Lessons from 2010: Refreshers

Some of the lessons we learned in 2010 were too important to wait for a wrap-up at the end of the year. Here's a look back at some of those lessons, with a hope that anyone who fell prey to these mistakes will make sure not to repeat them in 2011.

Active Management Is a Loser's Game -- While the data came in a little before the end of the year, it was bad enough for Bank of America Merrill Lynch to call 2010 the "toughest year on record" for active managers. Only 25 percent of active managers beat their benchmarks, though they had their excuses ready to go for their underperformance.

When active managers outperform, it's always because of their brains and hard work. When they underperform, it's always because of something outside their control. You never hear costs or market efficiency as reasons for underperformance. This allows investors to believe that things will be different next year, as active managers "account" for these issues.

Hedge Funds Are Compensation Schemes, Not Investments -- Once again, hedge funds turned in poor performance compared to the returns of publicly available indexes. The HFRX Index had a gain of 2.8 percent from January through November 2010. Here's how the other indexes stacked up:

Domestic Indexes S&P 500 -- 7.9 percent
MSCI US Small Cap 1750 (gross dividends) -- 18.6 percent
MSCI US Prime Market Value (gross dividends) -- 6.2 percent
MSCI US Small Cap Value (gross dividends) -- 16.2 percent
Dow Jones Select REIT -- 22.3 percent

International Indexes MSCI EAFE (gross dividends) -- 0.1 percent
MSCI EAFE Small Cap (gross dividends) -- 9.6 percent
MSCI EAFE Value (gross dividends) -- -4.2 percent MSCI Emerging Markets (gross dividends) -- 11.2 percent

Fixed Income Merrill Lynch One-Year Treasury Note -- 0.8 percent
Five-Year Treasury Notes -- 9.0 percent
20-Year Treasury Bonds -- 14.6 percent

An all-equity portfolio with 50 percent international/50 percent domestic, equally weighted within those broad categories, would have returned more than 9 percent. And a 60 percent equity/40 percent bond portfolio with those weights for the equity allocation would have returned 6.1 percent using one-year Treasuries, 9.4 percent using five-year Treasuries, and 11.6 percent using long-term Treasuries. Given the freedom to move across asset classes that hedge funds tout as their big advantage, one would think that "advantage" would show up. The problem is that the efficiency of the market turns that supposed advantage into a handicap.

There's No Value in Interest-Rate Forecasts -- In July 2009, The Wall Street Journal asked 50 economic forecasters where the yield on the 10-year Treasury note would be in one year. Forty-three expected the 10-year U.S. Treasury note yield to move higher over the year ahead, with an average estimate of 4.13 percent. Seven expected a rate of 5 percent or higher, while only two predicted rates to fall below 3 percent. The result? The 10-year Treasury yield slumped to 2.95 percent on June 30, 2010.

While the forecasts clearly turned out to be wrong, it doesn't mean the experts were incompetent. The point is that even the most talented analysts are unlikely to make reliable predictions.

Avoid Interesting Investments Such as Quant Funds and Long/Short Funds -- Quant funds and long/short funds have drawn considerable attention from the financial media. Unfortunately, the results haven't matched the hype. For the five years ending in October, long/short funds underperformed the S&P 500 by about 1 percent a year and the MSCI Small Cap Index by more than 3 percent a year.

The story is similar for quant funds. The group of 65 quant funds examined by Morningstar trailed three-fourths of their peers over three years ending July 28. Remember, interesting investments were designed to be sold, not bought. Also remember that many small fortunes were the result of starting with a large fortune and making interesting investments.

Follow the series: Lessons from 2010
Diversification Matters and Forecasters Don't Bad News, Good Returns Bad Strategies, Good Tax Management and Staying in the Market Refreshers
Hear Larry Swedroe discuss current investment trends and topics every Sunday at noon on 550 AM KTRS in St. Louis or streaming via the KTRS Web site. Can't catch the show? Download the podcast via www.investmentadvisornow.com or through the Buckingham Asset Management podcast page on iTunes.