The United Services Automobile Association (USAA) started during the roaring 20’s. Their story began with US Army officers who were refused insurance due to the risky nature of their careers (only 4 years removed from World War I). These men saw a business opportunity in front of them; mainly, setting up a mutual insurance company that focused on providing affordable insurance for our service men and women who were routinely rejected by the major insurance providers at that time.
Fast forward almost a century later and now we see USAA as one of the largest financial services companies in the entire country. While their original “bread and butter” was automobile insurance, their current service lineup includes the entire gamut of insurance products, banking, investments, and retirement planning. In its entirety, USAA manages somewhere around $60 Billion in total assets.
A recent report issued by Zacks Equity Research even listed some of USAA’s mutual funds that should be on investors’ radars. This includes their USAA Science & Technology (USSCX), USAA California Bond (USCBX), and USAA Aggressive Growth Fund (USAUX). We will take a deep dive into USAA’s fund lineup and see what kinds of conclusions we can draw.
The Problem
IFA has recently produced a series of articles that have focused on independence and financial advice. The motivation has been to create awareness among investors about the issues involved in having your entire financial life under a single umbrella. The main issues revolve around conflicts of interest. In today’s day and age where people expect efficiency and ease whether it is how we shop or communicate, there are potential drawbacks to having too much convenience when it comes to our personal finances.
We personally cannot speak about the quality of the insurance or banking services of USAA. A good starting point would be to look at their credit rating as an insurance company, the interest rates offered for their savings accounts, and a review of their customer service. But the one thing we can examine and speak to with a high level understanding is their investments.
As we have shown with Thrivent Financial, while the other areas of their financial services may be excellent, the investments they offer their clients are dramatically subpar. This is where the conflicts of interest arise. Although many USAA clients may be finding tremendous convenience with their finances being taken care of under one roof, it is not entirely in their best interest or is the best possible solution. To give some contrast, an independent financial advisor, like IFA, is required to find the best solution for our clients at all times.
The Methodology
We took a deeper look into the investment products of USAA and examined their performance since inception (like we have done for other fund families such as Fidelity, American Funds, Lord Abbett, JP Morgan, MFS Investment Management, and Thrivent Financial). What we have found is not surprising. The vast majority of their mutual funds have dramatically underperformed their respective benchmarks. In other words, this is just another case study that we can add to the mounting evidence that most investors are better served investing in a globally diversified portfolio of low-cost index funds.
Here is a review of the analysis we performed:
- First, we looked at the different expenses associated with these funds. This includes the expense ratio, any front-end or deferred loads, and 12b-1 fees. We also include turnover, which gives a rough indication of the amount of trading costs associated with each fund.
- Second, we computed the alpha for each of the 46 different mutual funds for each calendar year since inception based on Morningstar’s analyst assigned benchmarks
- Third, based on the average alpha and standard deviation of the alpha, we computed the t-statistic (a measure of statistical significance) for each fund. We will explain the importance of this measure later on.
- Lastly, because improper benchmarking is a serious concern whenever these types of analyses are conducted, we adjusted the returns for each equity fund based on the Fama/French 3 Factor Model. We will also explain the significance of doing so later on.
Expenses
The first part of our analysis focuses on costs, because these are one of the best indicators of future performance. In other words, there is a correlation between how much an investor pays and how much they receive in return. Unfortunately, it happens to be a negative correlation. The table below displays the costs for each of the 46 different USAA mutual funds and includes the expense ratio and turnover, which is a rough indicator of how much one is paying in trading costs.
On average, USAA investors are paying 0.89% per year to be invested in their strategies. Interestingly enough, the vast majority of their funds have relatively modest turnover averaging 29% across their entire lineup. A handful of funds are much more aggressive in their trading, but it is not universal. It does beg the question though. What are investors paying so much for? A 29% turnover implies an average holding period of each security of a little over 3 years. Either USAA’s portfolio management team believes that, on average, their relative bets on overpriced or underpriced securities will take 3 years to move towards intrinsic value OR they are charging unreasonable prices to be buy-and-hold investors.
The Alpha “Myth”
We then computed the alpha for each of the 46 mutual funds from USAA. Here is what we found:
- 10 funds (22%) had an average alpha that was POSITIVE (outperformed their Morningstar assigned benchmark)
- 36 funds (78%) had an average alpha that was NEGATIVE (underperformed their Morningstar assigned benchmark since inception)
The vast majority of their funds have failed to outperform their benchmark since inception. You can find their individual alpha charts at the bottom of this article. The most important metric to examine is the number of funds that had a “statistically significant” alpha at the 95% confidence level (t-stat greater than 2).
- Of the 10 funds that had a POSTIVE alpha, 1 (2%) had a statistically significant alpha at the 95% confidence level
- Of the 10 funds that had a POSITIVE alpha, the average t-statistic was 0.72, which means that, on average, we can only be approximately 50% confident that this outperformance is expected to persist into the future; no better than flipping a fair coin. And a fair coin doesn’t collect fees for its service
Measuring statistical significance is important when it comes to working with random variables, especially when we are advising investors with their money. Going back to flipping a fair coin analogy, it may seem plausible that if we completely filled Madison Square Garden with people and gave them a fair coin to flip, at least 1 person could flip 15 “heads” in a row. In fact, we can actually measure the odds of that happening. By random chance alone, we would expect approximately 1 out of 18,200 to flip 15 “heads” in a row. Does this mean that this particular individual has a special skill? Of course the answer is NO! They just got lucky.
The same can be said about an investment manager’s performance. Sometimes they outperform and sometimes they underperform this benchmark, but we must be careful about any conclusions we make based on their results. We could be fooled by randomness. This is especially true when we recommend any investment strategy for our clients. Going back to USAA, we can now say that we are 95% confident that only 1 fund has outperformed their Morningstar assigned benchmark. Does this mean we would recommend it for our clients? Let’s take a look at this particular fund.
The Potential Unicorn
The USAA Ultra Short-Term Bond (UUSTX) has outperformed its Morningstar assigned benchmark (Barclays Govt./Corp. 1 Year) on average by 0.94% per year. A couple of key characteristics about this fund that should be considered are its short life (5 years) and the credit quality. We believe these two factors alone can explain the outperformance. UUSTX is basically made up of 3 different types of fixed income: cash & cash equivalents (commercial paper etc.), low investment grade corporate bonds, and securitized assets (asset-backed and mortgaged backed). In comparison, the Barclays Govt./Corp 1 Year is also comprised of very high quality US government securities alongside corporate bonds and securitized bonds. In other words, UUSTX is taking more credit risk. While matching effective durations should be the biggest priority when assigning a benchmark, it is not robust. We would expect there to be a substantial premium on taking credit risk post a credit crisis (2008-2010) and we believe this is where the alpha has come from. Given the short time period and specific characteristic of low credit quality, it is very difficult to say whether or not this outperformance is expected to persist.
Better Benchmarking
In the last part of our analysis, we take each of USAA’s equity funds that have at least 10 years of performance history and adjust their returns by the Fama/French 3 Factor model. Our reasoning behind this is because more often than not, most actively managed funds change their overall exposure overtime to where they believe there is opportunity. For example, a large cap growth manager might start venturing down into mid-cap or small cap companies or might start buying stocks that are more value-oriented. A commercialized benchmark, like the S&P 500, is a general benchmark that doesn’t account for these small nuances. Because we know that overtime, small cap stocks are expected to outperform large cap stocks and value stocks are expected to outperform growth stocks, a manager who has more exposure to small cap and value stocks than their commercialized benchmark are expected to outperform their benchmark without really adding any additional value. We have written before about this issue here. By adjusting the fund’s alpha to accommodate for their exposure to the size and value premiums, we can develop a more accurate benchmark to base their performance off of.
Of the 46 different mutual funds, only 6 funds have performance history of at least 10 years. Once we adjusted their alpha for their exposure to the size and value premiums, we find that not a single fund fell within the statistically significant at the 95% confidence level region (the green section of the chart). See below.
Conclusion
USAA is a wonderful company that started with a very commendable purpose. As it has grown over the last century it has expanded its lineup of services. We can understand why that is the case. From a business standpoint, it can make sense to establish different channels of revenue. In the case of financial services, it is also very lucrative. Unfortunately, there is a natural conflict that arises from doing so. The focus can shift from servicing clients to maximizing revenue. Selling product versus giving sound advice. While investors may think that insurance, estate planning, taxes, and investing are all lumped into a single bucket at the end of the day, not scrutinizing each individual element of that plan can lead to overpaying for insurance and investing in subpar investment solutions. The compounding of these effects overtime can have a dramatic impact on accumulated wealth and standard of living in retirement. We have dissected the investment performance of USAA’s strategies to give powerful insight into one area of the financial planning process. Paying a premium in the vicinity of 0.50% per year more than simple index funds for inferior results is tremendous when compounded over a lifetime. We would recommend that investors work with independent financial advisors to ensure that their interests are being put at the forefront and are not just another piece of revenue.
And for Zacks Equity Research team, it might be time to go back to the drawing board.
Alpha Charts
Return to the Table
Here is a calculator to determine the t-stat. Don't trust an alpha or average return without one.
The Figure below shows the formula to calculate the number of years needed for a t-stat of 2. We first determine the excess return over a benchmark (the alpha) then determine the regularity of the excess returns by calculating the standard deviation of those returns. Based on these two numbers, we can then calculate how many years we need (sample size) to support the manager's claim of skill.
We have taken a deeper look at the performance of several other mutual fund companies and have come to one universal conclusion: they have failed to deliver on the value proposition they profess, which is to reliably outperform a risk comparable benchmark. You can review by clicking any of the links below:
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About the Authors
Tom Allen
Tom Allen is an Accredited Investment Fiduciary (AIF®), Certified Cash Balance Consultant (CBC) and a Chartered Financial Analyst (CFA®) Level III Candidate. Tom received his Bachelor of Science in Management Science as well as his Bachelor of Art in Philosophy from the University of California, San Diego.
Mark Hebner - Founder, Index Fund Advisors, Inc. Â
Founder and President of Index Fund Advisors, Inc., and author of Index Funds: The 12-Step Recovery Program for Active Investors. He is a Wealth Advisor, with an MBA from the University of California at Irvine and a BS in Pharmacy from the University of New Mexico with a specialization in Nuclear Pharmacy.