Greetings!
Here is your newsletter for June 2010, including some words about market timing and comparison between actively-managed mutual funds and the market.
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Risk Assessment: The Critical Decision Making Factor
In all cases, but especially during periods of heightened volatility (meaning 10 of the 11 years that I have been fortunate enough to be in this business), investors sitting on over-funded cash positions are looking for an arbitrary entry point into the market, one that will afford them some perceived advantage.
Most commonly, investors want to see an extended period of market gain before they will get in. On an emotional level (which after all is the motivating factor for almost all investors), this provides the confidence needed to act. The thought might be, "I've been sitting on all this cash with the intention to invest. Now that the market is up, it's safe to move forward, and I am willing to bet the entirety of my investment that it will continue to go up."
The problem of course is that this rarely happens, and if it does, the point of entry typically and unfortunately comes long after most of the gains have been logged into the market for that cycle. Thus, the investor misses the gains they were waiting for, while everyone who was in the market got to partake, merely because they just happened to be there.
More commonly these days, investors rightly mistrust short term market movements, and no 1 or 2 or 3 or 6-month increase will motivate them to act. So they stay in cash while the market rises and falls, as it has always done no matter the levels of volatility. At this point, investment management morphs into "market timing", a strategy that relies upon a guess. Ask yourself this: at what point in the trajectory of an extended market gain does it become advantageous to get into the market, and what is that decision based upon?
Let me be clear at this point: there is absolutely nothing, but nothing, wrong with carrying an over-funded cash portfolio, or over-weighting to stocks, bonds or real estate for that matter, so long as it is strategic and fits within a well-thought out investment policy.
An investment plan based on planning and policy
At Milestone Financial, all investment plans are strategic, and all portfolio allocations are based on an assessment of the clients feelings about risk.
By undertaking a process of information-gathering at the outset of the plan, and by seeking to understand an investor's experiences and attitudes about money, risk, and investing, we can set meaningful guidelines that determine the best lifetime portfolio for that individual, in any market environment.
Once a correct approach has been set forth and the portfolio falls within the parameters of the investor's comfort levels, there is no longer any reason to delay the point of entry. More importantly, there is no longer a need to base ones investment success on what one cannot successfully do on a consistent basis: time the market.
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Active Funds vs. The Markets
Proponents of active fund management believe that skilled managers can out-perform the financial markets through security selection, market timing and other efforts based on prediction. Indeed, multitudes of investors are willing to pay much higher fees for active vs. passive funds because they expect the managers to beat the index. Unfortunately, we know that very few managers accomplish this, and in any case we do not know in advance who these managers will be.
In their recently released Box Score report for the second half of 2009, Morningstar noted that "after accounting for sensitivity to risk, size and cost, only about a third of active funds had positive alpha (excess return relative to a benchmark) over the past three years.
While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active managers do not consistently deliver on this promise, according to research provided by Standard & Poor's.
S&P Indices publishes a semi-annual scorecard that compares the performance of actively-managed mutual funds to their S&P benchmarks. Known as the SPIVA scorecard1, the report analyzes the returns of US-based equity and fixed income managers investing in the US, international and emerging markets. The managers' returns come from the CRSP Survivor-Bias-Free US Mutual Fund Database, and the managers are grouped according to their Lipper style categories.2 The graph below features fund categories from the most recent SPIVA scorecard, and shows the percentage of active managers that were out-performed by the respective S&P Indices in one, three, and five-year periods, illustrating that the active manager universe usually fails to beat the market benchmarks over longer time horizons. Under-performance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.
Over the last five years, about 60% of actively-managed large cap US equity funds have failed to beat the S&P 500, 77% of mid cap funds have failed to beat the S&P 400, and two-thirds of the small cap manager universe have failed to out-perform the S&P Small Cap 600 Index. Furthermore, across the thirteen fixed income fund categories, all but one experienced at least a 70% rate of under-performance over five years.
In 2009, active funds experienced more success over a one-year period, and proponents typically highlight those results in the SPIVA scorecard. However, one-year results are not consistently strong from year to year, and investors should not draw conclusions from short-term results. Over three- and five-year periods, most fund categories have not out-performed their respective benchmarks.
The study compared the same actively-managed funds in the CRSP database to other benchmarks as well, and showed similar results over similar time periods. Over the past five years, about 65% of all US equity managers failed to out-perform their respective Russell Indexes, and 84% of fixed income managers failed to beat their respective Barclays Capital Indices.
Of course, the results of these studies will fluctuate over time and a majority of funds in a given category might out-perform over the short term. But the message is clear: as a group, actively-managed funds often struggle to add value relative to an appropriate benchmark - and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.
1. SPIVA stands for Standard & Poor's Indices versus Active Funds. The report covers US equity, international equity, and fixed income categories. The actively managed funds are grouped according to Lipper style categories.
2. The Center for Research in Security Prices (CRSP), at the University of Chicago Booth School of Business (Chicago GSB), is a nonprofit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks listed on the NYSE, Amex, and NASDAQ exchanges. The Survivor-Bias-Free US Mutual Fund Database includes a history of each US mutual fund's name, investment style, fee structure, holdings, asset allocation, and monthly data, including total returns, total net assets, net asset values, and dividends. All data items are for publicly traded open-end mutual funds and begin at varying times between 1962 and 2008, depending on availability. The database is updated quarterly and distributed with a monthly lag.
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Milestone Financial Advisors, LLC
Ten Key Portfolio Considerations: |
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- Reduce Expenses
- Diversify Systematically
- Seek to Reduce Taxes
- Think Long Term
- Maintain Discipline
- Maintain Prudent Cash Reserve
- Own Low Cost Funds
- Maintain Asset Allocation
- Add to Portfolio Systematically
- Connect Goals to Investments
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