Tag Archives: mutual funds

Performance Persistence within International Style Boxes

We earlier discussed how nominal returns and related investment performance metrics revert: Since portfolio performance primarily comes from systematic (factor) exposures, such simplistic metrics merely promote the high-risk portfolios during the bullish regimes and the low-risk portfolios during the bearish regimes. As regimes change, the leaders flip. We also showed that, when security selection returns are distilled with a robust factor model, performance persists within all U.S. equity Style Boxes. Prompted by reader interest, we now investigate performance persistence within International Style Boxes.

Measuring the Persistence of International Portfolio Returns

As in our earlier work on return persistence, we examine all Form 13F filings for the past 10 years. This survivorship-free portfolio database covers all institutions that exercised investment discretion over at least $100 million and yields approximately 3,600 international portfolios with sufficiently long histories, low turnover, and broad positions to be suitable for the study.

We split the 10 years of history into two random 5-year samples and compared performance metrics of each portfolio over these two periods. The correlation between metrics over the sample periods measures the metrics’ persistence.

International Portfolios’ Performance Persistence

The Reversion of International Portfolios’ Nominal Returns

The following chart plots the rankings of each portfolio’s nominal returns during the two sample periods. The x-axis plots return percentile, or ranking, in the first sample period. The y-axis plots return percentile, or ranking, in the second sample period. The best-performing international portfolios of the first period have x-values near 100; the best-performing portfolios of the second period have y-values near 100:

Chart of the random relationship between nominal returns for two historical samples for all international equity 13F portfolios

13F Portfolios, International Positions: Correlation between the rankings of nominal returns for two historical samples

Whereas past performance of U.S. equity portfolios was a (negative) predictor of future results, there is no significant correlation between the two for international portfolios – best- and worst-performers tend to become average.

The Persistence of International Portfolios’ Security Selection Returns

Due to the domineering effects of Market and other systematic factors, top-performing managers during the bullish regimes are those that take the most risk, and top-performing managers during the bearish regimes are those that take the least risk. Since Market returns are approximately random, nominal returns do not persist. To eliminate this noise, the AlphaBetaWorks Performance Analytics Platform calculates each portfolio’s return from security selection net of factor effects. αReturn is the return a manager would have generated if all factor returns had been flat.

International portfolios with above-average αReturns in one period are likely to maintain them in the other. In the following chart, this relationship is represented by the concentration of portfolios in the bottom left (laggards that remained laggards) and top right (leaders that remained leaders):

Chart of the positive correlation between risk-adjusted returns from security selection (αReturns) for two historical samples for all international equity 13F portfolios

13F Portfolios, International Positions: Correlation between the rankings of αReturns for two historical samples

This test of persistence across two arbitrary 5-year samples is strict. Persistence of security selection skill is even higher over shorter periods.

Performance Persistence within International Style Boxes

Measures of investment style such as Size (portfolio market capitalization) and Value/Growth (portfolio valuation) are common approaches to grouping portfolios. Readers frequently ask whether the reversion of nominal returns and related metrics can be explained by Style Box membership. Perhaps we merely observed reversion in leadership that is eliminated by controlling for Style?

To test this, we compared performance persistence within each of the four popular Style Boxes.

International Large-Cap Value Portfolios’ Performance Persistence

The International Large-cap Value Style Box shows the highest persistence of long-term stock picking results, yet the relationship between nominal returns within it is still nearly random. Powerful performance analytics provide the biggest edge for this International Style Box:

Chart of the random relationship between nominal returns and positive correlation between risk-adjusted returns from security selection (αReturns) for two historical samples for equity 13F portfolios in the Large-Cap Value International Style Box

Large-Cap Value 13F Portfolios, International Positions: Correlation between the rankings of nominal returns αReturns for two historical samples

International equity portfolios differ from U.S. equity portfolios, where security selection persistence was highest for the Small-cap Value Style Box.

International Large-Cap Growth Portfolios’ Performance Persistence

International portfolios in the Large-cap Growth Style Box also show a nearly random relationship between the two periods’ returns. However, their αReturns persist strongly. Whereas large-cap growth stock picking is treacherous for U.S. equity portfolios, it is more rewarding internationally:

Chart of the random relationship between nominal returns and positive correlation between risk-adjusted returns from security selection (αReturns) for two historical samples for equity 13F portfolios in the Large-Cap Growth International Style Box

Large-Cap Growth 13F Portfolios, International Positions: Correlation between the rankings of nominal returns αReturns for two historical samples

International Small-Cap Value Portfolios’ Performance Persistence

International portfolios in the Small-cap Value Style Box have the least persistent αReturns, in contrast to the U.S. portfolios:

Chart of the random relationship between nominal returns and positive correlation between risk-adjusted returns from security selection (αReturns) for two historical samples for equity 13F portfolios in the Small-Cap Value International Style Box

Small-Cap Value 13F Portfolios, International Positions: Correlation between the rankings of nominal returns αReturns for two historical samples

International Small-Cap Growth Portfolios’ Performance Persistence

αReturns within the International Small-cap Growth Style Box persist almost as strongly as within the International Large-cap Style Boxes:

Chart of the random relationship between nominal returns and positive correlation between risk-adjusted returns from security selection (αReturns) for two historical samples for equity 13F portfolios in the Small-Cap Growth International Style Box

Small-Cap Growth 13F Portfolios, International Positions: Correlation between the rankings of nominal returns αReturns for two historical samples

Summary

  • Whereas nominal returns and related simplistic metrics of investment skill revert, security selection performance – once properly distilled with a capable factor model – persists.
  • The randomness and reversion of nominal returns and the persistence of security selection skill hold across all International Style Boxes.
  • Security selection performance persists most strongly for International Large-cap portfolios.
The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
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Performance Persistence within Style Boxes

Common approaches to manager selection do a lousy job since nominal returns and similar simplistic metrics of investment performance revert: Most portfolio performance comes from systematic (factor) exposures, and such metrics merely identify the highest-risk portfolios during the bullish regimes and the lowest-risk portfolios during the bearish regimes. As regimes change, so do the leaders. In the past we demonstrated the reversion of mutual funds’ nominal returns, the reversion of hedge funds’ nominal returns, and the failures of popular statistics (Sharpe Ratio, Win/Loss Ratio, etc.) based on nominal returns. This article extends the study of performance persistence to the broadest universe of U.S. institutional portfolios and to the popular Size and Value/Growth style boxes within this universe.

Our earlier work also showed that, when security selection returns are properly calculated with a robust factor model, skill persists – portfolios of the top stock pickers of the past outperform market and peers in the future. We will now validate these findings across all major style boxes and note the particular effectiveness of predictive skill analytics for small-cap manager selection.

Measuring Persistence of Returns

We surveyed portfolios of over 5,000 institutions that have filed Form 13F in the past 10 years. This is the broadest and most representative survivorship-free portfolio database for all institutions that exercised investment discretion over at least $100 million. The collection includes hedge funds, mutual fund companies, and investment advisors. Approximately 3,000 institutions had sufficiently long histories, low turnover, and broad portfolios to be suitable for this study of performance persistence.

We split the 10 years of history into two random 5-year subsets and compared performance of each portfolio over these two periods. If performance persists over time, there will be a positive correlation between returns in one period and returns in the other.

Performance Persistence for all Institutional Portfolios

The Reversion of Nominal Returns

The chart below plots the ranking of nominal returns for each portfolio during the two periods. Each point corresponds to a single institution. The x-axis plots return percentile, or ranking, in the first historical sample. The y-axis plots return percentile, or ranking, in the second historical sample. For illustration, the best-performing filers of the first period have x-values near 100; the best-performing filers of the second period have y-values near 100:

Performance persistence for nominal returns: Chart of the negative correlation of nominal returns over two historical samples for all U.S. equity 13F portfolios

13F Equity Portfolios: Correlation between the rankings of nominal returns for two historical samples

Contrary to a popular slogan, past performance actually is an indication of future results: Managers with above-average nominal returns in one historical sample are likely to have below-average nominal returns in the other. In the above chart, this negative relationship between (reversion of) historical returns is visible as groupings in the bottom right (leaders that became laggards) and top left (laggards that became leaders).

The Persistence of Security Selection Returns

Nominal performance reverts because it is dominated by Market and other systematic factors. Top-performing managers during the bullish regimes are those who take the most risk; top-performing managers during the bearish regimes are those who take the least risk. As regimes change, leadership flips. To eliminate these disruptive factor effects, the AlphaBetaWorks Performance Analytics Platform calculates each portfolio’s return from security selection net of factor effects. αReturn is the return a manager would have generated if all factor returns had been flat.

Managers with above-average αReturns in one period are likely to maintain them in the other. In the following chart, this positive relationship between historical αReturns is visible as grouping in the bottom left (laggards that remained laggards) and top right (leaders that remained leaders):

Performance persistence for security selection skill: Chart of the positive correlation of risk-adjusted returns from security selection (αReturns) over two historical samples for all U.S. equity 13F portfolios

13F Equity Portfolios: Correlation between the rankings of αReturns for two historical samples

A test of performance persistence across two arbitrary 5-year samples of a 10-year span is especially strict. For most funds covered by the Platform, persistence of security selection skill is far higher over shorter periods. It is highest for approximately 3 years and begins to fade rapidly after 4 years. The chart above also illustrates that low stock picking returns persist and do so more strongly than high stock picking returns – the bottom left cluster of consistently weak stock pickers is the most dense.

Performance Persistence within Each Style Box

Measures of investment style such as Size (average portfolio market capitalization) and Value/Growth are a popular approach to grouping portfolios and analyzing risk. Though not the dominant drivers of portfolio risk and performance, they are often believed to be. Consequently, clients frequently ask whether the reversion of nominal returns and related metrics can be explained by Style Box membership and cycles of style leadership. To test this, we compared performance persistence within each of the four popular style boxes. It turns out style does not explain nominal return reversion and αReturns persist within each style box.

Large-Cap Value Portfolio Return Persistence

Portfolios in the Large-cap Value Style Box show especially high nominal return reversion (-0.23 Spearman’s rank correlation coefficient between samples). This is probably attributable to the high exposures of these portfolios to the cyclical industries that suffer from the most pronounced booms and busts:

Performance persistence for Large-Cap Value 13F Portfolios: Chart of the negative correlation of nominal returns and positive correlation of risk-adjusted returns from security selection (αReturns) over two historical samples for U.S. equity 13F portfolios in the Large-Cap Value Style Box

Large-Cap Value 13F Portfolios: Correlation between the rankings of nominal returns and αReturns for two historical samples

Large-Cap Growth Portfolio Return Persistence

Portfolios in the Large-cap Growth Style Box are the closest to random and show the lowest persistence of αReturns. Large-cap Growth stock picking is exceptionally treacherous over the long term. While it is possible to select skilled managers in this area, it is challenging even with the most powerful skill analytics:

Performance persistence for Large-Cap Growth 13F Portfolios: Chart of the negative correlation of nominal returns and positive correlation of risk-adjusted returns from security selection (αReturns) over two historical samples for U.S. equity 13F portfolios in the Large-Cap Growth Style Box

Large-Cap Growth 13F Portfolios: Correlation between the rankings of nominal returns and αReturns for two historical samples

Small-Cap Value Portfolio Return Persistence

Portfolios in the Small-cap Value Style Box show nearly random nominal returns. They also have the most persistent αReturns. Small-cap Value stock picking records are thus most consistent over the long term. This is the area where allocators and investors armed with powerful skill analytics should perform well, especially by staying away from the unskilled managers:

Performance persistence for Small-Cap Value 13F Portfolios: Chart of the negative correlation of nominal returns and positive correlation of risk-adjusted returns from security selection (αReturns) over two historical samples for U.S. equity 13F portfolios in the Small-Cap Value Style Box

Small-Cap Value 13F Portfolios: Correlation between the rankings of nominal returns and αReturns for two historical samples

Small-Cap Growth Portfolio Return Persistence

Portfolios in the Small-cap Growth Style Box have the second most persistent αReturns. This is also an area where allocators and investors armed with powerful skill analytics will have a strong edge:

Performance persistence for Small-Cap Growth 13F Portfolios: Chart of the negative correlation of nominal returns and positive correlation of risk-adjusted returns from security selection (αReturns) over two historical samples for U.S. equity 13F portfolios in the Small-Cap Growth Style Box

Small-Cap Growth 13F Portfolios: Correlation between the rankings of nominal returns and αReturns for two historical samples

Summary

  • Nominal returns and related simplistic metrics of investment skill revert: as market regimes change, the top performers tend to become the bottom performers.
  • Security selection returns, when properly calculated with a robust factor model, persist and yield portfolios that outperform.
  • Both skill and lack of skill persist, and the lack of skill persists most strongly; while it is important that investors correctly identify the talented managers, it is even more important to divest from their opposites.
  • The reversion of nominal returns and the persistence of security selection skill hold across all style boxes, but security selection skill is most persistent for small-cap portfolios.
The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
U.S. Patents Pending.
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Are Momentum ETFs Delivering Momentum Returns?

There is a large difference between momentum strategies in theory and in practice. Given that much of its model performance derives from illiquid securities and high turnover, the academic momentum factor is a theoretical ideal that is not directly investable. Consequently, real-world momentum products, such as momentum ETFs, are restricted to investable liquid securities and usually reduce the approximately 200% annual turnover of theoretical momentum portfolios. After these modifications, their idiosyncratic momentum returns mostly vanish.

We consider a popular momentum ETF and illustrate that its historical performance is almost entirely attributable to passive exposures to simple non-momentum factors, such as Market and Sectors. Investors may thus be able to achieve and even surpass the performance of popular momentum ETFs with transparent, passive, and potentially lower-cost portfolios of simpler funds.

Attributing the Performance of Momentum ETFs to Simpler Factors

We analyzed iShares MSCI USA Momentum Factor ETF (MTUM) using the AlphaBetaWorks Statistical Equity Risk Model – a proven tool for forecasting portfolio risk and performance. We estimated monthly positions from regulatory filings, retrieved positions’ factor (systematic) exposures, and aggregated these. This produced a series of monthly portfolio exposures to simple investable risk factors such as Market, Sector, and Size. The factor exposures at the end of Month 1 and factor returns during Month 2 are used to calculate factor returns during Month 2 and any residual (security-selection, idiosyncratic, stock-specific) returns un-attributable to factors.

There are only two ways for a fund to deviate from a passive portfolio: residual returns un-attributable to factors and factor timing returns due to variation in factor exposures over time. We define and measure both components below.

iShares MSCI USA Momentum Factor (MTUM): Performance Attribution

We used iShares MSCI USA Momentum Factor (MTUM) as an example of a practical implementation of a theoretical momentum portfolio. MTUM is a $1.1bil ETF that seeks to track an index of U.S. large- and mid-cap stocks with high momentum. The fund’s turnover, around 100% annually, is about half that of the theoretical momentum factor.

iShares MSCI USA Momentum Factor (MTUM): Factor Exposures

The following factors are responsible for most of the historical returns and variance of MTUM:

Chart of exposures to the risk factors contributing most to the historical performance of MSCI USA Momentum Factor (MTUM)

MSCI USA Momentum Factor (MTUM): Significant Historical Factor Exposures

Latest Mean Min. Max.
Market 88.44 84.12 65.46 96.03
Health 23.73 30.28 23.73 34.94
Consumer 74.02 32.53 13.10 74.06
Industrial 1.69 9.71 1.13 24.51
Size -10.47 -1.04 -11.09 7.67
Oil Price -2.90 -2.45 -4.94 -0.04
Technology 17.72 16.56 1.50 32.29
Value -4.86 -2.13 -8.00 5.20
Energy 0.00 1.86 0.00 4.12
Bond Index 6.51 1.08 -22.90 23.64

iShares MSCI USA Momentum Factor (MTUM): Active Return

To replicate MTUM with simple non-momentum factors, one can use a passive portfolio of these simple non-momentum factors with MTUM’s mean exposures as weights. This portfolio defined the Passive Return in the following chart. Active return, or αβReturn, is the performance in excess of this passive replicating portfolio. It is the active return due to residual stock performance and factor timing:

Chart of the cumulative historical active return from security selection and factor timing of MSCI USA Momentum Factor (MTUM)

MSCI USA Momentum Factor (MTUM): Cumulative Passive and Active Returns

MTUM’s performance closely tracks the passive replicating portfolio. Pearson’s correlation between Total Return and Passive Return is 0.96. Consequently, 93% of the variance of monthly returns is attributable to passive factor exposures, primarily to Market and Sector factors.

Once passive exposures to simpler factors have been removed, MTUM’s active return is negligible. Since MTUM’s launch, the cumulative return difference from such passive replicating portfolio has been approximately 1%:

2013 2014 2015 Total
Total Return 16.73 14.62 8.50 45.18
  Passive Return 16.06 16.48 4.55 41.34
  αβReturn 1.11 -2.46 2.54 1.12
    αReturn 3.91 0.05 0.29 4.27
    βReturn -2.71 -2.52 2.23 -3.05

This active return can be further decomposed into security selection (αReturn) and factor timing (βReturn). These active return components generated low volatility, around 1% annually, mostly offsetting each other as illustrated below:

iShares MSCI USA Momentum Factor (MTUM): Active Return from Security Selection

AlphaBetaWorks’ measure of residual security selection performance is αReturn – performance relative to a factor portfolio that matches the funds’ historical factor exposures. αReturn is the return a fund would have generated if markets had been flat. MTUM has generated approximately 4% cumulative αReturn, primarily in 2013, compared to roughly 1.5% decline for the average U.S. equity ETF:

Chart of the cumulative historical active return from security selection of MSCI USA Momentum Factor (MTUM)

MSCI USA Momentum Factor (MTUM): Cumulative Active Return from Security Selection

iShares MSCI USA Momentum Factor (MTUM): Active Return from Factor Timing

AlphaBetaWorks’ measure of factor timing performance is βReturn – performance due to variation in factor exposures. βReturn is the fund’s outperformance relative to a portfolio with the same mean, but constant, factor exposures as the fund. MTUM generates approximately -3% cumulative βReturn, compared to a roughly 1% decline for the average U.S. equity ETF:

Chart of the cumulative historical active return from factor timing of MSCI USA Momentum Factor (MTUM)

MSCI USA Momentum Factor (MTUM): Cumulative Active Return from Factor Timing

These low active returns are consistent with our earlier findings that many “smart beta” funds are merely high-beta and offer no value over portfolios of conventional dumb-beta funds. It is thus vital to test any new resident of the Factor Zoo to determine whether they are merely exotic breeds of its more boring residents.

Conclusion

  • Theoretical, or academic, momentum portfolios are not directly investable.
  • A popular momentum ETF, MSCI USA Momentum Factor (MTUM), did not deviate significantly from a passive portfolio of simpler non-momentum factors.
  • Investors may be able to achieve and surpass the performance of the popular momentum ETFs with transparent, passive, and potentially lower-cost portfolios of simpler index funds and ETFs.
The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2016, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
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The Risk Impact of Valeant on Sequoia Fund

“This is your fund on drugs”

The Sequoia Fund’s (SEQUX) hefty sizing of Valeant Pharmaceuticals (VRX) dramatically changed the fund’s risk profile from historical norms. With the proper tools, allocators would have noticed this style drift back in Q2 2015 when Sequoia’s key factor exposures moved two to three times beyond historical averages. What’s more, allocators would have noticed a predicted volatility increase of 25% and a tracking-error increased 70%. Though this analysis would not have anticipated Valeant’s subsequent decline, it would have warned fund investors that Sequoia’s risk was out of the ordinary. 

Sequoia Fund’s Risk Profile

Below is a chart of Sequoia’s major factor exposures, spanning a ten year history through June 2015:

Chart of the exposures of Sequoia Fund (SEQUX) to the risk factors contributing most to its risk

Sequoia Fund (SEQUX) – Historical Factor Exposures

(Note that this analysis and our model do not include Valeant’s recent heightened volatility: we are using the AlphaBetaWorks Statistical Equity Risk Model as of 8/31/15 and SEQUX’s positions as of 6/30/2015. In short, we are looking at the world prior to Valeant’s subsequent downside volatility.)

Sequoia’s stock selection and allocation decisions result in certain factor bets such as market beta (“US and Canada”, above), other factors (Value, Size), and sectors (Consumer, Health). The red dots above represent factor exposures in a particular month, the red boxes represent two quartile deviations, and the diamonds denote current (i.e. 6/30/15) exposures. Several sectors/factors are circled for emphasis: they are current exposures as well as outliers versus history. More importantly, these outlying factor bets are the direct result of Sequoia’s large percentage ownership of Valeant.

The Impact of Valeant on Sequoia Fund’s Factor Exposures

We examined Sequoia Fund’s factor exposures with and without Valeant. We assumed that the pro forma Sequoia Fund without Valeant would have increased all other positions proportionally to make up for the void.  For example, we increase Sequoia’s next-largest position (TJX) from 7.3% to 10.9%, and so on for all longs for the pro forma non-Valeant Sequoia portfolio.

Below is a chart comparing the most salient factor exposures of Sequoia Fund, with and without Valeant:

Chart of the exposures of Sequoia Fund (SEQUX) to the risk factors contributing most to its risk including and excluding the position in Valeant (VRX)

Sequoia Fund (SEQUX) – Factor Exposures With and Without Valeant (VRX)

Valeant has had a significant impact on Sequoia’s factor exposures. The factors with the highest delta are the same as those highlighted as outliers on the first chart above.

This is significant in several ways. First, the large Valeant holding increases Sequoia Fund’s overall volatility by 25%. Second, Sequoia’s tracking error is increased by its Valeant holding by 70%. Sequoia Fund volatility estimates with and without Valeant are below:

The main components of Sequoia Fund’s (SEQUX’s) absolute and relative volatility and variance including the position in Valeant (VRX)

Sequoia Fund (SEQUX) with Valeant (VRX) – Absolute and Relative (to S&P 500) Estimated Risk

The main components of Sequoia Fund’s (SEQUX’s) absolute and relative volatility and variance excluding the position in Valeant (VRX)

Sequoia Fund (SEQUX) without Valeant (VRX) – Absolute and Relative (to S&P 500) Estimated Risk

Valeant increases Sequoia’s overall predicted volatility (tracking error) by 26% (from 9.73% to 12.31%, annualized – gold boxes). Likewise, Valeant increases Sequoia’s tracking error by 69% (from 5.19% to 8.76% – brown boxes). Increases in both Absolute and Relative volatility are due to the incremental Residual Risk contribution of Sequoia’s large Valeant holding (graphically shown by the larger blue boxes in the “with VRX” charts, in contrast to smaller blue boxes in the “without VRX” charts).

Conclusions

In the end, this analysis is not about Sequoia or VRX. It is a single example of decisions that could have been avoided by a portfolio manager or questions that would have arisen to an allocator with the proper risk toolkit. Sequoia’s decision to make Valeant an outsized position did not go unnoticed from a risk standpoint. Increases in factor exposures of two to three times outside historical bounds were an early warning. The impact of this was increased predicted volatility – both on an absolute basis and relative to the S&P 500. A framework that warns of a fund taking large factor and idiosyncratic bets aids greatly in avoiding negative surprises.

The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2015, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
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Mutual Fund Closet Indexing: 2015 Update

An index fund aims to track the market or its segment, with low fees. An actively managed fund aims to do better, but with higher fees. So in order to earn its fees, an active mutual fund must take risks. Much of the industry does not even try. Mutual fund closet indexing is the practice of charging active fees for passive management. Over a third of active mutual funds and half of active mutual fund capital appear to be investing passively: Funds tend to become less active as they accumulate assets. Skilled managers who were active in the past may be closet indexing today. Simply by identifying closet indexers, investors can eliminate half of their active management fees, increase allocation to skilled active managers, and improve performance. 

Closet Indexing Defined

A common metric of fund activity is Active Share — the percentage difference between portfolio and benchmark holdings. This measure is flawed: If fund with S&P 500 benchmark buys SPXL (S&P 500 Bull 3x ETF), this passive position increases Active Share. If a fund with S&P 500 benchmark indexes Russell 2000, this passive strategy has 100% Active Share. Indeed, recent findings indicate that high Active Share funds that outperform merely track higher-risk benchmarks.

Factor-based analysis of positions can eliminate the above deficiencies. We applied the AlphaBetaWorks Statistical Equity Risk Model to funds’ holdings over time and estimated each fund’s unique factor benchmark. These passive factor benchmarks captured the representative systematic risks of each fund. We then estimated each fund’s past and future tracking errors relative to their factor benchmarks and identified those funds that are unlikely to earn their fees in the future given their current active risk. We also quantified mutual fund closet indexing costs for a typical investor.

This study covers 10-year portfolio history of approximately three thousand U.S. equity mutual funds that are analyzable from regulatory filings. It updates our earlier studies of mutual fund and closet indexing with 2015 data. Due to the larger fund dataset and higher recent market volatility, the mutual fund industry appears slightly more active now than in the 2014 study.

Information Ratio – the Measure of Fund Activity

The Information Ratio (IR) is the measure of active return a fund generates relative to its active risk, or tracking error. We estimated each fund’s IR relative to its factor benchmark. The top 10% of U.S. equity mutual funds achieved IRs above 0.36:

Chart of the historical information ratio for active returns of U.S. mutual funds’ equity portfolios

U.S. Equity Mutual Funds: Historical Information Ratio Distribution

 Min. 1st Qu.  Median    Mean 3rd Qu.    Max.
-5.34   -0.49   -0.22   -0.23    0.06    3.26

If a fund outperforms 90% of the group and achieves 0.36 IR, then it needs tracking error above 1% / 0.36 = 2.79% to generate active return above 1%. So assuming a typical 1% fee, if a fund were able to consistently achieve IR in the 90th percentile, it would need annual tracking error above 2.79% to generate net active return. As we show, much of the industry is far less active. In fact, half of U.S. “active” equity mutual fund assets do not even appear to be trying to earn a 1% active management fee.

Historical Mutual Fund Closet Indexing

Tracking error comes from active exposures: systematic (factor) and idiosyncratic (stock-specific) bets. The AlphaBetaWorks Statistical Equity Risk Model used to estimate these exposures is highly accurate and predictive for a typical equity mutual fund.

Over 28% (746) of the funds have taken too little risk in the past. Even if they had exceeded the performance of 90% of their peers each year, they would still have failed to earn a typical fee. These funds have not even appeared to try to earn their fees:

Chart of the historical mutual fund closet indexing as measured by the tracking error of active returns of U.S. mutual funds’ equity portfolios

U.S. Equity Mutual Funds: Historical Tracking Error Distribution

Min. 1st Qu.  Median    Mean 3rd Qu.    Max.
0.35    2.63    3.95    4.62    5.90   26.60

Current Mutual Fund Closet Indexing

Funds tend to become less active as they grow. To control for this, we estimated current tracking errors of all funds relative to their factor benchmarks.

Over a third (961) of the funds are taking too little risk currently. Even if they exceed the performance of 90% of their peers each year, they will still fail to merit a typical fee. These funds are not even appearing to try to earn their fees:

Chart of the predicted future mutual fund closet indexing as measured by the tracking error of active returns of U.S. mutual funds’ equity portfolios

U.S. Equity Mutual Funds: Predicted Future Tracking Error Distribution

Min. 1st Qu.  Median    Mean 3rd Qu.    Max.
0.92    2.45    3.20    3.52    4.29   20.90

Capital-Weighted Mutual Fund Closet Indexing

Since funds become less active as they grow, larger mutual funds are more likely to closet index. The 36% of mutual funds that have estimated future tracking errors below 2.79% represent half of the assets ($2.25 trillion out of the $4.57 trillion total in our study). Hence, half of active equity mutual fund capital is unlikely to earn a typical free, even when its managers are highly skilled:

Chart of the capital-weighted predicted future mutual fund closet indexing as measured by the tracking error of active returns of U.S. mutual funds’ equity portfolios

U.S. Equity Mutual Funds: Capital-Weighted Predicted Future Tracking Error Distribution

Min. 1st Qu.  Mean 3rd Qu.    Max.
0.92    2.10  2.79    3.72   20.90

Even the most skilled managers will struggle to generate IRs in the 90th percentile each and every year. Therefore, portfolios of large funds, when built without robust analysis of manager activity, may be doomed to negative net active returns. Plenty of closet indexers charge more than the 1% fee we assume, and plenty of investors will lose even more.

A Map of Mutual Fund Closet Indexing

As a manager accumulates assets, fee harvesting becomes more attractive than risk taking. Managers’ utility curves may thus explain large funds’ passivity. The following map of U.S. mutual fund active management skill (defined by the αβScore of active return consistency) and current activity illustrates that large skilled funds are generally less active. Large skilled funds, represented by large purple circles on the right, cluster towards the bottom area of low tracking error:

Chart of the historical active management skill as represented by the consistency of active returns and predicted future tracking error of active returns of U.S. mutual funds’ equity portfolios

U.S. Equity Mutual Funds: Historical Active Management Skill and Predicted Future Activity

In spite of the widespread mutual fund closet indexing, numerous skilled and active funds remain. Many are young and, with a low asset base, have a long way to grow before fee harvesting becomes seductive for their managers.

Conclusions

  • Over a third of U.S. equity mutual funds are currently so passive that, even if they exceed the information ratios of 90% of their peers, they will still fail to merit a typical fee.
  • Half of U.S. equity mutual fund capital will fail to merit a typical fee, even when its managers are highly skilled.
  • As skilled managers accumulate assets, they are more likely to closet index.
  • A typical investor can re-allocate half of their active equity mutual fund capital to cheap passive vehicles or truly active skilled managers to improve performance.
The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2015, 
AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
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When “Smart Beta” is Simply High Beta

WisdomTree Mid Cap Earnings Fund (EZM) vs. PowerShares Dynamic Large Cap Value Portfolio (PWV)

Many “smart beta” funds are merely high-beta, delivering no value over traditional index funds. On the other hand, some smart beta strategies are indeed exceptional and worth their fees.

Most analyses of enhanced index funds and smart beta strategies lack a rigorous approach to risk evaluation and performance attribution. Consequently, risky and mediocre funds are mislabeled as excellent, while conservative and exceptional funds are wrongly considered mediocre. Investors relying on simplistic analyses may end up with mediocre funds, hidden risks, and subpar performance.

The Not-So-Smart Beta

Some smart beta funds deliver consistent outperformance with high liquidity and low tracking error. Others merely deliver high market beta or high exposures to other common risk factors. Analyses of these funds’ performance are usually simplistic, failing to differentiate between the two groups.

Enhanced indexing and smart beta strategies are usually more active than the underlying indices. This can cause their risk to vary dramatically over time. For instance, a fund’s market beta can vary by 40-50% over a few years. This variation makes it difficult to determine whether a particular strategy is smart or merely risky. When a market correction arrives, risky funds suffer outsized losses.

Many estimate the beta of a fund by fitting its returns to the market or a benchmark using a regression, a technique known as returns-based style analysis. This is a flawed approach, which fails to accurately estimate the risk of active strategies. We discussed the flaws of returns-based style analysis in earlier articles.

A robust approach to estimating a fund’s historical risk and risk-adjusted performance is to evaluate its holdings over time. At each period, the risk of individual holdings is aggregated to estimate the risk of the fund. This is AlphaBetaWorks’ approach, implemented in our Performance Analytics Platform. Our analysis reveals that many “smart beta” funds are merely high-beta. These funds deliver no value over traditional index funds. On the other hand, some smart beta strategies are indeed exceptional and worth the fees they charge.

WisdomTree Mid Cap Earnings Fund (EZM) – Historical Risk

On the surface, the returns of the WisdomTree Mid Cap Earnings Fund (EZM) appear strong. The fund has dramatically outperformed its broad benchmark, the Russell Midcap Index (IWR):

Chart of the Cumulative Return of WisdomTree Mid Cap Earnings Fund (EZM) and of the Benchmark (IWR)

Cumulative Return of WisdomTree Mid Cap Earnings Fund (EZM) vs the Benchmark (IWR)

However, this is nominal outperformance, not risk-adjusted outperformance.

The main source of security risk and return is market risk, or beta. With this in mind, we analyzed the holdings of EZM and IWR during each historical period, calculated their holdings’ risk, and calculated the total risk of each fund. Not surprisingly, IWR’s beta has been stable, averaging 1.09 (109% of the risk of U.S. Market). Meanwhile, EZM’s beta has varied in a wide range, averaging 1.18 (118% of the risk of U.S. Market):

Chart of the historical beta of the WisdomTree Mid Cap Earnings Fund (EZM) compared to the historical beta of the Benchmark (IWR)

Historical Beta of WisdomTree Mid Cap Earnings Fund (EZM) vs the Benchmark (IWR)

EZM had higher returns, but it also consistently took more market risk. With greater risk comes greater volatility, and a down cycle will affect EZM more.

To determine its risk-adjusted return, we must compare the performance of EZM to the performance of a passive portfolio with the same factor exposures.  Below are EZM’s current and historical factor exposures:

Chart of the historical and current factor exposures of the WisdomTree Mid Cap Earnings Fund (EZM)

Historical Factor Exposures of WisdomTree Mid Cap Earnings Fund (EZM)

WisdomTree Mid Cap Earnings Fund (EZM) – Risk-Adjusted Performance

Instead of owning EZM, investors could have owned a passive portfolio with similar risk (a passive replicating portfolio). If EZM had profitably timed the market (varied its risk) or selected securities, it should have outperformed.

EZM’s risk-adjusted performance closely matches a passive replicating portfolio. Relative to its passive equivalent, EZM has generated negligible active return (abReturn in the following chart):

Chart of the historical passive and active returns of the WisdomTree Mid Cap Earnings Fund (EZM)

Historical Passive and Active Return of WisdomTree Mid Cap Earnings Fund (EZM)

PowerShares Dynamic Large Cap Value Portfolio (PWV) – Risk-Adjusted Performance

Let’s contrast the performance of EZM with the results of another smart beta option: PowerShares Dynamic Large Cap Value Portfolio (PWV).

PWV has also varied U.S. Market exposure by approximately 40%:

Chart of the historical and current factor exposures of the PowerShares Dynamic Large Cap Value Portfolio (PWV)

Historical Factor Exposures of PowerShares Dynamic Large Cap Value Portfolio (PWV)

PWV has consistently outperformed its passive replicating portfolio and produced strong active returns due to market timing and security selection:

Chart of the historical passive and active returns of the PowerShares Dynamic Large Cap Value Portfolio (PWV)

Historical Passive and Active Return of PowerShares Dynamic Large Cap Value Portfolio (PWV)

Conclusion

Performance evaluation tools lacking accurate insights into risk may rank the better-performing but riskier EZM ahead of PWV, which produced superior active returns. The accurate picture of their relative active performance emerges once both funds’ historical holdings are examined with a multi-factor risk model and their excess returns distilled.

Unsuspecting investors relying on simplistic analysis may conclude that a risky and mediocre fund is excellent while a conservative and exceptional fund is mediocre. At best, they will face higher-than-anticipated risks. At worst, they will get a nasty surprise when a correction comes.

The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2015, 
AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
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Mutual Fund Closet Indexing – Part 3

Why Most Investors Lose, Even if Their Manager is Skilled

An actively managed fund must take risk sufficient to generate active returns in excess of the fees that it charges. However, as skilled managers accumulate assets, they tend to become less active. Skilled managers who took sufficient active risk to earn their fees in the past may be closet indexing today. Consequently, over two thirds of the capital invested in “active” U.S. mutual funds is allocated to managers who are unlikely to earn the average fee, even if highly skilled. Simply by identifying these managers, investors can eliminate most active management fees and improve portfolio performance. 

Closet Indexing Defined

Our first article in this series discussed closet indexing and proposed a new metric of fund activity: Active Share of Variance  the share of volatility due to active management (security selection and market timing). The second article analyzed historical performance of U.S. mutual funds and discovered that over a quarter (26%) of the funds surveyed have been so passive that, even after exceeding the information ratios of 90% of their peers, they would still not be worth the 1% mean management fee.

Too Little Current Risk to Earn Future Fees

Thus far, our analysis improved on existing closet indexing metrics by evaluating past fund activity. The shortcoming of this analysis has been its failure to identify funds that have been active in the past but are closet indexing today. This article addresses the shortcoming: We analyze current and historical positions of approximately 1,700 non-index medium and lower turnover U.S. mutual funds, identifying those that are unlikely to earn their management fees in the future given their current active risk.

The Information Ratio (IR) is a measure of active return relative to active risk (tracking error). The top 10% of the funds achieve IR’s greater than or equal to 0.30; 90% achieve IR’s below 0.30:

Chart of the Distribution of Information Ratios for U.S. Mutual Funds

U.S. Mutual Fund Information Ratio Distribution

If a fund exceeds the performance of 90% of its peers and achieves IR of 0.30, then it needs tracking error above 3.3% to generate active return above 1%. The mean expense ratio for active U.S. mutual funds is approximately 1%. Therefore, if all funds were able to achieve the 90th percentile of IR, they will need annual tracking error above 3.3% to earn the mean fee and generate a positive net active return.

Tracking error is due to active risks a fund takes: security selection risk due to stock picking and market timing risk due to variation in factors bets. We applied the AlphaBetaWorks Statistical Equity Risk Model to funds’ historical and latest holdings and estimated their future tracking errors.

Over half (911) of the funds have such low estimated future tracking errors that, even if they exceeded the performance of 90% of their peers and achieved the IR of 0.30, they will fail to merit the 1% mean management fee:

Chart of the Distribution of Estimated Future Tracking Errors for U.S. Mutual Funds

U.S. Mutual Fund Estimated Future Tracking Error Distribution

Capital-Weighted Closet Indexing

Larger mutual funds are more likely to engage in closet indexing. While only 54% of mutual funds surveyed have estimated future tracking errors below 3.3%, they represent 70% of the assets ($2.4 trillion out of the $3.4 trillion total). Therefore, even if capital is invested with highly skilled managers, more than two thirds of it will not earn the 1% mean management fee:

Chart of the Distribution of Estimated Future Tracking Error of the Capital Invested in U.S. Mutual Funds

U.S. Mutual Fund Capital Estimated Future Tracking Error Distribution

A portfolio that primarily consists of large mutual funds may be doomed to generate negative active returns, regardless of the managers’ skills. The 1% management fee cited here is the mean. Plenty of closet indexers charge more and plenty of investors who remain with them stand to lose more.

Conclusions

  • Over half (54%) of active U.S. mutual funds surveyed are currently so passive that, even after exceeding the information ratios of 90% of their peers, they will still fail to merit a 1% management fee.
  • Over two thirds (70%) of active U.S. mutual fund capital surveyed will fail to merit a 1% management fee, even if its managers are highly skilled.
  • Skilled active managers do exist, but investors need to capture them early in their life cycles.
  • Investors must monitor the evolution of their skilled managers towards passivity.
  • By identifying closet indexers, a typical investor can eliminate most active fees and improve performance.
The information herein is not represented or warranted to be accurate, correct, complete or timely.
Past performance is no guarantee of future results.
Copyright © 2012-2014, 
AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
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Mutual Fund Closet Indexing – Part 2

Can a Fund Earn Its Fees if It Does Not Try?

To be worth the fees it charges, an actively managed fund must take some active risk, rather than merely mirror passive market exposures. However, over a quarter of “active” medium and lower turnover US mutual funds take so little active risk, they are unlikely to earn their management fees. In this article, we build on our earlier work and estimate the risk an active fund must take in order to earn the 1% mean management fee. Simply by testing for funds that are taking too little risk to generate positive net active returns, investors can save billions in fees each year. 

Closet Indexing Defined

Our earlier article discussed closet indexing and proposed a new metric of fund activity: Active Share of Variance – the share of volatility due to active management (security selection and market timing). This analytic relies on the factor analysis of historical holdings and is immune to the issues with holdings-based analysis and the issues with returns-based analysis that affect the popular closet indexing tests: Active Share and . This article uses the AlphaBetaWorks’ Performance Analytics Platform to objectively evaluate the level of fund activity necessary to earn a typical management fee.

Too Little Risk to Make a Difference

Is it possible for a highly skilled manager to take too little risk to earn management fees?

We surveyed 10 years of US filings history of approximately 1,700 non-index medium and lower turnover mutual funds with at least 5 years of filings. This group holds over $3.4 trillion in assets.

We applied the AlphaBetaWorks Statistical Equity Risk Model to funds’ historical holdings to estimate risk at the end of each month. We then attributed the following month’s returns to factor(market) and residual(security-specific) sources, estimated the appropriate factor benchmark, and calculated market timing returns due to variations in factor exposures.

The Information Ratio (IR) is a measure of active return relative to active risk (tracking error). The AlphaBetaWorks Performance Analytics Platform calculated historical (realized) IRs for all funds in the group. The 90th percentile of IR for the group is 0.30, which suggests that 90% of funds needed a tracking error above 3.3% to generate an active return above 1%:

US Mutual Fund Information Ratio Distribution

US Mutual Fund Information Ratio Distribution

Knowing that the mean expense ratio for active US mutual funds is approximately 1.0%, if all funds were able to achieve the 90th percentile of IR, they would need annual tracking error over 3.3% to generate a positive net active return. Over a quarter (445) of the funds in our survey realized tracking errors below this threshold; they have been so passive that, even assuming an IR of 0.30, they would have failed to generate 1% gross and 0% net active returns:

US Mutual Fund Tracking Error Distribution

US Mutual Fund Tracking Error Distribution

A Map of US Mutual Fund Skill and Activity

The evolution of skilled managers’ utility curves is one possible explanation for this reluctance to take risk. Perhaps, as a manager accumulates assets, fee harvesting becomes increasingly attractive. The map of fund active management skill and activity, included below, supports this hypothesis: Large skilled funds tend to be relatively less active. In fact, all the funds in the active and skilled (“Hungry”) group are relatively small:

US Mutual Fund Active Management Skill and Activity

US Mutual Fund Active Management Skill and Activity

Conclusions

  • Over a quarter (26%) of US mutual funds surveyed have been so passive that, even after exceeding the information ratios of 90% of their peers, they would still fail to merit a 1% management fee.
  • Large skilled funds tend to be relatively more passive.
  • Skilled active managers exist, but investors need to capture them early in their life cycles.
  • For this group alone, by identifying funds that take too little risk to generate positive active returns, investors could save between $4 and $10 billion in annual management fees.

Thus far, our work improves on the existing closet indexing metrics by evaluating past fund activity. In subsequent articles we will use the AlphaBetaWorks Performance Analytics Platform to analyze current risk and closet indexing, identifying those funds that are unlikely to earn their management fees in the future.

Copyright © 2012-2014, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.
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Mutual Fund Closet Indexing – Part 1

Are you Paying Active Fees for Passive Management?

Closet indexing may be practiced by 20% to 50% of “active” medium and lower turnover US mutual funds. To make this case, we improve on traditional holdings- and returns-based closet indexing metrics. Simply by testing for closet indexing, investors can save billions in management fees each year.

Closet Indexing

A 2009 study introduced the concept of Active Share to measure the degree to which a fund is actively managed, showing that active stock pickers outperform closet indexers. Another notable active management metric is with respect to a multifactor model.  Both metrics have their drawbacks:  Active Share relies on vulnerable holdings-based analysis. For example, suppose a manager holds a position in a benchmark ETF; this position will increase Active Share without making the fund more active. R² relies on returns-based analysis, which does not distinguish between passive factor exposures and market timing, among other limitations. Hence, both metrics are susceptible to manipulation and may not properly identify passive funds.

A Robust Approach

The AlphaBetaWorks approach relies on risk and attribution capabilities free of the above issues. We surveyed ten years of historical holdings of approximately 1,700 non-index medium and lower turnover mutual funds with at least 5 years of position history. This group manages over $3.4 trillion in assets. We used our proprietary Statistical Equity Risk Model on historical holdings to estimate fund risk at the end of each month. We then attributed the following month’s returns to factor (market), and residual (security-specific) sources. We compared the variance of residual and factor returns of the group to NASDX, a NASDAQ 100 ETF. We selected this ETF as a passive reference strategy that is more concentrated than broad market benchmarks but less concentrated than granular sector indices. Using an S&P 100 ETF yields similar conclusions.

For NASDX, factor exposures at the end of a given month explain approximately 95% of return variance in the following month. The remaining 5% residual variance is due to security selection.

How active are funds in our group compared to this 100-position ETF? A quarter (425 funds) had a lower share of residual variance – they were less active stock pickers:

Security Selection Share of Historical US Mutual Fund Variance

Security Selection Share of Historical US Mutual Fund Variance

Security selection is not the only source of active performance. The variation in factor exposures, or factor (market) timing, is another. The NASDAX’s historical factor exposures were not constant over the last 10 years. This factor exposure variation is responsible for 4.1% of monthly return variance. Eighty percent (1,354 funds) had been less active market timers:

Market Timing Share of Historical US Mutual Fund Variance

Market Timing Share of Historical US Mutual Fund Variance

Active returns consist of both security selection and market timing. In the case of NASDX, 93.3% of its 10-year monthly return variance can be explained by passive factor bets, while 6.7% is active. We call the latter figure the Active Share of Variance.

Using the F test to evaluate whether historical Active Share of Variance of a given fund exceeded that of NASDX, we produced a confidence level that a fund has been more active than the ETF. The following chart illustrates the confidence that each fund in our group has been active and shows Historical Active Shares of Variance due to security selection and market timing:

Distribution of Historical Active Share of Variance and Confidence that a Fund is Active

Distribution of Historical Active Share of Variance and Confidence that a Fund is Active

At the 95% confidence level, fewer than half of the funds (737) have been more active than the ETF; more than a fifth (350) have been less active. The test is inconclusive for the remaining 36% (602 funds), suggesting that investors can’t be certain that over half the “active” mutual funds surveyed are in fact active:

Distribution of Confidence that a Fund is Active

Distribution of Confidence that a Fund is Active

Conclusions

  • Over half (56%) of active US mutual funds surveyed are not significantly more active than a 100-position NASDX ETF.
  • Less than half (44%) of the funds are significantly more active that the ETF.
  • More than a fifth (21%) of the funds are significantly less active than the ETF.
  • Investors must be sure that they are not being charged active fees for passive management.
  • By identifying closet indexers within this group alone, investors could save between $4 and $15 billion in annual management fees.

This work improves on traditional holdings-based and returns-based analyses of fund activity. Admittedly, we use a subjective benchmark for activity – a specific passive ETF. In later notes we will use the AlphaBetaWorks Performance Analytics Platform to evaluate activity levels using objective metrics.

Copyright © 2012-2014, AlphaBetaWorks, a division of Alpha Beta Analytics, LLC. All rights reserved.
Content may not be republished without express written consent.

 

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