Archive for the ‘Investment Strategy’ Category

When we look at the recent popularity of bank stocks, it is evident that a lot of people will get burned. The recent run up has resulted in higher volatility, which means that just as quickly as things have risen, they will drop. And up until the point that the prices really start to head south, someone will keep buying up these “popular” bank stocks. Everyone except the mutual funds who, for the most part, know better that to get sucked into the popular investment strategy when things rise, they will only keep rising.

Taking a contrarian investment approach like those we discussed elsewhere on this site might help.

Or it might not. After all, financial services firms remain relatively unpopular unless we are talking specifically about the “big banks,” the same stocks and companies that burned people in the past. But not all financial services firms are created equally. People who want to know where to invest their money might do well to examine the smaller firms, like those where Ivy Small Cap Value fund invests.

After all, our recommended Ivy Small Cap Value Fund has rewarded investors with a 13.39% return YTD.

Evidently, the folks at Ivy are doing something right, yet in their top 25 holdings you will not find any Citigroup, AIG, Fannie/Freddie, et al. holdings. Not a single one of them. In fact, they invest a large chunk of their assets in Small-cap stocks… not large, not Giant. (To a lesser extent, they invest in Medium cap securities, but as a small cap focused fund, they are pretty keen on sticking to their small-cap guns.

Given that less than 4 months of the year have passed, a 13.39% return (as at April 9, 2010) is pretty respectable. They know where to invest, no doubt about that, especially when it comes to investing in financial services firms. So, for those investors who have enjoyed the volatility rise and continue to pour money into some of these unsupported (fundamentally anyway) financial services firms, don’t let yourself get burned. Invest in a mutual fund that pays the pros to put your money where it belongs — in the right firms.

As a follow up to our former Contrarian Investment Practices post, we want to take a closer peek at exactly where to invest if these contrarian theories have any merit. Of course, we will look at mutual funds specifically.

In a recent article published by Russel Kinnel, the Director of Mutual Fund Research over at Morningstar.com, it became quite apparent that Contrarian Investment practices actually do work. The methodology that Kinnel used involved investing in funds that were seeing cash outflows (the “unloved” funds) rather than those funds that were deemed most popular based on the dollar amounts of inflows (the “loved” funds).

What Kinnel discovered was that investing in the unloved funds yield returns that were better than not only the “loved” funds returned, but the S&P 500 as well. In some cases, those “unloved” returns were substantially higher — 8.1% for 3 years versus the “loved” returns of 6.24% and the S&P returns of 6.96%.

The same trend holds for a five-year period as well, with the “unloved” mutual funds outperforming (8.08%) both the loved funds (4.25%) and the S&P 500 (5.76%).

The Question becomes one about finding out what the “unloved” are.

Finding out what the unloved funds are poses something more of a challenge. Kind as he is, Kinnel pointed out in his article that the “unloved” funds or categories were the large-cap growth, large-cap value as well as world stock. Easy enough to find the top performers in these categories; simply visit Morningstar.com and use their free fund screener.

But what about those times when finding these unloved categories is more difficult than finding them in an article so kindly published by someone like Kinnel? Well, let’s take a look at Kinnel’s statistics once again. In terms of best performing mutual funds, the following trend emerges quite easily:

• Unloved categories will outperform the Loved categories
• The S&P 500 will outperform the Loved categories, but not the Unloved categories.
• The Loved categories will not outperform either the Loved categories or the S&P 500.

So, if you cannot figure out what the “unloved” funds are (or even what the “loved” funds are for that matter, meaning you can’t figure out what to sell), there is one option. Consider that the S&P 500 outperforms exactly what your friends buying and likely what the advisors are recommending… why not buy Index Funds?

Index Funds might not beat out the top Unloved categories as a whole, but will definitely outperform what your advisor is recommending (or even what your friends are buying). This is particularly convenient if contrarian investing is something that investors are unable to fully agree with (e.g. cannot stomach being possibly wrong with their contrarian choices as they fluctuate and fail to return a positive number for a couple of years). While this is not the absolute best way to achieve the best returns, it definitely is where to invest if you do not want the hassle and potential expense associated with learning about mutual fund inflows and outflows.

An interesting philosophy exists, whether you invest in mutual funds or straight equities, that suggests we can all know where to invest if we go against the current rather than with it. In other words, if we adopt a contrarian mentality, we stand see some sold long-term gains in our portfolios. As an investment strategy, this is not always an easy thing to do. When you get into picking the best mutual funds, it becomes even tougher. (And of course if we are short-term traders, then it becomes virtually impossible).

So, where to invest…

Common sense and history tell us that if we all invest in a single asset, we drive the price of that asset up. Look at Oil in 2007. Look at Gold today. Look Apple shares. But the risk you run when you follow the herd is that you end up buying that asset somewhere near the peak of its price range, exposing your portfolio and investment to some serious and very real risks. For these reasons, we often try to find that diamond in the rough, that undiscovered security that is trading at a terribly low valuation — look at RIMM seven years ago, for instance, Teck Resources (TCK) even 1 year ago. Again, with the power of hindsight, we would all be retired by now, and we would all be millionaires.

With this “find the diamond in the rough” mentality, a couple of things can happen. One, we take on exaggerated risks because the assets we buy are simply cheap; they lack the fundamentals to support investing in them at all. The second thing that happens is that we hit a grand slam, we pick the right security at the right time when everyone else threw money at the latest and greatest Wall Street gem. The latter, of course, is an example of Contrarianism and this is exactly how we should invest, according to some.

What is Contrarianism?

This type of investment practice can mean a different things for different investors. The obvious interpretation is to sell when and what others are buying, and vice versa. It speaks to Warren Buffett’s famous quote: “Sell when others are greedy and buy when others are fearful” (not an exact quote, but the message is bang-on).

On a deeper level, it involves going in areas that others are ignoring. It means buying Citigroup (C) when it was trading at $1.02 and everyone else was not only ignoring it, but buying bonds at ridiculously low rates. It also means believing in the company’s fundamentals, trusting that the Board is doing the right thing by appointing Vikram Pandit after Charles Prince resigned (of course, each company will be different, the names will change but, in Bon Jovi’s words, the streets are the same).

It is in my opinion that this second type of Contrarian investment practice is the one we want to adopt as amateur, novice and even intermediate investors. Not only is it less risky (e.g. ignoring a strong asset class altogether and dumping money into unfavored classes even when fundamentals do not support it), but we can actually apply this practice to mutual funds purchases.

Now, understand that great websites like Morningstar have built tremendous intellectual capital, websites, and businesses doing exactly the opposite. That is to say that their models often favor top-performing funds where regular investors are flocking (this website’s Top Picks are great funds that Morningstar has ranked well, also). And other sites like FundAlarm also takes this view, ranking funds as “dangerous” if they fail to meet or exceed their group or category for three measurement periods.

But Contrarianism takes a different view. Often, the mutual funds you should invest in under this theory are those with net redemption figures, which are often triggered by poor performance track records that gets noticed by those two websites mentioned in the previous paragraph. Some Small Cap Funds like the Ivy fund (YTD return of 9.74%) we like, for example, invest heavily in small to medium cap financial services firms. Investing in this Ivy fund could certainly be considered a contrarian move; investing, on the other hand in the High Yield Investment fund that we recommend (YTD return of 3.80%), would not have been.

While both funds above are in completely different asset classes, they have both outperformed their peers, which leads to a natural question: do Contrarian Investment Practices really work?

The simple answer is: yes they do, especially with mutual funds.

(More to follow… check back soon as we take a deeper look into this interesting investment strategy and provide a tangible foundation to our argument).

In an article published at Bloomberg.com on March 18, 2010, it was noted that bonds issued by financial services firms like JP Morgan and Credit Suisse in particular came with rates that were substantially higher than rates in the general market. What this means for mutual funds and growth funds in particular is that there is plenty of opportunity in the financial services sector. Let’s take a closer look.

The Bloomberg article in questions makes it quite clear that the debt sold by banks, brokers and insurers returned 0.81% compared to the broader market’s return of 0.48%. This is a premium of more than 80% over what the broader market dictates. Consider this for a minute as we explore another interesting comment that was made in the article in question.

Brian Machan, a money manager at Aviva was quoted as saying that very few people are “underweight” in financials. This means that mutual funds are heavily buying up this debt. They are doing it because it looks attractive. The reason it might look attractive is that the yield is expected to drop, thereby increasing the value of those bonds on the open market.

The flip-side is that the financial services firms issuing this debt find rates attractive. This means they expect rates to increase in the future, allowing them to finance debt at today’s currently low rates. All indications support a rising interest rate environment; if ever there was a time to issue corporate debt now be that time (to the benefit of the borrower, that is).

Now, getting back to the premium paid by these financial services firms. Consider why they might need to raise this type of capital. It is cheap. Plus it helps finance a whole lot of plans. These banks have something up their sleeve and it is just around the corner by the look of things.

As far as growth funds are concerned, the mutual funds that are bullish on financial services such as the Ivy Small Cap fund we wrote about already or the Dryden fund we bragged about earlier, send a strong message to the investment community: financial services stocks are expected to outperform. This sure seems to be supported by the level of debt they are confidently raising right about now.

Other growth funds that invest heavily in financial services stocks include the FBR Small Cap Financial fund which has a history of LOW risk and above average returns. Morningstar rates it as a 5-star fund! Like the Ivy Small Cap fund that we touted as our Top Small Cap Pick for 2010, the FBR fund has a large interest in Iberiabank and East West Bancorp, regional banks that stand to substantially benefit from a positive shift in the economy.

Regardless of what type of mutual fund you choose, ensure that your growth funds have at least some exposure to the financial services sector. Whether they are smaller, regional financial companies like those held in the IVY or FBR mutual funds or larger banks like JP Morgan and Credit Suisse, the indications are quite clear that these firms expect to reap the profits and rewards of an economic turnaround that is just waiting to happen.

Ask nearly every professional mutual fund manager what they do for a living and their response might surprise you. While normal people like the rest of the world see (many) mutual funds as fine examples of investment strategy, security picking and so on, the professionals who pull the trigger on trades actually see their roles in the investment management quite differently. In fact, they see their jobs more as risk managers than investment managers.

Their view makes perfect sense, of course. They are risk managers, no question about that. Take the AIM Diversified Dividend Fund, a 5-star fund as measured by Morningstar. That fund has $1.5 Billion worth of other people’s money… you bet they are risk managers! If Meggan Walsh, who has been managing this big fund since 2003 thought otherwise, the fund would not have made the investments it has made, it would not have achieved the high returns it has enjoyed and it would not have done so with average or below average risk.

Risk is the investor’s greatest consideration when throwing money at a security.

Consider that — average or below average risk while achieving high returns. This is key because returns can be quite easy if one is willing to take the risks. And that risk is loss of capital. Which sounds simple in many ways, but how many of us felt that taking on risk was a reasonable thing to do before the market correction of 2007, 2008 (ouch) and the first quarter of 2009?

Even though higher risk is frequently synonymous with higher returns, we often forget that higher risk often means higher probability for loss. And those losses are very real when they happen.

So the recommendation is really to shift our thinking from high risk = high rewards to one where we aim to achieve above-average returns by taking on less than average risk for those returns. The idea is to achieve more than the risk levels dictate. That means earning 10% when the Beta or assumed risk suggests we should only enjoy returns of 7% or 8%.

To illustrate, consider high-risk derivatives. While it might be nice to achieve 5% returns, if you could achieve these returns with guaranteed and insured term deposits, why bother with the high risk derivatives? It makes little sense, right? But if we could achieve 10% returns with those same term deposits, why not give up the excitement of the market? (Of course, this rarely happens, so we have no choice but to accept that higher risk).

Mutual funds help us achieve above average returns while enjoying below average risk. This is because mutual funds so something many of us fail to do on our own — they diversify. (They also measure risk better than we do because they have the staff to analyze financial statements, perform site visits, call up management and so forth). Ultimately, diversification saves these mutual funds when risk rears its ugly head more than anything else — after all, no amount of analysis and over-management can eliminate market risk; but diversification can surely reduce all other risks.

While individual investors might opt for a dozen or so investments, mutual funds like the AIM fund quoted here, hold over 75.  And with 78% of those assets as large cap or giant cap, they really are achieving better returns for less risk. And this is important especially when markets sour. Again, referring to the AIM fund, its performance has outpaced the S&P 500 for its YTD, 1-year, 3-year and 5-year periods. The performance speaks for itself.

And this is just one fund. Most properly managed funds will evaluate risks and trade accordingly. The result? Those total returns outpace the broader market and, just as equally, other funds in its category. For investors this means less losses in market downturns and greater returns when the markets turn around.

It may seems obvious to some and it is definitely obvious once it is pointed out to investors, but where to invest in periods of economic expansion is definitely not in typical bond portfolios. Instead, value funds or mutual funds with a good blend of value and growth securities would be the most logical place to start. As an investment strategy, this is not an art or a learned skill; it simply makes sense once the description of an economic expansion is properly understood.

So what is an economic expansion?

According to Smart Money, which published a great article about the Yield Curve, and economic expansion typically occurs immediately after a recession. Now, we have to be careful about how we define a recession. Yes, it means for tough economic times and periods of cutting back and sacrifices. But economically, a recession is different than what people like you and I experience. Instead, a recession is categories by certain economic statistics, including among other things, several periods of consecutive negative growth. Once that trend is broken and other economic statistics line up, that recession is over. And strange things start to happen.

Like what?

For starters, yields on treasuries and bonds steepen. This means that the rate on a 3 month treasury bill more than 3% lower than the rate charged on a 30-year treasury bond. As of today (March 15, 2010, that spread is more like 4.47%), this certainly holds true according to data on bloomberg.com. And if the Yield Curve is at all accurate in everything it has suggested since the late 1970’s, then we are in a period where the economy is expected to start growing quickly in the near future.

What does that tell us about where to invest!

Before we get to that, consider what it tells us about where not to invest. Obviously, when rates are expected to increase (everything we hear today combined with the yield curve tell us as much), bonds are out of the question. This means lightening up on income-class securities and moving money into equity based securities.

But does that mean growth funds or value funds (or a blend of both).

At the Mutual Fund Site, we have suggested that some small cap funds are actually no brainers. We outline the reasons why in some detail, but let’s look at the most fundamental reasons why some small caps are a good starting point:

• Value. Yes, we said it. Small caps offer tremendous value right now. Why? Because they were beaten down the credit crisis of 2007 dragged through 2008 and into 2009. The fear was that small cap stocks would disappear off the face of the earth once they could not fund their operations through credit or they went broke trying to make payments on higher-rate capital. In many cases, this did not happen and the survivors stand to benefit. In our case, we like regional financial institutions because they have government stimulus and people’s returning to work (okay, in some cases where employment is over 20% like in some areas of California, this seems like a stretch, but things will improve even in these highly unemployed areas) on their side. Plus, many of these companies have been very profitable during the last few years… even with the world crumbling around them!
• Small caps are one of the first segments to record steeper profit growth. This could be a numbers game in some cases, but it could also be the result of smaller companies willing to take the risks that larger corporations are unable to take. Blame it on smaller boards, less restrictive financial covenants, etc., but smaller cap companies take risks where larger companies simply will not… and this often bodes well for them.
• Lastly, small cap securities are one of the first to experience a “pop” in security price when recessions are over. Look at Citigroup as an obvious example (although you cannot say they are small cap, their story is quite well known). When it became clear that they would survive after all, its share price popped on the news alone. All they had to say was they were going to survive! Imagine a company that had numbers to back this up! Small caps have those numbers.

Does that mean we recommend small cap stocks? If small cap stocks are where to invest, what does that say about less risky alternatives?

Well, we believe that value funds are where to invest. Because even larger cap securities (and many mutual funds hold them) offer tremendous value, even in today’s market. And this is where investors should be — in value funds or funds that invest in such securities. Is it too late? No, not if we believe what the yield curve is telling us. I mean, look at GE, one of the world’s largest and most-diversified conglomerates. In 2008, its stock price touched below $6.00. Talk about extreme value… now it trade at nearly $16 and it still has inherent value.

Of course, we advise clients to be careful when they look at value funds and make sure they are investing in something that meets their investment needs and risk tolerance.

In order to achieve long-term growth within your mutual funds portfolio it is believed you will need to incorporate a fairly significant amount of equity or growth funds. While this certainly seems to be a valid argument based on historical rates of return and the difficulty associated with accurate market timing, not all investors need to have a portfolio that consists entirely or primarily of growth mutual funds.

For highly risk averse investors, loading up on growth mutual funds would obviously be imprudent and no financial advisor, tenured or otherwise, would ever recommend doing so. But imprudent would also be ignoring the growth asset class entirely.

Now there is a way for investors to ensure that they eliminate equity risk in their portfolio, even while investing in the wildest, highest of high risk equity funds. They do this by finding a guaranteed investment, whether it is a quality bond, term deposit or other virtually or entirely risk-free investment and working out how much interest they will earn over the time horizon of their investment.

Let’s take a closer look at an investment that pays 5% per year. If you had $10,000 in total to invest and you wanted to make sure that it was guaranteed over ten years, you could actually invest $3,860 in high risk equity mutual funds that could return whatever the market allows. The remaining $6,140 would earn 5%.

But regardless of the performance of those equity funds, the remaining $6,140 invested in that guaranteed or extremely low-risk investment at 5% would be worth $10,000 after ten years. This allows you to invest $10,000 today and enjoy absolutely no risk at all. The catch? That you wait 10 years without touching the $6,140.

The worst-case scenario would see the equity mutual funds worthless after 10 years. The best-case scenario is that the return is greater than 5%, leaving you with more than if you invest $10,000 in its entirety in the guaranteed 5% investment. Realistically, you should expect a higher return. Even a 7.5% return on the equity fund would bump your portfolio’s performance from 5% to a little over 6%.

Might not seem like a lot, but 7.5% over 5 years is really a lower-risk equity fund. And, really, the point is not so much that you are now outperforming your friends, but that you are achieving that performance without any risk at all to your capital.

When we have so many mutual funds to choose from, we often get lost in some of the irrelevant details. We seem to want to chase the next trend, the biggest or hottest sectors and so on. Bond funds, value funds, dividend funds; we talk about these specific investments right here on our site just as planner do with their clients. If we were looking at economic figures, we would call it micro-economics. But when it comes to investments and mutual funds in particular, taking a macro-economic approach might actually help tell us about where investors should steer their money.

If we look globally, for example, we see that the Japanese Yen has been taking a hit over the last week or so because of that country’s position on interest rates. Unlike the US where the economy is (finally) starting to grow and rates have increased (Fed Funds Rate) and are expected to continue to increase, Japan is looking to reduce rates so that people will borrow and therefore buy more. While this fiscal policy will devalue their currency, the implications for Japanese corporations, particularly those that export their goods, are actually very positive.

In fact, a devaluation in currency combined with increased foreign spending will have a turbocharging effect on Japanese companies that report their financial results in Yen. Not only will sales revenue increase, but if foreign dollars are being used to purchase goods, the currency conversion results in a forex gain on the financial statements.

This could be a bad thing in the long-term. As the Yen stabilizes and starts gaining in value again, the company may have forex losses which can offset or more-than-offset stable or even climbing revenues.

What this means for mutual fund investors that is that Japanese-heavy value mutual funds might be a safe bet for shorter-term gains. Why? Because the premise of a value mutual fund is that the securities held within the portfolio are undervalued. This can be based on any number of criteria, but are normally price-to-earnings, price-to-book (value), price-to-cash and so on and so forth. Ultimately, the fund manager will determine whether to include a security in his or her value fund, but the qualifying criteria will come down to one thing: the security is underpriced.

This security, mind you, can be equity or income based. Right now, investors would gain either way. Japanese bonds can very easily increase in value if rates start dropping. Japanese equities can also increase, but it could take more time before revenues start to increase and translate in to balance sheet strength.

Our next step is pick a value mutual fund that meets our specific investment objectives (with time and risk as the driving force behind such a decision).

Now this is a top-down investment approach. It is how the Mutual Fund Site comes across mutual fund recommendations. A financial planner and/or investment advisor will work this way as well. Except they do this by also understanding your goals and matching up your goals and beliefs as best as they can to the macro-economic situation.

A long-term investors who has a decent appetite for risk will be ill-served to keep all of his or her investments in domestic securities. It normally “fits” to incorporate foreign or global investments into the plan. It never (or it should never) involve finding a value fund and then justifying a reason why it makes sense.

With that in mind, buying any kind of mutual fund because of a recommendation is often the wrong approach. Taking a bottom-down, birds-eye approach to your investments always makes more sense.

There are plenty of reasons why investors should steer away from mutual funds that invest in gold. While some mutual funds have performed well thanks to their gold holdings, there is a lot of concern among professional money managers that gold may have reached the end of the profit road.

It could be one of those situations where hindsight will tell us that the warnings signs were all to apparent. Here are some of them:

Consider the abundance of infomercials on television that ask people to send in their unused gold to be converted into “cash.” At these prices, many of these companies are able to turn a nice profit from all of that activity – in fact, they can even offer to pick up the tab on the courier expenses and insurance. The bottom line is that Gold is at a healthy, attractive price right now… if you are selling it.

…there are some fundamental reasons to steer clear of gold and gold funds

When it comes to investing in gold, one of the most active players are Exchange Traded Funds. Think about that. ETF’s, not central banks, not large financial institutions. What this tells us is that retail investors, who are investing in these ETF’s, are picking up Gold at prices that are so attractive that some of the largest countries in the world are offloading the metal at extremely lucrative prices. What Contrarian Profits.com points out is that when these investors decide to take a profit, the selling of gold by these exchange traded funds will push the price of gold down faster and farther than most expect.

And this makes a great deal of sense. Consider oil. The year was 2008, the month was July and oil touched $147.30, the highest it had ever seen. Since then, oil gradually fell (okay, that’s being polite: oil actually fell like a stone) to under $40 by November of that same year. This does no suggest that gold will suffer the same fate, but nobody expected crude oil to take such a drastic hit in such a short period of time. In fact, some analysts were calling for oil to hit $250 by the following summer (it never reached that).

Although they called crude oil the new “liquid gold” there are more than just rhetorical similarities between the two. First off, oil ran up as the economy reached its peak. Gold, on the other hand became a lot more overbought as the economy reached its trough and has begun to recover. For gold to remain in high demand, the economy needs to remain beaten down and all other inflation hedging investments lights currencies as well as other commodities become less attractive. Ultimately gold prices can be seen as highly sensitive and linked to the economic cycle.

Secondly, oil is a commodity, just as gold is. Just as oil supply is essentially limited and its production is controlled by OPEC, so too is gold supply controlled. In fact, gold production and supply is also shrinking. The point here is simply that arguments that gold will continues to see its prices climb in steady succession are unfounded and cannot be mistaken as fact, despite what some of the others are saying.

Essentially, the Mutual Fund Site believes that gold is expensive right now. We agree with Contrarian Profits that there are some fundamental reasons to steer clear of gold and gold funds that are heavily invested in the commodity, including some Gold ETFs. But because of this uncertainty, we also do not recommend taking a short position against the commodity either; it is best to sit this one out rather than endure a painful recovery process like those who, in the 1980’s bought Gold in the high $500’s and had to wait over fifteen (15) years for the prices to reach such highs again.

Index funds are a hot topic for mutual fund investors because there is a growing belief that index funds will outperform actively managed funds within their respective categories (e.g. a fund that invests in small cap funds would underperform a small cap index fund). A lot of academic research has been done on this topic — more than the scope of this post (and site, in fact) can bear. Between the Efficiency Hypothesis and the Purity Hypothesis, most people can find the answers to their questions.

Why Index Funds Matter

Index funds are an interesting breed and a lot of people swear by their cost to performance ratio. Since index funds simply mirror an index (there is no real research involved, no “intelligence” since it has already been done by the appropriate index, like the S&P 500, the Russell 2000, etc.) these funds are the cheapest in terms expenses.

Cost is a huge factor when it comes to index funds.

What many investors argue is that actively managed mutual funds try to beat the index. Sometimes they win, sometimes they lose and statistically speaking it becomes less and less likely every year that they beat the index to repeat their performance. So, since sometimes they win and sometimes they lose, why not simply own the index and enjoy steadier returns?

So Why Bother With Actively Managed Funds?

Indeed, knowing the above information may make an actively managed fund seem like a big and expensive risk. However, there is a lot to be said about active management, particularly for people who believe in the fund manager who operates and oversees the fund (see our archived post about Anthony Bolton, arguably one of the sharpest investment managers around). When investors have such faith in a manager, they realize that they can employ that person for a fairly low price… even if it is a two, three or even four times the cost of a bland, regular index fund.

The prolific managers are not the sole reason why some people will choose an actively managed fund over an index fund. Since many funds can shift their positions fairly easily, they can often take advantage of market inefficiencies, whereas index funds are stuck owning whatever it is that they own. There is no flexibility to safeguard investors against security specific risks.

Not that these are exhaustive reasons, but they provide the starting point as to why so many investors might chose one type of mutual fund over another.

What The Purity Hypothesis Tells Us

That brings us to Beta. Now, according to William Thatcher, a Senior Consultant at Hammond Associates in St. Louis, MO, Beta can tell us whether or not our actively managed funds will outperform an index fund. But there is one catch: that the performance strength index in particular is a known factor.

How this works is as follows: Suppose small cap stocks are a strong performer in a given year. Based on the Beta of your small cap fund, you will know whether your fund outperformed or underperformed the index funds for small cap stocks. If your fund’s Beta is less than 1 (considered less style pure than the index) then it will underperform the index (and vice versa if Beta is greater than 1).

This makes sense of course. But what it also tells us is that an investor would need to accept a fair amount more risk in order to invest in a fund that has a Beta greater than 1.

The Purity Hypothesis takes things one step farther in demonstrating how to invest, whether in Index funds or actively managed funds. The problem again is trying to determine ahead of time what asset classes will perform strongest for any given year. Because if that much can be determined, then an investor can minimize risk while simultaneously improve returns by:

1. Investing in Index fund for the best-performing asset class (e.g. large, mid and small cap stocks or funds)
2. Investing in Index funds for the three investment styles for that group (e.g. value, blend and growth)
3. Investing in actively managed funds for the poorest-performing asset group (e.g. large, mid and small cap stocks or funds)
4. Investing in actively managed funds for the three investment styles for that group (e.g. value, blend and growth)

The theory presented here finds it support in Thatcher’s research and for the most part can be substantiated by back-testing (I say for the most part because I did not go back to every single period in history to back-test). And of course it makes a great deal of sense because on a risk-adjusted basis, the Index will always outperform active funds when that asset class it outperforming other asset classes. (Click to read the Full Report).

So, whether your mutual funds invests in small cap stocks or follow a particular index, if you can determine which asset class will outperform the market and which classes will fall behind, you can actually achieve great returns (and save a few bucks) by choosing index funds for the top-performing classes and actively managed funds for the poorest-performing classes.

Recently, the Mutual Fund Site presented a post about the easiest and smartest investment strategy: investing regularly on an automated contribution plan. This investment strategy is also (or better) known as Dollar Cost Averaging and makes perfect sense when used with mutual funds, whether more-volatile funds that invest in small cap stocks, index funds, or even bond funds.

Aside from buying more units when the markets are down (and less units when the market is up), Dollar Cost Averaging strips the issue of “market timing” out of your investment strategy. This can be fairly important because virtually nobody can “time” the market with absolute accuracy. That means only luck and no amount of research can help an investor buy at the absolute lowest.

Likewise, even the unluckiest investor will have difficulty buying at the absolute highest, but we often feel that way – that we bought at the highest and now our investments are doomed to fail.

This is where Dollar Cost Averaging makes great sense. Not only because it takes the “guess” work and “luck” out of the situation, but because historically it errs on the up-side. That means that if you use dollar cost averaging, your returns are more likely going to resemble the returns of someone who has the great luck and skill to buy at the absolutely lowest days.

This may seem strange because one would think that, statistically, you are more likely to buy the “average” or median between the best and worst possible days to invest. This would be true in a flat market, but historically markets have risen. Therefore, in a 10-year rolling average, even the “worst” possible day will be the best day at some point.

In fact, a Canadian Financial institution actually ran these numbers based on their market, the S&P TSX index. In their illustration, if you were to invest at the absolute worst days over the period of 1989 through to 2009, your returns would still be positive at 5.42% annually. The absolute best days: 7.36%.

And by employing a Dollar Cost Averaging strategy and invested each month on the first business day of the month, your return would have been 6.38%, less than 1% lower than if you had invested at the absolute best time possible for the year but nearly 2% better than if you had invested on the absolute worst days.

Interesting that a simple, more-affordable strategy could yield such positive results. But again, when you look at the historically rising market, it makes sense. In a declining market, the rates above would probably be reversed, but ultimately, investing through an automated investment program (dollar cost averaging) allows you the benefits of not having to worry about the impossibility of market timing, especially when it comes those riskier mutual funds, like those investing in small cap stocks. The investment strategy, however, can be used with other types of investments as well, even those in declining market-value environment such as bond funds.

Give it some thought….

One of the reasons we like the Ivy Small Cap Value fund so much that we named it as one of our top mutual fund picks for 2010 is that it invests heavily in the right kind of financial services firms. The kind that have great value, even if they are consider small cap stocks or mid-cap stocks. We feel that as an investment strategy, these types of securities will allow the Ivy fund to not only outperform in pure growth areas but with its generous dividend it will also generate some decent income.

One of our reasons for liking the Ivy fund is that its underlying securities stand to benefit handsomely from a housing recovery, something we have already started to see according to a recent post over at Reuters about Homebuilder Confidence.

So why Ivy Small Cap Value and not something like the Fidelity Real Estate Income fund? After all, some of these real estate funds produce fairly substantial gains and income — Fidelity’s sure is one of them with a nice 4.8% yield and high returns compared to its peers, along with its “low” risk rating. But comparing Fidelity’s fund to Ivy’s is not a proper comparison. You cannot compare the two.

You cannot compare a real estate income fund to a small cap value fund.

For starters, funds like Fidelity’s are part of the income class. They invest in income-producing securities with roughly 50% of their total holdings in bonds. Of the 20% they hold in  stock, guess what 91% consists of? (Hint, we talk about about them a lot and suggest the difference between “good” and “bad” financial services firms to hold. Somewhat surprisingly, they seem to be holding the “bad” ones).

In comparison, the Ivy fund is equity driven. They have a purpose, with roughly 40% of their portfolio invested in the type of securities that will benefit from the same recovery from which a pure real estate fund (equity based) should.

So while the Fidelity Real Estate Income fund exists to produce income, Ivy Small Cap Value exists to generate long-term gains with income being a nice bonus. For people who are bullish on real estate, Ivy still makes better sense as an equity play because it stands to profit from the recovery. For the Fidelity fund to remain attractive, rates would have to continue dropping, which is still possible given how fixed mortgage rates continue to drop).

Ivy, however, does not need a housing recovery to remain a top-performing small cap stock fund. Why? Because the majority of its securities are already profitable. Remember, there is a difference between good and bad financial stocks; Ivy knows the difference because they hold the good ones. And those firms will only see their revenues increase when housing makes its come-back.This of course is one of the benefits to holding small cap stocks in a portfolio in the first place.

Would we recommend the Fidelity fund as an income play? Not now (besides, we prefer the Janus High Yield Fund as our preferred income fund for the year. Does that mean the Fidelity Real Estate Income fund is a bad one? Definitely not; it just does not make much sense as an investment strategy right now. And we feel our statement is fully backed up by the yield curve.

As an investment strategy, putting $12,000 into a mutual fund today versus spreading that $12,000 over the course of twelve months (or $1,000 per month) is statistically not such a smart move… well, unless of course you invest $12,000 per month or at some kind of regular interval. This has nothing to do with the mutual fund in question. Instead, investing regularly has its share of perks, in fact enough of them that investors would be silly not to take advantage of them from Day 1.

To illustrate just how powerful regular investments can be versus single, lump-sum investments, consider that even if a security value drops, you can still come out with a gain if you make your investment purchases on a regular basis.

To add credibility to our little illustration, we will look at S&P 500 values for 2009. Our first investor will invest $12,000 on the first business day of January while our second will invest $1,000 every month on the first business day of that month. By December 2nd, they will have both invested at total of $12,000.

As we can see from the chart below, the investor who invests every penny at once will be ahead by 19% on December while the investor who puts $1,000 aside every month is only marginally ahead of that investor at 20.57%. The difference of $200.10 hardly seems worth it in the end… or does it? Putting yourself in the shoes of the two investors might tell us a different story as we work our way from month to month.

Take look at the Investor #1 who goes “all-in” on January 2, 2009. How would this investor feel one month later on the first business day of February when that $12,000 investment is down 11.41%, a loss of nearly three thousand dollars. Would Investor #1 be getting sick to her stomach on the first business day of March when that investment is down 24.79% or a heart-stopping $2,974.63?

In comparison, after that first business day purchase in March 2009, Investor #2 would have put $3,000 away and lost just 13.3% or $398.86. In absolute terms, Investor #2 would probably feel a lot better than Investor #1 at this point. And any sinking feeling of loss would be gone for the rest of the year for Investor #2 by the time the first business day in April rolls around and he see his investments roughly at a break-even point (a 0.26% gain actually) while Investor #1 is still not eating or sleeping because they are still down nearly 13% or $1,554.67.

In fact, while Investor #2 watches his investment gain throughout the rest of the year (except in July, when they slip from being “up” 12.27% in June down to being “up” only 8.53% in July), Investor #1 has to wait two extra months before they break even again… and that victory is really short-lived because in July they will have seen their investment swing back into the red again. Talk about an emotional roller-coaster ride for Investor #1 — while Investor #2 recorded just 2 “down” periods for the year Investor #1 was in the red for 5 of the 12 periods, a little more than 40% of the time!

And what if either Investor had lost part or all of their regular income and needed to draw on their investment after 3 months? At that point, only Investor #2 showed a gain of any type meaning Investor #1 would have been cashing in at the absolute worst time possible.

Of course, in the end, Investor #2 actually ends up being $200.10 ahead of Investor #1, thanks entirely to their regular contributions allowing them to purchase more units. After understanding the probable emotional turbulence that Investor #1 experiences, the extra $200.10 seems like only a single piece of what is really much-larger bonuses — these being the reduced stress levels, the added units and the lower dollar-value losses when things turn South.

This is not magic. You can run the figures yourself using S&P 500 closing prices found at Yahoo! Finance. But remember: investing regularly in mutual funds really can make a big difference.

Illustration A (S&P 500 values; Invest One-Time vs. Invest Monthly)

Illustration A

Over the last month or so, the Mutual Fund Site has had a lot to say about the financial services industry, whether we were bragging about our top small cap fund pick for 2010 (for those who have not read the post, the fund in question is the Ivy Small Cap Value fund), talking about the importance of dividend funds in building a profitable portfolio, or tooting our own horn about how we did a great job applauding Dryden’s approach with financials.

To tie these areas together, let’s consider that our 34% of our small cap fund pick for 2010 consists of regional financial services companies, many of which contribute heavily to the fund’s average dividend yield of 2.8%; many dividend funds will rely heavily on financial services companies whose stocks have become devalued to the point that the dividend yield alone makes them attractive assets to own; and Dryden’s Financial Services fund owns a substantial amount of high-dividend paying Canadian bank stocks.

The point above may not be obvious.

What we have here is something of a reverse-engineering problem. Consider that Canadian banks have been touted as the most solid in the world and they pay healthy dividends. Consider that dividend paying stocks are instrumental in ensuring healthy returns, whether inside or outside of a mutual fund investment. And consider, lastly, that Canadian banks are heavily involved in the retail banking segment of their  country, just like the regional banks held in the Ivy Small Cap Value fund are. In fact, those financial services firms in the Ivy fund are doing exactly what Canadian banks are doing – lending responsibly to Joe Public so he can go and buy himself a home, car, boat, whatever and get the economy turned around.

The point above might make a little more sense when you consider that regional banks are an important party in the economic recovery efforts that are being promoted by US officials like Barack Obama, Timothy Geithner, and a host of others who have taken a hard-nose approach with the “big” banks who are often blamed for bringing an end of the last economic boom and practically killing the global economy. In fact, a lot of these officials are trying to convince these big banks into behaving the way these smaller banks are behaving.

So what might that mean for the regional banks?

Well, it could be acquisition for one thing. Canadian banks, who conduct business in a similar manner as these regional banks, have been acquiring some of these regional banks for some time (and now with the US dollar as low as it has been, the Canadian Banks’ purchase power has increased) such as TD Bank purchasing Commerce Bancorp, an award-winning regional bank based out of Cherry Hill, NJ, in 2007.

More likely, however, is that these smaller banks, which pay bigger dividends (based on dividend yield) than their big bank counterparts like Citi and Wells Fargo, will have the support and encouragement of government. They are already operating the way the government would like to see them operate; they already understand responsible lending practices, they are already profitable and fiscally strong (one in particular has increased its equity value by more than 50% over the past two years alone!). The government should love these players.

And, most importantly, when the economy turns around and people start waiting in line for mortgage approvals, credit card approvals and other types of credit or credit-related services, these regional banks will see their income increase exponentially. Why? Well, they are already profitable and the economy is just slowly finding its feet.

It’s a perfect situation for mutual funds like the Ivy Small Cap Value fund (we went so far as to call buying this small cap fund a no-brainer). And for the strong-willed investor with the right risk tolerance, time horizon and investment objectives, it becomes and easy lesson in investment strategy, one that requires very little advanced research. It’s almost the best-kept secret in the mutual fund space (except we exposed it, and we are always proud to help out). And if you are not sure how to get your hands on these stocks, just head on over to Ivy and let them do the number crunching and trading for you.

Just yesterday (February 14, 2010) the Mutual Fund Site announced its top small cap pick for 2010 — the Ivy Small Cap Value fund. In that long-winded post, we outlined various reasons why this small cap fund is a no brainer, why all of the ducks are lined up and its sights for gains are clear for this year. With the mildly improving interest in housing thanks to the gradually improving employment figures, a lot of regional banks like those held by the Ivy Small Cap Value fund stand to profit. What emphasizes this fact is that a lot of regional banks are better positioned when financial service reform will start to take shape.

Okay, this entry is not intended to regurgitate what we wrote in our release or in the post. With that in mind, we will examine one area that makes this small cap mutual fund one of the most intelligent mutual funds available to the investors with the right risk tolerance, time horizon and investment objectives. Why? Because its dividend yield!

We have spoken at length about dividend funds and the importance of dividends in helping boost earnings withing a mutual fund. In fact, we have gone so far as to suggest that dividends can make the difference between what people perceive as a smart investor and an unlucky one. Where the Ivy Small Cap Value fund makes such a great investment is in its dividend yield of 2.8%.

Remember, value funds’ primary area of focus for returns lies in the abilities of the mutual fund manager to pick up underpriced assets. If the fund manager wanted dividends to prop up returns, he or she would be managing a dividend fund. With Ivy, the point is clearly in the “value” its assets offer. This can be supported by the relative low average P/E for the fund of just 15.7. This tells us that the underlying securities are clearly undervalued.

So where do these dividends come from, exactly?

We mentioned yesterday that three of its Top 5 holdings are Wintrust, IBERIABANK and East West Bancorp. Their dividend yields are 0.6%, 2.5% and 0.3% respectively (as of Friday’s closing price). Now, IBERIABANK’s dividend is clearly the highest, but still falls short of the fund’s average dividend yield. And with just 77 securities in its portfolio, obviously some of the other financials are paying much higher dividend yields. Look at First Niagara Financial Group as an example; they pay 4.1%.

And all of these financial services companies are strong. They have solid and/or growing equity positions, they are profitable and, well, they pay decent dividends.

Let’s look at some of the bigger financial services options out there.

• Citigroup. Its dividend yield is 0%.
• Wells Fargo. Its dividend yield is 0.7%
• Goldman Sachs. Its dividend yiled is 0.9%

The point here is that so many value investors will throw money at the big guns. Those are the large financial services firms listed here, two of which are terrific “buys” according to the well respected analysts surveyed by Thompson/First Call as well as other prolific stock analysts. But what about First Niagara, IBERIABANK and a handful of other in Ivy’s small cap fund?

These are what people call as investment “Secrets.” They are those dividends that people chase (within reason of course; no sense in buying a bankrupt stock even if it pays a 10% dividend!). The dividends that people wish they knew about.

Is there risk in a small cap fund? Yes. Is there risk in the Ivy Small Cap Value fund? Yes (although Morningstar lists its risk as low compared to its peer group). But when you have a small cap fund that pays 2.8% in average dividends, the fact remains that dividends are not only an important part of smart investment management, but are an essential contributor to a mutual fund’s returns.