Advisor Blog

According to a research report published by Vanguard, recent stock market volatility is not unexpected when compared to previous time periods of significant macroeconomic events.

"Although the stock market volatility... appears extraordinary relative to the calm of the last year, [data] demonstrates that the levels of market variations today are, in fact, "ordinary" relative to the volatility of other periods characterized by major gobal macro events." state authors Francis M. Kinniry Jr., CFA, Todd Schlanger and Christopher B. Philips, CFA.

From July 1992 to August 2011, the S&P 500 Index moved an average of 0.7% per day.  The daily volatility spiked - or doubled - to 1.46% when significant global events occurred.  "As a result, we would argue that... volatility in equities, although high and painful to many investors, was not unexpected, given the market environment and the widespread repricing of risk.  Thus, in Vanguard's view, to cast the current environment as a 'new paradigm' of volatility is misleading."

The Vanguard report found that from August 5 (the day that S&P downgraded US Treasury debt, kicking off this period of volatility) to August 30, the S&P 500 Index moved an average of 2.5% per day.  We examined the September and October time period and found that the average daily volatility was 1.6% and 1.5% respectively.  It is not unusual for volatility to spike and slowly decay (statistically, it is serially autocorrelated). 

In 2008, we saw 23 days when the S&P 500 moved more than 4%.  This level of volatility occurred for seven days in 2009, no days in 2010, and has occurred six times, so far, in 2011.  Movement of 1% happened on 129 days in 2008, 108 days in 2009, 67 days in 2010, and 59 days in 2011 to date.

The Vanguard report looked at the volatility of two hypothetical balanced stock/bond portfolios - an 80% S&P 500/20% Barclays Aggregate Bond and a 40% S&P 500/60% Barclays Aggregate Bond.  As expected, in 2008 and 2011, the S&P 500 experienced "markedly more volatility than the two more conservative portfolios." and concluded that investors with balanced, diversified portfolios have faced much less aggregate volatility than the headlines would suggest.  We concur.

Finally, the authors note that "realized volatility is a critical factor in the equity risk premium (ERP), or the extra return demanded by investors for investing in stocks instead of less risky assets such as bonds or cash" and that "periods of heightened volatility or risk can actually increase the forward ERP."  This is, of course, consistent with the message that risk and return in capital markets are inevitably related.

We frequently hear from investors that want to know why we prefer to use bond funds instead of purchasing individual bonds.  Usually, it's about the concept of holding the individual bonds to maturity in order to know the rate of return and be assured of not losing money.  In reality, however, there is a lot more to the decision and there are some significant benefits from investing in a bond fund.

First, let's consider how bonds fit into our asset allocation.  We view bonds as volatility reducers and not as income generators.  Our portfolios are designed for efficent total return and utilize a variety of investments that have varying degrees of correlation with each other.  By adjusting the asset allocation, we create a portfolio that has volatility characteristics that coincide with an investor's risk tolerance.  The majority of our clients have long time horizons and are most concerned with maximizing growth, so it is appropriate for their portfolios to have a significant allocation to equities.  These portfolios have very good long-term return potential, but will exhibit short-term periods of extreme volatility (it's a common lament in the world of financial economics that "there is no free lunch" - in other words, you can't have a high rate of return with low volatility).  Investors with high risk tolerance, a long time horizon, or both are willing to endure the volatility in order to achieve a high rate of return over time.

But, not everyone is well-suited for a volatile portfolio, even
though it may maximize expected return.  Some investors must rely on their portfolio to supply their living expenses or to meet a large financial obligation in the near future and a short-term drop in the value of their portfolio could be harmful.  These investors generally choose to have a greater allocation to bonds because bonds are much less volatile than equities.  From a practical standpoint, creating an income stream from the entire asset allocation with regular rebalancing of the portfolio meets the client's withdrawal needs.  The total return approach also shifts a meaningful portion of the tax liability to long-term capital gains (which are taxed at a lower rate than interest income), creating increased tax efficiency. 

A common myth about owning individual bonds is that you don't have to worry about losing money or having the bonds depreciate.  As usual, the truth is more complicated.  All bond prices move in response to changing interest rates, credit conditions and other variables.  It's quite possible for a long-term bond's price to drop by a couple of percentage points on a really bad day.  If you need to liquidate that position, you would suffer a capital loss.  Of course, if you plan to hold the bond to maturity, this short-term decline would not be an issue.  But, this only matters if you assume that the distributions from the portfolio must be generated from investment income and not from total return.  More often than not, the appearance of added safety is a function of not looking at the value of the bond over time, whereas bond mutual fund prices are calculated every day.  In reality, bond funds benefit more quickly from the higher prevailing yields that create a price decline.  So, although you may not have a simple and easily defined terminal value to expect, the evidence shows that bond funds will likely outperform individual bonds or a laddered portfolio of bonds over longer time periods.

Bond funds also provide superior diversification, more efficient reinvestment of interest payments, transaction cost advantages, and the ability to dynamically manage term and/or credit risk.  Owning the right bond funds can also be very inexpensive.  The funds that we use for most portfolios have expense ratios of less than 0.25% per year versus the 0.72% average for bond funds.¹

So, if laddered portfolios of individual bonds are not preferable to owning a bond fund, why do most of the salespeople at Morgan Lynch Barney BS Fargo Jones & Company do it?  Because it makes it look like they are doing something that adds value.  It doesn't really matter if it actually does or not.  Like far too many things in this business, it's all about creating a perception instead of about doing what's right for the client.

1. ICI Research Perspective, March 2011

We've compared the performance of a strategic asset allocation portfolio model to the universe of mutual funds, many of which employ active management - including tactical asset allocation, on a regular basis since 2008.  The papers examine both pre-tax and after-tax 10 year risk-adjusted returns.  The most recent update, based on data from 26,564 mutual funds, ETFs, and holding company depository receipts is now posted on the home page of our website.  You can read it here.  If you'd like to read one of the previous versions, simply request it via email to one of our advisors.

Strategic asset allocation as an investment management policy is based on studies that have found that portfolio return is primarily determined by asset class exposure, whereas tactical asset allocation attempts to predict future returns of asset classes and weight them to increase return, reduce risk, or both.  The data presents a compelling case for strategic asset allocation and further supports the conclusions of other studies that have found that active management, including tactical asset allocation, adds no value.

The report contains performance information for a strategic asset allocation portfolio and is subject to the same disclosures as the performance information posted on our website.  Read the applicable disclosure information here.

Real estate as a wealth generator is hardly a new idea. People owned property long before the advent of stock exchanges and other capital markets. In more recent times, large corporations and institutions have held commercial real estate in their portfolios.

But individual investors have not traditionally had ready access to a professionally managed, diversified real estate portfolio. This has changed in the last few decades with the development and growth of real estate investment trusts, or REITs. Now individuals can add a real estate component to their portfolio to improve overall diversification.

What is a REIT?

A REIT is a company that owns, operates, and/or finances real estate property.¹ Most of this discussion will address equity REITs, which manage different types of income-producing properties, such as hotels, office buildings, industrial facilities, apartments, and shopping centers. As commercial landlords, equity REITs typically generate dividend income from the rent paid by tenants. Many REITs in the US are traded on the public stock exchanges.

Publicly traded REITs offer investors several potential benefits:

Real estate exposure. While publicly traded REITs account for only a small portion of the real estate investment universe and the equity market, academic evidence suggests that REITs have similar returns to the overall real estate market .² 

Low correlations with financial assets. Over longer periods of time, historical correlations of REITs and stocks have been generally low. (Correlation refers to the co-movement of asset returns. When two assets are positively correlated, their returns tend to move together; when negatively correlated, their returns are dissimilar.)

Diversification. A REIT holds a portfolio of properties, which may specialize by property type and industry, or be broadly diversified according to industry and region. With the more recent advent of real estate securities overseas, investors can further diversify their exposure among foreign developed markets.

Higher yield, regular income, capital appreciation. Since REITs have to pay out a large fraction of earnings as dividends, they tend to offer higher-dividend income than equities, and this may benefit certain income-oriented investors. Total return of the shares is tied to income and change in market value.

Distinct asset class. While REITs are considered equity vehicles and can have significant exposure to the size and value risk factors, they are generally considered to be a separate asset class, due to their low long-term correlations with stocks.

Liquidity and transparency. Publicly traded REITs can be bought or sold whenever the stock market is open for business. The availability of market-determined share prices can reveal information about the market's assessment of the company's prospects, including the ability of the firm's management team.

Tax treatment. REITs operate as "pass-through" corporations in which most income goes directly to shareholders. They typically pay little or no taxes on corporate income.³

Investing in REITS

A REIT mutual fund that manages a portfolio of REITs typically offers more diversification than owning a single REIT. Most REIT funds are either actively managed or indexed. An active fund manager seeks to pick securities that appear undervalued-an approach that often results in over-concentration in a single category, which may raise risks and potential costs, including transaction costs and management fees. On the other hand, an index fund tries to replicate a benchmark, such as the FTSE NAREIT Equity REIT Index or the Dow Jones US Select REIT Index. Although index funds may have lower fees, securities held in the portfolios may experience buying and selling pressure when indexes are reconstituted.

Our preferred approach is a structured strategy. Rather than trying to replicate an index, a manager may choose securities based on risk-return characteristics, diversification benefit, and favorable price negotiation. By keeping costs low and trading efficiently, a structured REIT strategy seeks to generate improved returns over time. Advantages of this approach include broader, more systematic exposure to the REIT universe at a lower cost.

Adding a real estate component to a portfolio may be a good diversification move. But strategy and implementation are crucial, and before investing, you should consider how a real estate strategy and the REIT you select may affect your portfolio. Some factors that may come into play:

Asset coverage. Most actively managed stock funds and indexes include REITs in their equity holdings. This creates the potential for overlapping asset class exposure for investors who add a REIT component in their portfolio. Treating REITs as a separate and distinct strategy helps you achieve more precise risk exposure in the asset class weights. For example, investors with significant direct ownership in real estate may want to exclude REITs from the equity component in their portfolio to better control their overall exposure.

REIT category. Equity REITs may operate property in a specific area of expertise, such as retail, office and industrial, hotels, or health care facilities. Residential REITs own and operate apartment buildings and multi-family commercial dwellings, rather than single-family homes. Mortgage REITs, which lend money directly to real estate owners or invest in existing mortgages or mortgage-backed securities, are generally excluded from the equity REIT universe because they perform more like fixed income instruments, with income based on interest payments. Hybrid REITs combine the strategies of equity and mortgage REITs.

Diversification. As with financial assets, owning a broad mix of REITs can help reduce specific risk in a portfolio. This diversification eliminates exposure to a single REIT category, manager style, or geographic region. Also, adding international real estate can further enhance the potential diversification benefit.⁴ Correlations among international REITs are low across countries, regions, and equity markets, making them a useful complement to equities in developed and emerging markets.

Risk Considerations

REITs carry stock market risk, as well as risks specific to individual real estate properties, sectors, regional markets, and the operating firm. The securities are also subject to market pressures that may push share prices above or below the value of the underlying real estate. However, identifying a market premium or discount in a REIT is difficult since the underlying asset value reported by a REIT is based on an appraisal, which may be several months old. REIT returns also depend on the buying, selling, and operating decisions of management.

A manager may adopt risky strategies, such as heavy leveraging or lack of diversification. They may pay too much for properties, acquire poorly performing properties, change strategies regarding property mix, or make other business decisions that compromise performance. Investors holding foreign REITs or REIT funds are also exposed to risks specific to the country, such as legal structure, investment restrictions, ownership rules, tax treatment, and currency risk.

All of this underscores the importance of knowing your risk tolerance, carefully analyzing REIT fund managers, and diversifying to eliminate exposure to a single REIT manager or category.

Endnotes

1. Equity REITs make up about 91% of the REIT market. Mortgage REITs, which compose about 7% of the market, loan money to real estate owners or invest in existing mortgage-backed securities. Hybrid REITs combine the strategies of equity and mortgage REITs and make up about 1% of the market. Source: National Association of Real Estate Investment Trusts, Inc. (NAREIT).

2. Joseph Gyourko and Donald B. Keim, "Risk and Return in Real Estate: Evidence from a Real Estate Stock Index," Financial Analysts Journal 49, no. 5 (September-October 1993): 39-46.

3. A US REIT must invest at least 75% of its assets in real estate and derive at least 75% of its income from real estate property or interest on real estate financing. It must also distribute at least 90% of its income to shareholders to maintain tax-advantaged status. This pass-through provision allows REIT investors to have access to the same cash flows as investors in private real estate equity. REIT shareholders, however, generally must pay taxes on income they receive from a REIT.

4. Over the 20-year period from 1990 to 2009, the annual return correlation between US REITs and the US stock market was 0.498 (1.0 denotes exact positive correlation in returns).

Disclosures

The information presented above was prepared by Dimensional Fund Advisors, a non-affiliated third party.

Diversification neither assures a profit nor guarantees against loss in a declining market.

REITs vs. US Stocks

Annual Returns: 2000-2009

US Equity REITs are represented by the Dow Jones US Select REIT Index.
The US equity market is represented by the CRSP 1-10 Index.

Average Annualized Returns: 1990-2009

Returns in USD. Inception dates for Dow Jones US Select REIT Index is January 1978; CRSP Deciles 1-10
Index inception date is January 1926.

Indices are not available for direct investment, and performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

The Center for Research in Security Prices (CRSP), at the University of Chicago Booth School of Business (Chicago GSB), is a nonprofit center that also functions as a vendor of historical data. CRSP end-of-day historical data covers roughly 26,500 stocks-active and inactive-listed on the NYSE, Alternext, Amex (formerly AMEX), NASDAQ, and ARCA exchanges. OTC bulletin board stocks are not included.

It's no secret that most of the "green" mutual funds and portfolio strategies haven't exactly been stellar performers.  Most purveyors of this type of fund seem to be better at evaluating the environmental stewardship of companies that than they are at building a portfolio with a high expected rate of return.  Beyond that, the typical "green" fund is not designed to be effectively diversified across asset classes or to avoid sector concentration, so it may take more risk than is necessary.  If you're looking for a choice in this area that actually has a value strategy, good luck.

As usual, Dimensional Fund Advisors (DFA) has a better solution. 

In 2008, Dimensional launched the US Sustainability Core 1 and International Sustainability Core 1 portfolios. These funds enable investors to advance their environmental values while holding a broadly diversified portfolio with a rigorous focus on multifactor investment design.

Dimensional's sustainability strategy combines the benefits of their well known core equity approach with a sustainability overlay that applies a research-based environmental screen to the asset allocation. The strategy takes the initial weightings of the US Core Equity 1 Portfolio or the International Core Equity Portfolio, which feature marketwide diversification and higher exposure to small cap and value companies, then adjusts the weighting of each stock according to its sustainability score. The stocks of companies with high (favorable) scores receive larger portfolio weights, while stocks with low scores are underweighted or eliminated.

As a result, these portfolios offer the diversification, factor exposures, and cost advantages found in Dimensional's core equity approach-but with a data-driven overlay that commits higher relative weights to companies that demonstrate a stronger environmental commitment. The rating process, which is maintained by Sustainable Holdings, is superior to traditional screening approaches because it sorts companies by industry and applies gradual weighting to improve sustainability targeting and preserve core strategy characteristics.

If environmental sustainability is important to you, but you want to hold a properly structured portfolio, discuss it with us.  We can show you how the DFA sustainability portfolios can be integrated with your overall investment strategy, or help you create one.

So, you've decided to work with an advisor that operates under the standard of fiduciary duty and that, consistent with the overwhelming evidence that supports it, chooses to build portfolios based on passive asset class exposure.  So far, so good.

But, even fee-only Registered Investment Advisors offer a bewildering array of services with fee structures that vary widely.  Many appear to offer the same thing for surprisingly low fees that others offer for fees that seem outrageous.

First, decide what type of relationship you want.  Is it bare bones portfolio management - simple asset allocation and rebalancing?  Or, do you want tax management, advanced performance reporting, and complex portfolio design across multiple accounts?  What about wealth management services, like insurance and tax planning, trust administration, or a private banking relationship?  Will the advisor help with your employer's 401(k) and include that in the asset allocation?  Do you need the services of a family office - bill payment, travel arrangement, security services, property management, and/or legal services?

Keep in mind that many small or new advisors may charge fees that are less than the industry average while trying to build their practice.  They may operate out of their home or an executive suite.  They frequently do not have administrative support, in-house compliance programs, sophisticated security systems for the protection of confidential client data, or advanced reporting capabilities.  Are you comfortable with your confidential information residing on someone's home computer or should it be behind a firewall on an encrypted drive in an office that has a monitored security system?  All of these capabilities and safeguards add cost.  But, is it wise to ignore them?

What about the firms that offer a flat retainer fee instead of charging clients based on assets under management?  At first blush, it sounds like a great idea.  But, what is an advisor paid by a flat fee motivated to do?  The only way that that this advisor can increase profitability for his existing account base is to minimize the time spent on each client.  In contrast, the advisor that is paid on assets under management has an incentive to grow each client's portfolio and expand the relationship.  He may be much more willing to spend time with the client in order to do so.

If your primary focus is on portfolio performance, then the yardstick should be the risk adjusted after-fee, after-tax net return of the portfolio.  The advisory fee is actually irrelevant in the comparison of advisors if the risk adjusted net return is higher than that of the competitors.

Many portfolios that provide high expected rates of return are more tilted toward the risk factors that produce return (value and small cap stocks).  But this always comes at the expense of tracking error relative to the common indices (the DJIA, S&P 500, etc) that are talked about on the nightly news or by the CNBC "talking heads" (including clowns like Jim Cramer).  As a result, they require more "hand holding" of clients during the inevitable time periods when the portfolio will underperform the common index that the client uses as a comparison.  These advisors are justified in charging higher fees to compensate them for this activity and for the opportunity cost of lost time developing new clients and growing their practice.

Most prospective clients that engage in "fee shopping" vastly oversimplify the process and tend to choose an advisor for the wrong reason.  Even the fee structures between advisors can be confusing when the services offered are almost identical.  Some advisors that charge based on assets under management use a tiered fee approach and others use breakpoints.  We'll examine the two approaches in the next installment.

Photo by Brian Hillegas