FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
January 24, 2006

IN THIS ISSUE:

1.  Barron’s Top 20 Equity Mutual Funds

2.  The Problems With Listing “Hot” Funds

3.  Without The Drawdowns, What Good Is It?

4.  Buying High & Selling Low

5.  Big Bets On Small Cap Companies

6.  The “Snapshot In Time” Problem

7.  How We Select Mutual Funds For My Clients

Introduction

Every January, our mailboxes, inboxes and e-mail programs are bombarded with all sorts of forecasts, predictions and, of course, recommendations on how and where to invest your money.  Investment magazines are loaded with their favorite picks and strategies for the New Year.  Rarely, however, do these sources review their picks from last year – not a pretty sight in many cases.

Most of these annual rankings and recommendations, as I have pointed out so often in the past, focus on the latest “hot” funds or strategies.   Typically, they look at the highest performers over the last 12 months.  As everyone reading this E-Letter should know, the latest hot performers can go cold just as quickly as they got hot, and the losing periods (“drawdowns”) among the latest hot funds are often huge.

Yet the January 9 issue of Barron’s seemed to take a different approach for its New Year’s recommendations.  The editors focused on the top 20 equity mutual funds over the last 15 years.   It was their cover story and, at first glance, I thought I would be impressed.  There was, of course, a table in the middle of the article which listed the top 20 funds, and most readers, I’m sure, went straight to the table to see which funds had made Barron’s top 20 list over the last 15 years.

Barron’s list of the top 20 equity mutual funds is included in the pages that follow, but before you leap ahead, there are some problems you need to know about with these funds.  I will point out the problems as we go along.  The bottom line is, if you had owned Barron’s top 20 mutual funds over the last 15 years, you would have had a very ROCKY ride along the way!

Keep in mind as you read on that the 15 year period Barron’s considered, from 1991 to 2005, included the greatest equity bull market in history.  Given that, you would expect some good returns.  But as you’ll see, the losing periods were way beyond most investors’ tolerance levels.   Unfortunately, Barron’s failed to point that out, but as usual, I will. 

After we dissect the Barron’s study, I will explain to you how we go about selecting mutual funds at my firm.  The bottom line is, we look for mutual funds that have a history of delivering good returns in up, down and sideways markets, with limited drawdowns along the way.  Such funds are out there if you know how to find them, and I’ll tell you how.

Barron’s Top 20 Equity Mutual Funds

Let me begin by stating that I am a Barron’s subscriber and have been for over 20 years.  So, I like the weekly financial publication.  As I have stated in the past, I wish I could write nearly as colorfully and animated as Alan Abelson, Barron’s lead editor.  Yet while I am a fan of Barron’s, the January 9 cover story featuring the top 20 equity mutual funds over the last 15 years fell below my expectations in several areas.

Let’s get right into it.  The Barron’s article touting the top 20 equity mutual funds over the last 15 years was indeed tantalizing – even for me.  The cover page had a huge headline that read: “BETTER THAN BILL,” a reference to Bill Miller who manages the Legg Mason Value Prime Fund, which has beaten the S&P 500 Index in each of the last 15 years.   The cover page goes on to state: “No question that Legg Mason’s Bill Miller is a superstar… but we’ve found 19 funds that have done even better.”   I told you it was tantalizing, especially given that there are over 10,000 mutual funds out there.    

I am going to include the exact list of equity mutual funds that Barron’s picked below.  But before you leap ahead to the table, we need to talk about a couple of key points.

First, performance reporting for investment products has become very standardized in the last decade or so for several reasons.  Partly due to increased regulation, and partly due to credibility, there are certain criteria which are almost always included with the publication of a track record – at least from reputable sources.

Obviously, there is the net performance, usually expressed as an average annual return.  Then there is the time period over which the performance was generated (months or years).  Next, you typically see something like “standard deviation,” a measure of how consistent the returns were.  And then, you almost always see “Worst Drawdown,” which is typically the worst losing period during the entire performance record.

If you’ve been reading me for long, you know that avoiding big losses is the centerpiece of my investment philosophy.  I am as focused on the losing periods as I am on the upside potential, if not more so.  Why?  Because it doesn’t matter how much money you might make if you were scared out of the investment due to a big drawdown along the way.

This is not a typo: Because it doesn’t matter how much money you might make if you were scared out of the investment due to a big drawdown along the way.

So, I was very disappointed to see that the Barron’s editors chose to publish the glowing performance numbers for their top 20 equity mutual funds over the last 15 without also including the worst drawdowns for those same funds! 

Without the information on the worst drawdowns, you have less than half of the story.  Lots of mutual funds and other investment products have impressive upside returns, but their drawdowns can be huge.  You need to know this upfront.  Barron’s, for whatever reason, elected to omit this critical information.  But I didn’t!

Here’s the table included in the January 9 issue of Barron’s, but with the addition of the Worst Drawdown in the far right-hand column.  (For sake of space, I omitted the columns including the name of the current fund manager and when he or she started, etc.) 

* Total return and standard deviation are for December 31, 1990 through December 31, 2005.
** “Worst Drawdown” is a measure of the largest peak-to-valley losing period during the period of time covered by the above table.
*** Past performance is not necessarily indicative of future results.

There you have it.  According to Barron’s study of the Morningstar mutual fund database, these are the 20 top performing equity mutual funds over the 15 years from 1991 to 2005.  But before you rush out to buy these 20 funds, there are lots of problems I need to make you aware of.  I almost don’t know where to start.

That’s not true.  I do know where to start.  It’s where I always start – with the drawdowns.

Without The Drawdowns, What Good Is It?

As you can see, ALL of the funds listed have worst drawdowns in excess of 20%.  10 have worst drawdowns in excess of 30%.  And several, including the S&P 500 Index, have worst drawdowns close to or above 40%!  The average maximum drawdown for the funds listed in the Barron’s article is –30%.

We have all read the prominent (and required) disclaimer: Past performance is not necessarily indicative of future results.  However, I believe the past drawdowns are a better indicator of potential future risk, and are the primary risk measure my company uses when evaluating mutual funds and Investment Advisors. 

The maximum (or worst) “drawdown” of a program can best be described as the worst losing period an investment experienced from a performance high point to a low point (peak to valley).

At my company, we look not only at the worst-ever drawdown, but also at an average of several of the significant historical drawdowns.

While it is impossible to know if a fund or an Advisor will have similar drawdowns, or a new worst drawdown, in the future, studying the past losing periods is absolutely critical in my opinion.  In our analysis of funds and Advisors, we typically want to  know why the worst drawdowns occurred and what, if anything, has been done to make them less likely in the future.

If you are a long-time reader or client, you know why I concentrate so much analysis on drawdowns.  It takes a 25% return to recover from a 20% drawdown; it takes a 42.9% return to recover from a 30% drawdown; and it takes a 66.7% return to come back from a 40% loss.  All of the mutual funds in the table above had at least a 20% drawdown.  And the data above only shows you the worst drawdown; it does not tell you a thing about how often significant drawdowns occurred during that 15 year period!

Buying High & Selling Low

To understand why drawdowns are so important when analyzing any potential investment, we need to acknowledge one fact, even if it doesn’t relate to you: Most investors buy funds when they are flying high, and sell them when they are in the dumps.

I have frequently written about the studies from Dalbar, Inc. and other financial research organizations which demonstrate how most mutual fund investors tend to “buy high and sell low,” meaning that they chase returns in hot funds, and then jump out when losses occur.  The routine is all too familiar.  Investors read about the latest hot funds in a financial publication, or hear them discussed on the radio or TV, and decide that’s where their money needs to be.

Unfortunately, most of the high flying funds also have large drawdowns along the way, as you can see in the Barron’s table above.  And remember, these are the top 20 performers over the last 15 years, according to Barron’s study.

And there’s another issue you might not think about.  When the high-flying mutual funds get a lot of publicity, a huge influx of money usually follows.  It is not uncommon for these inflows to be larger than the fund manager can effectively deploy.  The result is that these hot funds often cool off quickly, and performance in subsequent years is often far short of the returns that gained them notoriety.  Unfortunately, investors seeking the returns promised by the financial media are often disappointed, especially when the next drawdown hits, and many times bail out and seek the next hot fund to invest in.

Investors tend to bail out of an investment when losses become more than they can bear.  The Barron’s table above shows that the smallest worst drawdown of any of the funds was still in the –21% range, and you don’t know how often similar losses might have occurred.  I would suggest that many investors would exit the fund long before reaching even this stage of loss, especially those who have a low risk tolerance.

Thus, the potential for loss is just as important as the average annual return of a prospective investment.  While the table in the Barron’s article did list each fund’s standard deviation, this measure is a rather poor indicator of just how much risk you may be taking when investing in a specific fund or with an Investment Advisor.

I actually chuckled when I read a sentence in the Barron’s article introduction that said, “…for long-term investors, what counts is the final number – not the gyrations in between.”  That was the tip-off that the funds touted had some serious drawdowns. 

It is also interesting to note in the table above that low standard deviations do not necessarily correlate with low historical drawdowns.  Perhaps the most interesting point, however, is that Bill Miller’s Legg Mason Value Trust, which is widely known for beating the S&P 500 for 15 years, has the highest maximum drawdown of any of the other funds shown, which is just a few percentage points less than the 44.71% drawdown of the S&P 500 Index.  That’s pretty risky, if you ask me!

Big Bets On Small Cap Companies

Another problem I have with the Barron’s article is the fact that most of the top performing funds they list have (or had) a heavy concentration in small cap stocks.  The article states, “…many of the funds have a small-cap value bias,” and “Small-cap value was by far and away the best asset class for the past 15 years…”  

While that statement on Barron’s part might in fact be true overall, there were various periods during those 15 years when small cap stocks underperformed and were very much out of favor.  That is likely when the high flying mutual funds in the table had some of their worst drawdowns.   There are times to be in small caps, and there are times to be in large caps.  The key is to know when.

If small cap stocks fall out of favor again – and they will – then many of the mutual funds in the table above will no longer be in the top 20.

Unfortunately, no one knows which market sectors will lead the way in the future, but what we do know is that trying to determine what the future may hold from analyzing a 15-year snapshot of the past – with no drawdown information - is largely an exercise in futility in my opinion.

The “Snapshot In Time” Problem

I have previously written about a money manager’s speech where he said that he could be the number one money manager in the US, IF he could pick the time period used to gauge the performance.  We call this “cherry-picking” a track record.  Most any money manager or fund has some period of time when their performance was stellar.

While the Barron’s editors chose to use 15 years as their time period (equal to that of Legg Mason’s Bill Miller), the same rule still applies.  Given virtually any stated period of time, there will always be investment programs that beat other investment programs.  Thus, if you choose a different time period, different funds and managers are likely to be at the top of the list.

This is especially true where you measure performance as compared to an index or set of indices.  In my Absolute Returns Special Report , I discuss how relative performance can actually be negative, yet still be promoted as “beating the market.”  How so, you might ask.  Well, if the market declines 20%, and your manager lost only 15%, then he can say that he beat the market.  But are you happy?  I don’t think so!

A final problem I have with this over-generalized statement is that it lumps all long-term investors into one pot, and decides what is best for them.  While the generalization is that all long-term investors care about final return, as noted above, many care about the risk they have to take along the way.  Others are interested in the tax efficiency of the programs they maintain, and still others may be interested in social investing.  This one-size-fits-all approach to the goals of all long-term investors is just one symptom of the index investing disease that is so prevalent in the financial media today.

Other Problems With The Barron’s Study

By now, it should be obvious that I do NOT recommend that you rush out and buy the 20 funds listed in the Barron’s table above.  Yet there are actually some additional reasons why you would not want to buy all these funds.  Here are the other reasons:

1.  Based on the Morningstar Principia Pro analysis software, all of the funds mentioned in the article are highly correlated with the S&P 500 Index.  This is very interesting, considering that many have small-cap and mid-cap biases.  This high correlation makes it likely that any investment in one or more of these funds might have to endure the same roller coaster ride that the S&P 500 Index experiences.

2.  Eight of the mutual funds listed in the article are closed to new investment, so you can get them even if you want.  Of the remaining funds open to investors, two have minimum investments of over $2 million, with another requiring at least $50,000 to invest.

3.  In an article that seeks to highlight the managers of these “successful” mutual funds, it is interesting that even the article admits that eight of the 19 funds have managers whose tenure is less than the 15 years covered in the performance study, with several of them having less than 5 years at the helm of the funds they manage.

4.  While most of the funds score “Excellent” on regulatory issues according to Morningstar, there are two of the funds listed in the Barron’s article that score “Very Poor” and another that scores only “Fair.”  Would you really want to put your money there?

5.  By focusing on a 15-year time period, the funds listed in the Barron’s article could “beat the market” if they did better than the S&P 500’s average return of 11.52% over the same period.  However, if we selected only the last five years, a fund with an average annual return of only 1% would almost double the S&P 500 Index’s return of a paltry 0.54%.  What good is that information?

Conclusions

Ironically, a quote in the article from Don Phillips, Morningstar’s managing director, seems very appropriate.  He said, “Avoiding big mistakes is the key to generating long-term wealth.”  Phillips made his comments in connection with a discussion of how many of the funds on the Barron’s list bailed out of tech stocks before the worst of the bursting of the tech bubble, a factor that might be more attributable to luck than skill.   However, the idea is still valid.

In my November 1, 2005 E-Letter and the Absolute Returns Special Report, I stressed how important it is to invest in programs that have the potential to avoid losses through active management strategies.  While the funds listed in the Barron’s article are considered to be actively managed, their strong correlation to the S&P 500 Index would seem to indicate that the market’s overall direction is more of an influence on performance than the skills of the managers.

I am convinced that the real purpose of the Barron’s article was to showcase managers who have competed well against Bill Miller, but have not had the distinction of beating the S&P 500 Index each year for 15 years. However, looking at the article as a whole, it certainly has the appearance of a recommendation of these funds, even if that appearance is unintentional.

Admittedly, some of the funds mentioned in the Barron’s article are quite good, but selecting investments from a list in a magazine or newspaper article is not the best way to go in my opinion.  A much more intense examination of the investment is required, and is usually best left in the hands of professionals.

How We Select Mutual Funds For My Clients

As noted at the beginning, there are many publications that recommend which mutual funds you should invest in.  The Barron’s study discussed above is merely one of many such examples.  What should interest you most, however, is how we pick mutual funds at my company – both for our many clients’ portfolios and also for my own.

For the last year, I have been emphasizing “absolute returns,” investment programs and funds with the potential to make money in up OR down markets.  If you have not read my latest Absolute Returns Special Report, you really need to do that if you are serious about investing in today’s tricky equity (and bond) environment.  This Special Report will help you understand why we recommend the investment programs we do, and how we select them.

Aside from my company’s analysis of Registered Investment Advisors, we also have access to mutual fund databases and analysis programs.  This sophisticated software allows us to evaluate the performance of all funds, and to select, among the thousands of alternatives, the ones that our analysis shows to have the best potential for ongoing absolute returns with limited risk. 

While these funds are not likely to be on the latest “Top Performers” list, and do not always beat the market, that is not their goal.  Instead, they seek to provide a reasonable rate of return through investment strategies that also manage the risks of being in the market.

My clients know the fallacies in chasing the latest “hot” funds.   So what we looked for among the thousands and thousands of equity mutual funds were those funds that I would characterize as “Steady Eddie” funds – those that have delivered good returns (although not necessarily the highest) through various and different market environments – with limited drawdowns.  

With our serious commitment to technology, we have software in-house that allows us to search the universe of mutual funds using virtually any selection criteria we choose.  We can “dial-in” those funds that meet our performance requirements.

Once a number of potential candidates are identified, we then run various combinations of these funds inside a single portfolio, in an effort to further enhance potential performance and reduce the risk of loss.  The culmination of all of this research is now available to our clients in the form of our Absolute Return Portfolios.

All of the mutual funds we have selected have some measure of active management as part of their strategies.  Investors who wish to take advantage of the Absolute Return Portfolios will have the choice of three different risk levels – Moderate, Moderate-Plus and Aggressive.  There is a slightly different mix of funds (5-6) in each category, but the objective is to produce attractive absolute returns.

We continually monitor the funds making up each Absolute Return Portfolio, and we have the authority to add, drop or replace a fund within a particular Portfolio, should that become necessary in the future.  Factors that might cause a fund to be dropped from a Portfolio include, but are not limited to: the loss of a key manager, regulatory problems, change in the investment strategy, or poor performance.  (As always, it is also important to remember that, while these funds have posted consistent positive returns in the past, there is no guarantee that they will do so going forward.)

** Whether you have ever invested with me or not, I think you will want to know the mutual funds in our Absolute Return Portfolios.  You will want to know which mutual funds – out of thousands – that I have my clients’ and my own money invested in today’s market environment.**

The minimum required to fully invest in our Absolute Return Portfolios is only $15,000. Individual accounts are opened at T.D. Waterhouse where the funds will be purchased and held.

To learn this valuable information, and get started, you will have to take the next step and become one of my clients.  It doesn't matter where you live, or that we have not met in person.  I have clients in all 50 states, most of whom I have never met. 

There are several ways you can initiate this easy process.  You can call us toll free at 800-348-3601 and one of my trusted Investor Representatives will be happy to send you information, with no pressure or obligation.  Or you can e-mail us at mail@profutures.com.  Or you can also click HERE to immediately access our online information request form.

I am very excited about our Absolute Return Portfolios and their potential benefits for investors at most any level, including even younger investors who may just be starting out.  The programs are also available for IRAs, trusts, etc. 

Given the numerous forecasts for another choppy year in the stock markets, now may be the time that you bite the bullet and see if we can help you experience some acceptable returns.

Very best regards,

Gary D. Halbert

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