"Buy-And-Hold" Bites The Dust - Now What?

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
November 11, 2008

IN THIS ISSUE:

1.  Economic Overview

2.  The Conventional Wisdom Was Wrong

3.  The Shortcomings Of Index Investing

4.  Are Low Fees The Key To Investment Success?

5.  Risk Management Is Crucial

Introduction

In the newsletter business, it’s rewarding to see market action reinforce the advice you have been giving in your publication.  Ever since I started writing this E-Letter, I have warned of the perils of passive “buy-and-hold” investing in general, and “index investing” in particular.  While adherents to these strategies like to trot out long-term charts and graphs supporting their case, I have always warned that passive investing can result in major losses at just the wrong time from the investor’s perspective.

However, I have to admit that being right rings hollow in the aftermath of the carnage we have seen in the US stock market since its peak in October of 2007, and especially over the last month or so.  It is estimated that over $8 trillion of investor value has been lost in the US equity markets since then, and no one knows how long the bear market may continue.  Many Baby Boomers are now realizing that their passive investments have incurred huge losses at a time when capital preservation is far more important to them.

How did we ever get to the point where buy-and-hold became investment gospel?  It’s as if investors were convinced that it’s OK to stay on the track and get hit by an oncoming bear-market train, since a bull-market train going the other direction would soon bring them back to where they were before, and eventually higher over the long term.  Yet it has always made sense to me to step off the tracks (go to cash or hedge) to avoid oncoming trains altogether.

Many investors are now feeling as if their portfolios have been hit by a train and it’s uncertain if and when one going the other direction (bull market) may come along.  Since many of the highest investment balances were held by Baby Boomers nearing retirement, it’s an even worse train wreck because they lack the lengthy time horizon that may be necessary for the market to regain recent large losses.

This week, I’m going to revisit the issue of passive investing, and especially index investing.  I’ll discuss why I think they became so popular, and why I continue to recommend actively managed programs that have the potential to reduce risk during market meltdowns.  First, however, I’m going to give you an overview of the latest economic forecasts I am seeing.  Let me warn you, the news is not good. 

Economic Picture Getting Darker

Every economic forecasting group that I read has downgraded its predictions over the last few weeks in light of the plunge in the global equity markets in October.  As noted last week, 3Q GDP was estimated at -0.3% (annual rate), and that estimate is likely to be downgraded later this month.  Most forecasters are now predicting that 4Q GDP will be down at least 1-2%.

While forecasts earlier in the year suggested that the economy would rebound to positive growth in the second half of next year, such forecasts have all but disappeared.  Now, there is a general consensus that the US economy will be negative for at least several more quarters to come.  Specifically, that this will be the worst recession since the Great Depression.  All of the sources I trust believe that it will take several years to work out of this financial crisis.

It remains to be seen if the stock markets have seen the bottom.  In any event, most forecasters I respect believe that once the stock markets have bottomed, they will move into a broad, multi-year trading range.  No one I respect is predicting a “V” bottom or a quick return to a bull market.

This is precisely why we need to revisit the problems associated with passive, buy-and-hold investment strategies.  These strategies got killed over the last year, especially the last month or so, and are not designed to do well in a broad trading range, which could persist for the next several years.  Fortunately, there are alternatives.

The Conventional Wisdom Was Wrong

The basics of passive investing are relatively simple.  You put your money into a diversified portfolio, usually based on “asset allocation” strategies, and leave it there during good and bad market cycles.  Armed with reams of historical data, the conventional wisdom was that including multiple asset classes in a portfolio would protect investors during all types of market conditions.  While changes are made periodically to rebalance allocations or adjust for advancing age, the portfolio is largely a “set it and forget it” instrument, so the theory goes.

The historical data also suggested that most hands-on mutual fund managers were not adding value above and beyond what the broad market indexes could provide, so mutual funds tied to various market indexes were developed to offer a low-cost alternative to actively managed mutual funds.  However, back in December 2005, I wrote an E-Letter about the potential drawbacks of passive index investing:

"'Index investing' is growing like wildfire among investors today…And it’s no wonder why.  The allure of a simple, low-cost investment strategy tied to market indices that have been shown to grow over long periods of time sounds irresistible…The main problem is that Wall Street’s ad machine is only telling half of the story.  They often use historical time periods that are far longer than what most people have to invest, and they also fail to disclose how much an investor might lose in a bear market or major correction.” 

To illustrate, during the 2000 – 2002 bear market, the S&P 500 Index lost over 44% of its value, and the Nasdaq Composite fared even worse, losing over 75%!  Unfortunately, however, neither investors nor Wall Street learned a lesson about how fickle the market can be, and at the worst possible times.

Thus, even with those huge 2000 – 2002 market losses fresh on their minds, investors still flocked to index investing as if there would never be another bear market or correction.  I think there were several reasons for this, including:

  1. Having just been through a major bear market caused some of them to think that the worst was over, and that the market would now over-perform in order to get back to historical long-term averages.  Unfortunately, they failed to study history, which shows that, since 1952, bear markets have occurred an average of once every five or so years, so we were actually due for a bear market.

    The market’s action during 2003 through 2006 seemed to confirm index investors’ convictions that happy days were, indeed, here again.  The S&P 500 Index gained 28.68%, 10.88%, 4.91% and 15.79% in 2003 through 2006, respectively.  This annualized return of 14.74% over those four years compared favorably to the 10% to 12% touted as the long-term average stock market return, so “reversion to the mean” became the watchword of the day.

  2. Though 2007 saw the first warnings of the subprime crisis, the Dow and S&P 500 market indexes still managed to hit all-time record highs in October of 2007.  Investors were convinced that this, too, shall pass and stayed invested.

  3. The bear market of 2000 – 2002 also claimed another victim, and that was the average mutual fund manager.  Unfortunately, all active management strategies seemed to be lumped into the same category by the financial media and Wall Street firms.  No difference was made between an active mutual fund manager and specialized strategies such as market timing, sector rotation, long/short or a variety of other active management techniques.  Wall Street even promoted flawed statistics to support their point, as I noted in my June 21, 2005 E-Letter.

  4. Investors were subjected to so many different investment opinions and theories that many of them just didn’t know which way to turn.  They were paralyzed by all of the conflicting information out there.  I call it “information overload.”  Thus, they chose the option that seemed to be the simplest, plus it was supported by Nobel Prize Winning theories.  How could they possibly go wrong?

  5. Since most index investing used asset allocation strategies based on the work of Nobel Laureate Dr. Harry Markowitz, many investors felt that using multiple asset classes including bonds and international investments would protect them in a bear market.  Another big plus was that the financial services industry found Markowitz’s theories relatively easy to incorporate into computerized portfolio modeling programs, resulting in highly effective proposal presentations.

    Unfortunately, we have learned that the subprime crisis spared no asset class as it ravaged global stock and bond markets.  The traditional correlation among asset classes broke down, which is often the case in severe bear markets.

  6. Finally, fees became one of the major selling points of passive index investing, especially among the financial media (more about this later on).  I now find it interesting that some members of this same financial media are now declaring that “buy-and-hold is dead.”  How convenient to be able to change your story to fit the times.

Over the course of my 30-plus-year career in the investment business, I have found that most investors’ goals are very simple.  They want to put their money into investments that are: 1) reasonably safe; 2) have the potential to earn a reasonable rate of return; and 3) will not suffer large losses along the way.  While these goals are relatively simple, how you invest to achieve them is not a simple process.

However, the investment industry is always willing to create products to fill investor demands, some of which are based on the conventional wisdom of the day.  For those wanting a simple solution, the financial services industry created a number of different “one-size-fits-all” investment products, with index investing being one of the most popular. 

They even created “target-retirement” and “lifestyle” funds that incorporated asset allocation so that investors need only know the year they wanted to retire in order to select the “right” investment.  I guess you could call this the ultimate in conventional wisdom portfolios.

Chinks In The Index Investing Armor

Before I discuss some of the arguments against index investing, let me say that I am a big fan of both index mutual funds and ETFs.  I feel that the ability to “buy the index” has changed the investing landscape in a number of positive ways, though I don’t always agree with proponents of buying and holding index funds.  Several of the Advisors whose programs I recommend use index mutual funds to facilitate their active management strategies, so I am a big fan.

That being said, I have often advised against combining index funds and asset allocation programs as the sole investment strategy in an investor’s portfolio.  The reason for this is within the passively managed nature of the index fund.  Index funds, by their very nature, will not exit positions and move to cash during bear markets or downward corrections.  An index fund will follow its underlying index, even if it dives right into the dirt (or gets hit by a train).

Index fund proponents say that this is no problem - just diversify among a variety of index funds covering various stock and bond asset classes, and everything will be OK in the long run.  I can best illustrate this strategy using an investment offer I once received from a financial Advisor back in 2005.  While the information is somewhat dated, the shortcomings are the same today as they were then.

The Advisor recommended only “index” funds allocated among a variety of selected funds based on traditional asset allocation principles.  The Advisor went on to illustrate the performance of a set of index funds over a 25-year period of time from 1979 through 2004.  The performance was excellent, especially as compared to fixed rate investments like CDs and fixed annuities.

The Advisor’s implication was clear: the market indexes will do well over long periods of time, so all you need to do is invest in his special blend of index funds and you’ll be just fine.  Since the time period included returns during the bear market of 2000 – 2002, it would seem that his argument would have been fair, right?

Sorry, but I’m still not convinced.  Here are just a few of the fallacies of this Advisor’s argument, in my opinion:

  1. It assumed the next 25 years will be the same as the last 25 years. Let’s see, did 78 million Baby Boomers retire in the last 25 years?  Were we afraid of terrorist attacks on our major financial centers prior to 2001?  Will Medicare and Social Security costs be the same percentage of government spending in the next 25 years as they were in the last 25 years?  And, of course, had we experienced a housing and subprime mortgage crisis resulting in a global credit crunch, massive Wall Street bailouts and a stock market meltdown?  (Hint:  “NO” is the appropriate answer to all of these questions.)

  2. The 25-year time period cited as an example doesn’t necessarily correspond to any individual investor’s actual time frame.  What if an investor’s time frame had them needing their money for retirement in September of 2002 at the bottom of the bear market?  I doubt index investing would have met with much praise at that point in time.  Fast forwarding to the present, what if a retiree needs money NOW?

  3. It doesn’t hurt your argument when you choose a 25-year period that just happens to include the longest bull market in history, along with a stock market bubble in the go-go 90s.  Let’s roll the clock on back a bit.  What if we chose a period of time from 1966 through 1982?  Over this 16-year span of time, the stock market went nowhere

    Even Vanguard’s John Bogle, the father of index investing, has pointed out that “each and every comparison we see is period-dependent.”  This means that the time period you choose can greatly affect the outcome of your analysis.  I have written about this before, but it is especially important in regard to index investing. 

  4. Finally, historical analysis of stock market returns does show that stocks increase in value over long periods of time.  Yet, there are many shorter periods in which stocks do poorly, or even lose money.  Investors are often confronted with glossy charts and graphs illustrating stock market performance data over 25 years, 50 years and even 75 years.  Yet, few people trying to make investment decisions today have a 50 or 75-year time horizon! 

    Let’s look at the timelines.  The youngest of the Baby Boomers are now nearing age 45, at which time they will have 20 years until retirement at 65.  A 50-year-old has only 15 years, and at 55, you’re looking at only a decade to accumulate wealth.  Are there lots of 10-year periods during which the major market indexes did poorly?  You bet there are, and we’re in one of them right now!

So, you have to ask yourself, what historical 10-year period will the next 10 years be like?  Don’t know?  Neither do I, and neither do economists, financial planners, mutual fund managers, or anyone else.

Because of these shortcomings, I continue to believe active management strategies with a historical track record of having provided reasonable returns with reduced risks are more appropriate for many investors than buy-and-hold index investing.  Some of the financial media are now agreeing with me, but where were they in 1995 when I first began to recommend these active management strategies to my clients?

Do Low Fees = Good Investments?

One facet of investing where the index proponents have been successful is that of fees.  Many investors will automatically reject any investment with expenses greater than those of an index fund.  They have bought into the idea that active management doesn’t pay, so they are not willing to pay higher fees for the expertise of an active manager.  They use fees as a simple way to eliminate alternatives from their investment radar screen.

Unfortunately, this simple criterion can eliminate many qualified alternatives.  After all, do you drive the least expensive car?  Why not?  Don’t all cars offer you a mode of transportation?  Do you shop for the least expensive doctor, lawyer or dentist?  Those who do many times find out exactly why they charge fees below the going rates. 

The important thing is not always what fees are being charged, but how the investment program has performed net of all fees and expenses.  Many people will pay more for a product or service if they can see, hear, or feel added value, and investments should be no different. 

Now, however, the focus on low fees is coming back to haunt many investors.  For example, the Vanguard S&P 500 mutual fund has one of the lowest fees around, at only 0.15%, but according to the Vanguard website, this fund had a year-to-date loss of 32.87% as of the end of October.

At the same time, the Niemann Equity Plus Program that I have featured in this E-Letter had a year-to-date loss of only 10.85%, net of Niemann’s 2.3% annual fee.  Would you pay an additional 2.15% fee to shave over 22 percentage points off of your losses right now?  I’ll bet you would!  (Past performance is not necessarily indicative of future results.  Niemann’s October 2008 performance is an estimate and may vary.  Be sure to see Important Notes at the end of this E-Letter.)

It gets even better – since the inception of the Niemann Equity Plus program in November of 1996, it has produced an annualized return of 12.25%, again net of all fees.  Over the same period of time, the Vanguard S&P 500 Index mutual fund has produced an annualized gain of only 4.32%, also net of fees.  Again, the lower fee alternative produced an inferior return to the higher-fee actively managed program.  Of course, there are no guarantees it will always do so.

Obviously, we have other programs that have higher and lower returns than the Equity Plus Program, but this comparison does show that relying on fees alone can be detrimental to your investment returns, even in comparisons spanning over a decade.  Of course, there are no guarantees.

Finally, there are some financial services companies that extol the virtues of low fees to “retail” investors, while at the same time offering hedge funds to their wealthy clients.  As you probably already know, hedge funds carry some of the highest fees of any investment vehicle. 

So, if high fees are such a bane on the investment industry, then why have wealthy individuals flocked to hedge funds as never before?  The answer is that there are some (albeit few) money managers who are able to provide value over and above their fees in the form of consistent risk-managed returns.  This is the type of money manager we look for to recommend in our AdvisorLink® Program.

What About Risk Management?

As I noted above, many investors seek investments that are: 1) reasonably safe; 2) have the potential to earn a reasonable rate of growth; and 3) will not suffer large losses along the way.   My biggest problem with index investing is that it can fail all three of these tests, and the recent market meltdown is a good case in point.

On the first issue of safety, you could say that index investing passes this test in one sense because there is little likelihood of losing money through embezzlement or fraud.  However, safety can mean more than protection from fraud.  One example is in regard to a type of mutual fund that has been getting a lot of attention lately.  There are some new index funds that allow investors to “short” the market, or participate in a fund that generates double the movement of the underlying market through 2-to-1 leverage.

As the stock market has been hit by loss after loss, these funds are looking very attractive.  Investors who have moved to these funds brag of outsized performance, and will continue to do so as the markets continue to go down.  However, when the markets do turn around, the leverage and short position will begin to work against the investor.  And since much of the gain is concentrated in the early days of a new bull market, losses could be big and quick.

Thus, while the ability to short the market and use leverage offer a lot of flexibility, they can also offer a lot of additional risk.  Unless managed by a competent professional using a disciplined strategy, I consider participation in leveraged and short funds little more than gambling.  You might win big, but you can lose just as big, and may never be able to recover your losses.

As for the second test of the potential to earn a reasonable rate of growth, index investing proponents would say that index funds pass this test with flying colors, considering the historical long-term return of the stock market.  However, as I have shown in this article, stock market returns are very period-dependent.  The shorter your investment time horizon, the better the chance that index funds will provide results below their long-term average.  In fact, there have been examples in the past where the stock market has gone virtually nowhere for 10, 15 or even 20 years.

On the final qualification that the investment program not suffer large losses along the way, index investing fails miserably.  Since there is no active management of the underlying portfolio, the investor is destined to rise and fall with the markets.  During the past bear market of 2000 – 2002, the major market indices had some tremendous drawdowns in value, with the S&P 500 losing over 44% of its value, and the Nasdaq Composite Index losing over 75%! 

In the current bear market, drawdowns have not yet accumulated to the low points experienced during 2000 – 2002, but they are very close.  As this is written, the S&P 500 Index is approximately 40% below its October 2007 peak.  The last bear market drawdown bottomed out in September of 2002, so that’s two 40% drawdowns in six years.  No wonder many retirees are saying they’re “done” with the stock market.

My staff and I have personally talked to a number of investors who needed their money for retirement during this time, only to find that a large part of their investments’ values had vanished into thin air.  Even if I were sold on the value of index investing over the long haul, I would still not recommend it to my clients simply because of this last shortcoming.

Conclusions

I would like to believe that the latest market mayhem will spell the end of one-size-fits-all index investing, but I know better.  Wall Street has sunk far too much money into literature and software to let the concept die a peaceful death.  Just as we saw index investing take off after the 2000 – 2002 bear market, I expect to see it marketed heavily once the market starts to come back from the current low point.

Oh yes, some of the marketing material will be changed to reflect the subprime debacle, but I will bet that the industry will attempt to explain the current market malaise away by saying it’s a “market aberration” that won’t happen again because of improved regulatory scrutiny that is almost certain to come.  Thus, Wall Street will attempt to skip over this bump in the road and do what they do best – marketing.

One of the primary reasons I agreed to write this weekly E-Letter in the first place was the hope that I might be able to make a difference by countering some of the expensive marketing efforts launched by the major Wall Street firms and large mutual fund families.  In this way, I can share some of the insights I have been able to gain from my 30+ years in the investment industry.  To that end, I hope that I have provided some information this week that will help you resist the siren song of index investing in the future.

Through the years, many of my readers have sought out some of the investment programs my company offers, but many have not.  While I’m the first to admit that some of our programs did a better job of limiting risk than others, almost all have been successful in holding risks to less than those of the S&P 500 Index, which is what they are designed to do.  Plus, we have a couple of programs that have actually made money during the down market.  Past performance, however, cannot guarantee future results.

If you are among those who have put off checking out our risk-managed investment programs, perhaps the current market meltdown will convince you it’s time to take a look.  Just give one of our Investment Consultants a call at 800-348-3601 or complete our online information request form.   You can also find out more about these programs and the strategies they employ on our website at www.halbertwealth.com

Wishing you a market bottom,

Gary D. Halbert

SPECIAL ARTICLES:

The Death of Buy and Hold
http://www.cnbc.com/id/27651174

The Specter of Deflation
http://www.realclearpolitics.com/articles/2008/11/the_specter_of_deflation.html

What lower oil prices mean for the world
http://www.ft.com/cms/s/0/5c238848-af5d-11dd-a4bf-000077b07658.html?nclick_check=1

IMPORTANT NOTES:  Halbert Wealth Management, Inc. (HWM) and Niemann Capital Management, (NCM) are Investment Advisors registered with the SEC and/or their respective states. Some Advisors are not available in all states, and this report does not constitute a solicitation to residents of such states. Information in this report is taken from sources believed reliable but its accuracy cannot be guaranteed. Any opinions stated are intended as general observations, not specific or personal investment advice.  Please consult a competent professional and the appropriate disclosure documents before making any investment decisions. There is no foolproof way of selecting an Investment Advisor. Investments mentioned involve risk, and not all investments mentioned herein are appropriate for all investors.  HWM receives compensation from NCM in exchange for introducing client accounts to the Advisors.  For more information on HWM or NCM, please consult HWM Form ADV Part II, NCM Form ADV Part II and Niemann’s Annual Disclosure Presentation, 2007, available at no charge upon request.  Any offer or solicitation can only be made by way of the Form ADV Part II.  Officers, employees, and affiliates of HWM may have investments managed by the Advisors discussed herein or others.

As benchmarks for comparison, the Standard & Poor’s 500 Stock Index, the Vanguard S&P 500 Index and the NASDAQ Composite Index (which include dividends) represent an unmanaged, passive buy-and-hold approach.  The volatility and investment characteristics of the S&P 500, the Vanguard S&P 500 Index and the NASDAQ Composite Index may differ materially (more or less) from that of the Advisor.  The performance of the S & P 500 Stock Index, the Vanguard S&P 500 Index and the NASDAQ Composite is not meant to imply that investors should consider an investment in the Niemann trading program as comparable to an investment in the “blue chip” stocks that comprise the S & P 500 Stock Index and the Vanguard S&P 500 Index, or the stocks that comprise the NASDAQ Composite.  Historical performance data is provided by the Advisor in compliance with the Global Investment Performance Standards (GIPS), except for the month of October 2008, which is an estimate which has not been verified for GIPS compliance.  The actual final performance number for October 2008 could change significantly from the estimate.  See the Annual Disclosure Presentation, 2007 for more details on GIPS performance.  Statistics for “Worst Drawdown” are calculated as of month-end.  Drawdowns within a month may have been greater.  PAST RESULTS ARE NOT NECESSARILY INDICATIVE OF FUTURE RESULTS.  Any investment in a mutual fund carries the risk of loss. Mutual funds carry their own expenses which are outlined in the fund’s prospectus.  An account with any Advisor is not a bank account and is not guaranteed by FDIC or any other governmental agency.

When reviewing past performance records, it is important to note that different accounts, even though they are traded pursuant to the same strategy, can have varying results.  The reasons for this include: i) the period of time in which the accounts are active; ii) the timing of contributions and withdrawals; iii) the account size; iv) the minimum investment requirements and/or withdrawal restrictions; and v) the rate of brokerage commissions and transaction fees charged to an account. There can be no assurance that an account opened by any person will achieve performance returns similar to those provided herein for accounts traded pursuant to the Niemann Equity Plus trading program.

In addition, you should be aware that (i) the Niemann Equity Plus trading program is speculative and involves risk; (ii) the Niemann Equity Plus trading program’s performance may be volatile; (iii) an investor could lose all or a substantial amount of his or her investment in the program; (iv) Niemann will have trading authority over an investor’s account and the use of a single advisor could mean lack of diversification and consequently higher risk; and (v) the Niemann Equity Plus trading program’s fees and expenses (if any) will reduce an investor’s trading profits, or increase any trading losses.

Returns illustrated are net of actual management fees, custodial fees, underlying mutual fund management fees, and other fund expenses such as 12b-1 fees.  They do not include the effect of annual IRA fees or mutual fund sales charges, if applicable.  All dividends and capital gains have been reinvested.  Performance is based on actual fee-paying, fully discretionary accounts in a composite.  Individual account performance may differ from the composite.  No adjustment has been made for income tax liability.  Some Funds also charge short-term redemption fees and excess transaction fees (Special Fees), which are billed to shareholders at the time of the event causing the fee.  All of these fees are in addition to Niemann’s advisory fees.  In selecting Funds in which to invest, Niemann considers the nature and size of the fees charged by the Funds.  Niemann will select a Fund only if Niemann believes the Fund’s performance, after all fees, will meet Niemann’s performance standards.  Consequently, Niemann may select Funds, which have higher or lower fees than other similar Funds, and which charge Special Fees.  When deciding whether to liquidate a Fund position, Niemann will take into consideration any Special fees which may be charged.  Niemann may decide to sell a Fund position even though it will result in the client being required to pay Special Fees.  Money market funds are not bank accounts, do not carry deposit insurance, and do involve risk of loss.  The results shown are for a limited time period and may not be representative of the results that would be achieved over a full market cycle or in different economic and market environments.


Read Gary’s blog and join the conversation at garydhalbert.com.


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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