As most of you know, one of the cornerstones of our investment
process is to “turn over as many rocks as possible” in
searching for investment opportunities, and one of the ways we
do that is to talk to hundreds of fund managers each year. Already
this year, we have spoken or met with over three hundred mutual
fund managers (or their colleagues) about their philosophy, process,
resources and positioning of their mutual funds.
As usual, there continues to be a great divergence of opinion
among fund managers about the markets’ future direction,
even among those managers that we consider to be the ‘best
of breed.’ Some of our favorite managers think the U.S. stock
market is an undervalued buy, while others believe we are in the
early stages of a new bear market. Some fund pros believe bonds
are a great buy at today’s yields, while others strongly
believe that you shouldn’t touch bonds with a ten foot pole.
On the subject of energy, some managers are loading up on energy
stocks with every pullback, which others are steering clear.
These diverging opinions are nothing new. For years we’ve
listened to smart money fund managers make opposing arguments about
the market. So, if many of them are wrong, how do they turn in
solid long-term performance numbers? The answer is by controlling
their bet sizes, diversifying their portfolios and focusing on
stock selection.
As we’ve mentioned numerous times in the past, we take a
similar approach. While we also have the resources, the historical
perspective, and have opinions regarding the direction of the market,
specific sectors and asset classes — you will never see us
completely load up on one asset class or market sector no matter
how strong our conviction may be. Just like some of our favorite
fund managers, we know we could be wrong, and making such bets
is not a formula for long-term success.
I’m emphasizing this point because it is such an important
one and it is the foundation of how we invest your money. We strongly
believe that having a diversified portfolio, albeit one with portfolio
positioning in line with our latest thinking on the markets and
appropriate levels of risks, is still the best way for us to help
you realize your long-term investment objectives.
Shifting Towards Quality
Despite our commitment to stay diversified, our most recent conversations
with fund managers did echo our view that higher quality companies
are more attractive than they have been in several years (see “Quality
is Cheap” in our May Letter). A movement towards quality
(and away from risk) was a common theme expressed by many of
the managers we met at Morningstar’s annual conference
in Chicago last month.
The first example of this trend is that many of the top managers
we spoke with are reshaping their portfolios to feature more exposure
to larger capitalization companies. The main thrust of their arguments
was simply better valuations, particularly given the underlying
growth rate of many of these firms. More stable, larger-cap companies
are by nature of higher quality (less risky) than smaller-cap firms.
And this is particularly so in a slowing economy.
Another example of this trend was an oft-repeated cautionary comment
from managers about taking on too much risk, and there seemed to
be a fresh appreciation for asset classes such as bonds and cash.
However, while a consensus view in favor of large caps appeared
to be developing, it should be noted that industry-wide, mutual
fund assets are still greatly underweight large cap names and overweight
small and mid-cap names. So, while large caps may be getting the
headlines of late, they are still unloved by the general public
and “under-owned” by mutual funds.
An example of a manager who has already repositioned his portfolio
towards quality is Bill Nygren of Oakmark and Oakmark Select, which
we own for a number of clients. Though Bill’s relative performance
has not been strong in recent years (he was clearly early on his
move towards higher quality, larger cap names), his reputation
as one of the industry’s leading stock pickers is well-noted.
As investors flocked towards the hot-performing riskier areas,
Bill’s funds have seen net redemptions. Despite his long-term
track record of achievement, and the confidence of many industry
professionals, fund flows are the ultimate test of market sentiment.
However, often the best time to buy a solid manager, such as Bill,
is when his relative performance is weak — exactly opposite
of what investors are now doing with the fund.
“You Can’t Eat Risk-Adjusted
Returns”
Investors always want to make more money than the market when it
goes up, but they don’t want to lose any money when it
goes down. Unfortunately, this is next to impossible to consistently
accomplish. A more reasonable goal is to participate in the bulk
of the market’s gains when it is rising, but lose less
than the market when it is falling. This is typically accomplished
by diversifying your portfolio to take on less volatility than
the market. If done well, this can offer a higher risk-adjusted
return than a less diversified, more aggressive approach.
We have often heard the statement “You can’t eat risk-adjusted
returns” made in defense of more aggressive approaches to
portfolio management. We just happen to disagree with it.
The point of that statement is that an aggressive (higher risk)
portfolio with an expected return of 10% return over a certain
(long) time period is better than a lower risk portfolio with an
expected return of 8%, because, after all, 10% is better than 8%.
Who cares if after taking into account the differences in relative
risks, the aggressive portfolio’s risk-adjusted return drops
to 5% while the lower volatility portfolio only declines to 7%.
You can’t “eat” that 2% advantage because what
you are actually going to earn is 10% and 8%.
But, and this is a very big but, that is only true if you stick
with each portfolio throughout that entire period. No jumping out
of the market during sharp declines, to wait until conditions improve
before getting back in.
And with the more aggressive portfolio, those declines will be
a lot sharper, a lot more emotionally straining, and a lot harder
to resist. In short, the more diversified, lower risk portfolio
approach greatly enhances the probabilities that most investors
will be able to “stay the course” through market thick
and thin and ultimately reach their long-term objectives.
Obviously, each individual has their own combination of investment
considerations, including investment objectives, risk tolerance,
time horizon, etc., and therefore the risk level that may be deemed
appropriate for their portfolios may be different. But numerous
studies have shown that investors are better served with diversified,
lower volatility portfolios, than by trying to chase the hottest
performing sectors in a higher-volatility mix.
The most recent study that backs up this notion was presented
at the Morningstar conference by Morningstar’s Don Phillips.
They divided each category or peer group of mutual funds into two
buckets. The first bucket contained those funds that had the most
volatility. The second bucket contained the less-volatile funds
from each category or peer group.
Looking at returns going back ten years, high-risk funds returned
8.3% while lower risk funds performed slightly better, returning
an annualized 8.7%. However, when they examined the returns actually
earned by investors in those funds, the difference became magnified.
On average, investors in the high-risk funds earned an annualized
return of only 5.1%, while investors in the lower-risk funds netted
8.5%. Poorer returns achieved by investors in higher-risk funds
is explained by the fact that they ‘buy high, and sell low,’ versus
investors in lower-risk funds who are less prone to sell their
funds during market downdrafts.
As Phillips noted, (and as we have long warned against) investors
tend to chase performance, which is easier to do with higher volatility
investments and portfolios. Investors too often buy after an investment
has already been hot, and sell after it has been cold.
Many in the industry may cite that investment costs are the biggest
problem that investors face, and while we agree it is indeed an
important consideration (please see our recent Research Perspective
on investment costs located at www.kobreninsightmanagement.com),
it is a distant second to the problem of chasing performance.
Yes, you can “eat” risk-adjusted returns.
In short, while a well-diversified, lower-volatility portfolio
may not be “sexy,” you will likely “eat better” ...
and sleep better as well.
Sincerely,
Eric M. KobrenRusty Vanneman, CFA
PresidentDirector of Research
Portfolio
ManagerCo-Portfolio Manager
