Three steps to outperformance in 2016 and other things that should scare you.

I don’t make any secrets of the fact that I feel a terrible love that in the world of investing dares not speak its name, that of loving actively run mutual funds.  From my own years of experience, I can tell you they still represent one of the most cost-effective ways for the average investor to access both some of the greatest individual money managers of our times along but to be fair, active managers have been getting killed with something like 98% underperforming their benchmark over the last ten years (according to FT anyway.)  Rather than join the crowd telling you this is just the last milestone on the path towards a world without active investing (which will never happen), let me tell you how I, a kid from the wrong side of New York (the non-NYC part) managed to create a top-performing mutual fund without even trying. 

A Star is Born:     

Way back in late 2014 I decided to create my own hypothetical mutual fund to demonstrate the “how’s and whys” of tracking error, mostly as a demonstration that the only time you really need to fear it is when you come across a “closet case” or a manager who’s essentially a benchmarker but charging an active fee.  My viewpoint on active managers comes down to this; if I’m paying you an active manager fee, you better damn well act like it.  There’s no greater crime in my book than misrepresenting yourself to investors and so my process revolves around the information ratio, looking at the amount of active return divided by tracking error.  Sometimes you’ll outperform and sometimes you won’t but there’s nothing worse than paying the money to take a chance and being robbed of that opportunity.

So was born the Yinzer Analyst Large Cap Core Super A Awesome Fund (YINZX) (trademark pending) and though the last few weeks may have been pretty dull for the markets, my little my little fund is up 7.06% after my very reasonable 1% annual management fee has been deducted.  That may sound excessive to you but consider what you’re getting for it, according to Morningstar.com, the average large-blend fund is up a mere 5.89% in 2016 through the end of July while using the ATAC Beta Rotation Fund’s (BROTX) 7.01% return and 36th percentile showing as a milestone, I’m assuming my little fund would be somewhere around the 35th percentile.  Not too shabby since I have way less turnover than BROTX and they charge a way higher fee plus a 2/90 redemption charge.

Hell, just for laughs let’s compare the trailing one-year performance again through July 31st.  YINZX would’ve been up almost 4.6% after fees while BROTX was up 3.29% and the S&P 500 TR was up over 5.6%.  If you’re about to throw shade, remember that the average large-blend fund was up 1.9% so I’m thinking with some colorful handouts and a national wholesaler, I’m well on my way to getting a few hundred million in new assets.  I’ll just have to add some colorful one-sheets describing my process, maybe something about sector rotation and not fighting the market when offensive sector valuations reach extreme levels, and call it done.

What is my process you ask?  It’s complicated, YINZX was slapped together to demonstrate how a passive fund generates tracking error so it’s history is just the monthly return of the S&P 500 TR minus an annual management fee of 1% which I take by pulling 8.33 bps out of the performance every month.  That 1% fee may sound excessive to you but guess what?  It’s pretty standard in the large blend space and so far, you’re thanking me in 2016 because my little fund is kicking some serious a&# this year which should tell you just how bad the situation has gotten for active managers.

Obviously I’m trying to point out in my own sad way that my little hokey fund is outperforming this year not because of any smart moves on my part but because of something fundamental to how active managers approach their craft.  I stand by my belief that active managers can outperform over long periods of time, but that’s challenging to do in an environment such as this for a number of reasons which are largely beyond their control.

Reason 1:  Style Bias:

I’m not talking about hating people who wear white socks with black shoes but that most managers, depending on what style box they’re in, will tend to stick to certain sectors to avoid getting too far behind their peers.  YINZX is a large-blend fund, same as the S&P 500 and holds the same sectors in the same weights just as you’d expect of a passive fund.  And how have those various sectors done over the last year ending 7/31?  Take a look:

TRAILING

Not surprisingly, the defensive favorites of utilities, consumer staples and telecoms which make up 17.5% of the S&P 500 have been killing it while the nearly 30% of the market tied up in healthcare and financial stocks has been lagging behind.

Take a look at one large-blend fund that HAS beaten its benchmark over the last decade even if the recent performance is a bit dicey, Touchstone Focused (TFOAX), up 3.47% for the year ending July 31st.  That’s 38th percentile performance and still almost 2X better than the rest of the funds in the space, not too shabby when you consider they have no utilities but how do they shape up against a real winner?

One of my favorite funds in the large-value space, Federated Strategic Value Dividend (SVAAX) was up 14.12% in the last year.  The big difference between the two?  Congrats if you pointed out the obvious and said utilities, TFOAX currently has none and only category average staples exposure in favor of more tech exposure while SVAAX has 45% in utilities and staples and another 20% in telecoms which is seriously out there even for the large-value space.

Both funds have other hallmarks of true active managers; both are heavily concentrated portfolio’s with less than 45 names each and low turnover meaning they have managers who know how to go for it and SVAAX’s performance tends to be highly cyclical, meaning sometimes he’s hot, sometimes he’s not but he’s always consistent.  In 2012 and 2013 the fund was in the bottom 5th percentile, 2014 the 37th and in the 1st in 2015 and 16 (YTD.)  In other words, he’s a great manager for this part of the cycle or this particular market, but if rates rise and utilities fall, SVAAX could be in for a fall.

Why aren’t people chasing SVAAX’s lead and rushing into defensive names?  For lack of a simpler explanation, that’s not the way they’re positioned in that space because too much exposure to value stocks and you risk being kicked into a different category.  Consider one of the top performers in the large-blend space this year, the ClearBridge Dividend Strategy Fund (LCBOX), up 9% for the year ending 7/31. The S&P 500 has 3.45% utilities and the average LB fund has 2.84% but LCBOX has 6.8% plus 14% in consumer staples compared to 10.2% for the category.  How have they gotten away with it?  Easy, they didn’t.  Morningstar historically classified the fund as Large Value and only recently moved it to Large Blend which isn’t a promotion by any stretch.  Compared to the rest of the large-blend universe, LCBOX’s annualized performance over the last three and five year periods is literally 50th percentile at best making it harder to sell the fund in today’s market.

After all, who wants to own the average or median fund when you can get a better one?  Means a good salesman and product specialist will be forced to spend a lot of time trying to explain the fund’s story and if they have better products to hawk, they’ll focus on those and LCBOX could get lost in the shuffle.  Even worse, rigid guys like yours truly who want large value instead of blend will have to decide if they want to keep the fund or swap it out for SVAAX.

Going back to Touchstone Focused, the fund is less cyclical with a slightly higher turnover, signaling that we have a manager who follows a philosophy that isn’t in vogue right now.  Kudos for placing as highly as he did with more tech and cash exposure and by forgoing utilities.  In fact, the fund places almost on the line between blend and growth making its performance even more remarkable as the category average performance for large-growth is less than half of that of large-blend over the past year.

Reason 2: 2 Fast, 2 Furious:

The second reason why so many managers are underperforming is that the market is just shifting too damn quickly for anyone to keep up.  Like I said before, LB managers will avoid certain sectors that have historically been a drag on performance like consumer staples and utilities so even if they wanted to increase their allocation to names in those spaces, they probably won’t have the analyst teams ready to find good picks.  But even if they did, sector rotation is happening so quickly that it’s hard for them to keep up!

Look at these charts for the utilities, telecoms and consumer staples sectors where I plotted the performance of state street sector funds over the performance of SPY:

xlu2

xlp

IYZ

Yes, they each show sudden sharp accelerations as the sector finds favor against the broader market, generally in late 2015 or early 2016 but with one caveat.  After an initial ramp up (outperformance) they begin to ramp down in a very jerky fashion as investors rush in and out of the space.  Remember that running a big mutual fund is sort of like sailing a large ship, it’s big and powerful but god forbid you need to make a quick stop and change direction.  That heavy volatility makes it difficult for active managers to reallocate to the space in a timely manner.  XLU relative to SPY went from 0 to 60 in just two months, which is probably about the amount of time it took for some active managers to make their decision to shift and started liquidating positions to free up cash.  Factor in the belief that this defensive rally is just mass hysteria and you can see why some large blend managers would choose to stay with their current holdings (or even buy more) than reallocate to defensive names.

Conclusion:

My chief takeaway from all of this?  First be ready to admit that running a fund that can beat the benchmark is harder than you think, ask the 98% or so of U.S. equity managers who couldn’t over the last decade.  Then look again at TFOAX which has beat the S&P 500 over the last ten years and with two managers (still the same subadvisor) to boot but if you jump in and out of funds and asset classes chasing performance, you’ll likely end up disappointed.  When it comes to picking a good fund, find a great manager and STAY with him.

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