Shares in larger domestic firms registered positive returns for the quarter with the Dow Jones Industrials up 1.26% and the S&P 500 advancing 3.43% for the ninety-day period. Small company stocks in the U.S. were the stellar performers for the quarter with a 7.75% return for the Russell 2000 Index. Measured in local currency larger foreign stocks enjoyed returns similar to those in the U.S., however a strong rally in the dollar converted a 3.75% gain in the EAFE foreign stock Index to a negative 0.97% when adjusted for the currency effect. After trailing stocks for the previous five quarters Real Estate Investment Trusts posted an impressive quarterly return of 9.99%. This asset class helped to offset the 7.86% dollar adjusted loss in the MSCI Emerging Markets Index for those investors with broadly diversified portfolios.
In light of a robust economy and the incremental increases in short term interest rates imposed by the Federal Reserve, 30-day T-Bills registered the highest quarterly return among government guaranteed fixed income investments at 0.42%. Treasuries with 1-3 year duration eked out a 0.21% total return while the Bloomberg Barclays Aggregate Bond Market Index fell slightly at -0.16% taking into account interest payments. The Aggregate Bond Index is off 1.62% for the year-to date. Meanwhile entities seeking to borrow money encountered higher costs with the prime rate now set at 5.0%, up from 4.25% late last year.
The recent setbacks for mutual funds that invest in international and emerging market stocks has triggered substantial dollar out flows from these funds even though their underlying shares are selling at multiples substantially below those in the U.S. This trend exemplifies a type of behavior that can cause an investor to actually underperform the returns achieved by the stocks or mutual funds in which he or she invests. That is, investors, left to their own devices, often sell investments that are performing poorly and, in turn, seek to purchase assets that have recently enjoyed gains, actions which disrupt the longer-term pattern in an asset’s accumulated return. Had investors simply remained invested in their mutual funds, resisting the temptation to follow the crowd and chase performance, their results would generally exceed those who trade on the news. But this is hardly new information. A recent study by Morningstar, Inc. indicates that for the past ten years the gap between mutual fund returns in the aggregate and those achieved by the average investor has been a mere 0.25%, one of the lowest spreads in history. Russel Kinnel, the study’s author, attributed the narrow spread to the fact that markets have been relatively stable over the past ten years with few bouts of “extreme volatility that trigger emotional responses that lead you to screw up”.
Fran Kinnery, a senior investment strategist at the Vanguard Group, cites the increasing popularity of Index Funds and Target Date Funds, the latter which combine several types of assets into one portfolio, as another reason for the shrinking spread in investor’s realized results. Both approaches tend to smooth out extreme results in individual securities and market sectors. Kinnery also points out that “more financial advisors are seeking to keep their client’s portfolios aligned with target allocations to stocks, bonds and other assets”. This alignment process, otherwise known as portfolio rebalancing, serves as a counterweight to the natural human tendency to buy high and sell low. Of course, we have both advocated and implemented a systematic rebalancing system for our clients for more than twenty years.
Although the Morningstar study suggests that investors appear to have generally avoided the buy high-sell low syndrome over the past decade, a view of the longer term, which includes the full breadth of the Great Recession and Financial Crisis, is not nearly as sanguine. The graph below illustrates the results of a study conducted by the Boston consulting firm Dalbar, Inc. which utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior. The chart compares the “average investor” experience for the most recent twenty year period with various asset class returns including large U.S. stocks (S&P 500), bonds (Bloomberg Barclays Aggregate Bond Index) and two balanced asset allocations with a 60/40 and 40/60 ratio of stocks to bonds. The Dalbar metrics serve as a useful warning for those who would enter the chase for “superior” investment results.