Fund-Blazing: Morningstar Fund Analyst Blog

Top Judges Battle over Mutual Fund Fees

M*_Ryan — Thu, 04 Sep 2008 14:18:57 GMT

Oakmark case raises tough issues and could be headed to the Supreme Court.

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Are Vanguard Explorer and Health Care Buys now that they are open again?

dculloton — Thu, 07 Aug 2008 18:09:32 GMT

Vanguard announced on Thursday that it had reopened the small growth fund Vanguard Explorer and sector offering Vanguard Health Care to new investors. These funds were worth hanging on to when they were shut and they are worth considering now, as long as investors maintain appropriate expectations.

Both funds have been closed for a while. Health Care shut its doors in March 2005 and Explorer about a year later in February 2006. Health Care has gained more than 7% annualized since it closed through July 31, 2008, but its total assets still haven't budged much from about $23 billion because it has seen a steady stream of outflows (or more investor redemptions than purchases) during that time. Explorer has lost about 1.5% from the time it shut off new investments through the end of July and also has seen steady outflows, so its total assets have slipped from $12 billion to $10 billion.

Make not mistake. These funds are still huge in absolute and relative terms. They are still both the largest funds in their respective categories by long shots. Their size could make it harder for them to outperform their peers and benchmarks by the magnitude that they have in the past. Yet, both funds have advantages that make them solid long term holdings.

They both have lower expenses than nearly all of their actively managed rivals. Health Care also still has Ed Owens and his team from Wellington Management, arguably among the best sector fund managers in the business. Explorer has seven subadvisors, and having that many cooks in the kitchen can lead to a mediocre stew. Yet each of the managers is experienced and has an independent approach that seems to compliment rather than confound the others'. Vanguard also made nice addition to the fund's roster of stock pickers earlier this year by hiring Lanny Thorndike, manager of small growth analyst pick Century Select Small Cap CSMVX, to run a portion of Explorer.

Furthermore Vanguard's record of closing funds when inflows get too hot to handle gives me some confidence. They use a wide array of tools to manage inflows and outflows, including redemption fees, adjusting minimum investment levels and capping the amount existing investors can contribute. Health Care for example will still require $25,000 for initial investments now that it's open, which limits its audience somewhat.

So, I think these funds still have a good shot at being above average holdings, though investors should realized they may not be has spry as they used to be. What do you think?

Dan Culloton
Editor, Vanguard Fund Family Report

Berkowitz and Byrne on Bargains

M*_Karin — Thu, 26 Jun 2008 20:00:19 GMT

Bruce Berkowitz, manager of Fairholme FAIRX, and Susan Byrne, manager of WHG LargeCap Value WHGLX, are two of our favorite large-cap managers. Here is a play-by-play on some of the sectors and individual stocks that they talked about at the Morningstar Investment Conference this morning:

Energy
Byrne has been hanging on to oil & gas firm Apache APA for 6 or 7 years. Lately, she’s been trimming back that stake but still sees excellent value in the firm. Byrne has been stress-testing energy holdings by assuming major drops in oil prices, and as for natural gas-related firms falling a bit behind, she sees global demand pushing those prices up over time.

Berkowitz has been ignoring the energy-related headlines. He’s fine with oil prices staying high (but acknowledged that he’s been driving a lot less!). One of his main concerns in this sector is how easy it is for government to tax energy. He also commented on how Buffett is spending tens of millions on wind power.

Health Care
Berkowitz is looking to health care since it’s such a stressed-out area and because baby boomers are getting into Medicare. So, he’s become a big buyer of HMOs. He noted that some drug companies have done a horrible job on their capital allocation, and since the November election has caused a huge fear in the marketplace, he has been able to buy them at a big discount to cash flows. Regarding pharma, Berkowitz thinks that a lot of the big firms have been arrogant in their attitudes toward generics over the years. He’s seeing more joint ventures abroad and Indian firms being bought out. Essentially, he thinks that something has got to give because competition from generics is getting big.

Financials
Byrne is staying away! She commented that they know how investment banks are run in the back, but it’s a problem of evaluating their business models. Basically, what is the business model if the balance sheet is no longer there? Unattractive return on equity, which was very different in recent years, has been another reason that she’s stayed away. Byrne plans to wait for transparency and doesn’t think it’s time to buy the banks because we aren’t in the midst of the same old cyclical story.

Berkowitz explained that it’s almost impossible to know what some of these firms own, which has resulted in a loss of faith. To illustrate, he’s not certain whether JP Morgan JPM had to buy Bear Stearns because of counterparty risk. So, like Byrne, he’s been staying away from financials. As for housing and real estate, as long as the cash is there, he is is OK with investing.

Another area that Byrne and Berkowitz agree on is homebuilders. Bryne doesn’t want to deal with the risk of off-balance-sheet contingencies. As for Berkowitz, he doesn’t see the value in trying to comprehend their balance sheets or free cash flows. Plus as governments became bigger partners all around the world, he sees things getting complicated since everyone wants a piece of your ownership.

Berkshire Hathaway
Berkowitz has brought his hefty stake in Berkshire BRK.B down, in part guided by Buffett’s modest projections in terms of beating the S&P 500. He noted that a post-Buffett company wouldn’t be quite as good and that he would like to see a successor in place while Buffett is still there. He explained that property/casualty insurance is a tough business because the money you get in premiums is so seductive that it can lead to big mistakes. He thinks that Buffett really has all points covered by writing to maximum losses and being over-capitalized, which most companies aren’t able to do.

GE
Byrne noted that her competitive advantage in researching a large firm like GE GE is valuing what the company can do in tough times as well as 3 to 5 years down the road. She mentioned the importance of solid cash flows, which allow large companies like this one to move forward and exploit their brand names.

Nike
Byrne mentioned Nike NKE as another firm that has generated enough cash flow to move forward and support its brands. Though WHG LargeCap Value doesn’t have any foreign holdings, Byrne puts a lot of emphasis on how the firms are faring abroad, particularly in Asia and South America. This is another reason that she’s hanging on to Nike.

Allianz OCC Value Loses Manager, Changes Teams

M*_Marta — Mon, 04 Aug 2008 21:16:39 GMT

On Friday, August 1, Allianz announced a management change at Allianz OCC Value PDLAX. The advisor is ousting Colin Glinsman of Oppenheimer Capital in favor of the Dallas-based dividend-focused team, NFJ Investment Group. Eventually, Allianz hopes to merge the fund into Allianz NFJ Large Cap Value PNBAX.

The fund's recent returns have been atrocious. It's down 27% for the year-to-date, after falling nearly 6% in 2007. Glinsman makes dramatic bets, and in the current market, he has been dramatically wrong. He loaded up on financials and has continued to buy as they've gone down. The fund is in net outflows, which only makes the situation worse.

We'd be remiss, however, not to point out Glinsman's long-term record. Although his tenure at this fund is short -- he took the helm in early 2005 -- he has racked up strong returns at Oppenheimer Quest Balanced QVGIX over his more than 15 years at that fund. That's not to say the Quest Balanced hasn't had its low points--Glinsman's big bets often come early and have made for a volatile ride, particularly in the short term--but we consider him a proven manager even so.

So the question is, Did Allianz drop Glinsman too soon? The advisor gave Glinsman less than a year to make a comeback, and since he hasn't, they've transferred the money to stronger performers. Maybe that's the best decision in this case, maybe the fund would otherwise continue to plummet for several more years, but I have to wonder if the advisor's timeframe is too short. Even NFJ's funds, which look so good now, will inevitably fall out of favor. NFJ is less aggressive than Glinsman, so maybe Allianz will have more patience with that team, but I certainly wouldn't want to see Allianz drop NFJ after serving less than a year as the market's whipping boy.

Let's hear your thoughts.

Marta Norton, Senior Mutual Fund Analyst

Vanguard's Brennan Sets His Succession Date

dculloton — Mon, 04 Aug 2008 21:00:35 GMT

Vanguard Chairman and CEO John J. Brennan, who announced in February that he would relinquish the CEO post before the end of the year, has set Aug. 31, 2008 as his departure date. As previously announced, the family's current president and former head of retail and institutional businesses, William F. McNabb, 51, will take over the CEO post from Brennan, 54.

Brennan, who had been CEO for 12 years and will remain chairman, has maintained that he is stepping aside because he didn't want to overstay his welcome or usefulness; that a certain amount of change at the top can be good for an organization. He's certainly going out near the top, having shepherded Vanguard through a tremendous period of growth, as I wrote earlier this year.

As for McNabb, I hope to learn more about him in the future, but here's what I have written about him in the past:

Meet the New Boss
It's harder to predict what the McNabb era will look like. McNabb, 50, seems cut from a similar cloth as Brennan. Like Brennan, he attended Dartmouth as an undergraduate and went to an Ivy League school for his MBA (Wharton). He's been with Vanguard for 22 years and most recently ran Vanguard's $700 billion institutional and international businesses. He also is known outside of Vanguard, serving on the board of Employee Benefit Research Institute and testifying before Congress and the Department of Labor. Indeed, the transition seems set up to ensure continuity. If Vanguard were one mutual fund, this would be a comforting way to handle a manager change--pick a seasoned successor who has worked closely with the previous manager and allow their terms to overlap to ensure a smooth handoff.
McNabb is unlikely to make drastic changes, but Vanguard is sure to continue changing. Based on McNabb's background and published comments, you can expect Vanguard to keep courting financial advisors (McNabb spearheaded efforts to ramp up the family's efforts in that area). Overseas growth also will be important, as will the institutional business and solution-oriented funds like target-date retirement offerings and the new managed-payout funds. Vanguard's new leader will have to manage its continued growth. He also will have to be familiar with retirement markets because a good portion of the fund owners who grew up with Vanguard are nearing or in retirement. McNabb's experience with institutional benefit plans will help there. Finally, Vanguard needs a leader who is steeped in the family's culture to ensure that it's not compromised as the firm continues to develop. I can find nothing in McNabb's public record that implies he will be anything but a staunch defender of Vanguard's main edge: its mutual ownership structure and commitment to serving shareholders.

What do you think the McNabb era will look like?

Dan Culloton
Editor, Vanguard Fund Family Report

Are Financial Stocks Misunderstood?

dculloton — Thu, 26 Jun 2008 14:54:54 GMT

Could all financial stocks need is a little understanding? When asked what the most misunderstood stocks were in their portfolios, members of the Ultimate Stock-Picker's panel at Morningstar's Investment Conference said financial stocks.

Robert Torray, manager of The Torray Fund TORYX, said huge financial companies that have seen their stock prices savaged by the credit crisis--such as Citigroup C, American Express AXP, and AIG AIG--could possibly double over the next five years. Their franchises still have considerable value that could not be recreated for where their shares are currently trading, which for some of the stocks is at or below book value, Torray said. "In my experience, big important franchises are not going to disappear," he said.

Charles Pohl, one of the mangers of Dodge & Cox Stock DODGX said most of the stocks in the fund's portfolio are misunderstood to an extent; otherwise they wouldn't be good values. But he said some of the analysis he sees on financial stocks looks misguided. The biggest mistake investors are making, he said, is assuming that if two companies have a certain amount of exposure to residential loans they will suffer the same losses in the current dire market for mortgages. Dodge & Cox holding Wachovia WB, for example, has been punished with the rest of the banks with mortgage exposure, and it has and will suffer losses, Pohl said. But the losses may be not as severe as the market expects because Wachovia maintained more conservative underwriting standards during the mortgage bubble, Pohl said.

The panelists, including Peter Langerman of Mutual Series, also pointed to commodity-linked industries and stocks as potential areas to avoid.

What do you think, are financial stocks misunderstood?

What are your favorite dividend funds?

DaveKath — Wed, 30 Jul 2008 15:40:12 GMT

My Short Answer column on Tuesday surveyed the landscape of dividend-focused investing, including high-yielding stocks and dividend-oriented mutual funds. On the stock side, I pointed out some of the risks of stocks with very high dividend yields and the importance of doing research to figure out whether a company's dividend is sustainable and likely to grow. Of course, I couldn't mention everything, and a few readers have written to ask why I didn't specifically mention payout ratio (the percentage of a firm's earnings that it pays out as dividends) or dividend growth rates. Indeed, those are both important measures for any dividend investor to be aware of. You can read more about them in my colleague Josh Peters' online columns, such as this one and this one. Josh's DividendInvestor newsletter and his book, The Ultimate Dividend Playbook, have even more details and examples.

On the fund side I gave plenty of examples, including both funds that aim for a high dividend yield per se, and those that hold dividend-paying stocks but aim for good long-term total returns rather than yield for its own sake. One reader suggested that I should have mentioned Alpine Dynamic Dividend (ADVDX), which makes a dividend distribution every month and has a yield north of 15%, with an emphasis on qualified dividends (those subject to the lower 15% tax rate). Morningstar doesn't actively cover this fund right now, but based on our earlier analyses and the current portfolio, this appears to be a decent option for fund investors who want yield above all else. However, it does come with quite a bit of risk, as shown by its terrible performance this year, when it has trailed 96% of the mid-cap blend category.

Are there other dividend-oriented mutual funds or ETFs that you like? Maybe a hidden gem that doesn't get as much attention as the T. Rowe Price and Vanguard funds mentioned in my article? Let's get a discussion going.

David Kathman

Morningstar

Whither Vanguard Windsor and Capital Value?

dculloton — Mon, 23 Jun 2008 22:56:01 GMT

Vanguard has made a major management change to one of its biggest funds and also to one of its most adventurous offerings.

The family has replaced manager Dave Fassnacht of the nearly $19 billion in assets Vanguard Windsor VWNDX and almost $500 million Vanguard Capital Value VCVLX with two colleagues of his from subadvisor Wellington Management. James N. Mordy a 25-year veteran member of the Radnor, Pa.-based team that has run the bulk of Windsor since its inception, will take over Windsor (AllianceBernstein remains the other subadvisor). Peter I. Higgins, who's been with Wellington for just three years but has put up attractive numbers at other funds, will take over the eclectic deep-value fund Capital Value.

It's still too early to fully evaluate the changes, but it seems the shift will be more dramatic for Capital Value. Vanguard seems less upset with the strategy Wellington Management has used for decades at Windsor than it is with Fassnacht's execution of it. The fund, which has decent long-term returns, lagged the category and large-value benchmarks during Fassnacht's four-year stint as lead manager. Much of that poor performance has come in the last year, but Vanguard maintains recent performance was not the catalyst for the change. Rather they said it was the result of an ongoing dialog among Vanguard, Wellington and the fund's board.

If they thought the fund needed to make drastic course corrections, though, they made an unusual choice. Mordy is the back-to-the-future candidate. He has been part of the team assigned to Windsor eight years longer than Fassnacht has been at Wellington, and has worked with its most successful managers, including John Neff and Charles Freeman. There are always some changes when a new manager arrives, but I don't think they'll be too dramatic at Windsor. It remains to be seen whether Mordy will fair better than Fassnacht.

Capital Value is another story. Peter Higgins, who used to work for the Boston Company and put up impressive numbers at Dreyfus Premier Midcap Value DMCVX from 1995 to 2005 (16.4% annualized versus 11.6% for the mid-blend category), works on Wellington’s Boston-based capital appreciation team. He’s value-oriented, but not a deep value contrarian like the Radnor-based Fassnacht was. Dan Newhall, a principal with Vanguard's portfolio review group that hires and monitors subadvisors, described Higgins to me as "a value guy, but maybe a bit more opportunistic." Higgins, who also has co-managed Hartford Stock Fund IHSTX for the last three years, likes cheap stocks, but also will consider stocks with accelerating earnings growth and will hang on to picks longer if their fundamentals are moving in the right direction, Newhall said. That jibes with our take on Higgins' style. When we wrote about his departure from Boston Company and Dreyfus Premier Midcap, we noted that he had a penchant for dipping into growth sectors often ignored by other value investors.

What it means for the fund long-term is harder to say. I liked Fassnacht's benchmark agnostic style and am on record saying his wide-ranging, eclectic, and contrarian style was an acquired taste, but one worth acquiring. I would have preferred Vanguard gave Fassnacht a chance because his was an approach that I bought into (Literally. I invested in Capital Value earlier this year.) But the early indication is that Higgins is not a slave to a benchmark either. His previous experience and success at least deserve a closer look.

Bottom line: Both Windsor and Capital Value are on probation. Do you think they deserve it?

Dan Culloton
Senior Mutual Fund Analyst
Editor Vanguard Fund Family Report

Filling Jean-Marie Eveillard's Shoes Will Be Tough: The Wait is Over!

M*_BridgetH — Mon, 07 Jul 2008 19:59:02 GMT

First Eagle today spelled out its succession plans following Jean-Marie Eveillard's (second) retirement from First Eagle Global SGENX and First Eagle Overseas SGOVX funds. A big part of that plan is new hire and portfolio manager Matt McLennan.

Who?

Of course, we didn't expect anyone famous. The pool of value investors with similar styles to Jean-Marie Eveillard is quite small, and even Eveillard remarked at Morningstar's recent investment conference at the end of June that he had no intentions of "poaching" from his value-oriented friends' shops.

McLennan, though, is perhaps a bit more obscure than expected. Don't get us wrong--he is credentialed. He's been with Goldman Sachs GS since 1994, including time as a small- and mid-cap portfolio manager and more recently as a global-value portfolio manager for Goldman's private wealth management clients. But he's been working in London for most of his career, and we haven't been able to find a public performance record by which to gauge his experience. In fact, we haven't been able to find much about him at all besides what was in First Eagle's press release, except that he's been a managing director at Goldman since 2002.

There are some encouraging signs for First Eagle fund shareholders--the biggest of which is that Eveillard himself was involved in the interviewing and hiring process. And First Eagle did take its time in finding a replacement. Finally, while the firm did suffer a big loss of research and portfolio-management talent when Eveillard's first successor, Charles de Vaulx, and others left the firm, other analysts have remained, and the team is currently adequately staffed. Abhay Deshpande, who worked with Eveillard on the funds in the late 1990s and early 2000s, will serve as comanager on First Eagle Overseas and assist on the other funds.

But there are many more questions. McLennan starts with First Eagle on Sept. 8, 2008, and it's unlikely we'll be able to speak with him until then. (He is currently bound by a non-compete clause.) Following are just some of our questions:

How do you think your and the funds' strategies are most similar? How do they differ?
What is your experience with fixed income, gold, shareholder activism, and Japan?
What role does cash play in your strategy?
What do you think of the current portfolio? What changes will you make, if any?
Are there pieces of the portfolio or strategy where you feel you need to get quickly up to speed?
What's your take on the financial sector? The energy sector? How do you see the portfolio changing, if at all, in those two areas?
First Eagle has focused more energy on Asia recently. Do you think that's a good move? What has been your experience with Asian securities?
What are your performance goals for the fund?
Could you share with us your previous performance record? How did your accounts behave during times of stress? In happier times?

Even with these questions answered, it will be tough to assign the high degree of confidence we have in Eveillard to McLennan (or Deshpande, or just about anyone else). But the answers will help us set appropriate expectations for the fund. What questions do you have?

The Skinny on Growth Investing

M*_Karin — Fri, 27 Jun 2008 17:11:29 GMT

Robert Hagstrom of Legg Mason Capital Management, Dennis Lynch of Morgan Stanley Investment Management, and Alex Motola of Thornburg Investment Management look at growth investing through different lenses. Here are some of the of insights they shared today:

On Style
Lynch looks for undiscovered value in high P/E stocks through things like cash flows, high return on invested capital, quality of earnings, low market penetration, and competitive advantage. He thinks that people equate growth to price momentum and that unfortunately “momentum” has a dirty ring to it. He explained that unlike traditional value investors who buy unloved stocks and sell them when they are hot, he aims to hold them while they’re still hot.

Motola acknowledged that there is certainly a marriage between value and growth, adding that he also looks for businesses that are turning around faster than what is perceived by the market in general. And Hagstrom, taking some cues from Warren Buffett, describes his investment process as trying to find the best tech franchises of the 20th century.

Financials
Hagstrom has ventured into the space, primarily because he sees the most mispricings occurring here. He picked up Freddie Mac FRE based on his belief that we are getting through the worst of the credit crisis and because it’s a dominant player in its business. While he believes that we aren’t out of the woods in terms of write-downs, he and his team have focused on building normalized earnings models to sniff out the best prospects. Additionally, Hagstrom still favors AIG AIG and Citigroup C for their dominant positions in their respective industries in addition to their strong brands.

Motola and Lynch told a different story. Motola indicated that the lack of transparency surrounding financials firms has kept him away. From time to time, he has scooped up banks and exchange stocks, but he indicated that he will keep poking around in other industries in the meantime. Lynch has stayed away from the space for similar reasons and acknowledged that he’s not sure he and his team would be able to pick out the right situations under current market conditions.

Energy
Lynch, also a Buffett fan, has a hefty stake in oil & gas firm Ultra Petroleum UPL, which he likes for its status as a lowest-cost provider of natural gas and years of drilling experience. Given what he sees in the firm’s competitive advantage, he views it as an acquisition target by one of its larger peers.

Hagstrom acknowledged that he missed the boat on energy. In 2003-2004, his team felt like there were more attractive alternatives to the energy space, such as Amazon AMZN. As far as his views on energy today, he believes that this is either a super cycle ready to pop or it’s morphing into a secular cycle. Noting that Wall Street is still treating earnings as if these are cyclical firms, we will be able to see the secular story unfold if multiples start to expand, and in that case, energy holdings are undervalued today.

Tech
Hagstrom has made a lot of money for shareholders on long-termers like Amazon and Google GOOG. He looks at these holdings in terms of economic return, as he doesn’t see that any competitor could get enough capital to unseat these industry incumbents.

All three of these managers own Google. Like Hagstrom, Motola bought Google went the company went public, which he considered to be a great opportunity as a smaller money management firm. Even though the company is spending a lot of cash on its workforce, he still finds the stock’s multiple very attractive because its competitors are still in disarray, and its dominant position in global market share (primarily in the U.S. and Europe) gives them pricing power. Lynch finds the valuation reasonable based on what they already do in addition to their scale and optionality.

Health Care
All three managers pointed to regulation as being one of the major challenges in this sector. For Motola, the recurring revenue aspect of many of these firms remains one of the selling points. He’s been moving more toward biotech, and he likes Gilead Sciences GILD, Alexion Pharmaceuticals ALXN, Genentech DNA, and Celgene CELG because these firms have proven drugs with a clear path to profitability.

Hagstrom also sees biotech replacing big pharma as the best opportunity for growth. And generally, he has stayed away from names with binary risk (where one failed drug could torpedo a company’s stock price) and thinks HMOs are going to be a tricky space because of the new administration.

Lynch finds the sector attractive because of inflation and demographics, but the trick lies in finding a way to play this big theme.

Three High-Conviction Picks from Undiscovered Managers

dculloton — Thu, 26 Jun 2008 23:16:07 GMT

Three fund managers whose names may not be widely known chose one household name and a couple of off-the-beaten-track companies as their highest-conviction stock picks at Morningstar's investment conference.

Ralph Shive, manager of 1st Source Income Equity FMIEX, said he's been buying General Electric GE for a while and is getting more excited the cheaper it gets. The stock is down by about 23% this year, due in part to the credit crisis's effect on its financial division. But Shive thinks the rest of the business--the industrial side of the conglomerate--is still in good shape and should benefit from the need to improve and build global infrastructure. And with its stock at 14 times his estimate of the company's earnings and offering a more than 4% dividend yield, Shive says it's as cheap as Wal-Mart WMT was a few years ago.

John Osterweis, manager of Analyst Pick Osterweis OSTFX, touted Valeant Pharmaceuticals VRX. The specialty pharmaceutical company has 350 branded products, but new management is working to streamline the firm and make it more efficient, Osterweis said. He expects the company to buy back stock. He also likes the prospects of some of the drugs in its pipeline, including an epilepsy treatment that Osterweis estimates could reap $1 billion in sales. That could transform the company from a seller of a hodge-podge of drugs to a blockbuster, Osterweis said.

Diane Jaffee, manager of TCW Relative Value Small Cap TGONX, also picked a drug stock: Arena Pharmaceuticals ARNA. The company has promising obesity and hypertension drugs far along the approval process. Arena also has high-profile partners, such as Merck MRK, to get the drugs to market, Jaffee said.

Zweig: Beware of Your Brain

M*_Karin — Thu, 26 Jun 2008 20:05:58 GMT

Jason Zweig, author of Your Money and Your Brain, talked to us about how neuroscience and psychology intersect with investing. Before making an investment, consider these brain-related landmines:

Our noggins are big balls of emotion that can also figure out complex mathematical problems. The two components are reflexive and reflective. The reflexive brain is emotional and leaps to conclusions, and this can lead to bad investment decisions. The reflective brain is controlled and empirical and must be switched on.

The prediction addiction. Dopamine (a motivation and reward-related chemical) fires after we get what we want and prepares us for action if it ever happens again. In a similar situation, it’s the prediction of the reward that causes dopamine to fire, not actually getting the reward. This is like a positive earnings surprise. In a third scenario, we predict a reward, dopamine fires, and no reward comes, then we fall into a motivational vacuum, because this is like a negative earnings surprise.

Patterns form fast in the human brain. Expectations set up automatically, and they are much stronger than experience.

Three’s a trend. For example, mutual fund companies tend to advertise funds after their third year of operation. It’s mostly because the number three has a magic feel to it.

Fear responses fire 25 times faster than you can blink your eye. These responses keep us alive, but keep in mind that this reaction is dangerous when it comes to your investments because fear can’t do cost-benefit analysis.

People have trouble understanding two identical scenarios when one is framed as a loss and one is framed as a gain.

We all have unconscious biases--you may be feeling when you think you are thinking.

Bill Bernstein on Bargains, Rebalancing, and Brains

dculloton — Thu, 26 Jun 2008 17:06:59 GMT

There are no screaming bargains among asset classes in the market right now, but there aren't any obvious sells, either.

That's what author, investment advisor, and former neurologist William Bernstein said at Morningstar's Investment Conference Thursday. It's worth paying attention to his opinion because eight or so years ago in his book, The Intelligent Asset Allocator, he crunched a lot of data and concluded that REITs, TIPs, junk bonds, and small-value stocks would have higher future expected returns than the large-growth stocks that were dominating the headlines and investors' portfolios at the time.

Currently Bernstein sees most stocks as modestly overvalued, and REIT yields as not that attractive. He's also worried about what effect currency fluctuations could possibly have on foreign equities, which have benefited tremendously recently from a weak dollar. He didn't include commodities in his overall assessment, though, because he doesn't use them (he doesn't like the futures markets and doesn't trust the retail funds and ETFs that offer commodity exposure). But he does think commodities are in a bubble.

Bernstein thinks about relative valuations among asset classes, but the author of the Efficient Frontier Web site is really a buy-and-hold investor who uses mostly passive funds from DFA and Vanguard. He spent a lot of time talking about the right way to rebalance a long-term portfolio. Bernstein has done considerable research into the best ways to rebalance--whether to do so at preset times on the calendar or when asset classes meet certain thresholds. He prefers the threshold method because he said he thinks it can result in better returns, though he admits that he has had trouble coming up with hard data to back that up. The difference between really good rebalancing and average rebalancing is about 10 or 20 basis points, or hundredths of a percent, in portfolio return, he said. No matter which form of rebalancing you choose, Bernstein has concluded that you can go two or three years without resetting your asset allocation.

The former neurologist said he doesn't pay as much attention to behavioral finance as you would expect for someone with a medical background, but he said it can help you understand what emotional responses to expect when tough investing decisions arise. Like a pilot who has to overcome his fear of pushing down on the plane's stick when losing speed (doing so helps gain airspeed), investors have to steel themselves to make the hard choice. Bernstein, a former pilot, noted that some of the best trades are made when you have a nauseous feeling in your stomach.

The biggest mistakes most experienced investors make, Bernstein said, are not knowing enough economic and market history and conflating economic growth with equity returns. The current credit crisis, the burst of the technology stock bubble, and the collapse of hedge fund Long-Term Capital Management have all been called 100-year storms in finance, but they've all happened in the last decade. China's economic growth has been astronomical in the past 15 years, but its equity market returned just over 1% from 1993 through December 2007.

Do you agree few asset classes look cheap? Are commodities a bubble? What's the best way to rebalance? And do you know your economic history?

Dan Culloton
Senior Mutual Fund Analyst

El-Erian: Yesterday's Market Colliding with Tomorrow's

M*_Karin — Wed, 25 Jun 2008 23:11:50 GMT

Mohamed El-Erian, co-CEO and co-CIO of PIMCO, kicked off the 2008 Morningstar Investment Conference by talking about his outlook on the global economy as well as some advice for investors during what he calls an increasingly uncertain environment. Here are some of the main takeaways:

To illustrate how the unthinkable has become thinkable in the past year, four events stand out: the financial crisis that originated in the most sophisticated financial system in the world, the bank runs that occurred in the U.S. and the U.K., the banking system worldwide raising $350 billion in capital--which was wiped out by write-downs, and a significant amount of that capital coming from emerging-markets countries.

Investors have to take into account the difficulties that policymakers have in dealing with inflation, unemployment, a weak dollar, and the health of financial system. When thinking about our investments, we must keep in mind that no solution solves all these problems.

The signs of major global change came through disruptions at the heart of the U.S. financial system, and in spite of heavy losses on Wall Street and institutional failures, the strength of emerging-markets economies will keep the global economy humming along. Though the rest of the world hasn’t been able to navigate a lot of the bumps, these countries will also have to deal with the consequences of the damaged credibility of sophisticated financial systems and highly leveraged institutions and transactions.

To navigate in these uncertain times, we must understand that the market is telling us something. Looking back, the emerging economies (post the Asian/Russian/Argentinean crises of the 1980s/1990s) and the corporate sector (post the Enron and WorldCom collapses) were the last sectors to recapitalize, and today the financial sector will continue to come under the pressure of shrinking balance sheets and higher regulation. We also need to think about pressure on the consumer sector down the road, especially since the U.S. consumer is facing declining housing prices. Borrowers can’t rely on housing prices to go up, and so the credit they used to be able to get through their mortgages has dried up.

Essentially, yesterday’s market is colliding with tomorrow’s, and we as investors need to decide which market we’re targeting to manage the transition. We need to expect the bumps in the years ahead to be like unexpected air pockets, so we need to know what risk levels we can handle and choose our investment management accordingly. We need to hard-wire ourselves to second-guess our assumptions and think about how cyclical events and long-term trends will affect our investments. Also, don’t get paralyzed by all the information and avoid investing altogether!

Some “Don’ts” to emphasize the above points:

Don’t treat the past year as a one-off situation
Don’t think we are going back to business as usual
Don’t forget that crises have opportunities
Don’t be fooled by the trap of narrowly framing asset class choices, since all investment portfolios will have to live through a bumpy transformation in the years ahead