MONEY stocks

China’s Boom Is Over — and Here’s What You Can Do About It

Illustration of Chinese dragon as snail
Edel Rodriguez

The powerhouse that seemed ready to propel the global economy for decades is now stuck in a period of slowing growth. Here’s what that means for your portfolio

Every so often an investment theme comes along that seems so big and compelling that you feel it can’t be ignored. This happened in the 1980s with Japanese stocks. It happened again with the Internet boom of the 1990s. You know how those ended.

Today history appears to be repeating itself in China.

Just a decade ago, China was hailed as the engine that would single-handedly drive the global economy for years to come. That seemed plausible, as a billion Chinese attempted something never before accomplished: tran­sitioning from an agrarian to an industrial to a consumer economy, all in a single generation.

Recently, however, this ride to prosperity has hit the skids. A real estate bubble threatens to crimp consumer wealth; over-investment in a wide range of industries is likely to dampen growth; and the transition to a developed economy is stuck in an awkward phase that has trapped other emerging markets.

No wonder Chinese equities—despite a strong rebound last year—are down around half from their 2007 peak.

iSCH1

Like the Japan and dotcom manias before it, China looks like an old story. “Do you have to be in China?” asks Henrik Strabo, head of international investments for Rainier Investment Management in Seattle. “The truth is, no.”

If you’ve bought the China story—and since 2000 hundreds of thousands of U.S. investors have plowed $176 billion into emerging-markets mutual and exchange-traded funds, which have big stakes in China—that’s a pretty bold statement.

In fact, even if you haven’t invested directly in Chinese stocks and simply hold a broad-based international equity fund, China’s Great Slowdown has an impact on how you should think about your portfolio. Here’s what you need to understand about China’s next chapter.

China Has Hit More Than a Speed Bump

After expanding at an annual clip of more than 10% a decade ago, China’s economy has slowed, growing at just over 7% in 2014. That’s expected to fall to 6.5% in the next couple of years, according to economists at UBS. And then it’s “on to 5% and below over the coming decade,” says Jeffrey Kleintop, chief global investment strategist at Charles Schwab.

Why is this worrisome when gross domestic product in the U.S. is expanding at a much slower 3%?

For starters, it represents a steep drop from prior expectations. As recently as three years ago, economists had been forecasting that China would still be growing at roughly an 8% clip by 2016.

The bigger worry is that the slowdown means that China has reached a phase that frustrates many emerging economies on the path to becoming fully “developed,” a stage some economists refer to as the middle-income trap.

On the one hand, a growing number of Chinese are approaching middle-class status, which means wages are on the rise. That sounds good, but rising labor costs chip away at China’s competitive advantage in older, industrial sectors. “You’re seeing more and more manufacturers look at other, cheaper markets like Indonesia, Vietnam, and the Philippines,” says Eric Moffett, manager of the T. Rowe Price Asia Opportunities Fund.

At the same time, the country’s new consumer-centric economy has yet to fully form. About half of China’s urban population is thought to be middle-class by that nation’s standards, but half of Chinese still live in the countryside, and the vast majority of those households are poor. Couple this with the deteriorating housing market—which accounts for the bulk of the wealth for the middle class—and you can see why China isn’t able to buy its way to prosperity just yet.

This in-between stage is when fast-growing economies typically downshift significantly. After prolonged periods of “supercharged” expansion, these economies tend to suffer through years when they regress to a more typical rate of global growth, according to a recent paper by Harvard professors Lawrence Summers and Lant Pritchett.

In some cases, like Brazil, this slowdown prevents the economy from taking that final step to advanced status. Brazil had been expanding 5.2% a year from 1967 to 1980, but that growth slowed to less than 1% annually from 1981 to 2002.

No one is saying China will be stuck in this trap for a generation, like Brazil, but China could be looking at a long-term growth rate closer to 4% to 5% than 8% to 10%.

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Your best strategy: Go where the growth is—at home. A few years ago the global economy was ex­pected to expand at an annual pace of 4.2% in 2015, trouncing the U.S.  Today the forecast is down to 3.1%, pretty much the same pace as the U.S. economy, which is expected to keep accelerating through 2017.

In recent years, some market strategists and financial planners have instructed investors to keep as much as 40% to 50% of their stocks in foreign funds. But ­dropping that allocation to 20% to 30% still gives you most of the diversification benefit of owning non-U.S. stocks.

The Losers Aren’t Just in Asia

China’s rise to power lifted the fortunes of its neighboring trade partners too, so it stands to reason that a broad swath of the emerging markets is now at risk. “China is still the beating heart of Asia and the emerging markets,” says Moffett. “If it slows down, all the other countries exporting to and importing from China will see their growth prospects affected.”

The country’s biggest trading partners in the region are Hong Kong, Japan, South Korea, and Taiwan, and all are slowing down. Economists forecast that the growth rates in those four nations will slip below 3% next year.

Beyond Asia, “you have to be careful with the commodity exporters,” says Rainier’s Strabo. China’s slowdown over the past five years is a big reason commodity prices in general and oil specifically have sunk more than 50% since 2011.

China consumes about 40% of the world’s copper and 11% of its oil. As the country’s appetite for commodities wanes, natural resource producers such as Australia, Russia, and Latin America will feel the blow.

Your best strategy: Keep your emerging-markets stake to around 5% of your total portfolio. If your only foreign exposure is a total international equity fund, then you’re probably already there. If, however, you’ve tacked on an emerging-markets “tilt” to your portfolio to try to boost returns, unwind those positions, starting with funds focusing on Asia, Latin America, or Russia.

Here’s another bet that’s now played out: A popular strategy in the global slowdown was to take fliers on Western companies with the biggest exposure to China—companies such as the British spirits maker Diageo (think Johnnie Walker and Guinness) and Yum Brands (KFC and Pizza Hut)—solely because of their China reach. And for a while, that paid off.

Now, though, the stocks of Yum and Diageo have stalled, and major global companies such as Anheuser-Busch InBev and Unilever have reported disappointing results recently in part owing to subpar sales in China as well as in other emerging markets.

Demographic Problems Will Only Make Things Worse

For years, China’s sheer size was seen as a massive competitive advantage. Indeed, China has three times as many workers as the United States has people.

Yet as the country’s older workers have been retiring, China’s working-age population has been quietly shrinking in recent years. Economists say this will most likely lead to labor shortages over the coming years, putting even more pressure on wages to rise.

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China’s demographic problem has been exacerbated by the country’s “one-child” policy, which has prevented an estimated 400 million births since 1979. But China isn’t the only emerging market suffering from bad demographic trends.

Birthrates are low throughout East Asia. The ratio of people 15 to 64 to those 65 and older will plummet from about 7 to 1 to 3 to 1 in the next 15 years in Taiwan, South Korea, and Hong Kong, dragging down growth.

Your best strategy: If you’re a growth-focused investor who wants more than that 5% stake in emerging markets, concentrate on developing economies with more youthful populations and more potential to expand. One fund that gives you that—with big holdings in the Philippines, Saudi Arabia, Egypt, and Colombia—is Harding Loevner Frontier Emerging Markets HARDING LOEVNER FRONT EM MKTS INV HLMOX 0.1151% . Over the past five years, the fund has gained around 7% a year, more than triple the return of the typical emerging-markets portfolio.

Another option is EGShares ­Beyond BRICs EGA EMERGING GLOBA EGSHARES BEYOND BRICS ETF BBRC 0.3049% . Rather than investing in the emerging markets’ old-guard leaders—Brazil, Russia, India, and China—this ETF counts firms from more consumer-driven economies, such as Mexico and Malaysia, among its top holdings.

The Parallels Between China and 1990s Japan are Alarming

For starters, China is facing a real estate crisis similar to Japan’s, says Nariman Behravesh, chief economist at IHS. With easy access to cheap credit, developers have flooded the major cities with excess housing. Floor space per urban resident has grown to 40 square meters, compared with just 35 square meters in Japan and 33 in the U.K.

Not surprisingly, prices in 100 top Chinese cities have been sliding for seven months. Whether China’s property bubble bursts or not, falling home values chip away at household net worth; that, in turn, drags down consumer sen­timent and spending, Behravesh says.

Other unfortunate similarities between the two nations: Excess capacity plagues numerous sectors of China’s economy, ranging from steel to chemicals to an auto industry made up of 96 car­ brands.

Also, Chinese officials face political pressure to focus on short-term growth rather than long-term fixes. This type of thinking has resulted in the rise of so-called zombie companies, much like what Japan saw in the ’90s. “These are companies that aren’t really viable but are being kept alive,” Behravesh says. Yet for the economy to get back on track, inefficiently run businesses have to be allowed to fail, market strategists say.

Your best strategy: Focus on the few major differences between the two countries. Unlike Japan, for instance, China is still a young, emerging economy. Slowdown or not, “the growth of the middle class will continue in China, and that will absorb some of the overhang in the economy, which is something Japan couldn’t count on,” says Michael Kass, manager of Baron Emerging Markets Fund.

What’s more, when Japan’s bubble burst in late 1989, stocks in that country were trading at a frothy price/earnings ratio of around 50. By contrast, Chinese shares trade at a reasonable P/E of around 10.

To be sure, not all Chinese stocks enjoy such low valuations. As competition heats up to supply China’s population with basic goods, valuations on consumer staples companies have nearly doubled over the past four years to a P/E of around 27.

At the same time, the loss of faith in the Chinese story means there are decent values in industries that cater to the established middle and upper-middle class, says Nick Niziolek, co-manager of the Calamos Evolving World Growth Fund. Health care and gaming stocks in particular suffered setbacks last year. And Chinese consumer discretionary stocks are trading at a P/E of just 12, down from 20 five years ago.

You can invest in such businesses through EGShares Emerging Markets Domestic Demand ETF EGA EMERGING GLOBA EGSHARES EMERGING MKTS DOME EMDD 0.0838% , which owns shares of companies that cater to local buyers within their home countries, rather than relying on exports. Chinese shares represent about 17% of the fund, led by names such as China Mobile.

That one of the world’s great growth stories is now best viewed as a place to pick up stocks on the cheap might seem a strange twist—until you remember your Japanese and Internet history.

MONEY index funds

The Smart Money is Finally Embracing the Right Way to Invest. You Should Too.

Investors turned their backs on traditional mutual funds in 2014 and began relying more heavily on indexing.

Since launching the Vanguard 500 fund in 1975, Vanguard founder Jack Bogle has been preaching the gospel of indexing — a plain-vanilla, low-cost strategy that calls for buying and holding all the stocks in a market and “settling” for average returns. He’s so fervent that his nickname in the industry is St. Jack.

Forty years laters, investors have finally found religion.

In 2014, the Vanguard Group attracted a record $216 billion of new money, largely on the strength of its index offerings and exchange-traded funds. These are funds that can be traded like individual stocks and that almost always track a market index.

Vanguard wasn’t alone. Blackrock, which runs the well-known iShares brand ETFs, attracted more than $100 billion of new money in 2014, a year in which investors both small and large embraced indexing, also known as “passive” investing.

By comparison, actively managed mutual funds — those that are run by traditional stock and bond pickers — saw net redemptions of nearly $13 billion last year, according to the fund tracker Morningstar.

There’s are several simple reasons for this:

1) Fund inflows generally follow recent performance.
And in 2014, the S&P 500 index of stocks outperformed roughly 80% of actively managed funds, noted Michael Rawson, an analyst with Morningstar.

He added: “When the market rallies strong, a lot of active managers tend to lag, maybe because they’re being more conservative, holding more quality stocks, or maybe holding a little bit of a cash — it is common for an active manager to hold some cash. So it’s difficult to keep up with the rising market.”

2) 2014 was a year when many heavy hitters espoused their preference for indexing.
In August, MONEY’s Ian Salisbury reported how the influential pension fund known as Calpers — the California Public Employees’ Retirement System — was openly considering reducing its use of actively managed strategies for its clients.

This came on the heels of a provocative column written by a Morningstar insider questioning whether actively managed strategies had a future. “To cut to the chase,” wrote Morningstar’s John Rekenthaler, “apparently not much.”

And as MONEY’s Pat Regnier pointed out in a fascinating piece on Warren Buffett’s investing approach, the Oracle of Omaha noted in his most recent shareholder letter that his will “leaves instructions for his trustees to invest in an S&P 500 index fund.”

3) Plus, new research from Standard & Poor’s shows that even if active managers can beat the indexes, they can’t do that consistently over time.

The report, which was published in December, noted that “When it comes to the active versus passive debate, the true measurement of successful active management lies in the ability of a manager or a strategy to deliver above-average returns consistently over multiple periods. Demonstrating the ability to outperform repeatedly is the only proven way to differentiate a manager’s luck from skill.”

Yet according to Aye Soe, S&P’s senior director of global research and design, “relatively few funds can consistently stay at the top.”

Indeed, only 9.84% of U.S. stock funds managed to stay in the top quartile of performance over three consecutive years, according to S&P. This is presumably because over time, the higher fees and trading costs that actively managed funds trigger become too difficult for even the most seasoned managers to overcome.

Even worse, just 1.27% of domestic equity portfolios were able to stay in the top 25% of their peers for five straight years. For those funds that specialize in blue chip stocks, the numbers were even worse. Of the 257 large-cap funds that finished in the top quartile of their peers starting in September 2010, less than half of 1% remained in the top quartile for each of the subsequent 12-month periods through September 2014.

As Soe puts it, this “paints a negative picture regarding the lack of long-term persistence in mutual fund returns.”

MONEY stocks

Your 3 Best Investing Strategies for 2015

Trophy with money in it
Travis Rathbone—Prop Styling by Megumi Emoto

Racking up big investing victories over the past six years was easy. Now, though, the going looks to be getting tougher. These three strategies will help you stay on the path to your goals.

There’s nothing like an extended bull market to make you feel like a winner — and that’s probably just how you felt coming into the start of this year.

Sure, the recent wild swings in the stock market may have you feeling a bit more cautious. Still, even now, the Standard & Poor’s 500 stock index has returned more than 200% since the March 2009 market bottom, while and bonds have posted a respectable 34% gain.

The question is, will the winning streak continue?

Should it persist through the current bout of volatility, the stock market rally will be entering its seventh year, making it one of the longest ever; at some point a bear will stop the party. Meanwhile, the Federal Reserve is signaling the end to its program of holding down interest rates and thus encouraging risk taking. And there’s zero chance that Congress will add further fiscal stimulus. In short, the post-crisis investing era—when market performance was largely driven by Washington policy and Fed ­intervention—is over. “As the global risks have receded,” says Jeffrey Kleintop, chief global investment strategist at Charles Schwab, “the focus is going back to earnings and other fundamentals.”

The stage is set for a reversion to “normal,” but as you’ll see, it’s a normal that lacks support for high future returns. For you, that means a balancing act. If you don’t want to take on more risk, you’ll have to accept the probability of lower returns. Following these three guidelines will help you maintain the right risk/reward balance and choose the right investments for the “new” normal.

1) Keep U.S. Stocks As Your Core Holding…

Stocks are expensive. The average stock in the S&P 500 is trading at a price of 16 times this year’s estimated earnings, about 30% higher than the long-run average. A more conservative valuation gauge developed by Yale finance professor Robert Shiller that compares prices with longer-term earnings shows that stocks are trading at more than 50% above their average.

“Given current high valuations, the returns for stocks are likely to be lower over the next 10 years,” says Vanguard senior economist Roger Aliaga-Díaz. He expects annual gains to average between 5% and 8%, compared with the historical average of 10%. Shiller’s numbers suggest even lower returns over the next decade.

That doesn’t mean you should give up on U.S. stocks. They remain your best shot at staying ahead of inflation, especially today, when what you can expect from a bond portfolio is, well, not much. “Stock returns may be lower,” says Aliaga-Díaz, “but bond returns will be much less, so the relative advantage of stocks will be the same.” And the U.S. economy, though far from peak performance, is the healthiest big player on the global field.

Your best strategy: Now is a particularly important time to make sure your stock allocation is matched to your time horizon. “The worst outcome for older investors would be a bear market just as you move into retirement,” says William Bernstein, an adviser and author of The Investor’s Manifesto. A traditional asset mix for someone in his fifties is the classic 60% stock/40% bond split, with a shift to 50%/50% by retirement. If your allocation was set for a 35-year-old and you’re 52, update it before the market does.

On the other hand, if you’re in your twenties and thirties, you should be far less worried about today’s prices. Hold 70% to 80% of your portfolio in equities. The power of compounding a dollar invested over 30 to 40 years is hard to overstate. And you’ll ride through many market cycles during your career, which will give you chances to buy stocks when they’re inexpensive.

2) …But Spread Your Money Widely

With many overseas economies barely out of recession or dragged down by geopolitical crises, international equity markets have been trading at low valuations. And some market watchers are expecting a rebound over the next few years. “Central banks in Europe, China, and Japan are making fiscal policy changes that are likely to boost global growth,” says Schwab’s Klein­- top. Oil prices, which have fallen 40% in recent months, may boost some markets as consumers spend less on fuel and step up discretionary buying.

But foreign stocks aren’t uniformly bargains. The slowdown in China’s economic growth threatens the economies of the countries that supply it with natural resources. Japan’s stimulus program to date has had mixed success, and the reason to expect stimulus in Europe is that policymakers are again worried about deflation.

Your best strategy: Spread your money widely. The typical investor should hold 20% to 30% of his stock allocation in foreign equities, including 5% in emerging markets, says Bernstein. Many core overseas stock funds, such as those in your 401(k), invest mainly in developed markets, so you may need to opt for a separate emerging-markets offering—you can find excellent choices on our ­MONEY 50 list of recommended mutual and exchange-traded funds. For an all-in-one fund, you could opt for Vanguard Total International Stock Index VANGUARD TOTAL INTL STOCK INDEX FD VGTSX 0.7638% , which invests 20% of its assets in emerging markets.

3) Hold Bonds for Safety, Not for Income

Fixed-income investors have few options right now. Today’s rock-bottom interest rates are expected to move a bit higher, which may ding bond fund returns. (Bond rates and prices move in opposite directions.) Yet over the long run, intermediate-term rates are likely to remain below their historical average of 5%. If you want higher income, your only alternative is to venture into riskier investments.

Your best strategy: If you don’t want to take risks outside your stock portfolio, then accept that the role of your bond funds is to provide safety, not spending money. “After years of relative calm, you can expect volatility to return to the stock market—and higher-quality bonds offer your best hedge against stock losses,” says Russ Koesterich, chief investment strategist at BlackRock. Stick with mutual funds and ETFs that hold either investment-grade, or the highest-rated junk bonds. Don’t rely solely on government issues. Corporate bonds will give you a little more yield.

You may be tempted to hunker down in a short-term bond fund, which in theory will hold up best if interest rates rise. But this is one corner of the market that hasn’t returned to normal. Short-term bonds are sensitive to moves by the Federal Reserve to push up rates. The Fed has less ability to set long-term rates, and demand for long-term Treasuries is strong, which will keep downward pressure on the rates those bonds pay. So an intermediate-term bond fund that today yields about 2.25% is a reasonable compromise. Sometimes in investing, winning means not losing.

Read next:
How 2% Yields Explain the World—and Why Rates Have Stayed So Low for So Long

 

MONEY mutual funds

How MONEY Selected the 50 Best Mutual Funds and ETFs

The making of the MONEY 50, our list of the world’s 50 best mutual and exchange-traded funds

The Criteria

To create the MONEY 50 list of the best mutual funds and ETFs, MONEY editors look for solid long-term performers with these important traits:

Low fees. Below average expense ratios are a good predictor of better-than-average performance. Expenses averaged 0.94% for actively managed MONEY 50 funds, compared to 1.33% for stock funds in general.

Long tenure. Good returns don’t mean much if the manager responsible for them is no longer around. The average tenure for a MONEY 50 manager is 12.4 years, compared to 5.5 years for funds in general.

Strong stewardship. You want fund managers who put shareholders first. Sixty-four percent of actively managed MONEY 50 funds received a Morningstar stewardship grade of A or B, compared to only 13% of funds in general.

Changes to the List

While we are cautious about making switches, events can force our hand. We are replacing three funds for the 2015 list:

Out: T. Rowe Price Equity Income T. ROWE PRICE EQUITY INCOME FD PRFDX 0.4954% . Longtime manager Brian Rogers is stepping down in October. His successor, John Linehan, has a wealth of experience, so shareholders needn’t sell. That said, the fund’s stellar record belongs to Rogers.

In: Dodge & Cox Stock DODGE & COX STOCK FUND DODGX 0.2023% . The management team has delivered impressive returns at low cost, beating 99%, 92%, and 67% of their peers over the past three, five, and 10 years, respectively. The fund watchers at Morningstar give Dodge & Cox an “A” for how it treats shareholders, taking into account fees, disclosures, manager compensation, and other factors.

Dodge & Cox Stock is a true value fund, meaning the managers look for unpopular stocks and hang on, expecting investors to come around and bid share prices up.

“You have to understand the firm’s strategy and be willing to hold on,” says Morningstar analyst Laura Lallos. For instance, battered computer giant Hewlett-Packard is the fund’s top holding, and the nine-person management team has other big technology bets, including one on Microsoft. A recent success: buying J.P. Morgan Chase after news of the London Whale trading scandal in 2012. The stock has risen almost 70% since then. That said, the fund fared poorly during the financial crisis. But over the years it has bested the market in up months and lost less in down months.

Out: Primecap Odyssey Aggressive Growth PRIMECAP ODYSSEY AGGRESSIVE GROWTH POAGX 0.8521% . After posting top returns for a decade and seeing an influx of money, the fund closed to new investors. That’s a positive for shareholders as management decided to go with its best ideas rather than find ways to deploy more cash.

In: iShares iBoxx $ Investment Grade Corporate Bond ISHARES TRUST IBOXX USD INVT GRD CORP BD LQD -0.0245% . Instead of replacing Primecap with an­other stock fund, we bulked up our fixed-income selection at a time when Treasuries, the go-to bond investment, pay so little.

Low-fee LQD buys the debt of such household names as Verizon, Goldman Sachs, and General Electric and has outperformed its peers. While blue-chip debtors are unlikely to default, corporate bonds are more volatile than Treasuries, so this fund should supplement, not replace, your core bond holding.

Out: Harbor Bond HARBOR BOND FUND INST HABDX -0.0812% Why? In a name, Bill Gross. The co-founder of Pimco left the bond giant in the fall for Janus. Investors have been pulling money from Harbor, a sister fund to Pimco Total Return, as Gross’s recent bets against Treasuries failed to pay off. Harbor has trailed 72% of its peers over the past 12 months, although the fund has a solid long-term record. Still, given management uncertainty at Pimco, we replaced Harbor.

In: Fidelity Total Bond Fund FIDELITY TOTAL BOND FTBFX -0.0925% . An experienced team led by Ford O’Neil has given investors a smooth ride at a lower cost than Harbor. The fund can invest up to 20% of its assets in non-investment-grade debt. Those “junk” holdings are one-seventh of the portfolio now. The idea is to add yield without significantly increasing risk.

Funds Under Review

While we seek out portfolios that beat their average competitor over five years, we don’t immediately eject funds on the list when their returns lag. Contrarian-minded managers can post subpar results before the market vindicates their thinking. That said, continued under­performance bears scrutiny. We’re watching the following funds:

Delafield DELAFIELD FUND INC DEFIX 0.7161% Managers J. Dennis Delafield and Vincent Sellecchia have whipped the average competitor that invests in midsize value stocks by 2.5 percentage points a year since 1999, but they’ve struggled the past two years, in part due to large holdings in industrials and basic materials, sectors that have lagged the broader market. Still, Delafield has finished in the top 15% of similar funds in three of the past six years.

Weitz Hickory WEITZ HICKORY FUND WEHIX 0.5339% Run by Omaha’s second-most-­famous value investor, Wally Weitz, this fund has trailed competitors badly over the past three- and 10-year periods, thanks to performance laggards such as security firm ADT. Plus, a large cash allocation meant Weitz didn’t fully capitalize on the bull market. Nevertheless, the fund ranks in the top 13% of peers over the past five years.

Wasatch Small Cap Growth WASATCH SMALL CAP GROWTH WAAEX 0.6682% Jeff Cardon, the manager since 1986, tries to find companies that have low levels of debt and can double their earnings in five years. While the fund’s 15-year record is impressive, Wasatch has trailed almost 60% of its peers over the past five years, thanks in part to its bet on energy stocks, which have fallen as oil prices decline.

See the full MONEY 50 list

MONEY investment strategies

Why Even “Proven” Investment Strategies Usually Fail

Monopoly money
Beware investment strategies that haven't been tried with real money. Alamy—Alamy

Anyone with a computer can find a stock picking strategy that would have worked in the past. The future is another story.

You probably know, because you’ve read the boilerplate disclaimer in mutual fund ads, that past performance of an investment strategy is no indicator of future results.

And yet, funnily enough, nearly everyone in the investment business cites past results, especially the good results. Evidence that an investment strategy actually worked is a powerful thing, even if one knows intellectually that yesterday’s winners are more often than not tomorrow’s losers. At the very least, it suggests that the strategy isn’t merely a swell theory—it’s been tested in the real world.

Except that sometimes you can’t take the “real world” part for granted.

Just before Christmas, an investment adviser called F-Squared Investments settled with the Securities and Exchange Commission, agreeing to pay the government $35 million. According to the SEC, F-Squared had touted to would-be clients an impressive record for its “AlphaSector” strategy of 135% cumulative returns from 2001 to 2008, compared with 28% in an S&P 500 index. Just two problems:

First, contrary to what some of F-Squared’s marketing materials said, the AlphaSector numbers for this period were based solely on a hypothetical “backtest,” and there was no real portfolio investing real dollars in the strategy. In other words, after the fact, F-Squared calculated how the strategy would have performed had someone had the foresight to implement it. Underscoring how abstract this was, the backtest record spliced together three sets of trading rules deployed (hypothetically) at different times. The third trading model, which was assumed to go into effect in 2008, was developed by someone who, the SEC noted in passing, would have been 14 years old at the beginning of the whole backtest period, in 2001. (The AlphaSector product was not launched until late 2008; its record since it went live is not in question.)

Second, even the hypothetical record was inflated, says the SEC. The F-Squared strategy was to trade in and out of exchange traded funds based on “signals” from changes in the prices of the ETFs. But F-Squared’s pre-2008 record incorrectly assumed the ETFs were bought or sold one week before those signals could possibly have flashed. The performance, says the SEC, “was based upon implementing signals to sell before price drops and to buy before price increases that had occurred a week earlier.” Not surprisingly, a more accurate version of even the hypothetical strategy would have earned only 38% cumulatively over about seven years, not 135%.

Call it a woulda, shoulda—but not coulda—track record.

Steve Gandel at Fortune has been following this story for some time and has the breakdown here on how it all happened. This kind of thing is (one hopes) an extreme case. But there’s still a broader lesson to draw from this tale.

Although it’s a no-no to say that a strategy is based on a real portfolio when it isn’t, there’s not a blanket rule against citing hypothetical backtest results. In fact, backtesting is a routine part of the money management business. Stock pickers use it to develop their pet theories. Finance professors publish papers showing how this or that trading strategy could have beaten the market. Index companies use backtests to construct and market new “smart” indexes which can then be tracked by ETFs. But even when everyone follows all the rules and discloses what they are doing, there’s growing evidence that you should be skeptical of backtested strategies.

Here’s why: In any large set of data—like, say, the history of the stock market—patterns will pop out. Some might point to something real. But a lot will just be random noise, destined to disappear as more time passes. According to Duke finance professor Campbell Harvey, the more you look, the more patterns, including spurious ones, you are bound to spot. (Harvey forwarded me this XKCD comic strip that elegantly explains the basic problem.) A lot of people in finance are combing through this data now. But if they haven’t yet had to commit real money to an idea, they can test pattern after pattern after pattern until they find the one that “works.” Plus, since they already know how history worked out—which stocks won, and which lost—they have a big head start in their search.

In truth, the problem doesn’t go away entirely even when real money is involved. With thousands of professional money managers trying their hands, you’d expect many to succeed brilliantly just by fluke. (Chance predicts that about 300 out of 10,000 managers would beat the market over five consecutive years, according to a calculation by Harvey and Yan Liu.)

So how do you sort out the random from the real? If you are considering a strategy based on historical data, ask yourself three questions:

1) Is there any reason besides the record to think this should work?

Robert Novy-Marx, a finance professor at the University of Rochester, has found that some patterns that seem to predict stock prices work better when Mars and Saturn are in conjunction, and that market manias and crashes may correlate with sunspots. His point being not that these are smart trading strategies, but that you should be very, very careful with what you try to do with statistical patterns.

There’s no good reason to think Mars affects stock prices, so you can safely ignore astrology when putting together your 401(k). Likewise, if someone tells you that, say, a stock that rises in value in the first week of January will also rise in value in the third week of October, you might want to get them to explain their theory of why that would be.

2) What’s stopping other investors from doing this?

If there’s a pattern in stock prices that helps predict returns, other investors should be able to spot it. (Especially once the idea has been publicized.) And once they do, the advantage is very likely to go away. Investors will buy the stocks that ought to do well, driving up their price and reducing future returns. Or investors will sell the stocks that are supposed to do poorly, turning them into bargains.

That doesn’t mean all patterns are meaningless. For example, Yale economist Robert Shiller has found that the stock market tends to do poorly after prices become very high relative to past earnings. It may be that prices get too high in part because fund managers risk losing their jobs if they refuse to ride a bull market. Then again, the same forces that affect fund managers will probably affect you too. Will you being willing to stay out of the market and accept low returns while your friends and neighbors are boasting of double-digit gains?

And even Shiller’s pattern doesn’t work all the time—stock prices can stay high for years before they come down. Betting that you can see something that’s invisible to everyone else in the market is a risky proposition.

3) Does it work well enough to justify the expense?

Lots of strategies that look good on paper fade once you figure in real-world trading costs and management fees. A mutual fund based on the AlphaSector strategy, by the way, charges about 1.6% per year for its A-class shares. That’s eight times what you’d pay for a plain-vanilla index fund, which is all but certain to deliver the market’s return, minus that sliver of costs. And there’s nothing hypothetical about that.

MONEY exchange-traded funds

Why Index Funds Are Like Cheap TVs at Walmart

"Why are you window shopping?" Sale inside sign on store window
jaminwell—Getty Images

You can get a great deal on exchange-traded funds tracking large stock indexes. But watch out for the extra spending that can pile up.

Every industry has its loss leaders, and the investment world is no different. The theory is that you will go to the store for the $12 turkey and stick around to buy dressing, cranberries, juice, pies and two kinds of potatoes.

In the investment world, the role of the cheap turkey is played by broad stock index exchange traded funds. While investment firms say they make money on even low-fee funds, their profit margins on these products have been narrowing.

There’s been a bidding war among issuers of exchange traded funds that mimic large stock indexes like the Standard & Poor’s 500 or the Wilshire 5000 stock index. Companies including Blackrock, Vanguard, and Charles Schwab have been competing to offer investors the lowest cost shares possible on these products. Right now, Schwab — which will begin offering pre-mixed portfolios of ultra-low-cost ETFs early in 2015 — is winning.

Their theory? You’ll come in the door for the index ETF and stay for the more expensive funds, the alternative investments, the retirement advice.

“We believe we will keep that client for a long time,” said John Sturiale, senior vice president of product management for Charles Schwab Investment Management.

Investors, of course, are free to come in and buy the cheap TV and nothing more. Here are some points to consider if you want to squeeze the most out of low-cost exchange traded funds.

A few points don’t matter, but a lot of points do.

“Over the long term, cost is one of the biggest determinants of portfolio performance,” said Michael Rawson, a Morningstar analyst.

If you have a TD Ameritrade brokerage account, you can buy the Vanguard Total Stock Market Index Fund ETF for no cost beyond annual expenses of 0.05% of your assets in the fund. At Schwab, you can buy the Schwab U.S. Broad Market ETF for an annual expense of 0.04%. That 0.01 percentage point difference is negligible.

But compare that low-cost index fund with an actively managed fund carrying 1.3% in expenses. Invest $50,000 at the long-term stock market average return of 10% and you’ll end up with $859,477 after 30 years of having that 0.05% deducted annually. Pay 1.3% a year in expenses instead (not unusual for a high-profile actively managed mutual fund) and you’ll end up with $589,203. You’ll have given up $270,274 in fees, according to calculations performed at Buyupside.com.

Don’t pay for advice you don’t need.

The latest trend in investment advice is to charge clients roughly 1% of all of their assets to come up with a broad and diversified portfolio — with index funds at their core. Why not just buy your own core of index funds and exchange traded funds directly, and then get advice on the trickier parts of your portfolio? Or pay an adviser a onetime fee to develop a mostly index portfolio that you can buy on your own?

You won’t give up performance.

High-priced actively managed large stock funds as a group do not typically beat their indexes over time. Even those star managers who do outperform almost never do so year after year after year.

Build a broad portfolio.

Not every category of investment lends itself to low-cost indexing. You may do better with a seasoned stock picker if you’re taking aim at small-growth stocks, for example. But you can make the core of your plan a diversified and cheap portfolio of ETFs at any of the aforementioned companies, and save your fees for those extras that will really add value — the gravy, if you will.

MONEY stocks

Virtual Reality Makes Investing — Yes, Investing — Dangerously Fun

StockCity
StockCity from FidelityLabs

A new virtual reality tool from Fidelity makes navigating the stock market feel like a game—for better or worse.

There’s no question: Strapping on an Oculus Rift virtual reality headset and exploring StockCity, Fidelity’s new tool for investors, is oddly thrilling.

Admittedly, the fun may have more to do with the immersive experience of this 3D technology—with goggles that seamlessly shift your perspective as you tilt your head—than with the subject matter.

But I found it surprisingly easy to buy into the metaphor: As you glide through the virtual city that you’ve designed, buildings represent the stocks or ETFs in your portfolio, the weather represents the day’s market performance, and red and green rooftops tell you whether a stock is down or up for the day. Who wants to be a measly portfolio owner when you can instead be the ruler of a dynamic metropolis—a living, breathing personal economy?

Of course, there are serious limits to the tool in its current form. The height of a building represents its closing price on the previous day and the width the trading volume, which tell you nothing about, say, the stock’s historical performance or valuation—let alone whether it’s actually a good investment.

And, unless you’re a reporter like me or one of the 50,000 developers currently in possession of an Oculus Rift, you’re limited to playing with the less exciting 2D version of the program on your monitor (see a video preview below)—at least until a consumer version of the headset comes out in a few months, priced between $200 and $400.

Those flaws notwithstanding, if this technology makes the “gamification” of investing genuinely fun and appealing, that could be big deal. It could be used to better educate the public about the stock market and investing in general.

But it also raises a big question: Should investing be turned into a game, like fantasy sports?

There are dangers inherent in ostensibly educational games like Fidelity’s existing Beat the Benchmark tool, which teaches investing terms and demonstrates how different asset allocations have performed over various time periods. If you beat your benchmark, after all, what have you learned? A lot of research suggests that winning at investing tends to teach people the wrong lesson.

“Investors think that good returns originate from their investment skills, while for bad returns they blame the market,” writes Thomas Post, a finance professor at Maastricht University in the Netherlands and author of one recent study on the subject.

In reality, great performance in the stock market tends to depend more on luck than skill, even for the most expert investors. That’s why most people are best off putting their money into passive index funds and seldom trading. It also means there’s not a lot of value in watching the real-time performance of your stocks—in any number of dimensions.

MONEY retirement planning

This Simple Strategy Can Help You Build a Successful Retirement Plan

Fox and hedgehog
Bob Elsdale—Getty Images

Should you be smart as a fox or wise as a hedgehog in your retirement planning?

No, it’s not a trick question. Nor a trivial one. Indeed, knowing whether you act more like a fox or a hedgehog can help you improve your approach to retirement planning, making for a more enjoyable pre- and post-career life.

The fox vs. hedgehog debate goes back to a statement attributed to the ancient Greek poet Archilochus: “The fox knows many things, but the hedgehog knows one big thing.” Alluding to that line, the philosopher Isaiah Berlin wrote a famous essay in 1953 titled, “The Fox and The Hedgehog.”

The idea behind the fox-hedgehog comparison is that you can divide people into two groups: hedgehogs, who see the world through the prism of a defining principle or idea, and foxes, who focus more on their experiences and the particulars of a given situation. You could say that hedgehogs are more likely to see the big picture, while foxes get into the weeds.

So what does this have to do with retirement planning?

Well, if you’re a fox, you’re always looking for some type of edge or way to exploit circumstances to your advantage. You track the ups and downs of the stock market with an eye toward getting in before a big upswing or out before a crash. You listen to investment pundits, hoping to score tips on stocks or sectors that are supposedly poised to outperform the market. Chances are you’ve been glancing at what the Dow and the S&P 500 have been doing as you’ve been reading this column.

In your continuing efforts to gain an edge, you’re also constantly on the lookout for exciting new investment opportunities—smart beta ETFs, the Bitcoin Trust, whatever—and revolutionary techniques that can enhance your reitrement-planning efforts. You probably believe that finding the best investments is the single most important thing to do to build a sizeable nest egg, when diligent saving actually trumps savvy investing.

If you’re a hedgehog, on the other hand, you’re probably more apt to believe that successful retirement planning comes down to following a few simple principles: saving regularly (preferably by putting your savings on autopilot), making the most of tax-advantaged accounts whenever you can and, to the extent possible these days, not pulling the trigger on retirement until you feel you have a large enough nest egg to give you a good margin of safety on withdrawals (as opposed to relying on some investing black-magic that’s supposed to help you squeeze more out of your assets).

As for new products and cutting-edge strategies, the hedgehog views them with more than a little skepticism and is more likely to see them as a gimmick or distraction than a can’t-miss opportunity. As a hedgehog, you believe it’s unlikely that the Next Big Thing can significantly improve on time-honored strategies like looking for ways to save a bit more, reining in investment costs and building a basic stocks-bonds portfolio that you rebalance periodically. So you’re more likely to pass on the latest fad, knowing that in the financial world, fads come along pretty frequently, and often leave disappointment in their wake.

Full disclosure: I’m primarily in the hedgehog camp. Thirty years of writing about retirement planning and investing has convinced me that true innovation is pretty rare, and that “sophisticated” strategies is often another way of saying “expensive” strategies. I believe that if you get the Big Things right—you save regularly, invest sensibly, set reasonable expectations and monitor your progress—you don’t have to resort to fancy techniques that too often have the potential to blow up on you.

That said, while we may live in a digital world, we humans are not digital. We’re analog. No one is solely a fox or a hedgehog. We may be more one than the other, but we have elements of both. And I think that whether you consider yourself mostly a fox or a hedgehog, you can learn from the other.

If you’re primarily a fox, for example, you might occasionally want to pull back and take a big-picture look at your retirement planning. You want to be sure that have a sound basic strategy in place and that you’re not undermining it by chasing every new product or approach that comes along. To help you improve your focus, you’ll probably want to cultivate some of the hedgehog’s skepticism.

Conversely, if you’re a hedgehog, you want to be careful that you don’t let your wariness about The New New Thing completely shut you off to the possibility of innovative approaches that may improve your planning and your retirement prospects. Truly transformative products, services and strategies may be rare, but they do come along.

ETFs have helped many investors lower investment expenses and their tax bills. New tools that can help you decide when to claim Social Security—which you can find in RDR’s Retirement Toolbox—really do have the potential for dramatically improving many people’s standard of living in retirement. You don’t want your “hedgehoggish” tendency to view the world from 30,000 feet make you overlook something at ground level that that may prove helpful to your planning. To prevent that from happening, try to think like the fox sometimes.

So the next time you’re contemplating your retirement planning, be sure to think like a hedgehog and make sure you’ve got a good overall retirement plan in place. Then make like a fox and see whether there’s anything worthwhile new or interesting that might help you improve your plan, even if incrementally.

Doing this will help you see from both fox’s perspective and the hedgehog’s. And you’ll reap the benefits of thinking, shall we say, like a hedgefox.

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MONEY Ask the Expert

Knowing How Many — or Few — Funds to Own

Investing illustration
Robert A. Di Ieso, Jr.

Q: I have an $800,000 portfolio. How many mutual funds should I own? — Lynn

A: The optimal number of funds will vary depending on your time horizon, tolerance for risk, and exactly what kinds of funds you choose.

That said, if you’re looking to build and manage a diversified portfolio of exchange-traded funds (ETFs) or index mutual funds on your own, a good number is either six or 10, says Bill Valentine, president of Valentine Ventures, a Bend, Ore.-based wealth management firm. This is true, he says, whether you have $800,000 or a more modest portfolio.

Anything more than that many funds will “do nothing for diversification,” Valentine says, and will only add cost and complexity to your strategy.

Let’s start by discussing the whole notion of diversification. To get the best balance of risk and reward, you’ll want to invest in lots of securities across many different asset classes. Investing in ETFs or index mutual funds takes care of the first critical point of diversification since most such funds are composed of hundreds of different securities.

Even so, a single fund focused on a single asset class won’t provide you adequate diversification. Likewise, investing in six funds that all hold, say, large blue chip U.S. companies won’t improve returns, and may even detract from them.

“It’s important to blend asset classes than don’t act too similarly to each other, otherwise you’ll lose the benefit of diversification,” says Valentine.

If you’re young and have a long time horizon, you may not own bonds in your portfolio. Valentine says you’ll still want to spread your bets across six primary investment classes.

They include U.S. large cap stocks, U.S. small cap stocks, foreign developed-market stocks (shares of companies based in Europe and Japan), and foreign emerging-market stocks (shares of companies based in faster-growing economies such as like China and India).

And to diversify your equities, you’ll also want to consider owning a small amount in commodities and real estate investment trusts, or REITs.

Exactly how you slice the pie will depend on your specific time horizon and risk tolerance. Note: Valentine is not a proponent of owning bonds if you’re young, but most advisers recommend a small allocation to fixed income, even in a relatively aggressive portfolio.

Now, if you own bonds as part of your mix, you may want to add as many as four fixed-income funds to that mix.

Valentine recommends bond funds that give you exposure to: the broad U.S. fixed-income market (reflecting high-quality corporate and government debt), U.S. high yield bonds (which expose you to higher-yielding but lower-quality corporate debt), U.S. inflation-protected securities (to safeguard your holdings against rising consumer prices), and foreign bonds.

Again, the exact percentages will vary based on the specifics of your situation.

MONEY

Most Financial Research Is Probably Wrong, Say Financial Researchers

Throwing crumpled paper in wastebasket
Southern Stock—Getty Images

And if that's right, the problem isn't just academic. It means you are probably paying too much for your mutual funds.

In the 1990s, when I first stated writing about investing, the stars of the show on Wall Street were mutual fund managers. Now more investors know fund managers add costs without consistently beating the market. So humans picking stocks by hand are out, and quantitative systems are in.

The hot new mutual funds and exchange-traded funds are scientific—or at least, science-y. Sales materials come with dense footnotes, reference mysterious four- and five-factor models and Greek-letter statistical measures like “beta,” and name-drop professors at Yale, MIT and Chicago. The funds are often built on academic research showing that if you consistently favor a particular kind of stock—say, small companies, or less volatile ones—you can expect better long-run performance.

As I wrote earlier this year, some academic quants even think they’ve found stock-return patterns that can help explain why Warren Buffett has done so spectacularly well.

But there’s also new research that bluntly argues that most such studies are probably wrong. If you invest in anything other than a plain-vanilla index fund, this should rattle you a bit.

Financial economists Campbell Harvey, Yan Liu, and Heqing Zhu, in a working paper posted this week by the National Bureau of Economic Research, count up the economic studies claiming to have discovered a clue that could have helped predict the asset returns. Given how hard it is supposed to be to get an edge on the market, the sheer number is astounding: The economists list over 300 discoveries, over 200 of which came out in the past decade alone. And this is an incomplete list, focused on publications appearing in top journals or written by respected academics. Harvey, Liu, and Zhu weren’t going after a bunch of junk studies.

So how can they say so many of these findings are likely to be false?

To be clear, the paper doesn’t go through 300 articles and find mistakes. Instead, it argues that, statistically speaking, the high number of studies is itself a good reason to be more suspicious of any one them. This is a little mind-bending—more research is good, right?—but it helps to start with a simple fact: There’s always some randomness in the world. Whether you are running a scientific lab study or looking at reams of data about past market returns, some of the correlations and patterns you’ll see are just going to be the result of luck, not a real effect. Here’s a very simple example of a spurious pattern from my Buffett story: You could have beaten the market since 1993 just by buying stocks with tickers beginning with the letters W, A, R, R, E, and N.

Winning with Warren NEW

Researchers try to clean this up by setting a high bar for the statistical significance of their findings. So, for example, they may decide only to accept as true a result that’s so strong there’s only a 5% or smaller chance it could happen randomly.

As Harvey and Liu explain in another paper (and one that’s easier for a layperson to follow), that’s fine if you are just asking one question about one set of data. But if you keep going back again and again with new tests, you increase your chances of turning up a random result. So maybe first you look to see if stocks of a given size outperform, then at stocks with a certain price relative to earnings, or price to asset value, or price compared to the previous month’s price… and so on, and so on. The more you look, the more likely you are to find something, whether or not there’s anything there.

There are huge financial and career incentives to find an edge in the stock market, and cheap computing and bigger databases have made it easy to go hunting, so people are running a lot of tests now. Given that, Harvery, Liu, and Zhu argue we have to set a higher statistical bar to believe that a pattern that pops up in stock returns is evidence of something real. Do that, and the evidence for some popular research-based strategies—including investing in small-cap stocks—doesn’t look as strong anymore. Some others, like one form of value investing, still pass the stricter standard. But the problem is likely worse than it looks. The long list of experiments the economists are looking at here is just what’s seen the light of day. Who knows how many tests were done that didn’t get published, because they didn’t show interesting results?

These “multiple-testing” and “publication-bias” problems aren’t just in finance. They’re worrying people who look at medical research. And those TED-talk-ready psychology studies. And the way government and businesses are trying to harness insights from “Big Data.”

If you’re an investor, the first takeaway is obviously to be more skeptical of fund companies bearing academic studies. But it also bolsters the case against the old-fashioned, non-quant fund managers. Think of each person running a mutual fund as performing a test of one rough hypothesis about how to predict stock returns. Now consider that there are about 10,000 mutual funds. Given those numbers, write Campbell and Liu, “if managers were randomly choosing strategies, you would expect at least 300 of them to have five consecutive years of outperformance.” So even when you see a fund manager with an impressively consistent record, you may be seeing luck, not skill or insight.

And if you buy funds that have already had lucky strategies, you’ll likely find that you got in just in time for luck to run out.

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