Stockpicker’s Delight
active management, active share, analysis, correlation, mutual fund

A recent piece in Barron’s proposes an investment into seven actively-managed mutual funds. This recommendation is motivated by the following observation:

A long, humiliating period for professional stockpickers might be giving way to something different. Stocks that have moved in near unison in recent years are beginning to chart more distinct paths. Data points that haven’t mattered in a decade, like the relationship between prices and fundamental measures of value, are starting to have more sway on returns. The divide between cheap stocks and expensive ones remains exceptionally wide, which could mean last year’s shift in favor of value investing is just the beginning.

Supposedly, were on the verge of entering the “stockpicker’s market,” as shown in this chart:

Average Pair-Wise Correlation of All S&P Stock Combinations

The myth that low correlations between stock returns lead to active manager’s outperformance has long been debunked. Similarly, a high active share is cited as one of the reasons actively-managed funds will outperform their passive peers. Please refer to our earlier post for a discussion of this topic.

So, this post will instead focus on the long-term performance of the funds featured in the article:

Time for Proactive Investing

The following charts with related statistics show the cumulative RealAlpha™ for each fund that has at least ten years of history through 2016 (to learn more about this and other patent-based performance measures Alpholio™ uses, please consult our FAQ). In all analyses, the number of ETFs in the reference portfolio was limited to no more than seven. The ETF membership and weights in each reference portfolio were constant throughout the entire evaluation period.

Here is a chart with statistics for the AllianzGI NFJ Dividend Value Fund (PNEAX; Class A shares):

Cumulative RealAlpha™ for AllianzGI NFJ Dividend Value Fund (PNEAX) over 10 Years

The fund cumulatively returned over 20.5% less than its reference ETF portfolio of lower volatility.

Here is a chart with statistics for the DFA US Large Cap Value Portfolio (DFLVX; Class I shares):

Cumulative RealAlpha™ for DFA US Large Cap Value Portfolio (DFLVX) over 10 Years

The fund cumulatively returned about 8.5% more than its reference ETF portfolio of lower volatility.

Here is a chart for the Dodge & Cox Stock Fund (DODGX):

Cumulative RealAlpha™ for Dodge & Cox Stock Fund (DODGX) over 10 Years

While the fund produced a 14% higher cumulative return than its reference ETF portfolio, by early 2016 it also lost virtually all of its cumulative RealAlpha™ generated since 2007.

The following chart is for the Sound Shore Fund (SSHFX):

Cumulative RealAlpha™ for Sound Shore Fund (SSHFX) over 10 Years

On a cumulative return basis, the fund underperformed its reference ETF portfolio by over 7.7%; most of that loss occurred over the past two years.

This chart is for the T. Rowe Price Equity Income Fund (PRFDX):

Cumulative RealAlpha™ for T. Rowe Price Equity Income Fund (PRFDX) over 10 Years

The fund’s cumulative return was over 23.3% lower than that of its reference ETF portfolio of a slightly higher volatility.

The final chart is for the Vanguard U.S. Value Fund (VUVLX; Investor Class shares):

Cumulative RealAlpha™ for Vanguard U.S. Value Fund (VUVLX) over 10 Years

The fund cumulatively returned about 9.1% more than its reference ETF portfolio of a slightly lower volatility. However, as recently as at the end of October 2016, the cumulative RealAlpha™ was only 4.4%.

In conclusion, only three out of the six funds analyzed above added some value when compared to their respective reference ETF portfolios. The rest of the funds underperformed, and in some cases quite significantly. It remains to be seen whether a combination of the expected low stock correlations in the market and a high active share of these funds leads to their significant outperformance in 2017.

To learn more about these and other mutual funds, incl. the composition of their reference ETF portfolios, please register on our website.

To learn more about the these and other mutual funds, including the composition of their reference ETF portfolios, please register on our website.


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Analysis of Vanguard Health Care Fund
analysis, mutual fund

Today’s profile in Barron’s features the Vanguard Health Care Fund (VGHCX, Investor shares; VGHAX, Admiral shares). This actively-managed $52.7 billion sector fund has a very competitive 0.34% expense ratio and a relatively low 20% turnover. According to the article, the founding long-term manager of the fund taught the current manager well, and

That foundation has helped [her] guide the fund to a 30.8% average annual return over the three years ended on July 29—6.4 percentage points better than the category benchmark, the MSCI All Country World Health Care index.

Given a 4.5-year overlap between the two managers, the remainder of this analysis will focus on the entire tenure of the current manager, i.e. a period starting in June 2008 (the first full month on board).

The prospectus benchmark for the fund is the MSCI ACWI Health Care Index. There are currently no ETFs that track this index; the closest approximation is the iShares Global Healthcare ETF (IXJ). Alpholio™’s calculations show that the fund returned more than the ETF in about 80% of all rolling 12-month periods, 82% of 24-month periods, and 96% of 36-month periods. Given that the fund has a majority of its holdings in U.S. equities, a domestic health care sector ETF may be considered as an alternative reference. When the iShares U.S. Healthcare ETF (IYH) is used for that purpose, these figures are 62%, 68% and 48%, respectively. However, in either case a single ETF does not adequately adjust for the fund’s risk.

In the simplest variant of Alpholio™’s patented methodology, a custom portfolio of ETFs with fixed membership and weights is constructed as an alternative to the analyzed fund. For the Vanguard Health Care fund in the above analysis period, such a portfolio had top-four positions in the Health Care Select Sector SPDR® Fund (XLV; constant weight of 37.2%), iShares Global Healthcare ETF (IXJ; 20.4%), Guggenheim S&P 500 Equal Weight Health Care ETF (RYH; 17.2%), and iShares U.S. Pharmaceuticals ETF (IHE; 9.5%). At about 13.6%, the fund’s standard deviation (a measure of volatility of returns) was only 0.2% higher than that of the reference portfolio. The fund produced about 2.5% of annualized RealAlpha™ and had a RealBeta™ of 0.66.

In a more elaborate approach, Alpholio™ builds a dynamic portfolio of ETFs with fixed membership but variable weights. Here is a resulting chart of the cumulative RealAlpha™ for the fund:

Cumulative RealAlpha™ for Vanguard Health Care Fund (VGHCX)

On a risk-adjusted basis, the fund added almost all of its value only in the last two and a half years. Over the entire seven-year period, the annualized standard deviation was 13.6% compared to 12.9% for the reference portfolio. The annualized regular RealAlpha™ was 3.25% and the lag RealAlpha™ 4.16% (to learn more about RealAlpha™, please visit our FAQ). The RealBeta™ was 0.636.

The following chart shows weights of ETFs in the reference portfolio for the fund over the same analysis period:

Reference Weights for Vanguard Health Care Fund (VGHCX)

The fund had only six equivalent positions: in the Vanguard Health Care ETF (VHT; average weight of 54.4%), iShares Global Healthcare ETF (IXJ; 28%), iShares 7-10 Year Treasury Bond ETF (IEF; 7.6%; representing the fixed-income holdings), iShares MSCI Japan ETF (EWJ; 5.7%), Vanguard Utilities ETF (VPU; 2.3%; also representing fixed-income investments), and iShares North American Tech-Software ETF (IGV; 2%; helping explain the remainder of the fund’s returns).

Under current management, the Vanguard Health Care fund had impressive risk-adjusted returns. However, most of the value was added only in the most recent one-third of the seven-year analysis period. The fund’s comparatively low expense ratio can be reduced even further to 0.29% by investing in the Admiral shares. The fund is characterized by a relatively low volatility of returns and held up well in the last major market downturn in 2008. The fund’s significant distributions, even though mostly in the form of long-term capital gains, make it more suitable for non-taxable accounts.

To learn more about the Vanguard Health Care and other mutual funds, please register on our website.

Disclaimer: Due to a multitude of random factors, perfect prediction of performance of an investment vehicle is nearly impossible. Therefore, the above analysis should be treated as merely one of the many inputs to an investment decision, and not as a definitive recommendation to buy or sell any securities. While Alpholio™ strives to provide original and useful insights into fund and portfolio performance, the ultimate investment decision belongs to you, the investor.

For a detailed explanation of Alpholio™’s patented analysis methodology, please refer to the FAQ.

© 2015 Envarix Systems Inc. All Rights Reserved.

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Comparing Fund Companies
active management, mutual fund

A recent three-part article from Morningstar compares American Funds with Vanguard. The first part claims many similarities between the two firms with respect to:

  • Long employee tenure
  • Staid funds
  • Low portfolio turnover
  • Multiple investment managers
  • High diversification
  • Risk aversion
  • Strong market correlations

This is despite all major differences — unlike American Funds, Vanguard

  • Focuses on indexing
  • Sells funds directly to retail investors
  • Has plenty of bonds funds
  • Offers ETFs
  • Services 401(k) plans
  • Is prominently featured in the media

The second part proposes several explanations why, despite those similarities, US equity American Funds have collectively suffered net outflows of $110B, while a single Vanguard Total Stock Market Index (VTSMX) fund gained $45B in net inflows over the trailing three years. Apparently, the main reasons were poor distribution and marketing decisions, and not a poor average fund performance, despite the latter being deficient by an annualized 0.5% vs. VTSMX over the last five years. This indicates that despite a roughly equal performance over the last ten years, and a superior performance over a fifteen-year period, the glory days of American Funds may be over.

The third part delves more into performance and tries to massage the numbers to support the thesis of equality. First, a 25-year time frame of analysis is picked. This is convenient because, as part two shows, the more recent performance of American Funds has been deficient.

Next, seven unidentified American Funds and ten unspecified index funds are chosen for performance comparison. Index funds from firms other than Vanguard are used, apparently to alleviate a low-cost advantage the latter have. Given that the analysis period starts in 1988, only three existing Vanguard index funds are applicable: 500 Index (VFINX), Extended Market Index (VEXMX), and Small Cap Index (NAESX). All these are Investor share class, which means the comparison does not take advantage of even lower cost Admiral shares that were introduced in 2000 (switching between share classes of the same fund is a non-taxable event). With all that, the selection of funds for the comparison is questionable.

Subsequently, a maximum 8.5% front load is applied to American funds. This is fair because an investor could not have purchased these funds without such a load 25 years ago. However, then an “industry standard” 1% fee is charged annually to index funds. This is ostensibly done to account for the lack of “financial advice” with index funds. This “equalization” approach makes no sense because the front load is paid only once, while the financial advice fee is charged annually and thus has a compounding effect. A one-time financial “advice” provided 25 years ago (i.e. “I recommend that you should buy this great fund [on which I get a commission]”) is not the same as continuous advice on asset allocation (typical with passive investments) provided over the 25 year period. Apples to oranges.

Next comes a simplified accounting for taxes, which, for the lack of data, extends the average annual performance penalty for American Funds recorded in the last 15 years to the entire 25-year period. It is unclear if this analysis takes into account the reinvestment of residual after-tax distributions into each fund (this is what an investor would do, absent any external funds to pay taxes). Nevertheless, it is at least an attempt to take an important performance factor into account.

In the end, were it not for the recurring management fee penalty, index funds would have clearly come on top. In addition, this performance comparison does not take into account the volatility of each fund. At a minimum, what were the ex-post Sharpe Ratios for each fund calculated over the entire 25-year period? The article does not say.

In sum, it looks like the article started with a thesis of an apparent equality between the two fund firms, and then concocted a cryptic and incorrect performance analysis to support this thesis. That is regrettable.

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