Tag Archives: investment

Beyond The Benchmark: Tracking Error Vs. Active Share

Summary We have reservations about using tracking error to gauge “active investing” because it relies on historical volatility data versus a benchmark to draw conclusions about risk. Active share, in our view, provides a clearer picture of how active a fund manager is as compared with drawing conclusions from standard deviation calculations. We believe the fund has to be meaningfully different to its benchmark to create an opportunity to deliver alpha. We believe active share more clearly shows how a fund and benchmark differ, a key to delivering alpha. By Rob Stabler, Product Director Active share, a tool for demonstrating how a fund’s portfolio differs from its respective benchmark, has been a common term among active investors over the last few years. Tracking error, which has a much longer history, is often regarded as another tool that does the same job. But the differences between the two measures affect how Invesco’s Global Opportunities investment team views their effectiveness and usefulness for investors. Tracking error: Useful from returns perspective Tracking error – the divergence between price behaviors of a portfolio and its benchmark – is a backward looking tool, using historical data to show the volatility of the fund’s returns versus that of its benchmark. It’s useful in demonstrating how closely a portfolio follows its benchmark from a returns perspective. However, it’s important to consider these two questions: What’s the benchmark? A fund with a low tracking error versus a volatile benchmark may not produce the return profile investors seek. Are upside and downside volatility equally important to investors? The most common method of assessing tracking error involves calculating the standard deviation of the fund and benchmark returns, which reflects both upside and downside volatility. In our experience, however, investors have been more concerned about the implications of downside volatility. More importantly, as active investors, our team’s main reservation about tracking error is acceptance of the benchmark as the right reference point for measuring volatility and, by implication, risk. In contrast, the investment world doesn’t revolve around the benchmark for our fund managers. We define risk as the potential for permanent loss of capital, using maximum drawdown and downside volatility as indicators. And we often view volatility – at least in the short term – as an opportunity to exploit valuation anomalies in the stock market. Active share: Looks at holdings and weightings Active share is a much simpler calculation that provides a snapshot in time. It measures how different a portfolio is from its benchmark by comparing the fund’s holdings and their weightings with those of the benchmark. We believe active share provides a clearer picture of how active a fund manager is than drawing conclusions from standard deviation calculations. In simple terms, a tracker fund that perfectly replicates its benchmark will have an active share of 0%, while an active fund that owns no constituents of its reference benchmark will have an active share of 100%. This measure is increasingly important, given the rise of passive investing and the need to differentiate between quasi-passive and genuinely active managers. Origin of active share The concept of active share was introduced in research by Martijn Cremers and Antti Petajisto, which indicated that portfolios with a high active share were, on average, likely to outperform their benchmarks, suggesting a positive correlation between performance and active share. 1 Additional research by Cremers and fellow economist Ankur Pareek 2 combined active share analysis with portfolio managers’ stock holding period, where long duration is defined as more than two years. The research shows clear outperformance, on average, of those strategies that combine high active share and long duration, or low turnover, of stocks. Of course, past performance does not guarantee future results. Earlier this year, Invesco published a white paper examining the historical outperformance of active management , using active share as the measuring stick for active management. Because high active share offers no performance guarantee, it’s possible to have a high active share portfolio that underperforms its benchmark. However, our team believes that to outperform a benchmark, portfolio construction needs to differ from the benchmark, and active share is a reliable, easy way of measuring this. So while active share doesn’t guarantee performance, we believe it’s a prerequisite – if you aren’t different, then you can’t hope to achieve a different result, good or bad. By-product of investment philosophy While we don’t explicitly target a high active share in the Invesco Global Opportunities strategy, it’s a by-product of our investment philosophy – concentrated and flexible investing that views risk as absolute, not relative. The result is an active share that is typically high, currently at 95%. Put simply, to create an opportunity to deliver alpha for our investors, we believe the fund has to be meaningfully different from its benchmark. In addition, we see no evidence to suggest a direct link between the strategy’s tracking error and performance. Sources “How active is your fund manager? A new measure that predicts performance,” Aug. 7, 2006. Patient Capital Outperformance: “The Investment Skill of High Active Share Managers Who Trade Infrequently,” Sept. 19, 2014. Important information Alpha refers to the excess returns of a fund relative to the return of a benchmark index. Standard deviation measures a portfolio’s range of total returns and identifies the spread of a portfolio’s short-term fluctuations. Drawdown is the largest cumulative percentage decline in net asset value as measured on a month-end basis. Absolute return refers to the return an asset achieves over a certain period of time, without comparison to another measure or benchmark. The information provided is for educational purposes only and does not constitute a recommendation of the suitability of any investment strategy for a particular investor. Invesco does not provide tax advice. The tax information contained herein is general and is not exhaustive by nature. Federal and state tax laws are complex and constantly changing. Investors should always consult their own legal or tax professional for information concerning their individual situation. The opinions expressed are those of the authors, are based on current market conditions and are subject to change without notice. These opinions may differ from those of other Invesco investment professionals. NOT FDIC INSURED MAY LOSE VALUE NO BANK GUARANTEE All data provided by Invesco unless otherwise noted. Invesco Distributors, Inc. is the US distributor for Invesco Ltd.’s retail products and collective trust funds. Invesco Advisers, Inc. and other affiliated investment advisers mentioned provide investment advisory services and do not sell securities. Invesco Unit Investment Trusts are distributed by the sponsor, Invesco Capital Markets, Inc., and broker-dealers including Invesco Distributors, Inc. PowerShares® is a registered trademark of Invesco PowerShares Capital Management LLC (Invesco PowerShares). Each entity is an indirect, wholly owned subsidiary of Invesco Ltd. ©2015 Invesco Ltd. All rights reserved. Beyond the benchmark: Tracking error versus active share by Invesco Blog

Coming Prices In Sector ETFs: Compared By Market-Makers

Summary Behavioral Analysis of the players moving big blocks of securities in and out of $-Billion portfolios provides insights into their expectations for price changes in coming months. Portfolio Managers have delved deeply into the fundamentals urging shifts in capital allocations; now they take actions on their private, unpublished conclusions. These block transactions reveal why. Multi-$Million trades strain market capacity, require temporary capital liquidity facilitation and negotiating help, but are necessary to accomplish significant asset reallocations in big-$ funds. Market-making firms provide that assistance, but only when they can sidestep risks involved by hedge deals intricately designed to transfer exposures to willing (at a price) speculators. Analysis of the prices paid and deal structures involved tell how far coming securities prices are likely to range. Those prospects, good and bad, can be directly compared. This is a Behavioral Analysis of Informed Expectations It follows a rational examination of what experienced, well-informed, highly-motivated professionals normally do, acting in their own best interests. It pits knowledgeable judgments of probable risks during bounded time periods against likely rewards of price changes, both up and down. It involves the skillful arbitrage of contracts demanding specific performances under defined circumstances. Ones traded in regulated markets for derivative securities, usually involving operational and/or financial leverage. The skill sets required for successful practice of these arts are not quickly or easily learned. The conduct of required practices are not widely allowed or casually granted. It makes good economic sense to contract-out the capabilities involved to those high up on the learning curve and reliability scale. It requires, from all parties involved, trust, but verification. What results is a communal judgment about the likely boundaries of price change during defined periods of future time. Those judgments get hammered out in markets between buyers and sellers of risk and of reward. The questions being answered are no longer “Why” buy or sell the subject, but “What Price” makes sense to pay or receive. All involved have their views; the associated hedge agreements translate possibilities into enforceable realities. We simply translate the realities into specific price ranges. Then the risk and benefit possibilities can be compared on common footings. A history of what has followed prior similar implied forecasts may provide further qualitative flavor to belief and influence of the forecasts. Certainty is a rare outcome. Subjects of this analysis We look to some 30 ETFs with holdings concentrated in stocks of economic sectors. They provide a wide array of interests and an opportunity to see comparisons being made of expectations for price change on common footings. Please see Figure 1. Figure 1 (click to enlarge) Market liquidity is addressed in the first four columns of Figure 1. What leaps out is the huge capital commitment made, apparently by individual investors, in several of the Vanguard ETFs. At their typical average daily volume of trading, less than half a million shares, in many cases it would take over 100 days for all investors to escape a change in outlook. The trade-spread cost to trade these ETFs is typically in single basis points of hundredths of a percent. That is in the same region of a $7 commission on a $10,000 trade ticket. Price-earnings ratios for these subjects range from 15 times earnings to 22 times. But appear to be of little influence in differentiating between their selection for portfolio participation. Where behavioral analysis contributes Investor preferences among these ETFs during the past year are indicated in the last two columns of Figure 1, reflecting on their price range experiences in that period, shown in the prior two columns. The SPDR Metals & Mining ETF (NYSEARCA: XME ), fluctuated the most, by 133% low to high, while the SPDR Consumer Staples ETF (NYSEARCA: XLP ) traveled by only 17%. The difference is mainly a substantial loss in gold stocks, compared to capital perceived to be risk-exposed fled to a defensive grouping. From a portfolio management viewpoint, what matters most is where holdings are priced now, compared with where their prices may go in coming months. Prices are, after all, what determine the progress of wealth-building, and are what can be a source of expenditure provision as an alternative to interest or dividend income. Ultimately price changes are the principal portfolio performance score-keeping agent. Where prices are now, in comparison to where they have been provides perspective as to what may be coming next. If prices are high in their past year’s range, for them to go higher means that their surroundings must also increase. If price is low relative to prior year scope, a price increase represents recovery, when and if it happens. As you think about the security’s environment, does it seem likely in coming months to be one of stability, of increase, or of possible decline? How would such change be likely to impact the security under consideration? First there is a need to be aware of what has recently been going on. The measure for that is the 52-week Range Index. The 52 week RI tells what proportion of the price range of the last 52 weeks is below the present price. A strong, rising investment likely will have a large part of its past-year price range under where it is now. Something above 50, the mid-point pf the range is likely, all the way up into the 90’s. At the top of its year’s experience the 52wRI will be 100. At the bottom the 52wRI will be zero. For XME at a 52wRI of 3, the damages during the past year continue to be evident at this point in time. For XLP a 52wRI of 75 reflects the supportive influence of buying up to the present. The ratio of 3x as much downside as upside prospective price change is not that concerning to many if next year’s sector price behavior is like the recent year. After all, 3/4ths of 17% is only about -12%. That’s far better than 3/4ths of a range in the Vanguard Health Care ETF (NYSEARCA: VHT ) where the 52wRI of 77 comes up against a range of 60%, or minus 45% All the 52wRI can do is provide perspective. A look to the future requires a forecast. With that, expressed in terms of prospective price changes, both up and down, a forecast Range Index, 4cRI or just RI, gives a sense of the balance between upcoming reward and risk. The historical 52wRI can’t do much more than frame the past, a reference that may produce poor guidance. Knowledgeable forecasting is what behavioral analysis of the actions of large investment organizations, dealing with the professional market-making community, can do. The process of making possible changes of focus for sizable chunks of capital produces the careful thinking of likely coming prices that lies behind such forecasts. Hedging-implied price range forecasts Figure 2 tells what the professional hedging activities of the market-makers imply for price range extremes of the symbols of Figure 1, in the same sequence. Columns 2 through 5 are forecast or current data, the remaining columns are historical records of market behavior subsequent to prior instances of forecasts like those of the present. Figure 2 (click to enlarge) A lot of information is contained here, much of potential importance. Some study is deserved. Exactly the same evaluation process is used to derive the price range forecasts in columns 2 and 3 for all the Indexes and ETFs, regardless of leverage or inversion. Column 7’s values are what determine the specifics of columns 6 and 8-15. Each security’s row may present quite different prior conditions from other rows, but that is what is needed in order to make meaningful comparisons between the ETFs today for their appropriate potential future actions. Column 7 tells what balance exists between the prospects for upside price change and downside price change in the forecasts of columns 2 and 3 relative to column 4. The Range Index numbers in column 7 tells of the whole price range between each row of columns 2 and 3, what percentage lies between column 3 and 4. What part of the forecast price range is below the current market quote. That proportion is used to identify similar prior forecasts made in the past 5 years’ market days, counted in column 12. Those prior forecasts produce the histories displayed in the remaining columns. Of most basic interest to all investment considerations is the tradeoff between RISK and REWARD. Column 5 calculates the reward prospect as the upside percentage price change limit of column 2 above column 4. Proper appraisal of RISK requires recognition that it is not a static condition, but is of variable threat, depending on its surroundings. When the risk tree falls in an empty forest of a portfolio not containing that holding, you have no hearing of it, no concern. It is only the period when the subject security is in the portfolio that there is a risk exposure. So we look at each subject security’s price drawdown experiences during prior periods of similar Range Index holdings. And we look for the worst (most extreme) drawdowns, because that is when investors are most likely to accept a loss by selling out, rather than holding on for a recovery and for the higher price objective that induced the investment originally. Columns 5 and 6 are side by side not of an accident. While not the only consideration in investing, this is an important place to start when making comparisons between alternative investment choices. To that end, a picture comparison of these Index and ETF current Risk~Reward tradeoffs is instructive. Please see Figure 3. Figure 3 (used with permission) In this map the dotted diagonal line marks the points where upside price change Prospect (green horizontal scale) equals typical maximum price drawdown Experiences (red vertical scale). Of considerable interest is that the subjects all tend to cluster loosely about that watershed. This strongly suggests that the overall market environment is neither dangerously overpriced or strongly depressed in price, confirmed by the SPDR S&P 500 ETF (NYSEARCA: SPY ) at [9]. The high-return, high-risk group is the previously noted, price-depressed XME metals sector at [8]. Precious metals may rebound or they may get worse; no clear indication seems present from this analysis. Numerous low-risk, low-return alternatives are offered at [11] and [16], with symbols offered in the blue field at right. VHT, the previously compared historical risk(?) alternative to XLP, now demonstrates the fallacy of driving the portfolio car by sole use of the rear-view mirror. Earlier a possibility of -45% downside exposure was intimated. Current appraisals of VHT in [11] and Figure 2’s columns (5) and (6) show an upside price change prospect of +4.4% and experienced worst-case price drawdowns of only -2.7%. Clearly, big-money is not scared of losing much of the past gains. They may be influenced by the knowledge that 88% of forecasts like today’s have wound up as profitable holdings over the next 3 months. Typically those net gains were achieved in about 5 weeks for a +37% CAGR. Compared to the market proxy ETF, SPY, the clearest advantage seen in Figure 3 is [17], the SPDR Retail ETF, with an upside of +8.7% and price drawdowns of less than -3%. The bottom blue row of Figure 2, included for such comparison purposes shows SPY with an upside of almost +7% and downside experiences of -4.5%. The other blue comparison rows of Figure 2 provide perspectives in terms of an average of all the 28 sector ETFs above, then an average of the day’s 20 best-ranked stocks and ETFs, using an odds-weighted Risk~Reward scale, and then the overall population averages of over 2,000 securities. This kind of comparing between alternative investments is what often distinguishes the experienced investor from the neophyte. There are so many intriguing possible stories of investment bonanzas that it may be difficult to keep focus. And for the newbie investor deciding on what combinations of attributes may be most important is a daunting challenge. An advantage of the behavioral analysis approach is that price prospects suggested by fundamental and competitive analysis are being vetted by experienced, well-informed market professionals on both sides of the trade. Looking back at figure 2, there is a condition that may disrupt the organized notions drawn from Figure 3. Column 8 tells what proportion of the prior similar forecasts persevered in recovering from those worst-case drawdowns, and for the resolute holder turned into profitable outcomes, often reaching their targeted price objectives. Batting averages of 7 out of 8 and 9 out of 10 are quite possible to accomplish by active investors. Column 10 tells how large the payoffs were, not only of the recoveries, but including the losses. And those gains, in comparison with the forecast promises of column 5 offer a measure of the credibility of the forecast. There will be circumstances where credibility will be low and recovery odds worse than 50-50. When such conditions appear pervasive, cash is a low-risk temporary investment, sometimes the treasured resource. Conclusion At present there is no outstanding sector ETF choice for asset allocation emphasis or the commitment of new capital. Neither is there grave concern for dangerous outcome from present sector positions. The SPDR Energy Sector ETF (NYSEARCA: XLE ) shows the most downside exposure as experienced by prior like forecasts, and recent history suggests that its problems may not yet be over. Active investors may find attraction in the higher-ranked (by figure 2’s column 15) sector ETFS sufficient to consider shifts of some capital from XLE to other health care or information technology ETFs.

401(k) Fund Spotlight: Loomis Sayles Small Cap Value

Summary LSSCX is really a small cap “core” or “blend” fund. LSSCX has consistently beaten the Russell 2000 Index by at least 2% over all relevant, historical periods. With almost 1/3 of the fund in financials and little exposure to utilities, consumer staples, and REITs, the fund is well positioned for a rising rate environment. Introduction I select funds on behalf of my investment advisory clients in many different defined contribution plans, namely 401(k)s and 403(b)s. I have looked at a lot of different funds over the years. 401(k) Fund Spotlight is an article series that focuses on one particular fund at a time that is widely offered to Americans in their 401(k) plans. 401(k)s are now the foundational retirement savings vehicle for many Americans. They should be maximized to the fullest extent. A detailed understanding of fund options is a worthwhile endeavor. To get the most out of this article, it is helpful to understand my approach to investing in 401(k)s . I strive to write these articles for the benefit of the novice and professional. Please comment if you have a question. I always try to give substantive responses. Loomis Sayles Small Cap Value Fund The Loomis Sayles Small Cap Value Fund has the following share classes: If the fund is an option in your 401(k), it will likely come in the form of the I (institutional) or R (retail) shares. These two share classes are also much older and hold most of the overall fund’s assets. The expense ratio for the I shares is 1.04% and for the R shares it is 1.29%. For the purposes of this article, I will assume the I shares are being discussed and name the fund by its ticker – LSSCX . The fund is closed to new investors. Most readers, if they have access to the fund, will have it only through their 401(k). LSSCX is best classified as a small capitalization (“cap”) core (or blend) fund. Small cap companies are loosely defined as having a market capitalization of less than $2 billion. The “core” or “blend” description means that the fund owns stocks described both as growth and value. Performance Evaluation Loomis Sayles is a mutual fund outfit best known for its prowess in the bond market and their flagship Bond Fund, the Loomis Sayles Bond Fund (MUTF: LSBDX ). The immediate question for us is, “Can they pick stocks?” and “Can they pick small cap stocks?” I’ll let the numbers do the talking. The following table compares the performance of LSSCX to its benchmark index, the Russell 2000: as of Sept 30, 2015 1 Year Return 3 Year Return 5 Year Return 10 Year Return Loomis Sayles Small Cap Value – Inst 1.2% 11.7% 12.3% 7.6% Russell 2000 Index -1.6% 9.2% 10.2% 5.4% Excess Return 2.8% 2.5% 2.1% 2.2% The fund has beaten the index by at least 2% over the last 1, 3, 5, and 10-year periods (as of September 30, 2015). This is a consistent record of excess returns which clearly makes the fund a better option than owning the index. The following table compares the performance of LSSCX to its peers, as represented by the Lipper Small Cap Core Index. This data was taken from Barrons . as of Oct 31, 2015 1 Year Return 3 Year Return 5 Year Return 10 Year Return Loomis Sayles Small Cap Value – Inst .7% 14.3% 13% 8.6% Lipper Small Cap Core Peer Index .7% 13.4% 11.7% 7.5% Excess Return 0% .9% 1.3% 1.1% Over the last year, the fund is even with its broader peer group, but has out performed the average over the last 3, 5, and 10-year periods (as of October 31, 2015). Over the last 5-year period the fund finished in the 22nd percentile of its peer group and over the last 10-year period it finished in the 15th percentile. This means that it outperformed 85% of all other small cap core oriented funds over the last 10 years. From a performance standpoint, LSSCX can best be described as a superior option to the index and an above average option when compared to its peers. Additional Performance Considerations It is important to realize that LSSCX is not going to give you any sort of exceptional performance (e.g., 5%+) over its Russell 2000 index benchmark over a longer period of time. This is because the fund typically holds 150 to 180 different stocks (152 right now), with no one stock comprising more than 1.5% of the fund. The fund is just too overly diversified to vastly outperform the index. That being said, I view the consistent 2% excess returns as very good. Loomis Sayles “rigorous fundamental, bottom-up analysis” (as they describe it) adds value and makes the fund a better option than an index fund. It would be interesting to see Loomis Sayles launch a more concentrated small cap fund that owns what they think are their very best ideas. I am thinking of the Invesco Select Companies Fund (MUTF: ATIAX ), which I recently wrote about, which invests in the managers best 25 small cap ideas. Well Positioned for Rising Rates Here is how LSSCX’s assets were distributed across sectors, as of September 30, 2015: Financials – 31.5% Industrials – 18.4% Consumer Discretionary – 18.3% Information Technology – 14.8% Healthcare – 4.2% Consumer Staples – 3.5% Materials – 2.9% Utilities – 2.6% Energy – 2.3% Telecom – 0% Almost one third of the fund is invested in the financial sector. In fact, the fund’s 2 largest holdings are Signature Bank (NASDAQ: SBNY ) and Cathay General Bancorp (NASDAQ: CATY ). These small banks would benefit from a rising rate environment as their net interest margin expands. By this I mean they could continue to pay depositors 0% to .25% while at the same time increasing their rates on auto loans, mortgages, and commercial loans, netting more profit. The fund has little exposure to utilities and consumer staples stocks that could suffer as their high dividends become less appealing in an environment of higher bond yields. Furthermore, digging through the holdings I can see that the fund also has minimal exposure to real estate investment trusts (“REITs”), which could also suffer for the same reason. I am not expecting substantially higher rates for several more years, but wanted to point this out for some investors who may have a more immediate concern. Rising rates in the U.S. would also imply a strengthening U.S. economy which would benefit U.S. small cap stocks. Valuation If LSSCX has a weakness in the current environment it is the low dividend yield, which currently only runs about .6%. However, the fund is attractive from a valuation standpoint. As of September 30, 2015, it had a forward price to earnings multiple (“P/E”) of 15.96. This is slightly below the index and gives credence to the fund’s “value” slant. (It does call itself small Cap Value, even though it is really a small cap core or blend fund.) I have no problem sacrificing dividend yield for lower valuations. Strategic Positioning I have really warmed to U.S. small cap stocks over the last few months in the 401(k) plans I manage for clients. It seems little noticed, but valuations have come down substantially to the point that they are now broadly inline with U.S. large cap stocks. Furthermore, the 2-year chart of the Russell 2000 Index looks compelling: ^RUT data by YCharts The index put in a higher low in 2015 than it did in 2014 and appears ready to break out to new highs. Am I predicting this? No. I am just considering a scenario where the U.S. dollar continues to rise, putting pressure on the earnings of U.S. multinationals but buoying the attractiveness of U.S. small cap companies with little international exposure. In such a scenario, I could see the S&P 500 index treading water while the Russell 2000 index logs some high, single-digit gains. Conclusion The Loomis Sayles Small Cap Value Fund is a good option in the current global macroeconomic environment. 401(k) investors may want to consider giving it the nod, or at least a higher weighting, over comparable small cap fund options and especially over small cap index funds. Investing Disclosure 401(k) Spotlight articles focus on the specific attributes of mutual funds that are widely available to Americans within employer provided defined contribution plans. Fund recommendations are general in nature and not geared towards any specific reader. Fund positioning should be considered as part of a comprehensive asset allocation strategy, based upon the financial situation, investment objectives, and particular needs of the investor. Readers are encouraged to obtain experienced, professional advice. Important Regulatory Disclosures I am a Registered Investment Advisor in the State of Pennsylvania. I screen electronic communications from prospective clients in other states to ensure that I do not communicate directly with any prospect in another state where I have not met the registration requirements or do not have an applicable exemption. Positive comments made regarding this article should not be construed by readers to be an endorsement of my abilities to act as an investment adviser.