Actually the above strategy, although on the surface it seems quite well thought out, is not a good approach to take at all. Why? Because of something called “style drift”. You don’t get truth in labeling with an actively managed fund; they often fill their portfolio with stocks outside their designated asset class. Not only does this make it difficult to construct a diversified portfolio, it makes it difficult to evaluate a fund’s performance. Even the funds listed on the box in my June 4 post may only have beaten their respective index by having a large portion of their portfolio invested in holdings outside that asset class.
To take one example, the a Dodge and Cox Stock Fund is labeled by Morningstar as a domestic large value fund it even gives it their highest 5 star rating over ten years. Yet even Morningstar’s analysis points out that the fund is 18.5% invested in non US stocks. http://online.wsj.com/public/fund/page/fund_snapshot.html?page=9&sym=dodgx Lipper also categorizes the fund as US Large Value and gives it their top rating in 4 of 5 categories. The Dodge and Cox website lists _character.aspthis fund alongside the firm’s international fund so it surely is not marketed as a global fund that has a mandate to invest anywhere in the world. Yet as one can find on the Dodge and Cox website 4 of the funds top ten holdings are foreign stocks, they alone make up 10.6% of the portfolio. The website compares the fund’s performance to the the US S+P 500 not a global index including ex US stocks. Thus they are clearly indicating they want potential investors to evaluate the fund as a domestic US fund.
What is the importance of the above example for an investor:
1. If one is trying to keep a particular allocation % between US and foreign stocks one would have to constantly monitor the extent of foreign holdings in this fund and adjust accordingly by reducing funds that are explicitly foreign stock funds. Of course if those foreign stock funds are active, they might hold some domestic US stocks. I’m getting a headache already. Using active funds in an asset allocation can be like a Rubik’s cube.
2. The performance numbers for this fund are meaningless to compare it to other large value funds or to the index. For example, through the end of May Dodge and Cox was -5.5% ytd a tiny bit better than the -5.6% for the vanguard large value index fund. Clearly, even that minimal difference didn’t come from good stock picking within the large value category. It came from the international holdings. In fact a close look shows that Dodge and Cox in aggregate did a bad job of stock picking among both domestic and international stocks. The vanguard developed international index fund was -2.2 % ytd. So in fact an index portfolio holding 18.5% developed international stocks (as Dodge and Cox does) and the rest large value stocks would have returned -4.96 % ,which is better than DODGX.
As the WSJ article below points out, the situations with Dodge and Cox is not unusual, in fact it is quite common my bolds my comments in (bold parentheses)
<strong>Fundamentals of Investing
The Drifters
You may think you know your fund manager's investment style. But don't be so sure --especially in turbulent times.
By KAREN HUBE
June 2, 2008; Page
As the stock market gyrates, you can take comfort in knowing you have a carefully worked out asset-allocation strategy in your mutual-fund portfolio, right?
Don't be so sure...
Some financial advisers caution that your portfolio may not be invested the way you think. The reason? During sharp shifts in the markets, some managers tend to veer out of their stated investment styles, with more frequency and to a greater degree than in calmer times, says Jeff Tjornehoj, a senior research analyst at data firm Lipper Inc. (although their fund data on the wsj website don’t take account of this) With markets down and highly volatile, "there is more of a temptation for managers to reach outside of what is typical for them in order to find positive returns," he says.
Research by Standard & Poor's Corp. indicates that drift heightens during market shifts. About 32% of all U.S. stock funds had "style drift" during the reasonably calm period in the stock market between March 2004 and March 2007. That compares with 46% during the tumultuous, post-technology-bubble period of June 2000 to June 2003, S&P found. S&P judges a fund's style by comparing the portfolio's total returns with the total returns of various style-based indexes and determining which one it most closely resembles. That is known as a returns-based approach. Other firms determine style based on the characteristics of the fund's underlying securities. That is known as a holdings-based approach.
For those who strategically allocate their money across asset classes and investment styles, a manager with wide discretion "can change the risk characteristics of your portfolio in ways you may not be comfortable with," says Steven Condon, investment director at Truepoint Capital, an investment adviser in Cincinnati.((!!!)
"It gets really problematic for investors if they own several equity funds whose managers are all drifting the same way -- then they are heavily overlapping in certain areas and getting far more exposure than they ever bargained for," says Ross M. Miller, clinical professor of finance at the University at Albany, State University of New York.
Adding Zip
Style drift can occur for positive reasons: Funds focused on small stocks, for example, can migrate into the midcap arena if the stocks they own have risen in price. "That's a good problem to have -- it means your small-cap manager has picked good companies," says Jay Berger, partner at Independent Wealth Management, an investment-advisory firm in Traverse City, Mich. In this instance, you may want to hang onto the fund for your midcap exposure and buy a new one to fill the small-cap space, he says
.(that’s pretty convoluted logic imo and pretty hard to implement: how often do you monitor it ? At what point do you make the adjustment he recommends, holding onto the fund that has more mid caps and buying more another small cap fund. Do you do this when the small cap fund’s holdings have risen to 25%, 50% 75% ? And where do you get the cash to buy another small cap with what cash ? by selling what ? And what about the problem of generating taxes (except in an ira) if you need to generate cash to buy that other small cap fund. My head is spinning already. And this problem would be totally eliminated by using only index funds.)
Some investors might like that their managers take the initiative to capture the best returns possible and add much-needed zip. "I believe the best way to go is with good managers who use their best judgment and invest wherever that takes them," says Jeff Bernier, managing director of TandemGrowth Financial Advisor, a wealth-management firm in Roswell, Ga. (yes if you don’t care much about asset allocation and believe in genius managers.)
An example is CGM Mutual fund, where manager Kenneth Heebner has one of the best 12-month returns of any U.S. mutual fund, up 35.6% through May 29. Earlier this year it had roughly 70% of its money in metals, mining, energy and bank stocks -- and 27% in debt securities. ( and its ten largest holdings make up 57.8% of the total portfolio so the fund is far from diversified, holding this fund is a big bet on the manager being a genius and continuing to make big money on his big concentrated bets. Though classified by Morningstar as a diversified large-stock fund, CGM Mutual says in its prospectus that it sometimes goes heavy on bonds, depending on Mr. Heebner's view of the economy.
Studies have come to different conclusions about whether style drift pays off in superior returns. In a 2002 study, Russ Werners, an associate professor of finance at the University of Maryland's Smith School of Business, found that managers of U.S. stock funds with style drift beat "style-pure" managers by three percentage points a year during the 15 years through 2000.
But Keith C. Brown, a University of Texas finance professor, found that style-pure funds beat drifters by 2.7 percentage points a year over a 12-year period that overlapped with the Maryland study. Mr. Werners used a portfolio-based analysis to determine style, while Mr. Brown used a returns-based one.
Any possible outperformance by drifters is largely irrelevant to those investors in the style-pure camp, because they aren't gunning for the highest possible returns. They say strategic asset allocation delivers high risk-adjusted returns, and they want managers sticking to what they are paid to do.
Don't assume that just because a fund's name specifies a style, it is therefore rigidly purist. Stock funds with names that reference a small-cap, midcap or large-cap style of investing must have at least 80% of their holdings in line with that style, according to a rule passed by the Securities and Exchange Commission in 2001. But there is a loophole: The rule says investment companies can take "temporary defensive positions to avoid losses in response to adverse market, economic, political or other conditions." In addition, the rule permits investment companies "to depart from the 80% investment requirement in other limited, appropriate circumstances, particularly in the case of unusually large cash inflows or redemptions."
"You only have to stick to that 80% during normal market conditions," says Bruce Leto, chairman of the investment-management group at law firm Stradley, Ronon, Stevens & Young LLP in Philadelphia. Because there is no official definition of what normal or abnormal market conditions are, "it's totally subjective to the manager," he says. "If you think the market is going into a tailspin, you can continue to call yourself by the same name and invest less than 80% according to your style." The SEC declined to comment.
Do Your Homework
It is hard to pinpoint style drift precisely as it is happening because information on fund holdings isn't available to investors on a real-time basis, Lipper's Mr. Tjornehoj says. "It's something that's only known for sure upon reflection."
The closest thing to a timely read for many funds is quarterly updates on funds' Web sites and in the SEC's Edgar database online (www.sec.gov4).
The University at Albany's Dr. Miller says investors can look for signs of drift by periodically comparing a fund's performance with that of its benchmark. "If returns aren't behaving the way they used to relative to the benchmark, that should give you cause for concern," he says.
Fund researcher Morningstar helps to pinpoint fund styles by plotting them on a grid of nine style boxes, including small, medium and large capitalizations and "value," "growth" and "blend" characteristics. (Value stocks are those considered cheap in terms of ratios such as stock price to per-share earnings, while growth stocks are those of companies whose earnings are expanding faster than the broader market's. Blend funds include both styles.) This information can be accessed free at www.morningstar.com5.
Morningstar President John Rekenthaler cautions that "the style boxes should be used as a guide, nothing else." If a fund crosses to blend from growth, for example, it doesn't necessarily mean it has made drastic changes. The fund may have been near the edge of the blend box all along, and moved into it after selling a few growth holdings.
Whether you are a style purist or willing to go with the flow of a style buster, there is no shortcut to doing homework on managers(or you could choose index funds in each asset category and not have to worry about this issue), says Steven Rogé, portfolio manager for R. W. Rogé & Co., a money-management firm in Bohemia, N.Y. He recommends reading the fund's prospectus and poring over any old reports of funds previously run by the manager.
Truepoint's Mr. Condon says the best way for most style-pure investors to ensure they get what they want is also the cheapest and least time-consuming: Invest in index funds.--.((obviously I couldn't agree more with that)
-- 6.
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