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When Should You Sell A Mutual Fund?

Lipper’s Jake Moeller examines some qualitative reasons to reconsider holding a mutual fund investment. Investors interested in this topic can also register to attend the Lipper UK Fund Selector & Fund of Funds Forum in London on July 14, 2015. As a former fund-of-funds manager, Lipper clients regularly ask me about sell triggers for mutual funds. This question is quite amorphous; there are many factors that could result in a fund no longer being “fit for purpose,” but that depends on how the fund is being used. When investors blend funds into a portfolio, they have different tolerances for a sell decision than when, for example, they hold a single fund in isolation. When I managed a guided-architecture platform from which I constructed a number of portfolios, I would often sell a fund out of my portfolios but still keep it on the guided-architecture platform. Such decisions are uniquely a factor of what fund selectors call “style bias.” A large-cap fund, for example, might underperform considerably in a sustained mid-cap rally, but that doesn’t mean it is a poorly managed fund. The following factors are some key reasons to consider letting a fund go: Fund manager departure Fund managers move house for myriad reasons: ambition, retirement, redundancy to name a few. If the departure is restricted to a single manager, this is generally a “hold and wait” situation. Many investors will follow the new fund manager, but a large fund house should have contingency protocols in place and the performance of the old fund shouldn’t necessarily head south. Where a fund house is very quiet about a key departure, there may be a legal covenant underpinning an unpalatable situation. A single fund manager departure can also signal the start of distracting team restructuring and destabilization. Respect the fund house that gets information out early. The less that is said, the stronger the sell signal. “Activeness” A fund manager who closely tracks an index may be doing so for perfectly legitimate reasons: a lack of conviction, a portfolio restructure, or staff changes can result in emergency indexing. It is the duration of this positioning that matters. An active equity fund manager’s maintaining an index position for over three months, for example, would certainly be a red flag. Marketing support Often overlooked in importance: when a fund house stops marketing a fund or has another flavour of the month, this can often be a bad sign. “Legacy” funds are often poorly managed, and with little inflow they potentially leave investors languishing at a disadvantage. The retrenchment of sales directors can often be another leading indicator that funds might switch to legacy footing or that they are expecting less supportive inflows into their business. Corporate activity A takeover, acquisition, or merger requires considerable analysis, but it can be reduced to a very fundamental issue: cultural compatibility. Not many strategic bond managers, for example, would take well to a new parent company’s investment committee favoring utilities at any cost “because that’s best for our balance sheet.” Capacity A fund that becomes too large to maintain a manageable number of securities in its portfolio is likely to become either an index hugger or to compromise the technical expertise of its manager. There are so many quality boutique funds in the market that there is no excuse for holding an active fund that has say 2,000 securities in it. Outflows Outflows in and of themselves are not always a concern. However, when they coincide with a falling share price (where the fund manager is listed) and poor performance, you have a pretty strong sell signal. You will want to get out before all the cabs have left the rank. Round peg, square hole Has your fund house recently appointed a head of U.K. equities for your U.S. portfolio? Fund management is a specialized task and is only rarely truly portable. An expertise in one area does not guarantee expertise in another. Such an appointment warrants critical review. Courage under fire If fund managers are underperforming when their style should be in favour, an investor needs to question the skill of the managers; most fund managers make bad calls in their career but restore faith by sticking to their guns. If poor stock selection results in a fund manager “tweaking” the process or compromising philosophies, this should act as a warning flag. Poor performance Differentiate symptom and cause. Poor performance needs to be understood, not reacted to blindly. Where poor performance is a result of style biases or out-of-favor portfolio selection, one may likely end up selling just as the fund turns around. Where poor performance coincides with any of the qualitative factors outlined above, it is unlikely to be coincidence. Furthermore, these factors may occur before performance starts to be affected. Such factors warrant serious consideration to saying adieu to a fund.

Do Hedge Fund ETFs Live Up To Their Hype?

Summary Hedge fund ETFs provide a convenient way for retail investors to gain exposure to hedge fund strategies. Some, but not all, hedge fund ETFs were relatively uncorrelated with the S&P 500. Hedge fund ETF performances have been uneven, with some funds outperforming while others lagged. Hedge funds offer investors an alternative to traditional investment funds. Hedge funds can use leverage to increase returns and can also invest in a wide range of derivatives and short positions. Over the years some have scored phenomenal successes while others have suffered spectacular losses. Hedge funds are not currently regulated by the Securities and Exchange Commission (SEC) so only “accredited investors” can participate. Accredited investors must have a net worth of at least a million dollars or an income greater than $200,000 a year. Even if you meet the financial requirements, most funds charge a 2% management fee plus take 20% of the profits. These high charges are not for me so I looked for some alternatives to hedge funds among the plethora of Exchange Traded Funds (ETFs). The hedge fund ETF category includes funds with a variety of strategies including convertible arbitrage, managed futures, merger arbitrage, and tend following. Note that the ETFs in this category do not actually invest in hedge funds but instead try to replicate hedge fund performance. There are currently 22 ETFs in the hedge fund category but only five have assets over $100 million. These larger ETFs are summarized below. IQ Hedge Multi-Strategy Tracker ETF (NYSEARCA: QAI ). This ETF is based on techniques called “hedge fund replication” that try to reproduce hedge fund returns using a portfolio of conventional assets. The fund goes long or short other ETFs in an attempt to replicate the risk-adjusted performance of a mix of hedge funds. QAI uses a rules based momentum strategy to decide which assets to buy or short. The portfolio can change monthly depending on the economic environment but generally this fund maintains a large net long allocation to bonds, which can be rotated among Treasuries, corporate bonds, floating rates, high yield, and convertible bonds. The fund also invests in equities, currencies, commodities, and REITs. The effective duration of the bond portion of the portfolio is a little over 4 years. The fund has an expense ratio of 0.91% and yields 1.3%. This is the largest hedge fund ETF with an asset base of over $1 billion and a daily average volume of more than 180,000 shares. IQ ARB Merger Arbitrage ETF (NYSEARCA: MNA ). This ETF invests in global companies where there has been an announcement of an imminent merger or takeover. Merger arbitrage attempts to capture the difference between the current price of the takeover target and the final price. This is a market neutral strategy that has typically been relatively low risk. The fund currently has 58 holdings with 45% in US stocks, 15% in non-US stocks, and 40% in cash. The expense ratio is 0.76% and the fund does not generate any yield. The daily volume averages only 23,000 shares so limit orders should be used when buying or selling this fund. WisdomTree Managed Futures Strategy ETF (NYSEARCA: WDTI ). This actively managed WisdomTree ETF provides returns based on the Diversified Trend Indicator (DTI). DTI is a trend following, quantitative strategy developed by Victor Sperandeo (also known as “Trader Vic”). The DTI is used to go long or short futures associated with 24 components in 18 sectors. The futures cover a wide range of the liquid future markets including currencies (50%), energy (19%), livestock (5%), precious metals (5%), industrial metals (5%), and agriculture (16%). The fund is rebalanced monthly. The expense ratio is 0.95% and the fund does not have any yield. The daily volume averages only 34,000 shares per day so limit orders should be used when buying or selling this fund. AlphaClone Alternative Alpha ETF (NYSEARCA: ALFA ). This ETF invest in the securities that are widely held by hedge funds and institutional investors. This strategy is possible because hedge funds that manage more than $100 million must periodically disclose their equity holdings. The selection of the securities is based on a proprietary index methodology. The portfolio is also risk-managed and can vary from long-only to a heavily hedged position. The portfolio currently consists of 74 holdings with 83% from the US and 17% international. The sector breakdown includes 24% technology, 20% health care, 14% consumer staples, and 14% industrials. The expense ratio is 0.95% and the fund yields less than 1%. The daily volume averages only 22,000 shares so limit orders should be used when buying or selling this fund. SPDR Multi Asset Allocation ETF (NYSEARCA: RLY ). This is an actively managed ETF that is focused on securities that traditionally provide good inflation hedges. The portfolio consists of 12 ETFs, with a focus on inflation-linked bonds (19%), commodities (17%), REITs (20%), and natural resource companies (38%). The fund has an expense ratio of 0.70% and yields 2.3%. The daily volume is extremely small with an averages of only 5,000 shares so limit orders should be used when buying or selling this fund. For reference I also included the following funds in the analysis: SPDR S&P 500 Trust ETF (NYSEARCA: SPY ). This ETF tracks the S&P 500 index and has an ultra-low expense ratio of 0.09%. It yields 1.9%. SPY will be used to compare the performance of the hedge fund ETFs to the broad stock market. To assess the performance of the hedge fund ETFs, I plotted the annualized rate of return in excess of the risk free rate (called Excess Mu in the charts) versus the volatility for each of the funds. I used 1% as an estimate for the risk-free rate. I would have liked to see how these ETFs performed during the 2008 bear market but the oldest fund was not launched until 2009. Most of the other funds only have a 3 year history so I used a 3 year look-back period from June, 2012 to June, 2015. The Smartfolio 3 program was used to generate the plot shown in Figure 1. (click to enlarge) Figure 1. Risk versus reward over past 3 years Figure 1 illustrates that the hedge fund ETFs have had a large range of returns and volatilities. To better assess the relative performance of these funds, I calculated the Sharpe Ratio. The Sharpe Ratio is a metric, developed by Nobel laureate William Sharpe that measures risk-adjusted performance. It is calculated as the ratio of the excess return over the volatility. This reward-to-risk ratio (assuming that risk is measured by volatility) is a good way to compare peers to assess if higher returns are due to superior investment performance or from taking additional risk. In Figure 1, I plotted a red line that represents the Sharpe Ratio associated with SPY. If an asset is above the line, it has a higher Sharpe Ratio than SPY. Conversely, if an asset is below the line, the reward-to-risk is worse than SPY. Some interesting observations are evident from the figure. With the exception of ALFA, these funds were significantly less volatile than the S&P 500. However, this decrease in volatility was accompanied by an even larger decrease in return. Therefore, with the exception of ALFA, SPY easily outperformed these hedge funds on a risk-adjusted basis. ALFA was the best performer among all the hedge fund ETFs (on both an absolute and risk-adjusted basis). This is not too surprising since piggybacking on the equity portfolio of hedge funds would be expected to perform well in a bull market. However, ALFA was very volatile and slightly under-performed SPY on a risk-adjusted basis. RLY was the worst performer. Again, this was not surprising since inflation has been tame and precious metals have been in a bear market. WDTI had the lowest volatility but also a relatively low return that only beat RLY. Even though MNA and QAI employed different strategies, they booked similar risk-adjusted returns. One of the advertised advantages of hedge funds is the low correlation with the stock market. To assess the validity of this claim, I calculated the pair-wise correlations between the funds. The results are shown as a correlation matrix in Figure 2. The symbols for the funds are listed in the first column and along the top of the figure. The number at the intersection of the row and column is the correlation between the two assets. For example, if you follow WDTI to the right for two columns you will see that the intersection with MNA is 0.004. This indicates that, over the past 3 years, WDTI and MNA were only 0.4% correlated. Note that all assets are 100% correlated with themselves so the values along the diagonal of the matrix are all ones. Figure 2. Correlation matrix over past 3 years The figure illustrates that, with the exception of ALFA, hedge funds provide good diversification relative to the overall stock market. As you might expect, ALFA is highly correlated with SPY since the portfolio of ALFA consists of popular stocks from the S&P 500. The managed futures fund, WDTI, is basically uncorrelated with all the other funds so it provides excellent diversification. The other ETFs (MNA, QAI, and RLY) are only moderately correlated with each other and the stock market.. For my last analysis, I reduced the look-back period to 12 months. The results are shown in Figure 3. What a difference a couple of years make. During this period, both WDTI and MNA performed well and had essentially the same risk-adjusted return as the overall stock market. ALFA again was the best performer and actually beat out the S&P 500 on both an absolute and risk-adjusted basis. RLY as again the worst performer, sinking well below the zero line. (click to enlarge) Figure 3. Risk versus reward over past 12 months. Bottom Line Hedge fund ETFs cannot all be lumped together and some lived up to their hype while other did not. ALFA was by far the best performer but it is highly correlated with the S&P 500. If you are looking for a hedge against a stock market correction, I would not use ALFA. However, if you are risk tolerant and want exposure to the overall market, ALFA is worth consideration. As a hedge, I like WDTI and MNA. These are low volatility funds, have a reasonable return, and are relatively uncorrelated with the stock market. In a bull market, these funds will lag but I do think they have lived up to their reputation as a vehicle to hedge the market. Unfortunately, the most popular fund, QAI, has not lived up to its hype. RLY may do well in the future but until inflation increases, I would avoid this fund. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

The Phases Of An Investment Idea

Investing ideas come in many forms: Factors like Valuation, Sentiment, Momentum, Size, Neglect… New technologies New financing methods and security types Changes in government policies will have effects, cultural change, or other top-down macro ideas New countries to invest in Events where value might be discovered, like recapitalizations, mergers, acquisitions, spinoffs, etc. New asset classes or subclasses Durable competitive advantage of marketing, technology, cultural, or other corporate practices Now, before an idea is discovered, the economics behind the idea still exist, but the returns happen in a way that no one yet perceives. When an idea is discovered, the discovery might be made public early, or the discoverer might keep it to himself until it slowly leaks out. For an example, think of Ben Graham in the early days. He taught openly at Columbia, but few followed his ideas within the investing public because everyone was still shell-shocked from the trauma of the Great Depression. As a result, there was a large amount of companies trading for less than the value of their current assets minus their total liabilities. As Graham gained disciples, both known and unknown, they chipped away at the companies that were so priced, until by the late ’60s there were few opportunities of that sort left. Graham had long since retired; Buffett winds up his partnerships, and manages the textile firm he took over as a means of creating a nascent conglomerate. The returns generated during its era were phenomenal, but for the most part, they were never to be repeated. Toward the end of the era, many of the practitioners made their own mistakes as they violated “margin of safety” principles. It was a hard way of learning that the vein of financial ore they were mining was finite, and trying to expand to mine a type of “fool’s gold” was not a winning idea. Value investing principles, rather than dying there, broadened out to consider other ways that securities could be undervalued, and the analysis process began again. My main point this evening is this: when a valid new investing idea is discovered, a lot of returns are generated in the initial phase. For the most part they will never be repeated because there will likely never be another time when that investment idea is totally forgotten. Now think of the technologies that led to the dot-com bubble. The idealism, and the “follow the leader” price momentum that it created lasted until enough cash was sucked into unproductive enterprises, where the value was destroyed. The current economic value of investment ideas can overshoot or undershoot the fundamental value of the idea, seen in hindsight. My second point is that often the price performance of an investment idea overshoots. Then the cash flows of the assets can’t justify the prices, and the prices fall dramatically, sometimes undershooting. It might happen because of expected demand that does not occur, or too much short-term leverage applied to long-term assets. Later, when the returns for the investment idea are calculated, how do you characterize the value of the investment idea? A new investment factor is discovered: it earns great returns on a small amount of assets applied to it. More assets get applied, and more people use the factor. The factor develops its own price momentum, but few think about it that way The factor exceeds the “carrying capacity” that it should have in the market, overshoots, and burns out or crashes. It may be downplayed, but it lives on to some degree as an aspect of investing. On a time-weighted rate of return basis, the factor will show that it had great performance, but a lot of the excess returns will be in the early era where very little money was applied to the factor. By the time a lot of money was applied to the factor, the future excess returns were either small or even negative. On a dollar-weighted basis, the verdict on the factor might not be so hot. So, how useful is the time-weighted rate of return series for the factor/idea in question for making judgments about the future? Not very useful. Dollar weighted? Better, but still of limited use, because the discovery era will likely never be repeated. What should we do then to make decisions about any factor/idea for purposes of future decisions? We have to look at the degree to which the factor or idea is presently neglected, and estimate future potential returns if the neglect is eliminated. That’s not easy to do, but it will give us a better sense of future potential than looking at historical statistics that bear the marks of an unusual period that is little like the present. It leaves us with a mess, and few firm statistics to work from, but it is better to be approximately right and somewhat uncertain, than to be precisely wrong with tidy statistical anomalies bearing the overglorified title “facts.” That’s all for now. As always, be careful with your statistics, and use sound business judgment to analyze their validity in the present situation. Disclosure: None