Adding Measures of Risk to Your Fund Evaluation

Picking your funds based solely on performance is a common mistake

Return numbers are the most readily accessible pieces of information available to you as an investor. As a result, it is too easy to make fund choices for your 401(k) based on those returns. The level of risk you assume in your portfolio based on fund choices is critical. Unfortunately that information is much more difficult to find and understand.

Morningstar, Inc. (www.morningstar.com) offers a free resource to find risk information on publicly traded mutual funds. If you navigate to the “Ratings and Risk” tab for a fund you are interested in, you can find measures of fund “volatility”. For example, you can see how a fund performs during periods when markets increase in value (Upside Capture) and when markets decline (Downside Capture).

Let’s look at the Upside/Downside statistics for Baron Growth, currently classified as a mid-cap growth fund. The top section of the snapshot below shows the behavior of Baron Growth’s returns versus the S&P 500. For example, over the last ten years, Baron Growth’s upside measure is 114.61 (the S&P 500 in this example would be 100). So, Baron Growth has tended to outperform the S&P 500 by 14.61% during up markets. Conversely, when the S&P 500 drops, Baron Growth tends to drop less than the market over the ten year period.

The bottom section provides you with the same measures for mid-cap growth funds versus the S&P 500 in general. This gives you a chance to see how other funds with similar investment strategies perform against the S&P 500.

If you find funds that perform better than the markets on the upside (a number above 100 on the top line) and the downside (a number below 100 on the bottom line), the fund may be a good addition to your portfolio “recipe”.

“What incentive does a bank have to buy two-year Treasuries at 20 basis points when they can park overnight reserves with the Fed at 25? What incentives do investment managers or even individual investors have to take price risk with a five-, 10- or 30-year Treasury when there are multiples of downside price risk compared to appreciation? At 75 basis points, a five-year Treasury can only rationally appreciate by two more points, but theoretically can go down by an unlimited amount.” - Bill Gross, PIMCO Investment Outlook, February 2012

My $3.99 Ground Beef is on Sale!!!

Now I only have to pay $5.95………

Buying stocks is no different from buying any other product – you perceive a value to you, then you look at the price tag. If the price seems fair, you buy. If the price is lower than you thought, you might buy a few extra. If the price is too high, you hold off and wait for a better time.

As simple as that sounds, investors often decide to buy no matter the price. Rumors spread of better economic times or solutions to fiscal problems. Maybe the “everybody else is buying” syndrome kicks in – or the desire to find higher returns “somewhere, anywhere” takes over.

Your retirement dollars are too valuable to follow the herd. Long-term returns are generally enhanced when patience is exercised. We are confident that the patience we exercise in client portfolios will ultimately be rewarded.

Treasury May Let Investors Pay to Lend to US

……..and you thought hamburgers were expensive

The U.S. Department of Treasury, according to recent reports, may allow investors the option of bidding for future Treasury issues with a negative yield.

From the minutes of the latest meeting of the Treasury Borrowing Advisory Committee:

“There was a lengthy discussion regarding the bid-to-cover ratios at recent Treasury bill auctions. It was broadly agreed that flooring interest rates at zero, or capping issuance proceeds at par, was prohibiting proper market function. The Committee unanimously recommended that the Treasury Department allow for negative yield auction results as soon as logistically practical. “

What does this all mean? Well, in the near future, you may have the option of giving the US government $10,000, and they will hold it for you for 90 days, and then give you back something less than $10,000.

The goal is to force investors into riskier asset classes in an effort to continue the price inflation we are seeing in most investment categories.

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Conservative Investors Rewarded in 2011
A treacherous ride to nowhere

Pretend for a moment you pulled off your best Rip Van Winkle imitation and slept through 2011. You pick up a “Year in Review” newspaper, and find out:

• A number of European countries (Portugal, Italy, Greece, Spain) are close to defaulting on their debt.
• The United States ran up another $1+ trillion in debt and lost its’ AAA credit rating.
• Over 13 million Americans remain unemployed. Another 8 ½ million are working only part time because they cannot find full time work.

You would have to believe your investments took a beating. Yet, you open up your retirement plan statement and find out things weren’t quite as bad as you expected.

Nobody made a bundle of money last year. If you owned mostly stocks, and mainly foreign stocks, you lost 4% or more. Conversely, if you emphasized bonds and cash in your assets, you managed to eke out a small gain (1% – 2%) – not enough to meet your long term needs, but enough to protect your principal in anticipation of better times ahead.

We were pleased to see that corporate earnings and dividend payments increased significantly last year. Earnings and dividends provide the basis for long term rates of return that can meet your retirement needs.

On the negative side, we went from historically low interest rates at the beginning of the year to ridiculously low levels today. Savers and retirees are unable to find income producing investments without accepting significant risk.

We remain extremely concerned with subpar growth in our nation’s level of output. If our shift to lower growth rates (which began almost a decade ago), is more permanent than we thought, even conservative projections of 5% long term rates of return will be called into question.

We discuss our thoughts for the next year on the following pages. We enter 2012 the same way we entered 2011, with a very cautious outlook.

Investment Professionals Weigh In on Market Outlook

The CFA Institute recently published their 2012 Global Market Sentiment Survey. The report analyzes responses to a November, 2011 survey of over 58,000 CFA Institute members across the globe. Among the findings:

• The current global financial crisis has severely impacted market trust and confidence. Almost 80% of U.S. respondents expect this low level of confidence to last at least three more years
• 52% of survey participants expect the sovereign debt crisis to get worse in 2012
• Mis-selling of financial products by advisers is perceived to be the most serious issue facing global markets

Globally, 59% of respondents predict that asset classes other than equities will be the top performers in 2012. The majority of U.S. respondents (56%), however, believe the equity markets will outperform other asset classes.
The full Global Market Sentiment Survey for 2012 can be found at the CFA Institute website (www.cfainstitute.org).

2011 Market Returns Mixed
Foreign stocks suffered significant declines

It was indeed a wild ride for the equity markets in 2011. The S&P 500 ended at almost exactly the same price it began the year – its only return came from the 2.11% dividend paid by S&P 500 companies. Monthly returns ranged from a decline of 7.0% in September (completing five straight months of negative market returns), to an increase of 10.9% in October.

Stock markets worldwide generated negative returns for the first time in three years. Investors who utilize both domestic and foreign stock funds have lost money over the last five years. Fortunately, bond funds have generated 6.5% gains annually since 2006, and cash has helped with a 1.4% compound return.

The average market strategist interviewed by Barron’s at the beginning of 2011 predicted a gain of 11% for the markets last year. Also, they collectively predicted that stocks would outperform bonds, especially U.S. Treasuries.
The 2012 survey predicts a market gain of 11.5%. Two of the ten strategists are predicting flat to down markets, unlike 2011, where almost all predicted gains.

Worldwide Sovereign Debt at Unmanageable Levels
Time to laugh at ourselves…if only it were funny

Other incredible statistics from usdebtclock.org:

• Total Federal/State/Local spending has exceeded $7.0 trillion dollars. That represents 46.7% of US Gross Domestic Product.
• Total US Debt (households, businesses, governments and financial institutions) has reached $56.5 trillion ($683,522 debt per family).
• US Unfunded Liabilities (promises made for Social Security, prescription drugs and Medicare, now exceeds $117 trillion, more than $1 million for each taxpayer.
• Hayman Capital Management provides a concise view of the debt situation for the rest of the world :
• Total global credit market debt has grown at a compound rate of 11% since 2002. Global real gross domestic product has grown only 4% during that same period.
• Total credit market debt is currently 310% of GDP (US Debt to GDP just surpassed 100% for the first time).

According to Hayman, “Throughout history, whenever total credit market debt breached 200% of GDP, it was commonly due to deficit spending fueled by borrowing as nations prepared for and fought wars. To the victor went the spoils (and debt pay-downs) and to the loser went defeat and default.”

We are fixated on worldwide debt levels for one important reason: As more and more resources are pulled from future production and consumption capacity, lower long term potential growth rates are reduced. For example, if we use a standard financial calculation like a dividend discount valuation model , we see the following results:

On January 18th, the World Bank cut its global growth forecast by the most in three years. The world economy will grow 2.5 percent this year, down from a June estimate of 3.6 percent, the Washington-based institution said. The euro area may contract 0.3 percent, compared with a previous estimate of a 1.8 percent gain. The U.S. growth outlook was cut to 2.2 percent from 2.9 percent.
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1. Hayman Capital Management, L.P November 30, 2011 Newsletter
2. The formula for the dividend discount valuation model:
(Dividend Payout)/(Required Rate of Return-(GDP Growth+Inflation))

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Unemployment Rate Voodoo
Producers Continue to Leave the Labor Force

The announcement of a decline in the nation’s unemployment rate from 9.0% to 8.6% was treated gleefully in news headlines. Unfortunately, there is more to the story.

Over the past 60+ years, the number of people who are participating in the labor force grows an average of 4% – 5% every three years. Over the last three years, however, the civilian labor force has declined. This is the first decline over a three year period since statistics were first gathered in 1948.

If labor force participation rates grew at near normal levels from 2008 to the present, the calculated unemployment rate would probably exceed 13%.

Labor force growth affects economic growth, which eventually affects stock market prices. Caution remains the prudent course.

Housing Inventories Continue to Drop
This is a good thing!

Residential real estate values may have the largest single impact on the health of the United States consumer and the economy as a whole. Consumer spending typically represents two-thirds of total U.S. production; the wealth effect of rising (or falling) home prices weighs heavily on consumer attitudes.

According to the National Association of Realtors (NAR), inventories of existing homes continue to slide, though at a snail’s pace. As inventories fall, prices may begin to stabilize. Price stability in the housing market will attract investment from those seeking exposure to the tangible asset.

Although we are nowhere near the long term historical average for housing inventories, it is, among other things, an encouraging sign that we are inching ever closer to a balanced inventory. We should applaud this drop in inventory as a sign of continued digestion by the market of its former housing binge.

Retirees’ Financial Health
A Snaphot

There is no question the financial upheaval in recent years has impacted the behavior of investors across the board. From private equity funds to retirement investing, strategies have changed to accommodate the ever evolving financial landscape.

In a study conducted by the Society of Actuaries (SOA), LIMRA, and the International Foundation for Retirement Education (InFRE), individual retirees were questioned in three consecutive surveys to gauge the degree to which the financial crisis has affected their investment behavior. The survey was issued prior to the financial crisis of 2008, in April of 2009, and again in the summer of 2011, and as a result it captured the change in sentiment during these unique times.

The results of this study show a recovery in the level of confidence retirees have in regards to the amount of savings accrued  for comfortable retirement living. Only 25% of retirees polled in 2009 were “very confident” they had enough money to live comfortably along with 54% who were “somewhat confident.” In 2011, the percentage of those who were “very confident” rose to 31% as well as 54% for those who are “somewhat confident.”

Perhaps the most encouraging among the changes in retiree behavior is the drop in the amount of household debt. Roughly 35% more households claim to hold absolutely no debt at all as a result of the ongoing financial crises. This data bodes well for a healthier consumer base in our consumer driven economy.

To conclude the study, retirement investors continue to remove risk from the table. Few can question the motivation behind such a trend as “risk” has become an exceptional foe to stable returns as of late. However, confidence levels are up among retirees and as a result we would expect to see spending levels creep back to pre-recession levels.

Nonetheless, a more conservative approach to retirement finances should help cushion retirees from financial losses in the event of a second recession. It is encouraging to see proactive measures being taken to combat future uncertainty.

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