Advisor Blog

Another recent article in Investment News addressed outflows from American Funds due to real or perceived performance issues. In the article, American Funds spokesman Chuck Freadhoff stated "We don't feel that over the long term, investors will do as well with a passive investment as they will active management, and we have the long-term track records to back that up."

We disagree with Mr. Freadhoff, so we looked for the "long-term track records" that he mentioned. In doing so, we found this document. At first glance, it looks impressive. But, upon further examination there are some glaring issues. First, the performance numbers on the first page don't take sales loads into account. That's misleading, since most investors in these funds pay them. At least that is disclosed at the top of the page and the second page contains load-adjusted returns. A bigger issue, however, is comparison to inappropriate benchmarks. For example, comparing value funds to the S&P 500 Index (dominated by growth companies and, at best, a blend of growth and value). American Funds could have chosen a value index, like the Russell 1000 Value, but that wouldn't have made the comparison look as good. Even more egregious is the comparison of their emerging markets fund to a world ex-US index instead of an emerging markets index that would have shown that it underperformed. This is very misleading.

Led by the excellent performance of US stocks, global equity markets posted strong returns in the quarter. Those returns, however, were not sufficient to overcome a dismal third quarter and most markets had negative returns for the year.

• Quarterly returns for the broad US market, as measured by the Russell 3000 Index, were 12.12%. Asset class returns ranged from 15.97% for small cap value stocks to 10.61% for large cap growth stocks. The strongest sectors in the quarter were energy and industrials, while the weakest one was telecommunication services. For 2011, the strongest sectors were utilities and consumer staples, while the weakest ones were financials and materials. Value outperformed growth in the quarter, but not in 2011.

• In US dollar terms, the quarterly returns for developed non-US markets were over 3%, above the historical average but far behind the US. For 2011, however, developed international markets as a whole lost over 12%. As in most of the past few quarters, there was much dispersion in performance at the individual country level. Greece, which remains at the center of Europe’s sovereign-debt woes, was by far the worst performer in the quarter and the year. At the other end of the spectrum, Ireland, the Scandinavian countries, and Australia were the top performers for the quarter.

• In US dollar terms, emerging markets gained about 4% in the quarter, in line with the historical average, but not enough to overcome their very poor performance of the third quarter. As a result, emerging markets lost almost 20% in 2011. Malaysia and other smaller emerging markets in Asia and Latin America such as Thailand and Peru posted double-digit returns in the quarter. At the other end of the spectrum, India, Turkey, and Egypt had double-digit negative returns in the quarter. 

Debt crises, sovereign risks, double dips and banking strains: Page One headlines can make for depressing reading these days. But being a smart news consumer—and smart investor—means keeping an eye on the lesser headlines. Here are seven you may not have seen:

• Robust Growth in Germany Pushes Prices—Analysts see a strong chance that German inflation will head towards 3 per cent by the end of the year against a backdrop of robust growth in Europe's biggest economy. (Reuters, July, 27, 2011)

• Brazil Domestic Demand Still Strong—The Economist Intelligence Unit says economic growth in Brazil surprisingly picked up speed in the first quarter, challenging the government’s efforts to cool the expansion. (EIU, July 6, 2011)

• Japan Retail Sales Top Estimates—Japan's retail sales rose 1.1 per cent in June, exceeding all economists' forecasts and adding to signs the economy is bouncing back from an initial post-disaster plunge. (Bloomberg, July 28, 2011)

• No Fear in China—Traders betting on gains in China's biggest companies are pushing options prices to the most bullish level in two years. The Chinese economy is projected to grow by 9.4 per cent in 2011. (Bloomberg, July 28, 2011)

• Southeast Asia Booms—Southeast Asian markets are the world's top performers in 2011 thanks to strong economic and corporate fundamentals. Thailand's index hit a 15-year high in July and Indonesia's a record high. (Reuters, July 22, 2011)

• Australian Boom Keeps Rate Rise on the Agenda—The Australian dollar hit its highest level in 30 years in late July as traders looked to the prospect of another rise in interest rates on the back of a resource investment boom. (WSJ, July 27, 2011)

• NZ Bounces Back—The New Zealand economy has grown more strongly than expected after the Christchurch earthquake, helped by improving terms of trade. The Reserve Bank signals it may raise interest rates soon. (Bloomberg, July 28, 2011)

Standing back from all this, the picture that emerges of the world outside North America and southern Europe is of robust economic conditions. If anything, policymakers in many parts of the world, particularly in Asia, are seeking to pull back demand, rather than stoke it.

Australia, for instance, is enjoying its best terms of trade in more than 50 years. An unprecedented investment boom in mining is injecting extraordinary wealth into the economy and has helped to push the Australian dollar to levels not seen since it was floated in the early 1980s.

Likewise, China, India and much of South-East Asia are seeing strong investment flows and worrying more about over-heating than anything.

This is not to say that all is right with the world. The aftermath of the global financial crisis has created severe problems, particularly in terms of public sector debt and deficits. But we know that that news is in the price. Meanwhile, economic activity in much of the world is thriving.

For equity investors, that means opportunities for wealth building are increasing, not decreasing. Moreover, the global economy is becoming multi-polar, rather than overly dependent on the US, which means the potential benefits from broad diversification are even greater.

That's why focusing too much on the day-to-day headlines with the US debt ceiling or European sovereign issues risks missing many of the good stories out there.

Sometimes, the best advice is to read the newspaper from the inside out.

I got one of the typical emails from a mutual fund company yesterday.  Their VP and Director of Investments had been on our website and wanted to set up a meeting.  Of course, the intention was to convince us to use his company's products, all of which are actively managed.  I wrote back and politely told him that we weren't interested because active management is, in a nutshell, a failed strategy that does not add to portfolio performance. 

No good salesman takes no for an answer the first time, and neither did he.  So, he sent me a white paper about the importance of having emerging markets exposure in portfolios and tried to make the argument that emerging markets are a "different animal" - that they are less efficient and that active management works best there.  Well, he was right about the importance of emerging markets exposure.  That's why we've always had a significant allocation to emerging markets equity. 

Does active management work better in these supposedly less efficient markets?  The argument is that a higher percentage of active managers beat their benchmark index in emerging markets.  But what benchmark are we using?  In this case, it's the MSCI Emerging Markets Index.  This is a broad index of emerging markets stocks.  So, I asked him if this was the appropriate benchmark for all of the emerging markets funds that outperformed it.  Since we know that the size and value effects are strong in emerging markets, couldn't a fund manager simply add small cap or value exposure and easily beat the broad index?  What happens to this analysis if these "outperforming" funds are compared to the MSCI Emerging Markets Value Index or the MSCI Emerging Markets Small Cap Index?

No response.

Here's the lesson contained in this example.  Almost every actively managed fund that "outperforms" an index over any significant period of time is being compared to an inappropriate index.  We saw this go on for years with Legg Mason Value and its manager, Bill Miller.  Miller was lauded by the financial press as the smartest asset manager in the universe because his value
 fund consistently beat the S&P 500, which is not a value index.  Since value stocks outperform the market as a whole, shouldn't a value fund be expected to outperform a market index?  Of course it should - and the same point applies to small cap funds.  Legg Mason Value imploded in 2008-2009, which is almost inevitable with active managers, so it's really a moot point with this particular fund.  But, the way active managers mislead by making inappropriate index comparisons is important to understand.