Our May commentary addressed U.S. stock market performance from January to May. As you may recall, returns had been up and down, large and mid caps had trounced small caps, and value had beaten growth. While the returns of Ariel Fund and Ariel Appreciation Fund were quite similar, the disparity between benchmarks made Ariel Fund look solid and Ariel Appreciation Fund appear lethargic. This commentary will focus more attention on assessing performance generally and on the Russell Midcap Value Index in particular.
Dissecting investment results can be tricky. First and foremost—and this is no secret—strong absolute returns sometimes mask poor relative returns, while low absolute returns can actually be solid in a given market environment. That is, a +10% gain is not astounding in the context of a market that is up more than +32%, as the market was in 2013. By contrast, a –10% loss would have been stellar for an equity portfolio in 2008, when the S&P 500 plummeted –37%.
Even relative returns, however, can be confounding. Portfolios typically compare themselves to specific benchmark indexes, but such indexes themselves can run hot and cold against the broader market and against active managers in the same niche. For instance, examine the following performance table from the midpoint of 2014:
Performance data quoted represents past performance. Past performance does not guarantee future results. All performance assumes the reinvestment of dividends and capital gains. Performance and rankings are those of the Investor Class shares. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. Performance data current to the most recent monthend for the Fund may be obtained by visiting our web site, arielinvestments.com.
If you look at Ariel Appreciation Fund simply in the context of its primary benchmark, it frankly does not look so good. The fund lags slightly over the 1- and 3-year periods, and inches ahead again only at the 5-year mark, while falling behind its benchmark again at the trailing 10-year period. Adding context tells a different story, however. The Russell index trounces the Morningstar categories closest to it. Meanwhile, Ariel Appreciation Fund outperforms its peers over the 1-, 3- and 5-year periods—earning a top decile mark in the last of these. Oddly, the benchmark is the outlier.
People generally assume a benchmark should be average and thereby fall in the middle of a category group, but that is not always the case. As a matter of fact, the following chart shows where the Russell Midcap Value Index would land in Morningstar’s Mid-Cap Blend and Mid-Cap Value categories:
A relevant index landing in the top half or even the top quartile of a mutual fund category would not be mind-blowing, but regularly achieving top-decile performance signals a hot index.
Indeed, the Russell Midcap Value Index lately looks hot against its Russell index siblings as well. Below is a broad selection of other Russell indexes—the value, core and growth versions of large, mid, smid, and small indexes.
People generally assume a benchmark should be average and thereby fall in the middle of a category group, but that is not always the case. As a matter of fact, the following chart shows where the Russell Midcap Value Index would land in Morningstar’s Mid-Cap Blend and Mid-Cap Value categories:
A relevant index landing in the top half or even the top quartile of a mutual fund category would not be mind-blowing, but regularly achieving top-decile performance signals a hot index. Indeed, the Russell Midcap Value Index lately looks hot against its Russell index siblings as well. Below is a broad selection of other Russell indexes—the value, core and growth versions of large, mid, smid, and small indexes.
In summary, the Russell Midcap Value Index beats its Russell peers in both the first and second quarters of 2014, and it also ranks number one out of twelve for the 1-, 3- and 5-year periods. (To pile it on, it was number one over the 10-year period as well, falling to number two over the 15-year mark.)
Finally, we want to note: the Russell Midcap Value Index has done this before. We used rolling five-year returns to see whether the index had long stretches of large outperformance versus the funds it should most closely parallel. We compared the Russell Midcap Value Index’s five-year returns to the Morningstar Mid-Cap Value category average as far back as we could. Similarly, we assessed the Russell 2000 Value Index against the Morningstar Small Value category average. While the small-cap index is fairly balanced against small value funds, the Russell Midcap Value has serially crushed the funds most like it. For instance, the Russell 2000 Value’s most remarkable stretch versus small value funds was a seven-month run, from August 1995 through February 1996, wherein its five-year returns topped the category’s returns by an annualized average of 350 basis points per period. The Russell Midcap Value’s streaks make that one look meager. Over an eleven-month period, from mid-1995 through mid-1996, it trounced the Morningstar Mid-Cap Value category by an average of 375 basis points per period. Then, for nearly four years, from late 2004 through late 2008, the Russell Midcap Value Index’s five-year returns topped the Morningstar Mid-Cap Value category’s returns for 46 straight months, by an annual average of nearly 350 basis points per year.
As we have said before, fully explaining this seemingly anomalous performance is no easy feat. The Russell Midcap Value Index has a hefty collection of REITs, which tend to have clusters of good returns of late, and it also features strong doses of utilities and energy stocks, which can strongly correlate with the REITs at times to give a boost. We think there is also likely a momentum component whereby the index captures good returns as stocks rise through it on the way from small to large, though their fall from large to small hurts it less. Investors need not, however, know such details. In our opinion, by far the more important point is: comparing portfolio returns to benchmark returns is a good starting point for assessing performance, but it is not an end point. One should also consider portfolio performance versus peers and the index’s performance versus other indexes. Certainly, stock-pickers can get hot, but they are not the only ones. Even unmanaged indexes run hot and cold, and it is important to know when they are doing so. Most importantly, at Ariel we are not going to mimic an index in order to chase its performance. For the most part, companies in the REIT and utilities fields, among others, fall outside our circle of competence. When they run, we have tended to plod along in our own direction.
This history begs an important question: should investors index mid caps? At Ariel we certainly see the rationale behind indexing efficient market areas. We see large caps as a quite efficient market but view small caps as inefficient (and micro-caps as highly inefficient). Mid caps are in the middle: as a group they often behave efficiently, but by themselves not all of them do, and not all the time. So we do think indexing mid caps would be a reasonable long-term strategy. On the other hand, we think talented managers can find an edge in mid caps over long periods, so we also do not consider indexing to be a slam-dunk by any means. Most importantly, we believe attempting to passively track the Russell Midcap Value Index at this point in order capture its remarkable returns would be performance chasing. And when investors chase returns, it proves very difficult to catch up: the high returns often decline just after they appear enticing.
The opinions expressed are current as of the date of this commentary but are subject to change. The details offered in this commentary do not provide information reasonably sufficient upon which to base an investment decision and should not be considered a recommendation to purchase or sell any particular security. Past performance is no guarantee of future results. Investing in mid-cap stocks is riskier and more volatile than investing in large-cap stocks. The intrinsic value of the stocks in which the Fund invests may never be recognized by the broader market. Investing in equity stocks is risky and subject to the volatility of the markets. Ariel Appreciation Fund often invests a significant portion of its assets in companies within the financial services and consumer discretionary sectors and its performance may suffer if these sectors underperform the overall stock market. For Morningstar Data Shown: © 2014 Morningstar. All rights reserved. The Morningstar information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of information.
As of July 31, 2014
The Russell Midcap® Value Index measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap Index companies with lower price/book ratios and lower forecasted growth values. Russell® is a trademark of Russell Investment Group, which is the source and owner of the Russell Indexes’ trademarks, service marks and copyrights. Investors should consider carefully the investment objectives, risks, and charges and expenses before investing. For a current prospectus or summary prospectus which contains this and other information about the funds offered by Ariel Investment Trust, call us at 800-292-7435 or visit our website, arielinvestments.com. Please read the prospectus or summary prospectus carefully before investing. Distributed by Ariel Distributors LLC, a wholly owned subsidiary of Ariel Investments LLC.
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