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One of my favorite ‘voices of sanity’ in the investing world is John Bogle, founder of Vanguard. In his book called The Little Book of Common Sense Investing, he lays out the evidence for one of the greatest pitfalls that investors make: they manage their portfolios by looking backwards (i.e. trailing performance) rather than looking forward. The tendency to choose asset allocations based on trailing performance is a major threat to the well-being of your portfolio. Consider these startling statistics from Mr. Bogle’s book (pp.89-90):

Studies show that 95% of all investor dollars flow to funds rated four or five stars by Morningstar.

These star ratings are based on a composite of a fund’s record over the previous 3-, 5-, and 10-year periods.

…a mutual fund portfolio continuously adjusted to hold only Morningstar’s five-star funds earned an annual return of just 6.9% between 1994 and 2004, nearly 40% below the 11% return on the Total Stock Market Index.

These statistics mean that an awful lot of investors are simply chasing trailing returns and are paying a substantial price for this tendency. Does this mean that a prudent investor will sell the asset classes that have been the big recent winners and buy the recent laggards? No. The fact that an asset or asset class has delivered high returns over some period of time does not mean that it is necessarily due for a correction. Some assets have a high risk / high return profile and some have a low risk / low return profile. The challenge is to determine when an asset or asset class has dramatically outperformed the return level that can be justified based upon its risk level. Emerging markets stocks have been out-performing in recent years, but that does not mean that they will necessarily be poor performers going forwards. Healthcare firms have delivered fairly anemic returns in recent years, but that does not indicate that we can expect high returns from these firms in the future. This may sound obvious, but it is remarkable how few people seem to be able to apply this concept.

In the table below, I have analyzed a series of iShares ETFs that have generated either modest returns over the last three years (through the end of February 2007) or high returns over this period. The iShares funds that have generated fairly low returns are going to be called our Laggards and those which have turned in impressive returns are going to be called our Leaders. I have not chosen the most extreme cases here. The Financial Sector (represented by IYG and IYF) has turned in fairly modest returns. Healthcare (IYH, IXJ) has also been pretty un-exciting. Domestic growth indices have not been great performers in recent years (IWZ, IJK). Software has also been in something of a slump over the past several years (NYSEARCA:IGV).

In the Leaders section, the big story has been international equities (EEM, EWG, EWC, EPP) and real estate (NYSEARCA:ICF), with energy (IXC, IYE) and natural resources (NYSEARCA:IGE) also staging a major rally. This has also been a great period for utilities (NYSEARCA:IDU).

The challenge for investors, of course, is to look forward. We have used Quantext Portfolio Planner [QPP] to generate a forward-looking projection for these ETFs. This portfolio management tool generates forward looking projections that tend to discount recent performance and bring expected future performance into line with the long-term risk-return balance of capital markets. This approach has been demonstrated to work well for portfolio planning.

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ishares

The projected future annual return generated by QPP for these ETFs is shown in the far right column of the table above. The iShares ETFs with the highest expected annual return are energy (IXC, IYE) and natural resources (IGE). Naturally, these are also asset classes with considerable risk, and we will discuss this more in a later section. The key point here is that even though these funds have delivered out-sized returns over the past several years, the risk levels in these funds justifies these returns so we can expect similar long-term average returns. We can also expect large swings in these asset classes, of course, and the allocation to a sector like energy requires some care regarding the right risk level for the total portfolio. On the other end of the spectrum, the model is projecting that real estate (ICF) and utilities (IDU) are likely to deliver considerably lower returns going forward than they have over the last several years. The same is true for Pacific stocks (NYSEARCA:EPP) and, interestingly, for Canada (NYSEARCA:EWC). The outsized returns that these sectors have provided cannot be sustained on a forward-looking basis. Emerging markets fall somewhere in the middle (NYSEARCA:EEM). Emerging markets (as a whole) are a high return play, but the future expected returns are substantially below what we have seen over the past several years.

On the other side of the table, none of the Laggards are expected to generate substantially higher future returns except for software (IGV) and growth-oriented indices are due for some improved future performance (IWZ). Modest returns in healthcare (IYH, IXJ) are projected to continue, as are the returns in the financial sector (IYG, IYF).

Some of these sectors look ‘mean reverting’ but many of these have expected returns that are generally in line with trailing performance. The funds or asset classes that generate the highest returns over any period will typically be high risk (i.e. high volatility). What goes up really far and fast can also come down far and fast. QPP projects that IXC has a 5% (1-in-20) chance of losing 46% or more in a single year—that’s a big drop. Similarly, QPP projects that EEM has a 1-in-20 chance of losing 36% or more in a year. These are very exciting asset classes and, given long enough, will reward investors. The big risk is that you need your funds before you can recoup the losses after a substantial decline. Even if the odds are in your favor, if you need to take your chips off the table, you can end up poor. In statistics, this is known as gambler’s ruin. You want to get the highest returns that you can, while minimizing the risk of having to sell heavily in a declining market. This is where Monte Carlo simulation tools are absolutely required—to help you find the right level of risk and return to take on. These results are, of course, all conditioned by some basic assumptions about future market conditions. Namely, QPP’s baseline assumption is that the S&P500 will deliver slightly more than 8% per year in total return and that market volatility will average around 15% per year (much higher than in recent years, but in line with longer market history).

The results that Mr. Bogle cites, that the big winners from recent years turn into the big losers in future years, reflect the fact that the big winners are invariably high volatility. They will often tend to generate returns that appear to follow reversion to the mean. This must not be confused with the fact that investors in high risk / high return asset classes (such as energy or emerging markets) can rationally expect average annual returns that are substantially higher than what they can expect from a broad equity index like the S&P500. Investors in these assets will, of course, need the fortitude to ride through major drops in asset value that can take years to recover from.

Investors’ tendencies to chase the funds with the highest trailing performance cost mutual fund investors an average of 4% per year between 1994 and 2004, as noted earlier. Forward-looking asset allocation strategies can help to temper the impulse to chase trailing performance. If I am considering an asset or asset class that has performed well in recent years, but which looks less attractive in my portfolio on a forward-looking basis (i.e. in projected outcomes), I will tend to look elsewhere. This factor is quite separate from the fact that certain high-performing asset classes are simply a high return / high volatility proposition so that expected high average returns go hand-in-hand with the potential for major swings.

Note: you can read the excerpts from Mr. Bogle’s book here.

Source: Outlook For Select iShares ETFs