While as fund managers you may not want index clones, some active funds have lagged peers and incur risks from big sector positions.
U.S. equity-focused fund managers had a strong 2013, with the average fund rising 34%, and mid-cap funds climbing even higher. However, while most year-end reviews highlight what worked best, it can often be educational to look at the laggards to see what can be learned from these funds as well. In many cases, the funds toward the bottom of their respective mid-cap peer groups ended up there by their managers taking significant risk at the sector level.
We have had numerous discussions with fund managers over the last four years since we at S& P Capital IQ introduced our holdings-based, quantitative star ranking methodology. One thing we noticed is that the vast majority of U.S. equity managers start with an individual stock selection process, seeking the best investment ideas according to certain criteria. The problem for investors who have chosen a manager in the latter camp is that the returns relative to the benchmark and to peers can gyrate sharply year to year if the highly weighted sectors are out of favor, adding risk.
Why would a manager take big sector positions? Well, according to S& P Capital IQ Dow Jones Indices' persistence scorecard, for the three-year period ended September 2013, only 20% of mid-cap funds maintained a top-half ranking over three consecutive 12-month periods, whereas random expectations would suggest a 25% success rate. This showing highlights why passively managed ETFs that seek to replicate a widely known benchmark at a much lower cost have gained traction. Perhaps taking a larger position relative to the benchmark may be a way for an active fund manager to stand out. (S& P Capital IQ operates independently from S& P Capital IQ Dow Jones Indices.)
High exposure to industrials was common in 2013.FPA Paramount is managed by Gregory Herr and Pierre Py. The mid-cap core fund rose 27.8% in 2013, which might be impressive in most years, but lagged the 34.5% peer average and the 33.5% gain of the passively managed iShares Core S& P Mid-Cap ETF that seeks to track the S& P MidCap 400 Index. Relative to the S& P Capital IQ 400 Index as of September 2013, FPRAX had larger weightings in industrials (40% of assets vs 16% in the index) and information technology (26% vs. 16%), with no exposure to financials (22% of the index) and just minimal exposure to energy and materials (13% combined for the index).
During 2013, the S&P 400 Index was led by health care, consumer discretionary and industrials stocks, with information technology and material stocks, while up on average, were notably behind the "400".
According to FPA's website, the managers select and value individual stocks based on the fundamentals of their underlying businesses and concentrate on the best ideas, typically 25-50 stocks; as of September 2013 there were 27. In 2012, the fund's 16% gain outperformed its peer average's 15.6% return.
Meanwhile Delafield Fund run by J. Dennis Delafield and Vincent Sellecchia, is also a concentrated portfolio, with typically 30 such holdings. During 2013, the mid-cap value fund rose 29.1%, lagging the 35.9% peer average. Delafield Fund also has significant exposure industrials, but also materials stocks. In contrast, the fund had no exposure to health care and minimal exposure to energy and financials. According to the fund's website, Delafield and Sellecchia seek undervalued companies that they believe are influenced by special situations, such as management changes, mergers and acquisitions, or hidden or unappreciated assets. The approach has worked at times in the past; in 2012, like FPRAX, DEFIX outperformed its peer average, rising 20.2% compared to 17.5%.
Taking large sector positions also worked out in 2013. For example, John Barr of Needham Aggressive Growth, who runs the mid-cap core fund, had 70% of fund assets in information technology stocks as of September 2013. According to Needham's website, Barr focuses on companies with long-term sustainable growth prospects and that offer disruptive products or services. So it is not surprising to us that technology stocks are well-represented and the fund's approach worked last year, with the 36.3% gain outpacing the 34.5% return for the mid-cap core fund average. Balancing out tech stocks is some exposure to Health Care and Industrials. However, five of the sectors each represented 1% or less of the fund's assets, according toS& P Capital IQ.
Barr, like the other managers highlighted in this piece, invests with a long-term horizon, evidenced by a recent 15% turnover rate, and has not always outperformed peers. Indeed, the fund's 14.6% gain in 2012 was 94 basis points behind the peer average and its 13.8% decline in 2011 was off by some 1000 basis points.
S& P Capital IQ's mutual fund rankings include coverage of over 7,500 U.S. equity share classes, taking into account a fund's relative performance record over the past three years as well as analysis on the underlying holdings from a valuation and risk perspective leveraging proprietary tools such as S& P Capital IQ STARS and S& P Capital IQ Quality Rankings.
A fund is not rewarded or punished in the ranking process for taking large sector positions. However, this can make it hard, we believe, for a fund to consistently generate strong performance compared to peers that are more cognizant of sector weightings from a risk-control perspective.
Todd Rosenbluth is S& P Capital IQ's director of ETF & mutual fund research.