The Buckingham Report

Most long-term-oriented investors understand that equity prices are volatile and that occasional downturns are the price one has had to pay to achieve long-term returns that have averaged 10% for large-capitalization stocks and 12% for small-capitalization stocks over the past eight decades.

Though the recent downturn in the equity markets has spooked many folks, it should be pointed out that according to Bespoke Investment Group, 10% losses have occurred on average every 16 months based on data going back to 1940. The recent stretch of 1,591 days since the last 10% tumble is the second-longest hiatus during that time period.

Judging by the number of trading systems we see at investment conferences and the amount of attention paid to short-term market predictions, we know that many investors are not content to simply invest for the long term as they still try to time their moves into and out of equities. After all, wouldn’t it be great to get out of stocks before a correction sets in and get back in just in time for the next rally? Alas, this is easier said than done as very few have achieved consistent success with efforts at timing.

In fact, as financial-services research firm Dalbar Inc. has determined, the average equity fund investor has earned only a 4.3% annualized return over the past two decades, compared to an annualized return of 11.8% for the S&P 500 over those same 20 years. Why is this? Dalbar states, “As markets rise, investors pour cash into mutual funds, and a selling frenzy begins after a decline. Tracking the dollars going into and out of mutual funds over a given month compared to market performance proves the correlation: as markets rise, cash flows swell; as markets decline, cash flows deflate.”

With impressive credentials and the best computing power at their disposal, the brightest minds on Wall Street don't want to ride through the stock market’s inevitable ups and downs either, so they have created alternative investment vehicles, commonly referred to as hedge funds. These are usually aggressively managed portfolios that use leverage, in addition to long, short and derivative positions in both domestic and international markets, with the goal of generating high returns, either in an absolute sense or as compared to a specified market benchmark.

Despite expenses that often total 2% in annual management fees in addition to an incentive fee of 20% of profits, investors, including supposedly conservative pension plan managers, have rushed to throw their monies at long/short, market-neutral and other types of hedge funds, lured by the potential for market-beating returns with limited market risk. This despite the lessons learned from the 1998 implosion of the massive hedge fund Long Term Capital Management and from the collapse of energy hedge fund Amaranth last year.

We also might add that exiting from a hedge fund can be far more complex than selling a stock or mutual fund. Many hedge funds give money back only at the end of a calendar month, or the end of a quarter, and then only if the request has been made 30 to 60 days in advance. Of course, for long-term-oriented investment strategies, a lengthy 'lock-up' period is not necessarily a bad thing!

Recent unprecedented (in the eyes of many hedge fund managers) volatility has led to more carnage in the hedge fund world. While the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund was completely wiped out–that is, investors lost 100% of their money–we trust that those who placed their assets in this fund understood the risks involved.

We are not so sure that we can say the same for those who put their faith in market-neutral hedge funds as there is an implied expectation, though it is certainly not guaranteed, that money should be made no matter the short-term direction of the market. Obviously, with published reports out in recent weeks suggesting that Highbridge Statistical Opportunities Fund lost 18% over the first nine days of August or that Black Mesa, which was said to own a portfolio with about $1.9 billion in long positions and $1.9 billion in short positions, was down roughly 7.5% over the first seven days of this month, it is not easy to be market-neutral. And we can’t overlook the fact that the $10 billion Goldman Sachs Global Equity Opportunities Fund supposedly lost more than 25% early this month, before receiving a $3 billion cash infusion from Goldman and other new investors.

As Bob Olstein said in this weekend’s Barron’s, “Investors have no idea how market-neutral or high-return fixed-income funds are deriving profits and holding down volatility. If you want to invest in derivatives or go long and short and you want to leverage up 10, 20 and 30 times to get higher returns, basic investment theory says you are going to take a risk somewhere…if it is cataclysmic and the derivatives go against you with that kind of leverage, the lights turn out. I don't like that bet.”

Recognizing that some may say that those who live in glass houses shouldn’t throw stones, we readily concede that our portfolios have taken it on the chin during the recent market turmoil. Interestingly, we have read that many of the hedge funds that were forced to unwind positions had big stakes in many undervalued stocks, such as those in which we invest. Still, our managed accounts have not seen any forced liquidations and we think it safe to say that our clients have no illusions that our investment strategy is somehow market neutral.

Looking at our managed account numbers from Q4 1990 to Q2 2007, our multi-cap value composite performance statistics show that we have achieved positive returns (net of fees) in 131 out of 201 months, or 65% of the time. On a quarterly basis, 46 out of 67 periods have been positive, representing a 69% success rate. And 87%, or 14 out of 16, of the calendar years have seen gains. Of course, more important is our long-term annualized performance record, as displayed below.

We formally calculate and publish our performance information quarterly, but I can say that in the interest of full disclosure, our managed accounts were down approximately 4% on average for the month of July and are off approximately 5% on average this month, as of August 28. Nevertheless, given the gains of the first half of 2007, the year-to-date returns, on average, remain modestly positive.

We realize that many will continue to be drawn to the siren songs of Wall Street's Whiz Kids, but we are content to make our money the old-fashioned way–by buying and patiently holding broadly diversified portfolios of undervalued stocks for their long-term appreciation potential. We know that we will endure periods of underperformance and that we will even suffer short-term losses along the way, but we offer no promises that there won't be any bumps along the road to long-term investment success.

After all, those who strive to smooth the journey via supposedly sophisticated trading strategies have often been unable to cope with the 100-year floods and 10-standard deviation events that seem to be happening all too frequently in recent years. Indeed, investors would do well to remember the old adage–if it sounds too good to be true, it probably is–as return is almost always commensurate with risk.

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Important Disclosures 

The Multi-Cap Value Composite includes discretionary equity portfolios using our standard value strategy of buying and holding for their long-term appreciation potential, a broadly diversified portfolio of undervalued and/or out-of-favored stocks. The minimum account size for inclusion in this composite is $100,000. Leveraged accounts are not included in this composite. At June 30, 2007 the Multi-Cap Value Composite represents thirty-seven percent of firm assets. For comparison purposes, the composite is measured against the Wilshire 5000, a broad market index. S&P 500 Index is widely regarded as the standard for measuring large-cap U.S. stock market performance and is included for comparison purposes against long-term composite results.

Al Frank Asset Management, Inc. (Al Frank), is an investment Advisor, registered with the Securities & Exchange Commission, is editor of Buckingham Report, The Prudent Speculator and the Prudent Speculator TechValue Report and weekly Hotline Updates and advisor for two proprietary mutual funds. Al Frank is wholly owned by AF Holdings, Inc. The firm maintains a complete list and description of composites, which is available upon request.

Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Non-fee-paying portfolios are included and represent less than 1% of the composite. From 1993 to 2000, non-fee-paying portfolios represented up to 5% of the composite. Prior to 1993, non-fee-paying portfolios represented up to 8% of the composite.

Beginning January 1, 2006, composite policy requires the temporary removal of any portfolio incurring a client initiated significant cash inflow or outflow of at least 25% of portfolio assets. The temporary removal of such an account occurs at the beginning of the quarter in which the significant cash flow occurs and the account re-enters the composite at the beginning of the quarter after the cash flow.

The U.S. Dollar is the currency used to express performance.  Returns are presented gross and net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees charged to the client. Additional information regarding policies for calculating and reporting returns is available upon request. Actual investment management fees vary beginning at 2% per annum. Our full management fee schedule is described in more detail in Al Frank’s Form ADV Part 2. The Multi-Cap Value Composite was created December 2005.

Opinions expressed are those of John Buckingham and are subject to change, are not guaranteed and should not be considered investment advice. Neither the information in this interview, nor any opinion expressed by Mr. Buckingham, shall be construed to be or constitute an offer to sell or a solicitation of an offer to buy any securities.