Mini-Course Series - Mutual Funds (Part 7) by Institute of Business & Finance

MINI-COURSE SERIES

MUTUAL FUNDS Part VII

MUTUAL FUNDS

STANDARD DEVIATION The most frequently used measurement of investment risk is standard deviation. The measurement is also used in math and science; it is calculated using a series of numbers. Standard deviation is a statistical measure of the degree to which an individual value in a probability distribution tends to vary from the mean of the distribution (think of a bell-shaped curve). The greater the degree of dispersion or variance in annual returns, the higher the standard deviation and risk.

Standard Deviations of Mutual Fund Categories Fund Category

Standard Deviation

Fund Category

Standard Deviation

Large Cap Growth

Foreign Sm.-Mid Growth

Mid Cap Growth

Foreign Sm.-Mid Value

Small Cap Growth

Foreign Large Value

Large Cap Blend

Foreign Large Blend

Mid Cap Blend

Foreign Large Growth

Small Cap Blend

World Allocation

Large Cap Value

Balanced

Mid Cap Value

Convertibles

Small Cap Value

Long-Term Gov’t

Precious Metals

Med-Term Gov’t

Natural Resources

Short-Term Gov’t

Technology

Emerging Mkts. Debt

Utilities

High-Yield Bond

Health Care

Multi-Sector Bond

Financial

World Bond

Real Estate

High-Yield Muni

Bear Market

Long-Term Muni

World Stock

Short-Term Muni

PART VII

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MUTUAL FUNDS

There are two negative aspects to standard deviation as a risk measurement. First, the concept is not intuitive. Sure, we know that nine is higher than four (and therefore considered riskier than four), but is nine a high number? However, once the advisor knows what the standard deviation is for the category or sector, it can be quite useful. The second negative aspect is that it is argued that since the formula for standard deviation treats negative and positive numbers the same, and no one ever minds upward volatility, it punishes an investment for doing particularly well. The counter to this argument is that history has shown that investments that go through extremely good periods (which may be as short as just several months), are very likely to also experience some very negative periods.

BETA A securityâ&#x20AC;&#x2122;s or fundâ&#x20AC;&#x2122;s volatility against a benchmark is measured by beta. The benchmark always has a beta of 1.00, regardless of how the markets are performing. The most commonly used benchmark for common stocks is the S&P 500; for bonds it is the Lehman Brothers Aggregate Bond Index. The higher the fundâ&#x20AC;&#x2122;s beta is above 1.00, the more volatile its performance is expected to be, and vice versa. It is important to point out that beta is a risk measurement that only incorporates market risk. A high or low beta has no bearing on whether or not an asset is of good or bad quality, performance, etc. There is only a modest-to-moderate relationship between beta and standard deviation (e.g., gold funds have a very low beta, but one of the very highest standard deviations). Beta will not reveal much about funds with highly specialized holdings, such as those investing in a single industry or sector. These portfolios can be quite volatile, reflected in lofty standard deviations, but their betas might be well below 1.0, even close to 0. This is because the returns of specialized portfolios frequently do not correlate closely with the overall market. Although it is rare, it is possible to have an investment whose beta is a negative number.

PART VII

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MUTUAL FUNDS

R-SQUARED R-squared measures a portfolio’s performance correlation to that of a benchmark; the S&P 500 in the case of large U.S. stocks. The S&P 500 always has an R-squared of 100, regardless of market conditions (just like the S&P 500 always has a beta of 1.00). A mutual fund’s R-squared can range from zero to 100; the closer the R-squared is to 100, the stronger the performance correlation. As an example, gold funds have had an R-squared of just three. A large cap blend fund would typically have an R-squared of close to 90 or higher. R-squared is frequently used to check the “validity” of a fund’s beta. In the case of domestic equities, beta measures market risk and R-squared measures the closeness of a fund’s holdings to the S&P 500 (“the market”), a fund with a high R-squared number is likely to have a beta that accurately reflects its stock market risk. As a generality, unless a mutual fund’s Rsquared is somewhere between 75 and 100, disregard its beta.

ALPHA Just like beta and R-squared have a relationship, so do alpha and beta. Alpha measures the difference between the expected and actual returns of a fund, based on its beta. Thus, if a fund’s R-squared number is not high (75 or greater), there is very little value in determining its beta or alpha. Alpha is sometimes referred to as Jensen’s alpha (or the Jensen performance index or simply the Jensen index) in order to distinguish it from how alpha is defined and used in the sciences. A positive alpha, no matter how small, is considered good. A negative alpha is considered bad or slightly below average, depending upon how negative the number. Advisory services view alpha as a way of measuring the value or worth of a fund’s management. If a fund returns more than what is expected based on its beta, it has a positive alpha. The higher the positive number, the (supposedly) better the manager, and vice versa. The advantage of alpha over comparing just return to the market is that alpha reflects the level of fund risk. Alpha is also used by management companies to indicate funds that are more aggressive in trying to outperform the market. A potential shortcoming of alpha is that it may not reflect management skill in selecting securities. Instead, a low alpha might simply mean that the fund has high expenses— something that is largely beyond the control of the people selecting fund securities. A second flaw with alpha is that a positive or negative number could be the result of good or bad luck. By reviewing a fund’s alpha over several periods, less luck.

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MUTUAL FUNDS

DURATION Duration, a concept first developed in 1938 by Frederick Macaulay, measures bond price volatility. It is a weighted-average term-to-maturity of the bond’s cash flows; the “weights” being the present value of each cash flow as a percentage of the bond’s full price. The cash flows include the redemption value of the bond, typically $1,000 (but discounted by the number used for present value—see below). Thus, a bond that is maturing in 6.5 years will have 14 cash flows between now and maturity (13 semi-annual payments plus a face value payment upon maturity). A Salomon Smith Barney study used the visual analogy of a series of tin cans equally spaced on a seesaw. The size of each can, which varies, represents the cash flow due (e.g., six months from now, one year from now, 18 months from now, etc.). The contents of each tin can represent the present values of those cash flows (e.g., using a discount of, say 5%, the “contents” of the first can might be $50, $47.50 for the second can, $47.50 x .975 for the third can, etc.—each can’s value is reduced by 2.5% more than the previous can because there is a 5% annual discount and bonds pay interest semiannually). Finally, the cans are evenly spaced; each space represents six months (the time between each semi-annual payment). The final payment of face value, which is also discounted, is included on the seesaw. All of the present value cash flows are then added up and divided by two; duration is the distance to the fulcrum that would balance the seesaw. Using the seesaw analogy above, a zero-coupon bond that matures in 15 years has a duration of 15 years. Why? Because the entire payoff occurs when the bond matures, 15 years in this example. All of the cans are empty—there are no semi-annual or annual interest payments. The investor receives nothing until the bond matures (or is sold prior to its maturity). The greater the bond’s duration, the greater its percentage volatility. In general, duration rises with maturity, falls with the frequency of coupon payments, and also falls as yields rise (the higher the interest payments, and the more frequent the payments, the sooner the investor is paid back). From the advisor’s perspective, duration can be defined as the approximate percentage change in the price of a bond for a 100-basis-point movement in interest rates. For example, a duration of five means the price of the bond will change by approximately 5% for a 100-basis point (1%) change in rates. Duration increases with lower coupon, lower yield, and longer maturity.

PART VII

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MUTUAL FUNDS

THINGS TO DO  Your Practice Take a different staff person to lunch each week. Ask them what works in the office and what changes are needed. Your interaction will increase employee productivity and loyalty at the same time.  The Next Installment Your next installment, Part VIII, will cover five topics: bond reinvestment risk, bank-loan funds, and target retirement funds. You will receive Part VIII in a week.  Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o

Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.

PART VII

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