Advisor Blog

We've previously written about the insurance sales scams called "Be Your Own Bank" and "Infinite Banking".  But, the recent lies produced by the salesmen hawking a similar concept under the name "Circle of Wealth" go beyond what we've seen before.

A "calculator" sent by the promoter of the scheme to insurance salesmen that he's trying to convince to use his system compares the performance of an Indexed Universal Life (IUL) policy to a hypothetical S&P 500 index fund.  Of course, the comparison is made over a very short time period that includes the 2008 stock market meltdown.  We once heard an insurance salesman claim that "if you take away the good years, the stock market really hasn't done very well."  Brilliant!  Here's a great example of that type of thinking. 

Beyond this, the "analysis" makes the following assumptions for the mythical S&P 500 index fund used in the comparison:

• Adds a 5.64% sales charge
• Adds a 1.5% "management fee"
• Assumes 100% annual turnover
• Assumes that all capital gains distributions are short-term and taxed at 28%

The truth is that anyone can purchase the Vanguard 500 Index without any sales charge and the annual expense ratio is 0.17% (less than that for share classes with larger minimum investments).  According to Morningstar, it has a 4% annual turnover ratio.  Since the fund invests in the S&P 500 index and companies very rarely spend a year or less as part of the index, most of the distributions are taxed at the advantageous long-term capital gains rate (currently a maximum of 15% - maybe going to 20% next year).

Mutual funds typically use a variety of active management techniques - stock picking, market timing and/or tactical asset allocation (overweighting the asset class or sector that they expect to perform best in the future) in an attempt to increase performance, reduce risk, or both.  In contrast, strategic asset allocation simply maintains a fixed target weight for the asset classes represented in the portfolio.  This is often described as a "buy and hold" investment philosophy and, according to much of the financial press and the salesmen pushing active management, it's outdated - "buy and hold is dead".

The Morningstar Principia database contains detailed information on the performance of the universe of 27,780 mutual funds and exchange traded funds (ETFs) as of March 31, 2012.  This makes it possible to compare the risk-adjusted performance of a globally diversified strategic asset allocation portfolio with increased exposure to value and small cap equities to the universe of funds. 

So, how many funds actually manage to outperform this terribly outdated method of portfolio management?  Surprisingly few.  To learn more, read the paper here.

"Did your portfolio return 117% over the past 10 years?  Ours did..."  That's the subject line in the email that was sent to investors by Morningstar.  It's obviously designed to grab your attention and if you have even a vague idea of the return that the S&P 500 generated over that time period, it probably worked.

According to Morningstar, "The past 10 years have been, well, complicated (to say the least).  From a long, brutal recession and fitful recovery to markets driven by fear and uncertainty, it has been a real test of any investor's mettle... which makes the simplicity and success of our strategy all the sweeter... for our flagship newsletter, Morningstar StockInvestor." 

Morningstar goes on to explain that their "tortoise portfolio" returned 123.2% and their "hare portfolio" returned 109.7% for a combined 116.5% as compared to 42.8% for the S&P 500 over the time period of 6/18/2001 through 4/1/2012.  That's actually closer to 11 years than 10 years, but I suppose that wouldn't sound as good.  If we advertised our performance in this manner, we would be in violation of SEC rules.  But, since Morningstar isn't a Registered Investment Advisor, they aren't held to the same standards.  Ignoring this, though, the performance sounds impressive - particularly when compared to the S&P 500.  But, how much risk did the portfolio take to generate this return?  We don't know because there isn't a shred of data about risk included in the advertising - no measure of beta or standard deviation anywhere.  No information about risk-adjusted return (Sharpe ratio, Treynor ratio, etc) to be found.  To call this incomplete would be a charitable description.

OK, ignoring risk (like Morningstar did), what about the return?  The numbers certainly sound good.  So, let's compare it to something we know like, oh, say - the Talis 100 portfolio, our globally diversified equity portfolio built with DFA funds.  We can't quite match the odd time period that Morningstar chose (starting 6/18/2001), but we can look at both 6/1/2001 and 7/1/2001 through 4/1/2012 - close enough.  And those numbers (adjusted for the fund expense ratios and the highest advisory fee that we charge and subject to important disclosures found here) are 145.2% and 144.4%, respectively.  I think it's fair to say that's a significantly better result.  So, how much risk did we take to get there?  Unlike Morningstar, you can visit our website and compare the standard deviation of any of our portfolio models to appropriate benchmarks.

A recent New York Times article by Tara Siegel Barnard titled "Why Panic? A couple's Nest Egg Better Left Alone" discusses the experience of a typical retired couple during the market plunge of 2008-2009.  It makes a number of good points and it is particularly interesting to us because the retired couple in the article are the parents of a long-time friend and colleague at DFA, Mark Gochnour.  Mark was the guy who happened to answer the phone when I first called DFA a dozen or so years ago. 

Among other things, the article discusses the importance of disciplined savings, choosing a portfolio with characteristics that fit within your risk tolerance, and being able to draw income from stable high-quality bond funds during periods of stock market stress.  At a conference a couple of weeks ago, I got to see how some planners have referred to this as the portfolio's "liquidity ratio", to borrow a term from balance sheet analysis.  Essentially, this is how many years of expenses can be covered without selling equity positions in the portfolio.  For retirees that choose to work with us for financial planning/wealth management, this is typically many years - more than enough time for the stock market to recover from even a serious decline. 

“It is really the simple things that I call the blocking and tackling of investing,” Mr. Gochnour said. “And you have to stay disciplined and stick with your plan, not only in good times but in more challenging times as well."  As the author points out, it also helps to turn off the television.

Clifford S. Asness (pictured in his office), Roni Israelov and John M. Liew, all from AQR Capital Management, were named co-winners of the annual CFA Institute's Graham and Dodd Award for their article on the benefits of global equity diversification.  The award recognizes excellence in research and financial writing in articles in 2011 issues of the Financial Analysts Journal, a publication of the CFA Institute. Their article, “International Diversification Works (Eventually),” was published in the May/June issue.

The paper concludes that although critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns, this observation misses the bigger picture.  Over longer time horizons, underlying economic growth matters more than short-term panics with respect to returns, and international diversification does an excellent job of protecting investors.

We frequently explain to clients that all investment portfolio designs are based on a set of tradeoffs.  Brad Steiman, Vice President at DFA, in his Northern Exposure article series does very good job of explaining one of the considerations in portfolio design in the following article.

Many aspects of life require careful consideration and balancing of the tradeoffs that arise from competing demands. For example, a common lifestyle tradeoff is working longer hours versus spending more time with your family. The competing demands within this decision are the income necessary to provide a suitable quality of life for your family versus the immeasurable benefits of quality time with your family. There is no right answer, but most people understand the tradeoff and attempt to find the balance that is right for them.

Successful investing and financial planning also require balancing tradeoffs. For example, a common investment tradeoff is that of risk and return. One of the competing demands is preservation of capital versus preservation of purchasing power. The former may allow for a better night's sleep during periods of heightened uncertainty and corresponding volatility, but the latter helps ensure you'll have a comfortable bed in the future when accounting for rising prices from inflation. Once again, there is no right answer, no "optimal" solution. Understanding the tradeoffs between preserving capital and preserving purchasing power will help investors find the balance that is right for them. This balance will depend on their definition of risk and attitude towards it.

Ameriprise has consistently recommended its own RiverSource (now renamed Columbia - fund companies love to change names when the old name is associated with unpleasantry) funds to its clients despite their high expense ratios and often poor performance while ignoring better alternatives.  This is what happens when an advisor eschews fiduciary duty and operates under the FINRA suitability rule.  Stuffing accounts full of their own proprietary mutual funds is a very effective way of transferring clients' wealth to the owners/shareholders of the firm. 

However, ERISA law requires that the sponsor of an employee retirement plan must act as a fiduciary.  Ameriprise tried to do the same thing with its plan participants and offered them its own funds as investment choices within their 401(k) plan.  The result is a lawsuit by their own employees/plan participants.  Apparently, they resent having to invest in the same funds that Ameriprise recommends to its clients!  According to Barron's "surely thousands of articles have been written on how to pick the best mutual funds and spot the worst. But here's a tip that doesn't often come up: If a fund company's employees are suing for being forced to invest in their own firm's mutual funds, you probably want to steer clear".  We agree.

Chuck Freadhoff, spokesman for American Funds, responded to my letter.  We had a good conversation and, while we still disagree on the value (or lack of it) of active management, we agree on some things - that a long-term focus is essential to investing success and that the right advisor relationship is key.  He also sent me a large package of data on their funds.  In upcoming articles, we will examine the performance of some of the funds through the lense of multifactor regression analysis.

American Funds is, as we briefly discussed in the previous article, a victim of its own choice of sales channel.  During the 2001-2002 bear market, many of their funds did better than the averages.  This became a simple selling point for the legions of brokerage salespeople that work for firms like Edward Jones (the largest American Funds sales outlet).  They sold the American Funds as a product based on past performance and their target market - the middle income and mass affluent - couldn't get enough of them.  The growth that they experienced from 2003-2007 propelled American Funds to one of the three largest fund companies in the world. 

Another recent article in Investment News addressed outflows from American Funds due to real or perceived performance issues. In the article, American Funds spokesman Chuck Freadhoff stated "We don't feel that over the long term, investors will do as well with a passive investment as they will active management, and we have the long-term track records to back that up."

We disagree with Mr. Freadhoff, so we looked for the "long-term track records" that he mentioned. In doing so, we found this document. At first glance, it looks impressive. But, upon further examination there are some glaring issues. First, the performance numbers on the first page don't take sales loads into account. That's misleading, since most investors in these funds pay them. At least that is disclosed at the top of the page and the second page contains load-adjusted returns. A bigger issue, however, is comparison to inappropriate benchmarks. For example, comparing value funds to the S&P 500 Index (dominated by growth companies and, at best, a blend of growth and value). American Funds could have chosen a value index, like the Russell 1000 Value, but that wouldn't have made the comparison look as good. Even more egregious is the comparison of their emerging markets fund to a world ex-US index instead of an emerging markets index that would have shown that it underperformed. This is very misleading.

Many business owners and 401(k) plan sponsors are scrambling to understand and comply with the new Department of Labor mandated fee disclosure regulations that will become effective only a few months from now. The new regulations explained under sections 408(b)(2) and 404(a) of the Employee Retirement Income Security Act of 1974 (ERISA) require additional disclosures to be made to plan sponsors and plan participants, and require all plan service providers to furnish much more information about their services, expenses and fees. ERISA section 408(b)(2), the service provider rules, become effective April 1, 2012, while the new 404(a) participant disclosure rules become effective May 31, 2012.

According to a January 16 article in Investment News, investors withdrew a net $81.5 billion from American Funds in 2011, including a net outflow of more than $33 billion for the company's flagship product, Growth Fund of America. No other mutual fund even came close to matching that amount of outflow. In fact, there was not an entire fund family that matched the outflow of just this fund. Fidelity Investments came closest with outflows of $28 billion. According to Morningstar, Inc. analyst Kevin McDevitt, Growth Fund of America ranked in the bottom 25th percentile of all large-cap growth funds for 2011.

A few years ago, we heard a lot about American Funds and it seemed that almost every brokerage firm was pushing them. I remember going to a local Chamber of Commerce meeting where there were three representatives from different local offices of the same brokerage firm - all singing the praises of American Funds.

In 2011, investors showed a strong shift away from actively managed funds. As a result, the Vanguard Group took in $29.5 billion in mutual fund inflows, the most of any mutual fund family. Could it be that a larger group of individual investors has finally caught on to the fact that active management is an expensive failed strategy?

The past year reminded investors that they should hope for the best, prepare for the worst, and be thankful when reality does not match their fears. Investors entered 2011 with hopes that the world economy would continue recovering from a long and painful deleveraging process. Equity markets had posted two straight years of positive performance, central banks remained committed to pro-growth monetary policy, and major developed nations were focused on reducing debt.

Another great article from Weston Wellington at DFA in his "Down to the Wire" column:

Equity investors around the world had a disappointing year in 2011 as thirty-seven out of forty-five markets tracked by MSCI posted negative returns. The US did well on a relative basis and was the only major market to achieve a positive total return, although the margin of victory was slim. Total return for the S&P 500 Index was 2.11%, and the positive result was a function of reinvested dividends—the index itself finished the year slightly below where it started.

Led by the excellent performance of US stocks, global equity markets posted strong returns in the quarter. Those returns, however, were not sufficient to overcome a dismal third quarter and most markets had negative returns for the year.

• Quarterly returns for the broad US market, as measured by the Russell 3000 Index, were 12.12%. Asset class returns ranged from 15.97% for small cap value stocks to 10.61% for large cap growth stocks. The strongest sectors in the quarter were energy and industrials, while the weakest one was telecommunication services. For 2011, the strongest sectors were utilities and consumer staples, while the weakest ones were financials and materials. Value outperformed growth in the quarter, but not in 2011.

• In US dollar terms, the quarterly returns for developed non-US markets were over 3%, above the historical average but far behind the US. For 2011, however, developed international markets as a whole lost over 12%. As in most of the past few quarters, there was much dispersion in performance at the individual country level. Greece, which remains at the center of Europe’s sovereign-debt woes, was by far the worst performer in the quarter and the year. At the other end of the spectrum, Ireland, the Scandinavian countries, and Australia were the top performers for the quarter.

• In US dollar terms, emerging markets gained about 4% in the quarter, in line with the historical average, but not enough to overcome their very poor performance of the third quarter. As a result, emerging markets lost almost 20% in 2011. Malaysia and other smaller emerging markets in Asia and Latin America such as Thailand and Peru posted double-digit returns in the quarter. At the other end of the spectrum, India, Turkey, and Egypt had double-digit negative returns in the quarter. 

We've been discussing the dangers of investing in life settlements for years, as have many other sources - including the SEC, GAO, Wall Street Journal and the Texas State Securities Board.

Life Partners, based in Waco, Texas and one of the largest brokers of life settlements has been charged by the SEC with fraud.  The SEC alleges that the company was systematically and materially underestimating the life expectancy estimates it used to price transactions. Life expectancy estimates are a critical factor impacting the company's revenues and profit margins as well as the company's ability to generate profits for its shareholders.

According to the SEC's complaint filed in federal district court in Waco, Texas, Life Partners misrepresented and failed to disclose in public filings with the SEC that the company's systematic use of materially underestimated life expectancy estimates constituted a material risk to the company's revenues. Beginning in 1999, the company used life expectancy estimates provided by Dr. Donald T. Cassidy, a Reno, Nevada-based doctor with no actuarial training or prior experience rendering life expectancy estimates. The SEC alleges that Life Partners failed to conduct any meaningful due diligence on Cassidy's qualification to act as a life expectancy underwriter and instructed the doctor to use a life expectancy methodology that was created by the company's former underwriter, a part-owner of Life Partners and that the company's executives were aware that the Cassidy-rendered life expectancy estimates were systematically and materially short.

Don't say we didn't warn you.

Ron Lieber, the New York Times "Your Money" columnist and editor of its "Bucks" blog has written another good article that discusses our investment philosophy.  In Lieber's column, he discusses the "Larry Portfolio", which he has named after Larry Swedroe.  If  you're a regular reader, you know that we think highly of Swedroe's research and his publications and have recently recommended reading his latest book, The Quest For Alpha.  His portfolio design and investment philosophy are based on the same principles and research that we employ.

Lieber's column states that "the point of any long-term portfolio for the vast majority of investors is to earn whatever return you need to meet your goals while taking the least amount of risk."  It goes on to point out that "between 1970 and 2010, small-cap value stocks outearned the S&P 500 by roughly four percentage points annually", referring to the small-cap value research done by Eugene Fama and Ken French.  "For illustration purposes, he points people to the S&P 500 index, which returned about 10 percent annually between 1970 and 2010.  If you wanted to gin up a portfolio to match closely (at 9.8 percent) that performance with much less risk, all you would have needed to do was put 32 percent of your money in a fund mimicking the United States stock index of small and value companies that Mr. Fama and Mr. French developed.  Then you'd put the other 68 percent of your money in one-year Treasury bills".

If you've paid attention to our investment philosophy, you'll recognize this - a tilt toward small-cap and value stocks with risk controlled by adding high credit quality short-duration fixed income in various proportions depending upon a client's risk capacity.

Lieber also points out important caveats about this investment philosophy.  For example, it won't track the indices that most people are familiar with, like the Dow, NASDAQ, or S&P 500.  "You have to tell yourself that you are not going to have portfolio envy or listen to what Jim Cramer is saying on CNBC.  Are you willing to pay that price?"  If you are, you might "see years like 2001 when the Fama/French index gained 40.6 percent while the S&P 500 lost 11.9 percent".  Mr. Lieber also discusses how "education is the armor that protects you from emotions" and the importance of "hiring an educator - an investment advisor - who protects you from the hair-trigger impulses that position your fingers over the sell button."

Unfortunately there aren't many responsible financial journalists.  Most try to sell newspapers and magazines with dubious research (Ten stocks/mutual funds to buy now!) or sensational headlines (Financial Armageddon!).  Fortunately, there are a few that provide a balanced and reasonable point of view. 

1968 was a turbulent year in the US and around the world.  In January, the war in Vietnam exploded with the start of the Tet Offensive.  Martin Luther King, Jr. was killed in Memphis and violence broke out in cities across the country.  Just two months later, Robert Kennedy was assassinated after announcing his victory in the California primary.  The democratic national convention was marred by violent clashes between police and war protesters.  Around the world, people - particularly youth and students, were demonstrating for change. 

Much like the shepherds and wise men during the first Christmas, people around the world turned their attention toward the heavens as Christmas approached that year.  Commander Frank Borman, Command Module Pilot Jim Lovell and Lunar Module Pilot William Anders launched aboard Apollo 8 on a mission to become the first humans to orbit the Moon in preparation for the big event of Apollo 11. They entered lunar orbit on Christmas Eve.

The Apollo crew sent Christmas greetings and live images back to Earth and read from the book of Genesis.  It is estimated that more than one billion people watched the historic broadcast or listened on the radio. The Apollo 8 crewmembers ended their history-making journey when they splashed down in the Pacific Ocean on December 27.

Here is the original broadcast:

It is said that those who ignore history are doomed to repeat it.  We should also learn from history in a contextual sense, as Jim Parker mentioned in our previous article.  It can be difficult to appreciate what we have without knowing where we've come from.  The lessons of 1968 are relevant today.  We live in a world with far less poverty and far more freedom, at least partially as a result of the struggles of the past and the technologies that were developed as we strived to meet the challenge of putting a man on the moon.  If we are dissatisfied with the status quo, as many of us are, then we have the freedom and the opportunity to effect change. 

From all of us to our valued clients and friends, best wishes for a safe and happy holiday season however you may choose to celebrate it.  Merry Christmas.  Happy Hanakkuh.  Happy Festivus!  And, best wishes for a New Year filled with peace, hope and prosperity.

As we near the end of a tumultuous year in the capital markets, it may be a good time to view recent events with a greater sense of perspective.  Jim Parker at DFA recently published an article on this topic.  Jim spent 25 years as a senior editor and writer for the Australian Financial Review and holds an an economic history degree from Deakin University and a journalism degree from Auckland Technical Institute.

The Good Old Days?

"The hardest arithmetic for human beings to master," wrote the great American working man's philosopher Eric Hoffer, "is that which enables us to count our blessings."

It's a piece of wisdom worth recalling after another year that has tested the nerve of many investors and prompted questions about what current generations have done to deserve to live in such a tempestuous stage of history.

As the year winds down (if that's the word for it!), financial markets are gripped by uncertainty over developments in the Eurozone crisis. Each day brings fresh headlines that send investors scrambling from virtual despair to tentative optimism.

While not seeking to downplay the very real anxiety generated by these events, particularly in relation to their effects on investment portfolios, it's worth reflecting critically on our often second-hand memories of the "good old days."

A Brief History of the 20th Century

Nearly 100 years ago, Europe was engulfed by a war that destroyed two centuries-old empires, redrew the map of the continent, and left more than 15 million people dead and another 20 million wounded. The economic effects were significant, with widespread rationing in many countries, labor shortages, and massive government borrowing.

Just as the Great War was ending, the world was struck by a deadly pandemic—the Spanish flu, which, by conservative estimates, killed some 50 million people. About a third of the world's population was infected over a two-year period.

A little over a decade after the Great War and the pandemic, the Great Depression cut a swath through the global economy. Industrial production collapsed, international trade broke down, unemployment tripled or quadrupled in some cases, and deflation made already groaning debt burdens even larger.

In the meantime, resentment was growing in Germany over its Great War reparations to the Allied powers. Berlin resorted to printing money to pay its debts, which in turn led to hyperinflation. At one point, one US dollar converted to 4 trillion marks.

In a new militaristic and nationalist climate, fascist regimes arose in Germany, Italy, and Spain. Under Hitler, Germany defied international treaties and began annexing surrounding regions in Austria and Czechoslovakia before finally attacking Poland in 1939.

This led to the Second World War, a conflict that engulfed almost the entire globe while Japan pushed its imperial ambitions in Asia, and Germany sought to conquer Europe. More than 50 million died in the ensuing conflict, including a holocaust of six million Jews. The war ended with the invasion of Berlin by Russian and western forces, while Japan surrendered only after the US dropped nuclear bombs on two cities, killing a quarter of a million civilians.

In economic terms, the war's impact was profound. Most of Europe's infrastructure was destroyed, millions of people were left homeless, much of the UK's urban areas were devastated, labor shortages were rife, and rationing was prevalent.

While the thirty-five years after World War II were seen as a golden age in comparison, the geopolitical situation remained fraught as the nuclear armed superpowers, the Soviet Union and the US, eyed each other. The breakdown of the old European empires and growing east-west tensions led the US and its allies into wars in Korea and Vietnam.

The cost of the Vietnam and cold wars created enormous pressures concerning balance of payments and inflation for the US and led in 1971 to the end of the post-WWII Bretton Woods system of international monetary management. The US dollar came off the gold standard, and the world gradually moved to a system of floating exchange rates.

In the mid-1970s, the depreciation of the value of the US dollar and the breakdown of the monetary system combined with war in the Middle East to encourage major oil producers to quadruple oil prices. Stock markets collapsed and stagflation—a combination of rising inflation alongside rising unemployment—gripped many countries.

While the 1980s and 1990s were a relative oasis of calm—aided by the end of the cold war—there still was no shortage of bad news, including the Balkan wars, the Rwandan genocide, and recessions in the early part of both decades.

In the past decade, there have been the tragedies of 9/11; the 2004 Asian tsunami; the 2011 Japanese earthquake, tsunami, and nuclear crisis; and now, the financial crisis sparked by irresponsible lending, complex derivatives, and excessive leverage.

Another Perspective

So from this potted history, it seems fairly clear that tragedy and uncertainty will always be with us. But the important point to take away from it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn't overlook the good either.

Alongside the wars, depressions, and natural disasters of the past century, there were some notable achievements for humanity—like women's suffrage, the development of antibiotics, civil rights, economic liberalization, the spread of prosperity and democracy, space travel, advances in our understanding of the natural world, and enormous advances in telecommunication. (Oh, and the Beatles.)

Today, while the US and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making advances too.

The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality, and raising education and environmental standards by 2015. In East Asia, the majority of twenty-one targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.

Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders while providing new avenues for the spread of ideas in education, health care, technology, and business.

Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change, and lifting the ability of the developing world to more fully participate in the global economy.

Rising levels of education and health, and workforce participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives, and fast profits but on sustainable, long-term wealth building.

Anxiety over recent market developments is completely understandable, and it is quite human to feel concerned about events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what we already have. These are ideas to keep in mind when we scan the news and long for the "good old days."

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