For every rash trade, there's an investor profiting on the opposite side. Here's a portfolio that capitalizes on poor investor behavior.
This article first appeared in the December 2010/January 2011 issue of Morningstar Advisor magazine. Get your free subscription today!
In the last In Practice article, we analyzed the risk-adjusted performance of mutual funds that use tactical asset allocation. Our research showed that, as a group, such funds had not acquitted themselves very well. Though a small subset performed impressively, the bulk fell short; their near-and long-term risk-adjusted returns were comparable, at best, to a passive mix of stocks and bonds (represented by Vanguard Balanced Index Fund
What last issue's piece didn't address was whether that also called the validity of opportunistic investing into question. That is, can an investor consistently execute a strategy that doesn't hew to a fixed asset allocation? The short answer, based on our research, is yes--we think there's a way, and it's right under financial advisors' noses.
The Investor Returns Gap
Advisors have a tough job. Their clients are bombarded with stimuli, which can make it hard for them to focus on long-term goals in a dispassionate way. Instead, clients are prone to emotions like fear and greed, and they focus on the short term. In investing terms, this behavior expresses itself as performance-chasing. Clients tend to chuck their losers and bear-hug recent winners.
We can quantify the harm clients do themselves using Morningstar Investor Returns, which measures the return of the average dollar invested in a fund. For example, the median investor returns gap (a fund's stated return minus its investor return) for all stock funds was 82 basis points annualized for the five years ended Sept. 30. Put another way, investors in the typical stock mutual fund cost themselves nearly a percentage point of returns by mistiming their purchases and sales. Therein lies the opportunity.
For every rash or impulsive decision to chase performance, there's an investor on the opposite side of the trade--the individual or institution that's buying on weakness, or selling into strength. In that sense, the investor returns gap isn't just a cautionary tale of returns that clients have frittered away. It's also a measure of the excess returns that cooler heads have been able to bag at their expense.
So what if we tried to systematically buy what investors were selling and avoid the areas they were embracing?
For years, Morningstar's director of mutual fund research, Russel Kinnel, has been running a hypothetical "buy the unloved" strategy for the Morningstar FundInvestor newsletter. The gist of the strategy is to invest in fund categories that have suffered the heaviest asset outflows. Generally, the strategy would have been profitable to investors who followed it.
Building on Kinnel's research, we devised our own version of a buy-the-unloved strategy. We built a hypothetical portfolio that invested in the five categories that suffered the heaviest outflows in each of the five preceding calendar years. The portfolio is reconstituted annually. We put a slight twist on things by putting progressively greater weight to the more-unloved categories of a given calendar year, a modification that further promoted contrarianism. We also placed greater weight on more-distant calendar years. We think this adjustment better acknowledged value investors' tendency to buy, and sell, too early.
To evaluate the strategy's success, we again will use the Vanguard Balanced Index Fund for comparison. Our strategy succeeded in a number of ways. For one, it protected the downside tenaciously. Its 53.3% downside-capture ratio (the extent to which it participated in the S&P 500's losses in months the S&P declined) was well below that of the Vanguard fund. In addition, the strategy's 25.3% maximum drawdown (from September 2007 to January 2009) was significantly less than the Vanguard fund's, which lost a third of its value over the same span.
The strategy wasn't just a bear-market standout, however. It participated meaningfully in the market's upside, as evidenced by its 64.2% upside-capture ratio, which slightly exceeds the Vanguard fund's 64.0% tally. Moreover, its returns surpassed the Vanguard fund's in just over half of all months in which the S&P gained ground, as well as 112 of 142 rolling one-year periods from January 1998 to September 2010. This translated to impressive long-term performance--the strategy's since-inception annualized returns topped the Vanguard fund's by two percentage points, but with less volatility.
We've taken pains to remind our clients that there's no such thing as an unsuccessful back test, and the hypothetical we ran is no exception. It's worth noting, however, that the hypothetical's success did not turn to a large extent on the intricacies of the weighting scheme we chose. In fact, we tested the strategy under a number of different scenarios and assumptions, some of which produced better hypothetical returns than the results described previously.
Nevertheless, a few other matters are worth keeping in mind. First, the strategy wasn't subject to issues like transaction costs. Second, it's not possible to invest in a category average. Third, buying the unloved can be a very unforgiving business at times; the strategy dramatically underperformed in 1998, when it lagged the S&P by nearly 20 percentage points.
Taking the Plunge
We think those issues are surmountable, though. The portfolio's turnover ratio is low (about 20% per year), which should keep a lid on transaction costs. Representative market indexes do a pretty good job of approximating category averages. Thus, one could fairly easily implement the strategy using low-cost, index-tracking ETFs. In fact, we intend to do just that--we're planning to launch an ETF-based version of the buy-the-unloved strategy in 2011.
What might the portfolio look like? The table simulates the portfolio's category holdings and weightings. (The 2010 list is a forecast based on flow data for the year to date through Sept. 30.)
The portfolio would be split roughly 70%/30% between stocks (including REITs) and bonds. Within the stock sleeve, there's a tilt toward U.S. large caps, growth equity in particular. By contrast, emerging-markets stocks and bonds, which have been magnets for inflows of late, are conspicuous by their absence. Moreover, the strategy would tread relatively lightly in government bonds, which has also been a destination of choice for investors recently.
To implement the strategy, we'd use ETFs like Vanguard Health Care
Bringing It Home
The buy-the-unloved strategy has the potential to invert the impulsive behavior that can lead to costly mistakes. Moreover, it can afford clients the chance to capitalize on the mistakes of others who are less disciplined. But, above all, it presents a good teaching opportunity to advisors seeking to illustrate the importance of planning and discipline, traits that are the bedrock of any enduring advisory relationship.
Jeffrey Ptak, CFA, CPA, is president and chief investment officer of Morningstar Investment Services.
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