Willing to Wait… But for How Long?

A recent article on Barron’s profiles Chuck Royce, the manager of the Royce Pennsylvania Mutual Fund for over 40 years. According to the article:

“The senior fund manager, 73 years old and regarded as a top small-cap investor, blames the Federal Reserve and its quantitative-easing program for distorting values in the stock market… For New York-based Royce, investing has always been about following a discipline. Those investors so eager to bolt for funds posting better returns should consider whether their new portfolio managers can match Royce’s 30-year record of 11.54% a year as of the end of the first quarter, versus 9.39% for the Russell 2000, or the 11.18% a year he’s managed over the past 10 years through May 8, better than 80% of all small-cap funds… In the short term, Royce hasn’t done as well. For the year through May 8, the fund’s 11.22% gain is worse than 81% of the small-cap funds tracked by Morningstar. Year over year, Royce posted a 19.75% rise, well behind the Russell 2000′s 24.17% gain.”

With that, how does the fund’s performance in the past eight years look from the Alpholio™’s perspective?

The chart reveals two distinct phases in that period:

• From early 2005 through late 2009, the fund largely did not generate any RealAlpha™
• From 2010 onwards, the fund exhibited a negative trend in cumulative RealAlpha™.

In its analysis of the fund titled “Royce’s flagship fund is a contender,” which was published in November 2012, Morningstar states that:

“The past few years have been uninspiring, but Royce Pennsylvania Mutual still has what it takes to succeed in the long term.”

The questions are: How long will the fund take to recover? Will it ever outperform its reference exchange-traded product (ETP) portfolio? The above chart does not offer an encouraging answer to either question.

Disclaimer: Due to a multitude of random factors, perfect prediction of performance of an investment vehicle is nearly impossible. Therefore, the above analysis should be treated as merely one of the many inputs to an investment decision, and not as a definitive recommendation to buy or sell any securities. While Alpholio™ strives to provide original and useful insights into fund and portfolio performance, the ultimate investment decision belongs to you, the investor.

For a detailed explanation of the patent-pending Alpholio™ analysis methodology, please refer to the FAQ.

© 2013 Envarix Systems Inc. All Rights Reserved.

Does “Going Active” Matter?

A recent article in Barron’s contains an interview with industry experts about the pros and cons of a growing trend of actively-managed exchange-traded funds (ETFs). In that context, the discussion covered one of the most prominent mutual funds, The Fairholme Fund. One of the experts, Ben Johnson, global director of passive-funds research at Morningstar, stated that:

Q: Are there any strategies not suited for the ETF structure?

“Some of the most successful strategies on the equity side may never end up in this format. Look at Bruce Berkowitz, manager of the Fairholme fund (FAIRX). He is Morningstar’s equity manager of the decade. And yet he is pretty much running from something as liquid as a traditional mutual fund, to say nothing of ETFs.”

The counterpoint to that statement was posted by AdvisorShares:

“Lastly, the prominent mutual fund (Fairholme Fund) cited by Morningstar’s Ben Johnson is a poor example of the type of strategy that wouldn’t be a good fit for the liquidity of an ETF. In fact, the mentioned fund is the perfect example of the inefficiency of the mutual fund structure. In the Fairholme example, a lot of hot money comes in which is more wear and tear on the portfolio manager to put the cash to work. There is a cost to do that: spreads and settlement costs that impact both the new investors and your long-time shareholders. Then something happens: the fund falls out of favor, all the hot money is flying out, the PM is now selling what he can to meet redemption requests with those costs again impacting the departing shareholders, but also being born by the long-term shareholders. In reality, it is the long-term shareholders that will suffer the most by the tax inefficiency of the capital gain generating transactions.”

Luckily, from the Alpholio™’s perspective, it does not matter whether Fairholme is constructed as a mutual fund or an ETF. What really counts is how much value active management by Mr. Berkowitz adds or subtracts on a truly risk-adjusted basis (RealAlpha™). In the past eight years, the results have been mixed.

© 2013 Envarix Systems Inc. All Rights Reserved.

Comparison of Dividend-Oriented ETFs

A recent article in The Wall Street Journal attempts to compare the Vanguard Dividend Appreciation ETF (VIG) to iShares Select Dividend ETF (DVY) and other “peer dividend ETFs.” As is typical for such cursory analyses, the article lumps together ETFs with the word “dividend” in their name, and focuses on short-term (up to three years) returns to draw conclusions about the funds’ performance. The article only briefly touches on the difference of holdings of the two funds.

So, what are the proper ways to compare these funds? Here is one alternative comparison based on Sharpe Ratios (all figures calculated and published by Morningstar):

ETF	Ticker	Category	3-Year SR	5-Year SR
Vanguard Dividend Appreciation	VIG	Large Blend	0.99	0.46
iShares Select Dividend Index	DVY	Mid-Cap Value	1.31	0.40
PowerShares FTSE RAFI US 1000	PRF	Large Value	0.83	0.42
WisdomTree LargeCap Dividend	DLN	Large Value	1.20	0.36
SPDR S&P Dividend	SDY	Large Value	1.10	0.53
iShares High Dividend Equity	HDV	Large Value	N/A	N/A

In the longer 5-year period, which spanned a major market downturn, the Vanguard ETF exhibited a return/risk characteristic superior to that of the iShares ETF. However, the SPDR S&P Dividend ETF beat both according to that measure.

Another way to compare the first two of these ETFs is to use the dividend discount model to arrive at the expected rate of return. According to the article, the Vanguard ETF’s holdings currently yield about 2% in dividends and are expected to generate over 9% of earnings growth in the next three to five years. Assuming that the current dividend payout ratios and earnings growth rates stay approximately constant in the future, the ETF should return about 11% per year in total. For the iShares ETF, these figures are 7%, 4%, and also 11%, respectively. However, these identical results stem from vastly simplifying assumptions.

Finally, the two ETFs address different segments of the equity market. According to Morningstar, in the last three years the Vanguard ETF was most closely matched by the US Core Total Return index, while the iShares ETF’s best fit index was the Dow Jones Industrial Average Price Return index. This indicates that since the iShares ETF effectively tracked a much more narrowly focused index, it should not necessarily be compared to the more broadly-oriented Vanguard ETF. Indeed, Morningstar classifies the Vanguard ETF into the Large Blend category, while it puts the iShares ETF in the Mid-Cap Value category. Hence, the two ETFs are not really peers. Only the rest of the above dividend ETFs could be considered peers by virtue of the common, Large Value, category.

© 2013 Envarix Systems Inc. All Rights Reserved.

Rebound at Third Avenue Value Fund?

A recent article in The Wall Street Journal describes a “rebound” in the performance of the Third Avenue Value mutual fund. Let’s take a look at this fund from the Alpholio™ perspective. To do so, we will use the institutional (TAVFX) instead of investor (TVFVX) class of shares, which, thanks to a lower expense ratio, should give the fund’s management greater credit for any generated alpha.

First, a cumulative RealAlpha™ chart for the fund:

The chart clearly shows that the only rebound the fund had was in a short period of outperformance in the second half of 2008. Otherwise, the fund exhibited a persistent downward trend in the cumulative RealAlpha™.

The following chart illustrates the major equivalent holdings of the fund in the entire analysis period:

From 2009 to 2012, the fund was predominantly invested in securities driven by the Hong Kong market — see the equivalent position in EWH (iShares MSCI Hong Kong ETF). The weight of this ETF peaked at over 73% in November 2009, and even most recently it was higher than 25%. Investors in this fund effectively had a foreign single-country fund in their portfolios. Such concentration is not something that most investors would expect. Alpholio™ provides a current analysis of all major funds, which gives investors an early warning on major directional bets their fund managers are making.

Disclaimer: Due to a multitude of random factors, perfect prediction of performance of an investment vehicle is nearly impossible. Therefore, the above analysis should be treated as merely one of the many inputs to an investment decision, and not as a definitive recommendation to buy or sell any securities. While Alpholio™ strives to provide original and useful insights into fund and portfolio performance, the ultimate investment decision belongs to you, the investor.

For a detailed explanation of the patent-pending Alpholio™ analysis methodology, please refer to the FAQ.

© 2013 Envarix Systems Inc. All Rights Reserved.

Yacktman vs. Yacktman

A recent article from Morningstar compares two sibling funds, Yacktman Focused (YAFFX) and Yacktman (YACKX). The thesis of the article is that:

“… the former’s unnecessarily high expenses dim its appeal relative to its cheaper sibling.”

The article goes on to say that:

“Since its 1997 inception, Focused has an R-squared, a measure of correlation, of 95.2 relative to Yacktman. Granted, Focused’s gross return since its 1997 inception edges Yacktman’s, an encouraging sign that management’s greater conviction has led to better results. But any incremental outperformance gross of fees has been more than absorbed by the fund’s higher expenses. Focused’s 9.65% annualized return net of fees during that same stretch trails Yacktman’s 9.87%. Based on how they’re investing their own money, though, the management team of Don Yacktman, Stephen Yacktman, and Jason Subotky believes Focused will ultimately trump Yacktman. None of them invests a dime in the Yacktman fund, but all three maintain positions of more than $1 million in Focused.”

…and, rightly so! Here are the Alpholio™ statistics for both funds from February 2005 through March 2013:

This analysis takes into account only the after-fee returns of both funds and their respective reference portfolios. Clearly, YAFFX performance on a truly risk-adjusted basis has been superior to that of YACKX: The discounted cumulative RealAlpha™ figures speak for themselves. In addition, the volatility of YAFFX was only slightly higher than that of YACKX. The managers are right by voting with their own money in favor of the former fund.

This is further corroborated by the trailing Sharpe Ratios for both funds calculated by… Morningstar itself:

Fund	Ticker	3-Year	5-Year	10-Year	15-Year
Yacktman Focused	YAFFX	1.08	0.74	0.69	0.42
Yacktman	YACKX	1.05	0.72	0.69	0.46

In the 3-, 5- and 10-year periods to present, the Sharpe Ratio of YAFFX was greater or equal to that of YACKX. The latter fund had a higher Sharpe Ratio only in the 15-year period, which indicates that any advantage of risk-adjusted performance it had over the former fund was confined to the 5-year period that ended 10 years ago. So much for a superficial observation that YACKX had a higher net return than YAFFX since the 1997 inception. Yacktman Focused’s markup is not “needless,” it is actually warranted by its risk-adjusted performance in the last 10 years, even if such an adjustment is made with a relatively crude measure of the Sharpe Ratio.

© 2013 Envarix Systems Inc. All Rights Reserved.

What’s in Your Wallet? Part II.

Building upon the previous post, here are more indications of how some mutual fund managers attempt substantial market timing, of which investors may not be aware.

A recent article from The Wall Street Journal describes several funds with large cash positions. One of these funds, FPA Capital, was a topic of Alpholio™ analysis published in a prior post. According to the article, the fund held 33% in cash at some date from year-end 2012 to March 31, 2013. Indeed, the fund reported 32.9% in cash and equivalents as of the latter date.

An investor could reasonably expect that a fund with the following investment objective and strategy would be almost solely invested in equities rather than cash:

“The Fund’s primary investment objective is long-term growth of capital. Current income is a secondary consideration. FPA Capital Fund seeks to fulfill this objective through investing primarily in small and medium-sized public companies.”

The Alpholio™ analysis clearly demonstrated that at times the fund’s equivalent cash position was as high as 52%, and that such market timing efforts did not result in generation of any meaningful RealAlpha™ in the analysis period. Caveat emptor!

© 2013 Envarix Systems Inc. All Rights Reserved.

What’s in Your Wallet?

…or, to paraphrase the slogan from Capital One’s credit card commercial, what’s in your portfolio? This important question came up in the context of a recent Wall Street Journal article, which stated that:

The number of bond funds that own stocks has surged to its highest point in at least 18 years, another sign that typically conservative investors are taking bigger risks to boost returns.

In particular, the article mentioned the Loomis Sayles Strategic Income mutual fund (ticker NEFZX, Class A shares) that lately increased common and preferred stock holdings to 19% of its portfolio. Per the prospectus, the stock allocation in this fund can be as high as 35%. Is that what an average investor would reasonably expect? Is monitoring stock allocation in quarterly filings sufficient? Certainly not.

According to the Alpholio™ analysis, at the end of March 2013, the fund’s equivalent positions in equity exchange-traded products (ETPs) totaled over 40% (in part, this reflects the fact that the fund can invest in convertibles and foreign debt):

The fund had a significant exposure to the healthcare sector (VHT, Vanguard Health Care ETF, weight of 10%), technology sector (MTK, SPDR® Morgan Stanley Technology ETF, 5.6%), and gold miners (GLD, SPDR® Gold Shares, 4.1%).

A recent Morningstar analyst report on the fund stated that

“Since mid-2011, the team has grown increasingly concerned about the potential for rising rates and the limited opportunity for upside in most fixed-income investments. That’s led it to take increasing advantage of the fund’s broad flexibility to invest up to 35% of the portfolio in stocks… This portfolio’s flexibility may hold appeal for those who share the team’s concerns about bond valuations. However, the fund’s large equity stake adds risk to the portfolio, which, with large positions in high-yield (20%) and non-U.S. dollar denominated bonds (30%), is already one of the multisector category’s most volatile.”

Alpholio™ provides a month-by-month or even more frequent insight into the equivalent ETP holdings of mutual funds. Investors can take advantage of this information to determine a true exposure of their portfolios to various types of securities.

Disclaimer: Due to a multitude of random factors, perfect prediction of performance of an investment vehicle is nearly impossible. Therefore, the above analysis should be treated as merely one of the many inputs to an investment decision, and not as a definitive recommendation to buy or sell any securities. While Alpholio™ strives to provide original and useful insights into fund and portfolio performance, the ultimate investment decision belongs to you, the investor.
For a detailed explanation of the patent-pending Alpholio™ analysis methodology, please refer to the FAQ.

© 2013 Envarix Systems Inc. All Rights Reserved.