Introducing CAPM Service

The latest service on the Alpholio™ patent-based analytical platform implements the capital asset pricing model (CAPM). Specifically, the service calculates the security characteristic line (SCL) with related statistics. In addition, the service provides statistics for the difference between periodic returns of the analyzed and reference securities.

In contrast to the traditional CAPM, which uses a theoretical market portfolio as a reference, the service allows the use of any available security. This has a practical implication of comparing concrete investment vehicles as opposed to evaluating a real security against an uninvestable “market” index, such as the S&P 500®. However, in both cases the reference is a single factor, whose periodic returns try to explain the returns of the analyzed security.

To demonstrate the service in action, let’s analyze the Vanguard Health Care Fund (VGHCX, Investor Shares; VGHAX, Admiral Shares). We covered this fund in one of the previous posts. This analysis will begin in January 2013, when the fund was fully taken over by its current manager.

Here are the fund’s exposures through June 2017, derived from the Fund Analysis service:

Reference Weights for Vanguard Health Care Fund Investor Shares (VGHCX)

The fund had equivalent positions in the Guggenheim S&P 500® Equal Weight Health Care ETF (RYH), iShares Global Healthcare ETF (IXJ) and iShares U.S. Pharmaceuticals ETF (IHE). Collectively, these positions formed a reference ETF portfolio with volatility comparable to that of the fund.

Let’s use the Total Return service to determine which of these three ETFs most closely tracked the fund’s returns over the same period:

Total Return of Vanguard Health Care Fund Investor Shares (VGHCX) and Reference ETFs (RYH, IXJ and IHE)

As could be expected, RYH, the ETF with the dominant weight in the reference portfolio, turned out to be the best fit. Therefore, let’s choose this ETF as a CAPM reference for the fund, using excess (i.e. net of risk-free rate) monthly returns of both securities:

CAPM for Vanguard Health Care Fund Investor Shares (VGHCX) and Guggenheim S&P 500® Equal Weight Health Care ETF (RYH)

The beta coefficient of the fund vs. the ETF was somewhat below one, a result of the slightly lower standard deviation (see statistics below the Total Return chart) and the 0.959 correlation coefficient (separately obtained from the Correlation service). With the t-statistic much higher than two, the beta coefficient was statistically significant. The alpha intercept, while positive, was not statistically significant. With the R-squared of almost 92, the regression fit was quite good.

Here is the expanded bottom panel of statistics:

Return Difference Statistics for Vanguard Health Care Fund Investor Shares (VGHCX) and Guggenheim S&P 500® Equal Weight Health Care ETF (RYH)

The mean difference between monthly returns of the fund and the ETF was slightly negative and had a substantial standard deviation. The low t-statistic indicated that the return difference was not statistically significant. By this measure, any value subtracted by active management of the fund could be attributed to bad luck and not a lack skill. If performance of the fund and the ETF were unchanged, it would take almost 212 years for the return difference to become statistically significant (and still be negative).

Since the fund had a considerable portion of its assets in foreign equities, IXJ could also be a relevant CAPM reference:

CAPM for Vanguard Health Care Fund Investor Shares (VGHCX) and iShares Global Healthcare ETF (IXJ)

In this case, the alpha intercept was large and statistically significant, although the R-squared was slightly lower. Similarly, the average return difference was a positive 0.35% and was statistically significant, requiring only 3.1 years to become so (statistics not shown here for brevity). This underscores that the choice of an appropriate reference security is critical because the CAPM regression uses only a single explanatory variable.

To try the new CAPM service, please register on our website.

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Analysis of Vanguard Health Care Fund
analysis, mutual fund

Today’s profile in Barron’s features the Vanguard Health Care Fund (VGHCX, Investor shares; VGHAX, Admiral shares). This actively-managed $52.7 billion sector fund has a very competitive 0.34% expense ratio and a relatively low 20% turnover. According to the article, the founding long-term manager of the fund taught the current manager well, and

That foundation has helped [her] guide the fund to a 30.8% average annual return over the three years ended on July 29—6.4 percentage points better than the category benchmark, the MSCI All Country World Health Care index.

Given a 4.5-year overlap between the two managers, the remainder of this analysis will focus on the entire tenure of the current manager, i.e. a period starting in June 2008 (the first full month on board).

The prospectus benchmark for the fund is the MSCI ACWI Health Care Index. There are currently no ETFs that track this index; the closest approximation is the iShares Global Healthcare ETF (IXJ). Alpholio™’s calculations show that the fund returned more than the ETF in about 80% of all rolling 12-month periods, 82% of 24-month periods, and 96% of 36-month periods. Given that the fund has a majority of its holdings in U.S. equities, a domestic health care sector ETF may be considered as an alternative reference. When the iShares U.S. Healthcare ETF (IYH) is used for that purpose, these figures are 62%, 68% and 48%, respectively. However, in either case a single ETF does not adequately adjust for the fund’s risk.

In the simplest variant of Alpholio™’s patented methodology, a custom portfolio of ETFs with fixed membership and weights is constructed as an alternative to the analyzed fund. For the Vanguard Health Care fund in the above analysis period, such a portfolio had top-four positions in the Health Care Select Sector SPDR® Fund (XLV; constant weight of 37.2%), iShares Global Healthcare ETF (IXJ; 20.4%), Guggenheim S&P 500 Equal Weight Health Care ETF (RYH; 17.2%), and iShares U.S. Pharmaceuticals ETF (IHE; 9.5%). At about 13.6%, the fund’s standard deviation (a measure of volatility of returns) was only 0.2% higher than that of the reference portfolio. The fund produced about 2.5% of annualized RealAlpha™ and had a RealBeta™ of 0.66.

In a more elaborate approach, Alpholio™ builds a dynamic portfolio of ETFs with fixed membership but variable weights. Here is a resulting chart of the cumulative RealAlpha™ for the fund:

Cumulative RealAlpha™ for Vanguard Health Care Fund (VGHCX)

On a risk-adjusted basis, the fund added almost all of its value only in the last two and a half years. Over the entire seven-year period, the annualized standard deviation was 13.6% compared to 12.9% for the reference portfolio. The annualized regular RealAlpha™ was 3.25% and the lag RealAlpha™ 4.16% (to learn more about RealAlpha™, please visit our FAQ). The RealBeta™ was 0.636.

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

Reference Weights for Vanguard Health Care Fund (VGHCX)

The fund had only six equivalent positions: in the Vanguard Health Care ETF (VHT; average weight of 54.4%), iShares Global Healthcare ETF (IXJ; 28%), iShares 7-10 Year Treasury Bond ETF (IEF; 7.6%; representing the fixed-income holdings), iShares MSCI Japan ETF (EWJ; 5.7%), Vanguard Utilities ETF (VPU; 2.3%; also representing fixed-income investments), and iShares North American Tech-Software ETF (IGV; 2%; helping explain the remainder of the fund’s returns).

Under current management, the Vanguard Health Care fund had impressive risk-adjusted returns. However, most of the value was added only in the most recent one-third of the seven-year analysis period. The fund’s comparatively low expense ratio can be reduced even further to 0.29% by investing in the Admiral shares. The fund is characterized by a relatively low volatility of returns and held up well in the last major market downturn in 2008. The fund’s significant distributions, even though mostly in the form of long-term capital gains, make it more suitable for non-taxable accounts.

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

Disclaimer: Due to a multitude of random factors, perfect prediction of performance of an investment vehicle is nearly impossible. Therefore, the above analysis should be treated as merely one of the many inputs to an investment decision, and not as a definitive recommendation to buy or sell any securities. While Alpholio™ strives to provide original and useful insights into fund and portfolio performance, the ultimate investment decision belongs to you, the investor.

For a detailed explanation of Alpholio™’s patented analysis methodology, please refer to the FAQ.

© 2015 Envarix Systems Inc. All Rights Reserved.

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