Advisor Blog

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. 

I attended a presentation last week by Clint Haggard and Byron Gossett that discussed creating a 100 year plan for sustaining family wealth and unity.  As most people know, creating wealth is one thing - sustaining it over many generations is a completely different challenge.  While the discussion was centered around high net worth families, many of the points are quite valid for most of us.

Here is the top ten list, in reverse order - David Letterman style:

10.  Have a shared vision with the next generation about management of assets (investment philosophy, charitable giving guidelines, disbursements, voting control, leadership).

9.  Have a scheduled meeting with beneficiaries of family wealth on a regular basis.  Seek to develop a culture that includes holding productive meetings.

8.  Create lasting memories and traditions with the next generation that do not necessarily revolve around material things.

7.  Encourage the next generation to "ride in the truck", allowing them to observe the older generation's approach to both business and relationships.  Be very intentional in training the next generation in effective communication skills.  [If "ride in the truck" is a confusing phrase, you're probably not from Texas or another area with a ranching or agricultural history.  It simply means to spend time together - working, playing, observing. - JBE]

6.  Support and encourage individualism in the next generation.  Learn to accept each person and their uniqueness.  Make it a priority to invest in the development of each family member so that they may reach their full potential.

5.  Create and follow a written Living Master Plan (LMP) that considers future generations, not just the next generation.

4.  Develop a standardized system to address such things as employing family members, compensation levels, levels of authority, and succession.

3.  Develop a system for addressing and resolving conflict in the family and/or the family business.

2.  Explore the possibility of using charitable foundations as a training ground or "laboratory" for teaching stewardship and philanthropy to the next generation(s).

And, finally...

1.  Utilize the services of objective and creative advisors who are trained and experienced in assisting with the above activities.

Since 2008, economic uncertainty and market volatility have tested the staying power of investors around the world. Many people fled equities during the worst months of the global financial crisis, while others waited for signs of a turnaround before investing more. Their emotional reactions may have exacted a large price on their wealth.

The graph below documents investor behavior during the stock market downturn in 2008 and subsequent market rebound. It offers a few key lessons about investing in turbulent markets.

Figure 1: Quarterly Equity Mutual Fund Flows

Industry vs Dimensional Relative to S&P 500 Index Performance (Jan 2008-June 2011)

For illustration purposes only. Industry net new cash flow data for US-domiciled equity funds provided by Investment Company Institute ©2011. Quarterly cash flows are estimates that are adjusted to represent industry totals, based on reporting covering 95% of industry assets. Dimensional's figures are based on net new cash from financial advisors in US-domiciled funds. Industry and Dimensional data reflect investment in US and international equity markets and do not include funds of funds. S&P 500 Index performance is based on monthly returns data. The S&P data are provided by Standard & Poor's Index Services Group. The S&P 500 includes 500 US stocks chosen for market size. Past performance is no guarantee of future results.

Reading the Graph

First, look at the shaded graph in the background, which plots the performance of the S&P 500 Index (measured by growth of a dollar) over this three-and-a-half-year period. The market began falling in late 2008 and hit bottom in early March 2009. It then reversed sharply and began a long climb through June 2011.

Now consider how mutual fund investors responded to the stock market's downturn and recovery. The orange line plots quarterly net cash equity flows for the US mutual fund industry over the same period. (Net cash flow is the difference between redemptions and purchases of shares in a mutual fund. A net cash outflow occurs when redemptions exceed purchases.) Equity fund flows were cumulatively negative over the period. Investors were redeeming more shares than they were buying, and on a net basis, capital was leaving mutual funds.¹

Note that these fund industry outflows followed the stock market downturn, and net flows stayed negative even after the market rebound. Investors were reacting to the falling stock market by either redeeming their fund shares or delaying the purchase of additional shares.² When the stock market suddenly rebounded in March 2009, investors who had reduced their exposure to equities missed a good part of the recovery.

This apparent lack of discipline is well established over longer time periods too. Industry analyses and academic research suggest that investors tend to focus on recent performance and make decisions that compromise long-term returns in their portfolio.³

Recent history illustrates why the average fund investor may fail to earn returns comparable to those of the average fund or market index. Markets change quickly, and investors must be in their seats to capture returns. Unfortunately, many investors let their emotions get in the way of participating in long-term market performance.

Now consider the upward-sloping blue line, which plots quarterly net flows into equity strategies offered by Dimensional Fund Advisors. These flows were cumulatively positive throughout the entire period, suggesting that shareholders in Dimensional's funds continued to purchase shares during the 2008–2009 market decline and after the March 2009 rebound.

As a group, these investors did not flee stocks en masse. In fact, they did the opposite by adding to their portfolios. Their discipline positioned them for the market rebound.

A mutual fund's net cash flows also may reveal the collective discipline—or lack of discipline—among its shareholders. In fact, the direction of net flows can impact portfolio management and performance, especially for funds invested in less liquid markets. Large net redemptions typically increase the direct and indirect costs of a mutual fund, which compromise fund returns.⁴ The assorted costs are not borne by redeeming shareholders but by the shareholders who remain in the fund.⁵ Therefore, consistently positive net cash flows are helpful to a fund's expenses, strategy, and performance.

Summary

The large net cash outflows from US-based mutual funds since 2008 document investor reaction to market volatility, while Dimensional's stable and positive net fund flows suggest disciplined behavior. So why would shareholders in Dimensional's funds behave differently? One reason might be the education, encouragement, and discipline offered by their financial advisor at that difficult time, underscoring the value of sound investment advice.

An advisor's steady hand helps investors apply discipline in all types of markets, which can positively impact individual performance over time. Moreover, when advisors influence the collective decisions of shareholders in a fund, the greater cash flow stability can prove beneficial to the fund's strategy, cost management, and returns.

1. Mutual fund investors redeem their shares by selling them back to the mutual fund and receiving cash proceeds based on the net asset value (NAV) of the shares at day's end. Redemption is a normal activity in a mutual fund, and liquidity is one benefit of owning fund shares. A fund manager may use inflowing cash to cover the redemptions or keep cash in a "liquidity reserve" for this purpose. When cash balances do not suffice, the manager may execute trades to raise the cash.

2. According to the Investment Company Institute, mutual fund flows do not offer a good measure of total demand for equities since funds hold only about 20% of the total US equities outstanding, with the balance held directly by individuals, institutions, and governments. Academic research offers some evidence that mutual fund flows do not drive market returns but reflect investor reaction to markets. (Roger M. Edelen and Jerold B. Warner, "Aggregate Price Effects of Institutional Trading: A Study of Mutual Fund Flow and Market Returns," Journal of Financial Economics 59, no. 2 (2001): 195–220.)

3. A Morningstar study compared the dollar-weighted returns of the average investor in a fund with the fund's published total return for the ten-year period ending Dec. 31, 2009. In US equities, the average investor in all funds earned 0.22% annualized, compared with 1.59% for the average fund. (Russel Kinnel, "Bad Timing Eats Away at Investor Returns," Morningstar.com, February 15, 2010.) Lack of investment discipline also is documented among individual investors who hold common stocks directly. Those who trade frequently pay a tremendous performance penalty for their actions. (Brad M. Barber and Terrance Odean, "Trading is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors," The Journal of Finance, April 2000.)

4. Direct transaction costs include commissions, bid-ask spreads, and price impact incurred when a fund makes trades in response to shareholder redemptions. Net outflows also may generate indirect costs on a fund by forcing its manager to alter the target asset allocation or make disadvantageous, uninformed trades to raise cash. See Qi Chen, Itay Goldstein, and Wei Jiang, "Payoff Complementarities and Financial Fragility: Evidence from Mutual Fund Outflows" (white paper, February, 2007).

5. Mutual funds typically meet a redemption based on the NAV at day's end but may execute a trade to raise cash on the following day. The redeeming shareholder cashes out at an NAV that does not reflect the trade, and the resulting costs are borne by remaining shareholders. See: "On the Run: Examining Patterns in Mutual Fund Redemptions," Knowledge at Wharton, http://knowledge.wharton.upenn.edu/article.cfm?articleid=2133, accessed September 27, 2011.

Now, listen to this, and I'll tell you 'bout the Texas...
I'll tell you 'bout the Texas Radio.
I'll tell you 'bout the hopeless night
Wandering the Western dream.

    - Jim Morrison, 1971

It seems that every time I turn on the radio over the weekend, I'm assaulted by a slew of what amounts to financial "infomercials".  They are actually very similar to the late-night TV commercials hawking everything from weight-loss pills to miracle hair growth remedies.  And, they are just about as credible.

These shows always have a disclaimer that's run at the beginning and the end of the show stating that the show is "for entertainment value only and should not be construed as investment advice".  At least, the last part of that statement is certainly true.  Unfortunately, we all know that they really are investment advice regardless of the disclaimer.

Some of the most incredible claims come from insurance salesmen trying to sell insurance products as investments.  The claims are often outrageous and frequently just plain wrong.  Last year, we heard one such show making claims that we knew were false.  So, we contacted the Texas Department of Insurance and made them aware of it.  They didn't seem to care much and actually said that there wasn't much that they could do until someone who bought the product complained about it.  In their own words, "we have to wait until the fraud actually occurs."  They suggested that we talk to the Attorney General about deceptive advertising.  That got us just about as far.  Don't count on the State of Texas to protect you from these lies.

As usual, the securities regulators are a little more vigilant.  One of the biggest spenders on "infomercials" in the D/FW marketplace is a guy that tries to convince people that they can hire his firm to time the market.  The host of the show uses a lot of silly sound effects and promises the "world's best" cookies to people that will attend his seminars.  FINRA and the SEC finally cracked down on his advertising practices, but he's still on the radio constantly - just being a bit more careful.

Then, there are the real bottom feeders - the guys pushing life settlements.  Despite all of the recent investigative reporting, many are still out there making unrealistic claims.  We've written about one particular group before - and they still have a website where they claim that "Our clients have never lost a penny of principle!"  Really?  Would you trust an advisor that doesn't know the difference between principle and principal?

It seems obvious that you shouldn't trust this type of "advisor".  But, how do you know who you should trust?  We've talked about this issue in previous posts.  Scott Maxwell has written about it in his essay series.  There are several good books that have been published recently that explain it well.  One of those is The Investment Answer.  We've recommended it before.  Another good one is The Little Book of Bulletproof Investing by Ben Stein and Phil DeMuth.