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Issue # 30 February 2001$6
per issue
Annual
Subscription $72 Don’t think of yourself as
indispensable or infallible. As Charles
de Gaulle said, the cemeteries are full of indispensable men.
Donald Rumsfeld Recommended Funds
Performance-Prices for week ending Jan. 26, 2001
Year-to-date Returns DJ Industrials: - 1.18
% S & P 500 + 2.63 %
Nasdaq Comp + 12.58 % Russell 2000 + 3.13 % MCSI EAFE (Foreign stocks) – 1.26 % Nobody
has ever bet enough on the winning horse
In the last issue, I cited a one-year Morningstar study showing that the average fund investor’s returns were 2.5% worse than the average fund during 2000. Another study, reported by Barron’s (1/22/01), of a 10 ¼- year period, came to an even grimmer finding. Financial Research (Boston) found that from1990 through the first quarter of 2000, “the average mutual fund’s three-year return was 10.92%, while the average invested dollar gained only 8.7% over the same period.” The reason for the dismal results was the same one cited by Morningstar: Investors’ “hyperactive pursuit of the hottest performers.” As an example, the study pointed to the fact that $91 billion of new money found its way to funds after their best-performing quarters while just $6.5 billion flowed into funds after their worst quarter.” ` A comparison of ending sums is impressive. The “chump,” who invested $10,000 and then did an average job of timing – or more properly mistiming - buys and sells during the period ended up with $23,530. The “champ,” who invested $10,000 in the average fund and then did nothing, ended up with $28,959. The champs beat the chumps by $5,429 - 54% of the original investment. There are two solutions to the problem that plagues the average investor. One, as easy as kicking a stump, is simply investing in funds and doing nothing. But that can be hard on the psyche because human nature usually wants us to make things better – to do something. The hell of it is that the doing is precisely what is the average investor’s undoing. Doing
it right: “As close as it gets to a sure thing in the mutual
fund business” – Morningstar FundInvestor If a do-nothing Rip Van Winkle strategy seems too much to bear (pardon the pun), there is another choice: do the opposite of what the average investor does. Capturing excess returns generated by the new-fund effect in “risky, unproven” new funds is obviously one approach. Another is a strategy recommended by Morningstar FundInvestor* ($99/year) that provides an elegant methodology to go against the now-crowd. As I explained last year, every year the publication identifies the three least-popular fund categories (measured by cash flow, not returns) from the previous year: “That means we’re asking you to buy exactly what everyone seems eager to dump.” The strategy they endorse is investing in all three categories and holding for the following three years. They have been reporting on unloved sectors since 1987, and “we’ve found that these unpopular categories have beaten the average equity fund more than 75% of the time…Moreover, unpopular categories have beaten popular ones 90% of the time (emphasis added).” This should get your attention. This is Morningstar - not a pinky-ringed tout in a Hackensack bucket shop. Morningstar admits that it’s not perfect and they point to periods when it hasn’t worked, but even so, as Olivia Barbee commented in their January 1999 issue, the unloved sectors are “as close as it gets to a sure thing in the mutual fund business.” I recommended the “unloved” strategy in my book, with one caveat: Don’t invest in the precious metals category, because the world’s central banks’ unpredictable selling routinely disrupts the * Morningstar FundInvestor
225 West Wacker Dr., Chicago, Il 60606 - 800/735-0700 - morningstar.com laws of supply and demand. While technology was the most popular sector in 1999, in 1989, 1990 and 1993, it was among the wallflowers. Is history likely to repeat? They recommend that you invest in all three categories with no more than 5% of your portfolio and that you use a tax-sheltered account, because the turnover can result in “ugly” tax penalties. Finally, although the say you can usually wait for up to a year after they make their recommendations, this year, they counsel buying “soon”…because this year’s sectors “have been largely driven by momentum investors in recent years, so they can get expensive very quickly.” For the first time, this year’s categories are very focused – all in the same geographic region: Pacific/Asia ex-Japan, Diversified Pacific/Asia, and Japan. Unlike prior years, FundInvestor makes no specific fund recommendations. Before considering investment candidates, can a case – hopefully not a basket case – be made for investment? A comprehensive
analysis of Asia’s prospects won’t be attempted from the Sierra foothills, but
a case can be made that compared to most categories, Asian stocks are relatively
cheap as shown by the following graph of global price-to-book ratios (courtesy
of ING Barings and Matthews International Capital Management) shows: |
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Despite Morningstar’s recommendation that you invest in all three categories, I’m not sure it’s necessary this year because of the regional concentration. Funds to consider: Matthews Asian Growth & Income Fund – is probably the safest vehicle for investing in the region, with 65% in convertible securities. As shown in last September’s NFF, if one had invested at the absolute top before the 1997 – 1998 Asian meltdown, it provided some downside protection compared to the average all-stock Asian fund: Asian
Meltdown: August 1, 1997 to August 31, 1998 Amount
Remaining %
Loss $10,000 Invested Average Pacific Asia ex-Japan
Stock Fund - 61.14 $ 3,886 Matthews Asian Growth &
Income Fund - 35.14 $ 6,249 Importantly, if they held on, investors in the Matthews fund got back to break-even by December 1999, 15 months after the bottom. Despite weakness in Asian markets last year, investors in Matthews Asian G & I are still slightly ahead, unlike the average stock fund investor who is still nursing 30% plus losses. Driehaus Asia Pacific Growth – is a rapid turnover, unorthodox fund and if you are timid, look elsewhere. The fund debuted in January 1998 and did “nothing” that year, losing 1%. When the Asian market recovered the following year, it gained 264.7%. No, that’s not a typo and no, the fund is not leveraged. Even after their scorching 1999 return, they managed to hold up relatively well in 2000, dropping “only” 29.6% compared to a 35.7% loss by their average peer. Portfolio turnover in 1998 was a scorching 367%, although it did drop in 1999 – to 363%. Driehaus was one of four managements I profiled in my book because they all shared some very desirable attributes: They are very successful old hands at the money management game, but new to the fund business. Their corporate cultures are investment-driven, not distribution-driven, and although they manage sizable assets, most of their funds are still small. Driehaus Asia Pacific’s assets, for instance, are a petite $21 million. How do they describe themselves? “We are active managers of active stocks.” Amen. Fidelity Pacific Basin – is a more conventional choice, although their 3% front-end load is galling (they also ding you an additional 1.5% if you exit within 3 months). As is often typical at Fidelity, they have had a large number of manager changes – 4 in the last 12 years. But their 3-year “best” Morningstar category rating (compared to similar funds, not the S & P 500) and Fidelity’s large research infrastructure means that this fund will probably deliver credible returns in a favorable environment – in 1999 it gained 119.6 %, beating the MSCI Pacific benchmark by 61.9%. These three funds are not NFF recommendations – I’m not in the unloved sector business. However, I’ll revisit the topic next year when Morningstar publishes their yearly report. Of course, if the sector soars, I might crow about it before then. Definition
of a cynic: A former optimist who kept score I don’t know why I didn’t think of “portfolio pumping,” because it’s not that different from “front running.” Front running, where brokers buy stocks for themselves before entering large orders for institutions, is patently illegal. I’ve speculated that fund sponsors might salt shares in a small fund before entering orders for their large funds, thereby boosting their small fund’s returns. I don’t know if that’s illegal and obviously it’s not a subject the industry talks about. And if I was an investor in the small fund that got some extra tweaking, I reckoned I’d let the lawyers work it out. Portfolio pumping, if it is practiced, uses the same physics principle: Big orders move small stocks. A special SEC task force has identified 30 to 40 funds whose performance inexplicably rose three to five percentage points on the last day of each quarter, which had a beneficial effect on their place in the quarterly performance rankings. The director of the agency’s office of compliance told the Wall Street Journal (apparently with a straight face) that, “We’ve seen this happen with some funds every single quarter. It may involve market manipulation.” So far no charges have been made. According to the Journal, an investment management unit of the Royal Bank of Canada made a $3 million (US$2 million) settlement with Canadian regulators last year involving what they call “high-close trading.” A director of Fund Democracy, a US “shareholder activist group,” said that the SEC would have difficulty prosecuting “since fund managers can defend last-minute purchases as evidence of investment acumen, rather than manipulation.” My bet is, unless those fund managers are masochists, last-day-of-the-quarter 3 to 5% gains a relic of the past. “FAST
and EAAAAAAAAAAAAAAASY MONEEEEE!!!” Speaking of protective regulators, the tale of Jonathan Lebed can’t pass into history without a parting nod. Lebed, 16 years old, agreed to a $285,000 settlement with the SEC in October. He had been trading online from his bedroom since he was 13, and made over $800,000. For undisclosed reasons, the SEC settlement allowed him to pocket over $500,000, without admitting or denying guilt. His alleged offense was a nefarious “pump and dump scheme,” that the SEC deemed to be “every bit as serious as other Internet fraud cases we brought.” Master Lebed was specifically cited for 11 of 16 trades of penny stocks such as Yes Entertainment Inc. and Havana Republic. Using “numerous aliases,” Lebed “plastered” internet message boards with hundreds of postings hyping low priced stocks that usually traded with very light volume. Although the SEC didn’t give examples of Lebed’s postings, the Wall Street Journal provided a typical example of another posting for Internet Business International Inc., a “small money-losing company” (symbol IBUI): “The FEMPS ‘Play of the Day’ is UBUI here at .21… A Fa$t 50%’er to.30 by Tuesday… Its FAST and EAAAAAAAAAAAAAAASY MONEEEEE!!!” While this in-depth research might not motivate us to invest our life savings, it apparently did excite some investors. Even though “nothing newsworthy” happened to the company that day, the stock climbed from .19 to .41 before dropping back. Clearly, something needs to be done to protect unwary widows and orphans and I for one, am heartened and encouraged that the SEC is protecting us from ‘Play of the Day’ scams from the likes of Lebed and FEMPS. If the SEC is really interested in protecting investors from themselves, I submit that a more suitable area of inquiry is investors’ appetite for the raft of exchange traded index funds (ETFs) that have been introduced. Used sensibly, they are a handy new wrinkle – they are “real” financial instruments, and unlike online teen predators, ETFs are “respectable.” The financial press has reported breathlessly on their introduction as if they are as important as was the original introduction of index funds. While ETFs are undoubtedly a boon to Wall Street toll takers, for the average investor, they are just the opposite. “Old fashioned” indexing encouraged investors to be at their best – to buy a diversified quality portfolio and keep it – it discouraged tinkering. ETFs, on the other hand, under the guise of respectability, are tinker-friendly – they make it easier, quicker, “cheaper” and more fun to trade – the practice that systematically torpedoes most investors. Nasdaq Composite “cubes” (symbol QQQ) are held by the average investor for less than a week! John Bogle
rightly calls ETFs “instruments of suicide.”
If the SEC really wants to protect us, how about slapping on a warning
label: WARNING
– The SEC has determined that frequent ETF
trading is hazardous to your wealth. 2000’s
Top 25 Since my original “Top 25” study in 1998, at the beginning of every year, I analyze the top 25 performing mutual funds to see whether there are common characteristics that can be used to pick future top performers – a theoretical “ideal fund profile.” The study was done of diversified US stock funds over the five-year 1993 – 1997 period – 125 funds in all. Sector and leveraged funds were excluded. The conclusions from the original study was the basis for starting NewFund Focus and led to increasing allocations to new funds – particularly in the small-cap and mid-cap sectors - in managed accounts. The original study found the following characteristics appeared disproportionately often in Top 25 funds: Fund age – 66 % were less than three (calendar) years old and 49% were one year old or less. Newness was a positive. Small Assets – Small funds dominated the list. In the original study, not one fund began its Top 25 year with more than $2 billion in assets. Most top performers started with a very small asset base – the median size ranged from $7 million to $85 million. Twenty percent started their winning year with virtually no assets. Small-cap sector – 70 % were small-cap funds. This finding was surprising because during most of the period analyzed, the large cap stock sector led all others by a wide margin Manager category – 77 % were “independent” managers – that is, not managed by brokers, banks or insurance companies. Broker-managed funds came in a distant last (5%). I’ve repeated the study every year and in general, the original “ideal fund profile” remains intact. In 1998, large-cap stock funds dominated (64%), but the following year, they reverted and small caps, once again, dominated the Top 25 (16 out of 25). 2000’s
Top 25 Diversified US Stock Funds Fund age – Fifteen of 25 funds (60%) were three years old or less. The percentage of new funds is slightly lower than previous years, but still much higher than it would be on a random basis. Small assets – Nineteen (76%) started the year with $50 million or less. Clearly, small is as beautiful as ever. Small-cap sector – Eleven (44%) were small-cap funds, while mid-cap funds totaled nine. While the small-cap sector still dominated, it was not as strong as in previous years. Mid-cap funds were the only ones showing positive returns last year, which undoubtedly helped mid-cap fund returns. As in most prior years, large-cap funds came in last with a 20% showing. Manager category – It was virtually a clean sweep for independent managers. With the exception of one boutique broker with two funds (S.G. Cowen, my alma mater, now owned by a French bank), no bank, insurance company or wirehouse managed funds appeared. Caveat: Because of many recent mergers and takeovers, the distinctions between the types of financial institutions are blurring and this category may become more difficult to analyze. Conclusion: No change in the original conclusions. The investing game is one of probabilities and the favorable characteristics of funds sporting the “ideal fund profile” should continue to deliver above average returns. January 30, 2001 Copyright
2001 |
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