Finding Star Fund Managers
active management, active share, correlation, performance persistence

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:

Subsequent Period Beating the Benchmark
1 year 58%
3 years 45%
5 years 56%
10 years 65%

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:

Rise in Closet Indexing

The active share in the aggregate portfolio of actively-managed U.S. stock funds has been also declining:

Active Share in Aggregate Portfolio of Active U.S. Stock Funds

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.

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Are ETF Fees Increasing?
exchange-traded product

An article in Forbes indicates that an average expense ratio (ER) of exchange-traded products (ETPs) increased from 0.61% to 0.62% over the 12 months to June 2013. The emphasis should be on average, as opposed to asset-weighted. That is because

Driving the fee increase is the cost of newly issued funds. Since 2010, the average net ER of a newly issued fund is 0.70%, according to Morningstar data.

Not surprisingly, as the ETP space becomes more crowded and basic indexing is increasingly well covered, more niche products with a small amount of assets under management (AUM) and, consequently, higher ERs are introduced. However, a straight ER average is less indicative of what a typical investor would pay compared to an asset-weighted average.

So, was there also an increase in asset-weighted fees? The 2012 and 2013 Lipper’s Quick Guides to OE [open-ended] Fund Expenses provide at least a partial answer. Here are the average asset-weighted fees for ETFs with “institutional” load types:

ETF Type 2011 ER 2012 ER % Change
All 0.330 0.306 -7.3
Diversified Equity 0.195 0.195 0.0
Sector Equity 0.417 0.397 -4.8
World Equity 0.451 0.424 -6.0
Other Equity 0.244 0.220 -9.8
Fixed Income 0.278 0.268 -3.6

For all ETF types, the ER decreased or stayed the same between 2011 and 2012, with an overall decline by about 7.3%. Therefore, on an asset-weighted basis, ETF fees exhibited an opposite trend to that on a straight average basis. That is great news for both ETF investors and Alpholio™, as the fund expense component of the (negative) excess return became smaller.

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Urban Myths of Mutual Funds
active management, mutual fund

A recent article from MorningstarAdisor discusses an urban myth that mutual funds have hidden fees of 140-200 basis points (bps), which are omitted from expense ratios. In this context, the article provides the following statistics:

Over the trailing 10 years ending March 31, 2013, the average U.S. large-cap equity fund, on an asset-weighted basis, trails the market index by its expense ratio plus about 39 basis points. Over the past five years, this figure shrinks to 25 basis points.

This means that an average large-cap fund not only failed to earn its expenses but also subtracted value on top of them. By how much in total? The Investment Company Institute’s report provides the following asset-weighted statistics of expense ratios for equity funds:

All Funds Actively-Managed Funds Index Funds
2003 100 bps 110 bps 25 bps
2008 83 94 17
2012 77 92 13
10-Year Average 87 98 18
5-Year Average 82 95 15

So, an average large-cap equity fund subtracted about 98 + 39 = 137 bps and 95 + 25 = 120 bps per year in the 10-year and 5-year periods, respectively. The non-asset-weighted statistics of fund expense ratios are even worse (all figures for 2012):

Equity Strategy Median Mean
Aggressive growth 137 bps 147 bps
Growth 124 131
Sector 146 153
Growth and Income 112 118
Income 112 120
International 147 155
Average 133 141

Of note here is the right skew of the expense ratio distribution (in all cases, the mean is greater than the median). This implies that some funds have very high expense ratios. Indeed the 90th percentile of equity funds has an average expense ratio of 216 bps or more, which is over 62% higher than the median of 133 bps.

Apparently, all this was not lost on he California Public Employees’ Retirement System (CalPERS), which this week decided to replace actively-managed strategies with passive ones even for asset classes other than equities:

The $1.64 billion defined-contribution plans, including the $1.1 billion 457 plan, will be adding passively managed U.S. equity, international equity, short-term-bond, intermediate-term-bond and real-asset strategies from State Street Global Advisors.

The investment committee elected to drop actively managed U.S. small- and midcap value and growth strategies managed by The Boston Co. Asset Management LLC, international equity managed by Pyramis Global Advisors, short-term bond managed by Pacific Investment Management Co. LLC, and intermediate and Treasury inflation-protected securities strategies managed in-house.

Fees for the funds will drop to 6 basis points, from 52, because of the change.

Evidently, even with an average expense ratios of 52 bps (which is close to the 10th percentile for actively-managed funds), original strategies failed to earn their keep.

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