Friday, November 11, 2011

Modern Portfolio Theory - Let's just call it Asset Allocation

In past 25 years, we have come to frame the simple logic of diversification in terms of rigorous statistical model developed by finance academics: Modern Portfolio Theory.  In its most comprehensive form, modern portfolio theory dictates that portfolio composition should include all liquid asset classes – not only US stocks, bonds and cash reserves but also international investments, short positions, foreign exchange and precious metal from financial market place.  Theoretically it might sound feasible but lets not try to complicate our lives.

For  nearly all investors, the principal asset classes of choice boil down to common stocks (for maximum total return), bonds (for reasonable income), and cash reserves (for stability of principal). Each differs in risk: stocks are the most volatile, bonds are less so, and the nominal value of cash reserves is inviolable. In fact I would suggest short term bonds as superior alternative to cash reserves or money market funds.

Why do we need Asset Allocation?

My guidelines are simple: as a crude starting point two thirds in stocks, one- third in bonds. Balance optimizes returns from stock market in order to reach investment goals such as the accumulation of assets for retirement, but it holds the risk of loss to tolerable levels by ownership of some bonds too.

The entire act of balancing and diversification revolves around risk mitigation. But what is risk - Risk, in turn, is defined in terms of short-term fluctuations in expected value. Risk is something far more difficult to quantify. It relates to hoe much you can afford to lose without excessive damage to your pocketbook or your psyche.

Following table offers some historical perspective on the frequency and severity of loss that investors with various allocations to stock and bonds have suffered since 1926.

Number of Years with a Loss
 Loss (%)
Three-Year Loss (%)

Two-Year Loss (%)
Two-Year Loss (%)  2008-2009

But does the above table suggest that bonds are better investments than stocks? Some who were completed invested in bonds during 1973 crash might argue but let’s look at the history.  For the long-term investor, however, it would have been tragic to do so. For in the 23 years that followed, stocks provided an annual return of 16.6 percent, compared to just 10 percent for bonds. A portfolio that began with just a 40 percent bond/60 percent stock allocation and was left untouched would have enjoyed a return of 14.6 percent. Bonds are best used as a source of regular income and as a moderating influence on stock portfolio, not as an alternative to stock. Remember, the goal of the long-term investor is not to preserve capital in the short run, but to earn real, inflation-adjusted, long-term losses.

So, the greatest benefit of a balanced investment program is that it makes risk more palatable. An allocation to bonds moderates the short-term volatility of stocks, giving the risk-average long-term investor the courage and confidence to sustain a heavy allocation to exquisites. Choose a balance of stocks and bonds according to your unique circumstances-your investment objectives, your time horizon, your level of comfort with risk, and your financial resources.

Striking Your Own Balance

How can you determine an appropriate balance of your own needs? Let’s look at the matrix to understand basics of asset allocation. The matrix assumes that the over long time periods the stocks outperform bonds and the stocks are more volatile than bonds.

The main points of the matrix are based on common sense. During the accumulation phase of your personal cycle, when you are building assets, you are putting aside money that you would otherwise spend. (It’s never easy, but always essential.) You invest your capital, and you reinvest your dividends and your capital gains distributions. Because you have no immediate need for these assets, you can put your capital at greater risk in pursuit of higher return. As a younger investor, you might allocate as much as 80 percent or more of your portfolio to stocks, with the remainder in bonds. As the later years of your accumulation phase begin, you are older and have less time to recoup any decline in the value of your portfolio. At that point, you might limit your stock exposure to no more than 70 percent.

During the distribution phase of your investment cycle- when you enjoy the fruits of the accumulation phase-you depend on a relatively fixes pool of capital t generate income for your needs. You are withdrawing the income generated by your investments, and you cannot afford substantial short term loss. At the start of the distribution phase, you might reduce your stock allocation to 60 percent or so. As you age you might want to cut it to 50 percent.

It would be imprudent for a highly risk-tolerant young investor (25 years old or so), who is just beginning to invest for retirement, to allocate everything to stocks, provided that the investor had confidence that regular investments could be made through thick and thin. In the distribution phase, a highly risk-averse older investor who has substantial means could cut the stock allocation to as low as 30 percent.

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Don't Be Naive About the NAV

A mutual fund calculates its NAV by adding up the current value of all the stocks, bonds, and other securities (including cash) in its portfolio, subtracting the manager's salary and other operating expenses, and then dividing that figure by the fund's total number of shares. For example, a fund with 500,000 shares that owns $9 million in stocks and $1 million in cash has an NAV of $20.

Stock prices change throughout the trading day, but mutual fund NAVs are calculated only once each day, based on the value of their stocks or bonds at the time the market closes. When you purchase a mutual fund, you buy shares at the NAV as of that day's close. As a result, you don't necessarily know the exact NAV of the fund at the time you put in your order to buy or sell.

Mutual funds, however, distribute any income or capital gains they realize to shareholders as dividends, which, in turn, causes their NAVs to fluctuate. Unless you account for such distributions, you could be underestimating a fund's actual performance by looking solely at its NAV. To accurately gauge a fund's performance, you need to examine its total return, which takes into account both the appreciation of the fund's holdings as well as any distributions the fund has paid out.

A fund's income payout, or yield, tends to interest those investors who need regular income, because they don't necessarily have to tap into their principal for their day-to-day living expenses. Savings accounts and cds pay income, but so do most bonds and some stocks. If you own a mutual fund that buys income-paying stocks or bonds, the manager passes on any income to shareholders.

Yield can be calculated in a variety of ways. Morningstar calculates this figure by summing the income distributions over the trailing 12 months and dividing that by the sum of the last month's ending NAV plus any capital gains distributed over the 12-month period.

Capital Gains 
The second key way you can gain from a fund is through capital appreciation—that is, if one or more of your fund's holdings is selling for a higher price than it was when the manager purchased it. If the manager sells the new, pricier stock or bond, the fund realizes what is called a capital gain. And even if the manager simply hangs on to the stock or bond that has gained in value, the fund will enjoy capital appreciation; in other words, its NAV will increase. That's because the NAV is a reflection of the value of all of the securities in a fund at a given point in time.

A distribution can be both forms Yield and Capital gains. A fund's NAV will change whenever a fund makes a payment to its shareholders, otherwise known as a distribution. Whenever a fund passes along income or capital gain to shareholders, its NAV drops. If a fund with an NAV of $10 makes a $4 distribution, its NAV slips to $6. Despite the shrunken NAV, shareholders are none the poorer. They still have $10: $6 in the fund and another $4 in cash. Unless they need the $4 in income to spend, most investors will reinvest their distributions back into the fund.

Total Return
Total return encompasses everything we have discussed thus far: changes in NAV caused by appreciation or depreciation of the underlying portfolio, payment of any income (yield) or capital-gains distributions, and reinvestment of those distributions. So, if you used only your NAV to calculate return that figure would be inaccurate, because you need to factor in the capital-gains distribution that you reinvested.

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Time To Part Ways With Your Favorite Fund - Adios Amigo

All good things must come to an end. Mutual funds can also lose their magic. We'd love to say that a good fund will always be good, but funds change. Performance slips. Managers leave. Strategies evolve. That's why funds need to be monitored. Here are some of the warning signs to watch out for. These aren't sell signals per se: 

Asset Growth

This may seem counterintuitive, but sometimes mutual funds actually need smaller audiences. As funds attract new investors and grow larger, their returns often become sluggish, weighed down by too many assets. They lose their potency and their returns revert to the average for their group. Some funds stop accepting money from new investors when their assets grow too large, but many don't. That explains why so many once-hot funds become mediocre. As hot shot funds grow, their returns may become sluggish, weighed down by too many assets. They lose their potency and become average. It happened to Fidelity Magellan FMAGX, which is no longer the total-return powerhouse it was when it had less than a billion dollars under its belt. This might even happen to FSCRX.

Asset size can impede performance for any fund, but some types of funds are hurt more than others. It depends on a fund's style.. Generally very large funds may have difficulty buying very small stocks. It's tough to put large dollar amounts to work in a small market. Small-cap stocks take up less than 10% of the U.S. market's overall assets; large caps, meanwhile, account for about two thirds of the market. It's therefore easier for a fund manager with a lot of assets to buy bigger companies than to own a small fry. Asset overload is especially detrimental to small-cap funds that trade a lot. Sometimes mutual fund shops will do the monitoring for you. No matter what they do, though, they have to make concessions or close the fund. More often than not, fund managers cope with huge asset bases by altering their strategies. Some will buy more stocks. And as a shareholder, you need to be aware of the change and consider whether or not this altered fund fits into your portfolio.

Manager Changes

Most mutual funds are only as good as the people behind them: the fund managers. Managers decide what to buy, what to sell, and when to make these changes. Because the fund manager is the person who is most responsible for a fund's performance, many investors wonder if they should sell a fund when their manager leaves.

Unfortunately, there is no one right answer to this question. You'll need to consider a few factors. For example, you may have to pay taxes on your sold shares, if they've appreciated since you bought them. And what you give up in taxes may not be offset by future gains in a different fund. You'll also need to consider the record of the new manager—perhaps he or she has already worked on the fund? Perhaps the manager has racked up a solid record at another offering? Keep in mind: A new manager may do just as well as the old.

Further, management turnover won't make much difference when it comes to certain kinds of investing styles.

The Fund Loses More than It Should

Suppose a bond fund loses more than 23% in a year in which its average peer suffers a much slimmer loss. Shareholders who expected boring bond performance should have sold.

The Fund Underperforms for a Long Period

While one year of underperformance may be nothing to worry about, two or three ugly years can get frustrating. The urge to sell intensifies. Before pulling the trigger, be sure you're comparing your underperformer to an appropriate benchmark.

The Fund Changes Its Strategy

Presumably, you buy a small-value fund because you want exposure to small-value stocks. If the manager suddenly starts buying large-growth stocks, you may have a problem. After all, you may already have a large-growth fund in your portfolio.

Your Goals Change

You don't invest to win some imaginary race, but to meet your financial goals. As your goals change, your funds should change as well. Suppose you start investing in a balanced fund with the goal of buying a house within the next five years. If you get married and your spouse already owns a house, you may decide to use that money for retirement instead. In that case, you might ditch the balanced fund for a pure stock fund.

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Thursday, November 10, 2011

Fund Manager - The Show Man

Mutual funds are only as good as the people behind them: the fund managers. Portfolio managers are the people who decide what to buy and what to sell, and when. Because the fund manager is the person who is most responsible for a fund's performance, knowing who's calling the shots and for how long is key to smart mutual fund picking.

We think it is always important to know who a fund's manager is, whether the fund is run by one person or a whole team. Equally important is how long the person or team has been running the fund. Make sure that the manager who built the majority of the fund's record is still the one in charge. Otherwise, you may be in for a surprise.

Impact of manager departure can vary fund to fund. Yacktman leaving YACKX might have different impact compared to Joel Tillinghast departing FLPSX. The reason is obvious –fund companies such as Fidelity, vanguard, etc have very deep bench of managers and analysts but that’s not true for fund run by a family or small company. Another example that stands out – Chuck Akre recently left FBR funds and started his own fund AKREX – this led to migration of some followers from FBR to Akre funds.

Infact we consider that a fund manager should have long term record and should be equipped with at least one bear and bull market. A captain of ship who has always sailed in smooth seas can turn blind eye to indications of forthcoming storm. If you're looking for new investments and find two equally good funds, choose the one with the more experienced manager. 

When Manager are not so critical to the Fund:

1.      Managers of index funds are not actively choosing stocks, but simply mimicking a benchmark by owning the same stocks in the same proportion.
2.      The difference in return between a great and an awful ultrashort-bond fund is a matter of one or two percentage points. So if your ultrashort-bond fund manager leaves, it's probably not a big deal.
3.      Manager changes aren't quite as troubling if you're talking about a fund from a family, such as Fidelity, T. Rowe Price, and American, with a number of good funds and a strong farm team.
4.      While this isn't always the case, you'll often find that funds run by teams are less affected by manager changes than funds run by only one person.

When Managers matter the most:

  1. One-manager funds.
  2. Funds run by very active managers who've proved to be adept stock-pickers or traders.
  3. Good funds from families that aren't strong overall, or from fund families that lack other strong funds with a similar investment style.
  4. Funds in such categories as small growth or emerging markets, where the range of possible returns is very wide.

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    Fund And Taxes - Underrated

    The profound impact of taxes on the fund returns ia subject too long ignored. Ifact the dichotomy is that a portfolio manager’s performance is measured and applauded on the basis of pretax return – never mind that the IRS confiscates healthy share of it. As we've already noted, mutual funds must pass along to their shareholders any realized capital gains that are not offset by realized losses by the end of their accounting year. Mutual fund managers "realize" a capital gain whenever they sell a security for more money than they paid for it.

    Fund managers must also distribute any income that their securities generate. Bond funds typically pay out yields, but so do some stock funds if the stocks they own pay dividends.

    Unless you own your mutual fund through a 401(k) plan, an IRA, or some other type of tax-deferred account, you'll owe taxes on that distribution—even if you reinvested it (used the distribution to buy more shares of the fund). That is particularly painful if you have just purchased the fund, because you are paying taxes for gains you didn't get.


    A fund's turnover rate basically represents the percentage of a fund's holdings that change every year. "Turnover" is the gross proceeds from all sales divided by the total assets in the mutual fund. In plainer English, turnover represents how much of a mutual fund's holdings are changed over the course of a year through buying and selling.

    It is ironic that a mutual fund’s high turnover excarbates the tax issue. Higher the turnover of a fund more taxes it can incur due to realized capital gains. This is more common for the small cap mutual funds. So the bottom line is a fund with turnover of 85% will be far more tax inefficient than a fund with turnover of 20%. Authoritative studies suggest that turnover rates would have to be reduced to 20 percent or less to engender a material lessening of the tax burden. Tax efficiency and maximizing money in the market that is compounding value is a key part of generating long-term, excess returns. In fact, when you calculate the effect of taxes, the margin of outperformance that many short-term oriented investors say they enjoy is whittled down. Although the standard defense is that you have to sell sometime, the reality is that if the money compounds over long periods of time and you capture lower tax rates for being a longer-term holder, on an after-tax basis the difference can be quite profound.

    Alleviate tax headaches by following these tips:

    1.      Ask a fund company if a distribution is imminent before buying a fund, especially if you are investing late in the calendar year. (Funds often make capital-gains distributions in December.)
    2.      Place tax-inefficient funds in tax-deferred accounts, such as IRAs or 401(k)s. If a fund has a turnover rate of 100% or more, it's a good indication that limiting the tax collector's cut isn't one of the manager's objectives.
    3.    Search for extremely low-turnover funds—in other words, funds in which the manager isn't doing a lot of buying and selling and therefore isn't realizing a lot of taxable capital gains.
    4.   Favor funds run by managers who have their own wealth invested in their funds. These managers are likely to be tax conscious because at least some of the money they have invested in their funds is in taxable accounts. Fund companies now have to report to the SEC annually how much managers have invested in their funds.
    5.     If you want to buy a bond fund and are in a higher tax bracket, consider municipal-bond funds. Income from these funds is usually tax-exempt.
    6.      Consider tax-managed funds. These funds use a series of strategies to limit their taxable distributions. Vanguard, Fidelity, and T. Rowe Price all offer tax-managed funds.

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    Fund's Risk - Did You Break A Sweat

    Risk can be defined in terms of short term fluctuations in expected value. Actually risk is something difficult to quantify. It relates to how much you can afford to lose without excessive damage to your wallet or your psyche. But a basic idea of volatility and it impact on returns can help an investor to select funds that suits his or her risk palate.


    While no single risk measure can predict with 100% accuracy how volatile a fund will be in the future, studies have shown that past risk is a pretty good indicator of future risk. In other words, if a fund has been volatile in the past, it's likely to be volatile in the future.

    Standard Deviation
    Standard deviation is probably used more often than any other measure to gauge a fund's risk. Investors like using standard deviation because it provides a precise measure of how varied a fund's returns have been over a particular time frame—both on the upside and the downside. With this information, you can judge the range of returns your fund is likely to generate in the future. For most funds, future monthly returns will fall within one standard deviation of its average return 68% of the time and within two standard deviations 95% of the time.

    Caveat - Using standard deviation as a measure of risk can have its drawbacks. It's possible to own a fund with a low standard deviation and still lose money. In reality, that's rare. Funds with modest standard deviations tend to lose less money over short time frames than those with high standard deviations. The bigger flaw with standard deviation is that it isn't intuitive.

    Beta, meanwhile, is a relative risk measurement, because it depicts a fund's volatility against a benchmark. Beta is fairly easy to interpret. The higher a fund's beta, the more volatile it has been relative to its benchmark.

    Beta > 1.0 = Fund’s Volatility > Benchmark’s Volatility
    e.g. If market goes up by 10% a fund with beta 1.1 will go up by 11%.

    Beta < 1.0 = Fund’s Volatility < Benchmark’s Volatility
    e.g. If market goes up by 10% a fund with beta .9 will go up by 9% but if market goes down by 10% it will just go down by 9%.

    The biggest drawback of beta is that it's really only useful when calculated against a relevant benchmark. If a fund is being compared with an inappropriate benchmark, its beta is meaningless.

    Beta and R-squared
    R-squared, which you can find under the Ratings & Risk tab of a fund's report on The lower the R-squared, the less reliable beta is as a measure of the fund's volatility. The closer to 100 the R-squared is, the more meaningful the beta is. Unless a fund's R-squared against the index is 75 or higher, disregard the beta.

    Treynor Ratio
    A ratio that measures returns earned in excess of that which could have been earned on a riskless investment per each unit of market risk. Sometimes referred to as the return vs. volatility ratio the Treynor Ratio is a measure of the excess return per unit or risk

    Treynor ratio= (Average Return of the fund – Risk Free return) /  Beta of the fund

    In other words, the Treynor ratio is a risk-adjusted measure of return based on systematic risk. It is similar to the Sharpe ratio, with the difference being that the Treynor ratio uses beta as the measurement of volatility.

    Risk Adjusted Returns

    We've focused on yardsticks that tell you either how good or how volatile a fund's returns have been. But there are also measures that treat performance and risk together: risk-adjusted performance measures. Let’s look at them.

    Alpha is the difference between a fund's expected returns based on its beta and its actual returns. If a fund returns more than what you'd expect given its beta, it has a positive alpha. If a fund returns less than its beta predicts, it has a negative alpha.

    Alpha= (Actual return – Risk free T-bill’s return) – Expected return based on Beta
    e.g. Actual return = 30%; Beta=1.2; Risk Free Return=3%;
    Bencmark’s return=20%; So based on Beta, Expected return=(20*1.2) 24%
    Alpha = (30-3) – 24=3%

    Because a fund's return and its risk both contribute to its alpha, two funds with the same returns could have different alphas. Further, if a fund has a high beta, it's quite possible for it to have a negative alpha. That's because the higher a fund's risk level (beta), the greater the returns it must generate in order to produce a high alpha. So, you would want to find high-alpha funds.

    Inherent problems with Alpha –

    1.      It's dependent on the legitimacy of the fund's beta. So, if a fund's beta isn't meaningful because its R-squared is too low (below 75), its alpha isn't valid, either.
    2.      Alpha fails to distinguish between underperformance caused by incompetence and underperformance caused by fees.
    3.      It's impossible to judge whether alpha reflects managerial skill or just plain old luck. Is that high-alpha manager a genius, or did he just stumble upon a few hot stocks? 

    Sharpe Ratio
    The Sharpe ratio uses standard deviation to measure a fund's risk-adjusted returns. The higher a fund's Sharpe ratio, the better a fund's returns have been relative to the risk it has taken on. Because it uses standard deviation, the Sharpe ratio can be used to compare risk-adjusted returns across all fund categories.

    Sharpe ratio = (Fund’s return – risk free returns)/standard deviation

    The higher a fund's Sharpe ratio, the better its returns have been relative to the amount of investment risk it has taken. If funds A and B both have same return of 25% but there Sharpe ratio is 1.09 and .74 then Fund A took less risk then fund B.

    The higher a fund's standard deviation, the higher the fund's returns need to be to earn a high Sharpe ratio. Conversely, funds with lower standard deviations can sport a higher Sharpe ratio if they have consistently decent returns. A higher Sharpe ratio just means that the fund's risk/return relationship is more or optimal.

    The lack of dependence on validity of beta is real advantage of Sharpe over Alpha. Moreover, it's easier to compare funds of all types using the standard-deviation-based Sharpe ratio than with beta-based alpha. But given no other information, you can't tell whether a Sharpe ratio of 1.5 is good or bad.

    Sortino Ratio
    The Sortino Ratio is an adjustment on the Sharpe Ratio in that it only penalizes downside volatility. This is done by creating a value known as downside deviation which is based on some minimum acceptable return (MAR) or hurdle rate which is a rate of return that an investor can set. This could be 3% annual risk free asset (unrealistic given current interest rates).

    Sortino Ratio = (Fund’s Return – Risk Free investment’s Return)/Downside Deviation

    The denominator of the Sortino ratio is calculated only with data from periods where performance was below the MAR. This differentiates the “positive” and “negative” volatiliy.

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    Fund Performance - Keep An Eye But Don't Chase

    Although past performance is certainly not an indication of future results, there are some clues to be found about the quality of a fund by correctly measuring its past performance. Usually, what will be discerned through a careful study of past performance is that not many mutual funds actually deliver anything close to what their advertisements claim.

    Relativity holds true when examining a mutual fund's performance. What constitutes a "good" return depends on your needs and the type of fund. That's where benchmarks come in to play.

    Personal Benchmark
    It means setting a benchmark for the returns required to reach your investment goal, whether it is a long-term goal (retirement in 25 years) or a short-term goal (paying kid’s college fees in 7 years). By knowing that benchmark, you can immediately rule out funds that rarely meet that hurdle each year, such as most bond funds. You can also rule out funds that can sometimes return much more than your personal benchmark, but take extra, unnecessary risk.

    Indexes as Benchmarks
    When looking at a mutual fund's past performance, a good and necessary step is to identify its Morningstar style box. Morningstar has broken down the world of domestic mutual funds into small-, medium-, and large-cap funds and by objective -- growth, value, or blend. The Morningstar style box looks like a tic-tac-toe board, as such:

    Once you know which "style box" a fund is in, you can compare it with the other mutual funds that are similarly classified, and in many cases to a relevant index fund.

    The index you'll hear about most often in mutual fund circles is the Standard & Poor's 500 Index, which includes 500 major U.S. companies. Yet despite its widespread appeal, the S&P 500's focus on large companies means it's not representative of the entire market and smaller stocks' performance in particular. It's therefore inappropriate to measure a fund that doesn't buy large companies The Russell 2000 Index, which tracks smaller U.S. companies, is a good tool to evaluate many small-company funds, while the MSCI EAFE( Europe Australia Far East) Index, which follows international stocks, is a good measuring stick for foreign funds. The Barclays Aggregate Bond Index is a good gauge for most taxable-bond funds.

    Peer Groups as Benchmarks
    The second type of benchmark you can use is peer groups, or funds that buy the same types of securities as your fund. This is another place where you can use the knowledge of Morningstar style box.

    Compare funds that buy large, undervalued companies with others with the same style—so-called large-value funds. Or compare those that buy only Latin America stocks with other funds that only buy Latin America stocks. That way, you're comparing apples to apples.

    Why don’t we just stick with index comparisons? Remember we are long term investors. There are times when entire fund category underperforms the corresponding index but we can not write them off because of this. In that case we use the peer comparison to figure out the best fund in the group. Peer benchmarking is important when you are trying to diversify you are portfolio. If a category underperforms today it doesn’t mean that you drop that category entirely from your portfolio. Underperformance of large value funds in 2000 is an excellent example. Same category outperformed S&P 500 by miles in 2009.

    The best approach is to use all the benchmarking judiciously because even though past performance does not guarantee future results but a fund that trounces its peers and sits in top quartile generally tends to repeat the performance for next few years till you see one of the multiple red flags. But ensure that you don’t end up overrating the performance. Only pick the ones which have faced the test of time and outperformed peers and benchmark both in bear and bull market.

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