August 10, 2014

Consistent Investing

After two unsettled weeks and a 6% drop in the market, let’s revisit a prediction made in August 2010 – impending doom.  Even when doom does show up as it did in late 2008, there are inevitably predictions of even more doom.  When doom does not show up as scheduled, it is a bubble which portends catastrophic doom.  Those who sound a cautionary note do not seem to get the same headlines as the doom predictors.

Each year the Employment Benefit Research Institute (EBRI) analyzes the activity of more than 20 million 401(K) participants.  In their most recent analysis of 2012 data,   EBRI found that a third of participants are “consistent participants”, i.e. employees who participate regularly in 401(K) programs despite the market environment. The portfolios of consistent participants overwhelmingly outperformed the two-thirds who were not as consistent.

Analysis of a consistent group of 401(k) participants highlights the impact of ongoing participation in 401(k) plans. At year-end 2012, the average account balance among consistent participants was 67 percent higher than the average account balance among all participants” in the EBRI/ICI 401(k) database. The consistent group’s median balance was almost three times [my emphasis] the median balance across all participants at year-end 2012.

This data did not include the 30% rise in the stock market in 2013, which only reinforces the point – it pays to participate regularly in a 401(K).   EBRI found that the superior returns of consistent participants was not due to any asset selection.  Their allocation was about the same as the entire group, about 60/40 stocks and bonds.

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Investor Sentiment

An indicator of investor sentiment is the price reaction to upside and downside earnings reports.  If a company reports earnings that are better than average expectations, that is an upside.  Conversely, if a company’s quarterly earnings fall below mean estimates, that is a downside. As the majority of companies in the SP500 have reported earnings for the 2nd quarter that ended in June, FactSet compared investor reaction to this quarter’s  earnings surprises with the average reaction over the past five years.  The sentiment overall has been negative.  There has been little positive reaction to positive earnings surprises and a more than average negative reaction to disappointing earnings reports.

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Target Funds

Some funds, called Target Funds, designate a specific year when an investor will need to start drawing some or all of the money from the investment.  As the fund approaches its target year, the fund adjusts its allocation to a more conservative blend of bonds and stocks.  A fund with a target year that is 12 – 15 years in the future may have a stock bond mix of 75/25.  A fund with a target date 5 years in the future may have a 60/40 stock bond mix. Vanguard’s VTHRX (2030) and VTWNX (2020) are examples which illustrate the difference in allocations.

The appeal of “set it and forget it” has helped these funds grow in popularity.  According to the Investment Company Institute (ICI) the number of target funds has grown from 6 in 1995 to almost 500 in 2013 (Table 53)  At the end of 2008, assets in target funds totaled $160 billion.  Five years later, in 2013, total assets had almost quadrupled to $618 billion.  New investment in these funds peaked in 2007 at $56 billion, then fell to $42 billion per year from 2008 through 2011.  New investment rose again to $52 billion in 2012 and 2013.

Because these funds have a blend of stocks and bonds, most investors would assume that the risk adjusted return (RAR) would be better than a fund fully invested in the stock market.  The Sharpe ratio, a common measure of RAR, computes a ratio of excess return to the volatility of the investment.  Excess return is the extra amount an investment earns compared to a risk free investment like Treasury bills.  If an investment has a Sharpe ratio of 1, then the investor got what they paid for in worry.  A ratio greater than 1 means that the investor got more than they paid for.  The 5 year Sharpe ratio of the SP500 is 1.24, meaning that an investor got about 25% more return than the volatility of the market. Keep in mind that the bull market is almost 5-1/2 years old. Over ten years, the Sharpe ratio of the SP500 was less than .5, meaning that an investor got half as much return for the amount of worry it cost them.  Many target funds do not have a long enough history to compute a ten year ratio.

An investor comparing the 5 year Sharpe ratio of their target fund may be surprised if their fund has a lower RAR than the SP500. Check the expense ratios on the fund.  Target funds that use indexes as their underlying investment may charge as little as $170 per year on a $100,000 investment in the fund. Some funds may charge $800 or more on the same investment. Lastly, what is the correlation between a target fund and the stock market?  A correlation of 1.00 means that the prices of two investments move in lockstep. Stockcharts.com let’s an investor compare the one year correlation of their fund with the SP500. A target fund with a correlation of .99, a high expense ratio and a lower than market Sharpe ratio might lead an investor to question the value of that fund.

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Constant Weighted Purchasing Index

As anticipated, ISM reported strong numbers in July for both the manufacturing and service sectors.  Employment and New Orders, two key components of the Purchasing Managers Index (PMI), were robust in the manufacturing sector at a reading near 65.  In the service sectors, which comprise most of the nation’s economy, employment did not get the same high marks but remains strong at 56.  The combination of new orders and employment in the services sector stands just below 60.

The composite of both manufacturing and services rose to 63.3, continuing the upward climb in this part of a cyclic trend that has been in place for more than three years.

If this pattern continues, we could expect further strong reports into the fall, before declining in October or November.

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Takeaways

Production and employment numbers are strong, causing some worry that the Federal Reserve may raise interest rates sooner than mid 2015.  A growing number of mid and short term investors feel that any near term upside has already been priced into the market.