One Hour Solution

One Hour Investment

By Chinh Pham

Date: 10/6/09

Summary:

Investing in mutual funds can be extremely difficult for the average investors due to the high number of funds, lack of clear sell guidance, and very time consuming. The one hour strategy shows investors when to buy, what to buy, and when to sell. The main benefits of this strategy to investors would be little time (one hour a year), simplicity (anyone can do it), and reasonable return.

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Major Trends

With the retirement of many baby boomers and the trends by employers to eliminate the traditional pension, employees suddenly need to become financially knowledgeable. Traditionally, large companies would provide for their employees’ retirements through the traditional pension. However, those defined benefit pensions, companies managed the risks of investments, are either being replaced by the 401K or are being changed to the defined contribution pension, i.e. the employees manage the investment risks. While this situation isn’t bad enough, some employers are also cancelling their medical coverage to their retirees and requiring retirees to pay more for their medical costs. On top of all this bad news, the traditional public safety nets within the US are broken down. Medicare and Social trust funds will be exhausted by 2017 and 2037 respectively (1).

In addition to all these financial burdens, employees are living longer. As a result, employees need to save more and invest better now than ever before. However, the current climate is very problematic for the average investors. It is very difficult to know what to do or how to begin this process. While it is great to know that the “market” has been averaging about 10 percent annually for the long run, no one has shown the specifics to the average investor on HOW to get this average return beyond the two popular choices of investing in index funds or picking some arbitrary actively managed mutual funds and hoping for the best.

This paper proposes a new simple system of selecting mutual funds to help the self-to-do investors who traditionally invest in actively managed mutual funds to 1) know when to purchase mutual funds 2) know when to sell mutual funds, and 3) what to mutual funds to buy. By following these steps, the average investors should be able to obtain reasonable return when investing in large cap funds.

Investing Basics

Given the complexity of financial statements and the limited financial knowledge, the average investors do not have the ability to analyze corporations to make intelligent investment decision. As a result, most investors choose to rely on professional investors to either manage their money directly or through mutual funds.

Mutual Funds are portfolios of money from many investors that invest in stocks, bonds, real estates, or other securities listed in their charters. Each investor in the fund gets a slice of the total ownership. Most mutual funds require only few hundred dollars or few thousand dollars to begin investing. Mutual funds allow investors to easily construct a diversify portfolio much easier and simpler than on their own (7).

There are many different categories of stock mutual funds, which are mutual funds that invest in stocks. The major categories of stock mutual funds are differentiated by the market value of the companies (small, mid, and large), investment philosophy (value, growth, and blend), and location (domestic and international).

Mutual funds are categorized by the size of the companies that they choose to invest in. Large-cap funds generally invest in companies with market value of greater than $8 billion. Mid-cap funds invest in companies with market value between $1 billion and $8 billion. Small-cap fund invest in companies with market value less than $1 billion.

The basic investment philosophy is growth, value, and blend. Growth mutual funds invest in growth stocks, which are stocks in companies with higher than average earnings and revenues. Growth stocks continue to grow as long as those companies continue to grow above average and meet market expectation. Value mutual funds invest in undervalue stocks, companies that the market should value higher but do not for various reason including underperforming in the short term or the specific industry falls out of favor with investors. Blend is a combination of growth and value investing.

Domestic mutual funds invest in US companies while internal mutual funds invest in international companies.

Index vs. Actively Managed Funds

Beyond the above categorization of mutual funds, there are also actively managed funds and index funds. Index mutual funds are passive funds that seek to mirror the market performance by buying many of the stocks that make up the stock market. Alternatively, actively managed funds seek to beat the stock market return by buying few stocks.

Advocates for index funds would state:
• 70 percent of domestic cap fund fail to beat the S&P 500 index over a five year period ending in December 31, 2008 (2)
• 58 percent of actively managed funds did worse than the index in 2008 (3)
• 71 percent of large-cap growth, 69 percent of large-cap blend, and 48 percent of large-cap value failed to beat the S&P 500 index in a five year period ending in June 2009 (6)
• Only 39 percent of large-cap funds beat the S& P 500 in the last 12 months ending June 2008 (4)
• Only 47 percent of large-cap fund beat the S&P 500 index from 1998 to 2007 (4)
• Median expense ratio for actively managed funds is 1.2 percent while the median expense ratio for index funds is .6 percent (3)
• Index funds are very tax efficient and very low fees

However, advocates for active funds would counter:
• Average actively managed stock funds were up 20.06 percent versus 14.77 percent for S& P index through August 2009 (5)
• Average active funds were down only 18.46 percent versus 19.65 percent for the index for the twelve month ending in June 2009 (5)
• Average active funds were down only 5.28 percent versus index funds over three year periods ending in June 2009 (5)
• 90 percent of the $12 trillion dollar in the mutual fund industry is held in actively managed funds (7)
• 57 percent of active funds surpassed the index when the market records loss or single digit gain (7)
• 54 percent of active funds surpassed the index in 2007 (7)
• Many retail investors are anxious in investing in stocks and are more comfortable with a professional manager watches their funds (7)
• Index funds cannot invest outside their original charter while active funds can roam around the world, particularly emerging market to invest (7)

Three big challenges to the average actively managed fund investors

1. What mutual funds to select

In today’s environment, there are thousands of mutual funds to select. There are at least 8,000 mutual funds at MS money and 13,000 mutual funds at Morningstar. There is no clear method to inform the average investors HOW to filter down all those funds into one specific mutual fund. The conventional wisdom states:

a) Select a low expense ratio mutual funds
b) Select a fund that is around at least 10 years
c) Ignore short term performance
d) Select fund with low portfolio turnover since high portfolio turnover can reduce performance

If investors follow the above advice, there are still hundreds of mutual funds available. The investors are still stuck with trying to figure out which mutual fund to select from the filtered list.

2. When to sell a mutual fund

Assuming investors finally decide to buy a mutual fund, there is no guidance on how long to hold the mutual fund and when to sell the mutual fund. If the mutual fund performs well, the decision is simple. However, when the mutual fund starts to underperform or lose money, it is not clear how long investors should continue to hold on to the mutual fund.

In any given year, some investment strategies are bound to outperform others. In some years, value investing will perform well while in other years growth will perform better. Current conventional wisdom states investors should hold their underperform mutual fund for at least two to three years to see if the fund will eventually perform. If the funds do not perform well, then the investors should sell.

The problem with the above “wisdom” is that no one knows if or when the fund will begin to do well. The fund could be having problems in the short term and then perform great later. Alternatively, the fund could continue to deteriorate. It’s very difficult for investors to evaluate while they are in that situation. However the situation turns out, the investors are stuck with a fund that is underperforming in the meantime.

There is no clear guideline today on when to sell the mutual fund even when the performance of the fund is poor.

3. How much time to spend in investing

Assuming that investors want to improve their returns, they will need to spend a fair amount of time researching to identify the “right” fund managers and mutual funds. After selecting and buying the mutual funds, investors will need to continue to monitor their funds’ performances versus their peers and the general market. When investors see that their funds underperform, investors will need to make the difficult decision of whether to hold on for a “little” longer or to sell. Once the investors decide to sell, they will need to begin the whole entire process again.

This whole process of researching, selecting, monitoring, agonizing, selling, and researching again is very time consuming and emotionally draining process. The total amount of time can range from several hours a month to several hundreds of hours a year. Many average investors do not have the time to do the research necessary to make an inform decision.

The one hour strategy to select mutual funds

Scope of the strategy:

The one hour strategy is a strategy to help do-it-yourself investors to obtain a reasonable return and beat the market index over a reasonable period of time. This strategy relies on investing in large-cap growth funds, large-cap value funds, and large-cap blend funds. Due to its focus, this strategy will likely result in higher volatility than the comparable market index S&P 500.
This strategy has only been tested with large-cap growth, value, and blend mutual funds. This strategy has not been tested with other categories of mutual funds.

The one hour strategy:

• On January 1st, use the mutual fund screener to identify the highest one year performance of no load mutual fund for these three categories: US Large Blend Stock, US Large Growth Stock, or US Large Value Stock.
• Purchase the mutual fund that has the highest one year performance in each category as of January 1st.
• Hold the mutual funds for one year until the following year January 1st.
• On January 1st of the following year, use the mutual fund screener to identify the highest one year performance of no load mutual funds for the same three categories. If the purchased mutual funds still have the highest one year performance in their respective categories, keep the mutual funds for one more year. Otherwise, replace the previously purchased mutually funds with the highest one year performance in that category.
• Repeat the process every year.

One of the best the best place to do mutual fund screening would be MSN Money.

Use the following steps to do the research:
• Step 1: Go to MSN Money
• Step 2: Select “Investing”
• Step 3: Select “Fund”
• Step 4: Under “Find Funds”, select “Easy Screener”
• Step 4: Select the Following parameters:
• Investment Focus: (select one of the following category: US Large Blend Stock, US Large Growth Stock, US Large Value Stock)
• Historical Performance: (select “1 Year” and “High As Possible”)
• Load/No Load: (select “No Load”)
Here is an example of selecting the highest no load US Large Blend Stock with BCVLX Vanguard Capital Value as having the highest one year performance.

Figure 1 – MSN Money Easy Fund Screener

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Figure 2 – Easy Fund Screener Results
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Testing Process

This test includes 234 no load mutual funds (87 large-cap blend funds, 86 large-cap growth funds, 59 large-cap value funds, and 2 index funds). The two index funds are VTSMX Vanguard Total Stock Market Index (tracks MSCI US Broad Market Index and contains 1,200 to 1,300 stocks) and VFINX Vanguard 500 index (tracks S& P 500 market index and contains 500 stocks). The test date range is from December 31, 1987 until September 30, 2009.

The test compares the performance using the one hour selection process with large-cap blend funds, large-cap growth funds, and large-cap value funds. The test assumes that investors select and buy mutual funds with the highest one year performance on January 1st each year.

Performance of the one hour process

Overall the performance of the one hour process is very satisfactory when compare against the performance of the market index as measured by the S&P 500 (VFINX) or the Total Market Index (VTSMX). From Table 1, the average annual returns since 1987 until September 2009 are as follow: Blend – 12.63 percent, Growth – 10.61 percent, Value – 11.00 percent, and S&P500 – 9.18 percent. From table 2 and table 4, $10k invested in 1987 would result in the follow: Blend - $133k, Growth - $90k, Value - $97k, S&P 500 - $68k. The strategy also compares favorably against other well known active mutual funds. In Table 4, Blend result returns $133k against $112k for the Sequoia (SEQUX) Blend fund while Value returns $97k against $70k for the Legg-Mason Value Fund (LMVTX).

From 1997 until September 2009, the annual returns are as follow: Blend – 8.65 percent, Growth – 6.33 percent, Value – 7.91 percent, S&P 500 Index – 2.37 percent, and Total Market Index – 2.89 percent. From Table 3, $10k invested in 1997 would result in the following: Blend - $27k, Growth - $21k, Value - $24k, S&P 500 - $13k, and Total Market - $14k.

Depending on the category and time frame, the performance of the one hour method exceeds the stock indexes by 1.5 percent to 3 percent annually or a $10k invested could increase between 50 percent to 100 percent more.

From 1987 until 1998, the S&P 500 index beat the active manage funds, whether blends, values, or growth. However, after 1998, the performance of the S& P 500 index and the total market index lagged the active the selection process by a sizeable margin.


Table 1 – Compare Active Performance vs. S&P 500 Index and Total Market Index

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Green represents highest performance of the year while Yellow represents next highest performance of the year.

Table 2 – Dollar Return for $10k investing starting 1987

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Graph 1 – Showing Return of $10k invested since 1987

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Table 3 – Dollar Return for $10k investing starting 1997

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Graph 2 – Showing return of $10k invested since 1997

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Table 4 – One Hour Mutual Funds vs. Sequoia (SEQUX) and Legg-Maxon Value Fund (LMTVX)

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Green represents higher performance of the between one hour process versus the actively managed mutual fund.

Graph 3 – One hour Blend vs Sequoia Fund (SEQUX)

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Graph 4 – One hour Value vs. Legg-Mason Value Fund (LMVTX)

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Why does this strategy works

There are several reasons why the one hour strategy was able to provide a reasonable return over 20+ years:
1. The one hour process relies on the principle that whatever strategy that allows the mutual fund managers to produce the highest returns in the past 12 months will also help the manager to produce satisfactory return though not necessary the highest return the next 12 months.

2. There is an easy and clear cut way to identify which mutual fund or mutual funds to select, i.e. select the highest one year return no load mutual fund for large-cap growth or large-cap value or large-cap blend.

3. There is a clear way to identify when to buy the mutual fund and when to sell the mutual fund, buy and sell mutual fund at every January 1st.

4. The January 1st buy-and-sell window forces practitioners to ignore short term market movements.

5. The one year hold window should allow practitioners to avoid most mutual fund redemption fees and to obtain long term capital gain tax rate.

Key Benefits of the One Hour Strategy

1. Time – the one hour strategy requires one hour or less in a year to identify the desired mutual fund versus many hours using any other methods.

2. Simplicity – the one hour strategy enables anyone to implement it without requiring any special training or expensive subscriptions.

3. Return – the one hour strategy enables anyone to obtain comparable performance relative the market index or any other mutual funds.

Final Implementation Detail

Can’t find my mutual fund

If the highest performance fund is not available at the investors’ brokerage firms, investors will then need to choose the highest performance that is available. For example, if the number one fund is not available, then choose number the number two fund. If the number two fund is not available, select the number two fund or keep selecting until one high performance fund is available.

Adding of new money during the year

If investors have money to invest during the year, investors can choose one of the two options: 1) wait until January 1st to invest the money or 2) select the highest 12 months performance funds at that point in time and then evaluate all funds at January 1st. The second option would likely trigger a short-term taxable event but the implementation would allow investors to immediate invest their money in the market.

Diversification of money

It is recommended that investors invest in at least one mutual fund in each category (large-cap growth, large-cap value, and large-cap blend) to provide some diversification. In addition, depending on the amount of money available and comfort level, investors may choose to invest in more than one mutual fund in each category. For example, on January 1st investors may want to invest in the three highest performing mutual funds rather than only the 1st highest fund. At the following January 1st, the investors should evaluate those funds against the three highest performing mutual funds the following year.

Answering Critics

1. Why doesn’t your strategy look at mutual fund expenses?
Answer: The fund total return already includes the mutual fund expenses. The strategy looks at the overall actual return, what the investor will receive rather than low expenses. In the long run, the only thing that matter is the overall return rather than low expenses.

2. Why doesn’t your strategy look at mutual fund managers and/or their experiences?
Answer: It is very difficult to evaluate quality managers. If a fund manager is good or lucky, it will show in his performance. If a fund manager is poor or unlucky, it will also show in his performance. Since it is difficult to know which is which, the strategy only evaluates the actual performance of the manager for one year.

3. Why doesn’t your strategy look at beta (or volatility) of the mutual funds?
Answer: If the investors follow the strategy, the investors cannot buy or sell the mutual fund (except adding new money) during the year and can only change the fund once a year. It does not really matter what happen during the year or how volatile the funds are. Practically speaking, since the strategy is designed to beat the market, investors should expect that the selected funds will likely have higher beta relative to other mutual funds since the selected funds are doing different things than the market index to obtain the high performance. As a result, high beta is not a concern.

4. Why doesn’t your strategy look at portfolio turnover?
Answer: Portfolio turnover is like mutual fund expenses and affects the gross return of the fund. The strategy does not care HOW the mutual fund managers obtain their results but only that they obtained the results. The impact of frequent trading, if any, is already calculated in the overall performance of the mutual fund.

5. Why doesn’t your strategy concern with being broadly diversify?
Answer: Each selected large cap mutual funds usually invested in at least 20 large cap stocks. There are fair amount of diversifications in investing in 20 large cap stocks. In addition, the intent of the strategy is to produce fair return (beat the market) rather than trying to match the market. It is necessary to focus on a handful of potential winners rather than every stock.

6. Why don’t you recommend using index funds rather than this complicated process?
Answer: It is fine to invest in index mutual funds for many investors. However, since 90 percent of the money in equity funds is already invested in actively managed funds, the investors need to know how to select these funds to get a reasonable fair return. In addition, during the last decade, index funds can lag active funds by a fair margin. The investors need to have alternative in where to invest their money.

Bibliography

1. “Let Them Go Bankrupt Soon, Solving Social Security and Medicare,” Samuelson, Robert J, Newsweek, 1 June 1 2009

2. “Investments that don’t stand a chance,” The Fool, 23 April 2009

3. “Index versus Active Mutual Funds,” Fowlkes, James, 23 March 2009

4. “In a down market, many funds managers were down even more”, Lauricella, Tom, Wall Street Journal, 2 October 2008

5. “How to select a top-flight manager,” Katzeff, Paul, Investor’s Business Daily, 8 September 2009

6. “More Evidence of the folly of active investment,” Hale, Nathan, Market Watch, 8 September 2009

7. “Debating Active Managers vs. Index Funds,” Luxenberg, Stan, The Street, 2 June 2008

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