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Third Quarter 2012 Quarterly Newsletter

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Say what? For those who think we haven’t been erudite or scholarly enough in these quarterly reports, we hope your mind will now be changed. For non-English majors, the word “obdurate” means pig headed, inflexible, rigid, unyielding. Not the stuff that makes for a good marriage. You might be hard pressed to find an instance where being obdurate is good. However, in the investment world, you should really hope that your investment vehicles are all very obdurate. If they don’t have this quality, there is no way to maximize the diversification of asset classes in your portfolio.

Most of our clients realize that we use very distinct asset class vehicles to build our portfolios. That is because each vehicle must represent a particular size and style and geographical location within the equity universe. Why? Because during most segments of a market cycle, each asset class performs somewhat differently in terms of risk, reward and price movement compared to other asset classes. By confirming each asset class in your portfolio is obdurate, we are making sure that all the parts are doing their job of dampening the diversifiable risk, which results in better long term performance. Without obdurateness, you can run into big trouble.

Before this gets any more boring, let’s look at a real world example – mutual fund purchases of the now infamous Facebook initial public offering (IPO). When the dust settled from this IPO, it was found that a dividend growth fund, a number of value funds as well as a mid cap growth fund had all purchased shares of Facebook stock.

Now let’s review those purchases. Here we find a mutual fund specializing in finding dividend paying stocks purchasing shares of a company struggling to produce earnings, much less pay a dividend. Value mutual funds purchasing a stock so drastically over-valued that it fell by over 50% within weeks of going public, and finally, a fund searching for mid-sized companies purchasing stock in a company with a very large value of $100 billion (more than 10 times the mid cap size)!

These examples of the wacky placement of Facebook shares are examples of mutual fund style drift. * (“Beware of style drift in mutual funds”. InvestmentNews 7/12/2012) Anytime a mutual fund owns stocks that do not accurately represent the specific asset class, sector or industry that the fund claims to follow, a drifting away from that fund’s stated purpose occurs. More importantly, style drift can lead to inferior returns. For example, if you are depending upon a fund in your portfolio to represent small value stocks, and the manager of that fund allows mid cap stocks or growth oriented stocks to drift into the portfolio, as soon as the small cap value cycle takes off, that fund will not perform in line with that asset class’s market move. Keep in mind, if your funds are not obdurate in their asset class makeup (size, style, etc.), then the delicate balance between that asset class weighting, and the proper rebalancing back to its original parameters, cannot take place. The result is performance that is not optimal and clearly not maximizing the reward consistent with risk taken.

That is the reason why strict asset class funds are so important in long term portfolio management, and why actively managed mutual funds usually underperform both individually and as building blocks of a total portfolio. The equity vehicles in your portfolio are comprised of complete asset classes, with no chance of style drift. So please remember to give the word obdurate a break the next time you see it being used as an unattractive adjective, because when it describes your portfolio construction, it’s a real thing of beauty.

Your Vanguard Shares Get Even Cheaper

If your portfolio owned any Vanguard fund shares, you may have noticed that they have recently been replaced with a different share class of the same fund. DHGWA has been given the opportunity to place our clients into an even lower cost class of shares (Admiral or Signal), which on average should reduce Vanguard’s already low internal expense ratio by another 30% or more. This switching of share prices was not a taxable event and your cost basis remains the same. You need to do nothing. This is an example of us continually performing our fiduciary duty to you – which is, doing what is in your best interest. This exchange will earn your portfolio a little bit more every month, quarter, year and the rest of the life of your portfolio. Congrats!

Third Quarter 2012 Asset Class Returns

The third quarter of 2012 continued the back and forth pattern of recent quarterly returns. After a generous first quarter, global markets pulled back in the second. Then, with little notice, they returned strongly to the upside in the third quarter, making year-to-date performance very attractive across the board. While all equity asset classes had generous single digit returns, some small changes in trend were noticed. Both Value and Small asset classes reverted to their normal outperformance, and pulled their YTD close to those of Large and Growth. For the first time in several quarters, International equity asset classes equaled or exceeded Domestic, perhaps pointing to a future when battered European economies will slowly start to bottom out. Interestingly, with a YTD return of nearly 25%, the winner for the year so far is International Real Estate -- at a time when most might guess it would come in last.

We are experiencing a classic case of equity markets climbing a wall of worry. Uncertain election results, potentially changing income and estate tax ramifications, a debt laden Europe attempting to right the ship, and other pre-Halloween goblins did a great job of keeping many out of the market. In the background, gone unnoticed by many, was the fact that our economy seems to be improving, if ever so gradually. Many short-term, undisciplined and skittish investors watched from the sidelines, waiting for the “right” time to enter the markets. As usual, by the time the financial landscape reaches that happy, carefree and less scary time, the markets will have already made an upward move in its ever discounting fashion. Once again, the eternal and ever popular market timing ritual will prove you cannot trust your emotions when dealing with equity investing.

By the time you receive your next quarterly report, the election will be over, the tax landscape will become much more visible, a slew of holidays will have come and gone, and we’ll even have an idea of what teams will have a chance of going to the Super Bowl. Oh, and we will also know if 2012 ended on a strong note, or not. In the meantime, get outside and enjoy the changing seasons, and have very happy and healthy holidays!


Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC