Investigations into improper advice

Ari Rosenbaum's always informational blog recently brought my attention to an article from Drinker Biddle detailing recent "investigations of broker-dealers related to their services to ERISA retirement plans."

The main points are:

1. That brokers and RIAs can act as plan fiduciaries even if they don't acknowledge that they are acting as plan fiduciaries, such as by giving individualized advice.
2. That these same brokers and RIAs could give prohibited advice by recommending a fund when, for instance, they receive "soft dollar" payments.

We think good data can be a part of helping brokers and RIAs show that the funds that they recommend to plans can be trusted.  And we think that plan sponsors can use good data to ensure that the advice they get from brokers and RIAs.

Fidelity Contrafund: How do they do it?

Motley Fool has a recent article by Selena Maranjian about closet indexing.  It does a great job of setting up the problem - indexing is good, but you should pay a low index fund price for it.

The problem, as we have discussed before, is identifying the funds that are closet indexing.  Ms. Maranjian suggests two different ways - looking at top ten holdings or looking at R-squared.  Looking at top ten holdings has obvious limitations when funds often have hundreds of holdings.  And we've discussed the shortcomings of R-squared in this space before.

So what is interesting about this article is that it presents us with a nice little mystery - Fidelity Contrafund.  As Ms. Maranjian points out, "Fidelity Contrafund, for example, has an R-squared of 94.87%, but it has significantly outperformed the S&P 500, on average, over the past five, 10, and 15 years." Taking a look at the top ten holdings as of 9/30/2011, I see recognizable, large companies like Apple, Google, Disney, Berkshire Hathaway, Wells Fargo, and Coca-Cola.

So how does Contrafund manage to outperform?  Ms. Maranjian chalks it up to a few good picks in stocks like priceline.com, Dollar Tree, and Chipotle.  But Contrafund had 453 holdings as of 9/30 - I don't think three good picks tell the whole story.

So I dug through Contrafund's Q1 2011 disclosures to the SEC to get a better idea of how they're doing it.  Morningstar classifies Contrafund as a US Large Cap growth fund, and it's easy to see why when looking at the top ten holdings list.  But it's complete list of holdings tell a different story.  I counted 27 stocks traded on the Hong Kong exchange including not-exactly-household names like "Hengdeli Holdings Ltd." and "Luk Fook Holdings International Ltd."  I also counted 16 Brazilian stocks including "Mills Estruturas e Servicos de Engenharia" and "Diagnosticos da America."  Even it's US holdings are not universally large cap, with small cap holdings like "Gardner Denver, Inc." and "Clean Harbors, Inc."

So my guess of how Contrafund achieves its outperformance while still having a fairly high R-squared is that its large positions are in US Large Cap growth.  However, it "juices" those returns through smaller investments in higher returns categories like small caps and emerging markets.

Now Contrafund definitely isn't a closet indexer.  But it is a style violator.  Why should you care?  Because you carefully select your asset allocation and rebalance annually.  When you select Contrafund as your US Large Cap growth exposure, you're not counting on this hidden overlap with your small cap and emerging markets exposure, so you're not getting the lack of correlation that you should get.  That will lower the effectiveness of your rebalancing going forward.

Finding closet indexers

Academic studies have shown that closet indexing is a big problem.  Studies like the one described in the influential Cremers and Petajisto paper show both that many funds closet index and that funds that do closet index tend to underperform.

So how do you avoid these bad funds?  Christine Benz at Morningstar recently wrote a post answering the question of whether an investor can look at the R-squared of the fund to determine if a fund is a closet indexer, specifically Selected American Shares.  Benz references the Cremers and Petajisto study's active share measurement of holdings overlap to claim Selected American Shares is not an index tracker.  However, R-squared is useful when detecting closet indexers as demonstrated in the recent Amihud and Goyenko paper.  Are we to believe that Selected American's poor recent performance aligning with it's rising R-squared is a coincidence?

Still, Benz is right to point out that R-squared is not a perfect mechanism to use to detect closet indexing.  (Neither is Active Share, but that's a point for a different blog post.)  For one thing, R-squared is calculated based on past performance.  Monthly returns are typically used, meaning you need a good chunk of data (several years) to get real significance.  This means it will fail to find closet indexing that is more short-term.  Studies such as the one done by Chevalier and Ellison suggest that mutual fund managers may closet index to "lock in" a good year.  Such closet indexing may only last a quarter or so, and would therefore go essentially undetected by R-squared.

Using correlated funds for tax-loss harvesting

Abraham Bailin posted a nice write-up on tax-loss harvesting complete with an example trade of selling one fund to book a loss for tax purposes and using the proceeds to buy another fund with a 0.99 correlation to the sold fund.  However, the write-up does not mention how to find these highly correlated funds.

There are no convenient sources for this data today, but Inveska will change that.  Inveska will make it easy for advisors to find statistically correlated funds so they can help their clients tax-loss harvest effectively.

New fiduciary rules coming

At recent post at AdvisorOne by Sherry Christie is among many discussing new rules that could extend the fiduciary standard to brokers.  It seems inevitable that some kind of rule change will happen, although it remains to be seen whether it will be a full fiduciary standard for brokers.

However, no matter what the new rule is, we think it will be important for brokers to prove to their clients that the mutual funds they recommend can be trusted.  Inveska will help them do that.