Tag Archives: literature

SGVIX: A Bond Mutual Fund For People With Few Options

Summary SGVIX has underperformed alternative options with lower expense ratios. Some employees that have their employer-sponsored accounts through fidelity may find SGVIX is the only government bond option available under tier 1 or tier 2. SGVIX has not done as poorly as I would expect based on the difference in expense ratios, but it still falls short compared to either intermediate treasuries or MBS. Fidelity does have good treasury mutual funds, like FLBAX, but employees are at the mercy of their retirement plans. The Wells Fargo Advantage Government Securities Fund (MUTF: SGVIX ) is one of the new tier two options for some employees that have their employer-based retirement accounts going through Fidelity. This is an area of interest for me because my wife recently received some literature on the new tiered options for her account. Since I handle my wife’s retirement accounts, she dropped the documents on my desk. That puts me in the unfortunate position of having to choose from a severely limited lineup of funds. The best mutual funds by fidelity have been removed from the options and investors that fail to either deal with more headache by creating a brokerage-link account or select new options will find themselves automatically defaulted to a target date plan based on their projected retirement age. There is nothing fundamentally wrong with target date plans. However, investors are stuck with being clumped together by age regardless of risk tolerance. If you are experiencing this kind of change to your retirement plan, you may notice some major problems with the literature sent out. For instance, in 19 pages there were precisely 0 actual expense ratios mentioned. If you happen to be given the same options that were available for my wife, this is the only government bond fund included in the tier 2 options. If investors want to assign an allocation specifically to government bonds, this is the only choice. Why You May Want Government Bonds Mid to long duration government bonds show a strong negative correlation with the stock market which makes them a great tool for diversifying portfolio risk. When an investor takes a small position in the long term government bonds they can immediately and materially reduce the total volatility of their portfolio because the bonds will often move up when the market moves down and move down when the market moves up. This is great for investors that would like to see a lower level of total risk and it makes government bonds a desirable asset class even though their interest rates are currently very low. For comparison sake, I ran a comparison including a couple of ETFs. I’m using the Schwab Intermediate-Term U.S. Treasury ETF (NYSEARCA: SCHR ) and the Vanguard Mortgage-Backed Securities Index ETF (NASDAQ: VMBS ). Hypothetical Portfolio I ran a quick hypothetical portfolio over the last 5 years and one month of data. Theoretically, the only reason you would own SGVIX is because it is the only option available, but for comparison sake I’m putting it in a very simple portfolio. (click to enlarge) You’ll see immediately that SCHR is offering a beta that is further into the negative territory which indicates that it will do better at offsetting the risk from a portfolio that is heavy on domestic equity. On the other hand you’ll see a lower beta for VMBS as investors may be less prone to buy into MBS when they are fearful of negative moves in the market. As a result, the negative beta is fairly low. The interesting thing about this sample period is that the total return on SCHR and the total return on VMBS are both superior to the total return on SGVIX. Correlation The chart below shows the correlation of each ETF or mutual fund with each other. Blue boxes indicate positive correlations and tan box indicate negative correlations. Generally speaking lower levels of correlation are highly desirable and high levels of correlation substantially reduce the benefits from diversification. You can see immediately that SGVIX has a higher correlation with SCHR than with VMBS and that makes sense since the portfolio in SGVIX better resembles SCHR than VMBS. The Holdings The chart below shows the holdings: (click to enlarge) As you can see, there is a mix of treasury securities and mortgage related securities. Due to that mix, I felt it was most appropriate to compare SGVIX with both a treasury ETF and a MBS ETF. Maturity The following chart shows the distribution of maturities in the portfolio. One major weakness here is that the portfolio is so heavily focused on the short term that it is incapable of providing a higher negative beta. The other issue is that such a strong short term focus results in weaker levels of income because the yield curve is currently providing materially higher interest by the time we look 3 to 7 years out than when we are looking at maturities under 2 years. Expense Ratio The biggest problem here, a reason that I expect SGVIX to consistently underperform similar investments is that the mutual fund carries a hefty net expense ratio of .49%. It is also showing a remarkable portfolio turnover rate of 349%. Despite heavy trading, it just can’t keep up with funds like SCHR which has an expense ratio of .09% or VMBS which has an expense ratio of .12%. Since the expense ratio is about .4% higher and the time period is about five years, I would estimate that it should underperform by about 2% during that time span. In that sense, the fund has done very well since it only underperformed VMBS by .4% and SCHR by .8%. The managers are creating value through intelligent security selections, but it is has not been enough value to pay for the higher costs. Conclusion Despite solid management, the expense ratio on SGVIX puts it in a constant uphill battle to try to stay even with lower expense options. Unfortunately, some investors may find their investing options severely restricted. The portfolio is designed reasonably well, but investors aiming to reduce portfolio risk as rapidly as possible would benefit more from using longer duration treasury ETFs to gain their diversification benefits with a smaller allocation. The only rationale I see for restricting investor’s choices is to push them into funds with substantially higher expense ratios. As I have been going over several of the funds, I’ve found the best options that were previously available have been entirely removed. It isn’t like Fidelity has no low cost long duration treasury funds. The Spartan® Long-Term Treasury Bond Index Fund – Fidelity Advantage Class (MUTF: FLBAX ) would have been a solid option and has an expense ratio of only .1%. For investors that have that fund as an option in their retirement account, I would take it in a heartbeat over SGVIX. FLBAX is far more volatile than SGVIX, but a beta of negative .47 means a fairly small allocation in the portfolio would be enough to counteract the positive betas from a portfolio that is heavily invested in the S&P 500 or a broad market index. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

Shock And Horror: Passive Hedge Funds

An academic article entitled “Passive Hedge Funds” has recently attracted quite a lot of comment in the Financial Times, Bloomberg, and on a variety of websites. Those whose ambition in life seems to be to discredit hedge funds and their managers at every turn have, of course, latched onto it. But the paper’s title is tendentious, its argument familiar and in some places flawed, and its conclusions really quite anodyne. Investors seeking hedge fund-like exposure through liquid alternatives will find that some products are similar to those described in that article; they should examine them very carefully before investing. The purported humor of math jokes often depends on the technical use of a term that has other, more familiar meanings. Thus, my college roommate’s knee-slapper about how every integer is interesting relied on a definition of ‘interesting’ as ‘having a unique property.’ The joke took the form of a mathematical induction: 1 is the multiplicative identity, 2 is the only even prime, 3 is the lowest true prime, 4 is the lowest perfect square… so if there is an uninteresting integer, it is interesting, because it is the lowest one. Maybe you had to be there. I am reminded of this moment of boundless mirth by a paper entitled ” Passive Hedge Funds ,” by Mikhail Tupitsyn and Paul Lajbcygier. This title has, inevitably, attracted comment, including headlines such as “Study: Hedge Funds Don’t Do S**t, Suck” (gawker.com) or, with less sophistication and élan, “New Study Argues Hedge Funds are an Even Worse Scam than We Thought” (vox.com) and even more prosaically, “The Case Against Hedge Fund Managers” (ai-cio.com). With the apparent exception of the latter, these commentators were so enamored by their deeply considered wisdom that they clearly felt no need to read the paper. Because its authors are quite explicit about their idiosyncratic use of the term ‘passive.’ They even put scare-quotes around it. The commentators just missed the punchline. It is hard to dispute Humpty Dumpty: “When I use a word, it means just what I choose it to mean ─ neither more nor less.” Since they take pains to explain what they mean by it, I have no argument with the authors’ use of ‘passive.’ They might have used ‘hippopotamus,’ which is more euphonious, but lacking poetic souls, they chose ‘passive,’ and missed the opportunity for a great title. The sense in which the authors use ‘passive’ to describe hedge fund return patterns is that they have linear correlation to hedge fund β. The crux of their argument is that “A manager with genuine investment skill should not only have “passive” linear risk exposures to alternative risk factors ( i.e ., alternative beta) but should also produce enhanced returns through nonlinear ‘active risk exposures.'” This is contentious, as will be seen below, but it is simply posited as a truth rather than justified. Was their choice of ‘passive’ tendentious and self-promoting? Of course: how else would a postdoc and an associate prof at Melbourne’s #2 university get noticed in the Financial Times or Bloomberg, let alone a temple to the Muses such as gawker.com? Was it helpful? Our commentators’ complete failure to understand the authors’ intent makes it rather obvious that it was not. The Tupitsyn and Lajbcygier article is, as their review of the literature makes clear, one of a long line of academic studies that propose models for hedge fund returns. Even critics more competent than our commentators tend to latch onto these studies as “proof” that hedge funds offer little value-added. But anything can be modeled ─ conventional mutual funds, sunspot frequencies, even (allegedly) the earth’s climate. Problems arise when, as Emanuel Derman and others have noted, the models are mistaken for reality. And hedge fund β ─ against which the authors argue hedge fund managers fail to add value ─ is, at best, a very peculiar concept, and arguably a spurious one. On consideration, the authors’ argument begins to look strangely circular: hedge funds fail to add value relative to metrics that derive from their own returns. This is something like arguing that I am a lousy swimmer because I am unable to swim faster than myself. I may well be a lousy swimmer, but comparison with my own performance will not establish that. A good portion of Tupitsyn’s and Lajbcygier’s analysis is devoted to returns on hedge fund indices. In choosing these as a database, they, like many before them, commit the fallacy of composition. The fact that you can calculate a mean return from a pile of reports does not indicate that there is such a thing as an average hedge fund: it is not only possible, but likely that none of the funds analyzed exhibited the mean return. Further, there is no reason to expect continuity from one time period to another: a fund whose return was close to the center of the distribution in one period may be an outlier in the next. Hedge fund returns are widely dispersed both synchronically and over time, so that the value of hedge fund indices is pretty much restricted to service as performance metrics for specific time periods. The standard error of the mean = s/√n, where ‘s’ is the σ of the population and ‘n’ is its size. Obviously, the error is significantly higher and thus the epistemic value of the mean significantly less, the more dispersed the population is. Given the wide dispersion of hedge fund returns, the value of their average is largely restricted to the bragging rights it gives to marketers fortunate enough to work for funds that have outperformed it. The authors are aware of these limitations, and devote some analysis to the returns of individual, real world funds. They find that most funds have strong linear exposures to familiar factor influences on investment returns. They conclude that “The nonlinear risk is more pronounced in arbitrage styles and styles following multiple strategies, and it is weaker in directional styles.” This should hardly be surprising ─ arbitrage is inherently non-linear ─ and it is not at all clear why the presence of linear risk in other sorts of strategies should somehow suggest dereliction of duty on the part of their managers. If, for example, a dedicated short fund carried no (negative) equity exposure, its investors would certainly have reason to object! Admittedly, fewer long/short funds make use of their ability to add value by adjusting their net exposure than might be expected, and with relatively stable long/short ratios, their exposure to equity risk factors would, of course, be linear. The same would be true of any long-only equity fund, and would certainly not attract criticism. In fact, long/short funds have increasingly tended to pursue a trading-oriented (“risk on/risk off”) response to changes in their risk perceptions in place of making changes to their short positions. As a group, hedge funds provide us with ample reasons to criticize them. Despite declining over the last few years, fees are in most cases still too high for the service provided. Lack of transparency inhibits rational analysis and portfolio construction, while providing a breeding ground for a wide range of abuses and sharp practice. The artificial mystique that this opacity fosters is repulsively reminiscent of Ozma of Oz. However, neither an adolescent potty-mouth nor accusations of fraud are not needed to make these points forcefully and to draw the appropriate conclusions for investors. Nor are “discoveries” that hedge fund α is not a matter of otherworldly powers to bend the laws of economics to the manager’s will ─ that their skills might be very similar in both nature and quantity to the skills that conventional portfolio managers exhibit. Tupitsyn and Lajbcygier have made a small contribution to the growing literature on hedge fund replication ─ nothing less, but certainly nothing more. Theirs is only one approach to hedge fund replication, and to my mind a less than satisfactory one. Factor replication is an inherently backward-looking approach to modeling, and when applied to the return streams from hedge funds, likely to result in some rather peculiar portfolios. A technique that I suspect has much more promise is the creation of robo-managers ─ algorithmic trading techniques that mimic the trading strategies hedge funds are known to pursue. Many hedge funds, particularly CTAs, are already effectively automated. While it is illegal to steal their code, it is possible to imitate it based on an analysis of their returns. In considering an investment in liquid alternative funds, many of which are “quantitatively-driven” in ways that are rarely specified explicitly and require research to understand, the nature of the security selection technique should be given careful consideration. Approaches similar to that of Tupitsyn and Lajbcygier are worth a look, but may not deliver all that they promise; the source of the factor exposures they purport to imitate must be investigated. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.