Intelligent Investing

Two Standards

2012-01-26T17:35:00.000-08:00

The Dodd-Frank Act (Wall Street Reform and Consumers Protection Act) was passed in the summer of 2010 in the aftermath of the global financial crisis. The bill required the Securities and Exchange Commission (SEC) to conduct a study of the standards under which investment advisors and broker-dealers provide investment advice.

The problem is that broker-dealers and investment advisors operate under different regulatory regimes and are subject to different legal standards. In its executive summary, the SEC notes that "retail investors are generally not aware of these differences or their legal implications." http://www.sec.gov/news/studies/2011/913studyfinal.pdf

Here's the issue:

Investment advisors are held to a fiduciary standard of care. They must, by law, serve the best interests of their clients. If a conflict arises between their interests and those of their clients, they must subordinate their interests to those of their clients.

Broker-dealers are held to a suitability standard of care. This standard requires broker-dealers to make recommendations that are consistent with the interests of their customers. Notice that this standard does not require broker-dealers to serve the best of their clients.

This week The Wall Street Journal provided an update on the battle over these standards: http://online.wsj.com/article/SB10001424052970204301404577171112474127468.html

Actively Managed Mutual Funds

2012-01-24T13:57:00.000-08:00

According to Morningstar, investors pulled $8.6 billion from actively managed mutual funds in 2011. They invested $76 billion into index funds and $121 billion into exchanged traded funds, most of which are passive.

Perhaps investors are really beginning to wake up to the fact that actively managed mutual funds consistently underperform their benchmarks. While there will always be funds that do outperform, it is impossible for an investor to know, in advance, which funds will.

Investors cannot control the market. But they can control how much they pay to be in the market. Intelligent Investors practice low cost, passive investing, because it allows them to capture the returns of the markets with very little cost.

Burton Malkiel on 2012

2012-01-07T15:11:00.000-08:00

As I review the performance of various asset classes in 2011, it is rather clear that the investment markets continue to struggle with the effects of the global financial crisis. There are very few asset classes that performed will last year.

I have read several books on the history of economic crises and the impact such crises have on the financial markets. The correlation between asset classes converges and there are often few places for investors to hide. Unfortunately, last year was no exception to this phenomenon.

Most investors have undoubtedly grown weary of watching their portfolios languish. The past several years, starting in the fall of 2007, have not been kind to investors.

I know from my self-directed reading that eventually crises end and asset classes begin to follow a more normal pattern of returns. However, the current economic crisis in Europe (and the United States) is rather acute and the deleveraging process that must precede market recovery will quite likely take longer than most expected and hoped.

The fundamentals of investing have not changed: proper asset allocation, diversification, low costs and systematic rebalancing. You might find this article by Professor Burton Malkiel in The Wall Street Journal reassuring, "Where to Put Your Money in 2012." Professor Malkiel and Richard Ellis co-authored The Elements of Investing, which I highly recommend.

Measuring Investor Risk

2011-12-22T14:36:00.000-08:00

I have used FinaMetrica's investor risk profile for several years to attempt to assess clients' ability to accept risk. FinaMetrica's found, Geoff Davey, was recently featured in an online interview I viewed. Davey identified three distinct forms of risk that investors confront.

Required risk measures the extent to which investors must expose themselves to market volatility and losses in effort to receive the returns they need to achieve their goals. We can use standard deviation as a means of measuring this risk.

Risk capacity refers to the investors' ability to accept losses. If an investor has a $10 million portfolio, a $50,000 loss is not a big deal. The loss is just ½ of 1%. An investor with a $500,000 portfolio would have lost 10%. A very big deal.

Risk tolerance is a psychological construct. It's a personality trait. It's what FinaMetrica measures with their profile.

When I write an investment policy statement for a client, I refer to all three kinds or risk.

Fund Stars Plummet

2011-12-18T15:23:00.000-08:00

I am always looking for evidence to support my belief that it is very difficult, probably impossible, to find mutual fund managers who will outperform their benchmark. It is not difficult to find managers who have beat the market in the past. That information is readily available through Morningstar.

The investment industry and the financial media will often celebrate fund managers who have outperformed the market for an extended period. So, I found it noteworthy that The Oregonian identified five mutual fund managers who have come upon hard times. As of the December 6, 2011, the date of the article:

Bruce Berkowitz was Morningstar's Domestic Fund Manager of the Year, 2009, and Stock Fund Manager of the Decade (2000-2009). His Fairholme Fund is down 29%. The Standard & Poor's 500 index is down 1%.

Michael Hasenstab was the Morningstar Fixed Income Manager of the Year in 2010. His Templeton Global Bond fund has lost 2.4% this year.

Bill Gross was the Morningstar Fixed Income Manager of the Decade (2000-2009). Gross runs the largest mutual fund in the world, the Pimco Total Return fund. The fund has gained 2% this year, but trails 91% of its peers.

David Herro was Morningstar's the International Stock Fund Manger of the Decade (2000-2009). His Oakmark International fund is down nearly 13% this year and is in the bottom 25% of its category.

Even the most accomplished fund investors can get derailed. Most eventually do.

The Financial Truth

2011-12-07T08:53:00.000-08:00

Today marks the 70th anniversary of the bombing of Pearl Harbor. It was a day that, as President Roosevelt said, would live in infamy. The attack drew the United States into World War II. The war brought out the best in this country. We were galvanized, emboldened and determined to preserve the values upon which this nation was founded.

We are facing yet another great challenge, although not one that will be fought in battle fields, in the skies or on the seas. It is a struggle in which the majority of Americans are finding themselves in trouble financially. Some are in truly desperate financial straits. This short video conveys the seriousness of the matter more powerfully than I can.

Financial Truth

Please watch it and then encourage those around you to save more, spend less and borrow less.

90, the new 70

2011-11-24T16:06:00.000-08:00

I read recently that, according to the Census Bureau and the National Institute of Aging, the number of people in the US who are age 90 or older has nearly tripled since 1980. This is pretty remarkable. At the turn of the last century, life expectancy in this country was 47 years. While that figure is skewed by much higher infant mortality, people were living much shorter lives than they are today.

Keep in mind that life expectancy is the average. Half of the people will reach that age. The other half won't make it. If you are in good health, eat well, exercise and avoid smoking and heavy drinking, you are likely to live beyond life expectancy.

If you are curious about how long you will live, you might try the calculator at Living to 100 http://www.livingto100.com/. I did and I learned that I better plan to live to 100. (All of my grandparents lived to age 90. One lived to 95 and another lived to 98. So, I have a decent shot at making 100.)

When I give clients a retirement planning questionnaire, they often put down an age for life expectancy that they relate to their parents and/or grandparents. The problem is that they are likely to live longer than the generations that preceded them.

A good financial planner will model at least 5-10 years beyond current life expectancy. If the your goal is to live comfortably for as long as you live (i.e. to not run out of money), then you should make sure you have a safety margin for those extra years.

Happy Thanksgiving!

This Time is Different

2011-11-10T11:40:00.000-08:00

If you are interested in placing the current global economic crisis in perspective, I recommend reading This Time is Different by Ken Roggoff and Carmen Reinhart. I read it while I was in Nepal and it helped me understand the history of these crises. We've been careening from crisis to crisis for literally hundreds of years. The current crisis is rather acute and we will not emerge from it any time soon.

I watched the republican presidential debate last night. I was not inspired. I would really like to see our leaders, in both parties, begin having a candid conversation with the American people about how we can solve our economic problems ... unemployment, national debt, budget deficit.

The solution is really pretty straightforward. But it is not easy and not appealing. So, no one really wants to talk about it. The solution is really pretty straightforward. But it is not easy and not appealing. So, no one really wants to talk about it. I'm sure they calculate that, if they tell us the truth, they won't stand a chance of getting elected.

Here's what has to happen:

1. We need reduce our expenses AND

2. We need to increase our revenue.

3. We may need to sell some of our assets to pay down our debt

Simple. This is what I advise clients to do if they are struggling with debt or negative cash flow. Our government is no different.

By the way, the title of the book is a tease. This time is not different.

Confidence has its Limits

2011-11-02T11:25:00.000-07:00

A prospective client sent me an article that ran in The New York Times on October 19, 2011.

It was written by Daniel Kahneman who is an emeritus professor at Princeton and winner of the 2002 Nobel Prize in Economics. He is a leader in the area of behavior economics.

The article, "Don't Blink! The Hazards of Confidence" is quite interesting.

Investors who believe they are able to beat the market would benefit from considering Kahneman's message.

Mutual Fund Fees

2011-10-30T14:53:00.000-07:00

I have been either very busy serving clients or out of the country for the past several weeks. So, for those of you who read my blog, that explains my absence.

I read an article in this weekend's Wall Street Journal titled, "Why Fund Fees Barely Budge." You can find it here: http://online.wsj.com/article/SB10001424052970203911804576651512398417294.html?KEYWORDS=fund+fees

The article notes that actively managed mutual funds charge an average expense ratio of 1.45%. In contrast, my firm's model portfolios have an expense ratio that averages about 0.25%.

But this is not the only expense incurred by mutual fund investors. Funds pay brokerage expenses and bid-ask spreads when they buy and sell for the fund. The article notes that actively managed mutual funds incur an average of 1.44% of trading costs annually.

Investors should keep these expenses in mind when they think about investing in actively managed funds. The active fund manager has to generate returns in excess of these fees in order for investors to experience returns that are better than the market itself.

Yet Another Reason to Invest Internationally

2011-09-04T11:30:00.001-07:00

Do you know what percent of the global stock market is comprised of companies based in the United States? Depending on the data you review, it somewhere between 35% and 40%. How much of your portfolio is made up of US stocks? I would anticipate that it's in excess of 50%.

Most investors are prone to domestic bias. This means that the percent of stocks they own is over weighted to their home country. If you live in Japan, you are tilted toward Japanese stocks. If you live in Germany, you own more German stocks. If you live in the United States, you own more American stocks.

Investors who want to own stocks based on global market capitalization should own no more than 35%-40% of stocks based in the U.S.

The Federal Reserve Bank of San Francisco has given investors a compelling reason to diversify away from U.S. stocks. Fed adviser Zheng Liu and researcher Mark Spiegel suggest in a recent paper that aging baby boomer will dampen U.S. stock values for the next few decades as they sell their investments to finance retirement. (Source: Bloomberg New)

“U.S. equity values have been closely related to demographic trends in the past half century. In the context of the impending retirement of baby boomers over the next two decades, this correlation portends poorly for equity values.”

So, consider shifting the equity portion of your portfolio away from U.S. stocks to international stocks.

The Mutual Fund Industry Wealth Transfer

2011-08-17T10:03:00.000-07:00

David Swensen, the chief investment officer at Yale University and the author of "Unconventional Success: A Fundamental Approach to Personal Investment," wrote an opinion piece on the mutual fund industry that appeared in The New York Times over the weekend. It's quite an indictment of an industry that offers products that are used by millions of investors.

In the article Swensen makes several important points:

The mutual fund industry has failed to deliver on its promises of market beating returns. Very few actively managed funds outperform the market itself.
Mutual funds are for-profit enterprises which means that there is an inherent conflict between their incentive to generate revenue and the investors desire to earn returns.Virtually every dollar earned by a mutual fund comes directly from its shareholders. This is a zero sum game.
Investors are lured into buying funds that have achieved high praise by mutual fund industry monitors such as Morningstar and Lipper. Unfortunately, such recognition is for historical results. It has nothing to do with what the fund will do in the future. Academic research tells that those funds that have performed well in the past may well underperform in the future. The phenomenon is known as "reversion to the mean."
Investors are prone to investing in hot funds only to find that they soon lag their peers. Many investors grow disillusioned, sell the once stellar fund and move on to the next hot fund. It turns out that funds often experience cycles of both superior and inferior performance. They follow each other (imagine the sine curve). Investors buy high and sell low and thus lock in results that are actually far worse than the funds they own. Dalbar has provided research on this for many years. It tells us that mutual fund investors do not come close to earning market returns. It also tells us that investors keep their funds for just over 3 years. Hardly a long term strategy.
Swensen tells us to "invest in a well-diversified portfolio of low-cost index funds." He points out that if investors had held their funds for 10 years, their results would have improved by 1.6% per year. This is a dramatic improvement in an industry that measures performance in basis points. (There are 100 basis points in one percent.)
Swensen also calls on the Securities and Exchange Commission to do more to regulate the mutual fund industry and protect investors.

Here's the link to the article:

The Mutual Fund Merry-G0-Round

I encourage you to read the article. I suspect those who do will find the case for Intelligent Investing - low-cost, passive investing - even more compelling.

2011-08-09T10:16:00.000-07:00

Yesterday financial markets across the globe reacted negatively today to Standard & Poor's downgrade of long term debt issued by the United States. Last Friday S&P lowered the rated from AAA to AA+ noting that the recent budget agreement failed to address the government's debt situation. Asian markets opened down and were followed by markets in Europe and the United States.

Despite the unprecedented downgrade, the United States is far from alone in its need to address its excessive national debt levels. The European Union has several members, including Ireland, Greece, Portugal, Italy and Spain that are struggling with debt levels that are unhealthy relative to the size of their economies.

To some extent today's stock market's reaction reflects investors' dissatisfaction with the general state of the US economy. The nation is burdened with an unsustainably large debt and its elected leaders have not demonstrated an ability craft an agreement that will result in a long term solution to the problem. At the same time, economic growth is waning, unemployment remains persistently high, and inflation is creeping into the broader economy.

The stock market is a place in which investors sometimes overreact to news out of fear, panic, and desperation. Yesterday was a good example. The broad market, measured by the Standard & Poor's 500 index, dropped by over 6%. Does that mean that the stocks which comprise this index were suddenly worth less than they were last Friday? No. It means that sellers overran buyers and drove the prices of these large companies down.

Cascade Wealth Management remains committed to the time-tested long term strategies of proper asset allocation, diversification and maintaining low costs. Our clients' portfolios, while down over the past few weeks, have not suffered the temporary losses that the selloff in the U.S. stock market would imply.

What should investors do in the midst of all of this volatility? I would suggest following the advice of Burton G. Malkiel in his opinion piece in yesterday's Wall Street Journal, "Don't Panic About the Stock Market." Malkiel, professor emeritus of economics at Princeton University is co-author of The Elements of Investing, a book I highly recommend. He encourages the investors to "stay the course." So do I.

2011-08-04T15:56:00.000-07:00

Today the global financial markets dropped rather dramatically. The Dow Jones Industrial Average fell by 513 points. The Standard & Poor's 500 index was down 4.8%

I received the following email from another investment advisory firm:

"The financial markets have been experiencing considerable volatility in the last two weeks. We have made changes to our models because we believed this could happen. We are continuing to monitor your portfolios in light of the recent economic and political events and believe the strategy we put in place is appropriate. We will continue to provide you with updates as we study the information available to us."

They believed this could happen? Well, we all know this could happen. Moreover, it happens with some regularity over the long cycles of the stock market.

The strategy we put in place is appropriate? I'd love to know what that strategy is.

Let's not forget the following:

The financial markets are prone to volatility. This has been the case for 200 years in this country.
No one knows what will happen tomorrow, next week or next year in the stock market. If someone tells you they know what is going to occur in the stock market, run in the opposite direction.
The stock market generally prices securities in an efficient manner. This means that identify mispriced securities is very difficult.
Given that the stock market is an efficient marketplace, waste no time trying to find the underpriced or overpriced security. Instead build a well allocated and properly diversified portfolio.
In times of market volatility, manage your emotions and not your portfolio.

Variable Annuities - Expenses Drag Performance

2011-08-03T15:56:00.000-07:00

With the economy weakening and the stock market faltering, investors are moving out of the stock market and seeking refuge inside annuities. Morningstar reports that investors withdrew $50 billion from stock mutual funds in the 12 months through April of this year. LIMRA reported that sales of variable annuities in the United States increased to $39.8 billion in the first quarter compared to $32.2 billion in the same period in 2010.

The problem is that investors generally have no idea how much they are paying for these insurance products. According to Morningstar the average fees for variable annuities are 2.51%. Many buy a rider that offers guaranteed minimum payments. These riders cost 1.03% on average. So, investors who buy these products can end up paying more than 3.5% in expenses.

These expenses are a significant drag on the performance of variable annuities. If the sub accounts inside the annuity earned an average of 8%, the return after fees would be 5.5%. In addition, income received from an annuity is taxed as ordinary income.

Some investors would benefit from including a variable annuity in their portfolios. But the fees make them unattractive investments for most investors.

The Debt Ceiling

2011-07-26T14:45:00.000-07:00

Several clients have contacted me in the past few weeks expressing concern about the approaching deadline to raise the nation's debt limit.

The Treasury Department has indicated the limit must be increased by next Tuesday, August 2, or the country may default on its obligations. Unfortunately, as of today, with one week to go, our elected leaders have still not been able to craft an agreement that will increase the debt limit.

Analysts have been speculating about the impact a default could have on the financial markets. No one really knows, because the United States has never defaulted. But clearly the effect would be negative and perhaps severely so.

I would not be surprised if the stock and bonds markets both dropped fairly dramatically, if it were to become clear that Congress and the Obama administration will not reach a deal.

However, as has been the case with our other events that have shaken the market -- remember when the markets opened after the September 11, 2001 attacks or when Congress voted down the Troubled Asset Relief Program in September of 2008? -- I expect the markets would recover and in a relatively short period of time.

I have read that some investors have decided to get out of the markets until this situation clears up. This approach assumes that we will actually know when things are stable again and when it's safe to re-enter the market. I know I do not have the ability to see into the future.

Moreover, the nation's financial predicament involves much more than another increase in its debt ceiling. (There have been 74 increases since March of 1962.) The government spends considerably more than it receives in revenue. We have a national debt that is nearing the total annual productivity of the country and, if not soon addressed, will simply dominate the nation's budget. Congress and the administration have to address this imbalance or the nation will be facing the kind of austerity measures that are currently being implemented throughout the Europe Union.

I have recently read three books on the history of crashes and depressions in financial markets. I was struck by how often these events occur and by how quickly the markets recover. While we cannot predict market events, we know they will occur and we know that eventually the markets heal.

Intelligent, long term investors need to remain disciplined and resolute in the face of these events. I realize this is not particularly comforting. But I know there is no better approach.

Dimensional Fund Advisors

2011-07-15T16:33:00.000-07:00

My blog seems like a good place to announce that Cascade Wealth Management will begin offering funds from Dimensional Fund Advisors in the very near future. I am very excited about this, as I believe DFA offers funds built on the finest academic research in the investment community.

DFA Funds are not directly available to retail investors. Investors can access them through a Registered Investment Advisor (e.g. CWM) which has been authorized by DFA to offer their funds.

DFA has several key principles:

Markets Work. DFA believes that the Efficient Markets Hypothesis (EMH) is valid. The EMH suggests that securities are generally properly priced and that it is very difficult, essentially impossible, to consistently identify securities that are mispriced. Consequently, it is misguided to attempt to outperform the overall market through active management strategies such as individual security selection and timing strategies.

Risk and Return are Related. The idea is that investors are rewarded for taking risk. The amount of the reward (i.e. return) is directly related to the amount of risk. However, the founders of DFA, Eugene Fama and Kenneth French, have developed a multifactor model which is the basis for DFA funds. I will come back to this model in a future blog.

Diversification is Essential. Portfolios should be structured to provide comprehensive diversification within and across global asset classes. Portfolio risk is composed of diversifiable or non-systematic risk and non-diversifiable, systematic or market risk (all interchangeable terms). Investors are only compensated for taking market risk. Investors must diversify sufficiently to eliminate non-systematic risk.

Structure Determines Performance. Asset allocation explains most of the variation of portfolio returns. DFA posits that over 96% of the variation in return is due to risk factor exposure. Thus, investors must get asset allocation right in order to be successful.

Look for more information about DFA funds in subsequent postings.

So what are you?

2011-07-06T15:23:00.000-07:00

I thought I might offer my take on the differences between savers, investors, speculators and gamblers.

Saver: A saver is someone who consistently sets aside some portion of her income for use in the future. The saver delays the gratification that comes from spending today and instead reduces current consumption below what her total income would allow her to spend.

The saver puts the money that is not spent in some kind of an account that will be secure and grow modestly in value. The saver's primary objective is to preserve the monies saved. Therefore, she will likely put her funds in an account that is guaranteed by the federal government. The money might be invested in a bank product like a savings account, interest-bearing checking account, a bank money market account or a certificate of deposit. All of these bank products are eligible for Federal Deposit Insurance (FDIC) up to a legal limit of $250,000.

The smart saver will seek to put enough into "safe" investments, so that emergencies can be met from these funds. A rough rule of thumb suggests that three to six times monthly expenses should be set aside in an emergency fund. The saver can tap this fund if her car needs repairs, an appliance must be replaced, or to get through a brief period of unemployment.

Investor: An investor is someone who is willing to accept investment risk with the expectation of receiving a return proportionate to the risk. The greater the risk of loss of principal, the greater the expected return.

Savers become investors once their emergency funds are fully funded. Savers should not "invest" funds that belong in their emergency funds. However, once the emergency fund has been fully funded, the investor should become an investor as well.

The investor will consider a wide universe of investments such as individual securities (e.g. stocks and bonds), mutual funds, exchange traded funds, limited partnerships or investment trusts. In fact, there are many kinds of investment that may appeal to the investor.

Speculator: A speculator is someone who is willing to accept a very high level of risk with the hope that she will be rewarded with a very high return. The speculator accepts a very high probability that she may lose some, or all, of her investment. The risk of loss with speculation is greater than it is with investing.

There are many ways to speculate. One can purchase an interest in a wildcat oil exploration project, raw land subject to future development, a start-up company with no revenue and in many other ventures. The speculator reviews information related to an opportunity that requires funds, evaluates the risks and potential returns and decides to participate or not based on her own assessment

Gambler: A gambler is a different kind of risk taker. The gambler has no ability to assess risk. He is willing to part with money for the hope that he may receive a large sum in return. Gambling is based on random outcomes and, as a result, the gambler has no influence over the outcome. People who part with their money in casinos are gamblers.

Gamblers seem to gain satisfaction from entertaining the possibility that they may receive a large "reward" for participating in the gamble.

So, what are you?

GAO's Advice for Retirees

2011-07-01T17:04:00.000-07:00

The General Accounting Office (GAO) released (June 2011) a study "Retirement Income: Ensuring Income throughout Retirement Requires Difficult Choices." I read the key findings and scanned the study. Here's what the GAO has to say to those approaching retirement.

Consider delaying the receipt of Social Security benefits until reaching at least full retirement age. The Social Security Administration permits recipients to start payments as early as age 62. Many Americans begin receiving benefits at this age. However, their payments would be higher by waiting to full retirement. Nearly three quarters of current beneficiaries took payouts before age 65. Those who wait to age 70 increase their benefits 32% compared to taking them at age 66.

Waiting to start Social Security has other benefits. The applicant continues to work and, hopefully, save. The period of retirement is reduced and, as a result, so is the amount of money required to fund living expenses during retirement.

The study suggests retirees may take withdrawals from their retirement savings at a rate of 3%-6%. This is a pretty widely accepted rule of them in the financial planning community.

For many this draw down rate will not produce sufficient income. The GAO suggests retirees consider the purchase of an immediate annuity which guarantees income for the life of the annuitant.

I find fee only advisors reluctant to suggest clients consider using annuities to fund retirement. Fee only advisors (and their clients) find annuities overly complex and expensive. They are often reluctant to have their clients transfer assets they may be managing to an insurance company. Further, the rates credited by insurance companies to annuities are quite low in the current investment environment rendering the effective return on annuities uninspiring.

I believe there is a place for an immediate annuity in many retirement plans. When I include immediate annuities in client retirement models, I see the model's performance improve.

The GAO study warns that many Americans are in jeopardy of living in poverty in retirement. The office calls for greater financial literacy and making annuities available in defined contribution retirement plans (e.g. 401(k) or 403(b)).

Investors have Lousy Timing

2011-06-23T10:56:00.000-07:00

The June/July issue of Morningstar Advisor (a trade publication for independent advisors) contains an article about how poorly investors time their purchases of mutual funds.

The article points out that, through most of 2009 and 2010, investors moved money from equity funds to bonds. The problem is that the stock market hit a low in March of 2009 and then proceeded to mount a rather aggressive recovery.

Investors who were moving from stocks to bond were heading in the wrong direction. They sold stocks when the market was low and moved into bonds after the bond market's very long rally.

Why do investors do this? Because they are driven by emotion. In the depths of the economic crisis, investors were panicked and fearful. What do people do when they feel this way? They run away. This reaction is instinctual. Taking flight is a helpful and appropriate reaction if you are being chased by a saber tooth tiger. In fact, it could save your life. It is not helpful if you are a long term investor trying to grow your wealth.

Stock Pickers Beaten Badly

2011-06-14T14:48:00.000-07:00

Three of the most highly regarded fund managers have recently lagged behind their peers and the market itself.

Investment News reports (Berkowitz, Heebner and Miller in tight battle — for last place) that Bruce Berkowitz, Kenneth Heebner and Bill Miller have posted results are all well behind the Standard & Poor's Index through June 9, 2011.

Mr. Berkowitz was Morningstar's fun manager of the decade. Mr. Miller beat the S&P 500 index 15 straight years through 2005. Mr. Heebner was manager of the best-performing diversified US stock fund over a 10-year period.

Here's the scorecard:

Manager - Fund - Return

Bruce Berkowitz - Fairholme Fund - 12%

Kenneth Heebner - CGM Focus Fund - 12%

Bill Miller - Legg Mason Capital Opportunity Fund - 11%

S&P 500 Index + 3.4%

Data source: Morningstar

What can we learn from the fall of these stock picking stars? We have more information that suggests that stock pickers are unable to beat the market indefinitely. Certainly some managers beat the market. We would expect some to beat the market and others to underperform the market. The problem is differentiating one from the other.

Moreover, we do not know whether managers who beat the market do so because of skill or luck. Certainly successful fund managers claim that their superior investing skills underlie their performance. But we also routinely hear from underperforming managers that bad luck has derailed their funds. So, is it skill or luck?

Some might suggest that the savvy investors should ride the stars as long as possible and then jump off when they start to falter. There are three challenges that must the investor must overcome to pull this off. First, the investor must be able to identify and invest with the stock picking star BEFORE he starts his winning streak. Second, the investor must have the conviction to stay invested with the star if/when a more compelling investing opportunity appears. Third, the investor must know when to fold 'em and move out of the fund BEFORE it becomes a losing fund.

We know that investors are rarely able to move in and out of mutual funds successfully. Dalbar's research shows that shareholders in mutual funds earn returns that are consistently lower than those of the funds in which they invest.

The lesson for intelligent investors: Waste no time searching for the next hot fund manager. Instead invest across asset classes and capture the returns of those asset classes using low cost, passive funds.

Investors Hunkered Down

2011-06-07T15:13:00.000-07:00

Prudential Financial recently conducted an online survey of investors, "The Next Chapter: Meeting Investment & Retirement Challenges."

http://news.prudential.com/images/20026/2011TLConsumerStudyFINAL.pdf

The study yielded some interesting data.

44% of the participants said they are not likely to ever put money in the stock market.

This is rather alarming, because it means a substantial portion of Americans are forsaking the asset class (stocks) with the greatest long term returns when compared to bonds, real estate and cash instruments (CDs, bank accounts, money market accounts).

61% believe the principles of investment diversification and asset allocation have changed.

The principles of successful investing have not changed. We know that markets are fickle. Asset allocation and diversification cannot and do not provide a shield from extreme market volatility. However, over long periods, no other strategy provides better results.

66% are concerned that they will miss out on the stock market recover based on their current portfolio mix.

Many investors bailed out of equities at or near the bottom of the recent stock market swoon. Since March of 2009, the low point, the stock market is up well over 100%. Investors who were not properly invested in equities lost out on this opportunity. Moreover, the opportunity will not present itself again until we have yet another economic crisis.

72% of Americans agree that they need to think differently about saving and planning for retirement.

The economic crisis, stock market crash and housing collapse may yield some long term benefit, if Americans actually begin reducing personal debt and saving more. Very few Americans are on track for a financially secure retirement.

69% believe few financial service firms are trustworthy.

The banks, wire houses, insurance companies, and credit unions have largely failed investors. In general, they have not served their customers in a fiduciary capacity. They have not engaged their customers in comprehensive planning. Instead they have offered complex and confusing products that have essentially transferred billions of savings from investors to large financial institutions.

Many Americans need to make a major change in their approach to retirement. If they do not, they run the risk of finding that the last decades of their lives will be something far less than golden. Among other findings, the Prudential survey suggests that the need for greater financial and investment literacy is great.

The Erosive Effect of Fees

2011-06-03T07:52:00.000-07:00

I often wonder if investors realize how important fees are to their long term investing results. My sense is that they really don't get it. If they did, they would embrace low cost, passive investing and avoid active management and high priced investment advisors.

The Department of Labor reports that for every 1% increase in fees, an investor's portfolio erodes by 28% over 35 years. So, if an investor would have had $1 million at the end of 35 years, instead she would have $650,000. This is an enormous difference.

Investors have no control over the performance of their market based investments. However, they do have the ability to work with advisors who charge low fees and invest in funds that have low internal costs. Intelligent investors realize that low cost, passive investing is the most reliable path to successful investing.

CDs - Investing in Reverse

2011-05-25T08:23:00.000-07:00

Investors in certificates of deposit (CD) continue to lose ground. Market Rates Insight reports that the interest investors earn on the highest paying CDs is now lower than the rate of inflation.

The rate on 5 year, callable CDs hit 2.4% in April, while the annual inflation rate ticked up to 3.16%. The result is a negative yield of 0.76%.

This drop in the real rate of return for CDs is not surprising. Shorter term CDs have carried negative inflation adjusted yields since late 2009.

CDs are often held by older and very conservative investors. They are perceived to be less risky than market-based investments.

It is true that there is little, if any, risk that investors in CDs will not receive their money back at the maturity of the CD. However, CDs do carry risk. The risk is that the investor will not be able to maintain purchasing power in the face of rising inflation.

Intelligent investors realize that risk comes in many forms. They also understand that there is no truly risk-free investment.

The Mystery of Hedge Funds

2011-05-10T16:04:00.001-07:00

The Wall Street Journal ran article on the front page a few weeks ago about how investors our pouring money into hedge funds. The Journal reported that hedge funds are managing nearly $2 trillion and are approaching the high point they reached in early 2008 before the economic crisis.

The recovery of the hedge fund industry is baffling. This industry claims to provide investors with returns that are better than those that can be achieved though such pedestrian vehicles as mutual funds. Hedge funds market themselves as sophisticated, exclusive, and elitist. They cater to the affluent investor who must meet the accredited investor standard. (According to the Securities and Exchange Commission, these investors must have an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. Alternatively, the investor must have a net worth that exceeds $1 million.)

Apparently many accredited investors are not particularly intelligent investors. If they were, they would realize that hedge funds have generally failed to live up to their claims. In 2008, hedge funds suffered their worst year on record with the average fund losing 19% according to Hedge Fund Research Inc.

As a result of losses and withdrawals the hedge fund industry shrank by a quarter. But the industry has rebounded and attracted $55.5 billion in net new money in 2010.

Now the average hedge fund earned 20% in 2009 and 10.3% in 2010. The Standard & Poor's 500 index increased 26.5% and 15.1% in those same periods. In the first quarter of this year, the average hedge fund rose 1.6% in the first quarter of this year compared to 5.4% for the S&P 500 index.

One has to wonder about investors who pour billions in to vehicles that routinely underperform the market. It's even more perplexing to consider that most of these hedge funds use strategies that carry risk that is far greater than the risk of the market itself. So, investors take on more risk than the market and are rewarded with lower returns than the market.

It does not end there. Hedge funds typically charge their investors a 2% management fee and they take 20% of the profits. I don't know how Hedge Fund Research reports their data. It could be before or after fees. If it's before fees, then hedge funds are even less appealing.

Intelligent investors don't accept the hype surrounding hedge funds. They are smart enough to ask serious questions before investing in anything, including hedge funds. Questions like:
How much risk is involved in this investment?
What is your performance benchmark?
How have you performed against that benchmark?
What fees will I be paying?

Sources: The Wall Street Journal, Hedge Fund Research

Got a POLST?

2011-05-07T12:07:00.000-07:00

Imagine you are involved in a serious accident. You are brought to the hospital and placed in intensive care. The ER docs are not sure you're going to make it.

You are unable to communicate. What do you want to happen? Are the docs supposed to take every measure to keep you alive? Are they supposed to make you comfortable and let nature takes it course?

Are your intentions written down? If so, where is that document? Who has copies?

According to the University of California, San Francisco, three quarters of us will be unable to make some or all of the decisions at the end of our lives. As a result, inappropriate care may be given and family members may be placed in very difficult emotional situations.

You can prevent this from happening by implementing a Physician Order for Life-Sustaining Treatment, or POLST. This document, which you and your personal physician sign, specifies the kind of care you would like to receive.

Oregon is one of 14 states that have a POLST program. The POLST is an official medical record that is stored in a state registry. You complete this document with your physician.

If you are interested in learning more about POLST, you can visit this page at the Oregon Health Science University (OHSU) web site, http://www.ohsu.edu/polst/.

Consider bringing the subject up with your doctor, the next time you're in for a visit.

Asset Location

2011-04-26T15:22:00.000-07:00

If you have been reading my blog for any length of time, you know how important asset allocation is to long term investment performance. Numerous academic articles and white papers have established that the manner in which funds are allocated into different asset classes is more important than any other factor which influences portfolio returns. Several sources suggest that as much as 90% of portfolio results are driven by asset allocation.

Today I would like to draw your attention to another factor which can significantly affect the returns you experience. I call it "asset location." It is the process of placing asset classes inside investment vehicles based on their tax characteristics.

Let's imagine an investor with a $1 million portfolio. This portfolio consists of three investment vehicles - $300,000 in a 401(k), $250,000 in an IRA and $450,000 in taxable account. Our investor earns $100,000. He's 50 years old and plans to retire in 10 years.

In this simplified scenario, the investor will have a portfolio consisting of 50% in equities and 50% in bonds. How should we allocate the $1 million across these two broad asset classes (equities and bonds) and across the three investment vehicles?

We know that bonds generally create income. Ordinary incomes taxes are 10%-35%. Our investor is in the 28% marginal tax bracket.

Equities can kick off dividends and capital gains. Qualified dividend income is taxed at 0%-15%. Our investor is in the 15% tax bracket. Short term capital gains are taxed as ordinary income. Long term capital gains are taxed at 0%-15%. Our investor is in the 15% tax bracket.

So, where do we place the $450,000 in bonds? These funds will go into either the 401(k) or the IRA. Why? Because the income coming from the bond funds we select will not be taxed inside these accounts. If we placed the bond funds in the taxable account, the income they create would be subject to a tax of 25%.

What about the equities? We should put these funds inside the taxable account. They may create some dividend income. If the dividends are qualified, the tax will be 15%. If the dividends are not qualified, the tax will be the ordinary income tax rate of 28%. Capital gains will be subject to tax at 15%. If we use exchange traded funds (ETFs), realized capital gains will not likely occur until the investor sells the ETFs.

Some investors might not think the asset location for tax efficiency makes much difference.

In this example, let's assume the equity return is 8% (2% dividends, 5.5% unrealized gain, 0% short term gains, and 0.5% long-term capital gains) and the return on the bonds is 3%. We'll assume the bonds are taxable, rather than municipal bonds.

If we locate the bonds in the non-taxable accounts (401(k) and IRA) and the equities into the taxable account (individual), in 20 years the investor will have $270,000 more than if we placed the bonds in the taxable account and the equities in the non-taxable accounts. This is an enormous difference and should serve to illustrate how important "asset location" is to Intelligent Investing.

A Distinction about Diversification

2011-04-19T12:58:00.000-07:00

I was on a webinar today that included Jason Zweig, a journalist for The Wall Street Journal, on its panel. I respect Jason. He is a voice of reason for investors.

Jason made a comment about diversification that we should all bear in mind. He said, "Diversification works over time. It does not work all of the time."

This is an important distinction. Investors who believe diversification does not work should review the academic research on the role of diversification in investment performance. The data indicates that risk is lowered and returns are enhanced through proper diversification. Modern Portfolio Theory proves this to be true.

Investors have their own proof that diversification does not work at all times. During the market crash of late 2008 through the spring of 2009 investors saw that even a well diversified portfolio can suffer sign cant losses. In times of crisis, virtually all asset classes tend to move downward.

Many investors (and far too many advisors) have made the claim that "diversification is dead." This is not true.

Investors who remained invested through the full cycle of market crash to recovery have generally fully recovered their losses. The losses they experienced were temporary.

Investors who divested during the market crash converted what would have likely been a temporary loss of value into a permanent, realized loss.

I have recently read two books on market crises, bubbles, manias, depression, crashes, etc. We know that these market events happen fairly routinely. In fact, they tend to happen every 10 years or so. This has been true for about 400 years.

Intelligent Investors will not be surprised when the next market swoon occurs. They will buckle their seat belts and ride it out. For doing so, they will be rewarded on the other side.

Let's Make a Plan

2011-04-15T12:01:00.001-07:00

The CERTIFIED FINANCIAL PLANNER Board of Standards is rolling out a $37 million awareness campaign. Based on market research, the board found that consumers who represent the typical CFP's target audience are generally unaware of the credential or the benefits of working with a CFP. Further, when they learned about the value of comprehensive financial planning and the role of a CFP in that process, they were more likely to seek the services of a CFP.

The board commissioned a leading marketing agency, Arnold-DC, to place print ads (The Wall Street Journal’s Money & Investing section, SmartMoney, Kiplinger’s, Money and Barron’s), run commercials on cable news networks (CNN, MSNBC and the Fox News Channel)and lifestyle cable networks (The History Channel, HGTV and ESPN) and position banners on select web sites (LinkedIn, Morningstar.com, Bloomberg and Forbes). The campaign is called "Let's Make a Plan." The position statement is "If you need your whole financial life pulled together, a CFP professional is uniquely qualified to help.”

It is no wonder that the CFP credential is not well known. There are dozens of credentials in the financial services industry. A small industry creates credentials, develops curriculum for them and then markets them to insurance agents, stockbrokers, and financial advisors. It is literally a business with some of these mills producing several credentials in areas that range from life insurance to long term care insurance to mutual funds. Almost all of them can be obtained by satisfying very weak requirements.

The strongest credentials are Certified Public Account, Chartered Financial Analyst and CERTIFIED FINANCIAL PLANNER. The CPA, CFA and CFP are also held to a fiduciary level of care when working with clients.

I hope that the CFP Board's campaign is successful. But I suspect it will take regulatory action to actually clean up the industry and provide consumers more information about the true nature of the credentials that advisors use to promote themselves.

Relying on Social Security

2011-04-10T17:23:00.000-07:00

The Associated Press and the LifeGoesStrong lifestyle website reported last week that nearly two thirds of Baby Boomers surveyed said Social Security will be either an "extremely" or "very" important source of income when they retire.

Most of those surveyed reported that their retirement accounts lost significant value during the economic crisis. Many indicated they plan to work longer than they anticipated. Few have saved nearly enough for retirement.

Social Security was never intended to be the primary, much less sole, source of income for retirees. It was conceived to complement the pension income employees receive through their employers and workers' savings.

Unfortunately, few employers offer formal defined benefit pension plans. Most companies have instead opted for a deferred compensation plan, such as a 401(k).

This would not be so bad if employees actually picked up the slack and saved more. However, they have generally not saved enough either through their plans at work or on their own.

The result is a generation that is headed toward retirement with very little in savings. While Social Security will surely remain a source of income for retirees, it will not provide nearly enough income to maintain the lifestyle that most Americans consider reasonable.

The Important will soon become Urgent

2011-04-03T17:02:00.000-07:00

Considerable research indicates that very few Americans are on track to save enough for retirement. Most are so far off course that they will likely face rather sobering choices when they reach the traditional age of retirement. Why is this?

Do Americans not care about their future? Surely this is not true. No one wants to spend the last decades of their life worrying about how to pay for basics like rent, food, and utilities.

Are Americans simply not able to save any money? We know that most American workers earn enough income to be able to save at least 10% of their gross income. There are many stories about how even those with low wage paying jobs are able to squirrel money away over their working lives.

Do Americans believe that Social Security will provide enough income to meet their needs? This is rather unlikely, given that it is common knowledge that Social Security is underfunded and will require significant revision to prevent it from collapse.

Are Americans relying on an inheritance to make up for what they have not saved? They had better not. Most Americans will receive no inheritance and those who do will rarely receive enough to make a significant difference in their financial condition.

My theory is that, while almost all Americans believe having sufficient savings in retirement is very important, is not an urgent matter. As we march through the decades of our lives, retirement is always far removed from reality. It is 40 years out, then 30 years out, then 20 years out.

We act upon that which is urgent. If your hand is cut, you stop the bleeding. If your house is on fire, you call the fire department. If the kettle is boiling, you pull it off the stove.

We may or may not act upon that which is important. If we feel it is important to brush our teeth, we do it. If we believe going to church is important, we go. If we feel getting an education is important, we go to school.

Then again most Americans would agree that exercise is important. But most Americans do not exercise. Most Americans feel it's important to maintain a balanced, nutritious diet. But most Americans do not. Most Americans believe charity is important. However, very few Americans give much of their time or money.

Americans know planning for retirement is important. But it's not urgent. So, they put it off. Only when it becomes urgent do most Americans act. Unfortunately, at this point, it is very difficult to do much to improve their prospects for comfortable retirement.

Saving Adds Up

2011-03-27T17:10:00.000-07:00

Most Americans will work for 40 or more years before retiring. Hopefully, they save enough money along the way, so that they can maintain their lifestyle for the remainder of their lives.

If a person started off earning $40,000, had 3% annual salary increases, saved 10% per year, and earned 8% on the amount saved, she would have just over $1.5 million at retirement. Her salary at retirement would be $130,000.

If she then retired and drew 4% per year from pool of savings, she would be able to received distributions of $60,000. These withdrawals could be increased for inflation and she would never run out of money.

You might note that $60,000 is less than half of her final salary. She would have Social Security. She might have a pension.

Planning for a Long Trip

2011-03-20T14:13:00.000-07:00

The Employee Benefit Research Institute's Retirement Confidence Survey was released last week. It found that more than half of those surveyed are "not at all confident" or "not too confident" that they will be able to afford the retirement they want.

Only 42% have tried to calculate how much money they'll need for retirement. Imagine getting on a plane for a long trip. If you were the pilot would you want to know how much fuel will be required to reach your destination? Would you want to make certain the plane had that much fuel and perhaps an emergency reserve in case you needed it?

Americans enter retirement for a journey that will typically last 20-40 years. Most of them don't bother to determine how much money will be required to make sure that the journey will be pleasant. Some of these people will eventually realize that they will have to work longer, save more and spend less. Others will not wake up to the reality of their financial situation until they have run out of money and are forced to make radical changes in their lives.

It is too bad our education system does not teach financial literacy. Too many people enter their working lives with little understanding of how much money is required to maintain a standard of living over several decades. If our schools taught this, more Americans would enjoy the retirement they envision.

CWM Model Portfolios

2011-03-13T13:14:00.000-07:00

I recently reviewed all of CWM's model portfolios. I started by looking at all of the asset class I thought might be appropriate for our portfolios. I considered 30 distinct asset classes:

ultra short bond fund
short term gov bond
short term bond
inter term gov bond
inter term bond
multi sector bond
world bond
emerging markets bond
inflat protected bond - short
inflat protected bond
intl inflat protected bond
large cap growth
large cap value
large cap blend
small cap growth
small cap value
small cap blend
micro cap
foreign large growth
foreign large value
foreign large blend
foreign small cap growth
foreign small cap value
foreign small cap blend
emerging markets large
emerging market small-mid
frontier markets
REIT - US
REIT - Foreign
commodities
Cash

I then searched for the no load mutual funds and exchange traded funds that are currently available for each of these asset classes. One asset class had no options. Other asset classes had several to choose from. I select 2-3 funds for each asset class and added them to my preferred list. My selections were based on the size of the fund, the cost of the fund, and the composition of the fund.

Next I reviewed the broad weighting of each of CWM model portfolios. I tweaked the level of stocks, bonds, and cash in each model. I broke down the amount of domestic and international exposure for both equities and fixed income.

Finally, I allocated specific weightings to each of the funds I placed in each of the asset classes. I ended up with 18-25 funds in each model portfolio.

I then used Morningstar's data to determine the expected return and risk associated with each portfolio. I also established a benchmark for each of the seven portfolios.

In comparison to the prior version of the CWM models, the revised versions are
• more tilted to international in both equities and fixed income
• include no long term or intermediate term bond funds
• include asset classes for which there were not fund options a few years ago
• no longer contain high yield bonds
• no longer contain preferred stocks

I believe these portfolios are well positioned for the future. When interest rates rise, the impact on these portfolios will be muted. As emerging markets develop, these portfolios will benefit.

One Star Funds Shine

2011-03-06T16:34:00.000-08:00

Morningstar recently found that nine of the top 10 stock funds over the past 24 months are one star rated funds. This is Morningstar's lowest rating in its five star scale. The system considers historical returns and risk.

What are we to make of this? Did the managers of these funds find some new method to dramatically improve their performance? Are there new managers running these funds? Were these funds in sectors that suffered poor performance in past years? Were the fund managers, among the thousands of funds tracked by Morningstar, just lucky after a stretch of bad luck?

There is probably no way to know for sure. But my first thought is of "reversion to the mean." This is the theory that performance eventually moves back to the mean or average. These top stock funds had performed well below the mean for several years. Perhaps they were simply due for a correction back to the mean.

We have recently seen this phenomenon with one highly acclaimed fund manager. Legg Mason's Bill Miller bet aggressively on financial stocks during the recent economic crisis. Unfortunately, the financial sector suffered massive losses and Miller's fund took a beating. As a result, his overall performance went from stellar to dismal. Recently, however, Miller's fund has recovered and is among the strongest performers in the past 2 years.

Again, I ask , is it luck or is it skill?

Finding Winning Active Managers

2011-02-27T17:07:00.000-08:00

I read an interesting article in the current issue of Morningstar's monthly magazine for advisors. The article compared the results of actively and passively managed mutual funds. The author asserts that a review of performance across all mutual funds does not support one approach over the other. He noted that there are more passive funds that produce performance around the overall average for comparable funds. (This is what we would expect.) Further active funds are more prone to performance both well below and well above the average for comparable funds.

I am a bit surprised that nowhere did the author mention the process involved in finding successful fund managers. It is well established that investors are not readily able to identify managers who beat their peers in advance. So, while there will certainly be managers who both underperform and outperform their peers, that is not the issue. Investors only benefit if they can identify these winning active managers beforehand.

Market Doubles

2011-02-18T08:29:00.000-08:00

The Standard & Poor's 500 index has now doubled its crisis low of 666.7 which it hit in March of 2009. According to Birinyi Associates, this was the fastest climb of 100% since 1936 when the index took 501 days to jump from 8.06 to 16.15. This time it took 707 days.

The point? Stay in the market.

Junk is Hot

2011-02-10T16:10:00.001-08:00

The Wall Street Journal reported yesterday that the yield on high yield bonds fell below 7% for the first time in more than six years. Investors, fed up with low yields in bank products and bonds, have thrown caution to the wind and added riskier debt to their portfolios.

As a quick refresher, when investors bid up the prices of fixed income securities (e.g. bonds), the yield goes down. A 7% yield is what we would expect from investment grade debt in a more normal interest rate environment. However, the current environment is far from normal.

I find this interesting, because I am responding in a rather different way. I have begun moving all clients out of intermediate term debt. We were never in long term debt, as the risk-return characteristics are unappealing. I am now moving out of intermediate term debt. I am also shifting and even greater percentage of the fixed income portion of client portfolios to higher grade debt. While I rue the low yields in short term, high grade bonds, I am not willing to take the risks associate with longer maturities and lower credit risk.

The Journal reports that high yield or "junk" bonds are up 2.57% this already. They were up 15.2% in 2010 and 57.5% in 2009. The risk premium - the extra yield investors demand to own riskier investments - has fallen to 4.68% over the Treasury yield. The historic risk premium is about 5% above Treasuries.

My self-directed research suggests investors are not adequately compensated for taking the risk associated with junk bonds. Therefore, I do not include them in client portfolios.

Time in the Market

2011-02-05T14:47:00.000-08:00

With very little fanfare, the stock market has roared back from the lows of March 2009. The Dow Jones Industrial Average recently crossed back over 12,000. It is now just 20% away from re-touching the high of 14,400 in October of 2007.

Some investors might point out that it has taken over three years to reach this point and that expecting a 20% return in 2011 is being highly optimistic. True.

But what a recovery we have witnessed. The Dow is up 84%. Most of my clients' portfolios are not far from where they were before the market crashed.

Many investors fled the stock market in the midst of the economic crisis. I am sure that many of these people thought would get back when things looked more stable. Well, do they look stable today? Let' see. We have massive budget deficits at every level of government, a $14 trillion national debt, unemployment that is stubbornly well above 9% and a housing market that is still deeply depressed. Several European countries are in dire financial straits. There is also major unrest in Egypt that threatens to alter the landscape of the Middle East.

I have seen numerous examples of investors who have stood on the sidelines as the market made this dramatic retracement. These people will never be able to capture those gains. They were apportioned only to those who stood in the arena with flames all around and refused to flee.

Successful long term investing has nothing to do with "timing the market." It has a lot to do with "time in the market."

Malkiel on Beating the Market

2011-01-30T16:33:00.000-08:00

"Telling people you cannot beat the market is like telling a six-year-old that Santa Claus doesn't exist. The six-year-old doesn't want to believe it. Neither do people on Wall Street." - Burton Malkiel, Princeton University professor and author of A Random Walk Down Wall Street and The Elements of Investing.

I highly recommend The Elements of Investing. I routinely give this book out to those who are interested in learning more about the keys to successful long term investing.

Analysts Get it Wrong - Most of the Time

2011-01-20T14:03:00.000-08:00

Ever wondered how effective equity analysts are in accurately predicting the prices of the stocks they monitor? Bloomberg reports that the prices of the stocks in the S&P500 that received the most "buy" recommendations from analysts rose 73% on average since March of 2009.

However, the stocks with the fewest "buy" recommendations gained 165%. For perspective, the S&P500 index has gained 88% since hitting a low of 1,271.50 on March 9, 2009.

Bloomberg found that the companies with the most "buy" ratings gained 8.7% in 2010. The stocks with the fewest "buy" ratings rose 20%.

What can we make of this? It is very difficult to predict what will happen with the market, much less individual companies. Analysts know more about the companies they follow than anyone except the senior management of the companies themselves. Even then they are not very good at predicting price movement. In addition, we may wonder about the incentives they may have to issue ratings.

Once again we turn to low-cost passive investing as the most intelligent approach for long term investors.

Hedge Funds Underperform and Overcharge

2011-01-16T14:28:00.000-08:00

I have long been suspicious of hedge funds. These privately managed funds are very lightly regulated. They are typically very secretive and unwilling to explain their investing methodologies. They charge very high fees that are typically 2% of funds under management and 20% of profits.

Hedge Fund Research reported that since the start of 2009, the average performance of hedge funds has trailed the return of the Standard & Poor's 500 index in six out of eight quarters. Hedge funds were up 10.4% on average in 2010 compared with a 15% gain for the Standard & Poor's 500 index, including dividends reinvested. (Source: The Wall Street Journal).

This is only part of the story, however. Most hedge funds pursue strategies that are risky. So, while we don't know for certain, it is very likely that in addition to underperforming the market, most hedge funds carried more risk than the market itself.

Investors should be very wary of hedge funds.

The January Effect

2011-01-05T15:15:00.000-08:00

The stock market is off to a very nice start in the first few days of the New Year. Some market technicians attribute this to the “January Effect” which describes a phenomenon in which stocks rally in the first few weeks of a new year. The buying is often attributed to investors who redeploy cash that was created from selling losing stocks in December. The selling is done to create tax losses that may be used to offset capital gains.

Given that investors often place the bulk of their savings in qualified retirement plans (IRAs, 401(k)s, 403(b)s, etc), one may wonder about the extent to which this “tax loss harvesting” actually occurs today.

It turns out that small cap stocks seem to benefit from the January Effect more than other stocks. Mark Hulbert, writing for Market Watch, points out that in all Januarys since 1926, small cap stocks have beaten large cap stocks by an average of 7%. The performance of large cap stocks in January is statistically indistinguishable from their performance during the other 11 months of the year.

The January Effect is a “market anomaly” - abnormal performance within the stock market that is contrary to the principles of an “efficient market.” Intelligent investors are very skeptical of such anomalies. If they were persistent, then smart investors would game the system and exploit them. This very action would eliminate the anomaly.

The Triple Net Return

2010-12-31T11:09:00.000-08:00

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!

The Market Recovery

2010-12-23T17:13:00.000-08:00

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!

Market Beating Fund Managers

2010-12-18T17:33:00.001-08:00

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.

Sharpe Ratio

2010-12-10T16:31:00.000-08:00

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.

Risk-Adjusted Returns

2010-12-02T09:25:00.000-08:00

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.

Correlation

2010-11-24T17:09:00.000-08:00

Over the past few weeks we have discussed some of the key building blocks for the construction of a portfolio.

We identified standard deviation as a measure of risk or volatility. The higher the standard deviation of a security (or a portfolio of securities), the greater the risk.

We came up with several methods to measure risk. We can use the simple mean (or average), the time-weighted return (also known as geometric return), and the money-weighted return. When evaluating investment or fund managers, we use the time-weighted return, because it allows us to most appropriately evaluate performance in light of flows into and out of a portfolio or fund over an extended period of time during which performance may vary.

Last week I introduced Beta which is the measure of the risk of a security (or a portfolio of securities) in comparison to the market overall. We learned a common proxy for the market is the Standard & Poor’s 500 index. The convention in portfolio theory is that the market has a beta of 1. A security with a beta greater than 1 will have price movements that are greater than the market. A security with a beta less than the market will have price movements that are less than the market.

We’re still missing a critical piece of information. That is the way in which securities (or asset classes) perform in relation to each other. This is called “correlation.” We’re looking for securities that will provide diversification. If some of the securities in the portfolio are “zigging,” we want others to be “zagging.”

We can calculate this relationship between securities with correlation coefficient. The formula is a bit involved. So, I won’t post it here.

Correlation is measured from -1 to +1. Securities that have a correlation of -1 are perfectly negatively correlated. If one moves up by 10%, the other will move down by exactly 10%. Securities that have a correlation of +1 are perfectly positively correlated. If one moves up by 10%, the other moves up by exactly 10%. Securities that have a correlation of 0 have no relationship with each other.

In reality most securities are positively correlated with each other. Intelligent Investors are interested in building a portfolio that will be well-allocated across asset classes. The less correlated the asset classes in the portfolio the lower the risk. You can Google “asset class correlation” and find all kinds of data on asset class correlation.

I’ll have more to say about correlation in future posts.

Beta

2010-11-19T10:23:00.000-08:00

Back to the classroom. In the past two weeks I have written about how to measure risk and return. We learned that we use standard deviation to measure the risk of a security. There are several methods to measure return, including the simple mean, the time-weighted return (also known as geometric return), and the money-weighted return.

So, now the question is, how do we combine securities in a portfolio? Can we simply add securities until we reach some reasonable number? Maybe 30 or 40?

Actually, what we really need to know is how securities act in the marketplace. How do they perform relative the market itself? We might consider the Standard & Poor’s 500 index as a proxy for the market.

We can readily find data for the return of the S&P 500 index. What about the risk of the market? The Capital Asset Pricing Model describes risk with the term Beta. Beta is a measure of volatility of a security. The market itself is assigned a beta of 1. The beta for any security can be calculated through regression analysis. Beta tells us how much the price of a given security will move relative to the market.

If a security has a beta of 1.0, its price movements will mirror the market. A security with a beta greater than 1.0 will be more volatile or risky than the market. A security with a beta less than 1.0 will be less risky than the market. If a security has a beta of 1.5, it will be 50% more risky than the market. A security with a bet of 0.75 will be 25% less risky than the market. What about a beta of zero? This means that there is no statistical relationship between the security and the market. A negative beta indicates that the security acts in opposition to the market. If the market return were up 10%, a security with a beta of -1.0 would theoretically be down by 10%.

So, does that give us enough information to start building our portfolio? No. Come back next week for another critical piece of this puzzle.

Measuring Return

2010-11-10T12:21:00.000-08:00

Let’s continue our discussion of Modern Portfolio Theory. Last week I suggested that portfolio construction involves carefully selecting securities based on their risk and return characteristics.

I probably should have mentioned that return can be calculated in various ways. The simplest is the mean or average. To calculate this return we simply add up all the returns and divide by the total numbers of return in the data set. If we had annual returns from 2000-2004 of -9.1%, -11.9%, -22.1%, 28.7% and 10.9%, the average return would be -0.70%. This was the actual return of the Standard & Poor’s 500 index.

When evaluating investment advisors, fund managers or portfolio managers, there is a different measure that gives us better insight into performance. Time-weighted return eliminates the distortions caused by the inflows and outflows of money over time. This is also called the geometric mean. It is calculated using holding period returns (HPR) for each investment period (e.g. a year) and linking them together.

The formula for holding period return is (ending value - beginning value + dividends/interest +/- other cash flow) divided by the beginning value.

To calculate time-weighted returns we add 1 to each of these HPRs, multiply these values against each other then subtract 1 from that result.

Here’s the formula

= [(1 + HPR1)*(1 + HPR2)*(1 + HPR3) ... *(1 + HPRN)] - 1.

If the investment period is greater than 1 year, then we need to annualize the return for the HPRs we calculated. The formula for this is (1 + compounded rate)1/Y – 1 where Y is the total time of years.

Yet another way to measure performance is money-weighted return. This involves calculating the internal rate of return. We calculate the return that will cause the inflows and outflows to be equal. For investment outflows include the purchase price, reinvested dividends or interest and contributions. Inflows include the proceeds from the sale of the investment, dividends or interest received and withdrawals. Calculating money-weighted return requires using Microsoft Excel or a financial calculator. We use the money weighted return instead of holding period return for investment periods that are greater than 1 year.

Source for formulas: Investopedia

Standard Deviation

2010-11-03T10:37:00.000-07:00

I will be teaching the Investment course in the CFP certificate program at the University of Portland over the next several weeks. The course provides an overview of investing fundamentals. I encourage students to think of the class as a fast paced review of many concepts. We run through them quickly and rarely go very deep into any subject.

One area that merits a bit more attention is Modern Portfolio Theory. Most investment advisors rely on MPT to build and manage portfolios. The theory involves attempting to manage the relationship between risk and return in a basket of securities. Using various research sources (e.g. Morningstar) we can identify the risk and return characteristics of a given security. MPT tells us we should combine securities in a way that maximizes the risk adjusted return of the portfolio.

How do we measure risk? First, we need to define risk. This is the chance that the return from the security will not be what we expected. We are, of course, concerned with returns that fall below our expectation. We’re happy if returns exceed our expectations.

We can measure risk using Standard Deviation. This measures the dispersion of historical returns from its mean (i.e. average). We take the square root of the variance to calculate standard deviation.

If a security earned 8% year after year, there would be no dispersion and, therefore, no risk. The mean would be 8% and the standard deviation would be 0.

But if the security earned -12% one year, +16% the next and +20% the following year, the mean would still be 8%. But the dispersion (and the risk) would be much greater. In fact, the standard deviation for that security is 17. Which would you rather own?

Intelligent Investors understand MPT and they use it wisely to build and manage their portfolios. I will be discussing other concepts that underlie MPT in future posts.

What are Emerging Markets?

2010-10-29T14:00:00.000-07:00

You have probably heard of emerging markets. But do you know what they are?

These are economies in nations that are rapidly growing and maturing. They are characterized by stable governments, established mechanisms for trading goods and services, a stable currency, controlled levels of inflation, and liquid securities markets. They are typically in a state of growth. Many will eventually become “developed” countries.

As of May 2010, Dow Jones classified the following 35 countries as emerging markets:

Argentina
Bahrain
Brazil
Bulgaria
Chile
China
Colombia
Czech Republic
Egypt
Estonia
Hungary
India
Indonesia
Jordan
Kuwait
Latvia
Lithuania
Malaysia
Mauritius
Mexico
Morocco
Oman
Pakistan
Peru
Philippines
Poland
Qatar
Romania
Russia
Slovakia
South Africa
Sri Lanka
Thailand
Turkey
United Arab Emirates

Why should investors care about these countries? Because investing in these countries offers the potential for relatively rapid capital appreciation. The companies in these countries are likely to grow at a faster rate than companies in developed markets like the US, Canada, Japan, and Western Europe.

In addition, investments in these countries are likely to have a relatively lower correlation with developed markets. This means that the values of investments in these countries will not move in lock-step with investments in developed markets.

Emerging markets belong in a low-cost, passively managed portfolio.

What are Emerging Markets?

2010-10-29T10:22:00.000-07:00

You have probably heard of emerging markets. But do you know what they are?

These are economies in nations that are rapidly growing and maturing. They are characterized by stable governments, established mechanisms for trading goods and services, a stable currency, controlled levels of inflation, and liquid securities markets. They are typically in a state of growth. Many will eventually become “developed” countries.

As of May 2010, Dow Jones classified 35 countries as emerging markets.

Why should investors care about these countries? Because investing in these countries offers the potential for relatively rapid capital appreciation. The companies in these countries are likely to grow at a faster rate than companies in developed markets like the US, Canada, Japan, and Western Europe.

In addition, investments in these countries are likely to have a relatively lower correlation than with those in developed markets. This means that the values of these investments in these countries will not move in lock-step with investments in developed markets.

Emerging Market Bonds?

2010-10-22T15:48:00.000-07:00

There has been a significant flow of capital into emerging market equities over the past several months. Some of this is “hot money” chasing what speculators consider as the next asset class to provide outsized short term profits. But some of this investment flow is coming from long term investors looking for diversification, income and long term capital gains.

So, what about emerging market bonds? Do they belong in a well-diversified, low cost, passive portfolio? Perhaps. These debt instruments may offer income that is less correlated to the bond markets in the developed markets. However, according to Morningstar, this asset class carries with it risk from currency fluctuations, foreign taxation, economic risk, political risk and differences in accounting and financial standards.

Right now there few ways to invest passively in emerging market debt. However, this will undoubtedly change. One option is the iShares JPMorgan Emerging Market Bond Fund (EMB). http://us.ishares.com/product_info/fund/overview/EMB.htm

I’ll have more to offer on this asset class when research companies (e.g. Morningstar) provide information about the investment characteristics of the funds in this asset class. What is correlation? What are fund expenses? What is the risk? What are the returns?

The Fiduciary Standard

2010-10-14T08:08:00.000-07:00

The Financial Planning Association (FPA) ran a two full page advertisement in The Wall Street Journal on Tuesday (October 12, 2010). It promoted the value of working with a financial planner who is a member of the FPA. One of the reasons cited is that members are required to adhere to a Fiduciary Standard of Care.

The section included several questions and answers. One of the questions addressed the fiduciary issue. It states, “A financial planner who upholds a fiduciary standard of care makes five promises to clients. They are required by law to (1) put your best interests above all, (2) act with due care and utmost good faith, (3) be transparent an disclose all facts, including the cost of services and recommended investment and insurance products, (4) avoid conflicts of interest, and (5) not mislead you.”

Smart consumers only work with financial planners who adhere to this standard. Unfortunately, it is not readily apparent to the consumer who does and who does not. So, I recommend simply asking.

Yale Endowment Falters

2010-10-01T13:23:00.000-07:00

Yet another large university endowment has indicated that it suffered significant losses during the recent economic storm. An article in The Wall Street Journal (September 25/26, 2010) indicates Yale’s endowment fell from $22.9 billion in June 2008 to $16.3 billion in June 2009. It has since recovered to $16.7 billion as of June of 2010.

The endowment earned 8.9% for the 12 months ending June 30, 2010. According to Wilshire Associates, this lagged the 13.33% median return for large endowments, pension funds, and foundations. The Dow Jones Industrial Average returned 18.9% for the same period.

The results at Yale are particularly interesting. I am a big fan of David Swensen who is the Chief Investment Officer at Yale. I’ve read Swensen’s book, Unconventional Success which advocates a passive investment strategy for individual investors. Swensen believes only large institutions with significant resources for in depth analysis and research should invest in areas such as private equity, real estate and hedge funds. As it turns out, these are the areas where Yale incurred its big losses.

The lesson for the individual investor is that a low cost, passive approach to investing will result in optimum long term results.

Is Gold an Inflation Hedge?

2010-09-23T13:39:00.000-07:00

Gold reached yet another record high yesterday, closing at $1,290.20 an ounce on the Comex division of the New York Mercantile Exchange.

The Federal Reserve recently indicated that it stands prepared to provide greater support to the U.S. economy. The financial markets translated this into additional purchases of US government securities, greater liquidity, a weaker U.S. dollar and the specter of inflation.

Let’s continue to explore gold. Is gold an inflation hedge?

If we consider the 35 year period, 1975-2010, inflation averaged 4.03% according to the Bureau of Labor and Statistics. But this really does not tell the story. If we look above at the price of gold, we see that it was flat or declining for about 20 years. Inflation was hardly non-existent during this period. Do you remember interest rates in the late 70s and early 80s?

The following chart shows the relationship between inflation and the price of gold over the past decade.

We have been in a period of very low inflation. However, gold has experienced a rather noticeable run up. So, at least over the past decade, the notion that gold is a hedge against inflation does not seem to be supported by the data. Particularly in the past decade and currently, gold seems to be acting largely independent of inflation.

Today the concern is rather equally balanced between inflation and deflation. There is little evidence that gold serves as a hedge for either.

Harvard doesn’t Beat the Market

2010-09-16T09:29:00.000-07:00

The Wall Street Journal recently (September 10, 2010) reported that Harvard University’s endowment fund posted a return of 11% for the 12 month period ending June 30, 2010. Harvard’s endowment, at $27.4 billion, is the largest college endowment.

Harvard manages the endowment internally through the Harvard Management company. The team managing the endowment is prominent in the endowment community for its positions in real estate, private equity and venture capital.

The median return for large endowments for the period was 12.3% according to Wilshire Associates. The Dow Jones Industrial Average returned 18.9% in this period. A portfolio of 60% stocks and 40% bonds would have outperformed Harvard’s endowment with a return of 12.6%.

I would add that the 60-40 portfolio would have undoubtedly taken on much less risk.

This is yet another piece of evidence that suggests that attempts to beat the market are fraught with risk. In addition they are burdened with significant expenses. The Harvard Management Company provides compensation that is comparable to that of the leading Wall Street money management firms.

The most intelligent way for individual investors to manage their portfolios is through low-cost, passive investments.

Gold Hits New High

2010-09-09T08:33:00.001-07:00

Concerns about the stability of European banks drove gold to a new all-time high on Tuesday, September 7, 2010. The Wall Street Journal ran an article on Tuesday suggesting that the stress tests for European banks may have understated their exposure to government debt. The fear is that some European nations may yet default on some of their obligations. Gold closed at $1,257.30 an ounce.

So, is it time invest in gold?

Investors are rewarded for investing in gold only if they can find someone else who is willing to pay more for it than they did. This is not a problem as long as the price of gold is going up as it has been for the past several years. But when the price of gold is going down or moving sideways, investors who hold gold may not be able to sell it without incurring a loss.

This naturally leads to the history of the price of gold. Has the price of gold risen in a manner that has made gold an attractive investment?

The world went off the gold standard in the early 1970s. Previously the price of gold was controlled by the world’s largest central banks under the terms of the Bretton Woods system which was negotiated after World War II. So, we’ll focus our attention on the period that followed.

In 1975, 35 years ago, gold was priced at an average of $161 an ounce. Today gold is trading at roughly $1,250 an ounce. This is a growth rate of 6.0%.

Source: http://www.kitco.com/scripts/hist_charts/yearly_graphs.plx

However, notice the price of gold actually drifted lower for the better part of this 35 year period. How would you have felt had you purchased gold in the late 70s or early 80s?

To put this in some perspective, the Standard and Poor’s 500 Index returned 11.7% from 1975 to 2009. (Source: Standard & Poor’s Index Services Group)

Based on this data alone, gold does not appear to be a particularly attractive investment.

Ibbotson on Investing

2010-09-02T11:26:00.000-07:00

The current issue of Money (September 2010) includes an interview with Roger Ibbotson (pp. 105-108). Ibbotson Associates publishes the Ibbotson SBBI Classic Yearbook which analyzes historical data for stocks, bonds, Treasury bills, and inflation. It is commonly the reference for the historical returns quoted in the financial press.

Ibbotson is a professor of finance at the Yale School of Management. He is the founder and former Chairman of Ibbotson Associates, a financial research and information firm that was acquired by Morningstar in 2006. He is also the founder, Chairman, and Chief Investment Officer for Zebra Capital, a hedge fund.

In the article, Ibbotson was asked about investing in index funds vs. actively managed funds. Here’s his response:

“To the extent you’re in index funds, you’re going to have less risk because you’re eliminating the impact of active management. You’ll also have lower fees. In actively managed funds, your risk level goes up, as will hat you pay in fees. The question is, do you think the funds you pick can compensate for the extra risk and higher fees? On average, the answer is no, but there can be a subset of investors who outperform.”

I would add there will always be some investors who choose actively managed funds and outperform the market. The issue is how long they are able to do this. Few will be able to do it consistently year after year. The question you have to ask yourself is whether you can be among them.

If you are not confident about beating the market, after expenses, then you are better off in a low-cost, passively managed portfolio. You will not beat the market. You will earn the returns of a broadly diversified portfolio. Your investing expenses will be a fraction of the typical actively managed fund.

If you review Dalbar’s research on investor performance results, you’ll find that if you achieve “average” results, you’ll be doing much better than the vast majority of investors, including large institutional managers.

Gold as an Investment

2010-08-27T16:01:00.000-07:00

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.

Selecting Passive Investments

2010-08-21T08:55:00.000-07:00

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:

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.
What does this investment bring to our portfolios? Does it provide income? Does it provide growth? Is it an inflation hedge?
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.
What is the return history of this investment? Naturally, we’re interested in investments that provide a healthy return for our clients.
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.
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.
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%.
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?
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?
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.

Selecting Passive Investments

2010-08-20T16:49:00.000-07:00

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

Morningstar: Fees Best Predictor of Fund Success

2010-08-11T13:57:00.000-07:00

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

Comment on the SEC Study on Fiduciary Issue

2010-08-09T13:34:00.000-07:00

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.

The New Normal

2010-08-06T16:25:00.000-07:00

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.

DIY Investing – 4 Questions

2010-07-30T14:03:00.000-07:00

I am often asked by prospective clients why they should work with an investment advisor. This question usually comes up after I have explained the differences between active and passive investing and why Cascade Wealth uses only passive investment strategies. At this point, most people are convinced that they should have a passive portfolio. It seems pretty simple. The goal is to capture the returns of the market and minimize expenses. There is no active management. No effort to beat the market. No trying to pick the next hot mutual fund. Just build a portfolio using low cost index and passive funds and keep an eye on it. … So, why would anyone want to pay an advisor for this?

I respond to this question by asking four questions. I tell these people that if they can answer “yes” to each question, then they probably don’t need an investment advisor.

1. Are you capable of learning how to passively manage your own investments? This requires understanding basic investing principles. It also involves learning a bit about Modern Portfolio Theory. The concepts are not extremely difficult to grasp. But becoming knowledgeable and competent takes some capacity for math.

2. Do you have the time to learn how to build your own portfolio? Do you have the time to monitor it and adjust it when necessary? The initial construction of the portfolio is important to the ultimate success of the portfolio over time. You really need to get that right. But you also need to monitor the portfolio over time. Passive investing is not neglectful investing. Also, will you systematically rebalance the portfolio when appropriate?

3. Will you enjoy managing your investments? We tend to avoid the things we do not enjoy. So, if you are not interested in managing our investments, you will probably not put in the effort that it requires. On the other hand, I do get concerned about those who are a bit too enthusiastic about managing their investments. They are prone to tinkering with things when it is not necessary.

4. Can you manage your emotions and make rational decisions about your investment regardless of what is happening in your personal life and in the world around you? This is the most important question. I meet many people who are able to answer the first three questions in the affirmative. But when they ponder their past experiences with investing, they realize they have not been able to keep their emotions out of the process. I believe a good investment advisor adds the value to client relationships by helping them manage the emotions we all feel towards investing.

Those who can check all four boxes probably can manage their own accounts and experience satisfying long term results.

A Convicted Criminal Speaks of Ethics

2010-07-21T16:10:00.000-07:00

I just attended the local chapter meeting for the Financial Planning Association. I do not often attend these meetings. But this luncheon offered 3 hours of Ethics credits which I need to maintain my professional credentials.

Over the years I have found most of these ethics-related sessions rather tedious. It has long amazed me that financial services representatives do such stupid things and cause such harm to their clients. While I acknowledge my own professional failings, I have never engaged in fraud, cheating, embezzlement, etc.

The speaker today was Patrick Kuhse. You have probably never heard of him. I had not until today. I won’t forget him.

Here’s what Patrick says about himself on his web site, www.speakingofethics.com, “I'd like to take you on my own personal journey, from successful stockbroker with a loving family and home in the suburbs of San Diego, to the jungles of Costa Rica as an international fugitive, to incarceration in two countries and back again. After spending four years in prison, I now devote myself to speaking to audiences worldwide about the importance of ethical behavior.”

This presentation was riveting. It had a message that was far more than how to be “ethical” in the financial services industry. It was about how any of us can lose perspective, commit critical thinking errors and slide into an ethical morass. I found it humbling.

Patrick opened his presentation with a reference to Socrates. The famous Greek philosopher would evaluate an issue, an opportunity or a situation by asking three simple questions:

1. Is this truthful?
2. Is this good?
3. Is this useful?

If Socrates could not answer each of these questions positively, he would simply move on.

How simple. We should ask ourselves these questions whenever we are uncertain about how to react to a set of circumstances.

Successful DIY Investors

2010-07-14T16:24:00.000-07:00

I recently read William Bernstein’s The Investor’s Manifesto. He wrote this in the aftermath of the recent stock market crash. Bernstein seeks to help investors regroup and reminds them of the strategies that lead to long term investing success.

In the foreword to the book, Bernstein identifies the characteristics of successful investors:

They possess an interest in the process of investing.
They have a basic knowledge of probability and statistics.
They have a firm grasp of financial history.
They have the emotional discipline to execute successful investing strategies.

How many self-directed investors truly possess these qualities? Indeed, how many investment advisors can make this claim?

The Responsibility of the Media

2010-07-07T17:01:00.000-07:00

An article from The New York Times News service ran in yesterday’s (July 6, 2010) Oregonian. The article was titled, “Get out now, stock theorist warns.” The article described how one stock market forecaster, Robert Prechter, is predicting that the Dow “is likely to fall below 1,000 over perhaps five or six years …”

Apparently, Mr. Prechter is a forecaster and social theorist who basis his work on something called the Elliott Wave Theory. I will admit that despite having been an avid student of investing for a decade and I have never heard of this theory. So, I went on the web and did some research.

As I suspected, Elliot Wave Theory is a form of technical analysis (source: Wikipedia.org). It is used to forecast trends in financial markets by identifying extremes in investor psychology, highs and lows in prices and other collective activities. The concept was developed by Ralph Nelson Elliott (1871-1948) who was a professional accountant.

I have studied technical analysis. It uses price and volume data in an effort to predict the direction of a security or the market in general. It has been widely discredited in the academic community. Burton Malkiel’s book, A Random Walk Down Wall Street, is probably the most well known work that refutes the notion that security prices follow any pattern. The Efficient Market Hypothesis, even in its weakest form, dismisses the usefulness of pricing data in market forecasts.

I find it disturbing that the media would pick up the shocking predictions of one prognosticator and suggest the investors should “get out” of the market. This to me is completely irresponsible journalism. I could easily find several equally credible market forecasters who predict that the market will reach some glorious new level in the next five years.

The truth is that no one knows where the market is going. A read of the most credible work on investing consistently warns readers to be wary of anyone who claims to know where the stock market is headed. There are two kinds of people. Those who know they do not know and those who don’t know they don’t know.

Shame on The Oregonian for printing an article that was clearly intended to incite the reader. Just what we need. Millions of investors panic and sell their investments. Then Mr. Prechter’s predictions just might come true.

SEC to “Study” Fiduciary Issue

2010-07-02T12:24:00.000-07:00

As I suspected all along, the House and Senate punted on the imposition of a fiduciary standard for all financial advisors. The financial reform bill has been renamed the Frank-Dodd Wall Street Reform and Consumer Protection Act of 2010 after House Financial Services Committee Chair Barney Frank (D-Mass.) and Senate Banking Committee Chair Christopher Dodd (D-Conn.). It calls on the Securities and Exchange Commission (SEC) to conduct a six month study of the issues surrounding the standards of care under which various financial advisors operate. Currently, stock brokers, insurance agents and other advisors operate under a “suitability” standard. Registered investment advisors must adhere to a “fiduciary” standard. [See my previous blog posts for an explanation of the differences in these two standards.]

The SEC must develop regulations that reflect the findings from this study. The bill’s provisions empower the SEC to impose the same “fiduciary” standard on broker-dealers that applies to registered investment advisers. Indeed, Representative Frank has indicated that he expects the SEC to do so. “We gave the SEC the power to do it,” said Mr. Frank from the House floor, “and they’re going to do it.”

We shall see. The bill must still pass in the Senate. With the recent passing of Senator Robert Byrd (D-West VA), that won’t happy until after the July 4th recess. There continues to be significant opposition to the bill in the Senate and it is not clear that the bill will pass as written.

Fiduciary Issue Still Unresolved

2010-06-23T17:00:00.000-07:00

The House and Senate continue to wrangle over the fiduciary issue as they reconcile their respective versions of the financial regulatory reform bill.

In case you have not been following this story, here’s the problem. Currently, investment advisors must provide advice and service that is in the client’s best interest. In addition, investment advisors must disclose conflicts of interest. Broker-dealers and insurance agents are required to offer products and services that are “suitable” for the client.

As you might imagine, the brokerage industry, the banking industry and the insurance industry all opposed to a fiduciary standard. They believe a study of the matter is necessary. They also claim a fiduciary standard would change their “business model.” … Yes, and this would clearly be in the best interest of their clients.

Under consideration is a watered down proposal that would empower the SEC to conduct a study of the standards of care currently in place in the financial marketplace and then establish a single fiduciary standard, if this would eliminate gaps in oversight of various types of financial advisors.

I am not optimistic about this. The forces acting against the fiduciary standard are incredibly powerful. The stakes are high for them. I predict Congress will fail to implement the fiduciary standard. … We should know the outcome soon, as the negotiators would like to complete the bill tomorrow.

The Risks Associated with Investing in Bonds

2010-06-18T09:35:00.000-07:00

Investors have been pouring money into bonds since the stock market swoon that began the end of 2008. In fact, according to the Investment Company Institute, there has not been a single month over the past 17 months in which the net flow into bonds has been negative. This is hardly true for domestic and foreign equities.

So, what can we make of this? Investors have clearly become less willing to risk their funds in the stock market. They would rather invest in bonds even if yields are at historically low levels. The yield on the 10 year Treasury is around 3.5%.

But are bonds as safe as most investors seem to think? What are the risks associated with investing in bonds? Here’s a quick overview:

Interest rate risk: When interest rates rise, the value of bonds goes down. The reason for this is that bonds have fixed payments in the form of coupons and a final maturity value. When interest rates rise, these fixed payments become comparatively less valuable. The only way an investor would be willing to be a bond with a lower coupon payment would be if the price of the bond itself were less. This adjustment maintains the marketability of the bond.

Call risk: Some bonds are callable by the issuer. This means that they can be bought back from the bond holders prior to maturity. Issuers tend to call bonds when interest rates drop, because they can re-issue new debt at lower rates and thereby reduce their financing costs.

Prepayment risk: Some bonds allow the issuer to repay portion of the outstanding principal prior to maturity. If rates have dropped, the bond holder will likely be unable to reinvest these proceeds at the coupon rate of the bond.

Yield curve risk: The yield curve represents the relationship between market interest rates and the time to maturity of bonds. Changes in the yields of bonds with different maturities can change the shape of the yield curve. When yields change, prices change.

Reinvestment risk: Bond holders receive payments for providing (i.e. loaning) the bond issuer a principal sum. Investors are concerned with their ability to invest these payments at attractive rates. If market rates drop, reinvestment risk rises.

Default risk: This is the risk that the issuer of the debt will be unable to make the required payments. Default is the failure to maintain the terms of the debt obligation. Issuers perceived to have greater default risk are required to compensate lenders with higher coupon rates.

Credit spread risk: The spread is the difference between yields on Treasury securities and any non-Treasury securities that are otherwise identical. Treasury securities are risk free. All other securities carry some form of risk. The spread represents the risk that the investor takes on for investing in securities that are risky.

Downgrade risk: This is the risk that a credit rating agency will lower its rating on a particular issue. When this happens, the bond is considered riskier. In order to compensate investors for this additional risk, the price of the bond will fall.

Liquidity risk: Liquidity refers to the ability to quickly sell a security. Bonds that can be readily bought and sold with relatively low transaction costs are considered liquid. Investors tend to prefer bonds that are liquid. Bonds that are relatively illiquid are not as attractive and, as a consequence, will sell at lower prices.

Exchange rate risk: This risk is associated with bonds denominated in currency other than the U.S. dollar. Investors who exchange US$ into other currencies and the purchase bonds in those currencies are faced with additional risk of converting the foreign currency back to US$. If the US$ has gained value during the foreign bond holding period, the investor will lose money converting back to US$.

Volatility risk: Bonds with options (call options, prepayment options, and put options) are subject to volatility risk. Change in the volatility of interest rates affects the value of bonds depending on the type of option that are embedded. Imagine a put option on a bond. If volatility increases, the value of the put increases. . This increases the value of the bond.

Inflation risk: Inflation erodes purchasing power. Bond investors are faced with using fixed coupon payments to purchase goods and services that increase in cost over time. If inflation jumps unexpectedly, bond values will drop.

Event risk: Bonds can drop in value if an adverse event occurs. A natural disaster, a corporate change or a regulatory change could cause credit analysts to downgrade a bond. This will lead to a loss in bond value.

So, while investors seem to be rushing into bonds, one wonders how well they understand the risks of investing in these securities.

Sources: Investment Company Institute, CFA Institute

Deflation Threat Remains

2010-06-12T12:14:00.000-07:00

The very tepid economic recovery has economists in developed countries pondering the prospects for deflation. Deflation is a general decline in the price of goods and services. Everything becomes less expensive. So, why the worry?

Deflation is typically caused by a decrease in consumer, government and investment spending. There has not been a period of sustained falling prices in this country since the Depression in the 1930s. In fact it is so rare that economists have not had many opportunities to study it in real time.

In Europe and the US, consumers are paying down debt, cutting their spending and saving more. Many countries in the European Union, afflicted with large national debts and budget deficits, are also being forced to cut back on spending. The result of this belt-tightening is a slow down in price increases. The Wall Street Journal reported this week that “excluding volatile food and energy sectors, consumer prices [in the US] were up just 0.9% in May, the smallest increase since 1966.”

Government policy makers find combating deflation very difficult. Traditional policy tools are designed to fight inflation, not deflation. Central banks can’t lower interest rates, because they are already almost zero. Government spending will only exacerbate budget imbalances and increase sovereign debt levels. Consumers will put off purchases, if they expect prices to be lower in the future. This further compounds the problem, as prices have to drop even further to entice consumption.

Lower prices lead to economic contraction. Wages fall, incomes drop, spending falls further, and on it goes. It is a downward spiral that can result in a reduction in overall economic welfare.

Let’s hope we don’t face a serious prospect of deflation, because the Federal Reserve has a very limited ability to do anything about it.

Congress Still Considering the Fiduciary Standard

2010-05-27T13:38:00.000-07:00

Last week the Senate passed a financial reform bill that, while the most sweeping since the Depression, failed to include amendments that would have held all financial advisors to a fiduciary standard. Apparently, Senators Menendez and Akaka, who support the fiduciary standard, could not garner enough support for their amendment. So, they pulled it, rather than allow it to be defeated.

All is not lost. The Senate and the House are currently assembling a team of lawmakers who will gather to reconcile differences in the Senate and House versions of financial reform legislation. Conference members may still include language modeled after the House bill which includes a fiduciary standard.

The Senate bill still includes a provision that requires the Securities and Exchange Commission to study the differences between the fiduciary standard and the suitability standard and make appropriate recommendations to Congress.

We do not need a federally funded study of this issue. Consumers deserve to be served by those who act in their best interests. It’s really that simple.

The banking, securities, and insurance industries are opposed to the implementation of a fiduciary standard. They are concerned that such a standard could impair their ability to conduct business, including selling proprietary products and charging commissions. They will lobby for the study and hope nothing comes of it.

Let’s hope our legislators defend consumers and pass a financial reform bill that includes the fiduciary standard.

Americans Confront the Reality of Retirement

2010-05-21T09:30:00.001-07:00

There were several reports this past week about American’s lack of preparation of preparation.

According to a study by Hewitt Associates, a global human resources consulting and outsourcing services company, employees will need 15.7 times their final pay when factoring in inflation and postretirement medical costs. Of the 15.7 times final pay, Hewitt estimates that Social Security will provide 4.7 of it, leaving employees responsible for making up the remaining 11 times final pay. This will likely have to come from company-provided plans and personal savings. But of the more than 2 million employees at 84 large U.S. companies it examined, Hewitt’s study found that only 18% of these people who are expected to work a full career will meet this goal.

TD Ameritrade released a survey indicates that 57% of Americans feel they are either a “little behind” or “far behind” in their planning for retirement. The majority (56%) indicated that they started saving for retirement later in life. The survey found that Americans are concerned about health care expenses, working longer than anticipated, outliving savings and managing their retirement savings.

There is an interesting parallel between what is currently happening in many European countries and the plight of many Americans. Greece, Spain, Portugal, and Italy (among other Euro countries) are dealing with the reality of excessive debt levels and government budget deficits. These countries can no longer finance their debts at sustainable levels. Further, they are no longer able to spend more than they take in. These countries are being forced to take austere measures to reduce debt, cut spending and balance their budgets.

Sounds remarkably similar to what many Americans are experiencing …

Funding Retirement

2010-05-13T10:00:00.000-07:00

The greatest threat to those who are retired is not death. It is running out of money. While no one looks forward to dying, without sounding insensitive, it is relatively inexpensive to die. There are final expenses which may include hospitalization, hospice care, a funeral or memorial, and burial or cremation. But these expenses are typically less than $10,000 for most people.

The much greater costs are those of living over a long period of time. Consider a person just now entering retirement who needs $4,000 a month to live comfortably.
Let’s imagine that Social Security provides $1,500 a month. That leaves $2,500 which must come from a pension or withdrawals from retirement savings.

How much money must a person have in savings to be able to draw $2,500 a month for the rest of her life? The rule of thumb in the financial planning community is that a sustainable rate of withdrawal is 3-6%. This will allow the retiree to maintain her purchasing power against the erosion of inflation and never run out of money.

So, if we assume a 4% withdrawal rate and a $2,500 monthly income need, our retiree will need $750,000 in retirement savings. This is significantly more than most Boomers have set aside currently for retirement. In fact, over half of that generation has less than $50,000 in savings.

Clearly, people need to save more. The question is, will they?

Wants vs. Needs

2010-05-07T11:12:00.000-07:00

Recent economic data from the Commerce Department indicates that consumers are beginning to spend again as we emerge from the longest recession since the Depression. Consumer spending accounts for 70% of the demand in our economy. So, the 0.6% increase in consumer spending in March might be cause for celebration.

Wages, as measured by the Labor Department’s employment cost index, rose 0.2% from February’s level. But personal income rose by just 0.3% in March.

What does this mean? Consumers are likely reaching into their wallets for their credit cards in order to pay for purchases. In fact, the personal savings rate fell from 3% to 2.7%, the lowest level since September 2008.

So, once again consumers appear to be spending beyond their means. We know this is not sustainable and we know how this story ends.
Perhaps we need to remind ourselves of the difference between a “need” and a “want.” A need is something that we need to exist. Food, water, clothing, and shelter all come to mind. A want is something that … well, we want. We want new cars, a Hawaiian vacation, a new HD TV … Do we need these things? Clearly we do not.

There is nothing wrong with buying things we want, unless this impairs our ability to save for the future. If we don’t save for the future, we will be hard pressed to pay for our needs, much less our wants.

The Fiduciary Standard – Hope Remains

2010-04-29T09:15:00.000-07:00

There may yet be hope for consumers of financial products and services. Senators Daniel Akaka (Democrat from Hawaii) and Robert Menendez (Democrat from New Jersey) have offered an amendment to the Financial Reform bill (Restoring America’s Financial Stability Act) that would remove a provision (Section 913) that would provide for a study of the whether the fiduciary standard should be imposed upon broker-dealers. The new language would mirror the House reform bill and authorize the Securities and Exchange Commission to adopt rules requiring broker-dealers who provide advice to comply with the fiduciary standard.

To review, under the current legal structure, most financial advisors, including stock brokers, insurance agents, and financial representatives in banks and credit unions are not required to put their client’s best interest first. Instead, they are required to offer products and services that are “suitable.” This is a lower standard than the fiduciary standard and leaves consumers vulnerable.

According to the web site fi360, there are five core principles to the fiduciary standard:

•Put the client’s best interests first;

•Act with prudence; that is, with the skill, care, diligence and good judgment of a professional;

•Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;

•Avoid conflicts of interest; and

•Fully disclose and fairly manage, in the client’s favor, any unavoidable conflicts

I strongly support the inclusion of a fiduciary standard in the Financial Reform legislation. I see no point in “studying” this issue. It is rather obvious that financial advisors should be required to act in their client’s best interest.

The banking, securities, and insurance industries are lobbying Congress in an effort to prevent the imposition of the fiduciary standard. Make your voice heard and tell your representatives in the House and Senate that the fiduciary standard is imperative to meaningful financial reform in this country.

The Moral Abyss on Wall Street

2010-04-22T16:17:00.000-07:00

The Securities and Exchange Commission has recently filed charges against one of the most highly regarded firms on Wall Street, Goldman Sachs. The lawsuit claims Goldman defrauded investors by misstating and omitting information about a complex financial product tied to subprime mortgages.

The SEC alleges that Goldman Sachs created the synthetic collateralized debt obligation (CDO) called ABACUS after it was approached by a leading hedge fund, Paulson & Company. John Paulson, the funds manager, asked Goldman Sachs to create a financial product that would allow his firm to essentially bet against it. Paulson’s firm was actively involved in structuring the transaction and paid Goldman Sachs $15 million to put it together.

According to the SEC, Goldman Sachs represented that the residential mortgage backed securities were selected for ABACUS by an independent firm, ACA Management. The debt inside ABACUS soon became non-performing and investors in allegedly lost more than $1 billion. Paulson & Company made billions betting against ABACUS and other similar financial products.

Goldman Sachs has denied the charges and indicated that it will defend itself. The firm claims that it was not required to disclose who provided input into the mortgage-selection process for the transaction or what their intentions were.

When I was a senior at Stanford University, I interviewed for an analyst position at Goldman Sachs. This was in the late 1980s when investment banking was one of the more attractive fields for students graduating in economics from leading universities. I remember studying Goldman Sachs and preparing for my interviews in Palo Alto and in New York. I also remember thinking that Goldman Sachs was clearly the premier firm on Wall Street. Ultimately, I was not hired by Goldman Sachs and I pursued other opportunities.

I am not particularly interested in the nuances of the law and whether Goldman Sachs committed fraud. Based on what I’ve read, Goldman Sachs may be able to defend itself against these accusations. What I find disturbing is Goldman’s failure to adhere to basic standards of fairness, honesty, and integrity. I am left wondering if Wall Street has reached a tipping point and fallen hopelessly into a moral abyss.

Fee Only Advisors Frown Upon Annuities

2010-04-16T08:46:00.000-07:00

So, why do most fee only financial planners and investment advisors view annuities with disfavor?

Annuities are expensive products. The internal expenses inside a variable annuity routinely exceed 3% per year. Annuities contain administrative expenses (0.10-0.30%), mortality expenses (0.50-1.5%), investment expenses (0.35-2.00%), and, in many cases, riders (0.25-1.0%). Let’s assume the annuity earns an average of 9% (this would suggest a rather aggressive allocation within the annuities subaccounts). The owner will lose 1/3 of the annuities growth to expenses. It is easy to see why an advisor serving in a client’s best interest, and therefore concerned about fees paid by the client, may discourage the purchase of an annuity.

Annuities are generally not very liquid. The owner cannot readily surrender the annuity and move the money inside the contract without incurring substantial charges. Charges are typically applied for surrenders that occur for 3-15 years from contract inception. These charges typically decline over time, but can start as high as 10%.

Annuities are insurance products sold by licensed insurance agents. These agents earn a commission for selling annuities. Commissions are usually 3-10% of the amount placed in the annuity. So, assuming a 5% commission and a $100,000 deposit, the commission will be $5,000. This strikes most non-commissioned advisors as excessive.

Many advisors also feel that insurance agents sell annuities to people in situations where they are really not appropriate. Annuities with heavy surrender charges over lengthy periods have been sold to retirees in their 80s. Annuities are routinely placed in IRA accounts, which makes little sense from a tax perspective. Insurance agents too often move the vast majority of a person’s investable assets into an annuity instead of spreading the assets across different investment vehicles.

While annuities certainly have many attractive features, they are generally expensive and illiquid. It is no wonder that fee only advisors view them with suspicion.

Annuities Can Play Role in Retirement Portfolio

2010-04-08T17:19:00.000-07:00

I grew up in the insurance industry. My father was a life insurance agent. I learned about insurance products at the dinner table as a kid. After I graduated from college, I entered the financial services industry as an advisor for a major life insurance company. I earned my Chartered Life Underwriter designation in my early 20s. So, I have pretty solid understanding of annuity products.

Over the years I have watched the insurance industry develop a vast array of annuity products. These products have become very sophisticated and, one might argue, too complex. In addition, most of them are very expensive. It is not unusual for an annuity to be loaded with expenses that total 2-3%.

So, while I like some of the features of annuities, I have not been particularly inclined to advise clients to purchase them. [Our firm is fee only. We do not sell any financial products.] Most clients do not understand the newer annuity products and few realize how expensive they are.

However, based on several recent articles and white papers, I am beginning to think there may well be a place for a low cost annuity inside a well structured retirement portfolio. Why? Because a guaranteed, fixed income stream from a highly-rated insurance company can serve to greatly improve the odds that the client will not outlive their resources in retirement.

Our firm has a responsibility to help our clients maintain their lifestyle after they stop working. Given that our clients are routinely living into their 80s and 90s, we need to be diligent about building a portfolio that can withstand the erosion caused by 30-40 years of inflation. We also need to attempt to insulate the portfolio from the impact of cataclysmic market drops as occurred twice in the most recent decade.

So, annuities may serve a valuable role in a retirement portfolio.

Supreme Court Weighs in on Mutual Fund Fees

2010-04-01T10:58:00.000-07:00

The nation’s highest court issued its views on Jones V. Harris Associates, in which investors in Oakmark mutual funds sued the fund manager for allegedly excessive fees. The case reached the Supreme Court after a lower court overturned the “Gartenberg standard.” Under this standard, which was established by a court ruling in 1982, the only way for an investor to prove that a fund’s fees were excessive was to establish that the fees were not properly negotiated with the fund board.

The high court re-established Gartenberg and went further. The ruling accepted the argument that judging whether a fee is excessive requires comparing the charges applied to different types of clients. This brings to light the large discrepancy in fees between individual/retail investors and institutional investors. This new interpretation may require fund managers to inform their boards how much they charge and explain the differences. This may prove very difficult.

Investors should realize that almost all fund companies are profit seeking. It’s pretty obvious that the more they charge you, the more profit they generate. Wise investors look for funds with low fees and high marks for stewardship from Morningstar.

Source: The Wall Street Journal

Congress May Fail to Create Fiduciary Standard

2010-03-26T14:35:00.001-07:00

For months I have watching the Senate Banking Committee and the House Financial Services Committee grapple with whether or not to impose a fiduciary duty of care on anyone offering advice on investments.

In case you are not aware, the fiduciary standard requires advisors to act in the best interest of another party. You may be thinking, “But aren’t all investment advisors required to do this?” No, they are not.

Currently, advisors inside banks, credit unions, insurance companies, and brokerage firms are only required to do that which “suitable” for the client. Under this standard, the advisor must recommend only those products that are suitable based on the client’s situation. This is a lower level of care and it has resulted in consumers being sold products and services that, while perhaps suitable, are not in their best interest.

As you might image, the companies that manufacture and distribute financial products are resistant to the idea of holding their advisors to a level of care that would likely result in a reduction in the sale of their financial products. The advisor inside a national bank, the agent for a major life insurance company, the broker for a major wire house would all be required to make only those recommendations and sell only those products that were in the client’s best interest.

The only advisors who are currently held to a fiduciary level of care are those who act under the Investment Advisers Act of 1940, those who carry the CERTIFIED FINANCIAL PLANNER (CFP) designation and those who operate in the retirement plan arena under the Employee Retirement Income Security Act of 1974 (ERISA). I am a CFP and Cascade Wealth Management is a Registered Investment Advisor acting under the 1940 Act.

The Certified Financial Planner Board of Standards, the National Association of Personal Financial Advisors (NAPFA) and the Financial Planning Association (FPA) formed the Financial Planning Coalition (www.financialplanningcoalition.com). The coalition’s mission is to ensure that financial planning services are delivered to the public with fiduciary accountability and transparency. I am a member of the NAPFA and the FPA.

It does not appear that Congress is going to find the courage to implement the fiduciary standard in the investment industry. The true losers are Americans who should be served only by those acting in a fiduciary capacity.

The CFA Institute on Indexing

2010-03-19T11:25:00.000-07:00

I am currently laboring through the coursework to sit for the Level 1 CFA Exam in June. The CFA Institute offers the Charted Financial Analyst charter. The CFA designation is held by, among others, portfolio managers, investment research analysts, and investment bankers. I decided to pursue the charter, because I believe it will help me better serve our clients.

I was also interested in obtaining the base knowledge that portfolio managers use to actively manage portfolios. We do not practice active management. I have never been persuaded by Wall Street’s message to consumers that investors can beat the market. The academic research indicates that very few active managers actually deliver above-average risk-adjusted returns. But since there so many firms attempting to do this, I want to know how they attempt to go about it.

While I am still in Level 1 of the CFA program - there are three levels to the CFA curriculum – it has been very interesting to see the position that the CFA institute takes on the issue of active portfolio management.

Here are a few quotes from CFA Program Curriculum, Volume 5, “Equity and Fixed Income.”

“The majority of professional money managers cannot beat a buy-and-hold policy on a risk-adjusted basis.” P. 93

“Without access to superior analysts or the time and ability to be a superior investor, you should manage passively and assume that all securities are properly priced based on their level of risk.” PP. 93-94

I am using a review program produced by Kaplan Schweser to prepare for the exam. In Book 4, “Corporate Finance, Portfolio Management, and Equity Investments,” the author states, “money managers as a group have not outperformed the buy-and-hold policy. P. 184

Further, “since you cannot, in general, expect to beat the market, you should attempt to match the market while minimizing your costs. One way to match the market’s performance is to put your money into an index fund.” P. 184

I find this very interesting. Why are so many advisors putting their clients in funds that are actively managed? Do they actually believe they can identify the few portfolio managers who do beat the market? Do they realize that this small group of managers is not consistent over time? Just because a mutual fund earned a 5 star rating from Morningstar last year does not mean it will do so again this year.

Hopefully, I will pass the Level 1 exam and move on to Level 2 and Level 3. I am very curious about the additional insights I will have into the issue of active vs. passive investment management.

Hunting for Yield

2010-03-11T13:56:00.000-08:00

There has been a lot of dialogue about how conservative investors can boost their yields with minimal risk. There really are no easy answers. Yet investors and their advisors continue to look for them.

I would suggest that this issue should be placed in a broader perspective. Inflation is largely non-existent right now, as measured by the government’s CPI numbers. In fact, in January prices actually decreased.

The issue for those requiring income is their ability to stay ahead of inflation and maintain their purchasing power. If inflation is running at 4% and I earn 6% in my income-oriented portfolio, my inflation adjusted return is 1.92%. If inflation is 0.5% and I earn 2.5% in my portfolio, my inflation adjusted return is 1.99%.

We did not hear much about the need for yield when inflation was running at 3-4%, because investors were able to earn enough yield in CDs, money markets, treasuries, high grade corporate bonds, and dividend-paying stocks to maintain a healthy margin over inflation.

I am, of course, ignoring taxes. But the point is that investors need to focus on their inflation-adjusted returns. The situation is not as dire as many believe.

Declining Projected Returns

2010-03-04T11:38:00.000-08:00

I read in The Wall Street Journal on Monday (March 1, 2010) (http://online.wsj.com/article/SB10001424052748703316904575092362999067810.html?KEYWORDS=calpers++rate) that CalPERS (the California Public Employees’ Retirement System) is considering reducing the projected rate of return used to make investment decisions. This is further validation of a growing sense in the investment community that investment returns are likely to be lower than they have been historically. (Note: The Pew Center on the States reports the most common projected rate of return among public pensions in the U.S. is 8%.)

Since 2003, CalPERS has assumed that the value of its stock, bonds and other holdings would increase by 7.75% per year. However, the board has been advised by its investment consultants that this is not likely to occur. BlackRock, a leading investment company, suggested that the huge pension would be “lucky to get 6% on your portfolios, maybe 5%.”

The lower projections will result in increased contributions needed from employees and local governments to meet future payouts promised to retirees and their beneficiaries. This is not good news in a state that is already facing dire financial conditions.

But what does it mean to you? Well, the same returns that affect massive institutional investors like CalPERS (and Oregon PERS by the way), affect individual investors like you.

The CalPERS portfolio is allocated broadly across multiple asset classes. You can see this on their web site. (http://www.calpers.ca.gov/index.jsp?bc=/investments/assets/assetallocation.xml) As of December 31, 2009, the CalPERS portfolio included 66% in global equities (stocks), 23.5% in global fixed income (bonds), 6.8% in real estate, 2.4% in inflation linked securities and 1.3% in cash.

Most economists expect income tax rates to rise from their current levels as the government seeks additional revenue to reduce the federal budget deficit and pay for social programs. Tax rates on dividends, interest and capital gains (the sources of investment income) are likely to increase by many percentage points.

This means that investors will give up more of their returns to the government. If we assume the CalPERS recent projected return of 7.75% and a blended tax rate of 30%, then the after tax return is 5.43%.

Now let’s imagine that the rate of inflation over the next 25 years runs at 4%. I realize that this is considerably higher than the current rate. But it is consistent with historical rates and it very likely understates the rate we will actually experience.

Now the 5.43% return, after subtracting inflation, is 1.43%. (This is an approximation. The actual inflation-adjusted return is actually slightly lower.)

We have, thus far, ignored expenses and fees. These costs include advisory fees, management expenses, commissions, etc. For investors in actively managed portfolios, these expenses can easily top 2.25%. (Note: Cascade Wealth Management builds passive portfolios which typically have total expenses and fees of less than 1%.) This would wipe out what’s left of the returns that have been adjusted for taxes and inflation.

So, investors need to consider carefully how lower future returns will affect them. If you are retired and rely on your investments for income, review the rate at which you are drawing from your portfolio. You want to make sure your investments support you for the rest of your life. If you are still working, make sure you are saving enough to meet your income needs in retirement.

Mutual Fund Families and the Destruction of Wealth

2010-03-03T16:01:00.000-08:00

Morningstar released a study of the extent to which mutual funds companies have created or destroyed their investors’ wealth over the past decade. The survey included the 50 largest mutual funds (measured by total net mutual fund assets).

TOP WEALTH CREATORS

FUND FIRM, WEALTH CREATED ($ MILLIONS)
American Funds, $190,953
Vanguard, $188,959
Fidelity, $153,082
Franklin Templeton, $78,442
PIMCO, $71,381

BIGGEST WEALTH DESTOYERS

FUND FIRM, WEALTH DESTROYED ($ MILLIONS)
Janus, -$58,397
Putnam, -$46,407
Alliance Bernstein, -$11,376
Invesco AIM, -$10,081
MFS, -$7,651

It is probably not fair to draw any profound conclusions from this study. However, those who follow the mutual fund industry will surely note that companies that destroyed the most wealth have not been considered strong stewards for their investors.

Active Fund Managers Fail to Deliver

2010-02-28T14:40:00.000-08:00

Morningstar announced the Second Half (2009) Box Score Report last week. This report tracks mutual fund manager performance across asset classes. Morningstar notes that, "after accounting for sensitivity to risk, size and style as well as costs, only about a third of active funds in the study had positive alpha over the past three years."

Alpha is a measure of a fund manager’s ability to create excess return relative to a benchmark. Investors are, presumably, willing to pay much higher fees for active funds (compared to index funds), because they expect the manager to beat the index.

Unfortunately, we know that very few fund managers accomplish this. Further, we do not know in advance who these managers will be.

Deflation

2010-02-19T12:53:00.000-08:00

The Department of Labor reported that the seasonally adjusted consumer price index rose 0.2% in the month of January. This was driven almost entirely by higher energy costs. Oil, which had fallen to $40 a barrel during the depths of the recession, bounced back 54% last year.

Core consumer prices, which exclude food and energy purchases, actually fell by 0.1% in January. The last time core prices fell was in December 1982. Economists surveyed by the Dow Jones Newswires were expecting an increase of 0.3% in the consumer price index and an increase of 0.1% in the core index.

Deflation is the decrease in the general price level of goods and services in the economy. It occurs when the rate of inflation falls below zero. We rarely talk about it, because it rarely occurs. The last major episode of deflation in this country occurred during the Great Depression. Not exactly an experience we wish to repeat.

This bout of deflation will probably last no more than a month or two. We can expect prices to begin to rise soon as the Fed begins to drain the economy of the massive amount of liquidity it offered in effort to stave off a second depression.

Inflation will be the far greater threat over the next several decades. It is very hard to imagine avoiding significant price increases as the supply of money declines, causing fewer dollars to chase the supply of goods and services.

Sources: The Wall Street Journal, Wikipedia

Valentine's Day

2010-02-14T12:42:00.000-08:00

Happy Valentine’s Day! I read today that Saudi Arabia pretty well bans Valentine’s Day by asking florists and gift shops to remove all red items in the days just leading up to February 14. Apparently the Saudis believe St. Valentine’s Day encourages immoral relations between unmarried men and women. Every year the Commission for the Promotion of Virtue and Prevention of Vice cracks down by raiding stores and removing offensive items. Saudi Arabia follows a strict interpretation of Islam called Wahhabism.

The story is a bit different here in the United States. Despite the crushing recession, Valentine’s Day spending is expected to rise 3.3% to $17.6 billion. We spend on flowers, greeting cards, candy, clothing, jewelry, romantic getaways and dining out.

Speaking of spending money, the online site kaChing asserts that investors pay 3.37% of assets per year for stock mutual funds. This is rather astonishing, given that the Investment Company Institute (ICI) suggests that the same mutual funds costs are 1.17%.

So, how does kaChing come up with its number? kaChing adds 0.94% for taxes and 0.2% for trading costs. Further kaChing averages the costs of each fund on the market, treating each of them as equals. The ICI weights each fund by the amount of assets it holds. Since large mutual funds tend to have lower expenses, the ICI’s method lowers the average.

Now let’s talk about kaChing. This web site allows members to invest by making trades that follow those made by “truly skilled investors we call Geniuses.” Members select a “genius” they wish to follow. They may follow their genius for free and make their own trades or, for a modest management fee, they may have Genius make the trades in their personal brokerage account. The fee is split between kaChing and the “genius.” These fees range from 0.25% to 3.00%.

These so-called geniuses all pursue active management strategies. You probably already know how I feel about active management.

Do Not Blindly Follow the Stars!

2010-02-04T17:03:00.000-08:00

Do you ever use Morningstar to research and select funds for your portfolio? If so, you’re not alone. Morningstar is the undisputed leader in providing investors with valuable information about the returns, risks and costs of mutual funds.

So, how do you select a fund? Most investors naturally gravitate to the funds that have a 4 or 5 star rating. They know these funds have done well in the past or they would not have received one of Morningstar’s higher star ratings. Investors figure if a fund has done well in the past, it is likely to perform well in the future.

Is this true? Advisor Perspectives, an e-newsletter, recently published a study suggesting that these star ratings have little predictive value. In fact, the research indicates that 5 star funds are likely to underperform their peers. According to Morgan Stanley Smith Barney’s Consulting Group, the top 10% managers can repeat their success. But, the study also points out, the worst 20% of performers are also likely to outperform in the future.

These findings are consistent with the concept of “reversion to the mean.” This is the theory that performance eventually moves back toward the mean or average. If this is valid, an investor could actually pursue a strategy which entailed investing in funds that have not performed well recently. The expectation would be that these funds, assuming there were no clear reasons for their underperformance, would eventually outperform as they moved back to the mean.

We do know this for certain. Past performance does not guarantee future results. Be careful about relying on the stars to reach your investing destination.

The Triple Net Return

2010-01-29T09:57:00.000-08:00

Since 1926 U.S. stocks have earned an average of 9.8% (Ibbotson). But what about inflation, expenses and taxes? Jason Zweig (a writer for The Wall Street Journal) calls this the net, net, net return. A recent survey of leading financial advisors found that they projected this long term future rate to be 6% on average.

In order for this to happen, Zweig points out that these advisors will have to deliver returns of 11-13% a year before costs. How likely is this? It’s not.

I am not sure how these advisors think the market will return more than the historical average return of 9.8%. There is a widely-shared view that equity returns are likely to be lower over the next few decades than they have been historically. The arguments for this include the expectation that millions of Boomers will shift from accumulation (buying equities) to distribution (selling equities) as they enter retirement. If there are fewer buyers for stocks, their prices will fall.

Let’s assume that the stock market does deliver 10%. A typical portfolio for a retired investor would be equally allocated to stocks (50%) and bonds (50%). If we assume that bonds earn 4%, then a weighted return would be 7%.

Let’s assume that inflation runs at 4%, expenses are 1%, and taxes are 30%. Depending on our method of calculation, our Triple Net return has become approximately 0%-2%.

This should be a wake-up call for investors approaching retirement.

Protecting Your Most Valuable Asset

2010-01-22T14:32:00.000-08:00

What is your most valuable asset? …. Time’s up. … It’s your ability to earn an income.

As such, it should be protected just like all of your valuable assets.

The Wall Street Journal ran an article this week about disability insurance that is a good review of the basics. Here’s the link: http://online.wsj.com/article/SB10001424052748704561004575013073100310794.html?mg=com-wsj#

As a CERTIFIED FINANCIAL PLANNER™, I feel strongly that most people should secure private disability insurance. So, I disagree with the author’s comment that employer-provided insurance is “likely to be a better deal.” Yes, it is likely to cost less.

But it will be inferior in several other ways. (1) It will have a definition of disability that will render it less valuable than a private policy. (2) It will not be portable. So, if you change employers, the group disability insurance will get left behind. (3) If it does pay a claim, the benefit will most likely be far less than you need to maintain your lifestyle.

It may be tempting to think that, if you’re covered by an employer-sponsored group plan, you don’t need to give much thought to disability insurance. I would encourage you to consider carefully if this coverage truly meets your needs.

Exchange Trade Funds Cross $1 Trillion

2010-01-15T07:55:00.000-08:00

Exchange traded funds (ETFs) are growing in popularity. Blackrock reported that exchange traded funds held globally now contain in excess of $1 trillion. Blackrock, which bought the iShares business from Barclay’s PLC last year, is the largest provider of ETFs.

Exchange traded funds trade like stocks on major exchanges. The issuance and redemption process for ETFs makes them more tax efficient than conventional mutual funds. The first generation of ETFs was created as index funds and has very low internal costs. We use many ETFs to build client portfolios. … Today there are actively managed ETFs popping up like weeds in the neighborhood park. Unfortunately, the newer ETFs tend be more costly than the first ETFs.

The growth in the use of ETFs has been breathtaking. They grew by 45% in 2009 alone bolstered by the recovery of the financial markets and a movement away from traditional mutual funds. ETFs still lag far behind mutual funds by a large margin. The Investment Company Institute reports that conventional funds held $19 trillion at the end of 2008.

Incidentally, hedge funds hold $1.53 trillion according to Hedge Fund Research and separately managed accounts contain $527 billion according to Cerulli Associates.

The Roth conversion - Read all about it

2010-01-10T13:22:00.000-08:00

In case you have not heard, 2010 may be the year to convert your traditional IRA to a Roth IRA. The reason for this is that the requirement that the taxpayer’s modified adjusted gross income is less than $100,000 has been lifted. In addition, for conversions occurring in 2010, taxpayers may report one half of the resulting tax in 2011 and the remaining half in 2012. Taxpayers can, of course, pay all of the tax in 2010. These changes were included in the Tax Increase Prevention and Reconciliation Act of 2005 (signed into law by President George W. Bush on May 17, 2006).

Much has been written on the Roth IRA conversion. The financial services industry has used the changes in the rules as an opportunity to bombard investors with information about conversions. The big financial firms hope to capture assets that may be both converted and moved from one firm to another. However, it is not just investment companies that are pounding the drum about the Roth conversion. Business magazines (Money, Kiplingers, Business Week, Forbes, Fortune), financial journals (The Wall Street Journal, Investor’s Business Daily, and local business journals) and investor web sites (Bank Rate, Money Central, Motley Fool, Market Watch) have all written about the subject. A quick Google search for “Roth IRA conversion” returns 1.54 million results. Even the non-business media have stepped into the debate. I was interviewed last week by The New York Times for an article by Tara Siegel-Barnard “New Rules Ease Roth Conversion, but Benefits Vary.” http://www.nytimes.com/2010/01/09/your-money/individual-retirement-account-iras/09convert.html

So, what should you know? The decision to convert must be weighed by every individual. There are so many variables involved, that there is no clear answer for anyone. If you are considering converting some or all of you Roth, sit down with an expert (CPA, tax attorney or CERTIFIED FINANCIAL PLANNER™ and explore your situation carefully.

ACTIVE MANAGEMENT FAILS TO DELIVER

2009-10-09T10:57:00.000-07:00

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%.

The Fiduciary Standard

2009-09-03T13:18:00.000-07:00

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.

Index Bonds Funds Beat Active Funds

2009-08-23T14:49:00.000-07:00

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.