Many Active Managers Follow Index

According to an article in Financial Planning online, active managers do not add significant value. The article sites a study by Sharath Sury, executive director of the Institute for Financial Innovation & Risk Management and an adjunct Professor of Economics at the University of California, Santa Cruz. Sury found that active managers have broad market exposures that cause their funds to look similar to indexes. Unfortunately, active managers charge more than index funds.

Interestingly, one of the reasons that active managers fail to deliver value is that they charge more.

Here's the link to the article: Active Managers Don't Add Value: Study

Small Caps Rise

The Russell 2000 index of small capitalization stocks has risen 36% since early October, according to The Wall Street Journal. The index is just 4.2% below the all time high of 865.29.

I find this particularly amazing, given that investors have pulled money from U.S. small cap mutual funds in 37 of the past 40 weeks, according to EPFR Global.

Intelligent investors understand the small cap stocks, both domestic and international, belong in a low cost, passive portfolio. They are long term investors and do not move tactically from asset class to asset class.

Investors Zig and the Market Zags

Investors pulled $2.8 billion from US stock funds in January, according to Morningstar. Investors were likely reacting to the poor results turned in by equities in 2011.

But the spurned market responded by turning in its best result for the month of January in 15 years. The Dow Jones Industrial Average rose 3.4% and the Standard & Poor's 400 gained 4.4% in January.

The lesson? Investors need to learn to remain steadfast. Successful investing does not require timing in and out of the market. Rather, successful investors develop an appropriate investment approach and remain committed to it.

Happy Valentine's Day

Two Standards

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

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

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

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.