Advisor Blog

Clifford S. Asness (pictured in his office), Roni Israelov and John M. Liew, all from AQR Capital Management, were named co-winners of the annual CFA Institute's Graham and Dodd Award for their article on the benefits of global equity diversification.  The award recognizes excellence in research and financial writing in articles in 2011 issues of the Financial Analysts Journal, a publication of the CFA Institute. Their article, “International Diversification Works (Eventually),” was published in the May/June issue.

The paper concludes that although critics of international diversification observe that it does not protect investors against short-term market crashes because markets become more correlated during downturns, this observation misses the bigger picture.  Over longer time horizons, underlying economic growth matters more than short-term panics with respect to returns, and international diversification does an excellent job of protecting investors.

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. 

One of our clients that we really appreciate recently read Joel Greenblatt's new book The Big Secret for the Small Investor.  He thought that it made some good points and asked me to read it.

He's right.  The book is written for the average investor and explains some important concepts using plain English and numerous good examples.  In my opinion, there are two really important topics that he covers very well.  First, the explanation of why the vast majority of mutual fund and professional money managers fail to beat their benchmark index.  He also provides a great explanation of why attempting to pick individual stocks using fundamental analysis is a seriously flawed method.  As an aside, Benjamin Graham - probably the most famous value investor of all time and father of fundamental analysis, admitted later in his life that most investors would be better off in an index fund.

The "big secret" that the book discusses is that a diversified portfolio of value stocks has a higher expected rate of return than the market.  If you're familiar with our investment philosophy, you already know that.  Greenblatt makes the point that more value exposure is better over long periods of time.  Right again. 

He also explains that there can be long periods of time when the value effect is absent and it's tough for most investors to stick to the strategy.  He nailed that one, too.  Then he goes off the rails and suggests that allowing for a +/-10% tactical weighting to stocks will help an investor stay the course.  He fails to mention that the value effect is very strong in markets around the world and that it occurs at different times in different markets, so a globally diversified value portfolio can be much more robust and deliver more return per unit of risk. 

He also fails in the discussion of the other factor that provides higher expected returns in an equity portfolio - exposure to small cap stocks, by dismissing it with a reference to one paper.  That's amazing, since it's very well researched and documented.  Nevertheless, the book is well worth reading for most individual investors.

One of my clients sent me a New York Times article from last Sunday's front page in which Charles Biderman, chief executive of a funds research company, stated that "people have lost a lot of money over the last ten years in the stock market, while there has been a bull market in bonds."

It is ce
rtainly true that a lot of people did lose money in the stock market over the past ten years.  In fact, if you invested a dollar in the S&P 500 on August 1, 2000 that dollar would have been worth about 93 cents as of the end of July 2010.  And, that's assuming you could invest in the index at no cost.  This certainly seems to support the conclusion that the stock market has had a "lost decade."  But, what happens when we take a closer look?

What if you had invested in a globally diversified portfolio of stocks in a portfolio that emphasizes exposure to value and small cap companies?  That's exactly what our Talis 100 equity portfolio does.  So, how did it perform over the same time period?  The dollar that you invested on August 1, 2000 would be worth $2.13 and that's after all of the fund expenses and the highest advisory fee that we charge.  This also assumes that all distributions are reinvested.

So, what if you had been prescient enough to have gotten out of the stock market on August 1, 2000 because you somehow saw this coming?  And, what if you had taken advantage of the "bull market in bonds" by investing in an intermediate bond index?  Again, assuming that there are no costs involved in doing this, a dollar invested in the Lehman (now Barclay's) corporate/government intermediate bond index would be worth $1.81.  We should also point out that most bond funds failed to beat this index.

So, why does the New York Times fail to mention any of this?  First, the media always feels the need to "dumb down" any analysis.  Apparently, they don't think that their readers are capable of understanding a more informative article.  And, it's easy to write a story that makes a very simple point - stocks are risky and dangerous, bonds are safe!  Considering the attention span of many readers, that might be right.  However, for investors that understand capital market behavior and the factors that actually contribute to returns, the past decade has been a very different experience.

To learn more about the performance of the Talis portfolio series, see comparisons to benchmark indexes, and access disclosure information click here.

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.