ETF Replacements For Contrafund

February 24, 2014

What would a shift out of a mutual fund and into an ETF look like up close?

Since exchange-traded funds have been eating mutual funds' lunch for years now, I imagine investors would like to think about how to make the switch to ETFs.

Fidelity's Contrafund is the largest actively managed U.S. equity mutual fund, so I challenged myself to find ETF replacements for Contrafund. Specifically, the goal was to match Contrafund's five-year returns and current portfolio.

A replacement could also be an improvement. Contrafund distributed 9.3 percent in capital gains over the 12 months to Feb. 7, 2014. At short-term rates, that translates to a 3.68 percent dead-weight loss. An ETF with similar pretax returns would be a long-term win for investors.

To get started, I decided to look at what Contrafund's website says the fund does. Here's the description:

Fidelity Contrafund is a diversified equity fund with a large-cap growth bias. Our investment approach seeks companies we believe are poised for durable multiyear earnings growth that is not accurately reflected in their current valuation. In particular, we emphasize companies with "best-of-breed" qualities, including those with a strong competitive position, high returns on capital, solid free cash flow generation and management teams that are stewards of shareholder capital.

Contrafund's published benchmark is the S&P 500 Index.

As of Dec. 31, 2013, Contrafund's portfolio was 88.42 percent U.S. equities and 9.35 percent developed-market equities, with the balance mostly in cash. Its top sector at that time was information technology, followed by consumer discretionary and its largest constituent is Google. Its style map shows it as a large growth fund, both currently and historically.

Finding The Right ETF To Match Contrafund

A near-90 percent allocation to U.S. equities suggests that the obvious place to start is with U.S. equity ETFs. The "large-cap growth bias" is not particularly useful, as definitions of both "large-cap" and "growth" can vary. Contrafund's style map consistency means a recent holdings-based analysis has a chance of leading me to a long-term match, barring future style drift.

My first step was to find Contrafund's market segment, by comparing its basic statistics with MSCI indexes covering a few parts of the U.S. market. Here's how I chose the comparison universe:

Contrafund's S&P 500 benchmark is a U.S. large-cap index, but many investors use it to represent the entire U.S. stock market. My test indexes were the MSCI USA Large Cap and the MSCI USA Investable Markets.

Again, Contrafund calls itself a large-cap growth fund. My test indexes: MSCI USA Large Cap Growth and MSCI USA Investible Markets Growth. (I threw in this last one for completeness.)

I found Contrafund's most recently published portfolio in Bloomberg's database. The portfolio has a weighted average market cap of $111 billion, and a trailing 12-month price/earnings multiple (P/E ratio) of 28.44.

Contrafund's $111 billion weighted average market cap and its 28.44 P/E ratio align it well with the MSCI USA Large Growth and the USA Investable Markets indexes.

Portfolio Statistics: Contrafund Vs. Four MSCI Indexes

Benchmark Name/Fund Name Weighted Average Market Cap P/E Ratio
MSCI USA Large Cap 130,279,459,332 18.59
MSCI USA Large Growth 123,162,786,854 22.20
Contrafund 111,081,703,395 28.44
MSCI USA Investable Markets 94,334,928,254 21.03
MSCI USA Investable Markets Growth 86,321,253,037 25.38

....

Regression Results: Contrafund Vs. MSCI USA Large Growth And Investable Markets Indexes

Large Growth USA IMI
1 year 5 years 1 year 5 years
Goodness of Fit 96.6% 96.3% 94.8% 94.5%
Beta 1.05 0.95 1.02 0.85
Alpha (95% significance) None None None None

"Large Growth" was the clear winner, with tighter correlations and less volatility.

Contrafund's claims to be a large-cap growth fund stand up to testing. Now that I've identified Contrafund's segment, I'll draw from a pool of ETFs to test as replacements for Contrafund; namely, the 16 U.S.-listed large-cap growth ETFs. You can find the full list on ETF.com's ETF Finder tool.

I quickly shrunk the field to 13 funds, because, of the 16, two track the Russell 1000 Growth index, and three track the S&P 500 Growth Index. BlackRock's iShares Russell 1000 Growth ETF (IWF| A-89) is both more efficient and more liquid than the Vanguard Russell 1000 Growth (VONG | A-89) for the Russell 1000 Growth, and the iShares S&P 500 Growth ETF (IVW | A -90) is the best choice among the S&P 500 growth trackers.

I also filtered out ETFs with less than five years of history. Eight funds are left.

Looking at Contrafund's beta to the MSCI USA Large Growth index allows me to narrow the replacement candidates list down to six funds.

That's because two of those remaining eight candidate funds, the First Trust Large Cap Growth AlphaDex Fund (FTC | B-59) and the Guggenheim S&P 500 Pure Growth ETF (RPG | A-56), have one- and five-year betas to this index that are out of Contrafund's range—1.15/1.09, and 1.17/1.21, respectively. In other words, these funds have been riskier than Contrafund.

The next step involves comparing key portfolio statistics for the six remaining funds with the Contrafund. The PowerShares Dynamic Large Cap Growth Portfolio (PWB | A-72) portfolio doesn't match Contrafund's. So, now I'm down to five funds.

Portfolio Statistics: Contrafund Vs. Six US Large-Cap Growth ETFs

Fund Tickers Fund Name #1 Sector #2 Sector Weighted Average Market Cap TTM P/E Ratio Worth Testing?
FCNTX Contrafund Technology Consumer Cyclicals 111,081,703,395 22.48 Yes
MGK Vanguard Mega Cap 300 Growth Technology Consumer Cyclicals 122,212,205,765 22.15 Yes
IVW iShares S&P 500 Growth Technology Consumer Cyclicals 126,092,536,150 20.62 Yes
IWF iShares Russell 1000 Growth Technology Consumer Cyclicals 96,211,924,137 23.07 No
PWB PowerShares Dynamic Large Cap Growth Consumer Cyclicals Industrials 76,179,516,130 25.71 Yes
VUG Vanguard Growth Technology Consumer Cyclicals 98,434,986,310 23.75 Yes
JKE iShares Morningstar Large-Cap Growth Technology Consumer Cyclicals 129,583,214,978 24.85 Yes

Finally, the quant magic can begin.

 

I can now compare each of the ETF candidate funds' returns to Contrafund's, looking for the tightest correlations and risk levels over the past one- and five-year periods.

Regression Results: Contrafund Vs. Five US Large-Cap Growth ETFs

MGK VUG IVW IWF JKE
1 year Goodness of Fit 0.96 0.97 0.96 0.97 0.96
Beta 1.03 1.00 1.04 1.04 0.99
5 years Goodness of Fit 0.96 0.97 0.96 0.96 0.96
Beta 0.95 0.92 0.94 0.93 0.91

Two good choices pop up: the Vanguard Growth ETF (VUG | A-89) and the Vanguard Mega Cap 300 Growth ETF (MGK | A-93). While VUG looks like a fantastic match over the past year, Contrafund's low five-year beta makes VUG look risky in comparison.

MGK seems a better match over the long haul.

Too bad VUG and MGK are not the same funds they were five years ago. In April 2013, Vanguard switched these two funds from tracking MSCI indexes to a new series from the University of Chicago's Center for Research in Security Prices (CRSP). The one-year regressions contain some data from Vanguard's MSCI days; the five-year regressions are irrelevant.

So now I have to test Contrafund against VUG's and MGK's current CRSP indexes.

CRSP publishes returns data back to September 2012—only enough for a short-term check. I ran an out-of-sample test of Contrafund's returns versus the pre-change CRSP index.

Regression Results: Contrafund Vs. VUG And MGK's New CRSP Indexes

Sept 2012 - April 2013 CRSP Mega Growth Index (MGK) CRSP Large Cap Growth Index (VUG)
Goodness of Fit 0.97 0.98
Beta 0.97 0.93

....

These Vanguard funds won't work, because Contrafund's low beta to the CRSP indexes implies that replacing Contrafund with either MGK or VUG could add risk.

Of the remaining three funds, the beta on the iShares Morningstar Large-Cap Growth ETF (JKE | B-89) beta looks attractive over the past year, but not over the five-year period. On that basis, I can't recommend JKE as a replacement for the Contrafund.

This leaves two funds, IVW, the iShares S&P 500 Growth ETF (IVW | A-90), and IWF, the iShares Russell 1000 Growth ETF (IWF| A-89).

How shall I choose?

Maybe I don't have to. Contrafund's weighted average market cap sits between IVW's and IWF's. A 50/50 combination of IVW and IWF has a weighted average market cap of $111.1 billion, just like Contrafund's. Also, it turns out the combination portfolio's five-year returns are a great match for Contrafund's.

Annualized Returns: Contrafund Vs. IVW, IWF And A 50%/50% Combination

Return As Of 2-7-14 1 Year 3-Year Annualized 5-Year Annualized
Contrafund 26.56% 14.19% 18.94%
IVW 24.26% 14.37% 18.38%
IWF 24.23% 13.47% 19.31%
520% IVW, 50% IWF 24.24% 13.92% 18.85%

It turns out that the 50/50 IVW-IWF portfolio is the best ETF proxy for Contrafund.

Some years Contrafund would have been the better choice, and in other years the IVW/IWF portfolio would have outperformed. But neither by much.

After taxes, the ETF portfolio probably would have prevailed nearly every year.

Annual Returns: Contrafund Vs. IVW, IWF And A 50%/50% Combination

Sept 2012 - April 2013 2013 2012 2011 2010 2009 2008
Contrafund 34.15% 16.26% -0.14% 16.93% 29.23% -37.16%
IVW 32.48% 14.39% 4.49% 14.85% 31.35% -34.95%
IWF 33.19% 15.03% 2.47% 16.47% 36.93% -38.47%
520% IVW, 50% IWF 32.84% 14.71% 3.48% 15.66% 34.14% -36.71%

Using the fund description, portfolio, historical returns and my knowledge of ETF history, I found substitutes with the same overall goals, the same weighted average market cap and a similar pattern of returns.

With their low costs, tax efficiency and transparency, IVW and IWF have every chance to prove themselves to Contrafund's followers.

So, which big mutual fund Goliaths should I target next?


At the time this article was written, the author held no positions in the securities mentioned. Contact Elisabeth Kashner at [email protected].

 

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