2012 Tepid Recovery and Strong Equities

The U.S. recovery continues to be tepid. At the same time, risks have intensified, including from the worsening of the euro area crisis as well as the uncertainty over domestic fiscal plans, says the IMF in its latest assessment of the world’s largest economy.

Yet, among equity mutual funds, certain categories had stellar returns, and even the more prosaic categories produced very solid returns.  According to Morningstar data, Global Real Estate funds were the top performing category with a scorching 31.8% gain, as of 12/31.12.  Despite political ineptitude, corruption in the sale of spectrum and food inflation, Indian Equity Funds returned 29.6% for 2012, the second leading category among global equity mutual funds in the Morningstar universe. Not surprisingly, Financial Sector Funds were the third leading category, fueled by relentless central bank monetary easing; financials returned 24.8% in 2012.

In the Large Cap Value fund sector, the leading mutual fund was the justifiably much maligned Fairholme fund. It rebounded on a modified, concentrated portfolio to return 35.8%, which is the number 2 top-performing equity mutual fund among all funds in the Morningstar universe.  Its fees are still too high for a large cap fund with such a large asset base. It's not clear what analytical infrastructure is generating ideas and returns, other than Bruce Berkowitz.  The fund returned to the well with a big stake in  Bank of America, an idea he bought at the bottom in 1992, and it proved rewarding again.  

Dodge and Cox Stock Fund, buoyed by holdings in consumer discretionary stocks, financials and telecom delivered 22% returns for the year.  Even as the fund made an ill-timed investment in Hewlett Packard, the well defined investment process, diversification, composition, low turnover and low expenses worked together to deliver better results than the average 15% return for all U.S. equity mutual funds.  

Midcap Value Funds returned 16.6% as a category, and the Legg Mason Capital Management Opportunity Trust returned an astonishing 41.1% for 2012, which makes it the best performing fund among all U.S. equity mutual funds.  What does this one year return demonstrate?  Very little.  Just as Apple is a cult stock, this fund was a cult fund for more than a decade.  Morningstar's analyst Bridget Hughes writes.  

 "With the added flexibility comes risk. Although the fund has had periods of spectacular performance, the lows have been devastating to performance and give rise to the question of the strategy's efficacy, even over the longer term."

Overall, equity investors seemed to take money out of equity funds, continued to pile into bond funds, and within equity funds moved to passive management versus active management.  Among the active managers, there is still a lot of "closet indexing," which makes some of the ridiculous management fees even more repugnant to whipsawed investors.

The mantra should be the same for individual investors buying equity mutual funds:

1.  Don't chase yesterday's performance.
2. Don't get enamored of a cult portfolio manager.
3. Buy from a fund sponsor with a track record, a proven strategy, an investment process, and sufficient analytical support the portfolio managers. 
4.  Higher fees are unjustified and don't buy superior performance. Never ever pay a front-end sales load. 
5. Your fund management team should eat their own cooking. 
6. Read the fund literature that comes your way.  It goes into the circular file for most investors, whereas consumers spend more time reading the instruction manuals for their smart televisions and game consoles. 
7. Understand, as best you can, how the fund is taking risk and how it adds value.  (3,5 and 6) will help you get there. 

Equities as an investment class face some long-term challenges in the coming years, but more about that later.  Happy New Year to our readers!  Keep those cards and letters coming.