That's A Plus

A year ago we began peering into the abyss.

Our mutual fund model, and by extension the typical client account, went into the plunge with six equity positions, a junk bond fund, and 30 percent of the portfolio in other types of fixed income funds. We implement a Flexible Beta discipline that varies clients’ risk profile based on current market conditions. Clients had some money on the sidelines, but it was almost impossible to avoid the bloodletting.

We try to get money on the sidelines during high risk markets for two reasons. First, we want to reduce clients’ risk exposure during these times, rather than sit tight and just encourage clients to “hang in there.”

The second reason we want to have money on the sidelines is so that we can take advantage of the buying opportunities that result from the market decline. We have often said that bear markets are easier to accept if you have money available to buy into the opportunity.

So, twelve months later, what did we buy and how did it work out?

First, as a point of reference, the broad market (as represented by the S&P 500 Total Return Index) is down about -6.9 percent.

About 360 days ago, we bought energy services stocks through a mutual fund. We bought them too early. If we’d purchased them 330 days ago, I’d be a lot happier. But in the model portfolio the position has a small gain (not quite 8 percent) and hopefully clients will see their holdings up slightly over cost, also.

Then, around November 1, the model purchased a fund that owns preferred stocks. At the time, bank stocks were actually outperforming the market, but we had been avoiding the stocks for many months and, frankly, I still didn’t trust the bank CEO’s who were saying that the worst was behind us. On the other hand, I think that the media was exaggerating the likelihood of massive bank failures and preferred stocks, which were dirt cheap so long as the institutions didn’t go bankrupt, looked interesting. It was another example where the work we do in individual securities helped uncover investment ideas that our fund-owning clients could use as well.

We sold those positions in July for roughly a 17% gain. The proceeds from that sale are still in cash.

The junk bond position we’d originally owned had fallen almost as much as the stock market had dropped. We were astonished at the bargains available in that sector last December so we decided not to sell that fund, assuming again that any sort of “muddle through” recovery would leave junk bond investors with dramatic capital gains on top of a nearly 20 percent current income return.

In fact, we were so enamored of the stock-like potential return on high yield bonds that we bought more of them on December 31, as a New Year’s present to ourselves and clients. That purchase, with 20/20 hindsight, was well timed. The model portfolio shows a nearly 63 percent gain in that position.

Note to clients - we consider those to be part of our "stock portfolio" at the moment.  They clearly performed more like stocks than bonds in last year's downturn.

These three purchases have helped the model portfolio weather the tumultuous economic environment. While the market has fallen -6.9 percent during the 12-month period ending September 30, 2009, the mutual fund model portfolio is up 9.9 percent over the same period. Clients need to check your statements to confirm that you are really up year-over-year while the market continued its slide.  Model returns and client returns do not always match, and I can't be more specific without catching hell from the regulators.

Now, granted, for a 9.9 percent return, I’m not certain that I wouldn’t rather have sat out the whole near-Depression scare and watched from the sidelines. But a plus is better than a minus. That’s all I’m saying.

Year-to-date, the model portfolio is up +30.65%. The market is up +19.3%. For pundits who say that we must be taking on extra risk to be beating the market, the burden is on naysayers to explain how these portfolios did better during a period of extraordinary turmoil while most risk-takers, worldwide, were being blown out of the water.  We believe in flexible beta.  The amount of risk that investors take on should vary across the market cycle.

Since inception, the chart below tells the story.

It's always easier to explain the past than plan for the future.  We'll get back to trying to give our best guess about the future in upcoming posts.

In trying times, such as these, we all learn to be thankful for the good things.  Right now, I am unbelievable grateful for the last year's client returns.  They had a plus in front of them.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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