Battle of the Market Timers
active management

A recent article in The Wall Street Journal explores a hypothetical market-timing performance of various investment newsletters.

To eliminate the effect of individual stock picks, equity positions in each newsletter’s portfolio were virtually substituted with the Vanguard Total Stock Market ETF (ticker VTI) in the the same dollar amount. In periods when the newsletter eliminated equity positions in the portfolio, VTI would be replaced with a typical money market fund. Then the returns and volatility of the virtual portfolio would be compared to those of a fixed portfolio of 100% VTI. Using this methodology, one of the top newsletters would generate almost twice the return with one-third less volatility of VTI in the five-year period through May 2013.

Unfortunately, such market timing does not generate RealAlpha™. The article underscores that

“It also is worth noting that the best-performing timers primarily focus on market trends of several months’ duration or longer, not trying to profit from shorter-term market gyrations.”

As discussed in the FAQ, this is a classic situation where one fixed benchmark, or even a combination of two fixed benchmarks, is not appropriate. In this case, a fixed 100% VTI benchmark is not applicable to prolonged (multiple-month) periods in which the hypothetical portfolio was invested in a money market fund with practically zero volatility.

A benchmark composed of VTI and a reference money market in fixed proportions in the entire evaluation period is better in that it attempts to match the overall risk of the hypothetical portfolio. For example, if over a five-year period the portfolio held VTI roughly two-thirds of the time and a money market one-third of the time, then a composite benchmark with such weights might be used. (Incidentally, this is similar to devising a proper benchmark for target date funds that consist of multiple types of assets, whose weights change over time.) However, this fixed dual-asset benchmark is also imperfect — at any given time, one part of that benchmark is not applicable to what the “binary” portfolio holds.

In the Alpholio™ approach, the benchmark would dynamically adapt to the holdings of the analyzed portfolio in each multiple-month sub-period. This is necessary for a true risk adjustment of the portfolio. Unfortunately, this would also result in little to no credit given for market timing.

Finally, the article only covers a five-year period starting right after the trough of the recent major downturn, i.e. a rebound portion of the market cycle. A longer period encompassing the entire cycle should have been used to assess market timing strategies.

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Overpaying for Money Management
active management

A recent article on MarketWatch refers to the op-ed in The Wall Street Journal to make a point about the hidden cost of money management. While the op-ed promotes index-fund over actively-managed mutual fund investing, the article correctly states that even in the latter most investors overpay for financial advice which typically costs about 1% on top of the expense ratios of passive vehicles.

However, the article then makes a mistake that is common in the financial press: it tries to directly compare the returns of one sample mutual fund (Alger Capital Appreciation, ticker ALVOX) to that of a single index (S&P 500® represented by the Vanguard 500 Index Fund, ticker VFINX) to make a statement about fund performance.

According to Alpholio™ calculations, since early 2005 the annualized standard deviation of returns of these funds was as follows:

Fund Volatility
ALVOX 18.25%
VFINX 15.61%

As can be seen, the volatility of ALVOX was about 16.9% higher than that of VFINX in this analysis period.

In addition, Morningstar currently provides the following standard deviations and categories of these funds:

Fund 3-Year SD 5-Year SD 10-Year SD 15-Year SD Category
ALVOX 16.07 20.84 17.43 21.67 US OE Large Growth
VFINX 14.02 18.84 14.56 16.17 US OE Large Blend

Again, the volatility of ALVOX was anywhere from 10.6% to 34.0% higher than that of VFINX in the respective analysis periods, which is also supported by the different classification of these funds. Therefore, comparing ALVOX to VFINX is highly misleading.

Both the article and op-ed seem to justify management fees if the financial planner “adds value” by adjusting asset allocation, i.e. periodically modifies the weights of index vehicles in the portfolio. In Alpholio™’s view, this type of adjustment does not add any RealAlpha™ because it only changes the risk profile of the portfolio, as reflected by its RealBeta™. A reference portfolio of exchange-traded products (ETPs) calculated by Alpholio™ will simply catch up to any such changes to match the risk of the managed portfolio. For a detailed description of the Alpholio™ methodology, please refer to the FAQ.

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Yacktman vs. Yacktman
analysis, mutual fund

A recent article from Morningstar compares two sibling funds, Yacktman Focused (YAFFX) and Yacktman (YACKX). The thesis of the article is that:

“… the former’s unnecessarily high expenses dim its appeal relative to its cheaper sibling.”

The article goes on to say that:

“Since its 1997 inception, Focused has an R-squared, a measure of correlation, of 95.2 relative to Yacktman. Granted, Focused’s gross return since its 1997 inception edges Yacktman’s, an encouraging sign that management’s greater conviction has led to better results. But any incremental outperformance gross of fees has been more than absorbed by the fund’s higher expenses. Focused’s 9.65% annualized return net of fees during that same stretch trails Yacktman’s 9.87%. Based on how they’re investing their own money, though, the management team of Don Yacktman, Stephen Yacktman, and Jason Subotky believes Focused will ultimately trump Yacktman. None of them invests a dime in the Yacktman fund, but all three maintain positions of more than $1 million in Focused.

…and, rightly so! Here are the Alpholio™ statistics for both funds from February 2005 through March 2013:

YAFFX Statistics

YACKX Statistics

This analysis takes into account only the after-fee returns of both funds and their respective reference portfolios. Clearly, YAFFX performance on a truly risk-adjusted basis has been superior to that of YACKX: The discounted cumulative RealAlpha™ figures speak for themselves. In addition, the volatility of YAFFX was only slightly higher than that of YACKX. The managers are right by voting with their own money in favor of the former fund.

This is further corroborated by the trailing Sharpe Ratios for both funds calculated by… Morningstar itself:

Fund Ticker 3-Year 5-Year 10-Year 15-Year
Yacktman Focused YAFFX 1.08 0.74 0.69 0.42
Yacktman YACKX 1.05 0.72 0.69 0.46

In the 3-, 5- and 10-year periods to present, the Sharpe Ratio of YAFFX was greater or equal to that of YACKX. The latter fund had a higher Sharpe Ratio only in the 15-year period, which indicates that any advantage of risk-adjusted performance it had over the former fund was confined to the 5-year period that ended 10 years ago. So much for a superficial observation that YACKX had a higher net return than YAFFX since the 1997 inception. Yacktman Focused’s markup is not “needless,” it is actually warranted by its risk-adjusted performance in the last 10 years, even if such an adjustment is made with a relatively crude measure of the Sharpe Ratio.

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