asks you to invest in "the power of math" with its new fund.
This new approach comes after the fund firm's power of stock-picking has been on the wane. The promise of the new
Janus Risk Managed Stock fund -- unveiled on Feb. 28 to little fanfare, and taking in a mere (for Janus) $20 million so far -- is to use quantitative strategies to consistently deliver lower risk and higher return than the
While a quant fund may seem a refuge for a scoundrel, the Risk Managed fund is a sweeping departure -- a more complex and interesting fund than its previous offerings that merits closer inspection. Thanks to Janus Risk Managed Stock fund, Joe Investor can fork over $2,500 and get the type of complex investing strategies generally available to high-net-worth investors and institutions.
Whether that's a good idea requires knowing what this fund does and how it should perform, something that's more than a little unclear from Janus' marketing literature. However, in its previous iterations for institutions, the offering has managed to successfully beat the S&P 500, albeit with tax consequences.
Before you go running for your checkbook, understand the risks in the strategy.
How the Fund Works
The fund could be categorized as an "enhanced" index fund, which is any fund based on a well-known index that is manipulated or "un-pure." The managers of the Janus Risk Managed fund try to improve on the efficiency of the S&P 500. This may strike some as strange, as the S&P 500 is considered the perfect "efficient" market portfolio. The whole theoretical underpinning of indexing is that stocks are priced efficiently: You can just buy a large basket of them at random and do just fine.
Most actively managed large-cap funds find it impossible to beat the S&P 500 even somewhat regularly. The sad reality of investing is that most professionals do not deliver stock picks that are consistently 2% better each year than the index, which is about how much all the fees and hidden trading costs add up to over low-fee, low-turnover index funds.
Given this state of affairs, coming out and saying you are going to improve on the index is a bold line. How does Janus stake such a claim?
Janus recently bought a majority stake in Intech, a boutique investment shop founded in the 1980s by mathematicians to harness the power of math and put it into practical applications in money management. Janus Capital, impressed with Intech's novel strategy and past performance, decided to take what has till now only been offered to institutional investors and mass market it through a plain vanilla mutual fund.
The new fund, and the many managed accounts run by Intech since 1987, is based on research published by E. Robert Fernholz, Ph. D., founder and chief investment officer of Intech in 1982. To understand what they have discovered and how they used it to run the portfolios the fund will mimic requires simplifying pages of complex equations and theory.
The evolution of what is known as "Modern Portfolio Theory," or MPT, started with Harry Markowitz in the early 1950s and continued with James Tobin and William Sharpe. The basic concept is that making a portfolio of two investments that are not perfectly correlated can produce a lower risk and higher return than simply averaging the two investments' risk levels and returns. You actually build some free return without taking any extra risk.
While the theory behind Intech attacks certain elements of MPT, the managers are primarily exploiting a mathematical loophole in the S&P 500 -- or any index, for that matter -- to earn a few percentage points of "free" return each year.
When Intech says the S&P 500 is inefficient, they don't care about inefficiencies that may arise from speculative mania about tech stocks, accounting shams like
or bad advice from analysts that many active managers cite in poking holes in indexing. All they claim is that there is a way to construct the S&P 500 a little differently that can have a better risk-adjusted return.
Stocks tend to move together, but some are more correlated to one another.
are both in the S&P 500; you would expect them to move more in synch than, say, Ford and
Also, some stocks are more volatile than others.
is prone to wild swings in price;
The S&P 500 is market capitalization-weighted, which means stocks like
are a larger percentage of the index than a stock like
. Intech asks the question: What if we weight the stocks with the specific goal of increasing return and lowering risk? Volatile stocks that are uncorrelated can be combined to build even higher risk-adjusted returns.
Two Steps to Outperformance
Covariance is a measure of volatility and correlation. Step One in the Intech method to beat the index is to identify volatile stocks with low correlations to the index -- they call it a volatility capture strategy. By doing so they are overweighing (compared to the real index) volatile stocks that move against the index and should lower overall volatility, yet retain some of the extra return of these more volatile stocks.
Step Two is active rebalancing. If they determine a stock like
should be 1.5% of their custom index, they will readjust it as it moves well beyond that allocation. In a real market cap-weighted index, a stock is whatever percentage it is, if PepsiCo is 1% of the index and the stock doubles, the manager doesn't have to do anything -- it's now a greater percentage of the portfolio and the other stocks are all slightly less.
With the Intech-Janus portfolio, the manager will sell some of the PepsiCo stock after it ran up to bring the percentage back down to the desired levels. The opposite happens if the stock falls. Percentages are set by covariance, not by market cap. This has a "buy low/sell high" effect.
In essence, Intech is trying to build a more properly diversified index out of the index by being more aware of how the stocks relate to one another and effect overall portfolio risk.
This is not all untried theory. Intech has been managing money this way since 1987. The fund is based on the same methodology used in Intech's "large cap core" portfolio. This portfolio has produced an average annualized return of 11.33% since inception in 1987 through December 2002, far higher than most stock funds. The S&P 500 index produced a 9.73% return over the same time period, or 1.6% less per year. That's a great track record, although not quite as spectacular as the 3% to 4% a year on average extra return a representative from Janus expects the new fund to deliver.
These returns were realized in private accounts before fees are taken into consideration. The fees on the Janus fund are 1.26% a year. That takes out much of the extra 1.6% spread over the S&P 500. Keep in mind an S&P 500 index fund has costs too, so figure in real money you would have earned an extra 0.5% per year on average over the last 15 years. That's still a good return.
Taxing Matters and Risk Levels
The Intech strategy is not tax efficient. Nowhere in Intech's work is after-tax return even considered. They manage the fund to beat the S&P 500 on a pretax basis. If you are considering this fund, you must own it in a tax-deferred account, as your after-tax return will have very little chance of outperforming a low turnover index -- what with all the weekly rebalancing happening in the portfolio leading to short-term taxable gains to distribute.
But the most serious mistake most investors are going to make buying this fund is not misjudging the tax-efficiency or expecting too much excess return, it is not understanding the risk level of the strategy. While the fund is called "Risk-Managed," for all practical purposes it is not risk managed in the sense of lowering risk.
The risk Intech is managing is the risk of underperforming the S&P 500, and in this area they have done a great job. Most investors do not think of that as risk; they think of risk as "losing money." The prospectus is fairly clear: "Risk controls are designed to minimize the risk of significant underperformance relative to the benchmark index."
This is not a failure on Intech's part. They could have managed the fund with a risk level a bit lower than the index, but then the fund would not outperform the index. They chose to beat the index at about the same risk level -- a noble goal, but not necessarily one shared by an investor leaving the "danger" of say, the Janus Olympus fund for a fund that is "risk managed."
The marketing department of Janus seems as confused about the new fund as a prospective investor would be. On its Web site, Janus lines all their funds up from safest to riskiest so an investor can get a sense of the relative risk of this fund. According to this graphic, the Janus Risk Managed fund is lower risk than every Janus all-stock fund. It is even lower risk then the Janus High-Yield bond fund. This is incorrect. Risk, as defined by standard deviation, would make this fund very close to the S&P 500. Over the history of this portfolio, the standard deviation was around 16.85, similar to the S&P 500.
Janus is a family of higher-risk stock funds. Still, the Janus Worldwide, Growth and Income, and Core Equity may be slightly lower risk than the Janus Risk-Managed fund. The Risk-Managed fund is almost certainly higher risk than the Janus High Yield bond fund. Investors who buy this fund should be prepared to lose about as much as they would lose in the S&P 500 if the market fell -- which has declined nearly 40% over the past three years -- and more than they would lose in virtually any bond mutual fund.
In Bad Times, but Maybe Not Good
Performance for the Intech portfolio does not consistently beat the S&P 500. Recent years have been spectacular, with outperformance more in the 3% to 5% a year range. A few years earlier, the portfolio underperformed the index by over 2% a year. The reason: The fund favors of smaller-cap stocks, which lagged the big guns in the S&P 500 during the late 1990s but have trounced the big-caps so far this decade.
The managers don't chose smaller-cap stocks from the index willingly -- these stocks tend to be more volatile and less correlated, so they get larger weights in the portfolio compared to the S&P 500. In years where larger-cap stocks outperform smaller-cap stocks in the index, the Intech strategy tends to underperform; in years like the last few where the large-cap stocks in the index fall the hardest, they outperform. Currently the fund has a lower average market cap than the S&P 500.
Intech is well aware of this market-diversity issue and has written about it extensively. Because most mutual funds own smaller stocks on average than the S&P 500, Intech tends to outperform the S&P 500 precisely when many other managers do. Intech says the strategy does better with increased volatility in the market -- there is more volatility to capture -- explaining the recent strong years for the portfolio.
There are also oddities related to stocks they sell climbing further or stocks they add to falling more, which could lead them to miss the index. According to Intech CEO Robert Garvey, there have been some tweaks in the pure math along the way to improve performance. There is also the chance that stocks chosen for a favorable covariance may change going forward. All these variables combined can only make for a portfolio that misses by 3% or 4% on the high end, as the fund is so closely based on the S&P 500.
Since inception through May 22, the fund has slightly underperformed the S&P 500. This probably has to do with large-cap stocks performing well in recent months compared to smaller fare, not the mutual fund's strategy.
The new Risk Managed fund Janus is more interesting than other funds launched by Janus in recent years. While Intech has lengthy experience managing this type of money, it's worth waiting to see how well the strategy does as a mutual fund. Just realize you can lose about as much as you would in the S&P 500.