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Who is making money from your investments? Agustin J. Fleites, CFA
May 2013
Abstract
The mutual fund industry makes it difficult for investors to assess the relative value derived from investment in their funds. This paper evaluates the long-‐term value derived by investors in Large Blend funds as classified by Morningstar. By addressing the limitations of performance universe comparisons, the challenges posed by survivorship bias prevalent in many published universes, and the impact of fund costs and taxes investors will gain a better understanding of who is making money from their funds. Over the last fifteen years the average actively managed Large Blend fund lost 47% of wealth generated to taxes and fund expenses. With investors struggling to build nest eggs, costs must be reduced and assets put back to work for their rightful owners.
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About Beta Capital Advisors Beta Capital Advisors LLC develops innovative investment programs to help investors meet their asset allocation objectives. The firm offers a differentiated approach to achieve competitive, well-‐diversified, low cost, and tax-‐efficient core asset class exposures. BCA also supports institutional and individual investors establish investment policy statements, develop strategic asset allocation plans, review investment programs, and conduct advisor due diligence. For institutional clients, BCA is uniquely qualified to provide advisory services relating to the design, structure, launch, and distribution of ETFs and related index-‐based investment products. About Agustin J. Fleites, CFA Agustin J. Fleites is Founder and Managing Director of Beta Capital Advisors LLC. An industry leader in the fields of asset allocation, passive investment strategies, and the development and application of Exchange Traded Funds, Gus has dedicated his career to the application of passive investment approaches to meet the asset allocation needs of investors. Gus established and managed the Asset Allocation group at SSgA, one of the world’s largest institutional asset managers, where he worked with pension plans, endowments, foundations, and government organizations to develop and implement their investment programs. He was also responsible for the development and launch of two of the most successful ETF platforms, SSgA and ProShares, where he led the development, management, and distribution of over 40 ETFs across the U.S., Europe, and Asia-‐Pacific. He and his teams introduced many of the most innovative and successful products trading today, including the SPDR Gold Trust (GLD)-‐the first commodity ETF and the first family of levered and inverse ETFs, and were responsible for the management and distribution of the world’s largest and most actively traded ETF, the SPDR (SPY). Gus and his family live in the south shore of Massachusetts where they are active in the local community. He is a graduate of the Wharton School of the University of Pennsylvania (BSE), Babson College (MBA), and is a Chartered Financial Analyst. © Beta Capital Advisors LLC
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Who is making money from your investments? Today’s economic environment has driven many to seek greater value in the goods and services they consume. With mutual funds capturing the majority of consumer investment dollars, can we assess their relative value? Can investors make their investments work harder? Large Cap Blend Segment The mutual fund universe (excluding money market funds) is quite diverse with close to twenty thousand funds (including all share classes) and assets of $9.8 trillion as of March 31, 2013. In this paper we will focus on assessing the relative value of funds classified as Large Blend by Morningstar, with $1.3 trillion in assets across 1,506 funds. This segment includes all funds with principal exposure to large capitalization US equities with neither growth nor value characteristics dominating. The segment typically represents the largest allocation in investors’ equity portfolios, and is the largest, and arguably the most competitive, segment in the mutual fund industry. Relative value can be assessed across multiple dimensions. Here we will focus on relative performance of funds versus their peer universe. We will include all actively managed funds with reported assets, including multiple class shares, to reflect the entire universe of choices open to investors in the Large Blend segment. Index funds are excluded to preserve the integrity of comparison across active funds. We will also evaluate the costs of holding these funds, assessing their expense ratios and tax holding costs. This analysis can help answer how much investors are paying for the performance generated by their funds. Analysis will be average asset weighted to reflect investors’ historical choices and not unduly represent less meaningful funds.
Index Fund Proxy Benchmark for Segment We will also indirectly compare peer performance to the S&P 500 index, a capitalization weighted-‐index representing the aggregate risk/return profile of the securities typically held by mutual funds in this market segment. While an index is not directly investible, it is possible to gain exposure through index mutual funds and exchange traded funds. We will use the Vanguard S&P 500 Index Fund as a proxy for the index. The fund replicates the holdings of the index but is also impacted by transaction costs, expense ratios, and taxes investors experience in their investment activities, allowing for a fair comparison with more actively managed funds. We selected this fund for its extended track-‐record (inception date 8/31/1976).
The ability to invest in the broad market through the Vanguard fund establishes a base from which to evaluate costs and performance for other funds. In principle, investors should be willing to pay a premium for excess performance over the market, but should they pay more for underperformance? Peer Universe Comparison Table 1 summarizes performance for all funds categorized by Morningstar as Large Blend. As of March 31, 2013 Morningstar classified 1,240 funds with one-‐year performance and 276 funds with a
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fifteen-‐year track-‐record in the segment. From the table it appears that there is significant value to be harnessed investing in the stronger funds. While the percentiles vary over time, for the last fifteen years over 50% of all funds beat the market index as proxied by the Vanguard 500 fund, with the average top two fund quartiles earning an attractive return premium to the Vanguard 500 fund. While the average top two fund quartiles have expense ratios that are approximately four-‐ to five-‐times that of the Vanguard 500 fund, the premium appears well deserved. Before reaching final conclusions, however, it is important to understand material limitations to peer universe comparisons and conduct more in depth research on the composition and dynamics of the large blend market segment.
Style Purity Style purity poses a significant challenge for peer universe comparisons. While there are 276 funds with a fifteen-‐year track record classified as Large Blend as of March 31, 2013, only 100 funds were consistently classified as large blend funds over the entire period (see Table 2 below). What happened to the other funds? Their managers may have been shifting exposures across different market segments. If such is the case, these funds should be assessed differently than those funds with more consistent risk exposures. They should be evaluated on the manager’s effectiveness reallocating assets across market segments and then the ability to generate value within the segments selected, an exercise beyond the scope of this study. But for certain, it is not appropriate to include these funds in a universe of funds that maintain consistent risk exposure to the Large Blend market.
The above table adjusts the initial peer universe to limit participation to those funds maintaining consistent exposure to the Large Blend segment as defined by Morningstar. While adjusting for style purity does not have material impact over the short-‐term, for longer term horizons the Vanguard 500 Fund becomes progressively more difficult for the active funds to beat. With a more homogeneous universe, the relative performance of the Vanguard 500 Fund improves from upper 38th percentile to 32nd percentile over ten-‐years and from 51st
percentile to 33rd percentile over fifteen-‐ years. Adjusting for style consistency substantially narrows the range of funds generating long-‐term excess performance versus the Vanguard 500 fund and highlights the strength of the proxy index fund generating competitive performance at a fraction of the cost of most other competing funds. Tax Costs Another shortcoming for peer universes is that they do not reflect the impact of taxes investors may be
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subject to. Fortunately, Morningstar computes the pre-‐liquidation, after-‐tax return for mutual funds. The calculation assumes investors will continue to hold their funds but pay taxes on dividend and capital gain distributions at the highest marginal income and capital gains rate applicable at the time of distribution. It also reflects the impact of any sales charges imposed. There is no attempt to capture any state or local taxes on distributions. From Table 3, over the fifteen years ended March 31, 2013 the average fund captures 71% of the pre-‐tax return after reduction for applicable taxes, representing an annualized performance reduction of 0.99% over the fifteen-‐year period. Another way to express this figure, Uncle Sam took on average 29% of the average performance for fifteen years! The index fund lost one-‐third as much (10% versus 29%) to taxes over this period.
While the tax efficiency of funds broadly varies, the inherent advantage is clear for lower turnover index funds to minimize tax impacts. Adjusting for tax consequences, the Vanguard 500 fifteen-‐year performance rank improves from 33rd to 14th percentile, continuing to narrow the field of funds producing excess performance relative to the market index fund.
Persistent Value-‐Add? Peer group comparisons are but a snapshot of performance at a given point in time; there is no information to help discern persistent ability to add value relative to peers over extended time horizons. For instance, top quartile performers in Table 1 may not reflect the same funds over the different time horizons represented. Moreover, today’s top performers may have little or no relation to past and future leaders. With evidence of performance persistence investors would focus on finding projected strong performers and then benefit from a long-‐term buy-‐and-‐hold strategy. Without evidence of persistence, the problem becomes more complex as investors need to continuously evaluate the universe of available managers and reallocate assets to projected future performers. Is there evidence of performance persistence in the Morningstar Large Blend universe? Table 4 provides ten-‐year performance rankings as of the first quarter of 1999, 2003, and 2008 for the universe of funds consistently classified as Large Blend. The table then illustrates the subsequent ten-‐year ranking of the initially ranked funds in subsequent five-‐year increments. At 3/31/1999 there were 53 funds with ten-‐year track-‐records through Q1 2013 consistently classified as Large Blend. By 2003 23% of the funds had been reclassified to a different style and 13% had become obsolete (liquidated or merged). Of the initial funds ranked in the top quartile, by 2003 only one-‐third maintained their ranking (8/25). By 2008, another 21% had been reclassified, 21% were obsolete, and only 16% maintained their top quartile ranking (4/25). As of the first quarter 2013, a further 9% of funds had been reclassified, 45% were obsolete, and about one-‐fourth of the funds maintained their top quartile ranking (6/25). As of 3/31/2003 there were 56 funds with ten-‐year performance through Q1 2013 consistently classified as Large Blend. By 2008 14% of the funds were obsolete and 2% had been reclassified, with 44% maintaining their top quartile ranking (11/25). By 2013, another 41% were obsolete, 4% had been reclassified, and only 20% maintained their initial rank (5/25).
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By 2008 there were 164 funds with ten-‐year track records classified as Large Blend. Five years later, 34% of the funds were obsolete, 5% of the funds had been reclassified, and about approximately one-‐fifth of funds maintained their initial top quartile rank (5/25). A few other interesting observations: while the majority of funds that became obsolete were initially ranked in the bottom or third quartiles, a not insignificant number of more attractively ranked funds also became obsolete in subsequent periods; funds rotated across quartiles in both directions, while not in significant numbers, bottom quartile funds moved up the rankings in subsequent periods; and despite the base universe already reflecting only funds consistently ranked as Large Blend, fund numbers continued to be whittled down as more were reclassified over time. Unfortunately there is little evidence of persistence in the long-‐term performance of large-‐capitalization, blend mutual funds. From Table 4 very few funds were able to maintain consistent rankings.
Curiously, for each year between March 31, 1999 to the first quarter of 2013, the Vanguard Index fund never ranks below the median fund for ten-‐year performance (8 top quartile and 7 second quartile). The challenge of identifying persistent outperformers appears a daunting one. With the list of funds demonstrating ability to generate long-‐term outperformance growing substantially narrower, we now learn that persistence in maintaining strong performance across multiple time periods is rare. Survivorship Bias Peer universes also do not provide an indication of how dynamic participation within the universe might be over time. From Table 1 we know there are 276 funds with a fifteen-‐year
track record classified as large-‐cap blend funds on March 31, 2013. With the benefit of hindsight we know over 50% of existing funds outperformed the index fund over that period. What the table does not illustrate is the number of funds that were created, became obsolete (either closed or merged into other funds), or were removed from the Large Blend universe for changes in style over this time frame. A bit of research reveals that over the last fifteen years, close to 2,500 funds (594 unique funds) were launched in the Large Blend segment (as currently
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defined). From Table 5 we learn that over the period 1,776 funds became obsolete and 175 were no longer classified as large blend by the end of the period. As of March 31, 2013 only 276 active (only 100 of which maintained consistent classification throughout the period) and 67 index funds remained classified as Large Blend.
While hindsight has 20-‐20 vision, in real time an investor was faced with a more challenging task identifying those funds expected to perform well. Compounding the difficulty of identifying persistent outperformers, we now add the dynamic entry and exit of funds to the challenge investors faced seeking attractive funds. Finding the proverbial needle in the haystack may be an apt analogy!
Taxes and Fund Expenses Table 6 summarizes the impact of costs on a $10,000 investment over longer-‐term horizons in the universe of funds consistently classified as Large Blend. For the five-‐, ten-‐, and fifteen-‐ year periods ending March 31, 2013 the Vanguard 500 fund generates after-‐tax wealth that would consistently place in or near the upper quartile of the universe. What is troubling to learn is the share of wealth created that is lost to taxes, sales charges, and fund expenses. The average fund loses 25-‐47% of wealth generated, with weaker, bottom quartile funds losing 37-‐69% of overall wealth generated. An investor in the Vanguard 500 fund, in turn, captures substantially more of the gross wealth generated over the period, losing 8-‐16% to taxes, sales charges, and expenses. For non-‐taxable (or tax-‐deferred investors), only the impact of fund expenses is relevant. Even here the advantage of the index fund is clear. While the average fund loses 12-‐20% of its accumulated wealth to fund expenses and the top decile and
quartile funds lose 8-‐15%, the Vanguard 500 loses only 2-‐4% of its value, a significant asset retention improvement for the index investor. Conclusion Appearances can be deceiving! A more careful analysis of the Morningstar Large Blend universe highlights the importance of comparing funds with peers of similar style and risk and understanding the impact of costs and taxes. While peer performance universes provide a summary snapshot they do mask the challenges investors face in selecting attractive funds from a universe experiencing significant turnover and with little evidence of sustainable long-‐term value-‐added. Absent a high degree of confidence in the continuous selection of successful mutual funds, index-‐based products may offer the strongest potential to participate in the long-‐term performance of large blend equity markets. Index funds can work harder for you, generating competitive long-‐term results and substantially reducing the proportion of wealth lost to fees, sales charges, and and taxes.
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Notes: