Tag Archives: portfolio

When Picking Mutual Funds, Don’t Be The Dumb Money

For the typical retail investor, mutual fund research reveals an uncanny ability to pick the worst fund categories at the worst possible times. The reason has to do with the tendency to base these types of decisions on “gut feeling” or emotion, rather than careful analysis. Investors feel most comfortable climbing aboard overvalued sectors of the fund universe towards the tail end of bull markets, only to flee to safety when stock prices are closer to their lowest. First identified by researchers Andrea Frazzini from NYU and Owen Lamont from Harvard, the poor timing ability of fund investors has come to be referred to as the “dumb money” effect. Emotion, limited attention, misguided perceptions and inexperience lead retail investors to make questionable decisions. This tendency to invest more in funds with high positive sentiment (for example tech stocks in the 1990s), and to pull out of funds with high negative sentiment (for example liquidating stock funds in 2008 and moving to bond funds), has led retail investors to lose on average about 1.5% annually, according to a 2007 analysis by Geoffrey Friesen of the University of Nebraska and Travis Sapp of Iowa State. Understanding investor behavior provides insight into why retail investors underperform the market. It also reveals how an investor, with a modest amount of additional effort, can improve their performance by avoiding common decision mistakes. Recent performance is the force that drives dumb money losses for many retail investors. This isn’t surprising since mutual fund advertisements and fund prospectuses tend to emphasize how well the mutual fund has performed in the past. Most investors shop for mutual funds the way they would for a toaster or microwave oven. Instead of researching the quality and durability of the product, they use shortcuts – cues of quality such as brand name recognition, an appealing marketing campaign, or a recommendation from a friend or family member. Yale researcher James Choi and his co-authors David Laibson and Brigitte Madrian of Harvard investigated how an average investor uses information on a mutual fund prospectus using identical S&P 500 index funds with different fund initiation dates. In addition to the prospectus, they gave respondents in different groups a “cheat sheet” that summarized differences in fund fees, and another that spelled out how the objective of all funds was to mimic the S&P 500. Samples of both employees and Wharton MBA students (with average SAT score at the 98th percentile) consistently focused on the obviously irrelevant fund performance rather than on fund fees even when presented with information that should have helped them make better choices. Brad Barber of UC Davis and Terrance Odean of Berkeley blame return chasing on the limited attention span of individual investors. According to their investor attention hypothesis, most of us have limited time to devote to researching mutual funds. We can either invest a huge amount of time and effort into learning how to evaluate and select funds, or we can simply invest in ones that capture our attention. The fact that mutual fund investors are attracted by the shiny funds does not serve them well in a market where sentiment can drive the value of securities too high or too low. A simple way to break the cycle of mutual fund underperformance is to develop an investment policy in which the investor maintains a diversified portfolio that reallocates periodically as market values change. This naturally works against investor sentiment by increasing investment in bonds when stock prices are rising and reducing one’s bond allocation when stock prices have fallen. Azi Ben-Rephael of Indiana University and his co-authors estimate monthly shifts between bond and stock mutual funds and find that investors consistently do the opposite-they shift to bond funds when equity values drop and back toward stock funds when equities rise in value. I use the monthly calculated shift in equity funds during the two significant equity bear markets of 2001-2002 and 2007-2009. In both cases, mutual fund investors move sharply toward bonds after stock prices have fallen. Investors appear to be unwilling to follow a disciplined long-run investment strategy by maintaining their portfolio risk exposure in a down market. Since poorly timed mutual fund sales are more harmful than poorly timed purchases, these flights to safety can have a significant impact on long-run portfolio performance. Including an investment policy statement inevitably leads to a discussion of the importance of rebalancing during good times and bad, allowing a client to anticipate portfolio volatility and follow a smart money strategy. Friesen and Sapp found that sentiment-driven underperformance on load funds was twice as large (1.92% per year) as the performance gap on no-load funds (0.96%). Incubated funds are also significantly more likely to be load funds. This is consistent with other studies that suggest that the mutual fund universe can be split between funds that are sold through the broker channel and funds that are bought through a direct channel. It is far easier to sell a privately incubated fund with significant recent excess performance, than it is to sell a fund with average performance. This is so even if neither fund is actually more likely to outperform in the future. It would be tempting to conclude that bad investor timing is primarily the result of inexperienced investors making bad choices, but a recent study by Ilia Dichev of Emory University and Gwen Yu of Harvard found that dollar-weighted returns on hedge funds are between 3% and 7% lower than time weighted returns. This is more than twice the dumb money difference observed in mutual fund investments. Since hedge fund investors are primarily institutions and extremely wealthy individuals, apparently even the professionals can get caught up in the excitement of investing in hot funds. Whether novice or professional, it is easy for an investor to fall into the trap of chasing returns of attention-grabbing funds. The good news is that investors who avoid relying on their emotions are much more likely to succeed in the long run. And a skilled investment advisor can help a client tune out the noise.

BSJF: The Shortest Duration High Yield Bond Fund I Can Find

Summary This fund is designed with a target termination date at the end of 2015, but the holdings have been changing quite substantially. My expectation is that the fund will be gradually selling out of their longer positions and transitioning to treasuries and cash. BSJF is fairly low in volatility since there is little duration risk. The fund has been trading at a slight discount to NAV which is one source of return for investors since the fund should pay out NAV at termination. Investors should be seeking to improve their risk adjusted returns. I’m a big fan of using ETFs to achieve risk adjusted returns relative to the portfolios that a normal investor can generate for themselves after trading costs. One of the funds I’m looking into is the Guggenheim BulletShares 2015 High Yield Corporate Bond ETF (NYSEARCA: BSJF ). I’ll be performing a substantial portion of my analysis along the lines of modern portfolio theory, so my goal is to find ways to minimize costs while achieving diversification to reduce my risk level. I’ll cover the holdings of the fund and then look at its performance in what I would consider a reasonable portfolio. Expense Ratio The expense ratio is .44%. Holdings Since this is a fairly interesting bond fund due to the presence of a termination date, I thought it would be useful to pull up their holdings a couple times before writing on them. Their holdings from early October are shown below: (click to enlarge) The first thing you should probably notice is that the ETF is the treasury bills being an ironic allocation for a junk bond fund. The situation is actually surprisingly simple. The bond ETF has an expected termination date of 12/31/2015. Most ETFs are long term investments, but BSJF appeared to be staying true to the name and expecting to simply terminate the ETF at the end of the year. The interesting thing is that when I went back to check on the fund in late October to see how much the Treasury allocation was increasing, I found it had disappeared instead. The most recent holdings are indicated below: (click to enlarge) As we get closer to the termination date I expect the percentage of assets coming from Treasury bill securities to increase materially. To be fair, the previous Treasury allocation did state that they were discount bills with a maturity of 10/22, which is two days ago. The irony for me at this point is the fact that the weighting for Kinetics has increased substantially from about 7% to roughly 10.8%. The par value of the position has not changed though, which suggests that the total assets have decreased substantially. The assets don’t appear to have been paid out, because the company makes their distributions very early in the month and the last distribution was $.03 per share on October 1st. Distributions The distribution is an area I really want to bring to investors. Have a look at the chart below (yeah, it is huge) and notice how the total distributions are paid out on a monthly basis but the size of the distributions has been shrinking lately as the fund is moving out of the higher yielding investments. (click to enlarge) The movement wasn’t really noticeably until the start of June, but now it is very clear that distributions are shrinking. Sectors The following chart breaks down the sector allocation of the underlying bonds. Finance is by far the heaviest weighting, but I’ve found that to be a trend when I’m examining these junk bond funds. If you’re going heavy on allocation to any junk bond fund with a strong exposure to a single industry, it would be wise to avoid overweighting the same sector in the equity part of your portfolio. Credit Credit risk is pretty significant here, but the bonds aren’t in default yet. Overall this is a fairly reasonable allocation for a junk bond portfolio. Building the Portfolio This hypothetical portfolio has an aggressive allocation for the middle aged investor, but should be fairly reasonable for a younger investor. Investors nearing retirement should aim for a significantly more conservative portfolio unless they have a high risk tolerance and a high ability to actually bear the risk. Retirees depending on the portfolio value should aim for something more conservative than this. A total of 40% of the portfolio value is placed in bonds. That makes it appear to be a fairly reasonable allocation for the middle aged investor. However the position in junk bonds is highly susceptible to losses at the same time as the equity positions because fear in the market will cause junk bonds to be sold off along with equity. You’ll also notice that emerging market bonds also have a positive correlation with domestic equity markets due to the influence of fear. The portfolio assumes frequent rebalancing which would be a problem for short term trading outside of tax advantaged accounts unless the investor was going to rebalance by adding to their positions on a regular basis and allocating the majority of the capital towards whichever portions of the portfolio had been underperforming recently. Because a substantial portion of the yield from this portfolio comes from REITs and interest, I would favor this portfolio as a tax exempt strategy even if the investor was frequently rebalancing by adding new capital. The portfolio allocations can be seen below along with the dividend yields from each investment. Name Ticker Portfolio Weight Yield Vanguard High Dividend Yield ETF VYM 30.00% 3.16% iShares U.S. Real Estate ETF IYR 10.00% 3.82% Vanguard FTSE Developed Markets ETF VEA 10.00% 2.94% Vanguard FTSE Emerging Markets ETF VWO 10.00% 3.12% Vanguard Emerging Markets Government Bond Index ETF VWOB 10.00% 4.73% Vanguard Long-Term Corporate Bond Index ETF VCLT 10.00% 4.54% Vanguard Long-Term Government Bond Index ETF VGLT 10.00% 3.12% I include the yield from each investment to aid investors looking for a higher yielding portfolio. If nothing else, this should provide a very quick reference point for which other ETFs mentioned here might also be useful in constructing your own portfolio. I picked VYM as a replacement for SPY in this portfolio due to it having a significantly stronger dividend yield and the assumption that domestic equity would be the core of the portfolio. The next chart shows the annualized volatility and beta of the portfolio since October of 2013, courtesy of Investspy.com. (click to enlarge) Risk Contribution The risk contribution category demonstrates the amount of the portfolio’s volatility that can be attributed to that position. To make it easier to recognize the risk impact of the various positions, I’ve built this portfolio to be equal weight with the exception of the position in VYM. Since this is the core of the portfolio, I’ve allocated 30% to the ETF. You can also see that VGLT has a negative total risk impact on the portfolio. When you see negative risk contributions in this kind of assessment it generally means that there will be significantly negative correlations with other asset classes in the portfolio. The position in VCLT is also very low in the impact on total portfolio risk. That is because these are very long duration high quality bonds. Even though they are not treasuries, they have a much higher correlation with treasury securities than with equity securities. Thinking of Modifications If an investor wanted to use something like this as a high yield portfolio while significantly reducing the risk, one way to do it would be to cut the allocations to VEA and VWO and to increase the allocations to VGLT and VCLT. That would create a lower risk portfolio overall and it would strengthen the yield on the portfolio. It should be noted that this modification would reduce the expected level of returns over the long term. A quick rundown of the portfolio I put together the following chart that really simplifies the role of each investment: Ticker Role in Portfolio VYM Core of Portfolio IYR Yield and exposure to equity REITs VEA International diversification VWO International diversification VWOB Strong Yield with International Diversification VCLT Moderate yield, moderate risk VGLT Strong Negative Correlation to Equity Correlation The chart below, created by Invest Spy shows the correlation of each ETF with each other ETF in the portfolio. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. (click to enlarge) Conclusion BSJF is an interesting junk bond fund because it has scheduled a termination date with the credit quality of the fund moving higher as it prepares for that date. Therefore, the correlation the fund has with other assets should be shifting over time. It is worth noting that the only negative correlation for BJSF is the correlation with long term treasury securities. Given that these are fairly short maturity instruments, I wouldn’t expect a strong correlation based on interest rate movements. You may notice that the correlation with VWOB is .40 which is much higher than the correlation with other bond funds. In that case the correlation is a combination of having some small amount of duration risk combined with substantial credit risk. Emerging market bonds tend to sell off in similar situations as domestic junk bonds which results in a higher correlation there. If you are interested in short duration bullet funds, this one would be a good one to keep an eye. Watch what happens with it over the next few months and see if it deviates materially from slightly longer duration bullet funds that won’t be expected to terminate. If nothing else, it should be interesting to watch the price movements. Investors interested in using the fund as a very short term holding should take note that the fund usually sells at a slight discount to NAV in the range of .1% to .2%. Since this is a short term holding, getting in with the discount is important to expected returns. I’ll be keeping an eye on how this fund does through the end of the year. If any readers are holding it, I’d love to hear from you in January about your experience with the liquidation of the fund so I can incorporate it into my analysis for other target date funds.

FXIFX Is Proof That Fidelity Can Offer A Great Target Date Fund

Summary Fidelity has at least two target date funds for the same date. FFFEX offers investors a high expense ratio and a complicated batch of underlying holdings. FXIFX offers investors almost everything they could ask for in a target date fund. The ratio of domestic equity to international equity allocation is great. The fund is moving into inflation-protected bonds slightly sooner than I would, but the underlying fund is a good choice. Fidelity has multiple options for target date funds. A reader recently suggested I check out the Fidelity Freedom® Index 2030 Fund (MUTF: FXIFX ). The suggestion came after I looked into the Fidelity Freedom® 2030 Fund (MUTF: FFFEX ). The only difference in the names of the two funds is that one uses the word “Index”, but the difference between the funds is notable. Expense Ratios FXIFX has an expense ratio of only .16% on the net level and .24% on the gross level. The net expense ratio is very competitive with target date funds for Vanguard. Investors can replicate the portfolio with a lower expense ratio by manually managing their portfolio to the same allocations, but the difference in expense ratios between FXIFX and using individual allocations to the underlying funds is very reasonable for investors that don’t want to manage the portfolio themselves on a consistent basis. On the other hand, FFFEX had an expense ratio of .74% and appeared stuffed with actively managed funds that should be substantially more profitable for the sponsor. The annoying thing, in my opinion, is that some investors will find that their employer offers FFFEX but does not offer FXIFX. That is unfortunate because I think the lower expense ratio fund will win out over the longer term. I don’t believe the actively managed portfolios will be able to beat their passive counterparts by enough to overcome the difference in expense ratios. Allocations The allocations for FXIFX are quite solid. Take a look at the holdings below: The first thing to notice is that this list is fairly short. I like to see simple allocations in target date funds. A few underlying funds with low expense ratios and fairly passive strategies make for great holdings. Ideally those holdings should be rebalanced fairly frequently for a target date fund to take advantage of movements in the market price of the underlying holdings. Domestic to International The domestic allocation is about 2.25 times the international equity allocation. I like that allocation strategy. Some funds would go slightly heavier on the international equity allocation, but I find a ratio of 2.5 to 1 ratio is pretty much perfect and even going as heavy as 2.2 to 1 would be reasonable. This fund falls within that desirable range. There is plenty of international exposure to benefit from the diversification without betting heavily on international funds outperforming domestic equity. Inflation-Protected Bond Funds I see a good reason for including inflation protected bonds, but I wouldn’t mind seeing this remain fairly low for another five years since this fund is aiming for 2030. At less than 1%, this isn’t a meaningful allocation yet. The underlying allocation is the Fidelity® Series Inflation-Protected Bond Index Fund (MUTF: FFIPX ) which has an expense ratio of only .05%. I like the expense ratio; I’m just not big on inflation-protected bonds in the current macroeconomic environment for anyone that is still working. For a retiree, it is certainly understandable to keep a chunk of their portfolio in these securities for dealing with living expenses over the next 12 to 24 months. Personally, I prefer paying for most living expenses with interest income from corporate bonds (currently too weak) or dividend income from established champions. How About Some REITs? I’d love to see a small allocation to domestic equity REITs in the portfolio. Perhaps I’m biased as a REIT analyst, but I like domestic equity REITs as an allocation for a mutual fund that I would expect to only be held in tax advantaged accounts. The biggest drawback over the long term to investing in equity REITs is the potential for paying high levels of personal income taxes on the dividends. If the allocation is going to be within a tax advantaged account, then the income should bypass that difficulty. Of course, I don’t provide tax advice. Future Allocations The following chart shows the planned allocation over the next few decades: This is a great allocation strategy for a target date fund. The investor planning on a very long retirement will probably want to supplement this portfolio with some dividend growth investing to have a growing stream of income from high quality companies. In my view, investors shouldn’t plan to just hold the target date fund and assume that they are done investing. This is not the start and the end of retirement planning, but it is one reasonable piece to include inside the portfolio. Conclusion FXIFX is delivering on the most important metrics I want to see in a target date fund. It offers a low expense ratio, a simple allocation, and a very intelligent ratio of domestic equity to international equity. The only weaknesses I see are extremely minor issues compared to everything Fidelity got right in this fund. For any investors trying to pick between FXIFX and FFFEX, I see a clear winner. FXIFX looks like it should be able to win out over a very long time horizon.