Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the third installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year.
Click here for Part 1
Click here for Part 2
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Lesson 4: Yesterday's Masters of the Universe, Tomorrow's Cosmic Dust
For believers in active management, the equivalent of finding the Holy Grail is identifying a manager who can persistently beat the market. The hero for many had been Bill Miller, manager of the Legg Mason Value Trust (LMVTX). 2005 was the 15th consecutive year his fund beat the S&P 500 - the longest streak on record. To the faithful, surely 15 years was the result of skill and not random luck.
On the other hand, perhaps the streak was purely a lucky one. In 2006, the fund returned 5.9 percent, underperforming the S&P 500 by 9.9 percent. Perhaps that was just one bad year, and the market just did not see what Miller saw as real value. Unfortunately, the fund repeated that dubious feat in 2007, losing 6.7 percent and underperforming the S&P 500 by 12.2 percent. The past two years left the fund with a three-year record of underperforming the S&P 500 by 7.3 percent per annum.
Was Miller a skillful manager who had just lost his touch? Or was he lucky and Lady Luck had abandoned him? How is an investor to know which is the correct answer? What should an investor in the fund do now? If an investor chooses to stay with the fund, how long should that investor wait before giving up? What if Miller turns the performance around after investors sell the fund?
There is even more bad news. Most of Miller's great returns came when the fund was much smaller. The great returns attracted huge cash flows, which kept increasing as his streak continued. The worst performance came when the fund had the most dollars. Thus, the returns actually earned by many investors in the Legg Mason Value Trust are well below the returns reported by the fund.
Of course, this is not the fault of the fund. Instead, the fault lies with investors who chose to ignore the evidence from academic studies that there is virtually no persistence of performance beyond the randomly expected, at least among winners. (Losers tend to repeat losing because of high expenses.)
As history suggests it would, the fund experienced large outflows in 2007. Investors withdrew almost $10 billion of assets in the third quarter of 2007 from the Legg Mason family of funds. Thus, even if Miller manages to once again outperform, many investors will not be there to benefit.
Other Funds
It is also worth noting that the domestic fund with the longest current streak of outperforming the S&P 500 also saw its streak end. Cambiar Opportunity (CAMOX), which had beaten the S&P 500 for eight consecutive years, lost 1.9 percent in 2007 and underperformed the S&P 500 by 7.4 percent. The fund's three-year performance trailed the S&P 500 by 1.6 percent per annum.
The lesson is that ignoring the SEC's warning about relying on past performance of actively managed funds is the financial equivalent of ignoring the surgeon general's warning about the dangers of smoking.
Lesson 5: The Importance of Portfolio Diversification
Insurance plays an important role in managing threats to financial security. People insure against the risks to their homes, cars and personal property. And they insure against premature death (life insurance), medical expenses (health insurance and long-term health care insurance), disability and even longevity (lifetime payout annuities).
The same principles of prudent risk management apply to investment portfolios. There are two asset classes - collateralized commodity futures (CCF) and Treasury inflation-protected securities (TIPS) - that provide a form of portfolio insurance because their returns are negatively correlated with the returns of stocks and nominal return bonds (bonds whose returns are not indexed to inflation). When an asset produces higher than average returns, its negatively correlated counterparts tend to produce below average returns. Thus, the addition of negatively correlating assets to a portfolio dampens the volatility of the overall portfolio and reduces volatility's negative impact on compound returns.
Both TIPS and CCF provide hedges against inflation risks, and CCF also provides a hedge against some event risks (such as an interruption of oil supplies). Academic research and historical evidence suggest that adding these assets will likely produce less volatile and more efficient portfolios (portfolios with higher risk-adjusted returns). In 2007, both TIPS and CCF produced above average returns. The Vanguard Inflation Protected Securities Fund returned 11.6 percent and the PIMCO CommoditiesRealReturn Fund returned 23.2 percent.
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