Alpha Power Investing Newsletter

October 12, 2011

Foot-Shooting

As of October 5, the MSCI Emerging Markets Index was down 31% from its 2011 high. Investors pulled $3.3 billion out of emerging markets funds in the five preceding days, according to Bloomberg.

Ho hum. This information simply confirms countless previous observations about the performance persistence of mutual funds and the remarkably predictable behavior of the average fund investor.

In my last newsletter, I made reference to the DALBAR study of mutual fund investor behavior. DALBAR, an investment research firm, has been updating this study annually for more than fifteen years and the data continue to support the conclusion that the average investor is a foot-shooting danger to him/herself. In this study, DALBAR examines the cash inflows/outflows of equity mutual funds to get a picture of the average return and average holding period experienced by fund shareholders.

In the latest study, which showed the average holding period to be less than three years, the average return continued to be a puny fraction of the market's return.

This shocking performance is due to two factors. First, mutual funds themselves are notorious underachievers compared to market indexes. Second, investors tend to chase performance, jumping onboard a bullish trend late in the game, then jumping off again when the hot market (or hot manager) turns cold.

The truth is that consistently superior performance by a mutual fund manager is a very rare thing. Not only must a manager navigate the changing tides of the business cycle and the constant evolution of companies and products, but must also overcome the continuous drag of management fees and trading expenses. It's no surprise that many mutual funds are simply disguised index funds.

Standard and Poor's keeps a running record of the performance persistence of mutual funds and the results aren't pretty. The most recent survey, ending March 2011, provides the following information.

Out of 560 funds measured, only 24 remained in the top quartile after three years. Even staying in the top half is quite a feat, since just 15.5% of all funds managed it. The numbers for five years are, of course, much, much worse ... in fact, 0% for top quartile persistence.

Is it any wonder, then, that performance-chasing is an investment strategy doomed from the outset?

The historically poor performance of the average mutual fund investor is also partially caused by the periodic time bombs that go off in the market itself. This summer is a case in point.

Personally, I'm surprised by the depth of this correction, which may be the beginning of a new bear market. It's a pre-election year, and as long-term readers know, the last pre-election year to suffer a loss was 1931. Since that time, the pre-election year has averaged a return of almost 18% (Dow Industrials with dividends) and is single-handedly responsible for the lion's share of the market's long-term return. As a result, 2011 is an anomaly, although the year may end up profitable with a sizable year-end rally.

Nevertheless, the market is following the pattern predicted by the annual forecasting cycle. Since 1949, about 80% of all bear market damage has occurred between April and November. In the pre-election year, this summer slump is normally slight or non-existent. The market crash of 1987 was another exception, yet the S&P 500 ended up 5.25% at year-end.

One simple way to finesse these investment obstacles is to invest in an index fund while avoiding the summer "dead zone". This strategy is unlikely to trigger the primordial "fear" mechanism of the brain or promote the tempting crowd behavior of the next "sure thing".

We have constructed a simple index to demonstrate the historical investment power of such an approach - it's called the Mid-Cap Power Index. This index is constructed as follows: each year, own the S&P MidCap 400 Index from November 1 to May 31, and then own the Barclays Capital Intermediate Treasury Bond Index the remainder of the year. This index trounces the S&P 500 both in absolute performance and in consistency of returns. The chart below shows the rolling three-year returns of the indexes over the past tumultuous decade.

As you can see, at the end of each and every quarter over the past decade, the Mid-Cap Power Index has produced gains for the previous three years. The S&P 500, by contrast, has gone through multiple three-year periods of significant losses. Over the entire period, the Mid-Cap Power Index has grown $1.00 to $4.00, while the S&P 500 has managed a paltry 30¢ increase.

The Alpha Mid-Cap Power Index Managed Account seeks to duplicate the results of the Mid-Cap Power Index after fees and expenses. For more details about this tactical strategy, go to the Programs and Performance section of our website at www.alphaim.net and click on the corresponding link to read the brochure.

Sincerely,
Jerry Minton, Ph.D.
President
1-877-229-9400, Ext. 11

Past performance is not a guarantee of future performance.

 
© 2011 Alpha Investment Management, Inc.
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