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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Following Leaders and Laggards
active management, analysis, mutual fund, performance persistence

An article in The Wall Street Journal provides evidence that following both the recent leaders and laggards results in inferior investment performance:

WSJ - Following the Leader

According to these figures, after 20 years investors following the portfolio of the previous year’s top-performing newsletter would end up with only 2.4% of their original investment. Those following the portfolio of the previous year’s worst-performing newsletter would finish with virtually nothing. In contrast, investors in a broad market index would realize a return of over 460% in the same period.

These findings are similar to those of the recurring SPIVA reports, discussed in a previous Alpholio™ post. Mutual funds in the top half of quartile of the population are more likely to revert to the mean than could be expected by chance. On the other hand, funds in the bottom quartile are more likely to continue to underperform, and eventually end up being liquidated or merged with other funds.

The article indicates that merely focusing on lower-risk investment strategies is insufficient. Instead, the investor should extend the observation period:

You would do much better to focus on performance over far longer periods than the past 12 months. That is because, when picking an adviser based on his track record, you implicitly are betting that the future will be just like the period over which that record was produced.

While there is no magical track-record length on which you should always focus, 15 years is a good rule of thumb. The past 15 years—from the beginning of 1999 through the end of last year—encompass two powerful bull markets as well as two punishing bear markets.

As an example of a suitable mutual fund, the article offers the Turner Emerging Growth Fund (TMCGX, investor shares) with the highest annualized return among diversified U.S. equity funds in that long time span. Let’s take a closer look at that fund’s performance.

First, data from Morningstar show that the fund’s 15-year annualized return of about 17.6% was significantly higher than the 10-year return of about 10.6%. This indicates that the fund may have outperformed early on since its inception in late February 1998. Indeed, in the first couple of years the fund generated a return of over 355%, no doubt riding the wave of appreciation of small-cap stocks caused by the Internet boom. While this performance could in theory be repeated, it seems unlikely.

In the next three years through February 2003, the fund generated a cumulative loss of only 21% compared to about 52% of an average small-growth peer. This was another contribution to the high annualized 15-year return. However, the fund failed to beat the iShares Russell 2000 Growth ETF (IWO), a practical implementation of its prospectus benchmark, in four out of six most recent years. This is further illustrated by the fund’s performance relative to its reference portfolio of ETFs since early 2005:

Cumulative RealAlpha™ for TMCGX

The chart shows that all of the cumulative RealAlpha™ the fund generated through mid-2008 was subsequently lost. The fund strongly rebounded only in the second half of 2013. Moreover, the reference portfolio had a lower volatility than that of the fund.

The next chart depicts ETF membership and weight changes in the reference portfolio over the same analysis period:

Reference Weights for TMCGX

The fund could have effectively been emulated by a collection of four ETFs: iShares Russell 2000 Growth (IWO; average weight 63.8%), iShares Morningstar Mid-Cap Growth (JKH; 25.4%), Vanguard Energy (VDE; 7.7%), and iShares 20+ Year Treasury Bond (TLT; 3.1%). Over time, the equivalent position in IWO became even more dominant, which implies that the fund’s characteristics were getting closer to those of its benchmark.

Only time will tell if the fund is able to outperform its reference portfolio on a consistent basis. There is no guarantee that the spectacular performance of early years will be repeated or even that the fund will be in existence in the next 15 years. In addition, as the above charts demonstrated, investor’s returns depend heavily on the timing on the initial investment. Therefore, while following the laggards is certainly not a fruitful endeavor, blindly following the leaders, even those with a long-term record, is not advisable either.

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Lack of Performance Persistence Matters in the Long Run
analysis, mutual fund, performance persistence

The December edition of the semi-annual S&P Persistence Scorecard brings better news than the July report — performance persistence of top mutual funds has slightly improved. However, percentages of domestic equity funds remaining in the top half of population for three or five consecutive 12-month periods were generally lower than those expected by mere chance.

Period Ending Top Half Expected
3 Years Mar-13 18.36% 25%
3 Years Sep-13 22.38% 25%
5 Years Mar-13 3.59% 6.25%
5 Years Sep-13 6.47% 6.25%

Only 7.23% of all funds remained in the top quartile for three years and 2.11% for five years to September. While this beat random expectations of 6.25% and 0.39%, respectively, figures for the same periods ending in March were 4.69% and 0.18%.

In this context, an InvestmentNews article says that

S&P’s findings reinforce the idea that short-term performance chasing in mutual funds is likely to end badly for advisers, but for long-term investors, the lack of persistence doesn’t necessarily mean a bad outcome, provided you can stomach the volatility.

The article gives an example of this year’s top-performing large-cap blend fund, the MFS® Equity Opportunities Fund (SRFAX; Class A shares), which beat 90% of its peers and the S&P 500® index by annualized 2% in the trailing five years, despite a rocky performance:

The fund’s journey to five years of outperformance wasn’t smooth though. In 2009 it ranked in the bottom 10th percentile of large-cap blend funds and in 2011 it ranked in the bottom half of its category.

The article concludes that:

So if you can handle a fund that dips every now and again, without a big change to the investment process or management, the lack of persistence shouldn’t matter over the long run.

This example, however, forgoes important details. First, although Morningstar classifies the fund in the large-blend category, the prospectus benchmark for the fund is the Russell 1000® index. Unlike the S&P 500®, that benchmark includes medium-capitalization equities. As of this writing, the annualized five-year return of the fund was 19.09% vs. 18.41% of the iShares Russell 1000 (IWB), a difference of only 0.68%.

Second, compared to its stated benchmark the fund’s holdings are tilted toward mid- and small-cap stocks (collectively, about 46%) at the expense of giant-cap ones. This, again, indicates, that a pure large-cap index is an inappropriate reference.

Third, let’s use Alpholio™ tools to further peek under the fund’s hood. Here is a chart of weights of exchange-traded funds (ETF) in the reference portfolio for the fund:

Reference Weights for SRFAX

The fund had top-four equivalent positions in the iShares S&P 500 Growth ETF (IVW; average weight of 23.8%), iShares S&P Mid-Cap 400 Growth ETF (IJK; 23%), PowerShares Dynamic Market Portfolio ETF (PWC; 21.2%), and iShares Morningstar Mid-Cap Growth ETF (JKH; 6.8%). This underscores the fund’s tilt toward not only mid-cap but also growth stocks.

Relative to the reference portfolio, the fund’s performance in the same analysis period was unimpressive:

Cumulative RealAlpha™ for SRFAX

The fund underperformed in 2009, so on a cumulative basis, its RealAlpha™ did not rebound until 2013. By this November, an investor who started with the fund in early 2005 would have not yet beat the reference ETF portfolio, as shown by the lag RealAlpha™ curve. In addition, the reference portfolio exhibited a lower volatility. (To get more information about this and other funds, please register on our website.)

The lack of performance persistence in mutual funds does matter in the long run and is more pronounced the longer the run is. In addition, as the above analysis demonstrated, relative performance heavily depends not only on the timeframe of the analysis, but also on the proper choice of the benchmark that fully adjusts for a fund’s risk.

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Searching for Consistent Outperformance
active management, mutual fund, performance persistence

Two studies from Vanguard underscore how difficult it is to identify actively-managed mutual funds that not only survive and but also consistently outperform their benchmarks.

The first study shows that the majority of funds across all asset classes failed to outperform their prospectus benchmarks over the past 15 years through 2012:

Vanguard - Funds Underperforming Prospectus Benchmark

The chart demonstrates that when assessing long-term performance, it is important to take into account liquidated and merged (“dead”) funds. Otherwise, statistics suffer from a “survivorship bias” that benefits funds still in existence. In addition, in most categories a median surviving fund exhibited a negative annualized excess return vs. the benchmark.

Statistics get worse when style benchmarks, assigned to fund categories, are used:

Vanguard - Funds Underperforming Style Benchmark

This is because many funds choose an inappropriate prospectus benchmark that does not reflect the fund’s actual investment style. In a majority of categories the survivors’ excess returns were even lower.

Finally, what are the chances that a fund ranked in the top quintile (20%) of U.S. actively-managed funds in terms of five-year returns through 2007 persisted in the same quintile in the next five years? About 15%, which is less than the 20% expected by chance:

Vanguard - Persistence of Ranking in Actively-Managed US Funds

As a matter of fact, about a quarter of such funds wound up in the lowest quintile, and about one-sixth disappeared altogether. Of all the funds available, only about 3% persisted in the top quintile in both five-year periods.

The second study shows that of the 1,540 U.S. domestic equity funds in the 15-year period through 2012, only about 18% survived and outperformed their respective style benchmarks:

Vanguard - Funds That Survived and Outperformed

However, almost all of these successful funds had five or more years of underperformance within the 15 years of analysis:

Vanguard - Periods of Successful Fund Underperformance

Moreover, about two-thirds of outperforming funds experienced at least three consecutive years of underperformance. In many cases, investors would have divested such funds and therefore not realize a full 15-year benefit.

All these findings underscore the need for a close monitoring of mutual fund performance. Outperforming funds are rare and do not persist in their winning streaks. Therefore, a dynamic analysis with a true adjustment for risk is required. Alpholio™ analyzes funds with a monthly frequency and provides buy-sell signals derived from the smoothed cumulative RealAlpha™ curves. These signals, among other inputs, can help investors make informed investment decisions. For more information about the Alpholio™ methodology, please visit our FAQ.

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Hedge Fund Stats
correlation, hedge fund

An article in Barron’s points out a disconnect between assets and returns of hedge funds:

As of Sept. 30, the industry managed a record $2.51 trillion in assets, according to the analysts at Hedge Fund Research. That’s also a huge recovery from the depths of the financial crisis, when the funds’ $1.87 trillion in assets fell by $400 billion.

The HFRI Fund Weighted Composite Index, which covers a wide range of strategies, was up only 5.5% from Jan. 1 to Sept. 30, while the S&P 500 rose 19.79%. The poor showing was no better than during the 10 years ended on Sept. 30, when the index, compiled by Hedge Fund Research, was up only 5.92% on an annualized basis.

Annualized returns for other periods to September 30 compiled by Hedge Fund Research (HFR) are also unimpressive:

Index 1-Year 3-Year 5-Year
HFRI Fund Weighted Composite Index 7.05% 3.85% 5.01%
HFRI Equity Hedge [EH] (Total) Index 11.08% 4.61% 5.22%
HFRI Event-Driven (Total) Index 12.32% 6.22% 6.85%
HFRI Macro (Total) Index -2.92% -0.60% 1.83%
HFRI Relative Value [RV] (Total) Index 7.18% 6.13% 7.70%
HFRI Emerging Markets (Total) Index 6.66% 0.22% 4.28%
HFRI Fund of Funds Composite Index 6.58% 2.50% 1.95%
HFRI EH: Short Bias Index [lowest] -17.06% -13.02% -12.79%
HFRI RV: Fixed Income-Asset Backed Index [highest] 10.19% 10.60% 12.01%

Not surprisingly, in the environment of low interest rates and modest economic recovery, the short-biased funds had the worst and the fixed income funds had the best performance in the past five years.

Meanwhile, the compensation of hedge fund personnel increased more in line with assets under management rather than performance. Per a Barron’s blog post, the 2014 Glocap Hedge Fund Compensation Report states the following figures:

A new study contends an entry-level analyst at a middling large hedge fund is taking home $353,000 this year. The figure, which includes salary and bonus, rises to $2.2 million for the average portfolio manager of a large fund. Overall, average compensation in the industry gained between 5% and 10% for the year.

This surely contributed to the huge increase in the number of hedge funds: from 2,392 in 1996 to 8,201 at present (567 more than before the financial crisis).

The influx of money into hedge funds is caused by institutional investors that, according to the 2013 Glocap Report, account for 77% of capital compared to only 12% contributed by high-net-worth individuals and family offices. The main reason is that after the financial crisis institutions want to minimize losses during market downturns, while sacrificing the upside during market rebounds (in 2008, the HFRI composite index fell 19.03%, while the S&P 500® lost 37.0%).

Also, hedge fund returns are supposed to exhibit low correlation with those of the market, which leads to improvement of return-to-risk characteristics of the investment portfolio. However, as the following chart from the HFR presentation to the US Dept. of Labor shows, historical correlation of the HFRI composite index to the S&P 500® has been quite high:

HFRI Correlation to S&P 500® (12-Month Rolling Window)

Furthermore, the correlation of the equity hedge fund index to the S&P 500® has been on the rise for a long time, which makes it very difficult for such funds to beat that benchmark:

Correlation of HFRI Equity Hedge Index with S&P 500&reg (Rolling 60 Months) Jan 1990 - Oct 2011

In sum, while some, especially smaller, hedge funds have attractive characteristics, performance of the overall industry leaves a lot to be desired.

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Funds Again Outperformed by Benchmarks
mutual fund

The semi-annual report from S&P Indices Versus Active (SPIVA®) once again demonstrates that the majority of mutual funds were outperformed by their benchmarks over the one-, three-, and five-year periods to June 30, 2013. Here are the statistics for the US equity funds

SPIVA® - Percentage of US Equity Funds Outperformed by Benchmarks

and global/international funds

SPIVA® - Percentage of International Equity Funds Outperformed by Benchmarks

The only category where active management prevailed was international small-cap.

The situation was similar in fixed income:

SPIVA® - Percentage of Fixed Income Funds Outperformed by Benchmarks

Over the five-year period, the investment-grade intermediate and, to a lesser extent, global income were the only two categories in which, on average, active management provided superior returns.

While valid, the above results paint only a partial picture of funds’ performance: the returns but not the risk. In contrast, Alpholio™, through its RealAlpha™ measure, clearly demonstrates how much value each fund added or subtracted on a truly risk-adjusted basis, i.e. with respect to a dynamic reference portfolio of exchange-traded products (ETPs).

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Capital Group Defends Active Management
active management, mutual fund

Capital Group (CG), the owner of American Funds, held a very rare meeting with the media, as reported by Bloomberg, Reuters and The Financial Times. What undoubtedly prompted the meeting:

The firm’s American Funds have lost $242 billion to withdrawals since the end of 2007, while Vanguard Group Inc., the largest index-fund provider, has attracted $607 billion, according to Morningstar Inc.

One way to counteract this shrinkage of AUM is to go on the offensive and promote an apparent dominance of active management over indexing. To that end:

Capital Group, based in Los Angeles, in a study released today, argued that its stock-picking mutual funds outperformed their benchmark indexes in the majority of almost 30,000 periods examined over the past 80 years. That included 57 percent of one-year stretches, 67 percent of 5-year periods and 83 percent of 20-year ranges.

The Capital Group study examined 17 of the company’s mutual funds that invest in equities or both equities and bonds. It measured their performance over every one-, three-, five-, 10-, 20- and 30-year period, on a rolling monthly basis, from Dec. 31, 1933, through Dec. 31, 2012.

Should investors care? Not really, because over such a long period of time, and especially in the last 15-20 years, the nature of investing has changed dramatically. There is more information available about both stocks and bonds, and this information is propagated with higher speed to a much broader investment audience, which makes markets more efficient and the job of an active manager more difficult. In addition, composite investment vehicles other than mutual funds — exchange-traded products (ETPs), tracking an ever-expanding spectrum of indices — have become readily available.

Finally, comparing just the returns of a mutual fund against those of its benchmark is largely meaningless because it does not fully adjust for the fund’s risk. Alpholio™’s methodology seeks to overcome this limitation by providing a dynamic, custom reference portfolio of ETPs for each analyzed mutual fund. Only the excess return of the fund over that of its reference portfolio, i.e. the RealAlpha™, counts.

According to the Bloomerg article:

Capital Group’s largest offering, the $123 billion Growth Fund of America, has seen its assets drop 31 percent in the five years ended Aug. 31. During that time the fund returned an annual average of 6.4 percent, compared with 7.3 percent for the S&P 500.

As an update to an earlier Alpholio™ post, here is how the risk-adjusted performance of this fund looked like since early 2005:

Cumulative RealAlpha™ for AGTHX

Despite a recent improvement, the fund’s performance in the last five years has been unimpressive. Small wonder many investors voted by withdrawing their assets.

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Doubling Returns in No Time
mutual fund

An article from MarketWatch points out that thanks to the financial crisis of late 2008, five-year annualized returns of mutual funds are about to roughly double, even if incremental returns through the end of 2013 are nil:

MarketWatch - What a Difference a Few Months Make

This will undoubtedly lead to a marketing promotion from fund companies and advisers touting the five-year “performance” of funds in absolute terms. Moreover, absent a major downturn, numbers will look even better in about six months from now, when the trailing five-year period starts at the market’s bottom in early 2009 (re: S&P 500®’s close at 676.53 on March 9 that year).

Investors focusing solely on fund returns in isolation of relevant benchmarks make a classic mistake. Luckily, Alpholio™ can help: not only does it provide a custom benchmark for each analyzed fund, but it also makes this reference portfolio dynamic, truly adjusting for an ever-changing risk taken on by the fund over the analysis period. Therefore, from Alpholio™’s perspective, the passage of fifth anniversary of the onset of the financial crisis is irrelevant.

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Betting on Manager’s Past Performance
mutual fund, performance persistence

A research paper from Gerstein Fisher echoes recurring findings from SPIVA® — there is very little persistence of performance in mutual funds, even highly-ranked ones:

Gerstein Fisher - Persistence of Top Quartile Fund Performance (or Lack Thereof)

Unlike the Performance Scorecard that uses consecutive one-year returns, the study focused on rolling three-year trailing returns in each fund category. This multi-year approach had a smoothing effect, so percentages of the top quartile persistence were higher than those found by SPIVA®. However, it is clear that after a few years, a very small percentage of funds remained in the top quartile.

Gerstein Fisher - Best to Worst and Worst to Best

As depicted above, the study also found that

…in the rolling 3-year periods between 2002 and 2012, the likelihood that a top performer would descend to the bottom quartile of returns turns out to be exactly the same (27%) [47% in the chart?], on average, as the chance that a “dog” of a fund ends up ascending to the top quartile in the following three years.

In short, statistically speaking, an investor would have been just as well off picking a professional manager with an abysmal record of returns as he would have been with a star manager.

So, what is an investor to do? Alpholio™ provides one possible recommendation: investigate a smoothed cumulative RealAlpha™ curve to determine whether the fund will continue to add value on a truly risk-adjusted basis. To learn more, please visit the FAQ and take a look at the analyses of sample mutual funds in this blog.

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Trust Goes Down, Fees Go Up
active management, financial adviser

InvestmentNews reports that an annual survey of retail investors by State Street found that only 15% (down from about 33% last year) of respondents trust financial advisers as a group. The key issues are: performance, unbiased and high-quality advice, and transparency. Apparently, investors…

…don’t believe the fees they’re paying are commensurate with the return on their investments.

Granted, the lack of trust is evidently coupled with a lack of understanding of the finance industry or a sufficient interest in investments. However, the chief issue of performance remains.

So, how to fix this problem? By increasing fees, of course. That is what Bank of America just did by planning to raise fees on its managed-account (flat-fee) platforms at Merrill Lynch.

The current minimum fee schedule for equities on the most popular Merrill Lynch Personal Advisor (MLPA) platform with $152B under management is:

Assets Under Annual Fee
$1M 1.00%
$2M 0.65%

The new rate schedule will be:

Assets Under Annual Fee
$250k 1.6%
$500k 1.4%
$1M 1.3%
$2M 1.0%

Therefore, MLPA clients will face fee increases of 54-60%. Over 14,000 ML advisers have to implement that change by the end of 2015; the only way to reduce the fee hike for clients will be to cut their own compensation. Naturally, ML advisers are worried. So should be the clients. Luckily, Alpholio™ can easily show these investors whether advisers earn their fees by generating a sufficient RealAlpha™ on the managed accounts.

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