AAII Investor Update: Stock Funds Stumble, But Don’t Fail

Thursday, October 13, 2011
Charles Rotblut, CFA
AAII Journal Editor

AAII Resources

Diversification: A Failure of Fact or Expectation?
Diversification hasn’t failed investors, but expectations might have.

AAII Discussion Boards
How often do you review your mutual funds’ performance?


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The third quarter was not kind to stock-oriented mutual funds. Out of the approximate 800 stock funds covered by our Quarterly Low-Load Mutual Fund Update newsletter, relatively few showed gains. Worse, among the winners, just one uses the traditional strategy of buying stocks; the rest invest in both stocks and bonds, are designed to move inversely to stock prices, or use other hedging strategies.

Despite the performance, stock funds did not fail their shareholders. Rather stock funds were victims of the securities that investors pay them to invest in. Stock prices fell globally last quarter. For a fund whose objective is to invest in stocks, losses were unavoidable.

The only options for investors were to buy contra funds or strategically shift to holding bond funds, particularly long-term government bond funds. Doing either would have required successfully timing the market. Unwinding these trades and moving back into stock funds require successfully timing the market a second time—a feat that is much easier said than done. If you held a mix of stock and bond funds (or just stocks and bonds), your portfolio’s decline was cushioned. Diversification did not prevent you from losing money last quarter, but it did lessen the blow as it is designed to do.

If you own stock mutual funds, particularly actively managed funds, look at the returns relative to those of their category peers. Though mutual funds like to tout their performance in advertisements, a fund’s absolute return is not the first thing you should look at. Rather, figure out what asset classes and subclasses your portfolio needs (e.g., U.S. small-cap stocks, emerging market stocks, bonds, etc.) and then find the best funds that fulfill those needs. Tax efficiency, expense ratios, yield and risk all should be considered when evaluating a fund.

Once you buy a fund, have patience with it and understand the factors that impact its performance. A good manager can have a bad quarter for reasons beyond his control. Such was the case for many funds over the past three months when narrowing correlations reduced the potential advantages of active management. This said, don’t stick with a poorly performing fund if the manager consistently underperforms his peers.

Hedge Funds Struggled Too

I realize that this is not much in the way of consolation, but hedge funds also fared poorly last quarter. Industry consultant Henessee Group calculated that hedge funds suffered their worst quarter since the fourth quarter of 2008. Henessee Group’s hedge fund index fell 3.78% in September and is down 5.53% year-to-date.

Diversification Hasn’t Failed

Opponents of diversification may try to use last quarter’s dismal results as proof that diversification doesn’t work. I would argue that diversification worked exactly as it historically has, but it is a long-term strategy as opposed to a short-term strategy.

It’s human nature to focus on the most current events and to forget the lessons from past experience. Yet there remain lessons from the last bear market that continue to apply today. One such lesson is that diversification does work during bear markets, as this March 2010 AAII Journal article explained.

How often do you review your mutual funds’ performance? Tell us on the AAII Discussion Boards.


The Week Ahead

As a reminder, you have until Monday, October 17, to undo (“recharacterize”) a Roth IRA conversion made in 2010. See this January 2010 AAII Journal article for an explanation of why you may want to convert to a Roth IRA or undo a conversion from a Roth IRA and go back to a traditional IRA.

Next week will be the first big week for third-quarter earnings season. More than 100 S&P 500 member companies are scheduled to report, including Apple (AAPL) on Tuesday. The Dow components reporting are International Business Machines (IBM) on Monday; Bank of America (BAC), Coca-Cola (KO), Intel (INTC) and Johnson & Johnson (JNJ) on Tuesday; American Express (AXP), Travelers (TRV) and United Technologies (UTX) on Wednesday; AT&T (T) and Microsoft (MSFT) on Thursday; and General Electric (GE), McDonald’s (MCD) and Verizon Communications (VZ) on Friday.

The week’s first economic reports will be the October Empire State manufacturing survey and September industrial production and capacity on Monday. Tuesday will feature the September Producer Price Index (PPI) and the October National Association of Home Builders (NAHB) housing market index. The September Consumer Price Index, September housing starts and the periodic Beige Book will be released on Wednesday. Thursday will feature September existing home sales, the October Philadelphia Fed survey and September leading indicators.

Several Federal Reserve officials will make public speeches: Richmond Federal Reserve Bank president Jeffrey Lacker and Chicago Federal Reserve Bank President Charles Evans on Monday; Federal Reserve Chairman Ben Bernanke on Tuesday; Boston Federal Reserve Bank President Eric Rosengren on Wednesday; Cleveland Federal Reserve Bank President Sandra Pianalto and St. Louis Federal Reserve Bank President James Bullard on Thursday; and Minneapolis Federal Reserve Bank President Narayana Kocherlakota on Thursday and Friday.

The Treasury Department will auction $7 billion of 30-year inflation-protected securities (TIPS) on Thursday.

October stock options will expire on Friday.

AAII Sentiment Survey

Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 39.8%, up 4.5 points
  Neutral: 23.9%, up 4.8 points
  Bearish: 36.4%, down 9.4 points

Long-term averages:
  Bullish: 39%
  Neutral: 31%
  Bearish: 30%

Take the AAII Sentiment Survey »

Bullish sentiment, expectations that stock prices will rise over the next six months, increased 4.5 percentage points to 39.8%. This is the highest level of optimism since July 21, 2011. It also ends a streak of 11 weeks when bullish sentiment was below its historical average of 39%.

Neutral sentiment, expectations that stock prices will be essentially unchanged over the next six months, rose 4.8 percentage points to 23.9%. This was the 13th consecutive week that neutral sentiment has been below its historical average of 31%.

Bearish sentiment, expectations that stock prices will fall over the next six months, plunged 9.4 percentage points to 36.4%. This is a six-week low for pessimism. It is also only the third time in the past 11 weeks that bearish sentiment has been below 40%. Despite this week’s decrease, pessimism is above its historical average of 30% for the 31st time out of the last 34 weeks.

The Dow Jones industrial average has jumped 8% higher from its October 3 close, and this rebound has alleviated some of the pessimism. Though a greater percentage of investors are looking for stocks to rise over the next six months, AAII members remain very cautious, as is evident by the above-average level of bearish sentiment. The pace of economic growth, worries about European sovereign debt, frustration with Washington and volatile market conditions are weighing on individual investors’ moods.

This week’s special question asked AAII members if they have recently begun bargain shopping for stocks. The majority of respondents said they had not. Several, however, said they would consider bargain shopping if prices fell by an additional 10% to 20%. Others were either waiting on factors beside price movement or simply had no intentions of buying stocks right now. A sizeable minority, however, said they have recently been bargain shopping for stocks.

Here is a sampling of the responses:

  • “No. Nothing has been resolved in Europe, and I expect lower guidance from U.S. companies.”
  • “I am not bargain hunting because the market will be down a lot in six months.”
  • “I am looking, but I will not be buying without another drop of 5% to 15%.”
  • “I have a cash position of more than 20% and will invest in stocks when they drop 10% from current levels.”
  • “No hunting yet, but I will soon be scouting the grounds for trophy picks.”
  • “I started in July and have been buying stocks ever since then.”

Are you bullish, bearish or neutral? Take the AAII Sentiment Survey and tell us.

Wishing you prosperity,

Charles Rotblut, CFA
AAII Journal Editor