When the major stock market averages declined by 10% from their 2007 highs on Monday, we were in official market correction. Sentiment is negative owing to the economic back drop of, at best, tepid growth according to the Fed, or a recession.

 

Consumers twenty-five year credit binge fueled by home equity loans, credit cards arriving in the mail, subprime and adjustable rate mortgages and automobile leases, appears to be over. Savings rates has plummeted from 14% to 0% (perhaps to a negative number if home values continue to decline). Pile on top of that the banks debt problems, high energy prices, the homebuilding industry’s woes, weak retail sales and declining consumer sentiment, it’s no wonder that many investors believe a recession is in the offing.

Investors face two challenges right now. If the economy is headed into a recession, where do I put my money? And, if the economy avoids a recession will I be in the right investments? The stock market anticipates the future. It will decline prior to the US entering a recession and it will start going up prior to the end of the recession. Investors who wait for certainty that a recession has begun will be selling stocks at the worst possible time. The same logic holds true if you wait to buy stocks until after the economic recovery, the market will have already moved higher in anticipation. Human psychology is a future complication. We’re most optimistic about the stock market when it’s roaring ahead and most inclined to buy; and most pessimistic and most inclined to sell, when it’s at its bottom. Of course, our investment strategy should be just the opposite.  The moral to this story is that you should invest for the long term and not try to time the market. 

 

If a recession is imminent, the stock market will decline by another 10%. How do you make money? To get technical, buy mutual funds, ETFs and stocks with negative betas or high alphas, such as gold, commodities, real estate and foreign stocks. Gold and commodities already have had good runs, the US commercial real estate market appears to be weakening and foreign economies are increasingly becoming intertwined with ours. Non-investment grade bonds have good yields but are not the place to be given the continuing bank credit problems. High grade bonds and Treasures have relatively unattractive yields, particularly as you go out in maturity.

 

The best performing stocks in a recession are likely to be industry leaders, companies with strong overseas sales, consumer staples and health care. The technology sector is solid and internationally focused, so we’ll add it to our list. Essentially we’re looking at companies whose sales will be strong during a recession. These stocks may not go up in price during a recession but they will perform relatively better than most other equities and are safe investments. The bottom line is it’s hard to make money during a recession.

 

If the Fed is right and we’ll see modest economic growth in 2008, the markets are at their lows and could move 20% higher over the next six months. How do you position your investments for this possibility? By staying in the market and buying the same mutual funds, ETFs and stocks as you did for your recession portfolio. The recession portfolio is a conservative portfolio. Although it will miss some of the dramatic gains made by small cap and more violate stocks, it also protects you from the downside of those stocks while enabling you to participate in any stock market rally.

 

What to do now? Review your long term goals and make sure you’ve got the right asset mix, take losses (up to $3,000 more than your gains, remembering to match short term gains and losses) to minimize your taxes, reposition your equity investments according to our recession scenario, move your bonds into cash and tighten your seatbelt. We’re in for a bumpy ride.

Let’s dispel the notion once and for all that index funds are only for passive investors. Sure, the original index funds tracked the S&P and were meant for investors who either believed you couldn’t beat the market or didn’t want to try. Since their beginning, index funds have expanded their breath. You can find a fund which tracks any of the major indices and most industry sectors, such as health care and technology. The first cousin of index funds, Exchange Traded Funds (ETFs), do the same thing – they track indices. Between index funds and ETFs you can mirror any major index, small index, industry sector, industry sub-sector (i.e., biotech or software), global region or individual country. You can also try to outguess the indices if you want. For example, you can buy a S&P index fund which weights all 500 stocks equally or one which weights them by market cap, and so on. (Note to investors: make sure you know what you’re buying.) Thus far, we’ve only focused on equity funds but index and exchange traded funds also are available for fixed income securities. These funds are particularly suited for fixed income investments (Treasury, corporate or muni) because they can buy and sell bonds at much lower spreads than individual investors.

 

The proliferation of index and exchange traded funds means you can construct an entire portfolio of these funds to meet almost any investment strategy and risk level. A combination of a S&P fund, mid-cap and small cap domestic equity funds, foreign funds and fixed income funds of varying maturities, and a real estate fund would fit many investors objectives for a diversified portfolio with good growth potential and reasonable risk.

 

A mix of funds with individual securities or using a fund to fill a gap in your portfolio is an equally good idea. For the investor who wants to participate in, for example, biotech or emerging markets, a fund will enable her to achieve diversification in that sector (and the riskier the investment, the more important diversification becomes) with only a small investment.

 

Index funds can be bought and sold once a day; some ETFs as frequently as every hour. The larger funds are liquid investments and, in many cases, more liquid than their underlying securities (bonds and small cap stocks, for example). Transaction costs are modest, perhaps nothing for a no load fund (subject to certain holding period requirements) and typical stock commissions for an ETF.

 

So what’s the downside? There’s a body of academic literature and models which “prove”’ that a small group of fund mangers can outperform the market, think Peter Lynch and Bill Miller. If you believe this, and I do, or you just want to hedge your bet (I shudder as I write those words because investing is not a bet, it’s hard work and serious business), you can mix some actively managed funds in with your index funds and ETFs. The other issue you have to consider is that index funds/ETFs can take different investment strategies to for the same index. I gave the example above of two S&P 500 funds that are constructed differently. They will perform differently as a result. Structure and performance differences are even more pronounced as you invest in riskier/smaller indices. Taking biotech, for instance, one fund may broadly diversify, another may invest in the ten largest biotech companies, and a third may take a different investment approach. As a result, their performance will widely differ. So, again, make sure you understand your fund’s approach.  You can’t tell a book or a fund by its name.  Index funds and ETFs have a place in your portfolio; they’re no longer just for passive investors. 

 

One of the mantras of mutual fund investing is to look at a fund’s turnover before you buy it. The implication is that a high turnover is bad. (Turnover is the percentage of a fund’s holdings that are traded during a year. Funds can have a turnover greater than 100%, which means that their average holding period per investment is less than one year.) Many mutual fund screening tools have portfolio turnover as one of their filters and you can usually find a fund’s turnover (expressed as a percentage) on the fund’s snapshot page or by doing a little digging on the fund’s website.  

 

Here’s the first argument as to why turnover is bad. Higher turnover results in higher expenses because of higher transaction costs. This is true both for stock and bond funds, although turnover is even more relevant for bond funds. Why?  Transaction costs are greater and trading spreads are wider for bonds (except for US Treasuries) than for stocks.  And, the upside potential of a bond or bond fund is limited, as compared to a stock or stock fund, particularly for short maturities and high quality, so transaction costs have a greater impact on returns.

 

Tax inefficiency is the second argument as to why an investor should avoid mutual funds with a high turnover. If you hold your mutual fund in a taxable account, rather than in a tax-deferred account such as a 401-K or IRA, the fund’s taxable gains (and losses) are taxed to you in the year they occur. The higher the turnover the greater the likelihood that these gains will be short-term and you will be taxed accordingly.

 

I’ll add my own reason to look at turnover. Just like the kid who couldn’t sit still in school, higher than average turnover might suggest a nervousness or lack of conviction on the part of the fund manager. Portfolio turnover varies by asset class. For example, small cap growth stock funds generally will have higher turnover than big cap value funds. So, turnover is somewhat relative. Some fund screeners allow you to sort for funds with turnover equal to the average for a particular fund type or you can look at the turnover ratios for funds within the same group and estimate what’s the norm. Unless your fund’s turnover is much greater than its peers, you shouldn’t worry. 

 

High turnover is bad, right? Wrong. For two reasons. The turnover expense is part of a fund’s overall expense and all funds are required to disclose their expense ratios. (A fund’s expense ratio is another sort in most fund screens and appears in its snapshot, oftentimes very near its turnover.) Unless a fund creates a lot of unwanted taxable income for you, its total expenses are of greater concern than its turnover, and a fund’s expense ratio pales in importance when compared to its return (see Calories Don’t Count). Once you’ve set your risk level, the best investment is the fund with the highest return, even if it has a higher turnover or higher expense ratio than its peers.

 

Return always comes first. Don’t forget its after-tax return. So buy mutual funds with the highest returns consistent with your risk level and investment objective, and consider putting those funds with high turnover in your tax-deferred account.

As I’ve written before (Parental Discretion is Advised; A Euro, a Yen, a Buck, or a Pound; The CIA Guide to International Investing), international mutual funds are an essential part of any investor’s portfolio. There’s an excellent article on global investing in the June 3rd New York Times: An Around-the-World Ticket for your Portfolio. 

 

As you’d expect, the stock markets of Western Europe are highly correlated to the U.S. market. Makes sense, doesn’t it? A good portion of BMW’s profits come from the U.S., so if the U.S. economy turns down (and the U.S. stock market), so does BMWs profits and its stock price on the German exchange. Also, as you’d expect, the stock market movements of emerging counties, i.e., Brazil (68%), China (53%), India (43%), Russia (35%), are not as closely correlated with the U.S. market as are the Western European markets. (Of course, they’re also more volatile.)

 

There are two surprises in the New York Times article. The first is the degree of correlation. Over 80% for Western Europe. The U.S. and Western European markets move together.   The second surprise is the uniqueness of the Japanese market. Movements in Japanese stock prices have only a 29% correlation with movements in the U.S. stock markets. That’s surprising because Toyota sells so many cars here and we all own at least one Japanese made TV.  But it goes to show that the biggest driver of any economy is what’s going on inside a country, not how much it exports.  Just like the Japanese culture, there are many unique aspects to the Japanese economy.  What’s also nice about Japan is it’s the second largest economy in the world and offers the legal and accounting safeguards of a mature county.   Thus, you can gain diversity without emerging economy risk.

 

Conclusion:   Diversify beyond Europe, and be sure to include Japan, in your international mutual fund investments.

The Best-Managed Mutual Funds by BusinessWeek, April 2, looks through a different lens in picking top performing mutual funds. The article, or more specifically Standard & Poor’s and Business Week, selected 24 top funds based upon risk-adjusted return rather then absolute performance.   This is the right way to evaluate a mutual fund’s (or any investment’s) performance. 

 

Understanding risk is a recurring theme of mine. The point is that funds which take more risk should have higher returns. A Chinese Internet fund should (may?) outperform a US Big Cap Value fund over time. The key to successful investing is to pick/know your risk tolerance level and then find the funds which will generate the highest return for your risk profile. 

 

Some of the S&P/BW “winners” come from well-known fund families such as Fidelity and T. Rowe price but many are funds, and even fund families, which are not household names. It’s a little bit of a black box as to how Standard & Poor’s/BusinessWeek pick their winners but its refreshing to see a non-conventional list and the stories of the funds make for interesting reading. (Note the common thread: the fund managers love what they do, they’ve been at the same fund for a while; they aren’t afraid to go against the herd and they cast their net wide to find interesting investments.)