more about the these and other mutual funds, including the composition of their reference ETF portfolios, please register on our website.
February 24, 2016
Merger Arbitrage Funds as Portfolio Diversifiers
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:
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:
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:
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.
November 10, 2014
Finding Star Fund Managers
A recent article in The Wall Street Journal’s Investing in Funds & ETFs report discusses merger arbitrage mutual funds. According to the article, such funds
…may offer an attractive way to diversify away from the risks of stocks or bonds …[but] can’t replace bonds, because their returns aren’t certain and come mostly through any price appreciation, not yield. But held in tandem with bonds, they can offer a way to hedge against interest-rate risk and might cushion part of a portfolio against stock-market volatility
Let’s take a closer look at these statements with the help of a recently introduced Alpholio™ App for Android, and specifically its Portfolio, Correlation, Total Return and Efficient Frontier services. For the purposes of this analysis, the base portfolio consists of 60% SPDR® S&P 500® ETF (SPY) and 40% of the iShares Core U.S. Aggregate Bond ETF (AGG), i.e. a traditional balanced mix of stocks and bonds. Here is the baseline chart with statistics generated from total monthly returns of both ETFs and quarterly rebalancing of the portfolio:
The reason why the beta of this portfolio is not exactly 0.6 (i.e. equal to the 60% weight of the SPY) is threefold. Alpholio™ uses a broader definition of “the market” than just the S&P 500® index. Also, the correlation between the market and AGG is not zero. Finally, the portfolio is rebalanced quarterly, not monthly, which can lead to a temporary divergence of SPY/AGG weights from the original 60/40% level.
For reference, in the same time frame a portfolio consisting of just the SPY would have an annualized return of 8.52% with a standard deviation of 14.25%, Sharpe ratio of 0.55 and maximum drawdown of 50.8%. Adding AGG to such an equity-only portfolio decreases its return but reduces its volatility even more, thus improving the Sharpe ratio. The maximum drawdown is also significantly diminished.
The article quotes two merger arbitrage funds with substantial assets: The Merger Fund® (MERFX) and The Arbitrage Fund (ARBFX). To effectively diversify the balanced portfolio, should either fund replace a portion of stocks, a portion of bonds, or a combination of both? What should be the extent of such a replacement?
To answer the first question, let’s take a look at the correlation between SPY, AGG and either fund using the Correlation service of the Alpholio™ app. Here is a chart of the rolling 12-month correlation coefficient for monthly returns of SPY and MERFX:
The starting date of the chart stems from the earliest availability of AGG whose first full monthly return was in October 2003. The average correlation of 0.56 indicates that MERFX was a marginal diversifier for SPY (generally, a correlation of 0.6 or less is desirable). Here is a similar chart for AGG and MERFX:
The average correlation of just below zero indicates that MERFX was a much better diversifier for AGG than SPY. Similarly, the average correlation between SPY and ARBFX was about 0.42 and virtually zero between AGG and ARBFX. Therefore, to effectively diversify the base portfolio, it should generally be better to allocate more of SPY rather than AGG to MERFX or ARBFX. However, this would also suppress portfolio returns — as the following total return chart shows, MERFX and ARBFX had steadier but smaller cumulative returns than SPY:
To answer the second question: a portfolio with the highest Sharpe ratio (i.e. the tangency portfolio) would be mostly composed of AGG and MERFX. Here is an efficient frontier chart in which the current portfolio, depicted by a standalone marker inside the frontier, had 80% in AGG and 20% in MERFX but no SPY and was very close to the tangency portfolio:
Adding MERFX at the expense of SPY decreased the portfolio volatility and increased its Sharpe ratio, but resulted in lower returns. To illustrate this further, here is a chart and statistics for a portfolio that consisted of 45% SPY, 40% AGG and 15% MERFX, rebalanced quarterly:
Ultimately, it is up to the investor to trade off portfolio returns for risk — some may choose to optimize for the highest return per unit of risk, while others may strive for higher returns at the expense of a sub-optimal Sharpe ratio. The Alpholio™ app for Android provides a set of tools that facilitate the exploration of historical data and construction of desired portfolios, with the usual caveat that the past performance is not a guarantee of future results.
January 27, 2014
REIT Correlations with Stocks
With the new Fund Manager of the Year awards from Morningstar, a question of future performance of star fund managers inevitably arises. Apparently, the awards carry little short-term predictive value:
While our Fund Manager of the Year awards are recognition of past contributions rather than predictions of future results, we’re confident in each one’s long-term prospects because of their deep research resources and willingness to stick with their discipline in good times and bad. We wouldn’t expect repeat performances in 2014, as our winners and their rivals will wrestle with lofty equity valuations, policy-related volatility, a still-recovering economy, and the specter of rising rates.
Indeed, statistics on award winners presented by an article in The Wall Street Journal are not too encouraging:
||Beating the Benchmark
Generally, the best long-term predictors of fund outperformance remain a low expense ratio (fees), minimal portfolio turnover (a proxy for trading costs), and divergence from benchmark index weightings. The latter measure, known as active share should be high:
Prof. Cremers says the best funds tend to have active-shares percentages that are at least 60%. Large-stock managers should ideally have an active share above 70%. Midcap managers should have active share above 85% and small-cap managers should exceed 90%, he says.
Unfortunately, the proportion of funds with such big active shares has been falling over the years, which gave rise to “closet indexing,” as a chart from a Lazard Research study demonstrates:
The active share in the aggregate portfolio of actively-managed U.S. stock funds has been also declining:
However, active is not always a guarantee of strong performance, as shown in an earlier Alpholio™ post.
As for fund fees, an article in The New York Times points out that
The average total expense ratio, which encompasses management fees and operating expenses but not brokerage commissions and other trading costs, is 1.33 percent of assets a year for domestic stock funds and 0.97 percent for domestic bond funds, according to Morningstar.
Over time, these fees add up. According to a paper by William Sharpe, which estimated an average expense ratio of stock funds at 1.12% compared to 0.06% (now 0.05%) for the Vanguard Total Stock Market Index Fund (VTSAX, Admiral Shares):
Whether one is investing a lump-sum amount or a series of periodic amounts, the arithmetic of investment expenses is compelling… Under plausible conditions, a person saving for retirement who chooses low-cost investments could have a standard of living throughout retirement more than 20% higher than that of a comparable investor in high-cost investments.
However, as a Gerstein Fisher study found, the cheapest funds may not always provide the highest returns:
We found that the best performing quintile of funds was the second most expensive quintile (i.e., the 21-40% highest-cost ones), whether we equally weighted funds or asset-weighted them. The consistent results of the study: the cheapest quintile of funds was not the best performing, but the most expensive funds were the worst performing.
Similarly to a low correlation, a factor that is often quoted to aid stock pickers is a high degree of dispersion (measure of spreading) of stock returns. At first blush, it would seem that, just as with active share, an increased dispersion is beneficial. However, all it does is to enlarge the dispersion of active fund returns, without necessarily moving the average, as another article in The Wall Street Journal indicates:
A bigger spread between the best and worst stocks hasn’t helped active funds as a group, but it does tend to make good funds better—and bad funds worse… To put it another way: Markets that aren’t moving in lock step give active managers more rope with which to climb above the pack or to hang themselves.
While a low cost and small turnover coupled with a significant active share are generally good screening criteria, funds clearly have trouble with performance persistence. As our analyses have repeatedly demonstrated, even the star fund managers stumble, so outperformance is fleeting. This is where the Alpholio™ methodology helps by showing momentum in the smoothed cumulative RealAlpha™ for each analyzed fund, from which buy/sell signals can be derived. To learn more, please visit our FAQ.
January 14, 2014
Hedge Fund Stats
Traditionally, real-estate investment trusts (REITs) provided a good diversification to other stocks in a portfolio. However, in the last several years, REIT returns have become highly correlated with returns of other equities. One theory, outlined in a Morningstar article, is that over the years REITs evolved from a small, illiquid and neglected to a mainstream and easility accessible asset class.
As an article in The Wall Street Journal indicates
From 1980 through 2006, stock performance of REITs moved in tandem with the broader market only 47% of the time, according to an analysis for The Wall Street Journal by Citi Private Bank in New York… Since then, as the bank’s research shows, REIT correlations have jumped to nearly 80%, erasing more than a quarter of a century in decoupling.
To illustrate that, Alpholio™ compiled the following chart of correlation between returns of the SPDR® S&P 500® ETF (SPY) and iShares U.S. Real Estate ETF (IYR):
The chart shows rolling correlations in trailing three- and four-year periods using total monthly returns of both ETFs since mid-2000. (As expected, thanks to a larger number of data points the latter curve is a bit smoother but lags the former one.) Either curve is characterized by four distinct phases:
- Through 2006, the correlation was indeed in the mid-40%
- From 2007 through 2008, the correlation gradually increased to about 70% and abruptly jumped to over 80% at the onset of the financial crisis
- From 2009 through mid-2013, the correlation stayed at about 85%
- Afterwards, the correlation decreased started to decrease.
The last two phases were caused, at least in part, by the Federal Reserve’s interest rate policy: a strong coupling of rising returns stimulated by low rates, followed by an indication of decoupling when rates rose. A better economic outlook is also a factor:
Improving conditions in the broader economy usually lead to lower real-estate correlations… In fact, correlations between the S&P 500 and REITs have dropped by about 10% since late last year.
Let’s take a look at the last phase in more detail, this time using trailing 18- and 24-month returns:
Here, thanks to shorter time windows the degree of decoupling in the last phase is more evident: the correlation reverted to about 50%. This would suggest that REITs might once again help with portfolio diversification. However, as the next chart shows, REIT returns are currently negatively correlated with the interest rate on a 10-year Treasury note:
With the prospect of rising interest rates this year, REIT returns are likely to continue to be depressed. At the same time, many analysts forecast 5-10% returns of the overall equity market (for example, S&P just increased its 12-month target for the S&P 500® index from 1895 to 1940, which implies an approx. 7% total return). Therefore, until interest rates stabilize, it may be too early to declare a structural decrease in correlation of REIT returns to those of other stocks. A permanent return to pre-2007 correlation levels would certainly help with portfolio construction.
October 31, 2013
Correlations of Factor ETFs
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:
|HFRI Fund Weighted Composite Index
|HFRI Equity Hedge [EH] (Total) Index
|HFRI Event-Driven (Total) Index
|HFRI Macro (Total) Index
|HFRI Relative Value [RV] (Total) Index
|HFRI Emerging Markets (Total) Index
|HFRI Fund of Funds Composite Index
|HFRI EH: Short Bias Index [lowest]
|HFRI RV: Fixed Income-Asset Backed Index [highest]
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:
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:
In sum, while some, especially smaller, hedge funds have attractive characteristics, performance of the overall industry leaves a lot to be desired.
August 28, 2013
Alternatives vs. Bonds
BlackRock has recently introduced a set of four iShares ETFs that follow factor indices. They are:
The first three of these ETFs debuted on April 16, 2013, while the fourth one three months later. Therefore, as of this writing, there are only 91 and 28 trading day data available for these ETFs, respectively. Traditionally, at least three years worth of data (a minimum of 36 monthly data points) are required to calculate a return correlation between two investments. However, it may be helpful to take an early look on how the return correlations among these ETFs and the iShares Core S&P 500 ETF (IVV) are shaping up so far:
Since daily returns are assumed to contain a substantial amount of “noise,” and the observation period is very limited, the above figures certainly cannot be considered very reliable. However, there is an early indication that the majority of correlations are lower than 0.6, which should aid in portfolio diversification. A research paper from BlackRock shows that idealized zero-net-investment factor portfolios constructed using Fama-French approach* can have much lower long-term correlations:
*MktRf = market, SMB = size, HML = value, CME = quality.
Only time will tell whether these new factor ETFs provide low inter-correlations and sufficient returns to truly benefit an investment portfolio. However, early signs are encouraging.
July 26, 2013
In light of a recent downturn in bonds caused by a perception of the Fed’s upcoming actions, a Barron’s blog post and a Morningstar article explore alternative investments with “bond-like” returns. However, it turns out that these alternatives behave mostly like stocks with poor return-to-risk characteristics, and thus do not provide diversification to a broader portfolio.
To illustrate, here are correlations to stocks and Sharpe Ratios derived from Morningstar’s statistics for mutual funds and ETFs mentioned in the post and article:
These three-year statistics indicate a high positive correlation to stocks coupled with sub-par risk-adjusted returns. This observation is corroborated by a new study from the Leuthold Group cited in The Wall Street Journal article that states:
“From 1994 through May, it found that hedge-fund correlations have slowly been inching up to 0.75, almost 36% higher than earlier levels. Since a measure of 1.00 represents lock-step movements, hedge fund returns are generally following the tendencies of stocks about three-quarters of the time… Funds with correlations to stocks of 0.6 or less are prized by investors since they can significantly reduce portfolio volatility and limit risks over full-market cycles.”
In the past month or so, these alternative funds held their value well relative to bond investments. This is supported by their negative or low positive three-year correlations to iShares Core Total U.S. Bond Market ETF (AGG), as estimated by Alpholio™:
|IQ Merger Arbitrage ETF
|IQ Alpha Hedge Strategy
For reference, the correlation of SPDR® S&P 500® ETF (SPY) to AGG over the same period is -0.33. Therefore, these alternatives do not provide a significant amount of diversification to a balanced equity-and-bond portfolio, but could be marginally helpful if the portfolio contains only bonds. However, even in the latter case they could be a drag on the risk-adjusted performance of the portfolio: at 1.31, the Sharpe Ratio of SPY is higher than that of any of the above funds.
July 26, 2013
Do Alternatives Diversify?
A couple of articles in InvestmentNews and The Wall Street Journal discuss the recent underperformance of risk parity funds. To recap what such funds do:
“Risk parity funds operate under the notion that the majority of risk in a portfolio comes from stocks. So instead of investing 60% of a portfolio in stocks, the funds lower the stock allocation and use leverage to boost the returns of the safer side of portfolio, e.g. bonds, to achieve the same returns with less risk.”
“Risk-parity funds use leverage to try to increase returns on bond investments so they more closely resemble returns of stocks. The basic idea of the strategy is that by equally distributing risks among stocks, bonds and commodities, the portfolio can weather huge price swings without sacrificing returns.”
The benchmark for these funds is typically a classic balanced portfolio of 60% stocks (e.g. represented by the S&P 500® index) and bonds (e.g. Barclays Capital Aggregate Bond Index). As indicated by a performance chart for one of the funds mentioned in the articles, AQR Risk Parity Fund (AQRIX), it is not easy to beat that benchmark even over a period of several years:
Lately, risk-parity strategies underperformed:
“That is mostly because stocks have tumbled along with bonds after the Federal Reserve hinted at a reduction in its stimulus program last month. Making things worse, commodities and inflation-protected securities, which are widely used by risk-parity managers as a hedge against inflation, also suffered heavy losses because of receding inflationary expectations.”
To see why, let’s consider the long-term and short-term correlation coefficients between returns of stocks, bonds and commodities, represented by SPDR® S&P 500® ETF (SPY), iShares Core Total U.S. Bond Market ETF (AGG), and PowerShares DB Commodity Index Tracking Fund (DBC), and iShares TIPS Bond ETF (TIP):
||7 Years (Monthly)
||1 Month (Daily)
|SPY – AGG
|SPY – DBC
|AGG – DBC
|SPY – TIP
|AGG – TIP
|DBC – TIP
The above figures clearly illustrate a significant increase in correlations between SPY and AGG, AGG and DBC, SPY and TIP, and AGG and TIP, in the last month. This explains losses suffered by risk parity strategies: stocks, bonds, and commodities all moved down in unison, and leverage exacerbated the bond downfall caused by rising interest rates. Thus, the basic premise of equalizing the risk contributed by uncorrelated components was broken, and risk parity turned to “risk disparity.”
July 26, 2013
A recent article in The Wall Street Journal discusses how wealth managers are increasingly investing their clients’ money in mutual funds that use hedge-fund strategies. The idea behind these “alternative” investments is a low correlation of their returns to those of the general market, which is supposed to protect portfolios during market downturns. Unfortunately, the price paid for this is a sub-par performance of such investments in normal market conditions.
Let’s take a look at correlations of some of the funds mentioned in the article. Correlation coefficients can be reverse-engineered from data provided by Morningstar:
|Natixis ASG Global Alternatives
|TFS Market Neutral
|Highbridge Statistical Market Neutral
The above figures are based on the most recent three-year period. As can be seen, correlations of these funds to the market are quite high.
For further reference, here are average correlations of three types of “traditional” alternative assets, i.e. REITs, commodities, and hedge funds, with stocks and Treasury notes, as calculated by Leuthold Group:
In the last four years, these correlations were much higher than their long-term historical averages.
Even institutional investors keep pursuing alternatives in the name of diversification. However, true diversification of a portfolio requires not only low correlations but also high returns of assets being added. While it may still turn out that alternative investments provide some degree of portfolio protection during the next market downturn, this assumption is becoming questionable.