Posts in Investment Vehicles

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Compared to actively managed funds that seek to “beat” the market by engaging in these now-outdated speculative strategies, passively managed index funds offer a more solid solution for sensibly capturing available market returns.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]

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.

 

What If Everyone Were an Evidence-Based Investor?

September 16th, 2016 Posted by Investment Vehicles, Investor Behavior 0 thoughts on “What If Everyone Were an Evidence-Based Investor?”

For as long as we’ve been in business, we have encouraged investors to adopt a patient, long-term approach to capturing the market’s expected returns. In industry parlance, some have categorized our approach as “passive,” versus active attempts to beat the market. We prefer to think of ourselves as evidence-based.

Call it what you will, a frequently asked question remains.

What if everyone were a passive investor? Wouldn’t the markets collapse?

The question has resurfaced in a recent AllianceBernstein client note entitled “The Silent Road to Serfdom: Why Passive Investing is Worse Than Marxism.” Its authors reportedly proposed that a “supposedly capitalist economy where the only investment is passive is worse than either a centrally planned economy or an economy with active market led capital management.”

If every investor embraced evidence-based investing, it is true that markets as we know them would cease to exist. But does that put passive investing on level with Marxism, or worse?

Is passive investing “unfair” or bad for the economy?

In “Indexing Is Capitalism at Its Best,” AQR Capital Management’s Cliff Asness counteracts the presumption that passive investing is an enemy to free market economies: “[T]he use of price signals by those who played no role in setting them may be capitalism’s most important feature. … That most of us and most of our dollars don’t have to pick stocks, or to price air conditioners, is a great benefit and taking advantage of it makes us honest smart capitalists, not commissars.”

In other words, we arrive at relatively efficient “supply and demand” pricing in our capital markets the same way we do in any other market around the world. Whether it’s for stocks or socks, donuts or dollars, all it should take is a handful of active, engaged players to create relatively fair pricing that interested buyers and sellers can agree to.

It’s also interesting to note that the players who object the most to allegedly free-loading passive investors are usually the same ones whose profits are being squeezed down by the market forces at work when passive investors avoid hyperactive trading costs.

In his review of the note, Morningstar’s John Rekenthaler observed: “Whenever active investment managers write about indexing, the suspicion arises that they arrived at the conclusion first, then searched for their reasons later. This AllianceBernstein paper does nothing to change that view.”

How many active investors does it take to keep the markets chugging along?

There is no definitive answer on how many active investors are required to set reasonable trading prices. In his ETF.com column, financial author Larry Swedroe explains that passive investors “receive all the benefits from the role that active managers play in making the financial markets efficient without having to pay their costs. In other words, while the prudent strategy is to be a passive investor, you don’t want everyone to draw that conclusion.”

Swedroe suggests that “at least 90% of the active management industry could disappear and the markets would remain highly efficient.” Vanguard founder John Bogle (who launched the world’s first public index fund) also has estimated that a 90% passive market should be sustainable. Burton Malkiel, author of the classic, “A Random Walk Down Wall Street,” has set the number even higher. “[W]hen indexing is 95 percent of the total, I might start to worry about that,” he says. “But I think with indexing [at] 30 to 35 percent of the total, there is [sic] still plenty of active managers out there to make sure that information gets reflected quickly. And in fact I think it’ll always be the case.”

How plausible is it that we’ll reach a breaking point, with too many passive investors?

Malkiel’s comments bring up another good point. Let’s say we’re wrong. What if, to remain relatively efficient, the markets need a lot more active players than we’re suggesting?

We’re still not worried about it.

Echoing Malkiel’s estimates, Swedroe observes of the U.S. markets: “Despite their growing share of the market (passive funds now control perhaps one-third of all assets under management), they still account for only a small percentage of trading activity. According to a Vanguard spokesman, on a typical day, only 5–10% of total trading volume comes from index funds.”

In other words, there are still plenty of active trades taking place for effective pricing, and there is good reason to believe that this necessary level of price-setting will persist indefinitely.

Behavioral finance is alive and well. The study of behavioral finance informs us that investors are, after all, only human, and are often driven by chemically generated instincts and emotions that have nothing to do with solid evidence and rational decisions. We see examples of this every time investors chase the latest trend or flee real or perceived risk en masse. Behavioral traits such as herd mentality, recency, and tracking-error regret take over, and are reflected in the market’s prices. This is not passive investing; it’s active. And it appears to have remained highly pervasive, among individual and institutional investors alike.

Capitalism is also alive and well. In their purest sense, “active” and “passive” investing represent opposite extremes on a vast spectrum of possibilities. A wholly passive investor would simply buy and hold the entire market and accept its returns. A fully active investor would always seek to trade profitably by forecasting future prices.

In reality, most investors are neither fully passive nor fully active. They are often more one or more the other, especially when we consider global markets. This means we should expect price-setting participants to remain a substantial force in the markets … regardless of what we call them, and which label may be more prevalent.

As Malkiel observes: “That’s the wonderful thing about capitalism. If you have free markets and somebody can jump into the markets if there is an opportunity, you can count on the fact that somebody will. … If in fact it was the case that markets were getting less and less efficient in reflecting information, believe me, there would be a profit motive for somebody to jump in.”

Evidence-Based Investing in Capital Markets

Where does that leave an evidence-based investor? To help us chart a sensible course in an environment where even our own instincts can steer us wrong, we turn to the best evidence we can find on how to effectively manage our money in markets that mostly set fair prices.

Practically speaking, that evidence informs us that generating long-term returns calls for a patient approach, focused on managing the market risks involved, minimizing unnecessary costs, and avoiding the many behavioral traps that otherwise lead investors astray.

If we can serve you by helping you invest according to these and similar principles – if we can serve your highest interests and personal financial goals – we believe you can expect that the capital markets will continue to serve you well, as well. If you have any questions, please give us a call at 203-985-0448.

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.

 

Reflections on Real Estate Investing

August 4th, 2016 Posted by Asset Allocation, Foreign Investing, Homes and Mortgages, Investment Strategy, Investment Vehicles, Investor Behavior, Loans and Debt 0 thoughts on “Reflections on Real Estate Investing”

Just as the natural world around us comes from the elements found in the periodic table of elements, capital markets are made up of asset classes, broadly organized into stocks, bonds, and hard assets like commodities and real estate.

As elemental as asset classes are to investing, it may make sense to include some real estate investments in your globally diversified portfolio. That said, as with any investment, there are better and worse ways to go about implementing an otherwise sound strategy … with a lot of misleading misinformation out there to add to the confusion.

If you intend to invest in the market’s risks and potential rewards with informed discipline rather than as a speculative venture, most of the same principles apply, whether it’s for real estate or any other asset class. To help you avoid hanging out with the wrong elements (so to speak), let’s review those essential guides.

Seek Global Diversification

As with stocks, it’s wise to spread your real estate risks around by diversifying the number and types of holdings you own. By diversifying your holdings across a number of investments and a mixture of property types, you are best positioned to earn the returns that the asset class is expected to deliver, without being blindsided by holding-specific risks such as property damage, deadbeat tenants or unscrupulous property managers.

One way to achieve diversification is through a well-managed, low-cost Real Estate Investment Trust (REIT) fund, or a “fund of funds” combination of multiple REIT funds. As one REIT fund prospectus describes, this enables you to own hundreds of properties across a diversified range of domestic and global companies “whose principal activities include ownership, management, development, construction, or sale of residential, commercial or industrial real estate.”

Understand the Risks and Expected Rewards

Why bother with real estate? The magic word is “correlation.” As Forbes contributor Frank Armstrong III wrote in 2013, “It’s really nice in times of volatile markets like now to have an asset class that may zig when traditional stocks and bonds zag. An asset with low correlation to others in your holdings can both reduce risk at the portfolio level and increase returns.”

In his July 2016 column, “The best performing asset class no one talks about,” Reformed Broker Josh Brown observes that, “Going back to the year 2000, REITs are the best performing asset class in the market, according to JP Morgan, up 12% on an average annual basis. … [I]t’s weird that people generally don’t focus on them.”

So, real estate can serve as a stabilizing force and a source of returns in your portfolio. But, like any investment, potential rewards are accompanied by notable risks.

  • Taxes – Real estate investing tends to be relatively tax-in Domestic and international tax codes vary and change, with different treatments required for different kinds of real estate investments. Due to potentially unfavorable tax treatments on distributions, they are best located in your tax-sheltered accounts, lest the taxes incurred exceed the benefits.
  • Liquidity – Unlike publicly traded stocks, which can usually be traded with relative ease in busy markets, real estate ventures can be relatively illiquid investments that don’t always lend themselves to being bought and sold on a dime. This can be tricky for an individual investor purchasing them directly. It also can impact a fund investor. If the fund manager is forced to place ill-timed trades to meet popular demand, the trades can be costly for all shareholders.
  • Volatility – Although an allocation to real estate can contribute to decreased volatility in your overall portfolio, the asset class itself typically exhibits a wide range of performance along the way. Some providers may try to mask this reality by playing fast and loose with their reporting strategies, but you really should expect a relatively bumpy course with your real estate holdings, whether or not it’s being reported to you as such.

Investors discovered these risks in 2007–2009 when a U.S. and U.K. housing market collapse generated a global credit crisis. Investors had been treating any and all real estate prices as sure bets, despite the underlying risks involved. We’re seeing these risks play out again in the U.K.: Due to heavy sell-offs, investors in Open Ended Property funds are discovering that the return “smoothing” they thought they were enjoying may have been built on a house of cards. As one columnist observed: “Just because risk is not immediately visible, does not mean it isn’t there.”

Select an Appropriate Allocation – for You

In light of its potential returns and known risks, evidence-based investment strategy suggests that stocks and bonds are typically the staples in most investors’ portfolios, with real estate acting more as a flavor-enhancing ingredient.

Beyond this general rule of thumb, your personal circumstances also may influence the allocation that makes sense for you. For example, if you are a real estate broker, or you own a rental property or two as a side business, you may want to hold less real estate in your investment portfolio, to offset the real estate risks that you’re already exposed to elsewhere.

Incidentally, we suggest you avoid treating your home as a real estate investment. If it happens to appreciate over the years, that’s great. But don’t forget that its highest purpose is to provide you and your family with a dependable roof over your heads. This is one of several reasons your home is best thought of as a consumable expense rather than a reliable source of investment returns. At the very least, you do not want to over-expose your home to the risk of loss.

Manage the Costs

As always, the less you spend on your investments, the more returns you get to keep. Given that there are well-managed REIT funds that offer relatively cost-effective and efficient exposure to the asset class being targeted … why would you choose a more complicated alternative where the costs may be both insidious and excessive?

Adopt a Long-Term Perspective

While it can often make sense to include real estate in your globally diversified portfolio, the advantages are accompanied by portfolio performance that may often deviate from “the norm.” That’s by design, to help you achieve your own financial goals, not some arbitrary norm. Given these practical realities, it’s essential to embrace a patient, long-term approach to participating in real estate’s risks and expected returns. If your time horizon or risk tolerance isn’t in line with such an approach, you may be better off without the allocation to begin with.

Use Investment Vehicles That Best Complement All of the Above

If an allocation to real estate makes sense for you and your financial goals, the final ingredient to successful application is to select a fund manager whose strategies align with yours. Look for a fund that clearly discloses the investments held, the approach taken, the risks realized, and the costs incurred. Consider a provider who scores well on all of these counts; offers diversified exposure to domestic and global markets; and appeals to disciplined investors like yourself, who are less likely to panic and force unnecessary trading during times of stress.

Also, note that you may already be invested in real estate without knowing it. It’s not uncommon for a stock or hybrid fund to include a shifting allocation to real estate. Unless you read the fine print in the prospectus, it’s hard to know just what you hold, in what amounts.

Ask for Help

Is real estate investing right for you? If it is, how much should you invest in, which holdings make sense for you, which account(s) should hold which assets, and how can you maintain control over your target allocations? These are the kinds of questions we cover when helping investors with their real estate investments, embracing each family’s highest interests as our personalized guide. Please be in touch at 203-985-0448 if we can help you with the same.

[Photo Credit: Flickr user thinkpanama]

Learning to Ignore Short-Term Fund Performance Relative to Indexes

July 28th, 2016 Posted by Economics, Investment Strategy, Investment Vehicles, Investor Behavior 0 thoughts on “Learning to Ignore Short-Term Fund Performance Relative to Indexes”

July 2016

Our clients generally understand that focusing on the short-term performance of a fund relative to another fund or an index is a waste of time. These differences rarely tell you anything important about long-term performance and, in fact, can lead to counterproductive behavior if you are prone to selling funds that underperform to move into funds that have outperformed. These performance differences, after all, tend to reverse more often than not. We call this “returns-chasing behavior” and it is one of the surest paths to poor long-term performance. Jared Kizer, OpenCircle’s chief investment officer through the BAM ALLIANCE, frequently receives questions about performance differences — from clients and advisors alike. He shares his insights below.

I have spent years thinking about this issue and analyzing hundreds of performance cases and performance attribution analyses. I find that there are two areas that drive a lot of these questions, and I hope to clarify both:

  • What do you mean by “short term”?
  • How big can performance differences be over short-term periods of time?

Before digging in, let’s talk about the structure of the funds we use in client portfolios relative to index funds.

Evidence-Based Funds Vs. Index Funds

The funds we use are rarely index funds, meaning by definition they will not precisely track well-known indexes. In fact, most of the funds we use have significantly different compositions from the indexes they are most frequently compared to. This is not an accident. We purposefully use funds that do not explicitly track indexes.

Going into all the details behind this is beyond the scope of this piece. In short, we want to maximize the benefits of indexing — low costs, generally low turnover of holdings, broad diversification and tax efficiency — and minimize the negatives. As great as index funds are, published research has shown they can have negatives. For example, some indexes rebalance in a way where other managers know the stocks (or bonds) that are likely to enter and leave the index on the rebalancing date. This degree of transparency can allow these managers to take advantage of index funds, which reduces long-term performance. This effect is most frequently documented in Russell’s indexes and some of the larger indexes like the S&P 500. Indexes also frequently do not target specific styles like size, value and momentum in ways we think make the most sense given what academic research shows.

Evidence-based funds can alleviate these problems, but that does not guarantee these funds will always outperform an index strategy or outperform similarly constructed evidence-based funds. In fact, they can underperform for long periods of time without offering an indication that the fund is designed poorly or managed poorly. Investors in these funds must remain disciplined during these periods to realize the expected benefits.

What Is “Short Term” and How Big Can Differences Be?

Investors are not always happy with my answer to the time horizon question. In truth, anything is possible for periods of less than five years — and by no means does even five years guarantee the expected result. I want to illustrate this point using performance comparisons over months, quarters and years. In the first figure on the next page, I take the month-by-month differences in return between the stock funds that compose our Risk Target 3 model and the indexes they are most frequently compared to. I then find the pair with the largest amount of underperformance (meaning underperformance of the fund relative to the index) for that particular month and plot that result over time. My analysis starts in October 2005 since that was the first full quarter where five of the seven stock funds in our Risk Target 3 strategy had live returns data. 

Figure 1: Differences in Monthly Performance

This analysis shows that in virtually every month at least one of the funds in our model portfolio has underperformed the index by 1 percent or more. In fact, there are multiple months where one of the funds underperformed the index by 2 percent or more. We also see that there are very few months where all the funds outperform their indexes. Let’s now move to quarterly returns.

Figure 2: Differences in Quarterly Performance

Here we see that the differences generally get larger, not smaller. There are now a decent number of periods where at least one of the funds underperformed the index by 4 percent or more. Keep in mind, this same concept holds true if we were comparing a particular fund to another fund (e.g., comparing DFA Small Value to DFA Targeted Value). We now move to annual returns.

Figure 3: Differences in Annual Performance

The first full year of annual returns data is 2006. While we have limited data to analyze, we generally see again that the differences get larger, not smaller. In fact, in 2008 one of the funds we use underperformed the index by about 13 percent. That does not mean the fund is bad and should be replaced. This is just the nature of shorter-term performance comparisons. We also now see that at least one fund underperformed its index over the full year in every period.

So, this analysis tells us that in periods going out to one year we can expect to see that some funds have underperformed their index by 4 percent or more. It also tells us there will be periods where a fund underperforms its index by even more. We expect and know this will happen with the funds we use.

If this degree of underperformance continues over even longer periods, our Investment Policy Committee has processes to evaluate results and determine whether anything is materially wrong with the fund’s strategy. Most frequently, we find that even longer periods of performance are completely explainable and not a reason to replace the fund. For example, for periods ending in 2015, many of the funds we use had underperformed indexes over longer periods of time because value stocks had done poorly relative to growth stocks. Many of our funds are deeply tilted toward value stocks when compared with indexes, so this was the main explanatory factor behind the performance result. In these cases, the funds did exactly what they were intended to do. It just happened to be a bad period for value stocks.

In summary, acting on short-term performance results is usually detrimental to long-term performance. By the nature of financial markets, the funds we use will periodically underperform indexes and other funds over longer periods of time. The key to seeing the expected benefits — as with many areas of evidence-based investing — is realizing this, not reacting to it, and having the discipline to stick with your strategy and the funds within it over the very long-term.

Survivorship Bias and Other Tricks of the Trade

July 21st, 2016 Posted by Economics, Investment Strategy, Investment Vehicles, Investor Behavior, Stock Options 0 thoughts on “Survivorship Bias and Other Tricks of the Trade”

One of the reasons we turn to evidence-based investing is to guide us past the misguided strategies that can otherwise cause an investor’s expected returns to run aground. That said, there is a lot of “evidence” out there. How do we determine which of it comes from sound science and which may steer you wrong?

Survivorship bias is one trick of the trade we must watch for when accepting or rejecting a performance analysis.

What Is Survivorship Bias?

Only the strong survive. This is a familiar adage because it’s often true – especially in our financial markets. That’s why it is important to remember the expression whenever we want to accurately assess a sample of past returns. Examples of a “sample” might be the returns from all actively managed U.S. stock funds during the past decade, or the returns from all global bond funds from 2000–2014.

Survivorship bias occurs when an analysis omits returns from in-sample funds that were closed, merged into other funds, or otherwise died along the way.

How Often Do Funds Go Under?

Some new funds are truly innovative, do well by their investors, and become familiar names. Less-sturdy ones may instead focus on trying to seize and profit from popular trends. For these, the expression “cannon fodder” comes to mind. They may (or may not) soar briefly, only to fizzle fast when popular appeal shifts.

In the competitive capital markets in which we operate, fund managers launch new products and discontinue existing ones all the time. Individual funds probably disappear far more frequently than you might think.

  • A recent S&P Dow Jones Indices analysis found that, for the five-year period ending in December 2015, “nearly 23% of domestic equity funds, 22% of global/international equity funds, and 17% of fixed income funds have been merged or liquidated.”[1]
  • As might be expected, the longer the timeframe, the higher the death rate. A January 2013 Vanguard analysis of survivorship bias looked at a 15-year, 1997–2011 sample of funds identified by Morningstar. The analysis found that 46 percent “were either liquidated or merged, in some cases more than once.”[2]
  • A May 2015 Pensions & Investments (P&I) article reported that Exchange-Traded Products (including ETFs) weren’t immune from the phenomenon either, having just reached the milestone of 500 products closed.[3] According to the “ETF Deathwatch” cited source, this represented a mortality rate of just under 23 percent.[4]
  • The same P&I piece cited Dimensional Fund Advisors and Vanguard analyses that estimated 15-year mortality rates for traditional U.S. mutual funds in the range of a 50/50 coin flip, or worse.[5]
  • A November 2015 article by financial columnist Scott Burns found similar survival rates for the 15-year period ending in 2014. “At the beginning of the period, there were 2,711 funds,” he reported. “At the end of the period, there were 1,139. Only 42 percent of the starting funds had survived.”[6]

Why Does Survivorship Bias Matter?

Why should you care about the returns of funds that no longer exist?

The funds that disappear from view are usually the ones that have underperformed their peers. The aforementioned Vanguard analysis found that, whether a fund was liquidated or merged out of existence, underperformance was the common denominator prior to closure.[7]

If these disregarded data points were athletes on a professional sports team, they’d be the ones bringing down their team’s averages. When assessing a team’s overall performance, it’s important to consider both the wins and the losses, right? Same thing with fund performance.

Instead, an analysis marred by survivorship bias is highly likely to report overly optimistic outcomes for the group being considered. While a degree of optimism can be admirable in many walks of life, basing your investment decisions on artificially inflated numbers is more likely to set you up for future disappointment than to position you for realistic, long-term success.

Moreover, survivorship bias is only one of a number of faults that can weaken seemingly solid reports. One way in which we at OpenCircle strive to add value to investors’ evidence-based investment experience is to help them separate robust data analysis from misleading data trickery. We hope you’ll be in touch if we can assist you with your own strategies and selections in a market that is too often rigged against the individual investor. Please give us a call at 203-985-0448. We look forward to speaking with you.

[1] Aye M. Soe, CFA, “SPIVA® U.S. Scorecard, Year-End 2015,” S&P Dow Jones Indices. Page 2.

[2] “The mutual fund graveyard: An analysis of dead funds,” The Vanguard Group, January 2013. Page 3.

[3] Ari I. Weinberg, “Learning from a walk through the fund graveyard,” Pensions & Investments, May 28, 2015.

[4] Ron Rowland, “500 ETF Closures,” Invest With an Edge, May 19, 2015.

[5] Weinberg, Pensions & Investments, May 28, 2015.

[6] Scott Burns, “The missing bullet holes problem,” The Dallas Morning News, November 13, 2015.

[7] “The mutual fund graveyard,” The Vanguard Group, January 2013. Page 2.