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  • Tadas Viskanta

    The Mirage that is Financial Literacy

    By Tadas Viskanta

    At present, the major stock market averages are hitting new all-time highs. So from outward appearances it would seem that many middle class Americans would be benefiting from this recovery from the financial crisis. Unfortunately you would be wrong. Currently the smallest percentage of Americans since 1999 are invested at all in the stock market. If anything, the rebound in the stock market only highlights the cracks in the personal finances of Americans that were exposed by the housing bust and subsequent financial crisis.

    The booming stock market aside, there is a growing realization that the retirement system that we have put in place is not working. When Larry Fink the head of the world's largest asset manager, Blackrock Inc., comes out in favor of additional mandatory savings and takes to task the asset management industry for selling products as opposed to solutions, you have to think that there is something afoot.

    Pound FoolishThat hope is difficult to find in the recently published, Pound Foolish: Exposing the Dark Side of the Personal Finance Industry by Helaine Olen.* The book is well worth a look as Olen takes to task pretty much the entire personal finance industry. Industry is in fact a good word to use because it highlights the fact that everyone providing the American public with financial advice is in some real way profiting from that advice. In short, caveat emptor.

    That means you need to take everything you hear from the personal finance industry with a big grain of salt. While much of what personal finance gurus say is either wrong or exaggerated, there is still a great benefit to learning manage your own finances. As Olen writes:

    To be clear, I'm not arguing that all financial advice is useless.  Understand and controlling our own money is among the most empowering activities we can undertake.

    There are plenty of villains in Olen's book and few (if any) heroes. A certain class of personal finance gurus come under scrutiny by Olen. After chronicling the rise of personal finance as a legitimate news topic Olen goes on to profile and take to task a slew of big name gurus. These include in no particular order Suze Orman, Dave Ramsey, Robert Kiyosaki, Jean Chatzy and Jim Cramer. Not surprisingly a quick peek at the top-selling personal finance books on Amazon will see a heavy dose of these names.

    Olen chronicles these personal finance stars because by understanding their rise we can better understand the sorry state of personal finance. Many of these personal finance personalities base their advice on their own colorful back stories. The problem is that oftentimes the lessons learned from these narratives are either wrong or contradictory but that does not prevent them from selling you their confident advice in increasingly aggressive (and expensive) ways.

    Although these personal finance gurus are illustrative of the problems facing the personal finance industry. Olen notes that America's institutions are failing consumers as well. At a time when middle class American incomes were stagnating we increasingly asked these Americans to be more responsible for their own financial futures. The steady decline of the defined benefit pension plan left Americans dealing with a mix of IRAs and 401(k) plans to fund their retirements. The financial crisis of 2007-09 showed the fragility of this system.

    Nor according to Olen is the financial services industry trying to do much to solve these problems in any meaningful way. While spending money to promote financial literacy it is still the case that the financial services industry is built on fees and commissions. Whether it be the high fees charged to 401(k) participants or the high commissions paid when Americans purchase the many flavors of variable annuities it is a sad fact that most Americans don't understand what they are paying for.

    Echoing Fink, if we were truly interested in helping Americans we would devise financial products that were cheap, transparent, simple and free of the ill-effects of leverage. While there have been some steps in that direction including the rise of ETF and index investments, in general, it is still the case that the financial services industry make money on our ignorance or inattention. It is not for nothing that few (if any) Americans have ever read their mortgage documents, or insurance contracts or mutual fund prospectuses in their entirety.

    Olen covers a number of other topics including the financial media, especially CNBC. She examines the ways in which women are not well served by the financial services industry. Olen spends a chapter on the housing bubble and its outgrowth from middle class Americans to try and catch up financially during a period of income stagnation. She also tackles the topic of financial literacy and whether we can truly ever educate the American public about the nuances of personal finances.

    Olen's message, as stated in the book's title, a dark one. Stock market gains aside there is little to be optimistic about when it comes to the state of personal finance industry. One of Olen's key takeaways is that government needs to provide the average investor with a better set of retirement saving solutions. A recent study comparing America's retirement saving regime to other countries shows us lagging badly behind. In a recent post I echoed this challenge that Olen emphasizes in her book:

    The challenge is that Baby Boomers who have seen the entire financial landscape change before their eyes are now reaching retirement age seemingly unprepared for it. While many in this demographic will suffer the consequences, it is also society at-large that will also have to come to terms with these self-induced problems. It would be naive to think that the financial service industry or its overseers in Washington will willingly push for much in the way of constructive change. In the end it may be the case that our financial goals are simply too ambitious and that we need to lower our sights. What is clear is that we as a society have failed and are continuing to fail the average saver.

    In my book I note how investing is an adult responsibility we all face whether we want to or not. Until there are wholesale changes in the way Americans financial lives are structured we are still largely on our own when it comes to our personal finance. The best we can do is try to become more knowledgeable about our finances and put into action clear, simple plans to reach our goals. Maybe we should pay attention to Kareem Abdul-Jabbar in Esquire when he talks about one of the things he wished he had known when he was 30:

    Become financially literate. “Dude, where’s my money?” is the rallying cry of many ex-athletes who wonder what happened to all the big bucks they earned. Some suffer from unwise investments or crazy spending, and others from not paying close attention...Hey, Kareem at 30: learn about finances and stay on top of where your money is at all times. As the saying goes, “Trust, but verify.”

    *The author checked Olen's book out, like a Luddite, from his local library.

    Items mentioned:

    The saddest thing about this epic stock market rally.  (Money Game)

    Larry Fink's radical retirement recommendation.  (Term Sheet)

    Pound Foolish: Exposing the Dark Side of the Personal Finance Industry by Helaine Olen (Amazon)

    Helaine Olen on the financial industry.  (Big Picture)

    How they do it elsewhere.  (NYTimes)

    Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere by Tadas Viskanta  (Amazon)

    Life Lessons with Kareem Abdul-Jabbar - Kareem on What He Wished He'd Known at 30 (Esquire)

     

    Tadas Viskanta is the founder and Editor of Abnormal Returns. Tadas is a private investor with over 20 years of experience in the financial markets. He is the co-author of over a dozen investment-related papers that have appeared in publications like the Financial Analysts Journal, Journal of Portfolio Management among others. Tadas is also the author of the well-recived book: Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere which culls lessons learned from his time blogging.

     

     

  • Money & Markets

    Hot Topic: Emerging Markets

    What emerging markets are on your radar, and what information are you considering or watching for before making an investment?

     

    Rick Ferri

    Rick Ferri:  Why try to pick single emerging countries when you can own them all in an emerging market index fund? Emerging market index funds owns thousands of stocks across dozens of countries and their performance beats most professionally-managed accounts. It’s your best way to gain instant diversification and earn your fair share of market returns.

    It’s difficult to imagine that U.S. investors would have more information about what’s happening in South Africa or Turkey than investors who live there. It’s hard enough living in this country trying to figure out where the U.S. stock market is heading.

    More than 75 percent of all professionally-managed mutual funds have not kept pace with the emerging market index over the past 5 years, according to S&P Indices Versus Active (SPIVA). If it’s this difficult for the pros to pick hot emerging counties, a regular person doing it has little hope for success. 

    There are several low-fee emerging market index funds on the market. The major difference among the indexes they track is whether South Korea is considered an emerging market or a developed market. Most index providers place South Korea in the developed market category, but MSCI handles it differently. This leader in international equity indexes is keeping South Korea as an emerging country.

    Why resort to hair-pulling and eye-rolling when trying to choose an emerging market fund when you can just buy the whole market? An emerging market index fund has diversification, low-cost, and the performance has beaten most of the pros.

     

    Eric Nelson

    Eric Nelson:  Out of the $38T invested in stocks around the world as of year-end 2012, 14% was in countries designated as “developing” or “emerging”.  For long-term investors who believe in holding globally diversified asset class portfolios, emerging markets stocks represent a core holding.  These 5 rules can ensure you get the most out of that allocation.

    #1 – Investors who want the higher expected returns from emerging markets must be willing to put up with higher risk.  The oldest data we have on emerging markets goes back to 1988.  Through 2012, emerging markets stocks (MSCI Emerging Markets Index gross div.) earned +12.7% per year vs. +7.2% for developed market stocks (MSCI World Index gross div.).  However, that higher return came with almost double the volatility. 

    #2 – Emerging markets allocations require extreme patience, as they can go extended periods with disappointing results.  For much of the late 1990s and early 2000s, emerging markets lagged behind developed markets by a significant margin.  From 1994-2000, while developed market stocks earned +12.8% per year, emerging markets actually lost 4.8%.  From 2011-2012, developed market stocks earned +5.2% per year, but emerging markets stocks lost -1.5%.

    #3 – Emerging Markets are no place for active management.  Over the last 10 and 15 years respectively, the DFA Emerging Markets fund (DFEMX) has beaten 68% and 82% of surviving emerging markets managers through April 26th.  Yet the DFA fund makes no attempt to pick the best countries, sectors, stocks, or time the market.  This result against active management is even greater than we see in domestic or international developed markets.  And results would have been worse still if we added back in the 30% or 40% of emerging markets active managers who did so poorly over the last decade or more that their funds disappeared from mutual fund databases altogether (along with their poor returns).

    #4 – Not all “passive” emerging markets portfolios are the same.  Vanguard is the expense ratio leader in emerging markets, as in most other asset classes.  But net of fee, expected returns matter more than expense ratios.  Alternatively, the DFA Emerging Markets fund keeps expense ratios relatively low while also focusing on a more balanced allocation across countries, and an emphasis on keeping turnover and buy/sell transaction costs to a minimum.  For this well-rounded effort, we see that DFAs Emerging Markets fund after expenses outperformed Vanguards Emerging Market Index Fund (VEIEX) by 0.4% per year over the last decade and 1% per year over the last 15 years through April 26th.

    #5 – Large and small value emerging markets asset classes add higher expected returns and enhanced diversification.  From 1999 through March of 2013, the S&P 500 Index compounded at +3.6% per year with a standard deviation (risk) of 17.8.  If we added just 10% to the DFA Emerging Markets fund (DFEMX), our portfolio return jumped a full 1% to +4.6% per year, and standard deviation (risk) only went up to 18.4.  Over this same period, emerging markets value stocks outperformed the large cap growth-oriented DFA Emerging Markets fund by 3% per year, and came with about 20% higher volatility. But if we instead added the 10% from the S&P 500 Index to the DFA Emerging Markets Value fund (DFEVX), a more diversified mix of over 2,000 large and small value stocks, the portfolio return increased to +5.1% per year, but standard deviation (risk) only rose to 18.6.  Over this period, adding riskier emerging markets value stocks to our S&P 500 Index allocation didn’t materially raise total portfolio risk (standard deviation went up by 0.8) because of their diversification benefits.  Portfolio returns, however, increased by a meaningful 1.5% per year.

    Source of Data: DFA 2013 Matrix Book, DFA Returns 2.0, Morningstar.com

    Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only. Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Advisory fees and other expenses incurred in the management of portfolios would reduce client investment results.  Indexes are not available for direct investment.

     

    ----------------------------------------------------------------------

     

    Richard (Rick) A. Ferri, CFA is the founder of Portfolio Solutions,  the low-fee investment management firm he founded in 1999, which currently manages more than $1 billion in assets.  He is the author of six investing-related books, and shares his insights as a frequent news commentator, Forbes columnist, media contributor and public speaker.  Rick holds a Master of Science degree in finance from Michigan’s Walsh College, where he has served as an adjunct professor. Prior to entering the financial industry, Rick served as a U.S. Marine Corps officer and fighter pilot before retiring from the reserves in 2001 with twenty years of service.

     

    Eric Nelson is a CFA charterholder who has worked in the investment industry for 15 years.  He is the co-founder of Servo Wealth Management, an independent RIA in Oklahoma City, Oklahoma.  Eric has a passion for educating investors about how capital markets work and helping his clients achieve and maintain financial independence while “simplifying complexity”.   Outside of the office, Eric enjoys spending time with his family and their three dogs, he is an avid runner and a diehard Syracuse Orange college basketball and San Francisco 49ers NFL football fan.  Eric’s research and commentary on investing can be found on his website www.servowealth.com  at the “Servo Thoughts” blog and the “Factors in Focus” newsletter.

     
  • John P. Reese

    The Diversity of Bull Markets

    By John P. Reese

    Is the bull market running out of steam? Given the bull's length (it hit the four-year mark in March) and height (within the past month the S&P 500 finally eclipsed its pre-Great Recession high), plus all of the lingering financial and economic fears around the world, many have been asking that question -- and some big recent down days for stocks have added to the concern.

    But what does history have to say? I recently looked back at all of the bull markets since 1957, the year that the S&P 500 benchmark came into its current form, to see what lessons, if any, we might glean about the current bull. I found that, for the previous nine bulls since then, the average duration was right at 48 months -- four years. Five of the nine lasted longer than four years, with the longest being the 1990-2000 bull market, which lasted 115 months.

    As for magnitude, during those past nine bulls, the S&P gained an average of 165.7%. This time around (through April 17), it's up 129.4%. (Bear markets, in contrast, tend to be much shorter in duration and smaller in magnitude than bulls. The average of the last ten bears going back to 1956 was just 15 months, and involved a loss of 34.3%.)

    The current bull is thus by no means atypical in terms of how long it has lasted or the overall gains it has produced. It has, however, proceeded more rapidly than many recent rallies. For the five previous bulls that lasted at least four years, the average gain through the end of Year 4 was 81.2%; through its first four years, the current bull was up 129.3%. Still, that's not the most rapid rise -- the 1982-87 bull gained 137.6% in its first four years. So again, nothing unheard of.

    But while the current bull is near historical averages in terms of length and magnitude, I found that the real lesson of past bulls isn't that you should expect a bull market to last a particular period or involve a particular level of gain. Instead, the lesson seems to be just how diverse bull markets can be. While the average length of one since 1957 is four years, individual bulls have ranged from 26 months (1966-68) to nearly 10 years (1990-2000). And the range of their gains has been even broader: At the low end was that 1966-68 bull, when the S&P gained 48.0%. At the high end, the 1990-2000 bull gained 417.6%.

    There has also been variation in terms of when a bull market (defined as a gain of at least 20% following a bear market, which involves a loss of at least 20%) eclipses its previous high, and, by how much it does so. At their four-year marks, three of the five previous bulls that lasted at least four years were at a level above the previous bull market's high. Two were not. The 1957-61 bull was among those that had beaten its previous high at the four-year mark; it lasted just two more months. The1974-80 bull was still below its previous high after four years; it went on for over two more years.

    That might make it seem like it's a bad thing to be above previous highs through Year 4 -- less room left to run, right? Not so fast. The 1990-2000 bull was well above its previous high at the four-year mark, and it went on for another six-plus years, with the S&P surging from 459.04 on its fourth birthday to over 1,500 by the time the bull run was over.

    All of this supports the idea that, with so many factors affecting stocks at any given time, getting the timing right on bull and bear markets is incredibly hard, if not impossible. Just because a bull market has been going on for only two years, that doesn't mean it has a long way to go -- had you jumped into stocks just two years into the1966-68 bull, you'd have been met only two months later with a bear market, one in which the S&P would decline more than 36%. On the other hand, just because a bull has gone on for four or five years or six years, that doesn't mean it's due for an end. If you jumped out of stocks at the four-year mark of the 1990-2000 bull, you'd have missed out on another 230% of gains before all was said and done.

    Using other factors to time bulls and bears can also lead to trouble. The 10-year cyclically adjusted price-earnings ratio on the S&P 500 crossed 32 in July of 1997 -- twice its historical average of 16, according to Yale Professor Robert Shiller's data. But while that might seem like a sign to bail on stocks, the S&P rose from under 900 to over 1500 in the next three years or so -- even though the 10-year CAPE stayed above that 32 mark the whole time. Similarly, the 10-year CAPE fell below its long-term average of 16 in June of 1973, about five months after a bear market had begun. Would that have been a "buy" signal? Not a very good one. The CAPE kept on falling, and the bear lasted another 16 months or so, with the S&P falling another 40% from the start of June through the market bottom.

    At the end of the day, given that bull markets tend to last longer and involve far greater gains than bear markets, an investor's best move is more often than not just staying the course and sticking to a long-term strategy through both bears and bulls. That's what Peter Lynch, one of the greatest mutual fund managers of all time, once told PBS. "They're gonna happen," Lynch said of corrections and bear markets. "When they're gonna start, no one knows. If you're not ready for that, you shouldn't be in the stock market."

    When one of the greatest investors of all time says that no one -- not even himself -- knows when bulls and bears are going to start and end, that says something. Trying to time the market, particularly based on individual pieces of data or, even worse hunches or gut feelings, is a very dangerous path for an investor. Yes, staying the course means you'll have to endure some big down periods. But over the long haul, you'll likely be better off than those who jump in and out of the market -- and far more often than not get burned by bad timing.

     

    John P. Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. He is the author of “The Guru Investor: How to Beat the Market Using History's Best Investment Strategies” and runs The Guru Investor blog. John, a graduate of Harvard Business School and MIT, is considered an expert in the systematic investing strategies based on the methods and principles of Warren Buffett, Peter Lynch, Benjamin Graham and other investing greats.

     

     

     
  • Eric Nelson

    What Should You Do About Bonds?

    By Eric Nelson

    So you are a recent retiree that would like to draw between 3% and 4% per year from your portfolio and leave some to the kids when you’re gone.  You’ve gotten off on the right foot: decided to use index funds instead of taking a flyer on individual stocks or other actively managed schemes, and settled in with a traditional 60% stock, 40% bond mix.  So far, so good.

    But these aren’t normal times for interest rates or the bond market.  Yields on fixed income are at extremely low levels, which mean future returns will be lower on bonds than we’ve become accustomed to.  If interest rates rise back to average levels, bond prices in the near term could fall and returns for fixed income could be sharply negative.  And the longer the bond, the worse the decline could be.  Should you make bond changes, and if so, which ones?

    The typical response from investors when bond returns don’t meet their requirements or expectations is to “reach for yield”, that is, buying longer term (10 years or more) maturities, or bonds with lower credit qualities (less than investment grade, BB or lower), or both.  Sure, riskier bonds carry higher yields and higher expected returns, but is that the best path to take?

    Table 1: Annualized Portfolio Returns (1928-2012)

    Asset Class

    START

    Change #1

    Change #2

    Change #3

    Change #4

    US Total Stock Index

    60%

    60%

    65%

     

     

    US “Tilted” Stock Index

     

     

     

    60%

    50%

    5YR Treasury Notes

    40%

     

    35%

    40%

    50%

    Long-Term Corporate Bonds

     

    40%

     

     

     

    Return

    +8.3%

    +8.6%

    +8.5%

    +10.0%

    +9.4%

    Risk

    12.3

    13.1

    13.3

    15.8

    13.3

     

    Table 1 looks at various changes the 60/40 retired investor could have made to increase their portfolio’s returns.  By looking at the last 85 years starting in 1928 in Table 1, we minimize the chance that we’ve chosen a period of anomalous results that wouldn’t be expected to occur over a longer period of time, such as just a strong bull market or painful bear market for stocks, or a period when interest rates only rose or fell.  Of course, the emphasis here should be on the relative results, not absolute returns, which will almost certainly be lower for all portfolios that include bonds due to lower interest rates.

    The original portfolio (“START”) is the 60/40 allocation mentioned above, representing 60% in the US Total Stock Index, and 40% in relatively short 5YR Treasury Notes.  “Change #1” replaces the allocation to 5YR Treasury Notes with a Long-Term Corporate Bond Index.  In doing so, we see the return of the 60/40 allocation went from +8.3% per year up to +8.6%, while risk (standard deviation) also jumped from 12.3 to 13.1.  So we saw a mild improvement in return, with what many retirees would consider a large increase in risk, as longer-term bonds have significant exposure to unexpected inflation.

    If that minor improvement in return was desirable, “Change #2” reveals that it could also have been accomplished by simply staying with the same US Total Stock and 5YR Treasury Note indexes, but shifting just 5% more to stocks for a 65/35 allocation.  While more stock also equals more risk, still maintaining a relatively sizeable allocation to shorter-term 5YR bonds is much safer than a big jump in inflation risk from longer-term bonds, and just might be a more palatable alternative.

    But “Change #3” and “Change #4” illustrate more efficient ways to get the job done.  “Change #3” maintained the 60/40 asset mix, but substituted the US Total Stock Index for an index of all US stocks that is “tilted” more towards smaller and more value oriented companies.  While small and value stocks have greater risk, they come with much higher expected returns and important diversification benefits during periods when larger cap growth stocks are disappointing (as has been the case since the tech collapse in 2000).  This return improvement can be seen in the results of “Change #3”, a compound return of +10.0% per year, 1.7% more than the original portfolio. 

    For some, this adjustment is exactly what is needed.   For others, the increase in risk is a bit more than they can tolerate.  For them, “Change #4” might be more agreeable.  It maintained the small cap and value tilted stock index, but lowered the equity allocation to 50%, with the remaining 50% in 5YR Treasury Notes.  This mix still generated a +9.4% return, over 1% more than the original portfolio and 0.8% more than the allocation that included long-term bonds.  And the 50/50 split did so without an increase in risk (standard deviation) above the long-term bond portfolio outlined in “Change #2”.  Surprisingly, the additional returns from tilting to small and value stocks were so high, the 50/50 mix actually earned the same long-term return as the US Total Stock Index (not shown) which is 100% in stocks but heavily weighted towards lower returning large growth companies, yet did so with 35% less risk (standard deviation)!

    Low interest rates have made the task of retirement planning a bit more challenging.  One of the bedrocks of a retirement portfolio – high quality fixed income, has very low future expected returns.  While retirees may be tempted to reach for yield by buying riskier long-term bonds, or lower quality corporate or “junk bonds”, the historical analysis above tells us this is not advisable.  The natural characteristics of fixed income securities are to provide stable but relatively low returns.  If more is needed from a portfolio, retirees are better served to consider tilting their stock holdings more towards small cap and value oriented companies through broadly diversified index funds, while maintaining their stock/bond split or even reducing it slightly if their plan allows for that.   As for what to do about bonds, assuming you already hold shorter-term, high quality issues, the answer is: nothing at all.

    ------------------------------------------------------------------------------------------------------------

    Source: DFA Returns Program 2.0; US Total Stock Index = CRSP 1-10 Index; US “Tilted” Stock Index = DFA Adjusted Market Value “US Vector” Index; 5 Year Treasury Notes = Ibbotson 5YR Treasury Index; Long-Term Corporate Bonds = Ibbotson 20 YR Corporate Bond Index; all portfolios rebalanced annually.

    Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only. Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Advisory fees and other expenses incurred in the management of portfolios would reduce client investment results.  Indexes are not available for direct investment.

     

     Eric Nelson is a CFA charterholder who has worked in the investment industry for 15 years.  He is the co-founder of Servo Wealth Management, an independent RIA in Oklahoma City, Oklahoma.  Eric has a passion for educating investors about how capital markets work and helping his clients achieve and maintain financial independence while “simplifying complexity”.  Eric’s research and commentary on investing can be found on his website www.servowealth.com  at the “Servo Thoughts” blog and the “Factors in Focus” newsletter.

     

     

     

  • Rick Ferri

    Top 5 Reasons to Buy Index Funds

    By Richard Ferri

    At times it seems like an impossible task to make the best of our investment portfolios. The economy is barely moving, stock prices are unpredictable, interest rates are low and there is uncertainty everywhere. Any help to increase our chance for success has to be seriously considered. That’s why learning about index fund investing is vital.

    Index funds increase your probability for reaching financial success. They’re very low cost mutual funds that are designed to give you the return of a market, such as the U.S. bond or equity market. You could try to pick investments that beat the markets, but that’s a costly bet that has a low probability for success. Index funds are a better way.     

    I’ve put together the top 5 reasons why index funds help millions of investors reach their goals and how they can help you, also.

    1. Performance

    Index funds provided higher return on average than mutual funds that attempt to beat the markets. Over the last five years, stock index funds beat about 75 percent of actively-managed mutual funds and bond index funds outperform about 85 percent of active bond funds. These figures include active funds that go out of business. This index fund advantage increases over time. The Vanguard 500 was the first index fund available to investors in 1975. It has outperformed 90 percent of all actively-managed funds that existed since its inception, including hundreds that did not survive.

    2. Portfolio Benefits

    Owning one index fund is a great idea; owning many index funds that cover several asset classes is an even better idea. There are more than 1,000 index funds and exchange-traded funds (ETFs) available that track many different stock and bond indexes. When you put the two or more index funds together in a portfolio, the portfolio results are better than the individual category results. As you add more index funds in different asset classes, the odds of an all-index fund portfolio outperforming an all actively-managed fund portfolio move to the very top percentile.

    3. Lower Cost

    The primary reason why index funds outperform is their rock-bottom cost. Expenses for index funds are just a fraction of actively-managed funds. Let’s look at these costs. Based on Morningstar Principia data (ending 12.31.12), a broad U.S. equity index funds cost about 0.1 percent per year. Compare that to actively-managed funds that charge about 1.1 percent per year. Bond index funds charge about 0.2 percent per year while actively-managed funds charge about 0.9 percent. It’s very difficult for active fund managers to make up the extra fees they charge and then beat the market on top of that. Some managers do for a while, but over time, the higher fees wear down fund performance and index funds outperform.

    4. Lower Risk

    It is common knowledge that diversification lowers portfolio risk. Nobel Prize winning economists, such as William F. Sharpe and Merton Miller, have long argued that the least risky and most efficient portfolio is one that holds all the securities of a market. When a company goes bankrupt, the negative effect will be less on a well-diversified index fund than on an active fund that holds fewer securities. The S&P 500 index fund holds 500 securities. The average actively-managed large cap U.S. blend fund holds only about 150 securities, according to Morningstar Principia (data ending 12.31.12). Actively-managed funds are less diversified, therefore more risky. By definition, this makes index funds inherently less risky than actively-managed funds.

    5. Reduced Taxes

    No one looks forward to paying taxes on their investment gains. One way to lower the tax burden is to buy tax-efficient mutual funds in a taxable investment account. Index funds and ETFs are more tax-efficient than actively-managed funds. That’s because these products have low turnover of securities within the portfolio and this means lower capital gain distributions at year end.  ETFs also have a special structure that lowers capital gain distributions by the way these securities are designed.

    We’re all trying to make the best of our investments during this tough time. Index funds give you a return over traditional mutual funds that attempt to beat the market. Wise investors are taking advantage of the lower cost and tax efficiency of an all index fund portfolio. You can too!

     

    Richard (Rick) A. Ferri, CFA is the founder of Portfolio Solutions,  the low-fee investment management firm he founded in 1999, which currently manages more than $1 billion in assets.  He is the author of six investing-related books, and shares his insights as a frequent news commentator, Forbes columnist, media contributor and public speaker.  Rick holds a Master of Science degree in finance from Michigan’s Walsh College, where he has served as an adjunct professor. Prior to entering the financial industry, Rick served as a U.S. Marine Corps officer and fighter pilot before retiring from the reserves in 2001 with twenty years of service.

     

  • Eric Nelson

    Intelligence and Successful Investing Don’t Always Correlate

    By Eric Nelson

    In the preface of the Fourth Edition to Benjamin Graham’s The Intelligent Investor, Warren Buffet writes, “To invest successfully does not require a stratospheric IQ, unusual business insights, or inside information.”

    Yet investors often search out the smartest, most educated investment professionals to manage their money, hoping to capitalize on information or research that no one else has.  An example of one such professional is Dr. John Hussman.  He is the president of Hussman Econometrics Advisors and manages the Hussman Funds.  He holds a Ph.D. in economics from Stanford and a Masters degree from Northwestern University.  Pretty impressive stuff!

    As an investor, Dr. Hussman has a very complex approach to “investing for long-term returns while managing risk”.  His website says their key elements in evaluating securities and market conditions are “valuations” and “market action”.  “Each unique combination of these conditions results in a distinct Market Climate, with its own profile of expected returns and risk”.

    With this combination of investment intelligence and complex market modeling, it’s logical to assume Hussman investment portfolios have prospered as an incredibly volatile stock market has offered ample opportunity for investors and money managers to jump in and out of stocks for maximum gains with minimal risk. 

    At the very least, we’d assume Hussman portfolios provided considerable value compared to us investment simpletons, who believe that markets are largely efficient and unpredictable, and after developing a broad-based index or asset class portfolio, think it’s better to just stay the course.

    Table 1: Annualized Returns Through 2/28/2013

    Portfolio

    1YR

    3YR

    5YR

    10YR

    Since 8/00

    Since 10/02

    Hussman Strategic Growth Fund

    -9.8%

    -6.0%

    -4.6%

    +1.6%

    +4.6%

    ---

    40/60 Asset Class Index

    +7.7%

    +8.2%

    +6.5%

    +9.2%

    +9.0%

    ---

     

     

     

     

     

     

     

    Hussman Strategic Total Return

    -1.8%

    +3.0%

    +3.2%

    +6.2%

    ---

    +6.2%

    20/80 Asset Class Index

    +5.6%

    +6.7%

    +5.8%

    +7.1%

    ---

    +7.0%

    But Table 1 indicates otherwise.  After a strong showing in the bear market of 2008, where the Strategic Growth fund only lost 9% and the Strategic Total Return fund gained 6.3%, Hussman and their models appear to have completely missed the recovery.  In the last 3 years, Strategic Total Return earned only 3%, while Strategic Growth actually lost 6% per year.  Over the last 10 years, their returns average out to a little under +4%—about a percent less per year than simply owning the Vanguard Total Bond index with no stock market risk at all. That’s the problem with market-timing and active management; you have to know when to get out and when to get back in.  Getting only one of those correct is often worse than not trying to guess in the first place.

    An alternative to this actively managed approach that is not dependent on forecasting future market cycles and climates, is to simply build and maintain a broadly diversified asset class portfolio of stocks and bonds geared to a particular level or risk and expected return.

    In 2008, the “40/60 Asset Class Index”, a combination of large/small and growth/value indexes in US and foreign markets with 60% in 5YR T-notes to dampen risk, lost 9.5%, in-line with Strategic Growth.  The “20/80 Asset Class Index” held the same indexes, but only 20% in stocks and 80% in 5YR T-notes, and in 2008 gained almost 2%.  Both allocations were simply rebalanced back to target once per year on January 1st.

    The difference, however, was by not trying to time the market with elaborate hedges and short strategies, the Asset Class indexes instead maintained enough high-quality fixed income to offset some of the equity declines during bear markets.  They also remained invested in stocks to various degrees at the same time, so when markets recovered they were well positioned to capture the positive returns as well.  The combination of the 20/80 and 40/60 versions earned over 8% per year, or about double the Hussman approach, without taking on additional risk.

    But even the reported Hussman returns overstate the results investors actually achieved in their funds.  Trying to outsmart the markets, Morningstar reports that the investor’s dollar-weighted return in the Strategic Growth Fund over the last 10 years was actually -2.8% per year, and only +3.3% for the Strategic Total Return Fund.  How could that happen?  During the bull market of 2003-2007, investors had little interest in Hussman’s “risk-management”.  Instead, they tended to buy these strategies only after stocks had fallen in 2008 and they were seeking refuge from further losses.  As markets recovered, they were poorly positioned to benefit from the unexpected stock gains.   Between the two funds, investors averaged only about +0.5% per year in returns, a result that could have been exceeded simply by sitting in a risk-free money market account for the entire period!

    This isn’t a plug for bond-heavy portfolios; each investor should have an allocation that makes sense for them.  And we’re not picking on Hussman either, their funds and their approach simply offer an example of how even the most intelligent and sophisticated approaches to investing often don’t lead to successful outcomes. 

    Instead, it’s important that investors heed the rest of the Buffet quote we opened this article with, “What’s needed is a sound intellectual framework for making decisions and the ability to keep emotions from corroding the framework”.  In other words: adopt an asset allocation based on your objectives, diversify broadly and target the recognized sources of expected return including smaller and more value oriented stocks, stay with your plan even when circumstances seem at odds with your approach, and don’t assume that above average intelligence or sophisticated models offer any reliable improvement in your odds of success.  That’s the smartest advice we can offer.

    ______________________________________________________________________________

     

    Source: DFA Returns Program 2.0; www.hussmanfunds.com; www.morningstar.com

    40/60 Asset Class Index= 8% S&P 500 Index, 8% DFA US large value index, 12% DFA US small value index, 4% DFA international large value index, 4% DFA international small value index, 4% DFA emerging market value index, 60% Ibbotson 5YR T-Note index, rebalanced annually

    20/80 Asset Class Index= 4% S&P 500 Index, 4% DFA US large value index, 6% DFA US small value index, 2% DFA international large value index, 2% DFA international small value index, 2% DFA emerging market value index, 80% Ibbotson 5YR T-Note index, rebalanced annually

    Past performance is not a guarantee of future results.  The returns and other characteristics of the allocation mixes contained in this article are based on model/back-tested simulations to demonstrate broad economic principles.  They were achieved with the benefit of hindsight and do not represent actual investment performance. There are limitations inherent in model performance; it does not reflect trading in actual accounts and may not reflect the impact that economic and market factors may have had on an advisor’s decision-making if the advisor were managing actual client money. Model performance is hypothetical and is for illustrative purposes only. Model performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. Advisory fees and other expenses incurred in the management of portfolios would reduce client investment results.  Indexes are not available for direct investme

     

    Eric Nelson is a CFA charterholder who has worked in the investment industry for 15 years.  He is the co-founder of Servo Wealth Management, an independent RIA in Oklahoma City, Oklahoma.  Eric has a passion for educating investors about how capital markets work and helping his clients achieve and maintain financial independence while “simplifying complexity”.  Eric’s research and commentary on investing can be found on his website www.servowealth.com  at the “Servo Thoughts” blog and the “Factors in Focus” newsletter.

     
  • John C. Bogle

    A Brief History of the ETF

    By John C. Bogle

    When I first studied the mutual fund industry six decades ago, I was struck by the promise of “daily liquidity.” Investors could liquidate their share of the funds they owned each day, essentially at an asset value determined at the subsequent close of business. I thought such a promise was remarkable, and it was honored almost without exception during the ensuing 60 years. Daily liquidity, along with professional management, diversification, convenience, and shareholder service were the keys to the fund industry’s enormous growth, which took place largely during the great bull market of 1982-1999. Fund industry assets soared from $2.5 billion in mutual fund assets when I joined the industry in 1951, to more than $6 trillion in 2000. While asset growth then slowed, it continued at a more reasonable 6 percent rate; with assets approaching $13 trillion as 2013 begins.

    Early in 1992, a visitor came into my office in Valley Forge, Pennsylvania, and tried to persuade me that the daily liquidity we offered for our index funds was not nearly good enough. He presented a design for a new “product” in which shares of the Vanguard 500 Index Fund could be traded instantaneously throughout the market day, and proposed that we partner with him. He was convinced that if Vanguard Index 500 shares could be traded on the nation’s stock exchanges just like individual stocks, it would vastly increase our client base by attracting a new breed of investors. (Of course, it would also attract speculators, though he did not use the word.)

    Think of it, he said: in addition to the diversification, the portfolio transparency, and the low expense ratios that Vanguard already offered, investors would gain the ability to sell shares short or buy them on margin; to trade easily on foreign exchanges; possibly to enhance tax efficiency; and to attract hedge funds and other institutional investors by enabling them to fine-tune their risk exposures on a moment-by moment basis. My visitor, soft-spoken though he was, was clearly a missionary for his concept.

    His name was Nathan Most, and he was head of product development at the American Stock Exchange. He laid before me a plan for a breakthrough innovation that would become known as the exchange-traded mutual fund. I listened to his presentation with interest and gave him my reactions: (1) there were three or four flaws in the design that would have to be corrected in order for the idea to actually function; and (2) even if the new design solved the problems, our Index 500 Fund was designed for long-horizon investors. I feared that adding all that extra liquidity would attract largely short-horizon speculators whose interests would ill-serve the interests of the long-term investors in our index fund. So, we found no community of interest. But we parted amicably, and would enjoy a nice friendship over the years that followed.

    As Nate Most told the story, on his train ride back to New York City he figured out how to fix the operational problems that I had found in his design. He then resumed his search for a partner, soon finding one at giant State Street Global Advisers. In January 1993, State Street introduced the Standard & Poor’s Depository Receipts. The “SPDRs,” based on the S&P 500 Index, have dominated the ETF marketplace ever since. Despite the amazing influx of new ETFs, year after year, the SPDRs remain the world’s largest exchange-traded fund—and now the world’s most actively traded stock—with assets exceeding $120 billion.

    ETF assets have grown, I’m certain, far beyond Nate’s highest expectations. With some $1.3 trillion now invested in ETFs, it is without hesitation that I describe Nathan Most’s visionary creation of the first ETF as the most successful marketing idea of the modern age of the securities business. Whether it proves to be the most successful investment idea of the age, however, remains to be seen. I have my doubts. So far, ETFs, in general, have not served their investors well. Indeed, how could ETFs possibly serve investors well? With over 1,400 ETFs—tracking an incredible 1,112 indexes(!)—picking an ETF is just like picking a stock, with all of the attendant risks. (I freely concede that speculating in index funds generally carries significantly less risk than speculating in individual stocks.)

    So, it’s hard for me to imagine that today’s ETFs will become the Holy Grail of investing—that ever-sought after way to beat the returns of the stock market. Yes, some ETFs offer the temptation to bet on narrow segments of the stock market, some now employ exotic leveraged strategies, and some make betting on commodities relatively easy. But six decades of investment experience have reinforced my basic tenet that short-term trading—yes, let’s call it speculation—is by definition a loser’s game, and long-term investing is by definition a winner’s game.

    “. . . All Day Long, in Real Time.”

    The early advertisements for the SPDR expressed its marketing proposition bluntly: “Now, you can trade the S&P 500 Index all day long, in real time.” I can’t help but wonder, if you’ll forgive the coarse language, “What kind of a nut would do that?” Yet day after day, the SPDR lives up to its promise—invariably the most actively traded stock in the entire world, with average daily trading volume of 144 million shares, or an astonishing $5.1 trillion in 2012 alone. With SPDR assets averaging about $110 billion for the year, that’s a turnover rate of 4,688percent. I concede the success of the ad’s message: Investors are indeed trading the S&P 500 Index all day long in real time—in huge amounts, and in unimaginable volumes. Nate Most, I think, would be proud that his dream has been realized.

    But the SPDR has spawned a whole host of followers, and the diversity of investment options seems to have reached far beyond the furthest reaches of what even an innovator like Most would have found appropriate. “Name an exotic product—any product you can imagine—and we’ll create it,” is the war cry of the new breed of ETF entrepreneur. These marketers are in the game, not necessarily because their so-called “product” may be good for investors, but because they may hit the jackpot, attract a lot of assets, and make a personal fortune. Some ETFs, used properly, are good for investors, while others are not. But the temptation for fund marketers to jump on the bandwagon of a hot new product is almost irresistible. During my career, I’ve seen scores of innovations, but I know of only a handful that has served the enduring needs of long-term investors. And ETFs hardly meet that standard.

     

    John C. Bogle (Bryn Mawr, PA) is Founder of The Vanguard Group, Inc., and President of the Bogle Financial Markets Research Center. He created Vanguard in 1974 and served as Chairman and Chief Executive Officer until 1996 and Senior Chairman until 2000. He had been associated with a predecessor company since 1951, immediately following his graduation from Princeton University, magna cum laude in Economics. The Vanguard Group is one of the two largest mutual fund organizations in the world. Headquartered in Malvern, Pennsylvania, Vanguard comprises more than 100 mutual funds with current assets totaling about $742 billion. Vanguard 500 Index Fund, the largest fund in the group, was founded by Mr. Bogle in 1975. In 2004, TIME magazine named Mr. Bogle as one of the world's 100 most powerful and influential people, and Institutional Investor presented him with its Lifetime Achievement Award. In 1999, FORTUNE designated him as one of the investment industry's four "Giants of the 20th Century." In the same year, he received the Woodrow Wilson Award from Princeton University for distinguished achievement in the nation's service."

     
  • Phil DeMuth

    Money Worries of the Rich and Famous

    By Phil DeMuth

    Having just launched my book for affluent investors (say, between $100,000 and $10,000,000), I recently began thinking about the terrible plight of those who are richer still: the super-high-net-worth.

    What are these folks worried about?  Why, money, of course.  What is more, they ought to be. Their money problems are far greater than they realize.  They are losing their booty.

    The merely affluent investor sits in a sweet spot.  He has enough money to escape the clutches of commission-based financial product salesmen and transport himself into the loving arms of fee-based investment advisors, who at least have a fiduciary responsibility to put his interests first.  This is mostly for show, but it’s still a nice idea.  The bones of less-than-affluent investors get picked over by entry-level, cold-calling financial predators.   

    Here’s the interesting part: the merely affluent investor also fares better than the super-high-net-worth.  The rich are serviced by a whole better class of sophisticated, relationship-based, upscale financial predators.  This makes sense, because they are where the money is.  The rich are carefully researched, not with an eye toward serving them, but the better to pick their pockets.  It continues to be hard to get good help these days.

    Fed up with the waterboarding they endured at the hands of prestigious private banking departments, the well-to-do saw the need to take matters into their own hands.   Thus was born the “family office.”  This is a structure set up to manage the financial affairs of a wealthy family (say, with $100 million or more).  As such, it is typically exempt from SEC regulation and oversight.  If you think that the government does a bad job regulating Wall Street, you can only imagine what goes on in areas they don’t regulate at all. 

    It’s not that people who work in family offices are any worse than the rest of us.  The problem is that they are exactly like the rest of us.  They succumb to the same agency pressures and incentives that we all do, subtly putting their own interests first and the family’s second.  The typical family office, like any office, will be run to promote the interests of the family office, all while making a great show of serving the family.  There will be important conferences to attend in London.  Superbowl tickets in the box of the trust officer.   A network of small kickbacks and favors to manage.  A general dressing up in the master’s clothes.  Even good people in these roles may find themselves tempted to stray, simply because it is so easy and easy to rationalize, a small step at a time.  Should they decide to turn to the dark side, the keys to the safe are in the desk drawer.

    Were someone in the family to awaken and realize that they have created is a monster, extricating themselves from this situation – where the office knows every intimate detail of the family’s personal and financial life – is a bit like a politician trying to fire J. Edgar Hoover, or a Roman Emperor realizing that he is completely controlled by the Praetorian Guard.  Easier to just let sleeping dogs lie.  After all, there’s plenty of money, for now.  

    What is the ostensible job of the family office?  First and foremost, investment management.   A recent hilarious article in Barron’s, describes how family offices have now decided to tilt their portfolios more toward equities, after five years of a bull market have run their course.  Often the view is that the family sock will swell under the “endowment” model, just like David Swensen’s fund at Yale, judiciously allocating capital among diversified long-term (and frequently illiquid) strategies.   But Yale has $20 billion to spend.  Can it really be assumed that the same level of intellect and diligence will be brought to bear with the family’s measly $100 million kitty?  Will they really play in the same league as Yale?  No, they are little black sheep who have lost their way.  Most hedge funds, private equity, venture capital,  and money managers are going to underperform a very simple portfolio the family could get from Vanguard for about a tenth of a percent a year.  Alternatively, they could simply lateral their money to Warren Buffett for one one-hundredth of a percent a year.  Mr. Buffett has done pretty well following this strategy himself, even without a family office to guide him.  

    What else does the family office do?  They assist with the family’s tax, estate, and charitable planning.  They respond to routine correspondence and answer the telephone.  They file prospectuses.  They pay Junior’s speeding tickets and find a good divorce lawyer for Missy.  

    Perhaps their most quixotic mission is to help the next generation prepare for the Atlas-like responsibilities of shouldering great wealth.   Thank you, Alfred.  The parents want their children to grow up to be hard-working, productive powerballs like they are, even though their offspring are handed a gazillion dollars at the starting line.  Trips to Costa Rica are arranged so these rich kids can learn the importance of healing the environment.  Caring psychotherapists are bussed in to help, hug, and hold hands.  No one has the nerve to tell the parents that it won’t work.  At least they tried.

    I have a friend whose father was a billionaire.  When he and his brother wanted a swimming pool, his dad bought them each a shovel.  “You dig the hole, I’ll build the pool,” his Dad offered.  However, most rich parents don’t want to be hated by their children.  Haven’t we worked hard enough?  Who needs the aggravation?   They write a check instead.  The children eventually turn into Paris Hilton, but at least they are well paid for having miserable, empty lives. 

    The rich are different after all.  Aided by the financial services complex, they waste millions of dollars every year.  The con is so smooth, they don’t even know it’s gone.   

     

    Phil DeMuth is an author, psychologist, and investment advisor whose articles have appeared in "The Wall Street Journal" and many other publications. He has made TV appearances on CNBC, Forbes on Fox, and Wall Street Week with Fortune. He has also collaborated with noted financial writer Ben Stein on several books that focus on prudent financial investing.

     

     

     
  • Tadas Viskanta

    Alternative Investments are No Longer all that Alternative

    Please accept my resignation. I don’t care to belong to any club that will have me as a member. - Groucho Marx  (Wikiquote)

    The same could be said for alternative investments these days. The pitch for alternative investments has been that they generate high returns with lower correlation to the broader stock market and economy. Throw in the (behind WSJ paywall) "hope and exclusivity" of these strategies and you have a potent pitch. So-called alternative assets include a wide range of assets and strategies including most prominently private equity and hedge funds. These funds are now finding ways to open their doors to smaller, more retail investors.

    Why is that? Many of the biggest private equity investors have come public and have transformed themselves into broadly diversified asset managers. The raison d'etre of publicly traded asset managers is to grow assets under management, hence earnings. The "retail-ization" of alternative investments represents a big part of this strategy. For example at least one private equity manager is trying to get their funds included in a 401(k) plan.

    The behemoth Carlyle Group (behind WSJ paywall) recently announced a plan to make their buyout funds available to individual investors with a minimum investment of $50,000. While for many that still seems high, it is a far cry from the multimillion minimums institutional investors face. Then again the very act of lowering its minimums may be a not altogether positive sign. It will be interesting to see if retail private equity funds become a mainstream alternative.

    In their favor, investors are desperate to generate returns in a zero-interest rate environment. Buyout funds seem to many like a way to boost portfolio performance, albeit at a high price. As well, many mass-affluent investors who have to-date been shut out of these funds could find the prospect of investing with "the best and brightest" an intriguing possibility. Before proceeding, investors considering an investment in private equity funds, or any other alternative investment, should keep in mind these four C's.

    1. Costs

    The best argument against alternative investments in general, and more specifically retail-focused products is costs. Inevitably these products have higher fees. This is due to the fact that most managers have structured their fees to include both an investment management fee and performance fees. These fees reduce investor returns on a one-for-one basis. So returns have to generate excess returns in order to offset these fees. Thankfully fees are one area individual investors have a high degree of control.

    2. Complexity

    Private equity funds are a very different animal than the open-end mutual funds and ETFs most investors are familiar with. In addition to the higher, multi-layered fees and leverage, it is difficult to value their holdings on an ongoing basis. Not until a holding is sold, goes public (or goes bankrupt) do you know its value with certainty. A recent study showed that private equity firms have historically overvalued their holdings to help aid fundraising.

    3. Crowding

    It is hard to argue that private equity is undiscovered. Historically the best returns for alternative investments has come before the crowd discovers them. A common mistake investors, even professional investors, make is to 'chase returns.' For example the returns to private equity and venture on a dollar-weighted basis are worse than on a headline basis. This is because money rushes into an asset class after the best returns have already been generated. Not surprisingly future returns can't keep pace.

    4. Correlations

    The other side of the crowding coin is increased correlations. Post-financial crisis private equity can no longer be considered an asset uncorrelated with equities. The same could be said for any number of asset classes as well. As high performing asset classes become recognized, they attract capital and almost inevitably become ever more correlated with the broader markets. There are number of reasons for this but one reason is that the best returns were generated when few were willing (or able) to invest. That sounds a lot like the situation with private equity.

    All of that being said, private equity plays a vital role in our economy by helping grease the wheels of capitalism. As I wrote in my book, Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere:

    The firms engaged in private equity and venture capital play a key role in the functioning of the market economy. It would be hard to imagine the markets without them. In a very real sense, all investors benefit from the work of private equity professionals and venture capitalists. The challenge for average investors is that they don’t have easy, inexpensive access to these asset classes. Whatever access they do have is mediated with layers of fees upon fees. As with most alternative investments, the allure of private investments is less than meets the eye.

    The bottom line is that there is no magic investment that consistently generates high returns and low correlations. So when considering any alternative investments keep in mind Groucho's words. If not Groucho, how about William Bernstein as quoted by Jason Zweig at (behind paywall) WSJ?

    Think of it like this, he [Bernstein] says: "The first person to the buffet table gets the lobster. The people who come a little later get the hamburger. And the ones who come at the end get whatever happens to be stuck to the tablecloth."

    The danger today is that investors plunging into alternatives are the last ones in the proverbial buffet line getting the "stuff stuck to the tablecloth." The vast majority of investors can safely ignore alternatives (and other active strategies). Focusing on those things over which investors have some genuine control like their savings rate, fund costs, turnover and taxes is a far better use of their limited time and energy.

    Further reading:

    The New Tycoons: Inside the Trillion Dollar Private Equity Industry That Owns Everything, Jason Kelly

    Unconventional Success: A Fundamental Approach to Portfolio Management, David Swensen

    The Ivy Portfolio: How to Invest Like the Top Endowment Funds and Avoid Bear Markets by Mebane Faber and Eric Richardson

    The Behavior Gap: Simple Ways to Stop Doing Stupid Things with Money, Carl Richards

    Skating to Where the Puck Was: The Correlation Game in a Flat World, William Bernstein

     

    Tadas Viskanta is the founder and Editor of Abnormal Returns. Tadas is a private investor with over 20 years of experience in the financial markets. He is the co-author of over a dozen investment-related papers that have appeared in publications like the Financial Analysts Journal, Journal of Portfolio Management among others. Tadas is also the author of the well-recived book: Abnormal Returns: Winning Strategies from the Frontlines of the Investment Blogosphere which culls lessons learned from his time blogging.

     

     
  • Rick Ferri

    3 Things to Know Before Selecting an Adviser

    By Rick Ferri

    Your portfolio needs some help and you’ve decided find an adviser. This can be an arduous task given the plethora of choices. It helps to decide exactly what you’re seeking and how much it costs before heading to the yellow pages. These 3 keys will help.

    1. Know what you want: Are you looking for a big picture financial plan or for portfolio management? It’s important to make this distinction because different advisers specialize in different things. Financial planners are generalists who help with the big picture: budgeting, insurance, tax and estate planning and some investing. They’re Certified Financial Planners (CFPs) or Chartered Financial Planners (ChFPs). Both certificates require about one year of class work, plus real-world experience.  Investment specialists are a different breed and hold a different title. Portfolio managers and investment analysts tend to hold a Chartered Financial Analyst (CFA) designation. This rigorous program requires a three year educational track plus years of experience. The CFA is to investing as a Certified Public Accountant (CPA) is to taxes.

    2. Seek a like philosophy:  Investing is personal. Your adviser’s beliefs about how to manage a portfolio should match your own. There are two general schools of thought: active and passive. An active strategy assumes the financial markets are inefficient and that an adviser can skillfully select winning investments year after year. A passive strategy is the opposite. It holds that the financial markets are relatively efficient and that spending a lot of time and money trying to beat them is a waste. Active strategies tend to involve more turnover than passive strategies and the fees are much higher.  If you believe in one or the other, be sure to seek a like-minded adviser. There are several great books and articles that will help you make this philosophical decision.  

    3. Decide how to pay:  Advisers are paid in four ways: by commission, hourly fee, retainer or assets under management (AUM). Many advisers are paid on commission to sell products. The sales “load” is embedded in the cost of a product such as insurance, some mutual funds and limited partnership. The commission model is questionable because advisers are not acting solely on your behalf if they’re paid to sell products. Hourly fee advisers charge by the hour for the work they do, much like an attorney or CPA. The concern here is that an adviser may create busy work just to bill more hours. The retainer model is an annual fee based on the amount of anticipated work an adviser will do during the year. The risk is that you pay the fee but don’t use the services. AUM is a percentage fee that is based on the amount of money you are having managed.  The range of AUM fees charged by advisers is very wide, even for the same services.  Some are as high as 1.5 percent per year and others as low as 0.25 percent.

    Know what you want, what you believe, and how you want to pay for the services before beginning a search for investment help.  These 3 keys will go a long way toward finding the right adviser.

    Richard (Rick) A. Ferri, CFA is the founder of Portfolio Solutions,  the low-fee investment management firm he founded in 1999, which currently manages more than $1 billion in assets.  He is the author of six investing-related books, and shares his insights as a frequent news commentator, Forbes columnist, media contributor and public speaker.  Rick holds a Master of Science degree in finance from Michigan’s Walsh College, where he has served as an adjunct professor. Prior to entering the financial industry, Rick served as a U.S. Marine Corps officer and fighter pilot before retiring from the reserves in 2001 with twenty years of service.