Buy High, Sell Low, Pro Edition

February 4, 2010

January was the first real down month since the market recovery began on March 9, 2009. In January, an investment in the Vanguard 500 Index Fund (VFINX), which owns the stocks in the S&P 500 and includes dividends along with (ultra low) fund expenses, would have returned a negative 3.6%. The only other interruption during the strong comeback was a 1.87% drop in October 2009.

Despite this relatively minor pullback, Vanguard 500 is still up more than 60% from the March 9th low. This spectacular run from the brink of disaster still leaves investors down around 30% below the fund's all-time high in 2007. That means those with a 100% allocation to the S&P 500  need the index to rise over 40% to get back to their peak value. 

As we noted in our last performance summary, most of our model portfolios ended 2009 at all-time high values – no need to wait for another 40% miracle.

Much of our returns came from buying good funds in out-of-favor fund categories. The rest came from increasing our allocation to stocks when the market was weak and cutting back when it was strong.

There have been ample opportunities over the last decade to buy fund categories that were cheap (relative to the broad U.S. stock market) and earn outsized returns during a period in which stocks essentially went nowhere. Since we launched the model portfolios during the last bear market eight years ago, we’ve owned REITs, utilities, emerging market stocks and bonds, micro caps, small caps, foreign stocks, junk bonds, and energy and natural resource stocks, among others. 

We may not see as many fund categories priced to beat the broad U.S. stock market by a wide margin over the next eight years, but we are buying the ones we think can do it. That's because U.S. stocks didn’t really "go nowhere" over the "lost decade"…they just went from really, really expensive to somewhat fairly valued. 

The only way the next decade will stink is if the economy goes nowhere or stocks go from fairly valued to really, really cheap, like they were in, say, 1982. Stranger things have happened. 

Since more of our gains may come from shifting our overall stock allocation at appropriate times, we want to point to a big danger in investing…bad timing.

Bad timing is a recipe for underperformance. That's why many experts recommend sticking with a permanent allocation to stocks and bonds in an index. Although we're not against this strategy (especially compared to the alternative: chasing hot funds and then selling them after they crash,) we try to get a leg up on the "Buy and Holders" by avoiding the crowd of investors that increase their stakes on the way up and sell on the way down.

For years, we’ve poked fun at the unwashed fund investing masses who buy high, sell low, and underperform benchmarks. But that doesn't mean "professionals" are much better at market timing. As a matter of fact, we just noticed a slipup by one of the biggest and best timers around — Mellon Financial.

Founded in 1983, Mellon Capital Management Corporation merged with Bank of America in 2007, and is now part of BNY Mellon. The firm describes itself as "a leader in asset allocation and quantitative investment strategies, with a history of innovation in portfolio management.” As a measure of its global success, the Bank of New York Mellon claims $22.3 trillion in assets under custody or administration and $1.1 trillion under management. Mellon Capital themselves manages $178 billion directly.

About $8 billion of that $178 billion is in the Vanguard Asset Allocation Fund (VAAPX). Mellon has managed the fund since its inception in 1988.

Vanguard Asset Allocation is a cheap way to get a good basic asset allocation between U.S. stocks, bonds, and cash (Treasury bills). The managers don’t pick stocks so much as they switch the mix between the three broad asset classes. At 0.39%, the fees for this service are cheap compared to most actively managed funds. Yet these fees are more than double what you could achieve switching up your own mix between Vanguard 500 (VFINX), Vanguard Long-Term US Treasury (VUSTX), and a Vanguard money market fund.

Unlike most balanced funds and target retirement funds, the mix is not fixed at, say, 60% stocks, 30% bonds, and 10% cash. The managers can increase the stock allocation if they think stocks are cheap, or pull back if they think stocks are expensive (sort of like what we do here, only we also choose fund categories we expect to outperform).

Unlike most market timers (although Mellon reps might call themselves asset allocators, they are essentially timing the market by choosing when to be heavy or light in stocks or bonds,) Mellon has done a very good job. Until recently. 

Mellon decided stocks were cheap in the late stages of the bull market in 2008; so cheap, in fact, they went all in with VAAPX. They shifted their allocation to 100% stocks. No cash, no bonds. Although the fund used bonds in 2005-2007 to beat the S&P 500 by a small margin each year, the shift to 100% stocks led their 2008 return to essentially mimic the S&P 500 in 2008, down 36.39% compared to Vanguard 500’s 37.02% drop. Sadly for investors, 2008 was a great year to be in Treasury bonds. Vanguard Long Term U.S. Treasury was up 22.51% in 2008. A fund equally weighted in each would have suffered only a mild drop. 

If the story ended there, it wouldn’t be that noteworthy. Good market timer gets sucked into buying the stock market dip that began in 2007, relying on the quantitative models that stocks were way cheaper than the "bubble" in Treasury bonds, only to learn stocks would fall far lower than most professionals ever imagined – over 50% from peak to trough – and that interest rates on government bonds would go ever lower, pushing prices much higher. It was a mistake many experts made.

But somewhere along the way, Mellon decided to increase their allocation to Treasury bonds and cut back on stocks. Apparently stocks, which were "cheaper" than bonds in 2007, were worth cutting back on after a huge drop. So Mellon turned to even more expensive bonds. 

We understand. It was scary in 2008. The natural tendency is to buy what looks good and sell what looks bad. After a 50% drop, you stop thinking what a bargain stocks are, and start thinking maybe this is halfway to the 90% drop we had in the Great Depression. Near the bottom of the crash, Mellon increased its bond allocation and cut back on stocks. At the very bottom, Mellon was down to a 90% allocation in stocks, a figure it continued to cut until reaching the current 70% in stocks – cuts made while stocks were cheaper than the 100% stock allocation. 

According to Mellon's own literature, the fund held 100% stocks through September 2008, then went down to 90% on November 5th, back to 100% on November 12th, and back down to 90% at the end of January 2009. It appears Mellon then went down to 80% stocks in May 2009, and 70% stocks in October 2009.

Trying to explain those moves in late 2008 and early 2009, the advisor pointed to increased volatility and Mellon's quantitative model to explain the changes in the allocation. 

Such bad timing meant Mellon was no longer 100% in stocks during the market comeback; they had a small allocation to Treasury bonds, which tanked as investors shifted back to risky stocks. Vanguard Asset Allocation ended 2009 with a 17.92% increase, a big miss to the 26.4% gain in the Vanguard 500 Index, which they would have enjoyed if they had just stuck with the 100% stock allocation. Another way of looking at it? Mellon had 100% of the market downside, but only 70% of the upside.

Often it takes two mistakes to lose investing — buying high AND selling low.

Vanguard Asset Allocation has a slightly negative five-year return, while the 500 Fund is up a smidgen (as of 12/31/09). Any small fixed allocation to Treasury bonds should have meant beating the 500 over the last five years, but mistiming wiped out the previous year’s gains against the S&P 500. It's worth noting Mellon handled the 2000-2002 crash much better than this last one.

It is very difficult to merely stay invested during a crash. To actually head into the fire after a huge drop is more daunting still. We’ll continue to try to avoid the mistakes Mellon made in this last crash by trying not to do what seems to be the right thing to do.