Understanding the Hussman Funds
The Hussman Funds are diversified, no-load mutual funds for investors seeking long-term investment returns, with added emphasis on capital protection in unfavorable market conditions.
Each Fund varies its exposure to market fluctuations - from neutral to aggressive - based on the unique return/risk characteristics of each Market Climate we identify.
We use an ensemble of evidence to classify investment conditions, with "valuation" and "market action" being the most important considerations .
Favorable valuation means that security prices appear reasonable in view of the stream of cash flows expected in the future. While earnings are important, the simple fact is that stocks are not a claim on earnings. In order to provide for future growth, a portion of earnings is reinvested in capital that will depreciate away. A portion is diluted by grants of options to corporate insiders. A portion must be retained as working capital to support future revenue growth. Stocks are a claim on free cash flow - the portion of earnings that remains after all other claims have been satisfied. This free cash flow can be used either to pay dividends or to repurchase stock for the benefit of shareholders (reducing the number of shares outstanding and thereby increasing the ownership stake of existing shareholders). The higher the price an investor pays for a given stream of future cash flows, the lower the long-term return earned by that investor. The lower the price an investor pays for a given stream of future cash flows, the higher the long-term return earned by that investor.
Generally speaking, favorable market action means that trends are advancing across a wide range of market internals. Market action gauges aspects of market behavior well beyond obvious trends of major stock indices and also considers extremes in the duration and extent of prevailing trends. For this reason, market action may be graded as positive even when major stock indices have recently declined and, conversely, may be graded as negative even when major stock indices have recently advanced. Deterioration in our measures of market action typically imply that investors have become sensitive to risk, that their "sponsorship" of stocks is not robust (based on measures such as trading volume), or that price trends have become so overextended that the market is highly vulnerable to disappointment. When security prices are richly valued, concerns about risk can drive prices quickly lower. For that reason, the Funds place added emphasis on protecting capital when both valuations and market action are unfavorable.
We analyze the quality of market action, not the extent or duration of any particular advance or decline. We don't expose ourselves to risk just because, say, the S&P crosses its 50-day moving average. Market action conveys an enormous amount of information. Most of this is conveyed not simply by obvious trends, but in more subtle ways - particularly how various elements of market action diverge from how they would be expected to behave, given the surrounding context.
A few examples may be useful. Suppose you are given a series of numbers and are asked to calculate the average. If the current average is 25, and the next number you are given is 25, there is no new information in that (other than slightly strengthening your confidence in the existing average). But if the next number is 30, now you've got new information and your average changes. This new information appears because the new data diverged from what your previous information would have anticipated. Statistically speaking, information is always in the divergences.
Most investors understand that stock prices are more sensitive to surprises in earnings than to the actual earnings themselves. The same is true for market action.
Suppose that Treasury bond yields are falling, and corporate bond yields are also falling. In this case, the broad decline in yields is a fairly pure interest rate signal. But suppose instead that Treasury yields are falling but corporate yields are rising. That divergence contains important and useful information - generally about oncoming economic weakness and a rising probability of corporate debt problems. Likewise, if manufacturing stocks are advancing but transportation stocks are declining, the divergence could be a signal that inventories are building without an improvement in final demand, or perhaps that market participants are concerned about energy prices.
In short, market action involves more than just obvious trends in major averages. We strongly believe that market action conveys information held by millions of other traders - not only about broad economic trends, but also about their own personal situations (income improvements, job losses, risk preferences, etc). Market action distills all of this information in ways that cannot possibly be conveyed by government statistics. Our interest is in measuring this information content - to gauge the quality of market action, not simply to chase raw and obvious market trends that may or may not have run their course.
The term "Market Climate" and associated graphics are service marks of the Hussman Funds.
Each unique combination of valuation and market action produces a specific "Market Climate", with its own average historical characteristics of expected return and risk. The Prospectus of each Fund reviews these Market Climates in detail.
The intent of our approach is not to "predict" market direction. Rather, the intent of this approach is to classify prevailing investment conditions with those historical instances having the greatest similarity, and to accept those investment risks that we believe are expected to be compensated by high returns, on average, while attempting to systematically avoid, hedge, or diversify away those risks which have historically not been compensated.
A useful analogy is to think of the market as a hat with both positive and negative returns in it. Buy-and-hold investors in stocks essentially believe that those returns are in the 10-12% annual range, but that they can't be predicted. Market timers, on the other hand, do think those returns can be predicted, and spend most of their time trying to forecast whether the next draw from the hat will be a gain or a loss.
Very simply, we don't believe that short-term market direction can be consistently or reliably predicted. Instead, we believe that some market conditions may have a higher average return/risk tradeoff than others, and that these conditions can be identified in a disciplined way. It is virtually impossible to reduce that average behavior into reliably accurate forecasts for specific periods of time.
Our discipline does not require us to predict the future. Rather, we attempt to objectively identify the present. Our intent is to hold a position that is consistent with the Market Climate prevailing at any given time. The Market Climate is not a formula but a method of analysis. The investment manager has sole discretion in the measurement and interpretation of market conditions.
It is possible to sail a boat to any destination, simply by adjusting the sails to the prevailing wind. No forecast is required except a very weak belief that the direction of the next gust is not completely random. As a technical matter, we identify the Market Climate on a weekly basis (though we are willing to act intra-week if conditions warrant). It would be completely correct to say that we have a small, statistically insignificant, and unreliable forecast about market direction for the coming week, and no forecast beyond that. For practical purposes, we simply have no meaningful forecast of future market direction. Nor are such forecasts necessary.
To learn more about Dr. Hussman's academic research, please see Time Variation in Market Efficiency - A Mixture of Distributions Approach and Market Efficiency and Inefficiency in Rational Expectations Equilibria, both on the Research & Insight page of this website.
A Note on Discipline
We believe that like Warren Buffett and Peter Lynch, the most successful investors share a common trait: discipline. It is important for shareholders to understand that we place a rigid emphasis on disciplined strategy. We believe that the key to superior long-term returns is to take investment opportunities when the evidence suggests high return/risk tradeoffs on average, and to avoid situations when the evidence suggests low return/risk tradeoffs on average.
Unfortunately, what holds true on average may not hold true in any specific case. All of the Market Climates we consider may experience short-term returns which are both positive and negative. As a result, we may occasionally be defensive during rallies that occur in a negative Market Climate, and aggressive during declines that occur in a favorable Market Climate. These instances may include both small and large market moves. We may occasionally be underweighted in securities or industry groups that are advancing despite negative characteristics, and overweighted in securities or industry groups that are declining despite positive characteristics.
These instances should be expected from time to time. They may seem unfortunate, but they are not predictable. Though we certainly attempt to limit our risks through diversification, careful hedging, and appropriate position sizes, we do not attempt to "correct" short-term difficulties if we would have to ignore our strategy to do so.
It is important for shareholders to understand that we do not try to "time" specific market advances and declines, or alter our position based solely on adverse short-term movements.
Investment Practices and Risks
Because the Hussman Strategic Growth Fund normally invests most, or a substantial portion, of its assets in common stocks, the value of the Fund's portfolio will be affected by changes in the stock markets. In addition, the Fund may purchase and sell futures contracts on broad-based stock indices (and options on such futures contracts), and may purchase and write put and call options on such indices. The fund may also purchase and write call and put options on individual securities and shares of exchange-traded funds ("ETFs") and similar investment vehicles.
The Hussman Strategic Growth Fund has the ability to hedge market risk by selling short major market indices in an amount up to, but not exceeding, the value of its stock holdings. When market conditions are believed to be favorable, the Fund has the ability to leverage the amount of stock it controls to as much as 1 1/2 times the value of net assets, typically by investing a limited percentage of assets in call options.
The value of the Hussman Strategic Total Return Fund will be affected by changes in the value of the U.S. bond market. In addition, the Fund may use options and futures on U.S. Treasury securities in order to manage the interest rate risk of its portfolio, and may invest up to 30% of assets in alternatives to the U.S. fixed income market, including foreign government bonds, utility stocks, precious metal stocks, shares of real estate investment trusts ("REITs"), shares of ETFs and other similar instruments.
When market conditions are believed to be favorable, the Hussman Strategic Total Return Fund has the ability to hold as much as 30% of net assets in U.S. Treasury zero-coupon bonds and U.S. Treasury interest STRIPS, which exhibit magnified price movements in response to interest rate changes.
The Hussman Strategic International Equity Fund invests primarily in the equity securities of foreign companies and U.S. companies that conduct significant activities or have significant assets outside the U.S. Accordingly, the value of the Fund will be affected by changes in the local value of international stock markets as well as fluctuations in foreign currencies versus the U.S. dollar. Investments outside the U.S. may also be affected by economic and political developments, differing regulatory environments, trading schedules, differing accounting standards, uncertain tax laws, and generally higher transaction costs in foreign markets. Foreign markets can be more volatile than U.S. markets.
In addition, when market conditions are unfavorable in the view of the Investment Advisor, the Hussman Strategic International Equity Fund may use swaps, index options and index futures to reduce its exposure to general market fluctuations or to market fluctuations within a specific country or geographic region.
While the intent of these strategies is long-term capital appreciation and preservation of capital, the investment return and principal value of the Funds may fluctuate or deviate from overall market returns to a greater degree than other funds that do not employ these strategies. An investor's shares, when redeemed, may be worth more or less than their original cost.
Read our Prospectus
The Prospectus of each Fund contains more information in a detailed, easy-to-read format, including information about fees and expenses. You can learn more about our research and market perspectives in the Research & Insight area of this website.
We consistently attempt to position the Funds in line with the prevailing Market Climate. So regardless of current market conditions, we believe that now is a good time to invest in the Hussman Funds. Account Applications for the Funds can be downloaded online. These materials may also be obtained by calling us at 1-800-487-7626.
Thank you for your interest in the Hussman Funds. We look forward to being a valuable and disciplined part of your investment program.
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