Morningstar Advisor - December 2010/January 2011 - (Page 26)

In Practice A Strategy That Loves Performance Chasers By Jeffrey Ptak For every rash trade, there’s an investor profiting on the opposite side. Here’s a portfolio that capitalizes on poor investor behavior. In last issue’s In Practice, 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 VBINX). 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 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. The Results 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, 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 26 Morningstar Advisor December/January 2011

Table of Contents for the Digital Edition of Morningstar Advisor - December 2010/January 2011

Morningstar Advisor - December 2010/january 2011
Contents
New on morningstaradvisor.com
Contributors
Letter From the Editor
What Strategies Do You Use to Help Retirees Hedge Against Longevity Risk?
Investment Briefs
Four Picks for the Present
Scaring the Swiss
Tech Is the Apple of Managers’ Eyes
How to Read an Sec Filing
A Strategy That Loves Performance Chasers
Things Fall Apart, Even in Industrials
A Future in Questions, Not Answers
Research Over Chocolates
Creating Portfolios That Confront Retirement’s Risks
Building in-Retirement Portfolios to Last
On the Lookout for Guaranteed Income Streams
What Fires Up Mairs & Power
All Aboard!
Aiming at Alternatives
Stuff Your Stocking with Out-of-Favor Bargains
Stable, High Yields (No Bonds Included)
Mutural Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks with Wide Moats
Twelve Bee, Huh?

Morningstar Advisor - December 2010/January 2011