FSO Editorials: Will Conventional Mutual Funds Survive...? by Robert B. Gordon 05/03/2004

Will Conventional Mutual Funds
Survive This Bear Market?
Three Exciting New Portfolio Suggestions
by Robert B. Gordon, Sc. D.
May 3, 2004

As we write this essay, the Dow, S&P and Nasdaq have clearly started down on the second huge leg of this great bear market. The charts show that they have finished waves 1 down and corrective wave 2 up. So, the longest wave 3 of 5 is ready and it may cause a few bullish investors to reconsider their position. Gold and silver stocks and funds have definitely topped and are headed much lower according to Robert Prechter.

It is time for investors, new and old, to add at least a small short position to their mutual fund portfolio. It is also time to sell any stock or fund not suited to a severe bear market. Do not delay in getting rid of your losers as the bear market may move faster than you expect.

Since most growth funds are built from the same mold and suffer from the same grave problems, it is quite possible that many, if not most of them, will vanish in coming decades. This industry has never been noted for creating really new tools for investors. But every time a firm brought out a new fund concept, good or not, it was quickly copied by the others. In recent decades, when one firm introduced a new type of growth fund, it was copied by the industry in a sort of "keep up with the Joneses" fashion.

The biggest single error made by all these fund leaders was to anticipate a perpetual bull market in which the investors bought, but never needed to sell. In doing so they failed completely to consider the previous history of market cycles over the past four centuries. They also, for some unknown reason, failed to learn the natural laws of stock market and economic cycles discovered by Ralph Elliott in the 1930s by which Robert Prechter forecast in 1995 the world’s greatest-ever stock crash and depression which is now underway and gathering momentum as we write.

I am quite unable to predict what the much smaller mutual fund industry will look like many decades from now. The leaders have never shown any great originality other than to copy their competitors' offerings. Our first short fund was brought out by a financial expert, David Tice, who had never managed a mutual fund before. This introduction has brought forth other short funds from small firms like Rydex.

Probably the greatest error of the mutual fund industry was their failure to permit their growth funds to shift into cash in a major bear market. The idea of keeping 5% cash during a known major bear market will cost investors trillions of dollars and may destroy the whole industry. When American Investors lose trillions of dollars in the current bear market, their furor vs. the fund industry will know no bounds. They may not return this century.

In a recent book review on FSO, Joseph Dancy covered this subject very well. It is presented below with his approval.

"Searching for Alpha: The Quest for Exceptional Investment Performance
by Ben Warwick, 224 pages, John Wiley & Sons; May 2000.

Most active investment managers under perform the major market indexes according to Ben Warwick, author of a book on this issue entitled "Searching for Alpha."

While the goal of beating the major market indexes may seem relatively easy, Warwick notes that of the 45 largest stock funds only one has beaten the Standard & Poor's 500 index over the five years ending in 2000 - and that fund outperformed by a scant 0.60% per year.

Warwick notes that because of the well documented underperformance of actively managed accounts many investors have been attracted to index funds. Index funds by definition neither under- nor over-perform the market. Approximately 35% of all pension funds are now indexed by money managers, and this percentage continues to increase each year.

According to academic theory the risk adjusted excess returns generated by the active investment manager is referred to as "alpha." Recent academic studies indicate that the ability of an investment manager to generate alpha - excess returns - has "dissipated dramatically" since 1970.

While managers have greater difficulty generating excess returns, the amount of money being actively managed has grown explosively. Pension fund equities under management have grown from around $1 trillion in 1990 to approximately $4 trillion in 1998 (and are certainly higher now).

Is their a correlation between the amount of assets being managed and the difficulties generating alpha? Warwick thinks a strong correlation exists.

Because of the amount of money under management has increased so dramatically, Warwick claims that institutions generally adopt a strategy targeting larger companies as investment candidates.

"The huge armies of analysts who cover these stocks make the sector tenaciously efficient," and he notes that this efficiency has made it "doubtful that any large-cap manager has the skills to consistently beat the S&P 500 index."

A number of studies back up Warwick’s point. Nobel price winner and Professor Eugene Fama’s studies (and numerous others) indicate that a portfolio’s performance is primarily a function of the investor’s choice of assets. On that note, a 1986 study by Brinson, Singer, and Beebower that found the following "determinants of portfolio performance":

Asset allocation/asset mix – 91%
Security selection/other - 9%
[Note: Please understand the great significance of these two numbers, RBG]

They conclude the most important decision an investor makes is how to divide up investments between different asset classes – that is how to allocate capital between cash, money market funds, T-bills, bonds, large capitalization stocks, small capitalization stocks, real estate, gold, art, antiques, timberland, oil & gas, etc.

This allocation decision will have more impact on the total return of a portfolio than the actual stocks or funds the individual chooses to add to the portfolio. Investing in larger, more liquid, companies in the past has yielded historical returns below those in other asset classes.

If Warwick is on point - and we think he is - equity investors would be well placed to invest in low cost index funds. Or, if their risk tolerance provides, in asset classes that have historically outperformed. For the serious investor "Searching for Alpha" is well worth reading. © 2004 Joseph Dancy"

Although index funds may beat managed funds in the long run, they will surely be very bad performers in the current bear market. The same fate will happen to any fund holding predominantly common stocks. Please note the surprising data above that indicates that the ASSET CLASS is ten times as important as the specific SECURITY in determining the final result of a portfolio. This strongly confirms my feeling that readers should select their own securities. This study puts the burden for success squarely on the shoulders of the investor. In other words, the chosen ratio of stable to volatile assets is supremely important. Then, in secondary importance, comes the selection of specific funds and the portfolio rebalancing actions. Please do not forget this very important fact.

After 5 decades of mutual fund ownership, I began several years ago to critically analyze why many funds did so poorly and especially why their bear market performance was so atrocious. The answer was very obvious; they lacked the right asset classes or the right mix of asset classes. Even quite large fund companies with scores of stock and bond funds did not have some of the asset classes needed for some market conditions. They had seen a generally rising market since 1974 and could not imagine a threat to harm their large revenue stream.

It was common practice for fund companies to copy the new funds that a competitor had issued. But the record of recent years shows that none of the large fund companies saw fit to organize a short fund. So it turned out that David Tice, an outside expert, originated the first fully-managed short fund. Then some of the smaller fund companies began to start a series of reverse index funds both with and without leverage. So, today, we have about twenty short funds to choose from.

I began to list mutual funds that fell in two classes that I defined as stable and volatile and then experimented with performance differences using various ratios of the two classes. It turned out to be quite easy to obtain desirable performance ranging from very conservative to quite aggressive by changing the stable/volatile ratio. During that period, I discovered the two very stable funds originated by Dr. John Hussman, a growth fund and an income fund, both of which can use option hedges to prevent loss in down markets.

We then developed the idea of rebalancing portfolios, not only to retain the original asset ratio, but also to gain extra profits from peak prices in the volatile assets. By moving gains from volatile to stable classes, the final return could be increased, but these temporary gains would have been lost in future market action if not taken in rebalancing.

The final result of all this work was a large number of portfolio examples covering just about every possible need from youth to old age. New readers should review our last six months of essays to get information that has not been duplicated recently. [Archive]

The fact is that many, if not most, public mutual funds grossly under perform the major market indexes after costs and expenses – to say nothing of the adverse impact of taxes. Public funds attract investment dollars from individuals due to their massive advertising and marketing efforts, which helps support the financial press and publications.

I receive very few e-mails from readers who have built a complete version of a portfolio I have described as an example. Usually, their message indicates they own just some of the funds. If this is happening, much of the problem must be from my failing to stress the great importance of each asset class in every portfolio.

Every bear market portfolio should start with 50% or more of stable or very stable assets which are few in number. Although I have given portfolio examples containing only two or three funds to get novice investors a convenient way to start, a serious portfolio aimed at stability and growth should have at least five or six components. This is still true if the objective is capital preservation for a period of 20 years.

In developing a list of stable and volatile funds, we relied on data thru 3 or 4 years of the current bear market. We cannot predict future returns other than to say that, in general, the stable funds will provide security of principal, while the volatile class provides growth potential. The only asset class that is known to perform well in down markets is that of the short funds. Hence we consider it advisable to include at least a small amount of a short fund in all portfolios.

The volatile classes were very carefully selected to have an expected rising price curve in the future plus large price swings up and down to provide future profits during rebalancing. The only asset classes we chose as appropriate now were gold and silver in several forms, natural resources like oil and gas, land and timber. Over the next twenty or more years, it is reasonable to expect changes in the list of volatile funds suitable for our portfolios.

Regardless of the nature or composition of portfolios we present, they should be built slowly with the stable funds acquired first, the short funds next and the volatile funds last. There need be no rush to complete a portfolio that may run for twenty or more years. We pity the plight of millions of investors holding conventional funds in the bear market now underway with a vengeance. Please try and help any family member or friend who is willing to seek advice. The losses in the months and years ahead will be very large and tragic.

Considering the tremendous uncertainties that lie ahead, we use the best asset classes and funds that are available. It is easier to plan and manage a conservative asset mix. It will surely have a minimum of problems in future years. As we decrease the percentage of stable assets and increase the volatile assets, there are more chances for the need to adjust the portfolio for an unexpected circumstance. It may require a change in one of the asset classes which can be done quite easily.

In the modern history of mutual funds over the last 30 years, only one fund was conceived as being a true permanent portfolio. So far it has fulfilled its objective of stability, but the Permanent Portfolio fund may have some difficulty in the current huge bear market, a condition it has never yet encountered. Its permanent ownership of 25% gold and silver may not be a problem, but the 30% common stock asset class may bring problems in the coming severe bear market.

Our goal has been to study the actual performance of all attractive funds over the past 3 or 4 bear market years and select those few best funds for use in our portfolios. We have identified several short term U. S. Treasury funds as "super stable." The list of stable funds is quite short and restricted to about 4 asset classes. The volatile fund list is restricted to asset classes in the natural resource category which are expected to show growth.

The best guess for the future stock market has to be that it will continue to fall in price. So, the asset class that will perform best in a falling market is that of the short funds. We believe that a small allocation of short funds should be in every portfolio, including the most conservative.

PERFORMANCE FROM 9/18/2002 TO 4/30/2004
Allocation	Percent	Fund	Weighted %
Hussman Strategic Growth Fund	30%	15.0%	4.5%
Hussman Total Return Fund	25%	7.2%	1.8%
Prudent Global Income Fund	25%	10.2%	2.5%
Prudent Bear Fund	12%	-12.1%	-1.5%
Reverse Bond Fund	8%	-1.5%	-0.1%
Total	100%		7.2%

This is a simple and very conservative portfolio with a modest annualized return over the past 18 months resulting from the long bear market rally. The short funds will certainly make a positive contribution in the big decline now underway. Please note that only 3 fund companies and managers are involved, all with fine records. Several of these funds have the ability to own gold and currently do own it.

There are no volatile assets in this portfolio, except for minor amounts that may be owned by the individual funds. The 20% short assets have predictable behavior. They will gain in the current bear market and lose in the bear rallies. Profits should be taken by rebalancing at the market bottoms and transferred to the stable assets. This portfolio, above all, is one that all conservative investors could sleep with and sleep well.

PERFORMANCE FROM 9/18/2002 TO 4/30/2004
Allocation	Percent	Fund	Weighted %
Stable Assets
Hussman Strategic Growth Fund	30%	15.0%	4.5%
Prudent Global Income fund	15%	10.3%	1.5%
60/40 Bond Stock Fund	15%	11.9%	1.8%
Total	60%		7.8%
Short Assets
Prudent Bear Fund	8%	-12.1%	-1.0%
Reverse Bond Fund	8%	-1.5%	-0.1%
Total	16%		-1.1%
Volatile Assets
CEF Gold/Silver (Amex)	6%	14.9%	0.9%
Leading Energy Fund	6%	31.5%	1.9%
Canadian Oil/Gas Trust	6%	41.6%	2.5%
PCL Timber REIT (NYSE)	6%	20.7%	1.2%
Total	24%		7.5%
Grand Total	100%	14.2%	14.2%

This portfolio has 60% in stable assets, 24% in volatile assets and 16% in short assets, a quite conservative mix. Note the considerable contribution of the volatile assets over the past 18 months. Their volatile prices will provide many opportunities to take profits at their highs and to receive asset transfers at their lows, This portfolio is considered to be very permanent and will be if the peaks and valleys in the volatile assets are used for periodic rebalancing. These added profits will be small in the first few years but will increase as the gains are compounded over the years.

In summary, we consider this 9 fund portfolio, a great, moderate growth portfolio with excellent diversification of the volatile assets. Three of them are readily available stocks with unique qualifications and the other is a large no-load mutual fund.

PERFORMANCE FROM 9/18/2002 TO 4/30/2004
Allocation	Percent	Fund	Weighted %
Stable Assets
Hussman Strategic Growth Fund	30%	15.0%	4.5%
Prudent Global Income fund	10%	10.3%	1.0%
60/40 Bond Stock Fund	10%	11.9%	1.2%
Total	50%		6.7%
Short Assets
Prudent Bear Fund	8%	-12.1%	-1.0%
Reverse Bond Fund	6%	-1.5%	-0.1%
Reverse Nasdaq Fund	6%	-32.7%	-2.0%
Total	20%		-3.1%
Volatile Assets
Leading Gold Fund	6%	37.8%	2.3%
CEF Gold/Silver (Amex)	6%	14.9%	0.9%
Leading Energy Fund	6%	31.5%	1.9%
Canadian Oil/Gas Trust	6%	41.6%	2.5%
PCL Timber REIT (NYSE)	6%	20.7%	1.2%
Total	30%		8.8%
Grand Total	100%	14.2%	12.4%

Despite its lower performance over the past year and a half, this more aggressive fund with an asset mix of 50% stable, 20% short and 30% volatile should do better in the long run. It was handicapped in this bear rally period by the losses in the short funds. But these losses should now be restored by transfer of assets from the other classes during a rebalancing action. This will then increase the gains from the short funds during the coming bearish market phase. If anyone does not understand this very important point they should write for clarification.

Based on extensive market experience, it can be stated with confidence that a portfolio with more diversification in the best asset classes will, in general, do better than a smaller portfolio with fewer asset classes. It should also be less volatile in its price swings and somewhat more conducive to a better night’s sleep.

Anyone with limited market experience should plan to start with one of our smaller, simpler portfolios and then move to a more volatile portfolio as experience is gained. It should be emphasized that none of our suggested portfolio will act like a money market fund. Every asset class we use will vary in price, some more than others. But each class will vary independently in its reaction to market ups and downs. One needs to look at the overall price swings in the portfolio first and then look at the individual asset classes. Any reader who cannot adjust to the daily price swings in one of our portfolios should put their money in the bank or in a money market fund. Please remember that we start with a stable base and add volatile components to add profits that come from their volatility. But we do not want uncontrolled volatility. We control the amount of volatility by carefully selecting the percentage of all volatile elements.

During the past week I have been overwhelmed by e-mails from this country and abroad. I have finally read them all and responded as best I could to questions. Do not hesitate to write as many as you wish to get your questions answered. Thank you for your very kind words about my health.

I have exerted myself recently to get my thoughts to you prior to the bear market phase that is now underway. I intend to write infrequently for a while and get some other work done. In addition to reading FSO, please visit Prudent Bear, Safe Haven and Fiend Bear for excellent essays by great authors.

Please take this new bear market phase seriously as it will eventually become very major and finally be big headline news. Take care of any unfinished business and help your extended family to understand the seriousness of this new decline. Remember our Elliott Wave experts predict the bear market will last for many decades and the Dow to eventually drop below the 500 level where it started in 1974. This is not a joke, but a very serious prediction based on past market history.