Past performance is no guarantee of future results.
Those are the words found on every U.S. mutual fund and ETF prospectus, and they are the primary reason investors should not blindly chase performance.
This year is a primary example. According to Todd Rosenbluth, director of ETF and Mutual Fund Research, CFRA (which recently acquired the equity and fund research business of S&P), the equity funds that prevailed in the first half of 2016, namely, defensive income-oriented sectors of the S&P 500, have lagged in the second half, where more economically sensitive sectors have been leading the market higher.
Investors who had favored funds focusing on dividend-paying sectors such as telecom and utilities which gained more than 20% in the first half, saw those sectors forfeit more than half those gains during the second half of the year through October 14. Leading the market now instead is technology, which is up 10.4% year-to-date.
Ideally, actively managed funds, unlike indexes – especially sector indexes – have the flexibility to capitalize on market changes, rotating out of an overweight position in one sector or stock into another, but according to CFRA’s MarketScope Advisor platform, only 22% of actively managed large-cap funds have beaten the S&P 500 since 2007 and the pattern is holding this year as well.
Rosenbluth recommends that advisors focusing on the top-performing fund at any one period of time understand why the fund has outperformed, knowing whether it tends to skew more defensive, which often lags during cyclical times but does well in chopper times, or skews more aggressive, when the opposite is true.
Advisors also need to understand how a fund has changed its portfolio over time, says Rosenbluth. “If active management is doing great they’re shifting exposures and rotating in and out of sectors.”
For example, Fidelity Strategic Dividend & Income Fund (FSDIX), which gained 8.5% through the first half, is up 9.1% through October 14. It was underweight consumer staples and had a market weighting for utilities relative to the S&P 500 at the end of August, which helped performance in the third quarter.
In contrast, the Bright Rock Quality Large Cap Fund (BQLCX), is up just 5.2% through mid October following an 8.6% gain in the first half. Two of its top 10 holdings at the end of August – CVS Health and Verizon Communications — have lost value since then. Such experiences also argue for limiting the percentage of assets in any one particular fund.
The situation is a bit different for ETFs. Here, advisors need to understand the construction of the ETF, whether it’s market cap weighted, or evenly weighted, for example, says Rosenbluth.. If it’s equally weighted it will be rebalanced on a quarterly basis, selling its winners and buying more of the losing stocks.
“In that sense those ETFs [also known as smart beta ETFs], behave more like active management, but in an environment where winners continue to run and losers continue to fall they will lag,” says Rosenbluth.
Equal weighting of the S&P 500 has served the Guggenheim S&P 500 equal Weight ETF (RSP) well, which is up 7.8% through mid-October, compared to the iShares Core S&P 500 (IVV) ETF, which has gained 6.2%.
The Guggenheim ETF, for example, has an equal exposure to Gap Shares and Wal-Mart, which have moved in different directions since June – Gap shares are up; Wal-Mart shares are down — unlike IVV, which more heavily weights Wal-Mart given that its market cap is about 20 times that of the Gap ($213 billion compared to $10 billion).
But advisors should keep in mind that RSP charges 40 basis points, compared to just 4 basis points for IVV, notes Rosenbluth.
“Do your homework. Know what you own and why it’s different than a cheaper alternative.”
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