Sunday, January 17, 2010

Enjoy a Laugh on My 10 Year Investment Plan

There is an old expression, “Man plans and God laughs.” Bear in mind, with absolute certainty, my ten year investment plan will give you a laugh or a cry. In last week’s blog I outlined how ten typical investment personalities would react to the publishing of fund performance results for various periods ending on December 31st. I promised that I would then provide how I personally reacted to the same data input. Please note that this is an idealized reaction, and does not completely represent how I am currently invested or how I will invest. Among the reasons that the following plan is “What I say” versus “What I do,” are inertia, taxes, expenses and not finding a comfortable fund manager for each component. In some cases I will be sorry that I do not follow my own advice,

First, I set my time horizon for a minimum of ten years, which allows for at least one, if not two, normal investment cycles. In terms of our own money and those of us charged with fiduciary responsibilities, almost all of us should consider longer periods. You should think in terms of the life of a new roof, not the patched one for which we too often opt.

Second, one of the bitter lessons for an equity investor is to look to the performance of fixed income funds as a guide to investment thinking. While 2009 produced double digit returns for longer maturity funds, an examination of their two to twenty year total reinvested return results are, for the most part, in the middle single digits. Recognizing that these are open-end funds which have inflows and outflows that need to be managed, the average returns are not a great deal different than the coupon on their underlying bonds, plus the benefit of interest on the interest income caused by the reinvestment function. In contrast, there was a considerable increment caused by price appreciation in 2009, as bond prices rose significantly. As a contrarian, I look for a reversal of this phenomenon in the years ahead. Until the current yields and the yields to maturity on US Treasuries reach 8%, I do not want to count on bonds to represent a strategic part of my portfolio, other than as a tactical reserve to dampen the volatility for the sole benefit of my nerves.

What is magic about 8%? In the Weekend edition of The Wall Street Journal, Jason Zweig stresses the need to take into consideration investment expenses (to pay wretches like me), taxes for some, and inflation for all. He suggests that using equity market data going back to 1926, the average stock earned 9.8% annually, but after deducting expenses, less than 4% would be produced net. I find it very difficult to get investment committees that I sit on to get their spending rate as low as 4%. In recognition that I will suffer some poor investment choices and that expenses of individual and institutional heirs will creep up, I would be happier with a 3% spending rate. (In one of the attacks of the government against accumulated capital, the government requires foundations, on average, to spend 5% of their capital yearly. So far this does not force families to consume their capital in this way.)

Third, if I desire, (I almost said need), at least an 8% compound annual growth rate on my capital to retain it, can I ask equity funds provide it? The answer is a classic half empty/half full glass of water. For most people that are alive today, the last ten years have been the worst ten years for equity performance. Only in the 1930’s were the results worse. On the other hand, there has never been a twenty year period of this kind of performance. Comparing +1.13% for the average US Diversified Equity mutual fund in 2009, with longer term periods, we note an average gain of 7.66% for 15 years, 9.73% for 25 years, 10.37% for 30 years and 11.74% for 35 years. These results are biased upwards due to dropping out the funds that ceased to exist. On the other hand, these performance averages are not weighted by assets. Almost by definition, larger funds over long periods of time do better than smaller funds, as they compound their performance with fresh capital and have lower average expenses, at least in the US.

Fourth, I look at the old question as to whether active (stock picking) produces better results than passive investing (indexing). In each of the periods ending in 2009, active, diversified managers produced better results even though they charge higher fees. When one reaches back to the 25 and 30 year records, S&P 500 funds beat the average US Diversified Equity fund. On the basis of these records, a contrarian would suggest that as money starts to flow out of S&P 500 funds, it is the time to consider adding index funds to an active fund mix. For me this makes good sense, as I am, for the most part, attracted to highly concentrated funds managed by skilled researchers and managers. The skilled researchers are the key to my selection. From my educational days at the race track, I learned, on balance, that it does not pay to bet against the house. Yes, occasionally some combination of trainer, jockey, or perhaps more accurately, some jockey’s agent, can successfully see a way a particular horse, (read stock), has an advantage over the others if things pan out as they expect and others don’t. In the fund world, these moments of advantage go to the funds that develop, at least for the moment, a research advantage.

Fifth, flowing from the fourth, I seek out relatively unpopular fields where the general lack of research gives a fund more insight than what is believed to be in the market. I find these opportunities often in smaller companies, difficult to understand companies and/or ones with poor near-term results and little or no public market image. In the past, I have found these in brokerage firm and money management stocks. At one point there were legal restrictions on the part of mutual funds owning brokerage firm stocks. This is far less true today.

Sixth, I plead guilty in the past to the trend of comparing funds within investment objective and size classifications as a way to sell my former fund ranking services. Today, I do not see much advantage using these as primary research selection filters. With some maturity on my part, I am now much more interested in research skills and portfolio management artistry than classification ranking. Thus I do not look at my own money in terms of growth vs. value, or large vs. mid vs. small. Further, for my purposes, I am not impressed with purity of style and/or size. I want my funds to own winning positions. (This is a view not shared by a number of the accounts that we manage, who believe that classification results are an important part of their fiduciary responsibilities. I do concede to them that classification comparisons are of significance to their communication responsibilities to their beneficiaries.)

Seventh, sometimes it is more important to be absent than to directly participate in one or more of the performance-leading categories. While they are legitimate options, there are three in particular that I would not currently add to an account that I could not redeem quickly. The three are the three best performing groups of 2009: Latin America 113.09%. Emerging Markets 75.74% and China 69.27%. I normally have an allergy to “hot” areas because rapid cash flow coming into a small area gets exploded when the almost inevitable large waves of redemptions occur. There is a tie that links these three geographically separated areas. Many of the companies held in these fund categories, as well as many US companies, are becoming increasingly dependent upon the growth of Chinese demand. There is the rising demand within China for consumer goods. China is now the largest car market in the world. The demand for selected raw materials to feed their industries to produce for domestic and foreign markets is becoming crucial to the valuation of stocks, and to a lesser degree bonds, around the world. Any slowdown in the creation of urban jobs in China can create extreme political problems. There are reports of factories being closed and people returning to their farm communities. Having sounded the caution, I believe it is still prudent to hold some emerging market funds as a hedge against our own domestic slow growth economy.

Eighth, I am avoiding the double and triple leveraged ETF and ETN funds that are individual fund leaders for many weeks throughout the year, as these highly volatile funds can have difficulty in extreme market conditions. At this point, we do not need leverage to meet our goals.

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