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 May 2008 Your Own Mutual Fund Portfolio 5 vs. Multi-Cap Funds
As an illustration, consider two widely promoted beliefs: (1) Index funds and ETFs can't beat the market, and (2) It's much more efficient for small investors to use mutual funds than individual stocks and bonds. After hearing them over and over, many (if not most) investors accept these as facts and invest accordingly. That's precisely what the pros want you to do because that's what leads you to them for your investment needs. The implication is, of course, that they can provide something you can't do for yourself.
But do investors really have to rely on investment managers and their mutual funds? To be sure, not everyone wants to spend time on this and for them, professional guidance is the way to go. But for others -- those willing to try something different and more importantly, willing to put in the time and research to do it well -- there's no need to look elsewhere. Portfolio 5, our quantitative multi-cap equity model is a prime example. It relies upon nine different exchange traded funds yet has managed to beat the market over its six-year history. Not only that, for most investors it's cheaper than a comparable actively managed mutual fund.
Actively Managed Indexes For the most part, the argument about an index fund always trailing its benchmark is true, but that's not the whole story. Think about how a successful active manager beats the market: It's probably through a combination of owning stocks in greater proportion than the index, not owning any shares of some stocks in the index, and investing in others outside the benchmark. But guess what? You can do this, too, but in a more controlled fashion using index funds and ETFs.
This is exactly what P5 does. It's a multi-cap model meaning it can draw from all domestic capitalizations and styles. By tilting towards one style or capitalization and away from others, the model has the potential to outperform broad market benchmarks. By limiting the number of potential holdings and focusing on index ETFs, transaction costs and overall expenses are minimized. More specifically, P5 is modeled after the Morningstar Stylebox which divides domestic equities into three capitalizations (large, mid, and small) and then further divides them into three styles (growth, core, and value). This yields nine potential categories (see Chart 1) and corresponding index holdings. These, in fact, are the model's only potential holdings. The model has a quantitative algorithm to "optimize" its mix of holdings based on historical correlations and current market conditions. It's "reoptimized" every quarter to keep up with the changing environment. If done correctly, the model should overweight top performing areas of the broad market while avoiding those that lag behind. ETFs (tickers and annual expenses shown on Chart 1) with expenses ranging from .09% to .25% are used to represent each of the nine categories. Even considering trading commissions, with limited transactions and only nine potential holdings, expenses are not much of an issue.
For a small investor, P5 is a good alternative to a multi-cap mutual fund. Returns and expenses compare quite favorably. In fact, in many instances, P5 is even better. The results bear this out.
Against the Indexes But if you look more closely at the charts, you'll notice that it trails four of the six style indexes. The two that it beats are both large cap, growth and value. It's no secret that large cap stocks have been the laggards over the past seven years. In a sense then, P5 has only outperformed the poorest performing styles -- along with its major benchmarks. It's understandable that by besting both large cap growth and value it would also surpass the S&P 500. After all, it's just the combination of the two. But what about the broad market Super Composite S&P 1500? Cap weighting is the villain here. Although the 1500 draws from all capitalizations and styles, it's heavily weighted towards large caps. As a result, since P5's inception (January 1, 2002) it's correlation with the S&P 500 is an almost perfect: 0.998. The two are virtually interchangeable. At the other extreme, it's only 0.798 with the S&P 600 Small Cap Value. The S&P 1500's correlation with P5 (0.924) is only slightly less than with the S&P 500. Although not as high as with the S&P 500 Growth (0.964) and Value (0.971), it's still higher than with any other cap or style index. Because the 1500 is so heavily tilted toward large caps and because P5 has tended to focus on mid caps (see, Mid Cap Preference), it's been able to outperform the benchmark. Of course a purist might view this as cheating. Everyone knows the easiest way to beat a benchmark is to invest in something other than the benchmark. In this case, if you want to be a predominantly large cap index, simply use some of the top-performing small or mid cap alternatives. In a sense, this is a legitimate complaint (see, Capsized). On the other hand, the typical goal of multi-cap investors (and managers) is not to outperform the S&P 1500, but rather the S&P 500. Ideally this should be accomplished without taking on an inordinate amount of additional risk or volatility. Here P5 has excelled: From inception, its Sharpe Ratio (a measure of risk-adjusted return) is 0.15 versus 0.09 for the benchmark. In this case, the changing mix of unmanaged index funds has beaten the broad index. From this perspective, P5 has been an effective multi-cap model.
Against the Funds So how does P5 compare to multi-cap mutual funds? Although 5068 funds are listed in this category, there are fewer unique funds than you might think; only 781 as of February 28, 2008. Rising dependence on asset allocation and Morningstar's emphasis on style purity has forced funds into specific styleboxes. In addition, as assets under management grow, multi-cap managers are finding themselves limited to only the largest, most liquid holdings. This was the fate of Peter Lynch's Fidelity Magellan.
P5 doesn't face such obstacles and that's worked in its favor. As you can see from Chart 4, it's handily beaten the average multi-cap fund over the most recent 1, 3, and 5-year periods. This is even more notable given that the P5 returns are capital appreciation only while the fund returns also include dividends. (We don't keep track of P5's dividends so don't have total return figures.) Digging down a little deeper on Chart 4, you'll notice that P5 beats all but 8.2% of the funds over the five-year period. In other words, it would place in the top decile for multi-caps. It would place firmly in the middle of the second decile for the three-year period. P5 was able to achieve these results with less volatility than the average multi-cap fund. For both the three and five-year period, P5's standard deviation, a commonly used measure of risk, is significantly lower than that of the funds. This results in higher risk adjusted return as measured by the Sharpe Ratio. Based on all this, P5 would be a strong contender for five stars. There is, however, one aspect of investing we have yet to consider: Expenses. Up to this point we've been penalizing funds by comparing their net results versus the gross results of P5. Some of that has been offset by the fact that we've used total return for the funds, but only capital appreciation for P5, but surprisingly, expenses don't make that much difference. The average expense ratio for multi-cap funds is 0.967%. This value would probably have been lower had we not excluded so-called "funds of funds" which invest solely in other mutual funds. Many of them only report their "overlay" management fee and not the internal fees associated with each fund. This is misleading because the investor has both sets netted out of his or her return. To avoid this problem, we eliminated all funds of funds from consideration. In the broad scheme of things, 0.967% is below average for a typical domestic equity fund. This is why many believe small investors can't cost effectively use stocks or even ETFs in their portfolios. Not only do the ETFs carry their own internal expenses (shown in Chart 1), trades involve commissions. High investment costs can negate even the best gross performance. But P5's expenses are surprisingly low. Going back to inception, P5 has averaged a little over seven trades a year. Since it's hard to make a partial trade, let's round that up to eight. Now consider an investor with $20,000 to invest. Using a discount broker charging $15 a trade, annual expenses, including commissions and ETF management fees, would come to 0.806%, about fifteen basis points lower than the average multicap fund.
Under these circumstances, an investor with a little under $16,000 to invest would still break even with the the average multi-cap fund on expenses. An investor using a no-frills discount broker charging only $10 per trade would break even with about $10,000 to invest.
It Can Be Done There is, of course, one thing about P5 that may still be out of reach for the typical small investor: the ability to periodically optimize the investment mix. Even with only nine potential holdings, their particular mix at any given time is critical to the model's overall performance. We'd like to think that P5's returns have been greatly determined by the mean variance optimization process we've used to rebalance it under changing market conditions. Most investors don't have such quantitative tools, and even if they did, many are just as happy to buy a good multi-cap fund and simply stick with it. There's nothing wrong with that approach, particularly for those lucky enough to find a good multi-cap fund. We've only considered the average returns and expenses, not the best. Even over the five-year period when P5 had its strongest comparative results, 8.2% of the actively managed funds were still able to beat it. There are some good multi-cap funds out there. The point here, however, is that it is possible -- even for the small investor -- to create a viable alternative to them, using ETFs. P5 provides some compelling evidence. Search this site! Just enter you key word or words: Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
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ONE OF THE BEST WAYS to get people to buy your service is to get them believe you can provide something they can't do for themselves. The financial services industry does this everyday. They've got individuals and even some institutional investors believing it's necessary to rely on the pros to navigate the dangerous financial markets.
