|"The Implications of Style Analysis on Mutual Fund Performance Evaluation"|
John C. Bogle, Founder and Chairman, The Vanguard Group
Starring: TIC-TAC-TOE Also Featuring: Pascal, God, Chess, and War Games
Morningstar Investment Conference
June 13, 1997
Consider the child's game tic-tac-toe. There is simply no way to win, even if a genius is playing against an opponent of only moderate intelligence. Each player, in turn, simply blocks the other player's previous move. (Of course, if one player is dull-witted or bereft of the power of concentration, a loss is easily accomplished.) In short, as a game that cannot be won, only lost, tic-tac-toe is the ultimate loser's game.
Exhibit I: Tic-Tac-Toe
This analogy quickly brings to mind one of the truly seminal articles about the challenges of investment management in increasingly efficient financial markets. Written by Charles D. Ellis, founder of Greenwich Research Associates, and published in the July/August 1975 issue of The Financial Analysts Journal, it was called, of all things, "The Loser's Game." In his article, Mr. Ellis observed:
"The investment management business is built upon a simple and basic premise: professional managers can beat the market. That premise appears to be false. The ultimate outcome (of the game) is determined by who can lose the fewest points, not who can win the most. Money management has been transformed from a Winner's Game to a Loser's Game."
When the article was writtennow more than two decades agothe Standard & Poor's 500 Index was virtually the only standard used by institutions to measure market returns. (Even it wasn't used very often!) And in those ancient days, the portfolios of most institutional managersand most mutual fundswere dominated by a blended list of the large cap stocks in the Index. In this modern day and age, however, other styles have developed, some with extreme emphasis on value or growth, or on medium or small cap stocks. Given variations in investment performance among these styles (at least over interim periods) and in volatility risk (in all periods), it seems only good judgment to compare "like with like."
To date, most mutual fund performance evaluations have been fairly simplistic: how has a fund performed relative to "the market"? The Standard & Poor's 500 Stock Index is usually used as a proxy for the market, despite the fact that it accounts for only about 70% of the capitalization of the U.S. stock market and is dominated by corporations with gigantic market capitalizations. (Its largest 25 stocks account, on average, for 1% of the entire market; the 6500 "non-500" stocks in the market have an average weight of 4/1000 of 1%.) But today, many funds resemble "the market" only tangentially.
So, under the concept of style analysis, a mutual fund is compared not with "the market," but with its peers following a similar investment style. For many years, this analysis was used by institutional investors via a box with a vertical axis running from large to small market capitalization, and a horizontal axis running from value to growth (usually based on ratios of market-to-book value or price-to-earnings). Each account got an "X" somewhere along each axis. It wasn't very complicated, but neither did it make it very simple to evaluate comparative performance.
Exhibit II: Institutional Style Box
Enter Morningstar. Its contributionand it is, as advertised, "a more intelligent way to select and monitor mutual funds"was to divide the simple box punctuated with dots into a nine-box matrixjust like tic-tac-toewhere each fund is, in effect, forced into one of nine boxes: large, medium, or small capitalization on the vertical axis; value, blend (mixed), or growth on the horizontal axis. The beauty of this system is that it immediately becomes possible to quantify the vital statistics of each fund's performance relative to its peers. Large cap growth funds are compared with other large cap growth funds; small cap value funds are compared with other small cap value funds; and so on. And, under the Morningstar system, each fund then gets a Category Rating, ranging from "one" (lowest 10%) to "five" (highest 10%)both, therefore, are very tough leagues to break into. Here is the current mix of the 741 equity funds with five-year records followed by Morningstar, which makes their detailed records remarkably accessible through its incredible Principia data base. This is the first of nine tic-tac-toe boxes I'll present today:
Exhibit III: Number of Funds (741)
But the Morningstar Category Rating System does accurately reflect general differences or similarities in return among the various categories. In the past five calendar years, interestingly, similarities were in the driver's seat. Only large cap growth funds (annual returns averaging about +12%) strayed from the +13% to +15% returns of all the other groups. Returns for each of the nine categories are shown in Exhibit IV.
Exhibit IV: 5-Year Return (%)
Exhibit V: Standard Deviation (%)
As Exhibit VI shows, the differences in risk-adjusted return ratings are also extremely widein fact, exactly 100%, from 120 for large blend funds to 60 for small growth funds. To make the point clear, if two funds had an equal volatility of 10%, a fund with a 120 risk-return ratio would return 16%, while a fund with a risk-return ratio of 60 would return 10% (assuming a risk-free rate of 4%). This is hardly a trivial difference.
The risk-adjusted return ratings among the nine boxes vary widely, largely reflecting the differences in the risks of the nine market segments during the period.
Exhibit VI: Risk-Adjusted Return Ratings
Now let's take a look at what happens when we begin to evaluate equity funds on the basis of their investment styles, as measured by their Morningstar categories. I'm going to use returns and standard deviations of return for the past five calendar years for this analysis in performance appraisal, and I'll try to answer the questions of what conclusions flow from style analysis. My first example is the Large Capitalization Blend Group -- mutual funds investing in giant companies with both value and growth characteristics. This category is composed of more than twice as many funds as any other group (211 of 741 funds analyzed over the five-year period), and some 40% of the assets of all domestic equity funds ($450 billion of $1.2 trillion of equity assets in the Principia data base), so it provides a solid platform on which to begin the analysis. Here is how the performance looks, ranking funds into four quartiles based on total returns for the period:
Exhibit VII: Large Capitalization Blend Funds (Ranked by Return)
We can see that even though returns rise, risk in this category remains virtually unchanged, with standard deviation remaining remarkably constant over the quartiles. Obvious result: the risk-adjusted return ratio increases by the same magnitude as the total return, from a ratio of 95 to 141 -- fully 46 points from the lowest to the highest. This 50% difference, dare I say, is "statistically significant." As it happens, this outcome for this large cap, blend (middle-of-the-road) fund category is typical. Seven of the nine categories (the exceptions are small cap value and medium cap growth) have fairly steady risk scores, whether returns are high or low. Hence, the top risk-adjusted ratings are consistently earned by the funds with the highest total returns.
The previous table, of course, is simply a recounting of the past. But as I looked at the data, I wondered whether there was an element that might have been used to determine in advance which large cap blended funds might most likely fall into the various quartiles. Of course, my first thought (this will hardly astonish you!) was whether relative fund operating expenses would not give an investor some forecasting ability. So, I divided the funds into cost quartiles, with funds with the lowest expense ratios comprising the first quartile, and the funds with the highest ratios comprising the fourth quartile. I don't think it will surprise anyone who has seriously studied investment returnseither from a theoretical academic basis or from pragmatic industry experiencethat costs matter.
In fact, the funds in the group with the lowest expense ratios had the highest net returns. At the same time, they assumed an identical level of risk (volatility), and therefore provided distinctly higher risk-adjusted returns. Here are the same data that I presented earlier, but arrayed by expense quartiles.
Exhibit VIII: Large Capitalization Blend Funds (Ranked by Cost)
Now, we seem to be on to something important. With risk astonishingly constant, high returns are directly associated with low costs. The risk-adjusted ratings provided by the lowest expense funds, in the large cap blend group, at 136 were more than 13% above the average of 120; the returns provided by the highest expense funds were 13% below averagea 26% spread. Clearly, expenses are a compelling factor.
Given this finding, I decided to add the expense ratios to the net returns to see how similar the gross returns would have been. Again, perhaps unsurprisingly, the gross returns in each quartile were substantially the same.
Exhibit IX: Large Capitalization Blend Funds
Net Returns vs. Gross Returns(%)
This example clearly confirms the theory that cost is a key determinant of relative total return.
Now the question is: do these relationships between return and risk prevail across the style boxes? The answer: they do, and they do so remarkably well. This next table shows the percentage difference between the risk-adjusted returns of the first quartile (lowest expense) funds and the fourth quartile (highest expense) funds, using the average risk-adjusted rating for that style box as the standard. For example, in the large cap blend category, low expense funds had risk-adjusted returns 13% greater (113) and high expense funds 13% lower (87) than the average.
Exhibit X: Relative Risk-Adjusted Return Ratings
The strong implicationif not the virtual certaintyof these figures is that, in each of the nine style boxes, an investor who doesn't seriously consider limiting selections to funds in the low expense group, and eschewing funds in the high expense group is someone who should take off the blindersperhaps even a bit of a fool.
The mutual fund world is one in which forecasting relative (to say nothing of absolute) returns based on past performance is indeed a fool's gamein general, a zero sum relative game. And past performance is all we have . . . almost. But we do have cost data, for those willing to look at it. And we now knowI would argue, as a certaintythat costs matter. It matters for equity funds in the aggregate; far more, to be sure, for bond funds; and infinitely moreindeed cost is virtually everythingfor money market funds. (But those groups are beyond the scope of my talk today.) And we know that it mattersindeed it is a prime differentiatorin the nine-box equity style analysis whose pattern parallels the surface of a tic-tac-toe game.
So, why not take the position that investors should act on the full implications of the thesis that costs matter. Because the lowest cost funds out there in the marketplace are index funds, why not just buy index funds in each of the nine style boxes? It is hardly a specious argument.
This matrix shows both the return and risk of a low-cost index fund in each of the nine boxes, compared with the average return of the equity funds managed in that style. The index funds are operating index funds in the three large cap groups (Standard & Poor's Indexes), and hypothetical index funds based on publicly produced indexes (with returns reduced by estimated fund costs of 0.3%) in the medium and small cap groups (Frank Russell Indexes). This pair of tables reflect the spreads of risk and return in each category:
Exhibit XI: Indexes vs. Funds: Returns and Risks (Percentage Points)
The net result is that the risk-adjusted ratings averaged 124 for the index group and 99 for the regular funds--an average premium of fully 25% in risk-adjusted return. It is a strikingly consistent premium, one that is remarkably parallel across the matrix. The relative risk-adjusted ratings are so dramatically in favor of the low-cost index approach as to defy even the most optimistic (or, for active managers, pessimistic) expectations. Here, there are no exceptions whatsoever to the pattern. Indeed, its magnitudes are so devastating to the concept of high-cost active management that I, for one, could barely believe the figures. But we've checked them "eight ways to Sunday," and correct they are:
Exhibit XII: Risk-Adjusted Ratings of Indexes vs. Equity Funds
Lest this difference seem unimportant, at the 25% level the annual return
in two funds with the same 10% standard deviation would be +16.5% for the
nine passively managed index funds versus +14.0% for the actively managed
traditional fundsa truly remarkable enhancement of 2.5 percentage points
per year. Much of this spread, of course, is accounted for by the lower expense
ratios and lower portfolio transaction costs for index funds. (Further, of
course, the index funds would also come hand in hand with substantial tax
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