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Thursday, April 30, 2009

Target Date Funds...This Doesn't Solve Their Problem

I have written several times about target date funds which claim to adjust the allocation between asset classes based on the target (retirement) date of the fund. The problem with these funds is the lack of clarity of the "glide path" in which the funds reduce the allocation to stocks and increase the allocation to bonds to reduce volatility as the target date approaches (see the example in the graphic at left). Since the investor is often not aware of the glide path, and the manager may change it the investor is often left in the dark. Target funds with the same date but different managers will often have different "glide paths". Additionally since the target date does fund does not "know" what other assets are held by the investor, the glide path may not be appropriate to the investor even if he plans to retire at the target date. For example if the investor holds his target date fund in his 401k and has considerable assets in taxable accounts it might be advantageous to draw first on the taxable account to fund retirement needs so as to accumulate more in the tax deferred account.

The WSJ today writes about new changes to the targe date funds but it seems to me they don't deal with the main problem which is outlined above. As the WSJ writes (my bolds):

...Some retirement plan sponsors have offered customized target-date fund lineups for three or four years, and it isn't unusual for plans with $1 billion or more in assets to do so, Mr. Suess said. Typically they are created with the help of a consultant, using funds already chosen for a company's defined-contribution or defined-benefit plan.

Among Hewitt Associates' clients, almost 20% of those with target-date funds mix their own, said Pam Hess, director of retirement research at the consulting firm. More broadly, it is probably closer to 5% of plans but growing significantly, she said.

Customized lineups are attractive for a variety of reasons.

They allow a company to avoid the risk that comes with placing all their assets with one entity. Also, the company may have already taken the time to select the best manager in each investment category, and now can negotiate lower fees by placing more assets with those managers.

"The plan sponsor has done a lot of work developing this core line-up," said David Wray, president of the Profit Sharing/401(k) Council of America. "Why wouldn't they want that to expand to their target-date program as well?"

It's simpler to change funds if one or more in a line-up are poor performers. A plan sponsor could remove an underperforming large-cap equity fund, for example, without having to change everything else, Mr. Suess noted. That can't be done with a bundled product.
There are now more consultants willing to take on the fiduciary duty of setting up so-called glide paths, which are the schedules for how a fund's assets will be reallocated over time, and of choosing investment managers.

James Worrell, president of GPS Investment Advisors LLC, a retirement plan consultant, said he has worked with two 401(k) plans that used their core funds to create age-based and risk-based portfolios.

Flexibility, performance and investment philosophy, in terms of construction of the funds' glide paths, are all factors driving the trend, he said.

Two Observations:

1. While it may be true that there is some advantage to incorporating funds from various fund families into the target date funds, it adds the additional pitfall of choosing active managers. Since we know past performance tells little about future performance among fund managers, how can one be sure the consultant picks the "best large cap manager" and what will be the criteria and frequency of decisions to drop "underperforming manager.

Of course this problem could be solved by making the allocation within the target date funds a mix of index funds or etfs covering major asset classes.

2. Using a consultant rather than the fund company to set the "glide path" doesn't solve any of the problems I outlined above, it merely changes who makes the decisions.

The "Better Mousetrap " Redux

The WSJ today has a short piece on fundamental index ets (see yesterday's post). The article lists the one year performance was relatively dismal for most of these etfs compared to the cap weighted s+p 500 (-38.1)and russell 3000.

But what I found more interesting is that the one year numbers seem to give credence to the argument that these "new methodologies" are simply another form of value weighted index and those have been available in funds and etfs for quite a long time.
Consider the one year performance for the etfs mentioned in the article:

Powershares Dynamic Market (PWC) -35.3
Powershares RAFi 1000 (PRF) -43.0
Wisdomtree Earnings 500 (EPS) -37.8
Wisdomtee Large Cap Dividend (DTN) -41.3

Now consider the performance for the same period for the following etfs and funds that have been around for far longer using "old" value weighter screens. Draw your own conclusions on whether the "better mousetrap" is really anything new.

DFA Large Cap Value (DFLVX) -41.88
Vanguard Value (Lg Cap) VTV -37.63
Ishares Russell 3000 Value (IWW) -38.62

Wednesday, April 29, 2009

Fundamental Indexing: A Better Mousetrap ?

Forbes recently reviewed the performance of Robert Arnott's fundamentally weighted index as well as those of some others (hArnott's firm's website is here. As the article notes the premise behind the fundamental index is that the more traditional cap weighted indexing places too great a weight on stocks with high valuations, leaving it exposed to what many have dubbed "bubble" risk. There is some merit to that argument. However, as many have noted, these "new" indexing techniques tend to look fairly similar to value weighted and cap weighted indexes designed to increase the weighting of more value and smaller capitalization stocks. This methodology is nothing particularly new, Professors Eugene Fama and Kenneth French have written about this methodology for decades and have pursued an indexing investment strategy based on this with the fund management firm Dimensional Funds Advisors.

And as we have noted in earlier posts, value weighted indices, particularly those in the large cap area have suffered greatly as of late. In the current environment the methodologies used by all of these various indices have generated large weightings for financials.

When the various quantitative screens for these various indexers use data reported in financial statements as their inputs they generate similar results and cannot take into account any analysis of those numbers. Thus outlooks for writedowns on book value, restatements of earnings, or dividend cuts cannot be incorporated into the index. While this approach may have the virtue of avoiding any subjectivity, under the extreme distress of the financial services industry in the current crisis, it has certainly hurt performance. Another variable that seems not to have been taken into account is any kind of limit on industry concentration for the funds. Those that formed these indices might argue that industry is not a relevant factor that determines returns and therefore one need not worry about over concentration in a particular industry. I find much fault with that assertion, certainly on a risk management basis.

Arnott had the unfortunate luck to unveil his fundamentally weighted indices in precisely the market environment least congenial to his methodology. You can follow the links to the forbes article with the performance numbers.

From the Forbes article (my bolds, my comments in italics)

Money & Investing
Can You Out-Index The S&P
Evan Hessel 04.27.09, 12:00 AM ET

As the former global equity strategist for Salomon Brothers, Robert Arnott built a reputation for knowing his way around the stock market. So it didn't go unnoticed when five years ago he boldly proclaimed he'd come up with a formula to beat index funds over the long haul.

The crux of Arnott's argument is that traditional index funds are flawed because the basis for determining how much of each individual stock is held in them is its total stock market value. When technology was on a tear, indexes such as the S&P 500 and Nasdaq were left loaded with the likes of Cisco Systems and, which promptly crashed. When financials got hot a few years later, indexes emphasizing large-capitalization companies had heavy weightings of Lehman Brothers and Citigroup.

Certainly, Arnott figured, there must be a better way to populate indexes. He crunched the numbers at Research Affiliates, his Newport Beach, Calif. advisory firm, and decided the best basis for filling indexes is not a stock's total market value but what he calls its ''economic weight.'' That he defined as a secret-sauce algorithm comprising revenue, cash flow from operations, dividends and book value.

The method fuses passive indexing with a value tilt. High-flying stocks with tiny earnings, but huge earnings multiples, get light weightings.

Arnott back-tested his index with 42 years of data and proclaimed he'd devised a way to beat the S&P 500 by 2 percentage points a year over the long haul. His pitch enticed Charles Schwab, Pimco, PowerShares and Nomura to license his indexes for a bevy of products that go by the appealing sounding moniker ''fundamental index funds.'' Investors have entrusted $18 billion to them.

The results to date: Yet more evidence that your best bet is still a plain vanilla index fund, like the benchmark S&P 500 one launched by Vanguard founder John Bogle in 1976 and essentially unchanged since. Such funds won't shield you from bear market losses. But with minimal fees, tax-efficient structures and the collective wisdom of the market baked in, marketcap- weighted indexes are still the performance champs over the long haul.

In the three years since its launch Arnott's Research Affiliates Fundamental Index 1000 has lagged the Vanguard 500 Index Fund and the Russell 1000 funds by 1.9 points each. His Rafi 1000 for Europe and Asia has bested the benchmark MSCI Europe Australia & Far East Index by 0.6 percentage points. Over the past year Schwab's Fundamental U.S. Large Company Index Fund is down 42.6% after fees of 0.5%. Vanguard's 500 Index Fund costs a quarter as much and is down 38.1%.

Arnott has some prestigious company in his quest to best traditional indexes. Wharton finance professor Jeremy Siegel has built (and marketed) similar products at WisdomTree Financial with similarly mixed results. WisdomTree's LargeCap Dividend Fund ETF has lagged the S&P 500 by 2 percentage points a year since its June 2006 inception. Its Earnings 500 Fund has trailed the S&P 500 by 0.2 percentage points annually since its February 2007 inception.

In tacit recognition that the dividend methodology can generate a very high weighting in financials, Wisdomtree has announced plans for a dividend weighted ex financials index etf.

Not surprisingly, given that they are attacking a bedrock claim of investment theory (that no mechanical formula can beat the market), the vendors of fundamental indexes have got a skeptical reception in academia. Harvard Business School's Andre Perold joked that Arnott's strategy is ''fundamentally flawed.'' Burton Malkiel, a Princeton professor known for his support of the efficient markets theory, suggested Arnott was just another stock picker in drag.


Malkiel and Bogle attacked Siegel's approach on the Wall Street Journal's editorial page in 2006. They argued that Siegel's claim of superior performance for a small-cap value stock index over five years would be disproved over the longer term. Siegel countered with a column claiming that value-oriented funds have beaten cap-weighted funds since 1925, the earliest date for which comprehensive stock data are available. So far the skeptics are winning the battle over fundamental indexing, but three years is, to be sure, too short a time to judge a system that is supposed to prove itself over a period of decades.

Arnott is sticking to his guns and attributes his underperformance to lousy timing. Research Affiliates rebalances its portfolios each March, selling stocks its models indicate are overweighted relative to their economic value and replacing them with cheaper ones. Stocks whose weightings were increased in March 2008: American International Group, Wachovia, Washington Mutual, Citigroup and Bank of America.

It may be "lousy timing" that hurt Arnott's indices but in my view it is the lousey timing resulting from the fact that his methodology is heavily depended on those financial ratios that have been least reliable when reported by financial institutions. The weighting on the companies listed above went up because the data used was so unreliable yet the (lower) market price reflected skepticism with regard to earnings, book value and future dividends. As efficient market and market cap advocates like Malkiel would point out, the market price reflected the prospective outlook for the companies. On the other hand the fundamental indexing formula saw the stocks as "underpriced" because it was using historical financial data and the prevailing market price.

''Investing against the market hurts on the way down,'' Arnott says. ''But there is always potential for huge gains when it reverts to the mean.''

Talking his book, Arnott argues that financials are undervalued now. If you don't count (presumably nonrecurring) writedowns of assets, then banks and insurers represent one-quarter of the stock market's earnings but only 10.3% of its value.

The above statement illustrates my observation: "If you don't count writedowns of assets" and assume no more will occur than financials are undervalued. Of course if you anticipate more writedowns or that financials will have to raise more equity in moves which could dilute current shareholder value,then the stocks are either fairly or overvalued. In other words Arnott thinks that "Mr.Market is "wrong" in its current valuation of financials.....

Arnott set up Research Affiliates in 2003. His strategy is influenced by two acclaimed finance gurus, Dartmouth's Kenneth French and the University of Chicago's Eugene Fama. Both make an exception to the efficient market theory for value stocks. These, they think, offer the best long-term returns.

Offering new fodder to critics who believe the only real value of trying to out-guess the market is its marketing appeal, Arnott has also created a fundamental index on steroids. Dubbed Enhanced Rafi, it aims to give investors a first peek at which companies' earnings may rise and fall by measuring ''net operating assets''--an amalgam of easily inflated accruals such as intangibles, goodwill, accounts receivable and capitalized investment as a percentage of total assets.

The theory is that companies with outsize net operating assets are more likely to have booked dubious accounting gains that could eventually be written down. Arnott's team admits the analysis penalizes firms in industries with high capital expenditure requirements and says it only underweights firms with the stock market's highest ratios. By this measure, General Electric deserves underweighting because its net operating assets represent 60% of its total assets.

(another indexing methodology that works except when it doesn't...we'll see)

Arnott is nothing if not ambitious and prolific. He is working on an alternative to prevailing indexing methodology in the fixed income arena as well, a variant on "fundamental indexing". More on that in the future.

Pimco has used Arnott's recent creation to roll out the Pimco Fundamental IndexPlus Total Return fund. It combines Enhanced Rafi with an actively managed bond portfolio in a bid to beat the S&P 500. The fund has failed miserably over the past 12 months, falling 48% after its hefty 1.7% in fees. Arnott blames a poorly performing bond portfolio. Vanguard's low-cost S&P 500 fund fell 38%.

Thursday, April 23, 2009

In Case You Needed More Proof That There Are Few If Any Genius Investors

From the WSJ

APRIL 22, 2009.Managed Funds Take Beating From Indexes .By SAM MAMUDI

NEW YORK -- Investors in actively managed mutual funds for the past five years have reason to wonder what they have been paying for: A new study from Standard & Poor's finds that 70% of large-cap fund managers who use the S&P 500-stock index as a benchmark for comparison have failed to match the performance of the index over that time.

That is double-bad news, given that the index was down 19% in the five years that ended Dec. 31. The failure of active management is replicated across almost all categories, not only U.S. stock funds but also bond funds and even emerging-markets funds.

What's more, those numbers are similar to the previous five-year cycle. From the close of Dec. 31, 2003 to Dec. 31, 2008, the S&P 500 fell 18.8%, but still beat 71.9% of U.S. actively managed large-capitalization funds, according to S&P Index Services.

"We consistently see that once you extend time horizons to five years, the majority of active managers are behind their benchmarks," said Srikant Dash, global head of research and design at S&P.

Things were even worse for small-cap active managers, Mr. Dash said. The S&P SmallCap 600 outperformed 85.5% of small-cap funds. That index fell 0.6% over the five years to Dec. 31.

Even among emerging-market funds, most lagged behind their comparable S&P index. The S&P/IFC Emerging Markets Index bested 89.8% of actively managed emerging-markets stock funds in the past five years.

Actively managed bond funds also struggled. Except for high-yield funds, at least 80% of bond funds trailed their comparable benchmarks across all categories, Mr. Dash said. Because of liquidity issues, bond benchmarks aren't as easy to replicate by index funds.

You can hear a podcast from on the subject here:

And the full S+P report is here.Two interesting points from the data

In 2008 80% large cap value managers outperformed the large value index. As pointed out here several times (and is mentioned by the analysts on the podcasts) this can be explained by the high weighting of financials in the large value indexes and doubtless many large value active managers limited their allocation to financials.

Advocated of active management often argue that as one moves into markets that are potentially less efficient the opportunities for outperformance by active managers increases, Emerging markets are often cited as an asset class where this would be the case. Yet the S+P data show that emerging market active managers do far worse than active managers in developed international and US markets in outperforming their index. Only 16% of active managers beat their index over a 3 year period and a little over 11% did so on a five year basis. For International developed the numbers were 24.5% and 26.5% respectively and for large cap US 35% and 28%.

Professor Eugene Fama of Yale and Kenneth French of Dartmouth have an academic paper on this issue that can be downloaded here.

Wednesday, April 22, 2009

Harvard Yale And Individual Investing

Two new books: How Harvard and Yale Beat the Market by Matthew Tuttle and and The Ivy Portfolio: How to Invest Like the Top Endowments and Avoid Bear Markets - Mebane T. Faber The Have appeared purporting to show how individuals can use the investing techniques of the Yale and Harvard endowments in their individual portfolios. This is despite the fact that books by David Swensen of Yale and Mohammed el Arian formerly head of Harvard Management do not recommend individuals attempt that approach. I gave both books a "latte read" (a short review over a coffee at my local bookstore) and I was not particularly impressed. The Tuttle book stresses the efficacy of using active managers despite their high fees, the Faber book (more on that book in a later post) is somewhat better although it's system to "avoid bear markets' amounts to market timing based on a moving average technical trading model.

The Tuttle book is reviewed in the WSJ today. The reviewer correctly points out that individual investors can incorporate part of the Yale/Harvard approach by adding asset classes such as real estate and commodities. Tuttle argues in his book that individuals can make use of hedge funds through "funds of funds" and other vehicles. In the book he argues that access to skilled managers is worthwhile despite the relatively high fees ( a view diametrically opposed to that of Swensen in his book Unconventional Success which is directed to individual investors.)

The reviewer, Dave Kansas notes in his review

The best part of Mr. Tuttle's book is his critique of mutual-fund investing. He notes that mutual funds are organized primarily around "style," meaning that a fund focuses on certain investing themes, like large-cap growth or small-cap value. Mr. Tuttle argues that style investing boxes in money managers. If large-cap growth isn't doing well, the manager is still "trapped" into investing in that arena or building up cash. The goal: just beat the large-cap growth benchmark. So if the large-cap index is down 25% and a large-cap fund is down 21%, it is doing "better" than the benchmark and the goal has been met. But that hardly helps the fund's investors.

Mr. Tuttle argues that investors should focus on skills rather than style. In other words, an investment fund should have a mandate to make money, not to stick to a certain benchmark. (This strategy is similar to the one followed by most hedge funds.) Some mutual funds now favor a skills-based approach, and Mr. Tuttle argues that more such funds will become available as style-based investing comes in for more scrutiny and criticism

I find fault with the above argument on several counts. If one accepts that "styles" correspond to asset classes that are not highly correlated, then it is logical to argue that consistently holding at least some allocation to all of these asset classes should over the opportunity to increase returns without increasing risk. This is a fundamental tenet of modern portfolio theory and although much of the theory is certainly under severe criticism of late this premise still holds as a useful foundation for building a portfolio.

Certainly the alternative put forward by Tuttle has even less intellectual consistency. To argue that "investors should focus on skills rather than style" and that skills based investors that can invest in any asset class will produce outstanding returns, is to put it mildly quite a leap of faith for the following reasons:

1. If there is overwhelming evidence that active managers do not display skill in beating their benchmark when they are constrained by style (see the other post for today) it would be reasonable to assume that investing skill is a rare commodity. Why would it be reasonable to assume that there are "skilled" investors that would consistently produce outstanding returns simply because they are allowed to invest across asset classes.

2. Since there is virtually no consistency of outstanding performance among active managers within asset classes why would one assume that managers of outstanding skill among the "go anywhere" asset managers could be identified and that once chosen their "skill" would continue.

3. "Skilled Managers" are not an asset class. Therefore relying on skilled managers can increase the risk on a portfolio considerably. If one chooses a single "skilled manager" one has traded the transparency and diversification of a multi asset strategy using index instruments for an "all in" strategy betting on the skill of the manager, it could be highly concentrated on a single asset class or even a very limited number of securities. Adding additional "skilled managers" doesn’t necessarily reduce the risk of the portfolio since they all could be following similar strategies and have high exposure to the same asset classes. Furthermore, unlike the transparent indexed portfolio there would be no way to reduce the risk of the portfolio other than liquidating part of the accounts invested with the "skilled managers" and investing cash or near cash instruments.

Many if not most of the absolute manager concentrate on a particular style although they are different than “traditional “ asset classes. In contrast to Mr. Kansas’ argument, few absolute return asset managers really “go anywhere” and can enter into any strategy that they think can make money. Thus hedge fund managers tend to specialize in areas such as merger arbitrage, convertible bond arbitrage, long short stock trades and others. Not surprisingly the returns within these styles tend to correlate highly.

Choosing absolute return managers may not solve the problem of “style boxes” one is simply swapping the style boxes of “traditional” asset classes for the style boxes of the hedge fund world. The widely used hedge fund indices break out performance by style and the hedge “funds of funds” available to retail investors usually strive to provide a mix of styles.

The problem of having mangers that are “locked in” to a style” is not solved by simply adding absolute return managers to a portfolio. For example choosing an absolute return manager that concentrated on convertible bonds would have locked one into a dismal performing asset class last year. Since the range of hedge fund strategies is so broad, a truly diversified portfolio of “skills based manger” would likely require successfully choosing managers that have outstanding skills exercising a whole range of strategies . One thing that is certain when one adds absolute return managers instead of index instruments to one’s portfolio: fees will be higher. And because of the short term trading and leverage used by many of these managers taxes and volatility are likely to be higher as well.

In sum Tuttle's "strategy" consists of giving money to a "skilled manager" (screened one assumes by an advisor like Tuttle)and hoping for the best from the "genius manager".
I am a big believer that investors can be easily (in the words of Naseem Taleb) be fooled by randomness and that what seems to be investing skill is in fact often luck or at best no indicator of future success. While all of us are rethinking some of our approaches to investing in light of recent developments, throwing out the idea of exposure to a range of asset classes (styles) and instead relying on finding "skilled" managers is in my view simply a recipe for increasing risk that is unlikely to meet much success.