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Messy Fund Managers Create An Illusion Of Skill

Mutual fund rating services divide mutual funds into categories based on their investment style. This helps investors compare the performance of one style to another and helps them compare the performance of individual funds in a particular style. While useful in many ways, this methodology can also create the illusion of superior performance when none exists. Among the most familiar investment style tools is the Morningstar Style Box, a nine-square grid that provides a graphical representation of a fund’s investment style. For stock funds, it classifies funds according to primary market capitalization (large, mid and small) and investment style (growth, core and value). Morningstar (NASDAQ: MORN ) tracks the performance of securities in the nine style boxes, creates style indices, and then compares fund performance to these indices. According to Morningstar magazine , the average actively managed US equity fund performance has fallen short of its comparable style box index in all nine categories over the past five years ending in June 2015. However, there are times when a majority of active managers appear to perform better than a style box index. Over the past three years, surviving large-cap value managers have fallen into this category by outperforming their benchmark index 62.7% of the time. See Figure 1 below. Outperformance by a majority of managers in a particular style is often followed by calls from the fund community to use active management in that style. There are those who begin to argue that the market is inefficient in certain areas. They say indexing doesn’t work in these styles and that active management works better. Don’t take these periods of active manager outperformance at face value. It is an illusion that is expected to fade over time. What’s actually occurring is the difference between pure style index returns and messy active manager returns. Style indices represent a pure selection of securities driven strictly by empirical measurements, while fund managers are often messy in their portfolio constructions. For example, the only securities you’ll find in a small-cap value index are small-cap value stocks. In a small-cap value fund , a manager may choose to extend into other style boxes by drifting outside of the pure style. (The fine print in the fund prospectus typically allows for this.) A fund with messy style drift often compares favorably to the style it is benchmarked against when the benchmark is lagging other styles. When enough fund managers in a category are messy in their stock selection, and the benchmark style performs poorly relative to adjacent styles, it creates a period when active style-drifting managers appear to be a better option for investors. This is a temporary illusion of superiority that is not expected to persist. Figure 1 compares the three-year performance of Morningstar Style Box returns to the percentage of managers outperforming their style index benchmark. The X-axis represents the three-year annualized Morningstar style index return and the Y-axis represents the percentage of managed funds that outperformed each style. Figure 1: Morningstar Style Box Performance and Percentage of Managers that Outperformed. Three years ending June 30, 2015. (click to enlarge) Source: Morningstar magazine, August/September 2015, chart and regression by R. Ferri Figure 1 graphically illustrates the relationship between style performance and the ability of active fund managers to outperform the style. Mid-cap Value ( MV ) earned 20.7% annually and outperformed all other styles; MV managers had a very difficult time outperforming this index and succeeded only about 9% of the time. In contrast, Large-cap Value (LV) earned 14.1% annually and was the worst-performing style index; LV managers had an easier time outperforming, winning about 63% of the time. The regression is close to 85%. This means the percentage of managers who outperformed in each style is highly correlated with the relative performance of the style index. The greater a style index outperforms adjacent styles, the fewer managers outperformed in that style and vice versa. This observation isn’t new in mutual fund analysis. William Bernstein wrote about the phenomenon in 2001 article, Dunn’s Law Review : The Life and Times of “Core and Explore,” in which he noted, “[T]he fortunes of indexing a particular asset class depend on its performance relative to other asset classes.” The concept was expanded by William Thatcher in a 2009 article, When Indexing Works and When It Doesn’t in U.S. Equities: The Purity Hypothesis . Both articles indicate an inverse relationship between a style’s relative performance to other styles and active management’s ability to outperform in style. This brings us to a couple of important questions. First, when do a majority of active managers outperform a poor-performing style? Second, can managers time styles and position their portfolios accordingly and make it worth investing in messy active funds? Tables 1, 2 and 3 help answer the first question: When do a majority of active managers outperform a poor performing style? The yellow box with the red numbers in each table represents the percentage of managers that outperformed that style over a three-year period ending in June 2015. The red box represents the performance of the Morningstar style index for that category. The green box represents the performance of surrounding Morningstar style indices. (click to enlarge) Table 1 indicates Large Cap Value (LV) managers had a great run over the three-year period ending June 2015. Almost 63% of active manager beat the Morningstar Large Value Index return of 14.1%. It’s easy to see why. The green areas in Table 1 represent the performance of adjacent styles indices: Large Core (18.3%), Mid Core (19.9%), and Mid Value (20.7%). All three had notably superior performance to Large Value. Any messy LV managers who invested outside of, but near the LV style index constituents would have added performance to their portfolio. Table 2 shows the opposite story for Mid Cap Value ( MV ) managers. Only 9.0% outperformed their style index. MV was the highest-performing style of the nine style boxes, so any messiness on the part of MV managers would have hurt their performance relative to the style index – and it did. Table 3 represents Small Cap Value (SV) managers, 33.6% of whom outperformed the Small Cap style index. Although the index performed satisfactorily at 17.0%, it underperformed the adjacent style indices, but not by as wide a margin as LV in Table 1. Accordingly, there was some benefit to active SV manages, but not enough to increase their win rate over 33.6%. This latest evidence substantiates what Bernstein and Thatcher have indicated in the past: It appears there is no truth to the cliché that the market is inefficient in one style and not another. It’s about style performance relative to adjacent styles, and how messy managers are about remaining within a style in their equity selection. Active fund managers look superior when their benchmark style performs poorly relative to adjacent styles, and they look bad when their benchmark style outperforms adjacent styles by a meaningful amount. Eventually, this all comes out in the wash. Active managers in every style have underperformed by about the same percentage. Please see The Power of Passive Investing for more analysis on this topic. The second question is easier to answer: Can active managers time styles and position their portfolios accordingly? They cannot. If they could, today’s Morningstar active versus passive results would show improvement since the time Bernstein wrote about it. But it has not. Managers do not appear to have persistent skill in timing investment styles. Mutual fund rating services help investors compare the performance of one style to another by creating style indices, and they help investors compare the performance of funds within a particular style. But raw data can create the illusion of superior performance when none exists. You’ll need to dig deeper into a manager’s performance to determine if he or she truly has ongoing skill or if it’s just an illusion. Disclosure: Author’s positions can be viewed here .

Fidelity Suffers Massive Active Funds Outflow

Summary According to Morningstar data, US-focused mutual funds and exchange-traded funds have seen $78.8 billion worth of outflows in the first seven months of 2015. Fidelity Investments witnessed the biggest outflows on the active side for both July and 1-year period. The Fidelity Contrafund Fund, the Fidelity Growth Company Fund and the Fidelity Low-Priced Stock Fund accounted for outflows of $2,360 million, $2,111 million and $1,463 million in July. We present 5 funds that were in the Top-Flowing Active Funds list. In our previous article, we discussed that domestic equity-focused funds are facing tough time in terms of fund outflows. According to Morningstar data, US-focused mutual funds and exchange-traded funds have seen $78.8 billion worth of outflows in the first seven months of 2015. Continued transfers from open-end mutual funds to collective investment trusts at Fidelity triggered much of the outflows. This is higher than any full-year outflows since 1993. The money had instead been poured into international funds. This time, we will look into the flows in active and passive funds; which in fact shows how outflows in active funds have led to record dismal numbers. The active funds saw outflows of $20,446 million in July, while inflows of $6,175 million were recorded on the passive side. Over the last 1-year period, $158,607 million flowed out of active funds, while the passive funds added $140,836 million. Inflows into passive funds failed to offset the outflows from the active U.S. equity funds. In July alone, estimated net outflows from U.S. equity funds increased to $14.3 billion from $8 billion in June. Outflows a Trend Now? According to the Morningstar Direct U.S. Asset Flows Update, passive U.S. equity funds saw inflows of $166.6 billion, while active U.S. equity funds lost $98.4 billion in 2014. Reportedly, 2014 was one of the worst years for active managers. Based on Standard & Poor’s 2014 SPIVA Scorecard (S&P indexes versus active funds), only 23% of actively managed domestic stock funds were reported to have outperformed the Standard & Poor’s Composite 1500 in 2014. Separately, Morningstar had revealed earlier that indexed equity vehicles, mutual funds and exchange-traded funds attracted $1 trillion in the five years ending March 31st. On the other hand, active management saw redemption of $266 billion over the same period. Many active managers run at a disadvantage against the indexed funds owing to higher costs of active management, efficient capital markets and intense competition. While a spokesman for Fidelity Investments called it a “cyclical trend”, a MarketWatch article notes that it is not cyclical, as investors are starting to understand this being a permanent trend. Fidelity Investments Witness Huge Outflows Fidelity Investments witnessed the biggest outflows on the active side for both July and 1-year period. Again, much of Fidelity’s outflows indicated continued transfers from mutual funds to collective investment trusts. Fidelity witnessed outflows of $10,101 million in July and $18,928 million over 1-year period. The Fidelity Contrafund Fund (MUTF: FCNTX ), the Fidelity Growth Company Fund (MUTF: FDGRX ) and the Fidelity Low-Priced Stock Fund (MUTF: FLPSX ) accounted for outflows of $2,360 million, $2,111 million and $1,463 million in July. Ironically, earlier this year, Fidelity ads had been vocal about the “power of active management”. Fidelity promoted via an ad featuring Joel Tillinghast, speaking in favor of active management and how its top stock pickers outperformed rivals. The Tillinghast managed Fidelity Low-Priced Stock fund claimed in the ad that it has outperformed the Russell 2000 index by 4.66% on annualized basis since its inception in 1989. A Bloomberg Markets Global Poll of financial professionals showed 42% were in favor of indexed products as the better option for retirement savings. Instead, only 18% supported actively managed funds. The waning popularity of actively managed funds was thus a wake-up call for Fidelity, which has built its reputation on active management. For the 1-year period, Fidelity saw outflows of $18,928 million on the active side, while passive funds accumulated $23,015 million. Franklin Templeton Investments and PIMCO were also big losers over the 1-year period. They witnessed outflows of $10,422 million and $176,451 million, respectively. Bottom & Top Flowing Funds Below we present 5 funds that were in the Bottom-Flowing Active Funds list: Source: Morningstar *Note: T. Rowe Price New Income witnessed $1,160 million of inflows over 1-year period. However, these funds have encouraging year-to-date and 1-year returns. They also carry favorable Zacks Mutual Fund Ranks. The Fidelity Growth Company carries a Zacks Mutual Fund Rank #1 (Strong Buy). It has returned 8% year to date and 14.6% over the last one year. The Fidelity Low-Priced Stock and the T. Rowe Price New Income Fund (MUTF: PRCIX ) carry a Zacks Mutual Fund Rank #2 (Buy) and have year-to-date return of 3.8% and 0.6%, and 1-year return of 6% and 1.6%, respectively. The Fidelity Contrafund also carries a Buy rank and has a year-to-date return of 7.8% along with 1-year return of 10.9%. The PIMCO Total Return Fund (MUTF: PTTAX ) carries a Zacks Mutual Fund Rank #3 (Hold). Below we present 5 funds that were in the Top-Flowing Active Funds list: Source: Morningstar Here, both the PIMCO Income Fund (MUTF: PONAX ) and the Metropolitan West Total Return Bond Fund (MUTF: MWTRX ) carry a Zacks Mutual Fund Rank #2 (Buy). However, Morningstar notes that inflows into PIMCO Income were not sufficient to offset outflows from PIMCO Total Return. PIMCO Total Return has lost $122.5 billion since September 2014. The fund family itself has seen substantial outflow as PIMCO’s total outflows since January 2014 was at $212.8 billion. Nonetheless, Morningstar opines that the numbers proving PIMCO Income to be a better performer is not completely fair. The Morningstar Direct U.S. Asset Flows Update mentions: “PIMCO Income is in the multisector-bond category as opposed to the intermediate-bond category, and it can afford to look for alpha by having much higher allocations to emerging-markets and high-yield bonds, for example”. Mutual funds would definitely want to see more inflows than the outflows. For that to happen, the domestic strength is of particular importance. China has sparked many concerns recently, and if investors decide to keep the money within the domestic boundaries, it would help domestic-stock focused funds to see inflows. However for active funds, it is getting difficult, as many active managers run at a disadvantage against the indexed funds owing to higher costs of active management, efficient capital markets and intense competition. Nonetheless, a turnaround would definitely cheer up the active funds. Original Post

Cost-Efficient Exposure To Momentum

By Alex Bryan In many cases, extrapolating past performance into the future is a bad idea. In fact, securities that have outperformed for several years tend to become more expensive and priced to offer lower returns going forward. But in the short run, recent performance trends tend to persist. Winners over the past six to 12 months tend to continue to outperform for the next several months, while those that have underperformed often continue to lag. This phenomenon is known as momentum. It has been observed in nearly every market studied and across different asset classes over long periods. Investors can get efficient exposure to stocks with positive momentum through iShares MSCI USA Momentum Factor (NYSEARCA: MTUM ) for a low 0.15% expense ratio. This fund tracks an MSCI index that targets large- and mid-cap stocks with strong risk-adjusted price momentum, which differentiates it from traditional momentum strategies studied in the academic literature. This focus on risk-adjusted performance may help moderate the fund’s risk profile and reduce turnover. Volatility in a stock influences price movements, but this component of returns may not last. Risk-adjusted momentum gives a better signal of directional price movements, which may be more likely to persist. MSCI built the fund’s index with capacity in mind, at the expense of style purity. It usually only reconstitutes twice a year and applies a wide buffer to reduce turnover. On paper, momentum strategies appear to work better with reconstitution every month, as momentum is strongest over shorter windows. But in practice, monthly reconstitution can create high turnover and transaction costs. The index’s more tempered approach may improve its cost-efficiency, though it can still experience high turnover. In fiscal 2014, its turnover was as high as 123%. However, it has not yet distributed a capital gain, thanks to the exchange-traded fund structure, which allows managers to transfer holdings out of the portfolio through a nontaxable in-kind transaction with its authorized participants. Momentum is less likely to persist when volatility spikes. In order to address this potential problem, the fund’s benchmark applies conditional rebalancing in between the schedule reconstitution dates when market volatility significantly increases. When this rebalancing is triggered, the index focuses on more recent momentum to construct the portfolio. Investment Thesis In theory, investors should arbitrage any predictable price pattern away. Yet simple momentum strategies have historically worked (on paper) in nearly every market studied. Behavioral finance offers the best explanation for the momentum effect. Those in this camp assert that investors tend to anchor their beliefs and are slow to update their views in response to new information. For instance, event studies have demonstrated that stocks that beat earnings expectations have historically tended to offer excess returns for many weeks after the announcement. Similarly, stocks that miss expectations have tended to continue to underperform. Investors may also be reluctant to sell losers in the hope of breaking even and quick to sell winners in order to lock in gains. This irrational behavior may prevent stocks from quickly adjusting to new information. Once a trend is established, investors may pile on a trade or over-extrapolate recent results, pushing prices away from their fair values, which may contribute to the long-term reversals underlying the value effect (the tendency for stocks trading at low valuations to outperform). While momentum strategies have a good long-term record, they may struggle during periods of high volatility or market reversals. As a result, the fund can underperform when it is most painful. For instance, its benchmark lagged the MSCI USA Index by 3.8% during 2008. Heading into a bear market, momentum strategies tend to overweight riskier stocks, which may underperform during a correction. After a market downturn they tend to load up on defensive stocks, and they may miss out on some of the upside during a sharp recovery. There is also a risk that momentum may become less profitable as more investors attempt to take advantage of it. That said, the momentum effect hasn’t gone away even though it was first published in academic literature in 1993. Like any strategy, momentum can underperform for years. This risk may limit arbitrage and allow momentum to persist. MTUM’s moderate style tilt takes some juice out of the strategy. However, it still captures the essence of the style and at a lower cost than if it pursued a more aggressive rebalancing approach. It has a good chance of beating the market if momentum continues to pay off. But even if momentum doesn’t pan out, the fund’s low expense ratio doesn’t hurt performance much. This is a compelling holding on its own, but it can also offer good diversification benefits to value-oriented investors. That’s because momentum tends to work well when value doesn’t, and vice versa. Therefore, putting them together may reduce the risk of significantly underperforming, as the chart below illustrates. It shows the aggregate wealth accumulated in the MSCI USA Momentum Index, the Russell 1000 Value Index, and a portfolio split evenly between the two, divided by the wealth accumulated in the broad MSCI USA Index. When the line is sloping up, the strategy is beating the market, when it is sloping down, the strategy it is underperforming. Keep in mind that the MSCI USA Momentum Index’s live performance record only started in 2013. Sources: Morningstar Direct, Analyst Calculations. Portfolio Construction MTUM tracks the MSCI USA Momentum Index, which draws stocks from the market-cap-weighted MSCI USA Index, which includes large- and mid-cap stocks. In May and November, MSCI calculates the ratio of each stock’s price returns of the past 13 and seven months (excluding the most recent month to take into account the tendency for performance to reverse during that horizon) to its volatility during the past three years. There isn’t a great theoretical reason to use price returns rather than total returns, but it shouldn’t make a big difference. The index averages these two scores and selects the highest-scoring stocks until it reaches a fixed target number of stocks (currently 122). In order to reduce turnover, new constituents must rank in the top half of the index’s target number of securities to get priority over stocks that were previously in the index. Stocks already in the index only have to rank within 1.5 times the target number of securities to remain in the index. Holdings are weighted according to both the strength of their risk-adjusted momentum and their market capitalization, subject to a 5% cap. In addition to the scheduled semiannual reconstitution, MSCI may rebalance the index when the month-over-month change in the trailing three-month volatility of the market is larger than the 95th percentile of such monthly changes historically. When this occurs, the index only uses each stock’s seven-month risk-adjusted momentum score. Alternatives AQR offers some of the purest momentum funds on the market. However, these funds are only available in a mutual fund format, which can make them less tax-efficient. AQR Large Cap Momentum (MUTF: AMOMX ) (0.49%) ranks the largest 1,000 U.S. stocks by total return over the prior 12 months, excluding the most recent month, and targets the third with the strongest momentum. It weights its holdings according to both the strength of their momentum and market capitalization and rebalances monthly with an adjustment to reduce turnover. While AQR Large Cap Momentum’s $5 million minimum investment may seem a little steep, there is no minimum investment for investors who gain access to the fund through a financial advisor. AQR International Momentum (MUTF: AIMOX ) (0.65% expense ratio) and AQR Small Cap Momentum (MUTF: ASMOX ) (0.65% expense ratio) might also be worth considering. PowerShares DWA Momentum ETF (NYSEARCA: PDP ) is another option, but it is difficult to justify its 0.65% expense ratio. It targets stocks with the best relative strength and rebalances its portfolio quarterly. Historically, PDP has been less sensitive to the standard momentum factor documented in the academic literature than MTUM. Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.