A MAXadvisor Spook Story

November 2, 2004

With Halloween all wrapped up, we felt now is the time to discuss our current investing fears. Here are the two biggest concerns today:

1) The nagging sensation that nothing is out of favor

Hunting for the best funds is only half the story when we build our portfolios. We start by figuring out which categories of funds we want and in what allocation (our top down portfolio construction method).

While the broad allocations to stocks, bonds, and cash only see minor adjustments for each risk level portfolio, the types of funds we favor can change more notably. Much of these allocation decisions are based on what other fund investors are doing with their money.

Research shows that fund investors tend to get overly excited about a category of funds close to the end of any out-performance streak. Performance chasing investors tend to avoid or abandon a category of funds just before the style or sector comes back into favor. Contrarian investors, like us here at MAXadvisor, try to profit from the performance chaser’s mistakes

Long term MAXfunds readers remember that the negative opinion we held on the market back in 2000 (which turned out to be uncannily prophetic, if we do say so ourselves) were based on this contrarian view. More recently, our decision to add allocations to categories like utilities, telecom, Japan, and emerging market, was essentially contrarian. Today, most of these formerly out of favor areas have been at the top of the performance charts for the past year or more, and some are now bringing in gobs of new performance-chasing money.

But this is a tough time to be a contrarian investor because there are currently few categories that look truly out of favor, in terms of raw performance compared to other categories, or by investor unpopularity. You couldn’t give away a utility fund a couple of years ago, which is why even Vanguard had to convert their utility offering to a more palatable dividend-oriented fund (right around the time utility stocks started whipping the S&P500 as it turns out).

It boils down to this: how does a contrarian investor find out of favor areas to invest in when nothing is out of favor? 

<b>2) What if everything falls to pieces at once?</b>

One of the foundations of modern portfolio theory is that a diversified portfolio has lower risks, and higher returns for a given level of risk. Mixing different asset classes not only protects downside, but allows investors to squeak out a little more upside return than the proper amount of undiversified risk would allow them. 

Such theories are based on what was observed in practice - because while many asset classes are correlated or move together, they are not perfectly correlated. Small cap value stocks may do well while large cap growth stocks slip. Junk bonds may outperform for six months while government bonds under perform.

This investing lesson was relearned the hard way by investors over the  past few years. The great bear market of 2000-2002 was mostly a large cap growth and technology phenomena. Investors in other asset classes might have wondered what all the fuss was about.

Our concern is that the benefits of diversifying one’s portfolio are currently dwindling. If most categories of investing have gone up during the last couple of years, surely they could drop together, too. What risk reduction does diversification offer if the entire market is moving in lockstep?  

We’re calling this risk correlation compression: this happens when distinct asset classes become correlated to such a degree that a diversified portfolio has risks that are similar to those of a less diversified portfolio.

Why is correlation compression going on? We have one possible explanation: after being taught a painful lesson by the collapse of tech and growth stocks, investors have built more diversified portfolios. By moving their money across asset classes in unison, they are correlating the assets (and are therefore reducing the benefits of diversification). 

<b>What does all this mean for our portfolios? </b>

We follow the broad principals of diversification when building our model portfolios, but tend to focus on the out of favor categories as the building blocks to improve upon the risk to return relationship ordinary diversification creates. While this high level of market correlation persists, we’re going to take a slightly different approach. 

Sector funds can help diversify a portfolio, but they are generally expensive to own. If the benefits of diversification are minimized, then much of the reason for buying sector funds disappears. 

The Dodge & Cox Balanced fund is cheaper to own than several more focused funds investing in utilities, energy, and corporate bonds (even though the more diversified stock fund can and does own stocks from all these sectors). By targeting specific parts of the market, investors are increasing costs, so there had better be a good reason for doing it.

We have two reasons for targeting specific markets: to add diversification, and to hit an out of favor asset class. Because of our two fears (that most everything is in favor, and is highly correlated) there just isn’t a very good reason for the excess targeting of fund categories that are usually expensive.

Without compelling reasons to target, we’ll focus a bit more on lower fee and more diversified funds.

 We’ve lowered the fund fees in our own portfolios quite a bit in the last year for this reason. We’ve lowered allocations to the sometimes expensive areas like junk bonds, foreign (including emerging market) bonds and stocks, small and micro cap stocks, and the like. We’ve always focused primarily on lower fee funds, but even the lowest fee funds in some categories are still more expensive than the most expensive Vanguard fund.

This correlation compression market has also caused us to consider a slight lowering of our portfolios’ overall stock exposure. If correlation compression is in effect, then risk is rising.  A portfolio that was 60% stocks should be 50-55% stocks to adjust for this heightened risk. 

So why haven’t we re-jiggered our allocations? Because we feel stocks are not wildly overpriced any longer and bonds are far from attractive today – and cash still has a negative return when adjusting for inflation. If money markets paid 4% like they did a few years ago, we wouldn’t think twice about cutting down our stock allocations one bit.

The good news is that while this correlation compression has us slightly spooked, you shouldn’t be. Our portfolio managers are keeping a sharp eye on the market, and wherever it’s headed you can rest assured that our model portfolios will be ready.

Happy Halloween!