Friday, October 9, 2009

ACTIVE MANAGEMENT FAILS TO DELIVER

The dramatic decline in the stock market that began exactly two years ago today has renewed the debate about the virtues of active vs. passive investment management.

An article in yesterday’s Wall Street Journal adds to the evidence that active managers fail to beat the indexes they use as their benchmarks. A study by Morningstar indicates that active managers were even less effective when their performance was measured on a risk adjusted basis. Only 37% of actively managed funds outperformed their indexes on a risk-, size- and style-adjusted basis over three, five and ten year periods.

Here’s a link to the article: http://online.wsj.com/article/SB125496189450072189.html

We remain firmly committed to our low cost passive approach to investment management. Our advisory fees are 0.75%. The internal expenses inside our model portfolios are consistently less than 0.25%. All in, clients pay less than 1%.

Thursday, September 3, 2009

The Fiduciary Standard

Did you know that, when you interact with advisors at brokerage firms, banks, credit unions and insurance companies, they are not required to act in your best interest? They are merely required to meet a “suitability” standard. This means they must put you in financial products that are appropriate. The meaning of “appropriate” is far from clear and is subject to broad interpretation.

In contrast Registered Investment Advisers and Certified Financial Planners are held to a “Fiduciary” standard. This is a legal standard that requires these advisors to act in their clients’ best interest. It is the highest level of care extended by an advisor to a client.

Cascade Wealth Management is a Registered Investment Advisor. Aaron and I are both Certified Financial Planners. We act in a Fiduciary role with all of our clients all of the time.

The Obama administration has proposed holding brokers who give investment advice to the higher Fiduciary standard. These would require brokers to offer investments that are less costly and more tax efficient. They would also have to disclose conflicts of interest, past disciplinary actions, and to generally act to put their clients’ interests before their own.

I join the Financial Planning Association (FPA), the National Association of Personal Financial Advisors (NAPFA), and the Certified Financial Planner (CFP) Board of Standards in calling for the administration to hold all financial advisors to a “Fiduciary” standard of care.

Sunday, August 23, 2009

Index Bonds Funds Beat Active Funds

We have more evidence that that Active Managers are unable to deliver results that are greater than the index against which they compare their performance. The Wall Street Journal weekend edition (August 22-23, 2009) referenced a study by Standard and Poor’s which indicates that index returns beat actively managed fund returns in all 13 fixed income categories over one and three years and in 11 of 13 categories over five years.

This is a bit surprising. Given the nature of bond investments, one might expect bond fund managers would be able to at least deliver the index. Frankly, they could do that if they did nothing. Instead their efforts to generate results greater than the index actually backfired.

The result is not just performance below the index. After management expenses, the results are ever worse. The average internal fund expense for a bond fund is 1.1% according to Lipper. So, the average actively managed bond underperformed the index by this additional amount.

Investors are wise to use no load passively managed funds for the fixed income portion of their portfolios. Another option would be to use individual bonds. However, for most investors, this will not provide sufficient diversification.

Thursday, July 30, 2009

Fed Chairman Recommends Diversification

Federal Reserve Chairman Ben Bernanke recently held a town forum with local citizens in Kansas City, Mo. The event was moderated by PBS NewsHour anchor Jim Lehrer. While I have not seen the entire interview, I have read excerpts of the program in The Wall Street Journal.

When asked about investment advice, Bernanke recommended that the questioner practice diversification and avoid trying to time the stock market. Bernanke is arguably the most powerful person in the global economy. He is highly educated and well trained. His comments should serve to reassure investors that the basic principles of investment management have not gone out of style.

What are the keys to successful investing?
• Allocate across a broad range of asset classes
• Diversify within asset classes
• Use passive investment vehicles such as no load mutual funds and ETFs
• Keep your investment costs low
• Do not attempt to time the market
• Do not attempt to buy the next hot investment
• Rebalance no more often than annually
• Do not actively manage your portfolio
• Manage your emotions

We call this “Intelligent Investing.” Wall Street would prefer that you ignore these principles and instead spend your money chasing investment returns. Ignore Wall Street and listen to Chairman Bernanke.

Monday, July 27, 2009

Index Funds in 401(k) Plans

I recently reviewed a client’s 401(k) account. He works for local technology company. The 401(k) plan is administered by a major insurance company. It offers proprietary funds from the insurance company and a number of actively managed funds. There are no passive funds available to participants.

I encouraged my client to contact the human resources department and express an interest in adding index funds to the menu of options. I explained that passively managed index funds capture the returns of the market (minus internal expenses). Actively managed funds are more expensive and routinely fail to beat their comparable index.

The Wall Street Journal ran an article recently indicating that employers are increasingly offering index funds inside their company 401(k) plans. Currently 90% of the $1.5 trillion in 401(k) and other defined contribution assets in mutual funds are invested in actively managed offerings. The article noted that fund companies prefer actively managed funds because they produce fees that are higher than index funds.

The 401(k) industry is in need of reform. Documents provided to plan participants fail to properly disclose expenses. These expenses drag down the performance realized by plan participants. The federal government is currently considering revising the laws surrounding 401(k) plans. Let’s hope our lawmakers have the fortitude to resist pressure from the major financial institutions to preserve the status quo.

Sunday, July 12, 2009

Active Managers: Skill or Luck?

Ever felt lucky? Perhaps you won a game of bingo at your church one Saturday evening. Maybe you won the drawing at the local Rotary meeting. Did you ever come back from a trip to Las Vegas with more in your wallet than you when you left?

Whenever you have felt lucky, did it occur to you that the outcome was totally beyond your control? Unless you were able to rig the results, you won because of the laws of chance. These laws suggest that results of such situations are distributed in a random manner.

Those on Wall Street would have us believe that certain money managers are able through the application of knowledge, skills and experience to achieve investment performance that is better than average. They point to notable figures like Peter Lynch who ran the Magellan Fund at Fidelity from 1977 to 1990 and who reportedly beat the Standard & Poor’s 500 index benchmark in 11 of those 13 years. Bill Miller, Portfolio Manager for the Legg Mason Value Trust mutual fund, beat the same benchmark for 15 consecutive years from 1991 through 2005.

I am not particularly persuaded by the suggestion that Peter Lynch or Bill Miller or any other money manager is somehow better than all the other mangers in the investment community. I am more inclined to believe that some managers were able to outperform the market, because the laws of chance tell us that in the universe of thousands of managers a few will.

Some will disagree and believe that some fund managers are more gifted than others. They are faced with another problem. How do you identify these managers before they put together their streaks of outperformance? I liken this to entering The Rose Garden in Portland. You walk to center court. Every seat in the facility (19,980 to be precise) is filled with a money manager. We can expect that the average performance of these managers will be that of the stock market, because this population is large enough to represent the market itself. However, we know that that some of the managers sitting in the stands will turn in performance that is better than the average. The question is who? If you are an investor you have to place your money with the managers you believe will beat the market before they actually do so.

I agree with Russell Wermers, Finance Professor at the University of Maryland who said, “[It is] exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone … By definition, therefore, such a fund could not have been identified in advance.”

Given that most fund managers do not beat the market, why would anyone gamble their financial future by investing with managers who they hope will beat the market in the future?

Saturday, June 27, 2009

Institutional Investors go Passive

A few days ago (June 22, 2009) The Wall Street Journal ran an article (“Active Managers Get the Cold Shoulder”) that indicated that large, institutional investors are moving away from active managers.

In a bear market, active managers are supposed to protect investors from losses. However, a growing body of data indicates that these managers have not been able to provide this shelter. The executive director of the Illinois State Board of Investment noted, “Active managers have not given us the added performance in a down market that we had hoped for.” The board recently moved $400 million from some large and small cap stock managers to index funds.

There is $2.3 trillion in public pension plans. A large and growing portion of these funds are passively managed. These funds are able to hire very bright investment talent. The movement towards passive management is a very strong indicator that active management simply fails to deliver consistent long term returns that are greater than the unmanaged market delivers.

You don’t have to be an institutional investor to invest passively. CWM offers low cost passive investment management to the retail investor. We call it “Intelligent Investing” and we encourage you to explore it.

Thursday, June 11, 2009

Fat Tail Distributions

I received an email newsletter today from a vendor that sells financial planning software to advisory firms like Cascade Wealth. This particular company is Money Tree Software and it is located in Corvallis, Oregon. While we are not currently using their software, I have in the past.

This email caught my attention, because it mentioned Monte Carlo Analysis. You may recall from one of my prior blog postings, this is the methodology used to test the probability of outcomes. Financial Planners often use Monte Carlo simulations to determine how likely clients are to reach their financial objectives.

The recent stock market crash has caused some advisors to question the reliability of traditional Monte Carlo Analysis. The problem is that these projections rarely show major market declines. The reality, as well all know, is that dramatic market drops are not only possible, but they actually occur. We have witnessed two of these periods in the last decade alone in the tech crash in the early 2000’s and the financial sector meltdown in 2008.

Money Tree plans to enhance its software by incorporating wider distribution patterns in their Monte Carlo simulations. This means that events considered statistically very unlikely to occur will be included in their simulations. If you have ever taken a statistics class, you may remember that a normal distribution curve looks like the graph below. It displays the outcomes that occur when the pattern of distributions is symmetrical with a single, central peak at the mean (or average) of the data. Half of the outcomes fall on each side of the mean.

The spread or dispersion of the outcomes is dictated by the standard deviation. In the graph below of a normal distribution, we can expect that 68.2% of the events will fall between -1 and 1. Only 1.5% of events will fall below at -2.5 or lower.
What would this graph look like if we assumed that more outcomes occurred towards the ends of the graph and fewer near the middle or mean? The tails would become thicker. The midrange would become thinner. This is sometimes described as a “Fat Tailed” distribution.

By giving greater statistical weight to the possibility that market returns could fall outside the traditional range, Money Tree’s software will reduce the probability that a given client scenario will succeed. This should motivate the planner and the client to make more conservative assumptions.

Thursday, June 4, 2009

Going Passive in Europe

If you hold a position on a subject that places you in the minority, it’s pretty nice when someone of substance enters the dialogue and supports your view. After investing hundreds of hours researching investment management, I am convinced that you, the investor, are best served by deploying your hard earned money in a low cost, passively managed portfolio. Unfortunately, the overwhelming majority of investment advisors would have you invest in an actively managed portfolio in attempt to capture returns that are greater than those of the broader markets.

This week in The Wall Street Journal, I came across an article that caught my attention, “In Europe, Are ‘Active’ Managers Worth It?” (June 3, 2009). Apparently European pension funds are questioning whether the performance they have experienced warrants the fees they pay firms to manage their assets. The Norwegian government recently dropped 16 of the 22 firms that managed its fixed income funds. Most of these firms practice active management and they all suffered substantial losses last year.

The governments of Italy, Holland, and Sweden have also shifted away from active management of their pensions. These countries are reducing fees and seeking better performance by shifting investments to passively managed funds. In the U.S., the California Public Employee Retirement System, one of the largest pensions in the world, has historically relied on passive investing in its publicly traded equity portfolio.

Those who advocate active management claim the strategy will minimize losses in a down market. However, as performance data become available, the record is showing that this did not happen during the recent stock market crash.

These massive pension funds are run by some of the smartest people in the global investment community. Their decisions to move away from active management serve to validate passive management.

If your portfolio is not currently passively managed, perhaps it’s time consider a change.

Friday, May 29, 2009

Remain Steadfast in a Storm

If you read the Money & Markets section of the Wednesday (May 27, 2009) Oregonian, you may have noticed a little article titled “The steady investors wins.” The article briefly describes how most investors realize investment returns that are substantially below those that the market itself produces. This should be a big wake up call for investors who continue to believe that they can “beat the market” through strategies like timing when to get in and out of the market, selecting “hot” mutual funds or relying an advisor to pick “winning” stocks. These strategies consistently result in poor performance.

In the scenario offered in The Oregonian the slow and steady investor put $10,000 in a S&P 500 Index fund and did nothing more. She simply let the money grow. At the end of 20 years, the account has grown to $49,725 based on the 8.35% return of the index.

The other investor is described as “squirrelly.” He also starts with $10,000. But instead of investing and holding steady, he attempts to improve his performance by moving in and out of the stock market. Twenty years later this investor ends up with $14,485 or a 1.87% return. This is the result earned on average by investors in stock mutual funds for period 1988-2008 according to Dalbar, a research company.

The difference in the two results is over $35,000. This is enough money to pay for a year at a private college, a brand new car, or the down payment on a place at the beach. If the starting value had been $150,000, then the cumulative difference would have been over a $500,000.

Intelligent investors are smart. They know they cannot “beat” the market. So, they make no such effort. Instead they build well diversified portfolios, minimize their investment costs. Intelligent investors are also disciplined. They know how to manage their emotions during the most difficult periods in the stock market. They simply wait patiently for the storm to pass. They know the market will eventually reward them for maintaining remaining vigilant.

Friday, May 22, 2009

Monte Carlo is Risky

Last week I discussed Monte Carlo Analysis as a tool financial planners use to model retirement scenarios for clients. The process involves applying random values to the assumptions inside a plan. With the use of modern computers we can run thousands of iterations each with a unique set of assumptions. The results can be reviewed to determine how often the client actually meets their objectives. Most advisors like to see a “success rate” of at least 90%.

Unfortunately, Monte Carlo Analysis is not without its flaws. A recent article in The Wall Street Journal (“Odds-On Imperfection: Monte Carlo Simulation”) discussed how Monte Carlo simulation may be less reliable than most advisors (and their clients) realize. The problem is that Monte Carlo assumes that stock market returns fall along a normal bell-curve shaped distribution. This would suggest that returns fall proportionately along the curve. If the average annual return of the stock market has been 10% (a reasonable view), then a return of 5% (5% below the norm) or 15% (5% above the norm) would not be surprising. However, a decline of 50% (60% below the norm) would be highly unlikely.

The reality is that stock market returns are more random than the bell-curve would suggest. Morningstar points out, for example, that the Standard & Poor’s 500-stock index has declined more than 13% in a month at least 10 times since 1926. The conventional bell-shaped curve would not predict this.

To address these limitations, some are moving away from the normal distribution and instead considering a “fat-tailed” distribution. This distribution assigns higher probabilities to extreme market events. This allows advisors and clients to anticipate how a deep bear market would affect the client’s portfolio.

Within the last decade we have experienced two stock market crashes. One was caused by the speculative bubble in technology-oriented stocks that took place from 1995 through 2001. The Nasdaq lost 39.3% in 2000, 21.1% in 2001 and 31.5% in 2002. The Dow lost 6.2% in 2000, 5.4% in 2001, and 16.8% in 2002.

We are still dealing with the aftermath of the crash began in the fall of 2007 and occurred when large financial institutions faltered under the load of packaged securities that failed to perform. The Nasdaq was up 9.8% in 2007 and down 40% in 2008. The Dow was up 6.4% in 2007 and the Dow lost 33.8% last year. Year to date the Nasdaq is up 1.97% and the Dow is down 4.4%.

The stock market is volatile. The static returns that are assumed in basic retirement plans are unrealistic and unreliable. Traditional Monte Carlo Analysis is helpful in modeling other scenarios. However, stock market returns do not follow the normal that underlies Monte Carlo simulation. Therefore, the investment advisory industry needs to develop other methods which will better enable investors to plan for retirement. Let’s hope this happens soon.

Friday, May 15, 2009

Black Swans & Monte Carlo

Imagine heading off into retirement with a financial plan that you took great care in developing. You carefully determined your budget including adjustments over time for various lifestyle changes … Perhaps more travel early in retirement, but less in your later years … Increasing medical expenses as you grow older … You assumed a conservative rate of withdrawals from your investments of 4-5% with the expectation that you would be able to maintain your purchasing power against inflation and that you would not run out of money … even if you lived to be 100. You entered into your Golden years confident that you future was secure.

Then along comes an event that is considered to happen perhaps once in a generation. That event is a dramatic drop in the stock market. It profoundly changes your finances and forces you to consider radical changes to the plan you felt was nearly infallible. The author Nassim Nichosals Taleb calls this a Black Swan event. The term comes from the assumption that “all swans are white.” In this sense, a Black Swan is a metaphor for something that cannot happen. However, in the 18th century, Black Swans were discovered in Western Australia.

If Black Swans exists and we know it, then perhaps we can plan for the possibility that we will experience one. In the financial planning field, advisors use computer modeling technology called Monte Carlo Analysis to test the sustainability of a client’s plan. The problem is that basic retirement planning software relies on values that are assumed to be static. For example, the rate of inflation and the growth rate for investments are assumed to never change. This is, on the surface, wholly unrealistic. Inflation is hardly fixed and the returns in the stock market are far from a steady X (pick your return) percent.

Monte Carlo Analysis attempts to resolve the problem of static variables inside a retirement plan. It randomly assigns different values to each of the key variables inside a retirement plan. The plan is then simulated to determine that unique outcome. With modern computers this can be done for tens of thousands of scenarios in a matter of seconds.

The good Financial Planner wants to know how many of these iterations results in an outcome that is satisfactory to the client. This might mean not running out of money before age 100 or it could mean leaving behind a substantial inheritance to one’s heirs. The computer will tell us how many of these outcomes were “failures” and how many were “successes” depending on our definition. At our firm we prefer to see a success rate of at least 90%. Anything less than that suggests a level of risk we feel is too great to bear.

Black Swans exist. Events that are unexpected and profound occur. Rather hope you never experience one (because you will), it’s better to plan for them. Monte Carlo Analysis is one tool that can help you.

Thursday, May 7, 2009

Variable Annuities: Watch Your Wallet

Given the performance of the stock market over the past few years, many consumers have become interested in annuities. These insurance products offer a guarantee of principal. They also allow the contract holder to defer taxes on the growth inside the annuity.

Advisors often market variable annuity products as a way to participate in the upside potential of the stock market while preserving the original value in the contract. The idea is to invest in the policy’s sub-accounts which are very similar to mutual funds. If these funds perform well the owners account value grows. If they perform poorly, at least the principal is protected. This is pretty compelling.

Unfortunately, this is only part of the story. These products are actually very expensive. An article in the May 4, 2009 issue of The Wall Street Journal (“Get Less, Pay More”) points out that the annual fees in variable annuities total close to 4% (according to annuitygrader.com).

Most consumers have no idea how much annuities cost. They tend to not read the prospectus or ask about fees. Many Advisors do not properly disclose these expenses or the commissions which may be as high as 10%.

If you are considering investing in an annuity, ask the agent for a complete disclosure of the fees (mortality and expense, surrender charges, management fees, commissions). Also, keep in mind there are low cost annuities available through TIAA-CREF, Vanguard, USAA, Ameritas and other companies.

We believe in transparency. You have a right to know all of the costs associated with the financial products you purchase. To learn more about “intelligent investing,” please visit our web site, cascadewealth.com.

Monday, May 4, 2009

Index Funds Beat Active Funds

The Sunday Oregonian ran an article in the business section (“In bear market, index funds outperform active investing”) about how poorly active managers have performed since the market reached its peak in the fall of 2007. It states that in 2008, 64% of actively managed U.S. stock funds were beaten by a broad market index, The Standard & Poor’s Composite 500.

Traditionally active managers were expected to protect investors during bear markets. The data does not bear this out. “The strident belief that active managers do well in a down market is a myth,” said Srikant Dash, head of research and design at Standard & Poor’s.

Cascade Wealth Management is one of the few investment advisory firms in the region that uses passive investment vehicles to build portfolios. Further, our investment advisory fees (0.75%) are significantly lower than those charged by most firms (1.0%). We are convinced that this approach results in lower expenses, greater tax efficiency and better long term performance.

I was not able to find a link to the article on the OregonLive web site. Please contact us if you would like more information about how passive investing can benefit you.

Friday, May 1, 2009

May Day 2009

Did you know that this day has ancient origins? It was a pagan holiday that marked the end of the winter season in the Northern Hemisphere. The spread of Christianity throughout the European continent resulted in the abandonment of the raucous celebration of pagan holidays. Instead May Day became a secular holiday to honor the arrival of spring. You may recall the dancing of the Maypole, the Queen of May and May baskets. May Day is also the International Workers’ Day, a celebration of labor achievements around the world.

What does any of this have to do with investing? Actually there is a significant movement in this country to increase the size and strength of organized labor. Unions are seeking to make it easier to enlist new members through more liberal sign up provisions called “card check.” Under this procedure, if the National Labor Relations Board were to verify that over 50% of the workers signed authorization cards, the traditional secret election would be bypassed and the union would automatically form.

If this legislation were to pass into law, it would strengthen labor’s ability to form unions. Historically, organized labor has bargained with employers over a wide range of compensation, benefits and rights issues. This would potentially cause a shift in the balance of power between labor and management.

We invest in companies, because we believe the people who work in the company will produce products and services that will results in profits for the company. It is the balanced and fair relationship between the employer and the workers that results in harmony in the work place. Stable companies are more likely to thrive than those characterized by rancor and strife. They are also more likely to reward their shareholder’s through dividends and capital gains.

Friday, April 24, 2009

Building Portfolios to Meet Objectives, not to Beat The Market

I would like to introduce a subtle difference in the manner in which investment advisors build portfolios for clients.

Most advisors get to know a client through a series of conversations. They ask the client about their financial circumstances, their investment objectives and their investment experience. They may also use a diagnostic tool to objectively measure the client’s tolerance for risk. Given this information, the advisor will then build a portfolio that will seek to maximize the return given the maximum level of risk the client can tolerate.

There’s a problem with this approach. The client has now taken on the maximum level of risk that the advisor believes she can tolerate. In a stock market environment like the one we find ourselves in currently, the client could suffer significant losses.

Is this the best way for the client? Probably not. What if, instead, the advisor worked with the client to quantify the financial goals the client wanted to accomplish and then built the portfolio specifically to meet those goals? Rather than attempt to deliver the highest returns possible, the advisor would seek to meet the goals and minimize the amount of risk the client incurred along the way. This would likely allow the client to have a much less rocky ride in the markets.

We believe this is the way your portfolio should be constructed. It’s not about maximizing returns. It’s about achieving your goals and minimizing risk.

Wednesday, April 15, 2009

CWM Blogs

Welcome to the blog for Cascade Wealth Management (CWM) - "Intelligent Investing."

CWM is an independent, fee only investment advisory firm. We offer investment management and financial planning services.

Our mission is to help our clients, people like you, reach their financial objectives. We advocate comprehensive financial planning and we practice low cost investment management.

We plan to blog about a wide variety of financial issues. These postings will be relatively short (no more than 300 words). We will post weekly … more frequently if we feel we have meaningful to content share with you.

One of our major objectives with this blog will be to build and support the case for low cost passive investment management. We are absolutely convinced that this approach is superior to "active" investment management.

Visit us often!