Volume 1 - Issue 29
April 4, 2005
An Asset Allocation Strategy
For The Intelligent Investor
||This week's report is about some research finding from a group in Bellevue, Washington called Evergreen Capital Management, LLC. They have built a proprietary model that is used to predict when mutual fund styles (large-mid-small capitalization, value-growth) are being overbought or oversold. They believe that their model is quite good at predicting returns relative to the overall market over the subsequent two years.
This report does an excellent job of weaving together many of the themes from my past letters and book, Bull's Eye Investing. We find behavioral finance, herd mentality, why investors fail, how Wall Street works, contrarian investing and more. I think you will find the results of their research along with their other comments very valuable the next time you find yourself scanning the top performing funds of the recent past and that is why I chose it as this week's Outside The Box.
- John Mauldin
AN ASSET ALLOCATION STRATEGY FOR THE
By Evergreen Capital Management, LLC
Worldcom implosion? Peanuts. Enron scandal? Just a rounding error. Lucent
meltdown? Chump change. When it comes to investor losses - as painful as the
aforementioned were - these events pale in comparison to the whopper of them
all: wrong way investing with mutual funds.
As Forbes magazine pointed out in their December 22, 2003 article, "Our Own
Worst Enemy", mutual fund investors have let one trillion dollars slip through
their collective fingers over the last decade. Even in an era when billions of
dollars are thrown around like subpoenas in Elliot Spitzer's office, a trillion
dollars is still a staggering sum of money. Sadly, it has been lost by those who
can least afford it: the average Joe and Jane, who generally have used mutual
funds because of their perceived fairness to the small investor.
How has this monstrous fiasco happened? As Forbes points out, and our extensive
research at Evergreen Capital Management confirms, it is because investors have,
in hunting parlance, shot behind the duck. Warren Buffett has weighed in on this
topic stating that most investors look through the rear view mirror instead of
the windshield, continually seeking out yesterday's winners and projecting out a
few years worth of strong performance infinitely into the future.
The Boston-based market research firm Dalbar has done several very comprehensive
studies of the results of mutual fund investors' behavior over the years. Their
2004 report, "Quantitative Analysis of Investor Behavior", came to the stunning
conclusion that the average mutual fund investor has realized a measly 3.51%
annual total return from equity mutual funds versus 12.98% for the S & P 500
over the past 20 years. Not only did they tremendously under-perform the overall
stock market, the typical mutual fund participant barely kept pace with
inflation over the same time period.
Dalbar further segmented the universe of mutual fund investors between those who
were consistent, or systematic, participants and those who tried to time the
market. Unsurprisingly, those who attempted to outwit the market only managed to
victimize themselves as they actually incurred negative returns of 3.29% per
annum. Showing that inertia does have some virtue, the steady-Eddy investor
produced a positive, but still deficient, return of 6.8% annually. When
extrapolated over millions of investors and trillions of dollars, it is easy to
see why this has been such a monstrous financial calamity as outlined by Forbes.
Yet there is a sunny side to this dark story: our work strongly suggests it is
possible for rational, independent-thinking investors to profit from this
phenomenon. We will outline the solution later in this article
To understand how this has happened, it is important to consider the role of the
Wall Street marketing machine in the creation and distribution of mutual funds.
The mutual fund industry has shown a rather cynical tendency to follow the old
Wall Street saw: "when the ducks are quacking, feed them." And feed them they
have, as the fund managers have churned out sector funds to exploit whatever the
current fad might be thus showing an acute awareness that money does chase
As a result, it is almost laughably easy for a fund company to raise billions of
fresh dollars and all the juicy management fees that come with the copious
inflows. They rake in these vast sums by touting their Select 20 Tech Fund, or
whatever topically exciting name it might brandish, in early 2000 after three
years of fantastic - and unsustainable - performance. Full page adds promoting a
5-star rating from Morningstar and highlighting the incredible results are
virtually irresistible. Unfortunately, the average mutual fund investor has
shown very little ability to resist, much to the detriment of their long-term
If one accepts the fact that the foregoing is true and the performance-chasing
mutual fund investor has indeed experienced very poor results, then this begs a
potentially rewarding question: is it possible to determine when this cohort is
making a major commitment to, or retreat from, a specific investment asset
class? For example, is the herd charging frantically into a style, like Small
Cap Value, or into a Region, such as Asia? Or are they bailing out in droves
from a particular sector, such as Real Estate Investment Trusts? If one could
accurately measure when this investor segment is either fever-pitch bullish or
despondently bearish, then it would be rational to expect that it is possible to
generate mirror-image returns; in other words, to produce returns in excess of
the market rather than below it.
There are those who slavishly follow the Efficient-Market Theory and who are
likely to immediately dismiss such a proposition. However, if there is a large
segment of the investment world that realizes inferior performance there must be
an immense amount of return - like the one trillion dollars alluded to above -
that flows to those who behave in an equal and opposite fashion. Once again
quoting Warren Buffett, "the market is very efficient at transferring assets
from the impatient investor to the patient investor." Buffett has methodically
carved out a chunk of that trillion dollar tragedy for himself and his
shareholders by being highly focused on the long-term. There are other very
skilled investors who have done the same though it is admittedly not easy. An
important attribute of all exceedingly successful investors is the willingness
to move counter to the herd. Long before Warren Buffett was known as the Oracle
of Omaha, one of the most legendary figures on Wall Street was Bernard Baruch
who advised: "never follow the crowd."
Therefore the key question is how does one avoid following the crowd or, better
yet, actually profit from the folly thereof? As Deep Throat said in the classic
Watergate movie, All the President's Men, "Follow the money." This is exactly
what we have done by analyzing mutual fund flows into and out of various
style-specific categories in the mutual fund universe from 1979 through 2004 (in the
case of the Mid-Cap style our analysis starts from 1986 when Russell began
tracking this segment separately).
Other studies have looked at equity funds in general and have found little
linkage between fund flows and subsequent returns. Yet our analysis, targeting
actual mutual fund styles, such as Large Cap Growth, shows a very clear inverse
relationship between extreme inflows, or outflows, and subsequent returns. The
critical element is to consider only extreme flows rather than attempting to
analyze all flows. We believe this is logical since it is only when overly
active mutual fund investors en masse reach the tipping point of overt
bullishness or bearishness that meaningful contrarian signals are generated.
Therefore, it is critical to ascertain what truly represents an extreme flow.
This is admittedly easier done for outflows than for inflows.
Our studies show that outflows are quite rare and are clearly indicative of
extreme investor pessimism. This is because there is such a powerful and
persistent current of money flowing into the mutual fund complex from 401(k) and
IRA contributions as well as normal savings that find their way into various
fund vehicles. In fact, mutual funds take in between $10 and $12 billion from
401(k) and similar plans in an average month according to Lipper's Fund Flows
Insight Report published in June 2004. To actually force a mutual fund style
into a redemption mode over an extended time frame requires an intense level of
negativity by a large segment of the mutual fund population which, based on our
counter-trend methodology, is a highly positive development.
While flows on their own are useful predictors of future performance for major
styles such as Large Cap Growth, we have found that their leading-indicator
capability is further enhanced by using a second, fundamentally-based factor.
Without divulging too much of our proprietary research, it is very clear that
when there is an alignment of extremely positive or negative fund flows with
correspondingly attractive fundamental readings, a predictive signal is
generated. For example, when Large Cap Growth inflows are extreme based on our
statistical measures and fundamentals are also exceedingly stretched, the odds
are very good that this style will under-perform the broad market over the
subsequent two years.
A key element in our analysis is to consider a future time period of at least
two years in order to measure outcomes. In the increasingly myopic milieu of
Wall Street, a two year time-horizon nearly represents eternity. The herd is
often right on a very short-term basis but almost always wrong longer term
especially when the second derivative of fundamental analysis is incorporated.
A specific example of where the herd acted correctly was the performance of
Small Cap Value funds over the last few years. Due to the massive bull market in
the 1990s in Large Cap stocks, particularly of the growth variety, Small Cap
valuations were gradually ground down to very depressed levels. Once the high
tech bubble burst in the spring of 2000, Small Cap, particularly Value, began to
dramatically outperform the Large Cap style. As the excellent relative results
gathered momentum, money came gushing in as usual. But in this case, because
Small Cap had started at such a subterranean point, the herd was moving the
right way and Small Cap continued to eclipse the performance of the Large Cap,
especially Growth, style.
However, by using the second factor of valuation analysis this "aberration" was
easily avoided. It is interesting that, after five years of Small Cap far
out-racing Large Cap, we are now looking at nearly a mirror-image of the beginning
of this decade: strong inflows into Small Cap Value funds and very stretched
relative valuations and persistent out-flows from Large Cap Growth funds with
reasonably attractive, though not rock-bottom, valuations. Accordingly, we
believe this is clearly a time to be emphasizing Large Cap over Small Cap and
Growth over Value.
As we expect to be the case with Small Cap Value in the relatively near future,
even when the performance-chasing mutual fund investors get it right in the
initial stage of a trend they still get it wrong when that trend inevitably
reverses. For example, in the late 1990s, this cohort began to funnel
unprecedented amounts of money into tech funds and, for awhile, they were
absolutely right. Enormous gains were produced by this sector, and these
intoxicating profits became like a gigantic vortex that sucked in even more
billions, the most graphic episode ever witnessed of money chasing performance.
By late 1999, both the inflows into growth funds and their fundamental
underpinnings were in the ionosphere. It was clearly not sustainable and,
following Stein's law, sustained it wasn't. Those unsophisticated investors who
originally caught the updraft of the phenomenal tech bubble, and who initially
found investment Nirvana, were soon its hapless victims. Rather than rationally
reducing their exposure to this mania, as Efficient Market adherents would
expect, they threw caution - and their collective net worth - to the wind. What
was initially one of the "little guy's" greatest success stories became, very
tragically, his darkest hour.
It is this recurring ignorance of the inevitability of reversion to the mean
that allows one to benefit from investors' high optimism in any given sector of
the market or their strong conviction to be out of a particular segment. This is
despite all the cold logic of Modern Portfolio Theory which tells us so
confidently that such anomalies shouldn't happen. Yet the reality is human
behavior isn't all that rational at times, and the financial markets are very
much a by-product of the emotions of the underlying participants.
Human beings are tremendously influenced by what Behavioral Finance academics
call the Recency Effect, meaning that what has happened recently is very
over-weighted in the decision making process. Best-selling financial author, John
Mauldin, recently wrote: "They (American investors) are born with a gene that
looks to their past experience and extrapolates that into the future." At
Evergreen Capital we call it "The Tyranny of the Temporary " and it is truly
the cruelest of tyrants. It leads the over-active mutual fund investor to
conclude that if his tech fund is up 80% over the last two years and his bond
fund is down 10%, then the tech fund is golden and the bond fund is trash. He or
she then proceeds to dump the bond vehicle and invest the proceeds into the
likely over-priced tech fund. Once this behavior reaches epidemic proportions
among the general investing public, the game is almost over - especially if both
the flows (measuring investor psychology on a very broad scale) and fundamentals
are in vertigo-inducing territory.
We obtained interesting results using aggregate mutual fund out-flows data
analysis. Perhaps surprising to the Efficient Market followers, we have found
over a 90% probability of outflows, combined with extreme valuations, leading to
out-performance of the market as a whole over the subsequent two year period.
Thus if Mid-Cap Value mutual funds in aggregate are experiencing persistent
out-flows, and the fundamentals for this style are compelling, then there is a 91%
likelihood that the Mid Cap Value style will exceed the performance of the S & P
500 over the next two years. This is based on analyzing data back to 1986 when
the Russell Mid Cap style category was incepted. Furthermore, the
out-performance is not trivial: it has averaged nearly 14% on an annualized basis
for this style.
Table 1 below summarizes the results, across the various style categories, of
our studies of extreme flows in conjunction with fundamental factors and the
weighted average annualized excess return of the subsequent 24 months. We
calculated geometric returns in excess of the S&P 500 based on quarterly data
and annualized the results.
1. Summary of style-specific mutual fund flows and valuations analysis over
the 1979 - 2002 period.|
| || || || || || |
of Total Obs.
| || || || |
available starting from 1986 to 2002.|
presented here are not representative of ECM's actual or hypothetical portfolios;
the returns are style-specific only.|
Lipper, Russell/Mellon, Barra|
extrapolated from these data sources for this table presentation is based
upon information that Evergreen Capital Management considers to be reliable
but does not guarantee as to its accurateness or completeness.|
Let me take a minute to explain how to read the table. If you take a look at the
first category - Large Cap Growth - you will notice that there were 9 quarters
(# of Obs.) in the past 23+ years when inflows into this Large Cap category
reached extreme proportions by historical standards and the corresponding
valuation factor was above its average at the same time. The Large Cap Growth
style under-performed the S&P 500 over the subsequent 2 year period in 7 out of
these 9 episodes which resulted in the 78% success ratio (accuracy). Moreover,
the average annualized under-performance relative to the S&P 500 was 2.1% for
this style. Coincidently, there were also 9 quarters of outflows coupled with a
low fundamental factor, and those signals were correct in every one of these
incidents generating an average out-performance of 4.2%. Finally, the spread
between the high inflow/high valuation and outflow/low valuation strategies for
the Large Cap Growth style produced an average annualized out-performance of
6.3% with an 89% signal accuracy.
Across all the styles on an annualized basis, the average excess return is a
positive 13.6%. Additionally, 85% of the quarters were consistent with our
theory which states that, on average, a particular style should out-perform the
S&P 500 in cases of out-flows/attractive fundamentals (77% accuracy) and under-
perform the S&P 500 when a style experiences extreme inflows/inflated
fundamentals (91% accuracy).
The results of this study seem promising for implementing style timing
strategies in domestic equity allocation. Our future studies will also examine
the potential of sector timing in the US and country rotation abroad based on
sentiment and fundamental factors. However, we will be the first to point out
the caveats. For one thing, it will be very difficult to fully capture the
amount of excess return stated above with a highly diversified portfolio and
rigid risk controls such as safeguards against over-concentration in any one
style. For another, the 1998 to early 2000 bubble period was the prelude to the
"perfect storm" for the financial markets, creating an ideal environment for
positioning in a contrary manner to a very irrational herd. Such a circumstance
may be a long time in the re-making but it will happen again, perhaps just not
Numerous studies have shown that the overwhelming majority of investment return
comes from optimized asset allocation; some analyses have found it to be over
90%. Consequently, utilizing a process that greatly boosts the odds of
performance-enhancing asset allocation is far from trivial. Furthermore, making
the right asset allocation at the dawn of this decade was critically important -
arguably the most significant investment rebalancing decision in a generation or
We tested our indicators to see what a recommended asset allocation would be as
the great bull market of the 1990s was drawing to a close, and we were given
unmistakable signals to be underweight in Large Growth, and overweight in Mid
and Small Cap Value. Many market veterans, especially those with extensive
experience and a value bent, made the same call but they were painfully early in
Importantly, the extreme readings necessary to trigger a material overweight in
Mid and Small Cap Value did not occur until the end of 1998 and beginning of
2000, respectively. We believe this accuracy is a function of tracking what the
market timing mutual fund investor - who has proven to be wrong so often over
time - is doing with their money (not just how they are feeling as with some
sentiment indicators) and then blending in the valuation measures. If you think
about it, once the least sophisticated, most emotional, least rational, most
gullible investors have made a huge shift into or out of a given asset class,
who else is really left to inflate a bubble or sell further into the late stages
of a bear market?
From an investor psychology standpoint, we believe there is an underlying reason
for mutual fund participants to exhibit such performance-destructive tendencies.
After 25 years of dealing with hundreds of individuals, we are convinced it
comes down to the fact that they don't really understand the mysterious workings
of the stock market. Moreover, they don't truly trust the advice of Wall Street
and often for good reason. As a result, they default to what they comprehend and
have confidence in - bottom-line performance. The problem is that, in the world
of financial markets, performance is cyclical, not linear; just when a
particular class looks the very best, it is likely to perform the worst.
Perversely, by pursuing the tangible but fleeting allure of short-term results,
the ultimate bottom line - solid long-term performance - is forfeited. Yet, for
those investors willing to shift their focus away from their over used rearview
mirrors and onto the expansive road in front of them, a radiant investment
horizon lies ahead.
Evergreen Capital Management Disclosure
I hope you have found the results of Evergreen Capital Management's research as interesting as I did.
Your never follow the crowd analyst,
John F. Mauldin
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