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.

I stumbled across the website of one of our local competitors yesterday and was shocked to see that this one-time purveyor of active management seemed to have done his absolute best to change into something quite different - in fact, to look as much as possible like us!  Over the past few years, we've had two advisors that have posed as clients in order to get the portfolio models that we use - and now they are both using them in their practices.  We've had entire portions of our website copied - word for word.  While imitation may, indeed, be the most sincere form of flattery, it's also important to be honest.

Politicians are often accused of "flip-flopping" when they change their opinions to maximize their popularity.  And, that just might be what's happening with our new convert to passive management.  There are only two possibilities:  1. He finally decided to pay attention to the overwhelming amount of evidence that actively managed funds are a terrible bet; or 2. He thinks that he will win more business with a passive strategy.  If it's the former, you have to wonder about his ability to practice critical thinking.  If it's the latter, you have to wonder about his sincerity.  Neither one is good.

Maybe it's time to add another question to the list of questions to use in selecting an advisor:  How consistent has your investment philosophy been over time? 

The Talis Investment Philosophy presentation has been updated with new information and more recent return data.  The presentation discusses the failure of active management, the size and value effects in global capital markets, risk/return tradeoff in fixed income securities, the importance of minimizing costs and explains the principals of successful investing:

• Markets work
• Diversification is key
• Risk and return are related
• Portfolio structure determines performance

Click here to view the presentation.