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Fund Spy

Subprime Crisis Yields Nasty Fund 'Surprises'

Why it's a mistake to fight the last war.

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Last week Gregg Wolper capably argued that despite all of the hand-wringing over the anomalous aspects of the summer subprime sell-off (try saying that 10 times fast), many of the market's chief behavioral patterns have remained intact. Bonds have outperformed stocks, high-quality bonds have beaten junky ones, and stocks and bonds from developed markets have trumped those from more exotic locales.

Within certain fund asset classes and categories, however, you can identify some performance patterns that could challenge your assumptions about what's safe and what's not. Some of the securities and fund types that fared well in previous market sell-offs have struggled mightily, while other securities and funds you might've filed under the "higher-risk" category have held up pretty well.

Russ Kinnel has already touched on the poor recent performance of ultrashort funds--which heretofore had seemed to be the tamest part of the fund world. What follows is a review of some of the other notable--and nasty--surprises for fund investors over the past month. The bottom line? It's a mistake to extrapolate too much from how investments have fared in previous market downturns, because every down market has different catalysts and affects some securities more than others. If you stay diversified and avoid overheating sectors, however, you'll stand a good chance of faring well in future downturns. That's because in this last correction--as in others--the areas that had recently enjoyed the biggest performance runups have proved the most vulnerable.

Value Has Underperformed Growth
For some investors, particularly those newer to the market, it's an article of faith that growth funds, with their high average price multiples and trend-beholden companies, are riskier than value funds. After all, the typical large-growth fund lost 25 percentage points more, on an annualized basis, than did the average large-value offering during the bear market from 2000 through 2002. However, growth stocks and funds haven't always gone down more than value, particularly when market participants are worried about economic growth. That was the case recently, as growth funds in every market-cap band outperformed their value counterparts throughout July and most of August. There are a couple of key reasons for this performance pattern. First, investors have feared that troubles in the housing market could cause a broad economic slowdown, and growth companies are generally more attractive in such an environment. Second, financials stocks, though they've staged a comeback very recently, have been at the epicenter of the subprime crisis, and such names are mainstays for most value funds. (We observed a similar performance pattern amid the Long-Term Capital Management crisis in 1998, with growth stocks outperforming financials and financials-heavy value funds.) That doesn't diminish the case for value stocks and funds, but it does reinforce that they won't star in every down market.

Small- and Mid-Cap Value Have Struggled the Most
In a related vein, the recent travails of small- and mid-cap value stocks and funds may have also been somewhat surprising to some investors. After all, these categories were champs during the last bear market, with funds in this group posting sizable gains even as the broad market struggled from 2000 through 2002. Small- and mid-cap value stocks and funds have gotten crushed during the recent correction, though, for reasons that in hindsight appear pretty logical. For one thing, some of these funds, such as  Hotchkis & Wiley Small Cap Value (HWSAX) and  Schneider Small Cap Value (SCMVX), owned some of the housing- and mortgage-related names that are at the heart of the current mortgage crisis. In addition, small- and mid-cap value stocks as a group have appeared vulnerable amid the credit crunch, because small concerns could have trouble securing the financing they need to survive. Finally, it all comes back to valuation: While small- and mid-cap value stocks were exceedingly cheap coming into the broad market sell-off in 2000, they were arguably pretty richly valued relative to their growth prospects at the outset of this correction. For that reason, we've been urging investors to lighten up on small value for a few years now.

Income Focuses Haven't Helped
Dividend-focused stock funds will tend to behave better on the downside than non-dividend-payers: Not only is an above-average dividend yield often a signal that a stock is cheap, but the ability to pay a dividend can signal a company's financial strength. Moreover, those dividend payouts can provide at least a small cushion in down markets. However, it's worth noting that during the recent correction, the performance of dividend-focused funds--which I'm defining here as any fund with a 12-month yield higher than the S&P 500's--was right in line with non-dividend-focused funds in the same categories. Here again, financials are the key reason behind the seeming anomaly: Stocks in the sector often pay above-market yields, but they've been roiled amid worries that the mortgage crisis and perhaps a generally cooling market could crimp earnings for banks, thrifts, brokerages, and asset managers. Real estate investment trusts--also prominent in many yield-focused funds--have struggled recently, too. In addition, some of the funds with high dividend yields are run by dyed-in-the-wool contrarians who have likely been buying amid the wreckage, thereby exacerbating their short-term performance problems. There's still good reason to believe that income-focused stock funds will have better defensive characteristics than funds that don't care about dividends, but don't expect that to be so in every market and with every fund.

Metals: Not So Shiny
Another recent market phenomenon that defies conventional wisdom has been the weak performance of precious metals stocks and funds. When all heck is breaking loose, the thinking goes, you can at least look to metals as a noncorrelated hedge and a stable store of value. Precious metals' defensive attributes were on full display during the bear market of  2000-02, but stocks and funds in the sector have been an extreme disappointment recently, losing 15% over the past month alone. That's the second-worst showing of any category save one, Latin America stock. A couple of explanations loom large. First, gold is often viewed as an inflationary hedge, but lately investors have been more worried about an economic slowdown than inflation. Also, some market participants who had been holding metals were forced to sell to raise cash to meet margin requirements amid sliding stock prices. Finally, the appetite for metals has been particularly strong in emerging markets over the past few years, and investors were spooked that the U.S. housing market swoon could have a dampening effect on global growth and, in turn, demand for metals. Over time, precious metals' correlation with the U.S. stock market has been low, but their recent performance serves as a reminder that the securities are, at best, imperfect diversifiers. Interestingly, commodities funds, which in recent years have emerged as a viable alternative to the traditional precious metals hedge, held up far better during the recent sell-off.

Long-Short Disappointment
A handful of long-short funds have also come up short amid the market's recent tumult, thereby failing to deliver on their promise of all-weather performance. True, the average one-month loss for the category is a perfectly respectable 2.7%, but that average conceals some extremes in performance. On one end of the spectrum are funds like  Hussman Strategic Growth (HSGFX), which has stayed well in the black recently thanks to its defensive positioning. On the other end are funds like  TFS Market Neutral (TFSMX), whose recent losses have been far worse than those of many long-only funds due to its small-cap focus and bad signals from its quant models. These disparate showings reinforce what we tend to think about the long-short category: There are a very small handful of offerings that earn their keep--such as the Hussman fund--and many more that are overpriced and easy to pass by.

 

Christine Benz does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.