Heresy #3: Successful Investing Can Be Simple (Introduction)

Most investors choose their mutual funds solely based on the fund's previous track record. Past performance is certainly a critical ingredient, but it is not the only ingredient to consider. When the nation's premier fund analysts select a fund, they do so after investigating many different factors. A good long-term performance record is often the first factor of many which the analyst will use. There are many, many different variables to consider, however. Sometimes (albeit extremely rarely), the other factors might even more than offset a somewhat disappointing track record. The key to analyzing funds is to be disciplined, thorough, objective, and well informed.

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For most investors, however, a fund's performance record is the beginning and the end of the research process. According to an April 1997 "Wise Investor" survey conducted by Montgomery Securities, 63% of all investors considered investment performance to be the single most important factor in assessing a fund. As a result, Morningstar's 4-star and 5-star funds (so-ranked exclusively because of the fund's previous performance record) took in 80% of the money invested in mutual funds during 1996. Investors looked for a hot funds in which to dump their money. That is how managers like Garrett Von Wagoner attracted a billion dollars almost overnight during the go-go 1990's.  Given the 2009 rush into bond funds after the 2008 market crash, it doesn't appear that things have changed much in the last 15 years.

Is previous performance important? Yes. Is is all-important? Absolutely not!

• The task at hand:

Identifying the successful 1 out of 5 mutual funds is not an easy task. With 4 out of every 5 mutual funds underperforming their benchmark, any fund chosen at random is likely to disappoint. Successful fund picking, even more than stock picking, is a challenging endeavor.  Furthermore, hiring an independent investment advisor raises the ante. These investment advisors must not only try to beat the market, but they must beat it by a large enough margin that their excess returns offset the 1% to 1.5% fee that they charge customers. In other words, not only must your investment advisor uncover the rare fund which outperforms the index, he must find the even less common outperformer which manages to beat the market by 100 basis points (equal to 1%) before any of that advantage is passed on to the client. The first 100 basis points of outperformance merely goes to pay his or her fee! This is quite a hurdle, indeed.

Ken Gregory has published Litman/Gregory’s research in the No-Load Fund Analyst since 1989. This newsletter is available to retail investors and incorporates some of the most in-depth fund analysis available anywhere. AdvisorIntelligence.com offers this same research to investment professionals, but also makes available the practice management advice and client communications that Litman/Gregory uses for their own clients. Stephen Savage now edits the newsletter (as well as AdvisorIntelligence.com), and for a subscription cost of $600 per year, retail investors get to piggy-back on the conclusions of 10 of the most experienced fund analysts in the country, five of whom have earned the prestigious Chartered Financial Analyst (CFA) designation!


Ken Gregory and his partner, Craig Litman, launched their investment advisory business in 1987, the year of the crash. The frightening plunge that October didn't help them as they began marketing their new business. They started the newsletter in 1989 to generate additional revenue for their struggling new enterprise. They were already performing the fund research anyway, they figured, so why not reconfigure their research for distribution via a newsletter.

It took about a year for the No Load Fund Analyst publication to really get off the ground. Perhaps coincidentally, at this same time the independent investment advisory industry also began growing rapidly. The newsletter's subsequent growth resulted from its national reputation as providing high quality, comprehensive information on mutual funds. Although the newsletter has never been aggressively marketed, Ken Gregory benefited from good press coverage. He was widely quoted in newspapers and periodicals, including Kiplinger's, Money, Worth, Mutual Funds Magazine (now defunct) and The Wall Street Journal.

There is no doubt, however, that Ken Gregory's trademark is his in-depth analysis. The Litman/Gregory team has been comparing funds based on distinct investment "styles" since the first issue of the No-Load Fund Analyst in November 1989. These styles enable an "apples to apples" performance comparison, and they've used these style categories long before it was popular to do so. Even before the first issue, Craig Litman and Ken Gregory were tracking fund performance, by investment style, and by 1989 their database extended back many years.

No-Load Fund Analyst was also ahead of the industry in monitoring rolling time periods when analyzing funds. By looking at 1 year performance, rolling through each quarter during the year, investment performance can be tracked in a more meaningful fashion.

Like most investors, the Litman/Gregory research team started by looking for funds with a solid investment track record. They looked at a fund's performance versus its peer group, and have data on these various peer groups which goes back more than 25 years.

One of the most important characteristics that they look for is dependability, which is measured by the fund's or fund manager's ability to consistently deliver above average investment performance. The No Load Fund Analyst research team also looks particularly closely at "down market" performance, to be certain that the fund is not taking extremely large risks which might result in particularly disastrous performance in the event of a market correction or the onset of a bear market.

The research team also considers how the fund fits into the total portfolio. This subjective review cannot easily be quantified. While previous correlations between different funds, or asset classes, can be measured, in reality these correlations - which existed during the past 10 years - are unlikely to persist into the next decade. Things do change. Today's economic environment is not exactly like yesterday's. Yesterday's fund correlations cannot reliably be depended upon to offer a repeat performance.

For example, the relationship between stocks and bonds during the 1980's and 1990's was very different from what investors experienced in subsequent years. At the beginning of the 1980's, bonds were experiencing an unprecedented sell off. Interest rates were historically high. During the period which followed, declining interest rates helped boost the stock market and the linkage between the two markets was remarkable.

By the turn of the century, however, interest rates were closer to 7% than 20%. Though rates continued to decline, falling from 7% to below 3%, the total returns experienced by falling from 20% to 7% would be much different than those experienced in the latter case. When rates declined from the 20% level, a large portion of bond's total return came from interest received. In the second instance, capital appreciation was a larger factor. This means that bonds would be much more sensitive to changes in interest rates, whereas in the early 1980's nominal interest rates were so high that the 20% coupon rate offset all but the most volatile swings in interest rates.

And while interest rates continued to fall, stocks failed to continue their upward momentum, instead resulting in what some have called the “lost decade” as the market has climbed little, overall, while still forcing investors to endure very steep ups and downs.

Gregory once observed that while these correlations between asset classes can be measured, the correlations typically provide a false sense of security because of how rarely history repeats itself exactly. Most experienced investors know that there's as much art to asset allocation as there is science. The black box hasn't yet been invested which can replace the experience gained by years of passionate involvement in the industry.

When considering investments in foreign market securities, the inability to extrapolate yesterday's correlations is even more true. Today's global economy means that yesterday's correlations between various foreign markets shed little light on how tomorrow's markets will react. What we call "emerging markets," today, were referred to as undeveloped markets just a couple of years ago. There is no historical precedent for today's global economy.

We also have precious little history with high yield bonds (used to the extent which we see them used today). At no time in the past have we converted so many bizarre fixed income assets (like mortgages, car loans, boat loans, credit card receivables, or commercial real estate loans) into publically traded securities. Today's institutional investors use options and derivative securities more than ever before.

Yesterday's market is not the same as today's, and tomorrow's will be even less relevant. What is needed is not only market experience (a picture in context provided by looking through a rear view mirror), but also sound investment judgment looking forward.

Performance records, too, cannot readily be extrapolated too far into the future. Too many important factors can change in the interim, not least of which are the names of the portfolio managers running the portfolio and the investment styles that they use.

Despite these difficulties, however, it is still very important to evaluate a fund within the context of the entire portfolio. Will the addition of the new fund raise the portfolio's overall level of diversification and reduce risk, or just the opposite? Are fund managers using similar investment styles, or different ones? Are foreign investment choices based on nations with economies that are all commodity based, or commodity dependent? Demographic, political, and economic changes render most of yesterday's statistics meaningless for tomorrow's world. Nevertheless, having a broad view of the entire portfolio, and how various funds and markets are likely to interact with each other, is now more critical than ever.

All of this study, review and evaluation doesn't sound simple, does it?  It's not simple for the analysts.  For newsletter subscribers, however, all it takes is a few minutes to write out a check each year, and a willingness to follow the advice of analysts who, I assure you, know more about these funds than you do.  It's the newsletter subscribers who have it easy.

Next post: What Might Be Different Now?

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

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Leading Indicators Weaken

The May-Investments Leading Economic Indicators have weakened significantly, indicating that the economy is not yet growing but has merely stabilized in the midst of a severe recession. Consistent with the weakening economic fundamentals, client portfolios have taken profits and moved toward a more defensive positioning over the past several months.

Some indicators are still strengthening – namely in the energy drilling and semiconductor billing activities. Other indicators have been strengthening, but caveats apply. For instance, retail sales have been climbing, but the Christmas season came in only 4.7% ahead of a disastrous 2008 season. Similarly, capital utilization rates have been climbing, but remain well below non-Recession levels. In the manufacturing sector, new order rates are rising, but inventory levels are starting to climb as well, indicating that orders may be ahead of sales.

Profits are climbing as fewer banks reported huge “one-time” losses as they did in 2008. On the other hand, banks do not seem to be raising provisions for bad loans, in spite of the fact that loans are still going bad and reserve levels are nowhere near normal levels.

A couple key indicators look to have “rolled over,” and are indicating that recent economic activity is unsustainable. The National Federation of Independent Businesses Outlook survey shows that small business optimism has faded. This indicates that job creation will continue to be sluggish, and the unemployment rate isn’t going to show any real improvement in the near term.

Growth in the M2 money supply, which was one of the few indicators in late 2008 that indicated that the economy could still rebound, has flattened out. Money growth is still positive, but just barely. For those of us who believe that money really matters, this signal is a big red flag to the optimistic expectations being broadcast from Wall Street and many of the big investment firms. Happy talk doesn’t matter. The money supply, however, matters a lot.

Finally, if you look at the root cause of many of today’s problems – a banking system more concerned with propping itself up than in making loans to cash-starved businesses and credit-worthy consumers – the problem just keeps getting worse. Commercial and Industrial loan portfolios are shrinking. A year ago, C&I Loans were increasing as banks stepped in to roll over debt borrowed in the so-called “shadow banking” system, which disappeared when Shearson and AIG went belly-up and the banking system imploded. Now, even this increase in market share can’t disguise the fact that lenders continue to tighten standards, sapping the economy of what little liquidity is left in the system.

As a result of these conditions, the May-Investments Leading Economic Indicator has turned down. It is now nearing the monthly low that it set in April of 2009.

Portfolios are now sitting on roughly 20% in cash (money market funds) and have another position in an inverse U.S. Treasury fund. These funds could be used to reinvest in stocks, at lower levels, if the stock market continues to decline from what we believe is the high end of a trading range.

Another 20% of the portfolio remains invested in high yield (“junk”) bonds. These funds were not immune from the market sell-off of 2008, and they provided tremendous profits during 2009. We consider them to be high yielding stock-equivalents, able to do better than traditional stocks in a muddle-through but profit-depressed economic environment that we expect.

About 20% of the portfolio remains invested to benefit from inflationary pressures which we anticipate in the precious metals and energy sectors. To be frank, however, these investments have not been working as well as we’d expected. The concern we have is that faltering commodity prices are not signaling a lack of concern about inflation, so much, as an economy that is rolling over as economic activity weakens. Updating the Leading Economic Indicator index, unfortunately, reinforces these concerns.

Finally, we have invested about 30% of the portfolio in traditional stocks, emphasizing companies in the insurance, software, and pharmaceutical sectors. These areas remain relatively strong and have reasonably healthy industry fundamentals in their favor.

As I’ve said before, we don’t raise red flags because we enjoy being a naysayer. I am anxiously awaiting a market where valuations are cheap and the economy is poised for growth. However, wishing it to be so won’t make it happen any sooner. I will continue to position the portfolio for the world as I see it. If, in fact, this economy rolls over and the market follows it down, we want to have money on the sidelines in order to profit, once again, from the ability to add money to stocks when prices are low.

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

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Attribution Analysis: Don't Try This at Home

Risk and return aren’t correlated, so picking the least risky alternative isn’t as easy as just going with a lower return alternative. Yet sometimes the higher returning fund has a lot of embedded hidden risk that can cost investors dearly.

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Rates of return are fact-based. As such, there shouldn't be a lot of play in them. A number is fixed, not subjective, after all. But with the millions of dollars at stake in fund flows and management fees, the industry has a tremendous incentive to make their fund returns look as good as possible.

To understand the tricks that fund sponsors play, and why they play them, all you have to do is understand the incentive system under which they compete for customers. In today's world, funds which post peer-busting top-of-the-chart fund returns will experience inflows of millions of dollars of customer money. Because management fees are assessed as a percentage of assets under management, ballooning fund sizes mean ballooning management fees.

Now, let's pretend you are a fund family with customers to solicit. All that matters is that you get to the top of the charts. How do you do that?

The first question you ask in seeking top of the chart performance is, "which chart?" If a fund's long-term performance stinks, maybe a different period could be selected which doesn't look so bad. Fund companies start slicing and dicing time periods every which way possible to see where their funds rank. The next trick is to find the best possible index to which the fund can plausibly be compared.

If you're really, really smart (and companies like Fidelity are really, really, really smart), you create a lot of different funds so that some fund, somewhere in your long list of funds, is always at or near the top. Investors remember seeing Fidelity's name always near the top of the list, while forgetting that last year it may have been Fidelity's technology fund, but this year it might have been Fidelity's gold fund that topped the charts.

One of my college professors at Stanford sponsored an investment contest and offered to pay $100 to the winner. We were all diligent in our stock picking, selecting some of the best (and worst) picks of the day. But we all lost to the professor, as had been the case in his class for several years running. Why? Because our professor realized that he wasn't really involved in an investing contest. The game theory behind his contest was much different than is the case with investing. It wasn't real money being invested. Losses didn't really matter. Only winning mattered. Furthermore, it was a winner-take-all situation. Only truly outstanding performance would have a shot at winning that $100. The best blue chip portfolio in the world wasn't going to win that contest. But a leveraged bet on gold, or S&P futures, might have a shot. By setting up a few highly leveraged portfolios and not caring that most of them flamed out in complete failure, my professor was able to come up with a winning portfolio each year.

From the fund manager’s perspective, hedge funds are a very similar contest. Dramatic outperformance is attributed to skill and results in billion dollar investor inflows. Reasonable outperformance is attributed to luck – the markets are efficient after all, and the sales effort will be difficult. Mediocre and underperforming funds close their doors. Only dramatic upside pays off.

And, generally speaking, it’s not the managers’ money at risk so the downside doesn’t theoretically matter. Hedge fund managers get bonuses based on 20% of gains. When managing large sums, a one-year payoff results in several lifetimes worth of reward. A $10 billion portfolio, up 20% in a year, rakes in $400 million for the senior members of the management team.

Mutual funds are involved in a similar contest. They "incubate" small funds and hope to buy volatility that generates top of the chart performance. Successful funds are hatched and marketed to the investing public. If they can market this record and attract a lot of customer dollars, they achieve the financial industry equivalent of winning the lottery. In a little over a year, Fidelity's popular Contrafund grew from a colossal $10 billion fund to an almost unthinkable $20 billion fund. As a result, the management fees that Fidelity earned on this fund doubled from $70 million a year to about $140 million. Now that's a lottery worth entering! By 2007 the fund had grown to $80 billion.

The huge sums of money which flow into these fund will probably dramatically change the nature of the fund's investment process. Can anyone at Fidelity, with a straight face, really tell you that Contrafund's investment strategy has been unaffected by the ballooning of that fund from $8 billion in 1995 to $80 billion in 2007?

On the flip-side, bad records are merged out of existence. Fund managers change funds and leave good performance records behind them. Beginning in 1997, the opposite is now true. The Securities and Exchange Commission has decided to let portfolio managers claim their previous track record, on an existing fund, when starting up a new fund. The managers can take their old record along with them when they decide to change jobs! Suddenly, two different funds may be advertising the same successful track record!

The very performance contest which drives fund managers to go all out for their shareholders, also makes it extremely difficult for fund investors to sort through the competing claims made by fund companies who are all looking for your money.

• The Investment Advisor's role:

Armchair investors should sit back and relax, having delegated the task of sorting through the lies, damn lies, and statistics to an advisor. The advisor's role is to monitor the investment risks being taken by the portfolio fund manager to be certain that they are consistent with the objectives set for that portfolio. When a so-called government fund starts boosting its return figures by speculating in interest-rate sensitive mortgage-backed securities or sub-prime securities, it is the advisor's job to see that a false sense of security is being painted and advise investors to choose a more conservative fund.

Investment advisors subscribe to services which track fund performance over long periods of time. By comparing a fund with its peer group and appropriate indexes, standout fund managers begin to shine through. If the portfolio managers for these funds jump ship, the advisors can move investors into a safe haven.

Advisors should help investors allocate assets to the most appropriate asset classes, not dump clients in all asset classes. In addition, the advisor should be tracking the performance of funds against appropriate benchmarks to be certain that the funds being used are providing satisfactory returns, and advisors should know how the fund performance was derived. Did the fund make a bet on a particular industry that paid off? Is the manager a whiz at stock-picking? Did the manager let cash build up? Was the outperformance an accident? It happens. All of these are critical questions to ask regarding a fund's performance, and investor should delegate the job of asking them to their professional advisor. This is not the time for amateur hour.

Any advisor who says the attribution analysis effort is easy either doesn't know what they're talking about, or is just blowing smoke.  Mutual funds are a black box between reporting snapshots.  There are very few advisors who have the information necessary to really know what is driving a particular fund's performance.  It is hard enough for me to really know what is driving performance in my own fund.  Without direct access to the trading data, it is extremely difficult for an outsider to determine whether a fund is performing well due to stock selection, industry concentrations, trading calls, or other factors.  Staying on top of portfolio construction, however, is an important part of managing total portfolio risk.

Don't be afraid of risk. Learn more about it. Develop a process that evaluates risk and invests your portfolio in asset classes where non-normal risk/return distributions mean that you are more likely to have above average returns. Don't assume a normal bell-shaped curve.  Seek out long-tail investments where the upside scenarios and payoffs are relatively larger than the probability of experiencing a loss.

Be flexible in the amount of risk you accept.  Attractive markets can justify above average risk. Unattractive markets should drive money to the sidelines. They should make investors risk averse. There’s nothing wrong with taking smart risks. Sometimes being overly conservative is a problem. Sometimes being conservative is the prudent thing to do.

Money is often made when perceived risk is high. Money is usually lost when actual risk is high. To make more and lose less, you have to understand what risk is, and what it isn’t.

Next post: Heresy#3:  Successful Investing Can Be Easy 

To start at the beginning of the Investment Heresies eBook, click here

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

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Markets Zero in on Profits During January

The May-Investments Index of Western Colorado Stocks slid -0.94 percent in January while the widely followed S&P 500 stock index fell -3.6 percent during the month (total return including dividends). U.S. Bancorp (USB) was the best performing stock in the index (+11.4 percent) while Airgas (ARG), which fell -11.2 percent, was the biggest laggard.

U.S. Bancorp recently reported fourth-quarter profits that were a penny better than expected and nearly double the profits reported a year ago. Revenues were also higher than analysts had anticipated. The Federal Reserve has pushed interest rates down almost to zero in an effort to bail out the banks, who are paying almost nothing for deposits but have been raising the price of loans to borrowers. U.S. Bancorp has benefitted from the Fed’s bailout policies, without having made the mistakes that many of the other big banks were making.

Airgas Inc. reported that third quarter profits dropped 25 percent, revenues fell 13 percent, and the company lowered its estimates for 2010 full year earnings as well. I’m afraid that earnings disappointments won’t stop with Airgas.  In fact, our watchword to investors for the year is, "Be prepared." Be prepared for earnings disappointments in a lot of sectors, because the analysts are expecting corporate profits to be up 25 percent this year and it’s going to be awfully difficult for companies to deliver that sort of profit growth in the current economic environment.

Over the past twelve months, the May-Investments Index of Western Colorado Stocks is up +29.5 percent through the end of January while the overall market has gained +33.1 percent over the same time period. The index began tracking the performance of local stocks three years ago and is down -8.86 percent since it launched, while the S&P 500 has declined -18.97% during the same period of time.

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

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