Warning: Avoid The 2007 "Top 10" Investment Lists

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
December 5, 2006

IN THIS ISSUE:

1. Year-end Flurry of “Top Investments” Lists

2. The Problems With Listing “Hot” Funds

3. Without The Drawdowns, What Good Is It?

4. Buying High & Selling Low

5. Other Problems With The Barron’s List

6. Risk Management Is The Bottom Line

Introduction

Get ready…they’re coming! Every January, mailboxes and inboxes are bombarded with all sorts of forecasts, predictions and, of course, recommendations on how and where to invest your money. Investment magazines are also loaded with their favorite picks and strategies for the New Year. Rarely, however, do these sources review their picks from last year – understandably so, since in many cases, their recommendations a year ago did not turn out so well.

As I have pointed out so often in the past, many of these New Year investment rankings and recommendations focus on the latest “hot” funds or strategies. Typically, they look at the highest performers over the last 12 months. As everyone reading this E-Letter should know, the latest hot performers can go cold just as quickly as they got hot, and the periodic losing periods (“drawdowns”) among the latest hot funds are often huge.

As I have continued to write this E-Letter over the past four-plus years, I have realized that there are certain topics that need to be addressed periodically – some every year. And the flurry of New Year investment recommendations and “Top 10” lists are certainly in that category. Sadly, many investors look to these lists of “hot” investments for guidance in their own accounts, often resulting in poor performance.

Because this year-end phenomenon is soon upon us, I am going to revisit the topic to prepare you for what is to come. I most recently addressed this topic in late January of this year when most of the “Top 10” lists had already been published. This time, I want to do a pre-emptive strike on these lists, and arm you with the information you need to know before even thinking about investing in any of these products. So here we go.

Revisiting Last Year’s “Hot” Performers

Since the articles about the top performing mutual funds for 2006 will be coming shortly, I’ll refer back to my January 24, 2006 E-Letter in which I discussed a column in the January 9, 2006 issue of Barron’s which had the typical New Year take on the best performing mutual funds. Yet the Barron’s editors broke from the standard mold of listing the top funds of the most recent one year and instead focused on the top 20 equity mutual funds over the last 15 years (January 1991 through December 2005).

It was their cover story and, at first glance, I thought I would be impressed. There was, of course, a table in the middle of the article which listed the Top 20 funds, and many readers, I’m sure, went straight to the table to see which funds had made Barron’s Top 20 list. I have reproduced Barron’s list of the top 20 equity mutual funds later on in this E-Letter, but before you leap ahead, there are some things you need to know about with these funds. I will point them out as we go along.

[Before we go on, let me note that I am a big fan of Barron’s as a financial magazine. I have subscribed for years and have always coveted editor Alan Abelson’s unique style of writing.]

But I must call a spade a spade, in this case. The bottom line is, if you had owned Barron’s Top 20 mutual funds over the last 15-plus years, you would have had a VERY ROCKY ride along the way!

Keep in mind as you read on that the 15-year period Barron’s considered, from 1991 to 2005, included the greatest equity bull market in history. Given that, you would expect some good returns. But as you’ll see, the losing periods were way beyond many investors’ tolerance levels. Unfortunately, Barron’s failed to point that out, but as usual, I will.

After we dissect the Barron’s study, I will explain to you how we go about selecting mutual funds at my firm. The bottom line is, we look for mutual funds that have a history of delivering good returns in up, down and sideways markets, with limited drawdowns along the way. Such funds are out there if you know how to find them, and I’ll tell you how we do it.

Barron’s Top 20 Equity Mutual Funds

As noted above, I have subscribed to Barron’s for over 20 years, and I like the weekly financial publication. The Barron’s article in January of this year, touting the Top 20 equity mutual funds over the last 15 years, was indeed tantalizing – even for me.

The cover page had a huge headline that read: “BETTER THAN BILL,” a reference to Bill Miller who manages the Legg Mason Value Prime Fund, which had, at that time, beaten the S&P 500 Index in each of the last 15 years. Unfortunately, it doesn’t appear he’s going to make it 16 years in a row, as his mutual fund is now trailing the S&P 500 Index’s performance by over 10 percentage points.

Even so, the January cover page went on to state: “No question that Legg Mason’s Bill Miller is a superstar… but we’ve found 19 funds that have done even better.” I told you it was tantalizing, especially given that there are literally thousands of mutual funds out there.

Before disclosing the exact list of equity mutual funds that Barron’s picked, we need to talk about a couple of key points. First, performance reporting for investment products has become very standardized in the last decade or so for several reasons. Partly due to increased regulation, and partly due to credibility, there are certain criteria which are almost always included with the publication of a track record – at least from reputable sources.

Obviously, there is the net performance, usually expressed as an average annual return. Then there is the time period over which the performance was generated (months or years). Next, you typically see something like “standard deviation,” a measure of how much up and down volatility the fund subjected its investors to over time. A low standard deviation is generally deemed to be indicative of low volatility and consistent returns, though there are many exceptions to this rule.

However, I almost never see a “Worst Drawdown” statistic in mutual fund promotional materials, or even in stories in the financial media. I’ll discuss more about drawdowns later on, but for purposes of this article, I’ll define this performance statistic as an indicator of the worst losing period during a fund’s entire performance record.

If you’ve been reading me for long, you know that avoiding big losses is the centerpiece of my investment philosophy. I am as focused on the losing periods as I am on the upside potential, if not more so. Why? Because most mutual fund promotional material makes the assumption that investors hold on during losing periods, but that’s not always true. Thus, it doesn’t matter how much money you might have hypothetically made if you were scared out of the investment due to a big drawdown along the way.

So, I was very disappointed to see that the Barron’s editors chose to publish the glowing performance numbers for their top 20 equity mutual funds over the last 15 years without also including the worst drawdowns for those same funds! After year-end when stories about the latest hot funds flow from the financial media, just see how many talk about the drawdowns those funds have experienced. I’ll bet you won’t find many.

Without the information on the worst drawdowns, you don’t have the whole picture. Lots of mutual funds and other investment products have impressive upside returns, but their drawdowns can be huge. You need to know this up front! Barron’s, for whatever reason, elected to omit this information. But I didn’t!

Here’s the table included in the January 9, 2006 issue of Barron’s, but with the addition of the Worst Drawdown statistic at the end. (For sake of space, I omitted the columns including the name of the current fund manager and when he or she started, etc.)

Fund Name	Ticker	Average Annual Return	Standard Deviation	Worst Drawdown
FPA Capital	FPPTX	20.0%	19.2%	-25.97%
Fidelity Low-Priced Stk	FLPSX	18.8%	12.8%	-21.84%
Calamos Growth A	CVGRX	18.3%	22.8%	-35.49%
Heartland Value	HRTVX	18.1%	16.6%	-27.82%
Columbia Acorn Z	ACRNX	18.0%	15.1%	-24.20%
ICM Small Co. Instl.	ICSCX	17.6%	14.0%	-22.10%
Hartford Cap Appr HLS, IA	HIACX	17.5%	17.3%	-37.34%
DFA US Micro Cap	DFSCX	17.1%	19.7%	-30.62%
Merrill Value Opportunity; I (Now Blackrock Value Opp I)	MASPX	17.1%	17.6%	-32.32%
Muhlenkamp	MUHLX	17.1%	17.5%	-31.00%
Federated Kaufmann; K	KAUFX	16.9%	19.7%	-31.72%
H&W Small Cap Value; I	HWSIX	16.9%	17.0%	-39.89%
Janus Small Cap Value; Instl	JSIVX	16.9%	15.3%	-27.58%
Neuberger Genesis; Inv	NBGNX	16.9%	13.4%	-26.56%
Laudus Ros US Small Cap; Instl	USCIX	16.8%	15.0%	-26.92%
Wasatch: Core Growth	WGROX	16.7%	18.1%	-38.43%
Mairs & Power Growth	MPGFX	16.6%	12.7%	-20.14%
Third Avenue: Value	TAVFX	16.5%	12.9%	-25.36%
Skyline: Special Equities	SKSEX	16.5%	15.4%	-31.80%
Legg Mason Value Trst; Prim	LMVTX	16.4%	17.9%	-42.37%
S&P 500 Index	SPX	11.5%	14.0%	-44.73%

* Total return and standard deviation are for December 31, 1990 through December 31, 2005.
** “Worst Drawdown” is a measure of the largest peak-to-valley losing period during the period of time covered by the above table.
*** Past performance is not necessarily indicative of future results.

There you have it. According to Barron’s study of the Morningstar mutual fund database, these were the 20 top performing equity mutual funds over the 15 years from 1991 to the end of 2005. Yet before you rush out to buy these 20 funds, there are lots of issues I need to make you aware of. I almost don’t know where to start.

That’s not true. I do know where to start. It’s where I always start – with the drawdowns.

Without Drawdown Information, What Good Is It?

Expressed as a percentage of the highest peak value, the drawdown statistic shows you how far an investment’s value has dropped in the past. While an investment is not doomed to repeat past poor performance, the worst drawdown can at least give you an idea of what you might expect during unfavorable markets.

Most of us don’t think much about risk during years when investments show a gain, but the drawdown statistic is able to show how much an investment may have dropped even in those times when it ended the year with a positive calendar-year return.

As you can see, ALL of the funds listed have worst drawdowns in excess of 20%. 10 have worst drawdowns in excess of 30%. And several, including the S&P 500 Index, have worst drawdowns close to or above 40%! The average maximum drawdown for the funds listed in the Barron’s article is –30%.

We have all read the prominent (and required) disclaimer: Past performance is not necessarily indicative of future results. However, I believe the past drawdowns are a good indicator of potential future risk, and are the primary risk measure my company uses when evaluating mutual funds and Investment Advisors.

While it is impossible to know if a fund or an Advisor will have similar drawdowns, or a new worst drawdown, in the future, studying the past losing periods is absolutely critical in my opinion. In our analysis of funds and Advisors, we typically want to know why the worst drawdowns occurred and what, if anything, has been done to make them less likely in the future.

If you are a long-time reader or client, you know why I concentrate so much analysis on drawdowns. It takes a 25% return to recover from a 20% drawdown; it takes a 42.9% return to recover from a 30% drawdown; and it takes a 66.7% return to come back from a 40% loss – all because after a loss, you have less capital to recover with. All of the mutual funds in the table above had at least a 20% drawdown. And the data above only shows you the worst drawdown; it does not tell you a thing about how often significant drawdowns occurred during that 15 year period!

Buying High & Selling Low

To understand why drawdowns are so important when analyzing any potential investment, we need to acknowledge one fact, even if it doesn’t relate to you: Many investors buy funds when they are flying high, and sell them when they are in the dumps.

I have frequently written about the studies from Dalbar, Inc. and other financial research organizations which demonstrate how most mutual fund investors tend to “buy high and sell low,” meaning that they chase returns in hot funds, and then jump out when losses occur. The routine is all too familiar. Investors read about the latest hot funds in a financial publication, or hear them discussed on the radio or TV, and decide that’s where their money needs to be.

Unfortunately, most of the high-flying funds also have large drawdowns along the way, as you can see in the Barron’s table above. And remember, these are the Top 20 performers over the last 15 years, according to Barron’s study.

And there’s another issue you might not think about. When the high-flying mutual funds get a lot of publicity, a huge influx of money usually follows. It is not uncommon for these inflows to be larger than the fund manager can effectively deploy. The result is that these hot funds often cool off quickly, and performance in subsequent years is often far short of the returns that gained them notoriety. Unfortunately, investors seeking the returns touted by the financial media are often disappointed, especially when the next drawdown hits, and many times bail out and seek the next hot fund to invest in.

Investors tend to bail out of an investment when losses become more than they can bear. The Barron’s table above shows that the smallest worst drawdown of any of the funds was still in the –21% range, and you don’t know how often similar losses might have occurred in the past. I would suggest that many investors would exit the fund long before reaching even this stage of loss, especially those who have a low risk tolerance.

Thus, I think the potential for loss, as represented by the historical drawdowns, is just as important, if not more so, than the average annual return of a prospective investment.

While the table in the Barron’s article did list each fund’s standard deviation, this measure is a rather poor indicator of just how much risk you may be taking when investing in a specific fund or with an Investment Advisor, at least in my opinion.

I actually chuckled when I read a sentence in the Barron’s article introduction that said, “…for long-term investors, what counts is the final number – not the gyrations in between.” I could not disagree more! That was the tip-off that the funds touted had some serious drawdowns.

Other Problems With The Barron’s Study

By now, it should be obvious that I did NOT recommend back in January that you rush out and buy the 20 funds listed in the Barron’s table above. Yet there are actually some additional reasons why you might not want to buy all these funds. Here are the other reasons:

1. Based on the Morningstar Principia Pro analysis software, most of the funds mentioned in the article are significantly correlated with the S&P 500 Index. This is very interesting, considering that many have small-cap and mid-cap strategies. This high correlation makes it likely that any investment in one or more of these funds might have to endure the same roller coaster ride that the S&P 500 Index experiences.

2. Six of the mutual funds listed in the article are now closed to new investment, so you can’t get them even if you want. Of the remaining funds open to investors, three have minimum investments of $2 million or more, with another requiring at least $75,000 to invest.

3. In an article that seeks to highlight the managers of these “successful” mutual funds, it is interesting that even the article admits that, at the time it was written, eight of the 19 funds had managers whose tenure is less than the 15 years covered in the performance study, with several of them having less than 5 years at the helm of the fund they currently manage.

4. While most of the funds score “Excellent” on regulatory issues according to Morningstar, there are two of the funds listed in the Barron’s article that score “Very Poor” and another that scores only “Fair.” Would you really want to put your money there?

5. By focusing on a 15-year time period ending in December of 2005, the funds listed in the Barron’s article could “beat the market” if they did better than the S&P 500’s average return of 11.52% over the same period. However, if we selected only the previous five years, including a bear market, a fund with a five-year average annual return of only 1% as of 12/31/05 would almost double the S&P 500 Index’s five-year return of a paltry 0.54%.

Risk Management Is The Bottom Line

Ironically, a quote in the article from Don Phillips, Morningstar’s managing director, seems very appropriate. He said, “Avoiding big mistakes is the key to generating long-term wealth.” Phillips made his comments in connection with a discussion of how many of the funds on the Barron’s list bailed out of tech stocks before the worst of the bursting of the tech bubble, a factor that might be more attributable to luck than skill. However, the idea is still valid.

I am convinced that the real purpose of the Barron’s article was to showcase managers who have competed well against Bill Miller, but have not had the distinction of beating the S&P 500 Index each year for 15 years. However, looking at the article as a whole, it certainly has the appearance of a recommendation of these funds, even if that appearance is unintentional.

While the funds listed in the Barron’s article are considered to be “actively managed,” their strong correlation to the S&P 500 Index could indicate that the market’s overall direction – up or down – is possibly more of an influence on performance than the skills of the managers.

Since past performance cannot predict future results, it’s impossible to tell which among any list of “top” funds will continue to perform well, and which will not. Selecting investments from a list in a magazine or newspaper article or on the Internet is not the best way to go, in my opinion. A much more intense examination of the investment is required, and is usually best left in the hands of professionals.

Conclusions

In my November 1, 2005 E-Letter, I stressed how important it is to invest in programs that have the potential to avoid losses through active management strategies. My clients know the fallacies in chasing the latest “hot” funds. Instead, they look to us to seek out investment programs with the potential to deliver reasonable returns (although not necessarily the highest) through various and different market environments – with limited drawdowns.

If you have not read my latest Absolute Returns Special Report, you really need to do that if you are serious about investing in today’s tricky equity (and bond) environment. This Special Report will help you understand why we recommend the investment programs we do, and how we select them.

Over the last few months, I have been emphasizing “absolute return” investment programs and funds with the potential to manage the risks of being in the market. Most recently, I have highlighted the Third Day Aggressive and Potomac Guardian Programs, as well as our own Absolute Return Portfolios, which all seek to help you reach your investment goals without the large drawdowns that so often cause investors to head for the exits. Click HERE to check out the estimated performance of these three programs as of November 30, 2006. Pay special attention to the average annualized returns (net of all fees and expenses) in relation to their worst-ever drawdowns. I think you’ll be impressed with what you see.

These investment programs are not likely to be on the latest “Top Performers” list, and do not always beat the market, which is not their goal. Instead, they seek to provide a reasonable rate of return through investment strategies that also manage the risks of being in the market. And since past performance can never guarantee that future results will be as favorable, we monitor all of our recommended programs on a daily basis.

Final Reminder: Time is running out on your ability to access the Potomac Guardian Program at a minimum investment level of only $25,000. As I have written in past issues, Potomac will be raising its minimum investment to $50,000 on January 1st. When you follow the above link, you will be able to view detailed performance and read more about each program, including Important Notes that contain key disclosures. If you like what you see, it is important to get your account paperwork started now so it can be completed by year-end, before the minimum doubles.

If you have any questions regarding these programs, or if you would like more information to be sent to you, there are several ways you can initiate this easy process. You can call us toll free at 800-348-3601 and one of my experienced Investment Consultants will be happy to send you information, with no pressure or obligation. Or e-mail us at info@halbertwealth.com, or CLICK HERE to immediately access our online information request form.

And a last note. If you are a regular reader of my weekly E-Letters, you have probably considered investing with my company before. But you may have hesitated because you live somewhere far away from Austin, Texas. You may have preferred to deal with someone in your local area that you can see personally from time to time. That is only reasonable.

But let me remind you that I have clients all across the United States – in every state. Many, if not most, of my clients I have never met. But we have great long-distance relationships. In today’s world of technological advances, you don’t need to be in the same town. So don’t let the fact that I’m in Texas and you are somewhere else stop you from taking advantage of the investment programs I recommend.

Wishing you profits,

Gary D. Halbert

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