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The Factor-Based Story Behind Successful Growth Funds

Summary Most large cap stock active fund managers underperformed their benchmarks in the 15 years to December 2014. Active large growth funds performed much better than large value funds vis-à-vis benchmarks. Virtually all of actively managed growth funds’ outperformance can be explained by quantitative multi-factor analysis. Americans have invested trillions of dollars in actively managed mutual funds in the hope of beating an index such as the S&P 500 or the Russell 1000 Growth. At Gerstein Fisher, we believe that markets tend to do a pretty good job of pricing risk and that most investors are better off “buying the market” (via an index fund) than trying to beat it. But we also think that there’s a better way to invest in equities than through either purely passive indexing or traditional active management. I’ll get to that method shortly after sharing summary results of a multi-step fund performance study that we recently conducted. Active Funds and Benchmarks We analyzed two Morningstar categories of funds, large cap growth and large cap value, from January 1, 1990 to December 31, 2014. During this 15-year period, 37% of the growth funds and 42% of the value funds disappeared-liquidated, merged, etc. We studied this aspect to eliminate survivorship bias in the study; obviously, funds that are shuttered by managers tend to be the poor performers. In the next step, we measured how many of the surviving funds outperformed their benchmarks during the 15-year time frame. Of the large cap growth survivors, 67.5% beat their benchmark (Russell 1000 Growth), while just 49% of the living value funds beat their bogey (Russell 1000 Value). All told, 42% of the large cap growth funds that existed in January 1990 beat their benchmark, compared to only 28% of large cap value funds. Moreover, the average outperformance for active growth was 2.14 percentage points per year vs. just 1.17 points for the active value funds. Two conclusions we can draw from this research are that 1) It is very difficult for professional portfolio managers to outperform an index, and 2) Growth appears to be the investing style that quite consistently performs best among actively managed funds. In fact, neither of these conclusions is either particularly new or surprising, as past research by Gerstein Fisher and others has amply demonstrated. See, for example, ” In Mutual Funds, is Active vs. Passive the Right Question? ” Explaining Outperformance But here is where the research gets really interesting. We conducted an extensive statistical analysis of the large cap growth funds that outperformed. We drilled down and studied whether quantifiable company characteristics, or “factors”, could be used to explain the outperformance. We honed in on just four factors– size, value, momentum and profitability-to measure the extent to which excess exposure (relative to the Russell 1000 Growth Index) to these factors could explain outperformance. I’ll digress very briefly to explain the theory and evolution of multi-factor investing. In 1976, Steve Ross published a landmark paper on Arbitrage Pricing Theory, which explained that security returns are best explained by more than one factor.* Since then, academics have identified dozens of quantifiable variables, such as momentum, that impact stock returns. In effect, even stocks from different industries that share similar such characteristics should generate similar returns. The Exhibit below illustrates the premiums over a 40-year period for the four factors we used to analyze the active growth funds. Note, for instance, that investors were historically rewarded with a 3-point premium (per year) for investing in more profitable companies and 3.5 points for being in smaller companies. (click to enlarge) Now back to our study. When we accounted for the momentum, size, value and profitability factors, we found that only 1.6% of the managers actually outperformed the benchmark (after adjusting for positive tilts to these four factors), or generated positive alpha (i.e., excess return of a fund relative to its benchmark). Another way of stating this is that 98.4% of the outperformers had higher factor exposure than the benchmark. For example, 95% of these winners had a positive tilt to value (relative to the Russell 1000 Growth Index) and 64% had higher-than-index exposure to smaller companies. Given this evidence that outperformance of active growth managers is almost entirely explained through their (witting or unwitting) excess exposure to certain factors, the next question is whether there is a rigorous, methodical, quantitative way to target certain factor exposures in order to outperform the index over extended time periods. We believe that there is-the Multi-Factor® quantitative investing style that underpins our three equity mutual funds. In the coming weeks, I plan to write a series of articles to elaborate on the principles and applications of multi-factor investing. In advance of that, I invite you to read a short piece we recently published on this investment strategy: ” What is a Multi-Factor Investment Approach? ” Conclusion Active fund managers have great difficulty beating passive indexes over long time periods. Actively managed growth funds perform well relative to benchmarks compared to value funds, but nearly all of the growth funds’ outperformance can be explained quantitatively by multi-factor analysis. *Finance students will recognize the factor-premium formula for portfolio return–+β11 +β22 +… … + β n n + –where portfolio return is described as the sum of the risk-free rate, factor exposures, and alpha. 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. I have no business relationship with any company whose stock is mentioned in this article.

China A-Shares: Worth The Wait?

MSCI decided last week not to include China A-shares on the MSCI Emerging Markets Index. The index compiler has decided to defer this decision until it sorts out outstanding issues with the country’s securities regulator. In the same week, data from EPFR Global showed that $9.3 billion was pulled out of emerging market funds and most was from China. This was the biggest weekly outflow in 15 years. Now, the Institute of International Finance (IIF) has warned that emerging markets may face more exodus as the US central bank approaches a “lift-off”. Before we focus on relevant mutual funds, let’s look into some other details. China A-shares The decision to not include China A-shares at least now comes as a temporary setback to China’s efforts to raise the standing of mainland capital markets and internationalize the yuan. China A-shares are listed in Shanghai and Shenzhen. These are denominated in yuan. However, this should be good news for other countries whose stocks are listed on the index. Emerging market investment instruments would thus gain, as this non inclusion will help keep the money flow to them. Outstanding Issues According to MSCI’s website, it will only include mainland shares after it resolves certain outstanding issues. The company said it will form a working group with China Securities Regulatory Commission, the country’s securities regulator for this purpose. Among the issues to be resolved were capital mobility, beneficial ownership details and restrictions on investment. The measured approach adopted by MSCI on A-shares has been praised by several market watchers and analysts. Restrictions on Investment Foreign investors still have to conform to restrictions on investments per the conditions laid down by authorities regarding the Shanghai-Hong Kong exchange link. This link which commenced in November provides investors with a brokerage account in Hong Kong with access to stocks listed on the mainland. However, foreign investors can purchase a maximum of net 13 billion yuan ($2.1 billion) of such shares per day. They are also subject to an aggregate quota of 300 billion yuan. MSCI has said that it will collaborate with Chinese authorities to ensure that such quotas correspond to the amount of assets under management of investors. Close coordination with China’s authorities will hasten this process, the index provider said. However, the announcement of the inclusion of A-shares and the implementation will be separated by a 12-month period. More Exodus On the other hand, IIF believes there may be more outflows from emerging markets. Jean-Charles Sambor, Asia Pacific director at the IIF, said: “We think the weakest emerging markets are likely to continue to suffer from pretty large outflows both on the debt side and equity side.” However, the outflows may be prominent for weaker economies having weak macro fundamentals. These economies mostly pertain to the Middle East and Latin America. Also, of the $9.3 billion outflows from emerging market funds, China equity funds accounted for $7.1 billion of the outflows. This probably hints that not all emerging market economies may be in a spot of bother. Short Term Setback Most analysts believe that this setback for A-shares is only short term in nature. Even though, the majority of market participants would have liked the inclusion to come much sooner, MSCI has sent out a clear signal. Fund managers would have to factor in the possibility of such a change taking place before 2016. In fact, China has already dealt with major concerns on market accessibility raised after last year’s MSCI review. Firstly, an announcement was made in November last year that shares bought via the exchange link will be temporarily exempted from capital gains taxes. Authorities have also reduced restrictions on having more than one broker. Additionally, they have also initiated a trial run of same day trading of select stocks. Funds in Focus If the setback is a temporary phenomenon, certain emerging market and pacific funds would continue to be great investments. The recent dismal performance should not be a cause for concern. Top-ranked funds with great fundamentals should be good additions to portfolios. In any case, the non-inclusion of China A-shares means money would stay with the other emerging market countries’ investment instruments. The following funds carry either a Zacks Mutual Fund Rank #1 (Strong Buy) or Zacks Mutual Fund Rank #2 (Buy) as we expect the funds to outperform its peers in the future. Remember, the goal of the Zacks Mutual Fund Rank is to guide investors to identify potential winners and losers. Unlike most of the fund-rating systems, the Zacks Mutual Fund Rank is not just focused on past performance, but the likely future success of the fund. They also have encouraging year-to-date and 3 and 5-year annualized returns. They carry no sales load and the minimum initial investment for these funds is within $5000. Matthews Korea Fund (MUTF: MAKOX ) seeks capital growth over the long-term. MAKOX invests a large chunk of its assets in common and preferred stocks of South Korea companies. The fund focuses on mid to large cap firms, but is not restricted to them. MAKOX currently carries a Zacks Mutual Fund Rank #1. MAKOX boasts year-to-date return of 12% while the 3 and 5 year annualized gains stand at 14.7% and 12.4%. Wells Fargo Advantage Asia Pacific Fund (MUTF: SASPX ) seeks capital growth over the long run. SASPX allocates a lion’s share of its assets in equities of companies located in Asia Pacific Basin. SASPX emphasizes on factors including earnings growth, financial condition and management efficiency for selecting companies. SASPX may also invest in participation notes. SASPX carries a Zacks Mutual Fund Rank #2. SASPX boasts year-to-date return of 9.3% while the 3 and 5 year annualized gains stand at 15% and 10.4%. Fidelity® Emerging Asia Fund (MUTF: FSEAX ) invests heavily in companies from emerging economies in Asia. FSEAX may also invest in other securities that are related to emerging markets of Asian countries. FSEAX focuses on acquiring common stocks of companies depending on factors such as economic conditions and financial strength. FSEAX carries a Zacks Mutual Fund Rank #2. FSEAX boasts year-to-date return of 7.2% while the 3 and 5 year annualized gains stand at 12% and 8.9%. Original article on Zacks.com

Not If, But When – A Breakdown Of MSCI’s Decision On China’s Onshore Equity Market

Summary On June 9th, MSCI stated that onshore Chinese equities will be added to their broad-based international indices. We believe investors should consider taking a position in the onshore markets today as international investment increases and China implements policies to sustain the onshore market rally. Three issues need to be resolved before immediate inclusion can take place. MSCI, a leading provider of index solutions globally, announced on Tuesday, June 9th that onshore Chinese equities will be added to their broad-based international indices upon the resolution of three outstanding issues. We previously wrote about the potential impact of this inclusion. As an MSCI client, KraneShares, along with several dozen mutual fund families and institutional brokers, attended MSCI’s Index Review Seminar, which was held the morning after the announcement. MSCI’s message at the seminar was clear; investors need to proactively prepare for the coming changes. Changes like the one MSCI announced on June 9th are rare, but when they happen they have historically driven performance in the affected economies. For example, in 2012 MSCI announced that it would include the United Arab Emirates in its emerging market index between 2012 and 2014; when the UAE’s inclusion was implemented, the MSCI United Arab Emirates IMI Index rose 238%1. This dwarfs the 130% rise the onshore Chinese markets have achieved since the rally began in the second quarter of 20142. We believe the onshore markets still have room to grow. Beyond MSCI’s decision, the recent surge in China’s onshore markets is backed by meticulous structural developments that have been decades in the making. We have listed a few examples of these developments below: Raising Domestic Consumption China’s policy makers are prioritizing increased domestic consumption in order to alleviate export dependency to the European Union and United States. Evidence of the policy’s success can be seen in China’s Year over Year retail sales data. According to China’s National Bureau of Statistics, retail sales in May increased 10.1% to $390 billion. The numbers indicate that China is catching up to well-established domestic markets like the United States. Additionally, the strong stock market has a trickle-down wealth effect on domestic consumption allowing Chinese investors to spend more freely. Stock Investing Replaces Housing China’s household savings rate is the third highest in the world at 51% of its GDP3. This rate is 300% higher than that of the United States4. Due to limited investment options in China, housing has traditionally been one of the most popular investment vehicles for Mainland Chinese citizens, which in return supported China’s urbanization policy. With housing softening, savings are finding a new home in the stock market. In fact, 4.4 million new onshore brokerage accounts have been opened by Chinese investors this year5. Monetary Policy China’s central bank has started to ease monetary policy. There have been two interest rate cuts and several adjustments to the reserve requirement ratio, which is the minimum amount of customer deposits that commercial banks must hold in reserve before making loans. The reserve requirement ratio was cut to 19.5% this year from 20% in 20146. More bank requirement cuts and targeted monetary policy are likely as policy makers continue to support growth. However, we do not believe that there will be more interest rate cuts because China’s leadership wants to keep the renminbi, RMB, stable ahead of the International Monetary Fund’s decision on the RMB’s inclusion into its basket of reserve currencies. Unlocking Shareholder Value in State Owned Enterprise Historically, China’s State Owned Enterprises, SOEs, have been undervalued compared to their privately owned counterparts. Unlocking shareholder value in state owned enterprises is a top policy in China today. This will take the form of increased mergers and acquisitions like the recent merger of China South Railroad with China North Railroad to form CRRC, one of the largest train manufacturers globally. Removing inefficiencies should raise the return on equity for State Owned Enterprises versus their private equivalents. We envision reform to heavily emphasize traditional sectors including industrials, basic materials and energy. One Belt, One Road Recently, China implemented the One Belt, One Road policy, which links Chinese manufacturers to Europe, Asia, Africa and the Middle East through improved overland transportation linkages and maritime port and logistic facilities. This spearheaded the launch of the Asia Infrastructure Investment Bank, AIIB, to help finance this policy. Debt Deleveraging China heavily restricted Initial Public Offerings and secondary offerings in the onshore markets for several years. Chinese companies had to rely on issuing debt to raise capital due to this limiting environment. The strong performance of the stock market allows new companies to list and for legacy companies to issue new shares. Proceeds can be used to pay down debt. The MSCI decision overview As the inclusion of the onshore market into MSCI broad indices has become a matter of when not if, China’s leadership is preparing its economy for massive inflows of foreign capital. Currently, China’s Securities Regulatory Commission, CSRC, is working with MSCI to address the three pending issues. The issues center around the programs China implemented in order to phase in the opening up of its economy. China has tightly regulated quota systems to allow foreign investors access to its onshore markets. The first program China launched was the Qualified Foreign Institutional Investor program, QFII, which gives specific foreign institutions access to the onshore markets. The second program to launch was the Renminbi Qualified Foreign Institutional Investor Program, RQFII, which is issued primarily to Chinese asset managers, and has been the catalyst for the launch of onshore China funds. China is gradually shifting focus from the QFII and RQFII programs in favor of even more accessible “connect” programs. The first connect program to go live was the Shanghai-Hong Kong Stock Connect that linked the Shanghai Stock Exchange to the fully internationally accessible Hong Kong Stock Exchange. We believe the Shenzhen-Hong Kong Stock Connect program should follow soon, which will make the entire onshore market fully accessible to international investors. The three issues: Quota Allocation Process: In its announcement MSCI stated that QFII and RQFII quota is still an issue because: “Large investors should be given access to quota commensurate with the size of their assets.”7 We believe this issue will be settled in the near future because quota restrictions are consistently being loosened. Capital Mobility Restrictions: The Shanghai-Hong Kong Stock Connect has a daily limit on the amount of stocks that can be purchased, which, if reached, could leave managers without access. MSCI would like to see this limit removed. Additionally the QFII program has a weekly redemption window, which MSCI would like to see increased to a daily window. Beneficial Ownership: Unlike ETFs and mutual funds, investors in separate managed accounts own the actual underlying securities held by their custodian. MSCI wants to ensure that investors with separate accounts are confident in their ownership in Chinese stock. Before the June 9th announcement there were lingering questions around how the onshore markets would be phased in. MSCI clarified that initially 5% of the onshore Chinese equities’ free float market cap would be included into their broad indices and that this weight will be increased incrementally. At full inclusion, China’s weight within MSCI Emerging Markets would be 43.6% overall, 20.3% Hong Kong listed companies, 20.5% onshore Chinese companies, and 2.8% U.S.-listed companies7. An incremental increase of onshore equities within broader indices is a logical strategy based on the large amount of money needing to be reallocated. We previously wrote about how the lack of a formal announcement on the Shenzhen-Hong Kong Stock Connect program could be problematic for inclusion. We suspect an official announcement about the launch of this program in the next several months. Ultimately the impediments are coming down as MSCI calls the launch of the Shenzhen-Connect program “imminent” and believes “further liberalization of the RQFII program”7 is coming. China’s leadership is motivated to continue opening up its economy to international investors. Having China’s onshore markets included into international indices helps bolster this goal. We believe investors should consider taking a position in the onshore China markets today as their inclusion within broad MSCI indices – and the accompanying international fund flows – are imminent and China is enacting policies to sustain the onshore market rally. 1 Return based off the MSCI United Arab Emirates IMI Index from January 2012 to May 2014. Definition: The MSCI United Arab Emirates Investable Market Index is designed to measure the performance of the large, mid, and small cap segments of the UAE markets. With 22 constituents, the index covers approximately 85% of the UAE equity universe. 2 Return based of the MSCI China A International Index from start of market rally 3/1/2014 through 5/31/2015. MSCI China A International Index Definition: The MSCI China A International Index captures large and mid-cap representation and includes the China A-share constituents of the MSCI China All Shares Index. It is based on the concept of the integrated MSCI China equity universe with China A-shares included. 3 Source: World Bank as of 2013 4 Source: World Bank as of 2013 5 Source: China Securities Depository and Clearing Corporation as of 5/2015 6 Source: CEIC Data as of 2/5/2015 7 Source for quote – MSCI, “Results of MSCI 2015 Market Classification Review” 6/9/2015 8 MSCI as of 6/2015 Disclosure: I am/we are long KBA, KEMP, KCNY, KFYP, KWEB. (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: ©2015 KraneShares Carefully consider the Funds’ investment objectives, risk factors, charges and expenses before investing. This and additional information can be found in the Funds’ prospectus, which may be obtained here: KBA, KFYP, KWEB, KCNY, KEMP Read the prospectus carefully before investing. Investing involves risk, including possible loss of principal. There can be no assurance that a Fund will achieve its stated objectives. The Funds focus their investments primarily with Chinese issuers and issuers with economic ties to China. The Funds are subject to political, social or economic instability within China which may cause decline in value. Fluctuations in currency of foreign countries may have an adverse effect to domestic currency values. Emerging markets involve heightened risk related to the same factors as well as increase volatility and lower trading volume. Current and future holdings are subject to risk. Narrowly focused investments and investments in smaller companies typically exhibit higher volatility. Internet companies are subject to rapid changes in technology, worldwide competition, rapid obsolescence of products and services, loss of patent protections, evolving industry standards and frequent new product productions. Such changes may have an adverse impact on performance. The ability of the KraneShares Bosera MSCI China A ETF to achieve its investment objective is dependent on the continuous availability of A Shares and the ability to obtain, if necessary, additional A Shares quota. If the Fund is unable to obtain sufficient exposure due to the limited availability of A Share quota, the Fund could seek exposure to the component securities of the Underlying Index by investing in depositary receipts. The Fund may, in some cases, also invest in Hong Kong listed versions of the component securities and B Shares issued by the same companies that issue A Shares in the Underlying Index. The Fund may also use derivatives or invest in ETFs that provide comparable exposures. The ability of the KraneShares FTSE Emerging Markets Plus ETF to achieve its investment objective is dependent, in part, on the continuous availability of A Shares through the Fund’s investment in the KraneShares Bosera MSCI China A Share ETF and that fund’s continued access to the China A Shares market. If such access is lost or becomes inadequate to meet its investment needs, it may have a material adverse effect on the ability of the Fund to achieve its investment objective because shares of the KraneShares Bosera MSCI China A Share ETF may no longer be available for investment by the Fund, may trade at a premium to NAV, or may no longer be a suitable investment for the Fund. The KraneShares FTSE Emerging Markets Plus ETF and KraneShares Bosera MSCI China A Share ETF may be concentrated in the financial services sector. Those companies may be adversely impacted by many factors, including, government regulations, economic conditions, credit rating downgrades, changes in interest rates, and decreased liquidity in credit markets. This sector has experienced significant losses in the recent past, and the impact of more stringent capital requirements and of recent or future regulation on any individual financial company or on the sector as a whole cannot be predicted. These ETFs may also invest in derivatives. Investments in derivatives, including swap contracts and index futures in particular, may pose risks in addition to those associated with investing directly in securities or other investments, including illiquidity of the derivatives, imperfect correlations with underlying investments, lack of availability and counterparty risk. The use of swap agreements entails certain risks, which may be different from, and possibly greater than, the risks associated with investing directly in the underlying asset. The KraneShares E Fund China Commercial Paper ETF is subject to interest rate risk, which is the chance that bonds will decline in value as interest rates rise. It is also subject to income risk, call risk, credit risk, and Chinese credit rating risks. The components of the securities held by the Fund will be rated by Chinese credit rating agencies, which may use different criteria and methodology than U.S. entities or international credit rating agencies. The Fund may invest in high yield and unrated securities, whose prices are generally more sensitive to adverse economic changes. As such, their prices may be more volatile. The Fund is subject to industry concentration risk and is nondiversified. The KraneShares E Fund China Commercial paper ETF invests in sovereign and quasi-sovereign debt. Investments in sovereign and quasi-sovereign debt securities involve special risks, including the availability of sufficient foreign exchange on the date a payment is due, the relative size of the debt service burden to the economy as a whole, and the government debtor’s policy towards the International Monetary Fund and the political constraints to which a government debtor may be subject. In order to qualify for the favorable tax treatment generally available to regulated investment companies, the Fund must satisfy certain income and asset diversification requirements each year. If the Fund were to fail to qualify as a regulated investment company, it would be taxed in the same manner as an ordinary corporation, and distributions to its shareholders would not be deductible by the Fund in computing its taxable income. Narrowly focused investments typically exhibit higher volatility. Internet companies are subject to rapid changes in technology, worldwide competition, rapid obsolescence of products and services, loss of patent protections, evolving industry standards and frequent new product productions. Such changes may have an adverse impact on performance. The KraneShares ETFs are distributed by SEI Investments Distribution Company, 1 Freedom Valley Drive, Oaks, PA 19456, which is not affiliated with Krane Funds Advisors, LLC, the Investment Adviser for the Fund.