Index Funds Advisors - Podcast

Alpha Bits or Lucky Charms?

Thu, 22 Dec 2011 12:21:20 GMT

Alpha Bits or Lucky Charms?

By: Mary Brunson & Jay D. Franklin | December 21, 2011

The long-standing debate regarding active vs. passive investing really boils down to one simple question: Is the excess (above benchmark) return earned by a manager due to luck or skill? With some 7,000 actively managed funds available, this question can be ferreted out by digging into the returns and variability of returns records of managers who have demonstrated persistence in delivering the elusive alpha.

The most noteworthy of such managers is Bill Miller who holds the record for the longest-running streak of outperforming the S&P 500 Index. During the 15-year period from 1991 through 2005, Miller’s stock picks led the Legg Mason Value Trust Fund (LMVTX) to consistently defeat the widely used benchmark index.

Miller’s feat brought him great notoriety. In 1999, he was named Morningstar’s “Fund Manager of the Decade,” and he was also included as part of Barron’s “All-Century Investment Team.” These accolades caused his fund to swell from $750 million in 1990 to more than $20 billion by 2006 when Forbes declared Miller to be "one of the greatest investors of our time."

Miller’s hot streak turned cold, however, when big bets in the financial sector during 2008 sent LMVTX into a downward spiral. By November 2011, the fund’s value had contracted to a mere $2.8 billion and Miller announced he would retire from the fund in the spring of 2012, thus removing any opportunity to reclaim his previous record.

Was Miller’s winning streak a result of skill in delivering alpha or mere luck? Alas, we will never know. Much more time is required to establish a high degree of confidence that Miller possessed stock-picking skill. And, to be fair, even if he had stayed on to redeem a presumption of prowess, it would take an additional 241 years of data to make this determination. While Miller is the only manager to have beaten the S&P 500 Index for 15 years, he remains mortal.

To see if you have enough years of returns to have reason to believe the manager has genuine skill, as opposed to fleeting luck, you simply need to enter two numbers into a calculator. They are:

1) The average difference in returns between the fund and the benchmark, known as the alpha
2) The standard deviation of the alpha

The calculator will then produce the number of years needed.

In order to establish this number for Miller, IFA compared his returns to the Russell 1000 Index (Morningstar’s designated benchmark) on a calendar year basis from fund inception through 2010. When the alpha and standard deviation of the alpha are entered, the calculator says we need 269 years of returns similar to Miller’s before an investor can anoint Mr. Miller as skilled.

(Click here to see the full size chart)

The problem for manager pickers is that the process largely focuses on the search for alpha bits, without considering the possibility that they might get lucky charms. Manager pickers should ask: “Is there a higher expected return with active managers, or am I just increasing the risk that my portfolio will go snap, crackle, pop?”

Watch on IFA.tv

Which Manager Should You Believe?

Mark’s interview with Dan Solin, with further discussion on the topic of investment alpha, and is it due to luck or skill.

IFA.tv – The Investment Education Destination:

IFA.tv now presents an educational series of webcasts produced in IFA's new state-of-the-art media lab in Irvine, California to teach investors how to become better investors. These webcasts explain the investing strategies found at www.ifa.com and in Mark Hebner's book, Index Funds: The 12-Step Recovery Program for Active Investors. Click here to watch IFA.tv.

It is IFA’s privilege to share this information with you. Each of our investment professionals welcomes the opportunity to assist you in your quest for risk-appropriate, low-cost returns. To learn more, please call 888-643-3133 or visit ifa.com.

Watch the Latest Episode.

December 22, 2011 -
Episode 9: Risk

About Us

Index Funds Advisors (IFA) is a fee-only independent financial advisor that provides wealth management by utilizing risk-appropriate, returns-optimized, globally diversified and tax-managed portfolios of index funds. (Learn more)

Index Funds Advisors, Inc.
19200 Von Karman Ave.,
Suite 150
Irvine, CA 92612

Call Toll Free: 888-643-3133 Local Phone: 949-502-0050 Fax: 949-502-0048

Pension-Gate

Thu, 20 Oct 2011 12:08:37 GMT

Pension-Gate

By: Mary Brunson | October 19, 2011

Plan sponsors and trustees of pooled investments such as retirement plans, foundations and endowments frequently implement an active investment strategy, relying on investment consultants and advisors to recommend fund managers whom they anticipate will deliver above benchmark returns.

Consider for a moment the inherent conflict that exists for such consultants who likely find it difficult to advise their clients to abandon what David Swensen terms “the loser’s game" of active management and recommend instead a purely passive portfolio. Following this idea to its logical conclusion, these consultants may surely know that their presumed necessity evaporates when plan sponsors embrace passive investing. As Upton Sinclair so keenly observed, “It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

Support for Swensen’s observation is found among analysis of state pension plans. An investigative journalist for St. Petersburg Times approached Index Funds Advisors (IFA) and a handful of other investment experts to collect some data regarding the risks and returns of Florida’s State Pension Plan, comparing then to various index portfolio strategies.

The results of the research were revealed in a July 31, 2011 article titled, “Easy investments beat state’s expert pension planners.” The article concluded that a simple index portfolio would have outperformed the state’s pension plan performance over the last ten years. The professionally managed SBA [State Board of Administration] performed worse—by more than a percentage point—than seven index-fund portfolios for the decade ending Dec. 31, 2010. “On average, a $100 investment in an index portfolio grew to $184, while Florida’s pension delivered just $157,” the article stated.

Florida’s $124 billion pension performance was far from alone in its lackluster performance when compared to simple indexing strategies. IFA has attempted to analyze the employee retirement systems for all 50 states. Data on more than 40 state pension plans have been received to date, yielding similar results with varying degrees of underperformance relative to the index portfolios.

The four accompanying charts depict the annual risk and return of various state pension plans, net of fees, compared to seven passively managed index portfolios comprised of a blend of diversified asset allocations. A best effort was made to estimate fees in states that report returns before fees are deducted. States were analyzed for both 10 or 11-year periods and 23 or 24-year periods and were charted based on either a June 30th or December 31st year-end date. The data show only one state succeeded to outperform, albeit negligibly, relative to the index portfolios.

Click here to view the full chart »

Click here to view the full chart »

Pension plans access the most highly reputed money managers and investment consultants, but have failed to outperform risk-appropriate benchmark index portfolios. This analysis leads an investor to inevitably conclude that the widely implemented, but costly process of relying on consultants to recommend the hiring and firing of investment managers offers a negative payout relative to a risk-appropriate set of index benchmarks. This sort of detailed analysis is likely the impetus for highly regarded industry legends such as 1990 Nobel Prize winner Merton Miller to assert as follows:

“I have often said, and I know this will get some of your readers mad, that any pension fund manager who doesn't have the vast majority - and I mean 70% or 80% of his or her portfolio - in passive investments is guilty of malfeasance, nonfeasance or some other kind of bad feasance! There's just no sense for most of them to have anything but a passive investment policy.”

- Merton Miller, Nobel Laureate in Economics, 1990, An Interview with Merton Miller, Investment Gurus, by Peter Tanous, February 1997

There is little doubt as to what the proper investment strategy should be for pension plans, but what of the individual investor with no such access to a pension for his or her retirement? IFA offers tools to help pave the way towards your retirement goals. One of these invaluable instruments is our Monte Carlo Simulation. By inputting your age and time horizon, initial wealth, periods of savings and withdrawals, investment risk level, and the option to Glide Path, you can ascertain, based on the simulation of 10,000 portfolio outcomes, the statistical probabilities of portfolio survival at various ages of your retirement. Our Monte Carlo Simulation is just one of the many tools IFA offers to match you with your portfolio.

New to IFAtube.com Mark Hebner discusses IFA’s new Retirement Analyzer

click here to watch the video.

About Us

Index Funds Advisors, Inc.
19200 Von Karman Ave.,
Suite 150
Irvine, CA 92612

Call Toll Free: 888-643-3133 Local Phone: 949-502-0050 Fax: 949-502-0048

Up and Down, Down and Up

Fri, 23 Sep 2011 10:28:13 GMT

Up and Down, Down and Up

By: Mark Hebner | Sept 23, 2011

Once again, we have experienced some intense volatility. Moments like these can be very scary for investors, making them susceptible to acting on visceral emotions. For this reason, I provide you some very important information.

Going or Gone?
When discussing the direction of the market, it’s important to use the past-tense verb. During times of high market volatility, people commonly make the mistake of saying, “The market is going down (or up).” Although it appears harmless, this statement implies that the direction of market prices is knowable. People making this statement often use it as the impetus for major investment decisions. Such decisions usually do not fare well, because they are based on the fallacy that one can predict the direction of future price movements. Investors can avoid this pitfall by understanding Eugene Fama’s finding that security prices move in a random walk. At any point in time, we only know the current and past price of any given security. Where the price will be even a second later is unknown. The market continuously sets prices in response to news, which by its very nature is unpredictable. Investors will accomplish an important step when they can say, “the market has gone down (or up)” without even having to think about it.

Free Market Forces
The job of free markets is to set prices so that investors are rewarded for the risks they take. To help explain this important statement, I created the Hebner Model, which attempts to simplify market forces into three variables: Price, Expected Return, and Uncertainty. Prices move in the opposite direction of economic uncertainty so that expected returns at a specified level of risk can remain essentially constant, resulting in a fair price. From fair prices we expect fair returns, meaning that investors should be compensated for their risk exposure over time.

The reason people invest is to get a return. At the time of a trade, buyers pay a price that reflects the risk associated with capturing the expected return. In other words, a fair price equals a fair expected return.

This model is based on Eugene Fama’s Efficient Market Hypothesis, which states that prices fully reflect all available information or news, economic uncertainty, and probabilities of future events, thus implying that market prices are fair.

The Hebner Model illustrated in the following painting attempts to diagram the three variables of Uncertainty, Expected Return, and Price, resulting in a distribution of returns shown at the bottom. The diagram shows the essentially constant expected return for a given investment portfolio. In this case IFA Index Portfolio 50 is shown at the fulcrum of the teeter-totter, and the period specific expected return can be estimated based on 30, 50 or 83 years of simulated returns, the Fama French Three or Five Factor Model, or any methods an investor chooses. Current news impacts uncertainty and is represented on the left side of the teeter-totter. This economic uncertainty includes the probabilities of future events. The price agreed upon by willing buyers and sellers is on the right side. When an investment’s price has fallen by 2%, one could infer that uncertainty has increased by about 2%. Alternatively, when the price has increased by 2%, without knowing the news, one could deduct that uncertainty has decreased by 2%. In other words, prices react to shifts in uncertainty so that expected returns remain essentially the same.

(See the full painting here)

From a fair price investors should expect: 1) a fair outcome, which would be a risk-appropriate or fair return, 2) an equal chance of being greater than or less than that fair return, and 3) the farther the actual return is from the expected return, the lower the probability of its occurrence.

So, before you trade, ask yourself: 1) Who is on the other side of my trade?; 2) Do I think I know more than they do?; and 3) Am I paying a fair price? In my opinion, your answers are as follows: 1) You don’t know; 2) It’s highly unlikely; and 3) If there are many willing buyers and sellers, by definition, it is a fair price.

For these reasons, market timing offers no advantage. Time pickers cannot forecast the direction of the market. There is no competitive edge that exists. The best way to earn the market’s superior return is to simply remain invested at all times in a low-cost, passively managed index portfolio.

See the expanded explanation of the Hebner Model here »

Whats New at IFA

Sept 22, 2011 Why I stopped trying to beat the market — The Globe and Mail

Sept 9, 2011 Watch John Bogle's latest interview with WSJ.

Sept 6, 2011 How can I tell if I'm saving enough for retirement? — USATODAY.com

Sept 5, 2011 The paper that was a major inspiration for John Bogle to create the first retail Index Fund. Challenge to Judgement: Perhaps there really are managers who can outperform the market consistently - logic would suggest that they exist. But they are remarkably well-hidden. by Paul A. Samuelson, The Journal of Portfolio Management, 1974. The evidence has grown with each passing year. - Another inspiration for Bogle: The Loser's Game, by Charles Ellis

Sept 3, 2011 How the Index Fund Was Born Wall Street Journal, 9/3/2011 (You may need an online subscription)

© Index Funds Advisors 2011

About Us

A Gross Mistake

Fri, 09 Sep 2011 11:35:56 GMT

A Gross Mistake

By: Jay D. Franklin | Sept 9, 2011

Once again, Mr. Market has shown us that he does not play favorites, and nobody is above a serving of humble pie at his table. His latest victim is none other than the “bond king” Bill Gross. You may recall that earlier this year, as part of his “new normal” prediction of extended low economic growth and de-leveraging by consumers, Gross eliminated all his exposure to U.S. government holdings in the Pimco Total Return Fund. With a whopping $243 billion in the fund, this was not easily accomplished. Rather than dumping billions of bonds on the open market, Gross took on derivative positions (such as futures and swaps) to hedge away his interest rate and U.S. dollar risk on U.S. government bonds. It would be interesting to know who is on the other side of those bets. It could only be a large institutional player such as Goldman Sachs.

So far (as of August 29th, 2011), the bet has not worked out too well for Total Return’s shareholders. The fund has returned 3.29% compared to 4.55% for Barclay’s Aggregate Bond Index. It was ranked 501st out of 589 bond funds in its category (Intermediate-Term Bond). To his credit, Gross owned up to his error by saying, “It was a mistake to bet so heavily against the price of U.S. government debt,”¹ the Financial Times reported. This may do little to assuage those investors who added $21.2 billion in new flows for Pimco Total Return during 2010 and year-to-date 7/30/2011 (estimated net flow from Morningstar Direct).

What are the lessons for investors?

Relying on economic forecasts as the basis of portfolio decisions can lead to heartbreak.
Even the most celebrated of pundits can be wrong, and more than once. Recall that on February 26th, 2009, Gross declared the death of equities. Since then, even with the recent downturn, the S&P 500 is up 61%. It is noteworthy that Mr. Gross’s guru grade from CXO Advisory is a below-average 46% (last updated in May of 2009).
Recent investors in the Pimco Total Return Fund should chalk up their underperformance to the tuition that Mr. Market never fails to extract from people who believe that some genius will deliver them high returns without high risk. Hopefully, they will learn that rather than trying to outsmart Mr. Market or beat him to a pulp, they should let Mr. Market work for them by owning a risk-appropriate portfolio of index funds, and pay no attention to the gurus.

To quote one of our favorite economists, Paul Samuelson, “I tell people [investing] should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

¹ Bill Gross, Financial Times, “Pimco’s Gross rues US debt ‘mistake,’” August 29, 2011, Dan McCrum

IFA Video Series

Is There Change On the Horizon?

Watch Mark Hebner’s latest video revealing a massive shift to passive investing »

Whats New at IFA

Sept 6, 2011 How can I tell if I'm saving enough for retirement? — USATODAY.com

About Us

Celebrate the Price

Tue, 23 Aug 2011 09:23:43 GMT

Celebrate the Price

By: Mary Brunson | Aug 23, 2011

Standard & Poor’s recent downgrade of U.S. debt has served as the impetus for enormous volatility throughout the global markets. Talk of troubles in Europe and even another recession in the U.S. have spooked the market and its investors—some of whom are now asking the time-honored question: Is it different this time?

Certainly, it is different this time, but isn’t the news always different? No two crises are the same. But, one critical function remains the same, and that is the market’s ability to price the news. This is no small task on the market’s part. This ongoing ability to absorb the news, collectively aggregate and reflect the opinions of all market participants and to arrive at a fair price for each security is an amazing fete which free markets accomplish spontaneously, elegantly and efficiently.

Reams of articles have hit the papers and the Internet to advise investors on what to do now. Most of which are supported by advertisements from firms whose profits increase with the volume of your trades. In an August 19, 2011 Wall Street Journal article titled “Last Straw or Time to Buy,” journalist Kelly Greene chronicles the advice that several financial advisors and money managers in the wake of the recent market turbulence. The article mostly discussed the misguided advisors who have either pulled back their expectations of future performance or are advising their clients to reduce allocations to equities.

Here’s why their advice is misguided:

Prices are considered fair because they are determined by millions of willing buyers and willing sellers.
Prices reflect the current and forecasted news.

Prices change so that (1) the expected return remains essentially the same, (2) there is an equal chance that the future return will be above or below the expected return and (3) the more the future return varies from the expected return, the less likely it is to occur.

A visual representation of this concept is found in the Hebner Model. To visualize how markets work, think of a teeter totter where the news (economic uncertainty) would be on the left side, the investment risk and expected return at the fulcrum, and the price on the right side.

The likelihood of identifying pricing mistakes and exploiting them for profit is a 50-50 proposition. And, don’t forget to account for the costs and taxes associated with trading. Will some gurus get lucky in calling the next market move? Of course, but luck is neither a reliable nor a repeatable skill.

Fear is on one side of the the trade and greed is on the other, both emotions being factored into the price. From here, the market has just as much chance of going up as it has of going down, and that is because of the magnificent pricing mechanism of the free markets.

So, the next time you hear an active investor utter those four most dangerous words: “It’s Different this Time”, remember the four most soothing words for passive investors, that news is already "Baked in the Cake.”

Click here to see enlarge painting

Whats New at IFA

Aug 22, 2011Does Active Management Protect You During Bear Markets? —CBS MoneyWatch.com

Aug 19, 2011Madoff Whistleblower: Big Banks Are Ripping Off Pension Funds —From Daily Ticker

Aug 17, 2011Q: What to do if you haven't saved anything for retirement? —From USA Today Ask Matt column

Aug 14, 2011The Mutual Fund Merry-Go-Round by David Swensen and Henry Blodget's take on it: The Mutual Fund Industry Is A Huge Scam That Costs Investors Billions Of Dollars A Year

Aug 9, 2011Financial Advsior Magazine 2011 Ranked Index Funds Advisors #65 (for asset category $1B and over)

Aug 8, 2011The Revenge of the Wall Street Rejects by Jay Franklin -What should you do today? Resist the Siren Songs of Speculation. Just Tie Yourself to the Mast and turn off the TV. - "I don’t get it. It doesn’t make sense. In Omaha, the U.S. is still triple-A rated. And if there were a quadruple-A, I’d give it to the U.S." —Warren Buffett on U.S. Treasuries, of which his Berkshire Hathaway owns more than $40 billion

Aug 5, 2011 Flawed Investing is Depleting Pension Assets

© Index Funds Advisors 2011

About Us

A Special Message From IFA

Fri, 05 Aug 2011 16:52:27 GMT

A Special Message From IFA

By: IFA | Aug 5, 2011

The stock market has delivered a very volatile week to investors, perhaps striking a nerve not felt since 2008. Thursday’s 500+ point drop in the Dow certainly caused many investors to recall the sickening downturn of what some call “The Great Recession.” Certainly, investors feel somewhat daunted as this week wraps up the worst week in the stock market since 2008.
In times of increased volatility such as we have experienced, it’s important to revisit five important lessons that are the underpinning of a successful investment strategy.

Markets are Efficient: We may not like the market’s reaction to the news that has dragged it down in the last week, but the market is doing its job. Willing buyers and willing sellers go to the market to agree upon a price for each security. Each price reflects all known information. It is important to understand this one simple point because if you decided to buy or sell now based on what has happened—don’t bother, it’s already in the price.
Market Timing is Speculation: Investors who take action based on what they think will happen next are merely speculating or gambling on a future outcome. Louis Bachelier admonished back in 1900 that the expected return on speculation is zero. Even worse, when costs are considered, the expected return on speculation turns negative. As Charles Ellis tells us, “Market timing is a wicked idea. Don’t try it –ever.”
Save Yourself from Yourself: Legendary investor Benjamin Graham tells us: "The investor’s chief problem - and even his worst enemy - is likely to be himself." How can investors avoid acting as their own worst enemy? In The Little Book of Behavioral Investing, James Montier tells us, “Once you have ordinary intelligence, what you need is the temperament to control the urges that get other people into trouble in investing.” In other words, realize that the long-term expected return of your investment portfolio has not changed in the wake of the current volatility, so look away. Sounds too simple? Yes, it is simple advice, but it is not always easy to follow. The media will do nothing to assuage the panic or fear. In fact, they will beat the drum because it keeps people tuned in. Their advertisers pay for eyeballs on the screen, and they’ll do whatever it takes to get them and keep them there. Turn off the TV; step away from the computer; go for a walk, instead. You’ll be glad you did.
Remember the Bad Times: Sounds odd, doesn’t it? Who wants to recall the angst of 2008 and early 2009? It was painful. The important thing is that those who held on came through far better than those who panicked and fled the markets. The market always carries a positive expected return. You don’t always get it, but it is always there. You cannot obtain the positive expected outcome of the market unless you are in the market—buying, holding, bearing and rebalancing risk. We know the drill, we have suffered extreme volatility in the past, and we have endured.
Remember Your Time Horizon: The best time to be in the market is when you have the money and the best time to be out of the market is when you need the money. If you need the money right now, the stock market is not the right place for you. But, if you have a time horizon of four or more years, you can withstand some volatility to increase your risk-adjusted returns. Spend some time in Step 4 and Step 9. Reacquaint yourself with the data showing the pitfalls of market timing. Remember when markets have shuddered in the past, Capitalism has been extremely resilient over time. Most importantly, make sure you are investing in line with your risk capacity. If your risk capacity is still where it should be, the hard work is over; you have earned the right to simply invest and relax.

If you would like to review any of these important lessons with your IFA advisor, please call 888-643-3133. We are always here for you.

Whats New at IFA

Aug 5, 2011 Flawed Investing is Depleting Pension Assets

July 28, 2011 Should you be worried about your IFA index portfolio? No. Read this classic from March 9, 2009 on the Resilience of Capitalism. Remember: the job of a free market is to set prices so investors are rewarded for the risk they bear. The news and it's implications are already baked in the cake.

July 27, 2011 Pension-Gate: An analysis of state and federal pension plans across the United States.

July 27, 2011 Court Rules Kraft’s 401(k) Plan May Have Holes

July 15, 2011 Investing in the Oracle of Omaha Falls Short - Also see Fortune Kookie

July 11, 2011More Evidence That Managers Can Not Find Over or Under Valued Stocks

July 6, 2011 Three Sources of Negative Alpha

July 5, 2011Non-Traded REITs: One More Way for Investors to Be Parted from Their Money

July 2, 2011 Your Broker Can Aid in the War Against Terrorism

© Index Funds Advisors 2011

About Us

The Never-Ending Pursuit of Alpha

Thu, 28 Jul 2011 12:36:39 GMT

The Never-Ending Pursuit of Alpha

By: Jay D. Franklin | July 22, 2011

As we have pointed out on many occasions, both stock-picking and hiring an active manager to pick stocks on your behalf are mug’s games. While some investors diligently study individual stocks and other investors handsomely pay active managers to deliver alpha (an additional return above and beyond what can be explained by exposure to risk), very few, if any, investors receive alpha on a consistent basis. Considering that the amount of alpha in the world that is available for capture is zero before costs and negative after costs, it is not difficult to understand why this is the case. The dearth of alpha is borne out by numerous academic studies by luminaries such as Eugene Fama and Ken French. Nevertheless, hope springs eternal as evidenced by the nearly 7,000 actively managed mutual funds in existence today.

In order to determine whether or not a fund manager has reliably delivered alpha, a multivariable regression analysis of historical returns can be conducted. This analysis reveals the extent to which the returns can be replicated with a combination of index funds as well as the value added or subtracted by the manager (i.e., alpha). One very important quantity produced in the analysis is the t-statistic of alpha which provides a measure of the probability that the alpha could have occurred from chance alone. In general, a positive alpha with a t-statistic greater than two indicates a 5% or lower probability that the excess returns are due to luck. IFA recently conducted its own study of 602 US equity mutual funds with ten years of returns data. We required that at least 90% of the funds holdings be in US equities and that the prospectus objective concur with the size/value style of the fund’s holdings (to minimize the impact of style drift). The results are shown below:

(Click to see the full chart)

The fact that so few managers delivered positive alpha is explained by the high hurdle of their own expenses that must be overcome; this is especially difficult in a market that while perhaps not 100% efficient, is efficient enough that the expenditure of resources in an attempt to outperform the market is likely to exceed any increase in returns resulting from said expenditure. Although a few managers appeared to deliver alpha, IFA cautions investors that the fact that there are so many managers virtually guarantees that there will be some who appear to have demonstrated true skill. Unfortunately, the number of such managers is no higher than what we would have if all of them were monkeys throwing darts at the Wall Street Journal. Two studies that elegantly address this point are:

“False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas” by Barras, Scaillet, and Wermers which evaluated 2,076 fund managers over 32 years and found that 99.4% of active fund managers showed no genuine stock-picking ability.
“Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates” by Fama and French which evaluated 819 actively managed funds over 22 years and found that 97% could not be expected to beat a risk-appropriate benchmark.

The myth of persistency in positive alpha was completely debunked in the Standard and Poors Persistence Scorecard which showed that the number of managers who remain in the top half or quartile of their peer group is lower than what we would expect from chance alone. The conclusion of all of these studies is inescapable. Investors’ resources are far better spent in focusing on the risk factors of market, size, and value. Asset allocation remains by far the most important determinant of future returns. After determining a risk-appropriate asset allocation, the next important task is to control costs. The pursuit of alpha has two essential problems: It is costly, and it may lead to missing out on the return associated with the risk factors of market, size, and value, which are the more reliable sources of returns.

Whats New at IFA

July 15, 2011 Investing in the Oracle of Omaha Falls Short - Also see Fortune Kookie

July 11, 2011More Evidence That Managers Can Not Find Over or Under Valued Stocks

July 6, 2011 Three Sources of Negative Alpha

July 5, 2011Non-Traded REITs: One More Way for Investors to Be Parted from Their Money

July 2, 2011 Your Broker Can Aid in the War Against Terrorism

June 22, 2011 Stock Pickers Are Picking Your Pockets

June 21, 2011 Planning for Retirement? Take Off Those Rose-Colored Glasses!

June 12, 2011 How would IFA design a target date retirement fund for 401(k) plans?

June 12, 2011 Take a look at the new IFA Matrix.

June 9, 2011 How big of sample do you need to be statistically significant?

June 8, 2011 Vanguard's Strategy for "Beating the Market" by Dan Solin

June 7, 2011 IFA's Concerns with Currency Speculation and Trading

June 5, 2011 CALPERS Arizona Land Speculation: The Taxpayer’s Dollars Are Just Dust in the Wind - The Use of Statistics in Making Investment Decisions

© Index Funds Advisors 2011

About Us

IFA Celebrates 1,000 Months of Data

Mon, 09 May 2011 10:17:26 GMT

By: Jay Franklin | May 6, 2011

As of May 1, 2011, IFA’s Index and Portfolio data now have 1,000 months (or 83.33 years) of history. This is no small milestone for IFA or for investors who understand the significance of very large data sets.

When making investment decisions, the value of long-term risk and return data cannot be overstated. Without it, investors are forced to resort to guesses and hunches about how to invest, leading to profound uncertainty about what the financial future might hold. This uncertainty can easily lead to investors throwing their money at the latest top-performing mutual fund manager, only to meet with bitter disappointment. The value of the data lies in how it shows us the relationship between risk and return. At the root of most mistakes made by investors is the fallacy that excess return can be captured without risk. The table below provides a simple illustration of the relationship between risk and return as of 4/30/2011.

IFA Index	1,000 Months (83.33 Years) Annualized Return	1,000 Months (83.33 Years) Annualized Standard Deviation	1,000 Months Growth of $1
US Large Company	9.47%	19.27%	$1,877.29
US Small Value	12.82%	26.07%	$17,079.31
One-Year Fixed Income	4.05%	1.52%	$27.31

It is easy to see that the risk and return of US Small Value exceeds US Large Company which exceeds One-Year Fixed Income. What might not be so apparent is that if we only had 20 or 30 years of data, we would not be able to draw these conclusions at a 95% confidence level, yet investors often make crucial decisions based on far less data (1 to 5 years).

At this point, it may be worthwhile to examine the ultimate source of the index data (i.e., prior to live fund data) used in the IFA indexes, The Center for Research in Security Prices (CRSP) , which is housed at the University of Chicago Booth School of Business was established in 1960 with the goal of building and maintaining historical databases for stock (NASDAQ, AMEX, NYSE), indexes, bond, and mutual fund securities. It is considered to be the gold standard of historical financial data in both the academic and corporate community. In the words of Professor Elroy Dimson of the London Business School, “No research initiative has had a bigger impact on finance than CRSP, and studies based on CRSP’s high-quality data have extended knowledge, underpinned innovation, and enhanced financial practice...Every finance professional owes an indirect debt to CRSP.” Unfortunately, there are too many “finance professionals” who do not even know what CRSP stands for. Their clients suffer the consequences. Currently, Eugene Fama, a well-respected professor of finance at Booth and Director of Research at DFA, is the chairman of CRSP. DFA bases several of its investment products on Fama’s findings from that database. Furthermore, The IFA Index Portfolios are constructed around the 3-Factor and 5-Factor models of Eugene Fama and Ken French.

A question sometimes asked is why not go back further than the CRSP data? For example, G. William Schwert of the University of Rochester published an article in The Journal of Business titled “Indexes of US Stock Prices from 1802 to 1987.” It is IFA’s opinion that while this research is valuable, the amount of data in those early years is simply too small to provide a basis for investment decision-making. For example, for the period from 1802 to 1845, the returns are based entirely on seven stocks (six of which are banks). Also, while the stock price data may be reliable, the accounting for items such as book value is quite murky at best. This makes it very difficult to study factors such as growth vs. value. One criticism leveled at CRSP data is that it begins just before the Great Depression, so it reflects a high level of volatility in the early years (through the end of World War II) relative to the volatility of later years (sometimes known as “the great moderation”). IFA encourages investors to examine both the 83-year (with Depression) and the 50-year data (without Depression).

To recap a highly relevant section of Step 9,

The first problem investors are faced with relative to history of stock market returns is the lack of quality long-term data in the financial media. Secondly, they are not aware that long-term data has more value to them than does short-term data. When looking at 80+ years of data many investors think it is irrelevant because they do not have 80+ years to live. This point of view overlooks the importance of sample size and the concern for sample error. When gathering information to characterize the risk and return of capitalism, the more quality data you have, the more accurate your conclusions.

While it may not warrant opening an expensive bottle of champagne, 1,000 months of data is indeed something worth feeling good about.

Whats New at IFA

April 2, 2011 The latest painting from IFA and Lala: Tax Loss Harvester. Also, new chart of the Dow Jones Commodity Index.

April 1, 2011 From Dan Solin on AOL Daily Finance:
Don't Gamble When It Comes to Your Retirement

March 26, 2011 Two new incredible charts that display data on Simulated Passive Investor Experiences: Time Diversification of Index Portfolios and Histograms of Simulated Passive Investor Experiences.

March 24, 2011 Two new Blogs: Concerns with Hedge Funds and Currency Diversification

March 22, 2011 THE BIG QUESTION: What are the chances that you will run out of money in your retirement? Now IFA will estimate this probability using a Monte Carlo Analysis of the risk of ruin. Just enter your assumptions in this form. What is the Monte Carlo Method?

March 21, 2011 An Oldie but Goodie from 16 Years Ago. Rex Sinquefield explains why all the news is baked in the cake and active managers have no advantage over the combined wisdom of all the market participants.

About Us

Wise Beyond Your Years

Fri, 01 Apr 2011 11:38:52 GMT

Wise Beyond Your Years

By: Mary Brunson and Robert Bray | April 1, 2011

The farther down the road of life we travel, the more we seem to face life choices that while they seemed clear at the time, find each of us perhaps looking back in bewilderment, muttering the rhetorical question: “What was I thinking?”

Imagine the power of being able to peer into your future to gain a good idea of what your life will be like in the future. One particular area of your life where such foresight would be very valuable is your finances. Knowing how much you will likely have saved, how much you will likely be able to live on, and how much you will likely leave behind for your kids, grandkids or favorite charity is considerably valuable information.

One way to peek into the prospects of your financial future is through a probability simulation commonly known as the Monte Carlo Method. This often-relied upon analysis is considerably superior to more commonly heard advice such as “just invest 5% of your paycheck and hope for the best.” The Monte Carlo Method simulates the potential effects of volatility, compounding wealth and inflation during an investment lifetime.

By drawing from actual historical data for a specific risk level, The Monte Carlo Method simulates thousands of portfolio outcomes to arrive at a distribution of success at achieving a desired outcome. Generally speaking, a level of satisfaction for a particular outcome is reached when 95% of the simulations either reach or surpass the intended goal. IFA employs random number generation from 83 or 50 year periods of historical data sets and assumptions particular to the investor. These assumptions include the investor’s timeline to retirement, contributions, and the risk and return characteristics of the specific IFA Index Portfolio used, as well as whether or not the Index Portfolio has been set to Glide Path (reducing a level of risk with each passing year).

The graph below illustrates the two phases of an investor’s life: accumulation (saving phase) and consumption (spending phase). Applying the same starting assumptions, the possible outcomes range from prosperity to defeat, all depending on the range of volatility associated with the investments.

Click to see the full chart

The Monte Carlo simulation enables an investor to get a good handle on how much money they need to accumulate so they will have enough to meet their needs (and hopefully some wants) in retirement. If the results do not provide a high enough probability of success, investors have valuable foreknowledge to help them improve their odds for success. An investor can identify a shortfall that may trigger them to save more, increase their risk level (to the greatest extent their risk capacity allows), decrease their anticipated expenditures in retirement, or push back their retirement all together, giving the investor more time to accumulate and less time to consume.

Revisiting the Monte Carlo Simulation each year allows investors to make sure they are on course — much like an onboard navigation system for a car. The closer one gets to their destination, the more finely tuned the directions become.

Work out your financial future right now using the Monte Carlo Simulation. This sort of disciplined analysis will likely go a long way toward preventing the regret of looking back to your younger days wishing you knew what you know now. This process might permit your 75 year old self the opportunity to tap your current self on the shoulder and say, “Thought you’d like to know.”

Whats New at IFA

March 26, 2011 Two new incredible charts that display data on Simulated Passive Investor Experiences: Time Diversification of Index Portfolios and Histograms of Simulated Passive Investor Experiences.

March 10, 2011 Should you get out of the market? Looking over the long term, David Booth reviews the history of the stock market and highlights the importance of time, not timing, in the achieving long term investment success.
Kenneth French explains why Manager Picking is such a terrible idea.

The IFA Blog has several new posts. Risks Worth Taking by Jim Parke
Thoughts from IFA on Fools and Children by Jay Franklin
Morgan Stanley Smith Barney To Cut Up To 300 Advisors and Trainees, by Mark Hebner
The Number of Investing Suckers Is Endless by Dan Solin

About Us

Fools and Children

Mon, 14 Mar 2011 17:00:56 GMT

Fools and Children

By: Jay Franklin | Mar 14, 2011

If Rabbi Yohanan were alive today, perhaps one of the categories of fools he would be referring to are the pundits in the financial media who endlessly bombard us with their market predictions. IFA has consistently warned investors that making investment decisions based on these predictions can be hazardous to their wealth.

As proof, we can direct you to the fine folks at cxoadvisory.com who track the predictions of the “gurus” and record the percentage accuracy of those predictions. The gurus include famous names such as Jim Cramer, Abby Jospeh Cohen, and Marc Faber of the Gloom, Boom and Doom Report. It is quite interesting that of the 61 graded gurus, 38 showed an accuracy below 50%! In other words, 62% did worse than if they had simply made random guesses. These results are corroborated by a study of expert economic predictions done by William Sherden of Stanford University who found that economists have no special ability to predict the turning points in the economy.¹

Michael McCracken of the St. Louis Federal Reserve Bank found that forecaster errors were four times larger when the economy was in recession than when it was not (i.e., the failure rates of the experts are much higher when their talents are most needed)².

All market forecasts rely to some extent on a macroeconomic prediction, and the movement of the economy (and the market) depends on the news, which by definition, is unpredictable. It is no wonder then that out of 32 market-timing newsletters, none of them delivered a higher return than the S&P 500 over a ten year period.

While it is always fun and amusing to find specific past predictions that failed to bear out, we could too easily be accused of cherry-picking after the fact and ignoring those few predictions that did come true. Fair enough. So instead, we will take note of a recent prediction made on February 22nd by Paul Farrell of Marketwatch.com quoting Jeremy Grantham of an impending market crash (a 31% drop in the S&P 500 to 910 by Christmas, 2011). Mr. Grantham has a 48% accuracy grade from CXO Advisory, so we will not be rushing out to sell our equity positions (not that we would if he had a higher grade). Mark your calendars to see if this prediction improves his track record.

To summarize, IFA wholeheartedly agrees with Warren Buffett who said, “A prediction about the direction of the stock market tells you nothing about where stocks are headed, but a whole lot about the person doing the predicting.”³ Better still is the quip from Buffett’s mentor, Benjamin Graham, “If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.” (Security Analysis, 1934) In the spirit of Rabbi Yohanan’s assertion, IFA suggests that you spend more time with your children and less time with the fools on CNBC, who definitely will not provide you with profits.

¹“The Fortune Sellers”, New York, John Wiley & Sons, 1998.

²“How Accurate Are Forecasts in a Recession?”, Federal Reserve Bank of St. Louis, Economic Synopsis, No. 9, 2009.

³Mark Sellers, “Could Stocks Still Be Undervalued?”, Morningstar, February 18th, 2004.

Whats New at IFA

March 9, 2011 The Efficient Market Hypothesis says that prices reflect all available information. In other words, the information is "Baked in the Cake". In a strict view, it says that it is impossible to beat the market. It also indicates that you are always paying a fair price. Fair prices are set so the investors are rewarded for the risk they take.

© Index Funds Advisors 2011

Feb 18, 2011 The Active Investor's Fallacy is similar to the Gambler's Fallacy, because active investors are gambling on an approximate normal distribution of future returns. The arguments for stock, time, manager or style picking are all fallacious. Visit Steps 3, 4, 5, and 6 to see why. Wiki says: In logic and rhetoric, a fallacy is incorrect reasoning in argumentation resulting in a misconception. By accident or design, fallacies may exploit emotional triggers in the listener... Fallacious arguments are often structured using rhetorical patterns that obscure the logical argument, making fallacies more difficult to diagnose.

About Us

The Big Story Behind Small Stocks

Fri, 11 Feb 2011 17:32:51 GMT

The Big Story Behind Small Stocks

By: Mary E. Brunson | Feb 11, 2011

Why do people pick stocks or try to spot the next hot sector? Likely, it’s because they are drawn in by captivating headlines of magazines and newspapers designed to sell subscriptions instead of developing a keen understanding of long-term historical data.

Here’s a quick and valuable tidbit that will prevent you from ever again dropping five bucks and change on a magazine touting hot stocks or sizzling sectors:

More often than not, small-cap value tilted portfolios outperform large-cap growth oriented portfolios. In fact, when we look at monthly rolling 12-month periods for the last 83 years, we see that IFA U.S. Small Cap Value Index beats IFA U.S. Large Growth Index 59% of the time. And, small-value beats large growth in greater percentages of the time in longer time periods such as 3, 5, 10 and 20 years, as seen in the chart below.

Click to see the full interactive chart

Last year proved to be no exception as small cap stocks outperformed large cap stocks by a significant margin in most global markets. But, stock pickers and asset class speculators had to ignore the headlines that claimed the ability to forecast the best-performing asset classes, and instead stay the course to realize the ultimate small-cap premium that came, left and then roared back.

Specifically, US small stocks started off strong in 2010 with the IFA US Small Cap Index quick out of the gate with a gain of 17.50% in the first 4 months, more than double the return of the S&P 500 Index for the same time period. That small cap premium faded, however, and by Labor Day both large cap and small cap indices were down for the year. A surprisingly strong rally during the remainder of the year drove the IFA US Small Cap Index up 32.43%, and for the year as a whole it was the best performance for US small stocks since 2003.

Small caps’ mighty roar was not predicted by leading financial pundits. Here’s a short list of some major financial media misfires for 2010:

In November 2009, the Wall Street Journal ¹ claimed “small caps aren’t looking that cheap anymore” and suggested that the stock market rally was in the midst of “an important change that has put the less-volatile large caps back in favor.”
Money’s 2010 ² Investor’s Guide said that smaller stocks’ rally had been played out, and as the bull market appeared to be maturing, it was time to switch gears and “bring your focus back to high quality blue-chip stocks this year.”
Smart Money ³ predicted the U.S. would remain mired in recession and pitched for large multinationals such as Procter & Gamble and Coca-Cola that “sell goods worldwide and don’t need an economic rebound to make money.”
Fortune’s 2010 ⁴Investor’s Guide issue repeated the refrain that an uneven economic recovery would reward clever stock-pickers: “Making judicious stock selections will be crucial in what is likely to be a topsy-turvy year.” It was indeed a topsy-turvy year for the markets, but even more so for Fortune’s ten stock picks that delivered an average price-only return of just 1.75%.

Long term stock market history provides our clearest path for investment success, and large sets of historic risk and return data are the best. At IFA, 83 years of history enables us to help our clients take the guesswork out of investing — focusing on science, not speculation. We don’t guess about what might happen in the short-term, but instead we rely on the simple fact that stocks have a positive expected return over time, and the degree to which you can invest your stock assets in small and value stocks, you have the highest probability of long-term investment success. And, investment success is what every investor wants.

¹Donna Kardos Yesalavich. “Large-Cap Stocks Are Back in Favor” Wall Street Journal November 12, 2009.

²Pat Dorsey. “What’s Ahead for Stocks” Money January/February 2010

³Reshma Kapadia and Russell Pearlman. “Where to Invest 2010” SmartMoney January 2010

⁴Katie Benner, Scott Cendrowski, and Mina Kimes. “The Best Stocks in 2010” Fortune December 21, 2009

Whats New at IFA

Feb 5, 2011 Get Your Financial House in Order. Complete a Home Budget and estimate your Net Worth. Then, see if your Retirement is on Track. Print out your reports and repeat each year. If you need help, call us.

Feb 5, 2011 Wall Street Running Amok by Jay Franklin

Jan 26, 2011 Rich and Poor Serve Their Wall Street Masters - by Dan Solin

Jan 25, 2011 Several introductions to the The 12-Step Program that Cures Active Investors.

Jan 22, 2011 Thoughts from IFA. Over last 9 yrs, 11 mos, Buffett ended up with the same return as IP45, but with almost double the risk.

Jan 20, 2011 The IFA Tax Advantage

Jan 16, 2011 Why does IFA advise clients to invest in DFA funds? See this whole page of 14 new DFA videos and explanations.

Jan 15, 2011 Fortune Magazine's Ten Most Admired Companies from 2001. Where are they now on the risk return scatter plot?

Jan 14, 2011 A great review of why investors should index, by Weston Wellington.

About Us

Fortune Kookie

Wed, 19 Jan 2011 15:46:59 GMT

By: Mary E. Brunson | Jan 20, 2011

As sure as the sun rises each day, every New Year delivers a freshly baked batch of stock market predictions (well, half-baked anyway).

Yep, every January, newspapers, blogs and financial television regale us with their signature picks of the “Top Ten Stocks You Need to Buy NOW!” and the “Stocks to dump faster than that stale fruitcake sitting in the tin on your kitchen counter.”

One very popular source for “hot stock tips” is Fortune magazine’s annual issue which touts “America’s Most Admired Companies,” ranking companies on attributes such as the ability to attract talent, financial soundness, and innovativeness. Their “Admired” portfolio is made up of the companies scoring the highest ratings—a veritable crème de la crème for investors. But, before you rush out to nab the latest roster of companies Fortune likes best, it might be a good idea to see how fortunate their picks have turned out to be.

IFA analyzed Fortune’s “Ten Most Admired Companies” (2001) (see below) as a whole portfolio and as individual companies, comparing them to the 20 IFA Index Portfolios for the 9-year, 11-month period studied (2/19/01—December 2010)¹.

The results of the study are shown in the Risk Reward Scatter Plot below, showing that the equal-weighted “Admired Portfolio” significantly underperformed every single IFA Index Portfolio — even the IFA Index Portfolio 5 which has 85% fixed income. Despite the fact that the “Admired Portfolio” portfolio carried slightly higher risk than the IFA’s riskiest Index Portfolio 100, it had a negative return for the time period. In contrast, the IFA Index Portfolio 100 earned an annualized 8.47% return, and did so with slightly less risk than the “Admired Portfolio” (after advisor and mutual fund fees). When you look at the performance of the individual stocks in the “Most Admired” lineup, the story gets worse for the Fortune tellers. In fact, nine of the ten stocks underperformed substantially from a returns perspective, despite the fact that they were far more risky, and seven of the ten ended up with a negative return for the period. Even Warren Buffett's widely touted Berkshire Hathaway stock failed to compensate investors for risk, delivering the returns of an IFA Index Portfolio 45, despite the fact that it took risk greater than an IFA Index Portfolio 80. Returns of all investments include reinvestment of dividends.

No Fortunes in Fortune

The quote that kicked off this article is stunningly accurate. Pro-index funds stories don’t sell magazines—a poor reason to perpetuate the myth that financial journalists or “Fortune Tellers” can pick the handful of stocks to achieve wealth — in fact, by the looks of it, it appears the best way to lose a fortune is to follow Fortune.

By the way, at IFA, we have our own fortune. It is from a fortune cookie that IFA President and Founder Mark Hebner received at a Chinese restaurant. We keep it nestled underneath the crystal ball which sits in IFA’s conference room. It is the only fortune we follow:

Fool Me Twice?

Thu, 13 Jan 2011 14:21:46 GMT

Fool Me Twice?
By: Mary E. Brunson | Jan 12, 2011

It's that time again; the wonderful time of the year when financial pundits clamor for blog space and camera time to share their predictions about how the market will behave in 2011.

Who can blame them? Inquiring minds want to know, and heck, they have nothing to lose and everything to gain because no one actually expects them to be right, but if they are — they'll achieve guru status.

So far, we have heard predictions on the growth of the economy, sectors, industries, inflation, and new consumer products that are sure to lure dollars out of savings and into commerce.

Certainly, a handful of them may turn out to be right (by chance alone), but before we set our financial compasses in any one direction, or permit ourselves to be pulled into the vortex of predictions, it might be wise to look back at a handful of last year's "big" predictions as reviewed by SmartMoney.com, and see just how accurate they turned out to be.

Last year, Chief U.S. economist Dean Maki predicted a solid growth in U.S. GDP of 3.5%. His optimism went largely unrewarded as the growth was about 2.7%. He blames "surprises" like declining exports and surging imports. So what does he predict 2011? He has decided to split the difference at 3.1%.
Robert Shiller was perhaps "irrationally un-exuberant" when he predicted a double dip in the housing market in 2010. He argued a disappearing tax credit would cause folks to lose interest in buying a home. In reality, the housing market was up for the year. What is Shiller's prediction for housing in 2011? He refuses to make one.
Bill Dunkelberg, chief economist at the National Federation of Independent Business, predicted that small businesses would boost borrowing to buy equipment and increase inventories. Even though the recession officially "ended" in June 2009, business owners failed to step up to the plate. The Federation said that more than half its members declined to take out loans in 2010. Dunkelberg has renewed his prediction for 2011, saying that it will be a year for business borrowing.
The economist formerly known as "Dr. Doom" may see the end of his 15 minutes of fame. --Nouriel Roubini predicted that 2010 would be embroiled in deflation, partially the result of falling demand for goods. Nope. It turns out that the seasonally adjusted annual rate of inflation was 1%.
Harry Dent, founder and CEO of the economic think tank HS Dent, foretold an economic apocalypse in 2010. In the summer of 2009, he predicted the market was going to go into a freefall throughout 2010 and 2011, with the DJIA bottoming out somewhere between 7,200 and 3,800 in mid-2012. Despite the DJIA's rise of 11% in 2010, Dent remains unwavering in his doomsday prophecy, stating "The markets will go up into March 2011 or so, but will then start to correct themselves." Apparently, his crystal ball is very clear to see so far ahead.

So there we have it, a very short list of the year that was foretold and the year that actually unfurled.

The primary problem with predictions is that they rely heavily on old news to predict new news. But, we see time and time again the failure of this practice.

In a more than timely coincidence, Burton Malkiel has just released his tenth edition of A Random Walk Down Wall Street. The original title was released some 40 years ago, and has sold more than 1.5 million copies.

Throughout the years and editions, Malkiel's message has changed little, continuing to tell us that you can't beat the market. In other words, you can't rely on predictions about future events to improve upon the returns that the market dishes out.

The essence of his message is clear, stock prices efficiently incorporate all information available at any given time and trade at fair value. There are no profits sitting around, waiting to be picked up by investors.

"Who knows what the future is going to be," but "the market is efficient enough so that it is unbeatable," he says.

Malkiel was recently interviewed by Henry Blodget who asked the pointed, but obvious question: "If you turn on CNBC there is a parade of people – people who get paid for their work and advice -- who actually think they can beat the market. Are these people dishonest or just completely delusional?"

Malkiel answered that behavioral economics suggest this hope is based on delusion. "People really do believe that they live in Lake Wobegon [and] that they are better than average," he stated but then added "When you are getting paid very handsomely for your advice, it is quite easy to be delusional."

Need a fresh resolution for this year and for good: Stop trusting the pundits and their endless stream of predictions. Trust the markets instead.

Watch Burton Malkiel's interview on tech ticker, and read the full article "Markets Aren’t 100% Efficient, But You Still Can’t Beat ‘Em"

Who Profits if Markets Are Inefficient?

Mon, 06 Dec 2010 00:00:00 GMT

Who Profits if Markets Are Inefficient?
By: Mary E. Brunson | Dec 6, 2010

Some 110 years after the impoverished and oppressed of France vigorously launched a long and bloody battle for fairness when they stormed the Bastille, a quiet revolution began in a French library where mathematician Louis Bachelier set forth his notion of fairness in stock prices through market efficiency. He asserted that there is no useful information contained in historical price movements of securities, and that speculating on future movements based on past movements would be a zero-sum game before costs, and negative after costs.

Bachelier’s work was largely ignored until the mid-20th century when notable financial scientists such as Paul Samuelson (Nobel Prize Winner), Alfred Cowles (founder of the Cowles Foundation now housed at Yale University), Paul Cootner (The Random Character of Stock Market Prices), Eugene Fama (Professor of Finance, University of Chicago Booth School of Business) and Burton Malkiel (Princeton Professor and author A Random Walk Down Wall Street) found empirical support for the assertion that prices reflect all information that can be known and that new information (which is unknown) is the only impetus for changes in price.

The body of work, formally inked by Fama as the Efficient Market Hypothesis has been at the center of a long and polarizing debate among financial experts.

Click to watch the video at hebnermodel.com

At the Heart of the Matter

Are there discrepancies in stock market prices that can be identified and exploited for profit? Can experts apply rigorous analysis to cull out the handful of stocks that are poised to outperform all of the others because such experts have the talent to spot a key aspect of a company that would otherwise elude the millions of other market participants? Bachelier, Samuelson, Cowles, Fama and Malkiel, among many others would say, “No, stock prices reflect all known or available information, and that mispriced securities cannot be spotted in advance and exploited for profit.”

In contrast, active managers the likes of Bill Miller (Legg Mason Value Trust), Jim Cramer, and those at fund companies such as American Funds, PIMCO, along with consulting firms and hedge fund managers, would argue that, yes, there are skilled managers who have acumen to beat the market. They would further assert that such experts are well-worth the additional expenses associated with finding them and investing with them.

Those of us who have been embroiled in the heated discussions surrounding these issues can readily attest to the passion and conviction that consumes each side of the debate. So visceral are these discussions that taboo conversations at parties extend beyond religion and politics to include “active vs. passive.”

A Détente?

A recent

SF Gate.com

article cites Meir Statman, a Santa Clara University finance professor and author of the book

What Investors Really Want

. Statman takes a unique position, providing welcome relief in this polarizing debate. In summary, Statman tells us that the market efficiency debate is a moot point because even if markets are not efficient, the expenses associated with capturing the inefficiencies erode excess returns, making indexing a superior investment approach regardless of your stance on market efficiency.

“You might say that individuals can beat the market by hiring a professional, but after paying all the expenses of the money manager, they are losing.”

And he adds:

“People in behavioral finance and standard finance come to the same conclusion. Don't try to beat the market. Whether it is rational, as people in standard finance say, or crazy, as I say, don't try it.”

Statman talked about behavioral finance and his new book in a Morningstar.com interview. When asked about his thoughts on index funds, he stated, "Well, index funds are fabulous. Now you say well can I do better than average? Can I perhaps exploit other people's cognitive errors? And the answer to that is probably yes. But the question really is how much does it cost you to exploit the cognitive errors of the others. Think about somebody who says there are $100 bills some place in the streets, so this is the equivalent of a cognitive error of other people, because they have left it lying down. Well, but it will probably take you three days to find that one $100 bill, if that. And so you're going to waste too much money looking to exploit other people's cognitive errors, and in the process you're going to really shortchange yourself by getting lower returns." Watch the full interview below.

Click here to watch the video

The Real Winners of Market Inefficiency

We can all continue to argue about market efficiency, but, even if markets are inefficient, the real winners are not the investors themselves — they who took all of the risk -- but rather the managers, the consultants, the brokers and the transfer agents who guarantee themselves their piece of the pie by convincing investors to believe they can enjoy excess returns through market inefficiency.

Perhaps Fred Schwed’s timeless tale says it best:

“Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said, ‘Look, those are the bankers’ and brokers’ yachts.’

‘Where are the customers’ yachts?’ asked the naive visitor."

The Role of Randomness & the Goal of Persistence

Fri, 24 Sep 2010 10:36:24 GMT

The Role of Randomness & the Goal of Persistence
Sept 23, 2010 By: Mary Brunson

I spent the last week participating in an institutional investing conference. There, I had the opportunity to speak with finance directors and treasurers of organizations from all over the country. Some of the attendees are retirement plan administrators and others oversee common assets such as foundation or endowment assets.

Occasions such as this are important because they cast light on the challenges and concerns faced by the individuals who oversee institutional investments. They also provide me with a good starting point for where to begin the education process for those who are responsible for institutional assets such as retirement plans—the sort of plan you might be investing in right now.

As I ruminate about the conversations I had with many of the several hundred attendees, a couple of prominent themes prevail in my mind.

1. Each treasurer, administrator and finance director has similar needs: maximize investment returns at a specified level of risk (asset allocation), keep investments low-cost, risk-appropriate and improve transparency.

2. Many rely on the selection and termination of investment managers who actively manage their funds as an investment strategy for their endowments, retirement plans and foundations.

When we look at the goals for these investments, it’s imperative for decision makers to realize that active management is not the optimal investment strategy.
Let me explain.

The Tyranny of High Costs
Costs are an inherent component of any investment strategy. However, active management includes fees that passive management avoids—namely the weighty salaries paid to the active managers and the increased trading costs associated with the high turnover of positions in actively managed investments. Portfolios of passively managed index funds cost about one-third as much as actively managed funds. Knowing this, there is a steep hurdle that must be overcome by active management to simply keep up with its index fund counterpart—the one they are supposed to beat.

Of course, there is a supposed rationale behind the higher fees of active management. The idea is that active managers can use their stock selection acumen to ferret out above-benchmark returns. They will carefully read analysts’ reports, meet with corporate executives and assess whether a company is mispriced in a way that would allow it to appreciate faster than the overall market.

However, we find that markets are very efficient and quickly absorb the information accumulated by thousands, if not millions, of global traders into a price within minutes of the release of such information. These “fair prices” obtained by willing buyers and willing sellers are at the heart of Eugene Fama’s Efficient Market Hypothesis. Two consequences of fair prices are that investors should only expect to earn higher returns when they take higher risks and that future returns are equally likely to be higher or lower than an appropriate return for the risk.

The results of fair prices have been affirmed by the plethora of active managers who have failed to use their countless resources, abundant business acumen, and well-positioned corporate relationships to identify mispriced or “unfairly priced” equities. As the result, they have also failed in their attempt to consistently exploit the other side of their speculative trades and secure higher returns than a risk-appropriate benchmark. A recent study of 2,072 managers over a 32-year period showed that, when properly benchmarked, 99.4% of active managers lacked “genuine stock picking skill.” The chart below tells the story.

All the News that is News
When we understand the principles of the Efficient Market Hypothesis, we accept that current prices reflect known information and are the best estimates of the impact of forecasted information. In other words, everything we know about a company, about its sector and about the local and global economy has already been factored into the free and fair market price of a stock, and the only information that can move the price—either up or down—is the information that we do not have, or news which has yet to be revealed to the market as a whole. Knowing this, we understand that an active manager who seeks to cull the future strong performers and eliminate the future laggards is merely engaging in a gamble or speculation as to whether the current price already includes that prediction.

Speculation Blues
Listen to the song here.
Decision makers recoil at the idea of speculating with their investments. But, active managers are, in fact, speculating about the news that will move future prices up or down. In 1900, French mathematician Louis Bachelier told us the expected return on speculation is zero, and that is before costs. So, the expected return on speculation is negative after costs. In several active manager studies covering multiple asset classes, on average, 92% of active managers failed to beat the benchmark index. This is the cost of speculation.

Las Vegas emerged from the hot sands of the southwestern desert for one reason only—the inherent human desire to speculate about an ultimate outcome. This explains why as one travels down the Las Vegas strip, they will see signs that say ‘Our slots return 97%.’ What they really mean is, “If you give us a dollar, you have an average expectation of getting 97 cents back.” In Las Vegas, the expected return on speculation will turn a dollar into 97 cents. Despite this fact, we can still hear the ding, ding, ding of the machines and the intermittent squeals of good fortune that lure those who do not have a grasp on the real odds of success. Those fancy casinos are built on that pervasive cost of paying to play. And the television programs and magazines that track and comment on the financial markets are largely paid for by advertisers who profit from active management and often tout their recent luck. If investors really understood their odds of success, they would probably choose to not gamble at Wall Street’s really big casino. Nobel Prize winner William Sharpe asks the simple question, “Why pay people to gamble with your money?” Unfortunately, the answer to this question can best be answered by Gary Bethke who tells us, “Odds are you don‘t know what the odds are.”

Randomness vs. Persistence
When we start reading peer-reviewed academic research, we encounter the studies like “The Selection and Termination of Investment Managers.” It determined that managers who were hired by institutions actually underperformed those who were fired by those institutions over the subsequent 3-years. These results clearly show the random nature of manager performance with luck being the primary determinant of success—and luck is not a repeatable skill.

Manager selection results from the analysis of small data sets. The industry standard for fund manager reporting is 1-, 3-, 5-, and 10-year performance. With randomness driving the markets in short periods, no clear-cut characteristics are evident during these abbreviated timeframes. Statisticians tell us that we need at least 20 years before we have enough data to have a clear direction as to an expected outcome. The chart below sets forth the contrast between small sets of data vs. large sets. In the Index Comparison chart for small value vs. large growth, we see the 1- , 3-, 5-, 10-, 15-, and 20-year outcomes based on 82 years of monthly rolling period returns. These are very large data sets and provide ample data for identifying risk and return estimates of various asset classes. When such large data sets are analyzed, we begin to see the probabilities of one asset class doing better than another: a large-growth index has outperformed a small-value index in 41% of one-year periods (randomness). Large-growth has even outperformed small-value in 27% of 10-year periods. However, in 97% of 20-year periods, small-value has outperformed large-growth. This analysis of very long term history is important to determine the optimal asset allocation and what risk factors best reward investors. As legendary investor and mentor to Warren Buffett said, “In the short-term, the market is a voting machine, but in the long-term, it is a weighing machine.”

The Lessons
When you analyze long-term, style-pure index data, conclusions about the optimal investment strategy become crystal clear:

An active manager’s short-term, above-benchmark returns are the result of lucky speculation, a non-repeatable skill. It is estimated that 3% of active managers will beat their benchmarks over long periods—through luck alone.
Large data sets that incorporate monthly rolling period returns provide a clearer picture of the real source of stock-market returns. For equities, a risk-appropriate tilt toward small-value markets around the world carries a higher expected return.
Markets are efficient and prices reflect all known information. Thus, stocks are fairly priced to reward investors for the risks they bear. The distribution of errors in the price looks similar to a bell curve and the errors are not known in advance.
An institution can improve its expected returns by simply eliminating unnecessary fees and expenses. The high cost of paying active managers to gamble with your money and consultants to hire and fire those managers is great place to start the cost cutting.
The best way to achieve higher risk-adjusted returns is simply to buy, hold and rebalance a risk-appropriate blend of low-cost, style-pure indexes that have long-term risk and return histories. When you do, you can invest and relax.

Proper Benchmarking and Alpha

Fri, 10 Sep 2010 09:56:39 GMT

Proper Benchmarking and Alpha
Sept 09, 2010 By: Mary Brunson

When you look at your own personal investments, or those of an foundation, 401(k) or defined benefit pension plan, proper benchmarking is the most critical factor in determining whether active managers possess the skill necessary to consistently deliver returns in excess of the risk-appropriate benchmarks.

A Little Background

In 1952, Nobel Prize winner and consultant to Index Funds Advisors, Harry Markowitz set forth his Nobel Prize winning notion that risk must be considered as well as return. Through his risk-reward scatter plot (LINK), you can estimate whether or not your investments have been optimized so that your expected returns are maximized for your current level of risk.

In 1964, Sharpe’s Capital Asset Pricing Model set forth the idea that the returns of investments are explained by how closely those investments have matched or correlated to the market portfolio. The market portfolio is considered a “beta” of one and investments with betas greater than one (more volatile) should have higher expected returns and visa versa. This single risk factor model is a common measure obtained from Morningstar or Lipper data, however, it only explains about 70% of the returns of diversified portfolios. This leaves room for benchmarking errors by active managers when they compare their returns to a single market portfolio and claim that they have beaten the market.

From Sharpe’s single risk factor model, assertions arose from active managers that the various active strategies, such as stock selection, manager selection, market timing, and sector rotation could produce returns in excess of the market, which is referred to as “alpha.”

This line of reasoning asserts there are mispriced securities and by avoiding the over-priced securities and acquiring the under-priced securities, active managers can beat the market. But passive investors have a very different perspective. They realize there are millions of willing buyers and sellers in the world, all of whom have easily obtainable and low cost access to publicly available information. In total, those market participants are trading about 10 billion shares per day based on this information. It is not plausible that the securities would be mispriced. To the contrary, publicly traded securities may be the most accurately and fairly priced item in the world. Stock and bond prices determined in a free market are instantly and continuously being updated based on new and randomly occurring information. The news describing the progress of global capitalism is on average positive. Therefore, the market increases in value over time as the result of the profits from capitalism.

The notion that active managers can skillfully and repeatedly beat markets is enticing, but academics have not been able to confirm “manager skill” in empirical research. Instead, they commonly label the very few managers who have beaten a multi-risk factor model as being just lucky. Unfortunately and by definition, luck does not persist.

Numerous studies have concluded that “alpha” is a myth and it essentially disappears when exposure to two other risk factors are properly measured. Therefore, the common assumption that the market portfolio, often measured by the S&P 500, is a sufficient benchmark for diversified portfolios has been shown to be incorrect.

In 2005, a study titled False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”, by Laurent Barras, Olivier Scaillet, and Russ Wermers investigated the presence of true alpha in 2,072 domestic equity mutual funds for the 32 years from January 1975 to December 2006. It concluded that when properly benchmarked (through a multi-factor regression, as opposed to the single factor regression), 99.4% of active managers failed to demonstrate genuine stock picking skill.

The Real Test of Above-Market Returns

Eugene F. Fama of the University of Chicago and Kenneth R. French of Yale University examined each of the post-1927 returns of every stock in the domestic markets, as well as the volatility of those returns, in search of commonalities that might explain why certain stocks deliver higher returns than others. Their ground-breaking Multi-Factor Model showed that Sharpe’s CAPM, although quite elegant, is incomplete. In addition to a portfolio’s exposure to the market as a whole, two other factors explained stock market returns over time: These are the degree to which the market portfolio carries increased or decreased exposure to small company stocks and stocks with high book-to-market ratios, also known as value stocks.

Since 1927, the portfolio that carried higher exposures to these markets also carried higher returns. But through diversification, the volatility was dampened to about the same as the market portfolio. This is why the Index Funds Advisors’ full equity Index Portfolio 90 is tilted toward small and value companies and invests in 12,000 companies, as opposed to 500.

The findings of Fama and French show that their three factors (market, size and value) explain more than 96% of stock market returns.

Over the last 82 years, the size premium (for greater exposure to small companies) has been 3.17%, and the value premium (for greater exposure to high book-to-market companies) has been an additional 5.04%. The market premium for broad market exposure above the return of 30 day T-bills has been 7.50%. Fama and French’s subsequent 5-Factor Model shows the risk premiums for fixed income, as well. These are term risk and default risk, where the premiums are 2.03% and 0.31%, respectively.

Fama and French further concluded that not all risk factors are worth taking. For stocks, 82 years of data have shown that growth stocks are not efficient uses of risk, with relatively high risk and low returns. For fixed income, long-term instruments carry higher term risk, but have not provided higher returns to adequately compensate for these risks. For investment committees who select active fund managers, these findings are critical, summarizing that true alpha can only be identified once investors have properly benchmarked against indexes that incorporate the multiple factors identified by Fama and French. And when this occurs, alpha becomes just a matter of luck. This leads investors to the unavoidable conclusion that they should cut their costs in half and simply buy a portfolio of indexes in the form of a small value tilted, globally diversified portfolio of index funds. The key issue remaining is what risk level is appropriate for each investor or group of investors and which blend of indexes is most likely to maximize returns at that level of risk. Then hold on, rebalance and let the earnings of capitalism justify the increased values over time.

These concepts are substantive and have endured much scrutiny under the watchful eye of peer reviews, Nobel Prize committees, and the institutional investing world largely governed by the Prudent Investor Rule and its five principles of prudence. They are also the guiding principles for the Index Funds Advisors approach.

Commodity ETFs Revisited

Mon, 30 Aug 2010 15:18:31 GMT

Commodity ETFs Revisited

By: Jay David Franklin, Director of Trading and
Investment Risk, Index Funds Advisors

Aug 30, 2010

IFA has consistently warned the investing public to steer clear of commodities. See here and here for two examples. The reason for this is quite simple. Commodities (or commodity future contracts) do not carry an expected return like equities and bonds. They are simply a bet on the future direction of the price of a good. In other words, they are simply a form of speculation which has zero expected return before costs and thus a negative expected return after costs. Futures markets are dominated by big institutional players like oil companies and large banks (think Goldman Sachs); retail investors can rightly expect to be parted from their money in short order.

Once the exclusive province of “sophisticated” investors, commodities have been made accessible to everyone thanks to a slew of exchange-traded funds such as USO (United States Oil) and UNG (United States Natural Gas). At the end of 2009, investors held $277 billion in commodity ETFs and other securities linked to raw materials—a 50-fold jump from $5.5 billion a decade earlier, according to the Bloomberg Businessweek article cited above. Investors who acted on their hunches about rising oil and natural gas prices and bought into these funds have been met with bitter disappointment. Buyers of USO at its inception date of April 12, 2006 have lost 48% of their investment as of July 31, 2010, even though the price of crude oil has actually risen by about 12%. The story is worse for UNG. Buyers of UNG at its inception date of April 18, 2007 have lost 84% of their investment as of July 31, 2010, even though the price of natural gas has dropped by about 40%. If you are shaking your head in disbelief, wondering how this is possible, keep reading, but it’s going to get a little technical.

The problem, in a word, is “contango”. If you ask the broker who wants to sell you USO and UNG what this means, he probably will not know. Contango refers to the situation where futures prices follow an increasing pattern by duration of the futures contracts. For example, if the 30-day oil futures contract is priced at $75 and the 90-day contract is priced at $80, then the market is said to be in contango. Why does this matter? Because commodity ETFs never actually hold the commodities themselves (due to high storage and insurance costs). Instead, they hold futures contracts that have to be replaced when they get close to expiration. In a contango market, the difference in price between the existing contract and the replacement contract is a direct cost to the ETF. The problem becomes more acute when you consider that the professional commodity traders know exactly when the commodity ETFs will have to roll over their contracts and can game them accordingly. In the words of Emil Van Essen, founder of a commodity trading firm in Chicago, “I make a living off the dumb money...These [commodity] index funds get eaten alive by people like me.” If you think of the dumb schmuck sitting at the poker table with his cards laid out for everybody to see, this statement is quite easy to believe. Greg Forero, Former Director of Commodities Trading at UBS, put it this way, "You walk into a casino, you expect to lose money. It’s the same with these products. You’re playing a game with a very high rake, a very high house advantage, and you’re not the house”.

Unfortunately, the beating has not been limited to retail investors. CALPERs (the California Public Employees’ Retirement System), the largest public pension fund in the U.S., has lost over $120 million in commodity futures since 2007, according to Bloomberg Businessweek. This misadventure will ultimately be paid for by California taxpayers, and perhaps by the rest of the U.S., should California require a bailout.

IFA’s advice to investors remains unchanged. Take the risks that are worth taking and avoid the ones that are not.

Resisting the Siren Songs

Tue, 17 Aug 2010 15:41:56 GMT

Resisting the Siren Songs
Aug 17, 2010 By: Mark T. Hebner, IFA President

I am pleased to share with you my latest painting and subsequent video titled “The Siren Songs of Active Management”, based on Homer’s epic poem The Odyssey. I commissioned the painting as part of my ongoing efforts to protect recovering active investors from heeding the sometimes overwhelmingly alluring temptations to trade.

In the heat of a struggle, such as that which we experiences from the end of 2007 through the beginning of 2009, we frequently fail to recall that we have faced and dealt with adversity before, and have been well-rewarded for our conviction.

Homer’s poem is particularly relevant to this message. In The Odyssey, Greek hero Odysseus suffered trials and tribulations as he spent a decade trying to reach his home in Ithaca after he successfully battled the Trojan War. There, his wife Penelope faithfully awaited his return while his son Telemachus vainly attempted to hold interloper suitors at bay as they consumed their food, pillaged their home, and curry favor with his mother.

During his long journey, Odysseus faced turmoil as he was nearly thwarted by the siren songs which beckoned him to surrender to their beauty, but Odysseus knew their deception would cause him to crash his ship upon the rocks if he heeded their message. He was curious to hear their songs, but he also knew they would lead him and his crew to certain death. He therefore ordered all his crewmen to stuff their ears with beeswax and tie him to the mast so he would be able to hear their alluring songs without being able to act upon their tempting messages. When he heard their beautiful song, he demanded to be untied. But remembering the orders he gave before he was influenced by the siren’s song, his crewmen bound him tighter. In the end, and after much turmoil over those ten years, Odysseus triumphantly returned home to his wife and son. He killed all of the suitors who invaded his home and took advantage of his family’s situation in his absence.

Investors can learn a lot from this story. While the tale was written some 2,300 years ago, it remains strikingly relevant today in the wake of what many call their “lost decade” and as Wall Street sirens sing the songs of buying and selling; selling and buying, and opportunistic suitors pillage the profits of the unsuspecting.

Indeed, the last decade has been filled with trials and tribulation for many investors, but those who kept their eyes fixed on the long-term reward of the journey, kept their wits about them, even tying themselves to the mast to avoid painful mistakes that might have given short-term relief, but would have ended in disaster, have emerged better off for their valor and sheer stick-to-itiveness.

Just as it was a painful and perilous decade for Odysseus, so too has it been for investors. The oft-quoted S&P 500 Index finished the 10-year period ending December 2009 with a total return of -9.1%, making it a favorite siren song for active managers who seek to besmirch indexing in a failed attempt to deflect from their own poor track records. But those who globally diversified their portfolios, bought, held and rebalanced risk-appropriate index portfolios that kept fees low and styles pure, emerged from the last decade far better off than they started. In fact, a globally diversified index portfolio with similar risk to the S&P 500 Index earned more than 75% during the same period that witnessed the S&P 500 Index turn negative (see chart below). This is the power of diversification and the long-held, time-honored virtue of indexing.

Like Odysseus, successful investors need to fill their ears with wax or tie themselves to the mast so the siren songs of Wall Street cannot have the opportunity to crash their retirement savings onto the rocky shores or pillage the profits that were intended for family, not commissioned interlopers.

Click to see the full painting

Upton Sinclair's Insight for Improving Your 401(k) Returns

Thu, 29 Jul 2010 10:56:29 GMT

It’s surprising that Upton Sinclair would provide today’s investors with an insight for investing success. He was born on September 20, 1878. His parents were very poor. His father was an alcoholic. His grandparents were quite wealthy. The stark difference in the financial circumstances of his parents and grandparents influenced him to become one of the most prominent socialists of his time. He even ran (without success) as the Socialist’s Party’s candidate for Congress from New Jersey.

What can this avowed socialist teach us about investing? Here’s a quote attributed to him. It says it all:

“It is difficult to get a man to understand something when his salary depends upon his not understanding it.”

The salaries of brokers and insurance company representatives depend on persuading employers with 401(k) plans to include actively managed funds (where the fund manager attempts to beat a designated benchmark) as investment options in the plan. Billions in fees is generated in this way. The overwhelming evidence supports the view that most of this money is wasted. Plan participants would achieve significantly greater returns if no actively managed funds were in their plans. Instead, the plans should offer a limited number of pre-allocated, globally diversified portfolios of low cost index funds, Exchange Traded Funds or passively managed funds.

People who make a living selling actively managed funds react to this news much like a speech by a vegetarian is received at a cattlemen’s convention.

One reader (a broker) patiently explained that I didn’t understand the math. He believes the support for index funds in the press is caused by its willingness to accept glib statements from bloggers (like me). He provided no data to support his view.

Two distinguished finance professors who clearly do “understand the math” are Eugene F. Fama, a Professor of Finance at the University of Chicago, Booth School of Business, and Kenneth F. French, a Professor of Finance at Dartmouth College, Tuck School of Business. In their recent study, Luck Versus Skill in the Cross Section of Mutual Fund Returns, they attribute outperformance of actively managed funds to luck and not skill. Because there is no evidence of skill, it’s not surprising those funds that do perform well over a given period of time typically cannot repeat their stellar performance.

The ramifications of this study hit brokers and insurance companies right where it hurts — in their pockets. If employers understood this data, they would not include actively managed funds in their 401(k) plans because those funds are likely to underperform passive benchmarks by almost 1% per year.

The reaction to studies of this sort is interesting. Another reader explained his strongly held view that “managed funds” should be in all 401(k) plans. He bragged his credentials included an M.B.A. He was a consultant to corporations and boards on how to reduce their fiduciary risk.

I responded with a number of studies (including some by Nobel Prize winners in Economics) rebutting his views. I encouraged him to send me peer reviewed studies with contrary data. I told him I had an easy solution for eliminating fiduciary liability, rather than simply mitigating it: Require investment advisors to 401(k) plans to be 3(38) ERISA fiduciaries and to accept 100% of the liability for the selection and monitoring of plan assets.

Here’s his response: He doesn’t believe in academic studies. He has no confidence in the committee that appoints Nobel Prize winners. He sent me no data.

The pattern is very familiar. Research is responded to with rhetoric, but no contrary data. Unfortunately, their clients often don’t have the sophistication to confront them with studies that demonstrate what they are selling is in their best interest, but not in the best interest of the participants in the plan.

Employers need to appreciate their potential exposure as fiduciaries to plan participants. It’s only a matter of time before an enlightened court reviews the studies and concludes the inclusion of any actively managed fund in a 401(k) plan violates the duty of prudence.

Brokers and insurance companies will never “understand” this evidence. Their salaries depend on their not understanding it.

Grading Your Employer’s 401k Plan

Thu, 15 Jul 2010 09:11:27 GMT

Grading Your Employer’s 401k Plan

When you head out each morning to work, you have an expectation that your employer is providing a safe environment. There is no heavy object loosely dangling above your desk and the coffee in the break room uses water that has gone through some filtration system. Your employer provides this safe environment at work because while at work they have a responsibility to the well-being of their employees. This responsibility extends beyond your physical and mental health. If they decide to offer you benefits such as a retirement plan, they must place your interests above all else, otherwise known as a fiduciary responsibility. The law has provided some guidance as to what constitutes fiduciary prudence in regards to employer sponsored retirement plans. These are laid out in the Employee Retirement Income Security Act, or ERISA.

A Little History

Gone are the good ole days of your parents’ pension plan. Funding your retirement was so much easier back in the day. Each paycheck, your employer would take out a portion of your earnings and, along with a little extra money from their own pockets, invest the funds for you and your colleagues. At retirement, the pension fund would begin sending you a paycheck every month calculated using a formula that included your years of service and salary. You should notice one important thing missing in that calculation — Investment Return!!! Investment returns were solely the responsibility of your employer. Whether the investments in the fund performed well or poorly, your monthly retirement check calculation would stay the same. Poor investment performance just meant that your employer had to make up the short fall to cover their obligation to you. This did not sit well with employers; they did not want to assume the risk of poor market performance. So, that risk was transferred to the employees utilizing a long standing yet little used section of the code known as the 401(k).

An Employers’ Duty

Now the 401(k) is the norm, and the pension plan is, for the most part, non-existent in private industry. Instituting a 401(k) plan may have transferred investment risk to the employees, but the responsibility to act in the best interest of the employee, or fiduciary prudence, still lies with the employer. The 401(k) plan must provide a reasonable process for selecting investments. Which begs the question, what is a reasonable process? Well, the Uniform Prudent Investor Act spells out that the reasonable process must be rooted in Modern Portfolio Theory. This means the process must take into account three important factors:

the trade-off between risk and return
offer investment products which provide broad diversification both within and across asset classes
charge fees appropriate relative to service

Unfortunately, it seems as though employers have misinterpreted their transfer of investment risk to the employee to also mean a transfer of fiduciary prudence. Too many employer-sponsored 401(k) plans violate nearly all three of the above factors. Investments are chosen based on recent outperformance (which has been proven overtime to be no indication of future performance) while ignoring risk, investment options are narrow and often ignore many asset classes, and fees are excessively large and many times hidden. The silver lining here is that employees are beginning to fight back. Lawsuits against prominent companies are mounting. Names like Wal-Mart, Caterpillar, Unisys, United Technologies, Honda, Boeing, etc. are all seeing their fiduciary prudence being questioned. To be fair, each of these companies has been sued but not all have received a judgment against them. That being said, the accusations tend to include the terms excessive fees, limited options, and even active management without similar passive options.

Grading Your 401(k)

Here are some important questions to research in your plan documents:

Do your fund expenses exceed the following:

0.35% for US Large
0.50% for US Small
0.50% for Real Estate
0.50% for International Large
0.80% for International Small
0.80% for Emerging Markets
0.35% for Fixed Income

Do the expenses include 12b-1 Fees (which are paid to the plan provider but only serve to lower your return)?
Is your plan missing one or more of the above asset classes?

Are you forced to choose from a menu of expensive actively managed funds without index fund alternatives?

Do funds tend to last only for a couple years in the plan, entering after recent good performance then leaving when they cannot replicate the performance?

Are you given little to no guidance on how to put together a risk appropriate portfolio using the fund selections available?

As a plan participant, employees should be unequivocally concerned with the asset allocation of their retirement plan. As an employee, if your retirement plan is unknown to you or poorly performing, a visit to your HR department is in order. You should seek passively managed options through index funds with a low cost structure. Here's a letter to ask your Plan Sponsor for Index Funds.

Special Edition of IFA Radio!
Your Rights as a 401(k) Participant

Click to play show

Can You Afford Sophistication?

Tue, 15 Jun 2010 12:08:10 GMT

Can You Afford Sophistication?

In the recent controversy swirling around Goldman Sachs, we have had the good fortune to be introduced to many charming Wall Street expressions such as "ripping the client's face off" or "blowing up the client". However, one term that has kept showing up like a bad penny (or a defaulted subprime mortgage) is "sophisticated investors". Specifically, Goldman has countered the SEC's charges of fraud with the claim that all the poor saps on the wrong side of the synthetic CDO trade were among the world's most sophisticated investors, and thus deserve neither sympathy nor recompense. The merits of Goldman's arguments will be left to the courts to decide. Our purpose here is to take a deeper look into the general application of the term "sophisticated investor".

It is IFA's position that the term "sophisticated investor" carries no value and is best expunged from our vocabulary. There are good investors who diversify both within and among asset classes, control their costs, and keep constant vigilance over their self-destructive behavioral tendencies. Investors who fail to do these things can be classified as poor investors (pardon the double entendre). It has nothing to do with one's level of investable assets. While it may be tempting to apply the "sophisticated investor" label to certain institutions such as Goldman Sachs which had not a single day of trading losses in the first quarter of 2010, we would be remiss not to point out that the bulk of these trading profits derived from their ability to borrow from the government (i.e., taxpayers) at zero and collect a spread on lending back to Uncle Sam, all the while using leverage to magnify their gains. Regarding Goldman's "recommended top trades for 2010" for its ultra-sophisticated clients, a recent article on Bloomberg.com showed that seven of the nine trades have been money losers so far in 2010. Some of the trades, such as buying the Polish Zloty while shorting the Japanese Yen almost sound a bit goofy. The spokeswoman for Goldman Sachs, Gia Moron (You can't make this stuff up!), declined to comment. Considering that the clients of Goldman Sachs are receiving investment ideas from a firm that does not owe them a fiduciary duty (as detailed in this column by Michael Hiltzik), the term "sophisticated" seems highly misappropriated.

When we hear that someone is labeled as a "sophisticated investor", two possible images come to mind. The first one is of the high net worth individual who has access to exotic investments that are off limits to the most investors. Chief among these would be hedge funds. IFA's well-known views on hedge funds may be found here. It is important to bear in mind that hedge funds are not required to report their performance, so the overall performance of various hedge fund categories reported by various databases is likely to be heavily upward biased. If you are a client of a major Wall Street firm and your broker tells you that you are a sophisticated (or qualified) investor, IFA's best advice is to turn around and run for the hills. This term is often used as a license to sell you a complex product with high fees and hidden risks such as leverage. The application of these terms to investors has often led to a dilution of fiduciary duty, which even if it is not explicitly contractual, is normally expected by clients. Just as Goldman and the other Wall Street sharpies regarded their trading partners (e.g., AIG) as sheep waiting to be slaughtered, clients of these firms have no reason to expect better treatment.

The second image of the sophisticated investor is the rocket scientist from MIT employed at Goldman Sachs who designs exotic derivative instruments that the rest of us can barely begin to comprehend. As with the wealthy hedge fund investor, risk and return are inseparable, and no application of brainpower will ever result in cheating risk. The market owes nobody a higher return merely because they are smarter than most of its participants. Every mathematical model in finance is built on assumptions, and 2008 taught us what happens when one of these assumptions turns out to be incorrect.

Other strategies that we associate with sophisticated investors are short-selling and buying on margin. However, thanks to companies like Profunds and Direxion, anybody, regardless of their level of "sophistication", can take a double/triple leveraged/short position in almost every index under the sun. A question worth asking is whether having access to these strategies is more likely to enhance or destroy wealth. The fact of the matter is that even if someone can successfully predict the return of an index over the next 1 to 12 months (which nobody can do except by luck alone), he will not be able to capitalize on his investment acumen using these instruments. For example, supposing on January 1, 2008, your crystal ball told you that by the end of 2008, the Dow Jones REIT index would fall by 37%, you would then put every penny you have into SRS, the Proshares Ultrashort Real Estate ETF, but you would be sorely disappointed to discover that you lost half of your money by the end of the year. You would have been better off with a long position in the index itself. Ouch!

When it comes to sophisticated investors, it is truly a case of the emperor having no clothes, so perhaps the world would be a better place if we limited our use of the word "sophisticated" to describe advanced tastes such as art, music, or literature.

Black Swans, Fat Tails and Your Money

Thu, 13 May 2010 17:46:59 GMT

Black Swans, Fat Tails and Your Money

On May 6th, 2010, the stock market suffered the worst one-trading day plunge in history as it dropped almost 1,000 points in less than a half hour. If you were watching CNBC, you would have thought we had been attacked by terrorists. People were screaming at the top of their lungs in the background, and the TV guests’ voices were fluctuating as though they had just seen a ghost.

This is what some people would call a black swan and these extreme events are expected in distributions that are known to have fat tails, like stock market returns. Black Swan events are described by Nassim Nicholas Taleb in his 2007 book, The Black Swan. The main idea Taleb seeks to drive home is that it is foolish to try to predict Black Swan events and that those events can have a significant impact for investors. One should instead make sure they are prepared to accept Black Swans in the short term and "time diversify" their investments over the long term, so that black swans become irrelevant. Investors should also beware that black swans are just as likely to be positive as they are negative returns and therefore over time the events offset each other.

"I think the machines just took over. There's not a lot of human interaction," said Charlie Smith, chief investment officer at Fort Pitt Capital Group. "We've known that automated trading can run away from you, and I think that's what we saw happen today." Likely, these words provide little comfort to the vast many investors or active fund managers who, with pre-set market sell orders or stop-loss orders, quickly had their money ripped out of the market as it sank like a rock; nor would they have been happy when they had no way to get their money back into the market when the market shot up like an Apollo rocket. The money people lost in the mind-boggling freefall created by automated computers and antsy money managers is money they will NEVER get back, except for those trades that were cancelled by the exchange. It was something straight out of a science fiction movie where machines started taking over people’s portfolios.

So you may be wondering how passively managed portfolios are impacted by such events? The rules of construction for the our favorite index funds from Dimensional Fund Advisors (DFA) allow for “patient trading” during the reconstitution or rebalancing of stocks in a fund. Most index funds adhere to a strict reconstitution date which coincides with the benchmark index. In contrast, DFA's are reconstituted on an ongoing and opportunistic basis. The objective of this strategy is to avoid the announcement of when certain stocks are added or dropped from the fund, creating what we like to call a "silent index."

These passive strategies can serve investors quite well in cases such as the whopping drop of last Thursday, as savvy passive fund managers provide liquidity to sellers of large blocks of shares. In many cases, this ability enables shrewd passive fund managers to complete their trades significantly below the price of the previous trade. IFA advises their clients to utilize passive fund managers who patiently trade with intelligence and confidence, as they benefit from the over-eagerness of those playing the speculation game.

A Black Swan Sighting.. It is a Good or Bad Swan?

Stated another way, while most traders are liquidity seekers (trying to dump stocks so they can buy the next hot stock), passive fund managers act as liquidity providers, relieving impatient active investors of those unwanted stocks -- frequently at a deep discount.

We encourage IFA clients to tie themselves to the mast, keep their eye on the long-term horizon and ignore the short term black swans. We know that we can not predict these rare events and recognize that such events are one of the reasons that our clients are rewarded for their patience over appropriate holding periods.

Who Should You Trust?

Wed, 28 Apr 2010 15:47:52 GMT

Who Should You Trust?

To hear Lloyd Blankfein tell it, the financial market system did its job. If it weren’t for that darn downturn in the housing market, everything would have been just fine.

True enough, the downturn in the housing market precipitated a horrific slide in valuations that snowballed into an overleveraging of epic proportions, one which had the US mints printing some $700 billion to cover the liquidity requirements of major banks and sending the US economy into the worst downturn since the Great Depression.

Despite the enormous government intervention, major corporations were flicked off the map and millions of people have been swept away from their homes. Millions of jobs were lost. Indeed, the last 2 years have been trying and extremely challenging.

Essentially, Blankfein argued that he and his 35,000 employees just did their jobs, giving the people what they wanted and harbored no responsibility to represent their own analysis or position with respect to the investments they sell.

In a heated Senate Subcommittee hearing held on April 27, the Goldman Sachs CEO argued that Goldman sold people the risk exposures they came for and were never obligated to disclose that the collateralized debt obligations (CDOs) they were packaging and selling long to their clients were the very same investments they were betting against (shorting) in their own investment accounts.

Did Goldman Sachs have the obligation to disclose this fact to their clients? Was Goldman wrong to sell billions of dollars of investment vehicles they secretly and frequently cite in emails as being what we’ll call garbage (expletive deleted and replaced)? Did Goldman break the law by not disclosing a major conflict of interest?

It’s very difficult to rationalize or justify the behaviors that played into the horrific downturn, especially when Blankfein earned a fat $9 million bonus in the same year when millions were losing their jobs and their homes — the result of the garbage (expletive deleted) assets Goldman sold and shorted.

At the heart of this case is what is Goldman permitted to do under the standard of suitability? The SEC asserts that Goldman’s conduct was not permissible. Blankfein vociferously disagrees. And the outcome may rely on answering this question? Is selling garbage (expletive deleted) investments illegal or just immoral? If the SEC determines it’s illegal, Goldman has a big problem. If it’s immoral, investors have a big problem.

We have a solution:
Close your eyes, click your heels three times, and say:

“There’s no one like a fiduciary, there’s no one like a fiduciary, there’s no one like a fiduciary.”

Fiduciaries are required to act with undivided loyalty to their clients. They are required to disclose how they get paid and reveal any corresponding conflicts of interest.

The Committee for the Fiduciary Standard states the five principles of fiduciary standard, as follows:

Put the client's best interest first.
Act with prudence; that is, with the skill, care, diligence and good judgment of a professional.
Do not mislead clients; provide conspicuous, full and fair disclosure of all important facts;
Avoid conflicts of interest.
Fully disclose and fairly manage, in the client's favor, unavoidable conflicts.

These are noble aspirations, ones which many big insurance companies and broker dealers would like to have you believe they are able to deliver to you, until, that is they are pressed on the issue as Blankfein was in his January, 2010 SEC hearing in which he stated, “We are not a fiduciary.” He added that Goldman must “fully disclose what an instrument is and be honest in our dealings, but we are not managing somebody else’s money.”

Unlike Goldman Sachs, IFA is a fiduciary. We willingly accept the responsibility to put our clients’ best interest above our own, and at all times, making investment recommendations that are squarely in the best interests of our clients and their ability to take on stock market risk.

We at IFA fulfill this standard for individuals, institutions, and retirement plans including 401(k), 403(b), and defined benefit plans, providing low-cost, no-load index mutual funds that carry 83 years of risk and return data.

We at IFA gladly accept this fiduciary obligation because we receive no revenue sharing and no incentives to recommend one fund over another, thereby avoiding conflicts of interest.

If there is one fundamental lesson that investors can learn from the horrible economic downturn and the fallout, it is this: always, always, always work with a fiduciary--one who will put in writing that they accept the fiduciary duty, and that they will put your best interests above their own, fully disclosing all revenue sources and potential conflicts. Doing so will give you a higher probability of success, and avoid unpleasant (expletive deleted) outcomes.

I.R.S.: Investment Returns Sucker

Thu, 22 Apr 2010 14:13:11 GMT

IRS: Investment Returns Sucker

By Robert Bray

A tapeworm is a parasite that can be ingested when you eat raw or undercooked meats. They attach themselves to your intestines, silently sucking nutrition meant for your body. At first, most people don’t notice them. They just take a little here and a little there and they don’t bother the host all that much.

Similar occurrences transpire within actively managed portfolios as silent partners, little by little, suck away investment returns.
These silent partners are the tapeworms of the investment world, extracting management fees, transfer costs, and taxes to grow fatter and happier. In addition, there are other silent partners that take a bite out of both realized and unrealized gains on investments, including:

Sales agents and stock broker who earn commissions or sales loads for individual stock and mutual fund trades
Federal and state income tax agencies that tax realized gains
Active fund manager
Accountants for investors and fund companies
Firms that charge investment advisory fees
Market makers who earn a bid-ask spread on transactions
Transfer agents who handle the share transfers for all those trades
Mutual fund distributors
If applicable, the brokerage firm that earns interest on margin accounts

Given that tax day is still freshly in the rear view mirror, let’s focus on the biggest tapeworm, err…silent partner of them all: the IRS (also known as Investment Returns Sucker). How can you prevent them from taking a giant chunk out of your returns next year? One way is to minimize your realization of capital gains. Almost all of most active managers capital gains are short term capital gains. On the other hand, most of the gains of indexers are unrealized gains.

Is it just us, or does this giant tapeworm resemble a big G — as in Government? Clearly, Uncle Sam is sad to hear about the low taxes paid by indexers.

Now, obviously it’s nearly impossible to completely eliminate Uncle Sam from your returns, but you can certainly make sure to keep the him at bay.

In addition to already being highly tax efficient, index funds can be tax-managed, offering further protection from taxes. On top of that, shrewd financial advisors can provide further tax benefits by applying tax-management trading strategies, such as tax loss harvesting which is the process of selling off funds in down markets to capture large losses which can be offset against future and significant gains. Additionally, by minimizing turnover, index funds maximize unrealized capital gains, allowing returns to remain undisturbed and contribute to the growth of the fund.

A study by John Bogle covers the 25-year time period from 1980 through 2005 and reveals the benefits of compounding wealth as well as the tyranny of compounding costs. The results of the study are depicted below, showing the effects of costs and taxes on the growth of $10,000 for the average equity investor, the S&P 500 Index fund investor, and an investor of a small-value tilted, globally diversified IFA Index Portfolio 100. As you can see, $10,000 invested in the average managed equity fund for the 25-year time period would have grown to $108,347 before federal tax considerations, with post-tax results of just $71,727. Meanwhile, $10,000 invested in the S&P 500 Index fund would have grown to a much larger pre-tax sum of $181,758, with investors enjoying an after-federal tax ending value 222% greater than the average equity investor. Even better, globally diversified investors who tilted their full equity portfolio toward small and value in an IFA Index Portfolio 100 would carry similar risk to the S&P 500 Index, but with allocation would have enjoyed pre-tax ending wealth of $306,975 and an after-tax value of $213,555, three times that of the average equity investor and 34% higher than the S&P 500 Index fund investor. This chart illustrates the value of buy and hold versus buy and sell.

An IFA study using data from Morningstar shows the value lost to taxes for the top 15 funds with the highest net assets.

Taxes have an enormous impact on long-term wealth accumulation, even when kept at bay. So over time, a portfolio’s return will be eaten away as the silent partners get their fill. The longer one uses active managers and inefficient tax strategies, the fatter the silent partners become. It’s time for you to truly understand the tyranny of compounding costs and their erosive impact on the ability for you to achieve financial security. It’s time to cut off the care and feeding of the parasites that feast on your returns.

Only Fools Rush In…and Out

Thu, 01 Apr 2010 16:09:49 GMT

Only Fools Rush In…and Out

In 1957, the news show Panorama on the BBC made and announcement that the mild winter and elimination of the dreaded spaghetti weevil, some Swiss farmers reaping the benefits of a fantastic spaghetti crop. Along with the announcement they had actual footage of people pulling noodles off of trees. Massive amounts of people bought it and they started calling the BBC. They actually wanted to know how they themselves could grow their very own spaghetti tree. Rather than burst the bubbles of these hoodwinked souls, the BBC simply said, “place a string of spaghetti in a tin of tomato sauce and hope for the best.”

This is considered one of the greatest April Fool’s Day hoaxes of all time. The question is how can so many people fall for something so ridiculous? The truth is the active managers jumping in and out of the market can be just as foolish as the people burying noodles in tomato sauce cans.

The stock market follows along a meandering path no one can discern. This is often referred to as the Random Walk Theory. This theory simply states the obvious: Nobody can consistently see what tomorrow will bring. Markets are moved by news. News, by its definition is unpredictable and unknowable. It’s why they call it news and not “olds.” So if the market is moved by news, it means the market is moved by unknowable and unpredictable factors. It begs the question, how can anyone expect to call it in advance?

From 1901 to 1990, the stock market return was approximately 9.5% per year. The SEI Corporation completed a study in 1992 that determined in order to just equal this average (just to equal it mind you…not beat it) a time picker needed to correctly select about 70% of the ups and downs of the market. Any idea how difficult that would be? Let’s take a look at some of the time picking all-stars.

The CXO Advisory Group tracks the forecasting records of market-timing gurus as seen in this table. The best of the gurus has a 63% accuracy rate, still well short of the required 70%. What is most interesting is that the average accuracy rate of all 51 forecasters is a little bit less than 50%. In other words, we could replace the whole group with coin-flippers or dart-throwing monkeys and we would have the same (or maybe even a little higher) level of accuracy. There are two lessons: 1) Don’t waste your time listening to the “experts” since nobody knows what the market will do in the short-term. 2) If the “gurus” cannot successfully forecast the direction of the market, there is zero reason to believe that you can do it, and you certainly should not pay anyone to do it on your behalf.

But there’s more at work against time pickers. Time pickers usually charge clients an annual fee of two to three percent of the value of their investment portfolios. Seems like a high price to pay for essentially nothing more than a paid gambler who bets with your money. The funds also generate short-term taxable capital gains due to the liquidation of fund stock positions to pay off departing shareholders. Enter index funds. Investors can avoid cost-generating, tax-creating moves made by managers and shareholders of active mutual funds by remaining fully invested in index funds at all times. Instead of being distributed and taxed, unrealized capital gains are profits that have not yet been realized for tax purposes. This means you are not taxed on these gains. Unrealized capital gains remain a growing part of the net asset value of a fund’s share rather than being distributed to the investor. The index fund manager minimizes portfolio turnover. This has the beneficial, little side-effect of maximizing unrealized capital gains.

With tax season in full swing, now is a great time to see just how much of your hard earned money you lost due to someone trying to time the market. Will your manager be making Uncle Sam happy? Index funds tend to make Uncle Sam a little down in the dumps.

There seems to be universal agreement among investment experts that time picking is like burying your money in a tomato sauce can. But, it’s not unusual for these same experts to actively tout its merits. Wall Street brokerage firms publish stock picking, time picking, money manager picking, and style picking studies to encourage existing and potential clients to change their investment strategies in midstream. This of course puts more sales commissions into the pockets of these firms and torpedoes more of your gains. Active management is one of the greatest April Fool’s jokes of all time, and most of Wall Street is in on it.

In Burton Malkiel's book, A Random Walk Down Wall Street, John C. Bogle is quoted as saying, "In 30 years in this business, I do not know anybody who has done it successfully and consistently, nor anybody who knows anybody who has done it successfully and consistently. Indeed, my impression is that trying to do market timing is likely not only not to add value to your investment program, but to be counterproductive." Don’t bury your assets in a tomato sauce can, ignoring the scientific evidence that it does not work. Invest in low-cost, no-load index funds…and watch your money grow.

The Siren Songs of Active Management

Investors must tie themselves to the mast to resist the incredible urges to trade.

One Year Later: Lessons from the Fall

Mon, 15 Mar 2010 16:28:36 GMT

One Year Later: Lessons from the Fall

Last week marked a significant milestone in the investing world. One year ago, on March 9, 2009, the market hit rock bottom in the heinous recession that marred 2007-2009 and shuttered the doors of legendary companies whose longevity seemed a foregone conclusion. Coincedently, on March 9th, IFA published and distributed via email Part II of our article on the Resilience of Capitalism, which was written to get investors to resist the temptations of the siren songs of active management.

Today, the amazing resilience of capitalism has demonstrated itself once again. A year ago, there was genuine fear, despondence and an utter lack of hope that the market could be restored. Many investors concluded that it was truly "different this time."

Then, there was no shortage of media pundits assuring us that this time, our economic goose was not only cooked, but burnt, and doom was certain—so certain that any signs of life in the market were largely deemed to be unreal and unsustainable.

Here's a handful of market predictions from last year that vainly sought to squelch hopes for the stunning rebound that followed. As you read these, keep in mind that on Tuesday, March 16, 2010 the Dow closed at 10,686.

"New research shows corporate bonds have been far better at predicting where the economy is headed than anyone thought. Unfortunately, that suggests the economy is going to get much worse." Justin Lahart, "A Warning from the Bond Market," Wall Street Journal, April 9, 2009. The Dow closed that day at 8,083.

"The March stock market rally that fueled hopes of a broader economic recovery was deceptive because 'real money' investors stayed on the sidelines." Anju Gangahr and Chrystia Freeland, "Head of NYSE Cautious over Rally in March," Financial Times, April 16, 2009. The Dow closed that day at 8,125.

"Without a sustained improvement in the credit market — the seat of the crisis — it seems irrational to expect a durable move higher in equities." Richard Barley, "Bond Markets Don't Buy the Rally," Wall Street Journal, March 26, 2009. The Dow closed that day at 7,925.

Pity the poor investors who heeded these warnings, and the thousands of other warnings just like them that littered the headlines of the papers, even as the rebound was in full force.

It's never easy to keep your head when so many others are losing theirs. However, a true understanding of the realities of market randomness, market efficiency and market history will avoid the knee-jerk reactions that can deal a deathblow to investor success. A true understanding of how much risk one can endure and the acceptance that this endurance will certainly be tested is critical for keeping us buckled into our seats during market turbulence.

Bottom line, if you have a long time horizon and you can develop nerves of steel, you give yourself the highest probability of investor success—the type of success that comes from intelligent and prudent investing, not speculation about short-term movements and which politician will say what.

Mark Twain once said, "October is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February."

Twain reiterates the indisputable fact there is no good time to speculate in the stock market. One of the main reasons for this is stock prices are fair because everything has been absorbed into the price. There is widespread dissemination of information available to all market participants. Every bad thing that drove prices down was already baked into stock prices. In the words of David Booth, "You've already paid for the risk, you may as well stick around for the expected return." The entire market follows the general principle of "fair price."

Pundits misguide investors that they can foresee the storm that will batter one's portfolio? Well, they better be more accurate than your local weatherman because if they're not on RIGHT on target, you can lose out on huge returns. And unlike the weatherman, there are no Doppler satellite images to follow: it's randomness. Accept it, live with it, and profit from it.

Big down days and big up days frequently come right next to each other. This is volatility—and it is why you have to stay in the markets to get the markets' superior return. Over the long-term investors are rewarded for the risks they take. You can't avoid risk and you can't cheat it. Risk is the source of returns. You do, however, have the option of lowering risk or avoiding it through the use of lower-risk or risk-free investments, but you will give up returns for this peace of mind.

As we mark the one year anniversary of the bottom of the recent and deep recession, ask yourself how many investors pulled out of the market in February or early March, terrified they were going to lose what they had left? How many do you think were smart enough to jump back in as the market came storming back. To this day, over a year after the bottom, there are people who are still nervous about getting back into the market. Imagine the types of returns someone would have missed out on if they were still waiting.

(Click here to Enlarge)

We have often heard, when you lose, don't lose the lesson. One year later, IFA's lesson remains unchanged:

It's always the right time to invest the right way.

The Siren Songs of Active Management

Investors must tie themselves to the mast to resist the incredible urges to trade.

Sweet Surrender

Mon, 01 Mar 2010 09:08:43 GMT

Sweet Surrender

Success in any 12-Step Program requires that the addict accept their powerlessness against their addiction, and to essentially surrender to a higher power — one that can lead them on their path to success.

For active investors, this higher power is the wealth of knowledge, research and empirical evidence that is the cornerstone of prudent and successful investing. In fact, so meaningful is this research, that many of the developers of sound, peer-reviewed financial research have won Nobel Prizes for their groundbreaking findings.

If an investor hopes to invest for a brighter future, the quality of the information they use to render a decision is imperative — higher-quality information and longer-term datasets will make for sound investments that carry expected returns and a higher probability of achieving that return. The key point here is the value of long-term data — and the longer-term, the better. Unfortunately, recommendations based on short-term data are the faire du jour for 90% of the information that fills the internet, airwaves, newspapers, magazines, and of course, the ever-irritating CNBC.

Many investors may see through this veneer of “news” which in reality is thinly veiled advertising from high-paying sponsors to induce investors to trade--and often. However, many who are wise to this shell-game, might be surprised to find analysts’ reports are not much better when it comes to reliable advice from a trustworthy source.
Case in point. Toyota (once again) came under fire earlier this week when internal documents were discovered that claimed the car company saved $100 million in recalls by obtaining a limited recall from regulators in 2007. Was it this news that prompted analysts to issue an “overweight” rating on the stock it the spring of 2007, and giving it a price target of $151? That stock was in the low 70’s last time we looked.

To further this point, following analysts’ recommendations on AIG Group would have annihilated an investor’s portfolio. In the three months prior to September 2008 (when AIG was given an initial $85 billion in bailouts), Citigroup, BofA, and UBS all gave this company a “Buy” recommendation. The former behemoth Wachovia gave it a market- perform rating. They were all very wrong, and investors who trusted them lost a huge amount of money. On September 8, 2008, that stock traded at $24. By Sept. 16 (just 8 days later), it was trading at $1.80.

Morningstar recommendations are an equally untrustworthy source of reliable information for investors. An example: In 1999, Legg Mason Value Trust manager Bill Miller was named "Fund Manager of the Decade" by Morningstar — a distinction which carried with it Morningstar's highest rating of five stars. Miller had beaten the S&P for 15 straight years and as far as short-term data followers were concerned, this guy was unstoppable – that is until he stopped and actually went into reverse, taking his shareholders’ returns along for a very painful retrenchment which actually saw investors in 2008 underperform the S&P 500 by a whopping 20 percentage points—losing 58% in that year according to the Wall Street Journal. Massive losses and a steady stream of redemptions from individuals and state pension plans alike shrank the fund by a whopping 75% in just one-year’s time. Ouch.

The Higher Power for Investors

The reason why traders who pick stocks, funds, time markets etc. fail over time is because markets are both random and efficient. These observations, research and groundbreaking discoveries made financial economist Eugene Fama a noteworthy frontrunner for a Nobel Prize in Economics. In helping to define what this really means, Fama said, “It’s a very simple concept. It says that prices basically reflect all available information so that in a strict view of the theory it would say it’s basically impossible to beat the market. You’re always paying a fair price, basically.” Watch Eugene Fama talk more about the efficient market here.

Fama’s ongoing and in-depth research about how markets work is a continuation of the Nobel Prize Winning research of noted economists the likes of William Sharpe, Merton Miller, Paul Samuelson and Harry Markowitz. Each earned his prize for ground-breaking discoveries about the market and the true source of stock market returns. Their findings are not messages that big brokerage houses will allocate big ad budgets to because they simply tell you to STOP TRADING.

Specifically, Sharpe quantified the risk premium of being in the market as opposed to T-bills. He said if you hold the market portfolio, you will earn the market’s rate of return.
Harry Markowitz advised that you simply can’t look for the highest returning investment and not consider the risk of that investment. Today, we look at hedge funds and their leverage. Think about it. If you have 10 to 1 leverage—not uncommon in hedge funds—it only takes a 10% decline before that investment is wiped out. Most people can’t handle that sort of risk—and by the way—NO ONE should take that kind of risk. It was Harry Markowitz’s risk reward optimization chart that actually allowed investors to plot their investments’ risk and reward data against all the other available investments to determine the validity of the risk. Most people don’t do this though, so they have absolutely no idea how much risk they are taking until it is too late—as was the case with AIG. By the way, individual companies carry at least twice as much risk as the index, but carry no increased expected return above the market—making all individual companies very bad investments.
Merton Miller determined a company’s cost of capital is returned to the shareholder. This enables us to establish an expected return—and guess what? The riskier companies carry a higher expected return.

Learning about the contributions of Nobel Laureates and other academics increases an investor's risk capacity and every incremental point in your risk capacity score carries with it an incremental increase in expected return (see the New Figure 3 for IFA Index Portfolio 90) . With a twist on "The Beatles" famous verse from "The End" on the Abbey Road album, investors could say, "And in the end, the return you make is equal to the risk you take."

Super Nova to Black Hole

Fri, 12 Feb 2010 10:21:49 GMT

Super Nova to Black Hole

William Bernstein, author of The Investor’s Manifesto: Preparing for Prosperity, Armageddon and Everything In Between, talks of the “Big Lie.” Here, refers to the myth that while indexing works for large-cap stocks, active managers still possess an edge in picking foreign and small-cap stocks.

While this big lie has been supported by some industry heavyweights, ie Fidelity chief Robert Pozen who said, "Active managers beat the relevant indexes on a regular basis for things like international funds, small-cap funds, etc.," this assertion bears no basis in reality. Active managers do not beat the indexes on a regular basis --unless by regular you mean a vast minority of the time. In fact, active managers typically fail—by a huge percentage of some 92% across asset classes, including large-cap, small-cap, emerging markets, international and fixed income. No, active funds do not regularly beat indexes over the long term.

Here are several comparisons of active equity fund managers versus index funds or indexes. As you can see passive beats active no matter how you slice it.

Passive Beats Active in
Equities, No matter
How You Slice It

Passive Beats Active in
Fixed Income, No matter
How You Slice It

(Click Here to see the enlarge chart)

These many equity and fixed income studies show that when William Bernstein refers to “The Big Lie”, there is no exaggeration in the use of the adjective “big.” It fact, it’s quite an understatement. The scope of the deception that managers beat markets is enormous, and sadly quite destructive to an individual’s ability to accumulate wealth. Investors who rely on the false promise that managers add value pay more to earn less. The weighted average expense ratio on international active funds is three times higher than its passively managed counterpart – and they clearly do not justify the increased expense.

Finally, a 32-year study showed just how likely the chance of success is for an active manager to actually possess skill enough to beat an index—less than 1%. That’s right, 99.4% of the time, active fund managers were shown to lack skill sufficient to beat a simple market index.

Jason Zweig described some of “hot” active managers from the past, "Most depressing of all, the "superstar" fund managers I encountered in the early 1990s had a disconcerting habit of fading from supernova to black hole…I soon realized that if you thought they were great, you had only to wait a year and look again: Now they were terrible."

Professional Advisors Prove Their Worth in 401(k) Plans

Mon, 01 Feb 2010 09:50:48 GMT

Professional Advisors Prove Their Worth in 401(k) Plans

In the wake of the recent financial crisis, 401(k) plan participants are scrutinizing their account value and performance. More than ever, they are putting a pencil to calculate and quantify their ability to retire. Meanwhile, a recent study shows that plan participants could substantially improve their odds of investing success and their assets by making one key move: following professional advice.

A January 2010 Hewitt/Financial Engines study shows that investors who received investing education from a professional source improved their returns by nearly 2% after fees were paid. (Source: Help in Defined Contribution Plans: Is it Working and for Whom? , January 25, 2010, by Hewitt Associates and Financial Engines)

The study which analyzed the returns of some 400,000 participants’ accounts determined that investment help such as target date funds, online advice, and the offering of managed accounts enabled participants to make smart investment decisions with minimal effort or expertise. The study concluded that by simply taking advantage of such opportunities, a participant can add thousands of dollars in additional retirement savings over time.

The findings of this study affirm those of a Charles Schwab study which arrived at a similar conclusion — professional advice is well worth the incrementally higher expense and pays for itself in spades for plan participants.

The 2007 Schwab study showed that 401(k) participants who received professional assistance or advice in allocating their 401(k) assets earned a significantly higher rate of return than those who did not receive assistance. Individuals who availed themselves of financial advice or plan-sponsored asset allocation models received substantially greater returns than those who chose to go it alone. The returns differential in the Schwab study was even more compelling, with an additional almost 3% to 5% increase in returns in exchange for professional advice. Source: Schwab press release dated Nov. 28, 2007, titled “New Schwab Data indicates Use of Advice and Professionally-Managed Portfolios Results in Higher Rate of Return for 401(k) Participants”

“It’s not surprising that people using advice are more likely to earn higher returns, but it is remarkable to see how much better they are doing,” said Jim McCool, Executive Vice President of Schwab Corporate & Retirement Services.

Asset Allocation is Key

While the affirmation of the value of professional financial advice is encouraging, the studies’ findings are not the least bit surprising to investing experts who understand the pivotal role played by asset allocation. Renowned investing expert Roger Ibbotson determined that more than 100% of variability of a fund's investment return is due to asset allocation. Participants who have the opportunity to receive professional advice regarding appropriate asset allocation are bound to significantly improve their odds of investing success.

Proper asset allocation should be done based on 30 years or more of historical risk and return data, not a few years of data or speculation about the future. Given this, an advisor who provides ample data about style pure indexes would offer individuals the highest probability of achieving their expected return, thus facilitating the very purpose of retirement investing — income replacement. This knowledge obliterates the utility of a fund line-up that consists of actively managed funds.

Performance Chasers Underperform

“Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors” analyzed a whopping 80,000 annual returns of institutional funds for the 22-year time period from 1984-2007 to conclude that “much like individual investors who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions. In fact, the study estimates that over $170 billion was lost over the time period examined,” and that is before transaction costs and consultant fees are considered. The study concluded that plan sponsors could have saved hundreds of billions of dollars in assets if they had avoided manager selection based on recent performance and held course.

This study and dozens (if not hundreds) just like it arrive at similar conclusions to reveal the best method for successful investment portfolio implementation is a risk-appropriate, low-cost and globally diversified index portfolio. The professional advisor who recommends such a strategy and provides online education to enable plan participants to identify the index portfolio that best matches their risk capacity is what industry experts would term “the total package” when it comes to investment advice.

The best way to achieve the total package, however, might very well be to not opt for a package deal, or “bundled plans.” One-stop shopping is very appealing, but it can also be very pricey.

Fees play such an important role in 401(k) plans, in fact, that plan sponsors are duty- bound to monitor and benchmark investment selections for fees, performance and appropriateness for plan participants. Plan sponsors can opt to delegate this onerous duty to a third party who is responsible for ensuring that investment choices are, in fact, in the best interest of the plan participants. It turns out that such a task is easier said than done.

The Fiduciary Shell Game

In a universe rife with "pay to play" inducements, it is pretty tough to find an individual to sign on the dotted line to accept responsibility for the investment selections of a plan — to become a real fiduciary who will commit in writing that their actions will always be in the very best interest of plan participants. Many companies prefer to provide the impression of being a trusted fiduciary, while the fine print says otherwise.

Insurance giant John Hancock bills itself as a leader in providing "fiduciary responsibility support," even going so far as to provide plan sponsors of retirement plans with its "fiduciary standards warranty." When pressed on the issue of fiduciary, however, John Hancock admitted they are not a fiduciary, nor do they have any desire to be one. Hancock’s decision to skirt a fiduciary obligation may largely be attributed to a desire to include and recommend funds that carry 12b-1 and other hidden fees. Accepting a fiduciary obligation presents a direct conflict of interest for advisors who choose to be paid by multiple parties—a fiduciary cannot serve two masters.

Index Funds Advisors is a 3(38) fiduciary when it comes to 401(k) plans. This means we are 100% responsible and liable for our investment decisions which include the selection, monitoring and replacement of plan investments options. We do so because we are fully committed to making independent investment choices that are in the best interest of plan participants. This commitment is precisely what is required to ensure that each plan participant has the highest probability of success in their retirement plan.

Do you have index portfolios in your 401(k) Plan? To learn more about IFA’s Retirement Services offering, please click here or call 888-643-3133. To review our new and exciting 401(k) Video Enrollment Program, click here.

Is Timing with ETFs a Good Idea?

Fri, 22 Jan 2010 15:35:16 GMT

Is Timing with ETFs a Good Idea?

By Mark Hebner

This is a question I get more and more frequently these days. On the one hand, I am pleased to see that people are making the move to indexing, but it's a bit frustrating to see that investors cannot free themselves from their prediction addiction--emphasis on addiction.

In no small part, this ferocious addiction is well-fed by a boon of market-timers who entice you to believe, for a handsome price, they can lead you to wealth without risk. The increase in their popularity, however, is not rationalized by their lackluster performance. Dig deep and you will likely find the only way to profit from market-timing with ETFs is to sell a newsletter about it.

The list of problems that occur with timing ETFs is a long one, but here are a few:

One problem is it follows the belief that somehow the ETF is priced wrong. This of course is a problem that plagues all kinds of stock picking and market timing "strategies." All the current news and the probability of future news are built into the ETF's price already.

Another huge problem with the trading of ETFs is investors aren't exposing their assets to a consistent risk exposure over time if they are pulling their assets in and out of the market. Just how reckless is this behavior? The Dalbar Investor Behavior Studies have been tracking these practices for a long time. Not so surprisingly, they found the investor was only getting about 25% of the fund's potential return over these periods because of their stubbornness on trading in and out of these funds.

In his Little Book of Common Sense Investing, Vanguard founder John Bogle weighs in mightily on the subject of ETF trading, He states:

"If long-term investing was the original paradigm for the classic index fund designed 31 (now 34) years ago, surely using index funds as trading vehicles can only be described as short-term speculation."
"If the broadest possible diversification was the original paradigm, surely holding discrete — even widely diversified — sectors of the market offers less diversification and commensurately more risk."
"If the original paradigm was minimal cost, then holding market-sector index funds that are themselves low-cost obviates neither the brokerage commissions entailed in trading them, nor the tax burdens incurred if one has the good fortune to do so successfully."
"Typical ETF investors have absolutely no idea what relationship their investment return will have to the return earned by the stock market."

...and Bogle's parting shot on trading ETFs provides an ominous warning:

"I suspect that too many ETFs will prove, if not suicidal to their owners in financial terms, at least wealth-depleting."

These observations go a long way in explaining why the average mutual fund investor only sees 25% of the returns. The moral is best explained by Brad Barber, finance professor, who tells us "Trading is Hazardous to Your Wealth." Indeed.

Why do investors fall prey to charlatans who tell them they can predict the market? The main reason is no one wants to settle for “average.” But average returns are really the superior returns. If investors had bought and held a globally diversified IFA Index Portfolio 100 for the last 20 years, they would have an average annualized return of 9.55% per year, and they would have had about as much risk as the S&P 500 Index which delivered 8.06% over the last 20 years (ifacalc.com). Buy and hold works best, but don’t forget the hold.

The landmark and definitive study of market timers was conducted by John Graham at the University of Utah and Campbell Harvey at Duke University. The professors painstakingly tracked and analyzed over 15,000 predictions by 237 market timing investment newsletters from June, 1980 through December, 1992. The conclusion of this 51 page analysis could not have been stated more clearly. "There is no evidence that newsletters can time the market.

In "The Elements of Investing" by Burton Malkiel and Charles Ellis, the authors discuss a psychologist from Berkeley named Philip Tetlock, who studied over 82,000 varied predictions by 300 experts from different fields over 25 years, and concluded that expert predictions barely beat random guesses. Ironically, the more famous the expert, the less accurate his or her prediction tended to be.

William Bernstein once said, "There are two kinds of investors, be they large or small: those who don't know where the market is headed, and those who don't know that they don't know. Then again, there is a third type of investor - the investment professional, who indeed knows that he or she doesn't know, but whose livelihood depends upon appearing to know."

As Charlie Ellis said, "Market timing is a wicked idea—don't try it ever."

IFA proudly announces Mark Hebner's IFARadio, aired every Sunday at 10am on KRLA870 in Los Angeles, or on the web at www.KRLA870.com. Mark and other investing experts deliver the most straightforward hour of investment advice you'll ever hear.

Can't make the time? Sign up for the IFARadio podcast, or listen now.

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All that Glitters is Not Gold

Fri, 08 Jan 2010 23:59:10 GMT

You can't spend 5 minutes listening to drive-time radio, or watch morning TV without being bombarded by ads screaming for you to "BUY GOLD NOW." They titilate with predictions of astronomical returns based on gold's recent rise in value, and encourage individuals to hop on board lest they miss the buying opportunity of the century.

The saddest part is most investors are driven to make important investment decisions based on fads and hype when they do not have the data. Smart investing requires that you get the information you need and know the characteristics of your investment. This knowledge will lead you to two imperative elements for smart investing:

the expected return
and
the uncertainty of that return--also known as risk.

In order to make an informed decision about investments, you need high quality estimates of expected returns and the uncertainty of obtaining them. Investors must obtain statisitics about investments, which is the science of collecting, organizing and interpreting data. This sort of information cannot be discerned from small samples of short-term price movements or from speculative hype about the near-term future of the economy.

Susan Dziubinski of Morningstar wrote, “Statisticians will tell you that you need 20 years of data – that’s right, two full decades – to draw statistically meaningful conclusions. Anything less, they say, and you have little to hang your hat on.”

So what does the long-term historical data say about gold? It says gold’s a sucker’s bet!

The longest term data we have comes from Morgan Stanley Capital Internatonal which covers the 48-year time period from 1945 to 1992. During this period, gold had an annual return of 4.9%, but its risk was 26% (as measured by standard deviation of monthly returns); compare that to US Treasury Bills which would have given you an annual return of 4.8% (almost identical) with a standard deviation of about 3%! Over the 48-year time period, gold investors took on 9X more risk to achieve a measly 0.1% higher return. That, my dear friends, is called uncompensated risk, aka “a sucker’s bet.”

When we look at the most recent 35-year period, gold delivered a return of 5.34% with the risk sitting at 17.6%. But here again we see you could have purchased a treasury bill that would have netted a 5.68% return with a risk of just 0.89%. So you would have taken over 17 times the risk for a lesser return.

Take a look at the risk and reward chart below for the past 35 years. The gold-colored button marked “G” plots the 35-year risk and return characteristics for gold. Compare these metrics to those of the IFA Index Portfolios, which ALL achieved higher returns and with less risk. When you look at long-term data like these, it is virtually impossible to make a compelling case for the addition of gold to any portfolio.

BREAKING NEWS

As I write this piece, scrolling headlines have posted the following: “Gold Prices to Rise in 2010”! Before you back up the truck to the mint, you should know the assertor of that statement was none other than the president of the Gold Trading Association, so much for an unbiased source with no conflict of interest.

In contrast, IFA has analyzed the commonly cited merits that would support adding commodities (gold and others) to a portfolio. Research conducted by Truman Clarke, Ph.D. and former Professor of Economics at USC (someone who stood nothing to gain from gold trading) unearthed a few facts you likely won’t hear from the peddlers of the commodity du jour:

The addition of commodities to a portfolio did not provide returns in excess of the Treasury bill return.

The addition of commodities to a portfolio did not improve diversification for stock and bond portfolios.

"Commodity futures do not appear to be effective inflation hedges for stock and bond portfolios."

Like last year’s spike in oil and its subsequent spill, or the real estate boom followed by an epic bust, speculative investing leads to extremely disappointing outcomes — the sort of outcomes that can easily be averted by those who invest according to long-term historical data.

Data! Data! Data! Don’t make an investment without it!

The Value of the Right Advisor

Tue, 22 Dec 2009 10:06:48 GMT

By now, you realize the benefits of an indexing strategy, and more importantly, the expensive false promises of active management. So the next logical question is, “Why should I seek the help of an advisor when I can just create a portfolio of indexes on my own using index funds at a place like Vanguard or purchase ETFs through a low cost broker like Charles Schwab?”

For those with very limited resources, funds from Vanguard or iShares offer an excellent assortment of index mutual funds for an investor to build a portfolio. However, once an individual has about $100,000 or more to invest, they need access to a broader mixture of asset classes. As economic research has shown, asset class allocation is the most important factor in determining a portfolio’s expected return level. In fact, asset allocation is 100% responsible for the variance in investment performance, according to a comprehensive study entitled, “Investment Policy Explains All,” which appeared in the Summer 1999 issue of The Journal of Performance Management.

IFA most frequently advises its clients to invest in mutual funds offered by Dimensional Fund Advisors (DFA). Among other advantages, DFA provides unequaled access to a broad selection of asset classes. Their value indexes are more valuable, and their small-cap indexes are smaller. These two advantages provide far higher risk-adjusted expected returns than a portfolio built with Vanguard. And for those asset classes that it shares with Vanguard and others like it, DFA just does a better job. In part, DFA’s indexes adhere to rules of construction that provide slightly greater latitude for allocating resources toward specific companies and the timing their inclusion within the indexes. This increased freedom enables DFA to avoid paying premiums for annual reconstitution or chasing stocks. DFA funds provided by IFA also engage in a rigorous and highly profitable securities lending process, the proceeds of which go directly to the returns of the funds holding those shares.

Below are graphs showing IFA’s use of DFA funds in direct comparison to Vanguard index funds and iShares.

(Click here to see the full IFA vs. Vanguard report)

(Click here to see the full IFA vs. ETF report)

DFA funds are only available through approved advisors like IFA to the general public. But a client does NOT pay IFA for their access to DFA funds. As demanded by DFA of its approved advisors, IFA’s advisors are well educated in financial market theory, articulate in describing the tenets of investing, and steadfast in focusing the client on the benefits of long-term investing. IFA advisors are committed to maintaining consistent exposures to risk-appropriate tilts toward small and value factors as identified by Fama and French, and they are committed to the tenets set forth in the Efficient Market Hypothesis and Modern Portfolio Theory. IFA provides, in a fully transparent way, all of the supporting data, documentation and theory for the reasoning behind the strategy.

But more than that, the ultimate value of a knowledgeable, passive advisor is their ability to provide the critical discipline needed to combat reflex reactions like pulling out of the market the way so many did as it spiraled out of control in late 2008. Those people who pulled out in early 2009, and did not trust the market to rebound as it has consistently done throughout its history, may now be facing a much more bleak future than those who had the stick-to-itiveness to hold on. IFA’s advisors stay fixed on the long-term and profitable history of the market rather than the stomach-churning volatility that can occur from month to month. IFA knows what to do, and has the discipline to do it.

Rash decisions are like a twisted hand diabolically spinning your retirement clock backwards. They stifle an investors’ ability to achieve long-term capital market rates of return. Knowing the hazards of responding to such impulses, IFA provides ample data to show WHY such investments are worthwhile and should be adhered to no matter what.

“Financial decision-making is not necessarily about money,” says psychologist Daniel Kahneman at Princeton University. “It’s also about intangible motives like avoiding regret or achieving pride.”

Just what is the price paid to skirt regret? The Morningstar Indexes Yearbook: 2005 delivers the numbers. In the report, Morningstar Managing Director Don Phillips presented the considerable difference between the return of index funds and those actually experienced by the individuals who invest in them.

He then contrasted that with the experience of the advisor-directed DFA funds. Phillips quantified the ample costs of the impulsive behaviors of non-advised passive investors. These behaviors resulted in the average no-load index fund investor receiving a return of 1.58% less per year than the actual funds themselves (7.07% vs 8.65%) for the 10-years ending 2005. By stark contrast, the average DFA fund investor received 0.91% more per year than the actual funds (10.81% vs 9.90%) for the 10-years ending 2005.

Details of the study are in the table below.

Using the numbers from the study, we can see that for the 10-years ending in 2005 the combination of a better implemented indexing strategy and the steady, rational hand of an advisor is quite a potent one. The average advisor-directed DFA investor received an annualized return of 10.81% where as the average no-load index fund investor received an annualized return of 7.07%. That is a difference of 3.71% per year or a 52% increase!

Phillips exhalted the merits of DFA's success, "Consider the success Dimensional Fund Advisors (DFA) has had in selling its funds through advisors who undergo training on the merits of passive investing and in portfolio construction theory. Consider that over the past decade the dollar-weighted return of all index funds was just 82% of the time-weighted return investors could have gotten with those funds. Yet, the figures for DFA are much better. In fact, the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns.Suggesting advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors," he concluded.

Legendary investor Benjamin Graham said, “People don’t need extraordinary insight or intelligence. What they need is the character to adopt simple rules and stick to them.” For investing, no truer words were ever spoken.

From Frying Pan to Fire

Fri, 04 Dec 2009 12:43:07 GMT

From Frying Pan to Fire

The findings of a recent landmark study reveal that plan sponsors are susceptible to the same performance-chasing behavior that plagues individual investors, causing them to lose hundreds of billions of dollars in asset values, while paying dearly to do so.

“Absence of Value: An Analysis of Investment Allocation Decisions by Institutional Plan Sponsors” recently appeared in the November/December 2009 issue of the Financial Analysts Journal, the depth and scope of which is surely to impact the manner in which institutional investors make investment decisions.

The study, written by Stewart, Neumann, Knittel, and Heisler, is a comprehensive follow-up to the Sunil Wahal and Amit Goyal study titled “Selection and Termination of Investment Managers” study which is well-documented here.

“Absence of Value” analyzed a whopping 80,000 annual returns of institutional funds for the 22-year time period 1984-2007, focusing on 1, 3 and 5-year performance periods to answer the study’s inquiry: Do plan sponsor decisions regarding the allocation of assets to specific asset class fund managers or the withdrawal of assets from them add value for the ultimate beneficiaries on whose behalf the plan sponsors are acting?

The exhaustive study concluded that “much like individual investors who seem to switch mutual funds at the wrong time, institutional investors do not appear to create value from their investment decisions. In fact, the study estimates that over $170 billion was lost over the period examined,” and that is before transaction costs and consultant fees are considered!

The comprehensive study set out to document whether the efforts typically employed by institutional investors provide a reasonable expectation of payoff that would justify the time and expense associated with them. “Pension plans, endowments and foundations are typically staffed with professionals with years of experience and advanced degrees. Working on their own or with the aid of consultants, institutional sponsors devote considerable time and resources to selecting asset classes and products that are expected to perform well in the future,” cites the study.

Using data from the PSN Investment Manager Database which includes only institutional products offered in separate accounts or pooled vehicles, and has no data on private equity, alternatives or hedge fund assets, the study analyzed the inflows and outflows of assets of specific fund products and their subsequent 1, 3 and 5-year returns. All performance information includes only gross returns of the products and the study estimates that an additional 1% of transaction costs should be factored into the returns.

The methodology of the study was to calculate asset flows for every product in the PSN database, collecting performance subsequent to inflows and outflows to determine whether products with significant inflows perform differently than products with significant outflows. Post-flow returns for a portfolio of products receiving the largest inflows were means tested against the returns for a portfolio of products experiencing the largest outflows. If different, the study examined the source of those differences. Similar analyses were conducted with account gains and losses.

The findings of this rigorous analysis showed that the funds which experienced especially poor results lose accounts in addition to assets. Interestingly, these products experienced especially strong performance subsequent to being fired. "The preceding analyses document that plan sponsors are not acting in their stakeholders’ best interests when they make rebalancing or reallocation decisions with plan assets. Portfolios of products to which they allocate money underperform relative to the products from which assets are withdrawn. Performance is lower over 1 and 3-year periods and shows no signs of reversal even after two more years,” the study concludes.

The chart below, “Value Gained or Lost When Moving Assets from One Manager to Another” quantifies the impact of their ill-timed decisions in favor of recent past performance.

(see the original study )

As the chart shows in only two years out of eighteen did plan sponsor decisions add value to the portfolio over the subsequent five years. In most cases, value was extracted from the impact of the transactions, with resulting 5-year weighted average impact, without compounding, resulting in a loss of value summing $170.2 billion for the full 18-year sample period, “a significant figure,” the study claims. This sum does not account for all of the money that is lost to the impact of active management fees and expenses. Assuming these costs add an additional 1%, this would mean that $100 billion of the $10 trillion in institutional assets is further eroded, and this does not even consider the high costs of consultants who detract from value, and as the study shows, facilitate the underperformance of returns.

The study’s data-rich findings provide further evidence of the random nature of stock prices and the futility of manager selection based on recent strong, but lucky performance. This study states, “Clearly, plan sponsors could have saved hundreds of billions of dollars in assets if they had simply held course.”

The study questions “why plan sponsors appear to fail in their goal of increasing the value of plan assets. Heisler et al suggest that certain comfort can be found in the use of historical track records, despite the preponderance of evidence that shows such data to be a poor predictor of future positive results. “Perhaps investment officers, either because they believe it themselves, or their supervisors do, find comfort in extrapolating past performance when in fact excess performance is random or cyclical,” the study states.

Paying for Pay to Play

Mon, 23 Nov 2009 10:53:44 GMT

Of the many failings of the flawed financial system alluded to by John Bogle, undoubtedly the most egregious flaw is the pay for play scandals that continue to rock the public pension universe.

Rife with conflicts of interest, consultants are handsomely paid to put in a good word to ensure that their benefactors wind up on the short list of money managers who can get their hands on the hundreds of billions of dollars of pension plans.

In just the last two weeks alone, big-name players have been publicly shamed and penalized for their roles in facilitating fraud and kickbacks:

Industry big-wig Marsh McLennan, parent of institutional consultant Mercer, paid a whopping $400 million to settle a class action lawsuit that was led by the Public Retirement Systems of Ohio, its State Teachers' Retirement Plan and its Bureau of Workers' Compensation, as well as the Investment Division of the New Jersey Department of Treasury.

According to the Ohio attorney general Richard Cordray, “The pension funds claimed the company violated securities laws by steering the schemes' business to insurance companies that paid Marsh & McLennan kickbacks known as "contingent commissions." The complaint said the firm allegedly generated fake bids to protect these insurance companies from competitors, according to Global Pensions.

JP Morgan settled last week with the SEC to get out from under charges that the company made unlawful payments to friends of public officials to win municipal bond business for a $1.4 billion sewer project in Alabama.

The SEC charged that JP Morgan and two of its former managing directors funneled about $8.2 million to close friends of several Jefferson County commissioners. As a result, the commissioners were swayed to select JP Morgan’s securities division to be the major underwriter for the bond offering.
The settlement cost JP Morgan nearly $750 million. The company was forced to pay a $75 million fine and forfeit $647 million in fees from the business, according to Yahoo Finance.

News continues to unfold about the pay for play scandal that struck Calpers, the biggest public pension plan in the US. Al Villalobos, former Calpers board member and president of Arvco Financial Ventures, has been fingered as the middleman recipient of as much as $65 million in fees for coordinating the introductions of fund managers to the Calpers board.

Against the backdrop of similar scandals throughout the country, the SEC has proposed a ban on placement agents for state and municipal pension plans.

The Calpers scandal arises at a time of intense scrutiny for California’s public officials, and leaves California taxpayers likely incited with anger at the prospect of having to make up the pensions plan’s shortfall. The fund lost $50 billion during the recent financial crisis, shrinking the fund by more than 23% through June 30, 2009, and racking up the fund’s worst fiscal year ever, according to The Wall Street Journal. In contrast, the median return of public-pension funds with $5 billion or more was a 19% decline, according to the Journal.

The alleged $65 million in kickbacks to Villalobos led to the investment of some $16 billion of Calpers money.

The beat-the-benchmark objective easily facilitates pay to play scandals. If pension plans simply bought and held the market indexes, they would accomplish two objectives:

They would earn market rates of return that are commensurate with their risk capacity.
and…
They would easily eradicate the pay for play scandals that plague the industry.

The US government’s pension planners seemed to have figured this out already. That is why some $200 billion of assets in the Federal Thrift Savings Plan (TSP) is invested exclusively in low-cost index funds (TSP.gov).

So, what would have been the outcome for the Calpers pension fund if it had simply bought, held and rebalanced a risk-appropriate Index Portfolio with risk and return characteristics consistent with IFA's advice?

The results are below. As you can see, for the 26-year time period from July 1983 through June 2009, the Calpers fund carried slightly higher risk than IFA’s Index Portfolio 65, but delivered 1.6% less annualized returns. It also had a risk of 12%, but only obtained the return of IFA's index Portfolio 35, which had an annualized return of 9.16% and risk of about 7.5%.

For Calpers Data: http://www.calpers.ca.gov/eip-docs/about/facts/investme.pdf
For IFA Data: ifabt.com

The beat-the-benchmark objective is a flawed one for all investors, individual and institutional. It leads to risk-adjusted underperformance. At the institutional level where highly paid money managers vie for the control of billions of dollars, the beat-the-benchmark objective can easily facilitate payoffs and conflicts of interest as financially motivated consultants may easily sway their recommendations to favor those who most lavishly grease their palms. By simply investing in low-cost index funds, these institutions could avoid the frustrating below-benchmark performance that results from the layers of high fees for speculation, and they can be assured that conflcits of interest will be virtually eliminated. After all, with low-cost index funds investing there is not enough profit from fees to even grease the palms of the decision makers.

The Case of the Fallen Fiduciary

Mon, 26 Oct 2009 12:55:42 GMT

Keep an eye out for best-selling novelist Patricia Cornwell’s next mystery novel. Likely here, Cornwell will invoke her intrepid crime-solving protagonist Dr. Kay Scarpetta to solve high crimes, misdemeanors and punitive breaches of fiduciary obligation not unlike those which Cornwell recently filed against her own investment management firm.

According to the October 23, 2009 issue of Financial Advisor magazine, Cornwell filed a lawsuit against Anchin, Block & Anchin a New York City wealth management firm, claiming that she lost many millions because the firm mismanaged her income, business and investments.

The claim alleges that the high-end concierge firm promised a luxury suite of services that included investment management, complete handling of personal and business matters and even such small but important details as “buying and delivering their toilet paper.”

Alas, however, it appears that the “jack-of-all-trades, but master-of-none approach to personal investments caused Cornwell to end up with far fewer assets than were reasonably expected through proper and prudent investment management.

Had Cornwell viewed her asset manager through the scrutinizing eyes of her attentive protagonist, surely she would have seen beyond the façade, asking the important questions that are imperative to identifying a trustworthy financial advisor.

Important Questions to ask a Potential Asset Manager

What sort of investments will you make on my behalf and how will you be paid for your services?

How much risk will you be taking with my investments and what is the return you expect to earn from taking those risks?

Do you have peer-reviewed, academic research which incorporates reams of long-term documentation to support your strategy?

Will my brokerage statement come from a reliable third-party provider like Charles Schwab or Fidelity?

Will my securities be transparent and marketable at all times?

In today’s “truth’s stranger than fiction” world in which the road to financial security is imperiled with advisor pitfalls of ignorance or clumsiness (misfeasance) and outright thievery (malfeasance), individual investors must assume the role of fiduciary detective when it comes to choosing whom they should trust with their hard-earned assets.

Had the above important issues been hashed out and sufficiently answered to the satisfaction of an educated investor, it is likely Cornwell would not be suing for recompense, nor would she have so severely underperformed her investment objectives.

Like many other highly successful individuals, Cornwell may have been enticed by the ease of life offered by the sweeping concierge services. Certainly, it sounds like a lovely luxury to abdicate the business of one’s business to a seemingly knowledgeable and trusting firm, but education should never be short-cut, due diligence should never be undermined, and transparency should never be sacrificed, lest trusting investors find themselves with far less to entrust.

This was some very expensive toilet paper.

False Discoveries of the Elusive Alpha

Fri, 02 Oct 2009 12:42:39 GMT

False Discoveries of the Elusive Alpha

David Swensen’s quote addresses the time-honored, but ill-fated attempts that manager pickers employ to beat the market. Most often, they hire active fund managers, in whom they confidently place their trust to deliver above-benchmark returns or alpha that would mirror some recent past result.

The term “alpha” represents the difference between the return on an investment and the return which could have been achieved in an index fund with similar risk exposure, quantifying a fund manager’s skill. A recent study by Laurent Barras, Olivier Scaillet, and Russ Wermers investigates the lack of true alpha in the results of 2,076 open-end domestic equity mutual funds for the 32 years from January 1975 to December 2006.

The study “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” employs the use of t-statistic hypothesis testing and statistical data to compare funds’ relative performance, employing a “False Discovery Test” to avoid errors which commonly plague statistical analysis and mitigate the effects of false positive and negative results. Unlike many previous studies of mutual fund performance, this method allows for distinctions to be made between fund results based on luck and those based on skill.

The conclusions of the study decisively reveal the folly of chasing alpha. Using data which prevents survivorship biases and excludes funds with less than five years of performance history, and taking into account the large effects of active management fees, the study concludes that 99.4% of all fund managers failed to demonstrate true stock-picking ability.

In a July 2008 New York Times article titled “The Prescient Are Few,” journalist Mark Hulbert digs into the results of the landmark study and its implications as described by Prof. Russ Wermers who headed up the study: “The number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives,” says Prof. Wermers--or as Hulbert puts it “just lucky.”

The chart below reveals the thin line of managers that have beaten the benchmark over time — “statistically indistinguishable from zero,” according to the study.

The study dovetails the findings of another seminal study: “The Selection and Termination of Investment Management Firms by Plan Sponsors.” This study reveals how governing boards of retirement plans, foundations and endowments frequently fall prey to manager picking consultants and the allure of past winners, hiring the hottest new fund managers only to fire them later because their past performance doesn’t persist in the subsequent periods. The study, conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University, reveals the negative impact of manager chasing and found that manager hiring and firing decisions made by consultants and board members of retirement plans, endowments, and foundations was a complete waste of money and the board members precious time. Their results demonstrate that during the ten-year period from 1994 through 2003, consultants and boards which based their fund manager hiring decisions on consistent above benchmark past performance were largely disappointed with subsequent index-like results. They often then fired their managers in favor of another recent top performer, repeating the cycle again. This cyclical motion undermines their investment policy statements and the opportunity of achieving optimal returns, the kind of returns that are available by simply buying, holding and rebalancing a passively managed portfolio of index funds that keeps costs low and controls risk.

Active Management Folly Revealed

Fri, 11 Sep 2009 15:46:47 GMT

"Smartest" Book Author Reveals Active Management Folly

IFA’s Dan Solin blew a gaping hole through the myth that active managers add value to an investor’s portfolio.

In a September 8, 2009 CNBC debate between Solin, IFA Senior Vice President and best-selling investment book author (Solin’s "The Smartest Retirement Book You'll Ever Read" was just released) and Doug Kreps, principal and managing director at Fort Pitt Capital Group an active manager, Solin revealed important data about the ongoing benefits of diversification — even in the face of the global market downturn suffered in 2008.

"Even though portfolios were decimated, diversification worked fine," said Solin. "Bonds didn't lose any money, and if you had a globally diversified portfolio of stocks, you probably lost less money than you would have lost if you didn't. It doesn't protect you from overall market declines, but it works better than the alternative."

Kreps concurred with Solin’s regard for the value of diversification, but asserted that an active manager could effectively guide an investor through diversification and add value.

Armed with data from a comprehensive study that covered a 32-year time period and the results of more than 2,100 active managers, Solin refuted Kreps’s argument and cited the results of “False Discoveries in Mutual Fund Performance,” the bombshell discovery which shows that 99.4% of the active fund managers were shown to lack any genuine stock-picking ability.

Referencing the recent Dalbar study of investor behavior, Solin revealed that an investor in a globally diversified, passively managed index portfolio would have earned at least 400% higher returns than the average investor who relies on speculation and performance chasing behaviors.

"What Wall Street does is package luck and sell it as skill. The real data shows that passive management, actually in the last 20 years has achieved a greater return than active management."

Solin’s summation of the importance of global diversification and the pertinent data that reveals the parasitic nature of active managers dovetails IFA President and founder Mark Hebner’s message from last week which set forth IFA’s Position Statement on Investing.

Diversification works. You can achieve diversification by buying, holding and rebalancing a low-cost portfolio of index funds that represent multiple asset classes from around the globe. You can maximize your peace of mind and your returns by investing in an asset allocation that is risk-appropriate for you and carries as strong of a small and value tilt as your risk capacity allows.

Click here to find out now which Index Portfolio is right for you.

Special Report: Does Diversification Work in Financial Crises?

IFA’s Academic Consultant and Nobel Prize Winner, Harry Markowitz, Mark Hebner and Mary Brunson detail the role of diversification during recent and historic downturns.

Click here to read the full paper

IFA's Position Statement on Investing

Fri, 04 Sep 2009 12:23:29 GMT

Investors who spend too much time in front of CNBC or Investor’s Business Daily can easily lose the forest for the trees. They get lost in minutia that can grip emotions, causing them to react impulsively and undo the long-term benefits of globally diversified capitalism.

March 2009 provides a fresh reminder of this truth. S&P 500 investors who were scared out of the market at the March low locked painful losses of 25.1% for the year. On the flip side, those investors who remained unshaken are now sitting on a gain of 12.3% for the year. Clearly, the cost of flinching is very high.

By simply understanding and adhering to a handful of investment truths, investors can maintain their confidence in the long-term returns of the market, and they can invest and relax.

To advance that end, here are my 16 principles that collectively define IFA’s Position on Investing:

1. On average, Capitalism earns a profit for its shareholders.

2. Companies have a cost of equity capital of about 10%, and that cost of capital is paid to the shareholders.

3. Nobody can see the future, and future prices are randomly moved by unpredictable news. Bad news results in lower prices and good news results in higher prices, all in an effort to keep expected returns essentially constant.

4. Free markets work best and current prices are the best estimate of a Fair Market Value. Fair prices result in a distribution of future returns that resemble a bell curve and are equally likely to be above or below the expected return.

5. Greater expected returns only come from greater risk. The expected return from speculation is zero and becomes negative after costs and taxes.

6. The expected annual returns for any of 20 risk calibrated IFA Index Portfolios are about 5% plus 1/2 the annualized standard deviation of returns over the last 50 years.

7. In a study of investor behavior over the 20 years ending 2008, the average equity mutual fund investor under performed the IFA Index Portfolio 100 by a 7.3% annualized return. The primary cause of the under performance was that investors chase past performance.

8. In a study of 2,100 stock pickers over 32 years, 99.4% of managers were shown not to have verifiable stock picking skill.

9. In a study of 15,000 predictions over 12 years from 237 Market Timers, there was no evidence of market timing skill.

10. In a study of 660 hiring and firing decisions of investment managers, the fired managers beat the hired managers.

11. In a study of 8,755 hired investment managers, the average hired manager out performed their benchmark by about 3% per year for the 3 years before hiring, however, they under performed their benchmarks by about 0.5% per year for the 3 years after hiring.

12. Over the 81 years ending 2008, the annualized return of a US small value index of equities beat large growth by 4.53% per year.

13. Save 10% of your annual income while you are working and spend only 5% per year of your savings in your retirement.

14. Buy a risk appropriate, globally diversified, small and value tilted portfolio of index funds anytime you have money to invest. Hold. Rebalance. Loss Harvest.

15. Only sell your investments when you need the money.

16. Hire a good passive investment advisor. Everybody will benefit from their expertise, teaching, coaching, service and independent advice. A study concluded that indexers with an advisor were 27% more successful at capturing the returns of index funds than those without good advice (see here).

I rest my case.

Mark T. Hebner
President and Founder, Index Funds Advisors

Probability in Motion

Thu, 03 Sep 2009 10:17:54 GMT

Probability In Motion

Say "HELLO" to Francis, IFA’s newest probability machine, named after Francis Galton, an English mathematician who was expert in many scientific fields.

(Click here to play the video of Francis in action)

Galton’s probability machine demonstrates how a normal distribution is created through the course of random events. IFA commissioned the creation of Francis to better communicate to investors the probability of outcomes of a portfolio that result from a series of random events such as news stories about a company or about capitalism, in general.

As you can see, the random falling of the beads ultimately forms a normal distribution that is represented by the bell-shaped curve. As you can also see, the distribution of the beads in the photograph bears a striking resemblance to the distribution of 600 monthly returns (50 years) for IFA’s Index Portfolio 100 which is indicated by the red overlay.

Like the random distribution displayed by Francis, Index Portfolio 100 carries a wide range of outcomes or a high standard deviation, but maintains a normal distribution with about a 1.05% average monthly return over the last 600 months, but with much short-term volatility.

We know that markets are moved by news which is both random and unpredictable and this news is rapidly incorporated into stock market prices. The degree to which your investment portfolio is exposed to the equities, and therefore vulnerable to equity market-moving news goes a long way to explain the expected range of outcomes the portfolio will experience. Investment portfolios with higher standard deviations have greater uncertainty of returns, but when properly constructed they carry higher expected returns. This relationship between an investment’s level of risk and its expected return is the classic economic trade-off.

The figures below illustrate the difference between the bell-shaped curves of the 600 monthly returns for the high-risk Index Portfolio 100 which carries a wide range of outcomes versus a low-risk Index Portfolio 10 which carries a narrow range of outcomes. The 100% equity Index Portfolio 100 endured greater price swings than the 20% equity and 80% fixed income allocation of Index Portfolio 10, but had higher returns. Over the 600 months, a dollar invested in Index Portfolio 10 would have grown to $28.53, while a dollar invested in Index Portfolio 100 would have grown to $296.05. This historical data supports the presumption that investors who have higher risk capacities are expected to earn higher returns.

A caveat: be certain that you can handle the wide range of short-term outcomes (volatility) that travels in lock-step with higher returns. Those who liquidated their portfolio in the latter part of 2008 or up to March 9, 2009 have paid a steep price for doubting the resilience of capitalism — especially now that major markets have enjoyed the best July in 70 years and IFA's Index Portfolio 100 has roared back 71.57% (net of fees) since its March 9th, 2009 low!

Oops, He Did It Again!

Thu, 09 Jul 2009 10:17:54 GMT

Oops, He Did It Again!

As predicted by IFA’s April Fool’s Day, 2008 issue, John Meriwether’s latest hedge fund, JWM Partners has imploded.

Back in 1998, Meriwether was at the helm of the seemingly wildly successful Long Term Capital Management fund which blew-up virtually overnight as a bad currency bet and 50 times leverage caused LTCM investors to lose a whopping $4 billion, setting in motion a global financial crisis.

To hear Todd Kenyon of Seeking Alpha tell it, hindsight provides a crystal clear picture as to what made LTCM go so wrong. “With merely $5B in capital, Long Term had borrowed about $125B and had off-balance-sheet positions with notional values of over a trillion dollars.”

LTCM investors may have been caught unaware, but, what would possess an investor to give Meriwether more money after such an aggressive and massive disaster?

What Meriwether lacks in investment savvy, he seems to make up for in salesmanship, convincing investors to give him billions and assuring them that he had taken the cure against excessive leverage. Meriwether’s new fund employed 15 times leverage, borrowing $15 for every $1 invested—still enough leverage to destroy the fund, which he did—again.

And why not try his luck again with willing participants? Meriwether knew the good that would come of it for him—if not for his investors.

According to Kenyon, Meriwether garnered a whopping 2% of assets under management plus 20% of gains, resulting in an incredible $46 million to Meriwether in 2008—despite the fact that the fund is down 44%!

Despite the massive leverage, the whopping fees and the lack of transparency, Kenyon reports that Meriwether’s fund spent years underperforming an index fund before it finally imploded, exposing investors to devastating downside without ever enjoying the upside.

The free markets pack a powerful lesson about a fool and his money soon parting.

Meriwether was able to sell his own brand of dreck because buyers were willing to accept the risks of 15 times leverage—despite the fact that Meriweither was a proven and colossal failure. Perhaps, they were too naïve to understand the enormity of the downside, or they were blinded by the mirage of easy money they saw in Meriwether’s crystal ball.

The reality: Meriwether was wrong—again. Investors lost big—again.

The deepest cut: Meriwether made a fortune while he wiped out investors.

The bitterest pill: Time online alludes to the idea that Meriwether may be getting ready to launch a new hedge fund.

Your Call to Action: Forward this email to everyone you know to prevent them from being a consumer of Wall Street’s dreck.

IFA video exclusive! Nobel Prize Winner Harry Markowitz explains the implosion of LTCM and the hazards of leverage. (Click here to watch)

Sign up now for IFA’s in-person educational workshop in Irvine, California.

Presenting “Murphy” IFA’s 10-foot tall probability machine, used to demonstrate the "random walk" of stock market prices.

Murphy in motion clearly illustrates the random nature of all things, including the stock market.

Socialism, So What?

Mon, 01 Jun 2009 10:09:32 GMT

Socialism, So What?

September 16, 2008 marked a watershed moment. That day the US government injected $85 billion into crippled AIG, citing that the company was too big to fail.

Nine short months after the move to rescue AIG, the record $3 trillion TARP plan has been widely tapped by troubled banks, insurance companies and automakers to mitigate the erosive effects of the troubled economy.

The government’s aggressive capital infusions have many US investors concerned that such intervention squarely positions the country's free market system on a collision course with socialism. Indeed, the US government holds a nearly 61% stake in GM, and a whopping 79% stake in AIG and rumors swirl daily about sweeping healthcare reform.

Such concerns are widely publicized. Newsweek magazine’s cover for February 16, 2009 announced, “We Are All Socialists Now.” The article stated, “Whether we want to admit it or not…the America of 2009 is moving toward a modern European state.” It concluded, “More government intrusion in the economy will almost surely limit growth.”

Such conclusions can certainly frighten investors, stirring overwhelming worry about their own financial outlooks. Such concerns are not new, however. History shows that after nearly every major economic downturn, questions arise as to whether the free market system remains an appropriate way to organize and direct the nation’s resources.

Many individuals may be surprised to learn that government intervention can play a key role in free market systems. Milton Friedman, widely known as the most vocal proponent of the free market system cited that the true cause of the Great Depression was the US government’s failure to act swiftly to inject capital into the failing banking system.

"The Federal Reserve system stood idly by when it had the power and the duty and the responsibility to provide the cash that would have enabled the banks to meet the insistent demands of their depositors without closing their doors," Friedman stated in “Free to Choose 3: Anatomy of a Crisis.”

But let’s momentarily entertain the much-articulated mantra that “it is different this time.” Let’s imagine that the US economy experiences a much greater degree of government intervention in the years ahead than it has in the past — how would such a development impact expected returns? Even under those circumstances, the reality is far from grim.

The chart below shows the relationship between equity returns and economic freedom rank. Economic freedom rankings data from Heritage Foundation awards their rankings in consideration of 10 specific elements. According to the data, Hong Kong secured the number one ranking, while the US ranks sixth and France ranks 64th out of 179.

It would be widely determined that the equity returns of a more Socialist-leaning France would be lower than those of the US. The reality, however, is quite the opposite. The chart’s vertical axis measures the equity returns of the countries. It shows that higher returns over the 39-year period were not always delivered to the countries with the highest degrees of economic freedom. Notoriously socialist-leaning countries relative to the US include UK, Canada, Sweden, France, Norway, Belgium and Denmark. The 39-year annualized returns of each of these countries defy the presumption that increased returns come from increased economic freedom.

The bar chart directly below depicts the 39-year returns shown in the above graph.

The bar chart below shows the 10-year returns for countries based on their economic freedom rankings, as well. As you can see, in both long-term and short-term data, economic freedom indicators dispute the commonly held belief that government intervention hampers returns.

While the data presented here may seem surprising, the explanation is very straightforward. Just as value investments demand a higher return relative to growth investments to compensate for the higher risk associated with them, so too should investments in countries with increased government intervention demand higher expected returns to compensate investors for the increased perceived risk of investing in them.

This research, once again points to the simple and profound truth that investment returns come from investment risk, proving once again that there is no free lunch — even for perceived free market economic systems

Stop the Insanity

Sun, 12 Jul 2009 10:09:32 GMT

Stop the Insanity

The 2008 bloodletting had millions of investors playing Howard Beale from the movie Network, screaming they’re mad as hell and they’re not going to take it anymore.

The sting was strong, leaving 90% of clients of brand brokrage firms planning to take money away from their brokers, according to a September 2008 Wall Street Journal article. But, investors will likely find future disappointment if they ignore Einstein’s observations about insanity.

Simply moving from one brokerage house to another will only send individuals out of the frying pan and into the fire. No relief can be expected for those who simply move from one stock-picking, time-picking or manager-picking speculator to another. The names and faces may change, but there is no reason to expect superior results if speculation is the investment strategy. A bad process leads to a bad outcome.

More than 99% of stock-picking managers have been shown to lack genuine stock-picking skill. A recent study cites that over a 32-year timeframe only 0.6% of active fund managers (speculators) showed any persistence — a number they determined to be “statistically indistinguishable from zero,” says financial journalist Mark Hulbert in his July, 2008 New York Times article "The Prescient Are Few."

To learn about the real source of stock market returns, please join IFA for an important live and in-person workshop:

“Managing Risk in Uncertain Times”

In this hands-on workshop to be held in IFA’s new corporate offices in Irvine, California, IFA President and Founder Mark Hebner will address the questions that currently trouble prospective investors, including:

Can you trust your broker or advisor to make the best decisions for you and your money?

Have you paid a steep price for taking too much risk?

Are your investments suitable for your future financial needs?

How can you invest for future growth and sleep at night?

Are management fees, commissions and taxes taking too big a bite out of your investment returns?

Mark will also show prospective investors a historically successful index investing strategy that is straightforward, transparent and tax efficient.

Indexing has been advocated by financial experts, including Warren Buffett, Charles Schwab and Vanguard Founder John Bogle, as well as Nobel Prize winning economists.

You will leave this informative workshop with:

An action plan for smarter investment decisions
A free asset allocation customized to your specific situation
A free signed copy of Mark Hebner’s book, Index Funds: The 12-Step Program for Active Investors

The markets have rebounded from their lows. If you are thinking about how to best invest your hard-earned money, and you have $100,000 or more to invest, make sure you attend this workshop — It'll provide you just the dose of sanity you need to invest wisely.

Dates and times are as follows:
Tuesday, June 23, 2009 6:30pm – 8:00pm
Saturday, June 27, 2009 10:00 am – 12:00pm

Seats are filling up quickly, so reserve your space right now by clicking here.

If you are unable to attend, please feel free to call Index Funds Advisors to speak with an Investment Advisor Representative about how you can sanely grow your hard-earned assets.

Please call 888-643-3133 or visit us at ifa.com

How to Ruin a Good Thing

Fri, 29 May 2009 10:03:04 GMT

How to Ruin a Good Thing

Buffett’s remarks absolutely nail the benefits of our global free-market system which has delivered healthy returns over time. The problem is that most people deprive themselves of those returns by trying to escape short-term volatility. They trade, they guess and they hang on to every little bit of information, making predictions about future events based on news that is already factored into stock prices.

These active investors get bogged down in day-to-day stories such as the potential impact of swine flu, North Korea, the outcome of GM, or whether Obama proved his salt in his first 100 days. They miss the forest for the trees, losing perspective of the historically positive effects of capitalism over time.

The overall impact of time on an investment in global capitalism has been very positive. But, the positive returns have not been consistent in the short-term. Over time, it is the businesses of the world that adapt to the evolving marketplace — profiting, adjusting or perishing. It is these businesses that pay us a risk premium for investing in them. This is why investors can expect to earn a return.

This return on an investment in global capitalism is available to all market participants, but so few actually get them. Active investors ruin a good thing and deprive themselves of the long-term returns of capitalism that are theirs for the taking.

Each year, Dalbar reveals the returns of the average equity investor, comparing those returns to the S&P 500 Index. The chart below shows the results of their Quantitative Analysis of Investor Behavior study for the 20-year time period from January 1989 through December 2008.

As the chart shows, the average equity investor in the study earned just 1.87% annualized return over the 20-year timeframe — significantly underperforming even the risk-free rate of return offered by a one-year T-Note! When inflation for the 20 years is considered, the returns of the average equity investor turned negative, with a $100,000 investment in 1989 worth just $82,288 net of inflation.

In contrast, an investment in the S&P 500 index would have earned an 8.42% annualized return for the 20-year period with a $100,000 having grown to $296,141 net of inflation. Even better, a globally diversified all-equity index portfolio such as IFA’s Index Portfolio 100 would have earned a 9.21% annualized return with $100,000 growing to $343,597 after inflation was considered. All investors had to do was buy, hold, and rebalance a risk-appropriate, low cost portfolio of index funds and get on with the joys of living.

Click to Enlarge the Chart

This significant study and many more just like it reveal the peril in store for those who attempt to circumvent market downturns and capitalize on market upturns. Commissioned stock brokers and active managers would have investors believe that these short-term movements have negative impact on long-term expected returns, when in reality it is the trading activities promoted by their self-serving recommendations that destroy investor returns. Any advisor who gets paid a commission or salary based on trading would starve if they told you “don’t just do something, sit there,” despite the fact that it is in following their recommendations that most investors ruin a very good thing.

Cramer Fact Check

Fri, 08 May 2009 10:03:04 GMT

Watch additional video of Dan's appearence on CNBC's Power Lunch

Cramer Fact Check

Fireworks flew when Dan Solin recently appeared on CNBC’s Power Lunch to express his dissatisfaction with the 401(k) offerings available to most employees in the U.S. private sector.

“The vast majority of 401(k) plans are really bad…They’re like a killing machine…they go around gobbling up assets of the 50 million people who have invested $2.7 trillion in these plans,” claimed Solin, a Senior Vice President for Index Funds Advisors and author of The Smartest 401(k) Book You’ll Ever Read.

When asked what could be done instead in the world of 401(k) investing, Solin answered, “One of the things that you could do instead is to give us more of ‘in Bogle we trust’ and much less ‘in Cramer we trust.”

Shortly thereafter, a characteristically contentious Cramer emerged to discredit Solin.

“The S&P is flat literally for 10 years, that’s John Bogle’s world,” Cramer argued. “I’ve had it with the people who tell me about the index fund. For 10 years they’ve done nothing,” Cramer ranted.

“You obviously have no understanding of what John Bogle’s world is,” Solin rifled back. “John Bogle’s world is appropriate asset allocation, a globally diversified portfolio of stocks and bonds. His world is not the S&P 500 for every investor, and if people had followed historically John Bogle’s world, they would be far, far better off either in or out of a
401(k).”

While Cramer’s vitriol may have perked up viewer attention, it was Solin’s facts that make him the clear winner of the impromptu debate.

Solin’s assertion regarding global diversification is strongly rooted in historical data. Proper asset allocation extends far beyond an investment in the S&P 500 Index, a large company index which invests only in the United States. No index funds advisor would encourage an individual to invest in this index alone.

Cramer’s oversimplification of index funds’ performance based on a single asset class makes him guilty of omissions so egregious that his statements rise to a level of gross misrepresentation.

Expanding on Solin’s argument, a globally diversified index portfolio was far from flat over the last 10 years, with the all-equity Index Portfolio 100 earning a total return of 72.39% for the 10-year period ending December 2008. The returns of this and 19 other risk-appropriate asset class blended portfolios starkly contrast Cramer’s portrayal of index funds’ performance. It appears that Cramer would have us throw out the baby with the bath water when it comes to index funds and the S&P 500 which underperformed its long-term average during the same 10-year time period.

The chart below shows a 10-year risk and return comparison between 20 IFA Index Portfolios and 20 Vanguard index portfolios that were created using IFA weights. The chart also plots the S&P 500 Index referenced by Cramer. The 10-year time period reflected in the chart ends December 2008.

True to Solin’s point, globally diversified index portfolios that were created using Vanguard indexes (the company founded by John Bogle) outperformed the S&P 500 Index. And the IFA Index Portfolios that are constructed with funds that carefully implement exposures to the Fama/French Five Risk Factors did even better.

Style purity, low expenses and total transparency make index portfolio investing a superior investment alternative to the commonly offered actively managed funds that litter the offerings of most corporate-sponsored 401(k) plans.

(Click to see the full IFA vs Vanguard report PDF)

The data in the above chart discredits Cramer’s sweeping statement regarding index funds investing. But what about Cramer’s own track record? To hear him tell it, had investors listened to him back in September, they could have exited the market at Dow 11,000 and re-entered at Dow 6,500. Certainly, any market timer who made such stellar calls would have an excellent track record, so what happened with Cramer?

According to CXO Advisory, an online group that tracks the accuracy of stock-picking gurus, Cramer’s track record is far from impressive. Tracking 59 measurable forecasts that Cramer made in New York Metro, CXO determined that 27 of Cramer’s picks or 46% were essentially right, while 32 or 54% were essentially wrong. With laws of randomness giving Cramer 50/50 odds of being right, he performed less well than what would be expected had he simply guessed or (borrowing from Burton Malkiel) thrown darts at The Wall Street Journal.

“All of us have that obligation to educate investors away from gambling, trading, speculating and listening to people who say they can pick stocks,” Solin admonished the interviewers.

“If investors learned how to invest intelligently, according to the teachings of John Bogle and many, many others, they would be far better off,” Solin concluded.

Testing Market Efficiency

Wed, 22 Apr 2009 09:52:23 GMT

Testing Market Efficiency
by: Jay D. Franklin, CFA, FSA
IFA Director of Trading & Investment Risk

During this turbulent period, certain pundits have questioned the validity of the Efficient Market Hypothesis. There is nothing new about this, as these questions have arisen in every highly volatile market since the formulation of the Efficient Market Hypothesis approximately forty years ago. As a specific example, the author of this article cites the magnitude of the 2008 drop as evidence that market prices were previously incorrect, but now, of course, they have been corrected. Furthermore, if the market was so obviously inefficient then, why should anyone believe that it is efficient now? Like so many others, the author of that article has confused hindsight with foresight.

In an interview seen here, Professor Eugene Fama, the father of the Efficient Market Hypothesis, describes a simple test for determining whether or not the market does a good job of setting fair prices. In order to understand this test, it is necessary to visualize what an inefficient market looks like. Such a market would have lots of what we refer to as irrational and not-so-skillful “noise traders" creating prices that are incorrect and/or are not fair, leaving ample opportunity for skillful traders to "beat an appropriate benchmark." In an inefficient market, we would see smart, skillful, highly informed traders that are consistently exploiting and making money at the expense of the irrational and dumb traders, but we see no evidence of such skillful traders. In fact, successful traders have been more appropriately deemed "just lucky."

Eugene Fama indicated that another attribute of an inefficient market would be higher daily volatility than would be estimated based on annual volatility. In an inefficient market, daily price swings would be high, possibly creating mispriced stocks. But, as "skillful traders” scoop up the mispriced stocks from the poor ignorant traders, the volatility would smooth out over time.

Based on fifty years of annual returns data, IFA estimated the daily standard deviation of the S&P 500 to be 1.09%. This estimate was based on dividing the annual standard deviation by the square root of 250, the approximate number of trading days per year. In an inefficient market, the actual standard deviation of daily returns should be much higher than the estimated 1.09%. IFA obtained the daily S&P 500 data from Yahoo! Finance for the last fifty years, and the actual daily standard deviation is 0.98%. According to Eugene Fama's test, this result would not be indicative of inefficient markets.

Given that the fifty year data shows no indication of market inefficiency, one may argue that the market over time has become progressively more efficient due to increased availability of information about companies or that it has become less efficient due to wider accessibility to uninformed traders. Breaking up the fifty year period into five consecutive ten year periods gives no indication of either increasing or decreasing efficiency. In fact the only ten year period where the estimated volatility was substantially lower than the actual volatility was the middle period (1/1/1979 to 12/31/1988), as seen below:

Actual vs. Estimated Daily Standard Deviations of
S&P 500 Returns - (Inefficient markets would be the opposite result.)

Sources, disclaimers and updates: ifabt.com

Even if the market is populated with unskilled traders, all that is needed for market efficiency is a sufficient number of intelligent participants with access to sufficient information. These informed and willing buyers and sellers compete to trade at a profit, and the price they strike is the consensus of their opinions of the stock’s value, otherwise known as the fair market value. As expressed by Marlena Lee of Dimensional, the market does its job of setting prices so that buyers can expect to receive a return that compensates them for the risks they bear.

As recently noted by Gene Fama Jr., the very fact that the Efficient Market Hypothesis still comes under assault is stronger testimony to its deep relevance. Furthermore, it is important to remember that asserting market efficiency is not equivalent to asserting that the market is right, just that it is more likely to be right than any single market participant. Also, even if markets are not perfectly efficient, they are efficient enough that the time and resources spent in attempting to uncover inefficiencies exceeds the profits to be gained. Those who believe they can prosper by taking advantage of a market that they perceive as inefficient would do well to remember the thought expressed by John Maynard Keynes well before Professor Fama articulated Efficient Market Hypothesis: “Markets can remain irrational longer than you can remain solvent.”

The conclusion of this analysis is that investors should invest, but never speculate. IFA keeps a crystal ball on its conference room table to remind us that nobody can predict tomorrow's news. When guests are asked to peer into the crystal ball, they see a fortune that Mark Hebner, IFA president and founder, received by chance in a fortune cookie from a Chinese restaurant. The message in that fortune says, "Invest, but never speculate."

Hedge Funds: A Fool’s Errand

Fri, 03 Apr 2009 09:52:23 GMT

Hedge Funds: A Fool’s Errand

Was it pure coincidence, or did the federal authorities plan the seizure of Bernie Madoff’s yacht to occur on April Fool’s Day?

Certainly, the more than 6,700 people who have filed claims for some semblance of recovery have spent ample time feeling foolish. But likely, fresh pangs of foolish guilt arose in the guts of those who had the unfortunate displeasure to watch as Madoff’s 55-foot vintage yacht—aptly named “BULL”—was tauntingly ushered away from the pier.

In the 3-1/2 months since the news broke about the biggest ponzi scheme in history, individuals have asserted that they knew Madoff was running a scam. As the dots continue to be connected, it becomes increasingly obvious that the signs were there, the flags were raised, and yet a $50 billion scheme was continually perpetrated on institutions and individuals. The warnings were ignored as people begged Madoff to take their money. When the illusion of a handsome and consistent return was dangled before their eyes, investors gleefully turned a blind eye to some very glaring problems:

Madoff had custody of his firm’s assets
The auditing firm was one man in a strip mall
If you asked for details about the investment strategy, you were not allowed to be a client
Madoff’s alleged consistent returns were said to be generated from equity investments

Madoff sleeps behind bars now, but the story is far from being put to rest.

His sweeping plea/confession has only accelerated the ongoing investigation that now centers on who knew what and when. Evidence is swiftly mounting against the much-talked about “feeder funds” that served as international gateways to Madoff’s scheme. In particular, hedge fund manager Walter Noel of the Fairfield Greenwich Group was slapped with a fraud charge for his part in wiping out $7 billion of his clients' assets in Madoff’s farce.

The charges, inked on April 1, assert that Noel’s firm fooled its investors about the due diligence it conducted with respect to Madoff’s asset management business. The documents describe the profound disparity between the due diligence the Fairfield represented to its clients and what actually transpired. "[We] attempted to discern how Fairfield possibly could not have discovered the fraud during their 18-year relationship [with Madoff]," the Massachusetts Secretary of State said. "The answer, quite simply, is that they were blinded by the fees they were earning, did not engage in meaningful due diligence and turned a blind eye to any fact that would have burst their lucrative bubble," the documents concluded.

Madoff’s vague disclosures and scant accounting methods facilitated the opportunity for backroom deals to victimize unwitting individuals and institutions who relied on what they believed to be “due diligence.”
The promise of due diligence is a shallow one when it is supported by opacity and absent ethical standards.

Index Funds Advisors mostly advises it's clients to invest in mutual funds from Dimensional Fund Advisors (Dimensional or DFA), a highly regarded fund family that is completely transparent.

How is DFA different from Madoff?

Dimensional is regulated under the Investment Company Act of 1940. Madoff ran a hedge fund which was not regulated under the Investment Company Act of 1940. Mutual funds are probably the most highly regulated investment entity in existence.
Clients receive monthly statements and online access to current account information from Schwab or another independent custodian, not Dimensional. Madoff was sending his own statements out.
Schwab, Fidelity, TD Ameritrade or other custodians, are independent of Dimensional Fund Advisors and Index Funds Advisors. When clients make deposits and place trades, that money is handled by Schwab or the other custodians. Dimensional is not the custodian of any client money.
Dimensional uses the largest independent accounting firm in the world, PriceWaterhouseCooper. Their existence relies on the integrity, diligence and accuracy of their reporting. Madoff's accountant, David Friehling, operated as a sole practitioner in a 13-by-18 foot office in Rockland County, New York.
A Net Asset Value (NAV) of each mutual fund is calculated every day. There was no daily NAV calculated for Madoff’s fund. PNC (for domestic) or Citibank (for international) calculates this based off of the actual holdings in the mutual fund entity. Schwab (or any other custodian that receives money from the client) does their due diligence to be sure that the shares of the fund they are holding actually represent interests in a fund that holds the securities.
PNC and Citibank are audited. They are commercial banks and are also highly regulated.
The assets held at DFA's custodian (PNC or Citibank) are separate from the commercial bank assets. If PNC or Citibank were to cease to exist, the funds would still exist, independent of them. The fund entity would just be moved to another custodian.

In regards to IFA, they are a Registered Investment Advisor with the SEC and approved by DFA to offer their funds to individual investors.

IFA provides exclusive online services and resources that educate clients on the principles of investing, including a Risk Capacity™ Survey that matches investors with risk appropriate portfolios. This is achieved by carefully measuring an investor’s Risk Capacity™ and matching it to a Risk Exposure in the form of an index portfolio. An Index Calculator is also provided that can calculate monthly risk and return data of all 20 IFA Index Portfolios and 20 IFA Indexes over the last 81 years. In total, there are about 41,000 monthly returns in the calculator. Lowell Herr of ITA Wealth Management calls ifa.com the "best investment site he has ever seen on the internet."

A Special Message From Mark Hebner

Fri, 27 Mar 2009 09:45:51 GMT

A Special Message From Mark Hebner

Dear Friends of IFA,

On March 5th 2009, Index Funds Advisors celebrated its 10th anniversary.

I am pleased to thank all of you who have helped make such a milestone both imaginable and possible.

I am especially grateful to our more than 3,000 clients have put their trust in IFA. You are a testament to the importance of education for long-term investing success.

In 1999, I embarked on a mission to change the way the world invests. I did so because I had learned the hard way that stock market speculation is both widespread and destructive.

Through extensive study and research, I found a smarter way to invest—a strategy based on rigorous academic discoveries and decades of data--and I wanted the entire world to share in what I learned.

I set out to replace speculation with science—to provide the meaningful data that would allow investors to make informed decisions about their hard-earned dollars. Decisions that were based on probability, not personality and about accepting uncertainty, not betting on it.

Back then, I knew the Internet was the only way to display the abundance of information that I had discovered, developed and assembled—the kind of information that would empower investors to let go of their need to predict the markets in favor of just buying and holding the markets—in risk-appropriate doses.

As you may know, my ifa.com website is an open book — quite literally! It contains a web version of my own book: Index Funds: The 12-Step Program for Active Investors. It also contains hundreds of studies, charts, articles, podcasts and instructional videos, along with exclusive video interviews with some of the most distinguished financial experts, including Eugene Fama Jr. and Nobel Prize Winner Harry Markowitz, who serves as an academic consultant to IFA. This abundance of unbiased information is the anecdote for investor confusion that leads to misplaced trust and poor decisions. As Warren Buffett recently said, “If you are confused and fearful, you don’t get over being fearful until you aren’t confused.”

Perhaps most important to you is the Risk Capacity survey that you can take in 5 to 10 minutes--right on the ifa.com website. In almost an instant, you will receive an asset allocation that matches your investment profile based on the answers you provide. It couldn’t be easier for you to get started on your path to risk-appropriate investing.

Like most financial advisors, we at IFA are asked constantly about our views on where the markets are going in the next several months. Unlike most financial advisors, our response is: “We don’t know.”

We don’t pick stocks or time markets at IFA. Instead, we rely on 81 years of risk and return data and on rolling period analysis that empowers us to help you make the best decision for you and your long-term situation—not what the market might do in the next 6 weeks or six months. If your time horizon is that short, you should avoid equities altogether. As Ben Graham, Warren Buffett’s mentor, so aptly pointed out, “In the short term, the market is a voting machine, but in the long term, it is a weighing machine.”

At IFA, we follow a blueprint that is driven by your Risk Capacity — the measure of how much risk is right for YOU -- not your friend, not your boss and not your in-laws.

That blueprint is called an Investment Policy Statement or IPS and it gives us the discipline to remain committed to a strategy that is supported by 81 years of risk and return data.

A properly constructed IPS enables us to follow a well-conceived, long-term investment strategy. Without the IPS, individuals can easily fall prey to fear or emotion, making decisions on an individual event-driven basis. This behavior most often leads to chasing short-term results and cuts off investors from the opportunity to achieve long-term market rates of returns — the returns they have the right to earn if they would simply get on the right investing track and stay there, especially during the extreme fluctuations in stock market returns like those we have seen recently.

History provides compelling data that broad market indexes reward investors over time with about a 9% average annualized return. Risk-appropriate tilts to small and value markets have shown to deliver additional returns to those whose time horizon permits these specific risk exposures. Important services such as rebalancing, tax managed investments and tax loss harvesting help IFA clients maximize their returns at a given level of risk.

It has been a wonderful decade for IFA, and first and foremost, we have our clients to thank. As a fee-only financial advisor, my team and I are here today because we have their trust — and we value that trust immensely.

We also extend our gratitude to the million or more ifa.com visitors who have quenched their thirst for unbiased investing knowledge — and who also know that I seldom meet a chart I don’t like; and to the many, many more who have learned about bell-shaped curves, rolling period returns and the magnitude of personal and financial satisfaction that comes from abandoning the prediction addiction in favor of unbiased research and history.

No grass is growing under our feet as IFA’s second decade is off to a very busy start. Soon, we will be occupying our new state of the art headquarters in Irvine, California. This new first floor facility in our same building gives us the latitude to expand into new information delivery systems like seminars and investing classes that will provide a personalized dimension to the IFA investor experience. Offices and regional representatives in Wisconsin, Florida, Pasadena, Westlake Village and New York further enable IFA to expand its foothold throughout the country. Whether in person, or at ifa.com, we encourage you to visit us and often.

Once again thank you for a wonderful first decade and stay tuned as ifa continues to advance its mission to change the way the world invests.

Mark Hebner

President
Index Funds Advisors

Naked Truths

Thu, 19 Mar 2009 09:45:51 GMT

Naked Truths

When Melanie Mize wrote her travelchannel.com review of the top nude beaches in the world, she described exotic locales, replete with tropical foliage and the ideal climate for achieving the perfect overall tan.

If Warren Buffett is correct, however, it appears that Mize overlooked the most popular destination for those who swim naked. Her oversight is completely understandable, however. After all, the corner of Wall and Broad doesn’t even sport a swimming pool, let alone a beach. Despite this fact, however, the ebb of the financial tide has many heretofore big fish scrambling for Wall Street’s own version of a fig leaf—good old American greenbacks.

The 16-month ebb of the financial markets has been very revealing, indeed. Those of us with the stomachs to watch the tide go out have witnessed some shocking events unfold:

We recently saw the admission of a $50 billion Ponzi scheme that operated, very visibly, for nearly 20 years under regulatory radar, that is until the market’s massive dive drove Madoff to come clean about just how dirty he really was. In an almost chilling and intensely audacious move, Madoff described, with a twisted sense of self-satisfaction, just how he was able to destroy the fortunes of thousands, and seemingly without a single trade. Madoff's plea statement

In an almost delicious irony, the same day Madoff was cuffed and carted away to jail, Jim Cramer unwittingly waded into the role of the emperor who has no clothes.

In a pitiful attempt at damage control in light of Jon Stewart’s recent blast against CNBC, Cramer confidently assumed the seat across from Stewart, only to squirm for 30 long minutes. During that time, Stewart methodically and systematically exposed both Cramer and virtually the collective whole of CNBC commentators as nothing more than cheerleaders who permit their corporate guests and analysts to make statements that are left unchecked, despite the reality that CNBC presents its reporters as hard-hitting investigative journalists.

Stewart seized the opportunity to reignite the fury that we posted on our ifa.com website back in December 2007 when Cramer bragged about the ease with which he could manipulate markets. Stewart’s characteristic humor turned angry as he asserted that Cramer’s remarks showed that analysts and correspondents at CNBC were painfully aware of the vulnerabilities of the financial system that could be played for profits and that CNBC viewers were vulnerable to be unwitting participants in a much bigger game.

"You know, look, we're both snake-oil salesmen to a certain extent," Stewart told Cramer. "But we do label the show as snake oil here. Isn't there a problem selling snake oil as vitamin tonic?"

Media coverage on Cramer’s evisceration is high.

In a March 16 Tech Ticker broadcast, host Aaron Task (the same fellow who interviewed Cramer during his inglorious indiscretion about market manipulation) asked Cramer to clear the air by appearing on Tech Ticker. According to Task, Cramer’s email response left little room for misinterpretation:

“I appreciate you asking me to come on and expressing the opportunity to call attention to it and continue to wreck my career, but I think I will take a pass.”

The recent pummeling of the financial markets has been far from a day at the beach. Nonetheless, for the last 16 months we have all watched as the financial tide rolled out. Sometimes painfully, we have been pulled by the currents of the markets, we have smelled the stench of rotten business practices as they litter the headlines, and we have seen just a few too many swimmers emerge completely naked and begging for cover.

Indeed, it has been painfully illuminating, but such revelations bring clarity. Charlatans, scheisters and showmen have been fully exposed for precisely what they are. Generations of investors have been provided with an up-close and personal view about the importance of transparency, the hazards of leverage, and the danger of blindly trusting snake-oil salesmen. Unfortunately, the currents of unwise practices and untrustworthy people will roll back in with the tide. They will only cease to pull at you when you become educated enough to not be led by them.

Eighty-one years of stock market history shows us that the tide rolls out and the tide rolls in. Over time, those who are properly outfitted can best withstand the short-term market currents. When your asset allocation is properly aligned with your risk capacity, you can sit on the beach, watch the ebb and flow of the tide (and the spectacle it may bring), and not have to worry about being overexposed.

Where's the Market Going?

Sat, 07 Mar 2009 09:40:31 GMT

Where’s the Market Going?

It’s a common question that emerges from the mouths of virtually every person living in the civilized world today, and yet it is an inherently flawed way of looking at the investment markets.

In The Big Investment Lie, Michael Edesess brings to bear an important point that IFA has emphasized for some time: when discussing the activity of the investment markets, one should speak only in terms of what the market has done as opposed to presuming what it will do.

We often hear television journalists or market-timing advisors announce “the Dow is going down” or “Apple stock is going up.” By using the term “going” when they should really say “went”, supposed pundits attach a presumption of continuity to an event that has occurred in the past.

Why is this seemingly innocent misuse of tenses so egregious? The answer lies in the fact that, in making such statements, they ascribe to themselves an aura of knowing what the market will do, making statements or recommendations that have the potential to strongly impact investors’ decisions and the outcome of their investments.

History continues to show that stock prices follow no discernible pattern in the short-term. As Edesess aptly states, “The stock market can turn on a dime, and always does. Prices are constantly twisting and turning without trend or predictable pattern. Their recent movement gives you nothing to go on.”

Prices respond to news, plain and simple. What further complicates investors’ ability to predict the future movement of stock prices is that markets can fall on what appears to be mostly good news and rise on bad news. We don’t know where the markets are going, and anyone who says they do has no more than a 50-50 shot at calling it correctly. This 50-50 chance is set into motion because equal and opposite opinions from buyers and sellers about the future direction results in a price that sets the odds for the short-term to roughly 50-50.

Over the long-term, positive trends do emerge for those who buy and hold a risk-appropriate portfolio. Since 1928, the capital markets have delivered an average annualized return of about 10% a year, but frequently with a whole lot of short-term volatility. The positive upward increase of the capital markets can only be realized when investors set aside their emotions and sit through the sort of stock market volatility that can be very frightening. This is just the sort of volatility we have experienced lately.

The current correction is the second worst in stock market history, with The Great Depression retaining the number one spot. During this time, it’s critically important for investors to understand that the markets are very resilient and can reverse themselves when times seem most dire.

An example of such a time is found when we look at the simulated Index Portfolio 100 returns for the two-year time period from July 1931 through June 1933. This was an incredibly volatile time period in which the worst monthly rolling 12-month time period in the last 81 years was the July 1931 through June 1932 with Index Portfolio 100 losing 72% in just 12 months. In the subsequent 12 months from July 1932 through June 1933, the same simulated portfolio roared back with a 264% gain. The total return for the 2-year period was a positive 3.52%. Any investor who held that Index Portfolio for the first year would have surely agonized over the massive 12-month losses, but would have been soundly rewarded by maintaining steadfast discipline. This is precisely the sort of discipline IFA is advising right now for each of its clients.

Certainly, we cannot predict how quickly the markets will recover. As physicist Niels Bohr put it, “It is difficult to make predictions, especially about the future.” Anyone who says they know where the market is going is not being truthful. The only question is whether they are being dishonest with you or with themselves.

IFA understands that investors are concerned about their investments. These rare and severely punishing drops in the stock market may find investors wondering how long it might take for their portfolios to recover from big losses. IFA’s investment research team has dug into 81 years of stock market data to create the following probability studies for recovery of the S&P 500 Index as well as for Index Portfolios 90, 70, 50, 30 and 10. The probability studies were created using 81 years of historical returns data for each Index Portfolio and the S&P 500 Index. Live data was used when available and was bridged with simulated data to provide returns data that goes back to 1928. See ifabt.com for more details.

The table below shows the percentage amount of loss for the S&P 500 Index as well as for IFA Index Portfolios 90, 70, 50, 30, and 10 during the 16-month time period from November 2007 through April 2009, as well as the percentage gain that is required to restore each portfolio to its end of October 2007 high.

The probabilities of achieving those post-drop recoveries are set forth in the line graph below which shows the probability of each portfolio recovering within a specified time period from 1-year through 20 years. The y-axis in the line chart below expresses the probability that each portfolio’s recovery will occur in the number of years expressed along the x-axis. For example, the IFA Index Portfolio 10 has a 70% probability of a full recovery or better in less than 2 years from the first day subsequent to the end of the time period stated.

As with all aspects of life, in the stock market anything can happen. The probability studies set forth reflect calculations that are based on the returns and standard deviation of returns from 81 years of history. They provide unemotional measures of the likelihood of outcomes based on all of our data. This is the best information available to us for making investment recommendations. IFA provides this important information so investors can make the most informed investment decisions for their hard-earned dollars.

Where Have All the Returns Gone?

Fri, 27 Feb 2009 09:06:00 GMT

Where Have All the Returns Gone?

As if the recent and severe down markets were not enough to provide perpetual heartburn for fund managers, recent and compelling study results continue to show that the high premium paid to active fund managers drags returns to levels lower than the indexes they attempt to beat.

The eye-opening conclusions emanate from two separate and recent reports:

A Standard & Poor’s study reveals that the majority of actively managed funds fail to outperform simple index funds.

In “Index Funds Are Hard to Beat,” Motley Fool’s Selena Maranjian digs into the results of the S&P study to determine, “funds run by actual human beings still can’t beat a copycat strategy of matching a broad index’s holdings.”

According to the article, the study revealed that for the 5-year time period from January 1, 2004 through December 31, 2008, the S&P 500 Index reported an average annual return of 7.58% while actively managed large-cap funds reported an average annual return of 7.19% on an equal cap-weighted basis.

A five-year comparison is too short a timeframe from which to draw any meaningful conclusions, however, as statisticians tell us that at least 20 years of data are required.

With that in mind, let’s look at a 2007 study which covers a 32-year timeframe. “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas” was conducted by Laurent Barras, Olivier Scaillet, and Russ Wermers. The study investigates the presence of true alpha (above-benchmark returns) in the outcomes of 2,076 open-end actively managed domestic equity mutual funds from January 1975 through December 2006.

The study applied the use of t-statistic hypothesis testing and statistical data to compare funds’ relative performance, employing a “False Discovery Test”. This was done to avoid the type of errors that commonly plague statistical analysis and mitigate the effects of false positive and negative results. Unlike many previous studies of mutual fund performance, this method allows for distinctions to be made between fund results based on luck and those based on skill.

Using data which prevents survivorship biases and excludes funds with less than five years of performance history, and taking into account the large effects of active management fees, the study concluded that 99.4% of all fund managers failed to demonstrate true stock-picking ability.

In a July 2008 New York Times article titled “The Prescient Are Few”, journalist Mark Hulbert chronicled the results of the landmark study and its implications. Quoting Prof. Wermers, Hulbert states, "The number of funds that have beaten the market over their entire histories is so small that the False Discovery Rate test can’t eliminate the possibility that the few that did were merely false positives,” says Prof. Wermers--or as Hulbert puts it “just lucky.”

An albeit miniscule percentage of lucky managers may provide a glimmer of hope for a confident investor to entrust their assets to an active fund manager. Our second recent study, however, reveals that even if an active manager is lucky enough to beat the index, any positive return is likely to be swallowed up the higher fees and expenses associated with them, causing the fund to underperform the index when all costs are brought to bear.

A February 2009 study by Mark Kritzman, M.I.T. financial professor showed that after fees and taxes are accounted for, “It is the extremely rare actively managed fund or hedge fund that does better than a simple index fund,” according to Mark Hulbert's February 21, 2009 New York Times article titled "The Index Fund Wins Again".

Kritzman’s study was designed to “accurately measure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund. Those include transaction costs, taxes and management and performance fees,” the article stated.

This task proved to be onerous. “It is surprisingly hard to measure these costs accurately. The bite taken out by taxes, for example, depends on the specific combination of positive years and losing ones, as well as the order in which they occur. That combination and order also affect the performance fees charged by hedge funds,” Kritzman told Hulbert.

“Mr. Kritzman devised an elaborate method to take such contingencies into account,” Hulbert noted. Once these expenses were isolated, Kritzman “calculated the average return over a hypothetical 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns — along with their turnover rates, transaction fees and management and performance fees — was based on what he determined to be industry averages,” the article continued.

Kritzman’s elaborate study concluded that when expenses, and taxes (federal and NY state) in the highest tax brackets,even when actively managed funds' gross returns were in excess of the index benchmark by as much as 3.5% to 9%, the net returns, on average, trailed those of the index.

Kritzman determined that expenses related to active funds imposed too great an obstacle for even successful fund managers to overcome, eating up a considerable percentage of returns: “Mr. Kritzman calculated that just to break even with the index fund, net of all expenses, the actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year,” cites Hulbert.

A 15-year study conducted by John Bogle revealed the silent but costly impact of fees and expenses. Bogle concluded that the average equity fund investor only kept about 47% of their cumulative returns for the January 1984 through December 1998 time period while an index fund investor held onto a considerably higher 87% of their cumulative returns. The “pie charts” below illustrate the results of the study and the source of the excessive fees and expenses that travel in lock-step with active management.

The implication of the fees analysis that plague active investors leave out a perhaps even more compelling part of the story, which is the fact that winning fund managers cannot be identified in advance. A small percentage, less than 1% according to the Wermer’s study, will beat the index, but it is really only by chance alone that an individual could successfully identify them.

The impact of all of these studies is best summed up in the Kritzman study’s conclusion, “It is very hard, if not impossible to justify active management for most individual, taxable investors, if their goal is to grow wealth,” he stated. “Even in a tax-sheltered account,” Kritzman said, “the odds of beating the index fund are still quite poor.”

Citing Kritzman, Hulbert concluded, “Those who still insist on an actively managed fund are almost certainly 'deluding themselves.’”

Risk: A Primer

Mon, 09 Feb 2009 16:17:17 GMT

Risk: A Primer

In his book Index Funds: The 12-Step Program for Active Investors, Mark Hebner identifies that 85% of investors are active investors. This means that a majority of investors handle their investments in one or more of the following ways:

They pick stocks or hire the latest hot fund manager to pick stocks for them
They think there are times to be in a market and times to be out of a market.
They shift in and out of styles or indexes in an effort to chase returns

There are many problems associated with these types of strategies, but let's limit this discussion to the fact that these approaches make poor use of risk. The risks that active investors take are generally and uncompensated.

Certainly, investors have an all too fresh understanding of the brutality of the equity markets, and many are reeling. Many are victims of flawed strategies, and they will continue to be until they learn how to implement the right amount and types of risk.

How can investors assemble a risk-appropriate portfolio?

Every investment carries an expected return and an uncertainty of that return. This is true of stocks and indexes. Most people who pick stocks think that they can find the handful of stocks that will do better than the index and avoid the stocks that will do worse than the index. This hope is based on the belief that stocks are mispriced (either overpriced or underpriced) and that they can exploit those mispricings for profit.

Eugene Fama is widely regarded as the "Father of Modern Finance." Among his many important and ongoing contributions to the financial markets is The Efficient Market Hypothesis which explains how and why markets work.

Fama's research shows that securities are fairly priced at all times, with the price agreed upon by a willing buyer and a willing seller to be the best indicator of a stock's value. The free-flow of information, research and analytics available to 6 billion market participants and all at the same time makes it virtually impossible for any one investor or analyst to possess an edge over all other market participants beyond that which would be expected by chance alone. In other words, investors cannot enjoy excess profits from picking stocks or actively managed funds. (See Eugene Fama Jr. explain efficient markets and the dimensions of risk.)

One of the implications of Fama's hypothesis is that every stock within an index has the same expected return as the index, but individual stocks carry more uncertainty of that return, or higher risk in the form of company risk such as fraud allegations, accounting issues, etc. An example of this type of risk is Enron which had issues specific to the company alone that brought down the energy giant. In contrast, the S&P 500 index which had an allocation to that company's stock was able to absorb the shock and earn that market's rate of return.

In Winning the Loser's Game, Charles Ellis describes stock group risk, which should also be diversified away in order to reduce unnecessary or uncompensated risk. Stock group risk is present when an investor owns multiple stocks, but as a group move up and down in price. This is called correlation. Portfolios that are highly correlated carry excessive concentration risk, and are not well-diversified. (see Nobel Prize Winner Harry Markowitz explain diversification).

How can investors make the most of risk?

All returns come from risk, but not all risks carry expected returns. How can investors feel certain that they are taking only those risks that have shown to carry return and leave the rest aside?

Take the Risk Capacity Survey

Fama and French's Three Factor Model identifies the source of stock market returns: market, size and value. Alpha measures a manager's skill in earning an average excess return that couldn't have been achieved through an index with risk exposures similar to the portfolio run by the manager. In short, did the money manager earn anything above the indexed return once the three factors have been accounted for?

The above chart tells us that a portfolio's expected return is determined by the portfolio's exposure to the market as a whole, as well as to the extent to which that portfolio is exposed to small and value factors. A globally diversified index portfolio that captures the right amount of these specific risk factors is an excellent method to implement efficient use of risk and to mitigate uncompensated and excessive risks that come with active investing.

So, how has a portfolio with varying and risk-appropriate exposures to market, size and value factors performed over time?

The chart below depicts the Roller Coaster of Risk and Return. It shows the volatility of five Index Portfolios (IFA Index Portfolios 10, 30, 50, 70 and 90) as measured by annual returns for the 50-year period from January 1959 through December 2008, as well as the growth of a dollar.

As you can see, Index Portfolio 10, with a large allocation to fixed income, had a much smoother ride than the all-equity Index Portfolio 90 for the 50-year time period, but with far less return.

Click here to watch IFA President Mark Hebner explain this chart. http://www.ifa.com/quoteoftheweek/rollercoaster.asp

Markets have dropped in value, what should investors do now?

Recent market turmoil has investors questioning if they should stay in the market. This depends solely on how you are invested right now. If you are holding a globally diversified Index Portfolio and your risk exposure matches your risk capacity, then you should stay put and keep your eyes fixed on the expected returns which remain about the same as they were when you invested.

If you are an active investor, you should cease all such approaches and get educated about the real source of stock market returns. IFA.com provides an abundance of charts, articles and videos that detail the pros and cons of every equity investment approach. IFA.com enables every investor to make informed decisions and replace fear, hope and speculation with 80 years of risk and return data on simulated passively managed, low-cost investments that capitalize on the ground-breaking discoveries of investing science.

Draw the Line in '09

Mon, 12 Jan 2009 16:17:17 GMT

Draw the Line in '09

It is entirely possible that most investors have but one good thing to say about 2008: "It's over!"

Given time, however, investors may determine that 2008 turned out to be a rewarding year after all, if not in the traditional sense.

With practically every equity asset class down in 2008, the only positive returns were in fixed income investments. A US Real estate index was down 37%, with many leveraged real estate investors finding themselves completely wiped out. Emerging Markets were down 50% and private equity, venture capital and hedge funds were hammered, as well. Investors with lock-up provisions find themselves especially pinched as their assets have declined and they can’t even get their money out. Anyone who jumped on the supposed inflation-hedging commodities markets was grossly disappointed as demand waned when speculation hit an all-time high. Those who had investments with Madoff's massive hedge fund scam have the inglorious distinction of feeling like the "biggest suckers who ever walked the earth," to quote former Madoff investor, Eric Roth. The Forbes May 2004 cover article on hedge funds, titled “The Sleaziest Show on Earth,” had a subtitle that investors ignored at their peril. It stated that “Hedge Funds will suck in $100 Billion from an ever-broader swath of investors. Pretty good for a business rife with exorbitant fees, phony numbers and outright thievery.” Bernie Madoff can now be added to the list of other hedge fund thieves reported in the story from nearly 5 years ago.

Certainly, many investors have sacrificed financial losses in the past year. They have also been presented with certain unavoidable, undeniable and hopefully, unforgettable truths that have the power to usher in a new breed of more discriminating investors.

A handful of lessons courtesy of 2008:

Don't pick stocks: Bear Stearns, Lehman, Wachovia, AIG, Fannie, Freddie-steady Eddies can turn into dead ducks.
Margin Cuts Both Ways: Unlike a bicycle, the ride down is not fun.
Broken Trust: Brokerage commissions, performance premiums and other incentives (often buried in the fine print) have the power to foster conflict of interest.
Liquidity Matters: It's your money. When you need it, you should be able to get it.
Transparency: What's in your portfolio? Do you understand it? Can you account for all of your holdings, and is information easily accessible and straightforward?
Prediction: As physicist Niels Bohr observed, “Prediction is very difficult, especially if it is about the future.”

2008 is painfully well-documented by financial journalists, but many are conflicted in their efforts. In one breath, they describe the ravaging effects to investors. But in the next breath, make predictions about where to invest in 2009. The reality is, however, until investors establish a true understanding of whom they can trust, they are vulnerable to the siren songs of active management that promise great wealth without regard to risk. The New Year provides a watershed moment for investors to finally avoid listening to those who do not harbor their best interests . This filter is a very simple one. It's the standard that requires fiduciaries to put their clients' best interests above their own.

To borrow a phrase from Amy Grant: "You've got to know who NOT to listen to." The New Year provides a watershed moment for investors to finally avoid listening to those who do not harbor their best interests (even if it is their own flawed judgment that works against their long-term best interests). This filter is a very simple one. It's the fiduciary standard and it requires fiduciaries to put their clients' best interests above their own, and at all times. For a detailed explanation of the fiduciary standard, click here.

Enlisting the services of a fee-only fiduciary can go a long way toward stemming the tide of deception that frequently travels in lock-step with active management and the brokerage industry.

Larry Swedroe aptly surmises, "Anyone who says active managers can win should wear a T-shirt that says, 'I can't add.'"

William Bernstein declared, "Brokers service clients the same way Bonnie and Clyde serviced banks."

And, in an almost prophetic stroke aimed at nursing the world through the impact of what was yet to come at the end of 2008, Vanguard founder, John C. Bogle released his latest book Enough.

In his book, Bogle states, "The rampant greed that threatens to overwhelm our financial system and corporate world runs deeper than money. Not knowing what enough is subverts our professional values. It makes salespersons of those who should be fiduciaries of the investments entrusted to them."

With no intent to alter the significance of what Bogle refers to as "Enough," IFA says "Enough!" to the illusions captured in the smoke and mirrors that drive Wall Street.

IFA says "Enough!" to the speculation that grinds down the value of investors' accounts while driving up commissions.

IFA says "Enough!" to the deception that lures trusting investors toward the elusive goal of market-beating returns, when reams of data and non-biased studies comprehensively reveal the folly that accompanies such a hope.

IFA says "Enough!" to the broken trust that will likely define 2008, if not the entire decade.

IFA urges investors to say "Enough!" and finally abandon the frustration that has plagued ill-fated attempts to beat the market. Hundreds of studies continue to show that market returns are the superior returns, and they come with zero conflict of interest. IFA advises on investable indexes that carry up to 81 years of risk and return data*. These investments are tax-efficient, globally diversified, low-cost, risk-appropriate and provide an excellent way for investors to capture market rates of return that are in keeping with an individual's risk capacity.

IFA advises clients to invest in investments that are tax-efficient, globally diversified, low-cost, risk-appropriate and provide an excellent way for investors to capture various market rates of returns that, as a whole, are in alignment with investors risk capacities.

IFA applies tremendous resources to help investors make sound investment decisions. The ifa.com website contains comprehensive and up-to-date data on Indexes and Index Portfolios. It also provides hundreds of articles and charts detailing landmark studies that pertain to virtually all investing strategies. We have posted dozens of IFA Films on youtube, iTunes and ifa.com, including interviews with some of the most highly regarded financial experts.

We are constantly add new information. Why… because when it comes to being a resource on proper and prudent investing, IFA will never say "Enough!"

Oh, How the Mighty Fall

Fri, 02 Jan 2009 16:09:26 GMT

Oh, How the Mighty Fall

Most elementary school children are taught the important tale of Icarus, the boy whose father made him a set of wings of wax and feathers to fly away from the island of Crete where the two had been imprisoned by an evil king. Icarus's father cautioned him that he must fly in a straight path and not fly too close to the sun. Icarus obeyed his father's admonition at first, but as he became overcome by the giddiness of the flight, he diverted from his path and flew too close to the sun. Icarus's wax wings melted and the feathers flew away, leaving him desperately flapping his arms as he fell into the sea to drown.

A modern-day depiction of this legendary myth is the harsh reality of the rise and fall of storied fund manager Bill Miller.

As manager of the Legg Mason Value Trust, Miller enjoyed the distinction of being the only fund manager who beat the S&P 500 Index for the 15 consecutive years from 1991 through 2005. Miller was heralded by ratings services and media who put the fund manager on a pedestal, encouraging new money to flood to the lucky manager and making a much bigger fund.

A year ago, Miller's fund had swelled to $16.5 billion as investors clamored to get their share of Miller's unprecedented streak, likely unaware that the fund was badly benchmarked and carried greater risk than the S&P 500.

Miller made a practice of buying just a handful of companies (less than 40 stocks), often in distress and risky. Some of Miller's former picks include Freddie Mac when, in the 1980's, it was under siege and seemingly threatened with bankruptcy. Miller took an aggressive position in the mortgage company; a bet that yielded a return of 50 times his original investment, giving the appearance of certain genius and prompted Morningstar to name Miller "Fund Manager of the Decade" and bestowing its highest five-star rating on Miller's fund.

The chart below shows how the next decade played out for investors who thought past performance was a reliable predictor of future returns. Despite the fact that Miller's fund carried about 40% more risk than the S&P 500 Index, and about 30% higher risk than IFA's Index Portfolio 100, his fund failed to deliver the higher expected returns that should have accompanied the higher risk he took over the ten-year period from December 1999 to November 2008. Investors would have been better off ignoring Morningstar's accolades and buying the benchmark S&P 500 Index which earned an average annualized return that was 3% higher than that of the "fund manager of the decade". Even more compelling, had an investor purchased a globally diversified all-equity IFA Index Portfolio 100, they would have earned an average annualized return that was 5% above the S&P 500 Index and 9.26% above Miller and with less risk than Legg Mason Value Trust.

Miller's underperformance was the result of concentrated investments among highly correlated stocks. This approach was an inefficient use of risk. In contrast, IFA's equity Index Portfolios invest across as many as 15 different asset classes that invest in about 17,000 companies in 40 different countries. As for IFA's Large Value Index (LV), a single asset class allocation for IFA's Index Portfolios, this Index invests in about 250 U.S. companies with a high book-to-market ratio (BtM). Fundamentally important, the BtM sort for IFA's LV Index excludes firms with negative or zero book values. In assessing value, additional factors such as price to cash flow or price to earning ratios may be considered, as well as economic conditions and developments in the issuer's industry. In other words, Miller's strategy of reaching for the falling knife would likely have been avoided by this important rule of construction that governs IFA's Indexes. (Watch Gene Fama Jr.'s video explanation.)

Of Flying High and Falling Fast

Miller's strategy was to "place big bets on stocks other investors feared," according to an article in The Wall Street Journal titled "The Stock Picker's Defeat".

According to the article, written by Tom Lauricella, "Mr. Miller was in his element a year ago when troubles in the housing market began infecting financial markets. Working from his well-worn playbook, he snapped up American International Group Inc., Wachovia Corp., Bear Stearns Cos. and Freddie Mac. As the shares continued to fall, he argued that investors were overreacting. He kept buying."

Lauricella continued, "What he saw as an opportunity turned into the biggest market crash since the Great Depression. Many Value Trust holdings were more or less wiped out. After 15 years of placing savvy bets against the herd, Mr. Miller had been trampled by it."

By his own admission, Miller admits, "The thing I didn't do, from Day One, was properly assess the severity of this liquidity crisis...I was naïve."

In an interview with Lauricella, Miller continues, "Every decision to buy anything has been wrong...It's been awful."

With massive losses and a steady stream of redemptions from individuals and state pension plans alike, Miller's fund is now valued at about $4 billion, less than a quarter of its value just a year ago. According to the article, which cites Morningstar data, "Value Trust's investors have lost 58% of their money over the past year, 20 percentage points worse than the decline on the Standard & Poor's 500 stock index."

Such massive losses have completely wiped out Legg Mason Value Trust's long-term record, and now the Fund Manager of the Decade's track record rests "among the worst-performing in its class for the last one-, three-, five- and 10-year periods, according to Morningstar", says the Journal.

Early lessons such as the tale of Icarus impart important truisms that should not be brushed aside, especially when it comes to investing your capital. Basic, but important lessons can stave off the sort of misery that comes with losing assets by ignoring common sense. Fundamental lessons like, "you don't get something for nothing... there's no such thing as a free lunch... if something is too good to be true, it probably is... and the higher you fly, the harder you fall..." apply to investing as they do to other aspects of life. So, make sure you apply them when it comes to entrusting your hard-earned capital. After all, those who fail to learn from history are destined to repeat it.

You’re a Mean One, Mr. Madoff

Mon, 22 Dec 2008 16:09:26 GMT

You’re a Mean One, Mr. Madoff

	Who Can You Trust? Mark Hebner Addresses Madoff Mayhem
IFA President and Founder Mark Hebner addresses the Bernie Madoff scandal as he asks and answers the most important questions that investors should be asking their advisors right now. [ click here to watch the video ]

If Hollywood acts quickly, they may be able to put together next year’s biggest holiday blockbuster: a remake of “How the Grinch Stole Christmas!”

This new twist on Dr. Seuss’s classic might realistically relocate the Grinch’s frozen home of Mt. Crumpit to Wall Street, where its latest and worst financial criminal Bernie Madoff could easily capture the leading role—that is if he’s not cooling his heels in the slammer.

The town of “Whoville” could easily assume the moniker of “Who’s Whoville” to better reflect the long list of celebrities, politicians, philanthropists, international banks, prominent business executives, sports team owners and average Joes who have just become less than average.

The screenplay might easily be penned by noted Hollywood screenwriter Eric Roth, best known for writing “Forrest Gump”. In an ironic twist, Roth was nominated for a Golden Globe award for his latest work, “The Curious Case of Benjamin Button” on the same day he learned that his retirement assets were cleaned out by Madoff. “I’m the biggest sucker who ever walked the face of the Earth,” Roth confessed to the L.A. Times. If ever a writer needed motivation—it’s clearly present with Roth.

As to the direction and production for the modern-day twist on Seuss, certainly that work is well in the hands of both Steven Spielberg, noted Hollywood director and Jeffrey Katzenberg, who were both duped by Madoff and suffered the loss of millions in personal fortune or charitable assets.

The one potential sticking point with the re-make is that the original story comes complete with a happy ending. If there is a happy ending in this new story, Hollywood will have to get very creative to fabricate one. Certainly, the selling off of Madoff’s assets cannot make the victims whole for the losses they have suffered. The insurance granted by the SIPC of $500,000 is largely viewed as paltry in the eyes of many such victims, but they may very well be lucky to even get that.

More than likely, most of the money is gone. Big-name attorneys will be in court to fight this one out for quite some time. In the final analysis, however, so many of Madoff’s victims will simply have to accept the fact that they were duped—and quite likely, that fact hurts as much as losing the money.

The emotional toll on Madoff’s victims is heavy. Decades-long relationships that were built on friendship, faith, trust and mutual interests with respect to charity and religion appear to have been just one big lie. As the months and years unfold, this revelation has the power to erode the spirits of those who have lost their money as well as their ability to trust.

At the root of all of this pain sits the once (and perhaps still) stubborn belief that active managers can persistently outperform market indexes. The inability for individuals to be content with market rates of return continues to be the well-spring of dissatisfaction for most, and agony for many.

In an interview with John Stossel, Burton Malkiel describes the reluctance to give up the belief that active managers can outperform a market index is “like giving up a belief in Santa Claus. Even though you know Santa Claus doesn't exist, you kind of cling to that belief. I’m not saying that it’s a scam. They generally believe they can do it. The evidence is, however, that they can't.”

The acceptance of this revelation is not defeatist, quite the contrary. In fact, it is IFA’s view that this acceptance is the primary first step in healing for Madoff’s victims and for the majority of investors who have been led to believe that active managers add value, when for the most part, they detract. Every investor has the ability—nay, the right—to earn the returns of capitalism that are available to all market participants when they simply buy and hold a portfolio of index funds.

Individuals don’t like to think of themselves as average—especially the uber-successful clients of Madoff. However it all came together, they operated under the perception that they did not have to settle for the average expected returns of markets (about 10% on average since 1929)—and that was at the heart of their undoing. As is often stated by learned investors, average returns are superior returns.

IFA certainly hopes that the many people who have fallen prey to the allure of a con man’s false promises will learn from this disaster and move forward to learn the real source of stock market returns as well as the critical importance of disclosure, transparency and liquidity.

IFA also hopes that if Madoff does end up in the slammer, that unlike the Grinch, they do not give Madoff the privilege of carving the roast beast!

Happy Holidays from IFA!

Last One In Has a Rotten Nest Egg

Fri, 12 Dec 2008 16:01:17 GMT

Last One In Has a Rotten Nest Egg

Hedge fund investors are likely waiting for the other shoe to drop as fresh news reveals a massive—nearly incomprehensible—hedge fund Ponzi scheme with estimated losses of a whopping $50 billion (yes, that is billion with a B) losses.

Early details reveal that the (until now) highly regarded former chairman of the NASDAQ Stock Exchange and a Wall Street veteran of more than 50 years was turned in by his sons for running a fraudulent fund of funds hedge fund that bilked other hedge funds out of billions.

Bernie Madoff confessed his long-running deception which involved reporting stellar, but fictitious earnings. When confronted by a special agent from the FBI who asked if there was an innocent explanation, Madoff replied, “There is no innocent explanation.” According to the indictment, Madoff conceded that it was all his fault and that he “paid investors with money that wasn’t there.”

The Ponzi scheme originated as Madoff invested and lost investors’ money. Instead of being honest about the bad returns, Madoff pumped up returns so new investors would want in. In doing so, he kept the deception going. If liquidations were requested, they were paid out using the investment contributions of later investors. The fund of funds hedge fund ran aground as hedge fund managers requested liquidations amounting to $7 billion to cover the liquidation requests from their own funds and there was no way to pay. Madoff’s hedge fund had a mere $200-$300 million in the coffers and not enough assets to sell to drum up that kind of cash.

Backed against the wall, Madoff came clean only after he had cleaned out his clients and “Madoff” with the money—attempting to pay out bonuses to select employees with the last of the remaining money. According to the indictment, witness statements express that Madoff intended to turn himself in once the last of the money had been dispersed in accordance with his master plan.

The indictment states that Madoff made use of his highly-esteemed reputation as a “leading international market-maker” to foster confidence among investors. His website offers the image of a company built by a man of both experience and integrity. It states, “The firm has been providing quality executions for broker-dealers, banks and financial institutions since its inception in 1960.”

Madoff’s deception was fueled by his ability to leverage his time served as a key and influential player on Wall Street. The indictment states that Madoff held himself out as ranking “among the top 1% of US securities firms” and “clients know that Bernard Madoff has a personal interest in maintaining an unblemished record of value, fair-dealing and high ethical standards that has always been the firm’s hallmark.”

An article in The Wall Street Journal details the scam: “Mr. Madoff ran the investment advisory as a secretive business, independent from the firm's proprietary trading and market-making operations.”
The Journal also cites two senior Madoff employees (reported to be his sons) as saying “Mr. Madoff ran the investment arm on a separate floor of the firm's offices. The two employees said Mr. Madoff kept the financial statements from the firm under lock and key and was "cryptic" about the firm's investment business.”

According to a Bloomberg.com article titled, “UBP, Bramdean, Pioneer Invested With Madoff Funds”, both European and US-based hedge funds were victims of Madoff’s scam. In addition to those named in the headline, New York based Fairfield Sentry Ltd. had $7.3 billion with Madoff. Kingate Management Ltd., run by FIM Advisers LLP in London also had money with Madoff. Additionally, Sterling Equities Inc., an investment firm run by the owner of the New York Mets, stated that he also had funds with Madoff, the article stated.

As a veteran Wall Street executive, Madoff was savvy enough to plot the deception, knowing that such a massive fraud could best be perpetrated through a hedge fund because required reporting to both the SEC and clients is far less restrictive than those of publicly traded mutual fund companies. Unlike traditional mutual funds which require investments in liquid assets that carry transparency and strict disclosure rules, hedge funds have far more latitude when it comes to types of investments, leverage and disclosure.

Opacity and loose disclosure requirements enabled Madoff to fabricate whatever returns would tantalize new investors and keep the pyramid scheme running. Because Madoff was not required to divulge holdings, his fund’s returns were merely a product of his twisted imagination.

Adding insult to injury, the scant recording documents that Madoff’s hedge fund did provide to both the SEC and clients were fraudulent, and they didn’t even match each other! Such epiphanies beg the question as to the integrity of the hedge fund databases that store the information—or misinformation, as it was.

Oddly enough, according to a Henry Blodget article from Clusterstock.com, investors of Madoff’s hedge fund are stepping forward to admit they knew Madoff was running a scam—and that is precisely why some invested with him. According to Blodget, “They, like many Madoff investors, assumed Madoff was somehow illegally trading on information from his market-making business for their benefit. They didn't consider the possibility that he was clean on that score but running a good old-fashioned Ponzi scheme.”

The important lesson here is that regardless of the presumed integrity of any hedge fund company, lack of transparency, inaccessibility to liquidity and loose reporting standards make it virtually impossible to quantify the risk of any one hedge fund. Even worse, hedge funds that invest in other hedge funds add even more layers of opacity, inability to access liquidity and nebulous reporting, at best.

It is IFA’s opinion that hedge funds deliver unnecessary risk that is nearly impossible to quantify and manage, making them an unsuitable investment for all investors. This opinion is supported by the Financial Economists Roundtable, a group of 32 senior financial economists who joined together to develop a formal statement on the trouble with hedge funds (Read the statement here).

Neither individual investors nor multi-billion dollar institutions should subject their assets to the hazards of hedge fund investing. A far more suitable investment for any size investor, both individual and institutional, is a risk-appropriate blend of transparent and fully liquid passively managed index funds —one that enables them to invest according to their own situation and preferences—allowing all investors to simply invest and relax.

Financial Fear Factor

Fri, 05 Dec 2008 15:55:58 GMT

Financial Fear Factor

Well, the proverbial cat is out of the bag. Earlier this week the National Bureau of Economics (NBER) weighed in on the U.S. economic activity. The seven-member panel, which constitutes a veritable “Who’s Who” of economic academics issued its verdict that, according to its defining parameters, the U.S. economy is in recession and has been since December 2007.

According to the NBER report, “The committee considers a range of indicators of economic activity, and many of them suggest declining activity in the first quarter of the current calendar year. These include payroll employment and the income-side estimates of domestic production”, otherwise known as unemployment and GDP.

The NBER’s confirmation of what many have long-suspected has made for a continuation of the topsy-turvy market climate that we have come to know—but not love.

Like few other words, the term “recession” can evoke a sense of fear for investors. Indeed, it is the lack of clarity of what’s ahead that prompts investors to worry about how deep the recession might be and how long it will last. It is important to remember, however, that this very uncertainty has been factored into market prices, facilitating the market decline that has pushed prices down to compensate buyers with an expected return that remains about the same as it was before fear took root. In other words, the free market is doing its job as buyers and sellers agree upon prices that continue to reflect the uncertainty of expected returns.

That short investing lesson is accurate, but is it enough to rejoin the frayed nerves of investors who are just plain sick of the financial and emotional roller coaster? Maybe, maybe not.

We have no way of fast-forwarding to know how severe or how long this current recession may be. But, we do have significant data on recessions that give historical insight as to the depth and duration of every recession that was dealt our predecessors. Let’s take a look at what history shows.

With information provided by NBER, the table below details the duration, depth and diffusion across industries of each U.S. recession dating back to January 1920. As the table clearly indicates, the depth and duration of recessionary periods since 1938 has waned significantly as impact on employment, decline in GNP (gross national product) and duration of recessions have all decreased since the depression that ended in 1938.

The bar chart below contains additional data compiled from NBER. It details the duration of every economic recession (contraction) and expansion period dating back to August 1929 with the current expansion period which ended in December 2007. The light green bars depict the duration periods (in months) of expansion, while the black bars depict the duration period (also in months) of recession or contraction. As you can see, over the last 80 years, the duration of expansion periods has increased, while the duration of recessionary periods has decreased.

Geoffrey Moore is the director emeritus of the Center for International Business Cycle Research at Columbia University. In his 2002 white paper titled “Recessions”(see footnote), Moore details a number of reasons for the trend of recessions decreasing in both duration and depth. He cites the growing importance of service industries like trade and transportation, which have more stable unemployment numbers than those of manufacturing. He states, “As the more stable industries have grown in importance, this has made the whole economy more stable and less susceptible to prolonged and severe recessions.”

Moore also credits the government for assuming a bigger role in the moderation of recessions, citing the infusion of unemployment insurance to stem the tide of lost income during downturns as well as assertive monetary policy which can make a more interest-rate friendly environment and free up much-needed credit during downturns.

It is important to understand that no two recessions are the same, and we have no way of predicting what shape the current recession will take, but we do know that fear has been a poor predictor of outcome.

An October 17, 1974 New York Times article cited a Gallup Poll in which 51% of individuals surveyed agreed with economists who had then predicted a “1930-style depression.”

At this time, the markets had experienced a steep 2-year decline, fear was rampant, and confidence was scarce. However, less than three months subsequent to this overwhelmingly gloomy prediction, the markets staged a vigorous and sustained upturn..

The chart below depicts the simulated performance of IFA’s all-equity Index Portfolio 100 for the time period from October 1974 through September 1979. As the chart shows, this blend of globally diversified indexes delivered an annualized return of 29.56% for the five-year period, with a total return of nearly 265%. Clearly, those investors who were led by fear were surprised and likely disappointed by missing out on some (if not all) of those significant returns.

The current headlines are filled with prognostications of how events will unfold, and there is certainly no shortage of opinions. IFA holds to a strict discipline of letting history guide our investing path. We do so because investment strategies that are driven by fear and speculation have shown to deliver inferior returns when compared with a straightforward asset class indexing strategy that carries 80 years of historical data. Reams of stock market data continue to show that buying and holding a risk-appropriate portfolio of low-cost, passively managed indexes has shown to be an excellent investing strategy—one you should never have to fear.

Are We There Yet?

Wed, 26 Nov 2008 15:46:11 GMT

Are We There Yet?

As we embark on the busiest travel time of the year, it seems all too fitting to question if we are there yet. The “there” to which we now refer is not the comforting destination where we will enjoy Thanksgiving dinner in the company of those we love. Right now, the destination we currently seek so desperately is a bottom for the equity markets.

Freshly haunted by October lows, November looked like it would give investors even less to be thankful for. Indeed, confirmation of an economy in recession, stock prices hitting levels not seen since Bill Clinton first took office, jet-setting auto executives arriving hat in hand begging for financial jump-starts, a $20 billion dollar bailout for Citigroup, a defense of last month’s $700 billion TARP plan, a newly added $800 billion TALF plan for consumers, and a 17% one-year decline in home values have certainly generated some queasy stomachs long before the turkey even hits the table.

Certainly, we have suffered some dark moments in the last 13 months, the darkest of which have unfolded in just the last six weeks. Credit markets are taking their own (not-so-sweet) time to ease and volatility has been higher than we have seen. Frustration with the markets finds more than a handful of investors asking if it’s time to step out or step up.

In a not-so-commonplace video appearance, Dimensional Fund Advisors’ CEO David G. Booth asks and answers the question that so many investors are asking: Why Stick Around In A Tough Market?

“This is a good time to invest in equities, and it is a good time to stick with your asset mix,” says Booth. He advises that his “return to normal” outlook has its foundation in three specific measures that include:

1) Valuation: Booth observes that dividend yields currently exceed Treasury yields, leading him to conclude that valuations are low.

2) Market Equilibrium: As the founder of DFA, Booth and his compatriots foster an equilibrium view of markets that is deeply rooted in the principles of market efficiency. Booth states that “market efficiency keeps us disciplined in these tough times.” He explains that huge volume of trading means that there are both sellers and buyers. Those who are now buyers of equities do so because all of the information that they possess tells them that the current price is a fair price. This is the way markets work. Our markets involve a voluntary exchange.

Booth elaborates on this concept of the voluntary exchange principle, stating that the market may be a more opportunistic place now as there may be more involuntary sellers than voluntary buyers. This can drive prices down to very attractive levels. He cites that the de-leveraging that must occur could be more favorable to buyers than to sellers who have to let go of their shares at low prices.

Distress selling can create opportunities for long-term investors who are able to provide liquidity when sellers desperately need it. Recently, we have seen some evidence of this sort of distress selling. Markets which seem to hold their own for nearly the duration of the trading day have dropped off sharply in just the last few minutes of trading. Sunil Wahal, finance professor and research associate for DFA, describes this circumstance of unprecedented volatility as an opportunity for long-term investors to provide liquidity to pressured sellers. Wahal’s paper titled “The Effects of Recent Market Volatility on Trading” concludes that those with enough risk capital and risk tolerance to provide liquidity can expect to eventually earn a return for it.

3) Intuition: Booth cites that periods of stress overlook optimism for the long-term perspective. Booth adds, “Governments can have an impact. Let’s hope it’s positive this time.”

Booth is far from a lone long-term optimist. In the wake of the economic disaster that has unfolded before us like a train-wreck in slow-motion, many long-term investors have weighed in on the long-term outlook for equities. In fact, America’s most-famed investor, Warren Buffett is cashing in his U.S. government bonds and gobbling up stocks.

In an October 17, 2008 Op-ed piece for the New York Times titled “Buy American, I am”, Buffett states:

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

“Fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now,” Buffett adds.

IFA makes no attempt to time markets. Rather, IFA lets history do the talking. Stock market history continues to reveal that no one can persistently pick the times to be in the markets for the upturns and be out of the markets during the downturns. Additionally, the increased volatility virtually ensures that those who capitulate will miss out on the kind of returns that were handed out when the markets, just this week, staged their biggest 2-day gain in more than two decades.

The inability to predict the time to exit the markets to avoid losses and the time to re-enter the markets to capture gains ensures that those who wish to earn the long-term returns of the equity markets must sit through the discomfort in order to reap the rewards. Buffett provides a sound (and fun) analogy:

“Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: “I skate to where the puck is going to be, not to where it has been.”

Certainly, Buffett’s rationale provides temperance and guidance for long-term investors. Buffett’s long-term optimism is rooted in the historical long-term prosperity of businesses that will earn profits over time. This is precisely why a globally diversified portfolio is such a prudent investment path. Diversification not only ensures that a portfolio’s holdings will not be annihilated in steep market downturns, but it also ensures that the portfolio will have full benefit of the global market upturn.

Market declines may feel interminable when we are in the thick of them. They are ravaging and they are brutal. But, history does show that the best way to survive them is to buy and hold as much risk as your personal situation can manage and keep your eyes fixed on the long-term expected return which remains about the same as it was before any of us ever heard about bailouts, TARP, TALF, or had to change the meaning of “Are we there yet?”

As indexers, we may still ask the question, but we can continue to expect our long-term returns, whatever the answer might be.

Don’t Try This At Home

Tue, 18 Nov 2008 15:46:11 GMT

Don’t Try This At Home

An October 20, 2008 Investment News article stated that 75% of affluent investors make their own investment decisions. This somewhat stunning statistic arises from a survey of 200 investors. Indeed, in light of the recent hideous blows dealt to investors, it is likely that many more may contemplate joining the ranks of the do-it-yourselfers, but IFA recommends that investors take time to learn before they leap.

The ranks of disgruntled investors are swelling, according to the September 30, 2008 issue of the The Wall Street Journal, which quotes a survey citing that "81 percent of investors with $1 million or more in investible assets plan to take money away from their current advisor. An even larger number — 86% — plans to tell other investors to avoid their advisor." The article cites that "irritation is especially high at the “brand” firms — large brokerages and banks." Not surprisingly, investors have awakened to the realization that if these big firms can't properly manage their own investments, they have no right to be managing the investments of individuals, Indeed, the Journal states "90% of clients of brand firms plan to take money away from their advisor and 70% plan to leave the advisor altogether. That compares with a mere 29% for the boutique, local advisory firms."

It is truly unfortunate that it has taken a devastating market blow to wake up investors to the destruction of speculation. But, we take life's lessons as they are handed to us. Clearly, the recent market downturn provides the proof-putting necessity for an understanding of what constitutes prudent investing. In part, IFA implements prudent investing in the following ways:

A prudent investment is one that looks at risk and the returns of the entire portfolio, not simply a single fund's risk or performance. IFA's 20 Index Portfolios provide risk-proportionate blends of as many as 15 IFA Indexes.

The portfolio must be properly diversified so as to avoid overconcentration that can result in unrecoverable losses. IFA Index Portfolios invest in as many as 17,000 companies.

The investments should be consistent with the overall portfolio objectives. For IFA, the portfolio objectives are established in accordance with an investor's risk capacity.

Prudent investing is fundamentally simple, but it is not easy. As legendary investor Benjamin Graham said, “People don’t need extraordinary insight or intelligence. What they need is the character to adopt simple rules and stick to them.”

By anyone’s measure, Graham is one of the most successful investors in American history. Indeed, Graham is widely known as the investing mentor to Warren Buffett. Why is it that Graham’s instructions for investing success can be so straightforward, so elementary, so respected and yet, so widely ignored? The answer to this question lies in a fascinating and emerging field of study referred to as “neuroeconomics.”

In Your Money and Your Brain, author and journalist Jason Zweig explains why our brains are programmed to work against our ability to achieve long-term investing success. Zweig describes the processes that the brain undergoes in search of ferreting out predictive patterns where there are none. He says, “Unlike other animals, humans believe we’re smart enough to forecast the future even when we have been explicitly told that it is unpredictable.”

Zweig tells us that this need to predict has served us well as we have evolved over time. In fact, it is this ability to anticipate that is largely responsible for our ability to thrive against nature in the early going. It enabled early man to anticipate both prey and predators. But, this overriding need to find predictable patterns where there are none — such as news and the resulting price movements — is destructive to our long-term ability for investing success.

Zweig tells us, “It’s vital to recognize the basic realities of pattern recognition in your investing brain.” He elaborates that the predictive brain leaps to conclusions, it is unconscious, it is automatic and it is uncontrollable. His advice? “Stop predicting and start restricting. Presented with almost any data, your investing brain will feel it knows what’s coming — and it will usually be wrong.”

Studies regarding investor behavior in the wake of market activity lend strong support to Zweig’s assertions. The results of Dalbar’s annual study called Quantitative Analysis of Investor Behavior show that for the 20 years ending December 2007, the average equity-fund investor earned an annualized return of just 4.5%, despite the fact that the S&P 500 Index earned a significantly higher 11.8% return. IFA’s Index Portfolio 100 showed simulated returns of 13.38% for the same time period. The study shows that investors, overcome by the urge to predict news or the future, acted on their impulses, got it wrong, and suffered significantly lower returns as a result.

Further support for the ill-fated predictions of investors is shown in data released from Trim Tabs, a fund research firm that tracks inflows and outflows of cash in the markets. The chart below illustrates their findings. Looking at the chart, you can see that in the first quarter of 2000 — not so fondly referred to as the Tech Bubble — investors rushed in thinking returns were higher, instead of constant and stock prices were cheap, as opposed to fairly priced for relatively low expected returns. Expected returns can be best estimated using the Fama French 5 Factor Model. For an explanation of this model, please call an Index Funds Advisor. Think of today's market as being an "unbubble."

In fact, the amount of money that flooded the market at that time was nearly double that of the previous two quarters combined. This rush into the market occurred right before the S&P 500 peaked in March of 2000, leaving many investors vulnerable to massive losses when the market quickly collapsed. To further that point, in the third quarter of 2002, investors withdrew huge sums of cash in capitulation of the battering markets. A whopping $41 billion headed to the exits just before the market bottomed in October, 2002, missing out on the big market run-up in 2003.

More recently in the unbubble, we see the same sort of behavior as $56 billion fled the markets in the first ten days of October, despite the fact that the price had already given up a punishing 25%. More than likely, those investors were still on the sidelines, denying themselves the returns that came from the best week the S&P 500 had in 34 years. Quite simply, investors do not stand a chance of investing success if they rely on their need to predict future events based on the past. We cannot know with certainty when the markets will turn around, but those who flee will likely not be properly positioned to benefit from the inevitable upturn.

Clearly, we see that the very essence of our human intelligence programs us to invest poorly. Our instincts work against us as we futilely seek predictive patterns of short-term movements against a future clouded by randomness. “Financial decision-making is not necessarily about money,” says psychologist Daniel Kahneman at Princeton University. “It’s also about intangible motives like avoiding regret or achieving pride.”

The key to achieving long-term investing success is to avoid predicting the future movement of the stock market and focus instead on your own personal ability to manage risk through investor prudence. Make sure that you are properly invested in a portfolio that you can hold despite market conditions. To learn which portfolio is right for you, go to ifa.com and take the risk capacity survey. By answering a few simple questions, you will be matched to an Index Portfolio that is appropriate for you and your circumstances. This portfolio is risk-calibrated, style pure, globally diversified, passively managed, fully liquid and transparent. Additionally, this portfolio can be implemented by using a variety of different indexes. Best of all, IFA’s prudent investment strategy is supported by some 200 peer-reviewed academic studies that reveal the wisdom and success that comes from abandoning the prediction addiction in favor of simply buying and holding a risk-appropriate blend of passively managed indexes, and enjoying your life.

Free Markets are Doing Their Job

Mon, 03 Nov 2008 15:33:00 GMT

Free Markets are Doing Their Job. Uncertainty is Higher. Prices are Lower. Expected Returns are About the Same.

October was a spooky month for investors. Certainly, many investors will breathe a welcome sigh of relief to close the books on the month that has handed out more tricks than treats to their portfolios.

October 2008 ends a period that will enter the record books as the largest 12-month monthly rolling loss in the last 50 years. To quantify, let's look at the IFA Index Portfolio 90, which is the equity portion of most of the IFA Index Portfolios.

Prior to Oct. 2008, the worst 12-month performance over the last 50 years, was from Oct. 1973 to Sept. 1974, where it lost 35.3%.
For the most recent 12 months from Nov. 2007 to Oct. 2008, it lost 43.1%.
However, the worst 2-year annualized loss was 22% back in Jan. 1973 to Dec. 1974, while the current 2-year annualized loss ending Oct. 2008 is 18.64%.
The current 10-year annualized return is +5.67%, while the worst 10-year annualized return was +4.27%, which occurred from Oct. 1964 to Sept. 1974.
If you had invested in a simulated Index Portfolio 90 back in Nov. 1988 (20 years ago), you would have earned an annualized return of 8.95%, growing $100,000 to $555,322, despite the unusual decline of 43% in the last 12 months.
Finally, based on the last 50 years ended Oct. 2008, the expected return of Index Portfolio 90 going forward is about 11.7%. This could also be considered the average cost of capital for the 17,000 companies in that portfolio. Remember that the cost of capital is paid to the investors. Please see www.ifabt.com for sources, updates and disclosures.

Many IFA clients established their risk capacity considering the worst 12-month loss in the last 50 years for their risk level. You may want to take the Risk Capacity Survey again to determine if your risk exposure should be changed based on this updated information, or other factors.

The job of the free market is to set prices so that investors will be compensated for the risk they bear. Thus, the prices of a globally diversified portfolio of stocks have come down 43%, which should be in proportion to the bad news about our global economy. To simplify, the 43% decrease in Index Portfolio 90's value reflects a 43% increase in the perceived uncertainty of achieving the expected returns associated with that portfolio. The price changed, but the expected return remains about the same. The good news is that investors owning equities at these lower prices should be compensated for the risks they bear. It's important to note that this will occur over an appropriate period of time. The more risk exposure, the longer investors should be prepared to wait to earn their compensation (expected annualized return).

To better understand this concept, imagine an approximately constant Expected Return set at the fulcrum of this teeter-totter. The Uncertainty of the Expected Return would be on the left side and Price on the right. The current price is moving in an equal and opposite direction to the perceived Uncertainty of the Expected Return of the investment. (also see this sketch)

If market forces between willing buyers and willing sellers caused prices to go down 5%, then it could be assumed that uncertainty of expected returns went up 5% based on negative unpredictable news about capitalism. In this case, the global sellers of about 10 Billion shares/day "pushed" prices down about 5% more than the global buyers of those same 10 Billion shares/day are "pushed" prices up. When uncertainty goes down 5% because of good news, prices go up 5%, allowing the expected return of the investment to remain essentially constant (it changes with the annualized return over some long specified period, like 50 years). If you do not know how to estimate the expected return of your equity and fixed income investments, the Fama-French Five Factor Model is considered the state-of-the-art by most academics. If you need help understanding it, an advisor at IFA can explain it to you.

If you think that prices are not set correctly to reflect news and expected returns, consider that researchers have determined that only about 0.6% professional investors have been able to exploit mispriced stocks and actually obtain returns in excess of risk adjusted market returns. Therefore, prices must be assumed to be set correctly, even if they were not in hind sight.

In the near term, nobody knows whether the news stories will be good and cause prices to go up, or bad and cause prices to go down. IFA acknowledges a lack of fortune-telling prowess to accurately forecast the near term perceptions of capitalism and the prices that follow. What we do know is that high levels of uncertainty create stomach-churning price changes, such as the S&P 500 Index suffering its worst month decline since 1987, then last week delivering the index's best one-week increase in the last 34 years, according to CNBC. We're fairly certain that only the very lucky predicted that outcome.

In the wake of all of this volatility, what should investors do now? The first action to take is to assess your risk capacity. Many investors have learned the hard way that their appetite for juicy returns comes with a sour after-taste from large losses in bad economic times. Your risk capacity is the measure of how much stock market risk you can manage in consideration of your time horizon, your investing knowledge, your attitude toward risk, as well as your savings and income.

If you are invested in a low-cost and globally diversified portfolio of indexes that matches your risk capacity, take a deep breath, accept that the combined knowledge of millions of traders in free markets around the world will do a better job at setting prices than any one individual, and put your investments out of your mind. Invest and Relax.

At IFA, the effort to calm investors goes far beyond lip service. It is supported by reams of stock market data that is readily available at ifa.com. This IFA exclusive data set shows the benefit of remaining calm in the face of high uncertainty, and the importance of relying on long-term data for proper decision making. Investors who may worry that their portfolios have entered an uncharted and apocalyptic era, will be empowered to know that prices have done the same, so that their expected returns remain relatively constant. For this reason, those investors whose time horizons are appropriate for their asset allocations have little to be concerned about. You should only be worried when markets are no longer free to trade, because then the prices are sure to be wrong.

The Resilience of Capitalism

Mon, 20 Oct 2008 15:33:00 GMT

The Resilience of Capitalism

by Mark Hebner,
President of Index Funds Advisors

October 20, 2008

In light of the very turbulent investment markets over the last few weeks, I offer the following much-needed perspectives.

Many investors may find themselves questioning their ability to remain in their investments right now. If you are concerned, the first step is to consider the proper time horizon for your investments. If your time horizon or liquidity needs have changed since you last took the Risk Capacity Survey, you should take the survey again to determine if an adjustment in your Index Portfolio (risk exposure) is necessary at this time. If you are routinely withdrawing funds from your portfolio, we recommend that you not withdraw more than 7% of your portfolio’s value per year, with a 5% withdrawal being optimal. When markets have declined, you should reduce your withdrawals to as low as you can stand. In other words, cover your fixed costs and reduce your variable costs.

As a general rule of thumb, the equity allocation of your portfolio should have an approximate time horizon or holding period of 7 to 10 years. This would indicate that you should have an allocation of fixed income that will meet your withdrawal needs for approximately 5 years. So if you are withdrawing 5% per year, you should have at least 25% of your portfolio in fixed income. Our Risk Capacity Survey is the best method to determine your asset allocation, because it considers all five dimensions of your risk capacity, of which time horizon is the most important, but not the only factor. (See Step 10: Risk Capacity of The 12-Step Program for Active Investors.)

History is not required to repeat itself, but out of the last 481 ten-year periods for Index Portfolio 90, not one had a annualized return below a positive 4.27% per year and the average annualized return in 10-year periods was 13.36% with a standard deviation of 4.21%. The highest return in 10-year periods occurred from 9/77 to 8/87, where Index Portfolio 90, a simulated and rebalanced blend of eleven indexes from around the world, earned 22.84% annualized over that 10 years.

To most people’s surprise, the worst 4-year period was a loss of only -1.74% annualized. In contrast, the last four years ending September 30, 2008 had an annualized return of 6.22% (see www.ifacalc.com and please note that the month of October 2008 is not over yet.). But if you invested the equity portion of your portfolio at just the wrong time, way back in January 1969, you would have gone through 6 years of gyrating ups and downs that resulted in an annualized loss of -5.29% per year. However, if you stayed the course for 10 years from this unlucky starting point, as IFA currently suggests you should do, you would have ended up with a positive 6.57% annualized return for the 10-year period ending in December 31, 1978. Remember that these well diversified portfolios contain about 17,000 companies from 40 countries around the world, what I like to refer to as Capitalism, Inc. Over time, these companies will make profits and that is what ultimately drives stock market returns. If they all stopped making profits for extended periods of time, we would have problems far beyond the stock market.

In an October 17, 2008 Op/Ed article, Warren Buffett stated that he is aggressively buying U.S. stocks, stating “If prices keep looking attractive, my non-Berkshire net worth will soon be 100 percent in United States equities.” Buffett continued:

“A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense. These businesses will indeed suffer earnings hiccups, as they always have. But most major companies will be setting new profit records 5, 10 and 20 years from now.”

“Let me be clear on one point: I can’t predict the short-term movements of the stock market. I haven’t the faintest idea as to whether stocks will be higher or lower a month — or a year — from now. What is likely, however, is that the market will move higher, perhaps substantially so, well before either sentiment or the economy turns up. So if you wait for the robins, spring will be over.”

“Equities will almost certainly outperform cash over the next decade, probably by a substantial degree. Those investors who cling now to cash are betting they can efficiently time their move away from it later. In waiting for the comfort of good news, they are ignoring Wayne Gretzky’s advice: ‘“I skate to where the puck is going to be, not to where it has been.”

Buffett’s advice is sound. The chart below puts into perspective the percentage of various time periods (days, months, quarters, years, 5-years and 10-years) that resulted in gains and losses for an all-equity Index Portfolio 90 over the last 50 years. If you need an explanation about the meaning of this chart, I explain it on this youtube video.

In William Bernstein’s book, The Four Pillars of Investing, he discusses market bottoms and the agony and the opportunity that exist at that point in time. In the section titled How to Handle the Panic he says, "What separates the professional from the amateur are two things: first, the knowledge that brutal bear markets are a fact of life and that there is no way to avoid their effects; and second, that when times get tough, the former stays the course; the latter abandons the blueprints, or, more often than not, has no blueprints at all." The blueprint for IFA clients is the Investment Policy Statement, the investment strategy is discussed and the answers to the risk capacity survey are spelled out and analyzed. Here is a paragraph from the IFA Investment Policy Statement:

“A properly constructed IPS provides support for the investment manager to follow a well-conceived, long-term investment discipline, rather than one that is based on constant revisions brought on by lack of knowledge, overconfidence or panic in reaction to short-term market movements. The absence of a written policy reduces decision making to an individual event basis and often leads to chasing short-term results that detracts from achieving long-term market rates of returns. The existence of a written and agreed upon policy encourages all parties to maintain their focus on the long-term nature of the investment process, especially during the extreme fluctuations in stock market returns.”

With respect to what we are hearing now about the markets, it is critically important to understand that capital markets have shuddered in the past, and have rebounded due to the impressive resilience of capitalism. In fact, sometimes, markets have changed course just when the headlines or consensus seems the most apocalyptic. Such as the Gallup Poll of October 1974, in which 51% of those surveyed predicted a great depression on the horizon. For the next 5 years from November 1974 to October 1979, Index Portfolio 90 grew by 22.2% per year for a total return of 172.5%. (see www.ifacalc.com and my youtube.com video)

We are making continuous updates to the ifa.com "What's New" column on the home page, but a recent important message from DFA’s Weston Wellington is titled “Is It Different This Time?" Click here to view it. This insightful and informative presentation reveals that time after time, headlines have been poor predictors of future market movements. I encourage you to take some time to view Weston’s outstanding research regarding stock market greed, fears and media hype in relation to what actually happened.

An important Marketwatch.com interview with Vanguard founder John Bogle provides further insight as to how to manage investments through this challenging time. He tells us that if you're following the rules of asset allocation, diversification and long-term time horizon, stay the course. This is precisely the advice IFA has been telling its clients since for almost 10 years. Many investors are just now learning these age old lessons of investing.
An investor’s return is explained by their risk exposure, not by the speculation they made on future prices. Way back in 1900, Louis Bachelier explained in his now famous paper, “The Theory of Speculation”, that investors should not expect to benefit from speculation on future prices. When you add in the cost of trading and trading mistakes, active investors should expect far less than the market rate of return for the risk they took.

As painful as the last few weeks have been, many investors have learned the hard way that poor risk management, leverage and lack of transparency carry steep levies. But as we have heard before, when you lose, don’t lose the lesson.

Nobel Prize winning economists and academics have revealed that broad-based diversification among low-cost indexes has shown to be the most prudent investing strategy over time. Harry Markowitz, the 1990 Nobel Prize in Economics winner and newly added Academic Consultant to Index Funds Advisors, recently stated, “In choosing a portfolio, investors should seek broad diversification. They should understand that equities and corporate bonds involve risk and that markets inevitably fluctuate. Their portfolio should be such that they are willing to ride out the bad as well as the good times. “

When the markets abruptly turn around, investors who bought and held risk-appropriate portfolios of low-cost passively managed index funds will be in position to benefit from the market’s reaction to the unexpected news events that will once again show the resilience of capitalism. In the meantime, as long as you invest according to your risk capacity and keep your eyes fixed on your time horizon, you should do your best to ignore the media and spend your time on the things in your life that you enjoy.

The 40-Year Old Lesson

Mon, 06 Oct 2008 15:14:05 GMT

The 40-Year Old Lesson

Once again, sage and timely advice echoes from Harry Markowitz, Nobel Prize winner and the highly regarded Father of Modern Portfolio Theory. Markowitz’s admonition about correlation’s intensifying impact on risk or volatility was inked some 40 years ago, but it seems hot off the press with respect to today’s market climate.

Markowitz’s observations of the vulnerability of a highly correlated portfolio have played out in painful and rapid-fire succession, with many investors learning too late the destruction of concentration in stocks that all rise and fall together.

Investors who focused their investments in the financial sector have hemorrhaged their portfolios, for many, irretrievably. Investors in Washington Mutual and Lehman Brothers were wiped out. Fannie Mae plummeted from an annual high of $68/share to $1.50/share. An emergency federal bailout of AIG staved off a total collapse of that company, shares of which dropped from $70/share to about $4/share.

There are long and painful explanations as to why these seemingly stalwart companies have crumbled, in some cases, overnight. The events that set the dominoes in motion have been well chronicled, but few if any of the stories describing the hideous turn of events focus on the important lesson of risk — risk that the companies took and the risks that their investors took.

An absence of a fundamental understanding of the perils of excessive risk (not to mention excessive leverage) have driven companies and investors straight into an economic avalanche, the fallout of which has proven to be devastating. But, despite the fact that so many have lost so much, will they carry away the lesson that will ultimately prevent them from ever suffering like this again? IFA sincerely hopes so.

IFA continues its ongoing efforts to educate investors regarding the intrinsic relationship between risk, return, time and diversification. IFA’s mission is to change the way the world invests, and from the looks of what has transpired — the world desperately needs our help.

Reams of articles describe the impact the recent market downturn has had on excessively risky and highly correlated portfolios. Of particular concern are the losses of those approaching retirement age. Many such articles detail the angst that plagues investors who are now forced to rethink how they will retire. Clearly, no one ever showed them how much risk they were taking in their portfolios. It’s obvious that no one ever quantified the amount of risk that was right for them — their risk capacity. It’s pretty clear that no one ever advised them as to the importance of global diversification and investing across multiple asset classes. And now, many investors are learning too late that these factors are more than “nice to haves” — they are imperatives.

Throughout the recent market downturn, we have heard the endless mantra: “It’s different this time.” Indeed, we at IFA do hope it’s different this time. We hope that every investor will finally take the time to learn the importance of investing with risk in mind. We hope that every investor will learn that proper risk is the source of stock market returns. Harry Markowitz gave us this valuable information 40 years ago. Investors who have invested without consideration of his advice have been punished during substantial market downturns, while those who have heeded the call have been empowered to earn the returns that capitalism delivers. Ideally, those who have lost this time will not lose the lesson. Let’s definitely make it different this time.

Eighty years of stock market history tell us that the equity markets will resume their upward climb. The vast majority of the world’s businesses will earn profits and deliver returns to shareholders. The extent to which you can profit from global capitalism is determined by your risk capacity.

If you have not already done so, find out how much risk is right for you by taking the Risk Capacity Survey. By providing answers to either the 5-question or 25-question survey, you will be matched with an Index Portfolio that is globally diversified, fully transparent, and invests across as many as 15 different indexes that carry 80 years of risk and return data. This risk-appropriate asset allocation will enable you to invest with an understanding of your expected risk and return. This understanding will advance your peace of mind and your ability to plan for your retirement. This understanding will enable you to invest in an efficiently correlated, risk-calibrated and globally diversified portfolio that maximizes efficiency and returns at a given level of risk — the amount of risk that right for you.

Should You Be Worried About Your Investments?

Fri, 26 Sep 2008 15:14:05 GMT

Should You Be Worried About Your Investments?

Recently, IFA president and founder Mark T. Hebner delivered an important message regarding current market turmoil.

His remarks addressed the significant impact that risk, return, time and diversification have on long-term investments, He also expressed IFA's commitment to help all investors learn how to invest properly, now and for the rest of their lives.

To watch the five-minute video, click on the banner above. The full text of his remarks appears below, along with the links of the historical time periods to which he refers.

" Hi, I'm Mark Hebner, president and founder of Index Funds Advisors. Like you, I have watched with interest the recent turmoil that has gripped the financial markets.

Many investors are worried about the outlook of their long-term investments. For some this concern is justified, and it may prove to be a catalyst to finally learn how to invest properly to achieve greater long-term investing success.

For those who are properly invested, history shows that their investments will withstand this market, just as they have other bad markets, and earn the returns that capitalism delivers over time.

This Site, (Ifa.com), will help you learn how to properly invest for now and for the rest of your life.

With respect to the recent market turmoil, you SHOULD be worried if you are overly concentrated in any one industry, a handful of industries or individual stocks.

You SHOULD be worried if you do not know how much risk you are taking with your investments.

You SHOULD be worried if you do not know how much risk is right for you. This is known as your Risk Capacity. (take our Risk Capacity Survey)

You should NOT be worried if:

You have a globally diversified portfolio that is the appropriate risk for your risk capacity.
You should NOT be worried if you are aware of the risk that you are holding, you know that the risk is appropriate for you and you are comfortable with that risk because you understand how your portfolio has performed since the Great Depression and in subsequent up and down markets since then.
You should NOT be worried if you are properly educated regarding stock market activity and you understand that while bad markets are scary, they have had little impact on the returns of investors who remain in globally diversified portfolios that invest in tens of thousands of companies throughout the world.
This site will help you put into perspective current market activity in light of 80 years of historical risk and return data for 20 risk-calibrated, globally diversified Index Portfolios. This site details other market downturns such as the one we saw in 1973 and 1974 and how long it took for the globally diversified portfolios to recover from their respective drops.

The 1973 and 1974 Market Downturn

How have your investments performed against an Index Portfolio? Click here for 80 years of monthly returns data to compare.

Back then, an incredible 51% of Americans who participated in a 1974 Gallup poll believed that the U.S. was headed for a 1930's style Great Depression. Two months after that article appeared, the markets turned around and the recovery was in a full swing.

Watch Video

The 1987 Dow lost 508 points in one day
(a 23% decline)

In 1987, the markets struggled. The Dow Jones Industrials lost 508 points in one day--a 23% decline.

People were scared then too. In fact, this was a moment when a lot of stock market investors realized that their fascination with the stock market was really an obsession, an addiction that threatened their long-term outlooks.

The New Jersey Compulsive Gambling Helpline reported that in the six weeks that followed that big drop in the Dow, 44% of the calls they received were from stock market addicts. Before that big drop, just about 2% of their calls pertained to the stock market.

Those who were brave enough to face their addiction, to admit that they had gone too far--taken too much risk and had suffered as a result--were able to recover, to get help and to have the opportunity to properly invest for a better life and a better financial outlook. This current market downturn provides such an opportunity.

Watch Video

I know of what I speak. I am the author of Index Funds: The 12-Step Program for Active Investors. My financial advisory business carries the singular mission to change the way the world invests.

I urge you to capitalize on the lessons delivered by the current market conditions and get invested properly.

Start right now by taking the Risk Capacity Survey. This simple survey can be taken in 5-10 minutes and it will tell you how much risk is right for you, and it will provide you with an Index portfolio that matches your risk capacity. Not only that, all 20 Index Portfolios are low-cost, risk-calibrated, fully transparent, risk/return optimized and carry 80 years of historical data.

I hope you find this data as inspiring as we do at IFA. Every chart, article and video reveals important information that will help you invest properly now and for the rest of your life. "

Fallen Market Perspectives

Wed, 17 Sep 2008 14:46:06 GMT

Fallen Market Perspectives

The recent turmoil in the financial markets has sparked a great deal of debate over who’s to blame and who’s to pay. Storied investment banks, brokerage houses, mortgage backers and insurers have tumbled like a house of cards seemingly as if struck by a faint breath of air.

Politicians have pontificated as to where to lay the blame for the current credit crisis that has led to the unraveling of three of the five largest investment banks. They and their wide assortment of selected mouthpieces work furiously to spread the message of how they alone can save Wall Street, taxpayers, and the U.S. economy.

Despite the frenzied pace at which hordes of media hounds seek to offer their views of events du jour, IFA thinks a more moderate view should be aired and heeded. In search of temperance to combat the race for ratings, we were struck by two articles which cast a far more circumspect view on the events that have transpired, and how investors can best view their investments earmarked for the long-term.

In a September 15, 2008 Wall Street Journal article, Brent Arends offers instructions for navigating emotions in the wake of the market’s recent bloodletting. Arends recommends that investors begin their perspective-building plan by, first rolling up their windows, and shouting:

“ohmygad-ohmygad-ohmygad!”

This initial, if not essential, catharsis can lead the way to real perspective regarding long-term investments.

In pondering how we can thrive in a post-Lehman world, Arends reminds us of previous shockwaves sent through the markets, including the 1994 collapse of Barings Bank, the implosion of Long Term Capital Management, and the devastation that we all felt when the Trade Towers fell to the ground. Yes, we have been here before, and while it is frightening in the moment, Arends advises that “the people who stay at the table and don’t make stupid moves here are going to be the ones who make the money in the years ahead.”

Further perspective comes to us from Jeremy Siegel, finance professor at Wharton and author of Stocks for the Long Run. In his September 16, 2008 Wall Street Journal article titled “The Resilience of American Finance”, Siegel states that “the recent turmoil does not mean the financial industry will shrink dramatically. In fact, the current crisis could well lead to an increase in the demand for financial services, as the world grapples with the need for new financial instruments, new risk management techniques, and the increasing complexity of the financial world.”

Siegel rightly points out that the demise of three of the five largest investment banks are the result of leveraged risk, leading us to discern that the perceived fragility of the system is not as tenuous as the media would have us believe. “Their demise was caused by bad risk management, and a failure to understand the high risks of an overheated real-estate market, the root cause of our current problems,” Siegel continued.

Siegel casts light on the real culprits of the crisis. He states “the lion's share of the blame must go to the heads of the financial firms that issued and held these flawed credit instruments and then, in many cases, "doubled down" by buying more when their price was falling.”

Siegel suggests that the crisis is drawing to an end. “Despite the recent turmoil, there is good evidence that the worst is over, especially for the commercial banks with access to Federal Reserve credit,” he states.

If we have reached a turning point in the credit debacle, IFA deeply hopes that the surviving investment banks will carry away a cautionary lesson about leverage and risk—one which IFA has practiced since it began its financial services practice which now stands at $1 billion and 1,700 clients strong—No Leverage, No Opacity, No Short-Selling.

IFA fully understands the hazards of excessive risk and leverage and has written frequently about their dangers, their inappropriateness, and how they are utterly unnecessary in any portfolio—individual or institutional.

IFA welcomes the opportunity to fulfill the need that has been revealed by the current economic crisis which Siegel claims “calls out for new products and services as well as more, not less, information about what is safe and profitable in the future environment.” With 80 years of risk and return data, complete transparency, risk/return optimization and 20 globally diversified Index Portfolios that invest in 17,000 stocks from 40 different countries, IFA is poised to provide professional investment advice to every investor who never again wants to feel the need to roll up the windows to scream.

What Are You Paying for Your 401(k)?

Fri, 12 Sep 2008 14:46:06 GMT

What Are You Paying for Your 401(k)?

The investing spotlight continues to shine brightly on defined contribution retirement plans, threatening to expose hidden costs that investment managers audaciously believed they could foist upon unsuspecting plan sponsors and participants.

In a flurry of momentous events that have transpired in just a few short months, the nearly 50 million American workers who participate in company-sponsored retirement plans, most commonly in the form of 401(k) plans, are poised to get some much-needed clarity on expenses, risks and returns associated with investing their retirement assets.

U.S. Rep. George Miller authored a bill to force disclosure of 401(k) fees and give incentives to companies that offer index funds as a plan option. Meanwhile, The SEC has set forth legislation that would improve the disclosure language regarding fees in the heretofore nebulous fund prospectuses. Not to be left out of the party, the Department of Labor has launched a bill that overlaps Miller’s bill, but one which critics say pales in comparison to Miller’s. Each of the three new regulations thrown on the table seeks to cast light on the hidden costs associated with company-sponsored retirement plans.

Michael Keenan’s article “The Elephant in the Living Room”, found in the May 2008 issue of Financial Advisor magazine, explains the real costs associated with most 401(k) plans—costs that are buried, despite the fact that they cost plenty and suppress returns. Keenan details the known (explicit) costs and hidden (implicit) costs of traditional 401(k) plans, giving plausible explanation as to why many 401(k) plans actually underperform their taxable account brethren.

Mistakenly presumed to carry the lion’s share of 401(k) costs, expense ratios are disclosed to plan sponsors and plan participants. Actively managed funds carry higher expense ratios. Active managers seek to beat the market through stock selection and market timing. They generally charge higher fees than passive managers as compensation for their perceived “skill.” Most often, these fees inflict a significant penalty on net investment returns. In both U.S. and non-U.S. strategies, the average actively managed mutual fund is considerably more expensive than the average passively managed fund.

The charts below reveal the disparity in expense ratios between actively managed funds and passively managed funds. Active managers, on average, charge more than twice the fees of passive managers. This is also true in the international fund universe, although the differences are not as large due to the higher costs of investing in non-U.S. markets.

When it comes to implicit or hidden costs associated with 401(k)’s, Keenan asserts that transaction expenses associated with actively managed funds are roughly equal to their also high expense ratios. Using research from a 2007 report provided by Investment Technology Group, Inc. (ITG) that studied data collected from its clients, which include “the vast majority of large fund managers in the U.S. and Europe”, Keenan determined that if an actively managed fund has 100% annual turnover, it incurs nearly 1% in transaction costs. When this occurs year after year, as is the case with active management, turnover expense is devastating to long-term portfolio growth.

Keenan states, “Index funds incur about 80% less in transaction costs than actively managed funds”. According to that assumption, index funds carry just 0.18% in annual transaction expenses.

The table on the right shows the turnover ratios of various funds for the one-year period for 2006. As you can see, passively managed index funds have far less annual turnover than actively managed funds. For example, the Dimensional Large Cap Value Fund had 9% annual turnover and the Dimensional Small Cap Value Fund had 27%--a sharp contrast to the Rock Canyon Top Flight Fund with turnover of more than 1600%. If we extrapolate from the ITG data, that fund’s turnover would have generated a whopping 15% in transaction expenses! What were they thinking?

The general excuse given by active fund managers is that they find opportunities to beat their index, and therefore their higher fees and transaction costs are worthwhile. The evidence, however, is to the contrary. The charts below show how rare it is that active beats passive.

Many investors know that excessive turnover triggers unpleasant tax consequences, but it significantly hampers returns for tax-advantaged accounts, as well. Plan participants suffer under the weight of these excessive and unreported fees.

A movement is under way to clear away the smoke and mirrors associated with retirement investing. There is an acute hunger for clarity and useful information pertaining to the intrinsic relationship between active management and excessive returns, expenses and returns, risk and time, and risk capacity and risk exposure. The proposed solutions, while long overdue, will take time to resolve, implement, and will be met with the usual politicking that will erode precious time. But, investors need answers now. You can obtain a world-class investing lesson at ifa.com. Hundreds of peer-reviewed academic studies, charts, graphs, benchmarking tools, portfolio simulators, calculators and a risk capacity survey will help you learn and invest according to the Science of Investing.

Index Funds Advisors matches individuals and institutions, including corporations, foundations, endowments and perpetual care entities, with risk-appropriate blends of indexes that have shown to deliver risk-optimized returns over time. To learn how you can implement a low-cost, risk-appropriate, passive rebalancing indexing strategy, click here.

Commodities: A Cautionary Tale

Fri, 05 Sep 2008 14:29:06 GMT

Commodities: A Cautionary Tale

For the last couple of quarters, commodity investments have captured intense investor interest, with many of our own clients having inquired as to our stance on inclusion given their latest rise in popularity.

Commodities have developed a reputation for providing a hedge against inflation and an apparent negative correlation to equities. Further research into this subject reveals that no such advantage proves out. A compelling study by former USC finance professor, Truman Clarke details the lack of substantiation for the bold claims made by commodities proponents. IFA has detailed that study and you can read the article by clicking here.

Deservedly so or not, commodities assumed their moment in the spotlight, prompting a need for further explanation as to what commodities are and the risks associated with them.

Quite simply, a commodity is a hard asset, an item that is purchased on the hope that an increased demand or a decreased supply for the item will cause its value to increase. Commodity investments differ from stock investments in that companies, on average, make about 10% of profits per year. Under most conditions, their stock value is expected to increase approximately 10% a year, on average, as well. The expectation of price appreciation for commodities is not based on profits, but rather on supply and demand. In short, commodities do not engage in capitalism.

Recently, the rapid rise in oil prices, based on supply fears and political tensions, caused rampant speculation in the futures markets. Oil futures were driven from $100 to $140 a barrel in a few short months, and investors loaded up on them, sending prices even higher.

The laws of supply and demand do ultimately prevail, however. Oil prices have recently retreated, and investors who purchased futures contracts have paid dearly for price speculation.

Even worse investment experiences have occurred for commodities investors who elected to invest in the Ospraie Fund, a hedge fund that was -- until just a couple of days ago -- one of the biggest players in commodities. That is, until the fund manager announced that it would unexpectedly fold its largest fund, the result of significant, precipitous, and unrecoverable losses the fund suffered in a single one-month period.

According to a Wall Street Journal article, dated September 3, 2008 titled “Ospraie Closes Largest Fund As Commodity Losses Swell”, “The Ospraie Fund fell 27% in August alone due to bets on oil, natural gas and structured products, and the fund has been selling off its holdings over the past three weeks, possibly contributing to a decline in commodity prices. The fund, whose assets peaked at $3.8 billion late last year, is the biggest run by Dwight Anderson, a veteran commodities investor.”

That statement quoted from the Journal is pretty incredible. A decline in commodity prices was actually set in place by an overextended hedge fund. Perhaps the most disconcerting aspect of the story is that it details massive losses that were incurred by Anderson who is described as “a veteran commodities investor.”

Anderson’s letter to shareholders stated, “The losses were primarily caused by a substantial selloff in a number of our energy, mining and resource equity holdings during a six-week period characterized by some of the sharpest declines in these sectors in the past ten to twenty years.” Anderson goes on to state that shareholders will not receive the sum total of what’s left of their assets until the end of the year “because the assets are hard-to-sell illiquid investments.”

Certainly, this commodities investing tragedy is made infinitely more complicated by the fact that it involves a hedge fund. Hedge fund managers are not regulated by the SEC, they are not held to disclosure standards, and they are handsomely paid in both a percentage of assets and performance. In other words, they are encouraged to take incredible risks with other peoples’ money because they have everything to gain and little to lose. IFA has summarized the hazards of hedge funds and you can read the summary here.

The simple, yet painful lesson for investors remains a cautionary tale regarding commodities speculation coupled with hedge funds investing. When you place a bet on short-term price movement in commodities, or you pay a hedge fund manager to place such speculative bets, it is only a matter of time before your luck and money run out.

Should You Invest in Down Markets?

Fri, 29 Aug 2008 14:19:36 GMT

Should You Invest in Down Markets?

Most seasoned investors know, on an intellectual basis, that they capture what Ben Graham calls a “basic advantage” when they stand pat, and even put new money to work after the market has lost ground. But, the decision to invest — the pledging of hard-earned dollars — does not take place in the mind, but rather, in the gut.

When the market hits a rough patch in response to news about war, recession, home prices or unemployment, many investors are challenged to tune out that nagging little doomsayer ever chanting “it’s different this time.”

Truly, it takes a gutsy investor to shake off worry and stand firmly entrenched in investments when they have lost value; in some cases, a lot of value. In Graham’s view, this is capitalizing on that basic advantage — holding on for the long-term expected returns that we rely on capitalism to deliver.

Capitalism is alive and well. It is not suffering and it is not ill. It is simply doing its job. It is absorbing the decisions of all free market participants as they digest news about local, national and global events that occur on an ongoing basis — every minute of every day. These free markets rise and fall as investors express their confidence in the markets as they are impacted by such events.

Most often, the global markets absorb similar degrees of positive and negative news. As a result, markets are not significantly impacted in the short-term one way or the other, and they continue their slow and relatively steady increase over time. However, once every few years, the markets receive really big news that sends them much higher or much lower. Lately, credit worries have dominated the news, and the markets have responded negatively, with both the Dow and the S&P having reached the cusp of bear market territory with nearly 20% declines from their highs.

Those investors who panic and sell in such times will likely look back to realize that they permitted themselves to be stampeded, to borrow Graham’s phrase. In other words, their guts couldn't take it, and they lost faith in the markets, reacting to the illogical fear that there will be no future good news to move the markets forward.

Take a look at the chart below, it shows that over the past 69 years, capitalism has delivered 21 significant market downturns. Certainly, human nature being what it is, the sentiment “it’s different this time” was just as difficult to shake off during each of those events as it is right now. But, history shows that those who had the guts to put their faith and trust in long-term capitalism were ultimately rewarded.

(For better quality and full disclosure for the chart, please click to see the PDF document)

From August 1939 through July 2008, the returns of an all-equity, globally diversified Index Portfolio 100 were the most volatile of the Index Portfolios represented. They also earned higher overall returns. Index Portfolios 50 and 5 enjoyed smoother rides, with significant allocations to fixed income dampening both volatility and long-term returns. The lesson here is clear, higher returns come with higher volatility.

Not all portfolios with similar levels of volatility carry the same expected returns, however. If you look at the chart carefully, you will see that IP 100 and the S&P 500 share similar volatility, but the returns of IP 100 are far greater than those of the S&P 500. If risk and return are so carefully intertwined, how can there be such disparity in returns between these two investments? The answer to this question is revealed in an important investing concept brought to light by Eugene Fama and Kenneth French. The two economists determined that substantial, but risk-appropriate allocations to both small and value stocks will increase the expected returns of a portfolio. The S&P 500 does not offer this type of exposure as it invests in just 500 large-cap U.S. companies. An investment in only small and value, however, carries significantly more risk than the S&P 500. IP 100 dampens this risk by investing across 11 asset classes that include investments in about 17,000 companies world-wide. Looking at the chart, you will see that this tilt toward small and value with global asset class diversification has enabled IFA investors to capture substantially higher returns at a similar level of risk. Over the 69-year timeframe, a dollar invested in the S&P 500 grew to about $1,200 while a dollar invested in IP 100 would have earned nearly $10,000. Merton Miller was right: "Diversification is your buddy."

In light of this important historical data regarding risk, return, time and diversification, your intellectual side is undoubtedly keenly aware of the importance of staying invested and investing, despite market conditions. But, intellect rarely prevails when it conflicts with the gut. So, for just a moment, imagine, if you can, a world without capitalism. Imagine a scenario in which 17,000 publicly-traded businesses around the world cease to profitably deliver the products and services that we all consume and use. Imagine the world’s markets failing — and all at once. Finally, imagine what your money would be worth if all of that actually came to pass…

If, like us, you simply cannot imagine the demise of the world’s markets, then follow your gut: Buy and hold capitalism, it works.

In tough markets, many investors find it difficult to adhere to an investing discipline, or to maintain a sound perspective that maximizes appropriate exposure to stock market risk to achieve long-term expected returns. Index Funds Advisors can help. Index Funds Advisors provides expertise in measuring and quantifying risk capacity for the long-term investment needs of individuals, 401(k) plans, institutions and corporations. This important measure enables investors to make sound decisions that can help them earn returns commensurate with the risks they take. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost, tax managed and efficient. To learn how you can Invest and Relax, call 888-643-3133 to speak with an Investment Advisor Representative, or go to ifa.com.

It's Not Easy Bein' Green

Mon, 18 Aug 2008 11:29:01 GMT

With plastic grocery bags under the threat of elimination, and gasoline prices having reached nearly $5 a gallon, many Americans have faced the impact of consumerism on the long-term sustainability of the environment. Many seek investments that reflect their environmental concerns, and “green funds” are rapidly cropping up to capitalize on the rise in interest. With an onslaught of funds that have hit the market, it’s important to understand the many ways that such an investment can be accomplished, and to be mindful of the choices you make with respect to green investing.

A fundamental underpinning of the 12-Step Program for Active Investors is that proper investing education enables investors to avoid the behavioral and emotional triggers that can lead to flawed decision making, excessive expenses and inferior returns. Certainly, concerns over the environment can trigger emotional responses among even the most educated investors. After all, no one among us wants to rush headlong into advancing the degradation of the planet. But, when considering this type of investment, it’s important to learn exactly how such funds are created, including how the funds are screened and what constitutes inclusion or exclusion.

Most green fund companies implement a screening process that actively seeks for inclusion in their funds companies engaged in activities considered favorable to the environment. IFA believes that such an objective inhibits broad diversification and undermines the evolution and adaptive nautre of capitalism. Consider that fossil fuel has not vanished from the marketplace altogether, so should it be excluded altogether from a diversified portfolio? Such a strategy may itself prove to be unsustainable.

IFA considers a superior strategy to be a weighting approach that seeks to reward companies that have a favorable impact on the environment, while imposing a penalty of underweighting to those that are viewed as having a less favorable impact and eliminating those that are considered to detract from the environment. This approach enables capitalism to do its job, and to reward investors who invest in a well-diversified portfolio that has about 90% inclusion of the traditional (non-environmentally conscious portfolios).

IFA’s Environmentally Conscious Portfolios seek to identify factors that the manager believes indicate whether or not a company, as compared to other companies with similar business lines, promotes sustainability by pursuing economic growth and development that meets the needs of the present without compromising the needs of future generations. A Portfolio may periodically modify its environmental impact considerations.

Relative to a portfolio without environmental impact considerations, a Portfolio will exclude or underweight securities of companies that, according to the Portfolio’s environmental impact considerations, may have a relatively negative impact on the environment as compared either to other companies in the Portfolio’s entire investment universe or other companies with similar business lines.

Despite the tilt to green companies, IFA's Environmentally Conscious Portfolios are free from industry bias. The typical “green” strategy will purchase the best green companies in a given industry, or they will eliminate industries entirely. Such a strategy creates significant portfolio inefficiencies. However, because IFA's Enviromentally Conscious Portfolios overweight the best and underweight the worst within a given industry, the portfolios' weightings are not significantly altered. Within each industry, the weight of the worst green performers are redistributed to the best performers, creating an incentive for companies to focus on green corporate governance.

Examples of the types of considerations that are expected to be used to evaluate companies’ impact on the environment are as follows:

Negative Factors:

Agricultural chemicals: The company produces substantial amounts of agricultural chemicals, including pesticides.

Climate change: A substantial percentage of the company’s revenues relate, directly or indirectly, to the sale of coal or oil and their derivative duel products.

Hazardous waste: The company has incurred substantial liabilities, such as significant fines or civil penalties, for hazardous waste or waste management violations.

Ozone depleting chemicals: The company is a manufacturer of ozone depleting chemicals such as HCFC’s methyl chloroform, methylene, chloride, or bromines.

Regulatory problems: The company recently has incurred substantial fines or civil penalties for, or demonstrated a pattern of issues regarding, violations of air, water, or other environmental regulations.

Substantial emissions: The company exhibits markedly high emissions of toxic chemicals into the air and water from individual plants.

Regulatory problems: The company recently has incurred substantial fines or civil penalties for, or demonstrated a pattern of issues regarding, violations of air, water, or other environmental regulations.

Negative economic impact: The company’s actions have incited major controversies regarding the quality of life or property values in the community.

Other environmental concerns: The company has had material involvement in an environmental controversy not covered by other factors.

Positive Factors:

Beneficial products and services: The company earns substantial revenues through the development of innovative products with environmental benefits, including remediation products, environmental services, or products that promote the efficient use of energy.

Clean energy: The company has taken notable steps to reduce the impact of its operations on global climate change and air pollution through the use of renewable energy or other clean fuels or through the introduction of energy efficient programs or sale of products promoting energy efficiency.

Environmental management systems: The company has exhibited a strong commitment to environmental management systems through ISA 4001 certification and other voluntary programs.

Pollution prevention: The company has established strong pollution prevention programs, including those designed to cut both emissions and toxic uses.

Recycling: The company either uses a significant percentage of recycled materials in its manufacturing process, or is a major firm in the recycling industry.
Other strengths: The company has undertaken noteworthy environmental initiatives not covered by other factors.

When considering a shift from your existing investment strategy, it is critical to carefully weigh both benefits and drawbacks. IFA’s Environmentally Conscious Portfolios substantially limit drawbacks. A significant benefit of IFA’s approach is that it effectively eliminates companies with very low sustainability scores, while increasing the number of companies with high sustainability scores. This concept encourages companies to improve upon their “green activities,” and fosters change for companies that are not currently seeking improvement in the efforts to go green. An additional and substantial benefit to IFA Environmentally Conscious Portfolios is that they maintain the tilts toward small and value that provide significant advantage over other index providers.

Drawbacks associated with Environmentally Conscious Portfolios are a small reduction in diversification as some companies are eliminated from the index, and an increase in the fund expense ratio that is on average about 10 basis points more per fund. As far as performance, there is no scientific data to suggest that Environmentally Conscious Portfolios will have performances that vary significantly from the Traditional IFA Index Portfolios.

Environmentally Sustainable Investing

Benefits	Drawbacks
Increased exposure to companies with high sustainability scores and reduced or eliminated exposure to stocks with low scores	A small reduction in diversification
Same tilts to small and value companies	Cost to screen for sustainability increase management costs

While an investment in a green portfolio is a simple choice for many investors to make, the choice of how best to implement a green strategy is not easy. There are many factors to be considered and IFA strongly recommends that such important decisions be made with the assistance of an independent fee only advisor. If you would like to learn more about how to invest with sustainability in mind, or about the investing and environmental benefits of IFA’s Environmentally Conscious Portfolios, please go to ifa.com, or call to speak with an investment advisor representative at 888-643-3133.

What’s your risk capacity? Take the no-obligation 10-minute survey, or call to speak with an Investment Advisor Representative 888-643-3133.

The highest compliment we can receive is the referral of your friends, family and business associates. Please feel free to forward this email to them, or put them in touch with your IFA Investment Advisor Representative. Thank you for your trust.

A 12-Step Program For Stockoholics

Mon, 11 Aug 2008 10:52:13 GMT

Bill Miller’s quote displays an enormous degree of self-awareness. While IFA welcomes Miller’s stunning epiphany, his revelation comes tragically late for shareholders who have been punished with a 34% loss in the last year.

For the 15 years from 1991 through 2005, Miller seemed unstoppable as he consecutively outperformed the S&P 500. But, Miller has fallen hard and his widely regarded reputation has begun to unravel. According to a Fortune article dated August 1, 2008(1), Legg Mason Value Trust Fund (LMVTX) has dropped 34% since last July while the S&P 500 fell 12%. LMVTX has hemorrhaged losses as assets have fled the fund. According to the article, the fund was valued at $9.7 billion after the exit of more than $2.4 billion in the first six months of this year. However, losses accelerated according to a Bloomberg article dated August 6, 2008(2) which reports that the Massachusetts state pension fund pulled its assets from the fund.

True enough, Miller is in need of a 12-step program and IFA is the perfect sanctuary for his recovery. As you know, IFA president Mark Hebner has developed his 12-Step Program for Active Investors as chronicled in his highly praised book Index Funds: The 12-Step Program for Active Investors. Miller’s stockaholic rehab can begin immediately with the following program:

Step 1. Active Investors: Recognize an Active Investor.

As a seasoned active investor, Miller knows that active investors hope to pick winners among the many stocks, times managers or investment styles. He also appears to have learned at the school of hard knocks that markets are moved by news. News is unpredictable and random. Markets are also efficient, so news is rapidly reflected in market prices. As a result, active investing is not a viable strategy for anyone, not even Bill Miller.

Miller seems well-prepared for Step 1 as his second quarter letter to shareholders states, “We were commiserating over how badly we had done in this market…and how we were all losing clients and assets over and above our losses in the market.” This revelation should aid in his recovery.

Click here to go to Step 1

Click here to watch video

Step 2. Nobel Laureates: Recognize that Nobel Prize winners researched the market.

Nobel Prizes have been awarded to academics for their analysis of how stock markets work. In stockaholic rehab, Miller would undergo a steady transfusion of unbiased academic studies that comprehensively reveal the error of his stock-picking ways and the overwhelming data that supports a passively managed indexing strategy. Additionally, Miller would be cut off cold turkey from sensationalistic news articles and analyst reports which are all generated for the purposes of driving commissions or selling papers.

Click here to go to Step 2

Click here to watch video

Step 3. Stock Pickers: Accept that stock pickers do not beat the market.

This is a crucial step for Miller to undergo so he may achieve a complete recovery. He would have to accept that the primary factor influencing the success of a stock picker is simply luck. Miller would receive concentrated doses of studies and visual aids in the form of pie charts, each of which compares the performances of active managers to a corresponding asset class benchmark. An average of these studies shows that the corresponding index outperforms their actively managed counterparts by a margin of 92%.

Click here to go to Step 3

Click here to watch video

Step 4. Time Pickers: Understand that no one can pick the right time to be in or out of the market.

In this Fourth Step, Miller would gain an understanding that investors are unable to time the markets due to the high concentration of returns and losses that occur in a time period of a few days. In a recent 10-year period, 100% of the total gain was concentrated in just 20 days – an average of just two days per year. It is impossible to pick that handful of days in advance.

Click here to go to Step 4

Click here to watch video

Step 5. Manager Pickers: Realize that winning managers were just lucky.

This step is a critical hurdle for Miller, one that will test his commitment to a full and complete recovery as a stockaholic. Miller’s so-called hot streak could render him reticent to accept the important premise that winning managers are lucky, not skilled. However, Miller did admit to the Wall Street Journal in January 2005 the following, “We’ve been lucky. Well, maybe it’s not 100% luck — maybe 95% luck.” Miller would have to take a bold leap and accept that his so-called streak was based on bad benchmarking. Yes, Miller’s track record did exceed the S&P 500 — a large-blend fund, but Legg Mason Value Trust is more comparable to a large value index.

The figure below plots the risks and returns for Miller's fund LMVTX, IFA's Large Value and Large Company Indexes and for IFA Index Portfolios 80, 85, 90, 95 and 100 for the time period from January 1991 to June 2008. This time period was selected because 1991 is the beginning of Miller's winning streak. As you can see, Miller's Legg Mason Value Trust carried significantly more risk than each fund or index depicted in the chart. However, investors were not adequately compensated for the risk they took. LMVTX earned returns in line with Index Portfolio 80, but it carried nearly 60% more risk. LMVTX also carried risk far greater than Index Portfolio 100 which earned significantly higher returns than LMVTX.

The risk and return story is even worse for investors who purchased LMVTX after Miller's streak was hyped. New money that poured into the fund as a result of a fresh "5-star rating" from Morningstar would likely experience even greater risk and lesser returns than plotted on the figure. To that point, it is worthwhile to consider that Morningstar ratings consider past performance. Past performance of actively managed funds is no guarantee of future returns. Just ask recent investors of LMVTX (which was recently downgraded to 1 star). Click here to go to Step 5

Click here to watch video

Step 6. Style Drifters: Comprehend active management style drift.

Most mutual fund managers drift from once recent winner to another, altering a fund’s stated objective. Miller appears to be no exception as he describes chasing the latest trends — albeit most unsuccessfully:

“…it was obvious we should not have owned homebuilders, or retailers or banks, and that I should have known better than to invest in such things. It was also obvious that growth in China and India and other developing countries would drive oil and other commodities to record levels and that related equities were the thing to own. While I am quite aware of our mistakes, both of commission and omission, when I ask what is obvious NOW, there is little consensus. If there is something obvious to do that will earn excess returns, then we certainly want to do it.”

In Step 6 of The 12-Step Program for Active Investors, Miller would learn to understand that there are no obvious ways to earn excess returns, and that style performance rotates randomly so it is not possible to consistently predict tomorrow’s winning style. In other words, don’t try to beat the benchmark, buy the benchmark.

Click here to go to Step 6

Click here to watch video

Step 7. Silent Partners Recognize the partners in your returns.

There are partners that silently and subtly take a large slice of investment returns. Over a 15-year period of time, active investors keep only about 50% of the total return earned by their investment while index investors keep about 85%. Manager fees, higher taxes, transaction costs all eat away at an active investor’s returns pie. For Miller’s LMVTX fund, investors pay an expense ratio of 1.7%. In contrast, the expense ratio for an all equity index portfolio is about 0.45%.

Click here to go to Step 7

Click here to watch video

Step 8. Riskese: Understand how risk, return and time are related.

In this important step in Miller’s recovery, he would have to fully comprehend the language of stock market risk. Lawyers speak legalese and the best investors speak riskese. Learning the language of riskese requires investors to have a basic understanding of the concepts of risk, return, time, correlation and diversification. Most investors chase the short-term returns of stocks, markets and styles and concentrate their investments in just a handful of stocks that are highly correlated and his fund is very poorly diversified. Miller’s LMVTX, for example, holds 97.5% of its investments in just 39 stocks. Additionally, Miller’s fund invests in value companies, which are known to be risky. Again, Miller earned a return in excess of the S&P 500 because he took more risk that the S&P 500. Similarly, Miller has underperformed the S&P 500 because he took more risk that the S&P 500. This is the downside of excessive risk, a downside that investors were likely unaware of as Miller was compared to the S&P 500. Simply put, you cannot cheat risk.

Click here to go to Step 8

Click here to watch video

Step 9. History: Understand the historical risk and returns of indexes.

Moving into the homestretch of The 12-Step Program for Active Investors, Bill Miller would likely be encouraged by Step 9. During this phase of the recovery program, Miller would be faced with reams of data regarding style-pure asset class indexes. He may very well find himself enjoying a sense of calm as he delves into 80 years of risk and return data and rolling periods analysis. He will then likely abandon his desire to pick stocks, markets and styles, choosing instead to focus on quantifying risk so he might rebuild his investing efforts upon a strong foundation of index data.

Click here to go to Step 9

Click here to watch video

Step 10. Risk Capacity: Analyze your five dimensions of risk capacity.

A risk capacity survey helps self-professed stockaholics determine how to invest their assets properly. Prior to investing, each individual should learn the extent to which they are able to take on stock market risk. A risk counselor or Investment Advisor Representative can help such investors quantify the appropriate amount of risk for their investments. This phase of stockaholic rehab includes analysis of five dimensions of risk capacity to arrive at a score that is matched to a corresponding index portfolio. These five dimensions are time horizon and liquidity needs, investment knowledge, net income, net worth, and attitude toward risk.

Click here to go to Step 10

Click here to watch video

Step 11. Risk Exposure: Analyze your five dimensions of risk exposure.

Step 11 of The 12-Step Program for Active Investors provides the magical moment when a recovering stockaholic learns their risk capacity score and is matched with a corresponding Index Portfolio. At this point, they can view the asset allocation that is just right for them, not too much risk and not too little. They can replace their compulsion to speculate with a more logical and moderated understanding of returns and volatility data. They will learn where their Index Portfolio sits on the risk reward chart known as Harry Markowitz’s efficient frontier. They can view the bell shaped curve that will show their average expected returns and the highs and lows for the portfolio for the last 80 years, and for many other time intervals.

Click here to go to Step 11

Click here to watch video

Step 12. Invest and relax.

The road to recovery for all stock market addicts, including Bill Miller, comes to a happy conclusion when they fully recognize that a strategy of buying, holding and rebalancing a portfolio of index funds is the best way for them to maximize the expected returns of their investments. They will be able to design, implement and maintain a portfolio that makes good use of risk, diversification, style purity and passive management. And when they do so, they will finally be able to invest and relax.

Click here to go to Step 12

Click here to watch video

IFA would be pleased to lead Bill Miller through stockaholic rehab. Additionally, IFA welcomes the opportunity to assist disheartened investors of LMVTX and other actively managed funds, as well as stock pickers, market timers and style drifters in learning the benefits of proper risk management and broad diversfication.

Index Funds Advisors is an expert in measuring and quantifying risk capacity for the long-term investment needs of individuals, 401(k) plans, institutions and corporations. This important measure enables investors to make sound decisions that can help them earn returns commensurate with the risks they take. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost, tax managed and efficient.

1. Bill Miller: Toughest market I've seen, Fortune, August 1, 2008http://money.cnn.com/2008/07/31/news/companies/miller_levenson.fortune/index.htm?source=yahoo_quote
2. Bill Miller's letter to investors, Fortune, July 31, 2008
http://money.cnn.com/2008/07/31/news/companies/miller_letter.fortune/index.htm?postversion=2008073109

IFA’s 20 Index Portfolios provide risk-appropriate allocations to as many as 15 IFA Indexes that carry 80 years of risk and return data. Through global diversification, IFA’s Index Portfolios are able to maximize investors' at the level of risk determined by their risk capacity.

What’s your risk capacity? Take the no-obligation 10-minute survey, or call to speak with an Investment Advisor Representative 888-643-3133.

Lessons From Benjamin Graham

Fri, 01 Aug 2008 10:31:57 GMT

Widely regarded as the “Father of Modern Security Analysis”, Benjamin Graham (1894-1976) has inspired many investors, including professional investor Warren Buffett. In Graham’s quote above, he explains the importance of selecting a portfolio that enables you to ignore the short-term ups and downs of the market that ultimately have little, if any, impact on long-term returns. A portfolio of index funds is the perfect vehicle for following Graham’s advice. In contrast to funds run by active managers, investment managers of index funds are far less active in the buying and selling of stocks. Index funds managers do not pick stocks or active managers. They do not time markets, pick styles, or make attempts to forecast the future. The analytic techniques that index funds managers use are quantitative or scientific. The following Table summarizes the primary differences between active investing and indexing.

(click or scroll down to view the enlarged table)

As the Table shows, approximately 15% of all individual assets and 44% of all institutional assets are currently invested in different index funds. Many institutional funds are 100% indexed. Even Charles Schwab and Company recommends that investors put 80% of their large cap assets into index funds, and Mr. Schwab himself has 75% of his mutual funds in index funds. Other indexing proponents include Barclay's Global Investors, Dimensional Fund Advisors, The Vanguard Group, Warren Buffett, Peter Lynch, numerous academic institutions, Economic Nobel Laureates, and Index Funds Advisors (IFA). Insurance companies use a similar approach to indexing when setting premiums for the risks taken by insuring against thousands of different random events. Most of those premiums are also invested in index funds while held in reserves for the inevitable claim payment.

Most investors believe that index funds investing means investing in familiar market indexes, such as the Standard and Poor's 500. S&P 500 funds are structured with the aim to provide the same investment performance as the S&P. By holding all the stocks in the same proportionate amounts as the S&P index, the fund index represents about 86% of the market value of all U.S. companies, mostly large blue chip stocks. The problem is that market indexes, such as the S&P 500, were not originally designed as investment vehicles.

Since the late 1980’s, index funds have expanded and are based on more discrete customized indexes. Originally designed for very large pension funds, institutional-style index funds are meant to capture various financial risk factors or dimensions of the market. Exposure to a risk factor such as company size or value constitutes a risk dimension of the market. Investors have been compensated with higher returns for risk exposure to these risk factors since 1929. These dimensions of the market can also be referred to as indexes. Indexes are groups of stocks that have common risk and return characteristics and comply to specific and clearly defined sets of rules of ownership. These groups of stocks include companies from the United States, foreign companies, and even emerging markets. There are additional indexes within these markets, such as value, large value, small growth, large growth, real estate securities, and many fixed-income investments, such as short-term and long-term treasury bonds, municipal bonds, and corporate bonds.

IFA’s 20 Index Portfolios provide risk-appropriate allocations to as many as 15 IFA Indexes that carry 80 years of risk and return data. Through global diversification, IFA’s Index Portfolios are able to maximize expected returns while minimizing risk.

What’s your risk capacity? Take the no-obligation 10-minute survey, or call to speak with an Investment Advisor Representative 888-643-3133.

Investors in Japan

Mark Hebner to visit the Land of the Rising Sun!

From August 12 through August 26, 2008, Mark Hebner will be in Japan, and he would like to meet with you. To schedule a 1-2 hour meeting with Mark, please call Laura Gomez at 001-1-949-432-0458.
Mark is also looking for a strategic business partner in Japan. If you are interested, please also call Laura.

Value of Long-term Equity Investing

Fri, 25 Jul 2008 10:31:57 GMT

James Pardoe's message provides a much-needed perspective on the long-term positive attributes of equity investing. Certainly, equity markets do not always deliver positive returns in a steady upward fashion. Instead, equity markets are volatile. This short-term volatility is the reason we expect a long-term return.

June 2008 was an ugly month for equities. A combination of oil prices hitting record highs and bad news about credit and housing caused the S&P 500 to give up about 8 percent for the month—a tough pill to swallow.

Sudden and sharp drops in the stock market make for scary headlines. They can also make for sleepless nights for investors who look at precipitous drops in their account balances without an awareness of the ample backdrop of historical data that shows we have been here before and eventually recovered the loss. For this reason, an understanding of stock market history enables investors to maintain confidence in capitalism and the long-term staying power of the equity markets.

IFA recently conducted a study of one-month declines in the all-equity Index Portfolio 90. The study covered the 38.5-year-time period beginning with analysis from the beginning of 1970 through June 2008 and filtered for the most significant one-month drops. The table below shows the results of the study. It lists 13 of the most significant one-month market downturns and subsequent recoveries for IFA Index Portfolio 90.

As the table shows, there have been some punishing one-month blows to the equity markets throughout recent history. October 1987 delivered a particularly spooky one-month decline for investors. The S&P 500 lost a whopping 21.5% that month and Index Portfolio 90 gave up 19.72% of its value.

Such quick and punitive drops surely sting investors. However, history shows that those who stayed the course were rewarded for their confidence. The study reveals that in the 1-year, 3-year, 5-year and 10-year periods subsequent to such blows, capitalism’s upward march largely regained its footing. For example, in the year that followed October 1987, from November 1987 through October 1988, Index Portfolio 90 surged ahead 24.08%.

This important data provides a solid backdrop against which you can make prudent decisions regarding your long-term investments. This information shows that we have indeed experienced volatility that has cut a wide swath through returns in even broadly diversified portfolios. However, despite these short-term blips, those who stayed the course were amply rewarded for their conviction. The key to successful long-term investing is to invest in balanced, risk-appropriate and diversified portfolios and focus on long-term returns.

Index Funds Advisors is an expert in measuring and quantifying risk capacity for the long-term investment needs of individuals, 401(k) plans, institutions and corporations. This important measure enables investors to make sound decisions that can help them earn returns commensurate with the risks they take. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost, tax managed and efficient.

What’s your risk capacity? Take the no-obligation 10-minute survey, or call to speak with an Investment Advisor Representative 888-643-3133.

Investors in Japan

Mark Hebner to visit the Land of the Rising Sun!

This information has been furnished to you by Index Funds Advisors, Inc., a fee-only Independent Financial Advisor registered with the United States Securities and Exchange Commission. Please see www.ifa.com/btp for complete sources, updates and disclosures.

DISCLAIMER: THERE ARE NO WARRANTIES, EXPRESSED OR IMPLIED, AS TO ACCURACY OR COMPLETENESS OF ANY INFORMATION INCLUDED IN THIS DOCUMENT. Use of any information obtained from such addresses is voluntary, and reliance on it should only be undertaken after an independent review of its accuracy, completeness, efficacy, and timeliness.

Nobody Told Me There’d Be Days Like These

Wed, 16 Jul 2008 10:25:59 GMT

Many investors in today’s equity markets may find new meaning to John Lennon’s 1984 pop hit "Nobody Told Me." Market drubbings may lead ill-advised investors to worry unnecessarily and perhaps even act on that worry—much to their detriment.

As you likely know (but may be in need of a refresher), equity markets are expected to steadily rise in the long-run. They are also expected to bounce all over the place in the short-term. During times as those we have recently endured, it becomes critically important to remember that short-term volatility has little, if any, impact on long-term expected returns.

This important investing concept is at the heart of Burton Malkiel’s A Random Walk Down Wall Street. Originally inked in 1973, Malkiel’s timeless investing classic (now in its ninth edition) provides an important reminder to each of us that in order to be successful long-term investors, we must tune out the short-term noise.

There are moments, however, when tuning out noise can seem a monumental task.Tickers that scroll predominately red can erode an investor's staying power. This is when the most stoic and successful investors hunker down and recall the important investing concepts that are provided by 80 years of history and the academic research of unbiased financial experts. Three such concepts follow:

1) You get paid for risk

Risky investments, particularly small and value equities carry higher expected returns over time. They also carry higher short-term volatility expectations. Indeed, this is the price an investor must pay in order to achieve those higher long-term returns.

The two charts below explain this increased volatility for increased reward concept. Figure 8-5 shows a distribution of 600 monthly returns of Index Portfolio 90, an all-equity portfolio which has achieved average monthly returns of 1.14% for 50 years. This portfolio also had a monthly standard deviation of 4.01% for that time period. Based on the average return and standard deviation of long-term historic data, a probability distribution of future outcomes can be estimated. In other words, we expect this Index Portfolio to achieve similar returns in the future but also carry a similar amount of volatility relative to an Index Portfolio with a more narrow range of volatility.

Figure 8-5

To that point, Figure 8-6 shows that Index Portfolio 30 has a more narrow range of monthly returns, but it also carries a lower expected return over time. Quite simply, investors cannot avoid risk and expect to earn returns above the risk-free rate.

Figure 8-6

(click to enlarge the charts)

Risk is the currency of return. A greater return is payment for investors subjecting themselves to greater uncertainty of those returns. Without the uncertainty of gain or loss, why would there be any logical reason for investors to earn money? This correlation is evident in virtually all stock market historical data.

2) Rolling Period Returns Can Provide Reassurance

A big obstacle for many investors is the high level of inaccuracy that comes from making decisions based on small samples of stock market data, or short-term market fluctuations. Rolling period returns data can go a long way toward solving this problem.

Rolling periods are created with monthly or annual data that overlap from one period to the next. Figure 8-9 illustrates how rolling periods are obtained using monthly frequency. As you can see Period #1 is the 12 years from January 1957 to December 31, 1968. Period #2 starts one month later on February 1, 1957 to January 31, 1969. Imagine this occurring 457 times over a 50 year period. This analysis helps capture the various experiences of 12-year investors who start their investments in July 1957, January 1963 or just about any month within the 50 years.

Figure 8-9

(click to enlarge the charts)

Table 8-1 is a rolling period analysis of Index Portfolio 100. (Similar information is available for each of IFA’s 20 Index Portfolios, and can be found by clicking here and choosing a portfolio.)

If you look at the red highlighted row in the figure below, you will see that it covers 12-year rolling periods (144 months each) and in the period from January 1958 to December 2007, there are 457 12-year rolling periods. As you read across the red highlighted row, you can see lots of interesting data about those rolling periods.

For example, you will see that for all annual periods shown, the average annualized return is about 14%. You will also see that the standard deviation of annualized returns of this Index Portfolio diversifies down to 3.95% when the Index Portfolio is held for the 12-year recommended holding period—a far cry from the 17.69% volatility number that exists for the 1-year period. This table further shows that the lowest rolling period return was for the 1/63-12/74 time period when the lowest average annualized return was 7.02% and a dollar invested during that time grew to $2.26. We also see that the highest rolling period return occurred from 1/75 to 12/86 when the average annualized return for that time was 24.24%,and a dollar invested during that period grew to $13.53. This type of information is invaluable for making important decisions, and for keeping you invested properly for the long term.

Table 8-1

(click to enlarge the charts)

3) Invest Right and Sit Tight

Certainly, many investors are currently lamenting “Nobody told me there’d be days like these.” IFA clients are likely NOT among them. Taking the important time to educate its more than 2,000 clients about risk, return and the impact of time on investments, IFA's clients are empowered to sit tight through market volatility, and to earn the long-term returns provided by an investment in capitalism.

If you would like to learn more about how you can invest right and sit tight, go to ifa.com, or simply call IFA to speak with an investment advisor representative, call 888-643-3133.

What do academics say about the relationship between economic conditions and expected investment returns?

1) Expected returns on bonds and stocks are higher when conditions are weak and lower when economic conditions are strong.
- Fama and French, "Business Conditions and Expected Returns on Stocks and Bonds," (November 1989), Journal of Financial Economics –

2) The risk premium is expected to be countercyclical: lower in good times and higher in bad times.
- Campbell, J. and J. Cochrane (1999), By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior, Journal of Political Economy, Vol. 107, 205-251

This information has been furnished to you by Index Funds Advisors, Inc., a fee-only Independent Financial Advisor registered with the United States Securities and Exchange Commission. Please see www.ifa.com/btp for complete sources, updates and disclosures.

The Smartest 401(k) Book You'll Ever Read

Thu, 03 Jul 2008 10:14:23 GMT

One of the most significant decisions you can make is choosing the right financial advisor. The right advisor can appropriately allocate your assets for a more secure future. The wrong advisor can lead you down a path of second guessing and investments that may not be in keeping with your best interests. Taking the time to learn the differences that distinguish qualified investment professionals from commissioned salespeople will prove to be time well-spent for you and your assets.

The greatest dividing line that separates financial professionals is fiduciary obligation. By law, a fiduciary must act solely in the best interest of the client. As such, a fiduciary is obligated to reveal any potential conflict, as well as to fully disclose how they are compensated for their services. Doctors, lawyers, certified public accountants and fee-only Registered Investment Advisors (RIAs) are fiduciaries. In April 2005, the SEC set forth recent regulations that require brokers and other financial professionals to include the following to indicate an absence of fiduciary obligation:

“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interests. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”

If you see this disclaimer, you should ask questions, request complete disclosures, and really question if this is the establishment that seeks to advance your best interests. After all, that’s why you hire a financial advisor in the first place, isn’t it?

How Does Your Advisor Get Paid?

The manner in which your advisor gets compensated speaks directly to the question of whose best interest is being served—yours or theirs. Essentially, there are three distinct compensation models for financial advisors:

Fee-Only Compensation: This model can minimize conflict of interest. A Fee-Only Advisor is paid for advice rendered and for ongoing management. No other compensation can be rendered by any other financial institution, thus advancing the fiduciary standard. Fee-only advisors are paid solely for their knowledge and their asset management services.

Fee-Based Compensation: Frequently confused with Fee-Only Advisors, but not at all the same, fee-based advisors may earn only part of their overall compensation from advisory fees paid by clients. They may also receive compensation for commission-based products they are licensed to sell, advancing an inherent conflict of interest. As such, fee-based advisors do not hold to a fiduciary obligation.

Commissioned Compensation: Commission-compensated advisors can face enormous conflict of interest. A financial benefit can only be derived through transactions, creating a bias toward account activity. Unbiased advice is an improbable outcome for investors who use the services of commissioned advisory services. Further complicating the conflict of interest issue, commissioned representatives can receive incentives for selling one investment over another.

Fiduciary Standard Requires Accountability

Fee-only Registered Investment Advisors are held to a higher standard than fee-based and commissioned advisors. Fiduciaries are governed by the Investment Advisors Act of 1940, which holds them to the obligation to act solely in each of their clients’ best interests, or face lawsuit for breach of fiduciary duty. Administered by the United Stated Securities and Exchange Commission, such a lawsuit can result in a permanent barring from practice within the securities industry, severe financial penalties and even criminal allegations resulting in possible prison time. In sum, fiduciaries are compelled to take their jobs very seriously.

Advisors who are affiliated with a broker/dealer are most likely not fiduciaries. Carefully read and understand the fine print that makes up the disclaimers on advertising materials offering services of a financial professional. You can most likely determine the presence of a fiduciary standard by doing so. The few minutes it takes to do so will surely reward you with peace of mind for years to come.

Investments with higher expected returns

Mon, 30 Jun 2008 10:05:47 GMT

William Sharpe tells us that if we want to achieve higher expected returns, we must be able to both emotionally and financially be able to withstand the increased volatility that inevitably comes with higher expected returns. Risk is the source of returns.

Sharpe’s Nobel Prize winning research was his 1964 Capital Asset Pricing Model (CAPM) in which he broke down a portfolio’s risk into systematic or nonspecific risk and nonsystematic or specific risk.

Systematic risk refers to the risks of the entire market as opposed to the risks specific to one stock. These market-wide risks are tied to large scale risks like the risk of capitalism being a viable economic social system. Other risks not specific to one stock include war, recession, inflation, and government policies. If you invested in the stock market, you cannot diversify away systematic risk. It is, in fact, the risk of investing in the market system.

Nonsystematic risk refers to those risks that are specific to individual companies. Examples include lawsuits, fraud, competition and other unique circumstances related to a company. The important fact for investors to understand is that there is no added expected return for nonsystematic risk above the expected return for systematic risk. This is a very big idea that essentially says that all stocks have an expected return that is the same as the market or a market index fund return. However, those stocks have more uncertainty of the expected return.

The incremental risk of one stock (nonsystematic risk) is unrewarded risk, and therefore should be avoided by investors. However, the systematic risk of capitalism is essentially the market risk and has earned an annualized return of about 10% per year for 80 years. But, in periods of less than 10 years, the annualized returns can be very volatile and uncertain. In periods longer than 20 years, the annualized returns of each period are far more consistent than one to five-year periods.

High risk exposure is like a scream inducing roller coaster with soaring highs and stomach churning lows. Investors should hop on a milder ride if they don’t like the extreme rush of the one they’re on.

The same concept applies to investing. However, not everybody has the capacity for such exposure to risk. Figure 8-23 shows the roller coaster like returns of five different index portfolios. The gold colored Index Portfolio 90 has higher highs and lower lows than the other lower risk portfolios. Also, note that the growth of $100,000 over 35 years is higher for the higher risk Index Portfolio 90. Figure 8-24 shows what the one index of small value stocks looks like on the same scale. These graphs provide a vivid illustration of the concepts of risk, return, and time. They are available in dynamic versions that allow movement and selection options, see below.

Click here to see the interactive chart

Commodity Futures

Fri, 20 Jun 2008 10:05:47 GMT

At times, commodity futures can turn out a strong performance. When they do, they seem to make a very appealing addition to an investment portfolio. But is the addition of an investment in a commodity futures index really such a great idea?

Proponents of commodity futures assert that the investment vehicles offer a positive average excess return. Additionally, it has been asserted that the addition of commodity futures to a conventional equity and fixed income portfolio can significantly reduce portfolio risk with added diversification, and deliver a great hedge against inflation.

If, through an investment in commodity futures, an investor can increase returns, lower risk and hedge against inflation, why wouldn’t we all buy them? And to further that point, why would anyone ever sell them? Both of these questions can be answered in a study conducted by Truman Clark, former professor of finance at University of Southern California. Clark’s analysis of commodities futures investments is titled “Commodity Futures in Portfolios” and was published for limited distribution to institutional investors and financial advisors in 2004.

Clark’s in-depth study of commodity futures includes experiments using the Goldman Sachs Commodity Index (GSCI), the industry benchmark. He stated that not one of the claims regarding excess returns, reduced risk or hedge against inflation was strongly supported by the empirical evidence.

GSCI Analysis

The GSCI contains 19 allocations to commodities with everything from metals, harvest food products, livestock and a hefty dose of petroleum and natural gas. Essentially, if you can mine it, grow it or put it on the BBQ, it’s in the index.

Daily reporting of the GSCI returns began in 1991. Goldman Sachs provides simulated returns histories for the 21-year time period from 1970 through 1990, but those returns carry selection bias. The figure below shows that the cumulative total returns for the GSCI since 1991 lag the returns of the S&P 500 Index, Long-Term and Intermediate Government Bonds, and just barely outperformed the One Month Treasury Bills for the 13-year 6-month period from January 1991 through June 2004. Of course, investors who cannot take on the risk associated with the S&P 500 Index would accept returns that come with lower risk. But, this is not the case with commodities. The standard deviation of returns for the GSCI was 16.62%, higher than the 14.51% for the S&P 500 for that same period.

The risks and returns associated with commodities don’t create a compelling argument for an allocation to them. However, many investors argue that commodities add an extra element of diversification to a portfolio, citing a negative correlation between commodities and equity or fixed income indexes. Clark tests this theory. He discovered that sample correlations between GSCI total returns (GSTR) and the returns of several equity and fixed income indexes shift depending on whether monthly or quarterly data are used. When monthly data are compared, the annualized standard deviation of returns for the GSTR is 17.7%, with the correlations between GSTR and the returns of other assets being slightly positive or near zero. These results suggest that there is no increased diversification benefit to be gained by combining commodities with stocks and bonds. Quarterly data reveals a slightly different picture as the correlations between GSTR and stock and bond returns appear to be negative or near zero and the standard deviation of returns at 16.4%.

Aware of this differential, Clark set out to quantify the diversification benefit of commodities. He constructed three base portfolios and added fully collateralized commodities futures to each. He identified the combination of stocks, bonds and commodities that would minimize standard deviation and hold the average return constant. In his models, Clark applied the quarterly data for commodities correlation in order to give them their best chance of producing economically significant reductions in standard deviation. Clark’s conclusions revealed that “in all cases, the reductions in volatility are trivial. The annualized standard deviations fall by at most seven basis points. The resulting increases in annualized compound returns are one basis point or less.” He summarized the results of his study by stating, “The potential diversification effects of commodity futures are meager.”

Finally, many investors are drawn to commodity investments because they are considered to be an effective hedge against inflation. Quarterly data shows that GSTR are correlated positively with inflation, while equity and fixed income indexes are negatively correlated. These data suggest that commodity futures can provide an effective hedge against inflation. Once again, Clark tested this assertion. Using the same model portfolios identified in the diversification study analysis, Clark repeated the same application using real returns. For each base portfolio, Clark’s objective was to minimize the standard deviation of real returns while maintaining the average real return. Again, these samples used quarterly statistics because they offered a best case scenario for the inflation hedge theory. The results of Clark’s experiments showed that the reductions in the standard deviation of real returns mirrored the results of the diversification study which revealed a reduction of seven basis points in standard deviation and an annualized compound rate of return of only one basis point, or less. Clark concluded, “the potential of commodity futures to serve as effective inflation hedges is trivial.”

In summary, as pertains to commodities allocations, Clark’s study concluded the following:

First, the average excess return of the GSCI over T-Bills was indistinguishable from zero. The average expected return of fully collateralized commodity futures may not be any greater than the Treasury bill return.

Second, an investor who added the GSCI to his/her equity and fixed income portfolio had very limited potential to reduce standard deviation to achieve a constant level of average return and dampen volatility. “Commodity futures do not appear to be “good diversifiers” for stock and bond portfolios,” Clark concluded.

Third, despite the GSCI’s positive correlation with inflation, adding the GSCI futures to a portfolio of conventional assets produces negligible reductions in the standard deviation of real returns and no appreciable hedge against inflation was identified.

Clark’s final assessment of the promise of commodity futures states, “The evidence indicates that the purported benefits of commodity futures are exaggerated... Investors acquiring commodity futures in expectations of higher returns, lower risk, and improved inflation protection are making bets. Current evidence indicates that the odds are against them.”

Eugene Fama Receives Morgan Stanley-AFA Award for Excellence in Finance

Thu, 12 Jun 2008 09:58:36 GMT

In the ultimate irony Morgan Stanley, an icon of active investing, and the American Financial Association jointly awarded its prestigious Award for Excellence in Finance to Eugene Fama, finance professor at the renowned University of Chicago School of Economics. If they really understood what he wrote about, they would stop picking stocks, timing markets and selling actively managed mutual funds.

Eugene Fama has provided powerful information about how stock markets work. His important work began to take shape with his 1964 doctoral thesis, “The Behavior of Stock Market Prices”. In his thesis, Fama set forth an explanation of market efficiency and why it ensures that the current price is the most accurate price. Fama asserted that actual prices are the best estimates of a stock’s fair value because competition among investors causes share prices to move swiftly, absorbing all current information and future expectations. This Efficient Market Hypothesis makes it virtually impossible for an analyst to consistently locate and profit from price anomalies.

Eugene Fama

Fama further asserted that past price patterns have no bearing on the future direction of stock prices. This assertion, known as “The Random Walk Theory”, essentially eradicates the notion that stock pickers can pick future big winners based on past performance or information that has already been revealed about a company.

Fama’s thesis, as well as his subsequent work, has transformed the investment industry. In fact, Fama’s important work has led to a proliferation of index funds—answering the call for a low-cost way to capture market efficiency and the expected overall increase in stock market equities as a whole over time.

Fama’s stock market research further led him to question why some stocks perform better than others. He joined efforts with Kenneth French (currently a finance professor at Dartmouth), and the two reconsidered William Sharpe’s Single Factor Model which asserted that stock market returns are explained by their exposure to the market as a whole. Fama and French determined the Single Factor Model on its own did not go far enough to explain differences in stock market returns as it accounted for just 70% of returns. Fama and French set out to identify additional factors that would explain all, or at least the lion’s share of stock market returns.

In June 1992, Fama and French, published “Size and Book-to-Market Equity: Returns and Economic Fundamentals”, their ground-breaking research paper that significantly improved upon William Sharpe's single factor asset-pricing model. Fama and French’s research led them to identify that, in addition to the market itself, a portfolio’s specific sensitivity to size and value impacts returns.

The two revealed their Three-Factor Asset Pricing Model which provides isolated and specific risk and return characteristics for small and value companies.

The figure below reveals the risk (standard deviation) and return characteristics for the Three factor Model. The returns (above the orange bars) are the average annual returns for the three Fama/French Risk Factors for the last 80 years. At last, investors can invest with specific risks and expected returns without succumbing to guesswork, speculation and fear.

Fama and French’s Three Factor Model serves as an invaluable tool for asset allocation and portfolio analysis. The Three Factor Model has revolutionized how portfolios are constructed and analyzed. From their findings, Fama and French soon introduced the first concentrated, empirical value strategies. Their research led to similar findings internationally, and they updated their studies in 1998 to include data from as far back as 1929. Fama and French’s ground-breaking discoveries and research indexes are the cornerstone for IFA’s globally diversified and risk-optimized investing approach.

IFA is thrilled that Eugene Fama continues to receive accolades for his research that so heavily influences portfolio construction. It is particularly encouraging, albeit ironic, that this prestigious award and acknowledgement comes from a brokerage house that thrives on active management.

A Good Portfolio

Wed, 04 Jun 2008 09:35:53 GMT

One day in the early 1950s, a Ph.D. candidate in economics sat in the library at the University of Chicago. The young man, Harry Markowitz, was studying leading investment guides used by professional money managers. The guides seemed to recommend that an investor should invest in stocks with the highest expected return and ignore all the rest. After a while, it dawned on Markowitz that investors should consider risk as well as return.

It was a simple conclusion; however, it spawned one of the most important investment ideas of the 20th Century, and has generated a whole body of scholarly work known as "Modern Portfolio Theory". Thirty-eight years later it earned Markowitz a Nobel Prize in Economics. The fact that trillions of dollars around the globe are now invested and managed according to the principle proposed by Markowitz is testament to its central importance in the investment process. This revolutionary insight has not only transformed the investment world of corporate and government pension plans, insurance companies, banks and other large institutional investors, it has also changed the way individual investors invest.

Markowitz knew that no one had really tried to systematically understand the importance of risk in the investment process. Up to that time, investors had focused on an investment’s return, but if they believed it contained some arbitrary, undefined notion of risk, then the investment wasn’t included in the portfolio. Markowitz understood quite clearly that risk and return are related. After all, investors like return and want to increase it, and they dislike risk and want to reduce it. On that day in the library, Markowitz set out to show investors how they could improve their investment performance by optimizing trade-offs between risk and return.

Because it seems so obvious, it’s hard to appreciate how truly profound Markowitz’s idea was. Of course both risk and return should be considered. In spite of the evident nature of this idea, the investment media continues to spread the “good news” of returns, while downplaying the “bad news” of risk.

In Figure 11-2 you can see a 10-year annualized return of efficient index portfolios compared to the average mutual fund (the green X), the S&P 500, and the only 86 managers in the Morningstar database with 20 years of managing the same fund. Morningstar® Principia® risk data does not go beyond 10 years, so the chart is shown using the 10 years from 1995 to 2005. About 10 actively managed funds are shown to be more efficient than the line of index portfolios. That means they are in the top left quadrant above the colorful line of buttons. Keep in mind that to have selected those funds 20 years ago would have been a near impossible task. Hindsight is 20/20. But index portfolios are always a better choice because they are consistent in their strategies.

Figure 11-2

Diversification in investing refers to the process of spreading out risk. Let’s look at a single stock in an index versus the entire index as seen in Figure 11-3. Because of the random nature of risk, no one knows what is going to happen in the short term to a subset of stocks in the index.

Figure 11-3

A subset of the index would actually be another index altogether with different risk and return characteristics. .

As Harry Markowitz stated, there are protections and opportunities that come with diversification. Investors who maximize them through global diversification will likely achieve the best investment outcome in the long run. They will also enjoy te smoothest ride along the way.

Is your portfolio properly diversified to match your risk capacity? Find out with a visit to ifa.com. Take the Risk Capacity Survey. You will be matched with an Index Portfolio that's right for you. Or, if you would like to speak with one of IFA's Investment Advisor Representatives to learn how you can improve your diversification for risk-optimized returns, call 888 643-3133.


	CLICK HERE TO LISTEN	Download MMM-062.mp3

Who still believes markets don't work?

Thu, 27 Mar 2008 09:35:53 GMT

At the heart of the debate of Active vs. Passive Investing, there exists the fundamental question as to whether there are market inefficiencies that are consistently identifiable and exploitable for profit.

Active investors believe that they can apply certain strategies, namely in the form of stock picking, market timing, manager picking and style drift to capture such market inefficiencies and garner wealth. In contrast, passive investors contend that all information that can be known is widely dispersed among all market participants, making it virtually impossible for any one person to consistently possess information they can exploit for profit.

The debate between active vs. passive investing has dragged on for more than 40 years; certainly far longer than necessary as reams of academic research continue to reveal the failure of active management to outperform a passively managed and properly selected market index benchmark. The debate wages on however, for three reasons: First, active managers have a compelling reason to keep the grand illusion of market-beating prowess alive: they charge more money than their passive manager counterparts. They justify this extra expense as the price that must be borne by investors who believe they can achieve “market-beating” returns.

In his eloquent opening statement prepared for just such an active vs. passive debate in October 1995, Rex Sinquefield, co-founder of DFA and now a director with the fund company, elaborated on the temptation of active investing. “It's easy to understand the allure, the seductive power of active management. After all, it's exciting, fun to dip and dart, pick stocks and time markets; to get paid high fees for this, and to do it all with someone else's money,” Sinquefield stated.

The financial motivation is clear for the advisor who actively invests on behalf of his clients, but what is the allure for his clients? This brings us to the second reason as to why the active vs. passive debate lingers on: Hope springs eternal.

While there exists little sound basis to justify active investing—surely the properly benchmarked returns readily reveal the failure of such a strategy—active managers prey on the emotions of investors. They would have them believe that certain signals, known only to them, can avoid large losses or capture big gains. At the center of this hope is the steadfast presumption that there are fundamental discrepancies in free markets that can be exploited for profit. While this notion dangles the carrot of easy money, no such promise can be fulfilled in efficient markets. But, you shouldn’t just take our--or anyone else’s--word for it. Due diligence is the cornerstone of prudent investing. To that end, the 15 pie charts below provide an excellent summary of the results of active vs. passive investing comparisons.

The many studies illustrate that across virtually all asset classes, the corresponding market index outperforms the vast majority of its actively managed counterparts. In fact, the average percentage of occurrences in which active beats passive is just 8%. Whether you look at market-timing stock and fund pickers or actively managed funds benchmarked to the S&P 500 Index, IFA’s Large-Cap Value Index, IFA’s Small Cap Value Index, IFA’s International Value Index, IFA’s Emerging Markets Blended Index, or Vanguard’s Intermediate and Long-Term Bond Funds, the market indexes overwhelmingly dominate the actively managed funds an average of 92% of the time. And some actively managed funds fared far worse. Case in point, in the Long-Term Bond Fund category, the comparison was a knockout blow to active bond fund managers. Sinquefield’s sums up the results of his own studies which mirror these results when he states, “The message is clear: the beat-the-market efforts of professionals are impressively and overwhelmingly negative. In any asset class, the only consistently superior performer is the market itself.”

The third compelling reason that the active vs. passive debate wages on arises out of bad benchmarking. Passive investors conclude that market returns are superior returns. As a result, passive investors buy a blend of market indexes, of market benchmarks, based on risk capacity. Their primary goal is to design and follow an asset allocation that will provide risk-appropriate exposure to markets which have a history of delivering optimized returns. Passive investors have no interest in beating benchmarks. In contrast to passive investors, active investors identify benchmarks that they are expected to surpass. This is faulty logic. The only way to beat a benchmark is to take on more risk than the benchmark, thus rendering the benchmark an inaccurate measuring stick by which to judge active managers. Risk is the source of returns, and taking on more risk is the only way to get more returns. It is also possible however, to take on more risk than the benchmark and not surpass it. This occurs when portfolios are not efficiently diversified and optimized for risk. In either instance, the benchmark is a poor measure to judge active managers.

The chart below represents the investing outcome of a Sample University Endowment Comparison. It is a real-life example of bad benchmarking. It shows the assets of ABC University Endowment with a beginning value of $100 million. The bar on the far left of the chart represents the blended benchmark used to measure the performance of the endowment. The middle column represents the actual growth of $100 million for the endowment. Judging from those two graphs, the managers did in fact deliver returns above the benchmark. However, when compared against IFA Index Portfolio 65, also a blended benchmark with the same equity to fixed income allocation as the university benchmark, we see that the endowment delivered returns far below the more appropriately designated benchmark. This graph illustrates the reason why investors should focus on identifying and allocating to the most appropriate benchmark possible as opposed to selecting a bad benchmark that has little, if any impact on the actual investing methods applied.

Despite the compelling data that clearly and comprehensively expose the folly of active investing, the debate continues. But, it would be wise to consider that, even if we did not have access to the hundreds of studies that comprehensively reveal the inferiority of an active strategy, we would also have to completely disregard the teachings of Adam Smith himself. Sinquefield points out that Smith “was the first to offer a comprehensive statement that markets work and that a free market is the best way for a social order to allocate resources. In his Wealth of Nations he shows that countries with such a system prosper, while those without do not.”

Written in 1776, Smith’s Wealth of Nations argues that free, unregulated economic competition would maximize profits, improve quality and innovation, establish a division of labor and control pricing structure. Smith also established that market competition acts as “an invisible hand” to orderly control pricing and market stability. Smith asserted that no “external designers” are required to control free markets, they function best when left alone to do their job, and he was right.

The portrait below was commissioned by IFA to represent Smith’s Invisible Hand. This colorful image shows the free market system at work as willing sellers and willing buyers make informed decisions based on all knowable information and arrive at a price that is satisfactorily agreed upon by both parties.

According to the logic of active investors, Smith's Invisible Hand does not work so well and mispriced stocks are easy to find. But, we know this to be patently false. We witness the free markets at work every minute of every day. Following the active investor’s reasoning to its logical conclusion, it insinuates that the free markets in which we all participate do not really work, and that there is information known only to a precious handful of individuals—an elite group whose lucky members will invest on your behalf, charging you a larger fee for that privilege. Such a market in which information is made available to a select group of individuals describes an entirely different type of social structure, one that is inherent exclusively in socialist economic structures. Sinquefield asserts, “It is well to consider, briefly, the connection between the socialists and the active managers. I believe they are cut from the same cloth. What links them is a disbelief or skepticism about the efficacy of market prices in gathering and conveying information.”

When you get down to it, the active vs. passive debate remains compelling only when an awful lot of reality is suspended. The simple truth is that market returns are the superior returns. The best way to invest your hard-earned money is to buy a passively managed and globally diversified blend of indexes that matches your risk capacity. You don’t need to try to beat the benchmark, you need to buy the benchmark. Over time, you will be best off by investing in a blend of market indexes. This low-cost, risk appropriate strategy is your best way to earn your share of the returns that are provided by our very profitable free market system, over the long term.

Which blend of indexes is right for you? The answer to that question is the most important determiner of your all-important asset allocation. Index Funds Advisors is an expert in measuring and quantifying risk capacity for individuals, 401(k) plans, institutions and corporations. This important measure enables investors to make sound decisions that can help them earn risk-optimized returns. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost and efficient.

What’s your risk capacity? Take the no-obligation 10-minute survey, or call to speak with an Investment Advisor Representative 888-643-3133.

Chances are you won't beat an Index Fund

Mon, 19 May 2008 17:50:53 GMT

David Swensen is an impressive investor. Since taking on the job of managing the Yale University Endowment back in 1985, he has generated net investment returns that average 16.8% a year, more than any university, foundation or pension fund.

Swensen is highly respected among his peers and aspiring investment managers, most of whom regard him as the gold standard for investment managers. In fact, former Harvard University Endowment investment manager, Jack Meyer, said in a 2005 interview, “I think David is the best in the business.”

Swensen’s reputation fast approaches legendary. In 1985, he took over the management of the Yale University Endowment with just $1.3 billion in the coffers, 45% less than it was worth previous to high inflation and poor stock market performance. At the time Swensen took the helm, spending was frozen, and the outside company formed by Yale to manage the endowment had been fired for poor management.

In an effort to bolster the endowment’s performance, Swensen looked no further than the lessons learned from his former economics professor and Nobel Prize winner James Tobin. Doing so, he quickly surmised that the fund suffered from a severe lack of diversification; more than 75% of the money was invested in U.S. stocks, bonds and cash. Swensen’s summary judgment was that the fund was “taking on too much risk and missing out on opportunities.”

Swensen set out to diversify the portfolio. In doing so, he grew the portfolio to more than $22 billion in assets as of April 2008. “Think of it this way:” states an article in the July/August 2005 issue of Yale Alumni Magazine, “a $10,000 gift made in 1985 would have grown by now [as of June 30, 2005] to $158,328, assuming none of it had been spent. That performance handily beats stock market returns of $95, 226, as measured by the S&P 500.”

Indeed, Swensen’s accomplishments are impressive. He is considered an unassuming hero to the New Haven campus, which is now pleasantly adorned with state of the art buildings, the result of $1 billion invested in facilities for science, engineering, and medicine, along with dramatic increases in financial aid. Quite simply, Swensen’s accomplishments have transformed the university. Certainly, there are plenty more improvements, additions and awards on the horizon as the endowment now spends annually 5.25% of the endowment’s value. This year, the allowable expenditures total roughly the same amount that the endowment was worth when Swensen came on board, an impressive irony.

Despite Swensen’s enormous success, there exists a cloak of secrecy surrounding the endowment’s investments. The tax status of the endowment allows for minimal tax-reporting disclosure, a privilege Swensen covets to the fullest. As a result, we have very little insight as to how Swensen achieved his exemplary returns. We do know, however, that the endowment invests in publicly traded companies; private equity, including timberland in Maine and Idaho, hotels and restaurants, and newly privatized companies in Russia and small companies in China—some of which are highly illiquid assets.

Academics have determined that over the long haul, returns from efficient markets are the result of risk, and they have identified a direct correlation between specific risk exposures and returns earned.

In contrast to the cloudy view we have of the Yale Endowment’s investments, index funds investing allows complete transparency and liquidity. Take, for example, IFA Index Portfolio 100, an index portfolio that invests in 11 indexes and carries 80 years of simulated risk and return data. The chart below shows a comparison of Yale’s Endowment, the S&P 500 Index and IFA Index Portfolio 100 for the 20-year period from 1985 to 2005 (the time period stated in the article, and assuming fiscal endowment year). As you can clearly see, you do not have to sacrifice transparency or liquidity to achieve those returns, you just have to buy a small value tilted all equity index portfolio that controls costs and turnover expenses.

Swensen himself is a vocal proponent of index investing, which he labels an “unconventional approach” because most investors follow active fund managers. He says they do so despite the fact that actively managed funds harbor an inherent conflict of interest that ultimately favors fund company profits over investor returns.

On numerous occasions, he has espoused the virtues of his unconventional approach that supports the buying, holding and rebalancing of a diversified index portfolio that keeps expenses and turnover low. An April 3, 2008 NPR article quotes Swensen, “’When you look at the results on an after-fee, after-tax basis over reasonably long periods of time, there's almost no chance that you end up beating an index fund,’ he says. The odds, he says, are 100 to 1.”

Finally, in his book A Fundamental Approach to Personal Investment, Swensen states, “Compelling data show that nearly certain disappointment awaits the mutual fund shareholder who hopes to generate market-beating returns”. Swenson continues, “the market contains a number of attractively structured, passively managed investment alternatives, affording investors the opportunity to create equity-oriented, broadly diversified portfolios.” And he concludes, “In spite of the massive failure of the mutual fund industry, investors willing to take an unconventional approach to portfolio management enjoy the opportunity to achieve financial success.”

Index funds, an alternative to actively managed funds

Mon, 12 May 2008 17:50:53 GMT

he investing spotlight continues to shine brightly on defined contribution retirement plans, threatening to expose hidden costs that investment managers audaciously believed they could foist upon unsuspecting plan sponsors and participants.

In a flurry of momentous events that have transpired in just a few short weeks, the nearly 50 million American workers who participate in company-sponsored retirement plans, most commonly in the form of 401(k) plans, are poised to get some much-needed clarity on expenses, risks and returns associated with investing their retirement assets.

Michael Keenan’s article “The Elephant in the Living Room”, found in the May 2008 issue of Financial Advisor magazine, explains the real costs associated with most 401(k) plans—costs that are buried, despite the fact that they cost plenty and suppress returns. Keenan details the known (explicit) costs and hidden (implicit) costs of traditional 401(k) plans, giving plausible explanation as to why many 401(k) plans actually underperform their taxable account brethren.

Keenan states, “Index funds incur about 80% less in transaction costs than actively managed funds”. According to that assumption, index funds carry just 0.18% in annual transaction expenses.

The table below shows the turnover ratios of various funds for the one-year period for 2006. As you can see, passively managed index funds have far less annual turnover than actively managed funds. For example, the Dimensional Large Cap Value Fund had 9% annual turnover and the Dimensional Small Cap Value Fund had 27%--a sharp contrast to the Rock Canyon Top Flight Fund with turnover of more than 1600%. If we extrapolate from the ITG data, that fund’s turnover would have generated a whopping 15% in transaction expenses! What were they thinking?

IFA is an expert in providing professional investment education and advice, enabling individuals, 401 (k) plans, institutions and corporations to make sound decisions that can optimize their financial futures. IFA specializes in the passive rebalancing of risk-appropriate, globally diversified index portfolios that are low cost and efficient. To lean more, click here.

Risks and benefits of hedge fund investing

Thu, 01 May 2008 17:35:09 GMT

In July 2005, a group of 32 distinguished economists met in Sonoma, California to discuss the risks and benefits of hedge fund investing. The eminent economists, including renowned professors from London School of Economics, Wharton, Stanford, Cornell, and UCLA, to name a few, as well as Nobel Prize winners and Federal Reserve Bank economists convened to discuss the pros and cons of hedge fund investing for institutions and wealthy individual investors. Their goal was to develop a cohesive statement to reflect their collective views regarding these increasingly popular, but unregulated investment vehicles.

Hedge funds have grown rapidly in recent years and are now about one-eighth the size of mutual funds, accounting for more that $1 trillion of assets invested today. Unregulated by the SEC, hedge funds fall under the category of limited partnerships, enabling them to disclose less information, and incorporate more aggressive investing strategies because their clients are considered to be “sophisticated investors”.

The Financial Economists Roundtable (FER) expressed concern that the rapid increase in popularity of hedge funds has fiduciaries and plan sponsors leaping into investment without fully understanding the risks associated with them. As such, they set forth their signed statement, delineating their concerns regarding hedge funds.

Based on their findings, we have compiled:

IFA’S TOP TEN REASONS TO AVOID HEDGE FUNDS

1.	"Hedge funds investors do not fully understand the true returns nor the risks they bear."
2.	"Hedge funds can employ leverage, thereby amplifying the variability of outcomes."
3.	"Hedge funds restrict redemptions so investment is largely illiquid."
4.	"Their management expenses are very high and their investment strategies are often risky with a small probability of very large losses."
5.	"The asymmetric fee structure creates an incentive for the general partner to adopt a high-risk investment strategy, since he/she stands to make a large return if the strategy is successful but not to suffer losses if the strategy fails."
6.	"The average life of a hedge fund is only about 3 years."
7.	"Expenses are high. The management fee to the general partner usually is 1 to 2 percent of assets, payable annually, and there often is an asymmetric performance fee in addition. This incentive, or carried interest, fee usually is 20 percent, and is often structured to be paid only if cumulative returns over time exceed a threshold return, known as the ‘high-water mark.’ When cumulative returns fall below this mark, the general partner can close the fund, then start a new one in order to establish a new base mark for generating performance fees."
8.	"The returns on many hedge-fund strategies are not normally distributed, but have a distribution characterized by fat tails...day by day there is a small probability of a large loss. Tail risk makes standard measures of return volatility and performance, such as the Sharpe ratio, inappropriate guides to investors. By its very nature, tail risk is difficult to measure."
9.	With the tail and exit risks involved, together with a lack of transparency, the FER has concerns about "whether a large exposure to hedge funds is appropriate for pension funds and other fiduciary investors who make investments on behalf of others, particularly retail investors."
10.	"Risk-adjusted average returns tend to be overstated, because of survivorship bias and other reporting and data problems, making it difficult to compare hedge-fund performance with competing alternatives."

The FER’s Executive Summary recommends:

Banking regulators should NOT rescue troubled hedge funds. Their justification is that the prospect of free government "bail-out" insurance will only encourage speculative behavior.

The development of a standardized measure of performance and risk to foster a deeper understanding about the real volatility and returns associated with hedge funds. They stated, “There should be standardized measures pertaining to gross and net returns, expense ratios, leverage, volatility of returns, credit risk and liquidity.”

In-depth research to determine the impact of an asymmetric fee structure on investment behavior.

Finally, the 32-member FER concluded that even if each of the recommended measures were implemented, they would still advise a stance of “buyer beware” or "Caveat emptor" when it comes to hedge funds investing.

If On The Chart It Doesn't Sit, Don't You Dare Buy It

The chart below represents Harry Markowitz’s Efficient Frontier, also known as a Risk Reward Optimization Chart. This simple, yet profound chart earned Markowtiz the Nobel Prize in Economics in 1990, along with William Sharpe (who is a member of the FER), and Merton Miller. The x-axis represents the risk of an investment, as measured by standard deviation of returns. The y-axis represents the reward of an investment as measured by annualized returns.

To View In Dynamic Form, Click on Chart

On this chart are plotted the 35-year risk and return characteristics for IFA’s 20 Index Portfolios (numbered sequentially 5-100), as well as for the 15 IFA Indexes (circled letters) and four market indexes tracked by IFA (squares), but not included in the Index Portfolios. (You can also view the 80-year, 50-year and 20-year Risk Reward Optimization charts by clicking on the menu on the right-hand side of the dynamic chart.)

As you see, we compare our IFA Index Portfolios and IFA Indexes against the Total Market Index, the S&P 500 Index and the NASDAQ Index. We can also plot other indexes and individual stocks on this chart to compare them against one or all of our index investments. However, you cannot plot a hedge fund on this chart. Recall the FER determined that hedge funds are not normally distributed. Head-to-head comparisons cannot be made between non-leveraged, transparent equity investments and leveraged, illiquid and opaque investments that carry risks not represented by standard deviation alone.

The risk reward optimization chart is the cornerstone of fiduciary prudence and Modern Portfolio Theory. Fiduciaries should never make an investment they cannot plot on this chart. And, given the abundance of prudent investments that carry ample risk and return data, they have no reason to do so.

Index funds are the ideal way to implement fiduciary prudence. They carry ample risk and return data. They are liquid, transparent, carry low fees, no leverage and no performance incentives. Best of all, your investment decisions will carry 80 years of risk and return data so you invest according to the laws of probability, not speculation.

Managers who can beat the street

Mon, 28 Apr 2008 17:06:47 GMT

Q: That's pretty pessimistic.
A: Yes. But because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value . The investment business is a giant scam. It deletes billions of dollars every year in transaction costs and fees.

Q: So what should individuals do?
A: Most people should simply have index funds to keep their fees low and their tax down. No doubt about it."

Jack Meyer’s assessment of the investment business and his conclusion that managers fail to even match their benchmarks are well supported in numerous studies. Specifically, a recent study conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University reveals the pitfalls associated with hiring managers based on their recent returns above benchmark. The study, "The Selection and Termination of Investment Management Firms by Plan Sponsors" found that manager hiring and firing decisions made by plan sponsors on behalf of retirement plans, endowments, and foundations was a complete waste of money and the board members’ precious time.

The professors built a unique dataset comprised of the hiring and firing decisions of approximately 3,700 plan sponsors over the 10-year period from 1994 to 2003. With data representing a whopping $737 billion allocated to hired investment managers and the withdrawal of $117 billion from fired investment managers, they concluded that plan sponsors hire investment managers after large positive excess returns up to three years prior to hiring. However, this return chasing behavior does not deliver positive excess returns thereafter as post-hiring excess returns were indistinguishable from zero.

The results of the study, as set forth in the figure below, reveal that during the ten-year period from 1994 through 2003, consultants and boards that based their fund manager hiring decisions on recent above benchmark past performance were largely disappointed with subsequent results. IFA incorporated into the study the estimated annual 0.5% management fee and an annual 0.5% cost of transition in the after-hiring manager returns.

The professors also determined that plan sponsors often fired their current managers in favor of another group of recent top performers, repeating the cycle again. This cyclical motion undermines their investment policy statements and the opportunity of achieving market rates of returns (index returns) commensurate with the risks they take.

In addition to analyzing the selection and termination of investment managers, the study also examined a set of round-trip firing and hiring decisions, tracking the subsequent performances of the fired managers as well as the hired. In reference to their findings, the study concludes, “the post-firing returns of fired investment managers are generally larger than the post-hiring returns of hired investment managers. Given the magnitude of the return differences, and the transactions costs associated with transitioning portfolios from fired investment managers (legacy portfolios) to hired investment managers (target portfolios), our results suggest that the termination and selection of investment managers is a costly endeavor".

The figure below illustrates the study’s determination that plan sponsors terminate investment managers after underperformance, but the excess returns of these managers after being fired are frequently positive. The chart set forth a matched sample of firing and hiring decisions, showing that if plan sponsors had stayed with their fired investment managers, their excess returns would be larger than those actually delivered by their newly hired managers.

The chart below reflects the results of manager picking by plan sponsors that hire and fire investment managers based on performance. In a larger context, this chart also illustrates, with abundant clarity, the cost of manager picking, the outcome of which is captured losses and missed opportunity — a bad combination!

The “Discussion” at the end of the study states, "How does one interpret this evidence? One way to think about this is in terms of opportunity costs and frictions. For hiring decisions that are necessitated by the termination of an existing investment manager (due to performance, organizational or reallocation reasons), the opportunity costs of hiring can be identified as the returns that the fired manager would have delivered relative to what the hired manager actually delivers. Our round-trip results suggest that these opportunity costs are positive."

Further evidence of the underperformance of institutions is found in the average investment performance of university endowments as determined from information provided by the National Association of College and University Business Officers (NACUBO). NACUBO’s membership totals more than 2,500 U.S. colleges and universities. In part, NACUBO provides comprehensive annual data that reports on the financial status of university endowments, and is the industry standard for such information.

The charts below show five and ten-year comparisons for the average nominal rates of returns for various levels of asset pools versus comparable IFA Index Portfolios. The specific IFA Index Portfolios were selected based on the average percentage asset allocation to fixed income/cash equivalents, as provided by NACUBO. For each of the time periods shown, and at all asset levels, the comparable Index Portfolios outperformed the average endowment's returns. This demonstrates that across all asset levels, it is a superior strategy to buy the asset class benchmarks rather than to attempt to beat them. Additionally, the Index Portfolios' returns were derived through global diversification, risk and return optimization, investment transparency and no use of speculation or leverage.

The passive rebalancing of index portfolios is a very low-cost and low-maintenance investment strategy that minimizes need for in-house investment staff, board member involvement, consultant involvement and the time consuming, useless and costly process of manager selection and termination.

Finally, given that this week’s investment lesson begins with the sage words of Jack Meyer, former investment manager of the highly regarded Harvard University endowment, it seems most fitting to include an interesting comparison of an index portfolio to the two most widely respected university endowments.

Most investors, institutional and otherwise, would consider themselves quite successful to mirror the performance of world-class endowments such as Harvard and Yale. In fact, their investment performances are considered second to none, and are likely the envy of every endowment investment committee. The very nature of the size of the two endowments enables them to invest in investments that are simply not available to endowments that do not have tens of billions of dollars to manage. In addition to fixed income and equities, big endowments heavily invest in alternative investments in order to further diversify their portfolios, purchasing private equities, hedge funds, commodities, natural resources, real property, etc. They hire expensive staff to implement their complicated investment policy statements. The risks of the portfolios of the behemoth endowments are incalculable, but their returns are not.

The chart below is a 23-year comparison between the average annualized returns of the Harvard and Yale endowments and the IFA Index Portfolio 100. As you see, over the 23-year period of time, there is scant difference between the returns of the three portfolios. However, the Harvard and Yale endowments carry risk that cannot be quantified, mostly due to leveraged positions in hedge funds, whereas the IFA Index Portfolio carries with it 80 years of risk and return data, without leverage.

The fundamental lesson to be learned by each of these studies, and the hundreds of other studies that reveal a similar conclusion, is as follows: stock market returns are compensation for risk, not speculation. The risk taken is the best explanation of the returns earned. Looking forward, the risk you take is the best determinant of the expected return. The key is to avoid all forms of active management, and instead become a passive rebalancer by investing in risk-appropriate allocations of index funds that carry long-term risk and return data for optimizing returns, rebalance to maintain that risk exposure, and call it a day. It’s that simple.

Index Funds Advisors specializes in matching individuals and institutions, including corporations, foundations, endowments and perpetual care entities, with risk-appropriate blends of indexes that have shown to deliver the rarely exceeded risk-appropriate returns over time. To learn how you can implement a low-cost, risk-optimized passive rebalancing investing strategy, click here.

Active Management Taxes

Mon, 14 Apr 2008 17:01:07 GMT

With April 15th quickly approaching, investors are busy collecting their 1099s, Capital Gains and Loss Reports, and brokerage statements and submitting them to their accountants for the annual bad news of how much taxes were generated by their investment managers last year. If you are a long-term, low-turnover, tax-managed and tax-efficient indexer (congratulations), Uncle Sam and most state governors will be sad to hear that you have kept your taxes to the absolute minimum.

But, if you are an active investor, they will be very pleased to see your contributions federal and state government. I hope active investors find joy in giving.

The Tax Effect

The tax effects on actively managed mutual funds are rarely evident from the reported data. Since investors do not feel the tax bite until the following April 15th, most investors do not consider more than 17% of their pre-tax returns as lost to taxes.

According to a study conducted by John Bogle over a sixteen-year period, investors only get to keep 47% of the cumulative return of the average actively managed mutual fund, but they keep 87% in a market index fund. This means $10,000 invested in the index fund grew to $90,000 vs. $49,000 in the average actively managed stock mutual fund. That is a 40% gain from the reduction of silent partners. The effect reinforces the substantial value of passively buying and holding stocks in an index fund.

Managers of Active Funds Seem to Manage Money as if Taxes do not Matter

Historically, many active mutual fund managers managed pension plans and other tax-free pools of money, so they did not have to worry about the tax impact of their investment trades. As a result, managers of active funds today often disregard the high taxes generated by their stock picks and market timing, not to mention the adverse effect these flawed strategies have on fund performance. Realized capital gains taxes are rarely highlighted in active mutual fund performance ratings, thereby catching the average active mutual fund investor by surprise when they prepare their tax return.

Let's review the case of Invesco’s Asian Growth Fund. At the end of 1997, this company distributed 21% of its net asset value, but lost over 38% throughout the year. An investment of $10,000 at the beginning of 1997 lost $3,800 before the $2,100 gain on which taxes must be paid. Realized capital gains can be taxed in two ways: long-term (12 months or longer) capital gains or short-term dividends. The federal tax code ensures that long-term capital gains are taxed at more than half the tax rate of short-term capital gains or dividends.

Another example of shareholders being hit with a surprise taxable event can be seen in Fidelity Magellan’s $22.36 per share (18% of total share value) distribution in May 2006. This unexpected and large capital gains distribution, which was prompted by a massive change (style drift) in Magellan’s stock holdings, caused an unnecessary and sizeable tax burden on the fund’s shareholders.

Taxes do Matter

Instead of being distributed and taxed, unrealized capital gains are gains that have not yet been realized for tax purposes. Unrealized capital gains remain a growing part of the net asset value of a fund, rather than being distributed to the investor. The index fund manager minimizes portfolio turnover, and so maximizes unrealized capital gains. When stocks in an active fund increase in value and are sold for a profit by the fund’s manager, the result is that the fund actually realizes taxable gains and investors pay most likely short term capital gains taxes on those distributions. On the other hand, by the time an investor is ready to realize an investment gain in an index fund, it will most likely be a long-term capital gain, which has compounded many years in their portfolio.

Stanford University released the results of a 30-year study in 1993 that examined the difference between the average pre-tax, after-tax, and liquidation performance of 62 actively managed stock mutual funds. Pre-tax performance assumes reinvestment of all distributions, after-tax assumes reinvestment of distributions left after taxes have been paid, and liquidation is selling out completely and paying all taxes, rather than reinvesting in the fund. The study also took into account differing tax brackets, whether high (55% taxes paid), medium (41%) or low (25%). According to the study’s results, between 1963 and 1992 it was found that a high tax bracket investor who reinvested after-tax distributions ended up with an accumulated wealth of 45% of the fund’s published performance. Investors in a middle tax bracket realized 55% of published performance.

The study also found that although each dollar invested in this group of funds would have grown to $21.89 in a tax-deferred account, the same amount of money invested in a taxable account would have produced only $9.87 for a high-tax-bracket investor. Taxes cut returns by 57.5%! The higher the returns of an actively managed mutual funds, the higher the probability of creating short term capital gains tax liabilites.

Actively managed mutual fund advertisements and published ratings feature pre-tax returns, often misleading investors. Only in the very fine print will you see mention of after tax returns. In fact, Robert Jeffrey and Robert Arnott showed in their 10-year study titled “Is Your Alpha Big Enough to Cover its Taxes?” that on an after-tax basis, and adjusted for fund loads or commissions, a simple low-cost and low tax S&P 500 index fund outperformed 97% of the active mutual funds in the study.

The primary reason passive investors pay taxes is to rebalance their portfolios, and this only makes sense because the benefits of maintaining of their target risk exposure level is worth the cost of the long term capital gains incurred from rebalancing.

So Uncle Sam is saying to active investors, "go ahead with your speculation; make my day." Passive rebalancers, on the other hand, avoid the uneccessary burden of high taxes and instead recognize that investors are compensated for bearing risk, not trading risk.

Hidden Fees in 401k

Mon, 21 Apr 2008 15:28:12 GMT

American workers scored a coup on April 16, 2008 when the Committee on Education and Labor passed a long-needed bill to expose hidden 401(k) fees and encourage every 401(k) plan in the country to offer an index fund investment option among the menu of choices. Doing so would protect plan sponsors from legal liability for participants' investment losses.

According to the legislation, the nearly 50 million American workers who save for retirement through company-sponsored retirement plans would receive clear and complete information about fees that the Committee suspects take an inordinate bite out of returns. The legislation approved by the Committee aims for full disclosure that will give individuals a clear understanding of the fees associated with their plans. Past surveys have shown that more than 80 percent of workers don’t know how much they are paying in fees on their retirement savings accounts.

“For too long, companies in the financial services industry have maintained a stranglehold on retirement savings that they didn’t earn and that don’t belong to them,” said Rep. George Miller (D-CA), chairman of the House Education and Labor Committee. “The purpose of this legislation is to take these hard-earned savings away from the special interests and return them to their rightful place – the retirement accounts of American workers. Workers are entitled to clear and complete information about their own savings,” Miller added.

According to a press release on the Committee on Education and Labor website, the revised version of the 401(k) Fair Disclosure for Retirement Security Act (H.R. 3185) adopted by the Committee, would:

“Require 401(k) service providers and plan administrators to provide complete disclosure of fees charged on 401(k) plans broken down into four categories: administrative fees, investment management fees, transaction fees, and other fees;

Help workers understand their investment options by providing basic investment information, including information on risk, return, and investment objectives;

Require plan administrators to offer at least one low-cost index fund to plan participants in order to receive protection against liability for participants’ investment losses;

Require service providers to disclose financial relationships so companies that sponsor 401(k) plans can make sure there are no conflicts of interest; and

Give the U.S. Department of Labor the authority to enforce new disclosure rules and fine service providers who violate them.”

“Miller said the issue is particularly important given that increasing numbers of American workers are relying on 401(k)s to help them pay for a decent retirement”, the release also stated.

Miller’s opening statement before the Committee requested a mandate for an index fund option plan choice. He articulated the virtues of index funds, stating, “Studies have shown that index funds outperform an overwhelming majority of actively managed, often higher cost funds.” Miller pressed not only for low-cost index funds options, but also education that would make investors more aware of the expected risks and returns that are associated with their investment options. He asserted. “To help workers better understand their investment options, the bill would require 401(k) plans to provide workers with key information on their options, such as historical risk, returns and fees.”

The need for employee education is dire. The evaporation of traditional pension plans forces many employees into a situation they do not understand. Under the pension paradigm, workers did not necessarily concern themselves with what their pension plans were invested in, or what their employers paid for those investments. Today, 401(k) plan investing requires that employees have the knowledge to make important decisions that will shape their financial futures.

Shedding light on the pervasive lack of investor education, the IFA chart below shows data revealed by Chairman Miller at the April 16, 2008 hearing. According to a July 2007 AARP study, only 17% of employees know how much they pay in fees and expenses in their 401(k) plans.

Further information revealed at the hearing shows that the lack of understanding about fees and expenses relating to 401(k) plans plays a devastating role in the long-term retirement savings of employees. The IFA chart below, assembled from material presented at the hearing, shows the extent to which excessive fees can delay workers’ retirements. Research from the Center for American Progress shows the additional months required to work in order to receive the same monthly income in retirement when fees exceed those of a benchmark index. The red bar on the right shows that a worker would have to work an additional 64 months – more than five years -- if they paid 2.0% in fees above the benchmark index.

The financial impact of high-cost vs. low-cost investments in retirement accounts is clearly set forth in the chart below which shows that investors who chose a high-cost option would, after 30 years, have a whopping 33% less than an investor who paid fees equal to fees charged by the average index fund!

The results of the studies go a long way toward explaining why the Committee has taken such a strong position in the advocacy of index funds investing:

Low fees and expenses
Historical risk and returns data
Higher expected risk-optimized returns

The more investment education an individual gains, the more desirable an indexing strategy becomes. In its wisdom, the Committee extensively researched the 401(k) investing landscape. It listened to independent consultants to analyze the existing system and make recommendations to improve upon the retirement investing experience of potentially hundreds of millions of Americans. Their research brought them to advocate an investing path that they themselves enjoy — index funds.

John C. Bogle brought this realization to light in his most recent book, The Little Book of Common
Sense Investing:

“The simple index fund solution has been adopted as a cornerstone of investment strategy for many of the nation’s pension plans operated by our giant corporations and state and local governments. Indexing is also the prominent strategy for the largest of them all, the retirement plan for federal government employees, the Federal Thrift Savings Plan (TSP). The plan has been a remarkable success and now holds some $200 billion of assets for the benefit of our public servants and members of armed services”, Bogle states.

Index Funds Advisors is an expert in advising individuals, 401(k) plans and institutions on the benefits of risk-appropriate index investing. If you would like to learn how you can keep your fees low and earn risk-optimized returns, call to speak with an Investment Advisor Representative at 888-643-3133, or go to ifa.com and get started by taking the Risk Capacity Survey.

Reported Mutual Fund Returns

Mon, 07 Apr 2008 15:17:17 GMT

In the June 2002 issue of Money Magazine, Jason Zweig gets to the bottom of what mutual fund investors really earn. He describes the difference between the returns that mutual funds report and the actual returns of the average investor in those funds. Active investors chase hot funds. As a consequence, they end up with less than one fifth the funds' annual returns. When inflation and our estimate of taxes are deducted, it is not a pretty picture for active investors. See below.

The table below illustrates some of the details of this unique study. The large gap between the funds' and shareholders' returns was a shock to even the researchers.

The reason for this gap is attributed to active investors who followed the destructive behavioral patterns that Dalbar Research had been describing since 1994. These patterns include waiting for funds to have a good year or two followed by pouring in a flood of cash just before the fund reaches its peak. Then they ride the fund to near bottom and sell.

One encouraging exception was the Dimensional Fund Advisors (DFA) institutional index funds. Because the shareholders of these funds buy and hold diversified portfolios at all times, they ride out the market gyrations and end up obtaining market rates of returns. The table below shows the worst big funds ranked by how investors performed relative to the funds and five DFA funds listed in the article.

In one example from the study, the Firsthand Technology Value fund racked up an impressive annualized return of 16% from 1998 to 2001. However, the investor return over this period was a devastating 31.6% loss. In total it was estimated that investors lost $1.9 Billion in this fund over this period, while the fund reported time-weighted returns of 16%. The head of fund marketing for Firsthand stated, "... people lost a lot of money because they took oversized bets in technology at the wrong time." A careful analysis of the chart below will reveal the tragedy of active investors behavior.

A study released by Dalbar in 2006 came up with similar results, but over a much longer period. The study indicated that during the 20 years from 1986 to 2005, the average stock fund investor earned returns of only 3.9% per year, while the S&P 500 returned 11.93%. On an inflation adjustedReturn, the average equity fund investor earned $19,625 on a $100,000 investment made in 1986, while the inflation adjusted return of the S&P 500 would have been $400,938 or 20 times greater, as shown in Figure 1-2 and Figure 1-3.

Dalbar previously conducted similar studies in 1994 and 1998. The 1998 study found that the return of the S&P 500 was five and a half times greater than what the average investor earned. All three studies showed that the average fund investor earned much lower returns than the S&P 500 or the average mutual fund. Clearly, investor behavior can have a far more negative impact on investment performance than investors realize.

Some investors can benefit from enlisting an investment educator or mentor who will focus on changing their investing behavior, encourage long-term investing, and discourage the gambling practices of trying to beat a market

Figure 1-2	Figure 1-3
Dalbar, Inc. Investor Behavior Studies 2001 - 2003 - 2004 - 2007

The fund tracking service Morningstar started disclosing these "investor returns" in 2006. On the Data Definition page of their web site, they state that "Morningstar investor returns (also known as dollar-weighted returns) measure how the typical investor in that fund fared over time, incorporating the impact of cash inflows and outflows from purchases and sales. In contrast to total returns, investor returns account for all cash flows into and out of the fund to measure how the average investor performed over time. Investor return is calculated in a similar manner as internal rate of return. Investor return measures the compound growth rate in the value of all dollars invested in the fund over the evaluation period. Investor return is the growth rate that will link the beginning total net assets plus all intermediate cash flows to the ending total net assets."

Now that Morningstar is tracking such data, investors bad behavior is finally quantified, as well the advantages of using a passive advisor who helps reduce investor error. In the Morningstar Indexes Yearbook: 2005, they analyzed how the average index investor did on their own versus those that are guided by an advisor using asset class index-type funds from DFA. Here is what they had to say:

"Consider the success Dimensional Fund Advisors (DFA) has had in selling its funds through advisors who undergo training on the merits of passive investing and in portfolio construction theory. Consider that over the past decade the dollar-weighted return of all index funds was just 82% of the time-weighted return investors could have gotten with those funds. Yet, the figures for DFA are much better. In fact, the dollar-weighted returns of DFA funds over the past 10 years are actually higher than their time-weighted returns [see Table 1-3]. Suggesting advisors who use DFA encourage very smart behavior among their clients, even buying more out-of-favor segments of the market and riding them up, rather than buying at the peak and riding the trend down, which is usually the case with fund investors."

Table 1-3

The emotions of active investors go up and down like a roller coaster, leading them to negative returns on average, after expenses and taxes are deducted. Results of studies like those presented herein should enable investors to resist the behaviors that have caused them such despair and poor results in the past.

The Bigger Fool

Mon, 31 Mar 2008 15:07:10 GMT

Could there be more appropriate quote to summarize a current hedge fund disaster on this April Fool's Day?

It appears that hedge funds investors may suffer from “Long-Term” memory loss. This is the only plausible explanation as to why investors could have lived through the hideous Long-Term Capital Management (LTCM) debacle that lost its investors $4 billion in 1998 and still trust one of its founders with their hard-earned dollars in more hedge funds.

Falling into the “fool me once, shame on you, fool me twice, shame on me” category are those who invested in JWM Partners LLC, knowing that the man at the helm, John Meriwether helped set into motion a global financial crisis when LTCM imploded ten years ago. This second time around provides a sickening sense of déjà vu for the hedge fund world as Meriwether’s latest and largest hedge fund, Relative Value Opportunity Fund, has plunged 28% this year and another broader market fund is down 6%, with “subpar performances last year” for both, according to The Wall Street Journal.

In a March 27, 2008 Wall Street Journal article titled “A Decade Later, John Meriwether Must Scramble Again”, Jenny Strasburg states “Some investors in the funds are seeking to get their money out. Mr. Meriwether and his colleagues at JWM Partners LLC -- which he launched in 1999 with LTCM alumni -- are trying to reassure investors in the two funds that they have slashed risk and will use their experience to survive this market crisis, preserving about $1.4 billion in assets.” They “will use their experience to survive”? While this statement may have intended to stem the tide of cash running for the door, any investor who has studied the devastation caused at and by LTCM should grab their cash and bolt.

Back in 1998, the disaster that boiled under the surface at LTCM was left unchecked as the hedge fund enjoyed a steady up-tick in value from its 1994 inception until February 1998. But, when the market, inevitably turned against the hedge fund, massive leverage of 50-1 was revealed (the fund actually borrowed as much as $50 for every $1 invested!) When the blood-letting was done, the fund had hemorrhaged $4 billion in losses, initiating a Wall-Street led bailout and congressional hearings on the dangers of hedge funds.

Meriwether’s latest hedge fund is frighteningly similar to LTCM. According to Strasburg’s article, “Mr. Meriwether's recent troubles partly stem from borrowing. His bond fund had $14.90 in borrowed money for every $1 in equity."

The fund’s performance is also reminiscent of what transpired at LTCM. Take a look at the chart below. Just as with LTCM, the fund showed profits for every year since inception. That is, until its excessive use of leverage caught up with the fund when the market turned and it fell off a ledge. In fact, this is IFA's new term for hedge funds: ledge funds. It is a portmanteau word: (a word that is formed by combining both sounds and meanings from two or more words.)

Leverage + Hedge Fund = Ledge Fund

Ten years after the devastation of LTCM, ledge fund managers seem to have remained brazen when it comes to excessive risk and speculation, perhaps expecting the investors are becoming increasingly desensitized to the enormous losses that come with ledge funds. And, why not? When most ledge fund managers get 2% management fees and 20% in performance fees, all of that leverage can fatten up a ledge fund manager’s bank account before the proverbial “you know what” hits the fan and investors limp away, having successfully transferred their wealth to the ledge fund managers.

APRIL 1 PROCLAIMED “INDEX FUNDS DAY”

AVOID THE FOOLISH BEHAVIOR OF STOCK PICKING

IFA, along with a consortium of top fee-only financial advisors, has formed an alliance to declare April 1 Index Funds Day to expose the biggest hoax played on investors every day. The active money management "you can beat the market" myth has fooled investors into thinking that money managers can beat the market by forecasting the next news story that will move market prices. The fact is, news is random and cannot be predicted. Likewise, stock price movement is volatile, so picking stocks is largely a matter of luck, and success cannot be sustained over time.

April 1st is the ideal time to draw attention to the differences between active investment management and indexing – to illustrate why it is a fool's game to think you can outperform a market average or index given the unpredictability of news and randomness of stock market prices.

We chose April Fools Day to showcase the foolishness of stock picking over index funds. Decades of research by top academics and Nobel Laureates continue to show that index funds, which are based on Efficient Market Hypothesis, will preserve and enhance an individual's portfolio over the 30 to 50-year average investment lifetime. This is in direct contrast with stock picking which may deliver good returns in the short run but seldom, if ever, over time.

Consider this – research has shown that only 3% of active managers beat an appropriate index over a period of 10 years or more. In fact, Dalbar Research's 2005 Investor Behavior report showed that the average equity investor earned 3.90% annually for the 20-year time period of 1986 through 2005, while the S&P 500 Index delivered 11.93% a year over the same time period. On an inflation adjusted return, the average equity fund investor earned $19,625 on a $100,000 investment made in 1986, while the inflation adjusted return of the S&P 500 would have been $400,938 or 20 times greater The math is there and it is not pretty for active investors.

Efficient Market Hypothesis coupled with a careful matching of risk capacity and risk exposure, are the keys to successful investing, not speculation. Active investors need to be aware that the expected long-term return on speculation is zero, minus their costs, which include commissions, management fees, margin costs, stock randomness and more.

History has shown that a diversified, tax-managed small-value-tilted portfolio of index funds will have better results than actively managed investments, which are higher risk and deliver lower returns over a portfolio's lifetime. Why is this important? Because close to 90% of individual investors actively manage stocks they pick themselves or they buy mutual funds where stocks are picked for them.

Free market principles are the cornerstone of capitalism. Low-cost globally diversified, risk-appropriate Index Portfolios that are bought and held over time are the best way to capture the returns of global capitalism.

DON'T BE FOOLED BY RANDOMNESS.

HAPPY INDEX FUNDS DAY!

Visit IndexFundsDay.com

A thing is worth only what someone else will pay for it

Wed, 26 Mar 2008 15:01:37 GMT

Many investors began their St. Patrick's Day seeing red, not green. Monday, March 17, 2008 capped the brief and very turbulent saga of Bear Stearns' (Bear's) precipitous fall which caused the company to land into JP Morgan's lap for an ultimately agreed upon price of $10.00 worth of JP Morgan shares in exchange for each share of Bear and the acceptance of their potentially large liabilities.

On Friday March, 14, Bear sold for $30/share. In an ironic twist, on Monday March, 17, the stock opened at $3.17 a share – one-tenth of the previous trading day’s value. A closed-door weekend dissection of Bear’s books revealed the disaster that bubbled to the surface and JP Morgan offered investors $2.32 a share to avoid a total loss and bankruptcy. One week later, shareholder mutiny loomed large and JP Morgan boosted their offer to $10 a share – one-third of the price at which the company traded just 10 days before. But, the story is far worse. In January 2007, Bear sold for $164/share or 16 times the March 24 offer from JP Morgan, according to MSN Money.

The specific missteps that led to the rapid-fire demise of Bear are well-covered in financial publications, and we shall leave the forensic accounting of Bear's implosion to them. We deem it significantly more meaningful at this time to focus on a far more important issue that Bear's crumble should bring to the forefront of investors' minds: Risk.

Investors of individual stocks expose themselves to concentration risk - a risk that is unrewarded and carries no increased expected return above the market's return.

Figure 8-11 depicts the reason that concentration risk has no benefit for investors. As you can see, each stock in a particular index carries the same expected return of that index. This is indicated by the Expected Return (the y-axis), which shows that an individual stock and its respective index have the same expected return. However, the uncertainty of that return (or risk) increases significantly as you shift to the right from the index to one stock. The statistical translation goes like this: over the last 80 years, an average stock in the S&P 500 had a return of about 10%, plus or minus about 50%, two-thirds of the years, while the S&P 500 index had a return of about 10%, plus or minus about 20%. two-thirds of the years. Since many studies show that investors cannot pick just the winning stocks in the index, there is a far greater certainty that you will earn the 10% by just owning the index. In other words, don't bother looking for the needle, just buy the haystack.

Figure 8-11

A part of the risk of a concentrated position in a single company is the possibility of near failure or bankruptcy. Joe Lewis, a British billionaire, lost one-third of his $3 billion fortune overnight by holding onto 11 million shares of the company when it went belly up. Bruce Sherman, CEO of Private Capital Management, a unit of famed Legg Mason, appears to have held nearly 5% of Bear when it limped into oblivion. And, Dallas money manager James Barrow would have far more money to manage now if he had known that Bear Stearns would implode and take with it the value of his near 10% stake in the ill-fated company.

“The sale price does not reflect the value of Bear Stearns" and "shareholders are being shabbily treated given that the transaction was not designed to maximize or even salvage their equity," the Police and Fire Retirement System of the City of Detroit, with 13,500 shares, said in a complaint in Delaware Chancery Court in Wilmington.

T-Shirts are now being sold on eBay emblazoned with: "I invested my life savings in Bear Stearns and all I have left is this lousy t-shirt." Looks like we have a new reason to call a drop in the market a "Bear" market.

Good companies can and do go bad and no one knows which ones will or when. Bear Stearns is not the first big company to fold and it won't be the last.

Take a look at Table 3-2. Some very big names have dissolved into obscurity after stellar runs of good fortune. As you can see by the total assets before bankruptcy, massive amounts of shareholder wealth have been obliterated. The degree to which an investor can absorb or overcome such an unlucky hit is directly tied to their portfolio's concentration in that one stock. When asked to sum up the most important investment concepts individuals should know, Nobel Prize-winner Merton Miller stated, "Diversification is your buddy."

Table 3-2

In the book Creative Destruction, McKinsey & Company consultants Richard Foster and Sarah Kaplan researched the original S&P 500, which was created in 1957. The survival of companies is similar to the survival of mutual fund managers. The Figure 3-1 shows that in the 41 years from 1957 to 1998, only 74 of the original 500 companies were still in existence and only 12 of those outperformed the S&P 500 Index over the 1957 to 1998 period. The study found that the odds of picking a winning stock that beat the S&P 500 Index was one in 42.

Figure 3-1

The moral of these stories is that today's success does not ensure tomorrow's survival. We hope that those who lost big in the Bear Stearns debacle will win a very big lesson: investors must diversify their investments, as well as their holding periods, so that these kinds of events will not destroy their portfolio.

Hedge funds are risky

Mon, 17 Mar 2008 13:37:45 GMT

Recent news has dealt a drubbing to many hedge funds investors. The subprime mortgage fallout has awakened a great many sleeping giants whose excessive appetite for leverage seems to have caught them flatfooted when the housing market turned sour and easy credit dried up. In the wake of the crisis, many hedge funds are steeped in leveraged credit risk, facing crises of liquidity and viability that are leaving even some of the most powerful players impotent against collapse.

A March 13, 2008 Times Online UK article by Suzy Jagger titled “Hedge funds on the brink as US Federal Reserve cash fails to ease crisis” reported that “the potential closure of six funds came as a leading private equity executive, who declined to be named, said that such funds were ‘snapping like twigs’, with one failing every day.”

So deep are the woes for some very large and big-name hedge funds that even the Fed’s $200 billion cash infusion couldn’t bring them back to moderate buoyancy. In fact, just one day after the Fed’s announcement, a whopping six well-known hedge funds with assets of $4 billion or more each lamented dim viability. For example, the crisis threatens the collapse of several Drake Management funds. According to Jagger’s article, Drake, which was founded by former Blackrock executives, just advised investors in its $3 billion Global Opportunities Fund that it was considering closing the fund. “The fund, which lost 25 percent last year, has already blocked investors from withdrawing their cash.” the article stated.

Additionally, the federal bailout plan was not enough to salvage a once burgeoning investment fund affiliated with the high profile Carlyle Group. This powerful Washington-based buyout firm is widely known for its “gold-plated connections”; former IBM chief Louis Gerstner sits at the company’s helm, while former British Prime Minster John Major and former President George H.W. Bush were both employed by Carlyle, according to The Wall Street Journal’s March 14, 2007 article, “Carlyle Fund In Free Fall As Its Banks Get Nervous.” The article states that the fund that “had ballooned to $22.7 billion back in the era of easy borrowing all but collapsed as banks rushed to sell assets backing the mortgage fund. Shares of Carlyle Capital Corp., which trades in Europe, are down 97% for the year, closing yesterday at 35 cents.”

With the current cascade of faltering and failing hedge funds, a great many managers are no doubt struggling for just the right words to explain to investors the disastrous turn of events that renders their investments virtually worthless. We suggest they borrow a time-honored line from Theodor Seuss Geisel, “This mess is so big, and so deep and so tall. We can not pick it up, there is no way at all!” (The Cat in the Hat, by Dr. Seuss, aka Theodor Seuss Geisel)

Glyn Holt’s article “Hedge Funds: Who'll Take the Toxic Waste?” delivers a no-nonsense, take off the rose colored glasses view of hedge funds. He writes, “Anyone who has delved into the literature on efficient markets should smell a rat when thousands of hedge funds are being launched each year, all flamboyantly claiming they can earn returns massive enough to cover their typically 2% management fee, 0.4% "administrative fee" and 20% incentive fee, not to mention the enormous brokerage fees the funds rack up on their frenetic trading.”

Problems associated with hedge funds extend far beyond excessive fees. Indeed, fees are a huge stumbling block for hedge funds, to be sure. But, when coupling those excessive fees and performance bonuses with liquidity problems, a lack of transparency, leverage that can reach 10 to 1, and zero regulation from the SEC, hedge funds can impose great hazard on your ability to keep, let alone make money by investing in them.

The following five points succinctly express IFA’s Concerns with Hedge Funds:

1) The Risks of Hedge Funds

“The risks facing hedge funds are non-linear and more complex than those facing traditional asset classes…such risks are currently not widely appreciated or well-understood” – Andrew Lo (MIT)

Hedge funds often employ leverage, which as we all know, is a two-edged sword. They also can concentrate their investments in risky securities, such as options which can easily lose 100% of their value. Conversely, they may take negative positions (shorts) in securities which can potentially have large appreciation, causing a large loss, which can be further magnified by leverage. Standard deviation does not adequately capture the risk of hedge funds, because a fund that is leveraged 10 to 1 goes out of business when it has a more than 10% decline in value. That does not happen in an index fund.

To cite some recent examples from the Wall Street Journal of 12/14/2007, Red Kite Metals (a fund that was up 188% in 2006) has dropped about 50% year-to-date 11/30/2007. Two hedge funds run by Second Curve Capital are down about 70% over the same period due to souring investments in subprime lenders, after gaining 55% in 2006. In 2007, Peloton Partners ABS Hedge Fund racked up an 87% gain, in early 2008 they were forced to liquidate their once high-flying ABS fund after gambling big on a mortgage bond rebound that didn't materialize. In September 2007, a hedge fund expert from Mesirow Advanced Strategies in Chicago estimated that 50% of all hedge funds goes out of business every year.

Bottom line: If someone tells you that he has had a terrific gain (or knows someone who had one) in a certain hedge fund, it is highly probable that the hedge fund manager made some risky bets which could easily go against investors in the future.

2) The Returns of Hedge Funds

“We conclude that hedge funds are far riskier and provide much lower returns than is commonly supposed.” – Burton G. Malkiel & Atanu Saha, “Hedge Funds: Risk and Return”, Financial Analysts Journal, November/December 2005.

The article cited above showed that every major category of hedge fund (eleven categories) on average failed to provide a higher risk-adjusted return than the S&P 500 from 1995 to 2003. Only one category (emerging markets) provided a higher unadjusted return than the S&P 500.

Hedge fund statistics suffer from a severe survivorship bias problem. Failed funds go out of business and their returns go unreported. Likewise, poorly performing (but still existing) funds are under no obligation to report their returns to anybody.

One other often overlooked problem with hedge funds is that their assets are often of a highly illiquid nature, and the market values of those assets are somewhat opaque. A relevant example would be structured investment vehicles (SIV’s) resulting from securitization of subprime loans. Two hedge funds run by Bear Stearns that bought these types of vehicles collapsed in July of 2007, wiping out $1.6 billion of investor capital. Interestingly, $400 million of that capital belonged to Barclays, the world’s largest investment bank. If this entity cannot protect itself from the sharks of Wall Street, what chance does an individual investor have? Bottom line: If the values of a hedge fund’s assets are uncertain, then so are the returns reported by that fund. Buyer beware!

3) The Expenses of Hedge Funds

“Our research has shown that in at least 80% of cases the after-fee alpha for hedge funds is negative…I’m not saying they don’t have skill; I’m just saying they don’t have enough skill to make up for two and twenty.” – John Cassidy, “Hedge Clipping”, New Yorker, 7/2/2007.

2% of assets and 20% of profits poses a high hurdle for an investor to receive a good experience in a hedge fund. If the fund (before expenses) receives an average market rate of return of 10%, the return to the investor (who took all of the risk) will be a mere 6.4%.

“On top of the enormous difficulties of identifying a group of genuinely skilled investment managers and overcoming the obstacles of extremely rich fee arrangements, investors confront a fundamental misalignment of interests created by the option-like payoff embedded in most hedge fund fee arrangements. Investors in hedge funds find generating risk-adjusted excess returns nearly an impossible task.” – David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment.

On those rare instances where a manager has the market convinced that he can provide above average returns, his fees (or assets under management) will increase to the point where the expected return to investors is no higher than what the market will provide (and most likely will be significantly lower). A perfect illustration is Renaissance Technologies under the widely acclaimed James Simons. Based on his stellar past record, this fund now charges an astounding 5% management fee and 44% of profits. In order for an investor to receive a 10% return, the fund itself must achieve a 23% return – A tall order to fill indeed. In fact, over the last 20 years Berkshire Hathaway has only earned about 20%/year, but also experienced a 23% standard deviation (risk) along the way.

4) The Myth of the Absolute Return Hedge Fund

“The term ‘absolute-return investing’ has no meaning. It misleads the listener into thinking it has substance that it does not have, and in our opinion, the term simply should not be used.” – M. Barton Waring and Laurence B. Siegel, “The Myth of the Absolute-Return Investor”, Financial Analysts Journal, March/April 2006.

Many hedge fund managers will claim that their funds are “hedged” against general market downturns. The funds most notorious for this type of claim are long/short funds. As William Sharpe so deftly asks, “If everybody was doing active management with hedge funds, and you put together all the hedge funds, what would you get? Treasury bills.” Investors must never forget that risk is the source of returns, and if they insist on reducing the risk to zero by hedging, they will have zero expected return.

The simple truth is that nobody can offer you an absolute return above T-Bills, without greater risk than T-Bills. While it is possible to generate a positive return above T-Bills for a period of time by selling out-of-the-money put options (or other derivative securities), such a strategy will eventually collapse. Therefore, even if a hedge fund can show a short term record of “absolute returns”, an investor should never think that these returns came without additional risk and that they will continue into the indefinite future. The distribution of past and expected future returns are approximately a bell shaped curve, with half of the returns being below the average and half being above the average.

5) What about a Fund of Funds?

Please note that all of the problems with ordinary hedge funds cited above are applicable to the funds of funds. The article by Malkiel and Saha cited above shows that the fund of funds category achieved a return that was 2.2% lower than the whole hedge fund universe (and 5.7% lower than the S&P 500). This shows that the managers of funds of funds have no special skill at picking other hedge fund managers. What a surprise!

Being a “qualified investor” does not entitle you to beat the market or to cheat risk. If you think otherwise, it is more than likely that someday you will pay a very high price to learn this lesson. Hedge funds will help you do just that.

The following table summarizes the key differences between index funds and hedge funds. We encourage every investor to make an informed decision when it comes to investing your hard-earned dollars.

The stock market is like a gambling casino

Tue, 11 Mar 2008 13:37:45 GMT

Over the last couple of months, rumors of inflation and recession have been bandied about among the news media with increasing frequency. Concerns over the US economy and the issues surrounding the housing crisis have incited fear that the economy may erupt into a situation not seen since the Carter Administration when recession and inflation dealt a double whammy to the stock market and gold soared to new heights.

IFA does not make predictions about future economic conditions. We take this position for one simple reason: all of the information that is knowable about the market and the economy is reflected in stock prices as they scroll across the screen.

As to recession: are we in one? We won’t know until we are at least two quarters into one because a recession is two back-to-back quarters of negative GNP. However, if we are in a recession, the best strategy still remains to hold. No one can predict future news.

Take a look at the total return of IFA’s Index Portfolio 70 during and one year after six recessions.

Recessions are a normal part of the business cycle and occur, on average, every six years. Furthermore, stock market history shows that recessions have provided good investment opportunities.

As to inflation: Inflation is an equal opportunity destroyer of an investment’s purchasing power. There is nothing you can do about its effects, but investing as large a portion of your portfolio in stocks for as long as possible is the best way to outpace inflation.

Burton Malkiel’s quote above explains why you should invest in the equity markets to the greatest extent your risk capacity allows. Rightfully so, you can expect that over time, equity investment returns will exceed the risk-free rate, a rate which essentially pays little more than the rate of inflation. You are entitled to receive a higher return when you take more risk. Of course, the more risk you take, the more volatility you should expect. This is your reward for hanging on through periods of volatility.

Investors should take on as much risk as their risk capacity allows to mitigate against the erosive effects of inflation. The figure below reveals the benefits of investing in Index Portfolios (IP) as opposed to various asset classes, including gold, silver, art, farmland and venture capital. As the chart shows, for the 48-year time period shown, globally diversified Index Portfolios. IP5, IP50 and IP100 maximized returns at their level of risk. Meanwhile, art, gold and silver carried unrewarded risk. Venture Capital carried more than twice the risk of IP100, with only small increase in return that did not justify the increased risk. It is important to note that this 48-year time period includes the 1973-1974 downturn which was painful in the short-term for stock market investors, but worked out very nicely for those who bought and held a risk-appropriate Index Portfolio.

Let's look at the substantial underpinnings of a globally diversified Index Portfolio. Specifically, what is in an Index Portfolio, and why do we carry such confidence in the success of an Index Portfolio in the long-term? In the most basic of terms, an Index Portfolio is an investment in global capitalism. In fact, the hypothetical stock certificate below represents Capitalism, Inc., IFA’s favorite stock and the only one we recommend. It shows the estimated 2006 market value, sales, net profits, great minds and hard-working employees that work for you when you buy and hold a globally diversified Index Portfolio. It shows $29 trillion in market value for more than 16,000 companies. The certificate reflects employment for more than 60 million people in 192 countries. Based on data regarding an-all equity Index Portfolio 90, Capitalism, Inc. has net profits of $3.5 million every minute, $5 billion every day and nearly $2 trillion for 2006. (Click on certificate to view disclosures.)

The individuals who collectively work toward the sustainability of capitalism apply world-class resources, brain power, technology, ingenuity and good old-fashioned hard work and perspiration to not just survive, but to thrive. Can anyone reasonably believe that Capitalism, Inc. will go out of business? And, if it did, your money would be worthless anyway.

We don’t know the news that will move the market – and neither does anyone else. If the news that hits the market is perceived as more bad than good, the market will go down. If the news is perceived as more good than bad, the market will rise. But, remember this important caveat: the news keeps on coming – all day, everyday. For this reason, it’s important for you to fully understand the history of the markets and how much risk you can take, and invest in a globally diversified portfolio that packs as much of the right risks as your risk capacity allows. Cost control, risk management and style drift avoidance are accomplished by constructing the portfolio with passively managed index funds.

Invest in Capitalism - It Works.

Chance Alone

Mon, 03 Mar 2008 13:31:44 GMT

For investors who seek the rewards of equity investing, there’s no surefire way to avoid occasional erosion of equity values. Case in point, the S&P 500 Index declined from its peak of 1,565 reached on October 9, 2007 to its recent closing low of 1,310 on January 22, 2008. This 16.27% decline is the price of risk.

Market declines are natural, unavoidable, and they are the reason why we can expect to earn a return that is commensurate with the level of volatility we are willing to accept. In fact, the flipside of the market’s recent decline is the benefit of that same risk that rewarded investors in the S&P 500 with a 101% return for the 5-year market increase that began on October 10, 2002 until October 9, 2007’s closing high. Returns for non-US equities for the same time period were higher still.

Investors cannot realistically expect to enjoy the profits of a market increase, but sidestep inevitable declines. This is because free markets respond to news as it occurs. Sometimes the news is good, and sometimes the news is bad, but we simply cannot know in advance the news that will move the markets. This concept is precisely why we call it “news”, as opposed to "olds". The only solution is to buy and bear as much risk as your risk capacity allows, expecting that stock markets will ebb and flow in the short term, but will result in an upward march over time due to the average profit-making attributes of capitalism.

Some investors, however, will argue that there are always good stocks for the times. In fact, an entire industry thrives on recommending a handful of “stocks to buy now”, leading investors to believe they can enjoy appreciation when the market rises, but avoid profit erosion in a market decline.

The firms listed below are widely considered to be industry leaders. As such, they have been included at some point among the top ten "Most Admired Companies" in Fortune's annual survey. These companies are most certainly considered to be successful investments, and on many stock pickers’ “short lists”.

As you can see, not one these stocks outperformed the S&P 500 Index’s 101% gain for the five-year period from October 9, 2002 to October 9, 2007. In fact, the share price for Wal Mart lost nearly 11%, while Pfizer was lower by more than 14.5% and 3M gave up a whopping 17% for the same five-year period that enabled double-digit growth for a simple US equity index.

The chart below reveals the real problem with stock picking. This comprehensive chart shows risk and reward data for the 20 IFA Index Portfolios, the IFA Indexes and the 30 individual stocks that make up the Dow 30 for the 20-year time period from 1987 through 2006. As you can clearly see, despite their highly regarded status, these 30 individual stocks are inefficient when it comes to return in exchange for risk. Not one of the stocks in the Dow achieved returns in excess of the risk they took. On the other hand, an investor who purchased an efficiently diversified Index Portfolio and held it had a high probability of achieving the returns of the market, minus taxes and costs. This investor would also avoid uncompensated risk in the form of concentration and/or speculation. The only question that remains is how much risk is right for you? Click here to take the Risk Capacity Survey to learn which Index Portfolio is right for you.

TO VIEW THIS CHART IN DYNAMIC FORM, CLICK HERE

History You Don't Know

Mon, 25 Feb 2008 13:23:14 GMT

The decision of how and where to invest your money is the key to long–term wealth accumulation. Only a good understanding of the long-term historical risk and return of various indexes will enable you to know how to allocate indexes in accordance you’re your risk capacity.

The importance of asset allocation cannot be overstated. A 1986 academic study conducted by Gary Brinson, among others, contends that more than 90% of a portfolio’s variability depends on the asset allocation, leaving less than 10% of a portfolio’s variability of returns to the fund manager.

So, the key to prudent investing involves first identifying the indexes that are available for investment. From there, you should extract from that universe the combination of indexes that provide the highest rate of return for the level of risk that matches your risk capacity.

This process of asset allocation is much easier when you understand that a big difference exists between track records of actively managed mutual funds and the historical returns of passively managed indexes.

The most obvious distinction is the difference in time periods, or to borrow a statistical term, the sample size. Statisticians will quickly remind you that the smaller the sample size, the more error there is in the information obtained from the sample.

Statisticians tell us that we need at least 20 years of historical risk and return data to determine luck over skill when it comes to fund manager performance. This quickly narrows the vast universe of fund manager data to the about 1,000 passively managed asset class indexes, eliminating active managers who do not have such a long-term track record.

Examining the historical risk and return data of indexes is a completely different exercise than examining the track records of specific active mutual funds. In sharp contrast to the unclear investment methods of active fund managers, indexes deploy a clear and consistent strategy, and they hold fast to that strategy over time.

The best index fund managers have identified the risk factors that generate higher stock market returns. They structure the rules of construction of those indexes for maximum exposure to those specific factors. This is the simple process of taking advantage of the fundamental relationship between risk and return.

Specifically, the groundbreaking discoveries achieved by Nobel-prize winning economists are the springboard for risk-appropriate asset class investing. A prudent asset allocation strategy is the best way for you to implement the important risk diversification methodologies set forth by Markowitz, Sharpe and Miller — the fathers of Modern Portfolio Theory. Building on their important Nobel prize-winning research, Eugene Fama and Kenneth French, two renowned economists determined that more than 90% of stock market returns come from exposure to three specific risk factors: market, size and value.

The chart below illustrates the historical impact of size and value investing across global asset classes. This is the type of historical information that enables you to select a prudent asset allocation. In the chart, you see 80 years of history for U.S. Large and Small Capitalization Stocks, 25 years of history for Non-U.S. Developed Markets and 18 years for Emerging Markets. Across each asset class represented here, you see that small and value carry increased risk and return characteristics for each time period shown. Fama and French’s discovery of the significant increase in risk and return for small and value enables you to isolate those specific risk factors in specific indexes to achieve higher expected returns that are commensurate with your risk capacity.

Higher Expected Returns?

Mon, 18 Feb 2008 13:23:14 GMT

Nonsystematic risk refers to those risks that are specific to individual companies. Examples include lawsuits, fraud, competition and other unique circumstances related to a company.

The important fact for investors to understand is that there is no added expected return for nonsystematic risk above the expected return for systematic risk. This is a very big idea that essentially says that all stocks have an expected return that is the same as the market or a market index fund return. However, those stocks have more uncertainty of the expected return.

The Trade-offs between Risk and Return

Risk and return are inseparable. This means that investors must often face bedeviling trade-offs between risk and return. There’s no way around these decisions, since they’re required in order to build portfolios. For example, sometimes investors look at short-term CD rates. They like the certainty and stability of CD returns, but they feel they need to obtain higher returns. So, these investors turn to stocks. But, when they focus on the years of negative returns, they become uncomfortable because of their aversion to losses.

The result of all this is the “eat well/sleep well dilemma.” That is, if investors want to eat well and earn higher returns with stocks, they need to be prepared to take more risk and go through the volatile roller coaster ride of fluctuations in the value of their portfolio. But if they want to sleep well, they must take less risk; that is invest in fixed-income investments such as bonds, and accept that they’ll earn lower returns. Thus, the price of obtaining greater long-term accumulation of wealth with stocks is frightening fluctuations in the value of a portfolio. There really is no free lunch in investing. It’s the same old story of risk and return trade-offs identified by Markowitz.

High risk exposure is like a scream inducing roller coaster with soaring highs and stomach churning lows. Investors should hop on a milder ride if they don’t like the extreme rush of the one they’re on. The same concept applies to investing. However, not everybody has the capacity for such exposure to risk. Figure 8-23 shows the roller coaster like returns of five different index portfolios. The gold colored Index Portfolio 90 has higher highs and lower lows than the other lower risk portfolios. Also, note that the growth of $100,000 over 35 years is higher for the higher risk Index Portfolio 90. Figure 8-24 shows what the one index of small value stocks looks like on the same scale. These graphs provide a vivid illustration of the concepts of risk, return, and time. They are available in dynamic versions that allow movement and selection options, see below.

Tax Loss Harvesting

Mon, 11 Feb 2008 13:14:48 GMT

As tax reporting documents trickle in and investors ponder their current tax situation, it’s a good opportunity to give you some insight into a powerful tax-savings tool called tax loss harvesting. In fact, the recent market downturn provides you with an opportunity to examine your specific situation to identify whether you can save on future capital gains taxes.

To save on future taxes, investors might consider the following strategy:

1.	Take the mutual funds in your taxable accounts that have recently gone down more than about 10% and a minimum of about $10,000, due to the market correction.
2.	Sell those funds and immediately invest them in the S&P 500 realizing a capital loss on the sold funds.
3.	Purchase the original mutual funds back after 31 days, to avoid the IRS Wash Sale Rule.
4.	Use the realized capital losses to offset future capital gains, reducing future tax bills. The losses can be carried forward until they are used up.

By transferring the money into the S&P 500, investors can remain 100% invested in the market. Additionally, certain institutional custodians charge no transaction fees when we buy and sell their specified S&P 500 index fund.

This tax-loss harvesting process is a commonly used technique that will reduce future capital gain tax liabilities.

While tax loss harvesting is a valuable tool, there are some risks associated with it. As such one should carefully consult with a financial advisor prior to making the decision to tax loss harvest.

Examples of such risks include:

1) If you move into the S&P 500 and the market dramatically increases during the 31 day interval, all your realized losses will be taken up by realized gains when you sell the S&P 500 fund. For this reason we will only sell funds that have lost about 10%. It is extremely unlikely that the market increases 10% in one month. In fact, over the last 50 years, the S&P 500 index has increased 10% in one month only 1.7% of the time.

2) The S&P 500 fund could incur a greater loss or a lesser gain than the funds you moved out of during the minimum 31 day interval. The likelihood of this is about 50% but the difference in value, if any, is likely to be small because of the short time interval. You should be aware of this risk before you pursue further any tax-loss harvesting.

Despite the risks mentioned, IFA frequently advises clients to harvest losses under the conditions described above. The painting below aptly depicts the reason why all tax-paying investors should understand and implement, if appropriate, a tax loss harvesting strategy. Of course, your decision to tax loss harvest should be carefully weighed and discussed with a qualified fee-only advisor who carries the fiduciary standard to act in your best interest. If you would like to take advantage of IFA’s expertise in tax-loss harvesting, or simply learn more about whether such action is appropriate for you, please call 888-643-3133 to speak with one of our many qualified investment adviser representatives.

Our favourite holding period is forever

Mon, 04 Feb 2008 13:14:48 GMT

Widely known as the Oracle of Omaha, Warren Buffett is one of the most admired investors in the world. Hordes of investors may bend a listening ear to capture Buffett’s every word, but few seem to heed his sage advice to buy and hold.

Here, Buffett advises that the ideal holding period for investments is “forever”. While many investors do not have the luxury of never selling an investment, IFA’s position is that investments should only be sold when an investor needs the money or if he loses faith in capitalism. IFA further advises its clients to construct a portfolio comprised of a risk-appropriate blend of passively managed index funds. Passively managed funds do not have a fund manager trading stocks to chase sectors and returns. This passively managed fund strategy has significant benefits:

Costs are held to a minimum — no big salaries and excessive trading costs to drive up the expense ratio.

Style purity — stocks are bought and held according to rules of construction that remain constant regardless of market conditions.

Tax-advantaged — buy and hold mitigates against excessive capital gains distributions that trigger a bigger tax bill.

Consistent exposure to risk – buying and holding specific asset class indexes that contain stocks that share the same risk and return characteristics enables investors to maintain an ongoing exposure to the indexes that carry 80 years of risk and return data.

Diversification – Global diversification enables investors to dampen volatility by investing in as many as 17,000 companies in 40 different countries.

The benefits listed above provide compelling support for Buffett’s buy and hold advice and incorporates global diversification to dampen risk. Thanks to the Nobel prize-winning research set forth by Harry Markowitz in 1952, many investors are just beginning to grasp the importance of “not putting all of their eggs in one basket”, and the importance of diversifying risk across multiple asset classes.

The important figure below shows the benefits of applying Buffett’s buy and hold advice and combining it with Markowitz’s diversification strategy. Specifically, the 20 IFA Index Portfolios plotted on the risk reward chart for the 50-year period from 1957 through 2006. The figure shows how risk, as measured by standard deviation, reduces the longer the Index Portfolio is held. For one-year holding periods, the 20 Index Portfolios show vastly different measures of risk. However, by just holding that same portfolio for two years, you can significantly reduce the risk of obtaining the expected return. And, when Index Portfolios are held for their recommended holding period, the standard deviation of returns for each Portfolio rests at just 4% or less, making the riskiest IFA Index Portfolio that is held for its 12-year recommended holding period only as risky as the lowest risk IFA Index Portfolio held for its recommended holding period of 4 years. This is why investors should first determine their risk capacity, then match that capacity to a level of stock market risk. Finally, they should reap the benefits of time diversification by holding the portfolio for the recommended time period.

Two Kinds of Investors

Mon, 28 Jan 2008 13:05:56 GMT

William Bernstein’s quote conveys two important messages. First, he articulates an investor’s inability to successfully profit from predicting the short-term future movements of the stock market. Second, and equally important, Bernstein sheds light on the parasitic industry that knows the randomness of short-term stock market movements, but profits wildly by preying upon the hopes and fears of investors. Cleverly crafted charts that describe double bottoms, resistance levels and breakout points, along with pseudo analytical reports alleging predictive profit patterns, all attempt to convince investors that frequent trading will help them avoid losses and earn big returns.

Wall Street’s motivation is abundantly clear. Recently, IFA estimated that the brokerage industry makes about $500,000,000 each day on the trading behaviors of active investors that costs them commissions, expenses and bid/ask spreads. Let’s look at why all that activity is distracting and destructive to long-term expected returns.

To save you some time, all you need to understand about time picking is the Random Walk Theory. This theory simply states that nobody can consistently see what tomorrow will bring. Just remember that markets are moved by news--news that is unpredictable and unknowable in advance (that is the very definition of "news"). Because news is random and unpredictable, the markets move in a random and unpredictable fashion. Period, end of story.

This simple and easy to understand concept about the markets was first published over one hundred years ago. Virtually all subsequent academic studies detailing actual stock market data conclude that time picking is not likely to be a successful investment strategy.

From 1901 to 1990, the stock market return was approximately 9.5% per year. The SEI Corporation completed a study in 1992 that determined that in order to just equal this average annual return over the ninety-year period, a time picker needed to correctly select about seventy percent of the ups and downs of the market.

They also determined that if a picker called one hundred percent of the declining markets and only fifty percent of the rising markets, they still would fail to exceed the return of the overall market during this period. To add a final blow, there was no consideration for the higher short-term capital gains taxes or transaction costs involved in this highly flawed strategy. No wonder ninety-five percent of market timing newsletters go out of business.

More bad news for time pickers. First, most of the gain achieved in a rising market is often concentrated at its beginning in highly concentrated surges. Because the markets go up on average, there are greater benefits to be in the rising markets than there are to avoid the falling markets. These additional tidbits were some of the conclusions of a New York University study completed in 1986. The clincher was that the academics found no evidence that time pickers could successfully time either the beginning of a rising market or the end of a falling market.

The Table below shows the benefits of buy-and-hold investing as opposed to the lunacy of time picking. This study examined the 2,516 stock market trading days for the ten-year period from 1997 to 2006. The data shows that during this period, the S&P 500 produced an annualized return of 8.4%. A smart and prudent investor who invested $10,000 in the S&P 500 at the beginning of 1997 and stayed fully invested was handsomely rewarded with a $12,444 gain by the end of 2006.

However, if just ten trading days with the largest gains were missed, the annualized return would have dropped from 8.4% to 3.4%. Instead of gaining by $12,444, the investor would have ended up with only a $3,992 gain. If the best 20 trading days were missed, which is less than 1% of the total number of trading days, the annualized return would have dropped to a minus 0.4%, yielding a loss of $360. Thus, more than 100% of the return would have been lost in just 20 days, or an average of two days per year. The random walk of any of the world's markets are impossible to predict.

To better visualize just how hard it is to find those 20 days, here is an image of the whole period in the study.

Another study from cypen.com found that being fully invested in the S&P 500 for the five-year period ended December 31, 1995 yielded a 16.5% average annual total return. If a market timer missed the twenty best days, that return fell to 7.3%. And if the sixty best days were missed (that's only twelve days per year), the return plummeted to -3.4%.

The odds against success in picking the right times are overwhelming, and the odds become worse over time with the high taxes and costs associated with frequent trading. So, in order to avoid the transfer of your wealth to Wall Street brokers, buy and hold a passively managed, risk-appropriate, globally diversified index portfolio and forget trying to predict short-term movements because the long-term picture looks promising for buy and hold investors.

Surprising truths about long and short-term investing

Mon, 21 Jan 2008 16:13:58 GMT

Charles Ellis was an early proponent of indexing. His quote addresses two important points: First, we should expect the stock market to rise over time, but take us on some ups and downs along the way. Second, the more educated we are about risk (the reason we should expect to earn a return), the better able we are to stay invested to enjoy the market’s superior risk adjusted returns over time.

The figures below illustrate Ellis’ point. They graph 50 years of monthly rolling period returns for Index Portfolios 90, 70, 50, 30 and 10 and the S&P 500. The figures show that the chance of incurring a negative return declines as the time horizon increases. In these studies, the chance of negative returns virtually disappeared when returns were graphed in monthly rolling five-year periods.

Figure 8-29a provides the percentage of periods that Index Portfolio 90 investors experienced gains versus losses over several periods of times. Investors are often surprised to see that on a daily basis, 48% of the daily returns are negative in an Index Portfolio 90. However, at 5-year monthly rolling periods, only 2% have been negative over 541 monthly rolling 5-year periods. And, out of 481 10-year periods, not one had an annualized loss. Figures 8-29 c-f show that Index Portfolios with lower risk than Index Portfolio 90 experience fewer periods of losses vs. gains, with Index Portfolio 70 showing 1% negative returns over 5-year periods, and zero periods of negative returns for Index Portfolios 50, 30 and 10.

Figure 8-29a	Figure 8-29b
Figure 8-29c	Figure 8-29d
Figure 8-29e	Figure 8-29f

Risk and return are inseparable. This means that investors must often face bedeviling trade-offs between risk and return. There’s no way around these decisions, since they’re required in order to build portfolios. The result of all this is the “eat well/sleep well dilemma.”

That is, if investors want to eat well and earn higher returns with stocks, they need to be prepared to take more risk and go through the volatile roller coaster ride of fluctuations in the value of their portfolio. But if they want to sleep well, they must take less risk; that is invest in fixed-income investments such as bonds, and accept that they’ll earn lower returns.

James K. Glassman aptly summarizes the investor’s choice: “In the stock market (as in much of life), the beginning of wisdom is admitting your own ignorance. One of the many things you cannot know about stocks is exactly when they will [go] up or go down. Over periods of days, weeks and months, no one has any idea what stocks will do. Still, nearly all investors think they are smart enough to divine such short-term movements. This hubris frequently gets them into trouble.”

Unforeseen Circumstances

Mon, 14 Jan 2008 00:00:00 GMT

This witticism uncovered by Burton Malkiel introduces Chapter 11 of his enduring classic A Random Walk Down Wall Street. This section of Malkiel's book rallies support for Eugene Fama's Efficient Market Hypothesis.

The Efficient Market Hypothesis simply states that market prices accurately reflect all available information at all times and that only unforeseen news or circumstances will provide reasons for future price changes. So, unless you can see the future, it is impossible to consistently beat the market averages. As French mathematician Louis Bachelier stated back in 1900, the expected return of speculation is zero, relative to the average.

A study by finance professor Richard Roll indicated that new information is reflected in market prices within just five to sixty minutes. Within that short span of time, there are hundreds, if not thousands of traders all competing to profit from the same information. If you are in charge of one billion dollars a 0.1% annual gain is worth one million dollars per year.

Consequently, managers of those funds are applying considerable resources to squeeze out every little gain from new information. For this simple reason alone, there is an absence of opportunities for one trader to consistently profit from all other traders who have access to the same information at the same time! Simply put, all of us as a group know more than any one of us, making it impossible for one person to consistently possess more knowledge than all the other traders combined. As a result, the price of a stock agreed upon by a buyer and a seller is the best estimate, good or bad, of the investment value of that stock. This simple logic makes it virtually impossible to capture returns in excess of market returns without taking greater than market levels of risk.

In Robert C. Higgins book, Analysis for Financial Management, he paints a vivid picture of how information is devoured by market participants: "Market efficiency is a description of how prices in competitive markets respond to new information. The arrival of new information to a competitive market can be likened to the arrival of a lamb chop to a school of flesh-eating piranha, where investors are--plausibly enough--the piranha. The instant the lamb chop hits the water, there is turmoil as the fish devour the meat. Very soon the meat is gone, leaving only the worthless bone behind, and the water returns to normal. Similarly, when new information reaches a competitive market there is much turmoil as investors buy and sell securities in response to the news, causing prices to change. Once prices adjust, all that is left of the information is the worthless bone. No amount of gnawing on the bone will yield any more meat, and no further study of old information will yield any more valuable intelligence."

Eugene Fama is a finance professor at the University of Chicago's renowned School of Economics. His groundbreaking research led him to develop a comprehensive theory that explains why stock market prices fluctuate randomly. His paper Market Efficiency, Long-Term Returns, and Behavioral Finance is the #1 downloaded academic paper on the web and explains the most recent challenges to this hypothesis. To watch a video of Professor Fama explain his Efficient Market Hypothesis, click on the box below.

You will almost never find a fund manager who can repeatedly beat the market

Mon, 07 Jan 2008 00:00:00 GMT

John Bogle's quote highlights that the past performance of money managers has no bearing on their future performance. In fact, every reputable study of mutual fund performance over the past 30 years has found there is no reliable way to know if past superior managers will win again in the future. This is why some variation of the disclaimer “past performance is no guarantee of future results” must appear in all mutual fund advertisements and prospectuses, even though the SEC allows it to be written in very small print.

Investment experts give several reasons why past performance is no guarantee of future results. The most frequently cited is that any outstanding track record turned in by a money manager is the result of the market favoring his particular investment style. One implication of this is that any such performance is entirely unpredictable—as is the time period that such good fortune may or may not last. Since market returns are correlated to risk factors (not to managers), there is no reason to expect that one manager will do better than another.

Despite the preponderance of studies that overwhelmingly reveal managers' inability to persist in performance, investors continue to succomb to the temptation to chase performance. Even more disturbing is the fact that insitutional investors such as governing boards of retirement plans, foundations and endowments frequently fall prey to manager-picking consultants and the allure of past winners. All too often, they impulsively hire the hottest new fund managers only to subsequently fire them because their past performance failed to persist.

A recent study conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University found that manager hiring and firing decisions made by consultants and board members of retirement plans, endowments, and foundations was a complete waste of money and the board members precious time. "The Selection and Termination of Investment Management Firms by Plan Sponsors" reveals the negative impact of manager performance chasing. The results, as set forth in the figures below, demonstrate that during the ten-year period from 1994 through 2003, consultants and boards which based their fund manager hiring decisions on consistent above benchmark past performance were largely disappointed with subsequent index-like results. They often then fired their managers in favor of another recent top performer, repeating the cycle again. This cyclical motion undermines their investment policy statements and the opportunity of achieving optimal returns, the kind of returns that are available by simply buying, holding and rebalancing a passively managed portfolio of index funds that keeps costs low and controls risk.