Sunday, December 21, 2008

Correlations: Useful, Labels: Misleading.

One of the characteristics of an equity Bear Market is everything goes down. Mathematically this phenomenon is described as the narrowing of correlations. In other words, almost every stock goes down about the same amount.

Because I am comfortable reviewing the performance of over 16,000 funds each week, in some regards I have a distinct advantage when developing investment policy. As an example, you might find the following method useful in developing your own investment strategy.

Most people look exclusively at the best fund in its class or at least the average performer. I take a very different approach when using fund classification as a tool for fund selection.

In this case I looked at the second worst performing fund in major so-called asset allocation buckets, broken down by investment objectives, using the 52 week period ending December 11, 2008. (I will be happy to discuss with anyone the benefits of excluding extreme examples.)

Key: (G) = growth, (C) = core, (V) = value

Second worst among Large Capitalization funds:
(G) - 60.22%
(C) - 55.58%
(V) - 52.27%

Second worst among Mid-Cap funds:
(G) -61.47%
(C) -58.88%
(V) -57.48%

Second worst among Small Cap funds:
(G) -61.52%
(C) -62.94% *
(V) -59.68%
* In the case of Small Cap Core funds, I used the fourth worst fund as the others had more derivatives in the portfolio.

Second worst among International Large Cap funds:
(G) -56.13%
(C) -54.26%
(V) -53.97%


1. Note the narrow performance correlation of these funds
2. Poor performance ranged between -52.27% and -62.94% compared to the average S&P 500 index fund of -40.21
3. International diversification in large caps did not help.
4. Slightly smaller losses were experienced in value oriented funds.
5. One can be exposed to losing half of one’s investment in many places.

Similar exercises can produce the same relative results when applied to most securities indexes.

In this “sound bite” world it is important to recognize that various labels, e.g. stock market, blue chip, growth and value, are not particularly useful in the selection process.

Please let me know if I should plan to write about selection criteria and due diligence in future blogs.

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