Five star fund: Morningstar has given the Hussman Strategic Growth Fund its highest rating of 5 stars for 3-year and overall performance as of 7-31-03.
Top in return per unit of risk: According to Morningstar data as of 7-31-03, the Hussman Strategic Growth Fund achieved the highest Sharpe (return/risk) ratio of any U.S. equity fund (ex-specialty) covered by Morningstar for the preceding 3-year period. The Sharpe ratio is an annualized measure of total return, over and above Treasury bill returns, per unit of risk as measured by the annualized standard deviation of Fund returns. The Sharpe ratio of HSGFX, as reported by Morningstar, was 1.47. The Fund had the only ratio above 1.2 among U.S. equity funds (ex-specialty), and was one of only 5 funds in this group with a 3-year Sharpe ratio above 1.0.
Lower expense ratio: Finally, I am pleased to report that due to the achievement of additional fee breakpoints and other economies, the expense ratio of the Hussman Strategic Growth Fund has been reduced again - this time to 1.40% as of August 11, 2003. According to Morningstar data, the average expense ratio for funds in the same category is 1.45%. The expense ratio of the Fund is affected by a number of factors, including the total amount of net assets of the Fund, and may change over time.
Additional information on the Morningstar Rating (tm) is at the bottom of this update. Standardized performance figures as of the quarter ended June 30, 2003 are also provided in other updates on this page.
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The Market Climate for stocks continues to be characterized by unfavorable valuations and moderately favorable trend uniformity. However, there have been enough blemishes in recent market action to move the Hussman Strategic Growth Fund to a 60% hedged position on last week's market advance.
It is important not to misinterpret this position. We continue to be aligned primarily to earn returns from market advances. However, potential market risks have steadily increased, based on our reading of market action. So we have taken the opportunity created by the recent advance to modestly reduce the sensitivity of our portfolio to market fluctuations.
As I've noted before, the two most frequent questions that run through my mind in the day-to-day management of the Funds are "What is the opportunity?" and "What is threatened?" In any aspect of life, be it investing, parenting, relationships, electricity grids, or international politics, when one is forced to react, it is often because one has already missed several opportunities to respond. Our obligation is to observe reality clearly, and to respond to opportunities before we are forced to react to crises. To be observant, to deeply understand, to act on principle, and to always look for chances to improve the situation - these are the best ways to mitigate threats to what we value.
Abrupt events such as last week's power outage also allow us to discuss the benefits and limitations of our investment approach. One of the striking aspects of market history is that the market's response to various events seems to be strongly conditioned by the condition of valuations and trend uniformity when those events have taken place.
Historically, major market crashes (1929, 1987, as well as numerous, less memorable plunges like 1962) invariably occurred after the market had entered the most unfavorable Climate we identify: unfavorable valuations and unfavorable trend uniformity. Indeed, what investors identify as the 1929 and 1987 crashes each occurred after the major indices had already experienced persistent declines of about 14%.
In my view, there is a clear analytical reason for this. Very few events have historically had a significant impact on the long-term stream of cash flows that could be expected from equities. Clearly, deep recessions can affect near-term cash flows, but for a security whose price is based on a discounted stream of cash flows over a period of many decades, the impact of a recession is actually quite small. The primary factor behind market crashes is not a reduction in future cash flows, but a spike in the risk premium demanded by investors. The impact of these spikes on stock prices is greatest when 1) risk premiums are very thin, and 2) investor preferences to accept risk are very weak. In our discipline, these are synonymous with 1) unfavorable valuation and 2) unfavorable trend uniformity.
Several years ago, a colleague at the University of Michigan produced a piece of research showing that an investor missing even a relatively small number of outstanding market periods would have earned very disappointing long-term returns. This was followed by counter-arguments noting that sidestepping even a relatively small number of weak market periods would have resulted in unusually strong market returns. Which view is correct?
As I note in Time varying market efficiency - a mixture of distributions approach, this issue can be quickly resolved by examining combinations of valuation and trend uniformity. For proprietary reasons, the paper uses a simple, even naive, set of criteria to define valuation (S&P 500 dividend yield high or low) and trend uniformity (position of dividend yield, T-bill yield and 10-year bond yield above or below their levels 26 weeks earlier, 2 of 3 defining the status). Yet the results are still very powerful. Looking at the best 30 market weeks since 1940, the clear majority of these strong returns occurred in conditions of favorable valuation. In contrast, the weakest 30 market weeks predominantly occurred in conditions of unfavorable trend uniformity.
Notice what this implies. The Climate with the largest number of strong weeks and fewest poor weeks is characterized by favorable valuations and favorable trend uniformity. The Climate with the smallest number of strong weeks and largest number of poor weeks is characterized by unfavorable valuations and unfavorable trend uniformity. The Climate with the fewest of each, and therefore the least volatile Climate, is unfavorable valuations, favorable trend uniformity. Finally, the Climate with the greatest level of volatility is favorable valuation and unfavorable trend uniformity. Interestingly, these general characteristics, derived simply by looking at outlier returns, also hold in historical data for the remaining periods, on average.
So while I don't believe that the market's return in any specific period can be predicted with any accuracy at all, I do believe that the relative probability of large advances and declines is influenced by the Market Climate in effect.
Of course, none of this can eliminate the basic fact that financial markets have risk. The acceptance of calculated risks is an essential fact of investing. Though we believe that the theoretical and historical evidence for our approach is sound, there is no assurance that market declines - even substantial ones - will not emerge during Market Climates that we define as favorable. Still, the historical tendency is for unusual market declines to occur during periods of unfavorable trend uniformity, particularly when valuations are unfavorable.
Market action reflects the trading of millions of investors, acting on their own risk preferences, information, and personal circumstances. As a result, market action conveys information that cannot possibly be captured in government statistics. In many instances, unfavorable market action contains the signal that "something is wrong" - a signal that often precedes unfavorable events. In other instances, such as the recent power outage, unfavorable events happen without notice. Still, market action provides useful indications about investor's attitudes toward risk, and therefore, indications about how strongly investors are likely to respond to these events.
The world will always have uncertainty and risk. We don't claim to remove those features from investing. Instead, we attempt to manage them effectively. As always, we align our investment positions and our expectations about the economy with the prevailing Market Climate.
In bonds, the Market Climate continues to be characterized by modestly favorable valuations and modestly favorable trend uniformity. We added a few percent to our holdings of long-term Treasuries in the Strategic Total Return Fund on the recent decline in bond prices. Our overall portfolio duration remains below 7 years; that is, a 100 basis point change in interest rates would be expected to impact the value of the Fund by less than 7%.
Morningstar rated the Hussman Strategic Growth Fund among 185 Mid Cap Blend funds for the overall and 3- year periods ending 7-31-2003, respectively. For funds with at least a 3-year history, a Morningstar Rating(tm) is based on a risk-adjusted return measure (including the effects of sales charges, loads, and redemption fees) with emphasis on downward variations and consistent performance. The top 10% of funds in each category receive 5 stars, the next 22.5% 4 stars, the next 35% 3 stars, the next 22.5% 2 stars, and the bottom 10% 1 star. Each share class is counted as a fraction of one fund within this scale and rated separately. The Overall Morningstar Rating(tm) is derived from a weighted average of the performance figures associated with a fund's 3-, 5-, and 10-year (if applicable) Morningstar Rating(tm) metrics. Past performance is not a guarantee of future results. Fee waivers and reimbursement of fund expenses by the Adviser, which capped the Fund's expense ratio at 2%, positively impacted the Fund's total return. As of 7-31-2003, the Fund's expense ratio was 1.45%, and such fee waivers were no longer required.
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