Winner Again, But for How Long?
mutual fund

An article in The Wall Street Journal recaps the results of the quarterly Winners’ Circle, a ranking of mutual funds according to their returns in the most recent 12 months.

The Winners’ Circle contest looks at diversified U.S.-stock mutual funds with more than $50 million in assets and at least a three-year record, based on preliminary data from Morningstar. It excludes index funds, leveraged index funds and inverse leveraged index funds.

For the fourth quarter in a row, the winner is Legg Mason Opportunity Trust (LMOPX, class C shares):

Legg Mason Opportunity returned 63.25% over the 12 months through September, according to Morningstar Inc. Nine stocks of about 60 in the $1.4 billion portfolio doubled in the past year, its managers calculate, while fewer than 1% of companies in the S&P 500 did so.

As a follow-up to a previous post, let’s again take a closer look at this fund from the Alpholio™ perspective. Here is an updated cumulative RealAlpha™ chart for the fund:

Cumulative RealAlpha™ for LMOPX

As the chart indicates, in the 12 months through August 2013 the cumulative RealAlpha™ for the fund was relatively flat. How is that possible, given that the fund had such a stellar return in that period?

The chart shows the cumulative RealAlpha™ since early 2005. The fund severely underperformed in 2008 (return of -65.5%) and 2011 (-34.9%), so despite its recent rebound and other years of outstanding returns, it has not yet started to generate a substantial RealAlpha™ on a cumulative basis. In other words, the penalty of poor past performance is factored into the cumulative RealAlpha™, similarly to how investment returns, both positive and negative, are compounded over time.

Although it is tempting to focus on short-term returns, Alpholio™ takes a longer view of the fund’s performance. As Bill Miller, the manager of the fund, states:

“there is no money manager that never has had a bad period.” He says “a streak creates a set of expectations that don’t make any sense and that it’s hard to live up to. If it’s positive, people are likely to end up disappointed.”

Consistent, long-term excess returns on a truly risk-adjusted basis are key to adding value for the fund’s investors.

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How Long Will This Comeback Last?
analysis, mutual fund

A couple of recent articles from The Wall Street Journal and MarketWatch declare a comeback of Bill Miller as a co-manager of the Legg Mason Opportunity Trust fund.

According to the first article

“For the third straight quarter, Legg Mason Opportunity Trust finished first in The Wall Street Journal’s ranking of diversified U.S.-stock mutual funds with more than $50 million in assets and at least a three-year record.”

This performance is attributed to the fund’s investment in stocks such as BestBuy, Netflix and Groupon. The second article gives a bit more of historical background of the fund:

“Legg Mason Opportunity was in the bottom 10% of its Morningstar peer group in 2007, 2008 and 2010, before finishing dead last in 2011. In 2012, it was up nearly 40%, ranking in the top 2% of large-cap value category; that was good, but it could be looked at as an anomaly because Miller had managed one good year (2009) amid his miseries. But the fund has gained nearly 40% again already this year, putting Miller close enough to the top that investors are thinking this hot streak might be the start of something big.

To put the fund’s performance in perspective, let’s take a look at the results of the Alpholio™ analysis of class C shares:

Cumulative RealAlpha™ for LMOPX

As the chart shows, the general trend of the fund’s cumulative RealAlpha™ in the past eight years has been downward, resulting in an aggregate alpha loss of about 75%. A pattern emerges: after each of the 2005-07 and 2009-11 plateau periods, RealAlpha™ decreased further. If history is any guide, the most recent period of relatively flat RealAlpha™ performance from the beginning of 2012 till present might be followed by another slide.

Alpholio statistics for the fund clearly demonstrate the amount of value the fund destroyed on a truly risk-adjusted basis:

LMOPX Statistics

Of note here is also the high volatility of the fund’s monthly returns, which approached almost 30%, or approx. twice that of the S&P 500® index, in the analysis period. Fund’s returns did not justify this elevated volatility, as its Sharpe Ratio was about half that of the index, according to Morningstar’s figures.

Moreover, while Morningstar currently classifies the fund in the US OE Mid-Cap Value category, its two equivalent exchange-traded product (ETP) positions with the highest weights are currently Vanguard Small-Cap Growth ETF (VBK, 57.3%) and Vanguard Financials ETF (VFH, 40.5%). The latter is a reflection of the 36.1% of holdings in financials as of March 31, 2013 stated in the latest quarterly report. At 27.7%, the second biggest subset of the fund’s holdings was in consumer discretionary sector, followed by 13.2% in information technology.

While investors might be tempted to draw conclusions only from the most recent performance, they should instead look at the longer-term record of the fund, which is not as encouraging.

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Analysis of Legg Mason Capital Management Value Trust
analysis, mutual fund

Legg Mason Capital Management Value Trust (ticker symbol LMVTX) is a mutual fund with approx. $2.3 billion in assets managed by Mary Chris Gay and Sam Peters. Currently, Morningstar rates the fund One Star / Neutral in the Large Blend category. The last Morningstar report on the fund, titled “The fund continues to struggle under new management.” was published in November 2012. The reason for this title is the departure of the longtime manager of the fund, Bill Miller, in April 2012. Let’s assess the fund’s performance using the Alpholio™ methodology.

First, the total return chart, which includes a reinvestment of all distributions into the fund and each member of the reference portfolio, respectively:

Cumulative Return of LMVTX and Reference Portfolio

The chart shows that the fund’ performance was significantly below that of its reference portfolio for the vast majority of the analysis period that began in early 2005.

This is further illustrated by the cumulative RealAlpha™ chart:

Cumulative RealAlpha™ for LMVTX

The chart clearly demonstrates the long-term negative trend in the cumulative RealAlpha™ of the fund. By the beginning of 2013, an investor who bought the fund at the beginning of 2005 and held to his/her investment would realize over 50% of loss compared to the reference portfolio. Please note that the fund underperformed the reference portfolio even in 2005, which was the last year of its 15-year streak of beating the S&P 500 index.

The overall statistics further highlight the dismal performance of the fund:

LMVTX Statistics

At over 20%, the fund’s volatility, measured by an annualized standard deviation of monthly returns in the entire analysis period, was high compared to that of the overall stock market. The volatility of the reference portfolio was lower than that of the fund. The overall discounted annualized RealAlpha™ figure was highly negative, which underscores that, compared to the reference portfolio, the fund destroyed a lot of value for its shareholders.

The following chart demonstrates the use of smoothed RealAlpha™ to automatically generate a hypothetical trading signal for the fund:

Buy-Sell Signal for LMVTX

The analysis starts with an assumption that the investor initially bought the fund in early 2005 and intended to hold this investment indefinitely, i.e. at least through early 2013. The blue curve depicts the cumulative RealAlpha™ in that entire period. Since there is some degree of high-frequency oscillation in that curve, its longer-term trend can be elicited from a smoothed approximation, depicted by the green curve. Subsequently, a simple decision criterion is applied to determine whether the investment in the fund should be retained. As long as the fund generates positive monthly increments to cumulative RealAlpha™, the investment in the fund is considered beneficial. Conversely, if the fund’s cumulative RealAlpha™ begins to consistently decrease, the investment is no longer considered attractive.

The signal would allow an investor to avoid a long period of the fund’s underperformance, interrupted only by a brief period of recovery in 2009.

The following chart shows the major investment “themes” of the fund over time:

Reference Weights for LMVTX

In the analysis period, the fund held equivalent equity positions in VFH (Vanguard Financials ETF; average weight of 21.4%), VCR (Vanguard Consumer Discretionary ETF; average weight of 19.3%), VHT (Vanguard Health Care ETF; 16.2%), MTK (SPDR® Morgan Stanley Technology ETF; 13%), IXN (iShares Global Technology ETF; 9.1%), and JKG (iShares Morningstar Mid-Cap ETF; 7.4%).

For clarity, smaller reference positions are collectively represented by the Other category in the chart. For example, this category includes an equivalent position in IXG (iShares Global Financials ETF; average weight of 7.1%).

Given the disastrous performance of the fund relative to its reference portfolio in the past eight years, the current expense ratio of 1.80% for class C shares, coupled with the 0.95% rear load, certainly do not add to the fund’s appeal.

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