The Float

Agility Matters

We've long argued (here, here, and here, for example) that most big mutual funds are a rotten deal for individual investors. Due to their size, trading costs, and diversification, many of these funds end up behaving like very expensive index-trackers over full market cycles.

Most of the evidence we've pointed to has focused on big, lumbering laggards. Yesterday's Wall Street Journal featured a story on the best-performing funds in the first half of the year, and the upshot is clear: Small is beautiful.

While their names mightn't be familiar to many investors, there were some stock funds that delivered stellar returns over the past year.

Among the seven best-performing funds in the 12 months to July 31, none is from the 25 largest mutual-fund companies and none of the funds has more than $700 million in assets, according to data from Morningstar Inc.

Despite the market downturn that saw the Standard & Poor's 500 Index lose 22% during the 52-week period, the seven funds, all of which invest in long-only securities and are mostly invested in stocks, have seen double-digit returns.

Six of the funds use "value" strategies, while four have concentrated portfolios and held fewer than 40 stocks, according to the most recent data. The figures suggest investors should take note of smaller funds, if nothing else than for their ability to be more flexible in challenging markets.

Indeed.

Source

Sam Mamudi, "Top Funds' Traits: Strategy and Size," Wall Street Journal, August 6, 2009

"Failure of a Fail-Safe Strategy"

Given the meltdown in so many asset classes over the last two years (remember: it was in the Summer of 2007 that the music first stopped without enough chairs), it has become somewhat fashionable to question the benefits of diversification across asset classes.

We've weighed in on this issue here and here, arguing that diversifying across relatively risky asset classes shouldn't be--and never should have been--seen as a means of reducing risk amid crisis conditions.

On Friday, Tom Lauricella filed another entry in the not-so-sure-about-this-asset-allocation-thing genre. As he so often does, Lauricella handles the material well, noting that correlations among risky asset classes had been rising before the recent meltdown. But the most important point about the last 24 months is that cash-equivalents and treasuries held up remarkably well, providing capital preservation and even some appreciation for investors who held them while risky assets cratered.

Lauricella's story opens with a Raymond James broker saying, AA-style, that he's "a recovering asset-allocationist." Near the end of his piece, Lauricella tells us about this broker's new style: more cash, and more flexible mandates for the active managers he hires for clients. We think this makes pretty good sense. As we've argued repeatedly in this space, asset allocation should be inexpensive and index-based; active management should be nimble and relatively unconstrained. In other words, they should be different, and purchased/pursued under different frameworks (not in the big, expensive mash-up of market- and manager-driven returns offered by most mutual funds).

Lauricella closes with this telling sequence about his example broker:

He says he is convinced there is a way to make diversification work. In fact, after the strains of last year, he says, many investments are behaving more like they did before 2008.

Asset allocation, he says, "might well have been injured....But I don't think it's gone forever."

No doubt. Properly understood and executed, asset allocation remains a perfectly intelligent strategy. To paraphrase Churchill's quip about democracy, asset allocation might be the worst thing out there...except all the others that have been tried.

One more note: Be sure to look at the WSJ's interactive graphic on asset-class correlations over the last 15 years. Good stuff.

Source

Tom Lauricella, "Failure of a Fail-Safe Strategy Sends Investors Scrambling," Wall Street Journal, July 10, 2009

From the Contrarian Files

From time to time a headline strikes us as an especially fraught suggestion that the investing herd is buying or selling en masse, often quite late in whatever the latest game might be. In Monday's Wall Street Journal, Shefali Anand came up with a classic of the genre: "A Taste for Risk--Again." Here's how the story opens:

It's amazing the difference a rally can make in investors' appetite for risk.

A few months ago, mutual-fund investors were yanking money out of stocks and high-quality corporate-bond funds and parking it in safer places, like money-market funds and U.S. Treasurys. Lately, however, as stock and bond markets have rebounded, mutual-fund investors have had a split personality.

They're back to buying relatively safe investments like high-quality corporate bonds. But they're also pouring money into the riskiest investments. They're lukewarm toward U.S. stocks but plunging into high-octane vehicles like emerging-market companies, commodities and junk bonds--making these among the 10 best-selling mutual-fund categories this year.

Unfortunately, the story doesn't deliver enough compelling data to get our contrarian hackles all the way up, but it's one of those things that gives us pause.

And here's another ingredient in our current caution. In the chart below, you'll see how the 20-day moving average of the S&P 500 (the red line) provided support on two key occasions during the rally off the market's March lows (especially on April 20^th/21^st and throughout mid-May). Then on June 15^th the S&P closed right on the 20-day, broke below it on the 16^th, and bumped its head on it at the start of July. In addition, the 20-day has rolled over.

In the relatively short term, we don't make much of moving average crossovers, but we've certainly noticed that the 20-day is now moving lower for the first time since the middle of March.

None of this is to say that the rally can't or won't re-ignite. But the Summer's burden of proof may have shifted from the bears back to the bulls.

Source

Shefali Anand, "A Taste for Risk--Again," Wall Street Journal, July 6, 2009

More From Dalbar

Back in March, we posted a brief overview of Dalbar's most recent edition of its "Quantitative Analysis of Investor Behavior," an authoritative study of the perennial gaps between market returns and fund returns on the one one hand, and fund returns and investor returns on the other. Summary: The numbers get uglier with each step away from market returns--and (stock) market returns haven't been especially thrilling in the first place!

Via Mebane Faber, we found Dalbar's fuller treatment of its 2009 report (which is through year-end 2008). This is good, important stuff. Take a look.

Target-Date Funds and Portfolio Completion

On Friday, Investment News reported findings from a Janus Capital survey of retirement plan participants and sponsors. The focus: Target-date funds in defined-contribution plans.

Two-thirds of investors believe that target date funds need to be combined with other funds to achieve a proper mix for their retirement portfolios, a white paper released yesterday by Janus Capital Group Inc. of Denver suggests.
...

The study also found that some plan sponsors did not apply the same level of due diligence to target date funds as other funds.

While 60% of plan sponsors said they evaluated individual target date funds and their underlying holdings when selecting a series of funds, 40% said they did not.

Now, that first set of findings--that many rank-and-file investors use target-date funds "off-label," by combining them with other investment options--typically unleashes a lot of tut-tutting from the financial services crowd. Having seen the composition of a lot of target-date funds, we reckon many of those investors are right...they aren't complete solutions.

Unfortunately, however, many retirement plans that include mediocre target-date funds will lack the complete investment lineup participants want (and need, whether they want it or not).

Now, it's certainly true that a large number of participants aren't clear on the all-in-one concept of target-date funds. And where participants find themselves trading investment vehicles around their target-date funds, they're likely to create more problems than they solve.

The important point here is that some participants have very good reason to view their plans' target-date funds as incomplete. Whether they can round out their portfolios effectively...well, that's another story.

On the question of plan sponsors and their due diligence, this is clearly problematic, and it's symptomatic of a larger shortcoming in the retirement plan marketplace: the informational asymmetry between busy, non-expert plan sponsors (i.e., buyers) on the one hand and financial services firms (i.e., sellers) on the other.

But let's stipulate that a given sponsor wants to perform the same due diligence on those target-date offerings. What are the appropriate criteria? In the fund-selection game, that question isn't any easier to answer in the target-date space as it is in the mutual fund space in general. What are the criteria? Past performance? Doesn't tell us much, and chasing the leaders tends to be a losing strategy. Expenses? That's a good place to start, but don't forget the hidden ones. Asset-class exposure? Sure, but isn't that a problem for investment professionals?*

Apparently Morningstar is going to take a swing at this by publishing ratings on target-date funds. Using an alliterative set of criteria--people, parent, performance, portfolio and price--Morningstar will try to help sponsors and participants make sense of the target-date universe. We'll reserve judgment on these ratings until we see them.

As always, however, there will be no substitute for dispassionate guidance, for sponsors and participants alike, from truly independent fiduciaries.

~~~~~~~~~~~~~~~~

* Indeed it is, which is why the hiring of truly disinterested, fully independent, product-agnostic fiduciaries is so immensely important.

Source

Sue Asci, "Target date funds shouldn't stand alone, most investors believe," Investment News, May 29, 2009

Caitlin Mollison, "Morningstar to introduce ratings on target date funds in 3Q," Investment News, May 28, 2009

Brett Arends' 12 Rules

Back on May 1^st, the WSJ's Brett Arends spun out "12 Rules for Investing in the Next Bull Market," most of which are insightful and helpful. We generally like Arends' work and this piece is no exception. Though we're quibblers by nature, this is pretty strong stuff and it deserves your consideration. Here are a few of Arends' rules followed by our comments:

2. Avoid big moves.
If you buy or sell heavily in one shot you're taking a needless risk. And waiting for the right moment to make your move is futile. You probably won't catch the bottom or the peak anyway. If a market trend has much further to run, then what's the rush? And if it doesn't...what's the rush?

No quibbles here. This is exactly right. 

6. Be truly diversified.
That means investing across a spread of different asset classes and strategies. As investors discovered last year, "large cap value" and "mid cap blend" funds don't offer diversification. They're just marketing gimmicks.

Though it's true that correlations rose sharply among risky asset classes during the last 20 months, we aren't willing to concede this point. There are ways to slice the market too narrowly, but historically there have been--and, we think, will be again--material differences in the risk/return profiles of various classes of equities. Tilting strategic portfolios in one direction or another by weighting assets classes isn't just a marketing gimmick. Or, to be more precise, it isn't necessarily, or always a marketing gimmick.

10. Be patient.
Investment opportunities are like buses. If you missed one, you don't have to chase it. Relax. If history is any guide, others will be along shortly.

Yes.

11. Don't sit on the sidelines completely until it's too late.
You'll probably end up splurging at the last moment. If you are afraid to invest, do it early, little, and often.

Yes.

12. And above all: Price matters.
After all, an investment is just a claim check on future cash flows, whether it be a company's profits, a bond's coupons or an annuity's income stream. By definition, shares in a solvent company are twice as good at half the price...and vice versa. It's amazing how many people get suckered into thinking it's the other way around.

And yes.

But then there's this morning's Arends column, in which he taps some recent research suggesting that near-term economic prospects have almost nothing to do with stocks' long-term returns, which in turn makes the notion of "price" a little less concrete that most investors--and certainly less concrete than most fundamental analysts--would like to believe. Here's an excerpt:

The stock market jumped 6% last week on growing hopes of an imminent economic recovery. It has risen 39% from the March lows on similar hopes. Of course, it had previously fallen nearly 60% on fears of a slump.

All these moves have one thing in common: Millions of investors have acted on the belief that share values are closely related to what will happen in the economy in the next few months and years. But are they right?

Not according to Ben Inker, director of asset allocation at contrarian fund company Grantham Mayo Van Otterloo & Co. In a recent and fascinating note ("Valuing Equities in an Economic Crisis, or How I Learned to Stop Worrying about the Economy and Love the Stock Market"), Mr. Inker persuasively argues that the next moves in the economy shouldn't actually matter too much to investors at all.

Why? Two reasons.

First, because most of the value of shares really depends on the cash they will generate many years, even decades, ahead. The next few years are only a minuscule part of the equation. "Since stocks do not have an expiration date and dividends grow over time," Mr. Inker argues, "the duration of stocks is extremely long. If we assume that half of the return from stocks in a given year comes from the dividends and half from the growth in dividends, most of the value of stocks comes from cash flows in the distant future."

(The second reason is that short-term deviations from long-term trends in economic growth are typically resolved back toward those long-term trends within a few years.)

"This sort of analysis is a useful antidote to stock market moods," writes Arends. Maybe. But the other way of looking at Inker's research is that all we really have in the short run is "stock market moods." Which means you either trade on the technicals (with some attention to short-term expectations of the fundamentals, as in a Keynesian beauty contest) or, like Joshua in War Games, refuse to play the short-term trading game in the first place.*

~~~~~~~~~~~~~~~~
* It's one of the great lines in movie history: The rogue computer program "Joshua," having realized that "global thermonuclear war" produces no winners, declares that "the only winning move is not to play."

Sources

Brett Arends, "12 Rules for Investing in the Next Bull Market," Wall Street Journal, May 1, 2009

Brett Arends, "How to Value Stocks? Ignore Economic News," Wall Street Journal, May 11, 2009

Ben Inker, "Valuing Equities in an Economic Crisis," Grantham Mayo Van Otterloo & Co., April 6, 2009 (registration required)

S&P Findings on Active Management

This isn't surprising, but it's important (emphasis added in bold):

Passively managed funds outperformed actively managed funds across all categories during the past five years according to [research from] Standard & Poor's Index Services, which was released today.

Between 2004 and 2008, the S&P 500 stock index outperformed 71.09% of actively managed large-cap funds, according to the year-end 2008 report from the New York-based research firm.

In addition, the S&P MidCap 400 Index outperformed 75.9% of mid-cap funds and the S&P SmallCap 600 Index outperformed 85.5% of small-cap funds.

"The belief that bear markets strongly favor active management is a myth," Srikant Dash, global head of research and design at Standard & Poor's, said in a statement. "The bear market of 2000 to 2002 showed similar outcomes."

Similar results were also reported for international-equity and fixed-income funds.

Among international-equity funds, the indexes outperformed a majority of actively managed non-U.S. equity funds.

For fixed income, the relative shortfall from the five-year benchmark ranged between 2% and 3% a year for municipal bond funds and 1% to 5% a year for investment grade bond funds, Standard & Poor's reported.

Here's a link to the S&P report itself. Especially impressive is the way S&P corrects for survivorship bias:

The Standard & Poor's Index Versus Active (SPIVA) methodology is designed to provide an accurate and objective apples-to-apples comparison of funds' performance versus their appropriate style indices, correcting for factors that have skewed results in previous index-versus-active analyses in the industry. SPIVA scorecards show both asset-weighted and equal-weighted averages, include survivorship bias correction to account for funds that may have merged or been liquidated during the period under study, and show style consistency for each style group across different time horizons.

As we've written over and over, some active funds do outperform the averages in given periods. (By definition!) The trick is to hire those funds before they win...and fire 'em before they lose. After all, hiring them after they've gone winning streaks raises the near-inevitable problem of mean reversion. And hiring them after they've gone on losing streaks isn't especially smart either, because the data show that under-performance is substantially more persistent than out-performance.

So what's the intelligent investor left to do? Favor passive over active vehicles, and ensure that any active vehicles are different enough from their passive counterparts to have a real shot at delivering positive alpha.

Source

Sue Asci, "S&P passive funds trumped active over past five years," Investment News, April 20, 200

Hussman on Bear-Market Rallies

Here's some good stuff from the always-worth-reading John Hussman:

Bear market rallies from oversold conditions are not predictable, in the sense that a market that has endured a steep selloff can easily continue lower another 10%-15% or more. Still, there has historically been some tendency –- on average –- for the market to rally off of deeply oversold conditions. The problem is that those generally positive averages mask an enormous amount of variation, so the actual return/risk ratio isn't nearly as attractive as one might imagine.

With the warning that the following figures do mask a very large amount of risk and variation, the charts below present the average percentage returns of the S&P 500 in the weeks following points when the index was at least 10%, 15%, 20%, 22%, and 25% below its 50-week smoothing. The 22% category is included because the sample size quickly becomes very small beyond that point. I've included two charts – one including data from 1940 through 2007, and the second including data from 2008. Note that the inclusion of 2008 makes an enormous difference, because the market simply failed to advance despite very deep compression -– a reminder about the risk and variation within these averages.

Oversold bounces: Average cumulative S&P 500 % returns 1940-2007 based on starting % below 50-week smoothing (time scale measured in weeks):

That's some serious mean-reversion.

Read the whole thing. And while you're in Hussman's 'hood, read this from Bill Hester on the significance of trading volume in bull markets and bear rallies.

Asset Allocation: Lessons from the Crash

We just ran across a fascinating little discussion of strategic asset allocation in Morningstar Advisor. Insofar as most asset classes suffered ugly losses in 2008 (in our Allocation Portfolios, the only exceptions were Treasuries and cash), one might wonder what lessons we should learn from the crash. We recommend the entire interview, but here's a highlight from David Drucker's conversation with Roger Gibson (emphasis added in underlined text):

Drucker: Was the 2008 market decline within the realm of possibility given the historical volatility of returns?

Gibson: Using Ibbotson data for the U.S. market from 1926 forward, the simple average return of S&P has been roughly 12%. If the S&P returns are normally distributed--which they're not perfectly--then you'd expect 95% of annual returns to fall within two standard deviations. One standard deviation is 20%, so two standard deviations give us a return range of negative 28% to plus 52%. Five percent of all observations would fall outside that range, so we know 2.5% of all observations will fall outside the range on the low side, and also on the high side. So looking back to 1926, we find the market's return outside two standard deviations three times: 1931, 1937 and 2008. Of course, you would also expect to see several years when returns fell in the 2.5% portion of the distribution on the high side, and we did see this in 1933 and 1954. So my point is that if you look at what happened in 2008 in the context of the good data we have on the U.S. market, and if you assume distributions are relatively normal, we actually have had experiences in the tail ends of the distribution that coincide with what we'd expect.

Drucker: So 2008 wasn't as improbable as most of us think?

Gibson: Not really. It was a crazy year, but we know those marbles are somewhere in the urn waiting to be picked. But I'd put all of this into an even longer historical context.

Drucker: How do we do that?

Gibson: We don't need to necessarily do anything differently. What will change [going forward] isn't volatility, but capital market assumptions. In other words, relative to whatever capital market assumptions advisors have been working with, 2008 will raise expected returns--in absolute terms--going forward, the spread between equities relative to fixed income will widen, and all kinds of risk premiums will widen too as a result of last year's experience. So if we look back through time, we were in a lower absolute return and lower risk premium world and, going forward, we'll be in a slightly higher absolute return world and higher relative risk premium world. During times of excessive optimism, people overshoot markets on the high side, and during times of extreme fear and panic, markets overshoot on the downside. In 2008, people panicked and dumped securities, which sets the stage for higher-than-normal rewards for people holding on.

Now go read the rest. It's all good stuff.

Monday Reading

A handful of new and old items to get the week started...

• We missed this when it first appeared, but it's no less relevant today than it was three weeks ago: "Index Funds Win Again."
• Daniel Gross weighs in on risk appetites. Short version: We gotta have 'em, not in the manic sense of the last several years, but we gotta have 'em. 
• Barry Ritholtz links to last night's 60 Minutes segments on Ben Bernanke, whose occasional expressions of flinty anger were refreshing--and seemed plenty genuine. 
• Interesting stuff from Calculated Risk (also channeling some James Hamilton) on the timing and sequence of recovery from post-war recessions. 
• We've written on "the financialization* of everything" in this space. Today the WSJ's Justin Lahart riffs on what de-financialization* might look like. (*Forgive the funky terms...they're unorthodox, but they just feel right in this context.)