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What if you could clone your investment adviser and save money? Well, now you can



Mark Rutte, Mark Rutte, Mark Rutte, Mark Rutte, Mark Rutte, Mark Rutte, Mark Rutte, Mark Rutte, Mark Rutte, Mark Rutte standing in front of a crowd posing for the camera


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Can investment advisers be cloned?

That provocative possibility was raised late last year by research from Vanguard, the mutual fund company. They hypothesized that, in many cases, you could duplicate the return of your favorite manager by investing in one or more so-called factor ETFs, such as value, small-cap or momentum.

If so, replacing that manager with that basket of ETFs would be preferable, since by doing so you would gain “greater transparency, more risk control, and lower implementation costs,” per Vanguard.

It’s one thing to assert that this might be theoretically possible, and quite another to show how often you could do so in practice. Vanguard did not address this latter question, so in this column — my regular monthly focus on the latest Wall Street research — I intend to make up for this lack.

To illustrate, consider one of the top-performing U.S. equity mutual funds over the five years through the end of 2020: The Fidelity Advisor Growth Opportunities Fund The fund has nearly doubled the annualized total return of the S&P 500 Index 32% to 16.3%.

Following the lead of the Vanguard research, I wanted to know if it would have been possible to replicate this fund, and not just its return but also its monthly volatility, by creating a buy-and-hold portfolio of six different factor ETFs:

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The answer is largely yes — by overweighting the momentum and small-cap factor ETFs, and underweighting the value and low volatility ETFs. To appreciate how good a clone this portfolio would have been, consider the r-squared of the correlation between the clone and the actual portfolio: It would have been 0.91, which means that 91% of the Fidelity Advisor Growth Opportunities Fund ’s monthly returns and volatility could have been duplicated by its clone.

This isn’t a criticism of the Fidelity fund. The fund’s managers deserve credit for creating the combination of factors that led it to outperform the market. But now that they have done so, the bar over which they must jump has been raised.

I know that can seem unfair. It used to be that managers were thought to have added value if they could beat the market. Now the hurdle they must clear is beating their clone.

The Fidelity Advisor Growth Opportunities Fund is just one example. To expand the analysis, I focused on all the U.S. equity-oriented model portfolios maintained by the investment newsletters my firm monitors. In each case, I calculated the r-squared of the correlation between the newsletter’s actual portfolio and its clone.

On average across all the newsletters, the r-squared was an impressively high 0.84. That means that it was possible to create a cloned portfolio that explains or predicts 84% of the average newsletters’ actual monthly returns.

And not only were these cloned portfolios highly correlated with the actual portfolios they were imitating, they also performed better. On average, the cloned portfolios produced monthly average returns that were 10 basis points better — equivalent to over 1 percentage point per year.

That’s very humbling indeed. It’s the equivalent of discovering that our clones are smarter, more athletic and good-looking than we are ourselves.

Unfortunately, there were a handful of managers who couldn’t be cloned, but that nevertheless beat the market. But they were in a small minority.

To be sure, the statistical calculations involved in conducting this analysis are formidable. So this is not something you can easily do by yourself at home. One possibility, according to Vanguard, is to use the functionality available at Morningstar Direct, though even that requires a considerable level of statistical sophistication.

In the meantime, however, Vanguard’s new research illustrates how high the hurdle is that a manager must jump over to justify following him with your hard-earned money. If he can’t, then you should construct a buy-and-hold portfolio of ETFs that, as close as possible, matches the characteristics of the manager in whom you were otherwise interested.

Mark Hulbert is a regular contributor to MarketWatch. His Hulbert Ratings tracks investment newsletters that pay a flat fee to be audited. He can be reached at [email protected].

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