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Index Funds Advisors, Inc. (IFA) recently completed an analysis of the performance of state retirement pension plans which showed that all of them would have fared better with a portfolio of index funds such as the ones offered by IFA. When confronted with these numbers, the often heard refrain of the administrators of these plans is that confining themselves to stocks and bonds is far too limiting for funds that have billions to invest. Instead, they must search for “alternative investments” such as hedge funds and private equity that are not available to the general public. IFA has repeatedly cautioned “qualified” investors against being seduced by the notion that they are going to “beat the market” merely because they can hire talented managers in an asset class that allegedly has exploitable inefficiencies. One study that reinforces this warning is “The Performance of Private Equity Funds”¹ by Ludovic Phalippou and Oliver Gottschalg of the University of Amsterdam. The authors analyzed a dataset of 1,328 funds (including both U.S. and international funds) and corrected for the following three common practices that upwardly bias the reported returns of the public databases that track the performance of private equity funds:

1) The residual values reported by private equity funds long after they have made their last payments to investors have traditionally been counted towards their returns. The authors argue that these residual values should be zeroed out since investors normally do not collect any part of the residual value.

2) When calculating the performance of private equity funds as a group, the weights are often based on capital committed. The authors argue that a superior measure is the value actually invested since funds generally do not invest all their committed capital at the outset.

3) As with hedge funds, there is a strong selection bias in that successful funds are far more likely to report their results than failed funds.

After addressing all three of these issues, the authors found that private equity funds underperformed the S&P 500 by 3% per year. Adjusting this underperformance to account for the additional risk of private equity brings it to a substantial 6% per year.

This study deserves the attention of institutional investors such as foundations, endowments, and pensions. This study belies the often-made claim that managers and asset classes that are only accessible to “qualified” investors will provide outsized returns that are unavailable to the remainder of the investing public.

¹ Phalippou, Ludovic and Gottschalg, Oliver, “The Performance of Private Equity Funds,” The Review of Financial Studies, Volume 22, Issue 4 (April 2009), pp. 1747-1776.

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This past year was a difficult one for small cap stocks across all geographic regions, as shown in the table below:

Of the three equity risk premiums identified by Eugene Fama and Kenneth French¹, the size premium is the smallest, and thus the most vulnerable to attack. An article in the September 2011 issue of Financial Advisor Magazine² went so far as to declare that there never truly was a small cap premium and that large cap stocks are a superior investment to small cap stocks. As we will see below the small cap premium is alive and well, and small cap stocks have a legitimate place alongside large cap stocks in a diversified equity portfolio.

Before going any further, it is important to understand exactly what is meant by a risk premium. The presence of a risk premium implies that investors can expect a higher return as compensation for the bearing of risk. In the case of small companies, it is easy to understand that these companies should have a higher cost of capital than large companies which tend to have highly-valued assets such as widely recognized brand names and deep pools of employee talent. This higher cost of capital should be paid to investors in the form of higher returns.

Fama and French obtained a quantitative measurement of the size premium (SmB = Small Cap minus Big Cap) by sorting the US equity market into deciles based on size and assigning the five smallest deciles to the “small cap” classification. For the 84 calendar years from 1927 to 2010, the average value of SmB was 3.24% with a standard deviation of 12.92%. When we apply a statistical test (the t-test) to determine if chance alone could explain the magnitude of SmB, we find that the probability of that occurrence to be less than 5% (t >2). Furthermore, if we break up the 84-year period into the two pieces before and after the publication of the Fama/French paper¹, we find that the average value of SmB was 3.35% in the 1927-1992 period and 2.84% in the 1993-2010 period. Contrary to the expectation that the small cap premium would disappear once it was publicly exposed due to numerous investors acting on it and thus driving up the prices of small cap stocks, the small cap premium actually persisted.

One very important aspect of the small cap premium is the standard deviation of about 13%. A standard deviation of this size means that it would not be uncommon for small cap stocks to lag large cap stocks by 10% in a single year (a one standard deviation event which has occurred in 9 of the last 85 years). The two standard deviation event of small cap stocks lagging by 23% or more has only occurred twice (1929 and 1973) in the last 85 years. Small cap stocks have beaten large cap stocks in 47 (55%) of the last 85 years, and in the first 12 years of this millennium, small beat large in 8 years (67%).

Any argument regarding the inclusion or exclusion of small caps in an equity portfolio should consider their diversification benefits. As shown below, a simple blended large/small portfolio (in the same proportion as used in most of the IFA Index Portfolios) captured a 0.8% higher annualized return than large cap alone with a manageable 1.7% increase in standard deviation. Also visible in the chart below is the much higher volatility of small cap stocks, as the higher return of small caps comes with higher risk.

To summarize, the question an investor should ask is not “should I be in large caps or small caps?” but rather “what is a sensible blend of large and small companies that will allow me to capture a risk premium without being tempted to sell out of my portfolio when it performs differently from the Dow Jones Industrial Average or the S&P 500?” Having an exposure to small cap stocks is still worthwhile, but it should be in moderation.

1. Fama, Eugene F. and Kenneth R. French. 1992. “The Cross-Section of Expected Stock Returns.” Journal of Finance (47):427-465.
2. Gary A. Miller and Scott A. MacKillop. 2011. “Rethinking Small Caps.” Financial Advisor Magazine www.fa-mag.com/component/content/article/8289.html?magazineID=1&issue=175&Itemid=73

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Weston Wellington
Dimensional Fund Advisors

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Throughout the year, investors seeking clues regarding the strength of business conditions or the prospects for stock prices were confronted with ample reason to rejoice or despair. Optimists could cite the strong recovery in corporate profits and dividends, the substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, and record-high share prices for leading multinationals such as Apple, IBM, and McDonald’s. Pessimists could point to persistently high unemployment, slumping home prices, tepid growth in retail sales, worrisome levels of government debt at home and abroad, and political gridlock in both Congress and various state legislatures.

Although the broad market indices showed little change for the year, there were opportunities to make a bundle—or lose one. Among the thirty constituents of the Dow Jones Industrial Average, thirteen had double-digit total returns, including McDonald’s (34.0%), Pfizer (28.6%), and IBM (27.3%). But losing money was just as easy: The three worst performers in the Dow were Hewlett-Packard (–37.8%), Alcoa (–43.0%), and Bank of America (–58.0%). If nothing else, the substantial spread between these winners and losers discredits the argument we often hear that all stocks are now marching in lockstep and that diversification is ineffective.

Achieving even modest results in the US market required more discipline than many investors could muster, since investor sentiment fluctuated dramatically throughout the year and the temptation to enhance returns through judicious market timing often proved irresistible.

For fans of the “January Indicator,” the year got off to a promising start as stock prices jumped higher on the first trading day, pushing the Dow Jones Industrial Average to a twenty-eight-month high. Bank of America shares jumped 6.4% that day, the top performer among Dow constituents. With copper prices setting new records and factory activity worldwide perking up, the biggest worry for some was the potential for rising prices and higher interest rates that might choke off the recovery. “Overheating is the biggest worry,” one chief investment strategist observed. By April 30, the S&P 500 was up 8.4%, reaching a new high for the year.

Stocks wobbled through May and June but strengthened again in July. On July 19, the Dow Jones Industrial Average had its sharpest one-day increase of the year, jumping over 200 points, paced by strong performance in technology stocks. Just a few days later, however, stocks began a precipitous decline that took the S&P 500 down nearly 17% in just eleven trading sessions. The century-old Dow Theory—a sentimental favorite among market timers—flashed a “sell” signal on August 3, and on August 5, Standard & Poor’s downgraded US government debt from AAA to AA+. As investors sought to assess the implications of sovereign debt problems in both the US and Europe, stock prices fluctuated dramatically, with the S&P 500 rising or falling over 4% on five out of six consecutive trading days in early August. Rattled by the sharp day-to-day price swings, many investors sought the relative safety of US Treasury obligations in spite of the rating downgrade, pushing the yield on ten-year Treasury notes to a record low. Stock prices hit bottom for the year on October 3 as some market participants apparently lost all confidence in equity investing. A Wall Street Journal article cited a number of individual investors as well as professional advisors who had recently sold all their stocks and did not expect to repurchase them anytime soon. “I feel like a deer in the headlights,” said one.

As it turned out, the article appeared in print on the second day of a powerful rally that sent the Dow Industrial Average surging over 1,500 points during the next 19 trading days, putting it back into positive territory for the year.

What can we learn from a difficult year like 2011? As Dimensional founder David Booth is fond of saying, the most important thing about an investment philosophy is that you have one. Many investors (as well as some allegedly professional advisors) apparently decided to switch from a buy-and-hold philosophy to a market timing strategy in the midst of an unusually stressful period in the financial markets. We suspect few of those adopting the change would have been able to clearly articulate their investing beliefs and why they had shifted.

Legendary investor Benjamin Graham offered the following observation nearly forty years ago: “There is no basis either in logic or in experience for assuming that any typical or average investor can anticipate market movements more successfully than the general public, of which he himself is a part.”

Good advice then, good advice now.

Mark Gongloff, “Investors’ Forecast: Sunny With a Chance of Overheating,” Wall Street Journal, January 3, 2011.

Jonathan Cheng and Sara Murray, “Stock Surge Rings in Year,” Wall Street Journal, January 4, 2011.

Matt Phillips and E.S. Browning, “Tech Sends Stocks Soaring,” Wall Street Journal, July 20, 2011.

Steven Russsolillo, “‘Dow Theory’ Confirms It’s an Official Swoon,” Wall Street Journal, August 4, 2011.

Damian Paletta, “U.S. Loses Triple-A Credit Rating,” Wall Street Journal, August 6, 2011.

Tom Petruno, “Investors Stampede to Safety,” Los Angeles Times, August 19, 2011.

Kelly Greene and Joe Light, “Tired of Ups and Downs, Investors Say ‘Let Me Out’,” Wall Street Journal, October 5, 2011.

Benjamin Graham, The Intelligent Investor (New York: HarperCollins 1949).

The S&P data are provided by Standard & Poor’s Index Services Group.

MSCI data copyright MSCI 2011, all rights reserved.

Yahoo! Finance, www.yahoo.com, accessed January 3, 2012.

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The returns of hedge funds have trailed behind those of the S&P since 2003: 18% vs. 29% total returns, according to Simon Lack of SL Advisors in a Wall Street Journal “MarketBeat” article. The 2% management fee and 20% performance fee (20% of the fund’s profits) add to the wide spread between returns. The difference in returns could possibly be even wider, because hedge funds get to decide if they want to be included in databases that are tracked and analyzed. In other words, there is a selection bias.

The article presents another comparison: hedge funds vs. a corporate bond index, as measured by the Dow Jones Corporate Bond Index. The index has grown 77% since 2003, adding to a list of examples demonstrating the underperformance of hedge funds when compared to market benchmarks.

As Jay Franklin cited in a previous IFA article, “every major category of hedge funds (eleven categories) on average failed to provide a higher risk-adjusted return than the S&P 500 from 1995 to 2003. Only one category (emerging markets) provided a higher unadjusted return than the S&P 500.”

Lack credits the underperformance of hedge funds to the large influx of assets into hedge funds over the last ten years, followed by a dissipation of “alpha” or outperformance “as more managers chase after a limited pool of market inefficiencies.” Data from Hedge Fund Research shows that the amount of capital raised from 1998 – 2002 more than doubled to $820 billion.

Lack advises investors who have an investment time horizon of five or more years to invest in U.S. stocks rather than hedge funds and addresses this issue in his new book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good To Be True.

New standards and fee models are being considered by certain hedge funds, which could enable investors to keep more of their money.

For further information on hedge funds, read Jay Franklin’s articles:
“IFA’s Concerns with Hedge Funds” @ www.ifa.com/section/hedgefunds.asp
“Hedge Funds on Edge” @ http://www.ifa.com/articles/Hedge_Funds_on_Edge.aspx

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Dan Solin

As the New Year starts, you may be considering a change in your investing strategy.  There are so many purveyors of financial advice that it can be confusing to separate fact from fiction.  Here are my choices for sources of good advice, based on solid data.  Unfortunately, these sources are often overwhelmed by the far more abundant bad and downright ugly advice, so I will designate those as well.

Good Financial Advice

1. John Bogle:  I like all of his books, but my favorite is The Little Book of Common Sense Investing.
2. Burton Malkiel:  A Random Walk Down Wall Street is still an investment classic, although it can take some discipline to get through it.
3. Larry Swedroe:  A prolific author of thoughtful books, my favorite is one of his early ones: What Wall Street Doesn’t Want You to Know.
4. Mark Hebner, the President of Index Funds Advisors (ifa.com) (with whom I am affiliated) has just released a condensed, updated and revised version of Index Funds, The 12-Step Recovery Program for Active Investors. This book will be available on Amazon January 31, 2012. The foreword by 1990 Nobel Prize Recipient, Harry Markowitz, alone is worth the price of the book.  If the research in this book doesn’t persuade you to fundamentally change the way you invest, you are suffering from cognitive dissonance.
5. William Bernstein:  Perhaps the deepest financial thinker of our time, all of his books are superb.  Everyone should read The Intelligent Asset Allocator and The Four Pillars of Investing.
6. Taylor Larimore, Mel Lindauer, Richard A. Ferri and Laura F. Dogu:  The Bogleheads Guide to Retirement Planning tells you everything you need to know about planning for retirement.
7. I wrote the Smartest series of books to empower all investors to avoid becoming victims of the securities industry and to demystify the process.  I don’t hide information and my books are not written to generate advisory business.  I tell you exactly which index funds you can purchase on your own, directly from major fund families like Vanguard and Fidelity.  Start with The Smartest Investment Book You’ll Ever Read and move on to the others.
8. Allan Roth:  How a Second Grader Beats Wall Street makes it simple to understand how to invest intelligently.

Bad Financial Advice

There is so much bad financial advice, I can only use categories:

1. Retail brokers:  They can’t pick stocks, time the markets or pick “hot” fund managers, yet they spend their days dispensing advice in each of these areas.  Your chances of having a prosperous New Year are greatly enhanced if you cancel your retail brokerage account.
2. Discount brokers: It’s fine to use them for the limited purposed of buying low cost exchange traded funds.  If you are relying on the data they provide to assist you with research and analysis, or their trading programs, they are a source of really bad advice.  It is unlikely your trades will be profitable, net of your transaction costs.
3. The Financial Media:  Much of the financial media gives a forum to pundits who make predictions concerning the direction of the markets or particular stocks, bonds or mutual funds. None of this information is helpful to investors.  A chimpanzee throwing a dart is likely to be as accurate as these “experts.”

The Ugly

The advice given by those in this category is no worse than typical bad financial advice.  What makes their advice “ugly” is that they have been given a forum to widely dispense their views, and they abuse that forum by providing information likely to harm you.

1. Jim Cramer:  All you need to know about Cramer are the views attributed to David Swensen on ABC.  Swensen is the manager of the $34 billion Yale Endowment: “On ‘Mad Money,’ Cramer promotes a mindless short-term approach to markets by encouraging frenetic trading of individual stocks. Such a high-cost, tax-inefficient strategy almost guarantees failure.”
2. Jeff Macke:  Macke is a host on Yahoo’s Breakout.  He uses this forum to discuss his trading strategies.  He provides no data supporting these strategies.  Recently, he cautioned his readers against pursuing a “buy and hold” strategy.  I gave this blog my “worst financial blog of 2011” award.

If you want to increase your chances for 2012 to be not just happy also prosperous, you would be well advised to focus on good advice and avoid the bad and especially the ugly.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read and The Smartest Portfolio You’ll Ever Own.  His new book, The Smartest Money Book You’ll Ever Read, was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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Bryan Harris
Dimensional Fund Advisors
Senior Editor

The past year reminded investors that they should hope for the best, prepare for the worst, and be thankful when reality does not match their fears. Investors entered 2011 with hopes that the world economy would continue recovering from a long and painful deleveraging process. Equity markets had posted two straight years of positive performance, central banks remained committed to pro-growth monetary policy, and major developed nations were focused on reducing debt.

By mid-year, however, optimism faded as troubling events around the world dominated headlines. The devastating earthquake and tsunami in Japan, political unrest in the Middle East, rising oil prices, a US credit downgrade, the threat of another global recession, and an escalating debt crisis in Europe weighed heavily on markets. As stock market volatility returned to global financial crisis levels, investors faced a major test to their discipline and staying power.

Although US stocks experienced some of the highest volatility in years, the broad US market delivered flat performance in 2011. Developed markets logged negative returns, and emerging markets had mixed performance, with most countries also underperforming the US. The bright spots were in the fixed income arena, where a flight to quality triggered by the euro debt crisis and US credit downgrade boosted returns on US government securities, inflation-protected securities, and municipal bonds.

The above headliner graph features some of the year’s most highly publicized events in the context of the Russell 3000 Index, a broad indicator of US stock market performance. These events are not offered as an explanation of market performance, but as an illustration that a volatile news environment can challenge even the most disciplined long-term investors.

The World Stock Market Performance chart below offers a snapshot of global stock market performance, as measured by the MSCI All Country World Index. Actual headlines from publications around the world are featured. Again, these headlines are just a sample of events during the year.

Throughout the year, investors could find a host of reasons to avoid stocks and wait for more positive news before returning to the market. As these select headlines suggest, determining the right time to invest is a difficult task since the market anticipates news and quickly factors in new information.

The Year in Review

In 2011, global diversification proved as important as ever. Although diversification may not have prevented losses, investors with broadly diversified portfolios were better equipped to endure the uncertainty. Major themes during the year included:

European Debt Problems

The sovereign debt crisis intensified as European authorities struggled to avert a Greek debt default and alleviate fiscal pressures in Italy and France. But these restructuring attempts fell short of market expectations, which spooked investors and raised concerns of additional sovereign debt downgrades and a possible breakup of the Eurozone. The crisis also hurt European banks holding large positions in sovereign debt. To avoid losses, leading institutions reduced lending and dumped assets, which depressed asset values. Higher borrowing costs in the most indebted countries, combined with reduced government spending and revenues, raised more concerns that the Eurozone was entering a recession in late 2011.

Economic Uncertainty

Since the global financial crisis in 2008, central banks and governments have taken bold measures to fuel business activity and stabilize financial markets—and investors have eagerly awaited signs that economic recovery has taken hold. The economic signals continued to be mixed in 2011. Favorable US news included strong corporate profits and dividends, substantial levels of cash on corporate balance sheets, low interest rates and inflation, a booming domestic energy sector, continuing strength in auto sales, record-high share prices for some multinationals, and improved fourth-quarter numbers in manufacturing, exports, consumer confidence, and employment. Pessimists could point to the longstanding jobless trend, slumping home prices, tepid growth in retail sales, worrisome levels of government debt, and political gridlock at both the national and state levels.

Although emerging economies showed resilience, investors were concerned that another recession in Europe would impact its trading partners in emerging economies—and particularly in China, where high inflation and a manufacturing slowdown threatened to send its previously fast-growing economy into recession.

Rising Volatility

Investors in US equities had to endure a heavy dose of uncertainty for their moderate gains. The S&P 500 Index reflected this volatility by closing up or down over 2% on thirty-five days in 2011, compared to twenty-two days in 2010. By contrast, before the global financial crisis, the index did not have a single day with a 2% or more movement in 2005, and only two days in 2006.

Market observers also documented higher correlations among individual stocks and between asset classes. In 2011, there were sixty-nine days in which 90% of the S&P 500 stocks moved in the same direction, which is more than the combined total for 2008 and 2009. Higher correlations are common during periods of uncertainty, as macroeconomic forces overshadow the impact of a company’s business fundamentals on its stock price.

Falling Commodity Prices

In early 2011, commodities soared with expectations of improving economic growth around the world. Copper, cotton, and corn hit all-time highs in the first half of the year. Crude oil experienced double-digit returns in response to anticipated higher demand and threats of supply disruptions tied to political unrest in the Middle East. The Dow Jones-UBS Commodity Index peaked in April, then fell 20% as the global economic outlook faded. The index returned -13% for the year—its first negative return since 2008. The most notable exception was gold, which set more records in 2011 and peaked at $1,888.70 per ounce in August before declining in the fourth quarter to return about 10% for the year.

Investor Risk Aversion

The fragile world economy made markets particularly vulnerable to shifting investor sentiment. During the year, investors reacted to uncertainty by moving to asset classes they deemed more stable, including large cap stocks and government bonds. Despite the Standard & Poor’s downgrade of the US credit rating in early August, investors fled to US government securities as concerns mounted over the sovereign debt crisis in Europe and political stalemate over the US debt ceiling.

2011 Investment Overview

Most global equity investors experienced negative returns in 2011. After a strong first-quarter start, developed equity markets grew more volatile in response to discouraging news on the economy and sovereign debt crisis. Despite a brief rebound in July and during the fourth quarter, most equity markets logged negative performance for the year.

The US stock market was one of the few developed markets to experience positive returns. The S&P 500 logged a 2.11% gain (dividends reinvested), and the Russell 3000 returned 1.03% for the year. Despite strong returns in the fourth quarter, developed and emerging markets logged negative returns, with thirty-seven of the forty-five countries that MSCI tracks posting losses. The MSCI World ex USA Index returned ­12.2% and the MSCI Emerging Markets Index returned ­18.4% for the year. Ireland and New Zealand were the only developed markets besides the US to end the year in positive territory. Indonesia was the only emerging market that ended the year with positive returns, and Egypt was by far the worst performer.

The US dollar fluctuated but finished about 3% above where it started against most developed-market currencies. It sharply appreciated against the main emerging market currencies, especially against the Indian rupee and the Brazilian real. This relative strength negatively impacted dollar-denominated returns of emerging market equities. The euro remained stable during the year even as analysts began predicting the dissolution of the currency zone, and the Japanese yen and the Australian dollar both gained against the US dollar.

Along the size dimension, large caps outperformed small caps in the US, non-US developed, and emerging markets. Value stocks underperformed growth stocks in the US, but mostly outperformed growth among emerging markets and had mixed results in developed markets.

In the fixed income arena, US intermediate-term government securities and TIPS performed exceptionally well, returning over 9.4% and 14.5%, respectively. Real estate securities in the US had strong positive returns and excellent performance relative to other US asset classes; in other developed markets, REITs had sharply negative returns but still managed to have good performance relative to other asset classes.

Quarterly Highlights

First Quarter

Despite natural disasters in Japan and other countries, increased political turmoil in the Middle East and North Africa, and rising commodities prices, world equity markets logged positive performance. Strong returns in January and February gave the US equity market its best first quarter since 1998. The broad US market gained over 6%, with all asset classes delivering positive returns. Investors were encouraged by improving economic data, especially in the labor market.

Overall performance in other developed markets was above average, although not as strong as in the US. Markets experienced divergent performance at the individual country level. Japan, which suffered a devastating earthquake and subsequent tsunami and nuclear crisis, had sharply negative returns for the quarter. Some of the worst performers in 2010—including Spain and Italy—were the top performers in the quarter. The US dollar lost ground against most major currencies except the yen, which helped the dollar-denominated returns of developed market equities.

Emerging markets had subpar but positive returns and trailed developed markets in the quarter. As in developed markets, there was much dispersion in the performance of emerging markets. Russia and other Eastern European countries performed exceptionally well in the quarter. The US dollar also lost ground against the main emerging market currencies in the first quarter, which contributed positively to the dollar-denominated returns of emerging market equities. Most fixed income securities had flat or slightly negative returns in the quarter. Inflation-protected securities, which had very strong returns, were the main exception. Real estate securities had strong returns in the first quarter and good performance relative to other asset classes.

Second Quarter

Despite weaker-than-expected economic data in the US, and Europe’s sovereign debt crisis, equity markets around the world were little changed in the second quarter. The broad US market was flat, and in US dollar terms, overall performance in other developed markets was slightly positive. As in most of the past few quarters, there was much dispersion in performance at the individual country level. Greece, which once again had to be bailed out by the European Union and the International Monetary Fund to avoid defaulting on its sovereign debt, had sharply negative returns for the quarter. New Zealand and core European countries such as Germany and France had strong positive returns.

The US dollar lost ground against all major currencies, which helped the dollar-denominated returns of developed market equities. Emerging markets had negative returns and trailed developed markets in the quarter. Indonesia and other small emerging markets in Asia did well. On the other hand, some of the largest emerging countries such as China, Brazil, India, and Russia had sharply negative returns and were among the worst performers. The US dollar also lost ground against the main emerging market currencies, which contributed positively to the dollar-denominated returns of emerging market equities. Most fixed income securities had excellent returns, especially inflation-protected securities. Real estate securities had strong returns and excellent performance relative to other asset classes.

Third Quarter

Equity markets around the world had their worst quarter since the end of 2008, as investors reacted negatively to the continuing sovereign debt problems in Europe, the budget stalemate in the US, and poor economic data in most developed countries and in some large emerging countries such as China. The broad US market lost over 15%.

In US dollar terms, overall performance in other developed markets was even worse, but that performance differential with the US was entirely due to currency fluctuations. Greece, which remained at the center of Europe’s sovereign debt problems, was by far the worst performer. At the other end of the spectrum, Japan, whose dollar-denominated returns greatly benefited from the strength of the yen, and New Zealand were the top performers. The US dollar gained against most major currencies except the yen, which hurt the dollar-denominated returns of developed market equities.

Emerging markets as a whole had similar performance to developed markets, but a strengthening dollar relative to the main emerging market currencies resulted in sharply negative dollar-denominated returns in most emerging markets. Peru and some of the smaller emerging markets in Asia did relatively well, while Russia and other European markets were among the worst performers.

Most fixed income securities had excellent returns. Despite Standard & Poor’s decision in early August to downgrade the credit rating of the US, investors rushed to the safety of US Treasury securities in light of weak economic data in the US and abroad, and especially among concerns about Europe’s ability to resolve its sovereign debt problems. Real estate securities had poor returns but good performance relative to other equity asset classes.

Fourth Quarter

Led by the excellent performance of US stocks, global equity markets posted strong returns in the quarter. Those returns, however, were not sufficient to overcome a dismal third quarter, and most markets had negative returns for the year. The quarter was also characterized by a sharp increase in volatility.

The broad US market gained over 12% in the quarter. In US dollar terms, the quarterly returns for developed non-US markets were over 3%—above the historical average but far behind the US. Greece, which remained at the center of Europe’s sovereign debt woes, was by far the worst performer in both the quarter and the year, while Ireland, the Scandinavian countries, and Australia were the top performers for the quarter.

The US dollar appreciated against major European currencies, which slightly hurt the dollar-denominated returns of developed market equities, and had mixed performance against the main emerging market currencies. In US dollar terms, emerging markets gained about 4% in the quarter, in line with the historical average, but not enough to overcome their poor performance of the third quarter. Malaysia and other smaller emerging markets such as Thailand and Peru posted double-digit returns. Turkey and Egypt had double-digit negative returns in the quarter.

Yields on Treasury securities across the whole maturity spectrum were little changed during the fourth quarter. With regard to credit risk, spreads between more- and less-risky fixed income securities generally became wider during the quarter. Real estate securities had positive returns in the fourth quarter but mixed performance relative to other asset classes. In the US, they were among the top performers, while in other developed markets, they trailed most other asset classes.

Russell data copyright © Russell Investment Group 1995-2012, all rights reserved. Dow Jones data provided by Dow Jones Indexes. MSCI data copyright MSCI 2012, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2012 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Citigroup bond indices copyright 2012 by Citigroup. Barclays Capital data provided by Barclays Bank PLC. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

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“And that’s how we rate mutual funds. Any questions?” the teacher asked. My hand shot up immediately. I had been recently hired by a popular investment rating company. While undergoing their training process, I was exposed to their faulty methodologies. They claimed to put investors first and I joined the firm for precisely that reason. But after a short period of time, I realized that their interest in helping investors was little more than a beautifully constructed façade.

I almost felt sorry for the teacher who had explained the company’s fund rating methodology. He wasn’t a manager or senior executive. He was just a regular employee who volunteered to teach the new hires. But one thing turned me flat out against him. A fellow new hire asked how well the fund ratings correlated with future returns. (In the interest of protecting the teacher’s identity, let’s call him Hermes.) Hermes responded, “Our users use it as if it was a predictive measure, but they do not correlate with future returns…and we never claim they do. We put it in the fine print at the bottom of the page that they do not predict future returns. Naturally, when we’re trying to pitch the rating system—well, we try not to mention that fact.” He laughed at his own humorless joke. Now, I felt no remorse. Now, I was no longer killing the messenger—he was an actor. He was a participant. And he found it funny that literally millions of investors used this rating system to their own detriment.

Finally, he called on me. I smiled a little bit. He didn’t know what he had coming. I had read several academic research papers examining our mutual fund rating system. All had shown it was a completely useless measure. And now, after seeing what it was based on—risk-adjusted returns against peers in arbitrarily chosen investment categories after literally dozens of studies have shown that a fund’s returns are uncorrelated from period to period—I was ready to roll over this guy.

“How can we use this measure that has been shown to deliver no value and effectively advertise funds that will end up destroying value for their investors? It’s useless.” I was being kind. It was not just useless. Something that destroys investors’ savings while lining the pockets of investment professionals is not simply useless but downright unethical. Hermes replied, “Well…I wouldn’t say it’s useless. We don’t claim it predicts future returns. If investors misuse it, we can’t do anything about that. It’s just a starting point.” I could’ve responded, but the eyes of the fourteen other new hires were all on me. I had already made a scene, so I just kept my mouth shut.

After the class, the woman who organized the classes spoke with me. She gave me two choices: stop asking questions or stop going to the classes and go back to work. I chose the latter. I immediately went to both my immediate supervisor and my boss to tell them what happened. They said my conduct was wrong and that I shouldn’t question the methodology. I said that what I did was right and refused to apologize. They sent me back to my cubicle to work, but I wasn’t about to give it up.

The next week, I set up a meeting with my boss. Let’s call him Sisyphus. Before meeting with him, I told a co-worker and friend what I was about to do. I told him I intended to challenge the system on the grounds that it hurt investors. He admired my courage but told me that I was playing a dangerous game. “The people who last here know how to play office politics, and that’s just an unfortunate fact.” “I don’t play politics. I do what’s right for the investors.” “Fine…just don’t get fired.” “I’d rather get fired than stand down.”

I left my friend and walked up to my boss’s desk. I jumped right into my argument. I told him that our mutual fund rating methodology was misleading. Our highest rated funds received huge cash inflows while our lower rated funds received cash outflows. We were a widely regarded firm, so I doubted this could simply be because our rating system was mostly performance based. Overall, our methodology was shown to be pretty mediocre. Sisyphus, of course, disagreed, replying simply, “It is a good starting point.” I asked angrily, “How can it be a good starting point if it does not predict future returns?” I spat out a thousand proven facts. At least 80% of actively managed funds underperform the S&P 500 in any 10 year period—and there are indexes that perform better than the S&P 500. If risk-adjusted returns are taken into account, funds lose out even more. Fund returns are uncorrelated, so distinguishing luck and skill is impossible. Not only is the rating system not a cure all, it’s not even a meaningful starting point. He replied naively, “People enjoy the act of searching for funds. If they have to pay thirty basis points to enjoy the act of finding an actively managed mutual fund, that’s fine. Hey, people pay for skiing.” I was floored. People pay for skiing. Apparently, the act of choosing an actively fund that loses out to an index fund is akin to skiing—highly enjoyable but with an acceptable price. And clearly, they were losing significantly more than 30 basis points, an unfortunate fact of which Sisyphus seemed quite ignorant.

I was told to get back to work, which I did, notably disillusioned from my experiences. An hour later, Sisyphus took me aside and told me that my employment was terminated. Of course, I expected it. But it was worth it. I asked briefly why I was getting fired. “You are very argumentative. This is something you should probably fix.” I nodded as I got up and left the office—one burden less on my conscience.

B1/8