A Look Back at 2011

January 20, 2012

The year 2011 delivered plenty of volatility and little reward for stock investors. Equity returns were largely inversely related to risk – the smaller in size or more foreign the stock, the worse it performed. It was the same story all year; Europe teetered on the edge of a debt collapse while the U.S. economy teetered on the edge of recession. 

Combine this underlying anxiety with near-constant political and media scrutiny on government debt problems, first at the state level (with manufactured fears of a big muni bond default), and then at the federal level (with manufactured debt ceiling fights and debt rating downgrades).

Of course, the eye of the storm is often the best place to invest, and in 2011 the winners were    muni and government bonds – the longer-term, the better. Longer-term municipal bonds went up 14%, and U.S. Treasuries gained 30%.

No one saw that coming. Even famed bond fund manager Bill Gross got this one dead wrong, and had a bad year to show for it, missing the bond index return by about 4% - his worst miss for PIMCO Total Return (PTTAX) since inception in 1997. We owned some government bond funds in our portfolios, but didn’t fare quite well enough to brag.

Europe, foreign stocks in general, and financials were the storms best avoided in 2011. Those areas were down 5-20% in 2011, as opposed to the S&P 500, which was basically flat, although with dividends still good for a 1.96% total return. Our Conservative model portfolio beat the S&P 500 with a 3.5% return (after fund expenses and buy and sell commissions), while our Aggressive portfolio missed with a negative 0.41% return.

It wasn’t that we didn’t have winners; it was that our increased allocations to foreign and financials didn’t pan out as well as U.S. stocks. We should have known better. Mutual fund investors are still favoring foreign funds, despite their underperformance for much of the past five years. Our underperformance alarm was triggered by a double-digit gap in foreign stock vs. U.S. stock returns, even if our out-of-favor with investors alarm wasn’t. We expect to increase our allocations to foreign stocks when we see sure signs that investors have lost their appetite for the exotic.

In our models, Health Care Select SPDR (XLV) was up 12.36% for the year as investors rushed into safer stocks. The same factored into American Century Utility Income's (BULIX) 11.12% run. We owned these funds in both of our portfolios because the categories had fallen somewhat out-of-favor in recent years, not because we expected a run to higher dividend stocks based on collapsing interest rates and fears of riskier stocks. These two funds were in the top 1% of all stock funds, including ETFs, in 2011.

Our Conservative portfolio outperformed the index largely due to a sizeable bond allocation and allocation to certain stock funds that did well. Unlike most investors, we didn’t favor cash and short-term bond funds last year, and therefore enjoyed some pretty significant gains as interest rates fell anew. Doubleline Total Return Bond (DLTNX), a newish fund that beat the benchmark bond index and was in the top 2% of its category last year, gained 9.40%. Another fund run by the same manager, Doubleline Core Fixed Income, which we own in client accounts, was in the top 1% of its category.

American Century Government Bond (CPTNX) posted a 7.54% gain as U.S. government bonds ruled the roost. And  CPTNX  wasn't even a longer-term bond fund, which is where the real double-digit action was. Vanguard Extended Duration Treasury (EDV), the longest duration type of bond fund, was the #2 overall best-performing unleveraged fund of the year, posting a startling 60% return – and that’s out of over 8,000 distinct funds, although we only owned it for the latter part of the year in our online portfolios. Of course, when rates go up, this type of fund can easily fall over 50%. 

American Century Core Plus (ACCNX) gained 7.04% - solid, but shy of the bond market index fund's 7.56% return in 2011. Metropolitan West Total Return (MWTRX) also underperformed the bond market index with a 5.51% gain, probably due to the presence of  some very low-rated, higher-risk bonds in the portfolio and a deficiency of longer-term, top-grade bonds. This was still better than the most famous bond fund, PIMCO Total Return. With a quarter trillion+ in assets, Total Return delivered an underwhelming 4% return in 2011(or slightly more or less, depending on the share class in which you invested). 2011 marks the first year ever we did not own any Bill Gross product in our model portfolios.

Surprisingly, emerging market bonds did well last year, as did some junk bonds. It’s the debt crisis during which no one seems that worried about debt…just the mysterious TBD aftershocks of the debt default.

Now for the bad news. What held us back wasn’t an off year for PRIMECAP Odyssey Growth's-2.23% return, a middle-of-the-road showing compared to similar funds in 2011, or even Satuit Capital Micro Cap's (SATMX) -5.94% loss (although we did cut our stake in this fund in mid-September 2011). These drops are not unusual during a run from higher-risk stocks. No, the real drag came from Royce Financial Services Fund (RYFSX), down 11.29% as investors expected another debt collapse to hit banks hardest, the way it did the last time. If only investing were so easy. Our guess is that other companies are just as likely to take a beating if Europe collapses. 

Speaking of Europe (and we wish we didn’t have to), Vanguard European ETF (VGK) fell 11.68%, and Scout International Discovery (UMBDX) slid 12.92% last year. We increased our stake in foreign and financial funds in September. Our biggest losers were our small stakes in ultra-short funds, down by deep double digits, even though we only owned them for a few months. Note that these small, high-risk positions are designed to protect against a greater calamity that would take our other stock funds down as much as 50%. 

It's worth noting we maintained risk levels that were quite a bit lower than the S&P 500 last year, which itself was lower-risk than the global markets. Our worst month was September, with our Conservative portfolio down 1.97% and -4.2% in Aggressive, as opposed to -7.05% for the S&P 500 .

2011 was a bad year for actively managed funds in general. The vast majority of stock funds lost to the S&P 500, and many bond funds missed the bond market index. For example, our PRIMECAP Odyssey Growth (POGRX) was down 2.23%, placing it squarely in the middle of a herd of hundreds of large-cap growth funds, yet still down 4% less than the S&P 500 and Russell 1000 Growth index. 

The S&P 500 beat around 80% of U.S. stock funds in 2011. This may have something to do with the massive shift of money exiting stock mutual funds (which in turn have to sell stocks they own) and piling into stock ETFs, which would push up the stocks in the market cap weight of the indexes. In general, the S&P 500 has more weighting to large cap than most funds, and larger-cap stocks are now doing better after having underperformed for most of the decade. 

We  could just be returning to the 1990's-type markets, in which most funds can’t overcome the higher fees, trading costs, and smaller-cap stocks they own relative to the index underperforming. Small-cap indexes were down almost 3% in 2011. The opposite condition existed in 2000, as a long run in large-cap stocks meant the S&P 500 was due to underperform, which we forecast over a decade ago.

It was also a year in which famous investors failed, a trend that really got going during the financial crisis, when many top managers loaded up the truck on financials and fell even harder than the hard-hit S&P 500. 

In 2011, out of the largest actively managed U.S. stock funds – the $20 billion plus club – only value-leaning American Funds' Washington Mutual (AWSHX) and Vanguard Windsor II (VWNFX) beat the S&P 500 (but not the big-cap value Dow, up over 7%). Vanguard Health Care (VGHCX) beat the S&P, but that’s due more to the rise of healthcare stocks in 2011 than fund manager acumen – our holding here Healthcare Select SPDR (XLV) was up 12.37% compared to VGHCX’s 11.45%.

The worst non-sector fund of the year may have been Fairholme (FAIRX), an old favorite around here (we actually removed it from our favorites list in 2009 for getting too big, too fast.) Fairholme fell  32% in 2011, and is now hemorrhaging hundreds of millions, although still big at about $7 billion. 

Another fallen angel, one that, unlike Fairholme, began falling back in 2007, was Bill Miller’s Legg Mason Capital Opportunity, down about 34% last year after falling approximately 65% in 2008. Bill Miller, once heralded as having the longest S&P 500-beating streak in the business (15 calendar years from 1991-2005,) is stepping down from Legg Mason Value Trust, the fund that made him famous, but not Legg Mason's Opportunity fund. The Value Trust fund was down only about 4% in 2011, but it has underperformed the S&P 500 over the last 5, 10, and 15-year periods, including a 55% decline in 2008. Not exactly a Michael Jordan-esque exit for the “Fund Manager of The Decade.”