Larry Swedroe: There's a Perfect Storm Brewing Part II

As we discussed at the end of last month, the outperformance of U.S. stocks relative to international stocks has led many investors to make certain errors frequently caused by the related behavioral mistakes of recency and tracking error regret. I noted a perfect storm was brewing, creating the potential for even disciplined investors to lose heart and abandon their financial plans should they fail to fully understand that the benefits of diversification are long term in nature.

I called the situation a perfect storm because, not only have domestic equities outperformed their international counterparts, but the large-cap stocks that dominate the broad-based indices reported on daily by the financial media (for instance, the S&P 500 Index and the Dow Jones Industrial Index) have outperformed small and value stocks as well.

The table below shows the year-to-date returns of five representative exchange-traded funds (ETFs).

This type of divergence in performance actually occurs with great regularity. Of course, investors never seem to care or complain when that divergence results in positive tracking error, for example when small, value and international stocks outperform.

Negative tracking error like we have seen this year, however, creates numerous opportunities for investors to fail the test of discipline. And it’s why the research shows that investors tend to underperform the very funds in which they invest. They buy after periods of good performance and sell after periods of poor performance.

The years 1998 and 1999 provide a good example of why Warren Buffett said that “the most important quality for an investor is temperament, not intellect.” The table below shows the returns for each of those years.

As you can see, while U.S. stocks outperformed international stocks, especially emerging market stocks, in 1998, the reverse was true just one year later. Emerging market equities outperformed their U.S. counterparts by more than 80 percent.

The three-year period from 2000 through 2002 provides us with another good example.

During this timeframe, U.S. large stocks underperformed U.S. small stocks by 11.7 percentage points a year and U.S. small value stocks by more than 23 percentage points a year. Each dollar invested in U.S. large stocks at the start of 2000 would have been worth about 62 cents three years later. Each dollar invested in U.S. small value stocks would have been worth more than twice that, having grown to about $1.28.

Unfortunately, no one knows whether a diversified portfolio will produce negative or positive tracking error relative to the S&P 500 Index in 2015. But what’s interesting is that, whether you believe in the active or passive management of portfolios, divergences in returns (or tracking error) provides opportunity. Let’s see why this is the case.

Active Management

If you believe in active management, divergences in performance provide you the opportunity to tactically shift allocations, buying future winners and selling future losers.

Unfortunately, there’s very strong evidence that tactical asset allocation (TAA) strategies are more likely to subtract value than to add it. For example, one study found that for the 12 years ending with 1997, the S&P 500 rose 734 percent on a total return basis. The average return for 186 TAA funds was a mere 384 percent.

In a more recent study, Morningstar examined the returns of 163 TAA funds during the period that ended July 2010. It’s important to note that by the end of the period under study, 39 of the TAA funds no longer existed due to merger or liquidation. Of the surviving tactical strategies, the median life span at period end was 37 months.

The study concluded that TAA funds, in general, failed to deliver on their promise of better risk-adjusted returns, or downside protection, than a traditional balanced index portfolio allocated 60 percent to stocks and 40 percent to bonds. For example, 64 of the 92 TAA funds that were at least a year old (or 70 percent) had worse performance since inception than Vanguard’s passively managed Balanced Index Fund (VBINX). The average underperformance was 2.6 percentage points per year.

Morningstar updated the study through the end of 2011. They again compared the returns of TAA funds to Vanguard’s Balanced Index Fund (VBINX), which as we know passively invests its assets in a 60/40 stock/bond mix. The following is a summary of their conclusions:

• Very few TAA funds generated better risk-adjusted returns than VBINX.
• Just 9 of the 112 TAA funds in existence during the period from August 2010 through December 2011 had higher Sharpe ratios (a measure of risk-adjusted returns) than VBINX.
• Only 27 of the TAA funds experienced a smaller maximum drawdown than VBINX, meaning the majority experienced larger peak-to-trough declines.
• Only 14 of the 81 tactical funds in existence since October 2007 posted lower maximum drawdowns during the 2008 financial crisis, the spring and summer 2010 market correction, and the recent European debt-related drawdown. Put another way, just 17 percent of the funds consistently provided the insurance for which investors were paying.

Morningstar again updated the study in 2013. And again, most of the TAA funds they examined failed to live up to their promise to limit downside losses and participate meaningfully in any upside. Morningstar found that over the 18 months ended June 30, 2013, only 28 of 142 funds they tracked (or 20 percent) produced higher returns than the Vanguard Balanced Index Fund.

In short, the best thing that can be said about tactical asset allocation is that it’s a strategy fraught with opportunity.

Passive Management

For those who know their crystal balls are always cloudy, divergences in returns can provide the opportunity to do something most investors only dream of — buy low and sell high.

Such investors do so by maintaining discipline and adhering to their investment plans through the tactic known as rebalancing. In this scenario, rebalancing would require investors to sell (at relatively higher prices) their outperforming U.S. large stocks to buy (at relatively lower prices) more of the underperforming U.S. small and value stocks, as well as international stocks. Unfortunately, as we mentioned earlier, behavioral mistakes prevent most individual investors from taking advantage of the opportunity to rebalance. Now that you’re aware of the behavioral errors, hopefully you’ll be able to avoid them.

The Bottom Line

There’s a perfect storm brewing that will test your investment temperament. You have now been forewarned about the mistakes of recency, home country bias, confusing the familiar with the safe, tracking error regret, and confusing strategy with outcome. Having the knowledge that these are costly errors should help you maintain your discipline.

Larry Swedroe is director of research for The BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country. He has authored or co-authored 14 books, including his most recent, The Incredible Shrinking Alpha: And What You Can Do to Escape Its Clutches. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.