Released: December 15, 2013 EXECUTIVE SUMMARY Using data from December 31, 2000 through March 31, 2013, the fi360 Fiduciary Scores for mutual funds were evaluated by MacroRisk Analytics to assess the scores efficacy as a screening criterion. We found that the scores have statistically significant content and are useful as part of a mutual fund portfolio construction process. In May 2013, MacroRisk Analytics (MRA) was provided a copy of the historical fi360 score database which was then merged with performance data 1 generated from www.macrorisk.com. For each period beginning with December 2000, MRA received the current fi360 score, the one-year average score, the three-year average score, the five-year average score, and the 10-year average score for almost 22,000 funds, a total of approximately a million observations. These periods were on a quarterly basis until December 2010. From January 2011 through the ending date of this study, March 2013, the period frequency was monthly. For each of these fund-date combinations, we merged the one-year, threeyear, and five-year future annualized returns, standard deviation of returns, and lower semideviation of returns observed for each fund. By integrating these forward data ( future outcomes ) with the spot and average fiduciary scores (the predicting data ), the resulting database facilitated powerful forwardlooking testing of returns and empirical risk over one-, three-, and five-year future time horizons. 23 After analyzing the observed relationship between various fi360 Fiduciary Scores as predictors of future outcomes data, MRA confirms that the top group of the fi360 Fiduciary Score Average (1 year), those in the top quartile identified as the Green category, consistently provides better results than the other averages and categories in several dimensions. The top quartile of the one-year average Fiduciary Score ( Green ) demonstrated higher median returns when looking at one-year, three-year, and five-year future annualized returns, as well as higher median annualized return to standard deviation (and lower semideviation) ratio over the same one-, three-, five-year forecasting horizons. 1 Annual returns and risk measures were computed from daily close NAV values. 2 The current database only includes currently traded mutual funds. Any fund which has stopped trading or has closed will not be included in this analysis. 3 A 10-year future time horizon analysis is not performed because of inadequate history.
INTRODUCTION TO THE fi360 FIDUCIARY SCORE The fi360 Fiduciary Score is an investment rating system used to evaluate open-ended mutual funds, exchange-traded funds (ETFs), and group retirement annuities on nine different criteria, as shown in Figure 1. The score, itself, ranges from 0 to 100, with zero being the most preferable, and is calculated on a monthly basis for investments possessing at least three years of trading history. There are five different fi360 Fiduciary Scores: Nine Criteria Used in the fi360 Fiduciary Score 1) Regulatory Oversight 2) Track Record 3) Assets in the Investment 4) Stability of the Organization 5) Composition Consistent with Asset Class 6) Style Consistency 7) Expense Ratio/Fees Relative to Peers 8) Risk-Adjusted Performance Relative to Peers 9) Performance Relative to Peers Figure 1 Nine Criteria Used in the fi360 Fiduciary Score First, there is the fi360 Fiduciary Score by its lonesome which is calculated monthly for appropriate investments using the nine criteria mentioned earlier. Second, the fi360 Fiduciary Score Average (1 year) is the rolling 12-month average of the fi360 Fiduciary Score. Third, the fi360 Fiduciary Score Average (3 year) is the rolling 36-month average of the fi360 Fiduciary Score. Fourth, the fi360 Fiduciary Score Average (5 year) is the rolling 60-month average of the fi360 Fiduciary Score. Fifth, the fi360 Fiduciary Score Average (10 year) is the rolling 120-month average of the fi360 Fiduciary Score. For example, it is important to note that an investment with only three years of trading history would require another year of trading history in order to compute the fi360 Fiduciary Score Average (1 year). The same logic applies for other periods. 2
fi360 FIDUCIARY SCORES EVALUATED MacroRisk Analytics (MRA) evaluated 16 different fi360 Fiduciary Scores, over one-year, three-year, and five-year future horizons, 4 across measures such as annualized returns, standard deviation, lower semideviation, and return/risk ratio. To make it easier to interpret the fi360 scores, colors will be assigned to each quartile. Figure 2 is a modified bar chart presented in the fi360 Fiduciary Score Methodology. 5 For example, the fi360 Fiduciary Score Average (1 year) of 20 will be referred to as FI1YR_GREEN. We present the notation for all 16 fi360 Fiduciary Scores below. fi360 Fiduciary Score 6 1) FI_SCORE_GREEN: fi360 Fiduciary Score between 0-25 2) FI_SCORE_LTGREEN: fi360 Fiduciary Score between 26-50 3) FI_SCORE_YELLOW: fi360 Fiduciary Score between 51-75 4) FI_SCORE_RED: fi360 Fiduciary Score between 76-100 0-25 26-50 51-75 76-100 Figure 2 Color Legend for the fi360 Fiduciary Scores and Their Averages fi360 Fiduciary Score Average (1 year) 5) FI1YR_GREEN: fi360 Fiduciary Score Average (1 year) between 0-25 6) FI1YR_LTGREEN: fi360 Fiduciary Score Average (1 year) between 26-50 7) FI1YR_YELLOW: fi360 Fiduciary Score Average (1 year) between 51-75 8) FI1YR_RED: fi360 Fiduciary Score Average (1 year) between 76-100 fi360 Fiduciary Score Average (3 year) 9) FI3YR_GREEN: fi360 Fiduciary Score Average (3 year) between 0-25 10) FI3YR_LTGREEN: fi360 Fiduciary Score Average (3 year) between 26-50 11) FI3YR_YELLOW: fi360 Fiduciary Score Average (3 year) between 51-75 12) FI3YR_RED: fi360 Fiduciary Score Average (3 year) between 76-100 fi360 Fiduciary Score Average (5 year) 13) FI5YR_GREEN: fi360 Fiduciary Score Average (5 year) between 0-25 14) FI5YR_LTGREEN: fi360 Fiduciary Score Average (5 year) between 26-50 15) FI5YR_YELLOW: fi360 Fiduciary Score Average (5 year) between 51-75 16) FI5YR_RED: fi360 Fiduciary Score Average (5 year) between 76-100 4 One-, three-, five-year horizons are not to be confused with fi360 Fiduciary Score Average of one year, three and five years. One can use the fi360 Fiduciary Score Average (1 year) to forecast returns one year, three, or five years into the future. 5 Visit www.fi360.com for more information. 6 The fi360 Fiduciary Score is not to be confused with fi360 Fiduciary Score Averages of one year, three, or five years because the fi360 Fiduciary Score is used to compute the various fi360 Fiduciary Score Average. 3
VARIABLES USED TO EVALUATE THE fi360 FIDUCIARY SCORES Annualized Return. The annualized return formula is: Ending value (1 Annualized Return = ( Beginning value ) Years) 1 Standard Deviation. Standard deviation is a widely used measure of risk. In this case, annualized standard deviation will be used for comparability. Standard deviation and annualized standard deviation 7 will be used interchangeably in this paper. Lower Semideviation. Lower semideviation is considered a better measure of risk than standard deviation because it calculates the portion of the standard deviation generated by days when the NAV goes down. It is more closely associated with an investor s definition of risk measuring loss than standard deviation which includes both loss and gain as risk. This analysis presents both standard deviation and lower semideviation but places more emphasis on lower semideviation. Return/Risk. The return/risk ratio is calculated by dividing annualized return by either the lower semideviation or standard deviation. A higher ratio is preferable. One-, Three-, and Five-Year Horizons. These are future looking observations, computed from the date associated with each fi360 Fiduciary Score. It should be stressed that the fi360 Fiduciary Scores and their averages are based on historical data whereas the variables (annualized return, standard deviation, lower semideviation, and return/risk ratio) in which they are assessed on are based on future data, that is, data observed after the calculation of the fi360 Fiduciary Scores. A technical note on some definitions Annualized Return vs. Annualized Mean Return vs. Mean Return vs. Annual Return vs. Average Annual Return vs. Total Return Financial assessments often utilize several similar sounding but technically different measures: annualized return, annualized mean return, mean return, annual return, average annual return, and total return. While this report uses annualized return, the other measures are discussed here for reference. Annualized return is defined to the left. Annualized mean return is calculated by multiplying daily mean return by the number of trading days in a year: (Mean of daily returns) 260 Mean return is a simple arithmetic average of returns. Annual return is the percentage return between the investment s NAV over a one-year period, from the beginning date to the ending date of the period. It could be computed as a trailing 12-month (TTM) window. Average annual return is an arithmetic average of annual returns. Total return is a return earned within a time period. For example, total return from March 3, 2012 to September 20, 2013 would have the following formula: Value on Sept. 20, 2013 ( 1) 100 Value on March 3, 2012 MacroRisk Analytics Research Services generally will use annualized return because this measure provides consistency and comparability allowing a comparison between investments of different time horizons. 7 Annualized standard deviation is calculated by multiplying the daily standard deviation by the square root of the number of trading days in a year: (Daily standard deviation 260) 4
Return % Return ONE-YEAR FORWARD HORIZON ANALYSIS Annualized Return Annualized Return One Year into the Future MacroRisk Analytics 8.0 evaluated each of 16 fi360 7.0 Fiduciary Scores ability to 6.0 maximize return one year 5.0 into the future and concludes 4.0 that the fi360 Fiduciary Score Average (1 year) between 0 3.0 and 25 ( Green ) performed 2.0 better than the other fi360 1.0 Fiduciary Scores analyzed. 0.0 The findings show that utilizing more historic information does not result in an increase in future one-year performance. Overall, with Figure 3 Annualized Return One Year into the Future (sorted in descending order) the exception of FI1YR_YELLOW, it can be seen from Figure 3 that GREEN and LTGREEN scores are grouped on the left half of the graph whereas YELLOW and RED scores are grouped on the right half of the graph. This shows that the fi360 Fiduciary Score of 50 or below tends to provide higher annualized return one year into the future than the fi360 Fiduciary Score above 50. This was to be expected, and MacroRisk confirms it. Risk If an investor s goal is to minimize his/her risk one year into the future, one is better off using investments with a fi360 Fiduciary Score Average (3 year) between 0 and 25 (FI3YR_GREEN). Figure 4 shows that to reduce an investor s risk, using three years of historic data is most beneficial. However, FI1YR_GREEN comes in a very 17.0 16.0 15.0 14.0 13.0 12.0 Risk One Year into the Future Lower Semideviation Standard Deviation Figure 4 Risk One Year into the Future (sorted by lower semideviation in ascending order) 5
Return/Risk close second showing its consistency to maximize annualized return and minimize lower semideviation and standard deviation one year into the future. Overall, the fi360 Fiduciary Score and its averages between 0 and 25, the Green scores, whether based on one-, three-, or five-year of score history, tend to minimize risk one year into the future better than the other color fi360 Fiduciary Score and its averages. Return/Risk When trying to maximize one s return/risk ratio, an investor is better off using the fi360 Fiduciary Score Average (1 year) of 0 to 25 (FI1YR_GREEN). Overall, as illustrated in Figure 5, the one-year average fi360 Fiduciary Score tends to provide higher return/risk ratio than its three- and fiveyear counterparts. Moreover, it can be generalized that the fi360 Fiduciary Score of 50 or lower provides better return-risk ratio over the long run than the fi360 Fiduciary Score of above 50 since almost all 0.6 0.5 0.4 0.3 0.2 0.1 0 Return/Risk One Year into the Future Lower Semideviation Standard Deviation Figure 5 Return/Risk Ratio One Year into the Future. Blue bars represent return/risk ratios computed by dividing annualized returns by lower semideviation. Orange bars represent return/risk ratio computed by dividing annualized returns by standard deviation. The graph is sorted by return/lower semideviation in descending order. GREEN and LTGREEN scores are grouped toward the left half of the graph representing higher return/risk ratios whereas almost all YELLOW and RED scores are grouped toward the right half of the graph representing lower return/risk ratios. 6
Relative Frequency Annualized Return Distribution for the fi360 Fiduciary Score Average (1 year) between 0 and 25, One Year into the Future Looking at the distribution of annualized returns, from December 2000 to March 2013, allows an analysis of the marginal value that the fi360 scores provide. For this analysis, annualized returns for the fi360 Fiduciary Score Average (1 year) between 0 and 25 will be compared against the annualized returns of almost 22,000 mutual funds. As expected, returns follow an approximate normal distribution. It is evident that the score does provide marginal value as it excludes a number of mutual funds with annualized returns below zero (as can be seen by the heights of light blue bars on the left half of the graph in Figure 6). At the same time, the score includes more mutual funds with positive annualized returns (represented by the heights of green bars 8 ). This is exactly how a screen should work. 50.00% 45.00% 40.00% 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Distribution of Annualized Returns One Year into the Future from December 2000 to March 2013 Annualized Return fi360 Fiduciary Score Average (1 year) between 0 and 25 All Mutual Funds Figure 6 Distribution of Annualized Returns One Year into the Future from December 2000 to March 2013 8 These are the small bars on top of the main distribution. 7
Return % Return THREE-YEAR FORWARD HORIZON ANALYSIS Annualized Return Figure 7 shows that if an investor has a three-year horizon, using the fi360 Fiduciary Score between 0 and 25 will tend to maximize his/her annualized return. Overall, the fi360 Fiduciary Score and fi360 Fiduciary Score Average (1 year) of 50 or below tend to maximize an investor s annualized return three years into the future. 6.0 5.0 4.0 3.0 2.0 1.0 0.0 Annualized Return Three Years into the Future Risk If an investor has a three-year horizon and he/she is trying to minimize his/her risk, using the fi360 Fiduciary Score Average (1 year) between 0 and 25 (FI1YR_GREEN) is the best option. If utilizing this option severely constrains the number of investments that an investor can choose from, in addition to the previous option, an investor can look at investments with the fi360 Fiduciary Score of 75 or lower (FI_SCORE_GREEN, FI_SCORE_ LTGREEN, FI_SCORE_ YELLOW) which 25.0 20.0 15.0 10.0 are grouped on the left side of the graph in Figure 8. Figure 7 Annualized Return Three Years into the Future (sorted in descending order) 5.0 0.0 Risk Three Years into the Future Lower Semideviation Standard Deviation Figure 8 Risk Three Years into the Future (sorted by lower semideviation in ascending order) 8
Return/Risk Return/Risk Figure 9 shows that if an investor has a three-year horizon and his/her goal is to maximize return while minimizing risk, he/she is better off using the fi360 Fiduciary Score (1 year) between 0 and 25. Overall, this Score tends to maximize the return/risk ratio three years into the future. 0.4 0.3 0.2 0.1 0 Return/Risk Three Years into the Future Lower Semideviation Standard Deviation Figure 9 Return/Risk Ratio Three Years into the Future. Blue bars represent return/risk ratios computed by dividing annualized returns by lower semideviation. Orange bars represent return/risk ratio computed by dividing annualized returns by standard deviation. The graph is sorted by returns/lower semideviation in descending order. 9
<-100% -100% - -95% -95% - -90% -90% - -85% -85% - -80% -80% - -75% -75% - -70% -70% - -65% -65% - -60% -60% - -55% -55% - -50% -50% - -45% -45% - -40% -40% - -35% -35% - -30% -30% - -25% -25% - -20% -20% - -15% -15% - -10% -10% - -5% -5% - 0% 0% - 5% 5% - 10% 10% - 15% 15% - 20% 20% - 25% 25% - 30% 30% - 35% 35% - 40% 40% - 45% 45% - 50% 50% - 55% 55% - 60% 60% - 65% 65% - 70% 70% - 75% 75% - 80% 80% - 85% 85% - 90% 90% - 95% 95% - 100% >=100% Relative Frequency Annualized Return Distribution for the fi360 Fiduciary Score Average (1 year) between 0 and 25, Three Years into the Future The fi360 Fiduciary Score Average (1 year) between 0 and 25 (one-year average Green ) was also analyzed to determine how much additional value it provided when trying to maximize annualized returns three years into the future. As illustrated in Figure 10, the score again provides value as it cuts down the number of mutual funds with annualized returns below zero (evident by the height of the light blue bars) and includes more funds with returns above zero (evident by the height of the green bars). When compared to the distribution of annualized returns one year into the future, the marginal value that the score provides three years into the future drops. 50.00% 45.00% 40.00% 35.00% Distribution of Annualized Returns Three Years into the Future from December 2000 to March 2013 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Annualized Return fi360 Fiduciary Score Average (1 year) between 0 and 25 All Mutual Funds Figure 10 Distribution of Annualized Returns Three Years into the Future from December 2000 to March 2013 10
% Return FIVE YEAR FORWARD HORIZON ANALYSIS Annualized Return Annualized Return Five Years in the Future For an investor with a fiveyear time horizon, the fi360 4.0 3.5 Fiduciary Score between 0 and 25 (FI_SCORE_GREEN) 3.0 tends to maximize his/her 2.5 return over the long run. One might note that when 2.0 compared to the one- and 1.5 three-year horizons, the fiveyear horizon has lower 1.0 annualized returns across all 0.5 16 fi360 Fiduciary Scores (see Figure 11). Since a five-year 0.0 horizon into the future is a long period of time and is extremely hard to forecast, the results in this time horizon might be due more to noise and chance rather than the fi360 Fiduciary Scores. The model used by fi360 might not be as robust for a longer future time horizon as opposed to one that s shorter. Figure 11 Annualized Return Five Years into the Future (sorted in descending order) 11
Return/Risk Return Risk There is little consistency between the ranking of the fi360 Fiduciary Scores and the absolute amount of volatility observed over the subsequent five years. However, the return per unit risk is a different story. 30.0 25.0 20.0 15.0 10.0 5.0 0.0 Risk Five Years into the Future Lower Semideviation Standard Deviation Return/Risk Figure 12 Risk Five Years into the Future (sorted by lower semideviation in ascending order) As was previously observed for other horizons, the mutual funds earning the best return to risk ratio were those with spot and one-year average scores in the Green category. To maximize annualized return while minimizing one s risk, an investor should select mutual funds with Green fi360 Fiduciary spot and one-year average 0.3 0.2 0.1 0 Return/Risk Five Years into the Future Lower Semideviation Standard Deviation Figure 13 Return/Risk Ratio Five Years into the Future. Blue bars represent return/risk ratios computed by dividing annualized returns by lower semideviation. Orange bars represent return/risk ratio computed by dividing annualized returns by standard deviation. The graph is sorted by return/lower semideviation in descending order. scores. It is instructive that using longer averaging periods than a year adds little to the average risk adjusted return. Using only one year of history tends to provide a better return/risk ratio five years into the future (Figure 13). The fi360 Fiduciary Score and its one-year averages can be found grouped toward the left half of the graph while the fi360 Fiduciary Score Average (three- and five- year) are grouped toward the right hand side of the graph. 12
<-100% -100% - -95% -95% - -90% -90% - -85% -85% - -80% -80% - -75% -75% - -70% -70% - -65% -65% - -60% -60% - -55% -55% - -50% -50% - -45% -45% - -40% -40% - -35% -35% - -30% -30% - -25% -25% - -20% -20% - -15% -15% - -10% -10% - -5% -5% - 0% 0% - 5% 5% - 10% 10% - 15% 15% - 20% 20% - 25% 25% - 30% 30% - 35% 35% - 40% 40% - 45% 45% - 50% 50% - 55% 55% - 60% 60% - 65% 65% - 70% 70% - 75% 75% - 80% 80% - 85% 85% - 90% 90% - 95% 95% - 100% >=100% Relative Frequency Annualized Return Distribution for the fi360 Fiduciary Score Average (1 year) between 0 and 25, Five Years into the Future Lastly, the marginal value for the fi360 Fiduciary Score Average (1 year) between 0 and 25 five years into the future is shown in Figure 14 below. Again, the score provided favorable results as it discards mutual funds with annualized returns over five years of below five percent (represented by the height of the light blue bars) and added funds with returns above five percent (represented by the height of the green bars). 50.00% 45.00% 40.00% 35.00% Distribution of Annualized Returns Five Years into the Future from December 2000 to March 2013 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% 0.00% Annualized Return fi360 Fiduciary Score Average (1 year) between 0 and 25 All Mutual Funds Figure 14 Distribution of Annualized Returns Five Years into the Future from December 2000 to March 2013 13
CONCLUSION Green is good. The top quartiles of scores identified mutual funds which, on average, had higher returns and lower risk than the other quartiles. Also, fresher information (either the spot or one-year average values) resulted in groups of mutual funds which performed better than corresponding groups based on longer average data. Future research will address whether multiple observations of green (for example, having five-year, three-year, one-year, and spot scores all in the green category) results in better performing subsets of those funds which have one-year or spot scores in the top quartile. 9 However, this research demonstrates that regular use of the fi360 Fiduciary Scores, particularly the spot and one-year average scores, can be an effective tool in identifying better subsets of mutual funds from those under consideration. 9 Preliminary results suggests this is a heads you win, tails you tie situation; it shouldn t hurt and it might help to impose the additional constraint of multiple fi360 scores being in the green category. 14
MacroRisk Analytics Research Services Contact Info: Sean Chasworth Director of Research research@macrorisk.com 888.502.3605 750 E. Walnut Street Pasadena, CA 91101 The research team for this report includes: G. Michael Phillips, Ph.D., Chief Scientist James T. Chong, Ph.D., Research Economist William P. Jennings, Ph.D., Chief Investment Strategist George Arzumanyan, Investment Analyst Sarah Underwood, Mathematical Programmer Sean Chasworth, Director of Research 15