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.

A reasonable portfolio

A lot of effort in the investment space has gone into giving people advice about their proper asset allocation. There’s a good reason for that – academic studies have shown that over 90% of variation in returns is determined by asset allocation. As a result, there’s a lot of advice out there. Academics talk about efficient frontiers and Monte Carlo simulations. Companies such as Financial Engines and Betterment have come along to help people.

Me? I’m more in the William Bernstein camp. The problem is that the inputs to the models are unknown. Things like the risk premium accorded to equities and correlations between asset classes are not very stable over time. Plugging historical data seems unlikely to work – times change, there are different periods, and the future almost certainly won’t look like an average of the past. Having written a Monte Carlo simulator for these types of things, I can tell you that it’s mostly junk. The answers you get heavily depend on whether you think the risk premium for equities will be 4%, 4.5%, or 5%, or other such wonky inputs. I wouldn’t believe anyone who says they know which it will be.

So what do you do, then? I’d start with simply being diversified and rebalancing your portfolio yearly. Also, no matter what you decide, stick to it. You don’t want to introduce unnecessary churn, and you don’t want to chase performance.

Beyond that, here is a reasonable portfolio. It probably won’t be the optimal portfolio over any time horizon, but, hey – it’s worth what you paid for it, and it’s probably just as good as anything else you’ll see.

30% US Large Cap (iShares IWB)
15% US Small Cap (Vanguard’s VB)
20% International (Vanguard’s VXUS)
10% Emerging Markets (Vanguard’s VWO)
5% REITs (Vanguard’s VNQ)
10% Treasuries (iShares IEF)
10% TIPS (SPDR IPE)