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February 2006 Issue
The economy surprised on the downside in the 4Q of last year. The
government reported that 4Q GDP rose at an annual rate of only 1.1% in the
last three months of 2005. This was a shocker since the average pre-report
estimate was for a rise of 2.8%. The question is whether this is a sign of
a recession just ahead, or is it merely a temporary setback in an otherwise
strong economy? I feel it is the latter and so does BCA.
The slowdown in the 4Q was largely the result of weaker than expected
consumer spending and federal spending. The slowdown in consumer spending
was largely due to the big drop in consumer confidence just after the
hurricanes, when gasoline prices soared above $3 per gallon across the
country. We also learned last month that the holiday shopping season was
not nearly as strong as earlier reported. Thus, the dip in GDP.
So where do we go from here? BCA believes that economic growth in the 1Q
will also come in below 3% in GDP, but not as low as in the 4Q. After a
slower 1Q, BCA expects the economy to rebound nicely in the remainder of the
year. More importantly, BCA predicts that the “longwave upturn” in the
economy will last several more years, with stronger than expected growth and
mild recessions, if any. The biggest concern BCA has is that energy prices
could spike higher, thus causing inflation to be higher than expected. But
they do not believe this is the most likely scenario.
BCA expects stocks to remain in a broad trading range with a mildly higher
bias. They expect bond yields to remain in a trading range also, with rates
falling slightly when the Fed stops hiking later this spring.
Given these difficult markets, we have recently developed several portfolios
of stock mutual funds that have historically delivered good returns in up or
down markets. We call these our Absolute Return Portfolios. I
have also written a new Absolute Returns Special Report which
discusses these portfolios and how they were selected. I highly recommend
that you call us for a free copy of this latest Special Report and learn how
you can take advantage of these funds, especially in these difficult times
in the stock markets. See more details on pages 7-8.
Every January, our mailboxes, inboxes and e-mail programs are bombarded with
all sorts of forecasts, predictions and, of course, recommendations on how
and where to invest your money. Investment magazines are loaded with their
favorite picks and strategies for the New Year. Rarely, however, do these
sources review their picks from last year - not a pretty sight in many cases.
Most of these annual rankings and recommendations, as I have pointed out so
often in the past, focus on the latest “hot” funds or
strategies. Typically, they look at the highest performers over the last 12
months. As everyone reading this newsletter should know, the latest hot
performers can go cold just as quickly as they got hot, and the
losing periods (“drawdowns”) among the latest hot funds are often huge.
Yet the January 9 issue of Barron's seemed to take a different approach for
its New Year’s recommendations. The editors focused on the top 20 equity
mutual funds over the last 15 years. It was their cover story and, at first
glance, I thought I would be impressed. There was, of course, a table in
the middle of the article which listed the top 20 funds, and most readers,
I'm sure, went straight to the table to see which funds had made Barron's
top 20 list over the last 15 years.
Barron’s list of the top 20 equity mutual funds is included in the pages
that follow, but before you leap ahead, there are some problems you need to
know about with these funds. I will point out the problems as we go along. The
bottom line is, if you had owned Barron's top 20 mutual funds over the last
15 years, you would have had a very ROCKY ride along the way!
Keep in mind as you read on that the 15 year period Barron’s considered,
from 1991 to 2005, included the greatest equity bull market in history.
Given that, you would expect some good returns. But as you'll see, the
losing periods were way beyond most investors’ tolerance levels.
Unfortunately, Barron's failed to point that out, but as usual, I will.
After we dissect the Barron’s study, I will explain to you how we go about
selecting mutual funds at my firm. The bottom line is, we look for mutual
funds that have a history of delivering good returns in up, down and
sideways markets, with limited drawdowns along the way. Such funds are out
there if you know how to find them. I’ll tell you how.
Barron's Top 20 Equity Mutual Funds
Let me begin by stating that I am a Barron’s subscriber and have been for
over 20 years. So, I like the weekly financial publication. As I have
stated in the past, I wish I could write nearly as colorfully and animated
as Alan Abelson, Barron’s lead editor. Yet while I am a fan of Barron’s,
the January 9 cover story featuring the top 20 equity mutual funds over the
last 15 years fell below my expectations in several areas. Let’ get
right into it.
The Barron's article touting the top 20 equity mutual funds over the last 15
years was indeed tantalizing - even for me. The cover page had a huge
headline that read: “BETTER THAN BILL,” a
reference to Bill Miller who manages the Legg Mason Value Prime Fund, which
has beaten the S&P 500 Index in each of the last 15 years. The cover page
goes on to state: “No question that Legg Mason's Bill Miller is
a superstar… but we’ve found 19 funds that have done even better.”
I told you it was tantalizing, especially given that there are over 12,000
mutual funds out there.
The exact list of equity mutual funds that Barron’s picked is on the
following page. Yet what shocked me is the fact that Barron’s
failed to include the “Worst Drawdowns” for each of the funds. I
have taken the liberty of adding that very significant piece of data to the
table in the far right column.
Fund Name
|
Ticker
|
Average
Annual Return*
|
Standard
Deviation
|
Worst
Drawdown**
|
FPA Capital
|
FPPTX
|
20.0%
|
19.2%
|
-25.97%
|
Fidelity Low-Priced Stk
|
FLPSX
|
18.8%
|
12.8%
|
-21.84%
|
Calamos Growth A
|
CVGRX
|
18.3%
|
22.8%
|
-35.49%
|
Heartland Value
|
HRTVX
|
18.1%
|
16.6%
|
-27.82%
|
Columbia Acorn Z
|
ACRNX
|
18.0%
|
15.1%
|
-24.20%
|
ICM Small Co. Instl.
|
ICSCX
|
17.6%
|
14.0%
|
-22.10%
|
Hartford Cap Appr HLS, IA
|
HIACX
|
17.5%
|
17.3%
|
-37.34%
|
DFA US Micro Cap
|
DFSCX
|
17.1%
|
19.7%
|
-30.62%
|
Merrill Value Opportunity; I
|
MASPX
|
17.1%
|
17.6%
|
-32.32%
|
Muhlenkamp
|
MUHLX
|
17.1%
|
17.5%
|
-31.00%
|
Federated Kaufmann; K
|
KAUFX
|
16.9%
|
19.7%
|
-31.72%
|
H&W Small Cap Value; I
|
HWSIX
|
16.9%
|
17.0%
|
-39.89%
|
Janus Small Cap Value; Instl
|
JSIVX
|
16.9%
|
15.3%
|
-27.58%
|
Neuberger Genesis; Inv
|
NBGNX
|
16.9%
|
13.4%
|
-26.56%
|
Laudus Ros US Small Cap; Instl
|
USCIX
|
16.8%
|
15.0%
|
-26.92%
|
Wasatch: Core Growth
|
WGROX
|
16.7%
|
18.1%
|
-38.43%
|
Mairs & Power Growth
|
MPGFX
|
16.6%
|
12.7%
|
-20.14%
|
Third Avenue: Value
|
TAVFX
|
16.5%
|
12.9%
|
-25.36%
|
Skyline: Special Equities
|
SKSEX
|
16.5%
|
15.4%
|
-31.80%
|
Legg Mason Value Trst; Prim
|
LMVTX
|
16.4%
|
17.9%
|
-42.37%
|
S&P 500 Index
|
SPX
|
11.5%
|
14.0%
|
-44.73%
|
*Total return and standard deviation are for December 31, 1990 through
December 31, 2005. **“Worst Drawdown” is a measure of the largest
peak-to-valley losing period during the period of time covered by the above
table. *** Past performance is not necessarily indicative of future
results.
Performance reporting for investment products has become very
standardized in the last decade or so for several reasons. Partly due to
increased regulation, and partly due to credibility, there are certain
criteria which are almost always included with the publication of a track
record - at least from reputable sources. Obviously, there is the net
performance, usually expressed as an average annual return. Then there is
the time period over which the performance was generated (months or years).
Next, you typically see something like "standard deviation," a measure of
how consistent the returns were. And then, you almost always see "Worst
Drawdown," which is typically the worst losing period during the
entire performance record.
For whatever reasons, Barron’s chose not to include the worst drawdowns for
the funds they selected. If you've been reading me for long, you know that avoiding
big losses is the centerpiece of my investment philosophy. I am as
focused on the losing periods as I am on the upside potential, if not more
so. Why? Because it doesn't matter how much money you might
make if you were scared out of the investment due to a big drawdown along
the way.
So, I was very disappointed to see that the Barron's editors chose to
publish the glowing performance numbers for their top 20 equity mutual funds
over the last 15 years without also including the worst drawdowns for those
same funds!
Without the information on the worst drawdowns, you have less than half of
the story. Lots of mutual funds and other investment products have
impressive upside returns, but their drawdowns can be huge. You need to
know this upfront. So I added it to the table.
According to Barron’s study of the Morningstar mutual fund database, the
funds in the table are the 20 top performing equity mutual funds over the 15
years from 1991 to 2005. But before you rush out to buy these 20
funds, there are lots of problems I need to make you aware of. I almost
don't know where to start.
That’s not true. I do know where to start. It's where I always start -
with the drawdowns.
Without The Drawdowns, What Good Is It?
As you can see, ALL of the funds listed have worst drawdowns in
excess of 20%. 10 have worst drawdowns in excess of 30%. And several,
including the S&P 500 Index, have worst drawdowns close to or above 40%!
The average maximum drawdown for the funds listed in the Barron's article is
-30%.
We have all read the prominent (and required) disclaimer: Past
performance is not necessarily indicative of future results.
However, I believe the past drawdowns are a better indicator of potential
future risk, and are the primary risk measure my company uses when
evaluating mutual funds and Investment Advisors.
The maximum (or worst) “drawdown” of a program can best be described as the
worst losing period an investment experienced from a performance high point
to a low point (peak to valley). At ProFutures, we look not only at the
worst-ever drawdown, but also at an average of several of the significant
historical drawdowns.
While it is impossible to know if a fund or an Advisor will have similar
drawdowns, or a new worst drawdown, in the future, studying the past losing
periods is absolutely critical in my opinion. In our analysis of funds and
Advisors, we typically want to know why the worst drawdowns occurred and
what, if anything, has been done to make them less likely in the future.
If you are a long-time reader or client, you know why I concentrate so much
analysis on drawdowns. It takes a 25% return to recover from a 20%
drawdown; it takes a 42.9% return to recover from a 30% drawdown; and it
takes a 66.7% return to come back from a 40% loss. All of the mutual
funds in the table above had at least a 20% drawdown. And the data above
only shows you the worst drawdown; it does not tell you a thing about how
often significant drawdowns occurred during that 15 year period!
Buying High & Selling Low
To understand why drawdowns are so important when analyzing any potential
investment, we need to acknowledge one fact, even if it doesn't relate to
you: Most investors buy funds when they are flying high, and sell them
when they are in the dumps.
I have frequently written about the studies from Dalbar, Inc. and
other financial research organizations which demonstrate how most mutual
fund investors tend to “buy high and sell low,” meaning that
they chase returns in hot funds, and then jump out when losses occur. The
routine is all too familiar. Investors read about the latest hot funds in a
financial publication, or hear them discussed on the radio or TV, and decide
that's where their money needs to be.
Unfortunately, most of the high flying funds also have large drawdowns along
the way, as you can see in the Barron’s table above. And remember, these
are the top 20 performers over the last 15 years, according to Barron’s
study.
And there’s another issue you might not think about. When the high-flying
mutual funds get a lot of publicity, a huge influx of money usually
follows. It is not uncommon for these inflows to be larger than the fund
manager can effectively deploy. The result is that these hot funds often
cool off quickly, and performance in subsequent years is often far short of
the returns that gained them notoriety. Unfortunately, investors seeking
the returns promised by the financial media are often disappointed,
especially when the next drawdown hits, and many times they bail out and
look for the next hot funds to invest in.
Investors tend to bail out of an investment when losses become more than
they can bear. The Barron’s table above shows that the smallest drawdown of
any of the funds was still in the -21% range, and you don’t know how often
similar losses might have occurred. I would suggest that many investors
would exit the fund long before reaching even this stage of loss, especially
those who have a low risk tolerance.
Thus, the potential for loss is just as important as the average annual
return of a prospective investment. While the table in the Barron’s article
did list each fund’s “standard deviation,” I feel this measure is a rather
poor indicator of just how much risk you may be taking when investing in a
specific fund or with an Investment Advisor.
I actually chuckled when I read a sentence in the Barron’s article
introduction that said, “…for long-term investors, what counts is the
final number - not the gyrations in between." That was
the tip-off that the funds touted had some serious drawdowns.
It is also interesting to note in the table above that low standard
deviations do not necessarily correlate with low historical drawdowns.
Perhaps the most interesting point, however, is that Bill Miller's Legg
Mason Value Trust, which is widely known for beating the S&P 500 for 15
years, has the highest maximum drawdown of any of the other funds
shown, which is just a few percentage points less than the 44.71% drawdown
of the S&P 500 Index. That's pretty risky, if you ask me! I want funds
that deliver good results without 40+% drawdowns.
Big Bets On Small Cap Companies
Another problem I have with the Barron’s article is the fact that most of
the top performing funds they list have (or had) a heavy concentration in
small cap stocks. The article states, “…many of the funds have a
small-cap value bias," and "Small-cap value was by far and away the best
asset class for the past 15 years…”
While that statement on Barron’s part might in fact be true overall, there
were various periods during those 15 years when small cap stocks
underperformed and were very much out of favor. That is likely when the
high flying mutual funds in the table had some of their worst drawdowns.
There are times to be in small caps, and there are times to be in large
caps. The key is to know when.
If small cap stocks fall out of favor again - and they will - then many
of the mutual funds in the table above will no longer be in the top 20.
Unfortunately, no one knows which market sectors will lead the way in the
future, but what we do know is that trying to determine what the future may
hold from analyzing a 15-year snapshot of the past - with no drawdown
information - is largely an exercise in futility in my opinion.
The "Snapshot In Time" Problem
I have previously written about a money manager’s speech where he said that
he could be the number one money manager in the US, IF he
could pick the time period used to gauge the performance. We call this “cherry-picking”
a track record. Most any money manager or fund has some period of time when
their performance was stellar.
While the Barron’s editors chose to use 15 years as their time period (equal
to that of Legg Mason's Bill Miller), the same rule still applies. Given
virtually any stated period of time, there will always be investment
programs that beat other investment programs. Thus, if you choose a
different time period, different funds and managers are likely to be at the
top of the list.
This is especially true when you measure performance as compared to an index
or set of indices. In my Absolute Returns Special Report, I
discuss how relative performance can actually be negative, yet still be
promoted as “beating the market.” How so, you might ask. Well, if the
market declines 20%, and your manager lost only 15%, then he can say that he
beat the market. But are you happy? I don't think so!
A final problem I have with this over-generalized statement is that it lumps
all long-term investors into one pot, and decides what is best for them.
While the generalization is that all long-term investors care about final
return, as noted above, many care about the risk they have to take along the
way. Others are interested in the tax efficiency of the programs they
maintain, and still others may have different needs or criteria. This
one-size-fits-all approach to the goals of all long-term investors is just
one symptom of the index investing disease that is so prevalent in the
financial media today.
Other Problems With The Barron's Study
By now, it should be obvious that I do NOT recommend that you rush
out and buy the 20 funds listed in the Barron’s table above. Yet there are
actually some additional reasons why you would not want to buy all these
funds. Here are the other reasons:
1. Based on the Morningstar Principia Pro analysis software, all of
the funds mentioned in the article are highly correlated with the S&P
500 Index. This is very interesting, considering that many have small-cap
and mid-cap biases. This high correlation makes it likely that any
investment in one or more of these funds might have to endure the same
roller coaster ride that the S&P 500 Index experiences.
2. Eight of the mutual funds listed in the article are closed
to new investment, so you can’t get them even if you want. Of the
remaining funds open to investors, two have minimum investments of over $2
million, with another requiring at least $50,000 to invest.
3. In an article that seeks to highlight the managers of these
“successful” mutual funds, it is interesting that even the article admits
that eight of the 19 funds have managers whose tenure is less than the 15
years covered in the performance study, with several of them having less
than 5 years at the helm of the funds they manage.
4. While most of the funds score “Excellent” on regulatory issues
according to Morningstar, there are two of the funds listed in the Barron's
article that score “Very Poor” and another that scores only “Fair.” Would
you really want to put your money there?
5. By focusing on a 15-year time period, the funds listed in the
Barron’s article could “beat the market” if they did better than the S&P
500’s average return of 11.52% over the same period. However, if we
selected only the last five years, a fund with an average annual return of
only 1% would almost double the S&P 500 Index's return of a paltry 0.54%.
What good is that information?
Introducing Our “Absolute Return Portfolios”
Ironically, a quote in the article from Don Phillips, Morningstar’s managing
director, seems very appropriate. He said, “Avoiding big
mistakes is the key to generating long-term wealth.” Phillips
made his comments in connection with a discussion of how many of the funds
on the Barron’s list bailed out of tech stocks before the worst of the
bursting of the tech bubble, a factor that might be more attributable to
luck than skill. However, the idea is still valid.
In my November 1, 2005 E-Letter and the Absolute Returns Special Report,
I stressed how important it is to invest in programs that have the potential
to avoid losses through active management strategies. While the funds
listed in the Barron’s article are considered to be actively managed, their
strong correlation to the S&P 500 Index would seem to indicate that the
market’s overall direction is more of an influence on performance than the
skills of the managers.
I am convinced that the real purpose of the Barron’s article was to showcase
managers who have competed well against Bill Miller, but have not had the
distinction of beating the S&P 500 Index each year for 15 years. However,
looking at the article as a whole, it certainly has the appearance of a
recommendation of these funds, even if that appearance is unintentional.
Admittedly, some of the funds mentioned in the Barron's article are quite
good, but selecting investments from a list in a magazine or newspaper
article is not the best way to go in my opinion. A much more intense
examination of the investment is required, and is usually best left in the
hands of professionals.
How We Select Mutual Funds For Clients
As noted at the beginning, there are many publications that recommend which
mutual funds you should invest in. The Barron’s study discussed above is
merely one of many such examples. What should interest you most, however,
is how we pick mutual funds at ProFutures - both for our many clients’
portfolios and also for my own.
For the last year, I have been emphasizing “absolute returns,”
investment programs and funds with the potential to make money in up OR
down markets. If you have not read my latest Absolute Returns
Special Report, you really need to do that if you are serious about
investing in today's tricky equity (and bond) environment. This Special
Report will help you understand why we recommend the investment programs we
do, and how we select them.
Aside from our continuous analysis of Registered Investment Advisors, we
also have access to mutual fund databases and analysis programs. This
sophisticated software allows us to evaluate the performance of all funds,
and to select, among the thousands of alternatives, the ones that our
analysis shows to have the best potential for ongoing absolute returns with
limited risk.
While these funds are not likely to be on the latest “Top Performers” list,
and do not always beat the market, that is not their goal. Instead,
they seek to provide a reasonable rate of return through investment
strategies that also manage the risks of being in the market.
My clients know the fallacies in chasing the latest “hot” funds. So what we
looked for among the thousands and thousands of equity mutual funds were
those funds that I would characterize as “Steady Eddie”
funds - those that have delivered good returns (although not necessarily the
highest) through various and different market environments - with limited
drawdowns. With our serious commitment to technology, we have
software in-house that allows us to search the universe of mutual funds
using virtually any selection criteria we choose. We can “dial-in” those
funds that meet our performance requirements.
Once a number of potential candidates are identified, we then run various
combinations of these funds inside a single portfolio, in an effort to
further enhance potential performance and reduce the risk of loss. The
culmination of all of this research is now available to our clients in the
form of our Absolute Return Portfolios.
All of the mutual funds we have selected have some measure of active
management as part of their strategies. Investors who wish to take
advantage of the Absolute Return Portfolios have the choice of three
different risk levels - Moderate, Moderate-Plus and Aggressive.
There is a slightly different mix of funds (5-6) in each category, but the
objective is to produce attractive absolute returns. Of course, there is no
guarantee that the funds will continue to perform as well in the future.
We continually monitor the funds making up each Absolute Return Portfolio,
and we have the authority to add, drop or replace a fund within a particular
Portfolio, should that become necessary in the future. Factors that might
cause a fund to be dropped from a Portfolio include, but are not limited to:
the loss of a key manager, regulatory problems, change in the investment
strategy, poor performance, etc. (As always, it is also important to
remember that, while these funds have posted consistent positive returns in
the past, there is no guarantee that they will do so going forward.)
Whether you are a current client, or a prospective client, I think you will
want to learn more about the mutual funds in our Absolute Return
Portfolios. You will want to know which mutual funds - out of
thousands - I have my clients’ and my own money invested in, given today’s
market environment.
The minimum required to fully invest in our Absolute Return Portfolios is
only $15,000. Individual accounts are opened at Ameritrade (formerly
T.D. Waterhouse) where the funds will be purchased and held.
There are several ways you can learn about our Absolute Return Portfolios.
You can call us toll free at 800-348-3601 and one of my trusted
Investor Representatives will be happy to send you information, with no
pressure or obligation. Or you can e-mail us at mail@profutures.com.
Or you can go to our website at www.profutures.com
to immediately access our online information request form.
I am very excited about our Absolute Return Portfolios and their potential
benefits for investors at most any level, including even younger investors
who may just be starting out. The programs are also available for IRAs,
trusts, etc. Given the numerous forecasts for another choppy year in the
stock markets, now may be the time that you bite the bullet and see if we
can help you experience some absolute returns. Past results are not
necessarily indicative of future results.
* * * * *
My Weekly E-Letters
We still have clients who do not receive my weekly Forecasts &Trends
E-Letters. If you are in this group, you are missing out on a LOT
of information. I write 6-8 pages of fresh material which is e-mailed to
our subscribers every Tuesday.
There are now computers available in the $200-$300 range which you can
purchase just to send and receive e-mail, if that’s all you want to do.
There are dail-up e-mail services that cost only $10-15 per month. Believe
it or not, lots of people get their e-mail for free by going to the public
library. The computers can be used at no charge, and a service called hotmail.com
will let you set up an e-mail account free of charge.
Getting up the learning curve is easy, and I promise that the ability to
send and receive e-mail will change your life. Your friends and relatives
will be able to instantly send you photos (and who doesn’t want more
pictures of kids and grandkids?).
You can search among dozens of databases for information on anything you
can imagine. You can read editorials from newspapers around the country
free of charge. You can get political information without the media spin,
etc., etc. So don’t procrastinate!
To subscribe to my weekly E-Letter, you can call us with your e-mail
address. Or you can send us an e-mail, and we’ll automatically put you on
the list. That way, you will have instant access to everything Iwrite.
Finally, you do not have to worry about privacy. We do not sell, rent,
trade or in any way share our clients’ e-mail addresses with anyone.
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