Wednesday, February 11, 2009

Mutual Funds Fees are Too High

This study on mutual funds, Identification And Performance of Equity Mutual Funds with High Management Fees and Expense Ratios by Haslem, Baker and Smith, finds that economies of scale are not generally shared with fund holders because the market lacks the competitive pressures to drive fund expense downward. This is due to product a variety of product differentiation strategies that probably have little correlation to a funds future sucess.

Active vs Passive

Another perspective on the active vs passive debate. Typically, its a toss-up before fees and a loosers game after. Good managers do exist but they cant be uncovered simply by looking at past performance.

Friday, February 06, 2009

Active Manager Underperformance in 2008

If your actively managed investment funds underperformed dramatically and collectively in 2008, Wurts & Associates developed a presentation which describes what happened. Their points may be useful in putting 2008 benchmark relative results in context for your investment committee.

Thursday, February 05, 2009

Target Date Retirement Funds - Best Practices

According to testimony before the Advisory Council on Employee Welfare and Pension Benefit Plans, evaluating Target Date Funds(TDF) is challenging, difficult, complex and one-size-does not fit -all. Best practices noted in the testimony

• the single most important decision is the design of the glide path of the TDF
• active/passive management, value customization and participant impacts are other important factors in considering the utility of TDFs
• TDF’s must be evaluated periodically (most often quarterly).
• fiduciaries should compare TDFs to their peers and relevant benchmarks,
• communications that effectively explain the TDF so participants clearly understand the underlying investments and how the glide path works is important also,
• a plan sponsor should consider what levels of defined benefit, Social Security benefit or other pension benefit that participants are likely to have,
• the design and structure should be compared to the plan’s unique demographics,
• consider individual participant risks - participants need to understand the limitations of these funds,
• customization will be big in the future,
• annuity type options or managed payout type funds are going to become more and more prevalent,
• benchmarking is a problem. Focus should be on trying to define a “process” for evaluating these things and not relying on one particular measure to monitor it,
• one firm’s TDFs would be appropriate if the plan sponsor is comfortable with the overall philosophy and that should not change based on the target date of the fund,
• looking at the underlying funds that may make a TDF could be illustrative since the underlying funds have likely been in existence long enough to build up a track record,
• liquidity of certain investments in a TDF may be a challenge,
• consider using different TDFs from different vendors,
• carefully evaluate costs,
• Plan sponsors should ask vendors for an investment policy statement,and
• sponsors should strive to maximize the number of participants who reach a minimum level of income replacement in retirement.

Mutual Fund Family Performance

Many publications provide periodic data or rankings on composite mutual fund family performance. A question arises as to whether investment fiduciaries should derive comfort or concern from these lists.

For instance, in a recent WSJ article, the performance of the 10 largest mutual fund families was profiled. The fund family rankings were based on asset weighted excess returns over their morningstar style box from the market peak in October 2007. The article acknowleges that "this overall scoring may have little correlation to your personal investment results" though they point out that "the results give some indication of how each complex has served its investors overall since the market peak".

The provides its own ranking of fund families based on its rating system which they indicate should "provide a solid framework for making informed, timely investment decisions".

There is often dissonance between lists. For instance, The Street's top performing fund family with more than 100 rated funds rates a 2.6 under the Morningstar ranking system where "the scores range from 1.0 to 5.0. A score below 2.5 is an indication that the firm has met with little success in that asset class. A score between 2.5 and 3.5 indicates the firm is about average".

All performance rankings have limitations, especially those based on short time periods. Family fund rankings have even less value since they dont reflect the characteristics of any specific investment strategy. They are simply an artifact of a set of asset class, investing process, research and outlook biases that may be correlated across funds in a family.

Investment fiduciaries whose investment programs, such as 401(k)'s, hold many investments from a single fund family may not be fully meeting their fiduciary responsibility to diversify plan assets. A study by Elton, Green and Gruber, "The Impact of Mutual Fund Family Membership on Investment Risk" finds:
"evidence that mutual fund returns are more closely correlated within than between fund families. As a result, restricting investment to one fund family leads to a greater total portfolio risk than diversifying across fund families. The increased correlation is due primarily to common stock holdings, but is also more generally related to families having similar exposures to economic sectors or industries. Fund families also show a propensity to focus on high risk or low risk strategies, which leads to a greater dispersion of risk across restricted investors. An investor considering adding an additional fund either inside or outside the family would need to believe the inside fund offered an additional 50 to 70 basis points in return to achieve the same Sharpe ratio."
Using fund family ranking information to assess the merits of an investment progam would be like selecting a job candidate by interviewing her family. Though some general traits may be "genetic", investment performance and therefore fiduciary attention should correlate to the unique characteristics of each investment fund.

Monday, February 02, 2009

401(k) Tweets

A new 401(k) program ranking tool, Brightscope, is now available on line. According to the firms press release;
"The new BrightScope Rating is a quantitative 401k plan rating developed by BrightScope, Inc. in partnership with some of the country's top independent fiduciaries, finance professors, and 401k experts. BrightScope Ratings take into account over 200 unique data inputs per plan and calculate a single numerical score to define 401k plan quality at the company level. The ratings algorithm runs thousands of simulations for each 401k plan in order to determine how quickly each plan will propel the average 401k participant to retirement. Using this rigorous approach, BrightScope ensures that every factor that affects retirement outcomes - such as company generosity, fees, investment menu quality, vesting schedules, and more - is accurately reflected in a company's rating. The site provides open access to 401k ratings, allowing anyone to compare any 401k plan with another."
Proclaiming the value of true transparency and disciplined benchmarking, the firm indicates that;
"Plan sponsors who use BrightScope can demonstrate to their employees, their board, their retirement committee, and to regulators that they are taking the necessary steps to improve the quality of their 401k plan."
Unfortunately, transparency isnt very transparent when a proprietery and presumably undisclosed process generates rank results. Fiduciaries would not be wise to rely on a quantitative "black box", especially one designed by industry experts....because we have seen where that will lead. The quality and timeliness of plan data inputs have been a persistent problem in past plan comparability efforts. A database that relies on voluntary data of unknow quality or stale but offical public domain data shouldn't necessarily be relied upon for fiduciary decision making either.

Perhaps, when a comprehensive suite of federally mandated investment and plan disclosures becomes available on a close-to-real-time basis and its ranking criteria and standards are revealed, a tool like this will have real value. Until then it will be an interesting curiosity.

While their intentions may be good and the output is interesting, Brightscope seems to sacrifice meaningful detailed information and a transparent ranking process for mindless usability. That may be a wise tradeoff to capture the eyeballs of the twitter generation but probably won't support its goal of being a fundamental fiduciary support tool that plan sponsors could really use.