Morningstar Advisor - February/March 2011 - (Page 49)

Selling Beta as Alpha By Samuel Lee Why large fund families charge active prices for closet indexers. If history is any guide, equity investors can look forward to mediocre returns. The U.S. market only yields 2% and historically has grown dividends by 1% a year. Throw in 2%–3% inflation and investors are looking at a 5%–6% expected return over the long run. The bond market is no safe haven, either; the BarCap Aggregate Bond Index yields 2.6% and faces the near certainty of rising interest rates. In this environment of diminished expectations, it’s even more important for clients to avoid putting their money in the hands of funds that hug benchmarks while charging high fees. In this article, we put the spotlight on 10 big closet indexers and offer alternatives, both active and passive, and explore why some fund companies are prone to closet indexing. We then suggest ways to find truly active funds. Active Share We calculated year-end active shares for all of the non-sector, non-specialty, active U.S. equity funds with more than $500 million in assets and 10-year histories, then narrowed the list down to the 10 largest funds whose 2010 active share (as of the third quarter) and trailing five-year active share were below 60%. Our list produced funds from nearly every major fund family (Exhibit 1). The funds collectively represent more than $200 billion in assets and are on track to rake in more than $1.4 billion in the coming year for hugging their benchmarks. They charge, on average, 0.71% annually; investors can buy the Vanguard Total Stock Market ETF VTI and pay only 0.07% annually. Barring radical changes by fund management, investors in these funds are on track for mediocre performance. Some funds we fingered as index huggers still edged out their benchmarks. What gives? While the funds largely indexed their stock exposures, they successfully timed their shifts between stocks, cash, and bonds to produce excess returns. We think they still deserve to be called closet index funds and viewed through a skeptical lens. Study after study shows that market-timing funds, in aggregate, destroy value, whereas stock-pickers can add value. It’s also hard to make much of a market timer’s record, because excess returns can come from a few lucky calls. American Funds Growth Fund of America AGTHX is the quintessential beta fund. It holds a slug of international stocks and has permanent stakes in cash and bonds, making it more like an aggressive allocation fund. A large-growth fund holding a big portion of cash and bonds usually will have, over the long run, better risk-adjusted returns than a pure growth fund thanks to the powers of diversification. The fund’s average allocation over the past five years is 71% U.S. stocks, 17% foreign stocks, 10% cash, and 2% bonds. We compared the fund’s returns from January 2005 to the end of October 2010 against a spliced benchmark of 10% iShares Barclays 1–3 Year Treasury Bond SHY, 2% iShares Barclays Aggregate Bond AGG, 71% iShares S&P 500 Growth Index IVW, and 17% iShares MSCI EAFE Index EFA. Growth Fund of America’s allocation at the beginning of the period is very close to this distribution, so the benchmark doesn’t suffer from look-ahead bias. We averaged the allocations to test whether American’s managers had any timing ability. If its managers could time shifts between assets to take advantage of relative valuations, its performance over the period should exceed its average exposures. The fund realized 3.19% annually, while the spliced index trailed with 2.95%, albeit with lower volatility; their Sharpe ratios were 0.053 We can unmask benchmark-hugging funds by calculating their active share, an ingenious measure of a fund’s active bets devised by Yale finance professors K.J. Martijn Cremers and Antti Petajisto. Active share measures the percentage of a portfolio that differs from its benchmark, with 0% meaning perfect index replication and 100% indicating pure active bets. The professors define closet indexers as funds with active shares of 60% or less. 49

Table of Contents for the Digital Edition of Morningstar Advisor - February/March 2011

Morningstar Advisor - February/March 2011
Letter From the Editor
First, Do No Harm
Do You Use Active or Passive Investment Strategies?
Best of Both Worlds
How to Build an Index
Accountable Investor
Nice Guys Finish First
Four Picks for the Present
Investment Briefs
A New Guardrail Against Risk
Tech Loosens the Purse Strings (a Bit)
It’s More About Costs Than Active or Passive
Play Your Stars
In Between Active and Passive
Selling Beta as Alpha
The Weighting Game, and Other Puzzles of Indexing
Leaving the Nest
Redefining Credit Risk
Another Vote for Market-Based Credit-Risk Measures
Big Opportunities in Small-Cap Stocks
Benchmarks? What Benchmarks?
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
VA Sales Slide, but Assets on the Rise
Indexing’s Lunatic Fringe

Morningstar Advisor - February/March 2011