Advisor Blog

According to a January 16 article in Investment News, investors withdrew a net $81.5 billion from American Funds in 2011, including a net outflow of more than $33 billion for the company's flagship product, Growth Fund of America. No other mutual fund even came close to matching that amount of outflow. In fact, there was not an entire fund family that matched the outflow of just this fund. Fidelity Investments came closest with outflows of $28 billion. According to Morningstar, Inc. analyst Kevin McDevitt, Growth Fund of America ranked in the bottom 25th percentile of all large-cap growth funds for 2011.

A few years ago, we heard a lot about American Funds and it seemed that almost every brokerage firm was pushing them. I remember going to a local Chamber of Commerce meeting where there were three representatives from different local offices of the same brokerage firm - all singing the praises of American Funds.

In 2011, investors showed a strong shift away from actively managed funds. As a result, the Vanguard Group took in $29.5 billion in mutual fund inflows, the most of any mutual fund family. Could it be that a larger group of individual investors has finally caught on to the fact that active management is an expensive failed strategy?

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.

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.