A Revolutionary Take on Morningstar’s Style Box

“If we could first know where we are, and whither we are tending, we could better judge what to do, and how to do it.”

Abraham Lincoln

It must seem mighty strange for a blog about investment products to be ripping off quotes from the great emancipator, especially one that began his famous “House Divided” speech as the nation tore itself apart over the issue of slavery and states’ rights.  Then again, anyone working in the mutual fund side of the asset management business probably feels that it’s a pretty apt comparison to what’s going on in the business today.  Seems every armchair portfolio manager can only talk about underperformance by active managers and why passive index replicators charging low fees are the only way to go, a topic even the DOL enshrined in its recent Conflict of Interest rules.   Most are probably wondering if the situation could possibly get any worse as Morningstar says over $300 billion in AUM fled actively run funds for the year ending 8.31.

Now I’m sure you’re reaching for the world’s smallest violin thinking they have no one to blame but themselves after so many in the business got rich by running what amounted to closet index funds charging high fees which in turn helped spark the ETF revolution and brought the Feds down on them.  Picture the powdered wigs and finery of the French revolution but instead of aristocrats saying “let them eat cake” the masters of the mutual fund universe were saying “fees less than 1% and no 12b-1?  I never!” Continue reading

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.  Continue reading

Monday Night Quarterback: Looking For a Great European Manager

Last Friday’s strong showing by the S&P 500 led by underperforming energy stocks may have felt like a “last shall be first rally” but one ETF we’ve paid close attention to, the iShares MSCI EMU ETF (EZU), took off with nearly a 2% gain to an already strong week.  While EZU didn’t close above it’s downtrend line on a weekly basis, it certainly is showing the sort of strength that gets the Yinzer Analyst’s blood rushing.



While there’s a lot of uncertainty about the upcoming ECB announcement on the 22nd where a long-anticipated QE program should be unveiled, it’s time to get off the sidelines and get into the game. For me, I want true EU exposure without a lot of British or other non-EU equity exposure, but what about those investors out there who’s portfolios are U.S. heavy and just need foreign equity period? Well you’re in luck because the Yinzer Analyst, instead of spending the entirety of the holiday catching up on Brooklyn 99 instead sought out five great funds that can add value to your portfolio.

For those readers who are new to the process; I first began by deciding what exposure I wanted, narrowing it down to the benchmark and Morningstar sector and then zeroing in on funds that I feel have the potential to outperform an index fund over a three to five year time frame. Without access to a data service like Morningstar Direct, it took a lot of time to piece together different sources but having used a few international funds in my day (although I currently have no positions in any of these funds), I do have some short cuts to the process.

First, I want exposure to large-cap developed stocks, not a 75%/25% developed/emerging market blend. This is key; after seven months of underperformance and with the ECB announcement coming up; my goal isn’t to gain Russian exposure or Brazilian exposure. My goal is to add European exposure plain and simple. Now there are a wide variety of funds that are Europe specific and we’ll talk about those later this week, but this exercise is for those investors with a U.S. centric portfolio who after five or six years need to rebalance and want to add international exposure. So this rules out benchmarks that include emerging market equities like the MSCI ACWI ex. USA or MSCI World; instead we’re going old-school with MSCI EAFE which has a 99% allocation to developed markets with Greater Europe making up 66% of that.

So heading over to Morningstar, I used their Premium Screener function to search for funds with a European heavy portfolio (greater than 60%) along with an initial investment at or below $2500 and still available to new investors (so long Oakmark.) If you don’t want to pay Morningstar prices, check out the new FundVizualizer tool from Putnam Funds. Yes, the focus is obviously on getting you to use Putnam funds but it has a lot of capability for a “free” service. Anyway, once you get rid of multiple share classes, you have a short list of about 75 funds split between the Foreign Large Blend and European Equity categories but our focus on a strong correlation to MSCI EAFE keeps the list below short and direct. Remember, these are the Yinzer Analyst’s recommendations but you still need to do your own research and check out the funds for yourself before you choose to invest in any fund. Read our disclosures for more details.

EuropeLet’s start with our top three funds by addressing the elephant in the room; it’s a pretty Pittsburgh heavy list but that was entirely a coincidence. FGFAX is one of the strongest performers in the Foreign Large Blend space over the last sixteen years since March Halperin took over as fund manager, placing consistently in the top five percent of funds in its category every year over the 3,5,10 and 15 year trailing periods. The fund has always held larger allocations to European equities, so much so that while MSCI EAFE is the official benchmark, Morningstar recognizes MSCI Europe as being the “best fit” benchmark to evaluate the performance against.

The story has changed somewhat in 2015 as the fund is down 2.38% through 1.16 compared to -.8% for MSCI EAFE and -.33% for the category. The main culprit seems to Swiss stocks including a 4% allocation to Credit Suisse that’s taken a nose dive since the start of 2015. One other feature to watch for in all active managers is a tendency to hold onto positions (campers) and FGFAX is no exception with an average turnover of 5% a year.

Next up is MFS International Value (MGIAX), which like FGFAX has placed in the top decile for active fund managers in the Foreign Large Blend space over the last fifteen years although unlike FGFAX is outperforming the benchmark handily this year with a return of .76% YTD. The fund recently had a change in management with long-time manager Barnaby M. Wiener (right?) appearing to have left the fund at the end of 2014 although he was replaced by another manager, Benjamin Stone, who has been with the fund since 2008. Normally this would put the fund on a watchlist, but MFS’s international funds have a strong reputation plus the prior service record of Mr. Stone is worth the benefit of the doubt.

Like FGFAX, MGIAX has a relatively low turnover ratio at 18% so again, expect somewhat cyclical performance but the fund has only underperformed EFA once in the last five years, delivering a five year annualized return of 9.36% compared to 4.45% for EFA. More impressive is that it did it with lower volatility than EFA and thus earned a suitably high information ratio although I’m sure my more cynical counterparts will point out that rarely do high ratios persist for long periods.

Finally, another strong candidate from the hometown team is the relatively small (less than $600 million in AUM) PNC International Equity Fund (PMIEX.) Normally, I wouldn’t look twice at a bank fund for the sole reason that banks usually haven’t the least incentive to actually spend money on active management. Historically the focus has been on providing a portfolio solution for in-house trust or wealth management accounts where the pressure to deliver performance has been somewhat less than you would expect to find with an independent advisor so active management fee’s for close indexer performance.  Always a bad mix.

What makes PMIEX different? Like crosstown rival FGFAX, this fund has a strong history of outperformance delivered under one manager who has been with the fund since 1998 although the turnover ratio is significantly higher with PMIEX at around 31% to FGFAX’s recent 5%. The fund also has more holdings, giving it a broader focus and lower tracking error relative to MSCI EAFE but helping it avoid some of the pain inflicted on Swiss equities although PMIEX is also underperforming the category so far in 2015 with a YTD return of -.75%. Investors can expect more “even” performance than FGFAX but if the focus is on really picking up Europe exposure, PMIEX has a significantly smaller positioning in the region relative to FGFAX but might offer a better solution for investors who need a “one and done” solution.

With three great options like that, why am I also giving you two “also rans” that at best have delivered market-like performance over the last several years? Because as great as the first three funds are, you never want to slavishly follow just one manager and both of these funds have had management changes in the last three years that can hopefully offer better performance going forward. How did I find them? I would have discarded them after my initial scrub but decided to do some digging for one reason; both funds are positive and in the upper quartile in 2015.

Let’s start with Goldman Sachs where a new manager took over the tiny Focused International Equity Fund (GSIFX) in early 2012 and proceeded to take it from a consistent underperformer to beating EFA in both 2012 and 2013. So why is he still managing a $200 million dollar fund? Because he was absolutely crushed in 2014, down nearly 13% to EFA’s 6.2% loss as heavy losses on BG Group and Banco Popular Espanol combined with a concentrated portfolio (hence ‘focused’) to kick him when he was down. Even with the shellacking, GSIFX’s performance was strong enough over the last three years to slightly outperform EFA.

So why do I like the fund? Because the manager’s a true active manager (underperformance is a risk you take moving away from the herd) who’s not afraid to take large positions and best of all, has shown he can outperform. Best of all, he’s willing to trade with highest turnover ratio in this class at a 121%.

Finally, mid-sized life insurance companies are historically as bad as mid-sized banks at running mutual funds, but I have high hopes for Sentinel International Equity (SWRLX). Not just because the Vermont based fund family once sent me five pints of Grade A medium amber maple syrup as a gift or because I still watch Super Troopers whenever it’s on Comedy Central. Like GSIFX, this fund added a new manager in late 2012 who delivered tremendous performance in 2013 with more middling performance in 2014. He’s managed to deliver solid performance with slightly less volatility, has a higher turnover ratio than the top 3 funds at 52%, has concentrated positions showing active management but most of all, what I like about this fund is what it doesn’t have…assets. There’s enough literature pointing out the historic outperformance of smaller funds with new managers to larger, more established funds constrained by liquidity concerns.

No matter which fund you choose, if any, remember that you always have options and it can’t hurt to start your search with some of Pittsburgh’s finest.

Sunday Night Recap: Does Every Dog Have Its Day?

The Yinzer Analyst is a simple man; he likes his beer cold, his Bills winning and his mutual funds simple so you can imagine over the years he’s found himself increasing disappointed, and not just by the Buffalo Bills.  The trend among mutual funds has been to develop increasingly opaque strategies as a way to justify high management fees for subpar performance when compared to index funds or ETF’s. From years of researching equity mutual funds I can tell you there are essentially three models; indexed, active managers who are actually indexers, and true active managers; and at the heart of every successful equity mutual fund is a process to find and select individual securities. Some are incredibly complex while others are simply the result of one manager’s particular process. One fund that has eschewed complicated strategies and has still managed to deliver superior returns is the SunAmerica Focused Dividend Strategy (A Share-FDSAX), once the darling of Barron’s magazine and that has since fallen on rough times.

Now when I say FDSAX has an easy to understand strategy, I mean it’s so easy that even someone relatively new to investing should be able to follow the logic behind its construction. Simply put, it’s something I like to think of as “Dogs of the Dow +” in this case actually the 10 highest yielding stocks in the Dow Jones Industrial Average plus 20 stocks from the Russell 1000 (which may also include the Dogs of the Dows.) The stocks chosen from the Russell 1000 are selected based on a screening process that looks at valuation, profitability and earnings growth. The portfolio is put together annually and with the positions more-or-less equally weighted with no concern towards sector weightings and held for an entire year. That’s all there is to it. Now I choose to call it the “Dogs of the Dow +” given that I think it’s fairly reasonable to assume that the 10 highest yielding stocks are likely to be the ten worst performers over the previous year and while the specific metrics used to pick the stocks for the Russell 1000 aren’t publicly disclosed, my assumption is that the system used by SunAmerica would be recognizable to stalwarts of the investment profession like Benjamin Graham.

At its core, the investment theory governing the portfolio construction process (as well as any valuation based investment strategy) isn’t quite reversion to the mean but something close; the idea that stocks will gravitate around an intrinsic value, occasionally becoming too expensive or too cheap relative to that value. Over time, investors will become reluctant to pay for already “overpriced” stocks and begin seeking out “cheaper” securities and as the Dow components are some of the largest and most widely followed stocks in the world, they’re a logical place for investors to start their portfolio construction process. As one of the most well-known relative valuation strategies, The Dogs of the Dow Theory has been used for decades, often with mixed results but typically over a long-time period it delivers returns in-line with the broader Dow Jones Industrial Average and often with the benefit of reduced volatility.

FDSAX is a good example of relative valuation strategies at work; after underperforming during the latter part of the mid-2000’s bull market, the FDSAX outperformed for 5 of the 7 years between 2007-2013 and in its worst year (2012) only lagged the S&P 500 by 320 basis points but something changed in 2014. Despite the strong outperformance by large-cap value stocks, FDSAX lagged the S&P 500 by 463 basis points and the fund dropped to almost the lowest quartile within the Large Value category. While the trailing three-year annualized return is still 19.84% compared to 20.41% for the S&P 500 and 18.33% for the category as a whole (with less volatility-win/win), it got me thinking…is there a problem with the Dogs of the Dow?

The general rule of thumb taught in business schools is that any moderately successful trading strategy that generates excess returns relative to the benchmark is bound to be copied and thus eliminating any further potential for oversized gains. But despite 6 years of college, one more and I could have been a doctor; the Yinzer Analyst has always been something of a heretic. Even after the popularization of the Efficient Market Hypothesis, there’s been ample evidence that shows some individuals can outperform the market both consistently and over sufficiently long periods to prove that there’s more to their outperformance than simple luck. Some degree of skill or investor psychology makes certain trading strategies repeatedly profitable.

So lacking anything better to do on a Saturday, I decided to slap together a quick experiment to test the Dogs of the Dow Theory and see if you can reasonable expect that the worst performers from one period (year) will outperform in the next. Now it’s been a long time since I studied statistics, so this is a fairly basic test and just to avoid being called a complete crack-pot, let me outline my process:

After pulling the performance data for all Dow Components from 2008-2014, I set up my worksheets to test whether a stock that outperformed (underperformed) the rest of the Dow Jones Industrial Average would outperform (underperform) in the next. So every year is really a two-period test. If you outperformed in 2009 (period 1) did you outperform again in 2010 (period 2.) To be included in the test, the stock had to be present in the Dow for the entire time frame in question. As an example, on 9/24/12, Kraft foods was replaced in the Dow Jones by United Healthcare and then on 9/23/13, Alcoa, Bank of America and Hewlett Packard were dropped and replaced by Goldman Sachs, Nike and Visa. So when I was looking at the period of 2012-2013, there were only 26 stocks to test (no United Healthcare, Alcoa, Bank of America or HP) while in 2014, I only had 27 Dow components to test (no GS, Nike or Visa since they weren’t included for all of 2013.)

I also only went back to 2009 as I was both pressed for time and not willing to beg someone with access to Direct or Bloomberg to pull additional return data for me. Still, I think the results in the table below are very illuminating:


As you can see at the bottom of every column, I choose to interpret the results with two basic formulas asking, “If you outperformed in period 1 (example 2009), what were the odds you outperformed in period 2 (2010?) In the 2009-2010 period, of the 16 stocks that outperformed in 2009, 8 outperformed in 2010. For 2010, the 12 Dow components that underperformed the total index in 2009 (P1) were equally as like to outperform versus underperform the benchmark in 2010 (P2). Although there are too many variables to count as to why one stock outperforms and another doesn’t, and there’s a host of ex-ante versus ex-post issues to consider, if you were simply picking the worst performing Dow stocks for your portfolio, it was a coin toss whether one outperformed the benchmark and another didn’t. While the odds worsened slightly in 2011 and 2012, they were only slightly worse than a coin toss and picking a prior winning stock to keep winning sure didn’t guarantee anything in 2010 or 2012.

What’s interesting to me is how the odds have worsened over the last two years to reach the sample extreme in 2014. If at end of 2013 you picked one of the 12 Dow components that underperformed that year, you had a ¼ chance of picking an outperformer in 2014. Only Cisco, Proctor&Gamble and Wal-Mart pulled that off. The other 9 underperformed for a second consecutive year or in the case of Coca-Cola, Chevron, IBM, McDonalds (all currently held by FDSAX) and Exxon Mobil for the third consecutive year in the row. Caterpillar (not part of the fund) has now underperformed for four years in a row, some global recovery. Of you could look at it in a different manner; there were 27 stocks in the Dow Jones Industrial Average in 2013 and 2014, if you had picked one at random on 12/31/12, there was a 1/3 chance that you would have underperformed the index over the next two years! No wonder FDSAX underperformed the benchmark in 2014 although it only underperformed the larger category of Large Value funds by 116 basis points. Assuming that most of the outperformers were index funds and that fee’s were a major determinant of outperformance last year, I might have to compare the fund’s performance to other active managers in the space to determine whether FDSAX is a Yinzer Analyst Best Buy, or at the very least how awful active management really was in 2014.

If you were part of the management team at FDSAX and if you selected 10 Dow Jones Industrial underperformers on 12/31/13 to include in 2014 and the relationship held, 7.5 (let’s round up to 8) of those stocks would likely underperform in 2014 and with an average weighting of 3.4%, 27.2% of your portfolio was going to underperform in 2014. That’s putting a lot of pressure on the rest of your portfolio to outperform so you can keep yourself around benchmark. If a similar relationship held for stocks within the broader Russell 1000, your chances of performing in-line with the benchmark were slim-to-none while outperforming after fee’s wasn’t even within the realm of possibility.

The question is what happens in 2015? Given the extremes between persistence in outperformers and underperformers in 2014; is it reasonable to assume that mean reversion might kick in and see the Dogs of the Dow finally have their day again in 2015? If so, thanks to its formulaic nature; FDSAX could find itself very well-situated to take advantage of that trend. Keep your eyes on those persistent underperformers like Chevron and IBM to see if they can give SunAmerica a happier New Year.

New Year, New You: Don’t pull a Costanza

New Year’s Day is traditionally the time to make resolutions on how you can improve yourself in the coming year but instead of making some grand promise that you’ll finally lose those ten pounds, or stop drinking with lunch, why not focus on your financial future instead? Americans probably spend a fraction of the time focusing on their financial futures that they devote to avoiding Cool Ranch Dorito’s when they go to the market and yet most New Years Resolutions end in failure because people aren’t willing to put the time and mental energy into them to be successful. So to celebrate our first New Year’s resolution at the Yinzer Analyst, we’re going to share one of our biggest “d’oh” moments and the lesson we’re resolved to take forward in 2015 and by making my shame a matter of public record, you can all help me avoid repeating the misfortunes of 2014.

Like many of the Yinzer Analysts’ biggest regrets, my worst moment in 2014 involved an ill-timed mutual fund investment in one of the year/s biggest losers and one of the worst “campers” I’ve ever invested with, Mainstay Marketfield (MFADX). At the start of the year, I had a minor “Hugh Hendry moment” and decided to up equity exposure but instead of loading up on some large cap core fund, it was time to go hunting for “alpha” instead. Now alpha has to be one of the most widely used yet incredibly vague terms in existence. Everyone knows what it means but damn if they know how to go about getting it, just ask any of the 86% of core managers who underperformed their benchmark in 2014. In this context, I was focusing on managers who could deliver a healthy “risk-adjusted” return with low correlation to the S&P 500. My market expectations for the year were not TOO far off the mark; mid-to-upper single digits with higher volatility than in 2013. My goal was to find managers who could deliver a somewhat like market return with less drawdown. I didn’t expect market like performance, but I was hoping I could get 60% of the upside with less volatility.

Being the Morningstar Direct wizard that I was, I naturally went through the category data until focusing more specifically on the Long/Short field. Now you couldn’t have found a bigger crop of losers than in long/short; as of 12/31/14 over the last five years they’ve managed to capture around 38% of the upside for about 51% of the downside for a five year annualized return of 6.85% compared to 15.45% for the S&P 500 TR. Not too impressive, especially given the relatively high fee’s charged by most managers. Now there were a select few managers I decided to pursue and ultimately focused on two names. The first was Mainstay which is really a global macro outfit that positions itself around global trends. Mainstay appeared to be the gem in the rough for a host of reasons:

  • MFADX had a lower R2 to the S&P 500 but had managed to generate impressive performance through 2013 although it returned roughly half of the S&P 500’s 32% for that year. The subsequent beta it generated for to calculate alpha was then essentially worthless, but the positive return and lack of a reliable relationship to U.S. equities was a win in my book.
  • Long Manager Track Record: The fund had a consistent management team that made itself readily available to answer questions. Part of my due diligence included a conference call with part of the management team.
  • Global Focus: Much like the Yinzer Analyst, the fund looked favorably on Japan and Europe’s growth prospects versus the U.S. although it remained heavily invested at home.
  • Information Sharing: One of the true hallmarks of a good fund is how much information its managers provide. When I was researching the fund in late 2013, you could access statements showing the monthly position in both long/short positions by market.

But as I was going through my due diligence process, a few cracks in the story began to emerge that caused me more than a little hesitation:

  • Prior Record: When going through the historical allocations, the first thing you would notice is how little their allocations actually changed from one period to the next. The fund was only down 12% in 2008 versus 37% for the S&P 500 but should have done even better. From what I can recollect, the fund had actually been adding equity exposure in late 2007 and was only saved from more serious losses by managing their inverse allocation. Over the next several years they made only small changes while leaving the core long equity allocation relatively unchanged. In 2009-2013 that was called prudent. Currently the fund has an annualized turnover of 32% and while not unusually low for long/short managers, MFADX does typically hold onto positions for extended periods. In other words, they’ve comfortable being wrong for a long period of time.
  • Asset Growth: MFADX had very quickly grown into one of the largest long/short funds in America and in fact had one of the most impressive growth rates in 2013. Strong asset growth like that isn’t necessarily a negative, but tends to reinforce the belief amongst management that their investment philosophy is beyond reproach while also acting to limit their ability to make investment decisions. It’s a lot easier running a $100 million fund than a $10 billion dollar one. Ask Peter Lynch about it.
  • Management: While having a long-term focus isn’t bad, that focus needs to be driven by a dynamic manager who can respond to changes in the market or their data but after 45 minutes of nonstop and entirely one sided dialogue, it became clear that intentionally unnamed manager, while very intelligent and well-spoken, was clearly locked into a specific market outlook. He was focused on a continuing global recovery that should see rates rise in the U.S. and abroad while focusing a large portion of the equity allocation on early global recovery leaders in the materials and capital goods fields. Think mining stocks and Joy Global while shorting Treasuries because you expect the ten year to burst through 3%. Oh, and also being long homebuilders and short utilities.

Now that sounded like a great story but that’s what global macro investing is; focusing on selling a great story. Look at the December 2013 commentary if you want an example of this; its six pages devoted to the failure of global monetary policy and inflationary forces. What’s the old joke about economists? If you were to lock 2 in a room for an hour and ask them to tell you whether the economy is growing they’d come out with 3 different opinions. GDP growth in the U.S. stumbled early this year but has since recovered but the growth has been uneven. Wage growth has been anemic and the housing recovery went nowhere in 2014, killing Mainstay on several of its long and short positions. Utilities were one of the biggest winners in 2014, so their short XLU position helped the fund stumble out of the gate.


Meanwhile the global recovery was stillborn so European and Japanese positions continued to lose ground as did new positions in EM equities in select markets like Hong Kong, Mexico and Brazil. The downfall of Mainstay obviously wasn’t a 2% position in Brazilian equities but how they reacted to their underperformance. They didn’t adjust many of their long positions quickly enough to prevent serious losses in the first half of 2014 only to add to EM equity exposure in their summer, just in time to take part in the summer shellacking.

I would love to tell you more about their missteps and after their July/August commentary they stopped publishing further updates despite traditionally having done it on monthly basis. Never a good sign when a fund that loves to chat about their positions suddenly goes quiet. Once their portfolio holdings through year-end are made available I plan to do more digging, but it might be a lonely exercise this year. At the end of 2013, the fund had net assets of over $19 billion while according to Morningstar it’s now closer to $9.1 billion. Those wirehouse boys sure are a fickle lot.

While Marketfield may be a true global macro fund, my second choice was a very traditional long/short fund, Diamond Hill Long/Short (DHLSX.) I decided to pair a traditional long/short manager with a strict U.S. focus with a global macro manager both for diversification of return sources as well as a sort of academic exercise. Depending on how well they did, whoever performed the best would get the entire allocation. DHLSX had everything I liked; stable management, consistent returns in the top quartile of funds, they were very approachable when it came to answering questions and providing information but most of all, they had a specific approach to investing.

Let’s be upfront about this, the Yinzer Analyst is a simple man and he likes to keep things simple. The more opaque you make the process, the more likely I am to think that you’re hiding something and I hate having to dig through old allocation reports or do a returns based analysis. What I enjoyed most about this fund was that Diamond Hill had a very simple approach to investing. They were classic, fundamental bottoms up researchers who don’t care about how far their weightings might drift from the benchmark although they do emphasize risk control on their short positions. To put it simply, they bought what they thought was cheap and sold short what they thought was too expensive; essentially the most basic definition of a long/short fund. While they didn’t set the long/short world on fire in 2014, they did manage a respectable 7.55% which, while underperforming a traditional 60/40 portfolio, its returns did have a monthly standard deviation in 2014 approximately half that of SPY. Unfortunately, it’s July and September monthly losses were nearly as bad or worse than the broader market but with less upside in August and the late fall rally.


So by know you’re asking the obvious question of why I would invest in a fund if I had such serious concerns about it? For the same reasons that most investors wind up making REALLY bad decisions; because they feel they have to do SOMETHING! My mistake wasn’t talking myself into investing with a manager who wasn’t nearly as active as he claimed to be, stuck in his rigid outlook and charging a high fee for his performance. My mistake was going against my gut and investing in a fund I knew had issues, but I was going to pull a Costanza and do the opposite of what my gut told me and hope for the best.

Fortunately for me, I was able to trim my allocation after one quarter and sell-out completely after two, limiting my downside to less than 5% while the S&P 500 was up over 5%. If I have been stuck in the fund all year, I would have been drastically better of investing in what I call my naive portfolio of 60% SPY/40% AGG to the tune of 2178 basis points difference in performance.

So when the market opens tomorrow; what will you choose to do?  Are you going to hold your nose and hope for the best or are you going to put the time into to make your resolutions a success?

Know Your Mutual Fund Managers: Watch out for Closet Indexers

First, apologies for the long gap between posts.  The Yinzer Analyst has been feeling a little under the weather and what with having already seen every episode of the Venture Brother’s twice and a slow week for the markets, I figured now was the perfect time to play catch-up and finally publish the once promised and often delayed posting on how to spot my least favorite category of fund managers; closet indexers.

There is literally nothing that upsets me more than people who take your money for a promised service and then fail to deliver. It’s happened to me dozens of times in my personal and professional lives and it’s always an infuriating experience. Investing in mutual funds is in an easier and more liquid way to invest with some of the greatest money managers in the world despite what you may have heard from any number of investment “professionals” you see on the nightly news. Finding myself increasingly as one of the few who’s still willing to defend mutual funds and active management, I decided it was time to man up and try to arm you with the tools you need to spot managers who whisper into your ear about their great process only to hand you lackluster performance. Of course, anytime you have a system that involves trillions of dollars, vague benchmarks and misaligned rewards systems, you have the potential for a handful of managers to abuse the public’s faith in the system.

How does it go? Well first, you’ve got cash and you need to invest it and being of sound mind, you search for a great mutual fund, do your research (or often your adviser claims to have done it for you) and you invest in a fund that promises NOT to outperform a particular benchmark but simply that it has system it believes adds long-term value. Looking at some very glossy and sexy handouts, you you’re your investment (hopefully without paying a load of some kinds) and in your naivety feel it’s okay to pay an “average” fee for the potential to outperform. What happens then? Well you most likely you forget about the fund until it’s time for your annual review or if your fund family is hopeful, you forget you have the account until it’s time to retire. That’s when you discover this top-rated fund managed to deliver hopefully “blah” performance in line with the median fund in the category and soaked up about 1% to 1.5% of your annual performance doing it.

Now I haven’t come to bury active mutual fund managers but rather to sing their praises and I’ll be the first to admit, managing money is not easy. Even when you have a well-defined benchmark with a specific subset of stocks to choose from, people are always demanding more and if you fail to meet the benchmark for one to two years, you’ll probably find yourself out of a job and hence the origin of the expression “career risk” and why managers in certain categories tend to cluster, all holding the same securities in similar amounts lest they get left behind. When it comes to managing a mutual fund, there’s no sin in being the average performer, but if you find yourself in the lower quartile once too often, you’ll be managing money for the “Widows of Retired Circus Freaks Retirement System” and guess what that pays?

So how do we go about spotting a closet indexer? First we have to take a deeper dive into the terrifying math behind the concept of “Tracking Error!”

Tracking Error:

Tracking error is actually a fairly simple concept that even a liberal arts major like myself can understand. Before we get into the basic formula, remember that every mutual fund has a benchmark, which for the lay people in the audience is simply an index that the manager of the fund has decided best represents his universe of available investments and has accepted as a valid metric to compare his performance to. For the rest of this paper, we’ll be looking at the universe of managers that Morningstar has pegged as “large cap blend” managers where the typical benchmark is either the S&P 500 Total Return index or the Russell 1000 Total Return Index. All the managers we will be reviewing have the S&P 500 TR listed as their primary benchmark and came from a Morningstar Direct list of 309 mutual funds where the only search parameter was their category and oldest share class. For the sake of simplicity, all share classes other than “A”, “Investor” or the lowest possibly minimum investment for that fund have been eliminated.

Tracking error is simply defined as the difference between the return of the portfolio in a given period minus the return of the benchmark. Using monthly returns, this would be represented as (Rp-Rb) but the number generated is typically useless by itself, so we look at the tracking error over a longer period of time. For example, if I had sixty monthly returns for the XYZ Fund and the S&P 500, I would simply calculate the tracking error for each month, find the standard deviation and then multiply it by the square root of 12. This gives me a more practical number that can be compared to funds across the same segment of funds to determine how closely they track their index.

It’s easier to understand tracking error by looking at a basic example and since the Yinzer Analyst is about as basic as it gets, this should work for us:

Sticking with the Large Blend theme, what if you could actually have invested $100 in the S&P 500, reinvested those dividends and resisted the urge to up and bail in the summer of 2012 like everyone else? Well as you can see below, 2013 was a very good year for the large cap stocks and you would have ended the year up 32.41%. Not too shabby, except for the fact that you can’t actually invest in an index but have no fear, Vanguard is here. No, I don’t work for Vanguard (although I do invest in their funds), I just like stupid rhymes.

So if you had purchased $100 worth of the Vanguard 500 Index Fund (VFINX) you would have earned the return of the S&P 500 minus about 17 bps for expenses. But those 17bps, while on the low end of the fee scale, introduced a certain amount of tracking error into process. For the sake of simplicity, let’s assume the .17% or 17bps fee is deducted monthly in equal installments throughout the year instead of quarterly or annually.

Now if you looked at our table, you’d see that each month a few cents are deducted from your account as the fees are liquidated and paid to Vanguard for its trading and record keeping. By the end of the year, you’d see both a slight difference in performance and minor tracking error from the fee liquidation. So tracking error isn’t a negative, it’s an inevitable part of the investing process. Anytime you look at the difference between your investment returns and a particular benchmark you have referenced your investments against.

VFINXVFINXTENow what if you decided to come to The Yinzer Funds (Ticker: YINZX -trademark pending) to invest in our new Large Cap Core Super A Awesome Fund where we charge an industry average fee of 1% or 100 bps annually and then just take your money and index it to the S&P 500? Well, to reuse the same tired chart, you’d see the following:

YINZXYINZXTEYes, literally all of the tracking error in these last two examples comes from fees, not from having holdings that aren’t part of the S&P 500 or over/underweighting sectors/individual securities. Literally, just whacking money out of your account (often to repay your adviser for investing with me in the first place) gets you a tracking error of 1%.

Now this was a very simple exercise to show you how to calculate tracking error, in practice it’s much more difficult because you first have to establish what the appropriate benchmark for the fund is. You would think that fund companies have a vested interest in presenting you with the most relevant and pertinent information but truthfully, they like having the process be opaque. As I mentioned before, there are two indexes that are commonly used for benchmarking large blend funds, but how do you determine which to use?

You can find everything you’ll need to do a quick-and-dirty check for closet indexers on the free side of Morningstar.com. First type VFINX into the quote field and then look at “Ratings and Risk” and scroll down to MPT Statistics. You can see here that the Best Fit and Standard Index both use the S&P 500 and the R2 (how much changes in the index affect changes in the mutual fund) is 1, indicating that all of the change in the fund is due to changes in the benchmark. The beta is also 1 and the alpha is slightly negative, exactly what we would expect from an indexed mutual fund.

Now I understand that many of you reading this have no interest/desire to actually download returns and calculate tracking error manually, so is there a quick and dirty way to get it from a website devoted to mutual fund information like Morningstar.com? Nope and there’s a great reason why. Tracking error is half of what’s needed to derive the information ratio, which is simply the active return of the fund (Rp-Rb) divided by the tracking error. It’s one of the most powerful tools used to analyze how effective a manager is at adding value against a benchmark, so logically the last thing they would want is for it to be something you could easily find on any website. These tools are available either by downloading the returns of the mutual funds from Yahoo Finance, sometimes from the fund families themselves and to those who subscribe to the more advanced Morningstar systems, Factset, Bloomberg, etc.

Now that we know what tracking error is as well as some of the more common tools for analyzing mutual funds, let’s start tracking down our closet indexers.

Index Funds

So how can we use tracking error to sort out the true active managers from the closet indexers out to collect your fees for below average performance? First I re-screened my list of 309 mutual funds in the large blend category looking at their five year tracking error versus the S&P 500 TR index and pulled together a list of true passive index funds as an example of how they would appear.


You can see a few common traits that are easy to find on Morningstar.com:

  1. They actually have index in the name. Very obvious but always start by eliminating the obvious!
  2. Holdings: They typically have the same number of holdings as the index
  3. Average Market Cap: Their average market capitalization is close to the index
  4. Fees: Typically very small; index replication is pretty easy and a very competitive market.
  5. Risk Statistics: If you go to Morningstar.com, type in any of these tickers and then go to Risk, you should look at their Alpha generation. It should be slightly negative as their simply replicating the index minus their small management fee. Beta should also be close to 1.

Two obvious questions that stand out are why is PIIAX’s tracking error/fee so large relative to the other 4 and why does PREIX has a large number of holdings? Large banks typically offer their own index funds as a convenience to clients and often will charge a higher fee as the client prefers the convenience of having all of their assets at one institution to opening a separate account to save on fees (and potentially losing the savings in ticket charges.) PREIX might be a case of semi-active management that we’ll be discussing later on.

And now that you can spot the index funds, here are a few examples of true active managers that I culled by picking 4 managers with a relatively high R2 to the S&P 500 and tracking error below 10, 1 manager with a lower R2 and a high tracking error that indicates a misfit benchmark.


What stands out? Typically they have smaller and more concentrated positions. Second, their performance is all over the map. Remember, just because they have higher tracking error doesn’t mean they actually performed any better; just that these fund managers actually try to outperform and you’ll have the opportunity to stand out more from the pack. Doesn’t mean they’re any good at it. Once you have a short list of funds, you have to go beyond the quantitative to the qualitative. USA Mutuals Barrier Fund is more commonly remembered by its former name, the VICE Fund. Supposedly focused on companies in very specific industries, it really screened stocks based on a strong name brand and prohibitive barriers to entry or other economic moat.

So now that we know what to search for to spot index funds (again besides looking at their names), how can we spot closet indexers? First we need to delineate closet cases from what are probably best called “semi-active” managers. Semi-active managers (“semi”) represent a perfectly valid strategy where they tend to hug the benchmark but will have small, active mis-weights against the index. For example, they might benchmark 90% of their assets to the index but overweight healthcare stocks while underweighting energy, which would have helped them, be in the top tier in 2014. In fact, Hartford Disciplined Equity has followed almost that exactly playbook and is nearly in the top decile for the trailing 1, 3, and 5 year periods. Their goal isn’t to drastically outperform the benchmark but to generate a small amount of alpha over time that should compensate investors for their fee’s plus a small return.

CLOSETLooking at the table, the semi active managers are distinguished from the dastardly closet cases by a few key characteristics:

  1. The semi’s typically have a slightly lower R2, slightly less negative or even positive Alpha and slightly higher tracking error. The first three managers all meet this criteria so I classified them as SA for semi-active.
  2. ClearBridge Appreciation might seem to be a borderline case of closet indexing, but if you look closely at its beta and average market cap, you’ll see that it’s really a giant core fund being shoved into the Large Blend category by Morningstar. For the amount of systematic (market) risk the fund has taken on, they’ve nearly generated enough of a return to compensate investors (less negative alpha.)
  3. The next four funds all meet my standard for closet indexers. High R2 to the index, High Beta, negative alpha and greater than -1 and most importantly, their tracking error less net expense ratio is typically around .5 to .6. These funds…are closet indexers. PNC Large Cap recently had a change in management in October of 2014 and hopefully their new team will be taking the fund in a more active direction.

The worst of the managers still in the closet is the Spirit of America Large Cap Value Fund, a fund so awful it’s in the lowest quartile on a 3 and 5 year annualized basis. Of couse, with all the difficulties active managers have had in the last year, it’s actually only trailing the S&P 500 TR by 127 bps in the last year. This fund represents almost everything I hate about closet indexers but if you’re wondering why you’ve never heard of the fund before, it’s because SOAVX is only available on one platform, the David Lerner Associates; a Long Island based broker dealer with around $9 billion in assets (according to their website.) And why would they use this fund. Spirit of America Funds was created entirely to provide products to David Lerner Associates which is probably the reason behind the high expense ratio and above average 12b-1 fee of 30 bps.

So to recap, why do I hate this fund? It charges high fees for essentially indexed performance and was designed and marketed solely to retain assets of clients who probably don’t know any better and never check their portfolio statements to see how much they’re missing out on. Over the last five years, VFINX has returned 15.53% annually versus 12.03% for SOAVX and that may not sound like a big difference; think about what that 3.5% difference would look today. If you have invested $10,000 in VFINX you’d have $20,581 through the market close yesterday compared to $17,647 with SOAVX. That’s over $2900 you would have missed out in just fees!