Vanguard money market funds Vanguard Research Brief October 2015

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Opal Shaw
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1 Global equity benchmarks: The Are prospectus buck stops benchmarks here: the correct barometer? Vanguard money market funds Vanguard Research Brief October 215 Key points n Around the world, both global and international 1 active equity fund managers use a wide variety of benchmarks to measure performance. n In many cases, the benchmark selected by an investment manager as a proxy for fund performance may not be the best reflection of the manager s actual investing style. When evaluating an active fund or manager s performance, investors often assume that the fund s benchmark, as identified in the prospectus, accurately reflects the investment mandate s goals, risk posture and opportunity set. But what if the chosen benchmark didn t truly reflect such characteristics, and any outperformance stemmed from the fund s exposure to higher-risk assets and not from manager skill? Knowing this would help investors determine whether the fund truly complements their existing portfolio over the long term. Using regression-based style analysis, we looked at active global, international and emerging market equity funds to determine how well prospectus benchmarks represented the funds mandates, whether enduring investment biases existed, and whether performance measures changed when applied to a better-suited benchmark. Our analysis incorporated Australia, Canada, Hong Kong, the United Kingdom and the United States. For each fund, we identified a best-fit, or customised, benchmark based on five global market segments that don t overlap. 3 We then analysed fundperformance characteristics using both the prospectus benchmark and the customised benchmark. n We analysed global equity funds in five domiciles and observed enduring exposure tilts, most distinctly towards emerging markets, in a significant subset of funds. 2 n Key fund performance measures didn t hold up when compared with customised bestfit benchmarks. Customised benchmarks: A few caveats Some criticisms to performance evaluation using customised benchmarks exist. One is that customised benchmarks corrections may misrepresent the manager s style if the style drift reflects an intentional active position incurred in an effort to beat a style-box index. Also, because customised benchmarks are estimated based on an active fund s past performance, it s important to consider how often one should update customised benchmark weights. Analysing an investment s style can occur only after the fact; it can t foretell what an active manager might do. An investor could conceivably replicate an active fund s strategic allocation (as suggested by its customised benchmark) by cloning the active fund s beta exposure through an indexing strategy. But such a replication strategy would have to assume that the fund s strategic asset allocation didn t change in the future. 1 We defined global as an investment mandate without borders or concentration, and international to exclude the fund s domicile from the opportunity set. 2 Global equity benchmarks: Are prospectus benchmarks the correct barometer? Joshua M. Hirt, Ravi G. Tolani and Christopher B. Philips, CFA, July The market segments we used were North America large and mid-cap; Europe large and mid-cap; Pacific large and mid-cap; emerging markets large and mid-cap; and global small-cap.

2 Prospectus vs. customised benchmarks The benchmark as identified in a fund s prospectus generally helps investors gauge a manager s performance, so it should reasonably represent the fund s investing style or objective. But the chosen benchmarks aren t always appropriate; active managers may permanently shift their exposure to riskier market segments in an effort to improve long-term returns. For example, a large-cap manager may dip into small-cap equities and retain that position across market and economic cycles. We identified customised benchmarks for each fund analysed by determining their average ten-year exposures. The period we studied, ended 3 September 214, included two global bull markets and a significant global bear market, and offered diversity in both volatility and regional divergence. We therefore concluded that average exposures that appeared to be significantly different from those of a reasonable benchmark may have been systematic in nature and best viewed as beta rather than alpha. Our style analysis showed that global funds generally tended to tilt strategically towards emerging markets at the expense of North America. (See Figure 1, which shows relative allocations to five global market segments by fund domicile.) An important implication of this finding is that emerging market equities are generally considered to be higher-risk, and should therefore, on average, reward investors with higher returns. So if a given manager demonstrates outperformance, investors must determine whether that performance was driven by skill (and can be considered alpha) or was the result of long-term exposure to a market segment (and may be more appropriately considered beta). Figure 2 illustrates how well prospectus benchmarks and customised benchmarks represented a fund s style over the ten years ended 3 September 214. Beta indicates fund returns compared with benchmark returns, where a value of 1 indicates a perfect relationship. R-squared indicates how well the benchmark fits the fund, where a value of 1 indicates a perfect fit. Although not a perfect match across all funds and regions, the customised benchmarks better represented fund allocations. This is evidenced in Figure 2 by the customised benchmarks data being less dispersed, or more clustered around values of 1. The greatest Figure 1. Our regression analysis results indicate systematic tilts Global funds regression weights versus global market cap Relative allocations to global market cap 15% % 4% 4% Europe Pacific North America Emerging markets Small caps 4% 3% 2% 1% 3% 1% 1% 4% 19% 1% 5% 4% 2% 6% 5% 2% 2% 4% 3% 5% 1% 4% United States United Kingdom Canada Australia Hong Kong Note: Data cover the ten years ended 3 September

3 improvement in R-squared values occurred in emergingmarkets funds, reflecting the relative allocations seen in Figure 1. The prospectus benchmarks poorer fit has two potential explanations: First, many active managers may have engaged in significant security selection and/or timing moves; and, second, the prospectus benchmarks were inappropriate. However, we should point out a grey area. We would expect an active fund to look different from its benchmark; too close of a relationship could call a manager s value into question when similar and less costly index investments may be available. But a benchmark with drastically different characteristics from a fund is a poor reflection of a manager s style and perhaps a misleading barometer of performance. Performance and volatility It can seem only natural to choose active management to exploit country, regional and currency opportunities within broad global mandates. Yet our analysis didn t uncover outsized performance. Compared with their prospectus benchmarks, 67% of global funds, 6% of international funds and 72% of emerging markets funds underperformed in the 1 years through 3 September 214. When compared with their customised benchmarks, relative performance was reduced further, to 86% of global funds, 87% of international funds and 77% of emerging markets funds underperforming. Volatility characteristics were also more closely aligned when funds were compared with a customised index. Figure 3 combines return and volatility impacts to show the change caused by moving to a customised benchmark. As a group, the distribution of the orange points is much tighter and positioned lower on the axis than the distribution of the yellow points, signifying volatility generally more in line with the customised, best-fit benchmark and lower excess return. A few final words Ultimately, when evaluating either the fit of a strategy within a broader portfolio or a fund s outperformance or underperformance, use of an appropriate benchmark is essential. Figure 2. Customised benchmarks better represented a fund s style a. Distribution of fund beta versus prospectus b. Distribution of fund R-squared versus prospectus and customised benchmarks and customised benchmarks Number of funds Number of funds Distribution of beta Distribution of R-squared 18 6 Versus prospectus beta Versus customised beta Versus prospectus R-squared Versus customised R-squared Notes: Charts reflect all global, international, and emerging-market funds in our analysis universe within United States, Canada, United Kingdom, Australia, and Hong Kong, versus both their respective prospectus and customised benchmarks as based on style analysis. Data cover the ten years ended 3 September

4 Whether customised or prospectus benchmarks are more appropriate in deriving a fund s alpha depends critically on the active fund manager s investment philosophy and strategies. Investors should consider several questions when evaluating an active fund: Does the active portfolio consciously possess a size or style bias? If so, why? Is the bias intentional, and have the managers been successful in the past? If an active fund s size and style tilts are sufficiently stable, could an investor potentially be better served by a lower-cost indexing strategy? Investors should be aware that if adjusting performance to a customised benchmark provides results that don t justify the fees paid for active management, passive exposures targeting the fund s specific risks or markets may be widely available at generally lower costs. Can a fund s past success be explained simply by a manager s skill in tilting towards other risk-factor exposures, or is it truly owing to manager skill in security selection? Figure 3. Customised benchmarks generally led to lower return and higher volatility 8% Annualised excess return % % Annualised excess volatility Excess volatility and return versus prospectus benchmark Excess volatility and return versus customised benchmark Note: Data cover the ten years ended 3 September 214.

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