Not-So-Crazy Talk

Moving With the Waves
Believing that buy-and-hold investing remains a valid investment concept, as I maintained on Friday, does not mean believing in a fixed portfolio allocation.

The case for buy-and-hold is easy. Before 2008, buy-and-hold investing had succeeded for several decades. Thus, to call for its demise is to argue that this time is different. It is hard to see why that would be so. Perhaps it made sense to toss aside the old rules in 1999, when the times truly did seem to be different, with stock valuations higher than they had ever been before, or have been since. But that is not when the warning against holding stocks for the long term was issued. Instead, it came after a market crash--when the message was compelling to listeners, but deeply unhelpful.

The case for a fixed portfolio allocation is not so straightforward. The mutual fund industry is littered with the corpses of stock-market-timers, and tactical asset-allocation funds that mechanically follow quantitative signals haven’t been impressive, either. On the other hand, many successful funds vary their asset allocations over time, with their managements either using signals as a tool rather than as a strict instruction, or dispensing with signals altogether and investing from the bottom up, permitting the asset allocation to fluctuate along with the trades.

I’ll be spending more time on this topic in the future. It’s something that I’ve thought about frequently over the years, but which I’ve not studied to any real extent, as it didn’t fit with my previous job descriptions. From observation, it seems that the best buy opportunities come when an asset has three strikes against it: 1) It’s relatively cheap according to one or more price measures; 2) its performance has been poor over the past several years; and 3) it’s unpopular with investors, as measured by U.S. mutual fund flows. Conversely, assets up for sale would be those that score well on all three measures. 

One current buy candidate is emerging-market stocks. They first struck my attention in June, when they plunged in price and frightened fund investors into net redemptions. As this occurred even as emerging-market company profits remain healthy, the valuations look to be attractive. The cyclically adjusted priced/earnings ratio (Cape ratio) for emerging-market markets stocks is far below that of developed markets, at 13 versus 24. This is a relatively large gap by the standards of the past 15 years, thereby suggesting that emerging-markets stocks might be a relative bargain.

(Yes, I've cast doubt elsewhere on the value of the Cape ratio as a buy/sell signal. However, that argument was not about the ratio itself, but about the time period selected, as I agreed with Jeremy Siegel that perhaps the current Cape ratio should be evaluated within the context of the past 15 years as opposed to the past 113 years. So that is consistent with this use of the ratio.)

Since June, the emerging-markets news has remained pleasantly discouraging, with market volatility and indifferent performance (although sadly, not as bad as in June) cooling investor passions. Mutual fund investors are still putting money into the category, but at a lower rate than before. What’s more, global fund managers now have their lowest emerging-markets stock exposures in more than a decade.

The anecdotal signs are good, too. I’m no longer reading glowing accounts of the Chinese and Indian booms. Instead, most of the current articles on those countries seem to focus on their growing pains, in particular inflation. The bloom looks to be off these roses. 

I have more work to do on the subject. If I convince myself of the merits of emerging markets, though, I will do more than merely write about the subject; I'll also make a trade. I don't do make moves often--only about once a year on average.

A Leap of Faith
This past weekend, The Wall Street Journal's Jason Zweig also discussed the issue of market-timers, albeit from a different perspective. Jason uncovered three firms that sell market-timing services to 401(k) investors. None of these three companies has a public track record in running funds. That means that instead of publishing performance figures that follow SEC standards and that are rigorously overseen by the self-regulatory agency FINRA, they receive only light oversight.

Case in point: Compass Investors. Compass quotes a spectacular gain for its model since Jan. 1, 1997, growing a hypothetical $100,000 investment to $755,000. That's great and then some. Of the 3,202 U.S. stock funds with a track record extending to Jan. 1, 1997, only 22 have performed that well. None of those funds from any major fund company. Neither Vanguard, T. Rowe Price, American Funds, nor Fidelity, nor DFA, nor anybody else in the top 20 has a fund that has kept up with Compass' model. 

However, you will need to take that Compass gain on trust, because as Zweig learned, Compass’ auditor hasn't shown up for any of the past six years. Even when the auditor was there, it didn’t verify the company’s performance results. (Whatever you think that auditors of investment-management companies do, they probably do less.) In contrast with this gain-on-trust, we know courtesy of Compass that the S&P 500 grew over that same time period from $100,000 to $221,000.

Except we don't know that, because that's not what the S&P 500 did. Over the time period, it actually grew to $303,000. Compass got the calculation wrong; it didn’t realize that its S&P 500 data was price only and that it needed to account for the index’s dividends as well when computing a total return.

The company flubs the simple, common calculation of S&P 500 performance, yet its sophisticated investment models accomplish what fewer than 1% of mutual funds can manage--while following a strategy of market-timing that no previous mutual fund has ever managed to implement successfully. Or so it says. 

My faith, regrettably, is lacking. 

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.