Friday, March 2, 2012

Investors are "Rerisking" by Focusing on the Past

Investors Are Focused On the Past
Regular reader (and fellow portfolio manager) Rich Sipley brought a column from last Saturday's Wall Street Journal to my attention.

Authored by columnist Jason Zweig, the piece discusses the widespread move away from domestic equities by individual and institutional investors.

The funds are largely moving into either fixed income or sector funds, or into funds focused on the emerging markets.

By focusing on the past, rather than looking ahead, today's investors are like driving down the road with your eyes fixed firmly in the rear-view mirror.

Bond returns have trounced stock performance over the last decade.  Moreover, bonds offer the apparent allure of safety, since everyone "knows" that bonds are less risky than stocks.

Well, maybe, but if you're buying a bond today - at rates last seen in the late 1940's - you're taking on more principal risk than you might realize.

As noted in yesterday's Random Glenings post, if you buy a 10-year Treasury note today at the prevailing yield of 2%, and rates return to the level of a year ago, you will see a capital loss of -13%.

True, you will eventually get your money back - but only if you buy the Treasury directly.  Buying a bond mutual fund, which typically maintains an average maturity in its portfolio, does not offer the same assure of return of principal.

Returning to the article:

Since the end of 2008, when the financial crisis was near its worst, investors have taken $105 billion more out of U.S. stock mutual funds and exchange-traded funds than they put in, according to Kevin McDevitt, a fund-flow analyst at Morningstar ... 

Last year, investors ditched a net $34 billion in funds holding the biggest U.S. growth stocks, like those in the Standard & Poor's 500 index. In 2011 they also got rid of more than $15 billion in funds that hold midsize stocks. Funds in both categories tend to be highly diversified, typically with 100 or more stocks across at least 10 industries.

And it's not just individuals that are fleeing the stock market, according to Mr. Zweig:
Between 2006 and 2011, college and university endowments cut their holdings in U.S. stocks to 16% from 25% of their assets, according to the Nacubo-Commonfund Study of Endowments. 

Meanwhile, these institutions raised their positions in "alternative strategies" such as hedge funds, private equity, real estate and commodities to 53% from 40%. Those alternatives carry their own risks—foremost among them the inability to trade at will.

In the third quarter of last year, estimates Trim Tabs Investment Research, pension plans sold a net $79 billion in U.S. stocks. Since the end of 2008, according to data from the Federal Reserve, pension plans have sold a net $1.3 trillion in stocks and bought $1 trillion in bonds.

 But does fleeing the US market in favor of the emerging markets make sense?

Not according to noted investment strategist Rich Bernstein.  In an article published in the Financial Times on Wednesday, Mr. Bernstein writes:

Despite 2011's dismal emerging markets equity performance, investors continue to believe that the emerging markets are largely immune to the developed world's credit hangover. But cycles often begin in the US, travel to Europe, and then end up in the emerging markets.  This cycle will likely follow that historical precedent. The emerging markets' difficult tugs-of-war between inflation and growth indicate that the emerging markets, rather than decoupling from the developed world, were perhaps the biggest beneficiaries of the global credit bubble.

Here's Bernstein's conclusion:

US-based assets (both stocks and bonds) continue as our favourites.  In fact, this significant secular shift is already under way.  Despite the recent attention-grabbing rally in risk-on assets, the S&P 500 has outperformed Bric equities for more than four years.