A fund’s duration can sometimes be a misleading measurement of interest rate risk if the bond fund has a meaningful weighting in convertibles, foreign stocks and bonds or derivatives. Haslem (2003) believes duration is a more accurate measurement when there are small interest rate changes. Duration tends to better reflect interest rate risk of portfolios of high quality bonds.
Fund popularity can be measured by percentage change in net cash flow over a stated period. Barbee (1999b) discovered unpopular funds had higher returns than popular funds from 1987-1998. Specifically, over 3-year periods, unpopular funds typically outperformed 78% of the time. In a separate paper, Ibbotson concluded picking funds that will outperform their benchmark is easier than trying to determine what investment style will perform best.
Bogle (1999b) concluded 92% of return shortfall for active managers was due to expenses. Expense ratio shows the percentage of fund assets annually spent for overhead (i.e., shareholder services, rent, administrative salaries, etc.) and management. The expense ratio does not include trading costs or reflect any bid-ask spread and does not include any sales commissions or purchase or redemption fees. According to Zweig (1997b), management (advisory) fees represent 60%+ of the total expense ratio.
In general, a currency futures contract locks in the exchange rate between two currencies. A company in one country selling products in another country can eliminate currency risk by purchasing a sufficient number of such futures contracts. Currency gains and losses represent a “difference in exchange value of the foreign currency and the domestic currency between the time the investment was bought and time it was sold” (Barron’s, 2014).
S&P 500 Sectors: Beta, Correlation, R2 & Weightings
Most of the information from Table 5 comes from State Street’s SPDR ETF website. SPDR ETF symbols are shown in parentheses. R2 figures are from Morningstar and represent fund categories; not shown are precious metals funds (R2 = 12) and natural resource funds (R2 = 77).
S&P 500 Sector Stats, November 2015
SPDR ETF Sector (symbol)
Barron’s defines R2 as a mutual fund term indicating “on a scale of 0 to 100, the percentage of a fund’s performance…explained by movements of its benchmark index.” For example, if the benchmark was the S&P 500, the typical large cap blend fund would likely have an R2 of > 90%. R2 can be used to gauge relevancy of a fund’s beta; the higher the R2, the greater the importance of beta.
For investors, serial correlation, also referred to as autocorrelation, measures predictability of returns from one period to the next. For example, if ABC returned 3% annualized over the past three years and then averaged close to 3% for the subsequent three years it would have a high serial correlation.
Systematic risk principle states expected return depends solely on asset’s systematic risk. Only the systematic portion is important when determining expected return (and risk premium). For example (Table 3), suppose you owned two assets:
Systematic Risk and Beta
Beta measures market risk, also known as systematic risk. A 1992 Journal of Finance article by Fama and French, The Cross-Section of Expected Stock Returns, shows past and current beta are not a good predictor of future beta—at least when it comes to individual stocks. Fama and French suggest stock betas tend to mean revert; a stock with a past beta of 1.5 or 0.8 should tend to move toward 1.0 in the future.
Risk-Return Characteristics of a 100 Stock Portfolio
A 2004 AAII Journal article by Daniel Burnside, How Many Stocks Do You Need to be Diversified, points out even a 100-stock portfolio will have a high level of return deviation: “a single security selected at random would have an average tracking error in its monthly return of 5.5% from a cap-weighted index…even a portfolio of 100 stocks will deviate from its target index by an average of 0.60% per month for the value-weighted approach...corresponds to an annualized deviation of ~ 2.1%.”