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Federated Makes Case For Truly Active Management

By DailyAlts Staff “It can pay to be active,” according to Federated Investment Consulting, whose recent whitepaper makes the case against passive indexing and for “truly active management.” Conceding that passive strategies can perform “as well as the average,” Federated argues that portfolios constructed with little regard to benchmarks can outperform, particularly during periods like the one we appear to be entering. Truly Active Management Actively managed funds seek to outperform their benchmarks, such as the S&P 500 for equity funds. Passively managed funds, by contrast, seek only to match the performance of the benchmark to which they’re indexed. Thus, in bear markets, passively managed funds tend to post wide losses, while actively managed funds have the flexibility to shift exposures to minimize losses or even eke out gains. According to Federated’s whitepaper , studies suggest “truly active management” can “generate the opportunity for outperformance” even after fees. These same studies show that “truly active management” tends to do better than passive management during periods of declining correlations across markets. For years, global central banks were “on the same page” coordinating monetary policy; but now the Federal Reserve is widely expected to begin raising interest rates in the U.S. sometime in 2015, while the Bank of Japan and European Central Bank are doing the opposite. This divergence of global policy is widely expected to result in the “declining correlations across markets” under which “truly active management” tends to outperform. But what is “truly active management?” Federated defines it simply as strategies “that construct portfolios with little regard to their benchmark,” in which security selection and weighting “deviates significantly” from the benchmark. These are “stock picking” strategies, and Federated believes “the virtues of stock picking may rise” since the U.S. stock market is near record highs and “the prospect for higher rates is threatening the outlook for bonds.” Federated also references a study conducted by Antti Petajisto and Martijn Cremers of the Yale School of Management that shows that funds with higher levels of active management outperform those that are considered “benchmark huggers,” as seen in the following chart: Historical Evidence Federated uses historical evidence in support of its thesis. The period of 2010-2011 saw increasing correlation, high volatility, and “low dispersion between the highest individual stock return and the lowest individual stock return.” These conditions naturally favor passive managers. But in 2012 and 2013, correlations fell and dispersion rose, creating the conditions under which active managers can more easily outperform. Passive strategies generated returns of roughly 16% and 32% in 2012 and 2013, but the returns of actively managed strategies were even higher. The top 25% of active managers have significantly outperformed passive strategies dating back to 1999. A $10,000 investment in a top quartile active manager made on December 31, 1998 would have grown to $35,411 by year-end 2013, while the same investment in the S&P 500 would have grown to just $19,854, according to Federated. This significant outperformance among the top 25% is a strong argument for investors to conduct thorough due diligence on prospective active managers. Conclusion “Active management has its issues,” Federated concedes near the end of the whitepaper, and chief among them are fees. But at the same time, Federated says “fees are relative,” and that low-fee options make sense for “highly efficient asset classes,” but not asset classes such as “international growth and value stocks, and small-cap core and value stocks,” which are “highly inefficient.” Management fees are justified since passive indexing to “highly inefficient” asset classes will result in relative underperformance, in Federated’s view. Most investors want to beat the average, and the only way to do that is through active management. Low-fee passive indexing inevitably results in average returns, minus a low fee. But active management, even with higher fees, can result in returns that greatly exceed the average, thereby resulting in market-beating returns – even after fees.

The ETF Retirement Portfolio Revisited

Summary After nearly its first full year, my ETF Retirement Portfolio is a qualified success; I continue to keep skin in the game. Most core holdings have performed very well. Some changes have been made to boost dividend yield and shore up the portfolio’s overall performance. In May, 2014, I presented a portfolio strategy that was intended to provide a solid core to a retirement portfolio 1 – I also have some skin in the game, having put a substantial part of my own portfolio in this strategy. After more than three quarters, the portfolio has gone through some changes: three of the original holdings are still in place, but there are now four ETFs, rather than the five I started with. For the time being, I see no substantive changes on the horizon, 2 so I wanted to update readers on the status of the portfolio (let’s call it ” ETF/RP “). The Philosophy Behind ETF/RP The retirement portfolio was considered (and constituted) after a particularly unhappy January in 2014, when I began wondering how I could position a large part of my investable funds so that I wouldn’t have to be overly concerned about how well those funds were doing. I dislike a formulaic approach to things – such as the “rule” about dividing one’s assets between a certain percentage of bonds and a certain percentage in equity, and so on 3 – so I wanted to try a way that would pay lip service to conventional wisdom while still sticking my neck out a little bit. By “retirement portfolio” I mean a portfolio for people who have already retired ; a portfolio designed to prepare for retirement should look a bit different, as the aims of the portfolio would be different (more towards capital growth, less towards income generation). The underlying aim of ETF/RP is capital preservation , which is perhaps the most important consideration for a retired investor. Retirees are not always in a position to make up for lost capital, so the risks taken have to be carefully evaluated with an eye to minimizing them. In addition, there were three things I sought from the portfolio: Modest growth potential; Potential for high dividend yield; Low maintenance. Seeking a high level of growth involves the assumption of higher levels of risk. The portfolio is thus not designed to generate growth in share value; rather, it is intended to secure as much capital as possible while offering the opportunity for growth. That growth may be modest , to be sure, but capital is in less danger of being lost. The highest dividend yields are going to involve the highest levels of risk; at the same time, yield is how the retiree acquires access to cash without selling shares. 4 The S&P 500 has an average dividend yield of 2.01%, 5 with the DJIA bringing in an average of 2.78%. 6 Prudent ETF choices can secure a higher yield, but – again – at higher risk. As for low maintenance, this is supposed to be for retirement. I want to do things other than managing my investments. 7 The goal at this point is to be able to leave the investments in place, thereby minimizing transaction costs; investors should feel confident that, but for the occasional flash crash or great recession, their investments are still at work making money. ETF/RP When I first began structuring the retirement portfolio it consisted of three ETFs: The SPDR Income Allocation ETF (NYSEARCA: INKM ) The iShares Morningstar Multi-Asset High Income Index ETF (BATS: IYLD ) The PowerShares S&P 500 Low Volatility Portfolio ETF (NYSEARCA: SPLV ) Gradually, two more ETFs were added to the collection: The iShares Moderate Allocation ETF (NYSEARCA: AOM ) The First Trust Multi-Asset Diversified Income Index ETF (NASDAQ: MDIV ) AOM quickly became the victim of less-than-enthusiastic performance, and was replaced by the PowerShares CEF Income Composite Portfolio ETF (NYSEARCA: PCEF ); PCEF itself recently became the victim to the same problem, and was replaced by the iShares Mortgage Real Estate Capped ETF (NYSEARCA: REM ). On 16 January, 2015, my shares MDIV were sold, the proceeds going to increase holdings in the other ETFs. The following chart reflects the performance of the portfolio (and each of its holdings) from inception (11 February, 2014) through 16 January, 2015. 8 (click to enlarge) INKM & IYLD As it turns out, INKM and IYLD are maybe the lynchpins of the portfolio, and they were chosen because they seemed to have just that kind of potential. The funds are structured alike, consisting of ETFs managed by their respective issuers, with attention paid to bonds (both corporate and government, U.S. and foreign) and stocks (U.S. and foreign, including emerging markets), as well as other instruments. 9 There are differences between the two, however, notably concerning their philosophies. INKM has a greater diversity of holdings than IYLD , and those holdings address capital stability; IYLD , on the other hand, places more emphasis on yield, it’s holdings consisting of instruments that produce more substantial income at some cost of increased risk. Both funds had their inceptions in April, 2012, so their performance has been in an environment dominated by quantitative easing. How these funds will perform now that easing has ended and interest-rate increases are on the horizon remains to be seen; to date, however, they have shown that they are not just “duplicate” funds. The following chart shows their performance since inception: (click to enlarge) INKM ‘s broader diversity has enabled it to provide significantly better performance than IYLD . At the same time, IYLD ‘s yield helps enable it to provide greater income, giving it a total return that helps make up most of the difference in performance: In a portfolio that seeks to provide both capital preservation and income generation, both ETFs fit the bill nicely – when working together. With INKM and IYLD , ETF/RP acquires exposure to bonds and other financial instruments, as well as accessing foreign markets. On a share-to-share basis, the funds combined to provide a dividend yield of 4.23% , and an appreciation in value of 6.49% for 2014. This strikes me as a solid foundation for an ETF-based retirement portfolio – both in concept and performance. SPLV I thought it important to have an element in the portfolio that would provide access to equities, and do so in a way that would hopefully minimize the influence market factors might have on the portfolio. This came with an acknowledgement that minimizing potential downward influence would also likely impact upward movement. There are several ETFs available that employ various “smart beta” strategies; my goal was to keep the portfolio simple, so I wanted the ETFs employed to be as basic as possible. SPLV is based on the S&P 500 – a solid foundation – and selects the 100 companies that have exhibited the least volatility for the past 12 months. The fund is reconstituted and rebalanced quarterly, which nominally boosts its expenses – note that its expense margin is lower than that of the other funds in ETF/RP – but, in return, one gets substantially better performance than is realized by the other ETFs. SPLV ‘s performance as part of ETF/RP is presented below: (click to enlarge) In the time that it has been in the portfolio, SPLV has outperformed the S&P 500 quite handily, although in historic measure, it is marginally lower than its “parent.” Close performance is all one can expect, however, and SPLV has so far provided more growth than I originally expected. MDIV At the time that I added MDIV to the ETF/RP I was looking for an ETF that would bolster the portfolio’s yield in a way that differed from that of IYLD . Where IYLD brought revenue from ETFs that managed high yield bonds and real estate, MDIV derived its revenue stream from direct investments in several areas that typically offer large dividends: MLPs, Utilities, Preferred Shares, REITs, and companies known for their generous dividends. Unfortunately, MDIV seemed to have difficulty getting off the ground, value-wise. Most important in its failure to perform was the one-two punch it took from a) the dramatic drop in oil prices, and b) the prospect of increasing interest rates. Although the fund has made some changes in its allocation since I bought it last year, it is still heavily weighted in REITs and MLPs. 10 Considered simply in terms of yield, MDIV may represent an interesting holding, as its yield is on a par with IYLD ; however, its status vis-à-vis capital preservation is less encouraging, and I do not expect its situation in this regard to change for the better any time soon. The following graph illustrates the influences that would seem to hamper MDIV ‘s progress: (click to enlarge) In the chart above, The United States Oil ETF LP (NYSEARCA: USO ) represents the extent of the drop in value oil’s recent plunge has caused; 11 MDIV components ONEOK Partners L.P. (NYSE: OKS ) and Memorial Production Partners L.P. (NASDAQ: MEMP ) have followed suit, as have others of MDIV ‘s MLP holdings. At the same time, REIT components focusing on mortgage-backed securities (i.e., mREITs) such as Capstead Mortgage Corp. (NYSE: CMO ) and American Capital Mortgage Investment Corp. (NASDAQ: MTGE ) are particularly sensitive to interest-rate pressures, and – with the prospect of an increase in interest rates by the Fed – have displayed some downward tendencies. 12 Whatever the outcome with respect to oil prices, it is unlikely that they will achieve levels seen before the recent drop anytime soon. This has raised various concerns about the sustainability of distributions to unit holders and the ability of indebted companies to make their interest payments. With Fed increases in interest rates almost a certainty by the end of the year (and possibly as early as June), there is room for concern that mREIT distributions and share value will also be hit. In light of the above, it strikes me as less than prudent to hold onto MDIV , at least as far as the ETF/RP is concerned. It looks to be very vulnerable to both a drop in share value (loss of capital) and a decrease in available distributions. It is possible to secure comparable yield from IYLD without the attendant prospect of loss of capital. It is also possible to secure larger yield than MDIV ‘s, albeit with continued risk to capital. It is a matter of weighing alternatives, and at this time MDIV does not seem to be a particularly good alternative. Thus, MDIV was dropped from the portfolio on 16 January, 2015, and no ETF was picked up to replace it. Instead, proceeds from the sale were used in increase shares in the other ETFs in the portfolio. REM In an article written in May, 2014, I discussed my reasons for replacing AOM with PCEF . 13 In the subsequent six months PCEF proceeded to drop by 2.94% – certainly offset by its dividends, but as with MDIV , it is possible to find higher-yielding ETFs. This is particularly true if one is resigned to suffering some loss of capital in the course of getting higher dividends. In November, 2014, I wrote an article examining both REM and the Market Vectors Mortgage REIT Income ETF (NYSEARCA: MORT ); 14 my examination satisfied me that REM was a reasonable fund to hold if one was looking for solid dividends and the prospect of share growth. In December I sold PCEF and replaced it with REM . I increased my position (as well as that of INKM , IYLD and SPLV ) when I sold MDIV . Selecting REM (particularly at the time when I did) brings with it the prospect of shaky capital preservation – at least until the nervousness about rate hikes diminishes. However, the performance reflected in the diagram above bought significant yield improvement: If I’m going to risk capital to secure dividend yield, I might as well get the highest yield I can reasonably get. 15 Moreover, REM has the advantage of being subject to only one primary risk factor (interest rates), while MDIV was subject to at least two major factors and PCEF was vulnerable to interest rates and the risk inherent in closed-end funds in general. REM thus seems the better opportunity – at least for the foreseeable future. Summary Clearly, in retrospect it would have been nice to have had all of ETF/RP invested in SPLV ; in the period from 11 February, 2014 through 16 January, 2015 that fund saw a total return of 19.07%. The portfolio did not do that badly, however: (click to enlarge) The combination of MDIV and the AOM / PCEF / REM position did hold down overall performance, but the “divestiture” of MDIV along with the introduction of REM ‘s high yield should bring about improved performance. 16 The portfolio is not quite one year old, and the next 12 months will no doubt see plenty of market vacillation – particularly as the Fed nears its first rate hike. I feel confident that the present allocation is well suited to current economic conditions. (click to enlarge) ” 5 ETFs For A Reliable Retirement Portfolio ,” Seeking Alpha , 6 May, 2014. Famous last words, no doubt. The formula would have me with 60% in bonds and 40% in equities, but (A) bonds have not been really “hot” of late, and I think the bull market still has some life left to it, even if it may be doddering its way into old age. Again, capital preservation: not only do we want not to lose any money, we don’t want to have to spend our capital, either. Through 31 December, 2014, according to the S&P 500 Fact Sheet available here . Updated 15 January, 2015, according to indexArb . So I spend much of my time sitting in front of a computer screen, researching investment material for articles, instead. A rather dramatic shift in ETF/RP ‘s performance in early May, and again in early November, reflects the redistribution of capital, as well as the infusion of accumulated dividends and extra cash. The infusion of capital was made to adjust the portfolio to reflect a market-value weighting schema. In the ETF tables that follow I present the expenses and investment income for each fund as reported in their most recent annual report. I also refer to the funds’ expense margin – a datum I develop and discuss in my article ” Ignore ETF Expense Ratios? Maybe .” Briefly stated, the expense margin identifies how much investment income a fund pays towards its expenses – it is, in a sense, a measure of a fund’s efficiency. MDIV may be examined at its homepage, here . Approximately 40% of its holdings are in REITs and MLPs, with another nearly 20% invested in the First Trust Tactical High Yield ETF (NASDAQ: HYLS ), which concentrates on high-yield corporate bonds. USO is presented for illustrative purposes, only. As of this writing, MDIV owns no shares of USO . Although these tendencies are – at least for now – apparently temporary. Whether they will reassert downward pressure once the Fed increases rates later this year (which seems evermore likely) remains to be seen. Downward pressure also seems to be coming from mortgage rates, which have been dropping slightly at this writing. ” Adjusting the ETF Retirement Portfolio ,” Seeking Alpha , 21 May, 2014. ” REM And MORT: Mortgage REIT ETFs For Growth And Yield ,” Seeking Alpha , 5 November, 2014. To be sure, there are (a few) ETFs that pay more dividends than REM , but – at least, to my estimation – the risk involved is more than I am willing to take. The total return of -0.24% attributed to REM reflects only the fund’s own -5.11% performance over less than two months, offset by a single quarterly dividend payment received in December. It was on the basis of that that I decided to drop MDIV . REM ‘s performance has been generally upwards the past two weeks.

Looking For A Great European Manager

Europe looks to take over as the market leader following the ECB QE Announcement. How can you find a great manager to give you the smart Europe exposure you want? Check out five great options. A lot of uncertainty about European equities has been resolved since the ECB announcement on the 22nd where a long-anticipated QE program was finally unveiled. Even with the leftist victory in Greece, there’s been a clear shift in momentum with the iShares MSCI EMU ETF ( EZU) finally breaking out on a weekly basis. The rally is still in its early stages, so don’t be surprised if we retest the upper boundary of the downtrend line in the near future. (click to enlarge) Looking at relative momentum versus the S&P 500 (using the SPDR S&P 500 Trust ETF (NYSEARCA: SPY )), there’s been a clear shift towards outperformance by EZU. Again, the move is in its early stages but could represent an optimal time to get consider going long. After all, if EZU loses steam here, what’s your downside target? For those technicians out there, we strong prior support around $35 while those looking for a catalyst have it in the ECB’s loosening of monetary policy versus the possibility of FED tightening. (click to enlarge) So if you think it’s time to get off the sidelines and get into the game, but don’t want to commit to an EU or Europe specific fund, this posting is for you. For me, I want true EU exposure without a lot of British or other non-EU equity exposure and added EZU to my portfolio last Thursday, but what about those investors out there whose portfolios are U.S. heavy and just need foreign equity period? Well you’re in luck because the Yinzer Analyst, instead of spending time living up to his new year’s resolutions, sought out five great funds that can add value to your portfolio. For those readers who are new to the process; I first began by deciding what exposure I wanted, narrowing it down to the benchmark and Morningstar sector and then zeroing in on funds that I feel have the potential to outperform an index fund over a three to five year time frame. Without access to a data service like Morningstar Direct, it took a lot of time to piece together different sources but having used a few international funds in my day (although I currently have no positions in any of these funds), I do have some short cuts to the process. First, I want exposure to large-cap developed stocks, not a 75%/25% developed/emerging market blend. This is key; after seven months of underperformance and with the ECB announcement coming up; my goal isn’t to gain Russian exposure or Brazilian exposure. My goal is to add European exposure plain and simple. Now there are a wide variety of funds that are Europe specific and we’ll talk about those later this week, but this exercise is for those investors with a U.S. centric portfolio who after five or six years need to rebalance and want to add international exposure. So this rules out benchmarks that include emerging market equities like the MSCI ACWI ex. USA or MSCI World; instead we’re going old-school with MSCI EAFE which has a 99% allocation to developed markets with Greater Europe making up 66% of that. So heading over to Morningstar, I used their Premium Screener function to search for funds with a European heavy portfolio (greater than 60%) along with an initial investment at or below $2500 and still available to new investors (so long Oakmark.) If you don’t want to pay Morningstar prices, check out the new FundVizualizer tool from Putnam Funds. Yes, the focus is obviously on getting you to use Putnam funds but it has a lot of capability for a “free” service. Anyway, once you get rid of multiple share classes, you have a short list of about 75 funds split between the Foreign Large Blend and European Equity categories but our focus on a strong correlation to MSCI EAFE keeps the list below short and direct. Remember, these are the Yinzer Analyst’s recommendations but you still need to do your own research and check out the funds for yourself before you choose to invest in any fund. Read our disclosures for more details. (click to enlarge) Let’s start with our top three funds by addressing the elephant in the room; it’s a pretty Pittsburgh heavy list but that was entirely a coincidence. The Federated International Leaders Fund ( FGFAX) is one of the strongest performers in the Foreign Large Blend space over the last sixteen years since March Halperin took over as fund manager, placing consistently in the top five percent of funds in its category every year over the 3,5,10 and 15 year trailing periods. The fund has always held larger allocations to European equities, so much so that while MSCI EAFE is the official benchmark, Morningstar recognizes MSCI Europe as being the “best fit” benchmark to evaluate the performance against. The story has changed somewhat in 2015 as the fund is down 2.38% through 1.16 compared to -.8% for MSCI EAFE and -.33% for the category. The main culprit seems to Swiss stocks including a 4% allocation to Credit Suisse that’s taken a nose dive since the start of 2015. One other feature to watch for in all active managers is a tendency to hold onto positions (campers) and FGFAX is no exception with an average turnover of 5% a year. Next up is the MFS International Value Fund (MUTF: MGIAX ), which like FGFAX has placed in the top decile for active fund managers in the Foreign Large Blend space over the last fifteen years although unlike FGFAX is outperforming the benchmark handily this year with a return of .76% YTD. The fund recently had a change in management with long-time manager Barnaby M. Wiener (right?) appearing to have left the fund at the end of 2014 although he was replaced by another manager, Benjamin Stone, who has been with the fund since 2008. Normally this would put the fund on a watchlist, but MFS’s international funds have a strong reputation plus the prior service record of Mr. Stone is worth the benefit of the doubt. Like FGFAX, MGIAX has a relatively low turnover ratio at 18% so again, expect somewhat cyclical performance but the fund has only underperformed the iShares MSCI EAFE ETF ( EFA) once in the last five years, delivering a five year annualized return of 9.36% compared to 4.45% for EFA. More impressive is that it did it with lower volatility than EFA and thus earned a suitably high information ratio although I’m sure my more cynical counterparts will point out that rarely do high ratios persist for long periods. Finally, another strong candidate from the hometown team is the relatively small (less than $600 million in AUM) the PNC International Equity Fund (PMIEX.) Normally, I wouldn’t look twice at a bank fund for the sole reason that banks usually haven’t the least incentive to actually spend money on active management. Historically the focus has been on providing a portfolio solution for in-house trust or wealth management accounts where the pressure to deliver performance has been somewhat less than you would expect to find with an independent advisor so active management fee’s for close indexer performance. Always a bad mix. What makes PMIEX different? Like crosstown rival FGFAX, this fund has a strong history of outperformance delivered under one manager who has been with the fund since 1998 although the turnover ratio is significantly higher with PMIEX at around 31% to FGFAX’s recent 5%. The fund also has more holdings, giving it a broader focus and lower tracking error relative to MSCI EAFE but helping it avoid some of the pain inflicted on Swiss equities although PMIEX is also underperforming the category so far in 2015 with a YTD return of -.75%. Investors can expect more “even” performance than FGFAX but if the focus is on really picking up Europe exposure, PMIEX has a significantly smaller positioning in the region relative to FGFAX but might offer a better solution for investors who need a “one and done” solution. With three great options like that, why am I also giving you two “also-rans” that at best have delivered market-like performance over the last several years? Because as great as the first three funds are, you never want to slavishly follow just one manager and both of these funds have had management changes in the last three years that can hopefully offer better performance going forward. How did I find them? I would have discarded them after my initial scrub but decided to do some digging for one reason; both funds are positive and in the upper quartile in 2015. Let’s start with Goldman Sachs where a new manager took over the tiny Goldman Sachs Focused International Equity Fund (MUTF: GSIFX ) in early 2012 and proceeded to take it from a consistent underperformer to beating EFA in both 2012 and 2013. So why is he still managing a $200 million dollar fund? Because he was absolutely crushed in 2014, down nearly 13% to EFA’s 6.2% loss as heavy losses on BG Group ( OTCQX:BRGYY ) and Banco Popular Espanol ( OTCPK:BPESY ) combined with a concentrated portfolio (hence ‘focused’) to kick him when he was down. Even with the shellacking, GSIFX’s performance was strong enough over the last three years to slightly outperform EFA. So why do I like the fund? Because the manager’s a true active manager (underperformance is a risk you take moving away from the herd) who’s not afraid to take large positions and best of all, has shown he can outperform. Best of all, he’s willing to trade with highest turnover ratio in this class at a 121%. Finally, mid-sized life insurance companies are historically as bad as mid-sized banks at running mutual funds, but I have high hopes for the Sentinel International Equity Fund (MUTF: SWRLX ). Not just because the Vermont based fund family once sent me five pints of Grade A medium amber maple syrup as a gift or because I still watch Super Troopers whenever it’s on Comedy Central. Like GSIFX, this fund added a new manager in late 2012 who delivered tremendous performance in 2013 with more middling performance in 2014. He’s managed to deliver solid performance with slightly less volatility, has a higher turnover ratio than the top 3 funds at 52%, has concentrated positions showing active management but most of all, what I like about this fund is what it doesn’t have…assets. There’s enough literature pointing out the historic outperformance of smaller funds with new managers to larger, more established funds constrained by liquidity concerns. No matter which fund you choose, if any, remember that you always have options and it can’t hurt to start your search with some of Pittsburgh’s finest.