Go Contrarian to Avoid Correlation

11/02/2012 7:45 am EST

Focus: FUNDS

The odds are still stacked against individual investors, but if you're willing to look outside the world of income stocks, contrarian funds may be a good investment, writes Kevin McDevitt of Morningstar FundInvestor.

With money rushing into index funds, active contrarians may offer a way to cut risk.

These funds may be of special interest to risk-averse investors who want equity exposure but are concerned about market risk. That’s understandable, since the whole notion of market risk has been turned upside down in recent years, not just by frightful headlines, but also by the headlong rush into passively managed index vehicles, open-end funds, and ETFs alike.

Nearly $575 billion, or more than 20% of beginning assets, left actively managed US stock funds from May 2006 through August 2012. Over that same span, passively managed vehicles collected $350 billion. As a result, passive fund market share has roughly doubled over the past ten years to 33% of US stock fund assets.

The problem with the increasing popularity of index funds is that it could diminish some of their virtues. To be sure, the case for index funds is very compelling. They offer low costs, broad diversification, and generally competitive risk-adjusted returns versus category peers without much manager risk (that is, the risk that a fund manager underperforms his index).

But flows into passively managed funds have arguably diminished the benefits of diversification and increased risk in equity markets. In a paper published this spring in the Financial Analysts Journal, Rodney Sullivan at the CFA Institute and Morningstar Investment Management’s James Xiong argue that ETF flows in particular have contributed to increased correlations among stocks, as they increasingly trade as part of index baskets rather than individually.

They estimate that ETF trading now accounts for roughly one-third of all trading in the US. Sullivan and Xiong also found that the average beta (a measure of market volatility) increased across all equity segments from 1997 to 2010.

Just as significantly, betas across market caps (large versus small) and styles (value versus growth) have converged over the past ten years. As a result, not only have betas risen over the years, but diversification benefits across market cap and style have fallen.

Crucially, Sullivan and Xiong also discovered “a meaningful relationship between passive investing and a rise in market risk as proxied by various market betas.” It’s reasonable to wonder whether the increased correlations during the 2000-2002 and 2007-2009 bear markets explain these trends, but bear in mind that these were only four of the 14 years studied. Correlations increased across all market environments.

Time to Get Active?
For investors looking to insulate themselves from this convergence, it may be time to consider going against the grain.

With US stocks increasingly moving together, funds that look less like the popular indexes—as defined by active share—may be in a better position to weather market swings. And with overall market volatility increasing, it arguably makes sense to define risk more in absolute terms, as many truly active funds do, rather than in relation to an index.

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That said, no equity fund can totally avoid market risk. If US equity markets seize up, all stock funds will feel the pain. However, some funds may be in a better position to mitigate the damage than others.

With this in mind, we looked for high active share large-blend funds with relatively low risk. (For this screen, we limited ourselves to the large-blend category, because it’s home to $800 billion of the $1.2 trillion in passively managed US stock assets.)

These large-blend funds are some of our favorites for several reasons. First, they offer above-average active share (compared with the typical actively managed Morningstar 500 large-blend offering) versus the Russell 1000 Index, plus downside capture ratios that are well below the category average.

First Eagle US Value (FEVAX) and Amana Trust Income (AMANX), in particular, stand out for their rock-bottom downside capture ratios.

Second, unlike many funds with high active share, their portfolios are not highly concentrated in their Top Ten holdings. True, both BBH Core Select (BBTEX) and FMI Large Cap (FMIHX) hold fewer than 30 stocks, but their positions tend to be fairly evenly weighted. Only two of BBH Core Select’s positions currently claim more than 5% of assets, and FMI Large Cap doesn’t have any.

Plus, none of the funds are overly concentrated in any one sector. Amana Trust Income does have 23% of its portfolio in industrials versus 10.5% for the Russell 1000. But Amana’s is a fairly conservative lot, with about half the weighting in diversified industrials such as 3M (MMM) and Emerson Electric (EMR).

Furthermore, per fund policy, no company in its portfolio has a debt/market cap greater than 30% and all must pay a dividend. Such prudent practices reflect the fact that Amana Trust Income is run in accordance with Islamic law. The resulting guidelines have made this a strong choice for conservative investors.

For instance, the fund does not invest in companies that generate more than 5% of their revenue through paying or receiving interest, which eliminates most financials. This avoidance of financials helped it avoid the worst of the 2008 credit crisis, falling 23.5% versus the S&P 500’s 37% drop.

Finally, Islamic law bars the fund from trading frequently, which is considered a form of gambling, and turnover is typically in the single digits. Finally, these funds are true believers in active management. Their active shares have been consistently high for years.

As Kathryn Spica pointed out in July’s Red Flags article, a fund’s active share can sometimes decline quickly as a result of a change in manager or strategy. Going back to December 2006, only Amana Trust Income has had an active share that fell below 80%, albeit briefly, in December 2008 to 78%.

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Related Reading:

Tactical Indexing Proves Its Worth

3 Closed-End Funds with Solid Income

4 ETFs that Leave Bonds in the Dust

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