Volume 58: To submit a question to MFI's panel of experts, please write to us.

This week's panel:

Frank Armstrong Frank Armstrong is author of Investment Strategies for the 21st Century, published here, and president of Managed Account Services, Inc., a fee-only advisor specializing in global asset allocation strategies utilizing no-load mutual funds. Frank is a Certified Financial Planner (CFP) with 24 years' experience helping investors build wealth. The firm, an SEC Registered Investment Advisor currently manages in excess of $60 million for over 140 clients worldwide. Visit Frank's Managed Account Services, Inc. for more information about the Alternative to Business as Usual on Wall Street or call 1-800-508-8500.

Greg Hilton Gregory Hilton is a Fee-Only® financial planner in the heart of Chicago. He is an attorney with a masters degree in taxation, a CPA, and a certified financial planner (CFP). Although his services are comprehensive he concentrates on the tax and investment issues of retirement and estate planning. His registered investment advisory is Cambridge Consulting, 500 N. Michigan Ave. – suite 1530, Chicago, IL 60611 (312)527-5171 E-mail: cc@cambridge.cnchost.com

Questions and Responses

• Do "beat the Dow" strategies work?
• How do distributions affect the value of my fund shares?
• Have large caps historically beaten small caps?
• What funds can protect me against a devaluation of the dollar?

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Do "beat the Dow" strategies work?

from William

Q: Do you have an opinion on the various beat the dow strategies? Some of them at least seem to have better returns  than the S&P 500, even considering (admittedly an imprecise calculation) taxes from the yearly reallocation.

A (Frank): The various Beat the Dow or Dogs of the Dow Strategies are all variations of value investing. Low price and high dividends are all characteristics of Value.

Over time, other credible research shows that value should handsomely beat growth style by a wide margin. Of course, nothing works every day or every year. We should expect years of underperformance along with a cumulative higher return. So, like every other investment strategy it takes a certain amount of discipline to achieve the results.

However, as usually described, the strategy is restricted to just a 30 stock universe of the largest companies in the US. In fact, value investing works in just about every market in the world for stock of all sizes. A Dogs of the S&P, or a Dogs of Nasdaq, or a Dogs of EAFE should all provide a higher return without additional risk (at least if you measure risk by standard deviation of returns).

I can't recommend the various Unit Trusts being sold by the brokerage houses. The expenses and commissions are far too high. Then there is the problem of 100% turnover generating tax events each year. In stead, I would recommend a value index strategy as more effective, lower cost, lower risk and lower turnover which means lower tax bills.

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How do distributions affect the value of my fund shares?

from Kris

Q: Can an individual or a retirement plan sell their mutual fund shares on the date of record (say a Monday) and still reap the rewards of the the cap. gains distrib. without suffering the decrease in the NAV because they no longer own the shares on the payment date?

Also, I notice on Ameritrade's statement that when buying a fund, the NAV is figured "as of trade date" but the trade date is actually one day later. How does this affect scenario above?

A (Greg): Yours is a common question and source of misunderstanding so let's get elementary. Your mutual fund shares are priced daily at net asset value (NAV). This is the total value of all the fund's securities, minus the liabilities, divided by the shares outstanding. Every year you receive a pro rata share of the dividends and profits that the fund received via its ownership of underlying assets. Funds that invest in common stocks generally make distributions once a year - which you can look up on the internet.

If you buy just before a distribution (which is usually in December) you are buying yourself a tax liability. It works like this: a fund is worth $10 a share before a distribution and $9 dollars after a $1 distribution. If you owned the stock at the time of that distribution you will have to pay tax on that $1. Conversely, if you sold the fund before the distribution you will get $10 per share and no tax liability (except to the extent the fund share itself performed). It pays to watch the distribution dates and sell/buy accordingly.

To answer your question more directly, you benefit from mutual fund ownership through increasing NAV's not through cap gain distributions. Regardless of when you placed the order or when your broker recorded the order, your values (and gains and losses for tax purposes) are calculated during the time you owned the asset - i.e. the "trade date".

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Have large caps historically beaten small caps?

from Dan

Q: I recently saw an article debunking Benz's 1981 conclusion that small caps beat large caps in the 1931-74 time period. Have you seen this article and, if so, has it altered your opinion on asset allocation involving small caps?

A (Frank): It's too early to dump all of our small cap stocks. The jury is still out on the paper, and there are a number of other papers that find a significant small cap premium.

However, the paper that provoked all the fuss, "The Delisting Bias in CRSP's Nasdaq Data and Its Implications for the Size Effect" (Tyler Shumway & Vincent Warther), will likely cause quite a fuss in academic circles. (The paper, not yet published, is available at the Journal of Finance site.)

The debate should be of more than just passing interest to all investors. The authors claim that the survival bias built into the Center For Research in Securities Prices (CRSP) database are so large that when returns are adjusted for the error there is no small cap premium!

Huge egos and reputations are at stake. The CRSP database is widely used by academics and institutions in part because it is supposed to account for survivor error. Access to the database costs big bucks. CRSP is associated with the University of Chicago, widely considered the premier Economics and Finance school in the world.

If the error in the CRSP database is as large as described, almost every research paper and institutional project that uses the database will have to be re-visited. For instance, the Fama-French three factor model would be in serious trouble. This model has been widely adopted to replace CAP-M as the best explanation so far of securities pricing and expected returns. Gene Fama, co-author of the model and considered one of the most influential financial economists, is closely associated with CRSP. He should certainly be aware of any survivor bias built into the system. Again, assuming that the error is as large as claimed, he would then have committed the academic's equivalent of a pilot landing with the gear up. No matter how hard you look at it, it's still one of life's embarrassing moments.

This issue won't be resolved any time soon. We haven't even heard from the other side. At this stage we can only say that the first serious shots have been fired in what will likely be a long campaign. Academics love this stuff. It gets their blood boiling.

In the worst case, all of us will want to re-evaluate and possibly reduce our small cap exposure. After all, who would take all that extra risk if they didn't expect a significant increase in return? We will all want to have some small caps because of the diversification benefit, but large exposures will not be optimum. Meanwhile, nobody is saying that small caps have less return than large, or that they aren't a valid separate asset class.

This is an important issue. But, for now, I'm holding off making any changes until more data comes in and the issue becomes clearer. One paper does not settle the question.

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What funds can protect me against a devaluation of the dollar?

from Forrest

Q: I'm trying to find funds that will protect against a devaluation of the dollar, specifically, a fund heavily invested in the currencies of the countries that will participate in the European Monetary Union as of January 1.

So far, all I've come up with is the Franklin-Templeton Hard Currency Fund with 77% in Europe, including 37.4% in the German Mark and 39.8% in the Swiss Franc (the franc, which won't be tied to the euro, is nevertheless partially backed by gold).

Any recommendations or ideas ?

A (Greg): Whether you make money overseas is going to depend upon two factors 1) how well those foreign markets perform and 2) the direction the U.S. dollar moves. I would protect myself against the first factor by investing in big, diversified international funds. The second factor, valuation of the dollar, is going to depend upon comparative rates of inflation and the direction each country's interest rates are moving.

I like the idea of investing abroad to catch other countries' business cycles but the effects of currency cycles, that you are attempting to ride, roughly cancel each other out in the long run. If you are insistent upon making currency bets I would much prefer T Rowe Price's Emerging Markets Bond Fund (which is roughly half bond and half currency) or a little fund called Compass International (which is predominantly currency). Unlike the fund you mention, these funds carry no loads and are much better rated.

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Important Disclaimer

Investing in equities involves a serious principal risk, and no assurance can be given that the techniques described here will be successful. Returns vary and you may have a gain or loss when you sell your shares. Past performance is no guarantee of future results. Index returns shown are historical and include the change in share price, reinvestment of dividends, and capital gains. Indexes are unmanaged and do not reflect the impact of transaction costs. Transaction costs would have reduced the total returns.

International investments, especially those in emerging markets, entail greater risks (as well as greater potential rewards) than U.S. investing. These risks include political and economic uncertainties of foreign countries, as well as the risk of currency fluctuations. These risks are magnified in countries with emerging markets, since these countries may have relatively unstable governments and less-established markets and economies.

Lastly, the questions and responses set forth here are for general informational purposes only and are not intended to substitute for performing your own independent research or contacting your financial or legal professional before making any investment decisions. We make no guarantees as to the performance of any investment strategy you choose and are not responsible for any losses you might incur.

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