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Apparent Value Added By Fund Management<br />
This element is the approximate value that appears to be<br />
added to the fund by the portfolio management process.<br />
Analysts eventually will be able to break down the performance<br />
contribution of active managers in a variety of ways.<br />
For example, with clean data it is possible to calculate the<br />
value added by the transactions the fund manager has made<br />
to change the <strong>com</strong>position of the portfolio during a quarter<br />
or a year, or to <strong>com</strong>pare the beginning of the period portfolio’s<br />
performance with the performance of an index. There<br />
is scope for ingenuity in analyzing an active manager’s<br />
ability to add value or highlight aspects of the investment<br />
process that have worked less well. As the availability of<br />
fund data from SEC filings improves, analyses of transaction<br />
costs and value added by a fund’s investment process will<br />
be<strong>com</strong>e more sophisticated. For example, the value added<br />
by fund management will be broken down into a number<br />
of distinct <strong>com</strong>ponents and a noise element. The total<br />
apparent value added is a residual in the example in Figure<br />
2. When we subtract the net tracking error (-1.88 percent)<br />
from the total of the cost elements in the left column (-2.65<br />
percent), we get a total for the positive elements of (+0.77<br />
percent). Adding the market timing loss (-0.02 percent), we<br />
get an apparent value-added residual of (+0.79 percent) for<br />
the fund manager’s efforts.<br />
What Is The Significance Of Figure 2?<br />
Figure 2 is simply an illustration of the kind of fund performance<br />
breakdown that is theoretically possible today and<br />
will ultimately be routine. To the extent that tracking error<br />
is measured relative to a reasonable benchmark, the costs<br />
incurred by the average fund will cause the net tracking<br />
error to be negative. The breakdown into cost and performance<br />
elements and <strong>com</strong>parisons to other funds and other<br />
managers will enhance the fund selection process. A fund<br />
analyst’s ability to perform this kind of analysis—and even<br />
more detailed breakdowns—depends on the fund industry’s<br />
adoption of a new data standard: XBRL.<br />
I will cover XBRL in depth in the next and final installment, to be published in the March/April issue of the Journal of Indexes.<br />
Endnotes<br />
1 Gastineau, Gary L., and Kritzman, Mark, “The Dictionary of Financial Risk Management,” Frank J. Fabozzi Associates (now a division of John Wiley & Sons, Hoboken, New Jersey),<br />
1999. See pp. 283-284.<br />
2 In addition to the indexes for the Sector SPDRs, the Nasdaq 100 capitalization weightings are modified to make it RIC <strong>com</strong>pliant. The price-weighted Dow Jones Industrial Average<br />
is usually RIC <strong>com</strong>pliant without modification, but it dropped out of <strong>com</strong>pliance at the end of March 2009.<br />
3 The constraints will be relatively tight for an index fund, but they should not discourage an index fund manager from trading away from the implementation time of an index<br />
change. In many large index funds, avoiding the official index implementation trading frenzy is akin to an opportunity to pick up money from the sidewalk.<br />
4 Israelsen, Craig L. and Gary F. Cogswell, “The Error of Tracking Error,” Journal of Asset Management, March 2007, vol. 7, No. 6, pp. 419-424 appropriately argues that the magnitude<br />
of tracking error (standard deviation version) is not a suitable performance indicator for active managers. I agree, and I use tracking error (performance difference version) only<br />
as an organizing framework.<br />
5 The most popular measure is prior period performance.<br />
6 See Edelen, Roger M., Richard Evans and Gregory B. Kadlec, “Scale Effects in Mutual Fund Performance: The Role of Trading Costs,” unpublished working paper, March 17, 2007.<br />
7 A fund that <strong>com</strong>bines small foreign holdings with a largely domestic U.S. portfolio may have an adverse tax effect for some of its shareholders that can be avoided by a fund that<br />
holds predominantly non-U.S. securities. Global funds with predominantly U.S. holdings are often tax inefficient for U.S. investors.<br />
Israelsen continued from page 45<br />
<strong>com</strong>ponents (in terms of dollar account value). Accordingly,<br />
the account balances will be<strong>com</strong>e disproportional over time<br />
(as demonstrated in Figure 3). The equity and equitylike<br />
portfolio <strong>com</strong>ponents (REITs and <strong>com</strong>modities) will tend to<br />
dominate the portfolio. This can be advantageous if, in the<br />
latter years of a portfolio, the equity-based assets perform<br />
well. But, if equity and equitylike assets suffer declines, the<br />
investor can experience heavy losses because of his disproportionately<br />
large allocations in equity.<br />
This potential portfolio imbalance can be solved by the<br />
active strategy of rebalancing. When equity assets have<br />
strong annual gains, their excesses are diverted (i.e., rebalanced)<br />
to the fixed-in<strong>com</strong>e <strong>com</strong>ponents of the portfolio<br />
(bonds and cash). Because bonds and cash seldom have<br />
negative returns, the gains are preserved in a fixed-in<strong>com</strong>e<br />
“lockbox.” As investors age, the notion of a lockbox be<strong>com</strong>es<br />
very appealing. During equity market downturns (i.e., 2008),<br />
the bond and cash portfolio <strong>com</strong>ponents—which have been<br />
systematically replenished through active rebalancing—will<br />
have sufficient reserves to provide needed liquidity.<br />
Summary<br />
The upper limit (or maximum parameter) of active-passive<br />
investing is an annualized return of 30 to 34 percent. This<br />
requires perfect luck or perfect foresight, neither of which<br />
represents a defensible tactical active strategy. By contrast, a<br />
portfolio with a randomly selected index at the beginning of<br />
each year generated a 9.05 percent annualized return over the<br />
39-year period from 1970-2008. This type of random active-passive<br />
portfolio represents a more logical performance threshold<br />
against which actively managed funds should be measured.<br />
Rebalancing a multi-index passive portfolio represents an<br />
“actively passive” portfolio that outperforms a passive-passive<br />
multi-index portfolio. Rebalancing represents a potent<br />
active strategy that seldom receives the attention it deserves.<br />
Rebalancing is often simply assumed to be a good idea. This<br />
research has quantitatively demonstrated just how good it is.<br />
More importantly, rebalancing is an active strategy that passive<br />
investors can probably live with.<br />
Most passive investors may recognize that they are, in<br />
fact, actively passive.<br />
www.journalofindexes.<strong>com</strong> January/February 2010<br />
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