Getting Even From 2008

Emerald Asset Advisors

Rob Isbitts

October 29, 2009

A "GreenThought$" Research Study

By Rob Isbitts, Chief Investment Officer, Emerald Asset Advisors LLC

"Don't get mad, get even" - Robert F. Kennedy

Over the years, my team and I have been very critical of the way some retail investors and their advisors evaluate investment performance. There is a tendency to give credence to performance "sound bites" instead of focusing on more meaningful marking periods.

For instance, we firmly believe that investment performance is best judged over "rolling periods," where you can account for the many different starting and ending points an investor might have. To us, this is more important than picking fixed time periods that are convenient for the reviewer, such as the customary year-to-date, past one, three, and five years, and calendar year-by-year. We don't deny that these views are useful; they are. But they are often used in isolation, which only gives a partial picture of how a manager has done.

There is an old expression on Wall Street that you "don't fight the tape." In other words, don't try to stop the masses from doing what they wish to do. Today's issue of GreenThougtht$ follows that idea, since we found a very useful way to extract some important conclusions out of short-term performance data. We are going to simply look at how several investment styles (as portrayed by their Morningstar mutual fund category averages) performed in 2008 and so far in 2009.

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The key question we pose is: which styles have recovered in the first 10 months of 2009 what they lost during 2008? We can then draw some conclusions about how advisors can keep their clients from falling so far behind where they started that they can't soon catch up. More importantly, we will learn some quick lessons about the importance of avoiding the "big loss" in portfolio management and investment style allocation.

We used data from Morningstar's mutual fund category averages and excluded high-quality bond fund styles. Since this study is concerned with the the fall and rise of growth strategies we thought that it would be most sensible to exclude Treasury and Muni Bond categories.

If you would like data from the full study, just email us a request and we will be happy to send it to you. For now, here is a summary of the study and our key findings for financial advisors and their clients:

Returns of 51 categories were studied. We recorded their 2008 full-year return, as well as their 2009 return through Friday, October 23rd. We calculated what a $100 investment in each category would be worth after experiencing the returns of 2008 and most of 2009. Finally, for those categories that have not recovered to $100 yet (the vast majority have not), we calculated the return needed from here to reach that $100 break-even level. We also summarized each group with a nickname to make sure you understand our conclusion:

SUMMARY OF THE DATA:

Group 1: "made a profit"

Of the 51 categories, a mere five have recovered to $100 or higher. They were World Bond (which barely fell in 2008), Emerging Markets Bond, High Yield Bond, Conservative Allocation and Equity Precious Metals. The general theme here is that the more they fell, the stronger they came back. The same cannot be said across the board in the study.

Group 2: "nearly back to even"

The six fund categories in this group are within less than 10% of where they ended 2007, and all of them need less than a 10% move from here to erase all of 2008's damage. The hodge-podge list included High Yield Muni, Bank Loan, Currency, Target Date Funds (with a 2000-2010 retirement target year), Convertibles, and perennial Emerald favorite, Long-Short funds. As with Group 1, there were fund types that exhibited very little volatility overall for each year (such as Currency Funds). There were also those that turned stomachs in 2008, only to rebound strongly so far in 2009 (e.g. Bank Loan and Convertibles).

The Long-Short category was the second-best performer on this list in 2008. It experienced a loss of 15.40% (recall that the S&P 500 Index was down roughly 37% in 2008) but has produced a modest 9.32% gain thus far in 2009. A common theme as we go through this - there are many ways to ride the market up and down. The key is to find a mix of strategies and styles that keeps you from jumping around to what's hot, and to reduce negative surprises versus your expectations.

Group 3: "hung in there"

Five strategies landed here, including Bear Market funds, Target Date (2011-2015 retirement target year), Moderate Allocation, World Allocation and Healthcare funds. These are all within 15% of returning to their pre-2008 levels. In our minds, any investment style that can keep you within this "striking distance" of where you were before the worst market decline of our lifetime deserves some praise. Remember, this is growth investing, not simply preservation of capital.

Group 4: "still a ways to go"

Ten categories ended up in this bracket, and all have their work cut out for them. They all need a 16% - 25% move up from here to get back to even. This group is dominated by small- and mid-cap stock categories, as well as tech (this year's sector darling, but it is still 20% down since 1/1/08) and Latin America. The latter is worth noting in that its 107% gain so far in 2009 came on the back of a 59% loss in 2008. As we have said in many meetings with advisors this year, "how many of your clients would still be around to experience the 107% rally after seeing their dollars turn into 41c each?!" It is pretty discouraging to double your money and still be 18% below your 1/1/08 value, but that's where Latin American stock funds are as of now. Importantly, that does not mean that you don't ever own them. It just tells you that you need to exercise some judgment in when to own them, in what size position, and what to build around them. That is the key to asset allocation in this century, as opposed to simply filling your "style boxes."

Group 5: "it's a long way home from here"

Of the 51 mutual fund categories studied, an astonishing 25 of them are in this final category. Think about that for a minute - nearly half of the mutual fund styles studied still need to return over 25% from this point just to regain their level from the start of 2008. The Large Cap Stock category, both US and non-US, is well represented in this group. So are Emerging Markets stocks, REITs, and other sectors like Financials, Communications and Utilities. All 25 categories lost over 1/3 of their value in 2008, and as this year clearly shows, the number one goal of any asset allocation strategy should be to avoid the "big loss." It is simply too hard to climb back from there. Even when many of these funds styles have recovered, their investors will be emotionally drained, and likely feel that the time invested was wasted. They went through all of that turmoil, their retirement is approaching faster and faster, and they made no progress toward it.

CONCLUDING THOUGHT$ ON THIS STUDY:

Perhaps the theme of this study could be summarized by the fact that the Emerging Markets fund category is termed by Morningstar as "Diversified Emerging Markets." A 54% drop there last year seems to diminish the attraction of that type of "diversification." Again, many of the standard investment categories failed last year, and this year's rally has still not reversed enough of the damage to satisfy many people. What's worse, following a 50% rally in the S&P 500 Index since early March, you have to wonder if the effort to break-even will take a step back soon, resulting in a longer break-even period.

Advisors and their clients should expand their horizons when considering what asset classes fill a portfolio. Relying on the traditional categories to persevere through a variety of market cycles is "so 1998," you might say. Well, it is almost 2010 and the writing is on the wall. The mutual fund industry, as with other investment vehicles, has a lot to offer beyond what many investors realize is out there. By combining what is there with a more common-sense approach to asset allocation and risk management, they can be set up to pursue their objectives with a greater probability of success...and hopefully a lot less pain along the way.

* ©2007 Morningstar, Inc. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results. Equity Style Box: Placement within the Morningstar® Equity Style Box™ is based on two variables: relative median market capitalization and relative price valuations (price-to-book and price-to-earnings) of the fund's portfolio holdings. All of these numbers are drawn from the fund portfolio holding figures most recently entered into Morningstar's database and the corresponding market conditions.

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Sincerely,

The Emerald Team

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