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K4 Fund Selection lets you quickly and easily build weighted factor models to evaluate and monitor mutual funds and ETFs. Listed below are the scoring factors, filters, and weights for this model. This illustration is for Large Cap Growth, but it can easily be adapted for other capitalizations, styles, or equity categories.
Basis for Model Design
Most investors want to pare back their
portfolio’s risk whenever the market becomes more volatile. Those
with less tolerance may want to liquidate their stock funds while
others may simply want to reduce their weighting in equity. Another
and often better alternative is to maintain the equity exposure in
the portfolio but employ more defensive funds. This allows the
investor’s allocation between stock, fixed income, and cash to
remain unchanged while offering some additional downside
protection. It can actually improve the portfolio’s long-term return performance by
minimizing the risk inherent in market timing. By retaining a
relatively constant equity allocation, the investor will be able to
benefit whenever stocks turn back up without having to gauge when to
jump back into the market. For example, were you loading up on stock funds when the market bottomed in March 2009? Investors
using defensive equity funds were already there.
Defensive equity funds are less volatile than
more aggressive bull market funds. They tend to have less market
risk (beta) as well as lower overall risk (standard deviation). This
doesn’t mean they’re immune to losses, but they typically don’t fall
as much as their benchmark or their peers (low down market ratio).
On the other hand, their low risk often makes them less attractive
when stocks are steadily moving up. As a result,
long-term and possibly even recent returns aren’t critical
distinguishing features in rating these funds. Other
frequently used factors such as batting average or up market ratio
aren’t very helpful either.
Klein Decisions’ K4 Fund Selection
can help you find defensive funds in all equity categories. Along
with risk factors and down market capture, you’ll also want to
consider expense ratio. Not only have studies shown that it’s
inversely correlated with fund return, its impact is much more
noticeable when returns decline. Finally, a measure of short-term
return can give you an idea of recent performance, although it’s
not as important as risk and down market ratio.
| Categories |
Selections |
| Product Type |
Fund |
| Asset Type |
Stock |
| Track Record |
5 Years |
| Domestic Equity |
Large Cap, Growth |
| Criteria |
K4 Factor |
Weight |
| Drag on Net Return |
Expense Ratio |
Lowest |
| Short Term Return |
1-Year Return +/- Category |
Lowest |
| Total Risk |
5-Year Relative Standard Deviation |
High |
| Market Risk |
5-Year Beta (Category Index) |
Highest |
| Downside protection |
5-Year Down Market Ratio |
Medium |
| Filter |
Limits |
| Average Manager Tenure |
> 3 Years |
| 5-Year Beta (Category Index) |
≤ 0.95 |
| 5-Year R2 (Category Index) |
≥ 75 |
| 5-Year Down Market Ratio |
≤ 95 |
| Closed to New Investors |
No |
| Closed to All Investors |
No |
| Distinct Portfolio |
Yes |
Results
Beta and down market capture are used as both
preference factors and filter items; the former use gives funds
higher scores for low market risk and down market capture while the
latter ensure that both factors are below the market and category
average. The r-square requirement establishes the statistical
significance of the category-relative factors. The distinct
portfolio filter eliminates multiple share classes, making the final
rank ordering more meaningful. The other filters ensure that the
current manager was responsible for the results and that the funds
are open to new investment. Although this example is for Large Cap
Growth, this model can be created in or copied to other categories.
Funds selected with this model using December 31, 2007 data provided excellent relative performance in 2008. In domestic equity, the top ten defensive funds outperformed their respective Morningstar Category and Russell Style Index in all nine Morningstar styleboxes. The average defensive fund also beat its Morningstar Category in all nine styleboxes as well as the Russell Style Index in six of the nine. By the way, the superior performance of the top 10 funds over the average fund reflects the difference in the results of a weighted factor model and a simple screening process.
When it’s time to review the funds, K4 Fund Selection users can simply copy
and rename each scenario with the current date. When you open a
copy, you can proceed directly to the results page and view the
updated data. The update is automatic with no data downloads or information to set up. You can then
compare the current results to those in the original scenario. This
is also a simple means of creating an ongoing archive of your
analyses to track the funds over time.
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