Friday, August 27, 2010

Gold as an Investment

I just finished writing an article on gold. You can find it on the CWM web site. I have been thinking about gold for several years. None of the CWM portfolios contain gold. Frankly, I have never considered it a serious asset class.

But, in light of ongoing market turmoil, I decided I needed to take a good hard look at gold. Is it truly an attractive investment? What are the benefits of investing in gold? What are the detriments? What are the returns relative to the risks? Does it belong in a low-cost, passive portfolio?
Here’s an excerpt from the article:

People have invested in gold for literally thousands of years. From what does gold derive its value?

Gold is valued because of its physical properties (an attractive yellow metal with a relatively high density) and its scarcity compared to many other physical objects. People have long considered gold precious and it is this quality that gives gold its value.

It is interesting to note that unlike many other conventional investments, gold produces no income for those who hold it. Many investments are valued based on the income they create. Examples include stock dividends, bond coupons, rental property income, etc. We can readily value these investments by determining how much income they are likely to produce and when it will be received.

Investments that do not generate income are more difficult to value, because the valuation process is far more subjective. These investments are worth whatever someone will pay for them. Think of art, antiques, stamps, baseball cards and other collectibles. These items are perceived by their collectors as valuable because of their uniqueness. A non-collector may well find no value in these items.

Gold is worth whatever the market determines. But understanding the basis for the value of gold is alchemy by itself.

Saturday, August 21, 2010

Selecting Passive Investments

Some of the largest hedge funds on the planet have been pouring investor funds into gold-related assets over the past year or so. The managers running these funds, including John Paulson, Eric Mindich, George Soros and David Einhorn, are among the shrewdest actors in the global marketplace.

If you are an astute investor, you might naturally consider whether you should place some portion of your portfolio in gold. Unfortunately, the hype surrounding gold is so overwhelming it is very difficult to separate fact from fiction. Nonetheless, it is worthwhile to wade into the sea of information about investing in gold to determine whether it belongs in a portfolio.

I sit on a small investment policy committee with two other advisors who also run their own firms. We get together quarterly to review our existing model portfolios, evaluate the individual asset classes currently held in these portfolios and consider new investments for inclusion in these portfolios.

We do not often make changes to the composition of our portfolios. While there are new investments entering the market daily (literally), we consider most of these to be introduced by the marketing and sales departments of large financial institutions. We’re pretty well convinced that Wall Street has the game set up to entice individual investors through glossy marketing brochures, fancy power point presentations and seductive conference calls to buy expensive products that are destined to underperform the market.

We are interested in those investment opportunities that satisfy criteria we believe are consistent with the fundamentals of low-cost, passive investment management. Many bright, highly-educated professionals are constantly researching and studying the elements that drive investment performance. So, we are certainly not alone in this process. But we do take a rather narrow approach to this process, because of our belief that markets are generally efficient and it is not possible to earn excess returns over long periods of time.

Here are 10 questions we ask about every investment we consider:

  1. Does the investment represent an opportunity to invest in a new asset class? An asset class is a group of investments that share basic characteristics, perform similarly in the market and are subject to the same laws and regulations. The application of this definition can be somewhat subjective. Is frontier investing a new asset class? Yes, we think it is. Is “clean tech” a new asset class? So far, I am not convinced. We currently track some 15+ asset classes.
  2. What does this investment bring to our portfolios? Does it provide income? Does it provide growth? Is it an inflation hedge?
  3. How do we invest in this investment? If we cannot access the investment through a no load mutual fund or an exchange traded fund, we’re probably not interested. These vehicles provide diversification, professional management, and low cost of entry.
  4. What is the return history of this investment? Naturally, we’re interested in investments that provide a healthy return for our clients.
  5. How much risk must investors accept to receive the returns this investment provides? Investors accept risk in order to earn returns. We’re keenly interested in the risk-adjusted returns an investment offers.
  6. What is the correlation of this investment with other investments in our model portfolios? Correlation refers to the relationship between assets. We like investments that do not act the same way. We can achieve diversification and reduce the risk of portfolio declines. Investments that are closely correlated with each other are less attractive, because they all tend to move in the same direction. When the stock market crashed in 2009-2009, we saw that most asset classes went down in tandem.
  7. What does it cost to invest in this investment? What are the trading costs (commissions bid-ask spreads)? What are the internal costs inside the vehicle? We like investments that have very low trading costs. We prefer investments that have internal costs that are less than 0.25%.
  8. How liquid is this investment? If we are to use a fund to invest in this investment, are there a large number of shares actively traded at all times? If we need to sell, can we get out quickly?
  9. What are the tax characteristics of this investment? Does it generate income (i.e. dividends) that receives favorable tax treatment? Does the asset instead grow over time and avoid taxation until it is sold? Would we put this investment in a taxable portfolio or in a tax-qualified portfolio?
  10. Finally, can we invest in this investment in a passive manner? Is there an index that tracks this investment? Are there passively managed funds that offer access to this investment? If only active funds invest in this idea, we’ll pass.

Friday, August 20, 2010

Selecting Passive Investments

Some of the largest hedge funds on the planet have been pouring investor funds into gold-related assets over the past year or so. The managers running these funds, including John Paulson, Eric Mindich, George Soros and David Einhorn, are among the shrewdest actors in the global marketplace.

If you are an astute investor, you might naturally consider whether you should place some portion of your portfolio in gold. Unfortunately, the hype surrounding gold is so overwhelming it is very difficult to separate fact from fiction. Nonetheless, it is worthwhile to wade into the sea of information about investing in gold to determine whether it belongs in a portfolio.

I sit on a small investment policy committee with two other advisors who also run their own firms. We get together quarterly to review our existing model portfolios, evaluate the individual asset classes currently held in these portfolios and consider new investments for inclusion in these portfolios.

We do not often make changes to the composition of our portfolios. While there are new investments entering the market daily (literally), we consider most of these to be introduced by the marketing and sales departments of large financial institutions. We’re pretty well convinced that Wall Street has the game set up to entice individual investors through glossy marketing brochures, fancy power point presentations and seductive conference calls to buy expensive products that are destined to underperform the market.

We are interested in those investment opportunities that satisfy criteria we believe are consistent with the fundamentals of low-cost, passive investment management. Many bright, highly-educated professionals are constantly researching and studying the elements that drive investment performance. So, we are certainly not alone in this process. But we do take a rather narrow approach to this process, because of our belief that markets are generally efficient and it is not possible to earn excess returns over long periods of time.

Here are 10 questions we ask about every investment we consider :

Wednesday, August 11, 2010

Morningstar: Fees Best Predictor of Fund Success

In case there was any doubt, Morningstar has settled the debate about the best predictor of a mutual fund’s future success. Perhaps you thought the funds with the most stars from Morningstar would shine brightest. Alas, this is not the case.

Morningstar’s research indicates the lower a fund’s fees, the better its performance. The findings were outlined in an article in The Wall Street Journal on August 9, 2010, “Low Fees Outshine Fund Star System.” This information should further motivate investors who are looking for ways to pick up the pieces from the recent stock market swoon.

Why do funds with lower fees perform better over time? Because funds that charge less leave more for their shareholders.

We know that actively managed funds charge more than passively managed funds. We also know that most of them underperform the market.

So, intelligent investors buy low cost, passively managed funds. As a result, they end up with more in their coffers

Monday, August 9, 2010

Comment on the SEC Study on Fiduciary Issue

I have mentioned that the financial reform bill that was signed into law last month includes language authorizing the U.S. Securities and Exchange Commission to conduct a study of the current standards of care that exist in the financial services industry for the delivery of financial and investment advice. Further, once the study has been concluded, the SEC has been authorized to impose a new standard.

If you wish to comment on this very important matter, you may visit the SEC at this location:

The National Association of Personal Financial Advisors, of which I am a member, has offered the following guidance:

(1) The bona fide fiduciary standard of conduct should apply to all those who provide investment advice to retail investors, without exception;

(2) No "hat switching" should be permitted - i.e., once a person is in a relationship of trust and confidence with his or her client, the fiduciary obligations of the advisor extend to the entire relationship. A client's trust would be subsumed by any attempt of the advisor to switch to a non-fiduciary (arms-length) product sales relationship.

(3) No denigration of the fiduciary standard of conduct currently existing under the Investment Advisers Act of 1940 should occur through the adoption of "particular exceptions" - the SEC should maintain the fiduciary standard of conduct as the "highest standard under the law."

(4) Restoring the trust of individual Americans in our financial system begins with individual Americans trusting in the individual advisor across the table from them. All the other reforms seen recently will fail to protect Americans if, at the final point of advice provided to individual Americans, the advisor fails to adopt the client's interest as his or her own.

(5) Americans need and desire truly objective, expert advice. The provision of such advice, in today's complex financial world, is essential for the future retirement security of hundreds of millions of Americans. Moreover, should Americans fail to receive objective advice, this will result in less capital formation, less private savings, and increased strain on federal and state government resources - precisely when governments are strained with their own fiscal difficulties.

I encourage you to make your voice heard on this issue.

Friday, August 6, 2010

The New Normal

Bill Gross manages more money than anyone on the planet, with the exception of a few (but not many) central banks. He is the co-chief investment officer of PIMCO which is located in Newport Beach, CA. Gross and his team manage over $1 trillion. PIMCO is known for its bond funds. But it has recently begun to develop equity funds.

Gross is one of the most respected voices in the investment community. He is frequently interviewed by major newspapers, network television and cable news programs. If you search for him on the web, you will receive thousands of pages.

CNN Money recently asked Gross about the “New Normal.” While I have heard and seen this term frequently since the recession began, Bill Gross was may have coined the term. He uses it to describe a prolonged period of deleveraging, reregulation and de-globalization. The New Normal will result in slower economic growth and lower inflation in developing countries.

The implications of Gross’ New Normal for investors are rather sobering. He anticipates equity returns will be around 5% instead of the historical 10%. For bonds returns will be around 4%.

Think about this. If Gross is right and if you have a portfolio that is comprised of 50% equities and 50% bonds, your weighted expected return will be 4.5%. If you pay taxes at the rate of 30% on this return, your after-tax return will be 3.15%. If inflation runs at say 3% (below the historical rate of 4%), then your inflation adjusted, after tax return will be just about zero! (Actually, it’s 0.15%)

Now, what can investors do to improve their returns? They can practice low-cost passive investment strategies. Investors who have actively managed portfolios can cut 0.50%-1.00% of expenses out of their portfolios by shifting to funds (mutual funds and exchange traded funds) that have lower internal expenses than actively managed mutual funds. They can save more by working with an investment advisor who charges less than the going rate of 1%.

Cascade Wealth charges 0.75%. Our portfolios have internal expenses of around 0.25%. So, all in, most of our clients pay about 1%. Investors with firms that actively manage their portfolios routinely pay 1.00% in advisory fees and another 0.75%-1.00% in internal fund expenses. In total these investor are often paying 1.75%-2.00%.

Do the math. If you have a $1 million portfolio, you can save $7,500-$10,000 by working with an advisor who practices low-cost passive investment management. You take no additional risk. You simply pick up another 0.75%-1.00% in net return by being an intelligent investor.