Some of the world’s best fund managers are hoping for a September to remember in terms of performance, following dismal investment returns in August.

Several prominent professionals with excellent track records, including Bruce Berkowitz, Morningstar’s stock fund manager of the decade, and bond king Bill Gross, have posted disappointing results year-to-date.

Even hedge fund master-of-the-universe John Paulson appears to have lost his magic touch this year, which is a sobering reminder of how unexpected and intense volatility can undermine even the most disciplined long-term investment strategies.

Bruce Berkowitz of the Fairholme Fund was anointed domestic equity fund manager of the decade last year by Morningstar after his value fund posted a 10-year annualized return of 13.2 percent, compared to an average gain of just 0.1 percent for the fund’s peer group.¹

However, market forces haven’t been kind to Berkowitz this year. The Fairholme Fund is down 26 percent year-to-date, ranking it dead last out of 311 other mutual fund managers in its category.²

Likewise in 2010, Bill Gross was recognized as fund manager of the decade by Morningstar in the fixed income category. The Pimco Total Return Fund he manages notched average returns of 7.7 percent per year over the last 10 years.³

But Mr. Gross also appears to have lost his magic touch this year, with his fund trailing its benchmark by a wide margin, although still up 3.8 percent year-to-date in a tough market. The Pimco Total Return Fund is ranked 501 out of 584 similar bond funds so far in 2011.⁴

Perhaps no fund manager has suffered a bigger reversal of fortune … including to his own personal wealth … than John Paulson.

Heralded as one of the best and brightest hedge fund masters — thanks to big gains he delivered during the financial crisis — Paulson earned acclaim and billions for his hedge fund investors by essentially selling short subprime mortgage-backed securities in 2008.

He then compounded this success by correctly turning bullish on beaten down financial stocks. In 2010, Paulson made more than $1 billion in gains as shares of Citigroup, one of his largest holdings, rose 43 percent. But so far in 2011, Paulson’s $35 billion Advantage Plus fund has plunged almost 40 percent in value through mid-August, according to investors.⁵

It’s Not Just the Mighty Who Have Slipped

You could chock-up this reversal of fortune as another cautionary tale about the dangers of mean reversion … the first shall be last. Everyone seems to notice when the mighty fall from grace. But this short-term underperformance by some of the world’s best money managers is also a sign of just how turbulent the investment world has become.

According to a Financial Times article, it’s not only the masters of the universe who have been humbled … “everyone has struggled, with two-thirds of managers of stock funds failing to beat the S&P 500 index benchmark in the past three years.”⁶

Pick up any newspaper or tune your TV to CNBC for more than a few minutes and you’re likely to be bombarded with the latest negative news about the economy, financial markets, and/or both at the same time. The sense of doom and gloom seems pervasive with so much uncertainty about the economy, the sovereign debt crisis in Europe and politics as usual in Washington.

But it’s also important to remember that every downturn is, in time, followed by a recovery. The silver lining of any market decline is the wealth created by taking advantage of long-term opportunities often found during turbulent times. Let’s take a closer look at opportunities in two prominent asset classes, stocks and bonds.

Opportunity for Stock Investors: Rather than spending too much time thinking about what could go wrong, investors should also focus on what could go right.

In the event that fears of a double-dip recession in Europe or the US are realized, we think it already has been largely priced in with the S&P 500 down over 17 percent from its peak in May.

In fact, a look back at historical market data shows that investors may not have as much to fear from falling share prices during a recession. Markets are discounting mechanisms. Typically, stocks peak before a recession starts and also begin to recover, often rallying sharply, before a recession has officially ended.

The typical bear market decline in stocks averages about 18 percent peak-to-trough over roughly a one-year period. Of course, there have been declines more severe than “average”, but there have also been plenty of market declines that were milder than what we’ve experienced this year.⁷

By the time we’re “officially” in recession, the S&P 500 has only declined 7.2 percent on average over the next six months.⁸ And one year after the recession low, stocks have typically gained back any lost ground and more — with an average gain of 42 percent over the next 12 months.⁹

In other words, we believe the worst damage to share prices has already been done. For long-term investors, we see more upside potential for stocks than downside risk at this point.

In our Banyan core equity portfolios we feel the probability for recession — which we still view as long odds — has already been discounted by the market at today’s levels. If we enter a recession, the worst may already be over. And if we avoid the dreaded double-dip … current share prices could be viewed as a bargain and stock values could experience significant appreciation.

Opportunity for Bond Investors: The bond market may have similarly overreacted to the perception of economic weakness and possibility of recession. Focusing too much on Armageddon scenarios has a way of doing that to markets. Just as bond markets were priced for perfection just a few months ago when 10-year Treasury yields were near 4 percent, today Treasuries seem to be priced for a near certainty of recession with yields falling below 2 percent recently.¹⁰

Of course, if the economy continues to struggle, bond yields could stay low or move even lower, but the recent rally in Treasury bond prices could also create an opportunity to rebalance your portfolio.

If you’re too heavily invested in long-term government bonds, this rally may present an excellent opportunity for you to take some profits, shorten the maturity of your holdings, and reinvest in higher-yielding securities, such as corporate or international bonds (or bond funds). Just keep in mind that investing in these securities can carry additional risk (credit, currency, political, etc.), but a well-diversified bond portfolio can also help boost your yield and also serve as a good hedge against market uncertainty.

Don’t Let Volatility Disrupt Your Investment Plan

We have not changed our view in believing we can still avoid recession. Even with recent weakness in the data, we expect the economy to muddle through with slow, uneven growth (GDP in the 1-2 percent range) without a steep economic contraction.

Remember, the distinction between a full recession and a slow-growth economy can make a meaningful difference in the upside potential for stocks, now that it seems like recession has already been priced into the market.

Even if we fall back into recession, we won’t find this out until well after the fact anyway. If that’s the case, most of the stock market correction may have already taken place by that point with more upside potential than downside risk ahead.

As a result, we are selectively looking for opportunities in the stocks and sectors that have performed well during recent market volatility. For instance, we have our eye on select technology companies like Apple (Nasdaq: AAPL), which is a globally dominant business with tremendous cash flow and rock-solid balance sheet. Several leading health care and consumer brand giants also appear attractive at today’s prices, including Covidien (NYSE: COV), a leading global medical device company.

Markets have been intensely volatile all summer, which has certainly disrupted the investment strategies of the world’s best money managers. Still, we seriously doubt investors with great long-term track records like John Paulson, Bruce Berkowitz and Bill Gross have suddenly lost their way. Instead, we believe this uncertainty and the turbulence that goes along with it has created a short-term disconnect between perception and reality.

This also creates new opportunities for attentive investors. Once these uncertainties are resolved, the gap between perception and reality should close, but by that time, the opportunity may be gone. At Banyan, we stand ready to be opportunistic.

Good investing,

Mike Burnick
Director of Client Communications
Banyan Partners, LLC

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¹ Financial Advisor: Morningstar’s Fund Managers of the Decade, 1/13/10
² Morningstar data, 9/2/11
³ Financial Advisor: Morningstar’s Fund Managers of the Decade, 1/13/10
⁴ Morningstar data, 9/2/11
⁵ Financial Times, Not so happy returns, 8/29/11
⁶ Ibid.
⁷ ValueScope Inc.,: Stock Market Performance During and After Recessions, 2009
⁸ Fidelity Investments (MARE): Tactical Handbook of Sector Rotations, 8/23/10
⁹ American Funds: Three lessons to learn from market volatility, 9/7/11
¹⁰ Bloomberg market data, 9/7/11

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Banyan Partners and the advisory accounts that we manage may have positions in the securities mentioned in this report and may purchase or sell such securities without notice.  The aforementioned investments may not be appropriate for all investors and past performance is no guarantee of future results.  Investors must make their own decisions based on their specific investment objectives, risk tolerance, and financial circumstances.

This commentary is not a complete analysis of every material fact with respect to any company, industry or security mentioned in this report. This report is solely for informational purposes and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy.

The discussion of historical mutual funds returns is for illustrative purposes only.  Investors also should consider such factors as fund performance against an appropriate benchmark and against other peer funds, across various investment periods (1 year, 3 year, 5 year, 10 year), as well as management fees and tax implications.  Past performance is no guarantee of future performance.