The Zombie-Like Stench of Precious Metal Funds
Thursday, July 18, 2013
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 47.7%, down 1.2 points
  Neutral: 31.0%, down 1.8 points
  Bearish: 21.3%, up 3.0 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

Yesterday, I was handed an investment report entitled “Zombies!” The report by Harris Associates L.P. focused on interest rates, but it could well have focused on precious metal funds instead. Investors holding those funds will feel like their portfolios were afflicted by the same plight causing havoc in AMC’s hit show “The Walking Dead.”

As I discuss in the July issue of our Quarterly Low-Load Mutual Fund Update (which will be posted to next week), the second quarter was a disastrous one for precious metals funds. The average quarterly loss for the funds tracked was 34.6%. Since the start of 2013, these funds have lost, on average 45.9%. Precious metals ETFs haven’t fared any better, down 47.7% for the six-month period ended June 30, 2013.

The natural reaction to seeing these numbers is to run, or the financial equivalent of running. (Just don’t scream; zombies are attracted by noise. And thanks to advances in entertainment technology, zombies move a lot faster in the decades since “Night of the Living Dead” was released in 1968.) Yet, unlike a fictional apocalypse, running is not always the best option when a fund incurs a significant drop in value.

The majority of a fund’s performance is determined by its objective. As such, your decision to invest in a fund specializing in a certain sector, industry, style or geographic area should also be determined in large part on how the fund’s objective fits within your overall portfolio strategy.

A manager required by his fund’s objective to invest in a particular asset class, a geographic area or a sector or industry has no control over the factors that directly influence a significant portion of the returns he realizes. When gold prices fall, there is little a precious metals fund manager can do to protect the portfolio from losing value. The same fund manager also does not deserve credit for delivering good returns simply because precious metals prices have risen.

This is why it is important to compare a fund’s performance against its peers. Asset classes, geographic markets, investing styles, sectors or industries all move in cycles. What was leading the market a few years ago may lag now or lag in the future. This diversity in returns is what makes portfolio diversification work; over the long term, the shifting market preferences can lead to less volatility for one’s portfolio.

There, of course, is another component to keep in mind when deciding what to do with a precious metals fund: the reason an investment was purchased. Commodity-related investments, such as precious metals funds, should only be purchased for two specific reasons: the expectation of short-term price appreciation or long-term portfolio diversification. These are separate reasons and should never overlap. It is very difficult to consistently realize positive returns through short-term trades; it is impossible to avoid losing money when a trade starts getting treated as an investment after the price drops. Speculation and investing are two different things. Never treat a fund (or a stock) bought for the purpose of realizing a short-term profit as a long-term investment because the price didn’t move the way you thought it would.

Most importantly, be sure you understand the historical volatility before making a long-term investment. Precious metals funds, for example, are subject to big price swings. Their ability to add long-term diversification comes at the emotional cost of dealing with some quarterly statements that reek of a zombie-like stench. It’s not a characteristic every investor has the risk tolerance to put up with, but commodity-related investments can have a role for those willing to put up with roller-coaster returns.

More on

Model Portfolios Updated

There was one change made to the Model Fund Portfolio this month. IShares MSCI Frontier 100 ETF (FM) was added to give the portfolio exposure to pre-emerging economies and provide additional upside return. The new addition replaces WisdomTree Emerging Markets SmallCap Dividend Fund (DGS), which was deleted.

The Model Fund Portfolio was down 2.5% for June. The newly implemented Conservative Portfolio (75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury Bond ETF) was down 1.9%. This compares to a 1.3% loss for the Vanguard Total Stock Market Index fund (VTSMX). Year-to-date, the Model Fund Portfolio has now gained 10.8% and the Conservative Portfolio is up 8.1%, compared to 14.0% for the Vanguard Total Stock Market Index fund. The Model Fund Portfolio has a compound annual return of 8.6% from its inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 8.0% annually over the same time period.

Last month, the Model Shadow Stock Portfolio gained 1.7%, outperforming the Vanguard Small Cap Index fund (NAESX), which lost 1.0%, and bettering the DFA US Micro Cap Index fund (DFSCX), which was up 0.5%. Year-to-date, the Model Shadow Stock Portfolio has gained 35.1%, beating the Vanguard Small Cap Index fund, which has gained 15.9%, and the DFA US Micro Cap Index fund, which is up 17.5%. The Model Shadow Stock Portfolio has a compound annual return of 17.8% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 8.7% annually over the same period.

AAII Sentiment Survey

The percentage of individual investors describing their short-term outlook as optimistic stayed above 40% for the third consecutive week in the latest AAII Sentiment Survey. Meanwhile, the percentage holding a pessimistic outlook stayed at an unusually low level.

Bullish sentiment, expectations that stock prices will rise over the next six months, declined 1.2 percentage points to 47.7%. This is the first time optimism has been above 40% for at least three consecutive weeks since February 21, 2013. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, declined 1.8 percentage points to 31.0%. Though neutral sentiment has declined for three consecutive weeks, it is above its historical average of 30.5% for the eighth consecutive week and the 14th out of the past 17 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 3.0 percentage points to 21.3%. This is the fourth time in five weeks that pessimism has been below its historical average of 30.5%.

Bearish sentiment remains at an unusually low level (-1 standard deviation is a reading at or below 21.8%). Since 1987, there has been a slight underperformance for the S&P 500 when bearish sentiment has been at similar levels: a median six-month return for the S&P 500 of 4.5% versus 4.7% for all periods.

The recent optimistic stance comes as stocks have rebounded off of their June lows and are approaching record highs. Some AAII members are encouraged by signs of continued economic growth and the length of the current rally. Others, however, are concerned about prevailing valuations, the slow pace of economic growth, interest rate uncertainty and a lack of progress on key issues by Washington politicians.

This week’s special question asked AAII members for their opinion about how clearly the Federal Reserve is communicating its intentions for monetary stimulus. Respondents were split, with 45% saying the central bank is being clear and 33% saying the Fed is not being clear. Some individual investors said the central bank is stating its intentions, but traders and market commentators are creating confusion. Others thought the Fed is purposely muddying their message.

Here is a sampling of the responses:

  • “I think the Fed has been quite clear. The market, however, seems to interpret the information differently.”
  • “The Fed is being clear, but the market speculators aren’t listening.”
  • “The Fed is being clear. You have to read what they say and not rely on all the talking head spin doctors.”
  • “It’s not clear to me because Fed officials couch their speeches in terms that may be interpreted in several different ways.”
  • “They are making it up as they go along. Their policy is as clear as mud.”

» Take the sentiment survey