World Beta Blog

I will be in Australia the week of February 20th, as always if you are around feel free to drop me a line to meetup.  I’ve never been to Australia, so if you have any recs fire them over!

Speaking at the ETF Conference here.

Nice PDF from Morningstar on ETFs.

Table of Contents Below:
Introduction

The ABCs of ETFs

Choosing ETFs the Morningstar ETFInvestor Way

An ETF Primer for Retirees and Conservative Investors 

Avoiding the Dividend Trap 

Create Your Own Bond Portfolio Using ETFs 

Target-Maturity Bond ETFs: The Next Evolution in Fixed-Income Investing 

Indexing’s Hidden Costs 

Indexer? Valuation Still Matters 

What to Watch for When Investing in International ETFs 

An Overview of Broad-Basket Commodity ETFs 

ETFs That Hedge and Diversify 

Warning: Leveraged and Inverse ETFs Kill Portfolios 

How to Analyze a Strategy ETF 

Proactive Tax-Planning Basics With ETFs 

Popular ETF Questions Answered 

Reading the Stars 

ETFInvestor: What’s Inside 

The ETF Numbers That Matter—and Why 

Morningstar ETFInvestor Strategies 

Get it while it’s hot! (HT: Abnormal Returns)

One of my top must reads of the year…

(PS If you are a CSFB client you can get the full/extended version in hardcover.)

Here are some long term charts based on the data from Morningstar / Dimson Marsh Staunton.

Below are the best, middle, and worst case scenarios for the main asset classes of sixteen countries from 1900-2011.  All are real return series on a log graph (except the last one).

First, here are the best cases for returns on your cash.  This chart goes to show that leaving cash under your mattress is a slow bleed for a portfolio.  I excluded Germany after the first series as it dominates the worst case scenarios (in this case hyperinflation).

Best Case:  -2.30% per year

Middle:  -4.10%

Worst Case:  -100%

Next up is real returns for short term bills.

Best Case:  2.25% per year

Middle:  0.71%

Worst Case:  -3.63%

(Real Worst Case, Germany -100%)

Followed by the real returns for longer dated bonds.

Best Case:  3.04% per year

Middle:  1.40%

Worst Case:  -1.91%

(Real Worst Case, Germany -100%)

And finally, the real returns for equities.

Best Case: 7.43% per year

Middle:  4.60%

Worst Case:  2.00%

And the same chart presented non-log…

Thought I would update this older post with a few new studies that take a look at active share, and illiquidity and momentum.

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 funds holding illiquid and high momentum stocks:  ”Using Liquidity and Momentum to Pick Alpha Managers“ - Idzorek

-Favor funds with high active share:  ”Equity Allocations: Thinking Outside of the Box”  Larson

-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

Option selling has always been a fascination for me, and long time readers may recall a lot of the posts I used to do on the subject years ago.  (07 – Are option selling funds a blowup waiting to happen, and 2008 – Kablooey.)

I could never understand why most option sellers only traded one market (usually US stocks) rather than a portfolio of world markets.  In a project I did back in the early ’00s I found that writing options away from the direction of the trend on a diversified asset class basket created some great numbers.

Kudos to Jared at Condor Options for tracking such a strategy in real time - lots of merit in a short vol strategy with long vol trading rules!

Fun paper from the good folks at Russell Research.  Although I would argue the volatility is an artifact of prices declining, and this could be called a trendfollowing approach….ie our paper on where the vol occurs:

Where the Black Swans Hide and the Ten Best Days Myth

Volatility Responsive Asset Allocation

Most stock market valuation models are not that predictive in the short term.  However, value tends to work great on longer term timeframes.  We rebuilt Hussman’s valuation models (both the PE and dividend ones) with the Shiller data, and right now at future P/Es of 15 the US stock market should do about 5% a year nominal (so, net of inflation maybe 2-3% per year) over the next decade.  P/E contraction to 10 means -3% losses per annum, and a future PE of 20 implies around 8%.  (We also rebuilt the Arnott models on CAPE and inflation here.)

We couldn’t find much in the way of Shiller CAPE’s for foreign markets, so we have built a lot of these in house.  There is a lot of evidence showing sorting countries on value produces outperformance over time (section in the Tweedy Browne paper and an old post here:  sorting countries by dividend yield).

Source:  Global Financial Data

For all the visual folks, source AAII:

One of the trends in ETFland is launching funds that fall under the banner of what I call ‘investable benchmarks’.  Depending on your worldview and strategic asset allocation mindset, you may favor an endowment style portfolio (heavy in equties, global, with decent chunks in real assets).  Or perhaps you fall under the risk parity spell (examine asset classes on a vol adjusted basis or economic regime basis, basically ends up with more in bond and usually requires leverage).  Recent article on Dalio here.

In any case, after you come up with the initial allocation there is not a lot more to do with the portfolio than rebalance it every so often and upgrade funds when better or more representative ones come out.  I am generally in favor of these portfolios being available to investors, but in no way do I think they should cost any more than 0.5% for a buy and hold allocation.  And over time I expect them to converge to around 20 bps as the old high fee model dies a slow mutual death.  Lots of these funds have garnered a ton of assets this year, and I was interested to see a filing the other day for a Permanent Portfolio ETF.  If they are smart they will come in at a reasonable cost.  But in general one can replicate these funds for free (and is why we put sample portfolios in our book for the buy and hold investor.)

We’re putting together a piece on dynamic risk parity (permanent falls under this banner I think) and endowment portfolios.  Stay tuned!