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.

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

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