Taking Crazy Pills
Who cares about Derek Zoolander anyway? The man has only one look! Blue Steel? Ferrari? Le Tigra? They’re the same face! Doesn’t anybody notice this? I feel like I’m taking crazy pills!
- Mugatu in "Zoolander"
Recently I attended the meeting of an investment committee that oversees a large pool of money. They are using the "endowment model," which I've written about before. What stood out to me were the fees charged by some of the active equity managers. For example, the small cap value manager is charging 1.3% per year. On $900 million in assets, the fund manager is making $11-12 million/year. Good work if you can get it.
So, for this cost, what is the fund manager delivering? Let's run some regressions.
Below are the results of a four-factor regression using monthly AQR data on a rolling 36-month basis. I tried other time periods (rolling 24- and 48-month) and the results don't really change. I started the regression Oct. 2010 because it was the lowest common inception date. All data are gross of fees.
The r-squares are high enough to give me some confidence in the explanatory power of the regression. Market and size exposure have the biggest impact on returns, followed by the value factor. The r-squared for the active fund increases to 91% if I use AQR's adjusted factors HML-DEV and QMJ. (1)
Both the active fund and the Vanguard fund show positive alpha before fees.(2) Unfortunately, neither has statistically significant alpha. The active fund's alpha has t-stat=1.82 and p-value=0.07. So I'm paying 1.3%/year for small-cap and value factor exposure, but no alpha. Re-running the regression from fund inception date did not change the results (except that the t-stat and p-value of the active fund's alpha got worse).
This seems like a bad deal for the investor. If I want small-cap and value factors, I can buy them for 0.20%. Versus the active fund, I've just improved my return by 1.1% before compounding.
And yet, the active manager has $900 million in assets and pulls $11-12 million per year in fees. I feel like I'm taking crazy pills. Also: maybe you and I should reconsider our life choices.
The investment advisor to the big pool of money argued that the active fund has better upside/downside capture than others. The active fund has about 90% of the upside of the Russell 2000 Value index, and 80% of the downside over 3- and 5-years versus about 1:1 for the other funds.
Well, okay, maybe? In my mind if I'm buying equities or particular factors, I want full exposure in the most cost-effective way possible. My key risk hedging tool is the bond portion of my portfolio, and I can buy this hedge for less than 1.1%/year.
(1) Side note, here's Morningstar's basic data for these funds:
I guess this tells me... something? The 'Since Inception' numbers don't mean much because these funds started at different times. Three- and five-year periods don't mean much because those time-frames are relatively short. There's no ten-year period shown because only two of the funds have been around that long. And yet, this was about the extent of the "analysis" available to me when I worked as a stockbroker.
(2) The results for the Vanguard fund (VIOV) may be the result of different underlying indices. The S&P Small Cap 600 Value index has a much bigger tech sector component, whereas the Russell 2000 Value has larger financial services and real estate sector exposure.
(3) I will judge you if you do not like "Zoolander."
Full Disclosure: Nothing in the above should ever be considered to be advice, research or an invitation to buy or sell any securities.