Bubbles

By Bob Wood

By now you have heard about the bubble in the real estate market. And perhaps you remember the technology stock bubble of the late 1990s. Well, it seems that bubbles are apparent in many places now, and some may be where you least expect them. Being unaware of these bubbles could cause some real pain in your investment portfolios.

While bubbles always seem obvious in hindsight—after bursting, recognizing them while you still have time to exit those markets is something of an art form. We all love the party while it is in full swing, and we hate leaving early for fear of missing out on “the big gains” — which surely will come.

Plenty of so-called experts always manage to calm the fears of investors who may listen with concern to those stamping the bubble label on asset classes that have soared above their true, intrinsic values due to investor greed or gullibility. Do you remember how many hired experts assured us over and over again that technology stocks selling for stratospheric valuations did not signify a bubble environment?

Of course, an inexhaustible supply of hawkers seem willing to say just about anything for a price. How many times in the late 1990s did you hear that the Nasdaq was on its way to 10,000? Or that the Dow would reach 36,000 during the late stages of the bull market in stocks?

Now, with inventories of unsold homes reaching new highs and numerous “for sale” signs appearing on front lawns overnight, some still are quick to assert that no bubble exists in real estate. Last year, for example, the senior vice president and chief economist for the National Association of Realtors, David Lereah, penned a new book,

Are You Missing The Real Estate Boom

? A description of the book found on the Amazon.com’s website quotes the author:

“The long-term fundamentals for housing remain strong into the foreseeable future,” claims Lereah. “Far from a real estate ‘bubble,’ what we are experiencing today is a phenomenon that takes place only once every other generation: a long-term real estate market expansion.

Isn’t it time you started taking advantage of it today?’’

He seems to indicate that everyone is getting rich in real estate, doesn’t he? Yet in the year since the book hit the stores, we have seen home-builder stocks beaten into the dirt and inventories of unsold houses hitting new highs monthly. Isn’t it odd how bubbles seem to burst just when the words of paid promoters become loudest?

Other bubbles exist in various markets now, but maybe none are more dangerous than hedge funds and mutual funds. If anyone doubts that we now have far too many hedge and mutual funds to choose from, simply take a look in your local newspaper or Barrons at the lists of funds available. And those lists do not include all funds!

Perhaps the sheer weight of all those investment options represents a threat to investor performance, with far too many mutual funds focused on narrow segments of the markets. Do you hold shares in mutual funds dedicated to domestic large caps, mid-caps or small-caps? Many people do, since there are about 7,000 mutual funds to choose from.

Add to your list of choices about 8,000 hedge funds! Which bubble represents the biggest danger to investors? I’d say it’s a toss up between these two. For mutual funds, especially those with narrow mandates conforming with the asset allocation strategies used by too many brokers, no proof shows that any offers value unavailable at lower costs than their proper benchmark index fund competitors.

In the Financial Times newspaper, a recent article pointed out that in the 20-year period ending in 2003, more than 80% of active fund managers failed to beat their benchmark index funds, trailing by 2% per year, on average. And for that you pay more in fees? And those funds trade far more often than their index fund competition, which simply take their positions at the start of the year and sit tight, making far fewer changes? How can funds with average annual turnover rates of 100% fail to beat the performance of funds managed by no one?

Yet I’m not saying that all actively managed mutual funds are bad deals. The top 20% do good work and are worth their fees. And, in fairness, I should note that the July 15, 2006 issue of Barrons calls one mutual fund family a standout performer in the corner of the fund universe of managers investing according to faith-based mandates. This fund company also runs an advertisement on this page, touting its five-star Morningstar rating. And, no, I do not know anyone at this company and have never spoken with anyone there.

But what extra value do large-fund families like Putnam, Oppenheimer, AIM or others offer for requiring payment of an up-front load? Or are you just buying shares in funds that, as a rule, lag their no-load, index competition? If all front end load-burdened funds disappeared tomorrow, what harm would investors suffer? In my not-so-humble opinion, investors would be better off!

The news gets worse with hedge funds, where standard fees charge 2% annually on the value of your account, plus you agree to share 20% of your gains with the fund manager. That well-paid manager had better be a real world beater, right? If you saddle yourself with a handicap like that, the fund manager must beat a benchmark by much more than mutual fund managers have been able to achieve over the life of those funds.

And is there really a need for 8,000 hedge funds? Are there really that many capable managers to go around, especially with competition for talent coming from all those mutual funds? I’m sure those answers are a resounding, “No!” And a recent study by one of the big brokers shows that hedge fund performance lately has been 96% correlated to that of the S&P 500, so who’s hedging what?

But, most likely, each and every one of these thousands of offerings will be heavily marketed and sold as the next great opportunity. So, they say, “You’d better not miss out on this opportunity!” What I’m saying, though, does not infer that talented hedge fund managers are non-existent; most of them are good enough to attract plenty of money based on performance, net of fees, and may even be closed to new investors. But many of the others will simply take more risk with the hope of generating strong, short-term performance and staying in business long enough for those ridiculously high expenses to accumulate in their own pockets.

To my thinking, these are some of the most dangerous bubbles facing us now, and, when they burst, they will surely cost investors plenty. I am sure beyond any doubt that most investors today should not attempt managing their own stock portfolios. Good mutual funds do make for a great alternative, and a simple portfolio of maybe four or five of the best funds should be plenty.

Start with a core fund, managed by someone with enough imagination to include all asset classes including small-, mid-and large-cap holdings, with enough exposure to foreign markets to add profit potential. A manager should be free to invest for value wherever he sees it, regardless of sector, and surround that choice with low-cost funds in sectors or asset classes with the best long-term potential. To me, that includes emerging markets, energy and gold.

Keep it simple! The fund’s Morningstar rating or its recent performance doesn’t really matter much — or even whether that rating has recently changed on your potential fund pick. A solid portfolio with low turnover and exposure to the right asset classes or market sectors will do just fine. By going against the crowd which frequently trades in and out of the hottest funds, you can remain calm while the market does summersaults like we’re seeing lately.

Oh, and don’t forget to include a healthy dose of those bear funds that I keep talking about!

Have a great week!

Bob