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From The No-Load Fund Investor, 2/14...
A Rough Month
The stock market was tumultuous in January. On average, the diversified U.S. equity funds in our database lost 2.8%during the month (and a few more percentage points in the early days of February). Though most kinds of stocks were down, large-cap indexes fell a bit more than small-cap ones. Healthcare stocks, especially biotechnology, bucked the trend by producing strong gains, as did metals & mining stocks.
The worst performances were overseas. While the MSCI EAFE index of stocks in developed foreign markets (mainly Western Europe and Japan) fell 4.1%, emerging markets fared much worse. For instance, broad emerging market exchange traded funds fell about 8.5%. Meanwhile, in a reversal from the situation as it existed in 2013, bond funds that invest in longer term, higher quality securities were up, as rates fell on longer-term Treasuries and other investment-grade debt.
Best Buys Commentary/Changes. Ostensibly, investors in U.S. stocks have been spooked so far this year by various fundamental factors: some disappointing earnings reports; slowing rates of economic growth in China; political and/or economic instability in some other emerging markets; a subpar report on the U.S. manufacturing sector. However, we think the market has been correcting mainly because after an excellent year last year, investors have been looking for reasons to take some profits in the face of valuations that are stretched in some areas.
Given the many plusses we delineated for the equity market in “Forecast for 2014” (January 2014), we think this will turn out to be a scary, yet moderate, correction, not the beginning of a new bear market. Therefore, we are maintaining the asset allocations within Best Buys.
Does Turnover Matter?
A few months ago, William Smead of Smead Value Fund (SMVLX; boldfaced in the Growth category of our Performance Comparison tables) told us that he thought the traditional bifurcation in the mutual fund world between passive (index fund) and active investing was incomplete. Instead, Smead said, there were actually three categories: passive, “way-too-active” and then a small slice of what he called “genuinely active.”
To determine in which of the three categories a fund would reside, one would examine its portfolio turnover. This measures the percentage of the fund’s assets that change securities from year to year. For example, if a fund’s assets remained constant over a year, and half the assets ended up in different stocks than at the beginning of the year, the portfolio turnover would be 50%.
Historically, an average turnover ratio for an actively managed stock fund was thought to be on the order of 90% or 100%. For a passively managed index fund, it would be considerably lower: less than 10% for a large-cap fund and 20% or 30% for a midcap or small-cap one. (With stock index funds, turnover primarily tends to happen when one stock replaces another within the index.) Smead defined “genuinely active” as turnover of less than 30% a year over a number of years. His own fund has a turnover ratio of just 11%.
Smead believes that buying and holding reasonably valued, high-quality companies in growing industries is the best way to compound wealth over time. Advocates of higher turnover have a different outlook. They believe they can buttress total returns by trimming or selling holdings when they become seemingly expensive on a short-term basis, or by buying certain stocks at the beginnings of upswings. Later, they sell these stocks relatively quickly to move into other stocks with ostensibly better potential for near-term profits. They may also buy and sell quickly on momentum, buying stocks in technical or operational uptrends and selling them when their stock prices or operating performance suffer some short-term turbulence, like a slightly disappointing quarterly earnings report.
For more of our analysis on mutual fund turnover and its impact on performance, see the February issue of The No-Load Fund Investor.
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