Wrong Place, Wrong Time

Posted August 21, 2010 by tponko
Categories: Current Environment, Mutual Fund Evaluation
Tags: , ,

Last week the Investment Company Institute reported investors poured $5.96 billion into bond funds, with much of that drawn from money market funds. Even with the yield on the super-safe 10-Year Treasury Note at the lowest level since 1955 (2.62% as of Friday, August 20), this is still an improvement over the paltry 0.04% average 7-day yield on a taxable money market fund. But this trade is neither as safe nor as beneficial as investors may believe.

Interest rates won’t stay this low for a prolonged period of time so unless long-term investors are willing to be short-term traders, they’re exposing their portfolios to significant risks. Let’s assume interest rates remain at current levels for a year, in which case investors will pick up basically 2.6% over money market yields. But if the economy finally does turn around in the following year, the 10-year yield will only have to rise a little over 3% to totally wipe out the prior year’s interest rate pick-up. If it goes to just under 4% (still well below the historical average), the overall trade will result in a 5% capital loss.

Of course investors may think they can dump their bond funds before this happens, but that’s easier said than done. When the market does begin to move against them, they won’t be alone in making their exit. With the yield differential so low, it will only take a few days’ movement to wipe it out. Since when are long-term investors expert market timers?

Right now bond funds are the wrong place to be. Long-term investors seeking higher current yields would be better served to consider equity income funds which not only offer higher dividends, but potential for dividend and capital growth as well. Arguably, this is now a safer trade than “super-safe” bond funds.

Comments: Be the first to comment

The Ultimate Target Date Fund

Posted August 12, 2010 by tponko
Categories: Mutual Fund Evaluation, Target Date Funds
Tags: , ,

OK, here’s one to think about: In a recent article in Financial Planning.com, a company spokesperson championed Vanguard’s efforts to help individuals make more educated decisions about their retirement investments. Apparently Vanguard does this is by offering investors a choice of 18 different target-date funds.

Really? Eighteen target date funds? Isn’t that a little overkill for an investment that’s supposed to be aligned with your retirement age? How many could possibly be appropriate? More importantly, because they are target date funds with varying risk, how could an investor analyze them anyway?

No one can fault a fund company for trying to distinguish itself from the crowded field of target date purveyors, but truth be told, the advisor who selects the fund family to be used in a retirement plan has a much greater say on participants’ portfolios than they do. An individual investor selecting a target date fund for taxable retirement savings is even more in the dark.

The problem comes from the fact that target date funds are devised to be a one-size-fits-all solution, but in reality, they can’t be. A good saver approaching retirement age needs more protection than growth potential. A poor saver of the same age probably needs a good roll of the dice to have even a passable chance of meeting his or her retirement goals. They’ve got the same target date but significantly different needs.

The ultimate target date fund doesn’t have to come in numbers, you only need one. All it must to do is fit your risk and return profile, have a decent probability of providing your desired retirement income, and do this without requiring you to save more than you comfortably can. You can’t find this in a family of target date funds, you can only create it yourself or with the help of a solid advisor. That won’t change if a fund company offers 18 or even 80 target date funds.

Comments: Be the first to comment

Different Perspectives

Posted August 3, 2010 by tponko
Categories: Mutual Fund Evaluation
Tags: , , ,

A different perspective is needed when monitoring funds over the short term rather than evaluating over the long. In the latter one set of statistics can be used for the evaluation, but in the former a sequence of data is more informative.

When you’re seeking new funds, comparing results to an unmanaged benchmark makes a lot of sense because the category composition can change dramatically over 3, 5, or 10-year periods. But when you’re evaluating funds you already use in specific asset classes (e.g. Small Cap Value), it makes sense to compare them to the current category. Not only will the category be more stable over the shorter time frame, it demarcates the universe of funds currently available to you. If you’re uneasy about your current fund’s return and it’s the top performing fund in the category then that’s too bad; it’s the best you can do. You need to know that when monitoring your funds in the category.

That’s why the short-term absolute returns and relative returns to the category can play important roles in ongoing monitoring. In most instances, your time horizon for this is at most 12-18 months.

As far as risk, you really do need more than 12 months to get a meaningful calculation but unless you’re using concentrated funds, risk characteristics like beta or standard deviation won’t change much from the past 12 months to the trailing 3 years. Three-year batting average can also give you a good sense of the fund’s consistency vs. the index – especially if you track it from month to month.

Which brings us back to the first and most important point: Many statistics aren’t very helpful as a one-time snapshot. Instead, you should focus on their trend from month to month or quarter to quarter. Return Category Rank tells you where the fund is now, but is it moving up or down? The batting average looks pretty good, but is it getting better or worse as oldest months roll off and newer months come on? You can’t answer these questions just by looking at one period’s statistics; they must be compared to form a sequence. A picture may be worth a thousand words, but in this case a trend is even more valuable

Comments: Be the first to comment

The Best Diversifier

Posted July 28, 2010 by tponko
Categories: Modern Portfolio Theory, Mutual Fund Evaluation, The Investment Decision Process
Tags: , , ,

Just about every day new ETFs appear covering increasingly esoteric corners of the financial market. The reason is simple: As correlations between traditional asset classes converge, managers are seeking new and different ways to diversify their clients’ portfolios. Presumably allocations to global equities, the VIX (volatility index), target maturity corporate bonds, international equity sectors, or bull and bear funds for retail and natural gas – all released in the past week – would do the trick.

While there’s no question these offerings are diverse, do they really supply diversification? Probably not.

Consider the chart below showing the rolling 5-year correlations of various categories to a plain vanilla portfolio consisting of 30% U.S. large cap funds, 20% U.S. small cap funds, 10% foreign funds, and 40% U.S. intermediate bond funds. The measurement period runs from January 1, 2000 through June 30, 2010, the common date for all Morningstar categories illustrated.

5-Year Rolling Correlations with Plain Vanilla Portfolio

Although it’s too early to include some of the most recent entries into the fund/ETF universe, the results are striking. The first thing that jumps out is the remarkable convergence of all correlations in the market turmoil in late 2008. When diversification was needed the most, the diversifiers didn’t diversify.

But even more important is the maroon line at the low-end of the chart, the best diversifier of the lot: the 30-Day T-Bill otherwise known as cash. That’s right, in a world of increasingly esoteric funds and ETFs, the best diversifier remains cash. Not only does it help stabilize portfolios, its expense ratio is zero, a far cry below any of the newer, more complex offerings.

One of my first and wisest mentors told me, “To create a well-diversified portfolio, you only need U.S. equities and cash.” Apparently he was right.

Comments: Be the first to comment

A Sell Strategy You Can Be Sold On

Posted July 22, 2010 by tponko
Categories: Mutual Fund Evaluation, The Investment Decision Process, Uncategorized
Tags: , ,

How’s your mutual fund sell discipline working out for you? You do have one don’t you? Actually you might not. Many advisors tout their well-developed and heavily researched fund evaluation models, but few are so forthcoming about their sell discipline. Those who are often couch it in general terms boiling down to, “If a fund stops behaving the way we want, we sell it.” That makes sense, but it’s hardly something that can be put into practice.

Some who use screening as a means of fund evaluation try to adapt the process to create a sell discipline. They might, for instance, consider selling a fund if it fails three of their ten screens. That’s a start, but it actually raises more questions than it answers. Why three? Why not four, or two, or seven for that matter? Does failing a screen by just .0001% reflect just as badly as missing by 10%? Is there a grace period of a month or two or is it just one and done? If so, won’t funds drift in and out of compliance on a monthly basis? What about turnover?

It’s much easier to base a coherent sell discipline on the ordering from a factor model. Unlike screening (which is essentially a set of mutually independent pass/fail tests), factor models allow the user to score funds on selected attributes and then sum up the results to arrive at a unique score for each fund. These scores can then be used to rank order all the funds in a selected set. That rank ordering also provides a way to monitor, evaluate, and yes, even decide when to sell the funds.

Because the funds are ranked, they can be divided up into top, middle, and bottom groups. The top group (e.g. 25%) can be considered the buy list. These are the funds considered when it’s time to add a new fund or replace a failing one. The second group (e.g. 26%-50%) could be the watch list. Funds in this group aren’t subject to replacement now, but will be should they fall below the lower limit. This is a fund “purgatory” where they can be closely monitored while they either rehabilitate themselves to move back up into the buy list or fall into the sell category. The final group (e.g. below 50%) is the sell list. Unless a fund simply rolls off the table, it generally won’t jump from the buy list to the sell list from one evaluation to another. It should spend some time in the watch list area so when it does come time to sell it, you can be more confident it won’t be back on the buy list next month.

But you can’t do this if you’re still relying on simple screening. If you’re ready to move up to actual fund evaluation and not just simple elimination, and if you really want a coherent sell discipline, you’re ready to begin constructing weighted factor models. Klein Decisions’ K4 Fund Selection is an efficient way to get started.

Comments: Be the first to comment

Finding and Keeping

Posted July 17, 2010 by tponko
Categories: Mutual Fund Evaluation, The Investment Decision Process
Tags: , , ,

Mutual fund evaluation models are generally designed to locate funds that meet a certain set of criteria. Screening processes set specific hurdles all funds must pass while factor models employ a more sophisticated approach allowing the user to weight the criteria and rank order the results. Either way, most models rely on historical data to find funds expected to perform well in the future.

But how do you monitor funds once they’ve been added to your portfolios? A simple solution is to continue to review them with the same evaluation process used to find them in the first place, but does this really makes sense? When searching for new funds, analysts tend to look for those that have been consistent performers, offered above average risk-adjusted return, and some sort of value added benefit. However, once funds have been added to actual portfolios, the emphasis switches dramatically to focus almost exclusively on return.

That’s right, whether you admit it or not, the key to retaining funds is momentum. That’s how clients evaluate the job you’re doing and, if you’re going to retain those clients, how you must evaluate them, too. Everyone likes to tout the value they add in the investing process, but we’re all eventually evaluated on the returns we produce.

As a result, the evaluation process used to locate funds really isn’t adequate for monitoring them. Instead, the latter should focus primarily on return and/or risk adjusted return. Funds that begin to fail these tests should become sell candidates regardless of how glorious their long-term history may have been.

There’s nothing wrong with maintaining two different evaluation models, one before inclusion in your portfolios and one after. In fact, it’s foolish not to do so.

Comments: Be the first to comment

Gold Hard Facts

Posted July 8, 2010 by tponko
Categories: Mutual Fund Evaluation
Tags: , ,

With gold up 9% for 2010, it’s no wonder gold funds are gaining a following. Advisors use them to diversify long-term portfolios and as trading vehicles for short-term accounts. As with most categories of funds, fees play a major role in net performance and ETFs (exchange traded funds) and ETNs (exchange traded notes) tend to have the lowest.

It’s not like there’s a lot of them out there. In fact, in June there were only six: Four ETFs and two ETNs. Of the six, two were leveraged (PowerShares DB Double Long ETN, ticker DGP and ProShares Ultra Gold, ticker UGL). True to therir name, their one-year performance essentially doubled that of the four non-leveraged funds. Of course their expenses were three to four times higher, too.

Speaking of fees, there’s quite a range here. BlackRock’s iShares COMEX Gold Trust (IAU) was the lowest at 0.25 with ProShares Ultra Gold was just shy of 1%, at 0.95%.

Before adding these to your asset allocations there are two things to consider. First, one of the advantages of these vehicles — the fact they trade all day like stocks rather than once a day like open end funds — can also be a negative. While SPDR Gold Shares (GLD) and the iShares COMEX Gold Trust trade with decent volume, the others don’t. That means there can be a noticeable spread between the bid and ask price. If you’re using them as trading vehicles, that can hurt both on the purchase and sale.

Secondly, they bear a tax disadvantage for longer-term taxable accounts. When sold, gains are taxed as regular income at higher rates than the favorable treatment afforded traditional open end funds and stocks. That’s because Uncle Sam considers gold — the underlying asset — to be a “collectible” rather than an investment.

So there’s potential when mining through these ETFs and ETNs, just do the due diligence to assure your clients get the gold and not the shaft.

Comments: Be the first to comment

Think Outside the Style Box

Posted July 4, 2010 by tponko
Categories: Mutual Fund Evaluation
Tags: , ,

It’s standard practice to divide client portfolios across different asset classes and then sift through funds to find the best representatives for each class. While that makes a lot of sense in theory, it doesn’t always work out in actual practice.

For example, small cap funds are usually expected to invest in stocks with market capitalizations ranging from $300 million up to $2 billion. These ranges roughly match those of small cap indexes such as the Russell 2000 or the S&P 600.

But think about the fundamental problem confronting small cap mangers: Success. If they truly stick to their small cap mandate, they’ll need to sell their winning stocks when they rise to exceed the $2 billion cap. If they don’t, they’ll be holding mid-caps and their funds won’t be true small caps.

But selling their winners means they’ll have to be replaced with the manager’s second and third best ideas – stocks they could have owned before but passed over for the ones they’re forced to sell. Not only that, transaction costs are incurred and capital gain distributions will be passed out to shareholders. Is “style purity” worth all this?

A better alternative is to think outside the narrowly defined style box. Rather than allocating one portion of the portfolio to small caps and another to mid-caps, why not simply allocate the total to the category of “small and mid-cap” sometimes referred to as SMID? Not only would that hold down transaction and tax costs, it would also open up the upper tier of small caps ($1.7 billion – $2 billion) that is often avoided by small cap managers because they’ll soon have to be sold. The S&P 1000 is an excellent benchmark for SMID funds.

It’s easy to get caught up in tightly defined investment styles, yet sometimes the best advisors are the ones that can think outside the style box. This is one of those instances

Comments: Be the first to comment

Categorically, “No”

Posted June 23, 2010 by tponko
Categories: Mutual Fund Evaluation
Tags: , , ,

Mutual fund evaluation often comes down to comparisons to peers, to indexes, and the market as a whole. Most evaluation tools offer a number of yardsticks from category averages to specific or broad unmanaged indexes. There are instances where each can be important, but all must be used with a degree of caution.

The most misused tends to be the category average. While this might seem to be the most appropriate standard — you are, after all choosing funds from a specific group — in many instances it isn’t.

There are several reasons for this, but the most important is the fact that a fund’s category is actually a moving target. Funds move in and out as their management and portfolios change. Funds that are real stinkers either fold or are merged into other less pitiful brethren. Morningstar periodically crams funds with broad mandates such as “All Cap” , “Value” or “Small Cap” into surrounding styleboxes, until they move away. As a result, comparing funds to their category is like running a race where you can’t see or determine the competition. The longer the time period, the less meaningful the comparison.

If you’re considering periods longer than a year, you’re better off using comparisons to a benchmark index. The more tightly defined your category (e.g. small cap growth) the more specific the index (e.g. Russell 2000 Growth). With more broadly defined classes (e.g. All Cap) consider using wider measures such as the S&P 1500 or the Wilshire Index.

On the other hand, the fund’s category can be effective if you need a relatively short-term standard, say less than a year. Because the time frame is so limited, fewer funds have drifted in or out, been merged out of existence, or were crammed in my Morningstar. Not only that, when used as a short term measure, the comparison to category can give you a sense of how the fund is performing now rather than three or five years ago. Because you’re picking funds now, it’s a good idea to see how they’re stacking up versus the competition.

Screens use all sorts of factors to narrow down the universe of funds, so in a sense, it really doesn’t matter if you use the category or not. But some of the best factor models (which are inherently more informative than screens) use long-term comparisons to unmanaged indexes to give a feel for consistency and short-term category comparisons to capture momentum.

Like virtually any tool, fund evaluation based on a comparison to the category can be valuable, but only if used properly.

Comments: Be the first to comment

Subpar Fund Evaluation

Posted June 10, 2010 by tponko
Categories: Mutual Fund Evaluation
Tags: , ,

Imagine a golf tournament where the goal is to never have a bogey. Any player exceeding par on any hole is immediately eliminated. Even a player who birdies the first 17 is still eliminated if he has a bogey on the eighteenth.

That’s certainly a different way to run a tournament, and it might be fun, but it’s not a very good way to determine the best golfer. In the end, all you have is a group of survivors. You don’t know who had the best score, only that those who make it through all eighteen holes never shot more than par. In fact, the guy who birdied the first seventeen holes and bogeyed the last may (and in fact probably does) have the best score, yet he’s not even in contention. You actually don’t know who, among the group of survivors, had the best score.

The problem with this approach is that it only focuses on one thing: “Winners” must simply meet a minimum standard on all holes. Each hole is its own independent test. The degree by which they surpass the minimum doesn’t matter, and since scores aren’t kept, there’s no way to compare those that do.

As odd as this is, it’s the method most analysts and advisors use when evaluating mutual funds. If you use a screening process, you use it, too. By only setting minimum standards for various factors eliminating funds that fall short of just one, you’re simply assuring the surviving funds have a minimum level of performance on each factor independently. You aren’t doing anything to consider their overall performance on all factors considered together. Just as the golfer who shot -16 was eliminated with a bogey on the last hole, you’re probably overlooking a lot of great funds that may miss just one or two of your screens – and that by a small amount – yet outperform on all the others by a wide margin.

If you want to improve your evaluation process – and probably save some time in the process — consider moving up to a true scoring process. Factor models enable you to score funds on each important factor. When these individual scores are summed, each fund ends up with a unique total score which can then be used to rank order them from top to bottom. Not only will you know which funds score the best, you can see how any fund in the category stacks up against the rest of the competition. Isn’t it time to start evaluating instead of just eliminating?

For more information and to help you take the step up to factor models, click here.

Comments: Be the first to comment

« Older Entries