Alpha Power Investing Newsletter

May 26, 2011

Stay Out of the Kitchen

Dalbar, Inc., one of the leading financial research companies in the U.S., recently released its annual survey of investor behavior. Each year Dalbar studies the cash flows into and out of the mutual fund universe to get a fix on the "average" investor in various categories. As usual, it quantifies the extent to which the average investor systematically underperforms various market indexes and the long-term returns of mutual funds.

For the twenty-year period ending December 31, 2010, equity investors earned 3.83% per year vs. the 9.14% annual return of the S&P 500. For the same period, fixed income investors earned 1.01% annually compared to the Barclays Capital Aggregate Bond Index return of 6.89%.

The 2011 study also found that the average holding period for equity investors was 3.27 years. Obviously, what is happening is that the average mutual fund investor is attempting to time the market, or some particular sub-section of the market, to no avail. This squares with what researchers know about investment decision-making; namely, that it tends to be emotional, story-driven, herd-like, and highly dependent on recent past performance.

The problem with investment stories and recent performance is that hot stories are compelling precisely because they have been confirmed by recent performance. Most investors want proof that the story is valid, and what better proof than recent results? In fact, hot stories are old news and savvy investors have already moved on. In almost every case, the future performance of the hot fund is ready to revert to the mean - since no hot story lasts forever.

Upon reflection, none of this should be surprising to anyone. After all, we're talking about human behavior, which everyone knows can be wildly irrational, particularly in crowds. Investment bubbles, whether in the stock market or commodities or real estate, appear frequently enough over time to remind us of our propensity for what is recognized in retrospect as optimistic lunacy. Conversely, market panics show how investors tend to throw away assets precisely at the moment when risk is at its lowest ebb.

Besides, there is very little value-added benefit to owning actively managed mutual funds over any time period. Every year Standard and Poor's produces its SPIVA (Standard and Poor's Index vs. Active) report which compares index returns to actively managed mutual fund returns in many categories and over multiple time periods. The annual results are very similar and, again, unsurprising. The average mutual fund in every category (large-cap, mid-cap, small-cap, growth, value, etc.) underperforms its index benchmark over statistically significant time frames (3-year, 5-year, 10-year, etc.). True, there are funds that add value over time. If you had invested in the Fidelity Magellan Fund when Peter Lynch managed it, you were lucky. The fund goes on living on past glories, underperforming the market for years in spite of Fidelity's repeated attempts to hire a competent manager. Consistent superior performance is rare in the mutual fund world.

The chart below documents the average performance of mutual funds (Lipper Large-Cap Growth, Lipper Small-Cap Growth) vs. their benchmarks since 1999.

As you can see, the average fund offered a value-negative effect compared to passive indexes. The Magellan Fund, the once-flagship fund of the Fidelity organization, was part of the mediocre crowd.

Chasing recent performance is self-destructive, market timing doesn't work, and actively managed funds won't save us from ourselves, let alone deliver superior returns in a reliable manner.

So what's an investor to do?

There's an old saying: If you can't stand the heat, stay out of the kitchen. In terms of the current discussion this means not getting yourself into a situation which is likely to trigger your irrational responses. For example, if you tend to fight in bars, don't go to bars.

Here's my solution. We know that the returns of the stock market are not distributed randomly over time. Instead, returns, on an annual basis, are "skewed" statistically into the six to seven month period beginning in late-October. Since 1949, for example, between November and May the average daily appreciation of the Dow Industrials is 27.4 times greater than the average daily appreciation of the other days of the year. We also know that 80% of all bear market damage for the past sixty years has occurred between May and November. We have a fairly good explanation for why this happens in the U.S. and in over 30 foreign markets. Finally, we know that the S&P MidCap 400 Index is the best performing passive benchmark over the long-term (30 years, 14% per year).

Sharpening our pencil, we come to the following conclusion: own the mid-cap index from November through May, then own a conservative bond fund the remainder of the time. The result is the Alpha Mid-Cap Power Index.

From the beginning of the 2000-2002 bear market until now, the Alpha Mid-Cap Power Index has generated an annualized return of 14.4% vs. 0.9% per year for the S&P 500 (as of March 31, 2011). For the past five years, the Mid-Cap Power Index returned 13.6% annually vs. 2.6% for the S&P 500. More importantly, the real inflation-adjusted annual return for the Mid-Cap Power Index was 11.7% vs. -1.8% for the S&P 500 over the last 11 ¼ years.

This simple strategy would have kept you on the sidelines during most of the two bear markets of the past 11 years, providing positive returns every year. In addition, recovery times were short, with almost complete participation in the bullish phases of the market. In effect, not much heat from the kitchen.

Investors concerned about the tax implications of two trades per year can easily convert their taxable accounts into tax-deferred accounts using a flat-rate variable annuity like the Monument Advisor* from Jefferson National. For $20 a month, this completely liquid investment instrument gives you access to over 300 no-load funds (including low-cost index funds) on a tax-deferred basis, just like an IRA.

To read about our mid-cap program, which seeks to duplicate the Alpha Mid-Cap Power Index net of fees and expenses, go to the Programs and Performance section of our website at www.alphaim.net and click on the Alpha Mid-Cap Power Index Managed Account link to read the brochure.

If you would like to discuss this or any of our investment programs, please call me at 1-877-229-9400.

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

*Not available in Ohio.
Past performance is not a guarantee of future performance.

 
© 2011 Alpha Investment Management, Inc.
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