Posted by: Aaron Pressman on August 14, 2007
There’s a dangerously misleading story in today’s Wall Street Journal, under the headline “Small Investors, Too, Get Nailed by Arcane Trades,” wherein we learn that some poor schlubs have lost a lot of money in wheat futures and shorting shares of Amazon (Symbol: AMZN). The reporters (four in this case) sum up:
Wall Street’s financial engineers have devised a wealth of products to help Main Street investors diversify or hedge like the pros. As a result, many ordinary investors have shifted toward foreign stocks and currencies, or “market neutral” funds that are supposed to be steadier than ordinary mutual funds. They’re dabbling in commodities futures and short selling, an investment bet that pays off if shares decline. Now these small investors are facing the same problems as Wall Street pros: Many of the hedges aren’t working as they expected.
Actually, the article has it exactly wrong. Diversifying is the correct strategy. Market timing, which is what many of the people they discuss are actually doing, is a well-known ticket to the poor house. And acting like an idiot is hardly confined to this year’s market. Is the futures-dabbling doctor any different than the millions who lost billions in Pets.com or Cisco Systems during the Internet bubble? Just because foolish investors use new products to act like fools doesn’t mean the new products are to blame. Argument by anecdote is weak — especially when the anecdotes contradict the reporters’ conclusion.
As I noted yesterday, most of these kinds of hedges ARE WORKING. For example, I just compiled a list of all the market neutral mutual funds I could find on Morningstar — 29 funds in all with total assets of just under $13 billion. How have these funds done versus the market? The S&P 500 is down 6.3% over the past month and 3.1% over the past 3 months, through yesterday’s close according to Morningstar. The 29 funds I checked are down 3.4% on average over the past month and 1.6% over the past 3 months. In other words, the market neutral funds are slamming the S&P 500. And many of the market neutral funds are pretty small (half have under $100 million in assets). If you weight the return by assets, which shows the true impact on investors, market neutral funds are down just 2.3% over the past month and 1.3% over the past three.
Even worse — most of the examples listed in the Journal article have also done better than the S&P 500. Shares of Newmont Mining (NEM) beat the S&P 500 by 6 percentage points over the past month and shares of Northgate Minerals (NXG) beat it by over 1 point, according to Google Finance. Natural resource funds have about matched the S&P’s one-month decline but are still up 18% on the year, according to the Journal’s own data (select the natural resource category from the drop-down list). Precious metal funds narrowly beat the S&P over the past month and the streetTracks Gold ETF (GLD) is up slightly over that period, easily slamming the S&P. The Journal doesn’t list a category for commodity funds but as we saw yesterday, ETFs and mutual funds that invest in commodity futures also beat the S&P. The CurrencyShares Swiss Franc Trust ETF (FXF) beat the S&P by over 6 percentage points, too, and it’s not even the biggest or best-performing currency fund in that category.
A few highly cherry-picked examples in the article did poorly. The iShares South Korea fund (EWY) lost almost 10% and its Brazil-tracking counterpart (EWZ) lost 13% over the past month. On the year, the South Korea fund still holds a 25% gain despite the past month while the Brazil fund remains up 26%. And as I’ve said ‘til I’m blue in the face, international equity markets don’t provide much of a diversification benefit anymore, especially when stocks go south. The American Century Long-Short Equity Fund (ALIAX) matched the decline in the S&P 500 over the past month but with $191 million of assets it’s hardly representative of the category — see above. The biggest hedging mutual fund I know of, the $2.8 billion Hussman Strategic Growth Fund (HSGFX), gained 2.2% over the past month.
Investors should be spreading their bets around. Academics in finance don’t call diversification “the only free lunch in economics” for nothing. Many of the financial product innovations of the past few years have opened new opportunities to do so — a critical need given the decreasing aid provided by international equity-type investments. Investors should obviously not be trying to guess what the market is going to do over short periods. Some goofballs always will, and I guess they’ll even be foolish enough to get on the phone with a reporter and chat about it. But that doesn’t mean you should be afraid to invest wisely across different asset classes.