Greetings!
Here is your Market Update and commentary for October and November, 2011.
I wish you a joyous and abundant Thanksgiving holiday with friends, family and loved ones. A thankful heart is not only the greatest virtue, but the parent of all the other virtues. - Cicero
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October Fest
| Ever noticed how gamblers always tell you about their big wins but tend to keep their even bigger losses a secret?
Going awfully quiet in recent days have been the analysts who just last month ago were saying it was time to bail out of equity funds. And it seemed a good call at the time for fearful market participants, given that global stock markets had suffered their worst quarter in nearly three years. Adding to the nerves were the predictable reminders by the financial media that two of the biggest crashes in U.S. history occurred in the month of October, in 1929 and 1987. While further volatility may well still lay ahead, those who took this advice and moved out of stocks at the end of September might now be ruing their decision, as the S&P 500 rose by nearly 11 percent in October, its largest monthly rise since 1991. The MSCI World Index rose by 10 percent, which was its largest one-month rally since April 2009.
It's not often appreciated by ordinary investors that markets are forward looking. We know the news has been bad, but it's what comes next that counts. Selling out after a bad run in the markets just means turning paper losses into real ones, leaving investors with the extremely difficult task of finessing their point of re-entry. The reversal of direction in October highlights this challenge. We don't know of course if the October gains are sustainable. Indeed, over the first two weeks of November, as sentiment around Europe has turned sour again, the S&P has remained flat. But we do know that markets can move quickly and that they respond to new information almost instantaneously. This is why market timing is so hard, and why the best approach is to maintain your chosen asset allocation, and to re-balance that allocation periodically.
Having a portfolio that is positioned to capitalize on an upswing, while maintaining enough cash and fixed income to potentially dampen volatility on the downside, remains our best strategic plan going forward.
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October Market Update
|  After a disappointing September across all major equity indexes, the markets achieved significant gains last month and in the first two weeks of November, as the Dow Jones Industrial Average gained nearly 1,500 points from it's October 3 closing low of 10,655, thus erasing much of the losses of patient investors like you.
Unfolding events in Europe
Events involving European political leaders and the sovereign debt crisis have dominated the news (and the markets) over the past several weeks, but on balance they seem to have been well received across the continent. Over the past six weeks, U.S. and European equity markets have risen as an agreement on the Greek bailout fund, an acknowledgment of the losses that will need to be taken in a bond restructuring, and the formation of a new unity government appear to have laid out a process to resolve that country's ongoing problems. Now the focus has quickly turned to Italy and Spain. Unlike Greece, which ranks as one of the smaller Eurozone economies, Italy and Spain are among the major players in the European Union. According to the International Monetary Fund, the economies of Italy and Spain are the third and fourth largest in Europe and in the top twelve economies worldwide. We witnessed an example of the impact of this last week when the yield on the Italian 10-year bond briefly rose above 7%, passing the key level which triggered bailouts for Ireland and Greece in 2010. In response, the Italian prime minister has stepped down and Italy's parliament has quickly passed austerity measures.
Because the the European Union represents a key trading partner, accounting for 29% of exports produced by S&P 500 companies, the sovereign debt crisis certainly requires our continued attention.
Yet despite the overhang of the debt crisis on global economic growth, we should note that according to Thomson-Reuters more than 60% of the companies in the S&P 500 have reported that earnings exceeded expectations for the third quarter. This may bode well for investors who yearn for the time when the prospects of American businesses were the primary drivers of our own financial markets.
The gyrations that surrounded Italy last week were much smaller than the swings connected to Greece, and the former country has thus far dealt expeditiously with the political and legislative challenges before them. If this trend continues, and if Q4 earnings match or surpass the numbers from the last quarter, it could support a case for market performance based more on U.S. conditions, and less on European headlines.
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Lessons In Mutual Fund Flows
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Since 2008, economic uncertainty and market volatility have tested the staying power of investors around the world.
Many people fled equities during the worst months of the global financial crisis, while others waited for signs of a turnaround before investing more. Their emotional reactions may have exacted a large price on their wealth.
Yet while the mutual fund industry as a whole experienced significant outflows during this period, Dimensional Funds experienced net positive flows into their equity funds.
The graph below documents investor behavior during the stock market downturn in 2008 and subsequent market rebound and contrasts this with the behavior of DFA fund shareholders, offering key lessons about investing in turbulent markets.
Figure 1. Quarterly Equity Mutual Fund Flows: Industry vs. Dimensional Relative to S&P 500 Index Performance, January 2008-June 2011.
Reading the Graph
First, look at the shaded graph in the background, which plots the performance of the S&P 500 Index over this three-and-a-half-year period. The market began falling in late 2008 and hit bottom in early March 2009. It then reversed sharply and began a long climb through June 2011.
Now consider how mutual fund investors responded to the stock market's downturn and recovery. The orange line plots quarterly net cash equity flows for the US mutual fund industry over the same period. (Net cash flow is the difference between redemptions and purchases of shares in a mutual fund. A net cash outflow occurs when redemptions exceed purchases.) Equity fund flows were cumulatively negative over the period.
Investors were redeeming more shares than they were buying, and on a net basis, capital was leaving mutual funds.1
Note that the fund industry outflows followed the stock market downturn, and that net flows stayed negative even after the market rebounded. Investors were reacting to the falling stock market by either redeeming their fund shares or delaying the purchase of additional shares.2 When the stock market suddenly rebounded in March 2009, investors who had reduced their exposure to equities missed a good part of the recovery.
This apparent lack of discipline is well established over longer time periods. Industry analysis and academic research suggest that investors tend to focus mainly on recent performance, making decisions that compromise long-term returns in their portfolio.3
Now consider the upward-sloping blue line, which plots quarterly net flows into equity strategies offered by Dimensional Fund Advisors. These flows were cumulatively positive throughout the entire period, suggesting that shareholders in Dimensional's funds continued to purchase shares during the 2008-2009 market decline and after the March 2009 rebound.
As a group, these investors did not flee stocks en masse. In fact, they did the opposite by adding to their portfolios. Their discipline positioned them for the market rebound.
A mutual fund's net cash flows also may reveal the collective discipline, or lack thereof, among its shareholders. In fact, the direction of net flows can impact portfolio management and performance significantly, especially for funds invested in less liquid markets. Large net redemptions typically increase the direct and indirect costs of a mutual fund, which compromise fund returns.4 The assorted costs are not borne by redeeming shareholders but by the shareholders who remain in the fund.5 Therefore, consistently positive net cash flows are helpful to a fund's expenses, strategy, and performance.
Summary
The large cash outflows from US-based mutual funds since 2008 document investor reaction to market volatility, while Dimensional's stable and positive net fund flows suggest disciplined investor behavior.
Why is it that shareholders in Dimensional funds behave differently?
One reason might be the education, encouragement and discipline offered by their advisors at a difficult time. Objectivity and an adherence to investment policy can help investors apply discipline in all types of markets, which can positively impact individual performance over time.
Moreover, when advisors influence the collective decisions of shareholders in a particular mutual fund, the greater cash flow stability can prove beneficial to the fund's strategy and returns.
1. Mutual fund investors redeem their shares by selling them back to the mutual fund and receiving cash proceeds based on the net asset value (NAV) of the shares at day's end. Redemption is a normal activity in a mutual fund, and liquidity is one benefit of owning fund shares. A fund manager may use inflowing cash to cover the redemptions or keep cash in a "liquidity reserve" for this purpose. When cash balances do not suffice, the manager may execute trades to raise the cash.
2. According to the Investment Company Institute, mutual fund flows do not offer a good measure of total demand for equities since funds hold only about 20% of the total US equities outstanding, with the balance held directly by individuals, institutions, and governments. Academic research offers some evidence that mutual fund flows do not drive market returns but reflect investor reaction to markets.
3. A Morningstar study compared the dollar-weighted returns of the average investor in a fund with the fund's published total return for the ten-year period ending Dec. 31, 2009. In US equities, the average investor in all funds earned 0.22% annualized, compared with 1.59% for the average fund. Lack of investment discipline also is documented among individual investors who hold common stocks directly. Those who trade frequently pay a tremendous performance penalty for their actions.
4. Direct transaction costs include commissions, bid-ask spreads, and price impact incurred when a fund makes trades in response to shareholder redemptions. Net outflows also may generate indirect costs on a fund by forcing its manager to alter the target asset allocation or make disadvantageous, uninformed trades to raise cash.
5. Mutual funds typically meet a redemption based on the NAV at day's end but may execute a trade to raise cash on the following day. The redeeming shareholder cashes out at an NAV that does not reflect the trade, and the resulting costs are borne by remaining shareholders.
Chart above for illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Figures are based on net new cash from financial advisors in US-domiciled funds excluding funds of funds. S&P 500 Index performance is based on monthly returns data provided by Standard & Poor's Index Services Group.
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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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