In this issue of “Under the Hood” we reference an article written by Bob Veres and give some insight into our decision-making process when it comes to evaluating different mutual funds. We also include an excerpt from an interview with one of our mutual fund managers.
HOW TO LOSE MONEY IN THE TOP-PERFORMING FUND
by Bob Veres
An article in the December 31st issue of the Wall Street Journal makes a point that many of us in the financial planning world have long suspected. It says that the CGM Focus fund was the top performing mutual fund, by far, over the past ten years, generating an annualized return of more than 18% a year since January 1, 2000.
Now here’s the punchline: the average investor in this top-performing fund lost an average of 11% a year over the same ten-year period.
How is it possible for investors to lose their shirts in a fund that posted outsized returns?
Most planning professionals know the fund’s manager, Ken Heebner, as a swing-for-the-fences investor, somebody prone to huge runups and equally scary drops.
A Chicago-based investment research firm called Morningstar – whose data is used by most financial advisors — calculated what is called the “dollar-weighted” return of the CGM Focus fund, which gives a picture of what investors in the fund actually experienced.
If you had bought and held Ken Heebner’s portfolio throughout the 2000s, you would indeed have received returns of 18% a year. But the fund was so up and down that investors were alternately panicked and selling out or optimistic and crowding back in.
The article says the most dramatic example came after the fund was up 80% in 2007. Investors flocked in, putting $2.6 billion into the CGM portfolio — just in time to catch its equally-dramatic 48% drop through the end of 2008.
There have been credible studies showing that the average investor underperforms the market, and this illustrates exactly how it happens. Right after an investment generates strong returns, people tend to jump on the bandwagon — and then they experience the subsequent return to reality.
When an investment is struggling, people tend to abandon it, and miss out on its recovery. Missing the upside and catching the downside, consistently, is human nature, perfectly understandable behavior.
But it inevitably leads to dismal investment results — as it did for the battered, unhappy, money-losing investors in the best-performing mutual fund of the 2000s
WHY WE PASSED ON CGM IN 2007
Bob Veres’ commentary illustrates why we were not recommending CGM in 2007 when it was generating so much excitement. That same sentiment is why we are currently emphasizing funds like Allianz NFJ Dividend Value Fund, which may not be popular at the moment, but have proven to outperform after periods of lackluster results.
ALLIANZ NFJ DIVIDEND VALUE, PNEAX
The following is an excerpt from an interview with Ben Fischer, portfolio manager of NFJ Investment Group, on the recent performance of Allianz NFJ Dividend Value Fund:
(The Full interview can be found at www.AllianzInvestors.com)
Q: Why haven’t the financials in the portfolio fully participated in the rally?
A: You need to remember that NFJ seeks to invest in low-priced stocks with attractive fundamentals. NFJ believes that many of the benchmark constituents that have driven recent index performance have not done so because of their fundamentals. In fact, many of the stocks that improved the most were those that declined most precipitously in 2008.
Further, among financials, it is the very lowest quality stocks that have delivered the best performance since the market bottom on March 9.
While we are not limited to investing in only high-quality names, our process does prevent us from owning the lowest quality names. This positioning has served our shareholders well in the past, and will do so over the long term.
Q: Your Morningstar rankings have been affected. Explain a bit about that.
A: Morningstar rankings can be useful, but must be understood in context. Growth has significantly outpaced value year to date. In that environment, a deep value manager like us will likely underperform relative to its Morningstar peer group.
Further, deep value funds like NFJ Dividend Value will lag traditional and relative value peers. In addition, given the way the rankings are weighted, one-year performance has a greater effect on longer-term rankings, so any performance lag over, say, four months, will have an unusually significant impact on three- and five-year rankings.
Q: Has the portfolio ever lagged its benchmark and Morningstar peers in the past?
A: Yes, in the late ’90s, when growth outpaced value, the portfolio lagged both its benchmark and peer group. Again in 2003, when lower quality names outperformed, the fund lagged the benchmark and its peers.
However, both of these periods were followed by periods of outperformance.
Q: What are you doing to protect your shareholders in this environment?
A: We are focusing intently on absolute yield. We are also focusing on the cushioning effect of dividends.
To the latter point, though dividend cuts by many companies have been well publicized, among the Fund’s holdings, raises have actually outnumbered cuts three to one. Only eight of 45 holdings have reduced payouts over the past year, and the median holding still pays more than it did one year ago.
We have also emphasized companies with no looming debt maturities or pension plan concerns. We have highlighted companies that have recently hiked their payouts, even in the midst of the current economic malaise, as NFJ views these companies as less likely to turn around and slash their dividends.
Further, in the future, dividends may become rarer, and company managements will probably think twice before instituting standard payout hikes unless they are certain that they can be maintained.
Thus, going forward, increasing dividends may work even better as an indicator of quality and management confidence.