Rebalancing Act
asset allocation, foreign equity, market, mutual fund, valuation

As the end of the year approaches, the investment industry is gearing up for the annual portfolio rebalancing act. An article in InvestmentNews gives the following example:

Still, advisers’ plan to stick to their long-term asset allocation was likely thrown out of whack this year by the divergence of stocks and bonds. For example, a client who started the year with a simple 60/40 portfolio comprised of the $287 billion Vanguard Total Stock Market Fund (VTSMX) and the $247 billion Pimco Total Return Fund (PTTAX), the two largest mutual funds in the world, would now have 66.3% invested in stocks and just 33.7% invested in bonds, pushing beyond the typical 5% leeway most advisers give their asset allocation.

To illustrate the divergence from asset allocation historical averages, here is a chart from a Vanguard blog post:

Mutual Fund and ETF Assets under Management

While the collective allocation of mutual funds and ETFs to equities has recently reached 57%, the biggest divergence from the historical median is in international equities. Allocation to bonds is also relatively high, while the proportion in domestic equities is close to the 20-year median.

The higher allocations to international equities and bonds are at the expense of cash. Assets in money market funds are at a historical minimum of about 18% in the observation period. This has undoubtedly been caused by the low interest rate policy of the Fed, which depressed returns of such funds. The danger is that when interest rates eventually rise, bond prices will suffer:

So in an intermediate-term bond fund, with an average duration of four to five years, the loss would be about 4% to 5%.

This means that it may actually be prudent for an average investor to shorten the duration by moving a part of investment in bonds to money market funds.

Historically, the proportion of international equities in the total equity allocation has been about 19%; currently, it is about 27%. The argument for keeping it high is a relatively low valuation of foreign stocks compared to domestic ones:

Stock Valuation per Market Region

When rebalancing portfolios, it is also important that investors understand the true exposure of their mutual fund holdings to various asset classes. The recurring problem, which Alpholio™ addressed in several prior posts, is that managers in some equity funds (especially value strategies) hold a large percentage of assets in cash. As a result, asset allocation in the overall portfolio can be distorted unbeknownst to the investor.

Alpholio™ provides current information on the exposure of mutual funds to various asset classes. This information is not obtained from the regulatory filings or selective disclosures of fund holdings, which suffer from a number of problems.

In sum, when rebalancing a portfolio either on a fixed schedule or as a result of divergence from prior allocations, investors should take into account a broader market and interest rate context, rather than just follow rigid rules.

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Selective Disclosure of Holdings
mutual fund

A trio of MarketWatch articles lament a more frequent disclosure of mutual fund holdings to select institutional clients and business affiliates than to individual shareholders.

The first article states that

First and foremost, as a shareholder, you should recognize that a fund’s trading record is your intellectual property.

As a result, you most likely believe that the funds you own report their holdings—which easily can be reverse engineered to show transaction trends—every quarter, as required for nearly a decade now by the Securities and Exchange Commission. But many funds report their holdings more frequently than that, often giving their details—with active investment themes redacted—to data firms like Morningstar and Lipper on a monthly basis. The purported benefit to more-regular disclosures is that it helps research firms evaluate and categorize funds, which is good for shareholders.

The funds also typically give those updated portfolios to their top clients, pension funds and institutional money managers.

The problem is that data collecting firms resell this information

In describing a product called “full holdings data for institutional investors,” for example, Morningstar documents say the research “provides the most up-to-date portfolios available and makes waiting for SEC filings from EDGAR [the commission’s online document depository] unnecessary.”

although the second article indicates that this particular product has received little interest from hedge funds. While there is no evidence of “front running” individual fund trades based on that information, knowledge of collective trends in funds is apparently valuable:

In short, if you can tell where managers, on the aggregate, are going, you can ride the crest of the waves they create.

The second article gives an example of American Funds having recently broadened the scope of additional disclosures:

Under the disclosure rules, the firm releases its portfolio quarterly, but then makes more frequent and regular disclosures to the fund’s “custodian, outside counsel, auditor, financial printers, proxy voting service providers, pricing information vendors, co-litigants (such as in connection with a bankruptcy proceeding related to a fund holding) and certain other third parties … each of which requires portfolio holdings information for legitimate business and fund oversight purposes.”

More than half of all mutual funds disclose their holdings more frequently than required by the SEC. (To be precise, at a minimum the disclosure has to be made within 60 days from the end of the first and third quarter in the fiscal year of a fund.) In fairness, some funds publicly post such information on their websites, which also benefits individual investors. On the other hand, firms like AthenaInvest™ mine funds’ data to run a family of Global Tactical ETFs.

The third article realizes that allowing funds to only make quarterly disclosures or forcing them to make monthly disclosures is not practical. Hence, a compromise solution:

If funds exercise the option to disclose their holdings more often than required, they should be required to give that extra information candy to everyone, or to no one at all.

Any such regulatory change, if undertaken at all, will undoubtedly take time. Meanwhile, Alpholio™ can help level the playing field for underprivileged investors.

Even a more frequent (monthly) disclosure of holdings suffers from a number of problems, which we outlined in one of the previous posts. This is especially true for funds with high turnover ratios, in which portfolio composition changes rapidly. While not showing individual securities, the Alpholio™ analysis demonstrates an effective exposure of each fund to major investment factors modeled by exchange-traded products (ETPs).

The analysis is updated monthly with a significantly shorter lag than that of the regulatory disclosure. The results of the analysis are much more comprehensible than a long listing of individual holdings. They are also less susceptible to portfolio manipulation at the end of the reporting period.

Finally, Alpholio™ also helps investors to easily navigate the actual regulatory disclosures of fund holdings published on EDGAR. To access this information, all a subscriber has to do is to select the fund by its ticker or name, click View Filings, and click Quarterly Schedule of Portfolio Holdings. For convenience, the list of all N-Q filings is arranged in reverse chronological order.

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What’s in Your Wallet? (Part II)
analysis, mutual fund

Building upon the previous post, here are more indications of how some mutual fund managers attempt substantial market timing, of which investors may not be aware.

A recent article from The Wall Street Journal describes several funds with large cash positions. One of these funds, FPA Capital, was a topic of Alpholio™ analysis published in a prior post. According to the article, the fund held 33% in cash at some date from year-end 2012 to March 31, 2013. Indeed, the fund reported 32.9% in cash and equivalents as of the latter date.

An investor could reasonably expect that a fund with the following investment objective and strategy would be almost solely invested in equities rather than cash:

“The Fund’s primary investment objective is long-term growth of capital. Current income is a secondary consideration. FPA Capital Fund seeks to fulfill this objective through investing primarily in small and medium-sized public companies.”

The Alpholio™ analysis clearly demonstrated that at times the fund’s equivalent cash position was as high as 52%, and that such market timing efforts did not result in generation of any meaningful RealAlpha™ in the analysis period. Caveat emptor!

© 2013 Envarix Systems Inc. All Rights Reserved.

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What’s in Your Wallet?
analysis, mutual fund

…or, to paraphrase the slogan from Capital One’s credit card commercial, what’s in your portfolio? This important question came up in the context of a recent Wall Street Journal article, which stated that:

The number of bond funds that own stocks has surged to its highest point in at least 18 years, another sign that typically conservative investors are taking bigger risks to boost returns.

In particular, the article mentioned the Loomis Sayles Strategic Income mutual fund (ticker NEFZX, Class A shares) that lately increased common and preferred stock holdings to 19% of its portfolio. Per the prospectus, the stock allocation in this fund can be as high as 35%. Is that what an average investor would reasonably expect? Is monitoring stock allocation in quarterly filings sufficient? Certainly not.

According to the Alpholio™ analysis, at the end of March 2013, the fund’s equivalent positions in equity exchange-traded products (ETPs) totaled over 40% (in part, this reflects the fact that the fund can invest in convertibles and foreign debt):

Reference Weights for NEFZX

The fund had a significant exposure to the healthcare sector (VHT, Vanguard Health Care ETF, weight of 10%), technology sector (MTK, SPDR® Morgan Stanley Technology ETF, 5.6%), and gold miners (GLD, SPDR® Gold Shares, 4.1%).

A recent Morningstar analyst report on the fund stated that

“Since mid-2011, the team has grown increasingly concerned about the potential for rising rates and the limited opportunity for upside in most fixed-income investments. That’s led it to take increasing advantage of the fund’s broad flexibility to invest up to 35% of the portfolio in stocks… This portfolio’s flexibility may hold appeal for those who share the team’s concerns about bond valuations. However, the fund’s large equity stake adds risk to the portfolio, which, with large positions in high-yield (20%) and non-U.S. dollar denominated bonds (30%), is already one of the multisector category’s most volatile.”

Alpholio™ provides a month-by-month or even more frequent insight into the equivalent ETP holdings of mutual funds. Investors can take advantage of this information to determine a true exposure of their portfolios to various types of securities.


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Mutual Fund Holdings
active management, mutual fund

A recent article from MarketWatch describes how many mutual funds were recently burned by large stakes in the Apple Inc. stock and by exposure to gold. The article correctly states that

“The issue for investors is that they buy funds based on past performance, without regard for how those numbers were achieved. One way funds top the performance charts is by taking additional risks, concentrating a portfolio or going hard into the hot asset; investors enter when the fund is on a hot streak, and then are disappointed when the market turns and the strategy falters.”

The article proposes the following solution:

“In the end, investors should look at their quarterly statements and see the reasons behind their disappointment. If the cause can be isolated as too much exposure to any stock or asset class, that’s a sign that it’s time to look for better balance from the funds in a portfolio.”

Unfortunately, there are multiple problems with trying to determine a fund’s exposure from its statements:

  1. Filings are infrequent (quarterly).
  2. Statements contain point-in-time snapshots of the fund’s portfolio, so an investor really has no idea how the portfolio evolved over the course of the quarter.
  3. The snapshot is subject to manipulation, such as “window dressing.”
  4. The snapshot is available with a substantial lag of several weeks from the end of the quarter; by the time the investor reviews the statement, the fund’s portfolio is likely completely different.

Alpholio™ solves this problem by providing an up-to-date analysis of the fund, which clearly shows all equivalent positions in exchange-traded products (ETPs). Our service gives the investor an ability to see exactly the risks the fund manager is taking and the concentrated bets he/she is making well in advance of the quarterly statement. This will be clearly demonstrated in an upcoming post on exposure of one well-known mutual fund to gold as a major factor.

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