The Bottom Of The Barrel

The past year has shown that even professional money managers of mutual funds with an impeccable past record are not immune to failure. MarketWatch reported that “In a bad year, these funds were the worst:”

Investors reeling from the 39% plunge of the Standard & Poor’s 500 Index this year should console themselves that it could have been worse: three of the worst mutual funds of 2008 have racked up losses of more than 60%.

Among non-leveraged U.S. stock funds with at least $100 million in assets, none did worse than Bill Miller’s Legg Mason Opportunity Trust , which as of Dec. 30 was down 66% this year.

The second worst performer, according to Morningstar Inc., was Winslow Green Growth, which is down 62% this year. The third-biggest loser was another fund from Legg Mason Inc. (LMGTX), which is down 61%.

The losses of these funds represent a lag of roughly 20 percentage points behind their broader category — domestic stock funds were down an average of 40% in 2008.

Opportunity Trust, which Greg Carlson, fund analyst at Morningstar, said was Miller’s go-anywhere fund, enjoyed market-beating returns from its inception in 1999 until its streak ended in 2006. But this year’s losses are so heavy that the fund’s three- and five-year annualized returns are now deeply in the red, down 27.9% and 14.5%, respectively.

The second Legg Mason fund, Growth Trust, a large-cap growth fund, is managed by Robert Hagstrom, a member of the Legg Mason Capital Management team.

Both funds suffered because of heavy bets in financial stocks that collapsed in value. Opportunity Trust held shares of Countrywide Financial, which was taken over by Bank of America Corp., and IndyMac Bancorp, which was seized by federal agencies after being declared insolvent. What also hurt Miller was his misreading of the broader economic environment.

“He continued to try to position the fund for a recovery,” said Carlson. “[As well as financials] he was also buying and adding to his holdings in home-building stocks and Internet companies including Amazon.com Inc., Expedia Inc. and Yahoo Inc.” This year, Amazon stock is down 44.9%, Expedia has fallen 73.3% and Yahoo is down 47.3%.

Growth Trust dived into companies including Freddie Mac and American International Group Inc. But despite its poor 2008 showing, Morningstar is bullish about the fund’s prospects.

“Legg Mason Growth will soar again,” said Bridget Hughes, senior fund analyst at Morningstar, in a Dec. 17 report. “We’re confident that the fund will perform well in an upswing. In fact, since mid-November, it has gained more than 7.5%, putting it near the category’s top (and ahead of its Legg Mason siblings).”

“Not that you can magically exclude bad years, but prior to the past year, the fund maintained a strong long-term record, even with periods of weakness mixed in,” said Hughes.

Legg Mason would not comment directly for this article, but in a statement Mark Fetting, president and chief executive officer, said, “Chairman and Chief Investment Officer [of Legg Mason Capital Management] Bill Miller has built a tenacious team of long-term investors. Thus far in their 26-year history, any period of underperformance has been more than offset by subsequent outperformance. We fully support their thoughtful action plans for improvement.”

I am not bringing this up to dwell on negatives, but to see if lessons can be learned. It appears that even professional fund managers don’t seem to be able to recognize a bear market if it hits them squarely in the face. To continue buying and holding stocks that were in obvious downtrends based on the very questionable assessment that they represented “value” surely backfired big time.

While I don’t have much sympathy for fund managers, I am concerned about the effects on the individual fund investors who, based on Legg Mason’s reputation, followed these funds blindly into abyss. How else can you describe a loss of over 60% when the market as a whole declined “only” some 40%?

Read the highlighted paragraphs again, in which Morningstar is desperately trying to put some lipstick on that pig. Sure, the funds may recover and do well in the future, but look at the damage they have done to not only an investor’s portfolio but his psyche.

If you were unfortunate enough to have your portfolio “diversified” in all 3 funds, you’re down a horrific 60% for the year. Look at the long-term consequences. Your $100k portfolio is now worth $40k. For you to get back to $100k, you need make 250% on the balance.

How likely is that and how long will that take? Given enough time, it’s likely; the question is whether you will still be alive to see it. Let’s say, given the current state of the economy, you could manage to compound your entire portfolio at a rate of 8% from hereon forward. That means it would take you 9 years to double your money and bring the balance to $80k. You’d then need another 3 years to get back to your original $100k.

So you’ve spent 12 years of your life making up losses assuming that you can consistently compound at 8%. If the market has another bad period, the time frame could easily increase to 15 years.

And all this could have been avoided with the proper use of a sell stop discipline. Makes buy-and-hope look kind of ridiculous, doesn’t it?

About Ulli Niemann

Ulli Niemann is the publisher of "The ETF Bully" and is a Registered Investment Advisor. Learn more
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