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Why You Should Avoid Mutual Funds With A High Tracking Error!

In general, all investment returns of actively managed mutual funds can be seen as a combination of alpha (excess returns) and beta (market returns). So investing in an actively managed mutual fund is a decision to get a blend of a possible alpha and beta.

If an active managed fund has a high tracking error relative to its underlying index, the manager seeks to generate returns in excess of his benchmark. A tracking error is the difference between the performance of a fund and the performance of its underlying benchmark/index. For that reason, fund managers with a higher tracking error have the potential to outperform their benchmark in bull markets while achieving a degree of capital preservation relative to their benchmarks in declining markets. That is basically the main reason why retail investors are getting exposed to actively managed mutual funds.

For example, according to Fidelity's website, the Fidelity Select Technology Fund (MUTF:FSPTX) invests primarily in companies which processes products or services that will provide or will benefit significantly from technological advances and improvements. However, no benchmark was mentioned on their website. As this fund focuses on technology and is mainly invested in the U.S. we compare that mutual fund with the Technology Select Sector SPDR (NYSEARCA:XLK) and indeed it might be a suitable benchmark (Chart 1), since the correlation coefficient between the fund and the XLK is around 0.96! In other words, in 96 percent of all cases, the actively managed fund (FSPTX) as well as the Technology Select Sector SPDR are moving in the same direction.

(click to enlarge)

Benchmark XLEClick to enlarge(Chart 1)

If the mutual fund is outperforming its benchmark, investors would not mind to pay for the additional alpha, as the fund manager was able to pick the right stocks. However, measuring alpha can be quite tricky. For example, if a fund manager claims his benchmark is the S&P 500 (NYSEARCA:IVV), but he might mainly invest in higher-beta stocks within the Russell 2000 (NYSEARCA:IWM), he will mostly outperform the S&P 500 during good market conditions. In such a case, investors will only get expensive beta returns, although they are paying for alpha. However, since no benchmark was put on Fidelity's website, investors just can guess about the degree of pure alpha, the fund has delivered so far, although the fund was outperforming clearly our selected benchmark.

Instead of investing in actively managed funds with a high tracking error, investors can easily get exposed to the underlying market through inexpensive and easily achievable exchange-traded funds. In addition, if they want to achieve an outperformance versus their market of choice, they can easily create a so called active beta core-satellite portfolio consisting of different exchange-traded-funds.

The active beta core-satellite portfolio is a strategy, where the core of the portfolio consists of a passive investment that tracks the benchmark of choice. Additional positions, known as satellites, are added to the portfolio, to achieve a possible outperformance. Since a possible outperformance is generated by adding different beta markets, investors will not get any additional alpha, instead they will just purely benefit from the diversification effect, which should lead to the same results: to outperform the underlying benchmark in bull markets while achieving a degree of capital preservation relative to their benchmarks in times of market turbulences.

In our article, we investigate if an active-beta portfolio with a similar tracking error relative to the Technology Select Sector SPDR will achieve better results than the actively managed fund.

According to our calculation, the Fidelity Select Technology Fund (FSPTX) has an annualized tracking error of 9.4 percent relative to the Technology Select Sector SPDR (from 2003-05-05 until 2012-08-21). We have created an active-beta portfolio that has nearly a same annualized one year tracking error relative to the XLK like the Fidelity Fund.

In our example this active-beta portfolio consists of following:

  • 50 percent in Technology Select Sector SPDR ,

  • 15 percent in iShares Barclays 20+ Yr Treasury Bond (NYSEARCA:TLT) and

  • 35 percent iShares MSCI Emerging Markets Index (NYSEARCA:EEM).

  • There is no allowance for transaction costs or brokerage fees.

If we have a look at Chart 2 we can see, that the annualized one year rolling tracking error of the active-beta portfolio relative to the XLK is quite similar compared to the tracking error of the Fidelity Fund.

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Rolling Tracking ErrorClick to enlarge(Chart 2)

Table 1 presents the results of our back tests from 2003/05/05 until 2012/08/21. The active-beta portfolio has clearly outperformed both, the active managed fund as well as the underlying benchmark.

Performance Ratios

The active-beta portfolio has an annualized return of 10.8% while the Fidelity fund has only generated an annualized rate of return of 9.7%. More importantly, on a risk-adjusted basis (Sharpe Ratio), the active-beta portfolio is strongly outperforming both (Chart 3), the actively managed fund as well as the XLK.

(click to enlarge)Historical PerformanceClick to enlarge(Chart 3)

If we have a closer look on draw down numbers, we can see that the active-beta portfolio has the lowest maximum draw down. The maximum loss for the active beta portfolio was only 49.2 percent compared to 61.2 percent for Fidelity Select Technology Fund. In total, the active-beta portfolio was reaching a new high after 183 days compared to 158 weeks for the actively managed fund.

(click to enlarge)Drawdowns ABClick to enlarge

(click to enlarge)Drawdowns FundClick to enlarge

(click to enlarge)Drawdowns BMClick to enlarge

The bottom line: The potential to outperform the benchmark is one main advantage that actively managed funds have over passive ETFs, and this might be the only reason why investors are getting exposed to them. Unfortunately, evidence that actively-managed funds can consistently outperform their relevant index is difficult to find. Fund managers are getting paid for creating alpha through stock picking and not for market timing skills. For that reason, they are often permanently fully invested, even in times of market turbulences. The problem is that only 30 percent of a typical stock's performance is determined by company specific issues while the remaining 70 percent are external factors, according to a Morgan Stanley research which was published in early May this year. For that reason, it might be better for retail investors, to create their own active beta core-satellite portfolio, instead of relying on the investment managers' stock picking skills.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.