Advisor Blog

"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.

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 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.

Here is another great article by Weston Wellington at DFA.  We've discussed Bill Miller and Legg Mason Value Trust before.  Miller's recently announced retirement provides another reason to examine his track record and the track record of active management.

Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller's most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron's included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as "one of the greatest investors of our time." A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to "think about thinking" suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller's bold and concentrated investment style would never be confused with a "closet index" approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller's overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund's expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund's performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion's share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has "lost his touch" or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, "As William James would say, we can't really draw any final conclusions about anything." Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

REFERENCES

Andy Serwer, "Will the Streak Be Unbroken," Fortune, November 27, 2006.

Edward Wyatt, "To Beat the Market, Hire a Philosopher," New York Times, January 10, 1999.

Tom Sullivan, "It's Miller Time," Barron's, October 12, 2009.

Diana B. Henriques, "Legg Mason Luminary Shifts Role," New York Times, November 18, 2011.

Standard & Poor's

Morningstar Inc.

As we all know, salesmen frequently tend to overstate the benefits of the products that they sell because they have a financial incentive to do so.  We are constantly hearing about supposed “market beating” investment strategies.  My email inbox is full of information from portfolio managers that claim to have found the holy grail of investing – more return with less risk.  Unfortunately, a closer look at these strategies invariably shows that they are nothing more than short-term anomalies with no statistical evidence to support them, fantasies based on back-tested strategies that fail miserably ex-post (see Beware the Backtested Portfolio), or – in some cases – blatant dishonesty.  And, of course, there is every combination of these factors.

This leads us to question the motives or misunderstandings of the seller.  Are they really that naïve?  Are they being dishonest?  Are they incapable of doing the math and reliant upon what someone tells them to sell?  Why do they blindly believe what they are told?  Why don’t they apply critical thinking and question what’s being asserted?  Maybe they just don’t really want to know – or, maybe this what you get when you don’t apply a fiduciary standard to investment advice.

This reminds us that we need to be cautious about our own beliefs.  They need to be questioned and they need to hold up to scrutiny.  We take pride in basing our advice on rigorous academic evidence.  But, we also know that new research can drastically alter the landscape and that we need to consider it.  Recently, there have been a series of publications that have questioned the size premium – the belief that stocks of smaller companies produce higher average returns than those of large companies.  Some studies have gone so far as to suggest that there really is no small cap effect – and there never was.  Obviously, since a tilt toward small cap stocks and value stocks is a key part of our investment philosophy, it’s important that we examine this research.

Rolf Banz documented the existence of the size premium in his dissertation published in 1981.  Banz used data from 1927 through 1981 and found that average returns increased monotonically as company size decreased.  Fama and French found a similar relation in their 1992 publication while examining data from 1963 through 1990.  However, in the period of time after the publication of the Banz study, the relationship between size and return has been flatter than in the earlier period.  This has led some researchers to question the continued existence of the effect.        

Some have claimed that it is simply an anomaly that has disappeared as it has become known and investors have attempted to exploit it.  The concern is valid, but the conclusion that the premium has disappeared is not.  Anomalous patterns do tend to be traded away after being publicized.  But, compensation for bearing additional risk does not.  Small cap stocks are measurably more volatile and linked to both systematic default and business cycle risk, so the market demands additional compensation for bearing this risk.

Further review of the research shows that there is an explanation for the change in small cap stock behavior.  In the earlier time period, the size premium existed across all small cap stocks regardless of valuation.  In later time periods, the data clearly shows that the size premium remains quite significant for small neutral and small value stocks, but the relation is reversed for small growth stocks.  So, the supposed disappearance of the small cap premium is really nothing more than the underperformance of small cap growth.  Incidentally, this is completely consistent with what we find in large cap stocks – value outperforms growth.

There is a very simple way to adjust portfolio construction to take this into consideration – eliminate exposure to small cap growth stocks, particularly at the extremes.  We rely on Dimensional Fund Advisors (DFA) to provide cost-effective and highly diversified small cap exposure in our portfolio construction.  As you might expect based on their reputation for research driven solutions, DFA recognized the issue with small cap growth stocks last year and excluded them from their small cap portfolios.

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.

I'm not quite sure how I missed this.  It was really cold in Texas last week, but I hadn't realized that hell had, indeed, frozen over!  Suffice it to say that I don't read Barron's.  But, at DFA's Dallas study group meeting yesterday, a lot of the participants found this to be rather amusing.  It's a lot like CNN choosing Glenn Beck as man of the year or Fox News choosing George Soros for some honor.  Nevertheless, it did actually happen.  Here are some excerpts from the article:

Dimensional Fund Advisors, whose quant[itative] funds operate almost like indexes, was in precisely the right markets and watched its pennies.-

Of course, it’s impossible to time stock- and bond-market changes and the strategy that’s paid off for the best big fund families – as well as investors – is a diversified one. Our No. 1, DFA, is a global asset manager that oversees $206.5 billion in all and owns a mind-boggling 13,000 stocks, or about 70% of the world’s publicly listed equities. Because DFA’s investment process is purely quantitative, it doesn’t have the option of succumbing to fear in the face of adversity. It certainly helped that DFA focuses much of its attention on some of last year’s highest-performing equity areas – value, small-cap and emerging markets.-

The privately held firm (Arnold Schwarzenegger is an investor) also is known for keeping a lid on costs that can rob shareholders of performance points, steering clear of some foreign markets where it doesn’t believe funds can get a fair shake on prices.

Weston Wellington, a Vice President at DFA, once said "Fama doesn't read Barron's and readers of Barron's don't read Fama."  That may still be true, but the Barron's readers might at least now know who he is.

David Booth, Chairman and Co-Chief Executive Officer of Dimensional Fund Advisors interviews Eugene Fama, Ken French, and Robert Merton and explains the importance of Dimensional's relationships with leading thinkers in the field of modern finance. 

• Eugene Fama is the Robert R. McCormick Distinguished Service Professor of Finance at The University of Chicago and is widely recognized as the "father of modern finance." 
• Ken French is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth College.
• Robert Merton is a Nobel Laureate and finance professor at Massachusetts Institute of Technology.

View the video here.

One of our clients found this article by Ron Lieber in The New York Times.  We've previously written about Gordon Murray and The Investment Answer.  This article provides "the rest of the story" about Gordon's terminal brain cancer and why he felt compelled to write a book that explains how investors can be successful by taking the "anti-Wall Street" approach.

One of our really astute clients asked me why DFA's funds do not emphasize dividend paying stocks.  It's a good question and certainly timely.  It seems that every issue of Barron's and every CNBC show has some "expert" proclaiming that, because corporate earnings have grown and stock prices have remained depressed by fear, there are extraordinary opportunities to buy stocks that pay a high dividend.

Since a dividend is a distribution of corporate earnings to shareholders, it is always accompanied by a similar reduction in the share price.  It is simply a transfer of ownership and it is a taxable event to the shareholder.  Under our current tax law, non-qualified dividends are taxable at the shareholder's ordinary income rate.  In general, dividends paid by US companies that are held for a certain period of time are qualified dividends.  Qualified dividends are taxed according to a more advantageous rate, like long-term capital gains.  So, in a taxable account, the dividend distribution actually results in realization of a gain and taxation that would not have occurred if the earnings had been retained. 

What is the difference between a dollar paid as a dividend and a dollar that is the result of a capital gain?  Ignoring taxes, not a thing.  So, why would a dollar paid as a dividend be so desirable?  It's not.  But, it turns out that stocks that pay a high dividend tend to perform better than stocks that pay no dividend or a low dividend.  Why?  Because they are value stocks. 

But, is sorting stocks by the dividend/price ratio an effective way of adding value exposure to a portfolio?  Academic research indicates that it is not.  The purpose of any scaled price ratio based sort is to produce dispersion in the returns of stocks that can then be used to select stocks with the highest return.  It turns out that the dividend/price ratio does this, but it is a weak relationship and it is statistically unreliable as compared to other methods (and even to other scaled price ratios, like earnings/price and cash flow/price).  What works the best?  According to the research, it's the book-to-market value, or BtM.  And, guess what?  That's the factor that DFA uses to define value stocks.  It's already built into our portfolios.

I saw one of those dumb Scottrade commercials last night where the founder (when he's not out flying around in his purple Scottrade helicopter) touts their "research" capability and suggests that individual investors should use it to pick stocks.  A quick Google search turns up a zillion or so websites and newsletters touting how to do that using dividends.  And, of course, you could.  But, it's unlikely that the results will be quite as spectacular as they might like you to believe.

In another interesting Dow Jones article, the author points out that "the pain from the recent market downturn was felt far and wide—but not shared equally" and that "the classic type of mutual fund, which employs an army of stock pickers to invest in big U.S. businesses, has fared a lot worse than low-cost index funds which simply ride the ups and downs of the market."

That's not news to us, but it is apparently news to a lot of people.  According to the article, investors have pulled more than $174 billion from U.S. large company stock mutual funds in the last three years and, in fact, these funds haven't experienced a positive flow since June 2009.  Some of the industry's best-known names have bled investment dollars, including American Funds Investment Company of America (-$16.1 billion), Dodge & Cox Stock Fund (-9.1 billion), and Fidelity Contrafund (-$1 billion).  In contrast, index funds have suffered much less.  Large company stock index funds and ETFs have actually seen inflows of more than $147 billion in the last three years while actively managed funds were hemorrhaging.

This trend vindicates many investing experts and academics who have long questioned why individual investors pour money into actively managed funds that, as a group, seem unable to beat the market.

Before we celebrate, though, it is worth pointing out that individual investors have continued to chase performance in the "hot" areas of the market, particularly in emerging markets stocks and bonds.  That being said, it's also interesting to note that the best performing emerging markets stock fund in the Morningstar emerging markets category (based on load adjusted 10 year annualized return) is DFA Emerging Markets Value, a passively managed fund.  Oh, and we've been using this fund in our portfolio constructions for many years.

It seems that if something can be "dumbed down", it will be.  This is particularly true when it comes to mutual fund selection and the results are disturbing.

In an article titled "Stargazing: Five-Star Investors Revisited", Tom McGuigan and Tim Courtney examined 248 mutual funds that were five-star rated by Morningstar as of December 31, 1999.  The findings are very interesting.  As of December 31, 2009, exactly ten years later:

• Only four of the original 248 funds were still five-star rated.
• Of the 248 funds, 87 had ceased to exist.
• Of those still in existence, all had been downgraded to an average of just under three stars.

Not a single small cap value fund was rated five stars in 1999.  Yet, over the next ten years, this asset class proved to be the best performer.  The average return for five-star funds over the ten-year period was worse than the average return for all funds in every category except international stocks.  Even then, the five-star international stocks only beat the average by about a tenth of a percent per year.

Beyond all this, the study found that investors in five-star funds achieved lower rates of return than those that invested in the average fund.  Why?  Probably because they bought them in 1999 and dumped them at a loss when the market turned down over the next few years.

You might find this surprising, but we don't.  We know that fund rating services cannot identify, in advance, funds that will outperform.  We also know that investor behavior is the most important determinant of portfolio performance.

Scott Maxwell recently attended a conference where an insurance firm's investment arm offered advice to their sales force on how to win investment business from prospective clients.  The advice was to comb through the prospect's portfolio and look for funds that had one or two-star ratings.  Then, ask the prospect why he or she would do business with an advisor who obviously can't count stars.  When Scott pointed out that the ratings had no correlation with future performance, he was pointedly reminded that this was about winning business and not about what's best for the client. 

The selection of a fund should be based on the fund's statistical contribution to the portfolio.  In his recent article, "Stars or Straws", DFA's Jim Parker discusses the foundation for choosing one fund over another.  "Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.

So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:

• Are the risks being taken related to return?
• Are those risks targeted in a reliable, consistent way?
• How diversified is the fund?
• Does it make promises it can't keep?
• What is more important - individual judgement or clear processes?
• Are the underlying strategies driven by forecasts?
• Does the fund take account of costs and taxes in its decisions?
• Does the fund manager communicate in a clear and consistent way?

While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.

But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them."

A very good client asked me to discuss the difference between DFA's structured asset class funds and index funds.  It came up again in a meeting today.

Index funds were created when managers realized that most actively managed funds failed to beat their benchmark index.  John McQuown and David Booth (DFA) created the first S&P 500 index fund at Wells Fargo in the early 1970s and John Bogle at Vanguard created the first retail index fund around the same time.  Since then, open end mutual funds and ETFs have been created to track virtually any index that exists.  Some even track inverse, multiple, or multiple inverse indices.  But, in all cases, the goal of the index fund is to minimize tracking error - in other words, to mimick the performance of the index as closely as possible. 

This means that index funds must buy and sell securities frequently based on fund flows, corporate actions, and changes to the indices that they are designed to track.  Frequent trading is expensive and large-scale trading by many funds tracking the same index creates wide bid/ask spreads in stocks of companies being added to or removed from an index.  Further, indices are not usually constructed to maximize exposure to the small cap and value factors we know determine the performance of a diversified portfolio.

With one exception (DFA US Large Company is an S&P 500 index fund), DFA's funds do not track indices.  Instead, DFA uses academic definitions of asset classes and the funds target ownership of all securities that meet the asset class definition.  For example, DFA's US small cap value fund owns about 1500 stocks of US companies that are smaller than the 500th largest company trading on the NYSE, NASDAQ, or American Stock Exchange and that have a high book value relative to their market value. 

Since DFA does not have a mandate to track an index, the fund is free to trade patiently.  DFA's status as one of the world's largest providers of liquidity for small cap stocks allows them to negotiate favorable pricing in large block transactions.  Securities lending creates additional income in many DFA funds and the funds employ momentum screens that index funds cannot use.  Because DFA's funds are not directly available to retail investors, hot money flows in and out of the funds are limited.  This also reduces expenses and helps to avoid forced realization of capital gains.

In summary, DFA's funds are similar to index funds in that they employ the principles of passive management - no stock picking or market timing.  But, they are far more sophisticated in many other ways.  The bottom line for investors is stronger exposure to the factors that have been proven to generate return.  To learn more about DFA, visit their public website.

Are UMAs - Unified Managed Accounts - the next "big thing" or just a new way for brokers to push products?  What is a UMA?  It's the evolution of the SMA - the Separately Managed Account.  SMAs are managed accounts that hold a portfolio of assets that are customized to fit a client's particular risk, tax, and other individual requirements.  They are appealing primarily because of the customized tax management that can be implemented.  A UMA is similar account that holds a variety of different types of assets - potentially including individual stocks, ETFs, mutual funds, even allocations to particular managers - all coordinated by the "overlay manager" that is responsible for the client-specific tax and risk customization mandates.  But, does this actually provide value to the client or is it just another way for "advisors" to sell something?

A customized tax management strategy can be very advantageous, particularly for high net worth clients.  But, an SMA or UMA structure is not necessary in order to implement effective tax management.  The whole idea of a UMA - or at least how it's being marketed - depends on the concept of active manager selection.  But, we know that active manager selection is a failed strategy and many academic studies show that it does not add to return.  Does packaging it in a new acronym change that?  Of course not.

Most of the supposed advantages offered by the UMA structure are already being realized in the familiar "tax hybrid" portfolio structure that many advisors (including us) already use.  For clients that require more advanced and flexible tax management, an SMA with low expenses and a structured exposure to asset classes is a much better solution.  For high net worth clients with this need, Dimensional Fund Advisors (DFA) offers separate account management.

The bottom line is that a UMA is just another way to package something expensive (active management) that doesn't work in a sophisticated sounding structure and sell it to clients that don't know any better.  So, even Oprah doesn't need an UMA  (note that this should not be construed as personalized investment advice for Oprah).

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.

DFA just announced that it will merge its US Large Company Portfolio into the US Large Company Institutional Index Portfolio on May 7, 2010.  Other than a change to the symbol from DFLCX to DFUSX, this is should be transparent to most clients.  However, it is important to note that, as a result, the expense ratio will decline by 4.5 basis points.  The expense ratio for DFLCX was already low at 15 bps, but this demonstrates DFA's continued commitment to do what is right for clients.

For most shareholders, this is a non-event.  The investment objective of both funds is the same - approximate the return of the S&P 500 index.  No action is required by shareholders.  However, since the required notifications are just being sent out, we expect to hear from clients that have questions.  That's fine, of course, and we are glad to explain this.  But, it lets us know who is paying attention to our website.  We strive to update this site frequently with useful and relevant information and commentary.  We hope you will use it!

Jim Cramer, the CNBC pundit of "Mad Money" fame, has declared 2010 to be the "year of active investing."  Even if that's the case, and the historical probability indicates that it won't be, active managers have a lot of work to do to catch up. 

Morningstar recently announced the introduction of a new "Box Score" report that analyzes the performance of actively managed US equity fund managers.  The analysis starts with a universe of 22,000 US equity funds and prunes the list by aggregating multiple share classes and eliminating ETFs, sector funds, bear market funds, long/short funds, and lifecycle funds.  They also exclude funds deemed to have a passive investment approach, including the DFA strategies.  All funds available for purchase at the beginning of any particular time period are included, so the results are free of survivorship bias.  Morningstar compares the results to their own stock indices, which seek to capture the returns of the nine distinct Morningstar style boxes and evaluates performance by calculating both Jensen's alpha and a more comprehensive Fama/French alpha.  The report is similar to the SPIVA report published by Standard & Poors that we've discussed before.

Morningstar finds that 41% of actively managed funds outperformed their respective indices for the three-year period ending June 30, 2009 using Jensen's alpha.  But, Morningstar notes that "once the Fama/French factors are taken into account, active managers' outperformance relative to the indices falls materially."  By the latter measure, only 37% of managers outperformed, and average alpha was negative in all nine style categories.

S&P reports that only 31% of large cap core funds for the five-year period ending June 30, 2009 outperformed the S&P 500 index.  Results were even less favorable for non-US markets, where 13% of the international funds and 10% of the emerging markets funds outperformed their respective benchmarks.  We often hear that non-US stock markets exhibit greater pricing errors than the US, supposedly offering opportunities for clever stock pickers.  The numbers suggest that this is fantasy.

Fixed income markets were no less challenging.  For the same five-year time period, S&P found that 22% of intermediate government funds were outperformers, and the number dropped to 11% for high-yield funds and to only 2% for mortgage-backed securities funds.

Many investors think that active managers can somehow avoid losses in bear markets by carefully selecting superior individual stocks or by shifting out of stocks altogether before market declines occur.  The numbers do not support this view.  In fact, the numbers present compelling evidence that supports the idea that a broadly diversified, passively managed portfolio offers the best path for clients seeking to achieve their investment goals.