Licking the wounds

Investors are waking up to headlines that shout more market turmoil, so it’s no surprise they’re begging for answers. While this discussion doesn’t provide that, it will briefly explain what happened and remind investors of rational investing basics that have worked in the past.

NO MORE ALPHABET SOUP

The global scavenger hunt for yield made mortgage-backed securities (MBSs), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs) hot. But when these once dubbed high credit quality securities fizzled, it brought on effects unforeseen by the engineers of the products – a credit market avalanche that wiped out much of the value in these securities and left many former banking giants for dead.

The recent round of government bailouts and the persisting economic uncertainty has created chaos in the markets that has left few participants unscathed. And investors that have entrusted their hard-earned coin to investment professionals have been disappointed. It’s completely understandable since mutual funds are touted as diversified investment vehicles that should handle market curveballs.

No doubt, hindsight is 20/20 since some of the funds affected are on our analyst pick list. But the recent events serve as a painful, but useful, reminder to investors that they need to understand the risks inherent in the strategies of the funds they own and ask if they’re comfortable with those risks.

Cases in point are funds run by John Arnold and his team at AGF International Advisors. That team’s strategy favours stocks with high dividend yields and low price-to-earnings, a seemingly conservative investment strategy. While investors may have felt that they were holding a diversified portfolio, the approach in practice has generally guided the funds toward financial services names. One would have had to be asleep over the past few quarters to not know that this has been a bad place to be. Also, many funds run by billionaire Michael Lee-Chin’s firm, AIC Limited, have suffered the same fate. The firm’s affinity for financial stocks led them to take concentrated bets and the rest, as they say, is history.

Bottom fishing for rebound opportunities has also gotten managers into trouble. Just ask the folks over at Brandes, who have built a successful track record by investing in stocks cast aside by the market. This time around, they tried to catch the falling knife with fi- nancials.

Brandes isn’t alone when it comes to deep-value strategies that have been punished. Mackenzie Cundill Emerging Markets and Mackenzie Cundill Recovery, run by London-based manager James Morton, have been clobbered. Two main reasons: 1) his value approach points him to securities that are typically out of favour; 2) these two funds have significant exposure to emerging markets, which had performed well in the past, but have been among the hardest-hit markets recently.

WHAT TO DO NOW?

Investors have a couple of choices. They can sell all of their mutual funds, withdraw the money and stash it under their mattresses, but even that carries risks. Bailing out now may not be the smartest thing to do; research, conducted by Morningstar on fund flows shows investors have a knack of buying high and selling low.

It’s still anyone’s guess whether the markets are at a bottom or not. While the current turmoil is mostly driven by the flux in the financial markets, the real economy may further slow or even grind to a halt if consumers and corporations weld their wallets shut. But rather than time the markets, having a long-term approach that cuts out the shortterm noise should give investors better success.

Most of us don’t have the time or the know-how to dig into the inner workings of a company’s financial statements to determine its investment merit. For that reason, investors should stick with capable managers with track records – particularly showing that they’ve weathered past storms. This isn’t a guarantee that they’ll do well, but all things being equal, it’s as good a measure as any. Also, focus on managers that haven’t veered from their investment strategies because of near-term uncertainty. Much like trying to time the markets, managers that try to get too cute with timing trades can miss the boat when a stock or a bond rebounds. Not to mention that frequent trading increases the transaction costs, which ultimately leaves less for unitholders.

And finally, diversify, diversify, and diversify; this means across asset classes, sectors, and countries. It’s been easy falling in love with domestic equities and bonds because of the strong run in commodities and the Canadian dollar. But as the past few months have shown us, Canada is not bulletproof. The best course of action: Stick with a long-term plan and remain patient. Remember, these are the times that legendary investor Warren Buffett live for.

Philip Lee is a fund analyst at Morningstar Canada.