Tag Archives: mutual funds

Active Vs. Passive & The Simple Reasons You Can’t Beat An Index

Just recently, I was reading an article from Larry Swedroe which “discussed” the “Surprising Results From S&P’s Latest SPIVA Analysis.” To wit:

“Over the 15-year period, on an equal-weighted (asset-weighted) basis, the average actively managed U.S. equity fund underperformed by 1.4% (0.74%)per annum. The worst performances were small caps, with active small-cap growth managers underperforming on an equal-weighted (asset-weighted) basis by 1.99% (0.90%) per annum, active small-cap core managers underperforming by 2.43% (1.82%) per annum, and active small–value managers underperforming by 2.00% (1.71%) per annum. So much for the idea that the small-cap asset class is inefficient and active management is the winning strategy.”

As Larry concludes from that analysis:

“S&P’s SPIVA scorecard provides persuasive evidence of the futility of active management.”

See, according to Larry, it is clear you should just passively index in funds and everything will be just fine. 

If it were only that simple.

We Are Supposed To Be Long-Term Investors

In any given short-term period, a manager of an active portfolio may make bets which either outperform or underperform their relative benchmark. However, we are supposed to be long-term investors, which suggests that we should focus on the long-term results, and not short-term deviations. 

The following chart of Fidelity Contra Fund versus the Vanguard S&P 500 Index proves this point. Which fund would you have rather owned?

(Source: Morningstar)

Finding funds with very long-term track records is difficult because the majority of mutual funds didn’t launch until the late “go-go 90’s” and early 2000’s. However, I did a quick look up and added 4-more active mutual funds with long-term track records for comparison. The chart below compares Fidelity Contrafund, Pioneer Fund, Sequoia Fund, Dodge & Cox Stock Fund, and Growth Fund of America to the Vanguard S&P 500 Index.

(Source: Morningstar)

I don’t know about you, but an investment into any of the actively managed funds over the long-term horizon certainly seems to have been a better bet. 

Even Index Funds Can’t Beat The Index

Do you want to know what fund did NOT beat the index according to Morningstar? The Vanguard S&P 500 Index fund. 

How is it that a fund that is supposed to purely replicate an index, failed to exactly match the performance of the index. 

Simple.

Fees, taxes, and expenses.

Unfortunately, in the “real world” where people actually invest their “hard earned savings,” their overall returns are constantly under siege from taxes, previously commissions, fees, and most importantly – taxes. 

An “index,” which is simply a mathematical calculation of priced securities, has no such detriments. 

The chart below is the S&P 500 Total Return Index before, and after the same expense ratio charged by the Vanguard S&P 500 Index Fund. Since most advisers don’t manage client money for free, I have also included an “adviser fee” of 0.5% annually. 

Of course, if your adviser is simply indexing for you, then maybe the real question is exactly what are you paying for? 

The Differences Between You And An Index

Which brings us to why you, nor any investment product that exactly mimics the S&P 500 index, can actually match it, must less beat it.

While Wall Street wants you to compare your portfolio to the ‘index’ so that you will continue to keep chasing an index, which keeps money in motion and creates fees for Wall Street, the reality is that you and an index are very different things. This is due to the following reasons:

1) The index contains no cash, 

If you maintain cash for expected expenses, taxes, or any other reason, your performance will lag the benchmark index. 

2) The index has no life expectancy requirements – but you do.

While it may sound great that if you just hold an index long-term you will generate 8-10% annual returns, the reality is that your investment horizon between accumulation and distribution fall within one “full-market” cycle. Start on the wrong end of a cycle (high starting valuations) and the end result will be far less than advertised.

3) The Index does not have to compensate for distributions to meet living requirements.

At the point in life when you begin withdrawing money to live on, performance is affected by the withdrawals against the value of the portfolio.  (Read more here)

4) The index requires you to take on excess risk.

Cullen Roche once penned a salient point:

“Benchmarking is a pernicious thing in financial circles. Not only because it disconnects the way the client and a fund manager understand the concept of ‘risk’, but also because the concept of benchmarking seems to be misunderstood.”

Risk is rarely understood by investors until it is generally too late.

Chasing the S&P 500 index requires you to have your portfolio fully allocated to equity risk, at all times. This vastly increases the “risk profile” of the portfolio which may not be optimal for investors approaching, or in, retirement. (Read more here)

5) It has no taxes, costs or other expenses associated with it.

As noted above, an index does not have to pay taxes on realized gains and dividends, does not have management fees, or other expenses which must be covered. All of these items will lead to underperformance from one year, to the next, versus an index.

6) It has the ability to substitute at no penalty.

In an index, if a company goes bankrupt, the index simply takes it out and substitutes another stock in its position. The index value is then adjusted for the “market capitalization” of the new entrant and the index resumes. However, in your portfolio, given you only have a “finite” amount of capital, when a company goes bankrupt, or losses the majority of its value, you have to sell that stock at a loss and buy the replacement with whatever is left or add more capital. 

It’s Your Brain, Man

Unfortunately, investors rarely do what is “logical,” but react “emotionally” to market swings.  When stock prices are rising, instead of questioning when to “sell,” they are instead lured into market peaks. The reverse happens as prices fall. First, comes “paralysis,” then “hope” that losses may be recovered, but eventually “capitulation” sets in as the emotional strain becomes too great and investors “dump” shares at any price to preserve what capital they have left. They then remain out of the market as prices rise only to “jump back in” about mid-way to the next market peak.

Wash. Rinse. Repeat.

Despite the media’s commentary that “if an investor had ‘bought’ the bottom of the market,” the reality is that few, if any, actually ever do. The biggest drag on investor performance over time is allowing “emotions” to dictate investment decisions. This is shown in the Dalbar Investor Study which showed “psychological factors” accounted for between 45-55% of underperformance. From the study:

“Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market. Market upswings rarely coincide with mutual fund inflows while market downturns do not coincide with mutual fund outflows.”

In other words, investors consistently bought the “tops” and sold the “bottoms.”  You will notice the other two primary reasons for underperformance was related to a lack of capital to invest.  This is also not surprising given the current economic environment.

The Only Question That Matters

There are many reasons why you shouldn’t chase an index over time, and why you see statistics such as “80% of all fund underperform the S&P 500.” The impact of share buybacks, substitutions, lack of taxes and trading expenses all contribute to the outperformance of the index over those actually investing real dollars who do not receive the same advantages. 

More importantly, any portfolio that is allocated differently than the benchmark to provide for lower volatility, create income, or provide for long-term financial planning and capital preservation will underperform the index as well. Therefore, comparing your portfolio to the S&P 500 is inherently “apples to oranges” and will always lead to disappointing outcomes.

“But it gets worse.  Often times, these comparisons are made without even considering the right way to quantify ‘risk’. That is, we don’t even see measurements of risk-adjusted returns in these ‘performance’ reviews. Of course, that misses the whole point of implementing a strategy that is different than a long only index.

It’s fine to compare things to a benchmark. In fact, it’s helpful in a lot of cases. But we need to careful about how we go about doing it.” – Cullen Roche

For all of these reasons, and more, the act of comparing your portfolio to that of a “benchmark index” will ultimately lead you to taking on too much risk and into making emotionally based investment decisions.

But here is the only question that really matters in the active/passive debate:

“What’s more important – matching an index during a bull cycle, or protecting capital during a bear cycle?”  

You can’t have both.

If you benchmark an index during the bull cycle, you will lose equally during the bear cycle. However, while an active manager that focuses on “risk” may underperform during a bull market, the preservation of capital during a bear cycle will salvage your investment goals.

Investing is not a competition and, as history shows, there are horrid consequences for treating it as such. So, do yourself a favor and forget about what the benchmark index does from one day to the next. Focus instead on matching your portfolio to your own personal goals, objectives, and time frames. In the long run, you may not beat the index, but you are likely to achieve your own personal investment goals which is why you invested in the first place.

Value Your Wealth – Part Six: Fundamental Factors

In this final article of our Value Your Wealth Series we explore four more fundamental factors. The first four articles in the Series researched what are deemed to be the two most important fundamental factors governing relative stock performance – the trade-off between growth and value. In Part Five, we explored how returns fared over time based on companies market cap. Thus far, we have learned that leaning towards value over growth and smaller market caps is historically an investment style that generates positive alpha. However, there are periods such as now, when these trends fail investors.

The last ten years has generally bucked long-standing trends in many factor/return relationships. This doesn’t mean these factors will not provide an edge in the future, but it does mean we need to adapt to what the market is telling us today and prepare for the day when the historical trend reverts to normal.  When they do, there will likely be abundant opportunities for investors to capture significant alpha.

The five prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Part Five: Market Cap

Four Factors

In this section, we explore four well-followed factors to understand how they performed in the past and how we might want to use them within our investment decision-making process.

The graphs in this article are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

Earnings to Price

Investors betting on companies with a higher ratio of Earnings to Price (E/P), also known as the earnings yield, have historically outperformed investors betting on companies with lower E/P ratios. Such outperformance of companies priced at relatively cheap valuations should be expected over time.

The following chart compares monthly, ten year annually compounded returns for the highest and lowest E/P deciles. 

The graph of E/P is very similar to what we showed for growth versus value. Other than a period in the 1990s and the current period value outperformed growth and the top E/P companies outperformed the bottom ones. This correlation is not surprising as E/P is a key component that help define value and growth.

Investors buying the top ten percent of the cheapest companies, using E/P, have been docked almost 5% annually or about 50% since the recovery following the financial crisis versus those buying the lowest ten percent of companies using this measure.

Given our fundamental faith in mean reversion, we have no doubt this trend will begin to normalize in due time. To help us gauge the potential return differential of an E/P reversion, we calculate future returns based on what would happen if the ten-year return went back to its average in three years. This is what occurred after the tech bust in 2000. In other words, if the ten year annualized compounded return in late 2022 is average (4.81%) what must the relative outperformance of high E/P to low E/P companies be over the next three years? If this occurs by 2022, investors will earn an annual outperformance premium of 28.1% for each of the next three years. The returns increase if the time to reversion is shorter and declines if longer. If normalization occurs in five years the annual returns drop to (only) 14.75%.

Needless to say, picking out fundamentally solid stocks seems like a no-brainer at this point but there is no saying how much longer speculation will rule over value.

Cash Flow to Price

The graph below charts the top ten percent of companies with the largest ratio of cash flow to price and compares it to the lowest ones. Like E/P, cash flow to price is also a component in value and growth analysis.

Not surprisingly, this graph looks a lot like the E/P and value vs. growth graphs. Again, investors have shunned value stocks in favor of speculative entities meaning they are neglecting high quality companies that pay a healthy dividend and instead chasing the high-flying, over-priced “Hollywood” stocks. Also similar to our potential return analysis with E/P, those electing to receive the most cash flows per dollar of share price will be paid handsomely when this factor reverts to normal.

Dividend Yield

Over the last 100 years, using dividend yields to help gain alpha has not been as helpful as value versus growth, market cap, earnings, and cash flows as the chart below shows.

On average, higher dividend stocks have paid a slight premium versus the lowest dividend stocks.While dividend yields are considered a fundamental factor it is also subject to the level of interest rates and competing yields on corporate bonds.If we expect Treasury yield levels to be low in the future then the case for high dividend stocks may be good as investors look for alternative yield as income. The caveat is that if rates decline or even go negative, the dividend yield may be too low to meet investors’ bogeys and they may chase lower dividend stocks that have offered higher price returns.

Momentum

Momentum, in this analysis, is calculated by ranking total returns from the prior ten months for each company and then sorting them. Before we created the graph below, we assumed that favoring momentum stocks would be a dependable investment strategy. Our assumption was correct as judged by the average 10.89% annual outperformance. However, we also would have guessed that the last few years would have been good for such a momentum strategy.

Quite to the contrary, momentum has underperformed since 2009. The last time momentum underperformed, albeit to a much a larger degree, was the Great Depression.

Our initial expectation was based on the significant rise of passive investing which favors those companies exhibiting strong momentum. As share prices rise relative to the average share price, the market cap also rises versus the average share and becomes a bigger part of indexes.  If we took the top 1 or 2% of companies using momentum we think the strategy would have greatly outperformed the lower momentum companies, but when the top and bottom ten percent are included momentum has not recently been a good strategy.

Summary

Factors give investors an informational edge. However, despite long term trends that offer favorable guidance, there are no sure things in investing. The most durable factors that have supplied decades of cycle guidance go through extended periods of unreliability. The reasons for this vary but certainly a speculative environment encouraged by ultra-low and negative interest rates has influence. Investors must recognize when they are in such periods and account for it. More importantly, though, they must also understand that when the trends are inclined to reverse back to normal. The potential for outsized relative gains at such times are large.

At RIA Advisors, Factor analysis is just one of many tools we use to help us manage our portfolios and select investments. We are currently leaning towards value over growth with the belief that the next market correction will see a revival of the value growth trends of the past. That said, we are not jumping into the trade as we also understand that growth may continue to beat value for months or even years to come.

Patience, discipline, and awareness are essential to good investing. 

Value Your Wealth – Part Five: Market Cap

The first four articles in this series focused on what might be the most important pair of fundamental factors – growth and value. Those factors have provided investors long-standing, dependable above-market returns.  Now, we take the series in a different direction and focus on other factors that may also give us a leg up on the market. 

The term “a leg up” is important to clarify. In general, factor-based investing is used to gain positive alpha or performance that is relatively better than the market. While “better” than market returns are nice, investing based on factor analysis should not be the only protection you have when you fear that markets may decline sharply. The combination of factor investing and adjustments to your total equity exposure is a time-trusted recipe to avoid large drawdowns that impair your ability to compound wealth.

We continue this series with a discussion of market capitalization.

The four prior articles in the Value Your Wealth series are linked below:

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

Part Four: Mutual Fund and ETF Analysis

Market Cap

Market capitalization, commonly known as market cap, is a simple calculation that returns the current value or size of publicly traded companies. The formula is the number of shares outstanding times the price per share. For example as we wrote this article, Apple has 4.601 billion shares outstanding and Apple’s stock trades at roughly $210 per share. Apple’s market cap is $966.21 billion. 

Most investors, along with those in the financial media, tend to distinguish companies market caps/size by grouping them into three broad tiers – small-cap, mid-cap, and large-cap. Over most periods, stocks in the three categories are well correlated. However, there are periods when they diverge, and we are currently amidst such a deviation. Since September 1, 2018, the price of the Large Cap S&P 500 Index has risen by 4.1%, while the price of the Small Cap S&P 600 Index is down 12.9%.  Deviations in historical relationships, whether short or long-term in nature, can provide investors an opportunity to capitalize on the normalization of the relationship, but timing is everything. 

Historical Relative Performance

The following graphs are based on data from Kenneth French and can be found HERE.  The data encompasses a wide universe of domestic stocks that trade on the NYSE, Amex, and NASDAQ exchanges.

The data set provides returns based on market cap groupings based on deciles. The first graph compares annualized total return and annualized volatility since 1926 of the top three (High) and bottom three (Low) market cap deciles as well as the average of those six deciles. To be clear, a decile is a discrete range of market caps reflecting the stocks in that group. For example, in a portfolio of 100 stocks, decile 1 is the bottom ten stocks, or the smallest ten market cap stocks, decile two is the next ten smallest cap stocks, etc.

The next graph below uses monthly ten year rolling returns to compare total returns of the highest and lowest deciles. This graph is a barometer of the premium that small-cap investing typically delivers to long term investors.

The takeaway from both graphs is that small-cap stocks tend to outperform large-cap stocks more often than not. However, the historical premium does not come without a price. As shown in the first graph, volatility for the lowest size stocks is almost twice that of the largest. If you have a long time horizon and are able and willing to stay invested through volatile periods, small caps should fare better than large caps. 

Small-cap stocks, in general, have high expected growth rates because they are not limited by the constraints that hamper growth at larger companies. Unfortunately, small-cap earnings are more vulnerable to changes in industry trends, consumer preferences, economic conditions, market conditions, and other factors that larger companies are better equipped and diversified to manage. 

Periods of Divergence

The second graph above shows there are only three periods where large caps outperformed small caps stocks since 1926. Those three exceptions, the 1950’s, 1990’s and, the post-financial crisis-era are worth considering in depth.

The 1950s The Nifty Fifty- The end of World War II coupled with a decade of historically low interest rates disproportionately helped larger companies. These firms, many global, benefited most from the efforts to rebuild Europe and partake in the mass suburbanization of America.

The 1990s Tech Boom- With double-digit inflation a distant memory and the swelling technology boom, larger companies that typically benefited most from lower rates, less inflation, and new technologies prospered. While this new technology benefited all companies in one form or another, larger ones had the investment budgets and borrowing capacity to leverage the movement and profit most. 

The 2010’s Post Financial Crisis Era –The current period of large-cap outperformance is unique as economic growth has been prolonged but below average and productivity growth has been negligible. Despite relatively weak economic factors, massive amounts of monetary stimulus has fueled record low corporate borrowing rates, which in turn have fueled stock buybacks. Further, the mass adaptation of passive cap-weighted investment strategies naturally favors companies with large market caps. Circularly, passive investing feeds on itself as indexed ETFs and mutual funds must increasingly allocate more to large caps which grow in size relative to the other holdings.

To reiterate an important point: the current period of outperformance is not based on solid economic fundamentals and resulting corporate earnings growth as in the two prior periods described. This episode is a byproduct of monetary actions.

The graph below highlights the distinction between the current period and the two prior periods where large caps outperformed.  

Summary

Historically, small-cap stocks tend to provide a return premium over large-cap stocks. However, as we pointed out, there are periods where that is not the case. Currently, large-cap stocks are the beneficiaries of overly generous monetary and fiscal policy. We do believe the relationship will return to normal, but that will likely not occur until a bear market begins.

As we wait for a normalization of valuations and traditional relationships that have become so disfigured in this cycle, we consider the current relative valuations on small-cap stocks similar to those we described in value stocks earlier in this series. The time to weight your stock portfolio allocation more heavily toward small-cap opportunities is coming, but every investor must decide on their own or with good counsel from an advisor when to make that adjustment.  When appropriate, a gradual shift to small-cap stocks from large caps depends on an investor’s risk appetite and defensive preference.

More importantly, have a plan in place because when the market does meaningfully correct, the premium small-cap stocks provide will likely help cushion against a stock market correction. 

Value Your Wealth – Part Four: Mutual Fund & ETF Analysis

Parts One through Three of the series are linked below.

Part One: Introduction

Part Two: Quantifying the Value Proposition

Part Three: Sector Analysis

In Part One, the introduction to our Value Your Wealth series, we documented how recent returns for investors focused on growth companies have defied the history books and dwarfed returns of investors focused on value stocks. In particular: “There have only been eight ten-year periods over the last 90 years (total of 90 ten-year periods) when value stocks underperformed growth stocks. Two of these occurred during the Great Depression and one spanned the 1990s leading into the Tech bust of 2001. The other five are recent, representing the years 2014 through 2018.”

In this, the fourth part of the Value Your Wealth series, we focus on growth and value mutual funds and ETFs. Our purpose is to help determine which professional value and growth fund managers are staying true to their stated objectives.

Fund Analysis

A large part of most investor’s investment process starts with the determination of an investment objective. From this starting point, investors can appropriately determine the asset classes and investment strategies that will help them achieve or even exceed their objectives. 

Once an investor decides upon an objective, strategy, and asset class, they must select individual securities or funds. This article focuses singularly on assessing growth and value mutual funds and ETFs. In particular it shows how an investor focused on growth or value can choose funds that are managed properly to meet their goals.

Investors usually key on the following factors when selecting a mutual fund or ETF: 

  • Declared fund strategy (Growth or Value in this case)
  • Prior period returns
  • Fee and expense structure
  • Reputation of the fund family and possibly the manager

These four factors provide valuable information but can be misleading.

For instance, prior returns provide a nice scorecard for the past but can be deceptive. As an example, if we are currently scanning for value funds based on performance, the highest ranking funds will more than likely be those that have leaned most aggressively toward growth stocks. While these funds may seem better, what we believe is more important the fund managers adherence to their objectives.  Given we are looking forward and believe value will outperform growth, we want fund managers that we can trust will stick with value stocks.

It is also important not to shun funds with the highest expenses and/or gravitate towards those with the lowest. We must be willing to pay up, if necessary, to achieve our objectives. For instance, if a fund offers more exposure to value stocks than other comparable value funds, it may be worth the higher fee for said exposure. Conversely, there are many examples where one can gain more exposure to their preferred strategy with cheaper funds. 

Most investors check the fund strategy, but they fail to determine that a fund is being effectively and cost efficiently managed towards their stated strategy. 

We now compare the largest growth and value mutual funds and ETFs to assess which funds offer the most value, so to speak. 

Mutual Fund/ETF Analysis

In order to limit the population of value and growth mutual funds and ETFs to a manageable number, we limited our search to the largest funds within each strategy that had at least 85% exposure to U.S. based companies. We further restricted the population to those funds with a stated strategy of growth or value per Bloomberg.

In prior articles of this series, we have used Bloomberg growth and value factor scores and our own growth and value composite scores. While we would prefer to use our own computations, the large and diverse holdings of the mutual funds and ETFs make it nearly impossible for this exercise. Accordingly, Bloomberg growth and value factor scores provide us the most accurate description of where the respective funds lie on the growth/value spectrum. It is important to note that Bloomberg assigns every fund both a growth and a value score. We consider both scores and not just the score pertinent to growth or value.

We understand most of our readers do not have access to Bloomberg data. As such, we provide a DIY approach for investors to track growth and value exposure amongst mutual funds and ETFs.

Growth and Value Scores

The scatter plot below shows the 54 funds analyzed. Each dot represents a fund and the intersection of its respective growth (x-axis) and value scores (y-axis). The funds most heavily skewed towards value (high value scores and low growth scores) are in the upper left, while heavily growth oriented funds are in the bottom right (high growth score and low value scores).  Information about the funds used in this report and their scores can be found in the tables below the graph. Certain funds are labeled for further discussion.   

A few takeaways:

  • VIVAX (Growth -.60, Value +.37): While this value fund is farthest to the left, there are other funds that offer more value exposure. However, this fund has the lowest growth score among value funds.
  • DFLVX (Growth -.43, Value +.68): This value fund offers an interesting trade off to VIVAX sporting a higher value score but a less negative growth score.
  • AIVSX (Growth +.10, Value -.05): Despite its classification as a value fund, AIVSX has a slight bias towards growth. Not surprisingly, this fund has recently outperformed other value funds but would likely underperform in the event value takes the lead.
  • FDGRX (Growth +.88, Value -.64): This growth fund offers both the highest growth score and lowest value score. For investors looking for an aggressive profile with strong growth exposure and little value exposure, this fund is worth considering.
  • VPMCX (Growth -.04, Value +.16): Despite its classification as a growth fund, VPMCX has a slight bias towards value.
  • In our opinion, the six funds with growth and value scores near zero (+/-.20) in the red box do not currently have a significant growth or strategy orientation, and as such, they are similar to a broad market index like the S&P 500.

It is important to stress that the data represents a snapshot of the fund portfolios for one day. The portfolio managers are always shifting portfolios toward a value or growth bias based on their market views.

 (CLICK on the tables to enlarge)

Data Courtesy Bloomberg

The data above gives us potential funds to meet our strategic needs. However, we also need to consider fees.  

Fees

The scatter plots below isolate growth and value funds based on their respective growth or value score and fees charged.

We circled three groupings of the growth funds to help point out the interaction of fees and growth scores. The four funds in the blue circle have average or above average fees versus other growth funds yet provide a minimal bias towards growth. The yellow circle represents a sweet spot between low fees and a good exposure to growth stocks. Lastly, the red circle shows funds where  heavy exposure to growth comes with above average fees.

This graph circles three groupings of value funds to help point out the interaction of fees and growth scores. The blue circle contains funds with little to no bias towards value. The yellow circle represents a good mix of value and cheap fees. The red circle, our sweet spot in this graph, shows that heavy exposure to value can be had with fees near the group average.

Alpha and Bad Incentives 

Alpha is a measure that calculates how much a portfolio manager, trader, or strategy over or underperforms an index or benchmark. From a career perspective, alpha is what separates good fund managers from average or bad ones.

We mention alpha as we believe the current prolonged outperformance of growth over value is pushing professional fund managers to stray from their stated objectives. As an example, a value based fund manager can add exposure to growth stocks to help beat the value index he or she is measured against.

Adding growth to a value fund may have proven to be alpha positive in the past, but we must concern ourselves with how well the fund manager is adhering to the fund’s objective Simply put, we are trying to find managers that are staying true to their objectives not those who have benefited from a deviation from stated strategy in the past.

It is important to note that positive alpha can be attained by sticking to the stated objective and finding stocks that outperform the index. This is the type of alpha that we seek.

DIY

As discussed, growth and value factors can change for funds based on the whims of the portfolio manager. Therefore, the data provided in this article will not age well. If you do not have access to Bloomberg to track value and growth scores we offer another approach.

Morningstar provides a blunt but effective style analysis tool.  To access it, go to www.morningstar.com and select your favorite fund. Then click on the tab labeled Portfolio and scroll down to Style Details.

The following screen print shows Morningstar’s style analysis for value fund DFLVX.

The box in the top right separates the fund’s holdings by market capitalization and value growth classifications. We can use this data to come up with our own scores. For instance, 59% (46+13) of DFLVX is biased toward value (red circle) while only 6% (5+1) is in growth companies (blue circle). To further demonstrate how a fund compares to its peers, the Value & Growth Measures table on the bottom left, compares key fundamental statistics. As shown by three of the first four valuation ratios, DFLVX has more value stocks than the average for funds with similar objectives.

Summary

The word “Value” in a fund name does not mean the fund takes on a value bias at all times. As investors, we must not rely on naming conventions. This means investors must do some extra homework and seek the funds that are truly investing in a manner consistent with the funds, and ultimately the investor’s, objective.

As we have mentioned, we are at a point in the economic and market cycles where investors should consider slowly rotating towards value stocks. Not only is the style historically out of favor, many of the names within that style are unjustifiably beaten down and due for mean reversion to more favorable levels. We hope this article provides some guidance to ensure that those who heed our advice are actually adding value exposure and not value in name only.

In The Market Carnage, One Long-Short Fund Looks Impressive

Some mutual funds short stocks (bet on them to go down) at least with part of their portfolios, and Morningstar has a long-short category with 248 of them. I ran a screen on Morningstar.com’s premium mutual fund screening tool to see which of them had lost 3% or less for the year-to-date period through December 24th and also had a five-star rating, meaning a fund’s volatility adjusted return put it at the top of the category over at least the last 3 years. For the year through December 24th, the S&P 500 Index dropped 10.36% including dividends.

My return criteria were admittedly arbitrary, but hopefully not unreasonable. If a long-short fund is down 5% when the market is down 10% in one period, has the fund failed? It’s not easy to say. But I wanted to be more stringent and see if any funds that had done well against each other for an extended period of time had also weathered the storm the market has delivered recently with a better than -5% return for the year.

First of all, 38 of 248 long-short funds (or only 15%) dropped 3% or less for the year. Also, the category average return was -9.14%, only slightly better than the index’s loss including dividends. That was a little disappointing; it’s unclear that the category is earning its keep.

The fund that made the grade, dropping 3% or less and posting a five-star rating was the PIMCO RAE Worldwide LongShort Plus (PWLIX) fund. The fund has been around since late 2014, and is subadvised by Robert Arnott’s firm Research Affiliates. Arnott and others are listed as portfolio managers.

This is not a typical long-short fund whereby a research team proceeds stock-by-stock, deciding what to buy and what to short on valuation or other factors. First, this funds gets its equity exposure (both long and short) through index-tracking equity derivatives which are collateralized with a bond portfolio. The fund tries to deliver positive returns with its equity exposures, of course, but also through its bond portfolio delivering a higher return than the cost of the derivatives.

Second, this fund is normally long a worldwide index of low volatility, high yielding, and low leverage stocks and short a worldwide capitalization weighted index where stocks are ranked according to the value the market accords them. Market capitalization indexes arguably create distortions, whereby the prices of the largest stocks are unduly elevated and those of the smallest stocks are unduly depressed. That means the combination of being long an index not based on market capitalization and shorting a capitalization weighted index can benefit an investor by owning relatively cheap stocks and shorting relatively expensive stocks.

Besides low volatility stocks outperforming capitalization weighted indices in long terms backtests, the fund can benefit from what it calls “dynamically managed global equity market beta.” In other words, the fund typically has more equity exposure when markets are less volatile and less when they’re more volatile. The fund’s literature argues that these three sources of return – the low volatility equity income strategy, the actively managed absolute return bond strategy, and the dynamically managed global equity market beta strategy – are uncorrelated.

It’s likely that the correlation argument is true. After all, the low volatility equity income strategy is similar to a value approach to stock investing. The low volatility strategy was devised by a finance professor named Robert Haugen who studied the works of Benjamin Graham and took issue with the assertion of modern academic finance that one had to incur high volatility to achieve a superior return. Haugen showed that high volatility stocks were mostly what Graham called the “glamour” stocks that ran hard for a while, but wound up flaming out. Lower volatility, boring companies that didn’t capture investors’ imaginations (and then disappoint them by not fulfilling extreme expectations) plugged along and eventually produced superior returns.

The dynamically managed global market beta strategy, however, is a kind of momentum strategy. If it’s adding exposure when market are calm, it’s likely adding  exposure when they’re going up – or at least not declining and vice versa.

So the two equity strategies fight against each other to some extent – or complement each other, depending on how you look at it. One potential problem is if low volatility equity income strategies are much in favor now and, therefore, become so expensive that they don’t have much return potential over market capitalization strategies. Then the investor is dependent on the momentum-like dynamically managed beta strategy and the bonds outstripping the cost of the derivatives for return.

But maybe relying on two strategies isn’t so bad. And the fund has acquitted itself well, producing a 7.84% annualized return for the 3-year period through December 24th, 2018. That’s better than the S&P 500 Index’s 6.65% return and amounts to a performance good enough to land the fund in the top percentile of the Morningstar long-short fund category over that stretch. The fund has achieved that superior return with lower volatility — a 6.82% standard deviation of returns compared to a 9.4% standard deviation of returns for the index.

The comparison to the S&P 500 Index — the typical way Morningstar displays returns for long-short funds on its website — may work too much in the fund’s favor lately since shorting international stocks has undoubtedly helped it. But the fund has also been long international low volatility stocks, and, overall, it’s been easier to beat a global index lately than a domestic one. three years is also not a very long period of time, but we don’t have much more history on this fund. Investors will have to make due with that for now in their analyses.

Finally, while the institutional share class’s 1.28% expense ratio isn’t cheap by plain equity fund standards, it is compared to long-short funds, where shorting stocks, which can entail paying dividends, can get expensive in a hurry.

Altogether investors have a long-short option worthy of consideration in this fund, which has the potential to beat the index simply and provide an uncorrelated source of returns in a portfolio.