IFA Radio - Blog

Nobel Laureate, Harry Markowitz

Index Funds Advisors — Fri, 04 Jun 2010 00:00:00 GMT

Whenever Nobel Laureate, Harry Markowitz talks, the economic world listens.

In 1952, Harry Markowitz developed the simple, but profound notion that investors must consider not only return, but the risk associated with their investments. Markowitz’s ground-breaking discovery earned him the 1990 Nobel Prize in Economics, and sparked the financial revolution called: Modern Portfolio Theory. Markowitz is widely known as the father of Modern Portfolio Theory.

Today, Harry Markowitz’s highly acclaimed research serves as the framework for the Prudent Investor Rule, as well as for the investment strategies of institutional investors around the world. It is estimated that some $7 trillion dollars in institutional assets are invested in accordance with Professor Markowitz’s Nobel-Prize winning discoveries.

Markowitz’s research supports IFA’s investment strategy: A portfolio that carries broad-based diversification among low-cost and passively managed indexes has shown to be the most prudent investing strategy over time.

"Don't bet the ranch.
Get more bang for your buck.
Maximize output relative to input.
Nothing ventured, nothing gained.
Diversify instead of striving to make a killing.
Don't put all your eggs in one basket; if it drops, you're in trouble.
High volatility is like putting your head in the oven and your feet in the refrigerator."

These common sense sayings capture the essence of Harry Markowitz's brainstorm, sparked one afternoon as he sat in the University of Chicago library reading a book about the current thinking of stock market investing. At 25 years old, Markowitz thought investors should be equally concerned with the volatility or risk of investments as they are with the return of investments. Thirty-eight years later, this innovative, practical theory earned him the 1990 Nobel Prize in Economics. This landmark contribution to the investment world was first published in 1952 in an essay entitled, "Portfolio Selection."

Listen to the exclusive interview with Harry Markowitz on IFA Radio here…

Read his recent article, “Does Portfolio Theory Work During Financial Crises?” here…

There's safety in numbers

Index Funds Advisors — Mon, 31 May 2010 00:00:00 GMT

So now that you know about the different aspects that lead to your risk exposure, it comes time to select the right investments. I cannot imagine what it must be like to look at all the investment options available today with all the active managers telling people the different places they should put their money. It’s sort of like Superman with his super-hearing; how do you hear the one call you should listen to through the madness and chaos? As the old saying goes, there is safety in numbers. David Astor once quipped, "Don't invest all your money in just one or two stocks. That's the danger. I know a man who put all his money in just two stocks --a paper towel company and a revolving door company. He was wiped out before he could turn around."

Fortunately, if you listen to IFA Radio and read this column, you will have a filter set up to drown out almost all of the noise being broadcast from the corner of every block on Wall Street. We move away from speculation towards investing. We move away from essentially asking our manager to place a bet on a stock with our money against another manager betting on that same stock to do the exact opposite. Have you ever stopped to think about who your manager may be betting against? What if Warren Buffett is on the other side of that bet? You need to be invested in several stocks FOR THE LONG HAUL. The best mutual funds around are put together by a company called Dimensional Fund Advisors because their funds are in an almost literal sense the implementation of academic research. But it is not as simple as walking down to a local DFA office and buying a fund.

DFA funds require a minimum trade amount of $2 million per fund purchase unless the purchase is made through a DFA approved fee-only advisor. This is why it is important to find the right DFA advisor. While most advisors require minimum account sizes of around $250,000 IFA’s minimum account size is $100,000. IFA’s DFA indexes are custom designed portfolios that capture the risk factors that explain 95% of stock market returns. Those factors include the company’s size (market capitalization) and their value (book to market ratio or BtM).

On the whole, IFA’s DFA indexes lean towards smaller size and higher value oriented stocks. Based on the higher long-term returns of these factors, there are higher expected returns for long-term investors with IFA’s index funds. However, past performance is not a guarantee of future performance.

Dalbar surveyed investment advisors four times between 1997 and 2004. The study was titled “The Professionals’ Pick.” They rated DFA as the best overall no-load mutual fund company in 1997, 2000, 2002, and number two in 2004. DFA rated highest in the “Investment Management” and “Current Use” categories in the 2004 survey.

We now go back to the bell curve. At IFA, we like to ask people, “What shape is your bell?”

Every portfolio has a bell shape curve that estimates what investors should anticipate when they look at the future. The future is a bell shaped curve for ALL investors as there is no specific return they can expect. Depending on your risk capacity, your risk exposure (or bell) will look very different. Here are 20 different portfolios with different risk exposures.

As you can see, different people have different shaped bells. The red bell has a much greater range of returns because it is exposed to more risk. The ivory bell is more of a spike because it is not exposed to much risk at all.

The process of prudent investing is the intelligent management of risk. At its most fundamental level, this process matches each investor’s capacity to expose his assets to the risk of the market. An investor’s risk capacity slowly erodes as an investor closes in on the need to withdraw money from the account in their twilight years. Investors should revisit the Risk Capacity Survey at least once a year. This will help you determine where your risk exposure should be. Equipped with that knowledge, you will be able to drown out all the voices so the one you hear is the one for you.

Matching People with Portfolios

Index Funds Advisors — Mon, 17 May 2010 00:00:00 GMT

Most investors approach investing with only returns on their mind. What did this manager earn recently? How did this stock do last year? What did that fund bring in over the previous 6 months? The reality is investing is more about the risk than the returns themselves. Remember, it’s the risk that produces returns. This is not a “What came first, the chicken or the egg?” type scenario. It is definitive: One must take on risk to earn a return. A simplified way of looking at it is if risk were a currency, return would be the products. If I spend $5, I typically get rot-gut wine. If I spend $200, I get a fine bottle of French Bordeaux. In the same way, if I spend 5 “units” of risk, I can expect to get a little in return. If I spend 200 “units” of risk I can expect to get a large return.

Risk is a four letter word in investing. It’s the veritable elephant in the room. The standard discussion of risk revolves around the uncertainty of your expected return. It’s the amount of certainty (or lack thereof) that determines the level of risk for a given investment. So with Risk Capacity, discussed last week, we must find how much risk is right for you. Risk Exposure is matching that Risk Capacity with a portfolio that demonstrates a matching exposure level. That is why our Matching People with Portfolios mantra came into being.

The man I like to call The Father of Risk and the creator of Modern Portfolio Theory, is our very own Nobel Prize winner, Harry Markowitz. It was the light bulb that turned on over his head way back in the early 1950’s that illuminated the simple fact that we should be paying just as much attention to risk as return. Markowitz knew no one had ever really tried to systematically understand the importance of risk in the investment process. It just had not happened. To the contrary, 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. It was crystal clear to Markowitz that risk and return were related. It only made sense since investors like return and want to increase it. Transversely, they dislike risk and want to reduce it.

So how does one spread out their risk?

Diversification, diversification, diversification.

Everyone knows the expression, “Don’t put all your eggs in one basket.” The saying basically illustrates the fact that if something happens to that basket, you lose everything. Let’s look at a single stock in an index versus the entire index.

5 Factors Determining Your Investment Future

Robert Bray — Mon, 10 May 2010 00:00:00 GMT

Simply put, Risk Capacity is a person’s ability to earn stock market returns. This is an individual aspect that changes from person to person. So, one of the main objectives of the investment process is to match up your capacity for holding risk with your exposure to risk. Robert Arnott once said, “Design a portfolio you are not likely to trade... akin to premarital counseling advice; try to build a portfolio that you can live with for a long, long time."

Now, as much as people would like to think they are an intricate part of their investment process, when you approach your investments with a passively managed style, this is the only part of the process for which the investor actually adds value. They provide the information needed so we can strike the proper balance between eating well and sleeping well.

There are five factors that go into measuring one’s Risk Capacity.

1. Time Horizon and Liquidity Needs – This estimates how soon investors may need to withdraw money from their investments. If you have a child who is a senior in high school and is eyeing a private college, you will likely have a low score since there will be a need for large amounts of money in less than two years. A higher score would go to a young married couple on the go with no kids.

2. Attitude Toward Risk – This estimates aversion or attraction to risk. Risk is defined as "the possibility of loss," and this category addresses the ability to stomach the inevitable decline of any investment subject to risk. A high score suggests a capacity of tolerating high risk investing to obtain the potential for higher returns. A low score indicates a risk aversion and the need to invest more conservatively.

3. Net Worth – This estimates capacity to take various levels of risk with investments. A fully paid-off house paid and a million dollars in the bank provides a cushion for the uncertainty of future cash needs. Because life is a random walk, we are never certain of tomorrow’s requirements. The more assets there are in reserve, the higher one’s capacity is for risk.

4. Income and Savings Rate – This estimates excess income and ability to add to savings. A high score indicates that a large percentage of income is discretionary and is available for investing. A low score indicates that all or almost all income is being used for ordinary expenses and not being added to annual investments.

5. Investment Knowledge – This estimates an investor’s understanding of the 12-Step Program for Active Investing and the immense benefits of passive investing. A high score indicates a good understanding of Modern Portfolio Theory and the failure of active management. A low score indicates that a review of this 12-Step Program may be needed.

Risk Capacity-adjusted investing is an entirely new way for investors to understand their ability to earn returns. Quite simply, you need a reasonable time horizon. IFA’s highest risk Index Portfolio has a holding period of 15 years. Nerves of steel are also imperative. It does an investor no good to seek more return through higher risk, only to panic and sell at a low. Knowledge can go a long way toward quelling this sort of panic—as can a good chunk of money (security) in the bank. All of these aspects, when properly measured and invested, will empower investors to achieve a higher level of certainty in their ability to earn returns based on the proper types and amounts of risk they take. In so doing, investors will remain focused on their long-term expected returns that travel alongside the risks they take.

The Past Supports the Passive

Robert Bray — Mon, 03 May 2010 00:00:00 GMT

"Those who are ignorant of investment history are bound to repeat it. Historical investment returns and risks of various asset classes should be studied. Investment results for an asset over a long enough period (greater than 20 years) are a good guide to the future returns and risks of that asset. Further, it should be possible to approximate the future long-term return and risk of a portfolio consisting of such assets."

- William Bernstein, "The Intelligent Asset Allocator"

Active management really only exists because people don’t know the history of the market. Active managers are basically providing their potential clients with returns of a 3-5 year period. Occasionally they pop out the 10 year returns and on EXTREMELY rare occasions they present a 15-year return. But why are these occasions so rare? Take a wild guess.

Investors have to look at this small sample size and ponder how representative of the future is it. Statisticians call this the standard error of the mean; in layman’s terms: the average. Have you ever noticed all the fine print on investment websites that says “Past performance is not an indicator of future results” or something similar to that? Well, that’s because the sample size they typically take (3-5 years) is in no way, shape or form enough to get any real representation of what the investments will do. Statisticians say that 20 years is the bare minimum when trying to gauge what returns will be in the future. The bigger the sample size, the more accurate the average. If someone took a political poll for who the next president should be, and they only polled 10 people in a small town in Arkansas, would you take that poll to the bank as to who will win the election? Of course not. A poll of 10,000 people spread across the different areas of the country would be a much better representation of who the next Commander in Chief will be.

When a person is looking at the history of a money manager, it is like being the general manager for a baseball team. I want to sign a 3rd baseman, and there is a 3rd baseman on the market that batted .350 last season and hit 40 home runs. Sounds like a slam dunk, right? Sign him up! Well, hold on one second. Isn’t it better to look at career stats before shelling out millions of dollars for a long term contract? There’s another player who batted .310 and had 36 home runs, but his career averages are much higher.

So looking at that table, which player is the better choice to sign to a multi-million dollar contract? Clearly, the sample size being extended from one season to the previous 7 makes a HUGE difference in the decision. You begin to ask yourself questions about Player A. Was he lucky? Since it’s baseball, did he take performance enhancing drugs? Meanwhile, Player B does what he always does. When it comes to your money, you need to capture as much of the interaction between people and capitalism as possible. Here are some comparisons of active managers versus an index fund or index. If you see more red than green, then indexers win.

Click to Enlarge

So what does history show us time and time again? The past supports the passive! Having a good understanding of the long-term historical risk and return of various indexes helps investors build an asset allocation according to their risk capacity that gives optimal exposure to risk factors that HISTORY has shown to be the most rewarding. So which player are you going to choose: The perennial all-star on his way to the hall of fame, or the one-year, flash in the pan who has struggled most of his career just to stay in the big leagues?

How Strong is Your Stomach?

Robert Bray — Fri, 23 Apr 2010 00:00:00 GMT

“In investing, what is comfortable is rarely profitable."

-Robert Arnott

How many times have you been able to have your cake and eat it too? It rarely happens in any walk of your life. So let’s just cut right to it. You cannot have astronomical returns without taking risk. They go hand and hand. People are perfectly comfortable talking about the return portion of the investment process, but how squeamish do people get when they realize they may lose money in their investments? After the crash of 2008, people are far more cognizant of this possibility, but people are still looking for that perfect investment that has zero risk and hefty returns. People are also still looking for a pill that will help them lose weight while they eat country fried steak and massive cinnamon buns at the mall. Neither exists. With your investments, you are indeed on a roller coaster. Stocks will go up and down and produce a lot of volatility in your portfolio.

Bonds are added to your portfolio to reduce its volatility so you’re riding a merry-go-round instead of a roller coaster.

This is not to say there are no twists and turns in the bond market. You ARE getting a return, so there has to be some risk somewhere in there, and that risk comes in 2 forms. The first is the term factor, which is the difference between the returns of long-term government bonds and short-term Treasury bills. The annual average return for the term risk factor has been 1.99% for the 80 years from 1927 to 2006. The second risk factor is the default factor. It measures the difference between long-term corporate bonds and long-term government bonds, assuming that governments are less likely to default than corporations...not necessarily a given as of late. The annual average return for the default risk factor has been 0.31% for the 80 years from 1927 to 2006.

Bonds also work well for people who know they are going to need their money at a certain time. We call that a liquidity event. You should start putting money away in bonds to prepare for the upcoming liquidity event which the industry calls a liability. These are things like the purchase of a house, college tuition for your children, etc. If you have a liquidity event coming within the next 6 months, you shouldn’t be in the stock or bond market. You should be in a money market account or checking account.

So when we look at fixed income, we want to keep the volatility low. Now, what we discovered is once you hold a bond over 5 years, the risk starts to escalate dramatically; much faster than the annual returns. Look at the chart below.

So with this in mind, what we like to do is take the bond component of a portfolio and divide it into four bond funds. 25% goes into 1 year, 25% goes into 2 year, 25% goes into 5 year government, and 25% goes into a corporate and government mix from all over the world. What this creates is a beautiful diversification of bonds that create a great fixed income portfolio. There are around 350 different bond issues within those 4 funds, and that diversification protects you from the failure of some bonds like General Motors bonds or Lehmans bonds. We don’t even like to use municipal bonds. Yes, you may not be paying taxes, but the issuer knows you won’t be getting taxed so they lower the return accordingly. And in the off chance the issuer does give you a high return, the bond will likely be called.

Bonds can lower your risk, and they help you not be that guy running for the garbage can as you stumble off the roller coaster, but they are not completely risk free. Cause let’s face it, there are still people who get sick on merry-go-rounds.

To read more about Step 8 and the previous weeks' discussion click here.

Improving Your Odds of Investment Success

Mark T. Hebner — Mon, 19 Apr 2010 00:00:00 GMT

There are many languages throughout the world. You have Chinese, Japanese; lawyers speak legalese. But the one language that’s of the utmost importance for you to understand is the language spoken by advisors, statisticians and underwriters: RISKESE. But to understand Riskese you’re going have to take a trip back to the classroom. You’re going to have to go back to that class you probably needed intravenous caffeine just to stay awake through. You have to go back to statistics.

This is just a short blog so before you start frantically searching for your back button, this is going to remain simple. The main dialect, if you will, of Riskese is standard deviation. Standard deviation, when used as a tool by investors, is a statistical measure of the historical volatility of a stock, mutual fund or portfolio. Typically it’s computed from a minimum of 36 monthly returns. standard deviation measures the probability of where a stock is likely going to land. However, statisticians tell us we need at least 20 years, or 240 months of returns for more reliable probability analysis.

"The most important questions of life are, for the most part, really only problems of probability."

-Marquis de Laplace, Theorie Analytique des Probabilites

The concept of probability is based on risk. What are the chances one thing will happen over the other and what is the risk of taking one side over the other. Risk is one of, if not the most important factor in determining how to efficiently manage investments because it determines the variation in your returns on the asset. It gives investors a mathematical basis for investment decisions. The overall concept of risk is as it increases, the expected return on the asset should increase as a result of the risk premium earned. Investors should not expect high returns on an investment if they aren’t taking a high degree of risk. If you bet on the Yankees to win the World Series, you should not get the same return as if you bet on the Pirates to win the World Series. You are obviously taking a lot more risk by putting your money on the Pirates.

So what the best way to describe probability and standard deviation? Well, it’s the old bell curve from statistics class. Remember this graph?

Most things in life you measure turn out to be a bell curve. When you are deciding on a movie, most of the time the quality of the movie falls into the middle of the curve. Once in a while you see something horrible like “Waterworld”. Once in a while you see something fantastic like “Lord of the Rings”. But most of the time it’s around the middle of the bell; a little bit below or a little bit above average.

If you look at the bell curve for the annual returns of the stock market, and you look over the last 50 years, the middle of that bell would have the most frequent occurrence which for the total market is a return of about 10%. And then the statisticians come up with an area called the standard deviation which is the area around the average. That standard deviation is what happens most of the time. In fact, 68% of the time you should see the average, plus or minus one standard deviation. So if the middle is 10% and the standard deviation is 15%, then most of the time you could expect the investments to fall between -5% and 25%. I’m sure everyone loves that 25% number, but that -5% probably has a lot of people squirming. But investing is NOT comfortable. Investment manager, Robert Arnott once said, “In investing, what is comfortable is rarely profitable.” And that’s why investors do poorly. When discomfort strikes, they panic. By staying invested in index funds over the long term. You get that 10% return that sits in the middle of that bell because there will be times when you have that -5% punch in the gut. But you will also have those 25% gains.

Now, there are different types of risk, and one particularly damaging one is concentration risk. What concentration risk basically boils down to is a statistical sampling error. It’s important to bring up the statistical analysis when talking about investments and the language of risk. Concentration risk is one of the single most important risk factors to avoid when dealing with your investments. This is because it at least doubles the risk or uncertainty associated with getting your expected return, but it, in no way, increases your expected return. In other words, when you concentrate (stocks or sectors), you willingly accept more volatility and diminish your ability to capture the return you otherwise have the right to expect. The anecdote for concentration is diversification.

There are two types of diversification:

1) Stock and market diversification: Select a globally diversified portfolio of multiple asset classes and styles. You can get a large array of different stocks and countries. A full equity, globally diversified portfolio has about 13,000 different stocks from all over the world—about 40 different countries. This is a truly diversified investment portfolio. This sort of diversification will reduce the uncertainty of capturing the average expected return as diversification works to dampen volatility. For investors who have the risk capacity to handle a bit more risk, the full equity portfolio can be tilted toward small and value in order to capture the higher expected returns that have rewarded investors over time.

2) Time diversification: Time is a key element and provides increased diversification. Once you have the large selection of stocks and securities, you need to get a large selection of time. This means you need any months (a long holding period) as opposed to just a few. This is what we call The Law of Large Numbers. Don’t buy one stock, buy an index. Don’t buy one index, buy 11 and hold it for as long as your risk capacity allows. A full-equity, small-value tilted IFA Index Portfolio 100 has a recommended holding period of 15 years. If you do not have 15 years to fully benefit from time diversification, then you must reduce your holding period and your equity to fixed income ratio in order to maintain the certainty of achieving your expected return.

A Little Off the Top?

Robert Bray — Mon, 05 Apr 2010 00:00:00 GMT

A tapeworm is a parasite that is usually ingested when you eat raw or undercooked meats. They silently siphon off nutrition meant for your body from your intestines. 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. A similar thing happens with people's investments every day. There are silent partners sucking money out little by little. A tape worm can grow up to 30 feet in length while they are entrenched in a human.

Silent Partner

Likewise, these silent partners slowly siphon off fees, transfer costs, etc. making them fatter and happier. Silent partners are those who share in your realized or unrealized gains. In most cases, a silent partner would provide some sort of contribution to aid in your venture, but in the case of your investments, these silent partners lurk in the shadows. There are numerous silent partners that take a bite out of realized and unrealized gains on investments. These partners include:

1. The sales agent or stock broker who earns a commission or load for individual stock and mutual fund trades

2. Federal and state income tax agencies that tax realized gains

3. The fund manager who actively invests the stocks in a mutual fund

4. Accountants

5. Firms that charge investment advisory fees

6. Market makers who earn a bid-ask spread on transactions

7. Transfer agents who handle the share transfers for all those trades

8. Mutual fund distributors

9. If applicable, the brokerage firm that earns interest on margin accounts

I think it’s only fitting that with tax day coming in about two weeks, we talk about the biggest tapeworm, err…silent partner of them all: the IRS. They are, without a doubt, the biggest silent partner out there.

Now, I know this is a political hot button, but I have to cite a new Bloomberg Report in order to make my point crystal clear as to how parasitic the IRS can be on your portfolio. Taxes on investments are only going to get worse due to recent legislation. The Bloomberg report, among many others, cites that the new healthcare bill would add an additional 3.8% tax on investment returns and income. “The new tax would apply to income from interest, dividends, annuities, royalties, capital gains and rents for individuals who earn more than $200,000 annually and joint filers reporting more than $250,000, according to the legislation,” the article said.

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

A tax efficient or tax-managed mutual fund means that the published return and the after-tax return should be similar since there are minimal taxable distributions from the fund. Index funds can be tax-managed, in addition to the natural advantages of low turnover in the index fund. Managers of tax-managed index funds employ tax-managed trading strategies such as tax loss harvesting of stocks that large losses, while most managers of actively manage funds have high turnover of their stocks and manage the fund as if taxes were not important to their performance.

Instead of being distributed and taxed, unrealized capital gains are profits that have not yet been realized for tax purposes. There is no need to pay taxes on these gains. The tapeworm can’t touch it. 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 neat, little side-effect of maximizing unrealized capital gain. So what does all this mean to the investor? The numbers show a DRAMATIC difference between the average equity investor and an investor who simply went with an S&P 500 Index Fund.

John Bogle did a study that covered the 25-year time period from 1980 through 2005. He analyzed returns and tax implications between the average equity investor and an S&P 500 Index Fund. The annual return of the average actively managed equity fund was 10%. The average annual return of the S&P 500 Index Fund was 12.3%. So… case closed right, Index Funds win. Well, as you have come to expect from IFA, we don’t stop with a little bit of data to backup our claims. This study gets far worse for the average equity investor. Index investors were also subjected to lower taxes despite their higher returns. The active equity fund investor paid about 3 times the tax rate at 1.8% as opposed to the 0.6% by the index investors.

S&P 500 Index Fund investors enjoyed an after-tax annual return of 11.7%, while the average equity investor settled for a much smaller annual return of 8.2% — a 3.5% difference. Since this is a 25 year study, there is obviously 25 years worth of compound interest built into it. So what did that 3.5% difference per year mean over the life of the study?

$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. That’s 33.8% gone to our favorite tapeworm. $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 sum of $158,975 with just 12.53% going to federal taxes.

So the final tally is $71,727 vs. $158,975. THAT’S OVER DOUBLE THE AMOUNT! Look what the gains would have been had someone invested in IFA's Index Portfolio 100. The returns would have been triple after taxes! This study is just the tip of the worm. Look at how much other big funds have lost to taxes.

Taxes have an enormous impact on long-term wealth accumulation, even when kept at bay. So over time, a portfolio will become weaker and weaker as the silent partners get their fill. The longer one uses active managers, the longer the worms get. People need to get into their portfolios and start whacking the worms clinging to the walls. This is not one of those symbiotic relationships. They are using their investors to grow fat and happy. How many tapeworms have grown to 30 feet while feasting on your portfolio?

Active Managers are Dust in the Wind

IFA Radio — Mon, 29 Mar 2010 00:00:00 GMT

Style drift refers to the tendency of active managers and actively managed mutual funds to deviate from their stated or expected investment style. This drift can occur gradually over time, like when a "small-cap" manager starts buying larger and larger companies as their fund asset base grows.

Style drift prevents an active investor from optimally reducing diversifiable risk because the manager of a typical active fund does not remain consistently invested in the same asset class. On the surface, this does not seem to be much of a problem, but investors who reduce diversifiable risk get a bonus. The bonus is increased return.

The recent “Standard & Poor’s Indices Versus Active Funds Scorecard, Year-End 2009” study looks at funds and their categories. It then figures out how much these funds drifted from their particular style on a one, three and five year basis. Here is the 5-year portion of the study.

As you can see, the funds supposed style consistency is more than just a tad off. In fact, the lion’s share of the asset class managers veered off course by a whopping 40% of the time!

Style drift is a key component when considering whether or not a money manager indeed beat their benchmark. If they benchmark themselves against the S&P 500 and then invest in a bunch of small cap value, it’s an inaccurate benchmark. Consider this, if I were to compare the miles-per-gallon of two different car manufacturers, but took 10 large trucks/ SUVs from one company and 6 large trucks/ SUVs with 4 COMPACTS from the other, which company is going to appear to do better?

Take The Capital Group for example. They just issued their runaround..err…article, “Why this was not a lost decade.” (which we here at IFA already knew, but of course we aren’t using what one would call manipulated data to come to that conclusion) In this article they state that their funds delivered “alpha” above the S&P 500. Suffice to say, they have been disingenuous in their presentation.

First off, they compared nearly all their actively managed American Funds to the S&P 500 Index over the past decade. How is that fair? I would have expected more from such a widely used company. They should have at least compared their funds with appropriate indexes to show a reasonable “apples to apples” comparison. Many of their funds hold international stocks, value, small…basically every stock imaginable. How is it even logical to show all their funds against the S&P 500?

And in case you were wondering if this style drift phenomenon was brought about recently by the latest recession, hate to burst your bubble, but it’s been going on since companies realized it was an effective form of data manipulation.

Back in 1996, the widely regarded Magellan Fund tried to beat its benchmark through some very egregious style drifting. Jeffrey Vinik was manager of Magellan at the time. He started shifting its asset allocation to only 70% equity, despite the fact it was benchmarked against the large-cap blend S&P 500. Vinik had invested twenty percent of the fund in bonds and ten percent in short-term marketable securities. He was betting that long-term bonds and short-term marketable securities would outperform the equities market.

Instead, the market soared to new heights, bonds fell in value, and Vinik, of course, was out at Fidelity.

So the question is obviously, “How can I avoid these pitfalls when deciding how to invest?

Know what you are buying. Compare the objective and strategy with the fund holdings. Don’t just look at the style profile, but also evaluate size, geography, asset classes and industry concentrations. Are they staying true to their style? Remember, active managers are motivated to beat the benchmark, andtaking more risk to do so is certainly not out of the question.

Establish the proper benchmark for the fund and compare fund performance to the index. Deviation from the benchmark will cause the fund to underperform or outperform—a red flag that the risk exposure is out of whack.

Maintain a proper risk exposure. Periodically review your portfolio’s exposures and potential style drift. This allows you the opportunity to rebalance your portfolio and bring your asset allocation back into equilibrium.

Hire IFA. Style drift can potentially create big problems in your portfolio. Misaligned incentives and conflicts of interest may lead to unwanted and hidden risk factors in your portfolio.

The Madness Doesn’t End in March with Active Managers

Mark T. Hebner — Mon, 22 Mar 2010 00:00:00 GMT

Well, it’s tournament time for NCAA Basketball, and I am reminded of how a great deal of the population picks their brackets. Most people don’t have any idea who the best teams are because they just started to tune into the season as their office pool is getting formed and they don’t want to be left out. So they pull up all the sports pages, the bracketology websites and so on and read all this “expert analysis” as to who will walk away with the tournament, who’s seeded too high or too low, which players are hot, etc.

For anyone who has played in NCAA pools with any consistency over the years, you know your bracket can be obliterated in the first two days despite the fact you felt you heeded some sage advice. You wonder how you could have been stupid enough to pick that upset, or how you should have picked the team based on something other than the color of their jerseys. The reason I bring this up is it’s kind of like talking to some of these money managers. They tell you which sectors were strong or will be strong this year, which companies are poised for a big run and how they have done all this research and have some great information that no one else has. The reality is grossly different.

Jonathan Clements once said in the Wall Street Journal, "Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry [and it's fund managers]. All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight year olds everywhere, actively-managed stock funds still have an ardent following among otherwise clear-thinking adults. This continued loyalty amazes me. Reams of statistics prove that most of the fund industry's stock pickers fail to beat the market. For instance, over the 10 years through 2001, U.S. stock funds returned 12.4% a year, vs. 12.9% for the Standard & Poor's 500 stock index."

We did a study where we looked at the top 100 managers in one year to see if they remained in the top 100 the following year. What we found was only about 15% of the top 100 managers from the one-year periods repeated their top 100 performance in the second year. In 1999 and in 2007, 0% of the top 100 managers made the list in the following year.

Now, we realize one year is not an ideal time frame to look at to get a real sense of a money manager’s “skill.” So we did an analysis of the Morningstar database of 800 domestic equity funds with 10 years of returns. In the image below, the top portion shows the rankings of 800 managers from best to worst for a five year period from 1991 to 1995. Then, without rearranging the order of the managers, we showed their returns over the next 5 years. Now if these managers had skill, the bottom graph would at least look somewhat similar to the graph above. There would be a few frauds exposed as being lucky, but for the most part, the general “bowtie” shape SHOULD remain constant.

Well, it came as no surprise to us that what appears to be a sorting of skilled and unskilled managers in the first period turns into complete and utter randomness in the subsequent period. If managers were truly picking with skill, would the bottom graph really look like that? I kind of wonder how a couple of those guys at the end still had clients after losing an average of 16-18% a year for ten years.

An old investment proverb observes that “markets make managers.” This means that if the market favors a money manager’s particular investment style anyone can achieve outstanding performance.

Markets can make a money manager look good or bad — a factor that’s independent of their “skillful” stock picking or market-timing abilities. An active money manager that an investor selects will usually turn out to be a winning or a losing manager because of the behavior of the market itself, rather than the manager’s skill at picking stocks or timing markets. Active money managers play a game that’s almost entirely random in conferring long-term investment success among them.

So since the market makes the managers, why not just go with the market and buy low-cost, tax-efficient index funds? I always like to say, odds are you don’t know what the odds are. If you follow my blog, you are beginning to know the odds…

After the Fall

Mark T. Hebner — Sun, 14 Mar 2010 00:00:00 GMT

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.

Today, the amazing resilience of capitalism shows us a very different picture than we all saw one year ago. Then, there was genuine fear, despondence and an utter lack of hope—no, belief—that the market could be restored, and that it was finally and 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:

“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. April 16, 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. Today the Dow is well above 10,000.

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.

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 Price is Right!

Mark T. Hebner — Sun, 07 Mar 2010 00:00:00 GMT

Stock pickers are exactly what their name implies - active investors who pick stocks or choose fund managers to pick stocks on their behalf. They do so because they are convinced that certain market prices are mismatched from their true values, and these matches can be identified and exploited for profit. So what’s the harm in this? Well, the PRICE IS RIGHT when it comes to stocks. Occasionally, there are some securities that may be mispriced, but they are impossible to identify in advance. This is because all knowable information about a company is available to all market participants at the same time. Willing buyers and willing sellers come together to agree upon a price that factors every detail about the company—its prospects, its financials, its products, and its role in its industry and the condition of the global economy. Any stock picker who believes they know more than all of the market participants makes a very faulty and very financially dangerous assumption.

Here’s the best assumption to make when it comes to stock market investing. The current price is the best estimate of a stock’s fair value. The only thing that can move this price up or down is the news which we do not know. This news can be about the market and capitalism in general or the company itself. News, by its very definition, is unknowable in advance. This is why it is called “news” and not “olds.” So since the price is moved by news, and news is unknown until it happens, what exactly do they know that they think will move the stock? There are 300,000 Bloomberg terminals for up-to-the-second trading between buyers and sellers. If news hits, it gets built into the stock price almost instantly. I suppose a stock picker could know about some news in advance of the general public…ask Martha Stewart how that technique worked for her.

Nobel Laureate Merton Miller once said, “If there's 10,000 people looking at the stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that's all that's going on. It's a game, it's a chance operation, and people think they are doing something purposeful... but they're really not.”

The reality is far different from what brokerage houses or stock-picking fund managers advertise. Here’s what their clever commercials will never tell you: the chances of a stock picker beating an appropriate index are just 1 in 36, the same long shot as throwing snake eyes at the craps table! In fact, less than three percent of managers even beat their proper benchmark. Think about it. If a company releases news about a product that’s going to put them on the map, the seller is going to know about that and he’s going to sell that stock with the product release in mind and the buyer will be willing to pay more based on this awesome new product hitting the shelves. The price agreed upon by a willing buyer and a willing seller is the most accurate approximation of a fair price. So when a stock picker buys a “hot” stock they are guessing or speculating. The expected return on speculation is zero, and that is before you account for your costs associated with trading. Returns come from exposure to specific risk factors—NOT speculation.

A recent study looked at the results of 2,076 open-end domestic equity mutual funds — funds that had professional stock pickers at the helm--for the 32 years from January 1975 to December 2006.

The study “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” applied sophisticated t-statistic analysis to compare funds’ relative performance, employing a “False Discovery Test”. This eliminated errors that would be responsible for false positive and negative results, and allowed for the distinction to be made between fund results based on luck and those based on skill.

The conclusion of the study was very bad news for stock-picking managers. It showed that after paying the hefty fees associated with active management, 99.4% of the fund managers failed to demonstrate true stock-picking ability, and were incapable of beating their appropriate benchmark, and that those who did were “statistically indistinguishable from zero.”

The uphill battle of the stock picker does not end with a need to be utterly clairvoyant – something of which the overwhelming majority has no mastery. Their returns need to beat the market by a considerable amount above and beyond that of a buy and hold index fund because of taxes. Stock pickers manage their portfolios as if taxes don’t matter. The average active manager has approximately a 100% turnover rate per year, while index funds range from 5% to 35%. This has an absolutely brutal effect on the overall performance of a portfolio.

There is a substantial incentive for investors to hold their stocks for a year or more. For stock sales with holding periods of less than one year, the gain is treated as ordinary income and subject to the full federal and state tax rate. Depending on the tax bracket and state of residence, this could be 39.6% for federal taxes and 11% for state taxes, and can have a dramatic impact on actual returns. For holding periods of one year or more, the tax rate is reduced to the long-term capital gains rate of 15%. That is an enormous difference over the life of a portfolio. Depending on the size, we’re talking hundreds of thousands of dollars of compounded interest.

So why are there still so many stock pickers out there despite all the obstacles? Burton Malkiel, author of A Random Walk Down Wall Street, said, "It's 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 this is a scam. They generally believe they can do it. The evidence is, however, that they can't." Help these poor stock pickers see the light. Join the movement of No More Active Funds!

Look to a Higher Power

Mark T. Hebner — Sun, 28 Feb 2010 00:00:00 GMT

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."

The Addict's Denial

Mark T. Hebner — Sun, 21 Feb 2010 00:00:00 GMT

One of the things addicts have trouble doing is admitting they are an addict. Recently, Jason Zweig of the Wall Street Journal dug into a new study by Mercer and the IRRC Institute. According to the article:

“A new study by Mercer, the consulting firm, and IRRC Institute, an investing think tank, asked the managers of more than 800 institutional funds how often they traded. Two-thirds had higher turnover than they predicted; on average, they underestimated their turnover rate by 26 percentage points. Even though most are judged by performance over three-year horizons, their average holding period was about 17 months, and 19% of the managers held the typical stock for one year or less.”

Can anyone say denial?

“One vehemently denied being too focused on the short term, complaining that hedge funds ‘have caused market-wide turnover to increase’ and that ‘retail investors tend to look at short-term performance and move in and out of funds’ too quickly. Those who live in glass houses shouldn't throw stones; this manager, according to Mercer, holds the typical stock for about 27 weeks at a time.” You can take this back to the Dalbar study that found over a 20yr period from 1989-2008, the average stock investor returned 1.87% per year while the S&P 500 returned 8.35% per year. Look at the data in the chart below!

click to enlarge

Like all addicts, their compulsive behavior not only escapes them, but hurts them in ways they probably aren’t even aware. Jason Zweig points to another study in his article, “A study of pension-fund stock portfolios found that, on average, the funds would have raised their annual returns by nearly a full percentage point if the managers had gone on a 12-month vacation and never made a single trade.”

All hope is not lost though. We are starting to see a turn of the tide where a great deal of investors are beginning to realize index funds are the way to go, but they just can’t let go of the active trading addiction as evident by this new fad of short term ETFs. It’s sort of like an alcoholic who switches from whiskey to beer and thinks they are cured. Sure, they are starting to pull away from the hard stuff like picking individual stocks and trading them on “gut instincts” or information they just received (which coincidentally almost the entire investing world probably received at the same time). But the fact that they still feel the need to trade the index funds actively shows they are not cured.

People also need to realize the media is in the back pocket of these active traders who buy advertising on their affiliates. These places MUST sell an active strategy since their source of income is trade, trade, trade. Fidelity is even offering free trades with select iShares’ ETFs.

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. This means investment returns are more dependent on the investor’s behavior than the performance of the investment itself. A Dalbar study showed that most investors invariably buy high and sell low because they rely on emotions and that ever dangerous “gut instinct.” Jon Lukomnik, co-Author of the Mercer/IRRC Study from earlier, said, “It takes a very secure person to say, ‘I don’t have to trade.’”

Warren Buffet said back in February 1992, "The stock market serves as a relocation center at which money is moved from the active to the patient."

Market Timing is Indeed Perilous

Mark T. Hebner — Sun, 14 Feb 2010 00:00:00 GMT

I really want to dissect a bit further the people out there who think they can time the market in order to get maximum returns. This basically means people who would have had the “foresight” to jump out of the market back in October 2007 and then jumped back in the market in March 2009. How many people got that one right? I’m reminded of a quote by Charles D. Ellis, author of Winning the Loser’s Game, when he said, “Market timing is a wicked idea. Don’t try it-ever.” But why is it a wicked idea? Surely there must be some sort of sign the market is about to take a dip. Surely the professionals who know more about the market than the average main street investor can guide you in and out of the indexes across the globe.

Well, if you studied economics at MIT or went to Boston University’s School of Management, you’d likely be given the book Investments. That book, the one some of the most prestigious schools in the country use to train our economic minds of the future, says this about the stock market:

"Statistical research has shown that, to a close approximation, stock prices seem to follow a random walk with no discernible predictable patterns that investors can exploit. Such findings are now taken to be evidence of market efficiency, that is, evidence that market prices reflect all currently available information. Only new information will move stock prices, and this information is equally likely to be good or bad news."

Interesting because that seems to fly in the face of what all these mutual fund gurus and bombastic television personalities are saying.

So is this book being used to teach the brightest minds in our country wrong? Are there actually people who can see some organization or patterns in the random walk of Wall Street? The only way to find out is to look at the data.

In 1998, Jeffrey Lauderman wrote a BusinessWeek article titled Market Timing: A Perilous Ploy, analysis which included an interview with Mark Hulbert, who monitors the time pickers recommendations. Mr. Lauderman emphatically dispelled the myth of market timing, which he called a guessing game. Hulbert's conclusion provided a knockout blow to all 25 newsletters he tracked. NONE of the newsletter timers beat the market. For the 10 year period ending 1988 to 1997, the time pickers' average return was 11.06% annually, while the S&P 500 stock index earned 18.04% annually and the Wilshire 5000 earned 17.57% annually. Compare how the S&P 500 did against the different market timing newsletters over the last 10 years.

Click Above Chart to Enlarge

So looking at this chart, the evidence seems to overwhelmingly be on the side of the textbook, not the investment gurus screaming at you on CNBC to buy-hold-buy-sell-hold-sell-buy….

Now, what if I told you there was an investor (who would had to have made some deal with the devil) that was actually able to nail 100% of the bad markets and 50% of the good markets for the past NINETY years? I’m sure almost everyone would be flocking to this superstar. Well, this superstar would STILL have fallen short of the overall market return over that period. Those are the types of odds these market timers are up against. They can be right more often than not and still not be able to keep pace with the market.

Legendary writer Mark Twain summed it up best, "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."

No More Active Funds!

Mark T. Hebner — Sun, 07 Feb 2010 00:00:00 GMT

“When it comes to fund managers and market strategiests, this year’s hero usually turns into next year’s zero.”

-- William Bernstein, The Investor’s Manifesto: Preparing for Prosperity, Armageddon and Everything In Between

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.

click here for full size image

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.

click here for full size image

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."

IFA President Mark Hebner has launched a campaign to expose the big lie:

Join the movement. Improve the financial futures of yourself and those you care about. Let the active managers know that the con is over and the massive wealth extraction will be reversed!

Pundits' Pathetic Prophecies

Mark T. Hebner — Sun, 31 Jan 2010 00:00:00 GMT

I can’t take these stock market pundits trying to tell me where the market is “going.” These self-appointed gurus have no idea of what tomorrow’s news will be, but they make predictions about how the market will move. Everything we know about a stock is already built into the price. The only thing that will move a stock price or a market’s value up or down is the news we do not know. Bottom line, anyone who professes to know where the market is going is at best guessing and at worst, lying to get a commission or sell a product.

Investors who rely on market predictors are doomed to underperformance relative to a reasonable benchmark. In Step 2 of my 12-Step Program for Active Investors, I lead investors to a wealth of information that renders the nonsensical predictions of modern-day charlatans utterly useless, and recommend a sounder source — a higher power, if you will -- for investment advice.

Step 2 deals with Nobel Laureates. The Nobel Prize in Economics is an award for outstanding contributions to the science of economics and is generally considered one of the most prestigious awards for that science. The nomination, review and final awarding process is a rigorous one, including ample peer review and scrutiny of an individual’s body of work and its quantifiable contribution to the world of economics. Higher power, indeed.

When it comes to bona-fide credible information for sound investing, academic economists have no skin in the game beyond providing rigorous data that will withstand the competitive and intellectual scrutiny of their peers. They are driven by a need for credibility that must be substantiated with cold-hard facts that cannot be manipulated by human emotion. Jim Cramer and his merry band of ill-fated market timers and stock pickers could spend the rest of their lives learning from these folks — and turn out far better off financially.

Paul Samuelson was the first American to win the Nobel Prize in Economics. When they awarded Samuelson his prize, the Swedish Royal Academics stated that he “has done more than any other contemporary economist to raise the level of scientific analysis in economic theory.” Known for his uncanny ability to bring his message to the people, Samuelson was famous for saying:

“Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

and…

“It’s not easy getting rich in Las Vegas, Churchill Downs, or the local Merrill Lynch office.”

and…

“This message (that attempting to beat the market is futile) can never be sold on Wall Street because it is in effect telling stock analysts to drop dead.”

William Sharpe won the Nobel Prize in Economics in 1990. He said, “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.”

Harry Markowitz won his Nobel Prize in 1990 for his determination that risk must be considered as well as return. He recently said, “If it perfectly fine to own an undiversified portfolio so long as God Himself is providing the portfolio advice.”

Daniel Kahneman won the Nobel Prize in Economics in 2002. In an article entitled “Investors Can’t Beat the Market” that appeared in the Orange County Register he said, “Question: So investors shouldn’t delude themselves about beating the market? Answer: They’re just not going to do it. It’s just not going to happen.”

The overwhelming majority of investors have nary a clue about the abundance of academic brainpower that has been applied to the determination of how to invest successfully, and you’re sure to not hear about such sound research on Mad Money because the sponsors who profit from trading would shut it down.

As Step 2 so overwhelming points out, there’s a stark contrast between peer reviewed, non-biased academic research and the falderal that fills the pages of financial rags the likes of The Wall Street Journal, Barron’s, Forbes, Fortune, and Money. Perhaps Warren Buffett best summarized this reality when he said, “The only value of stock forecasters is to make fortune-tellers look good."

An Advisement About Advisors

Mark T. Hebner — Sun, 24 Jan 2010 00:00:00 GMT

I just can’t take the high fees advisors charge to actively manage portfolios.

When you pay an active manager to buy and sell in your account—all based on their speculation about what they think the market will do, you are paying a relatively high fee without a valid reason to do so.

Market-timing advisors charge somewhere in the neighborhood of 1.5% to as much as 4% to trade your portfolio. Since numerous studies have shown that market timing does not work, you do NOT need these services, as they will lead to the erosion of your wealth.

According to Roger Ibbotson, more than 100% of variability of a fund's investment return is due to asset allocation. Proper asset allocation should be done based on decades of historical risk and return data, not a few years of data or speculation about the future. Remember those who live according to the crystal ball, very soon eat ground glass.

However, there are legitimate and valuable advisor services that are worth paying a reasonable fee for. Your advisor should fulfill certain roles for you throughout your investing career. There are seven basic roles I like to point out that an advisor worth his fee should not only provide, but excel in.

The Expert: You need an advisor who can provide expertise in assessing the state of your finances and developing risk-appropriate investment strategies to help you meet your goals.

The Independent Voice: The global financial turmoil of the past two years has demonstrated the value of an independent and objective voice in a world full of product pushers and salespeople.

The Listener: The emotions triggered by financial upheaval are real. IFA will listen to your fears, seek out the issues driving those feelings and provide practical long-term answers.

The Teacher: Getting you beyond the fear-and-flight phase of investing often is just a matter of teaching you about risk and return, the power of diversification, the importance of asset allocation and the virtue of discipline. With IFA's extensive investor education program, we have a unique set of tools to be your teacher.

The Architect: Once these lessons are understood, IFA becomes an architect, helping you to build a long-term wealth management strategy that caters to your own risk capacity and lifetime goals.

The Coach: Even when the strategy is in place, doubts and fears will inevitably arise in your mind. At this point, IFA becomes a coach, reinforcing academic investment principles and keeping you on track.

The Guardian: Beyond these roles is a long-term role as a kind of lighthouse keeper or guardian, scanning the horizon for issues that may affect you and keeping you informed.

Since you can’t time the market, a good advisor will ensure that you get on that bull and you stay on it – NO MATTER WHAT. This is sometimes the hardest part of the advisor’s job, and the advisor that can accomplish this task for you is worth every penny you pay them. Investor emotions can be destructive. When you have a properly allocated and risk-appropriate index portfolio matched to you, you should invest and relax. Just hold on.

Legendary investor and Warren Buffett’s mentor 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.”

Where's the Trust?

Mark T. Hebner — Sun, 17 Jan 2010 00:00:00 GMT

I just can’t take the fact that investment professionals will not accept fiduciary liability for their clients! A fiduciary is someone responsible for acting in the best interest of the client — putting the client’s best interest above their own. It’s egregious when a service provider gives the illusion of acting as a fiduciary — only for the client to learn (always the hard way) that this was NOT the case.

IFA Senior Vice President, Dan Solin has posted many painful stories about this very issue on his blog at AOL’s Daily Finance. He’s exposed some pretty nasty cases. One that leaps to mind involves John Hancock and its silence on its fiduciary status. 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." Of course that makes them sound like they’re a fiduciary, right?

Well, when taken to task, John Hancock (JH) admitted they are, in fact, not a fiduciary, nor do they have any desire to be one. When a JH client questioned their fiduciary status, JH sent an email stating, "John Hancock is not in a position to act as a fiduciary with respect to any particular plan and nowhere in our materials do we say that we are."

They absolved themselves of responsibility, despite the fact that they gave a strong impression of undertaking the responsibility associated with a fiduciary—namely avoiding conflict of interest through self-dealing in the form of pay to play and hidden fees.

This begs the question: Why would you want to invest with a company who cannot act as a fiduciary on your behalf because they are putting their own monetary interests ahead of yours? After a mere few seconds of thought, most people would say, “No Way!” The problem though, is most people don’t even know to ask these questions until the problems arise — and then, it’s usually just too late and it’s time for the lawyers to get involved.

John Bogle testified about this very problem before the Committee on Education and Labor, U.S. House of Representatives, he said, in part:

“The multiple failings of our flawed financial sector are jeopardizing, not only the retirement security of our nation’s savers but the economy in which our entire society participates.”

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

Here are five critical questions to ask a potential advisor:

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, Fidelity, or TD Ameritrade?

Will my securities be transparent and marketable at all times?

When it comes to whom you trust with your assets, fiduciary trust should never be assumed, education should never be short-cut, due diligence should never be undermined, and transparency should never be sacrificed. If a person doesn’t ask the tough questions of their potential asset manager, the trusting investors may find themselves with far less to entrust.

Learn more about the fiduciary standard and what it means to you.

Click here to see: Is Your Advisor On the Right Track?

All that Glitters is Not Gold

Mark T. Hebner — Sun, 10 Jan 2010 00:00:00 GMT

The commercials driving everyone towards gold are driving me crazy. I just cannot take it anymore! The saddest part is most investors are driven to making 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: 1) the expected return and 2) the uncertainty of that return (also known as risk).

In order to make an informed decision about investments, you need an understanding of the probability of future returns and the uncertainty of obtaining them. This sort of information cannot be discerned from short-term price movements or 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 that gold is a sucker’s bet!

Over the 48-year period ending in 1992, gold had an annual return of 4.9%, but its risk was 26% (as measured by standard deviation of monthly returns). When you 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 this 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.

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 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 statement, scrolling headlines have posted the following: “Gold Prices to Rise in 2010”! Before you back up the truck to the loading dock of 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.

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!” he cried impatiently, “I cannot make bricks out of clay!” , Sherlock Holmes, The Adventures of the Copper Beeches.

Media Creates Uphill Battle for the Investor

Mark T. Hebner — Sun, 03 Jan 2010 00:00:00 GMT

I have no idea how these talking heads can get away with these predictions where they scream at the camera with enough conviction to persuade almost anyone within earshot about the stocks they’re trying to push or the funds they’re promoting. The media bias towards active investing is certainly due in no small part to them being sponsored by financial institutions that NEED you to trade to stay afloat. But you have to resist trading.

ODDS ARE YOU DON'T KNOW WHAT THE ODDS ARE...

The next time you see a couple guys on the financial news shows (who if you noticed are always changing, likely because none of them ever stay on top for long) recommend certain stocks or hedge funds, just think about the latest flavor-of-the-month financial advice. Right now, a lot of “experts” are saying large growth is where you should be. The problem is if you look at all the 12 month periods over the last 81 years, the large growth sector was a better place to be about 41% of the time. Nice little number except it’s just enough to keep the investors chasing their tails. It gives investors enough faith that it’s possible since they are confident they know what they’re doing. Unfortunately, predicting large growth over large value follows the same principle that all other stock picking does: pure chance. I wouldn’t put much stock into it. (pun intended)

You really need to look at the amount of time you plan on keeping the investment. Let’s take a look at the different percentages over certain holding periods when large growth outperformed large value:

12 month period = 41%
5 year period = 32%
10 year period = 23%
15 year period = 15%
20 year period = 8%

So over a 20 year holding period you have a 92% chance of being better off in large value as opposed to large growth. Keep your eye fixed on the long term, not the short term movements.

This is another reason why it is so vital to figure out your risk capacity. There are too many people jumping into investments they hear are smart on TV when the reality is even if they are smart, they may not be smart for them.

Holding steady in the large value stocks is not only the move with the least amount of stress, it’s also the smarter move.