The Invisible Chasm

One difference between Morningstar’s results reporting (1-, 3, 5 and 10 year) and ours (up cycle, down cycle, full market cycles plus standard periods) is that theirs contains an invisible chasm. That chasm exists for funds that were around during the 2007-09 market crisis but that do not have a 10 year track record yet. The only thing that Morningstar will report is their records for the past five years or less. No matter how catastrophic their performance during the meltdown, they receive no penalty for it. Their 3- and 5-year return ratings cover only the recent bull market and their star ratings (and risk grades!) are based only on their performance in the good times.


How much of a problem is that? We set the screener to “age= less than 10 years” and “display period = down cycle 5, 2007-09” which shows funds that invisibly endured the entire market crisis.


By our best estimate there are 800 funds whose crisis records are masked. Among the notables in that crowd are:


ProShares Ultra Financials (UGY, remember that you can’t spell UGLY without it!) has a five-year annualized return of 21%. It also had a maximum drawdown during the financial crisis of 96%. To be fair, this fund is not intended to be held; it’s a trading vehicle that might normally be held for a few hours to a few days.


Causeway Emerging Markets (CEMVX) has over $2 billion in assets and a five-year record that places it in the top 25% of all emerging markets funds. Its 67% drawdown, though, was among the 10 worst for any diversified EM (non-BRIC, non-Russia) equity fund.


Thornburg Global Opportunities (THOIX) has a five-year record in the top 1% of its peer group but its 61% decline – third-worst in its peer group – was far greater than the 36.9% averaged by its “flexible portfolio” peers.


That argument is not that these are bad funds. Far from it. The argument is that one very important aspect of their character is not easily or immediately visible using standard measuring periods.


When eventually a fund passes the 10 year mark, the 10 year record (including the crisis) will count for 50% of its overall rating, with the shorter 3- and 5-year cycles accounting for the other 50%. A domestic-equity fund that reaches the 10-year mark in 2016 will receive credit for its splendid 2013 returns (the Total Stock Market Index booked a 34% gain) in its 3, 5 and 10 year weightings but for its miserable 2008 only in the 10 year one. One solution is to look at a fund’s down-cycle 4 and 5 performance, maximum drawdown and bear market deciles, each of which offers a partial answer to the question, “jeez, if it’s a five-star fund, how much downside could there be?”