AlphaClone & the "Value Effect"

Great article entitled"Rob Arnott's Magic Indexing Formula" by Shawn Tully at Fortune magazine recently. The article describes Arnott's investment research approach and how his FTSE RAFI US1000 index, which is offered by Charles Schwab as a mutual fund and by Invesco Powershare as an ETF (ticker: PRF), has outperformed the S&P500 index by 2.4 percentage points per year since inception (12/30/2005). Impressive. For those of you unfamiliar with Rob Arnott and his RAF indexing approach it is definitely worth a look.

Arnott's approach as described in the article basically boils down to one simple premise, market cap weighted indexes tend to over weight expensive growth stocks with potentially very adverse results. To illustrate this dynamic, the article points out an astonishing fact that Arnott discovered early in his career; from 2000 and 2002, the average stock in the Russell 3000 increased by 20% while the index fell by 20%. To avoid this systemic flaw, Arnott's index weights stocks based on their “economic footprint” instead of their market cap. The approach takes into account a company's revenues, cash flows, book value and dividends to derive it's “economic footprint” and then weights the stock accordingly. The result, termed “the value effect” is that the index tends to overweight companies trading at cheap prices and underweight companies trading at high multiples – which I'm sure we can all agree is a good way to approach stock selection.

We think that the “value effect” is also a big reason (but not all the reason) why AlphaClone delivers performance. As we've often stated, where there are speed bumps and train wrecks in the market you'll find our managers picking through the wreckage. I've seen it happen every time the market has pulled back significantly. More specifically, managers in our database tend to love two kinds of stocks; value stocks and GARP (growth-at-a-reasonable price) stocks, both of which play into the “value effect” described above.

We thought it would be worth while to compare the performance and holdings of one of our index clones against that of Arnott's PRF strategy. Our AlphaClone Hedge Fund Index [AC/HFI] Top Holding clone is perhaps the most representative clone for hedge funds in our universe as it invests quarterly in the largest holding from each hedge fund in our database. Holding are weighted in proportion to the number of holders (i.e. if six managers hold stock x and three managers hold stock y, then stock x would have twice the weight as stock y). The results are interesting.

While our clone outperforms PRF by a significant amount (see table below), both strategies trounce the broader market. As of 3/31/2010, Arnott's PRF index returned 3.04% annualized since inception (12/30/2005) while AC/HFI returned 4.1% annualized over the same period.

AC/HFI Backtest vs. PRF – Annualized Return Since Inception

* Results are from 12/30/2005 to 3/31/2010. Source: PRF results are from PowerShares. AC/HFI results are from AlphaClone.

It's also worth noting that roughly two thirds of the 128 unique holdings in AC/HFI's current portfolio also appear as a current holding in Arnott's PRF portfolio. Perhaps even more interesting is that for stocks that appear in both strategies, there is broad agreement on which stocks to overweight (see table below).

AC/HFI vs. PRF: Top 20 Common Holdings & Relative Weights

* “Weight Ratio” is the holding's actual weight in each strategy divide by the strategy's equal weighted allocation.

That is quite a bit of overlap, but what about the 47 stocks in AlphaClone's portfolio that don't show up in PRF? Well if PRF picks 1000 stocks based on their relative value, then the 47 AC/HFI stocks that don't appear in PRF must be more growth oriented stocks. The table below lists the ten stocks that have the highest allocation in AlphaClone's portfolio but which also do not appear in PRF. As predicted, six of the ten stocks have higher P/E ratios than their sector or sub-sector but there are a couple of surprises as well; Priceline [PCLN] and Wet Seal [WTSLA] both have P/E ratios that well below their sub-sectors. In fact Wet Seal has the lowest P/E ratio of any other company listed in the Apparel Stores sub-sector. Why don't they appear in Arnott's index? More on that later.

Top 10 AC/HFI Stocks Not In PRF

* P/E of sub-sector is used unless unavailable, then P/E of the sector used.

Digging still deeper, we compared the current sector allocations for each of the two strategies. The table below outlines the current sector allocations for each.

The two strategies agree on quite a bit:

• Both strategies are the most bullish on the Financials sector, allocating roughly twice as much to it as they do to the next highest allocated sector.

• Four of the top five sectors in each strategy are the same; Financials, information Technology, Consumer Discretionary and Energy. Combined the four sectors account for 64% of AlphaClone's total portfolio vs 55% of Arnott's.

• Both strategies rank Consumer Discretionary third amongst all sectors

But there are also some notable differences:

• AlphaClone's strategy seems to show a lot more conviction as measured by the spread between the highest allocated and lowest allocated sector; 28 percentage points for AlphaClone vs. 17 percentage points for PRF.

• AlphaClone allocates nearly twice as much to the Materials sector and only half as much to the Industrials and Consumer Stapes sectors. AlphaClone's allocation to Utilities is also only one tenth that of PRF albeit both allocations are relatively low.

In summary, both the PRF and AC/HFI strategies overlap significantly across sector and individual stock allocations, and both outperform the market by a significant amount. But what gives AC/HFI the edge in performance? In our humble opinion it simply boils down to active stock selection (AC/HFI) vs. passive stock screening (PRF) . AlphaClone fund managers are the best stock pickers in the world and you can bet they are doing their homework when they make a stock a top holding. Like Arnott, our managers love value screens but they also love growth stocks that they believe are priced right and perhaps above all they are opportunistic by nature and well trained at taking advantage of those opportunities.

We are huge fans of Rob Arnott and Research Affiliates. In many ways, the firm serves as a role model for AlphaClone and what we aspire to become. Their ideas are simple, powerful, intuitive and they've been able to build a formidable research and asset management business around that simplicity. AlphaClone has that same goal and you can bet we're looking to offer a family of ETFs and managed funds as well. Stay tuned.