ProFutures Investments - Managing Your Money
The Big Secret Mutual Fund Companies Are Hiding

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
August 20, 2013

IN THIS ISSUE:

1. SPECIAL REPORT: Mutual Funds Are Keeping a Big Secret From You

2. Will the Fed Cut QE Purchases at September Meeting?

3. To Taper Or Not – It’s Still Bernanke’s Call

4. Taper Talk Very Bad For Interest Rates

Overview

Do you know that most (if not all) mutual fund and ETF sponsors are keeping vital information about their funds secret from you? We’ll start today’s E-Letter with a discussion about what that valuable information is and why fund companies don’t want you to know about it. I'll also tell you how you can download my latest FREE Special Report entitled, "The Secret That Mutual Fund Companies Don't Want You to Know."

Better yet, after you read my latest Special Report, I’ll show you how to beat the fund companies at their own game by learning this secret about the actual mutual funds (or ETF’s) in your own portfolio. This is information you really need to know, and you may be very surprised by what you learn!

From there, we shift our focus to the Fed. As you will recall, Fed Chairman Ben Bernanke first hinted of reducing “quantitative easing” (QE) bond and mortgage purchases in late May, and stocks and bonds took an immediate hit. In late June and July, Bernanke tried to walk-back the idea of “tapering” Fed purchases, and stocks soared to new record highs. However, in the last few weeks, “taper-talk” has become widespread again.

Most forecasters now believe that the Fed will cut its monthly QE purchases from $85 billion to around $65 billion at its next policy meeting on September 17-18. That prediction sent stocks reeling last week, and 10-year and 30-year Treasury bonds plunged to their lowest level in two years.

So, will Bernanke really do it after saying last month that the Fed would not taper “for the foreseeable future?” I believe that Bernanke has the votes to reduce QE purchases – if he so wishes; and I also believe he has the votes to continue as is – if that’s what he wants. If he chooses to taper, that will almost certainly put more downward pressure on stocks and bonds.

Mutual Funds Are Keeping a Big Secret From You

In my July 9 E-Letter, I shared the results of a study undertaken by the Financial Industry Regulatory Authority (FINRA), a major financial services regulatory body. The FINRA study administered a simple, 5-question test on matters of economic and investment basics. The results? The general public bombed on this test, scoring a dismal 58%.

In that E-Letter, I offered my readers a chance to try their hands at FINRA’s five question test, as well as take on seven additional basic economic and investment questions developed by my staff.

If you didn’t take the Financial Literacy Test, you really should! Just click on the button at right.

Take the Financial Literacy Test

As I reported in my July 23 E-Letter, my readers did exceptionally well on both the original FINRA questions as well as the seven additional questions we added. While I expected my E-Letter readers to do better on the original five-question test, I was pleased to see that my readers scored an average of 95.6% on the FINRA portion of the test and 84% on the entire 12-question quiz.

The test did highlight a couple of questions that even stumped many of my readers. One of the most missed questions dealt with basic knowledge about bonds. Most people taking the exam knew that when interest rates go up, bond prices go down. However, fewer were aware that long-term bonds are usually affected far more than short-term bonds by rising interest rates.

In an effort to help my readers better understand how bonds work, we have developed a new “Bonds 101” Video presentation. This informative video serves as a primer on the different types of bonds and how market forces affect each. It’s a very good video and we’ve received a lot of compliments on it, so I encourage you to click on the link above to take a look.

The next question that many of those taking the quiz missed was #7 in regard to “drawdown,” one of the most important measures of an investment’s risk. It’s an investment evaluation tool that we use extensively in our due diligence evaluations. Yet, less than half of those taking the test knew what drawdown is.

Maximum Drawdown

Maximum (or max) drawdown refers to the worst-ever losing period for any given investment. It’s a measure of how far the investment dropped in the past from its highest peak value to a subsequent valley or trough. For example, the worst drawdown for the S&P 500 Index was 50.95% in the bear market of 2008-2009.

Whenever we analyze a potential investment or investment advisor, one of the very first things we look for is their max drawdown. It helps answer the question of how much an investor could lose in an investment and over what period of time. Max drawdown is a key reading of the downside risk of that investment or money manager. We generally assume that if a max drawdown happened once, the investment could lose that much (or more) again in the future.

To be fair, it’s not surprising that over half of those who took our test missed this question. That’s because the mutual fund industry tries so hard to hide this statistic from you.

As a general rule, you won’t find “drawdown” statistics on mutual fund fact sheets, marketing materials or in prospectuses because it is often a big negative. Instead, they use less telling risk measures such as alpha, beta and standard deviation that are usually meaningful only when compared to benchmark indexes or other mutual funds.

While most investors focus on annualized returns when selecting an investment, you should also pay attention to the worst drawdown – even if you have to pry that information out of the investment’s sponsor.

Why Do Mutual Fund Companies Hide Drawdowns?

I believe that mutual fund companies try to keep drawdown statistics a secret because it doesn’t fit into their “relative return” view of the world. Mutual funds like to compare their performance to stock and bond market indexes. Think how often you hear commercials for mutual funds bragging that they beat this or that market index. Sounds impressive, doesn’t it?

That is until you realize that a mutual fund can beat the market even if it loses money. In 2008, the S&P 500 Index dropped 37% for the year. Given that performance, a mutual fund could truthfully claim that it “beat the market” by incurring a loss of only 20% or even 30%.

Plus, revealing drawdown statistics would often show that many mutual funds have drawdowns near or exceeding those of the unmanaged indexes. The sad fact is that many mutual funds don’t beat the market when it’s going up and often match losses when the market is going down. Don’t believe me? Take a look at the max drawdowns of five very large, well-known mutual funds compared to that of the S&P 500 Index:

S&P 500 Index Total Return -50.95%
Vanguard 500 Index Trust -50.92%
Fidelity Contrafund -46.34%
American Funds Growth Fund of America -48.80%
Dodge & Cox Stock -59.22%
Franklin Income Fund -39.07%

(Max drawdowns measured as of month-end.
Intra-month drawdowns could be higher.)

Get Our Free Drawdown Special Report

I mentioned in my July 23 E-Letter that I was working on a new Special Report that deals with the subject of max drawdowns and why mutual fund and ETF sponsors want to keep them a secret. I’m pleased to announce that this new Report is now finished and is available to you, free of charge, by following the download instructions below.

This eye-opening Report is one that you won’t want to miss. In it, I not only tell you why mutual fund companies want to keep max drawdown a secret, but I also highlight:

  • The advantages of using drawdown as an investment analysis tool;
  • The shocking amount of return required for the above-listed funds just to get back to breakeven after experiencing the drawdowns shown;
  • How drawdowns can delay and even derail your financial goals;
  • How passive buy-and-hold strategies cannot effectively manage drawdowns; and
  • How to beat the mutual fund companies at their own game by discovering the max drawdowns of the funds you own.

To get your FREE copy of my newest Special Report, just click on the link below. Feel free to pass this information along to friends and relatives, as I’m sure many of them have no idea what a drawdown is, or that it’s being hidden from them by the mutual fund companies.

Drawdown Special Report

Will the Fed Cut QE Purchases at September Meeting?

Over the past few weeks, stock market investors have become intensely focused on whether or not the Fed Open Market Committee (FOMC) will finally decide to reduce its huge monthly purchases of Treasury bonds and home mortgages at its next policy meeting on September 17-18. For a variety of reasons, the consensus is that the Committee will vote to cut back on its QE purchases at this upcoming meeting.

I have written frequently on this issue over the last several months, so my readers are well aware that the Fed has been looking at curtailing its $85 billion per month purchases of bonds and mortgages for several months now. Since late last year, the Fed has been buying $45 billion a month in US Treasuries and $40 billion in mortgage-backed securities (MBS).

The big question now is, when will the Fed start to reduce these huge monthly purchases? As noted above, Fed Chairman Ben Bernanke first floated this idea back in late May, and the stock markets basically freaked out in June, as you can see in the chart below. Bonds plunged as well.

The negative reaction to Bernanke’s suggestion to curtail QE purchases – which came to be referred to as “tapering” – was so severe that the Fed Chairman basically ‘walked back’ the idea in early July. He went so far as to say on July 10 that he didn’t expect tapering to occur “for the foreseeable future.” With that assurance, the Dow and the S&P 500 indexes soared to new record highs in July and earlier this month.

Dow Jones Industrial Average

Since then, however, fears of the Fed tapering before the end of this year have re-intensified. While Bernanke hasn’t threatened to curtail QE purchases this month, several members of the FOMC have suggested in various speeches that the time has come to start cutting back on the monthly Treasury bond and mortgage buying.

The next FOMC meeting is on September 17-18, and this meeting will be followed by a press conference with Mr. Bernanke. Given the references to tapering by several members of the Committee in the last few weeks, many analysts and investors alike have come to the conclusion that the FOMC will vote to reduce its monthly purchases of bonds at that meeting.

As you can see in the chart above, this news has weighed heavily on stocks this month. The Dow sank from a record high of 15,658 on August 2nd to near 15,000 as this is written. While that is not a huge move, the growing fear is that there’s more to come, especially if the Fed votes to taper on September 18. I would agree.

To Taper Or Not – It’s Still Bernanke’s Call

While several members of the FOMC have made it clear that they believe it is time for the Fed to reduce its monthly QE purchases, there are others on the Committee that have stated recently that the $85 billion in monthly purchases should continue, especially given the weak economic recovery.

In July, Bernanke assured Congress that there was no “preset course” for tapering or ending QE, and that it depended largely on the economy. At one point earlier this summer, Bernanke referred to a target of 6.5% unemployment. The July unemployment rate fell to 7.4%, but few expect the rate to fall to 6.5% anytime soon. Interestingly, Bernanke has not mentioned the 6.5% reference since then, but we still believe his focus is on the economy and employment.

On that note, 2Q GDP came in at only 1.7% (annual rate) following only 1.1% in the 1Q. Neither of those numbers suggests a healthy recovery, and would not suggest that the Fed will curtail QE purchases anytime soon. Nevertheless, “taper talk” is back in style with many forecasters expecting it to begin just after the September 17-18 FOMC meeting.

I still believe it all comes down to Bernanke; I continue to feel that he has the votes on the Committee to continue QE beyond the September meeting – if he wants to. On the other hand, I also believe he has the votes to taper – if he wants to. If he does, most analysts expect the FOMC to curtail purchases from $85 billion a month to $65 billion. That, of course, is just an estimate, but it was enough to roil long-dated Treasuries over the last few weeks, and now the stock markets as well.

I think this all boils down to whether or not Bernanke feels a responsibility to begin to finish what he started before his term is up in January.

Taper Talk Very Bad For Interest Rates

Back in May, before Bernanke hinted that the FOMC was considering curtailing its QE purchases this year, the yield on the 10-year Treasury Note was near 1.6%. As this is written, the yield is nearing 2.9%. That’s a rise of almost 75% in just 4½ months! You can see in the chart below that the yield dropped in July when Bernanke was ‘walking back’ the threat to taper, but since then it has spiked to the highest level since the summer of 2011.

CBOE Interest Rate 10-Year T-Note

The carnage in the 30-year Treasury bond market is not as bad – yet. In early May, the 30-year yield was near 2.8%. Today it is approaching 3.9%. That’s a rise of 36% in just 4½ months. And if the Fed decides to taper its bond purchases next month, the long-bond will very likely get hit hard again.

FYI, the talk is that if the Fed votes to taper next month, it will only reduce its monthly purchases of Treasuries. It is not expected that the Fed will reduce its monthly purchases of mortgage-backed securities, at least not initially. As noted above, the Fed currently purchases $45 billion a month in Treasuries and $40 billion in MBS. So, if they cut Treasury purchases to only $25 billion a month (as is widely expected), that could be another big hit to bonds.

Finally, none of what is happening in bonds, and even stocks, should come as a surprise to my regular readers. I began warning about this as early as August a year ago when I released my “Bond Bubble” Special Report. And I have warned about a bear market in bonds often since then. Hopefully, you reduced your exposure to long-bonds well before now.

Wishing you low drawdowns,

Gary D. Halbert

P.S. - If you do nothing else after reading today's E-Letter, do yourself a favor and download my new DRAWDOWN SPECIAL REPORT. You really need to know the secret that mutual fund companies are deliberately hiding from you!
 
After you learn the secret, you'll definitely want to check the mutual funds (and ETFs) you own to see their historical worst drawdowns. Since most fund companies won't give you that information, we'll give it to you FREE of charge. So be sure to read this Special Report.

Read Gary’s blog and join the conversation at garydhalbert.com.

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