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Was 2011 a Harbinger or Merely a Pause?

Here is a riddle: What does a doctor need to have lots of to be successful? Answer: Patients (i.e. patience) Here is a similar question which is not intended to be funny: What does a funds investor need to have lots of to be successful? The answer is the same - patience.

Just think about it. How many fund investors do well over a short period of time? My answer: Hardly any. In order to see your assets grow, it will more often than not seem as though you are not getting anywhere, even over multiple year periods, or at best, moving in very slow motion.

The reason why most people are not particularly successful as investors is they don't stick to their investment program for a long enough time to enable the sometimes miniscule gains to start to actually amount to something significant.

I have been observing lately that no matter what my mind wishes will be the day-to-day direction of my investments, not only don't I have any control over this aspect of my commitment to investing, but that any progress that I make is likely to be excruciatingly slow. While I may become highly frustrated that this is the case, in most instances, it will later be proven wrong to have given up on the quest merely because of these at times slow, and highly unpredictable, short-term results. (The exception, of course, is particular fund choices which were not good investments to begin with.)

While there may be times, such as back in the late 1990s when nearly every stock fund investment seemed to support one's sense of perpetual winningness, 2011's market is much more typical. The market might give you a little only to take it away in short order.

But while success as an investor may mostly seem like a near impossible task for those who expect to see measurable results within a year, two, or even more, there is little doubt that there will nearly always be some winning categories of investments regardless of the broader investment environment. But one must be open to this possibility and at least moderately vigilant enough to seek out these opportunities. This is why we endorse getting away from an "all or none" or mere buy and hold approach to investing. Most investing trends are clearly visible; investors should emphasize funds and categories that are doing well, while at the same time, keeping an eye out for overvaluation.

What concerns us the most is that at least for the time being, the bullish trend in stock prices stemming back to March 2009 appears to have been broken. That is, over the last year, almost all categories of stock fund returns are in negative territory. And almost all categories of foreign funds are actually in bear markets, having dropped over 20% from where they stood earlier in the year and yet to have regained these losses. For example, one measure of developed and emerging markets excluding the US still shows a drop of approximately 25% since the April 2011 high. US small and mid-cap funds should also still be considered in a bear market, although having recovered back about half of the lost ground since Oct. This suggests, to us, that until returns turn positive over the prior 12 mos., one is creating more risk if one adds to these holdings.

According to our research-based model for forecasting long-term category performance, nearly all stock fund categories should be regarded as HOLDs, but there are no outright SELLs.

Some Interesting Data on Outperforming the Market

After the rather paltry, and in most instances negative, performance of the great majority of stock funds during 2011, investors might be tempted to think that these investments are headed nowhere fast. But that could easily overlook the fact that, for the most part, stock funds have still been an excellent place to be since 2009. As a year-end summary of the S&P 500 Index for each of the past 3 years, as well as for the entire period demonstrate, returns show up well as compared to most equivalent stretches:

Calendar Year(s) Total Return
2009 26.5%
2010 15.1
2011 2.1
2009-2011 14.7 (annualized)

However, over the last 5 and 10 year periods, the average annualized return for the Index have been -0.3 and +2.8%, respectively. This is one of the potential problems, then, of being a "buy-and-hold" stock investor. If, on the other hand (a very big if, of course), one can get a sense of relatively good and relatively poor performance ahead for the market mainly from economic fundamentals and existing trends, there might be the possibility of doing better: During such periods, one could perhaps sidestep stocks and profit more from being in bonds.

So how have people been doing who move out and/or in from the Index for whatever reason? (E.g. They might be trying to time the market, or, perhaps they merely needed to have additional cash on hand.) We were surprised to discover that while year over year, ending Nov. 30, 2011, the Vanguard 500 Index Fund (VFINX) returned 7.7%, investors' returns within the fund based on monthly flows of cash out of and into the fund were 10.5% over the last year. Over the last 3 years, while the gap shrank, it was still a substantial 1.7% favoring shorter-term holders. Over longer periods, though, investor returns were generally less than buy-and-hold returns.

How about for small cap stocks as represented by NAESX, Vanguard's fund that closely mirrors the Russell 2000 Index? Once again, during the last year, there was about a 3% advantage to moving out and/or in vs. buy-and-hold (7.2 vs. 4.5%) The gap here persists as well over 3 years, and only begins to shrink over very long periods (i.e. 15 years).

This seems to contradict prior evidence that stock investor returns usually run less than buy and hold returns. (If interested, see our Nov. 2009 article on the subject.) Perhaps the explanation for this is that, in general, investors have been pulling money out of stock funds over the last decade and this has finally started to work toward their advantage. Since returns have generally been mediocre at best, and weak especially in the latter part of this year, pulling out has proven to be slightly superior than holding on.

Unfortunately, investor returns in bond funds has continued to trail those investors who bought and held. Thus, if the intention was to decide when was a good time to either enter or exit from these funds, investors have still not been able to be successful.

Of course, if an investor is able to outperform the market, they can do so either by a) picking outstanding market-beating funds (see my last month's Newsletter on the subject), b) successfully timing being in or "less in" the overall market, or, c) successfully selecting which categories or types of stock/bond funds will outperform the overall market over a given period, or some combination of each.

A recent academic research study shows that certain mutual fund managers can successfully outperform by both a) stock picking skill (including which sectors to select and when) and b) overall cash raising/lowering market timing skill. While the first skill has been shown through research to exist but only among the best managers, the research evidence for timing skill among managers has been hard to come by.

Mutual fund investors are obviously substituting picking managers (or passive indexing) for actually having to pick individual stocks. Those investors who base their fund choices on researching the field for the best managers may have a significant advantage. Additionally, it remains true that some mutual fund investors might also possess timing and advantageous category selection skills as well.

The above cited paper suggests that timing skills are particularly important during recessions. Successful fund managers (and we would suggest successful fund investors) "hold more cash in recessions, their portfolios have lower market betas, and they tend to engage in sector rotation by investing more money into defensive industries in recessions." (Note: The percentage of fund's defensive allocation can be viewed using the Portfolio tab on morningstar.com). The authors find the astute analysis of fundamental economic data, such as industrial production and non-farm employment growth, is one of the reasons that the most successful fund managers are able to outperform.


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