The Latest Dalbar Study & A Performance Update

This month, I will review the latest Dalbar Study, which once again shows that the average mutual fund investor makes only a fraction of what the market makes.  I will also give you a performance update on our market timing programs that I have recommended over the last year or so. 

On July 15, 2003, Dalbar, Inc. (a Boston-based financial research firm) updated their Quantitative Analysis of Investor Behavior (QAIB) , originally released in 1995.  The findings of the latest update are consistent with what Dalbar found in the past.  The average mutual fund investor is making less than market returns because of frequent switching among funds.

In the latest QAIB study update, Dalbar analyzed mutual fund data for the period from January of 1984 through December of 2002, which includes the recent bear market in stocks.  I was interested to see if the bear market had changed investors’ habits of jumping from fund to fund, trying to find the latest “hot” performer.  Unfortunately, the 2003 QAIB update continued to confirm the findings of the original study:

The average equity fund investor earned only 2.57% annually over the 19-year period (Jan 1984- Dec 2002) included in the study, compared to  the S&P 500 Index average annual return of 12.22% and annualized inflation of  3.14%.  (Yes, you read it right.  The average mutual fund investor’s gain was less than inflation over the last 19 years!)

The average fixed income mutual fund investor fared a little better, but not up to the market's performance.  The average mutual fund investor had an annualized gain of 4.24%, which was better than the average equity fund investor, but still behind the long-term government bond index of 11.70%.

Once again we see that most investors don’t buy mutual funds and hold them long-term.  If they did, most would make roughly what the market indexes make.  Instead, most investors switch from fund to fund, thereby greatly reducing their returns.  This argues for professional management.

ADVISORLINK - Market Timing Programs Performance Update

Editor’s Note :  As many of you will remember, we started our AdvisorLink program back in the mid-1990s when I first reported the results of the Dalbar study.  Hundreds of clients indicated that they, like the Dalbar study indicated, were not making what the markets make in their mutual fund investments.  They asked us to expand our business to include market timing Advisors, which we did.

In light of the latest QAIB study update, I thought it would be appropriate to review how the   AdvisorLink programs I have recommended the most over the last year and a half have fared during the bear market.  Here are the results for our recommended programs from Capital Management Group, Niemann Capital Management, and Potomac Fund Management. 

In all cases below, the performance information is quoted as of June 30, 2003 and is net of all fees and expenses.  Drawdowns are measured based on month-end performance information.  Performance information has been supplied by the various Advisors, but is also checked for accuracy against the actual performance in my own personal accounts at each of the Advisors, which are monitored on a daily basis.  Also, be sure to read all of the important disclosures that follow my conclusions on page 7 of the newsletter.

When reviewing this information, it is also important to remember that one of the major goals in market timing is to reduce the risk of being in the market by going to cash, but this risk cannot be eliminated entirely.  No market timing system is perfect, and all will generate losses from time to time.  Those Advisors described below have shown the ability to reduce this risk during the course of one of the worst bear markets in history.  That’s quite an accomplishment in my book.

Capital Management Group, Inc.

Capital Management Group’s (CMG’s) programs date back to January of 1992, so each has over 10 years of actual trading signals.  Both of CMG’s investment programs invest exclusively in high-yield bond (aka: “junk bond”) mutual funds through a custodial account held at Trust Company of America. 

While both of CMG’s programs manage high-yield bond funds, an inherently risky investment, preserving principal is their number one goal.  Manager Steven Blumenthal has found that high-yield bonds are typically less sensitive to day-to-day swings in interest rates than Treasury bonds, and their price movements are often less volatile than higher quality corporate bonds.  Blumenthal believes this price stability helps to offset the increased credit risk of high-yield bonds.  CMG has been able to deliver excellent performance, with minimal drawdowns, by applying a market timing strategy to high-yield bond funds.

The CMG high-yield bond timing programs do not seek to primarily gain from the higher rates of interest paid on high-yield bonds, but rather they  seek capital appreciation from price movements of these bonds.  CMG offers two different high-yield bond programs, the Managed Program and the Leveraged Program.

CMG’s Managed Bond Program specializes in what they call “Investment Stop-Loss Risk Management.”  In layman’s terms, this means that CMG seeks to invest in high-yield bond funds during periods of rising prices, and move to the safety of money market funds during periods of declining prices.

The Managed Bond program also follows a strict stop-loss discipline on each and every trade in an effort to minimize losses.  If a trade incurs a loss equal to a pre-set point, CMG exits the trade and moves to the safety of a money market fund.  As the program experiences positive returns, these stop-losses are ratcheted up in an effort to lock-in profits.

The Managed Bond Program invests only in large, well-known high-yield bond mutual funds, and typically invest only in funds that limit their exposure to any one bond issue to 2% or less of the funds' overall portfolio.  This helps to moderate the effects of any one particular bond issue experiencing problems.

As a result of moving into and out of the market, the program has historically been in the safety of a money market fund over 50% of the time.  CMG’s Managed Bond Program typically does  only about three to six round-trip trades per year, but may be more or less active depending upon the high-yield bond markets.

Managed Bond Performance Highlights:  The CMG Managed Bond track record is one of the steadiest market timing performance records I have ever seen.  Since its inception, the Managed Bond program has produced an average annualized return of 12.11%.  This compares favorably to the S&P 500's performance of 9.8% over the same period of time.

Most impressive, however, is the Managed Program’s ability to minimize losses while producing these impressive returns.  Since inception, the Managed Bond program has never had a calendar-year loss.  Even better than that, the Managed Bond Program has a worst-ever peak-to-valley drawdown of only -3.28%.   Compare this to the a drawdown of over -44% for the S&P 500 during the same time period.

The true worth of a money manager is measured in terms of “alpha,” or additional returns that are the result of the skill of the manager.  To best measure CMG’s alpha, we need to compare its performance to the high-yield bond market.  Using the Credit Suisse First Boston (CSFB) High-Yield Bond Index as a benchmark, the CMG Managed Bond Program has shown to have significant alpha.  CMG’s average annualized return of 12.11% significantly beat the CSFB High-Yield Index which produced an average annualized return of only 8.6% over the same period of time.  Even more impressive, CMG’s worst-ever drawdown of only -3.28% was less than half as large as the worst-ever drawdown of the CSFB High-Yield Index, which fell by -8.65%.  So, CMG beat the benchmark on the upside and during losing periods!

CMGis having another banner year in 2003. Year-to-date, the Managed Bond Program is up 15.3% as of June 30, 2003.

CMG's Leveraged Bond Program is managed using the same “Investment Stop-Loss Risk Management” trading discipline as the Managed Bond Program, so I will not repeat the description of their methodology.

The big difference in the Leveraged Program is, as the name implies, the use of brokerage margin to create a 2:1 leveraged position.  For example, if you invest $25,000 in the CMG Leveraged Bond Program, approximately $50,000 of high-yield bond funds will be purchased for your account, borrowing the additional $25,000 on margin within the brokerage account.  The effect of the leverage will be to approximately double the gains or losses experienced within the account.

Obviously, the use of margin and leverage within a brokerage account increases the risks to the investor, so this Program is suitable only for aggressive investors who understand the risks of using leverage.

Leveraged Bond Performance Highlights:  As with CMG's Managed Bond Program, the performance of the Leveraged Bond Program since its inception in 1992 has been impressive.  The average annualized return of the Leveraged Program is an impressive 18.35% since inception, compared to the S&P 500 Index’s average annual return of only 9.8% and the CSFB High-Yield Bond Index's average of 8.6% over the same period of time.

As might be expected, the risk of the Leveraged Bond Program as measured by its worst-ever drawdown is greater than that of the non-leveraged Managed Bond Program.  The Leveraged Program's worst-ever drawdown is -7.3% , just over double that of the Managed Bond Program.  Considering the 2:1 leveraged utilized in the Leveraged Program, this is fully to be expected. 

Even though the Leveraged Bond’s drawdown is higher than that of the Managed Bond Program, it is still far better than the S&P 500 Index drawdown of over - 44% and the CSFB High-Yield Bond Index drawdown of - 8.65%. 

Like the Managed Bond program, the Leveraged program is also having a banner year.  As of June 30, 2003, the Leveraged Program was up 25.4% year-to-date.

Analysis:  Many ProFutures clients have enjoyed superior returns over the past 10 months by investing in CMG’s programs.  Those who opened their  accounts with CMG in September of 2002 when I first recommended it are sitting on top of returns of over 24% in the Managed Program and in excess of 38% in the Leveraged Program.

Yet, there are many other ProFutures clients and prospects who have expressed an interest in the CMG programs, but can't quite “pull the trigger.”  Reasons vary for hesitating to invest in these programs, but most of those I talk to are concerned about the possibility of interest rates rising in the future, and the inherent additional risk found in high-yield bonds.

Fortunately, the CMG programs adequately address both of these issues.  As Manager Steven Blumenthal has pointed out, high-yield bonds do not react to interest rate changes in the same manner as Treasuries or high-grade corporate bonds.  In fact, rising interest rates resulting from economic growth can actually improve the price of high-yield bonds.

The second objection regarding the additional risk of high-yield bonds is addressed in CMG’s ability to go to cash when there is an elevated risk of holding such bonds.  That, coupled with CMG's strict guidelines on fund selection discussed above, has helped to moderate the exposure to credit risk over the program's 10-year-plus existence.

While we all have to remember that past performance is not necessarily indicative of future results, CMG presents a compelling case for investing in their high-yield timing programs.  With a 10-year record and an average annual return of 12.1% and a worst-ever drawdown of only 3.3%, the Managed Bond program has been nothing short of outstanding.  The Leveraged program has been even better, although it does involve more risk.

CMG’s normal investment minimum is $50,000, but ProFutures clients may invest as little as $25,000.  CMG's annual management fee is 2.25%, plus a Trust Company of America custodial fee of approximately $75 per year.

Potomac Fund Management, Inc.

Potomac Fund Management is owned by Rich Paul and is located in the Washington DC area.  Potomac has several different timing programs, but our favorite is the Fidelity Conservative Growth program, which is one of the long-term success stories of our AdvisorLink Program.  It was among the early market timing programs offered by ProFutures, and has continued to provide steady returns and stability of principal for our clients who have invested in it.

Unlike a “rapid-fire” approach that moves in and out of the market quickly, the Conservative Growth program tends to move slowly in small increments, rather than in or out of the market in a single day.  However, Potomac’s programs can move to predominately cash in severe bear markets, as they did over the past three years.

The Conservative Growth program’s market timing methodology is based on both technical and discretionary factors.  On the technical side, a computerized market timing model decides whether to be in or out of the market.  If there is a “buy” signal, other technical indicators are used to decide which mutual funds are to be used.  Over the course of time, if the relative strength of the funds changes while the buy signal is still active, Conservative Growth will move to other funds. 

While the technical systems are the primary basis for decisions, Rich Paul will sometimes use his many years of investment experience to assist in portfolio decisions.  This discretionary element provides flexibility that is simply not available in a non-discretionary technical system, and can be the difference between profits and losses.

I said above that the Conservative Growth program can move “predominately” to cash because it is difficult for them to have a 100% cash position.  This is because Potomac uses some funds that are not friendly to market timers, so they must be careful not to trade frequently.  As a result, Conservative Growth may hold certain long positions even in a downward trending market, which can lead to losses.

To address this, in 2002 Potomac began using the Rydex short funds to hedge these long positions, and did so quite effectively.  This flexible approach allowed the Conservative Growth program to hold long positions where necessary, offsetting losses with gains from the short positions and thus minimizing drawdowns.

Another strength of the Conservative Growth program is the group of mutual funds used.  Potomac screens the universe of mutual funds to select those with a history of doing well during down markets.  Thus, if the market goes down while the Conservative Growth program has long positions, losses are likely to be less than those experienced in the overall market.

Conservative Growth Performance Highlights:  The Conservative Growth Program has been a steady performer since 1996 when it was developed.  The average annualized rate of return for this program is 11.5%, compared to the S&P 500 Index average annualized return of only 7.1% over the same period of time.

The Conservative Growth program seeks to conserve principal during down markets, and this has been achieved.  The worst-ever drawdown of the Conservative Growth program is -8.1% since its inception, while the S&P 500 Index experienced a drawdown of over -44% during the same time period.  Very few equity mutual fund timing programs can boast of a single digit worst-ever drawdown.

In 2003, the Conservative Growth Program was up 7.75% as of June 30, 2003.  It is up even more since that date.

Analysis:  Due to the selection of low-volatility mutual funds in this program, both gains and losses will generally be less than those experienced by the overall market.  This provides a smoother ride for the investor and makes it less likely that losses will lead to an emotional decision to redeem.

Since Potomac’s market timing model moves into and out of the market on a more gradual basis, the Conservative Growth program will sometimes miss the beginning days of a rally, and be long during the beginning days of a market decline.  However, this gradual movement also helps the Conservative Growth program avoid being "whipsawed" by short-term market action.

While the addition of short trades to hedge long positions has increased the risk of the Conservative Growth program somewhat, we believe this is a real “plus” to the program.  It should prove very valuable should we go back into a bear market.

I believe the Conservative Growth program is appropriate for those who want the potential to earn  stock market-type returns, but with smaller losses during down markets.  Not many market timing programs can boast coming through the recent bear market with a worst-ever drawdown of only -8.1%.

The Potomac Conservative Growth program has a minimum investment of only $15,000, so it is available to investors of almost any size.  The annual management fee for this program is 2.5%.

Niemann Capital Management, Inc.

Don Niemann, principal of Niemann Capital Management (NCM) employs a proprietary methodology based on the concept of money flow.  As investors move money among the various mutual funds in different asset classes, the relative value of each asset class fluctuates up and down.  NCM’s system analyzes market data on thousands of mutual funds in an effort to anticipate where money will be moving next, and then position clients accordingly.

Niemann’s market timing programs are administered much like the Conservative Growth program discussed above, in that movements into and out of the market are gradual, and not rapid-fire.  However, Niemann tends to use a wider variety of mutual funds that provide more “bang for the buck” than those used by Potomac.  As a result, Niemann’s programs delivered annualized returns that are greater than Potomac’s, but so are the worst-ever drawdowns.

While NCM offers three different money management programs and all are available to ProFutures clients, I will only be discussing the Risk Managed program in detail because I feel it is the best program Niemann has to offer based on risk-adjusted returns.  If you would like more information on the other Niemann programs available through ProFutures, give one of our Investor Representatives a call at 800-348-3601.

As I stated above, the Risk Managed program is managed on the basis of money flow into and out of a pre-selected group of approximately 2,000 equity mutual funds.  The Risk Managed program does not include any bond or international funds in its population of eligible funds.

This restriction on the type of funds utilized means that the Risk Managed program is more likely to seek the safety of cash when domestic equity funds fall out of favor.  This is why the Risk Managed program is deemed to be more conservative than other NCM programs, since it generally spends more time in cash than Niemann’s other strategies.  However, the Risk Managed Program has return and maximum drawdown statistics that are actually better than Niemann’s more aggressive offerings.

Risk Managed Program Performance Highlights:  The Risk Managed Program has performed extremely well since its inception in October of 1996.  Since that time, Risk Managed has produced an average annualized rate of return of 16.1%, which compares very favorably to the S&P 500 Index's return of only 7.6% over the same period of time.

The Risk Managed program also lived up to its name by limiting downside fluctuations and preserving capital better than the S&P 500 Index.  The worst-ever drawdown of the Risk Managed Program is -17.3% since its inception, while the S&P 500 Index experienced a drawdown of over -44% during the same time period.

In 2003, the Risk Managed program is up 8.43% as of June 30, 2003.  It is up even more since then.

Analysis:  Though the Risk Managed program is deemed to be less aggressive than Niemann’s other strategies, we recommend it only for moderate to aggressive investors.   The program is clearly more aggressive that Potomac’s Conservative Growth. 

Since the Risk Managed Program is not a rapid-fire market timing system, it will be slower to enter rallies and exit declines than some other programs.  However, with recent market volatility, this also means that Niemann has less of a chance of being “whipsawed” by short-term market fluctuations.

Niemann seeks to moderate risks associated with gradually entering and exiting the market by choosing low-volatility mutual funds and diversifying among many different holdings.  The track record is a good indication of their success so far.  For investors who are willing to take on more risk in search of higher returns, the Risk Managed program is an excellent choice.

Niemann's minimum account size is larger than our other programs at $100,000, but their communication and quarterly reporting to clients is second to none.  Niemann's annual management fee is 2.3%.

Performance During The Bear Market 

While the inception-to-date performance information provided above on the various AdvisorLink programs can give you some indication of their performance during the recent bear market, I think it is also important to highlight exactly how these programs performed from April of 2000 through June of 2003.   For reference, the S&P 500 Index had an average annualized loss of -11.16% over this period of time, with the largest calendar-year loss in 2002 of -22.09%.

Both of the CMG high-yield bond timing programs performed extremely well during the recent bear market.  The Managed Bond Program had an average annualized gain of 12.41% from April of 2000 through June of 2003, and the Leveraged Bond Program had a gain of 14.94% over the same period.   This compares well against the S&P 500 Index loss, and also compares well to the CSFB High-Yield Bond Index that produced a gain of only 6.54% during the bear market.  Neither CMG program had a calendar-year loss during the bear market.

The Potomac Conservative Growth program achieved an average annualized gain of 2.81% during the years of the bear market, which is phenomenal compared to the losses incurred in the market indexes.  The Conservative Growth Program did have its first calendar-year loss during the bear market, posting a return of -4.04% in 2002.  While the S&P 500 Index plunged to a drawdown of over -44% during the bear market, Potomac's worst-ever drawdown never exceeded -8.1%.

The Niemann Risk Managed program produced an average annualized gain of 2.23% during the bear market.  The Risk Managed Program also produced a worst-ever drawdown of -17.25% during the bear market.  While this is almost double their prior worst-ever drawdown, it is still significantly less than the market’s -44.71% drawdown in the S&P500 over the same period of time.   I feel the greater drawdown is primarily attributable to the mutual funds Niemann uses, and the fact that they did not start utilizing short trades to hedge long positions as early in 2002 as Potomac did.

Conclusions

The brokerage and mutual fund industries want to tell us that market timing doesn’t work.   While I'll be the first to admit that many professional market timers have troubles, the ones I have highlighted in this issue of Forecasts & Trends have proven their abilities in both bull and bear markets.

In this article, I have provided three answers for investors who are looking for a place to invest during uncertain times: Capital Managment Group, Niemann Capital Management and Potomac Fund Management.  As you have just read, all three have been very successful for over a decade, and they also performed respectably in the recent bear market.  We do have other market timing programs as well, but space prohibits mentioning all of them in this article. 

If you are looking for a place to invest that can potentially participate in up markets, but has the proven ability to go to cash in down markets, then you need to give us a call at 800-348-3601.

If you are considering investing in any of the programs discussed above, please be sure to read the required performance disclosures below.

Performance Disclosures

Disclosures Common To All Programs:   ProFutures Capital Management, Inc. (PCM), Capital Management Group, Inc., Potomac Fund Management, Inc., and Niemann Capital Management are Investment Advisors registered with the SEC and their respective states.  This article does not constitute a solicitation to residents of any jurisdiction where the program mentioned may not be available.  Information in this article is taken from sources believed reliable but its accuracy cannot be guaranteed.  Any opinions stated are intended as general observations, not specific or personal investment advice.  Please consult a competent professional and the appropriate disclosure documents before making any investment decisions.  There is no foolproof way of selecting an Investment Advisor.  Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.

PCM receives compensation from the Advisors in exchange for introducing client accounts to the Advisors.  For more information on PCM or any Advisor mentioned, please consult Form ADV Part II, available at no charge upon request.  Officers, employees, and affiliates of PCM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poors 500 Stock Index (which includes dividends) and the Credit Suisse First Boston High-Yield Bond Index represent unmanaged, passive buy-and-hold approaches.  The volatility and investment characteristics of the benchmarks cited may differ materially (more or less) from that of the Advisors.  Historical performance data was provided by the Advisors and where possible verified by PCM from selected customer account statements and/or independent custodian statements.   However, since only selected accounts were analyzed, there can be no assurance that the performance in these accounts was consistent with others.   In all cases, performance histories reflect a limited time period and may not reflect results in different economic or market cycles.  Statistics for "worst drawdown" are calculated as of month-end.  Drawdowns within a month may have been greater.  PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.

Investment returns and principal will fluctuate so that an investor's account, when redeemed, may be worth more or less than the original cost.  Any investment in a mutual fund carries the risk of loss.  Mutual funds carry their own expenses, which are outlined in each fund's prospectus.  An account with any Advisor is not a bank account and is not guaranteed by the FDIC or any other governmental agency.

Returns illustrated are net of the maximum Advisor management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees.   They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable.  Individual account results may vary based on each investor's unique situation.  No adjustment has been made for income tax liability.  Performance for other programs offered may differ materially (more or less) from the program illustrated.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss. 

Disclosures Specific To CMG's Bond Timing Programs:  In calculating account performance, CMG has relied on information provided by the account custodian.  The CMG Risk Management Plan is a technically based strategy offered by CMG.  The illustrated performance is based on actual account performance from 2000 to present (Trust Company of America client accounts).  The results from November 1992 to 2000 are based on actual trade signals applied to the mutual funds.  CMG trades various high-yield bond funds.  CMG traded most of the stated funds but not all funds for the period reflected.  The performance information provided accurately reflects the blended results of an assumed investment in the funds when applying actual price movements of the funds. 

This illustration should not be construed as an indication of future performance, which could be better or worse than the period illustrated.  The period 1992 - 1997 was a period of generally rising fund prices.  The period 1997 - 2001 was a period of generally declining prices.  A money market rate of 5% was assumed from 1992 - 1999.  All dividends and capital gains have been reinvested.  The results shown are net of CMG's 2.25% annual management fee.  Investment returns and principal are not guaranteed.

Disclosures Specific To Potomac's Fidelity Conservative Growth Program:   Potomac's performance results are based on the Fidelity Conservative Growth Model Portfolio, an actual account that is considered representative of the majority of client accounts with similar investment objectives.  Returns for the Model Portfolio are time-weighted, total returns that reflect the reinvestment of dividends and capital gains distributions.  Potomac's performance is net of the maximum (2.5%) advisory fees.

Individual investors' objectives, financial situations, their specific instructions or restrictions on investments, or the time at which an account is opened or additions made may result in different trades and returns from the Model Portfolio. 

Disclosures Specific To Niemann's Risk Managed Program:  Performance results are presented net of transaction costs and Niemann Capital Management's actual management fees, currently 2.3%.  All profiles and reports have been prepared solely for informational purposes, and are not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instrument or to participate in any particular trading strategy.   All Niemann performance results for the Risk Managed Program include all actual, fee-paying and non-fee paying, fully discretionary accounts under management and held in custody at Fidelity Investment Advisory Group.  All dividdends and capitl gains were reinvested.

Niemann, its affiliates or its employees may have positions in and may effect transactions in securities used within the Risk Managed Program.  The Risk Managed Program may be unsuitable for certain investors depending on their specific investment objectives and financial position.