(PUB) Investing 2015

October 2015 Vol. 24 No. 2

FundInvestor Research and recommendatio s for the s riou fund investo

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When Funds Get Bloated

In order to test predictive power, I grouped funds by their bloat ratio and then tracked returns over the ensuing five years. I looked within large-cap U.S. funds, mid-cap U.S. funds, and small-cap U.S. funds. I backed out expense ratios for the test in order to isolate bloat. One positive effect of asset growth is that expense ratios usually fall, so I wanted to keep that out of the equation. I also excluded funds under $100 million, as they are less likely to survive and less likely to be considered by many investors. I looked at funds over a number of rolling three-year periods in order to capture a variety of market environments. I then looked at the average of those periods to understand what was going on. Small Caps Are the Most Bloat-Sensitive We grouped small-cap funds by decile, then looked at ensuing returns, success ratios, alphas, three-year Morningstar Ratings (or “star ratings”), and informa- tion ratios. Only the star rating is after expenses (as well as adjusted for risk and loads). The pre-expense returns for the least-bloated decile were 11 . 51% annualized versus 10 . 04% for the most- bloated decile. The information ratio was 0 . 31% for the least-bloated decile versus 0 . 23% for the most- bloated. The least-bloated decile had a star rating of 3 . 04 versus 2 . 69 for the most-bloated. The success ratio for the smallest bloat decile was 43% , and for the bottom it was 35% . The success ratio tells you what percentage of the group survived and outper- formed its peers. It is a way of preventing survivorship bias from creeping into the data.

RusselKinnel, Director of ManagerResearch and Editor

Fund Reports

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Has asset growth altered your fund’s strategy? Has it done so to the point where it starts to hurt performance? These are the questions that the bloat ratio aims to answer. The bloat ratio is a figure I came up with years ago to dig into issues of liquidity and trading costs. The raw ingredients for bloat ratio are the fund’s turnover ratio, the fund’s top 25 holdings and the number of shares it holds, and the average daily trading volume for those holdings. First, divide the average daily trading volume by the number of shares owned by the fund. That tells us how many days’ trading volume the fund owns. The bigger the number, the less liquid the position. If a fund owns, say, 10 days’ trading volume of a stock, it might take months to get out without crushing the price. Then, we take the average of the fund’s trading volume figures and multiply by the turnover ratio. (That 10 days’ trading volume position might be manageable for a fund with 10% turnover, but the trading costs will likely be steep for one with 100% turnover.) That gives us the bloat ratio. It has merit both for descriptive and predictive power. It helps you understand the fund’s bloat relative to peers. In addition, changes in the bloat ratio can signal changes in strategy, including those brought on by asset bloat.

Fidelity Small Cap Discovery Matthews Pacific Tiger PIMCO Total Return Tweedy, Browne Worldwide High Dividend Yield

Morningstar Research Buy Stock-Pickers, Avoid Sector-Rotators, Part 2

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The Contrarian

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Freshly Minted Medalists

Red Flags

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These Funds Are Not Worth the Price

Market Overview

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Leaders & Laggards

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Manager Changes and News

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Portfolio Matters 16 7 Common Withdrawal Mistakes

Tracking Morningstar

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Analyst Ratings

Income Strategist

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When the Fed Raises Rates

Changes to the 500

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FundInvestor 500 Spotlight

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