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INVESTMENT & ECONOMIC ANALYSIS: Spring 2002
SOCIAL TOPICS (Archive): INVESTMENT & ECONOMIC ANALYSIS
Published, Spring 2002 By Bob Lincoln The annualized rate of return for the Standard and Poor's 500 Index (S&P 500) for the five years ending in December 2001 was 10.7 percent, consistent with the long term average rate of return on stocks. But the unusual path of those returns tells us something about the risk and return characteristics intrinsic to index funds, and importantly, the benefits of true core investing, stressing broad diversification and reasonable valuation. The first three years, 1997-1999, were among the best stock market years of the century, with the S&P 500 gaining 108 percent and the technology-laden NASDAQ rising an astounding 215 percent. In stark contrast, the years 2000 and 2001 were the first two consecutive down years for the S&P 500 since 1973-1974 and produced a loss of 20 percent for the S&P 500 and 52 percent for the NASDAQ, reducing the five year return to about the historical average. Why did so many investors go along for this wild ride just to end up with an average return? The whole phenomenon of index investing and a new paradigm for thinking about risk in the 1990s explains much of the story. Investors began to think of risk simply as deviation from "the market." This belief is based on the assumption that a market index is always efficient; that is, through diversification it provides the best return-to-risk ratio. The argument is that managers who follow a "core" approach, stressing diversification and risk control, should have investment returns and portfolio characteristics that mirror the S&P 500, by definition the core of the market. A core manager may be criticized for taking risk by changing style if a portfolio's returns and characteristics, such as average price/earnings ratio or average market capitalization, differ too much from the S&P 500. We believe strongly that such relativistic thinking displays a fundamental misinterpretation of the true concept of investment risk. It confuses the manager's risk that portfolio returns will deviate from the S&P 500 benchmark with the investor's appropriate concern that his or her portfolio's return will vary sharply and unpredictably from year to year. The unusual investment performance of the S&P 500 over the last five years came about almost entirely from the price increases and decreases of high-priced technology/internet stocks. In 1998, with the S&P 500 up by 28 percent, the average stock gained only 4 percent. In 1999, when the S&P 500 was up 21 percent, there were actually more stocks that decreased in value than increased. Almost all of the S&P 500 return came from the price increases of a relatively few large and highly valued stocks. At the end of 1999, the 100 S&P 500 stocks with the highest price/earnings (P/E) ratios had an average P/E over 60 and accounted for close to half of the market value of the index. The other 400 stocks, accounting for the remaining half, were reasonably priced at an average P/E of about 17. In other words, the market-weighted index became concentrated, unbalanced, and inefficient in this period, exposing index investors to substantial risk. In 2000 and 2001, the technology sector was the big loser. In 2000 the technology sector lost 32 percent, accounting for just about the entire 9 percent decline in the S&P 500. The average stock actually gained 10.5 percent in 2000. Similarly in 2001, technology stocks lost 26 percent, leading the S&P 500 to a loss of 12 percent while the average S&P stock lost only 2 percent. At Walden, we think of ourselves primarily as core investors with a focus on higher quality stocks. Throughout the 1980s and for much of the 1990s we implemented an equity investment approach that sought "above-average companies at average prices." Over most of this time period, "average price" was defined as the P/E relative to the S&P 500. But in 1998 and especially in 1999 the P/E of the S&P 500 increased to unprecedented high levels. More importantly, as noted above, the variation of P/E ratios for individual stocks grew dramatically. In such an environment our core equity approach, which provides broad diversification and controlled risk, and avoids extremely high-priced stocks, led us to a portfolio with an overall P/E well below that of the S&P 500. How did a true core investor fare over the full 1997-2001 market cycle? The accompanying chart below shows the returns of the Walden social equity core composite versus the S&P 500. As expected, the Walden returns trailed the S&P 500 for 1997-1999 but held up much better in 2000 and 2001. The result is a total return for the five years of 87.6 percent (13.4 percent annualized) compared with 66.2 percent (10.7 percent annualized) for the S&P 500. Importantly, this positive outcome was accomplished with less variability of returns than experienced by the S&P 500. Other managers who followed a true core approach realized returns that followed a similar pattern. (Past performance is not a guarantee of future results.)
Investment Risk and Return 1997-2001
* TAX-EXEMPT SOCIALLY SCREENED EQUITY COMPOSITE. Index fund investors trust the market to be extremely efficient. They believe that market forces will act to value securities correctly. However, recent experience demonstrates that the market undergoes periods of irrationality that result in added risk for index investors. A true core approach can produce as good or better returns than the market index, and do so with less risk.
Bob Lincoln is a senior portfolio manager and United States Trust Company of Boston's chief strategist. Bob chairs our Investment Policy Committee and manages value, growth and core portfolios.
Disclosure Notes (the terms "account" and "portfolio" used herein are inter-changeable): (1) (a) United States Trust Company Boston (USTC) investment management has prepared and presented these results in compliance with the AIMR-PPSTM for all periods. AIMR has not been involved with the presentation or review of this report. (b) A list of all USTC Composites is available upon request. (c) See table above for performance regarding USTC's Tax-Exempt Socially Screened Equity Composite. (d) A fee schedule will accompany all presentations. (e) Past performance is no guarantee of future performance. (2) Firm: (a) USTC (the "Firm") is defined as an independently operated wholly owned subsidiary of the Providence based bank holding company, Citizens Financial Group, Inc., effective 1/11/00. (b) USTC offers portfolio management, of primarily U.S. based securities, in separate or commingled vehicles for: taxable, tax exempt and socially responsive investing. (c) USTC, the Firm, manages assets totaling $3.7B in over 800 client accounts as of 12/31/99. (3) Construction: (a) All actual fee paying, fully discretionary accounts are included in at least one composite defined according to similar strategy or investment objective. This composite includes: all separately managed, tax-exempt, equity portfolios with social screening criteria applied, including the equity segment of applicable balanced portfolios. (b) The minimum account market value (MV) for composite inclusion is $1mm and accounts remain in the composite even if its MV subsequently falls below $1mm. (4) Disclosures: (a) Performance is gross of management fees but net of trading costs; thus, Client's return will be reduced by these and any other expenses incurred in the management of its account. (b) The dispersion, of portfolio returns (full year) around the aggregate composite return, is an asset-weighted standard deviation. (c) When a balanced portfolio segment is included in a single-asset composite: (i) cash is allocated based on actual use in the segmented strategy, 1% equity and 99% fixed income, consistent with USTC's investment policy, which is to view cash as an integral part of the fixed income portfolio. (ii) segment performance is only for the periods 1/1/93 through present (pre 1/1/93 segment data is not available). (iii) account segment market values which fall below $1mm are allowed, as an exception to (3) (b) above. (5) Calculations: (a) Performance is calculated using trade-date b) Composite returns for each account is calculated monthly and asset-weighted by monthly beginning MVs (as of 1/1/99). Performance for periods 1/1/91 to 12/31/98 is calculated quarterly and weighted by quarterly beginning MVs.
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