Classic financial planning says that investments in both the stock market and real estate are the keys to building long-term wealth. The implication is that both these assets outperform inflation and should be invested in steadily over time. The popularization of this concept among the American middle class, and the common method for applying it that involved investing a certain amount ($50, $100, $1,000, etc.) month in and month out, fueled the rapid growth of no-load mutual funds. The “trading” restrictions on these investment vehicles only further bolstered buy-and-hold’s popularity.
Now, however, with stocks and real estate in turmoil and most investors convinced that buy-and-hold is a fool’s game, investment companies are loosening their restrictions. Many fund families, such as Rydex, have no redemption fee. This means they can be used for market timing because they don't have any penalties for active trading. Exchange-traded funds (ETFs) have made “active investing” even more accessible. If you’re so inclined, there are now ETFs that are both positively and negatively correlated with the S&P 500, Treasury bonds and even sectors such as currencies, precious metals and energies.
In 2008, seven years of stock market gains were lost. Century-old financial monoliths went bankrupt. Terms such as “dollar cost average” have become anathema. Following this historic shift, a review of the previously unassailable buy-and-hold approach is in order, along with some suggestions of what should come in its wake.
A HUMBLE BEGINNING…
The popularity of buy-and-hold increased in earnest in the mid-1960s, perhaps culminating with the landmark paper “Efficient Capital Markets: A Review of Theory and Empirical Work” by Eugene Fama Sr. in 1970 and the book “A Random Walk Down Wall Street” by Burton Malkiel in 1973. However, the roots of the concept were hardly new.
French mathematician Louis Bachelier, who later gained notoriety for his work in Brownian motion, published papers in the early 1900s and concluded that “past returns have no predictive value on future returns. Both were statistically independent.” The concept of Wall Street stepping to the beat of a “random walk” was born.
Half a century later, British statistician Maurice Kendall (1953), the University of Chicago’s Harry Roberts (1959), along with Fama, showed evidence of “statistical independence” in stock returns and the “nil predictive power” of various techniques of “chartists.”
Paul Samuelson and Benoit Mandelbrot demonstrated a decade later that such randomness could co-exist with a link between fundamentals and stock price, explaining that such randomness in returns is expected from a well-functioning stock market: “Investment in stocks is a fair game.” The “fair game” concept is that today’s stock price (with all available information) reflects the expectations of investors. Therefore, tomorrow’s price should change only if investors’ expectations change, which should be randomly positive/negative as long as investors are unbiased. This is the core of the Efficient Market Theory (EMT).
EMT was not universally accepted, however.
In 1980, Sanford Grossman and Joseph Stiglitz argued that an extremely high level of market efficiency is internally incompatible as it disallows the profitable opportunities that motivate security analysis to produce information. In addition, market “frictions,” they said, limited market efficiency and the level of efficiency differed across markets, depending on costs of analysis and trading.
Further, by the late 1970s and early 1980s, inconsistencies such as seasonal tendencies became apparent. For example, one involved the likelihood that small-capitalization stocks accelerated in value in January. Arguments against these tendencies included one that this “January effect” was a premium necessary to compensate investors in small stocks, which tended to be illiquid at the turn of the year.
Research on long-term returns further challenged EMT. In 1981, Robert Shiller pointed out that stock index returns were over volatile relative to aggregate dividends, and in 1985 Werner DeBondt and Richard Thaler showed that over the long term, stocks tended to overreact. The following year, Lawrence Summers showed that prices could take long, slow swings away from fundamentals, which would be undetectable with short-horizon returns.
For the most part, these arguments rarely escaped the Ivory Towers in which they were conceived. Perhaps it has been the market itself, without the aid of academia, that has made the best argument against buy-and-hold. Few would agree that such extreme “six-sigma events” as the 1987 stock market crash, the Internet bubble and the most recent stock market slide, occurring within the relatively short period of two decades, are consistent with the random-walk theory. Even if these events can be rationalized, the truth is today’s investors are not comfortable with buy-and-hold. They are looking for a different way.
ENTER THE ETF
Thankfully, the demise of the passive stock investment strategy has been accompanied by the growth of an investment vehicle that lends itself perfectly to active investment: ETFs.
An ETF is traded on a stock exchange much like a stock. It holds the underlying assets over the course of the trading day to equal the dollar value for the number of outstanding shares. Most ETFs track some underlying index/instrument. They are taxed like stocks and if held long term are taxed as capital gains.
An ETF combines the valuation feature of a mutual fund with the tradability of a stock. You can enter and exit on stops, limits and trade them intraday. ETFs have been available since the early 1990s, and in the past few years, their number has increased dramatically. While ETFs have long been based on indexes, in 2008 the U.S. Securities and Exchange Commission allowed the creation of “actively managed ETFs.”
Although ETFs require you to spend money on commissions to buy and sell, they have a lower expense ratio than most mutual funds. Moreover, you can hold ETFs for any period you want without any penalty. This is unlike mutual funds, where you get penalized if you liquidate before a specific time period.
There are positively correlated ETFs, negatively correlated ETFs (which are particularly beneficial since you can’t short stocks in an IRA) and leveraged ETFs. There is an ETF for almost every sector, such as currencies, metals, energies and livestock.
In addition to providing an excellent vehicle for self-directed active investing, ETFs have opened up an evolution in managed investments. These managed accounts, run by registered investment advisors, charge only a management fee (typically 2% or less) and trade your account for you. Many of these investment advisors used to buy managed mutual funds for the clients. The new breed is instead using well-tested strategies to trade baskets of ETFs.
One example is Tuttle Wealth Management of Stamford, Conn. According to Matthew Tuttle, the problem with mutual fund managers was their strategies were not transparent. ETFs are transparent by design and lend themselves perfectly to what he describes as tactical asset management. Another firm in this same vein is Select Advisors in Exton, Pa. It is a clearinghouse that licenses trading strategies from third-party developers and trades your accounts with those strategies for a management fee.
STRATEGIC INVESTING
We can develop a basic trading system for the S&P 500 using signals generated on the cash index to trade the ETF SPY (or “Spyder”) on the long side and the ProShares Short S&P 500 fund (SH) on the short side.
One simple system would use intermarket analysis to outperform a traditional buy-and-hold approach. We could rely on a classic relationship between the long bond futures and the S&P 500. Basically, when the S&P 500 is in a downtrend and T-bonds are in an uptrend, buy SPY. When the S&P 500 is in an uptrend and T-bonds are in a downtrend, buy SH. To detect the trend, we could use a six-day moving average for the S&P 500 and a 16-day moving average for T-bonds.
Unfortunately, SH has only been traded since 2006. However, we can still see how the results for just the long side of the market – that is, trading SPY – compare to buy-and-hold. From May 1, 1998, to Nov. 7, 2008, we get the results shown in “Buy and sell.”
During this period, the strategy made 16.52 points. The first trade on July 24, 1998, had an entry price of $114.97. On Nov. 7, 2008, the market closed at $93.86. Clearly, the strategy greatly outperformed buy-and-hold during this period.
The world is changing. The Federal Reserve is trying everything possible to prop up the banking system by lowering rates and pumping liquidity into the markets. This is dramatically increasing our national debt. However, unless banks loan that money out to customers, we will have low interest rates without the benefits. This is the same scenario that has hamstrung Japan for more than a decade.
Unless we return to the heyday bull markets of the 1950s-60s and 1980-90s — a highly unlikely scenario — then America’s middle class will need to find a new place to store its nest egg. The answer may be a new philosophy and a new investment vehicle to go with it. The era of buy-and-hold is over. That of active investing has begun.
Murray A. Ruggiero Jr. is a consultant. His firm, Ruggiero Associates, develops market timing systems. He is the author of “Cybernetic Trading Strategies” (Wiley). E-mail him at ruggieroassoc@aol.com
