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Do the opposite
Investors should go foreign

An old episode of the popular sitcom Seinfeld featured one of its main characters, George Costanza, undertaking a dramatic behavioural change. George figured that his basic instincts were so bad, that he would simply do the opposite of every one of his urges. It worked amazingly well. There is a valuable lesson here for mutual fund investors.

The past

For calendar 1999, pure stock funds accounted for 82 percent of net sales. Almost half of that - 37 percent of total mutual fund net sales - went to U.S. and other foreign stock funds. But sales momentum into foreign stock funds accelerated as the year progressed - and spilled into 2000. During the year 2000, stock funds accounted for 102 percent of total mutual fund net sales, of which nearly 60 percent went to foreign stock funds.

The subsequent performance is now part of the greatest bubble in history but it's interesting to note that foreign stock funds - the very funds for which investors showed insatiable hunger - far outperformed the then-shunned Canadian stock funds.

Over the past five years (ending September 30), Canadian stocks have returned an average of 6 percent per year. U.S. and overseas stocks, by contrast, have lost an average of about 4 percent per year over the same period. That's an outperformance by Canadian stocks of roughly 10 percentage points annually for the past five years.

However, five years ago, U.S. and foreign funds were looking much better if compared - at that time - based on past returns. Therein lies the problem - and the opportunity.

The present

The striking trend in mutual fund sales today is not only investors' collective preference for yield or income oriented funds but the apparent hesitation to step back into foreign markets. That's not to say that no foreign funds are attracting money. Big, strong past performers in the global equity class from AIM-Trimark, Brandes, and Mackenzie, for example, have been raking in money hand over fist.

I am not, however, suggesting that people pile into technology funds now. But today's trend has a common denominator with most past trends in investor behaviour; namely that investors follow past performance. Such behaviour invariably leads investors astray of the 'buy low, sell high' mantra. This has translated to long-term mutual fund investor performance that has not compensated for the risk taken.

A glance at sales figures over the trailing one and two years doesn't reveal any dramatic difference in sales of stock funds. However, when you consider that income trusts are just another form of Canadian equities, it's clear that investors are showing a strong preference - still - for Canadian equities over their foreign counterparts. Performance and perceived stability play a big part in this preference.

Foreign stock funds saw more than $384 million walk out the door. In both absolute and relative terms, this is the highest figure in two years - since the awful third quarter of 2002. Canadian stock funds - when excluding dividend and income trust funds - also remain in net redemptions but not at the increasing pace of foreign funds.

Rationale

There are two rationales that come to mind that explain this behaviour. Investors are simply replacing significant portions of their stock exposure with income trust funds. The perceived safety of monthly distributions and the demographics case for an increasing demand for yield combine for a good supply and demand picture going forward. Plus, overseas stocks - having lost 4 percent annually for the last five years - just don't look nice.

Again, the underlying issue here is largely one of past performance. And history strongly suggests that investing on this basis is a losing proposition.

Advice

I estimate that the current exposure to foreign stocks - considering only IFIC reporting mutual fund assets - is near the median for the last eleven years. But it's at its lowest point since March 2003 and (before that) June 1998. Not coincidentally, mutual fund investors' peak allocation to foreign stocks of more than 48 percent was reached in August 2000.

Those dates should ring a loud bell since they are near past troughs and peaks in performance. I'm not suggesting that we're at the beginning of a bull market for overseas stocks. But overseas markets are cheaper and offer some diversification benefits. Plus, with our dollar flirting with the US$0.80 range, currency risk has been substantially reduced. Granted, I said this when the loonie was in the low-to-mid 70s (U.S. cents per Canadian dollar) but this is even truer today.

Advisors and investors may be weary of buying investments from a class with already negative performance, but that's really the better time to build long-term exposure.



Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...