Evaluating Lazy Portfolios
analysis, asset allocation, portfolio

MarketWatch tracks eight lazy portfolios. Each of these simple portfolios consists of three to eleven, low-cost, no-load index mutual funds from Vanguard®. The fund membership and weights in each portfolio remain constant over time. (In theory, this implies that each portfolio would have to be perfectly rebalanced daily. This is not only impractical but also impossible because the fund’s daily NAVs, and hence their new weights, are not known until after the market close.)

Unfortunately, MarketWatch compares lazy portfolios solely on the basis of annualized returns in one-, three-, five- and ten-year periods. Volatility of returns as well as other performance measures are not taken into account. Luckily, Alpholio™ can help – not only does our Basic Portfolio service provide ample statistics, but it also allows for a selectable periodic rebalancing of portfolio positions to their original weights. For the purpose of this analysis, let’s assume a 15-year evaluation period from July 2001 through June 2016, as well as quarterly rebalancing of each portfolio.

Let’s start with the most complex Aronson Family Taxable Portfolio that consists of 11 funds. The following chart shows the cumulative return and related statistics for this lazy portfolio:

Aronson Family Taxable Portfolio - Cumulative Return - 15 Years

The fixed-income portion of the portfolio comprises inflation-protected securities (15%), long-term Treasury bonds (10%) and high-yield corporate bonds (5%). The portfolio’s holdings also include domestic (40%) and foreign (30%) equities.

The alpha and beta of the portfolio were measured against the broad-based U.S. stock market ETF, and not just a large-cap index, such as the S&P 500®. Because high-yield bonds generally have a substantial correlation to equities, it could be expected that the portfolio’s beta would be approximately between 1 – (0.15 + 0.10 + 0.05) = 0.7 and 1 – (0.15 + 0.10) = 0.75, which it was at 0.73.

The key measures of risk-adjusted performance are the Sharpe and Sortino ratios. Unlike the former, the latter penalizes portfolios with a large downside deviation.

Finally, the maximum drawdown measure is the maximum percentage loss of the portfolio value from a peak to a subsequent trough. Given the chosen evaluation period, this typically means a decline in each lazy portfolio’s value from October 2007 to March 2009.

The following chart shows rolling volatility (measured as a standard deviation of two years of monthly returns) and accompanying statistics for the portfolio:

Aronson Family Taxable Portfolio - Rolling Volatility - 15 Years

As could be expected, volatility of the portfolio significantly increased during the financial crisis. In general, a good lazy portfolio should maximize returns, minimize volatility, and reduce the magnitude of volatility changes over time.

Similar charts and statistics can easily be generated for all lazy portfolios. They are not published in this post to limit its size. Instead, here is a summary table of statistics:

Portfolio Annualized
Return
Alpha Beta Sharpe
Ratio
Sortino
Ratio
Maximum
Drawdown
Aronson Family
Taxable
6.96% 0.22% 0.73 0.53 0.76 42.08%
Fundadvice
Ultimate
Buy & Hold
6.49% 0.22% 0.62 0.55 0.81 36.58%
Dr. Bernstein’s
Smart Money
6.12% 0.18% 0.65 0.51 0.75 38.00%
Coffeehouse 6.89% 0.25% 0.63 0.59 0.86 36.16%
Yale U’s
Unconventional
7.89% 0.31% 0.69 0.61 0.88 42.94%
Dr. Bernstein’s
No Brainer
6.12% 0.11% 0.83 0.43 0.63 44.48%
Margaritaville 5.86% 0.14% 0.71 0.45 0.65 41.29%
Second
Grader’s
Starter
5.92% 0.05% 0.94 0.39 0.56 49.08%

The Yale U’s Unconventional portfolio had the highest risk-adjusted returns, as measured by the above Sharpe and Sortino ratios. This was likely due to the relatively large positions in REITs and long-term government bonds, both of which benefited from falling interest rates. Please also note that at times, correlation between returns of the REIT and total stock market mutual funds was quite high (which reduced portfolio diversification), as illustrated by the following chart:

Rolling 36-Month Return Correlation between VGSIX and VTSMX

The Coffeehouse portfolio had similar characteristics. Compared to others, this portfolio also exhibited the smallest maximum drawdown.

The Fundadvice Ultimate Buy & Hold portfolio had the third best return-to-risk profile, as well as the second lowest maximum drawdown. While bond funds in this portfolio had short and intermediate maturities, its total fixed-income component was significant, as was the case with the previous two portfolios.

For completeness, here are the statistics for lazy portfolios over a ten-year period through June 2016:

Portfolio Annualized
Return
Alpha Beta Sharpe
Ratio
Sortino
Ratio
Maximum
Drawdown
Aronson Family
Taxable
5.94% 0.01% 0.75 0.46 0.65 42.08%
Fundadvice
Ultimate
Buy & Hold
5.06% 0.00% 0.65 0.43 0.62 36.58%
Dr. Bernstein’s
Smart Money
5.41% 0.01% 0.67 0.46 0.66 38.00%
Coffeehouse 6.33% 0.09% 0.66 0.54 0.78 36.16%
Yale U’s
Unconventional
6.85% 0.10% 0.74 0.52 0.73 42.94%
Dr. Bernstein’s
No Brainer
5.64% -0.06% 0.83 0.41 0.59 44.48%
Margaritaville 4.95% -0.05% 0.73 0.39 0.54 41.29%
Second
Grader’s
Starter
5.76% -0.10% 0.93 0.39 0.56 49.08%

Over this shorter evaluation period, the Coffeehouse portfolio had the best risk-adjusted returns, followed by the Yale U’s Unconventional portfolio, and Dr. Bernstein’s Smart Money portfolio that had a slightly higher Sortino ratio and a smaller maximum drawdown than the Aronson Family Taxable portfolio. This goes to show that the ranking of portfolios heavily depends on the analysis time frame.

We hope that this analysis will give investors additional insights into historical performance of lazy portfolios. Of course, there is no guarantee that this performance will be repeated in the future.


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Active vs. Passive in the Bogle Family
active management, analysis, mutual fund

An article in The Wall Street Journal contrasts passive and active stock investment strategies of the two members of the Bogle family. The father, John ‘Jack’ Bogle, practices the former approach

Jack Bogle is the founder of Vanguard Group and considered by many investors as the father of passive investing, or using funds that try to capture the return on an entire broad basket of securities, such as the S&P 500.

while the son, John Bogle Jr., prefers the latter one

The junior Mr. Bogle then started Bogle Investment Management LP, his current firm, in 1999. Like many active managers, he uses computer models to analyze earnings surprises, relative stock valuations, corporate accounting and the like.

Results have apparently been in favor of active management:

The flagship Bogle Small Cap Growth Fund was launched 14 years ago and has delivered an annualized return since then of 12.4%, compared with 8.6% for its benchmark index, the Russell 2000, according to Morningstar.

However, this statistic is misleading. As of the end of November 2013, the 10-year annualized return of the Bogle Small Cap Growth Fund (BOGLX) was 8.89%. The annualized return of the iShares Russell 2000 ETF (IWM), which follows the fund’s stated benchmark, was 9.01% in the same period. Moreover, the iShares Russell 2000 Growth ETF (IWO), implementing a benchmark more relevant to the fund, returned an annualized 9.19%.

The fund’s lifetime outperformance cited by the article is mostly due to the 1999-2000 period when small-cap growth stocks enjoyed a strong run-up during the technology market bubble. In its first year since inception on October 1, 1999, BOGLX returned about 69.9% compared to about 21% of the Russell 2000® index in the same period.

Let’s also take a look at the fund’s performance from the Alpholio™’s perspective. Here is a cumulative RealAlpha™ chart since early 2005:

Cumulative RealAlpha™ for BOGLX

The fund started to significantly underperform its reference portfolio of exchange-traded funds (ETFs) in mid-2007, well before the onset of the financial crisis. From mid-2008 to mid-2012, the fund’s cumulative RealAlpha™ was relatively flat. The fund began to outperform only about a year ago:

This year, John Bogle’s fund has generated total returns of 40%, through Tuesday, according to Morningstar, compared with 35% for the Russell 2000 and 34% for the similar Vanguard fund.

The following chart shows the percentage ETF weights in the fund’s reference portfolio over the same analysis period:

Reference Weights for BOGLX

Just three ETFs, iShares Russell 2000 Growth (IWO), Vanguard Small-Cap Growth (VBK), and iShares Morningstar Small-Cap (JKJ), collectively accounted for about 85% of the reference portfolio on average. This indicates that a substitution of the fund with a better-performing collection of alternative investments was relatively straightforward.

It looks like the elder Mr. Bogle was right after all — it is difficult for a stock picker to outperform on a truly risk-adjusted basis. To access more information on BOGLX, please register on our site.


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Is Index Investing Extinct?
active management, exchange-traded product

An article in Forbes laments a recent change of focus in ETF industry conferences from traditional “market-tracking” products to active investment strategies. By “market-tracking,” the author clearly means the classic market-cap weighted indexing that is prevalent in ETFs.

This brings up two questions. The first one: What really qualifies as active management? A one-time decision to invest in the entire stock market, such as through the Vanguard Total Stock Market ETF (VTI), is arguably an act of active management. So is a decision to split the investment portfolio between 60% VTI and 40% iShares Core Total U.S. Bond Market ETF (AGG). Likewise, a decision to adopt

“a fixed asset allocation to various asset classes based on an investor’s long-term needs.”

Periodic portfolio rebalancing to such a fixed allocation is also a form of active management, if not market timing, even if conducted on a fixed schedule. That is because one of its attributes is to “buy low, sell high,” i.e. lock in the gains in appreciated assets to cheaply purchase other assets in anticipation of a reversal to the mean.

Similarly, any modification of a “fixed” asset allocation in response to a change in the investor’s age or life circumstances also qualifies as active management.

Finally, it is worth noting that indices tracked by passive ETFs are also actively managed. Over time, the membership of securities in the index will change, and frequently so due to an arbitrary decision from a management committee rather than as a result of an explicit formula. A recent recomposition of the Dow Jones Industrial Average is one case in point. Another example is a recent switch of the Vanguard Emerging Markets ETF’s (VWO) underlying index from MSCI to FTSE, which caused all South Korean stocks to be removed from the fund.

Active management inevitably takes place at all stages of the investment process, even one based on passive instruments.

The second question that arises: Where is the ETF industry heading? The first wave of ETFs was about attaining economies of scale while implementing traditional market indices. It created a few dominant providers but resulted in a race to the bottom in management fees.

The second wave was about spreading horizontally to all niches of the market. Many of such exotic strategies failed to garner minimum assets of $50-100M that are typically required for an ETF to survive.

The third wave is about non-market-cap indexing, whether equal-weighted or fundamentally-weighted (“smart beta“). Such funds are a blasphemy to market-cap indexing purists who spend a lot of time poking holes in these strategies.

The next wave, pending regulatory approval of infrequent reporting of fund holdings, will be about active management. The ETF structure is attractive to actively-managed mutual fund vendors because it allows them to lower fees and survive the onslaught of cheap market-cap indexed ETFs.

All this makes traditional fee-based advisers nervous:

In the end, most advisers continue to do what’s in their clients’ best interest; they create a long-term asset allocation, buy low-cost index fund, and then stay the course!

The problem is that in many cases investors pay a recurring annual fee of anywhere from 0.2% to 1.5% of assets for a one-time setup of a portfolio pie-chart (frequently with small variations from the adviser’s “moderate” allocation template), followed by periodic rebalancing and reports. That enables a typical adviser to spend only about 11% of time on investment research, while devoting about 18% to client acquisition and prospecting, and 48% to client management.

In the end, the market will rightly decide what type of financial products survive and flourish. Marketing gimmicks aside, innovation in the ETF industry is a good thing because it gives investors more financial instruments to choose from at an ever-decreasing cost. Alpholio™ can use these new products to form reference ETF portfolios that better explain the performance of actively-managed mutual funds and arbitrary portfolios.

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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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