It's Not The Fund Performance It's The Time Period That Determines Fund Choice (At Least for Some)

This one is really unbelievable the WSJ writes how the turn of the year is a boon for many mutual fund performance reporting. Not because they had a particularly good year, but simply because their 5 year performance numbers no longer include the tough market performance of 2 002.

Incredibly the mere turn of the page on the calendar creates a massive change in the way individuals and pension fund consultants (can you believe that one) decide where to invest:
Some mutual funds report a flood of calls from pension consultants and others who have noticed their funds suddenly showing up as strong performers, as 2002 no longer drags down their average. Other funds are reporting renewed intake of investor cash after years of selling, as well as new interest from overseas clients.
Until recently, "the consultant and adviser community would say, 'No one wants to talk to you, because of your five-year number.' " But now, "we're at this real inflection point" where there is interest on sales calls, says Kevin Divney, a manager of the $4.7 billion Putnam New Opportunities Fund. It swung from an average 5%-a-year loss for the five years through

In other words “experts’ and individuals are choosing investments with their eyes locked firmly in the rearview mirror.

Most interestingly the change in the performance numbers is not attributable to the managers’ skill (surprise) but simply to the area of the market that they were invested in .As the article notes:

The 20 worst-performing U.S. diversified stock funds with over $1 billion, ranked by five-year annualized returns through 2005, were mostly growth funds.

From our perspective we would note 2 things: 1 these funds should be compared to a growth index not absolute returns 2. We are big believers of tilting investments towards value which long term experience has shown produces superior returns Of the funds listed in the graphic above, it seems that only one of these funds has been around for 10 years, Putnam New Opportunity with a ten year return of 4.36&


In our portfolios we do not make use of growth funds,since this category historically offers poor risk/return characteristics compared to value stocks. The large cap value fund we use: DFA Large Value has the following track record 5 yr (through 2005) 9.14, 5 yr (through 2006) 12.37, 10 year 11.92


In other words be careful how you choose funds and be careful one kind of pension consultant you hire.

Say What ?

From the special Morningstar Fund Picks insert in the Jan 20 -21 WSJ:

When choosing thse funds, don't look only at past returns since that can result in fruitlessly chasing performance. Instead also screen for management performance. Morningstar, for instance,looks at whether managers have outperformed their peer group in previous years of not.

In other words: don't fruitlessly chase performance by fund, since past performance tells little about future performance. Instead follow the lead of the Morningstar analysts and chase performance based on manager performance. And presumably that's not a fruitless exercise.

Got it (i think)

The Asset Class or The Manager

We are big advocates of index funds and definite belief in the work of Fama - French and others which has shown the outperformance over long periods of small cap and particularly small cap value stocks.

The January 1999 WSJ discussed small cap funds praising their benefits.
The article gave a summary of the reasons why small cap mutual funds should have a place in its portfolio . In a chart called Small Can Make it Big it listed top performance of some small cap and small cap value funds for 2003 -2006 attributing the success to manager skill.

Here is the honor roll along with 3 yr performance

Birmival Oasis 35.8%
Pacific Adviors Small cap 26.1%
Gartmore Small Cap 25.8%
Paradigm Value 23.5%,
Keeley Small Cap Value 22.7%,
Dreman Contrarian Small Cap Value 22.1%,
Royce Value Service 20.1%
Wasatch Micro Cap Value 19.4%
DWS Dreman Small Value 19.4%

Impressive evidence of stock picking skill no doubt, right ?

Well not exactly. Here are the 3 year returns for Dimensional Fund Advisors (DFA) funds in the same categories

DFA Small Cap Fund 19.35%
DFA Small Value Fund 26.5%
DFA XSmall (microcap ) fund : 25.85%

In other words only one of the funds in the above list beat all 3 of the DFA funds, two of the DFA funds out of three DFA funds would place second or third on the list, and all of the DFA index, non actively managed funds woul have made (or missed by.o5%) the list.

So was it really manager stock picking skill and not the asset class that generated the return. I certainly don't think so.

Later on I will check the longer term performance of the funds, their after tax returns and the volatility (riskiness ) of the funds compared to the DFA index funds

Hedge Funds...Hope Springs Eternal

In a NYT article entitled Hedge funds: Like Them or Loathe Hedge Funds Aren't Going Away

The article repeats the oft cited mantra of those that have drunk the hedge fund kool aid:

A number of recent studies show that hedge fund investors are satisfied with the performance of their investments, even if that performance appears on paper to be less than stellar. Widespread demand for risk-adjusted returns of 8 to 10 percent ensures that the money spigot will stay turned on. (Risk adjusted means that the portfolio is hedged. If the market slumps, the fund’s returns should not.)

I have yet to see the evidence that these funds, which often engage in leveraged investments could possibly generate long term returns equal to the long term expected return of stocks with lower risk. While the laws of economics are not the laws of physics the idea that an entire asset class has found the goose that lays the golden egg: higher returns with no more risk is literally incredible. And what does is this assertion based on: nothing more than a belief that an entire asset class is managed by absolute geniuses !!

As the article itself states:

There are more than 9,000 funds that vary greatly in the kinds of investments they make, returns they seek and strategies they employ.

Are we to believe that among these 9,000 funds or even a significant minority of them we find managers who have suspended the Nobel prize winning theories of finance (risk and return ) are linked at the hip.

Then again the author doesn't quite know her finance she writes:

Widespread demand for risk-adjusted returns of 8 to 10 percent ensures that the money spigot will stay turned on. (Risk adjusted means that the portfolio is hedged. If the market slumps, the fund’s returns should not.)

Well that is just wrong. As in the case of options a porfolio can be hedged and still lose money. Joe investor buys a stock at 100 and buys an 80 put. The stock falls to 60. He is hedged because he lost $20 (+ the option premium) versus the unhedged investor who lost $40. But he still lost money.

Despite the availability of expertise to disabuse them of their illusion across the quad among the Finance faculty college endowments are flocking to these hedge funds:

For example, the top performers of the 2007 Commonfund Benchmarks Study of Educational Endowments, a survey of college, university and other educational endowments and foundations in the United States, were almost 50 percent invested in “alternatives” — hedge funds, private equity, real estate, distressed debt, energy and natural resources and venture capital.
Hedge funds constituted the largest portion — 44 to 70 percent — of the alternatives category

Now that is a mouth dropping statistic : 25 -35% of the endowment dollars are in hedge funds.

And Surprise look what the results are:

Even though hedge funds represented the bulk of investment dollars, their returns were lackluster. In 2006, the Standard & Poor’s 500-stock index had a total return, when dividends were reinvested, of 15.8 percent. Overall returns for alternatives averaged 14.6 percent. Energy and natural resources produced a stunning return of 40 percent; distressed debt, 26 percent; and private equity, 19 percent. Hedge funds turned out only 10.6 percent. But investors did not seem to be bothered.

You can throw out the energy and natural resources return number as having anything to do with expected long term returns. Anything else would reflect a severe case of what behavioral economists call "recency" (what happened last year will happen in the future).

But the kool aid drinking goes on:

“It was nice to see hedge funds were doing what they are supposed to do,” said John S. Griswold Jr. executive director of the Commonfund Institute, a research organization dedicated to educating the nonprofit community about investing. “They should lag a rapidly rising stock market,” he explained, “because hedging has a cost.”

Mr Grisworld should get some education himself at a business school (basic finance textbook):
The only way to reduce risk and be truly hedged in an investment portfolio is to buy puts (giving away some upside) or adding (not subtracting as they are doing) short term bonds to a portfolio. WHat they are doing is simply putting faith in a "genius" (and one that takes 20% of the returns for himself). Figure a long term return for stocks is 8% and for bonds 5%. A 70/30 stock bond portfolio return would be 7.1%. A hedge fund would have to turn in a return of 8.5% (after fees) to generate that return for the endowment. So the expectation is that the hedge fund will be able to consistently have the same risk as a 70/30 portfolio and generate higher returns after fees at the same time. Yes, it must be the goose that lays the golden egg.

and here is one of the illogical conclusion that one of my favorite authors Naseem Taleeb likes to point out.

Heavy investments in alternatives and hedge funds in particular have paid off for endowments. More than 79 percent of the growth in endowments with assets of $500 million to $1 billion resulted from investment returns (as opposed to gifts, for example). Institutions with more than $1 billion derived more than 75 percent of their returns from their investments, according to the Commonfund survey.

1. Since the article already stated the S+P 500 (assumedly under the period under examination) outperformed the hedge funds, a more accurate statement would be" investing in alternatives hurt endowments as opposed to simply investing in an index fund,

2. Now this one is really a beaut

Heavy investments in alternatives and hedge funds in particular have paid off for endowments. More than 79 percent of the growth in endowments with assets of $500 million to $1 billion resulted from investment returns (as opposed to gifts, for example)

This says absolutely nothing about the investment returns and quite a bit about the fundraising prowess of the universities. If an endowment grew it's gifts by 2.5% and stuck all its investments in a money market account at 5%, its endowment would grow more from investments than gifts. And if a college with a $100 million endowment got a $20 million gift, it would have grown in that year more from gifts than investments. Unless of course their hedge fund genius generated a 20% return.

Attention endowments : want to generate better risk adjusted returns for your endowment : ramp up the fundraising.

Of course no matter how bad hedge funds are for endowments the case is much more so for individuals. A few reasons:

1. The best performing (given the caveats) hedge funds require minimums of $10 million or more. You're not going to find them in that $100,000 "fund of funds" your broker is offering.

2. Endowments are able to often generate lower fees than the standard 2 and 20 (2% annual fee + 20% of the profits). Using the 2 and 20 formula the fund manager would have to generate a return of 12.5% to give you an after tax return of 8% (the long term expected return for stocks). If you think he can do that at less risk, you visited that endowment manager and were served some kool aid.

3. Endowments pay not tax on their investments. You on the other hand will get whacked in taxes from your hedge fund. Hedge funds trade actively so they are either on a mark to market basis (they pay tax on realized and unrealized gains) or they likely get their profits taxed almost entirely at short term (regular income tax) rates. Those taxes come out of returns whether or not you take money out of the fund. A strategy with index instruments will generate minimal taxes unless you take money out of the fund. And if you do take the money out and held the fund over one year you will pay lower long term capital gains rates.

Year End Review

The year end reviews of Mutual Fund performance have been published and as usual they present information that is likely to be like poison in the hands of most investors. Most dangerous are the lists of "top performing" mutual funds which will undoubtedly wind up on the buy list of many investors despite the fact that past performance of mutual funds has been proven by extensive academic research to be of little or no use in predicting future performance. Same goes for the gushing articles about investing geniuses at mutual fund company X or Y.

The sections aren't useless however, and if you connect the dots a bit you can reach some interesting conclusions. In the midst of a puff piece on the mutual fund company T Rowe Price
the NYT notes that:

... T. Rowe Price has come lumbering back. According to Morningstar, the average return of its funds was 9.85 percent, annualized, over the five years ending Nov. 30, edging out rivals like American Funds, Fidelity Investments and Vanguard.

Now there is a useless statistic !! The average return of a fund company is an absolutely meaningless statistic. No one invests their money in equal amounts across all of the funds of a particular company so no investor is ever going to get the average return of a fund company (and btw is that a simple average of all funds, only stock funds, weighted by size of the fund etc etc ?).

And comparing the average return across fund companies is equally pointless. Does Fidelity have more short term bond funds designed to provide lower returns at lower risk than T Rowe? Does T Rowe have more international funds than its competitors and the statistic simply reflect the great performance of international stocks in the last five years.

The article goes on to state:


With that success has come new customer cash. T. Rowe Price collected nearly $40 billion in net inflows from the beginning of 2002 through October last year, nearly double its amount from 1995 through 1999.

Sounds great right ? Well not exactly, the large inflow of cash makes it exceedingly unlikely that going forward the performance of T Rowe will continue to be as stellar as described. In fact T Rowe funds will increasingly run into one of the many problems with actively managed (as opposed to index) funds. The large amounts of cash they need to invest will be a drag on performance.

Interestingly that same NYT section presents the findings of an academic study on just what the impact of "liquidity trades" trades necessitated by investments or redemptions in a fund as opposed to "valuation trades" trades actually based on a manager's strategy. The study found a hypothetical portfolio of valuation trades to outperform the liquidity trades by 3.5%.

The article notes (my bolds)

The relative performance of the two liquidity portfolios was nearly opposite that of the valuation-motivated versions, with the buys now lagging the market and the sells outperforming it. In fact, the liquidity-motivated sells outperformed the buys by two percentage points a year, on average. In other words, the transactions that managers must make to meet liquidity needs eliminate much of the profit from trades made for valuation reasons. Transaction costs, which were not included in the calculations, coupled with management fees, eliminate the rest of that profit for the average fund

The Professors conclusions:

The professors interpret their findings to mean that mutual fund investors pay a high price for the chance to invest or withdraw money at any time. And the cost is borne by all investors, whether or not they take advantage of the opportunity. The investment implication is clear: don’t pay for liquidity unless you need daily access to your money.

How does this relate to the T Rowe story ? Quite simply a fund company "blessed" with massive cash inflows is going to burdened with the need to make large amounts of liquidity trades that are going to be a drag on performance.

Once again the academic research leads to the conclusion that actively managed mutual funds have a tremendous hurdle to beat simply to match their relevant index. The professors conclude that the liquidity trades, transactions costs and management fees (not to mention the taxes paid by investors) drag down the performance of actively managed mutual funds. Since index funds invest across an entire index fund consistently they do not engage in buys and sells of individual stocks based on liquidity.

What is the best choice for investors according to the study's author:

Professor Gibson says he instead favors open-end mutual funds that significantly restrict short-term trades

While the Professor seems to still hold out hope for active managers (probably because he did not quantify all the costs of an active fund) In my practice I have found an even better solution:

The funds of Dimensional Funds Advisors (DFA) although they are open end funds preempt the problem of excessive movement in and out of their funds. They make the funds available to individuals only through advisors committed to long term investing. In fact if they see a particular advisor is rapidly moving monies in and out of their funds they throw him out. Thus even their index funds targeted at smaller parts of the market (micro cap or emerging markets value for example) have little need to engage in trades simply to create liquidity.