As we close out 2010 and begin a new year, many of us will be considering resolutions and goals. I would encourage all investors to commit to determining how much they are spending for investment management. How much are you paying your advisor? How much are the internal costs of the funds inside your portfolio? What is your tax rate for capital gains, dividends and interest?
Jason Zweig, a journalist for The Wall Street Journal, calls this the “net, net, net” return. Every investor should know this. I would suggest that investors who are paying more than 1%-1.5% in advisory fees and portfolio expenses are overpaying. My firm’s clients pay less than 1.00%.
Some investors might argue there is nothing we can do about taxes. So why pay much attention to them? Well, investors can actually do something about portfolio-related taxes. “Asset location” is the process of placing investments in the most tax efficient accounts within a clients’ portfolio. Investments that are inherently tax-inefficient, because they generate current income, should be placed inside tax-qualified accounts like IRAs, Roth IRAs and 401(k)s. Investments that are tax-efficient, because they create little current income can be placed in taxable accounts.
Many investment analysts suggest the next several decades will bring market returns that are significantly lower than they have been. If this occurs, managing fees, expenses and taxes will play a very important part in intelligent investing.
Happy New Year!
Friday, December 31, 2010
Thursday, December 23, 2010
The Market Recovery
The Dow Jones Industrial Average closed at 11,573 today. The Dow is up 13.86% year to date.
How far we have come from March of 2009 when the Dow fell as low as 6,469. In less than two years, the Dow is now within a reasonable distance of the all-time high, 14,164, reached in October of 2007.
What would it take for the Dow to once again reach this high point? A 22% increase.
The lesson: Markets are cyclical. Intelligent Investors understand this and they have the courage to remain committed to their investment plan even during the darkest of markets.
Merry Christmas!
Saturday, December 18, 2010
Market Beating Fund Managers
The debate about active vs. passive investment management will never end. This weekend‘s Wall Street Journal offers support for the active argument. In the article “The Return of the Market Beating Fund Manager” we learn that active stock fund managers may be able to beat the market with greater success than they have in the past.
The article suggests that active fund managers will benefit from a recent trend in which stocks are not as closely correlated as they have been recently. This should allow skilled managers to identify stocks which will outperform others.
In addition, there are some new tools which allow investors to find stock funds that will outperform their peers. “Active share” measures the percentage of fund assets that are invested differently from the fund’s benchmark. This could be helpful, because many large stock funds have become “closet index” funds which merely track their benchmark rather than attempt to beat it. A study by Antti Petajisto, a visiting assistant professor of finance at New York University’s Stern School of Business, found that one-third of U.S. stock funds essentially mimic their market benchmark. In contrast, the article argues, those funds with a high “active share” are more likely to beat the market. Professor Petajisto found that most active stock pickers beat their benchmark by 1.26 percent annually after fees.
I would very much like to review Professor Petajisto’s research. It is certainly not consistent with the data I have seen over the years on the success of active fund managers. Most fund managers underperform the market. There will always be some manager that beat the market. The problem is that we cannot know in advance who these managers will be. Furthermore, there is no way to know how long this market-beating performance will last.
Wouldn’t it be nice if we could identify the star fund managers in advance, stay in their funds until they lose their Midas touch and then jump out of their funds and into the next hot funds? Unfortunately, this is simply not possible.
The article also notes that actively managed U.S. stock funds have average expenses of 1.39% according to Morningstar, compared to 0.1% for inexpensive index funds. This is a big difference and active managers must beat it in order to outperform their benchmark. The reality is that very few of them do.
Friday, December 10, 2010
Sharpe Ratio
We know that investors “purchase” investment returns by parting ways with their money and accepting risk. The risk, of course, is that the money will not earn the return that was expected or, worse yet, that not of all of the money is even returned.
Investors are often concerned about returns. They want to know what the investment has returned in the past. They also want to know what the return is likely to return in the future. Unfortunately, while we usually know the former, the latter is unknown. Past performance is no guarantee of future results and future performance may be lower than past performance. We need to look no further than the market crash of 2007-2009 to see that markets can deliver terrible performance.
While investors should be concerned about performance, they should be even more concerned about risk-adjusted performance. The question is how much risk must an investor assume in order to receive the anticipated return. Given two similar investments that have identical returns, investors should select the investment with the lower risk. Alternatively, given two investments with identical risk, investors should select the investment with the highest return.
Nobel Laureate William F. Sharpe developed a formula to measure risk-adjusted returns. The Sharpe Ratio is calculated by subtracting the risk free rate from the rate of return for the investment (or a portfolio) and then dividing that result by the standard deviation of returns. The proxy for the risk free rate is Treasury Bills. We learned in an earlier post on my blog that standard deviation is a measure of risk.
We can compare investments using the Sharpe Ratio. The investment with the higher Sharpe Ratio is the preferred investment. We can also use the Sharpe ratio to simply evaluate performance in isolation. The higher the Sharpe Ratio, the better. A negative Sharpe Ratio suggests that a risk free investment would have performed better.
Intelligent Investors are very concerned about risk-adjusted returns.
Investors are often concerned about returns. They want to know what the investment has returned in the past. They also want to know what the return is likely to return in the future. Unfortunately, while we usually know the former, the latter is unknown. Past performance is no guarantee of future results and future performance may be lower than past performance. We need to look no further than the market crash of 2007-2009 to see that markets can deliver terrible performance.
While investors should be concerned about performance, they should be even more concerned about risk-adjusted performance. The question is how much risk must an investor assume in order to receive the anticipated return. Given two similar investments that have identical returns, investors should select the investment with the lower risk. Alternatively, given two investments with identical risk, investors should select the investment with the highest return.
Nobel Laureate William F. Sharpe developed a formula to measure risk-adjusted returns. The Sharpe Ratio is calculated by subtracting the risk free rate from the rate of return for the investment (or a portfolio) and then dividing that result by the standard deviation of returns. The proxy for the risk free rate is Treasury Bills. We learned in an earlier post on my blog that standard deviation is a measure of risk.
We can compare investments using the Sharpe Ratio. The investment with the higher Sharpe Ratio is the preferred investment. We can also use the Sharpe ratio to simply evaluate performance in isolation. The higher the Sharpe Ratio, the better. A negative Sharpe Ratio suggests that a risk free investment would have performed better.
Intelligent Investors are very concerned about risk-adjusted returns.
Thursday, December 2, 2010
Risk-Adjusted Returns
Over the past several weeks I reviewed several measures of return, risk and correlation. These tools allow the intelligent investor to evaluate securities and determine how they will perform relative to each other inside a portfolio.
Many retail investors do not appreciate the relationship between the return of an investment and the risk of that investment. If we were to ask investors rather generally about their investments, many would be able to tell us how they have performed in terms of rate of return. However, if we were to ask how much risk they accepted to achieve those returns, few investors would know.
Investing involves balancing the risk and return of investments. You might think of the process this way. When you invest you enter the marketplace with a bucket of risk. The marketplace consists of all kinds of investments offering various amounts of return and requiring the acceptance of proportional amounts of risk. If you are willing to accept no risk, your only option is securities issued and guaranteed by the United States government. You will not lose your money. However, the return you receive will be very low.
If you are willing to accept a very large amount of risk, you might invest in highly speculative hedge funds or private equity. These investments can return 20%, 40%, 50% or more. However, you could also lose some or all of your money.
The point is that investors should be aware of how much risk they are accepting when they deposit their money in an investment. The most attractive investments are those that have relatively high risk-adjusted returns.
Given the choice between two investments with the same expected, which are otherwise similar, the rational investor will place money in the security with a lower level of risk. Alternatively, if two investments have similar levels of risk, the rational investor will select the investment with the higher expected return.
Of course the amount of money you receive from your investments will also be a function of how much money you are willing to part with. The more you are willing to invest, the more you are likely to receive.
Many retail investors do not appreciate the relationship between the return of an investment and the risk of that investment. If we were to ask investors rather generally about their investments, many would be able to tell us how they have performed in terms of rate of return. However, if we were to ask how much risk they accepted to achieve those returns, few investors would know.
Investing involves balancing the risk and return of investments. You might think of the process this way. When you invest you enter the marketplace with a bucket of risk. The marketplace consists of all kinds of investments offering various amounts of return and requiring the acceptance of proportional amounts of risk. If you are willing to accept no risk, your only option is securities issued and guaranteed by the United States government. You will not lose your money. However, the return you receive will be very low.
If you are willing to accept a very large amount of risk, you might invest in highly speculative hedge funds or private equity. These investments can return 20%, 40%, 50% or more. However, you could also lose some or all of your money.
The point is that investors should be aware of how much risk they are accepting when they deposit their money in an investment. The most attractive investments are those that have relatively high risk-adjusted returns.
Given the choice between two investments with the same expected, which are otherwise similar, the rational investor will place money in the security with a lower level of risk. Alternatively, if two investments have similar levels of risk, the rational investor will select the investment with the higher expected return.
Of course the amount of money you receive from your investments will also be a function of how much money you are willing to part with. The more you are willing to invest, the more you are likely to receive.
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