Unconventional Wisdom

The Evolution of an Investor

This is a very informative and entertaining article by best-selling author Michael Lewis.  It's Labor Day, so print it or download it and enjoy. 

Blaine Lourd was an extremely successful stock broker and, at the height of his career, was an advisor to many well known celebrities.  This is his story.  If you've long suspected that Wall Street puts its own interest ahead of the client's, this will certainly make that belief crystal clear.  But, the article goes beyond the sordid truth about broker behavior and suggests a better business model.  You just may recognize it.

The Stock Market's "Lost Decade"

One of my clients sent me a New York Times article from last Sunday's front page in which Charles Biderman, chief executive of a funds research company, stated that "people have lost a lot of money over the last ten years in the stock market, while there has been a bull market in bonds."

It is certainly true that a lot of people did lose money in the stock market over the past ten years.  In fact, if you invested a dollar in the S&P 500 on August 1, 2000 that dollar would have been worth about 93 cents as of the end of July 2010.  And, that's assuming you could invest in the index at no cost.  This certainly seems to support the conclusion that the stock market has had a "lost decade."  But, what happens when we take a closer look?

What if you had invested in a globally diversified portfolio of stocks in a portfolio that emphasizes exposure to value and small cap companies?  That's exactly what our Talis 100 equity portfolio does.  So, how did it perform over the same time period?  The dollar that you invested on August 1, 2000 would be worth $2.13 and that's after all of the fund expenses and the highest advisory fee that we charge.  This also assumes that all distributions are reinvested.

So, what if you had been prescient enough to have gotten out of the stock market on August 1, 2000 because you somehow saw this coming?  And, what if you had taken advantage of the "bull market in bonds" by investing in an intermediate bond index?  Again, assuming that there are no costs involved in doing this, a dollar invested in the Lehman (now Barclay's) corporate/government intermediate bond index would be worth $1.81.  We should also point out that most bond funds failed to beat this index.

So, why does the New York Times fail to mention any of this?  First, the media always feels the need to "dumb down" any analysis.  Apparently, they don't think that their readers are capable of understanding a more informative article.  And, it's easy to write a story that makes a very simple point - stocks are risky and dangerous, bonds are safe!  Considering the attention span of many readers, that might be right.  However, for investors that understand capital market behavior and the factors that actually contribute to returns, the past decade has been a very different experience.

To learn more about the performance of the Talis portfolio series, see comparisons to benchmark indexes, and access disclosure information click here.

Everything You Need To Know About Selecting Mutual Funds

Could everything that you really need to know about selecting mutual funds be contained on a napkin?  Probably not, but a recent Morningstar study suggests that examining a fund's expense ratio may tell you more than you can learn from reading Money Magazine or listening to the talking heads on CNBC.

Morningstar examined five categories of equity and fixed-income funds over multiple periods beginning in 2005, 2006, 2007 and 2008 and ending in March 2010. Funds were sorted into quintiles based on expenses and the performance of the cheapest funds was compared to that of the most expensive. They computed total return for funds surviving through March 2010 as well as a "success ratio" measuring the percentage of the initial group that went on to survive and outperform their peers.

Unsurprisingly, cheap funds outperformed their expensive cousins. Commenting on the results, Morningstar Director of Mutual Fund Research Russel Kinnel observed: "In every single time period and data point tested, low-cost funds beat high-cost funds.¹

Even more interesting, the study repeated the analysis using Morningstar's ratings and found that the expense ratio was a more reliable predictor of performance.  A lot of people might find that surprising, although we don't - see our previous post on this subject.  This is just another example of how actively managed funds (expensive) are unable to consistently outperform passively managed funds (inexpensive) and how performance of actively managed funds is usually inversely correlated with their expense ratio.  Because active management does not reliably create additional return, high expense ratios become insurmountable obstacles.

1. Russel Kinnel. "Fund Spy—How Fund Expense Ratios and Star Ratings Predict Success" Morningstar, August 9, 2010

 

 

Dividend Investing

One of our really astute clients asked me why DFA's funds do not emphasize dividend paying stocks.  It's a good question and certainly timely.  It seems that every issue of Barron's and every CNBC show has some "expert" proclaiming that, because corporate earnings have grown and stock prices have remained depressed by fear, there are extraordinary opportunities to buy stocks that pay a high dividend.

Since a dividend is a distribution of corporate earnings to shareholders, it is always accompanied by a similar reduction in the share price.  It is simply a transfer of ownership and it is a taxable event to the shareholder.  Under our current tax law, non-qualified dividends are taxable at the shareholder's ordinary income rate.  In general, dividends paid by US companies that are held for a certain period of time are qualified dividends.  Qualified dividends are taxed according to a more advantageous rate, like long-term capital gains.  So, in a taxable account, the dividend distribution actually results in realization of a gain and taxation that would not have occurred if the earnings had been retained. 

What is the difference between a dollar paid as a dividend and a dollar that is the result of a capital gain?  Ignoring taxes, not a thing.  So, why would a dollar paid as a dividend be so desirable?  It's not.  But, it turns out that stocks that pay a high dividend tend to perform better than stocks that pay no dividend or a low dividend.  Why?  Because they are value stocks. 

But, is sorting stocks by the dividend/price ratio an effective way of adding value exposure to a portfolio?  Academic research indicates that it is not.  The purpose of any scaled price ratio based sort is to produce dispersion in the returns of stocks that can then be used to select stocks with the highest return.  It turns out that the dividend/price ratio does this, but it is a weak relationship and it is statistically unreliable as compared to other methods (and even to other scaled price ratios, like earnings/price and cash flow/price).  What works the best?  According to the research, it's the book-to-market value, or BtM.  And, guess what?  That's the factor that DFA uses to define value stocks.  It's already built into our portfolios.

I saw one of those dumb Scottrade commercials last night where the founder (when he's not out flying around in his purple Scottrade helicopter) touts their "research" capability and suggests that individual investors should use it to pick stocks.  A quick Google search turns up a zillion or so websites and newsletters touting how to do that using dividends.  And, of course, you could.  But, it's unlikely that the results will be quite as spectacular as they might like you to believe.

A Bull Market in Pessimism?

Call it a "fear bubble".  Individual investors are, for the most part, shunning the equities markets due to the perception of risk.  Has this created a bubble in bond prices?

The Economist, in an August 19 article states that "a lot has to go wrong to justify today's rock-bottom bond yields".  According to the article, US equity mutual funds have seen an outflow of $7B so far this year, but bond mutual funds have had inflows of $191B.  Since bond prices and yields have an inverse relationship, bond investors have recently enjoyed handsome returns.

Has this "rush to bonds" created a bubble in bond prices?  Most of the drop in treasury yields can be attributed to a decline in the expected inflation rate.  Yet, while investors have piled into nominal bonds, the yield spread over inflation-linked bonds has narrowed, bringing down the implied inflation rate.  In fact, some analysts believe that this indicates only a 10-15% probability of deflation over the next five years. 

As deflation fears subside, will investors dump bonds and create a violent sell-off?  The US core CPI fell to 0.9% in July and there are signs that it may be bottoming.  Core producer prices rose faster than expected in July.  Bonds may also be expensive when compared to stocks.  Analysts at JPMorgan recently calculated the US equity risk premium and concluded that it was at a record high.  But, will this be enough to convince investors to start bailing out of bonds?  Probably not - at least as long as the central banks keep interest rates low and continue to buy debt.

 

Fixed Income Risk in Your Portfolio

With interest rates near historical lows, some investors may be anxious about a possible rate climb and its potential impact on their fixed income investments. Rising interest rates typically cause existing bonds to lose value. While investors might hold short-term instruments to manage this risk, an interest rate decline could spoil this strategy by forcing investors to reinvest in lower yields when their short-term instruments mature.

Rate movements in either direction affect portfolio returns. This is true in any market environment, regardless of the current rate level. The larger question is how to manage the risk. As you read the financial headlines and evaluate your current fixed income exposure, it may be helpful to consider these principles about fixed income investing:

Interest rate movements are unpredictable.

Academic research offers strong evidence that the bond market is efficient, and that bond prices and interest rates are not predictable over the short term.¹ This uncertainty is reflected in the often-contradictory interest rate forecasts offered by economists, analysts, and other market watchers.²

Even when the experts share similar views on the direction of the economy and credit markets, reality often proves them wrong. Last year’s Wall Street Journal forecasting survey offers a recent example.³ Among fifty economic forecasters surveyed in 2009, forty-three expected the ten-year US Treasury note yield to move higher over the next year, with an average estimate of a 4.13% yield. Only two respondents predicted rates to fall below 3.00%. The ten-year Treasury yield slumped to 2.95% on June 30, 2010, and rates on thirty-year mortgages fell to their lowest level since Fannie Mae began tracking them in 1971.

Today’s bond prices already reflect expectations for tomorrow’s business conditions and inflation, and these expectations can change quickly in response to new information. This new information is unknowable. Investors who accept market efficiency should not be surprised when the credit markets foil the experts. If prices were easy to forecast, you should find a host of fixed income managers with market-beating returns. But most of them underperform their respective benchmarks over longer time periods.⁴

Since no one has a reliable method for determining whether interest rates will rise or fall in the near future, investors should avoid making fixed income decisions based on a forecast, media coverage, or their own hunches.

 Pursuing higher expected returns requires more risk taking.

The strong link between risk and return appears in all properly functioning capital markets. When investing in stocks, bonds, or other assets, investors must accept more risk to pursue a higher potential return.

In the fixed income markets, earning a return above short-term government instruments is usually a function of assuming more term and credit risk. Term risk refers to a bond’s maturity, and credit risk refers to the creditworthiness or default potential of the borrower. Bonds with longer maturities and lower credit quality are usually considered riskier and have offered higher yields and returns to compensate investors for higher risk.

On the term side, investors who commit their capital for longer periods of time are exposed to the amplified effects of changing interest rates. Bond prices and interest rates move in the opposite direction: When rates rise, the value of an existing bond declines; when rates fall, bond values rise. The market adjusts the price to match the yield available on a new instrument. The longer the bond’s maturity, the greater the price adjustment for a particular interest rate change. A long-term bond is more exposed to rate changes than a short-term instrument, and usually (but not always) offers a higher yield to compensate investors for the extra risk. Also, lower-coupon bonds are more affected by interest rate changes than higher-coupon bonds. For example, if rates move 1%, a bond that pays 3% will experience a greater gain or loss than one paying 5%.

On the credit risk side, the government is considered the strongest borrower in the market, so it has a lower cost of capital relative to other issuers. The most creditworthy companies are considered relatively safe, but they must still offer a higher rate than the government to compensate investors for taking more default risk. The weaker a corporate borrower’s financial condition, the more it must pay in yield to attract investors. Investors seeking higher returns on the credit spectrum must bear a higher risk of default.⁵

Investment strategy should drive fixed income decisions.

Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation. Each objective may involve a different portfolio approach, or a combination of strategies to manage tradeoffs. For example, investors who want to maximize current income may not be strongly concerned with the effects of short-term price volatility. They may extend maturity or accept slightly lower credit quality when the market offers a yield premium for doing so. On the other hand, investors seeking long-term wealth appreciation may commit most of their portfolio to equities and keep their fixed income investments short term and high quality to buffer the volatility of stocks.

Regardless of your approach, you should know the difference between controlling risk and avoiding it. You cannot eliminate risk, but you can manage your exposure by diversifying across maturities, industries, countries, and currencies to reduce the impact of rates, inflation, currency fluctuations, and other risks. Your decision to take more term and default risk may depend on the current state of the yield curve and credit spread.

Many factors influence the direction of interest rates and performance in the bond markets, and these are too complex for anyone to reliably predict. Rather than placing your faith in the experts or reacting to economic news, manage your fixed income component from a portfolio perspective. Your strategy should reflect your overall investment goals, risk tolerance, and other personal financial considerations. This is a solid approach to managing your portfolio in an uncertain interest rate market.

 

Endnotes

¹ Eugene F. Fama, “The Information in the Term Structure,” Journal of Financial Economics 13, no. 4 (December 1984): 509-528. Also: Robert R. Bliss and Eugene F. Fama, “The Information in Long-Maturity Forward Rates,” American Economic Review 77, no. 4 (September 1987): 680-692.

² Mark Gongloff, “Two Treasury Forecasts: a Grand Canyon-Size Gap,” Wall Street Journal, April 10, 2010.

³ Wall Street Journal Forecasting Survey, www.wsj.com, accessed July 7, 2010.

⁴ Christopher R. Blake, Edwin J. Elton, and Martin J. Gruber, “The Performance of Bond Mutual Funds,” Journal of Business 66, no. 3 (July 1993): 371-403. Also see Standard & Poor’s Indices Versus Active (SPIVA) Scorecard for the US, Canada, Australia, and Europe (http://www.standardandpoors.com/indices/spiva/en/us).

⁵ The yield curve plots the current relationship between rates and maturity, and the credit spread plots the risk-return relationship across the range of credit qualities. The curves offer a current snapshot of how markets are pricing term and credit exposure.

Talis Portfolio Performance

One of the benchmarks that we pay attention to is where our equity portfolio (Talis 100) ranks as compared to the universe of mutual funds.  The Morningstar Principia database is useful for this analysis.  We've identified some issues with survivorship bias in this database in the past that cause this type of analysis to understate the relative performance of our portfolio, but it's still an interesting snapshot.

Comparing portfolio performance to single asset class performance is not meaningful, so we sort the database by the Morningstar category and look at funds that use some sort of allocation, either to equities or to equities and fixed income.  We include all global, foreign, and US allocation funds as well as balanced funds in the analysis because they are most comparable to our portfolio and could reasonably be used by an investor as a complete portfolio solution.

There are 5163 funds found in these Morningstar categories.  Of those, 61 had a load adjusted 10 year annualized rate of return that exceeds the 10 year annualized rate of return for the Talis 100 portfolio adjusted for our highest advisory fee for the 10 year time period ending June 30, 2010.  In other words, the strategic asset allocation used in the Talis 100 portfolio with asset class exposure provided by DFA funds outperformed 98.8% of the 5163 diversified mutual funds over this 10 year period of time, even when adjusted for the highest advisory fee that we charge.

Since many of these funds are actively managed and attempt to tactically allocate to asset classes that they expect to outperform in the future, this also serves to illustrate the folly of that investment philosophy in practice.  Our portfolio simply maintained a constant exposure to asset classes over time and was rebalanced annually.

We haven't taken taxes into account here, so this is most relevant for qualified accounts.  But, previous work that we've done shows that the outstanding tax efficiency of our portfolios makes the analysis even more favorable.  We'll take a look at the load-adjusted after-tax performance in a future article.

Stock Pickers Lose Out To Index Funds - Again

In another interesting Dow Jones article, the author points out that "the pain from the recent market downturn was felt far and wide—but not shared equally" and that "the classic type of mutual fund, which employs an army of stock pickers to invest in big U.S. businesses, has fared a lot worse than low-cost index funds which simply ride the ups and downs of the market."

That's not news to us, but it is apparently news to a lot of people.  According to the article, investors have pulled more than $174 billion from U.S. large company stock mutual funds in the last three years and, in fact, these funds haven't experienced a positive flow since June 2009.  Some of the industry's best-known names have bled investment dollars, including American Funds Investment Company of America (-$16.1 billion), Dodge & Cox Stock Fund (-9.1 billion), and Fidelity Contrafund (-$1 billion).  In contrast, index funds have suffered much less.  Large company stock index funds and ETFs have actually seen inflows of more than $147 billion in the last three years while actively managed funds were hemorrhaging.

This trend vindicates many investing experts and academics who have long questioned why individual investors pour money into actively managed funds that, as a group, seem unable to beat the market.

Before we celebrate, though, it is worth pointing out that individual investors have continued to chase performance in the "hot" areas of the market, particularly in emerging markets stocks and bonds.  That being said, it's also interesting to note that the best performing emerging markets stock fund in the Morningstar emerging markets category (based on load adjusted 10 year annualized return) is DFA Emerging Markets Value, a passively managed fund.  Oh, and we've been using this fund in our portfolio constructions for many years.

The DFA Academic Feedback Loop

Dimensional Fund Advisors (DFA) has long been known for its deep working relationships with many of the world's leading financial economists.  The body of work produced by these academic leaders has been recognized as some of the most important research into capital market behavior in the modern era. 

As practicioners, one of the many advantages we have as a result of our association with Dimensional Fund Advisors (DFA) is the ability to participate in the "academic feedback loop": 

• Academic leaders in the field of asset pricing find new sources of risk and return in advance of the industry.
  
  
• Dimensional engineers strategies and brings client feedback to these financial economists and researchers for further testing and enhancements.
  
  
• Empirical research becomes more relevant to practical investing, and practical investing is backed by solid theory and economic knowledge.

This process allows practioners, like us, to influence the development of new strategies at DFA.  There have been many examples of the feedback loop in action, including the launch of DFA's core funds and the recent additions to DFA's fixed income strategies.  DFA commits substantial resources to this process and the results benefit our clients.

 

A Risky and Wild Investment

According to a Dow Jones report, no less than the Government Accountability Office (GAO) has warned consumers about participating in life-settlement transactions "due to a lack of clear, consistent state oversight."  The Securities and Exchange Commission (SEC) and the Financial Regulatory Authority (FINRA) have issued similar warnings in the past.  The SEC has long maintained that life settlements should be regulated as securities.

Despite all this, salesmen continue to push life settlements as low risk investments.  We have always disagreed.  While it is true that life settlements are not correlated with the stock market, that does not make them riskless or even low-risk investments. 

Investors in life settlements are making a bet that the insured party will die within the time frame used in calculating the touted return.  If that happens, it's a money maker.  But, it certainly does not always happen that way.  And, if the insured lives significantly longer than expected, the investor may realize a very low rate of return - or even lose money.  It is entirely possible that this can happen due to medical advances or changes in lifestyle.

It's also quite possible that the underwriters have underestimated the the life expectancy of the insured.  This can also lead to a lower than anticipated return or a loss.  According to Stephan Leimberg, editor of Tools and Techniques of Life Settlement Planning, "Life expectancy tables have not been accurate - particularly for small face-value policies."

There is also legal risk associated with fraud or lack of insurable interest.  In such cases, insurers will not pay the death benefit and the premiums may or may not be returned. 

Finally, there is significant liquidity risk.  The investor will have no access to funds invested in a life settlement and, if for any reason the insured lives longer than expected and the investor is unable to maintain the policy premium payments, all of the investment may be lost.  The market for resale of the policies is thin and illiquid.

The Dow Jones article calls life settlements a "wild investment" and comes to the conclusion that "the risks of life settlements are greater than the potential rewards."  We agree.