Contents:

-Look at What Many Fund Investors Are Doing (And Do the Opposite)
-Why Core Inflation May Fall Further Than Expected

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Look at What Many Fund Investors Are Doing (And Do the Opposite)

Summary: For investors who rely on their funds' websites (or newspapers) to inform them as to their funds' performance, they may not be getting what they see. This is because many (or most) investors are influenced by the markets' performance into either buying or selling by virtue of a seemingly "logical" assumption: Best to buy when the market appears strong; best to sell when it looks bad for the market. But, as a result, they often buy when their mutual funds' have already achieved some of their better gains and so gains will not likely be as good going forward. Likewise, by the time many fund investors decide to sell, or exchange to another "safer" fund, much of the underperformance may already be over.

Evidence reported in this research article, as well as elsewhere, shows that the returns that are measured by the "in and out" decisions of investors (called "Investor Returns") are significantly less than those achieved by either buy and hold investors, or, those minority of investors who tend to adopt an opposite (contrarian) type of strategy. Further, by investing in volatile, concentrated types of funds, investors are more subject to realizing a negative performance gap between the total returns reported by the funds and the Investor Returns as reported by Morningstar.com

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In a decade during which stock fund investors have generally not fared well, making the bad news even worse is the fact that, on average, investors have been getting only about 62% of the returns earned by their stock mutual funds. This comes from no less influential sources as Morningstar.com and Vanguard founder, John Bogle. And investors who have gravitated to the newer kid on the block, exchange traded funds (ETFs), have suffered this effect considerably more than those in non-ETF funds. Even bond fund investors may be surprised to see their returns may not be nearly all they are "supposed" to be.

This means, for example, that if your fund reports an annualized return of say 5% per year over the last 5 years, the average investor really only earned 3.1%. Or, in other words, stock fund investors are losing 38% of what they might have been earning. And for some funds, the failure to earn the fund's stated returns is far greater, even turning what appear to be positive returns into negative ones. (This loss is pre-tax, and therefore, not a result of reducing a 5% return to around 3% when taxes are considered; in fact, such an already abbreviated 3.1% return would be perhaps reduced to around 2% for someone in a combined tax 33% bracket.)

Why Fund Investors Fall Short: An Example of Oft-Repeated Missteps

In Sept. 2004, Fidelity Value Fund (FDVLX) was already very popular fund with assets of about $8 billion. It had been significantly outperforming the S&P 500 over the prior 5 years and other funds in its midcap value category over the prior 1 and 3 yr. periods. Between then and Sept. '06, its assets doubled to 16 billion. Then, over the following yr., thru Sept '07, its assets grew another 37% to 22 billion, more than doubling its 17.5% return during the same period.

Obviously, investors were pouring money into the fund due to its attractive performance. Up to that point, it continued to have an outstanding 5 yr. track record (15.7% ann.), far outdistancing the same performance of the average US stock fund at 8.4% per year.

So how did FDVLX fare over the 5 yrs that followed this huge swell in the amount investors put in? For investors who began (or added to) their position exactly on Sept. 30, 2004, the 5 yr. annualized return since then has been 2.1%. Had an investor invested in the average diversified stock fund, their return would have been no better, just 1.8% ann.

But here's the problem: Investors, as a group did not all begin investing in/adding to FDVLX exactly on Sept. 30, 2004. Rather, they invested (or withdrew) funds throughout the following 5 yr. timeframe. You need to be aware that the tables of mutual fund performance reported by fund companies on their websites or in newspaper performance summaries only show performance from the 1st day of a reported period thru the last. As such, they capture the performance for "buy and hold" (BH) investors who maintained their position during the period. However, they do not show the performance for many, if not most investors, who either add to, or withdraw/exchange from, the fund during the period.

When taking into consideration the totality of actual purchases, and sales out of FDVLX, we now get a much poorer picture of how FDVLX investors did. During the 5 yr. period above, overall investor performance, or what has been called "investor return" was reduced from the above figure of +2.1% to -3.6%. This represents a -5.7% underperformance from the results you will see reported almost anywhere else! (However, you can find investor return data for FDVLX, or any other fund, reported on the Morningstar.com website under the "Performance" and then "Investor Returns" tabs.)

But there is even worse news for investors who were involved in purchases or sales of FDVLX during the one year ending 9-30-09. Had they owned the fund over the entire yr., their fund-reported total return was -5.45%; however, Morningstar's data shows that since many FDVLX investors sold over the period (total assets dropped from about 18 billion to about $8 billion), their average investor return dropped a stunning -15% more than otherwise reported (-20.45% investor return vs -5.45% total return). Obviously what happened was that as stock prices tumbled starting in Oct. '08, investors bailed out to a huge degree. They have likely continued to do so even as the fund's price has about doubled from the March lows. Because these investors sold while prices were low, their actual returns were far lower than had they held their position for the entire year.

It is perhaps inevitable that all of us, as investors, have a tendency to be more interested in buying/adding to our funds when prices are relatively high. Likewise, we experience the greatest psychological pressure to sell when a given investment has deteriorated. If, over time, investors were generally good at judging better or worse times to enter or exit their funds, then actual investor returns achieved would prove to be better than the total returns reported for funds. But, unfortunately, just the opposite is usually the case. This is what accounts for the 38% of underperformance by actual stock fund investors, referred to above.

Now that we have reported dismal experience of FDVLX investors, let's look at how some additional funds have done.

Several Domestic Stock Funds

First, the good news: Investors choosing some domestic index funds have at times done nearly as well or better than those funds' buy and hold (BH) investors.

Vanguard 500 Index (VFINX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	-6.87%	-6.87%	0%
3	-4.37	-5.48	+1.11
5	+3.12	+0.94	+2.18
10	+0.39	-0.23	+0.62

By comparing the performance gap (the difference between the Investor Return and the Total Return), we can get a measure of the degree of success of investors' actual monthly investments into the fund. Since the differences shown are positive (or zero), VFINX investor decisions as to when to buy and sell mainly helped them to do somewhat better than BH investors.

Note: A positive performance gap by a fund (as shown above for VFINX), does not necessarily mean it was a particularly good investment during a period, just that many investors did better than the return of BH investors. The Investor Return itself is the best measure of how good an investment performed for the typical investor in the fund.

Vanguard Small Cap Index (NAESX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	-2.51%	-4.08%	+1.57%
3	-1.80	-2.83	+1.03
5	+4.87	+3.66	+1.21
10	+5.82	+5.72	+0.10

Once again, many investors in this fund did a little better than BH figures.

Now compare these results to those of two actively managed Fidelity funds:

Fidelity Magellan Fund (FMAGX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	-6.03%	-1.10%	-4.93%
3	-5.54	-5.03	-0.51
5	+1.37	+0.13	+1.24
10	-1.54	-1.21	-0.23

Here, especially during the last year, many investors did considerably poorer than the BH results for Fidelity Magellan for the same reason as reported for FDVLX above.

Note: By comparing any given fund's Investor Returns with those for VFINX, you can see how that fund's investors did contrasted to VFINX's; so, VFINX Investor Returns were better than for FMAGX, except over 1 yr. (FMAGX is classified as a Large Growth fund; VFINX is Large Blend.)

Fidelity Small Cap Stock (FSLCX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	+8.38%	+11.54%	-3.16%
3	-0.60	+0.47	-1.07
5	+4.48	+5.25	-0.77
10	+6.03	+8.70	-2.67

Comparing index to managed domestic funds, index investors are apparently more committed to being in for the long halt. And because the above 2 managed funds were significantly more volatile than index funds of their same category, it was that much more difficult for investors to remain placid when prices were dropping (or rising).

International Funds

Especially over the last 5 years, some of the biggest setbacks investors have had was in their decisions as to when to get into, add to, or get out of international funds. Consider the following:

Vanguard European Stock Fund (VEURX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	-20.84	+0.91%	-21.75%
3	-10.00	-3.37	-6.63
5	-0.20	+6.51	-6.71
10	+0.23	+3.42	-2.19

These results show that just as with FDVLX and Magellan above, investors have had an extremely poor track record in terms of deciding when to put money into and out of the fund. (The nearly -22% performance gap was a jaw-dropper for me!)

Now look at results for a more diversified international fund as well as comparing them to VFINX above:

Vanguard International Growth Fund (VWIGX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	+2.94%	+4.34%	-1.40%
3	-3.15	-1.38	-1.77
5	+5.57	+7.52	-1.95
10	+2.65	+4.08	-1.43

This "go anywhere" international fund's investors certainly did extremely better than those who went into the more narrowly defined VEURX, but they still were hurt by when they made their entries and exits. While investors in VWIGX did a little better than those in VFINX on a Total Return basis, about half of the outperformance was "washed away" as a result of poor timing on their part (eg. returns over the full 10 yrs. shrank from over a 4% advantage on a Total Return basis to little over a 2% advantage on an Investor Return basis.)

Bond Funds

Relatively recent Investor Returns from bond funds are in many ways even more troubling than for stock funds because almost without exception, bond fund investors virtually always got their timing wrong over the last 10 years. However, since bonds are usually less volatile to begin with, the absolute magnitude of differences with Total Returns do not typically become as extreme as for some stock funds, as shown above.

First, look at the results for the two largest bond funds, which are both relatively less volatile and and more diversified than most:

Vanguard Total Bond Market Idx (VBMFX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	+9.00%	+10.49%	-1.49%
3	+4.56	+6.42	-1.86
5	+3.57	+5.09	-1.52
10	+4.27	+6.03	-1.76

PIMCO Total Return Instit (PTTRX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	+15.55%	+18.32%	-2.77%
3	+7.53	+9.16	-1.63
5	+5.68	+6.93	-1.25
10	+5.99	+7.55	-1.56

But when more risky or specialized are bond funds considered, entry and exit decisions are likely to influence the results even more so. The first fund below is a high yield ("junk") bond fund and the second is a bond fund that invests outside the US.

Fidelity Capital & Income (FAGIX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	+19.21%	+22.44%	-3.23%
3	+3.13	+5.84	-2.71
5	+4.57	+7.41	-2.84
10	+4.07	+6.32	-2.25

Amer. Cent. International Bond (BEGBX) Returns (Annualized)
No. of Yrs. (thru 9-30-09)	Investor Return	Total Return	Performance Gap
1	+9.91%	+13.46%	-3.55%
3	+5.58	+7.91	-2.33
5	+3.97	+6.11	-2.14
10	+4.88	+6.72	-1.84

The longer-interval Investor Returns for these above 2 volatile funds dropped down sufficiently from their Total Returns as to wipe out any advantage they might have had vs VBMFX for each of the funds on a buy and hold basis. Overall, while each the above bond funds have shown excellent results for BH investors, unfortunately, the typical investor suffered from the kind of relatively big performance robbing returns for many investors.

Conclusion

No matter which funds one chooses, whether stocks or bonds, you will probably find similar performance gap results to those we report here. Actual fund investors, when making decisions as to their investments, tend to underperform total return tables due to investing more when times appear good, and withdrawing funds when net asset values are declining.

So, it appears best to stick with well diversified, less risky/volatile funds if wish to get the closer to the Total Return than the (usually less) Investor Return. If you do invest in more concentrated, riskier types of funds, make sure that you carefully consider your entry/exit points because the majority of other investors' results in these funds have shown that it is very difficult to get one's timing right. As emphasized so many times in my newsletters, you want to invest in well-regarded, recommended funds when their prices are fairly beaten down, not when they are high. You should generally try to be contrarian, meaning that when other investors are thinking it is a good time to buy (or sell), you should consider the doing the opposite.

And since bond investors have had such a particularly poor sense of when to get in/out of bond funds, the fact that bond funds are now experiencing huge inflows would suggest that it is likely that those investors just coming into bond funds now will not do particularly well in the years ahead. Likewise, since stock fund investors have been pulling money out of stock funds over the last 6 or more months, since these investors too are usually wrong-footed in their timing, it appears more likely than not that stock prices in the years ahead will do better than most of these people expect.

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Why Core Inflation May Fall Further Than Expected

The minutes of the Federal Reserve’s September board meeting, issued in mid-October, contained some forecasts/predictions about future inflation rates that are worth exploring, specifically:

Most participants anticipated that slack in both labor and product markets would be substantial over the next few years, leading to subdued and potentially declining wage and price inflation.

With the significant under-utilization of resources expected to persist through 2011, the staff forecast core inflation to slow somewhat further over the next two years from the pace of the first half of 2009. [Author's note: The core inflation rate of the first half of 2009 was 1.8%]

A few preliminary observations are in order. The minutes reflected the public dispute among board members concerning the prospects for future inflation but indicated that “most participants” believe inflation over the “next few years” would be “subdued and potentially declining.” The staff predicted that core inflation would decline further “over the next two years.” Such long-term predictions on inflation rates are unusual in the Fed minutes but these predictions drew almost no attention in the financial press.

The minutes did not say whether the staff believed that core inflation rates would fall below the Fed’s target range of 1.5% to 2.0%, announced in 2008. Even if the staff held that opinion, it is unlikely that it would have been included in the minutes, which are in significant part a public relations tool intended to influence financial markets. Such a statement would have given support to those commentators arguing that deflation is a serious threat which could cool markets and delay a recovery.

Some prominent commentators have indicated that core inflation will fall below the target range. In October, Nobel Prize economist Paul Krugman stated, “Suppose that core inflation stays at 1.6% [the then current annual rate], although in fact it’s almost sure to go lower.” Jan Hatzius, the highly respected Chief Economist at Goldman Sachs, concurs, “We have core inflation falling through next year to close to zero.”

During the past decade core inflation has ranged from a high of 2.6% in 2006 to a low of 1.4% in 2003 and has averaged 2.2%.

The Fed has repeatedly indicated, when making interest rate decisions, that core inflation is more important than headline inflation, which includes volatile food and energy prices.

The devil is in the details and a critical detail of core inflation is the "rental" component. "Rent" makes up approximately 40% of core inflation and is by far the largest component of the index. Eight percent of the core inflation index is the amount actual renters pay. Thirty-two percent of the index is the "owners’ equivalent rent" – the amount that the government estimates owners would pay in rent for their residences. Counterintuitively, since 1983, the actual price of homes and the amount of mortgage payments have played no role in government inflation indexes.

September’s inflation report indicated a decrease in both the rent and owner equivalent rent price components. For the first time in the past 17 years, these components registered small, but significant monthly declines. Over the past decade, these component sub-indexes have averaged between 0.2% and 0.3% monthly growth. In September, both sub-indexes registered 0.1% declines. For the past three months, the two sub-indexes combined have been flat – no growth whatever. Growth in these component indexes slowed in February and came to a halt in June before turning negative this past month.

A variety of factors have contributed to the decline in the rental sub-indexes. There are a record number of vacant housing units - the vacancy rate for the third quarter 2009, is 11.1%- the highest level since the Census Bureau began collecting data in 1956. It is almost certainly the highest vacancy rate since the Great Depression. The rate exceeds 15% in 10 of the 75 Metropolitan Statistical Areas, including Atlanta, Austin, Indianapolis, Phoenix, Cleveland and Richmond. Overbuilding during the housing bubble has created an excess supply of both single family homes and apartment units (some of which developers have converted from condominium projects). High unemployment has resulted in younger tenants doubling up, some returning home to live with parents and a slower level of household formation. Tax incentives for first-time buyers as well as enhanced housing affordability due to falling prices have made homeowners of some renters. All these factors have contributed to increased rental vacancies, putting downward pressures on rents.

Prominent real estate research firm Reis, Inc. predicts that apartment vacancy levels will climb further during the next two quarters.

An open question is whether we will experience the first year-over-year decline in the rental components since the owners’ equivalent component was created in 1983. Prior to the collapse of the housing bubble, many commentators saw that housing prices had climbed year-over-year for more than 50 years and predicted they would continue to do so. The housing bust proved their predictions wrong. The inflation rental indexes may now be the next domino to drop. A year-over-year decline in those indexes would significantly increase the risk of zero percent core inflation or outright deflation.

There has been a clear downward trajectory in rents and owners’ equivalent rent over the past three years. That trajectory and momentum are unlikely to reverse as long as the unemployment rate climbs. Most economists believe that the unemployment rate will exceed 10% in early 2010 and thereafter decline. Increasing rents and falling vacancies are likely to lag the peak in unemployment by several months while the newly employed tentatively enter the housing market. If rents stay flat in the coming two years, core CPI would almost certainly fall below the Fed’s target range. If rents were to further decline for a year or two, there would be a serious threat (35% to 40% chance) of outright deflation in the core index. At present, the most likely scenario is that the rental indexes will be flat for at least a year. For investors, this situation diminishes the chances of significant increases in the Fed Funds rate from their near zero current level during the coming year.

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