An Asset Allocation Strategy For The Intelligent Investor

Contact John Mauldin

Volume 1 - Issue 29
April 4, 2005

An Asset Allocation Strategy
For The Intelligent Investor

By Evergreen Capital Management, LLC

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
INTELLIGENT INVESTOR
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 performance.

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 financial health.

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.

TABLE 1. Summary of style-specific mutual fund flows and valuations analysis over the 1979 - 2002 period.

Style	Event	Average	Average	# of Obs.	# of Total Obs.
		Excess Return	Accuracy	(By Quarter)	(By Quarter)

Large Cap	Extreme Inflows/High Valuations	-2.10%	78%	9	93
Growth	Outflows/Low Valuations	4.20%	100%	9	93
	Net Total	6.30%	89%	18	93


Large Cap	Extreme Inflows/High Valuations	1.40%	31%	13	93
Value	Outflows/Low Valuations	6.50%	95%	19	93
	Net Total	5.10%	69%	32	93


Mid Cap	Extreme Inflows/High Valuations	-8.40%	100%	14	65
Growth *	Outflows/Low Valuations	10.30%	92%	12	65
	Net Total	18.70%	96%	26	65


Mid Cap	Extreme Inflows/High Valuations	-5.80%	100%	4	65
Value *	Outflows/Low Valuations	14.50%	91%	11	65
	Net Total	20.30%	93%	15	65


Small Cap	Extreme Inflows/High Valuations	-9.50%	83%	6	93
Growth	Outflows/Low Valuations	1.70%	43%	7	93
	Net Total	11.20%	62%	13	93


Small Cap	Extreme Inflows/High Valuations	-6.70%	100%	6	93
Value	Outflows/Low Valuations	17.80%	100%	18	93
	Net Total	24.50%	100%	24	93

All Styles	Extreme Inflows/High Valuations	-4.90%	77%	52	502
	Outflows/Low Valuations	8.70%	91%	76	502
	Net Total	13.60%	85%	128	502

*Data was available starting from 1986 to 2002.

The returns presented here are not representative of ECM's actual or hypothetical portfolios; the returns are style-specific only.

Data Sources: Lipper, Russell/Mellon, Barra
The data 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 as drastically.

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 more.

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 doing so.

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
johnmauldin@investorsinsight.com

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