Notes, Views, and the Occasional Provocation May / June 2009  

Few investors were spared last year as markets across the world plummeted. Even ultra-wealthy folks – those with at least $30 million to invest – lost nearly twenty-four percent of their net worth during 2008. Many other investors lost much more.

Now many people are looking for a cure. Many money managers purport to hold one, declaring that the old investment rules are dead. But as the article below illustrates, such claims deserve the utmost skepticism, since taking action itself can create new, more intractable risks.

May the current market rally continue a little longer, and may you have a very good summer.

Warm regards,

Milo Benningfield

A Tale of Two Funds
Fighting the markets often loses out to riding them intelligently, as illustrated by two well-regarded, but diametrically opposed mutual-fund strategies. more

From the BFA Blog
Several highlights from our blog at more

BFA Media Quotes
Recent media quotes. more

A Tale of Two Funds
Now that the markets have rallied over 35% since early March, the phone calls have begun: disappointed investors are looking for ways to rebuild their portfolios. They report devastating losses from 2008, some upwards of 40 and 50% – losses that more than a few of them locked in forever by selling equities and going to cash just before the recent rally began.

I tell them perhaps the rally will crumble and they'll get a second chance. But I have no silver bullet to offer, and I can see it disappoints them.

Such investors are susceptible right now to the siren call of newly minted investment strategies promising to protect them from Treasury bubbles, hyperinflation, and a host of other market ills. The head of an organization for wealthy investors recently described their mood:

Many of our members believe we are in a trader's market where long-term investing should be shunned but trading opportunities should be seized.1

"Taking action" has become the theme, as it always does during a bear market, when the urge to feel we are exerting control becomes the strongest. And there are many ways to seize the day: you can build a better model, make a better forecast, or develop a smarter investment thesis. But before doing so, you'd do well to study the example of two highly regarded mutual funds run by The Vanguard Group:

The Vanguard Balanced Fund (VBINX) is classified by Morningstar as a "moderate allocation" fund and holds a static allocation of 60% stocks and 40% bonds. The stock allocation is passively managed and mirrors the MSCI U.S. Broad Market Index, a proxy for the entire domestic market. The bonds, too, are passively managed and track the Barclays U.S. Aggregate Bond Index. It relies on its static – or "strategic" – allocation to capture market returns over time and is about as straightforward an investment strategy as you can find.

In the other corner, we have the Vanguard Asset Allocation Fund (VAAPX), also classified as a "moderate allocation" fund. It follows a "tactical allocation" strategy – the very investment approach being touted by many money managers as the smarter way to invest after last year's market rout. The fund's experienced manager is given complete freedom to roam "among bonds, stocks, and cash according to valuation determinations of a quantitative model" in an effort to beat the U.S. market.2

Last year should have been one of the Asset Allocation Fund's finest hours. "Supported by a big team of portfolio managers, analysts, and traders," its manager had some of the best analytical firepower in the world at his disposal and could have chosen at any moment to sidestep the financial-sector train wreck that occurred. Alas, in 2008, the Asset Allocation Fund lost a whopping 36%, while the Balanced Fund staunched the flow with a 22% decline.

How so? A May 15, 2008 Morningstar analyst report provides the answer:

The [Asset Allocation] fund's positioning stems from [the manager's] long-term outlook. [He] thinks that it's a good idea to invest in equities now, despite the asset class's current struggles due to last summer's credit crisis and souring investor sentiment. . . . He believes that investors have overreacted to the recent credit crunch, unnecessarily driving down valuations. Accordingly, as of March 31, 2008, [he] placed 100% of the fund's assets in stocks so the offering will benefit when the stock market rebounds.

Convinced of this thesis, the manager chose to maintain that 100% equity exposure during the rest of 2008, causing the fund's tremendous decline.

Anyone can have a bad year. But if we look at the two funds' performance over the past ten years, the picture hardly gets better. A $10,000 investment in the Balanced Fund (VBINX) in May 1999 through last month would have bested the Asset Allocation Fund (VAAPX) by almost 25% in dollar terms:

Moreover, within the past decade, the manager of the Asset Allocation Fund had not one but two of the biggest bear markets in a generation – what should have been fertile ground for tactical allocation. But as the chart above shows, the Asset Allocation fund actually fell behind the Balanced Fund in each of the bear markets, suggesting, at a minimum, that even smart tactical allocation might not be much of a portfolio insurance policy.

Underperforming examples such as the Asset Allocation Fund – and there are many – cause many experienced investors to concede that "taking action" in the public equity markets offers little chance to beat them. They contend, however, that so-called "alternative" strategies such as private equity, derivatives, and real assets such as timber and real estate offer compelling opportunities.

Perhaps. But such strategies also expose investors to a whole new set of risks – for example, the inability to convert investments to cash when needed. It was, in fact, a liquidity crisis last year that has put the vaunted Harvard Endowment – a poster child for alternative strategies – on track to report a whopping 30% decline in a few days for its fiscal year ending June 30th.

All this is not meant to be an argument in favor of ditching thoughtful portfolio structures for the simplicity of the Vanguard Balanced Fund. Given the right investor circumstances, there are many elements of the Balanced Fund that can be improved upon for purposes such as tax management, international diversification, and currency hedges, among others.

But this tale of two funds underscores the lesson that taking action alone is not enough and often produces little more than the illusion of solving our problems. Worse, taking action often compounds the very problems we are trying to solve by introducing an entirely new and unmanageable layer of risks.

Investors considering new strategies, particularly strategies predicated upon a forecast (i.e., all active strategies), would be well-advised to consider the insights of hedge-fund manager John Seo, who has spent a lifetime studying how to mitigate risk:

As a boy, John Seo learned everything he could about the Titanic. "It was considered unsinkable because it had a hull of 16 chambers," he says. The chambers were stacked back to front. If the ship hit something head on, the object might puncture the front chamber, but it would likely have to puncture at least three more to sink the ship. "They probably said, What are the odds of four chambers going?" he says. "There might have been a one-in-a-hundred chance of puncturing a single chamber, but the odds of puncturing four chambers, they probably thought of as one in a million. That's because they thought of them as independent chambers. And the chambers might have been independent if the first officer hadn't gambled at the last minute and swerved. By swerving, the iceberg went down the side of the ship. If the officer had taken it head on, he might have killed a passenger or two, but the ship might not have sunk. The mistake was to turn. Often people associate action with lowering risk or controlling risk, but experience shows more often than not that by taking action you only make the risk worse."3

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From the BFA Blog
We update our blog at almost weekly. You can access it from the link or by going directly to the home page of our website at You can also click on the links below to go directly to recommended posts.

What Do Apple, China and Iran Have In Common?
Apple has made the Internet ubiquitous, causing problems for authoritarian governments. But it's not so keen on being open itself.

When "Good Enough" Isn't
President Obama's proposed regulatory changes seek to hold stockbrokers to the same heightened standard of care that applies to Registered Investment Advisers.

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BFA Media Quotes

The New York Times, June 20, 2009
Milo was quoted at length in Tara Siegel-Bernard's article, "For Older Investors, Old Rules May Not Apply," which discusses some of the challenges involved in determining a prudent allocation for retiree portfolios. After addressing issues concerning equity allocations, bonds, and annuities, he noted that ultimately, "Cash is risky, stocks and bonds are risky, life is risky." Read the article.

The New York Times, June 6, 2009
Milo was quoted in Ron Lieber's article, "Finding Financial Advice in an Age of Bad Behavior," which discusses misconduct by advisors who belong to the well-regarded fee-only organization, the National Association of Personal Financial Advisors (NAPFA). Mr. Lieber stated, "I still believe that a NAPFA planner should be among the first people you see when shopping for financial assistance," citing Milo's observation that "[s]o many good people in the organization have sweated blood to build a fiduciary culture in the midst of perhaps the most avaricious environment in the history of man." Read the article., April 30, 2009
Milo was quoted in Marilyn Kennedy Melia's article, "Help For Second-Home Owners," which addresses strategies overextended homeowners can take to ease the burden of an unaffordable second home. Milo noted that such homeowners might be better off arranging a "short sale" of their second home, rather than continuing to try to make mortgage payments. Read the article.

That's it for now. Thank you for reading. Please look for our next newsletter in August.

Best Regards,

Milo Benningfield

1 "Time for A New Strategy," The New York Times, May 21, 2009.

2 Morningstar Analyst Report, March, 20, 2009

3 "In Nature's Casino," The New York Times Magazine, August 26, 2007.

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