Notes, Views, and the Occasional Provocation September / October 2010 

Last quarter's strong returns should have made investors happy. Unfortunately, many of them were reconfiguring their portfolios in anticipation of a market crash, with assets continuing to flow out of equity mutual funds and into bond funds. This is an age-old story that we touch upon in this month's newsletter.

Warm regards,

Milo Benningfield

When Risk Shows Up, Returns Often Follow
According to the news headlines, a market crash was nearly assured last quarter. Instead, the markets had one of their strongest quarters ever, with most asset classes delivering double-digit positive returns. more

BFA Media Quotes
Recent media quotes. more

When Risk Shows Up, Returns Often Follow
The U.S. and international equity markets rallied strongly last quarter, reversing previous months' declines:

Major Asset Classes1 June - Sept 2010 Returns
U.S. Stocks
European Stocks
Emerging Market Stocks
U.S. Real Estate
Int'l Real Estate

Unfortunately many investors abandoned course in May and June as markets sank and did not receive those returns. Concerns about Greek bonds, the BP oil spill, and last May's "flash crash" convinced many people that the markets were about to tank again.

It also didn't help in August when the media widely reported that an obscure technical indicator known as the "Hindenberg omen" was predicting a September market crash. Many investors thus sold their positions in time to miss the best September since 1939.

It's hard to blame investors for being skittish after the biggest market crash since the 1930's. Like earthquake victims who dive under the table for months afterward any time a passing truck rattles the windows, investors naturally fear a repeat of the 2008 Credit Crisis. The problem is, when it comes to financial assets, investors' instincts cause them to dive in the wrong direction.

Why is this? There are many behavioral explanations - we're wired to flee danger; we believe that what just happened will continue; we move in herds. Another culprit is the common misunderstanding about the relationship between expected stock returns and the real economy.

Many investors believe that the return premium offered by stocks over more stable assets such as Treasury bills - the so-called "equity risk premium" - rises during times of strong economic growth and declines when we slide into recessions. But rising stock prices actually reduce expected returns as projected company earnings get "baked" into stock prices. Conversely, as prices adjust downward during recessions, expected stock returns rise, compensating investors with the possibility of earning higher returns over cash.

In other words, the equity risk premium runs counter to the business cycle, as illustrated in this conceptual graph2:

This relationship between the business cycle and financial assets is counterintuitive and no doubt escapes many investors who see little hope that once the risk shows up for financial assets, the returns will eventually follow.

On the other hand, some investors do understand the relationship between stock premiums and the economy, but believe they can benefit from dramatic moves in and out of asset classes to capture the Holy Grail of investing: participation in market upsides combined with avoidance of the drops. The long-term evidence shows, however, that most investors fail in this quest. For example, a recent study by TrimTabs Investment Research shows that over the past decade, when the S&P 500 Index was roughly flat (counting dividends), investors lowered their equity returns a whopping 20% by moving in and out of the markets.

Of course, this doesn't stop Wall Street from abetting the quest after each bear market by promoting strategies known variously as "dynamic asset allocation," "bear-market funds," and "go-anywhere" mandates. But as it turns out, the pro's don't have much more luck with their timing calls than other investors.

For example, a recent Morningstar study found that most so-called tactical strategies haven't been able to beat a simple 60/40 mix of U.S. stocks and bonds in the Vanguard Balanced Index Fund:

  • Over two-thirds of such strategies that were at least a year old as of July 31 underperformed the Vanguard fund by over 2.5% since their inception.
  • Over two-thirds of the funds with at least a three-year track record failed to offer any sort of insurance during market declines, suffering drawdowns that were similar to or worse than the Vanguard fund.3

The results for tactical strategies would have been even worse if Morningstar had included all the tactical funds that had been closed - nearly 30 funds since 2006 - or the funds with poor records that were thus merged into other funds, wiping out those poor results forever.

Prudent portfolio management does require that allocation adjustments be made along the way, especially in response to investor circumstances. But investors seeking to capture long-term returns on financial assets such as stocks would do well to remember a simple rule: equities offer a potential premium over safer assets not in spite of economic, geopolitical and other risks; they offer higher expected returns because of them.

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BFA Media Quotes

Reuters, October 6, 2010
Milo was quoted in Aaron Pressman's article "Analysis-Quant Firm AQR Looking for Retail Investors," which discusses the launch of a new "risk parity" mutual fund that seeks to improve upon the traditional balanced stock/bond portfolio. The fund, however, leverages its fixed-income positions in order to justify a lower equity weighting, and Milo noted, "I find it mind-boggling that mutual fund providers are already selling leverage again so soon after the credit crisis." Read the article.

Buinessweek, August 30, 2010
Milo was quoted in Ben Steverman's article "Investors Embrace Bear Market Funds," which discusses a variety of investment strategies that aim to let investors participate in market upside while protecting against losses. Milo noted that

[A]lternative investments can make sense in "small doses." But he is staying away from bear market funds.

If you want to reduce your exposure to the stock market, the best way is simply to sell stocks and buy cash or bonds, he says. And, unlike other investments, bear market funds pay no interest or dividends—in fact, investors must pay the dividends of the stocks they're shorting.

"Bear market funds seem to promise something magic. They seem to promise protection during a down market, a way of making money without taking risk," Benningfield says. "They're making a false promise that they can't deliver on."
Read the article.

Thank you for reading. Please look for our next newsletter in November.

Best regards,

Milo Benningfield

1 MSCI Indices, all returns in local currency; Dow Jones U.S. Select REIT Index; Dow Jones International.

2 Graph designed by Dimensional Fund Advisors.

3 "Tactical Strategies Miss Their Mark," Morningstar Advisor, Oct/Nov 2010.

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