World Beta Blog

Today at the R Finance conference in Chicago and Tuesday at NAAIM in San Diego.

Come say hello!

There was lots of news recently centering around PIMCO’s decision to launch an actively traded ETF version of their flagship Total Return Fund.  This is notable as the fund is the largest mutual fund in the world weighing in at $235B.  That makes the mutual fund about 50x bigger than the entire active ETF space is currently.

While notable, I don’t think people realize how big of deal this is.  Granted I have a bit of a bias since I run an active ETF, but note that I also run private hedge funds and separate accounts so I am familiar with all of these structures.  We considered doing a mutual fund as well as indexed ETFs (had two queued up for the fall of 2008 with one of the world’s top media properties to launch on the NYSE before they got cold feet).  Below we take a quick look at why ETFs, and especially active ETFs, are getting ready to take off.

(Note:  I am ignoring the leveraged ETFs and strange derivative/ETN ETFs here.)

The main way investors have invested in funds over the past few decades have been mutual funds, but with the exception of index funds, they have failed the individual investor.  Most mutual funds have too many legacy issues, including:

1.  Multiple share class structure (take a look at Total Returns whopping 8 versions, soon to be 9 all with different price structures.)  Many mutual funds are designed to be sold with massive load charges on the front or back end that benefit the broker but not the investor.

2.  Add in the even more ridiculous 12b-1 fees.

3.  Add in the ridiculous .20-.40% fees to Schwab or Fido for listing on their supermarket and you will see why most mutual funds will eventually lose out to ETFs.  If I’m trying to launch a low cost fund, how in the world can you give away 20-40 bps just for the privilege of allowing someone to buy the fund?  What if you’re trying to launch a fund that charges 20-40 bps total?

4.  ETFs (both index and active) have lower expense ratios than their mutual fund counterparts.  For passive equities they are about half (40-50 bps difference).

5.  The whopper is the the tax efficiency of ETFs.  I don’t think most people REALLY understand the benefits just yet.  If you look at Matt Hougan’s PowerPoint linked below almost zero ETFs make distributions (due to the creation/redemption process) whereas mutual funds receive inflows/outflows daily and may very well have capital gains to pass along even in a year when you lost money on your fund.  (Here is an article that talks about finding mutual funds with embedded losses.)  However, ETFs, due to their unique structure, should really never have any major distributions outside of income from income securities.  That is an enormous structural benefit to ETFs that I really don’t think most advisors understand.

Below is a screenshot from a PPT from IndexUniverse (I asked them to see if they could come up with a figure for % of mutual funds that make distributions/year and will report back).  If anyone knows this stat email me.   The average equity mutual fund loses more than 2½ percentage points of its return to taxes each year:

What is more interesting to me is that Vaguard touts the tax efficiency of their mutual funds since they have patented a hub-spoke share class structure that allows them to offload the capital gains onto the ETF which can then offload them in the creation/redemption process.  This is a huge competitive advantage of course against other mutual funds but is already built in to any ETF offerings. (More on their patented structure here and here.)

The foreign listed hedge funds never really got off the ground due to their structure (essentially like closed end funds here).  They could trade at discounts and premiums to their NAV.  Again, 2008 imploded the sector as many of these funds traded at massive discounts as liquidity dried up (not to mention PFIC issues for US investors which render them impossible to invest in).

ETFs have corrected the discount problem with the creation/redemption process. I think you’ve seen the first wave of ETFs that are clearly superior to their mutual fund cousins.  No sales charges, no 12b-1 fees, and most importantly no tax issues.

The big public funds are all rushing into the active space (State Street, Vanguard, Blackrock, PIMCO, etc) but I think this area is going to get really interesting is when the hedge funds start listing:  the Third Points and Greenlights of the world.  Back in 2007 Bill Ackman wanted to launch a public fund.  Exciting times indeed.

This is a really interesting piece from the bubblemaster himself (330 and counting).

Time to Wake Up:  Days of Abundant Resources and Falling Prices are Over Forever

When is a BUBBLE no longer a BUBBLE, but a PARADIGM SHIFT?  ie when is THIS TIME REALLY DIFFERENT?

HT: SD

Click to enlarge:

From Arnott,  The Biggest Urban Legend in Finance:

“A 30-year stock market excess return of approximately zero is a huge disappointment to the legions of “stocks at any price” long-term investors.But it’s not the first extended drought. From 1803to 1857, U.S. equities struggled; the stock investor would have received a third of the ending wealth of the bond investor. Stocks managed to break even only in 1871. Most observers would be shocked to learn there was ever a 68-year stretch of stock market underperformance. After a 72-year bull market from1857 through 1929, another dry spell ensued. From1929 through 1949, stocks failed to match bonds,the only long-term shortfall in the Ibbotson time sample. Perhaps it was the extraordinary period of history—The Great Depression and World War II—and the spectacular aftermath from 1950–1999, that lulled recent investors into a false sense of security regarding long-term equity performance.”

This length of underperformance in years is roughly  the same as a human’s current expected lifespan in the US.

Bonds outperformed stocks over an entire lifetime (and to be clear during this time life expectancy was around 40 years in the US so really this is TWO lifetimes).  So, really when one is talking about stocks for the long run, they must mean something other than a human.  A tortoise, deep sea tubeworm,  or sequoia tree perhaps…

Nice post here that traces the phrase ““Cut short your losses,” – Let your profits run on”:

Some nice pieces on taxes as tax day approaches!

There are some great articles in the Bloomberg Government Insider spring 2011 issue but I can’t seem to find any links.

From Barron’s:

Getting ready for a monster upcoming travel schedule, made even more pleasant due to a recently installed Achilles tendon where my ACL used to be.

As always, drop me a line if you want to meetup!

While most mutual funds underperform a simple index (and the vast majority underperform after tax), does that mean one cannot build a metric that predicts fund performance better than random?

I was at the Morningstar ETF conference this past summer and learned a pretty amazing statistic: roughly all inflows into mutual funds go into 4/5 star rated funds or new funds.  That was astounding to me.  The Morningstar star ratings (background at the bottom of the post) have been measuring past risk-adjusted performance for over two decades.  What they DO NOT do is offer any clues to future performance.

Don Phillips, President of Fund Research at Morningstar, stated:

“The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.”

Morningstar, quite impressively, actually disclosed a few months ago that simply using expense ratios was a better metric for predicting future performance that their star ratings. “Investors should make expense ratios a primary test in fund selection,” Russel Kinnel, director of mutual fund research at Morningstar, said in an article about the study. “They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.”  (Older 2007 study here.)

It would be interesting to see Morningstar present this metric on gross and net-of-fee returns to try and isolate the impact of fees (their current ratings are net of fees so naturally include the expense ratio as a factor).

If I was Russ or Don, I would commission a study in house (or possibly with some cheap local U of Chicago PhD’s) or even open it up Netflix style to a competition.  There have been numerous studies that illustrate ways in which one can pick mutual funds (maybe call it SuperStars? ha).

I’m sure there are more (email the papers to me and I’ll add them), and some of these probably overlap (ie high fees and low Morningstar ratings).  A lot of these factors are successful in selecting hedge fund manages on AlphaClone as well.

Most of these links are from the fantastic blog CXO Advisory.  It would be interesting to see a white paper that combines these factors into one metric.

Ways to improve your chances when picking mutual funds:

-Favor new funds.  Academic paper here: “Performance and Characteristics of Mutual Fund Starts” Karoui and Meier

-Favor cheap funds.  Academic paper here: “Performance and Characteristics of Actively Managed Retail Mutual Funds with Diverse Expense Ratios” Haslem, Baker, and Smith

-Favor funds with higher ownership stakes (manager skin in the game).  Academic paper here: “Portfolio Manager Ownership and Fund Performance” Khorana, Servaes, and Wedge

-Favor funds with high “Active Share” (holdings very different from the benchmark).  Academic paper here:  “How Active is Your Fund Manager? Cremers and Petajisto

-Favor funds with low assets under management.  Academic paper here: “How Active is Your Fund Manager? Cremers and Petajisto

-Favor funds with recent momentum.  Academic paper here: “How Active is Your Fund Manager? Cremers and Petajisto and here “The 52-Week High, Momentum, and Predicting Mutual Fund Returns” Sapp

-Favor funds with redemption fees.  Academic paper here: “Redemption Fees:  Reward for Punishment” Nanigan, Finke, Waller

-Avoid funds with low Morningstar Stars.  Academic paper here: “Selectivity, Market Timing and the Morningstar Star-Rating System” Antypas, Caporale, Kourogenis, and Pittis

-High conviction picks outperform.  Academic paper here:  “Best Ideas”  Cohen, Polk, Silli

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What is the Morningstar Rating for mutual funds (a.k.a. the star rating)? Fact sheet here.

How does Morningstar calculate its star ratings?

Funds are ranked within their categories according to their risk-adjusted return (after accounting for all sales charges and expenses), and stars are assigned such that the distribution reflects a classic bell-shaped curve with the largest section in the center. The 10% of funds in each category with the highest risk-adjusted return receive five stars, the next 22.5% receive four stars, the middle 35% receive three stars, the next 22.5% receive two stars, and the bottom 10% receive one star.

Funds are rated for up to three periods–the trailing three, five, and 10 years and ratings are recalculated each month. Funds with less than three years of performance history are not rated. For funds with only three years of performance history, their three-year star ratings will be the same as their overall star ratings. For funds with five-year records, their overall rating will be calculated based on a 60% weighting for the five-year rating and 40% for the three-year rating. For funds with more than a decade of performance, the overall rating will be weighted as 50% for the 10-year rating, 30% for the five-year rating, and 20% for the three-year rating. The star ratings are recalculated monthly.

Sounds pretty similar to the Sharpe Ratio (or more specifically the Sortino Ratio)

I can’t think of an area of investing individuals know less about than currencies.  (As an aside: We are currently writing a paper on currency investing strategies…)

Today there is an article in the LA Times on currency trading (note: I didn’t say investing).  FXCM and Gain are the two biggest brokers with a combined 260,000 accounts.  Roughly 75% of customers lost money every quarter (both are public and have to disclose such stats to the CFTC).  This is exacerbated by one simple metric: 50 to 1 leverage (that is down from 100-1 of a few years ago but still more than 2 times leverage allowed to stock traders).  You can also make a deposit by credit card.

The business model for forex trading is to burn the customer and then find another one,”  said Larry Harris, a USC professor and the former chief economicst at the SEC.

Gain ending up making an average of $2,913 from every active trader it had last year, even though the average bustomer account contained only $3,000.  FXCM was $2,641 and $3,658.

Michael Greenberger, a University of Maryland professor and head of trading and markets at the CFTC said, “Once you have things that are done off exchange you are pretty much at the mercy of the dealer – telling you what the price is,telling you what you owe.  Anybody I cared about – I’d say, ‘Stay away from this.’”

CFTC chairman Gary Gensler recently said it was the “largest area of retail fraud” his agency oversees.

Investor beware.