Posts in Investment Strategy

An Index Overview (Part IV)

June 1st, 2017 Posted by Asset Allocation, Financial Education, Foreign Investing, Investment Strategy, Investment Vehicles, Uncategorized 0 thoughts on “An Index Overview (Part IV)”

Part IV: Index Investing – Opportunities and Obstacles

Legend has it, a pharmacist named John Pemberton was searching for a headache cure when he tried blending Coca leaves with Cola nuts. Who knew his recipe was destined to become such a smashing success, even if Coca-Cola® never did become the medicine Pemberton had in mind?

In similar vein, when Charles Dow launched the Dow Jones Industrial Average (the Dow), his aim was to better assess stock prices and market trends, hoping to determine when the market’s tides had turned by measuring the equivalent of its incoming and outgoing “waves.” He chose industrials (mostly railroads) because, as he proposed in 1882, “The industrial market is destined to be the great speculative market of the United States.”

While the actively minded Dow never did achieve market-timing clairvoyance (and neither has anyone else we’re aware of), he did devise the world’s first index. We’d like to think his creation turned into something even greater than what he’d intended – especially when Vanguard founder John Bogle and other pioneers leveraged Dow’s early work to create among the most passive ways to invest in today’s markets: the index fund.

Bogle launched the first publicly available index fund in 1976. Initially dismissed by many as “Bogle’s folly,” its modern-day rendition, the Vanguard 500 Index Fund, remains among the most familiar funds of any type.

Index Investing Is Born

In defense of Dow’s quest to forecast market movements, it’s worth remembering that his was a world in which electronic ticker tape was the latest technology, there were no open-ended mutual funds or fee-only financial advisors, and safeguards and regulations were few and far between. Essentially, speculating was the only way one could invest in late-nineteenth century markets.

Compared to actively managed funds that seek to “beat” the market by engaging in these now-outdated speculative strategies, passively managed index funds offer a more solid solution for sensibly capturing available market returns. As the name implies, an index fund buys and holds the securities tracked by a particular index, which is seeking to represent the performance of a particular slice of the market. For example, the Vanguard 500 Index Fund tracks the popular S&P 500 Index, which in turn approximately tracks the asset class of U.S. large-company stocks.

Compared to actively managed solutions, index funds lend themselves well to helping investors more efficiently and effectively target these three pillars of sensible investing:

  1. Asset allocation – How you allocate your portfolio across various market asset classes plays a far greater role in varying your long-term portfolio performance than does the individual securities you hold.
  2. Global diversification – Through broad and deep diversification, the sum of your whole risk can actually be lower than its individual parts.
  3. Cost control – The less you spend implementing a strategy, the more you get to keep.

Index Investing: Room for Improvement

As we’ve described throughout this series, indexes weren’t specifically devised to be invested in. There’s often a lot going on underneath their seemingly simple structures that can lead to inefficiencies by those trying to retrofit their investment products on top of popular indexes.

Index Dependence – Whenever an index “reconstitutes” by changing the underlying stocks it is following, any funds tracking that index must change its holdings as well – and relatively quickly if it’s to remain true to its stated goals. In a classic display of supply-and-demand pricing, this can generate a “buy high, sell low” environment as index fund managers hurry to sell stocks that have been removed from the index and buy stocks that have been added.

Compromised Composition – Asset allocation is based on the premise that particular market asset classes exhibit particular risk and return characteristics over time. That’s why your investment “pie” should be carefully managed to include the right asset class “slices” for your financial goals and risk tolerances. As we described in Part III of this series, if you’re invested in an index fund and you aren’t sure what its underlying index is precisely tracking, you may end up with off-sized pieces of pie. For example, the S&P 500 and the Russell 3000 are both positioned as U.S. stock market indexes, but both also track some real estate. If you don’t factor that into your plans, you can end up with a bigger helping of real estate than you had in mind.

Introducing Evidence-Based Investing

So, yes, index investing has its advantages … It also has inherent challenges. No wonder academically minded innovators from around the globe soon sought to improve on index investing’s best traits and minimize its weaknesses. In fact, many of these thought leaders were the same early adapters who introduced index fund investing to begin with. Building on index investing, they devised evidence-based investment funds, to offer several more advantages:

Index-independence – Instead of tracking an index that tracks an asset class … why not just directly capture the asset class itself as effectively as possible? Evidence-based fund managers have freed themselves from tracking popular indexes by establishing their own parameters for cost-effectively investing in most of the securities within the asset classes being targeted. This reduces the need to place unnecessary trades at inopportune times simply to track an index. It also allows more patient trading strategies and scales of economy to achieve better pricing.

Improved Concentration – Untethering themselves from popular indexes also enables evidence-based fund managers to more aggressively pursue targeted risk factors; for example, an evidence-based small-cap value fund often has more flexibility to hold smaller and more value-tilted holdings than a comparable index fund. This provides more refined control for building your personal investment portfolio according to your unique risk/return goals.

Focusing on Innovative Evidence – Evidence-based investing shifts the emphasis from tracking an index, to continually improving our understanding of the market factors that contribute to the returns we are seeking. By building portfolios using fund managers who apply this same evidence to their funds, you can make best use of existing academic insights, while efficiently incorporating credible new ones as they emerge.

An Index Overview, Revisited

From describing an index’s basic functions, to exploring some of the intricacies of their construction, we’ve covered a lot of ground in this four-part series on indexing. To recap, indexes can help us explore what is going on in particular slices of our capital markets. In the right context, they also can help you compare your own investment performance against a common benchmark. Last but not least, you can invest in funds that track particular indexes.

Equally important, remember that indexes do not help us forecast what to expect next in the markets, nor do high-water markets such as “Dow 20,000” foretell whether it’s a good or bad time to buy, hold or sell your own market holdings. And, while low-cost, well-managed index funds may still play a role in your overall investment portfolio, it’s worth ensuring that you select them when they are the best fit for your evidence-based investment strategy, not simply because they are a popular choice at the time.

What else can we tell you about indexes or index investing? Let’s take a look at your unique financial goals, and see how indexing fits into your globally diversified world of investments. To learn more, please get in touch with us at OpenCircle Wealth Partners, 203-985-0448.

[Photo curtesy of ekta kapoor]

 

An Index Overview (Part III)

May 11th, 2017 Posted by Financial Education, Investment Strategy, Investment Vehicles 0 thoughts on “An Index Overview (Part III)”

Part III: Index Mechanics – Interesting Idiosyncrasies

Market indexes. You read about them all the time, such as when the Dow Jones Industrial Average (the Dow) topped 20,000 points in early 2017 … and then broke 21,000 just over a month later. In our last piece, we explored what those points actually measure, which isn’t always what you might guess. Today, we’ll take a closer look at the mechanics of indexing, to gain a better understanding of why they do, what they do.

The Birth of Indexing

When you hear the term “stock index,” you’re in good company if the first thing that comes to mind is the S&P 500; some of the world’s largest index funds are named after it. We’ll talk more about index investing in our next piece, but we’ll note here that, despite its familiarity, the S&P 500 is a babe in the woods compared to the world’s first index. That honor goes to the Dow.

The Grand Old Dow

As described in “Capital Ideas” by Peter Bernstein:

“The first Dow Jones Average appeared in the Afternoon News Letter on July 3, 1884. It consisted of the closing prices of eleven companies: nine railroads and two industrials. [Charles] Dow’s idea was to provide an overall measure of the performance of active companies, at a time when an average day’s activity on the New York Stock Exchange was about 250,000 shares.”

Eleven companies, nine of them railroads, wouldn’t make for much of a market proxy these days! And yet the Dow still only tracks 30 stocks, as it has since 1928. Plus, it still uses mostly the same methods for tracking them. As expressed by James Mackintosh, a senior market columnist for The Wall Street Journal (the effective birthplace of the Dow): “It’s time to ditch the Dow. After 120 years, the venerable Dow Jones Industrial Average is an embarrassing anachronism, abandoned by professionals and beloved only by a media that mostly knows no better. It needs to be updated or, better, replaced.”

And yet, despite its flaws, the Dow persists. Markets are made of people, and people can be sentimental about their past. More pragmatically, the Dow serves as a time capsule of sorts, offering historical perspective no other index can match. It’s also just plain familiar. As its parent company the S&P Dow Jones Indices says, “It is understandable to most people.”

 How Do Indexes Get Built?

What about all those other indexes? New ones come along whenever an indexer devises a supposedly better mousetrap for tracking market performance. If enough participants accept the new method, an index is born.

That’s our free markets at work, and it sounds simple enough. But if we take a closer look at the various ways indexers track their slices of the market, what may seem clear at a glance is often seething with complexities just under the surface. Here are some (not all!) of the ways various indexes are sliced and diced.

Which Weighting?

How much weight should an index give to each of its holdings? For example, in the S&P 500, should the returns delivered by Emerson Electric Company hold the same significance as those from Apple Inc.?

  • The Dow is price-weighted, giving each company more or less weight based on its higher or lower share price. As Mackintosh explained, “share prices are arbitrary, as they depend on how many shares are issued; some companies have very high prices, which give them more influence on the Dow, even though they may be less valuable overall.”
  • Market-cap weighting is the most common weighting used by the most familiar indexes around the globe. It factors in outstanding shares as well as current share price to give more weight to the bigger players and less to the smaller fry.
  • Some indexes are equal-weighted, giving each holding, large or small, equal importance in the final tally. For example, there’s an equal-weighted version of the S&P 500, in which each company is weighted at 0.2% of the index total, rebalanced quarterly.

There are many other variations on these themes. The point is, indexes using different weightings can reach significantly different conclusions about the performance of the same market slice.

Widely Inclusive or Highly Representative?

How many individual securities does an index need to track to correctly reflect its target market?

  • As we mentioned above, the Dow uses 30 securities to represent thousands of publicly traded U.S. stocks. A throw-back to simpler times, it’s unlikely you’ll see other popular indexes built on such modest samples. In its defense, the Dow favors stocks that are heavily and frequently traded, so prices are timely and real … at least for the 30 stocks it’s tracking.
  • At the other end of the spectrum, the Wilshire 5000 Total Market Index “contains all U.S.-headquartered equity securities with readily available price data.”
  • The S&P 500 falls somewhere in between, tracking around (not always precisely) 500 publicly traded U.S. securities.

Tracking a Narrow Slice or a Mixed Bag?

What makes up “a market,” anyway? Consider these possibilities:

  • If an index is tracking the U.S. market, should that include real estate companies too?
  • If its make-up tends to include a heavier allocation to, say, value versus growth stocks, how does that influence its relative results … and is it a deliberate or accidental tilt?
  • Is an index broadly covering diverse sectors (such as representative industries or regions) or is its focus intentionally concentrated?
  • If it’s tracking bonds, are they corporate and municipal bonds, or just one or the other?

The Use and Abuse of Indexing

How well do you really know what your index is up to? Remember, in Part I of this series, we described how every index is a model – imperfect by definition. How might each index’s inevitable idiosyncrasies be influencing the accuracy of its outcomes?

We’ve just touched on a few of the questions an indexer must address. Like the proverbial onion, many more layers could be peeled away and, the deeper you go, the finer the nuances become.

One practical conclusion is that some indexes are much easier to translate into investable index funds than others. In addition, some lend themselves better than others to a sound, evidence-based investment strategy. In fact, indexes often may not be the ideal solution for that higher goal to begin with. In our next and final segment, we’ll explore the strengths and weaknesses inherent to index investing.

[photo curtesy of Kiss My Buttercream]

An Index Overview (Part II)

May 9th, 2017 Posted by Financial Education, Investment Strategy, Investment Vehicles, Uncategorized 0 thoughts on “An Index Overview (Part II)”

Part II: A Few Points About Index Points

As we covered in our last piece, indexes have their uses. They can roughly gauge the mood of a market and its participants. If you’ve got an investment strategy that’s designed to capture that market, you can see how your strategy is doing in comparison … again, roughly. You can also invest in an index fund that tracks an index that tracks that market.

This may help explain why everyone seems to be forever watching, analyzing and talking about the most popular indexes and their every move. But you may still have questions about what they are and how they really work. For example, when the Dow Jones Industrial Average (the Dow) exceeded 20,000 points last January, what were those points even measuring?

An index’s total points represent a relative value for the market it is tracking, calculated by continually assessing that market’s “average” performance.

If that’s a little too technical for your tastes, think of it this way: Checking an index at any given time is like dipping your toe in the water to see how the ocean is doing. You may have good reasons to do that toe-check, but as with any approximation, be careful to not misinterpret what you’re measuring. Otherwise, you may succumb to misperceptions like: “The Dow is so high, it must be in for a fall. I’d better get out.”

With that in mind, when it comes to index points, we’d like to make a few points of our own.

Indexes Are Often Arbitrary

It helps to recognize how popular indexes become popular to begin with. In our free markets, competitive forces are free to introduce new and different structures, to see how they fly. In the same way that the markets “decided” that the iPhone would prevail over the Blackberry, popular appeal is effectively how the world accepts or rejects one index over another. Sometimes the best index wins and becomes an accepted reference. Sometimes not.

Measurements Vary

Different indexes can be structured very differently. That’s why the Dow recently topped 20,000, while the S&P 500 is hovering in the 2,000s, even though both are often used to gauge the same U.S. stock market. The Dow arrives at its overall average by adding up the price-weighted prices of the 30 securities it’s tracking and dividing the total by a proprietary “Dow divisor.” The S&P 500 also takes the sum of the approximately 500 securities it’s tracking … but weighted by market cap and divided by its own proprietary divisor.

With mysterious divisors, terms like “price-weighted” and “market cap,” and additional details we won’t go into here, this probably still doesn’t tell you exactly what index points are.

Think of index points as being like thermometer degrees. Most of us can’t explain exactly how a degree is calculated, but we know hot from cold. We also know that Fahrenheit and Celsius both tell us what the temperature is, in different ways.

Same thing with indexes. You can’t directly compare an S&P 500 point to a Dow point; it doesn’t compute. Moreover, neither index adjusts for inflation. So, while index values offer a relative sense of how “hot” or “cold” a market is feeling at the moment, they can’t necessarily tell you whether a market is too hot or too cold, or help you precisely predict when it’s time to buy or sell into or out of them. The “compared to what?” factor is missing from the equation. This brings us to our third point …

Models Are Approximate

There’s an important difference between hard sciences like thermodynamics and market measures like indexes. On a thermometer, a degree is a degree. With market indexes, those points are based on an approximation of actual market performance – in other words, on a model.

A model is a fake copy of reality, with some copies rendered considerably better than others. Here’s what Nobel Laureate Eugene Fama has said about them: “No model is ever strictly true. The real criterion should be: Do I know more about markets when I’m finished than I did when I started?”

Your Take-Home

According to Professor Fama’s description of a model, indexes have long served as handy proxies to help us explore what is going on in particular slices of our capital markets. But, they also can do damage to your investment experience if you misinterpret what they mean.

For now, remember this: An index’s popular appeal is the result of often-arbitrary group consensus that can reflect both rational reasoning and random behavioral bias. Structures vary, and accuracy is (at best) approximate. Even the most familiar indexes can contain some surprising structural secrets. In our next post, we’ll unlock some of them for you. Ask us a question at (203) 985-0448.

 

[photo curtesy of ACSM_1954]

 

An Index Overview

May 8th, 2017 Posted by Financial Education, Investment Strategy, Investment Vehicles 0 thoughts on “An Index Overview”

Part I: Indexes, Defined

Since nearly every media outlet on the planet reported the news, you probably already know that the Dow Jones Industrial Average Index topped 20,000 for the first time on January 25, 2017. But when a popular index like the Dow is on a tear, up or down, what does it really mean to you and your investments?

Great question. In this multi-part series, we’re going to cover some of the ins and outs of indexes and the index funds that track them.

What Is an Index?

Let’s set the stage with some definitions.

An index tracks the returns generated by a basket of securities that an indexer has put together to represent (“proxy”) a particular swath of the market.

Some of the familiar names among today’s index providers include the S&P Dow Jones, MSCI, FTSE Russell and Wilshire. It’s perhaps interesting to note that some of the current index providers started out as separate entities – such as the S&P and the Dow, and FTSE and Russell – only to consolidate over time. In any case, here are some of the world’s most familiar indexes (with “familiar” defined by where you’re at):

  • S&P 500, Nasdaq Composite, and Dow (U.S.)
  • S&P/TSX Composite Index (Canada)
  • FTSE 100 (U.K.)
  • MSCI EAFE (Europe, Australasia and the Far East)
  • Nikkei and TOPIX (Japan/Tokyo)
  • CSI 300 (China)
  • HSI (Hong Kong)
  • KOSPI (Korea)
  • ASX 200 (Australia)

…and so on

Why Do We Have Indexes?

Early on, indexes were designed to offer a rough idea of how a market segment and its underlying economy were faring. They also helped investors compare their own investment performance to that market. So, for example, if you had invested in a handful of U.S. stocks, how did your particular picks perform compared to an index meant to track the average returns of U.S. stocks? Had you “beat the market”?

Then, in 1976, Vanguard founder John Bogle launched the first publicly available mutual fund specifically designed to simply copy-cat an index. The thought was, instead of spending time, money and energy trying to outperform a market’s average, why not just earn the returns that market has to offer (reduced by relatively modest fund expenses)? The now familiar Vanguard 500 Index Fund was born … along with index fund investing in general.

There are some practical challenges that prevent an index from perfectly replicating the market it’s meant to represent. We’ll discuss these in future segments. But for now, the point is that indexes have served investors across the decades for two primary purposes:

  1. Benchmarking: A well-built index should provide an approximate benchmark against which to compare your own investment performance … if you ensure it’s a relatively fair, apples-to-apples comparison, and if you remain aware of some of the ways the comparison still may not be perfectly appropriate.
  2. Investing: Index funds that replicate indexes allow you to indirectly invest in the same holdings that an index contains, with the intent of earning what the index earns, net of fees.

Indexes Are NOT Predictive

There is also at least one way indexes should NOT be used, even though they often are:

Index milestones (such as “Dow 20,000”) do NOT foretell whether it’s a good or bad time to buy, hold or sell your own investments.

Indexes don’t tell us whether the markets they are tracking or the components they are using to do so are over- or underpriced, or otherwise ripe for buying or selling. Attempting to use current index values as a way to time your entry into or exit from a market does not, and should not replace understanding how to best reflect your unique investment goals and risk tolerances in an evidence-based investment strategy.

In fact, market-timing of any sort is expected to detract from your ability to build wealth as a long-term investor, which calls for two key disciplines:

  1. Building a cost-effective, globally diversified portfolio that exposes you to the expected returns you’d like to receive while minimizing the risks involved
  2. Sticking with that portfolio over the long run, regardless of arbitrary milestones that an index or other market measures may achieve along the way

As one commentator observed the day after the Dow first broke 20,000: “Sensationalism of events like these [Dow 20,000] has the ability to trigger our animal spirits or our worst fears if we don’t have a long-term investment plan to keep them in check.”

So first and foremost, have you got those personalized plans in place? Have you constructed a sensible investment portfolio you can adhere to over time to reflect your plans? If not, you may want to make that a top priority. Next, we’ll explore some of the mechanics that go into indexing, to help put them into the context of your greater investment management. Ask us a question at (203) 985-0448.

[photo curtesy of journeyman62 at flickr.com]

Building an Evidence-Based Plan — April 2017

April 27th, 2017 Posted by Investment Strategy, Uncategorized 0 thoughts on “Building an Evidence-Based Plan — April 2017”

Intro: THE FOUNDATION FOR A BETTER WAY TO INVEST    

“Control what you can control.” —David Butler, co-CEO, Dimensional Fund Advisors

By following the above five words from Butler, investors can help simplify their complex financial lives. Out of thousands of pages of scientific research, a cornerstone of evidence-based investing emerges: Control what you can control. Control the fees you pay and your trading costs. Control your tax efficiency and your asset allocation. Control how closely your emotions are tied to an up-and-down market. Bigger picture, you can take better control of your entire financial experience.

This article looks at foundational tenets of evidence-based investing, as practiced by OpenCircle, to give you confidence when you think of where you are and where you want to go.

DIVERSIFICATION

“Diversifying your wealth across a variety of market risks helps you remain on course and in the driver’s seat, even when the road ahead is uncertain.” —Manisha Thakor, director of wealth strategies for women, the BAM ALLIANCE

For an example of why we stress the importance of having an internationally diversified portfolio, just go back a few weeks. The first quarter of 2017 closed strongly for developed international and emerging markets (up 7.4 percent and 11.5 percent, respectively). This came when many investors had cooled on international stocks after they significantly underperformed U.S. markets from 2008-2016. But not so long ago (2002-2007), the MSCI World ex USA Index returned 128.7 percent compared with 42.5 percent for the S&P 500 Index. Diversifying your portfolio so it has exposure to both U.S. and global equity markets allows you to capture market upswings and withstand its downswings over the long haul.

Picture1

Click here or the image to see the up-and-down nature of various asset classes on a year-by-year basis from 1992-2016 as well as their 20-year annualized averages and the single best and worst years of these classes from 1997-2016.

All of this underscores the importance of being diversified and — the topic we’ll address next — being disciplined.

DISCIPLINE

“Inactivity strikes us as intelligent behavior.” Warren Buffett

Buffett is really smart and really good at making money. But he makes an important point when it comes to someone having the ability to outsmart the market. “Success in investing doesn’t correlate with IQ. Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people in trouble investing.”

Too many investors buy stocks during upswings when all feels good and sell during downward spirals when uneasiness seeps in. This lack of discipline can cause investors to be on the sidelines when markets rebound, causing missed opportunities. Click here or the image to see the cost to investors when they miss the best one, five, 15 and 25 days of market performance during a 45-year period.

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Patience and prudence are central to an evidence-based strategy. Stay true to your well-devised plan while rebalancing periodically. Doing so will keep your portfolio in line with your target allocations and will enable you to capitalize on buy-low/sell-high opportunities.

MANAGING RISK

“The makeup of your portfolio depends entirely on your unique ability and willingness and need to take risk.” Larry Swedroe

Swedroe, a prolific author and the director of research for the BAM ALLIANCE, says the ability to take risk is largely defined by the investment horizon, the stability of an investor’s income and the need for liquidity. Swedroe says the willingness to take risk can be succinctly summed up through the “stomach acid” test. Can you stick to your plan even when the market goes down for an extended period? This includes rebalancing — selling what has done relatively well or held its value and buying what has done worse. The need to take risk is determined by the rate of return that is needed for you to reach your financial goals.

Picture3Of course, the word unique is critical as well. The ability, willingness and need to take risk are highly personal decisions. They vary for each investor’s specific circumstances. However, you can view general guidelines for prudent asset allocation decisions by clicking here or the image.

FOLLOW THE EVIDENCE

“It’s just fun to do research, learn new stuff, and potentially have an impact on the way other people are thinking about the world.” Kenneth French, professor, Dartmouth College

No room for speculation, prognostication or hunches, the evidence-based world is rooted in decades of objective research on the long-term behavior of financial markets. We use that evidence to tilt portfolios toward the asset classes that have delivered the highest returns over the long haul and should continue to do so. Click here or the image to see the return profiles of distinct asset classes during the period of 1931-2016.

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This research leads to plans that keep costs low, minimize risk and implement tax-efficient strategies. The evidence results in portfolios that are diversified domestically and internationally. Those same portfolios use fixed income to dampen volatility and address the risk tolerance of each investor.

To learn more, please be in touch with us at OpenCircle, 203-985-0448.

2016 Year in Review

February 2nd, 2017 Posted by Economics, Investment Strategy 0 thoughts on “2016 Year in Review”

If you were with us this time last year, you may recall that the markets were in a much gloomier state amidst a panic-driven sell-off. The demoralizing numbers were reflected in the early days of 2016, as well as in Dimensional Fund Advisors’ 2015 Market Review, released about a year ago. At the time …

  • USA Today reported on “the worst four-day start to the year ever for the broad U.S. stock market.”
  • The Financial Times reported a global “climate of fear,” following the temporary trade halt in China’s stock market.
  • Plenty of other headlines were crying out that we’d best prepare for the worst. “This year is a wake-up call to think about lower returns for the next several years,” one such prognosticator fretted at year-end 2015.

Not so fast. That may be the biggest take-away from Dimensional’s newly released 2016 Market Review, which we now share with you. While annual 2015 and early-2016 performance had been marred by nearly universal negative-to-low returns (especially from small-cap and value stocks), 2016 annual returns were nearly as polar opposite to that experience as returns can get.

“Many investors may not have expected global stocks and bonds to deliver positive returns in such a tumultuous year,” Dimensional’s 2016 review concludes. To say the least!

We invite you to take a closer look at this latest review and let us know if we can discuss any of the questions or ideas it may generate for you. We’re particularly fond of this key message:

“This [market] turnaround story highlights the importance of diversifying across asset groups and regional markets, as well as staying disciplined despite uncertainty. Although not all asset classes had positive returns, a globally diversified, cap-weighted portfolio logged attractive returns in 2016.”

What message were we delivering this time last year? We were urging anyone who would listen to avoid turning scary market risks into permanent personal damage by selling in fearful reaction to the near-term news.

On the flip side – but for the same, evidence-based reasons – we now caution you against reading too much into, or piling too many of your investments into, the recent outperformers. For managing market highs and lows alike, we are guided by the following sensible advice expressed in Dimensional’s 2016 review by Nobel Laureate Eugene Fama, a founding board member for the firm:

“There’s no information in past returns of three to five years. That’s just noise. It really takes very long periods of time, and it takes a lot of stick-to-it-iveness. You have to really decide what your strategy is based on – long periods of returns – and then stick to it.”

Well said. Please let us know if we can say more, or we can otherwise assist you with your planning for 2017 and beyond. Give us a call anytime at 203-985-0448.

[Photo Credit: reynermedia on Flickr.com]

 

Structured CDs: Buyer Beware!

September 29th, 2016 Posted by Investment Strategy, Investment Vehicles, Investor Behavior 0 thoughts on “Structured CDs: Buyer Beware!”

Most investors are familiar with Certificates of Deposit (CDs). You purchase one, and the bank pays you a bit of interest on it, plus your principal back. They don’t yield much, but they’re nearly as dependable as it gets. As such, CDs can often serve as sensible tools for offsetting the risk inherent to pursuing higher expected returns in the stock market.

Wall Street’s product pushers, however, have figured out a way to swipe the name from this traditional household workhorse and turn it into a monster money-maker … for themselves, that is. We’re talking about “structured” or “market-linked” CDs. The name may seem familiar, but the rules of engagement are quite a bit different.

A recent Wall Street Journal article, “Wall Street Re-Engineers the CD – and Returns Suffer,” exposed the ways that big banks are peddling these products. It starts with a tempting pitch that goes something like this: As long as you hold the product to maturity, your principal is returned. If the stock market goes up (as defined by whatever market “basket” the providers happen to choose) you also receive a percentage of the increase.

At a glance, what’s not to like about this sort of “heads you win, tails you don’t lose” appeal? Unfortunately, there are usually plenty of traps lurking in the fine print. Positive returns are typically capped to single-digit annual percentages, while negative returns can plummet much more steeply before they’ll no longer impact your end returns. And the fees can run into multiple percentage points of the structured CD’s face value.

The WSJ article reports (emphasis ours): “The adviser who actually sells the [structured] CD, for example, can get commissions of up to 3% of the CD’s value, according to information sent to brokers reviewed by the Journal. ‘Banks have to be delighted with these structured products,’ said Steve Swidler, a finance professor at Auburn University. ‘There’s virtually no risk to them, and [the banks] sit back and rake in fees.’”

It may be easy to overlook the significance of these costs and imbalances, especially if you’ve decided that you’re okay with paying extra for the promise that you will not lose your nest egg. But in fulfilling their role as a safe investment, structured CDs can be more than a little skewed in favor of the big banks. From the WSJ article:

 

  • “[O]f the 118 structured CDs that were issued at least three years ago, only one-quarter posted returns better than those of an average five-year conventional CD. And roughly one-quarter produced no returns at all as of June 2016.”
  • “[M]arket-linked CDs issued since 2010 by Bank of the West … revealed a similar pattern. Sixty-two percent produced returns lower than an investor would have received from a five-year conventional CD, while almost a quarter have yet to pay any return at all.”

 

Given how many other far less complex and costly ways there are to expect similar results, why start with an uphill climb? The WSJ article noted how one investor, a 79-year-old widow, was shocked to see her $100,000 investment immediately drop to $95,712 after incurring upfront fees. The fees had been disclosed in the 266-page description that came with her purchase, but she hadn’t read it. Would you have?

“This was not a CD as I know a CD,” she complained.

Our preferred approach?

  • Insist on transparent costs and clear, understandable performance reports.
  • Be highly skeptical of one-off products that promise both higher returns and lower risks. There are almost always expensive tricks and traps lurking in the fine print.
  • Focus instead on investing according to a well-thought-out, customized plan that positions your total portfolio to reflect your long-term goals and risk tolerances.

These essential concepts may not be fancy or new-fangled, but unlike those allegedly higher returns that a structured or market-based CD is supposed to deliver, they’re far more likely to see you through to your own end goals.

Questions? We would welcome your call at 203-985-0448.

 

Presidents, Politics, and Your Portfolio: Thinking Beyond Stage One

August 31st, 2016 Posted by Investment Strategy, Investor Behavior, Politics 0 thoughts on “Presidents, Politics, and Your Portfolio: Thinking Beyond Stage One”

It’s no surprise that this year’s U.S. presidential race has become a subject of conversation around the globe. In “Why Our Social Feeds are Full of Politics,” Canadian digital marketing executive Tara Hunt observes, “American politics, it seems, makes for high-intensity emotions far and wide.” The intensity will probably only increase as the November 8 election date nears.

We are by no means endorsing that you ignore what is going on in the world around you. Politics and politicians regularly and directly affect many aspects of our lives and our pocketbooks. But as you think through this year’s raucous race, remember this:

The more heated the politics, the more important it is to establish and maintain a well-planned, long-term approach to managing your investments.

So go ahead and talk politics all you please – and if you are an American, be sure to vote. But when it comes to your investments, it’s best to ignore any intense emotions and the dire or ebullient predictions that spring from them, as dangerous distractions to your financial resolve.

Thinking in Stages

Have you ever heard of stage-one and stage-two thinking? They’re terms popularized by economist Thomas Sowell in his book, “Applied Economics: Thinking Beyond Stage One.” Basically, before acting on an event’s initial (stage one) anticipated results, it’s best to engage in stage-two thinking, by first asking a very simple question:

“And then what will happen?”

By asking this question again and again, you can more objectively consider what Sowell refers to as the “long-run repercussions to decisions and policies.”

Investing in Stages

In investing, we see stage-one thinking in action whenever undisciplined dollars are flooding into hot holdings or fleeing immediately risky business. Stage-two thinking reminds us how often the relationship between an event and the world’s response to that event is anybody’s guess and nobody’s certain bet. A recent Investopedia article, “Does Rainfall in Ethiopia Impact the U.S. Market?” reminds us how market pricing works:

“No one knows how any of these events will impact markets. No one. That includes financial advisors who have access to complex computer models and investment strategists in the home office with cool British accents. They don’t know, but their livelihood depends upon appearing to know. Few of them are ever held accountable for the innumerable predictions they got wrong. They simply move on to the next prediction, the next tactical move.”

Investors should avoid trying to predict future market pricing based on current market news.

Reflections on Presidential Elections

Stage-two thinking is especially handy when considering the proliferation of predictions for anything from financial ruin to unprecedented prosperity, depending on who will next occupy the Oval Office.

Again, the problem with the vast majority of these predictions is that they represent stage-one thinking. As financial author Larry Swedroe describes in a US News & World Report piece, “Stage one thinking occurs when something bad happens, you catastrophize and assume things will continue to get worse. … Stage two thinking can help you move beyond catastrophizing. … [so you can] consider why everything may not be as bad as it seems. Think about previous similar circumstances to disprove your catastrophic fears.”

In the current presidential race, we’re seeing prime examples of stage-one thinking by certain pundits who are recommending that investors exit the market, and sit on huge piles of cash until the voting results are in. At least one speculator has suggested that investors should move as much as 50 percent of their portfolio to cash!

And then what will happen?

Here are some stage-two thoughts to bear in mind:

  • Regardless of the outcome of the election, there’s no telling whether the markets will move up, down or stay the same in response. By the time they do make their move, the good/bad news will already be priced in, too late to profit from or avoid.
  • In the long run, the market has moved more upward, more often than it moves downward, and it often does so dramatically and when you least expect it.
  • Moving to cash would generate trading costs and potentially enormous tax bills. Worse, it would run contrary to having a sensible plan, optimized to capture the market’s unpredictable returns when they occur, while minimizing the costs and manageable risks involved.

In this or any election, stage-two thinking should help you recognize the folly of trying to tie your investment hopes, dreams, fears and trading decisions to one or another candidate. Politics matter – a lot – but not when it comes to second-guessing your well-planned portfolio. If you still have questions, please give us a call at 203-985-0448.

OpenCircle’s Fixed Income Methodology

August 24th, 2016 Posted by Investment Strategy, Retirement Planning, Saving 0 thoughts on “OpenCircle’s Fixed Income Methodology”

For a deeper understanding of how we approach fixed-income investments based on academic evidence, this analysis will help. Learn how we balance credit risk, interest rate risk, and reinvestment risk. To discuss further, please call us at 203-985-0448.

The Role of Fixed Income

OpenCircle’s fixed income philosophy starts with the premise that most portfolios contain elements of equities in addition to fixed income. Both asset classes have their specific roles to play: equity for capital appreciation and fixed income as a portfolio stabilizer and a diversifier of portfolio risk. It is important for both asset classes to maintain their clearly defined roles throughout the life of the portfolio. For fixed income, this means ensuring the fixed income portfolio is not stretched in search of additional yield by assuming imprudent risks. Purchasing low-credit-quality bonds or bonds in risky market sectors are strategies that fall into the risk-stretching category.

 

 

Academic Evidence

There are three primary risks within the fixed income markets: 1) credit risk, 2) interest rate risk and 3) reinvestment risk. We will discuss in detail these risks and how our approach to fixed income can combat them.

Credit Risk

Credit risk is the risk that a fixed income security will not pay all principal and interest. Arguably, any security that is not a Treasury bond (or a bond issued by another highly rated government entity) has some measure of default risk. The primary way to assess the reward of bearing credit risk is to look at the credit premium, which is measured by comparing the returns between investment-grade corporate bonds and their Treasury counterparts. One difficultly with measuring the credit premium is that high-quality data only goes back to the late 1980s, unlike most other market data that can be traced to the 1920s. Despite this relatively short period of data, we can still draw some interesting conclusions.

From 1989–2015, the investment-grade credit premium averaged only 0.43 percent per year, with volatility around 6.6 percent and a Sharpe Ratio (a measure of risk-adjusted returns) of only 0.07.

This last figure compares rather unfavorably to the Sharpe Ratio of 0.40 for the equity risk premium (stocks – bonds) over that same time period, making the equity markets much more advantageous from a risk/return perspective. Lastly, the investment-grade credit premium has a positive correlation to the equity markets, meaning they both tend to underperform or outperform at the same time. This makes investment-grade corporate bonds less effective as a portfolio diversifier.

Investment-grade bonds are only half of the credit spectrum in the fixed income markets. To properly evaluate the full credit spectrum, the high-yield credit premium must also be measured. From 1989–2015, the high-yield credit premium averaged 2.9 percent per year. While this premium looks enticing on the surface, it comes at a price in the form of much greater volatility of 16.3 percent. Factoring in the increased volatility, the Sharpe Ratio for the high-yield credit premium drops to only 0.18, which is still well below the equity risk premium of 0.40. More alarming, the high-yield credit premium is the correlation to the equity markets, which is very high at 0.61.

Due to their low Sharpe Ratios and high correlations to equities, we avoid both investment-grade and high-yield corporate bonds.

Interest Rate Risk

This is the risk that a fixed income investment’s value will change due to a change in the level of interest rates. Longer-term bonds are more sensitive to interest rate risk than their shorter-term counterparts. Longer-term bonds do carry higher yields to compensate investors for accepting more interest rate risk. The question then becomes how far out should an investor go on the yield curve to get the proper balance between yield and interest rate risk?

The first thing we want to look at is the term premium, which examines whether interest rate risk has been rewarded. Traditionally, the term premium has been measured as the difference in returns between short-term Treasury bills and the five-year Treasury note. From 1927–2015, the term premium averaged 1.9 percent with a Sharpe Ratio of 0.37. The risk-adjusted return of 0.37 compares very favorably to the equity risk premium of 0.40 over that same time period, indicating that extending to the intermediate portion of the curve is an attractive option. Another important piece of data to note is that the term premium has zero correlation to the equity premium, making it an ideal diversifier.

Much like the credit premium, we also need to look at the full yield curve and examine term premium for the long-maturity portion of the curve. This is best examined by comparing the returns on long-term Treasury bonds and the five-year Treasury note. Over that same 1927–2015 period, the longer-term premium was only 0.7 percent, which is well below the 1.9 percent premium for the intermediate portion of the curve. The risk adjusted returns as measured by the Sharpe Ratio are also significantly less at 0.12 versus 0.37 for the intermediate-term premium. This data clearly shows that extending to longer-maturity securities has not been rewarded historically.

Based on this evidence, we invest in short- to intermediate-term bond portfolios in an attempt to capture the term premium. We avoid long-term bonds and their lower risk-adjusted returns.

Reinvestment Risk

This is the risk that future interest and principal payments, when received and reinvested, will earn less than the prevailing market interest rate. Traditionally, bonds with long maturities will have less reinvestment risk because they lock in the rate of interest earned on principal for a longer period of time.

Our Fixed Income Philosophy

The next logical question: How do we most effectively balance these risks associated with fixed income? The most effective way to combat these risks is through the use of a well-constructed bond ladder. A bond ladder is a portfolio of fixed income securities with equal weights that come due in varying maturities. For example, if a client had $1 million to invest in fixed income and wanted to create a 1–10-year bond ladder, he or she would purchase bonds in $100,000 increments in each year from 1–10 years.

A bond ladder is such an effective tool because it is able to strike a balance between both reinvestment and interest rate risk while also helping mitigate credit risk. Credit risk is the easiest of the three risks to hedge because it is the most straightforward. This risk can easily and effectively be reduced in a portfolio by limiting fixed income purchases to only high-quality bonds.

Reinvestment risk and interest rate risk are much harder to hedge as they compete with each other. For example, the most effective way to reduce interest rate risk is to buy only short maturities in the portfolio. Unfortunately, this strategy greatly increases reinvestment risk because principal and interest will need to be reinvested often. On the opposite end of the spectrum, purchasing longer-term bonds would be the most effective solution to fully hedge against reinvestment risk because that would lock in the yield on the portfolio for a greater period of time. The downside is these long-term maturities would increase the interest rate risk in the portfolio. A bond ladder balances these risks. The short-term maturities help protect the portfolio against interest rate risk while the intermediate-term maturities help reduce reinvestment risk. The ladder strikes a balance between these two risks by lowering the overall volatility of the portfolio while diversifying equity risk.

Although not a portfolio risk, per se, asset location is another important consideration when investing in the fixed income markets. Asset location is the process of determining what asset classes to place in tax-advantages accounts (Roth IRAs, IRAs and other retirement plan accounts) versus taxable accounts (joint accounts, individual accounts, etc.). The logic here is simple: If possible, strategies with high effective tax rates should be sheltered in tax-advantaged accounts. Fixed income fits this definition because the bulk of the return is generated from coupon interest, which is taxable at a client’s marginal tax bracket. Because of this, fixed income is sheltered in tax-advantaged accounts as much as possible.

Constructing Fixed Income Ladders

Now, let’s discuss how bond ladders are constructed. To deliver the best after-tax returns, we build customized fixed income ladders with targeted durations between three and five years using the most optimal mix of taxable, tax-exempt and inflation-protected securities. The duration and mix of securities is all predicated on the asset location and tax status of each individual client as no two portfolios are constructed the same.

Distinguishing Features

A pure, academically based philosophy relying on peer-reviewed literature:

  • Optimize risk-adjusted rates of returns.
  • Do not incur expenses attempting to “beat the market” by forecasting interest rate movements or selecting mispriced securities.
  • Minimize costs by reducing price markups and avoiding costly infrastructure expenses of an active portfolio management approach.
  • Maximize after-tax returns by strategically locating tax-efficient assets in taxable accounts and tax-inefficient assets in tax-advantaged accounts and tax-loss harvesting year-round.

True customization based on a client’s individual circumstances:

  • A thorough discovery process uncovers a client’s needs and objectives, including financial objectives, risk tolerances, current and future income needs, tax status, health status, gifting requirements, and philanthropic desires.
  • Create a written fixed income investment plan tailored to each investor.
  • A comprehensive approach considers assets across all investable accounts.

Diversified instrument implementation:

  • Employ both taxable and tax-exempt securities to provide the best after-tax yield.
  • Use TIPS to hedge against unexpected higher inflation.
  • Use both individual securities as well as bond funds when appropriate.

Portfolio maintenance:

  • Screen portfolios daily for any changes in credit quality.
  • Monitor portfolios weekly for upcoming maturities and redemptions.
  • Monitor portfolios for 18 other material events that could affect credit quality.

 

Parenting Your Wealth in Uncertain Markets

August 18th, 2016 Posted by Investment Strategy, Investment Vehicles, Investor Behavior 0 thoughts on “Parenting Your Wealth in Uncertain Markets”

In the face of political drama at home and abroad, it’s certainly been a summer for trying our patience, hasn’t it? For anyone who has ever been a parent or a child – that is, for everyone – there are several comparisons we can draw between good parenting and good wealth management. For both, plenty of patience is one of the most important qualities to embrace.

Patience Is Your Greatest Strength

As an investor, you probably have plenty of “those days” when you wonder whether your money is ever going to grow up. It doesn’t do as you hoped for. It misbehaves. It runs with the wrong crowd. It ignores your best efforts to protect it from harm.

But then there are those other days. Suddenly, your money hits a growth spurt, exceeding all expectations! It’s then that you realize that many of the greatest challenges you and your investments faced along the way are the same ones that are contributing to its strength and shaping its character over time.

In the Markets, “Unusual” Is Business as Usual

As much as we would prefer our wealth to mature in a calm, orderly way, there is solid evidence to demonstrate that returns are far more likely to occur in these sorts of anxiety-generating fits and starts.

For example, you may recall that January 2016 was an unsettling time in the market, with particularly petulant returns. Some pundits blamed China and oil and what-not. Especially in retrospect, there was no incredibly obvious reason; it was just in one of those moods.

On the flip side, in the wake of the June 23 Brexit referendum, when we might have expected the market to remain in a funk for a while, it took a dive but then mostly continued upward, especially in the U.S., where stock market indexes experienced a number of record highs in July.

During the January doldrums, Vanguard published an overview of how common it is for markets to lurch into correction territory or lower, despite their overall upwardly mobile track record. Vanguard observed, “Since 1928, the Standard & Poor’s 500 Index has spent 40% of the roughly 88-year span in some sort of setback – a correction or bear market. Over that same period, however, the index has produced an average annualized return of about 10%.”

Vanguard concluded: “A review of corrections and bear markets suggests that patience and discipline are the best responses to market turmoil.” Our point exactly.

No Favorite Child

That’s not to say that you should plan for 10% annual returns in your financial future. Most investors are wise to offset the heated risks involved in pursuing higher expected returns with an appropriate helping of “cooler” holdings. We also suggest employing global diversification to manage the market risks that you do take on. Spreading your risks among multiple kinds of holdings around the world can be compared to raising several children, without choosing a favorite. Each is expected to contribute in its own special way.

The Importance of Being There

What parents don’t have days when they wish they could bypass some of the drama and skip straight to the good stuff? And yet we know that child-rearing requires us to be there for our offspring 24×7, through thick and thin, on good days and bad.

We also know that, even though we give it our all, there are no guarantees. The most you can do is the best that you can – day in, day out – with the most accurate information you can find. If patience is your greatest virtue, consistence and persistence are your power tools to maximize it.

So it should be with investing, where you should avoid the temptation to jump in and out of uncertain markets. We know they are going to often misbehave and sometimes disappoint. We even know that they may never deliver as hoped for. But once you have done everything you can to position your portfolio for the outcome you have in mind, you’ve also done everything you can to stack the odds of success in your favor. The rest is where that patience comes in.

The Power of Patience

Consider the article by Chicago Tribune financial columnist Jill Schlesinger, “Time in the market – not market timing – is the secret to investment success.” In it, Schlesinger shares stock market research dating back to 1927, finding that “for those who invest for a single day, the chance of losing money is 46 percent, but for those who invest with a 10-year investment horizon the chance of success improves dramatically – to 87 percent.”

The Wall Street Journal personal financial columnist Jason Zweig offers us a visual of the same phenomenon in his article, “Volatility: In the Eye of the Beholder.” There, he considers a year’s worth of S&P 500 returns:

“Viewed daily over the 12 months that ended March 31 [2016], the S&P 500’s moves look superficially like the EKG of someone having a heart attack. Viewed quarterly, they resemble a shruggie emoticon without the smirk. And seen over the full sweep of the last 12 months, the market’s moves look like a whole lot of nothing happening in slow motion.”

Zweig describes how time has a way of smoothing out the best and worst days, and tilting the odds in our favor. As a bonus, a patient investment strategy also tends to minimize trading activities, and the costs involved, which can further contribute to your end returns.

By thinking of your wealth from this perspective, it might help you take a deep breath and carry on as this year’s politics unfold – or whenever you face difficult decisions on how to best care for your precious holdings. By sticking with a disciplined plan, day in and day out, you stand the best odds for raising wealth that you’ll be proud to call your own in the end.