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Beware Of The Lists Of "Top" Funds For 2007

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
January 2, 2007

Beware Of The Lists Of “Top” Funds For 2007

IN THIS ISSUE:

1.  Here Come The New Year’s “Hot Funds” Lists

2.  The Problems With These “Hot” Lists 

3.  The “Drawdown” Dilemma

4.  What About A Portfolio Approach?

5.  Kiplinger’s “WORLD’S Three Best Funds”

Introduction

Happy New Year!!  I hope everyone reading this had a wonderful holiday break – I certainly did.  I also hope that you are rested and ready for another good year in the markets and your investments.  I hope that my articles, analyses and investment suggestions in this E-Letter will make you a better investor.

To kick off the New Year, we will return to a topic I wrote about in my December 5 E-Letter in which I warned you about the flurry of investment articles we would be seeing around the first of the year touting the best mutual funds to own.  I’m already seeing articles in the investment media hailing the “Top” funds to own for 2007. 

In the pages that follow, I will analyze one such article that appeared in late December touting the seven best funds to own now.  It will probably not come as a surprise, but I beg to differ with the author, as most of the funds he recommends are very volatile and have large historical losing periods.  One of the recommended funds has had a drawdown of over 50%, another with a drawdown of over 43%, and another with a drawdown of over 37%.  These are not mutual funds I would recommend to you!

We will also look at the latest mutual fund advice offered in the January 2007 issue of  Kiplinger’s magazine in an article entitled “The WORLD’S three best funds.”  The Kiplinger’s editors tout three international mutual funds, none of which I would recommend to you.

As we so often see with these lists of supposedly hot funds, financial writers tend to look only at the upside performance of the funds they recommend, and pay little or no attention to how volatile these funds are and what kind of losses they incur during bear markets or downward corrections.  Unfortunately, some readers of these “hot funds” articles will take their advice and switch to the recommended funds with no knowledge of how risky they are.

So, let’s take a look at some of the supposedly expert advice that has been offered in the last couple of weeks.

Here Come The New Year’s “Hot Funds” Lists

In my December 5 E-Letter, I discussed how the financial media would soon be awash with lists of hot investments for the New Year.  Well, 2007 has finally dawned and I am already seeing some of the usual New Year investment articles trickle out.  Actually, some even came out before year-end as journalists wanted to get a jump on everyone else with their favorite picks.  Look for more “Top Ten” and “Hot Funds” investment lists this week, but beware.

For example, in the December 12 issue of Fortune magazine was an article entitled “Funds That Mint Money,” with a list of seven mutual funds that the author says are his top choices for 2007.  This same article was reprinted by others including CNNMoney.com in late December.  In an effort at journalistic imagery, the author seems to equate these funds to having unlimited access to the US Mint.  Sadly, some readers will probably blindly follow his advice and rush out to buy these funds.  Don’t say I didn’t warn you!

This article hyping the author’s list of top mutual funds gives me heartburn on several levels.  Let’s start with his byline to the title of the article which reads: The numbers don’t lie.  Here are seven great choices that investors can count on for the long term.”  The first problem I have with this byline is that it is promissory.  Investment Advisors and licensed brokers are prohibited from making promissory statements, much less printing them.  We can only say that investors MAY be able to count on them, or they are POTENTIALLY great choices, but we can’t make such flat-out statements and still comply with regulations.

Why is this so?  Because of that often-seen warning when discussing investment performance – “past performance is not necessarily indicative of future results.”  This means that no matter how good a manager has been in the past, there’s no way to be sure he or she will continue to perform well in the future.  The investment industry has its share of fallen stars, and there’s no way to tell for sure who the next one will be.  That’s true for everyone, even the author of the Fortune article.

This brings up a good point you need to understand.  While Investment Advisors, brokers and others who are registered with the SEC, NASD, CFTC, NFA or other regulatory agencies are prohibited from making promissory statements, and are required to use the “Past performance is not necessarily indicative…” disclaimer, others who are not registered can make all the promissory statements they wish, citing their First Amendment right to do so.  This is true of many journalists active in the financial media.  So be sure to keep this in mind when you read ads or other promotional material. 

This is an important point because some investors think articles published in high-profile magazines and elsewhere are screened by some organization that can reasonably assure that the author(s) knows what he’s talking about.  They are not.  In some cases, such articles may be reviewed to make sure the performance numbers are accurate, but rarely is there any review to insure balance, or that all relevant facts - including risk factors - are covered.

If you get nothing else from this brief discussion, please remember this: Journalists who are not registered can say pretty much anything they want, and their predictions are often nothing more than guesses.  They may be educated guesses, but they are guesses nonetheless. 

The Problems With These “Hot” Lists

The Fortune magazine article I will dissect below is accurate in terms of the performance data for the funds it recommends.  However, in my opinion it is misleading in terms of its lack of discussion about the risk factors associated with the same funds.  Furthermore, the author’s suggestion that these funds will continue to be big winners in the future is strictly his opinion, and may or may not be accurate.  And I would be willing to bet that he’ll have a different list of funds next year!

In the spirit of full disclosure, while this E-Letter is a journalistic piece, I also am in the business of managing money.  Therefore, any time I discuss specific investments, I must include necessary disclosures and disclaimers.  I also have to disclose to you when I am giving you my own personal opinion, and do my best to insure that nothing I say in the E-Letter is misleading.

With that said, let’s take a look at the actual numbers for the seven funds featured in the Fortune article.

The “Drawdown” Dilemma

My second problem with Fortune’s “Mint Money” article is that the author failed or chose not to include any information about the losses – or “drawdowns” – incurred by the mutual funds he recommends.  As regular readers of this E-Letter know, I consider the historical drawdowns of any investment to be just as important as the upside performance.  So I will include the drawdown information on the seven funds in the Fortune article for you below.  Prepare to be surprised!

With today’s computer technology, it is possible for virtually any journalist (or individual for that matter) to get access to tons of mutual fund information, and then slice and dice it any way they want.  They can get top performing funds in virtually any sector, asset class, expense range, brokerage availability, manager tenure, etc., etc.  However, just because a fund lands on the top of the heap in some screening software for some limited timeframe, that doesn’t mean “investors can count on [them] in the long term,” as the Fortune author suggests.

As I noted in my December 5 E-Letter, the “maximum drawdown” of a mutual fund or a money manager is an important consideration when evaluating these investments.  Just as a reminder, the “maximum drawdown” is simply the greatest losing period from a high peak value to a subsequent low. 

To use a stock index as an example, the S&P 500 Index reached a peak value in March of 2000.  From there, the value of the Index dropped until reaching its low point in September of 2002.  Over that period of time, the S&P 500 Index experienced a drawdown of over -49%, and has yet to make it back to break-even. 

That’s right, it has been more than six and one-half years since the S&P 500 Index hit its peak value of 1527.46 in March of 2000, and investors in mutual funds based on that Index are still waiting to break even – if they haven’t already given up and moved to cash or some other investment.

Now, let’s look at the drawdowns for the funds recommended in the Fortune article.  The table below shows the name of the fund, its average annualized return over the 10-year period referenced in the article, and its worst-ever drawdown:

Fund Name 10-year Avg.
Annual Return
Worst Drawdown
American Century Equity Income 12.69% -16.67%
Excelsior Mid Cap Value & Restructuring 12.69% -26.93%
Pennsylvania Mutual 14.44% -22.64%
T. Rowe Price Capital Appreciation 12.30% -14.70%
Fidelity International Discovery 11.14% -43.12%
Vanguard International Value 9.14% -37.76%
T. Rowe Price Emerging Markets 11.28% -50.24%

As you can see, some of the funds are better than others and, in fact, one of the funds is included in our Absolute Return Portfolios program.  Yet, others leave a lot to be desired from a drawdown standpoint.  Do you think it is important to know that a mutual fund lost over 30% or 40% or more of its value at some point in the past?  I do!

What about a 50% drawdown?  That’s exactly what you would have gotten if you invested in the T. Rowe Price Emerging Markets Fund during this period.  Of course, emerging markets funds are, as a general rule, very risky and are usually appropriate only for aggressive investors, but oops, the Fortune author forgot to mention anything about this fund’s risk category in his article!

As you can see in the table above, the inclusion of the worst drawdown data paints a starkly different picture of the funds the Fortune article recommends.  In all seven of the funds the author recommends, the worst drawdown is higher than the average annual return.  In the last three funds in the list, the worst drawdown is apprx. four times higher than the average annual return.  These three funds would NOT make it onto my recommended list!  In fact, there is only one fund in the list above that I recommend.

On the cover of my Absolute Return Special Report, I quote Warren Buffet, who said:

“The first rule of investment is don’t lose.  And the second rule of investment is don’t forget the first rule.  And that’s all the rules there are.”

It’s clear that Buffet understands the concept of drawdowns as they relate to investment losses.  My own experience over three decades of advising clients echoes his sentiments.  I have found that investors start to long for the safety of cash whenever their month-end drawdowns get close to 10%.  As drawdowns increase, more and more investors tend to head for the exits.

All of this is to say that, in my opinion, evaluating a mutual fund, or any other investment, without looking at its historical drawdowns is imprudent. 

What About A Portfolio Approach?

At this point, some of you may be thinking that the Fortune author meant for investors to consider these funds as a part of a portfolio, rather than as individual funds.  To be fair, he does mention that the funds are a “portfolio designed to help the buy-and-hold investor help himself,” but offers no further discussion.  Does he mean that investors should choose a fund or two from his list, or does he mean all of the funds should be combined into a single portfolio?  Unfortunately, he doesn’t say.

Even if we assume he means that the funds should be combined into a portfolio, should each fund be given equal weight, or should different percentage allocations apply?  What about the risk tolerance of the investor?  Should that be taken into account?  Again, the article is silent.

To see how these funds would have performed as a combined portfolio, my staff combined six of the funds into a single portfolio.  We used just six because the article mentioned two very similar international funds, so we just used one of them.  Each fund was given an equal weighting in the original portfolio, but we did not rebalance the portfolio after that.  With significant allocations to small-cap, mid-cap, international and emerging market funds, I would consider this to be an aggressive portfolio.

The combined portfolio bears this out, as the 10-year average annual return was 13.04%, but with a worst drawdown of almost -20%.  We then looked at other drawdowns experienced by the portfolio, and saw that there was another loss of over 18% and still another over 12%, all since 1998.  To me, this means even a portfolio of these funds would be consistently at risk for double-digit drawdowns over time.  This is why I would not recommend a portfolio of the funds in the Fortune article.

Kiplinger’s “WORLD’S Three Best Funds”

Kiplinger’s is a wide-circulation investment magazine you can find on most any newsstand, including most large grocery stores.  I happen to like Kiplinger’s, and they put out some good information.  In their January 2007 issue, however, they fail to provide adequate risk information on the latest funds they recommend, at least in my opinion.

To begin with, Kiplinger’s seems to believe that international stocks will outperform US domestic stocks in 2007.  They aren’t alone in that view, although I personally do not share that position.  It will not surprise me if US stocks outperform most international stocks again in 2007, but that is not the point I wish to make here.

Since Kiplinger’s believes that international stocks will be the big winners in 2007, they offered a list of  “The WORLD’S Three Best Funds” with absolutely no discussion of risk factors or drawdowns!  Here are the three international mutual funds they tout:

Dodger & Cox International Stock
Julius Baer International Equity II A
Artisan International

Once again, when we look at the drawdowns, these are NOT funds I would recommend, even for more aggressive investors.  Let’s look at the numbers.

Dodge & Cox International Stock Fund has only been around since 2001 but has some very sexy numbers on the surface.  According to Morningstar, Dodge & Cox International has an average annual return of 18.39% for the period from 2001 to November 2006.  Very nice!  However, the same fund had a worst drawdown of –31.33% from May 2002 to March 2003.  Yet Kiplinger’s describes this fund as “rock-steady.”  I don’t think so!

Artisan International Fund looks good, too, on the surface.  According to Morningstar, Artisan International has an average annual return of 17.42% for the period from 1996 to November of 2006.  Once again, very nice!  However, the same fund had a worst drawdown of –55.89% from February 2000 to March 2003 during the bear market, and another drawdown of –23.63% in 1998.  Yet Kiplinger’s describes this fund as a “perfect match” to go along with Dodge & Cox. 

On first glance, the Julius Baer International Equity II A seems the strangest choice of all three.  This fund has only been open two years, and thus has a very short track record.  My guess is that the Kiplinger editors chose this fund as it appears to be a clone of the Julius Baer International Equity I fund which has been around since 1999, but is closed to new investment.  Both funds have the same investment strategy.

Since JB International Equity I has the longer record, let’s take a look at it.  According to Morningstar, JB International Equity I has an average annual return of 13.44% for the period from 1999 to November of 2006.  Also very respectable.  However, the same fund had a worst drawdown of –42.09% from February 2000 to March 2003 during the bear market.

Unfortunately, Kiplinger’s failed to provide its readers with any of the drawdowns noted above.  I’m sure some people read that article and will rush out to buy those funds, not knowing that they are quite volatile and have had very large drawdowns in the past.

Conclusions

As I noted in my December 5 E-Letter, it is best to ignore the flood of “hot performers” or “top 10 funds” lists that always come out this time of year, as the authors of these articles rarely include enough information to help you determine whether the risk factors associated with their chosen “hot” funds are suitable for your personal financial situation.

While the Morningstar database is considered the “Gold Standard” for mutual fund research, you need to remember that it is merely a tool, and not an Investment Advisor.  Just because you own a set of wrenches doesn’t mean you’re ready to do all of your own car repairs.

The same goes for the financial media.  Fortune and Kiplinger’s are respected members of the financial media, and I like much of their work.  However, I used these two particular articles to point out to you that journalists can make broad, general statements that licensed securities brokers and Registered Investment Advisors cannot. 

Remember that when you’re tempted to take action in response to a financial news article’s glowing endorsement.  Journalists are under pressure to come up with new thoughts and ideas on a regular basis, so the same author may recommend something entirely different next year or even next month.  They’re almost always chasing the latest hot funds.  I call it the Mutual Fund Merry Go-Round!

At my company, we have a completely different approach to selecting mutual funds.  We look for funds that have delivered consistent results with limited drawdowns in the past.  If you would like more information, check out our Absolute Return Portfolios on our new website www.halbertwealth.com or call us at 800-348-3601.

And remember, regardless of what the investment writers may say, past performance is not necessarily indicative of future results.

Wishing you a happy & profitable New Year,

Gary D. Halbert

SPECIAL ARTICLES

Democrats to tackle modest proposals
http://www.latimes.com/news/nationworld/world/la-na-congress2jan02,0,3069119.story?coll=la-home-headlines

UN chief must clean up mess Annan left
http://www.nydailynews.com/news/ideas_opinions/story/484900p-408276c.html

Hillary & Nancy – A tale of 2 women
http://www.pittsburghlive.com/x/pittsburghtrib/opinion/columnists/zito/s_486317.html


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Forecasts & Trends E-Letter is published by ProFutures, Inc. Gary D. Halbert is the president and CEO of ProFutures, Inc. and is the editor of this publication. Information contained herein is taken from sources believed to be reliable but cannot be guaranteed as to its accuracy. Opinions and recommendations herein generally reflect the judgement of Gary D. Halbert (or another named author) and may change at any time without written notice. Market opinions contained herein are intended as general observations and are not intended as specific investment advice. Readers are urged to check with their investment counselors before making any investment decisions. This electronic newsletter does not constitute an offer of sale of any securities. Gary D. Halbert, ProFutures, Inc., and its affiliated companies, its officers, directors and/or employees may or may not have investments in markets or programs mentioned herein. Past results are not necessarily indicative of future results. Reprinting for family or friends is allowed with proper credit. However, republishing (written or electronically) in its entirety or through the use of extensive quotes is prohibited without prior written consent.

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