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 July 2009 Cats and Dogs Mutual Funds May Look Like Stocks and Bonds, But They Aren't
On the other hand, the increased use of funds has some advisors scrambling to distinguish their services from the competition. If the management fee is simply based on picking a handful of funds to build a portfolio, why can't the investor cut out the middleman and do it at home? Popular funds often find their way onto numerous recommended lists making it even harder to discern the individual advisor's value. In an effort to break out of this trap, some are starting to increase their due diligence when selecting and monitoring funds for their clients. One approach is to step up the qualitative review by seeking to match funds with managements claiming to adhere to one specific strategy or segment of the market (or conversely avoid specific segments of the market) with those making complementary claims. Another approach is to seek funds that have low correlations with others to be included in the portfolio as a means of limiting risk and possibly increasing potential return. This is a lot more work and requires more skill than many investors can supply on their own, resulting in a viable selling point. While it's encouraging that some advisors are willing to go to these lengths to distinguish their services (and hopefully make more money in the process), the effort in many instances is wasted. Whether they realize it or not, these paths are up their sizzle without really supplying more steak.
Vastly Different Investments You might be wondering what the big deal is because after all, everybody knows funds differ from individual securities and indexes. No one in their right mind with even the most minimal investment experience would ever confuse them. True enough, but that's not the point. The important thing to realize is that because funds are different, they have to be evaluated differently. The same techniques used to evaluate stocks and bonds in order to build well-diversified portfolios won't work with funds. It's easy to see why even some of the most diligent managers can get confused about this. When you look at the average fundamentals of an equity fund's portfolio, it's all in the same terms as the characteristics of an individual stock. You've got P/E and P/B ratios, there's an average market cap, and even an average ROE and debt/equity ratio. Bond fund portfolios have average weighted maturities and durations just like individual fixed income securities. But there's a lot more going on under the hood of a fund portfolio. Speaking from experience, fund managers have a lot more to consider than fundamental ratios of their holdings or other factors concerning CEOs and CFOs of companies issuing stock. Instead, they have to be concerned maintaining liquidity for anticipated flows into and out of their funds. They have to make sure their holdings don't exceed allowable limits set in their prospectuses or the guidelines of the regulatory authorities. Each year they have to overcome their own expense ratios and trading costs if they hope to create representative returns. A little window dressing goes on, too, when it's time for the annual and semi-annual reports. Individual stocks and bonds aren't subject to these factors, but they can play a major role in mutual fund management.
We'll Do What We Say -- Until We Do Otherwise
This is counterbalanced by some of the requirements of the Securities and Exchange Commission which oversees funds. Regulations require a fund's prospectus to state its investment objective, a specific benchmark, and present periodic comparisons of the fund's performance and characteristics to that benchmark. Fund risks must also be detailed. In an effort to maintain as much leeway as possible, funds often state their objective in as general terms as possible. They also pick a broad benchmark so holdings and return comparisons are legitimate, but not necessarily telling. That's why, for example, you see small cap value funds using the S&P 500 as their benchmark. In up markets small caps as a class will tend to beat the large cap index, and when big stocks are leading the way, fund management can always point out the difference between the index and the fund. With good marketing support, they win either way. Of course mutual funds are like all other product providers -- they have to distinguish themselves from the competition, too. Although they may be reluctant to commit to too many specifics in their prospectuses, management will be more forthcoming when addressing advisors and others in their distribution channels. In fact, there's often an army of wholesalers traveling around to spread their story and drum up business. That's why research into fund managers' actual styles and investing preferences is often more qualitative than quantitative. Advisors willing to go this extra mile can turn up this information and hopefully, use it to build better portfolios for their clients. The problem arises because there was a reason funds didn't want to commit this information to the prospectus. As a case in point, several years ago an advisor was bragging that his shop was taking a new and better approach to client asset allocation. Not only were they attempting to find an optimal strategic combination, they were seeking funds that complemented each other within the various categories. His example was mixing one fund whose manager avoided utility and energy shares with on that solely concentrated on them. That sounded like a good approach until energy and utility stocks led the way when others faltered. A review of the semi-annual report revealed that there had evidently been a change of tune and the fund manager no longer avoided utilities and energy companies -- the fund's portfolio had over 34% in those two sectors. So much for complementary investing.
Now don't misunderstand, this is by no means an indictment of the fund industry and its managers. With so much emphasis placed on performance -- and short-term performance at that -- there's a tremendous amount of pressure on them to if not outperform, at least not fall too far behind. While a little more truth in advertising might be welcome (e.g. "All else being equal, we avoid utilities and energy."), it's certainly understandable that funds would want to distinguish themselves, too, while still struggling to keep up in the performance-oriented marketplace. And don't forget, what happened in this instance wasn't any sort of regulatory violation because the fund's prospectus never limited the investment sectors. Unlike stocks or bonds, mutual funds are constantly changing, driven not by the needs and markets of an underlying company but by the changing market and investor sentiment. Stocks of good companies can and do fall behind the overall market, but they're often still considered good stocks. Mutual funds aren't afforded that luxury and it makes no sense to evaluate them as if they were.
The Constant is Change As we've pointed out before, effective diversification is more that just a collection of holdings with different risk and return profiles, it's also a function of correlation. That's the main reason anyone would consider checking funds' correlations when attempting to build a more effective allocation. But it's also important to realize correlations aren't really static. We may think of them as such, but they really aren't. Even the correlations between broad indexes change over time. The problem is, fund correlations change a lot faster. Once again this the result of fund mangers have the ability to make more significant changes to their funds in shorter time than would ever occur in individual holdings or broad indexes. To illustrate this point, we went back to 1979 to measure changing correlations over five year increments. We considered a simple portfolio of large and small cap domestic stocks, foreign stocks, and domestic bonds. These were represented by the S&P 500, Russell 2000, MSCI EAFE, and Barclays Capital (Lehman) Aggregate Bond Indexes, respectively. We also screened the Morningstar database for representative funds. The job was actually fairly simple since we were requiring a 30-year track record. In most instances there was only one fund surviving that screen and where more than one did, we took the one with the longest track record. This gave us MFS Massachusetts Investors Trust A (MITTX), Steward Small-Mid Cap Enhanced Index Indv (TRDFX), DWS International S (SCINX), and Putnam Income A (PINCX). Keep in mind these indexes and funds weren't selected because of their performance, but simply to serve as proxies for the four market categories. We didn't even compare performance over the thirty years, we only looked at correlations. That was enough. The differences between the fund correlation changes and index correlation changes between June 1979 and May 2009 are shown on Chart 1. Aside from the minor change between domestic large cap and small cap, the funds experienced considerably more change in all other categories. Now you might think this would only be natural over a period of thirty years, but there's two things to consider. First, Chart 1 measures 30-year changes for both indexes as well as funds. Cumulatively, the difference was generally much greater for the funds. Secondly, in breaking the thirty years down into five year periods, the same pattern appeared. In all periods, correlations were more volatile for funds. This is noteworthy because the stability of the correlations affects the value of the allocations drawn upon them. The more volatile the correlations, the more changeable the allocations. Ideally, you'd want correlations to remain fairly constant over the time between optimizations. Again, the funds showed much more volatility over five years periods than the indexes, and five years is typically viewed by investors as "long-term". These differences translate into the comparable allocations as well. Charts 2 and 3 show resampled allocations with the same standard deviation (12.17%) the funds and the indexes based on May 2009 data. This standard deviation was used because it was at the midpoint of the fund efficient frontier. The fixed income allocations are similar, but the others are significantly different. The fund portfolio uses only three of the four asset classes, completely avoiding domestic small caps. In contrast, the index allocation is more diversified with over 12% dedicated to small caps. This is cautionary regardless of how an advisor would use the funds. If the strategic allocation was created first using the indexes and then populated with the funds, the resulting mix wouldn't be efficient. In order for it to be, it would have to resemble (if not be) the allocation created using the funds. On the other hand, one might be tempted to skip the index allocation altogether and simply use the efficient mix of funds. But to do so in this case would be to only use three of the four potential funds, providing less diversification across asset classes than a portfolio based on the index allocation. Wasn't increased diversification the goal of this undertaking? It all comes back to the problem of treating funds like individual securities and indexes. It just won't work. Funds are their own animals -- that's neither good nor bad. Even if you could succeed in training your cat to fetch, sit up and beg, and roll over, it still will never be a dog. It might do some of the same things and at time look like a dog, but it's still a cat. Fundamental differences still exist. The same is true for funds, individual securities, and indexes. Trying to make funds something they're not isn't a sound way to improve the investing process. It's nice when an advisor does something different, but it's better when it's actually beneficial to the investor. Search this site! Just enter you key word or words:
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UTUAL FUNDS HAVE BECOME the investment of choice for many money managers. For the most part this is a welcome development because funds provide immediate diversification and professional management. They can be traded much more cost effectively than individual stocks and bonds, and don't require nearly as much research, background and skill on the part of the advisor.
