January 25, 2011
Target Date Funds May Be Trouble
The Investment View from Prescott, Arizona
Everyone likes the softer, easier way of doing things, and Lifestyle or Target Date mutual funds are the industry’s latest attempt at making investing a single, simple decision. “What year will you retire? We have a fund for that!” goes the common line.
Successful investing is anything but simple, and this seductive sales pitch is attractive to the lazy side in each of us. But Target Date funds are leading investors on a very dangerous path. In fact I would not be surprised if Target Date funds will be the scandal du jour five or ten years from now.
The reason I say this is that virtually all of these funds use a formulaic approach to investing with the common theme being using more conservative investments the closer one gets to retirement. Where a Target 2050 fund may hold 90% stocks, the shorter date funds are mostly bonds.
This makes sense in a general financial planning manner. An investor should take less risk as the need to access savings gets close.
On the whole this is a good strategy but not always. Do you remember the old adage about a person being able to drown in a pond that was only knee deep – on average?
The problem with the systematic adding of bonds to a portfolio is that this style of investing ignores the realities of the current market.
That reality is that toward the end of last year, interest rates made what appears to be a long term bottom in a 60 year cycle of interest rates. This strongly suggests that interest rates will generally be rising for the next 30 years or so.
In a rising interest rate environment, bonds have a greater risk of loss regardless of the owner’s age. If interest rates rise from 5% to 10%, a ten year maturity Treasury bond will lose almost a third of its market value. That is a lot of risk from an investment added to a portfolio to keep it conservative.
So adding more bonds to a portfolio right now is exactly the opposite of what a more conservative investor should be doing, yet this is the path that Target Date funds take as they all blindly follow their formulas.
If your mutual funds have a year in the name, such as 2025 or 2030, you may have a Target Date fund. Sure, Target Date funds are easy, but there are lots of easy ways to lose money. The idea is to NOT lose money, and the probability of Target Date funds disappointing investors over the next 10, 20 or 30 years is very, very high.
On A Personal Note…
There have been no travels for me in the past two weeks and none planned for a while, either. It feels strange to stay in one place for a month straight when you travel for 70-80 days a year – about half of that on business and half for pleasure.
Some years back I realized I would probably never really retire in the traditional sense. My work is the most intellectually stimulating thing I have ever done and even if I were to retire, I would start my day the very same way, with a cup of coffee at the computer seeing what the markets are doing.
The insight that I should not plan a normal retirement led me to become much more of a specialist and streamline my business over the last 10 years. Since I am not an every-day trader, I just need to monitor the investments we hold at least once a day, something I can do from my Blackberry if I am traveling.
Since I act like I am already retired, this is a pace I figure I can keep going at for many years, but a month straight at home. Wow! My honey-do list is even shrinking.
How’s The Market Doing?
The market finally broke down this week after being greatly overextended to the upside.
Stock markets always zig and zag along their main trend. Since early December, however, the zigs and zags have been almost non-existent as the market crept up day after day.
In fact, according to Jason Goepfert of SentimentTrader.com, the persistency of the advance in December set a new 82-year record with 81% of days up.
What began last week may be termed a stock market “correction”, a technical term for a reversion back to the average of the current trend – a zag to most of us. However, I do not think this particular zag is the end of the rally that began in March of 2009, but I do expect this to be a scary shakeout even if it doesn’t last all that long.
The stock markets are in a strong period due to the political cycle that affects the stock markets positively in year 3 of a presidential term.
In addition, the Fed is buying Treasury bonds on the open market, which replaces them with cash. All of that cash has to go somewhere, and the stock market is a logical place.
In a couple of unscientific readings of the economy, I have begun getting a lot of response to the space I am renting in my office building, whereas last year the response was a little above zip. Also, a friend in the commercial construction business says there are a lot of jobs coming up for bid, compared to only a few last year.
Even $100 per barrel oil is a sign that industrial demand for energy is rising – more good news for the economy.
The gold market is struggling to get out of its own way, and I expect it to be weeks or perhaps even a month or more before gold can resume its uptrend.
The decline in Treasury bonds has leveled off this month, but Treasuries are still a terrible place to invest right now – low return and high risk. Not my kind of investment.
Who Owns Our National Debt?
The United States’ total public debt outstanding was approximately $13.562 trillion at the end of the government’s fiscal year on 30 September 2010. As of 4 January 2011, the United States’ total public debt outstanding has surpassed 14 trillion dollars and is continuing to grow rapidly.
The chart below, courtesy of Politcal Calculations, shows that U.S. individuals and institutions, including the Social Security, U.S. Civil Service and Military trust funds, own 68.2% of the U.S. national debt, while foreign nations own the remaining 31.8%.
The big surprise of the chart is that China, contrary to popular opinion, only owns 7.5% of the U.S. debt.
What’s Going On In Your Portfolio?
I am unhappy with the performance of the Careful Growth portfolios over the past 6 months, and as I mentioned in the last newsletter I am making changes to our strategy to bring them more in tune with the current market conditions.
One difference between investing in a mutual fund and investing with me is that most mutual funds tend to apply the same methodology year in and year out regardless of market conditions.
Mutual fund methodology is spelled out in the fund prospectus and they are required by law to stick to what is written down. If their methods are no longer in sync with the market you have to be the one to change because they are not going to.
At Hepburn Capital, I make the changes so you don’t have to. When I recognize that something is not working I change it, so my strategies continually Adapt to Changing Markets®. And that is what I am doing right now.
Each strategy of mine has several components. Some parts of the Careful Growth strategy have worked exceptionally well. The individual stock picking, implemented a year or so ago has done very well, with a number of large gainers from that group. During periods when we were fully invested we outperformed the broad market indexes and this is why.
The number of winning trades vs the number of losing trades continues to be good.
Also working very well this past year were my exit strategies. Knowing “when to hold ’em and when to fold ’em”, as Kenny Rogers would say, is the most important part of any good money management strategy.
During the “flash crash” last May, I had already gotten exit signals on enough holdings that we were only about 40% invested on May 6th (the day the market dropped 9% in one day), much of that in just a few minutes. This held our losses to less than half of the S&P 500’s losses during this troubled time.
Risk avoidance is the number 1 stated goal of this strategy, and I feel that I have delivered on that very well.
What has not worked is our reentry back into the stock market in July, September and December after successful exits during sharp corrections.
My reentry strategy was too slow to react, and it cost us the opportunity to make money by keeping us out of the market for a large part of those rallies. Almost all of our under-performance for the year (compared to the S&P 500 Index*) can be traced to slow reentries in the second half of 2010.
When I explain the alternatives, most clients agree they would rather lose opportunities than lose money, but the opportunity cost this past year was just too great, so I am making changes to correct that.
Our new reentry system will be quicker to respond, with less time spent in cash or other safe harbor investments. I still expect to keep our risk profile low for a growth strategy, with an enhanced system of Safety Net features designed to get us out of the market before significant declines can go too far. When you come in for a review, I’ll be happy to show you the details of this three-phase protection.
I think this new system will give us much better performance, without an increase in overall risk. I thank you for your patience while I worked these changes out.
Riddle:
Q:
If you break me,
I do not stop working.
If you touch me,
I may be snared.
If you lose me,
Nothing will matter.
What am I?
A:
One’s heart.
Our Spotlight Strategy
Careful Growth Strategy
If you want to outperform the U.S. stock market while taking only a fraction of the risk, our Careful Growth Strategy may be for you.
* The model accounts mentioned in this article are hypothetical examples of how the strategy may work as designed. Activity in client accounts may be different from that in the model in amount of each investment, specific timing of trades, and actual security used, which may vary from account to account. Not all trades are profitable. It should not be assumed that current or future holdings will be profitable. A list of all trades in these accounts for the past 12 months will be provided upon written request.
** The S&P 500 and Nasdaq Indexes are unmanaged lists of stocks considered representative of the broad stock market. Investors cannot invest directly in the S&P 500 Index.
Balanced Strategy Description and Performance Information
Careful Growth Strategy Description and Performance Information
Flexible Income Strategy Description and Performance Information
This newsletter may contain forward-looking statements, including, but not limited to, statements as to future events that involve various risks and uncertainties. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause actual events or results to differ materially from those that were forecasted. Information in this newsletter may be derived from sources deemed to be reliable, however we cannot guarantee its accuracy. Please discuss any legal or tax matters with your advisors in those areas. Neither the information presented nor any opinions expressed herein constitute a solicitation for the purchase or sale of any security.
