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. 

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.

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.

Studies show that investors typically fall into three distinct types - the "do-it-yourselfer", the validator, and the delegator. Our firm typically works with the latter. But, we hear a lot from the "do-it-yourself" crowd and they frequently want to know if our DFA based portfolios outperform their self-constructed Vanguard portfolios by enough to justify the advisory fee that we charge. Even though we think that this is a vastly oversimplified analysis, it's still interesting.

We recently went through this analysis with a prospective client that has an account well into the 7 figure range. We looked at several versions of his Vanguard based portfolio and at a version that attempted to replicate our DFA portfolio allocations using Vanguard funds. We evaluated the portfolios using Morningstar Principia and considered after-tax performance net of all fund and advisory fees. None of the Vanguard portfolios even came close.

Why is this the case? First, DFA offers asset class exposure that Vanguard does not and some of the asset classes are very important (like International Small Cap Value and Emerging Markets Value). DFA's structured asset class approach creates stronger tilt toward small cap and value than can be replicated in Vanguard's indexing strategy. These are the two factors, in addition to market beta, in the Fama-French three factor model that determine expected rate of return.

Edward Tower and Cheng-Ying Yang at Duke University produced a study in 2007 that came to the conclusion that, after adjusting for advisory fees, "the enhanced indexing strategy of DFA has, over the period considered [the period in the study was 1999-2006], outperformed the passive indexing strategy of Vanguard." Our analysis clearly showed the same result and included the 2007-2009 time period. Ironically, one of the reasons that DFA's funds outperform is that they aren't made available to individuals through the retail brokerage distribution channel. Consequently, DFA does not experience the "hot money" flows that retail mutual funds have to contend with.

Beyond just portfolio performance, we've found that clients of advisors associated with DFA have typically behaved in a much more disciplined manner than individual investors that do not work with an advisor. The value of an advisor includes much more than access to an exclusive fund family. We work with clients to assess their risk tolerance using a statistically validated process that compares them to a population of about 300,000 other investors. We then create an Investment Policy Statement that outlines exactly how we plan to structure the client's accounts, how they will be managed, how performance is measured against benchmarks, and how they are rebalanced. We may decide to construct the portfolio as a tax hybrid by putting the least tax efficient asset classes into tax-free or tax-deferred accounts. We have developed portfolio designs that are optimized for tax efficiency using DFA's tax-advantaged or tax-managed funds and those may be appropriate. We may reduce exposure to certain asset classes depending upon other investments that the client has made. We evaluate and coordinate with the client's employer sponsored retirement plans. When appropriate, we may recommend tax loss harvesting at the fund level and, in some cases, may perform a 31 day swap with a portfolio of different funds, while maintaining market and factor exposure. Our management process adds significant value beyond our moderate fee structure.