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From The No-Load Fund Investor, 10/16...
The U.S. stock market finished the month essentially unchanged, and therefore continued to be up about 7.7% year to date. Large-cap value was the worst broad investment area in September, while the growth style showed improved relative strength. So far this year, however, the average value fund and ETF in our database is beating the average growth product by about five percentage points.
Our best recommendations over the past month have been those that include at least some in the way of foreign growth stocks and foreign small cap stocks. These would include Artisan Global Opportunities (ARTRX) in the first case and Grandeur Peak Global Stalwarts (GGSOX) in the second, for example. While both funds are attractive for current purchase, before you buy please be aware of potential capital gains distributions within regular accounts by any actively managed mutual fund, including these two, by the end of the year.
Best Buys Commentary. We are making no changes this month in our allocations or specific recommendations. The market has been holding up partially thanks to the decision by the Federal Reserve Board to delay increases in interest rates, probably until December. This is pretty much what we have been expecting, because we didnít see the central bank increasing rates much at all this year before the presidential election.
Earnings growth has been fairly poor across the stock market, though the total has been brought down over the past many quarters by the energy sector. If you strip out energy, earnings havenít been that bad. Priced off recent earnings, the stock market, while not exorbitant, is on the expensive side. This argues for moderately conservative asset allocations such as those in our core Best Buys models (especially Retirement and Income & Capital Preservation), as we believe large returns over the next year are unlikely from these levels, given earnings and likely Fed policy after the election.
Active vs. Index: Small Caps
Standard index mutual funds and ETFs attempt to match the risk and return profile of a particular index, otherwise known as a benchmark. To do so, they invest in all of the indexís holdings, or at least a large representative sample, constructed in the proper proportions (usually weighted by market capitalization). Since the fund world is highly competitive and thereís virtually no way for a typical index fund to beat its benchmark, index funds pegged to the same benchmark tend to compete on cost. Therefore, they tend to have miniscule expense ratios as compared to actively managed funds in their respective peer groups.
To beat the index funds in its peer group, an actively managed fund must produce enough total return to exceed the difference between its expense ratio and that of the index fund. The average such difference is about one percentage point. Though that may not seem like a high hurdle at first glance, in fact itís nearly 10% of the stock marketís average annual return over many decades; during leaner than average periods, it can be an extremely daunting hurdle.
Managers of active funds employ various strategies to attempt to beat their benchmarks. In the late 20th century, a significant percentage of managers left 20%, 30% or more of their fund assets in cash when they thought equities were due for a fall. Though this strategy is out of fashion now, a few managers still try it. Others invest aggressively in speculative stocks, hoping to achieve above-average returns over the long run by shouldering above-average risk. Some invest in a relatively small number of stocks and/or sectors, hoping that a concentrated portfolio of their best ideas will overcome. Still others maintain wide diversification, but attempt to beat the market with a multitude of small bets on specific stocks.
The first three of these strategies are problematic. Timing the market is a tricky business. In my (Editor Mark Salzinger) 25- plus years in the investment-advisory field, I canít recall any timer who got both the downturns and upswings right. In a market with a generally upside bias, itís dangerous for a fund manager to leave a big percentage of assets in cash, which is more likely than not to be a drag on returnsóespecially if big returns come in a relatively small number of days that a timer could miss. Meanwhile, a growing body of financial research suggests that instead of boosting long-term returns, speculative stocks hurt them. Though the most volatile stocks tend to outperform in strong bull markets, they underperform so much in bear and even flat markets that their long-term returns pale in comparison to those of less volatile strategies. While focused strategies can work at times, we prefer that even focused managers maintain diversification, including across sectors.
You can read our full analysis on active vs. indexed investing in the October issue of The No-Load Fund Investor.
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