5-facts-your-broker-wont-tell-you

Posted on March 15, 2012 by Dan Solin
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Many investors rely on brokers and the financial media for advice on investments. This is unfortunate, because much of the advice from these sources is demonstrably wrong and harmful to financial health. Here are five investment facts your broker will never tell you:

1. Index investments are growing. By some estimates, $2.3 trillion is invested in passive funds and exchange-traded funds. What do these investors know that your broker is keeping from you?

2. Index funds have higher expected returns. According to an article by Christopher Philips in the Journal of Indexing, index fund investors can expect to outperform a majority of higher-cost actively managed funds over similar time periods. The evidence is quite compelling. Every report prepared by Standard & Poors comparing index to actively managed funds over the past 10 years found that, during a five year market cycle, a majority of active funds in most categories failed to outperform indexes. Is your time horizon longer than five years? If so, why is your broker recommending higher cost actively managed funds that are likely to underperform comparable index funds?

3. Index funds are more tax efficient. It’s not the returns of a fund that should be your sole concern. It’s how much of those returns you keep, after taxes. Philips notes the typical actively managed fund distributes a whopping 50 percent of its annual price appreciation in the form of capital gains, creating tax liability for holders of its shares. In stark contrast, index funds distribute an estimated minuscule 0.5 percent as long-term gains. Turnover in a portfolio creates taxable gains. Actively managed funds have much higher turnover than index funds because actively managed funds chase returns. Index funds sell only when necessary to track the index.

4. Indexing works in both highly efficient and less efficient markets. When you mention indexing to brokers, it is much like advocating a vegetarian diet at a cattlemen’s convention. The reaction can range from outrageous to simply mistaken. Brokers love to tell you how indexing might have some benefit in highly efficient markets like the U.S. government bond market. In contrast, they will note that in less efficient markets, like small-cap U.S. and high yield bond funds, active managers strut their stuff and outperform. The data is to the contrary, but don’t expect them to show it to you. Philips looked at 15 years of data as of December 31, 2011. Active managers in both small-cap U.S. equity and high-yield U.S. bond funds underperformed significantly.

5. Index funds outperform in bull and bear markets. You may have heard this statement (or some variant): In bear markets, active fund managers shine because they can shift assets in and out of the market and minimize losses. It’s bunk. Phillips calculated the percentage of active managers who outperformed the market during various bull and bear markets. He found that in four of the seven bear markets since January 1973, the average actively managed mutual fund underperformed the index. It’s worse in bull markets. Active fund managers underperformed in seven of the eight bull markets examined.

If you knew these facts, you would not invest in actively managed funds. Now you know.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read, and The Smartest Portfolio You’ll Ever Own. His new book, The Smartest Money Book You’ll Ever Read, was published on December 27, 2011.

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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Escaping from the Great Vampire Squid

Posted on March 14, 2012 by Jay Franklin
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As a blogger, sometimes there is a dearth of topics to write about, and sometimes Christmas comes early. My benefactor for today is Greg Smith, a former executive director at Goldman Sachs who tendered his resignation as an op-ed in the New York Times. If you have not read it, please do so immediately, especially if you are a Goldman client.

According to Smith, his primary reason for quitting Goldman is the devolution of its culture into a “toxic and destructive” environment where clients (or “muppets”) are viewed purely as a source of profit  – and the extraction of said profits is expressed in high poetic diction like “ripping their eyeballs out.” Naturally, Smith asks the proverbial question, “How did we get here?”

His answer centers on the three ways that Goldman “services” its clients: a) persuading them to buy stocks or other securities that Goldman is trying to clear from its inventory. It reminds us of Robert Soros’s admonition, “You are just a buyer of Wall Street’s dreck.” b) getting clients to trade the products that provide the highest commissions to Goldman, or “elephant hunting.” c) If all else fails, selling them illiquid opaque products with 3-letter acronyms like CDO’s. One cannot help but be reminded of William Bernstein’s quip about stockbrokers servicing clients in the same way that Bonnie and Clyde serviced banks.

While we might be tempted to think that as long as we are not Goldman clients, none of this should concern us. Unfortunately, however, many of us are unwitting Goldman clients via the public pension funds entrusted to Goldman and its deep involvement in the debt-based financing of public projects.

While we certainly applaud and congratulate Smith for his courageous public stance, the one point we would contest is Smith’s assertion that the Goldman Sachs of twelve years ago was a place of high corporate culture where the notion of putting the client first prevailed. Twelve years ago was the very top of the Internet bubble where Goldman made billions at their clients’ expense from underwriting IPO’s for dot com companies that are now either defunct or trade as penny stocks. Further details may be found in Matt Taibbi’s article, “The Great American Bubble Machine” where he famously described Goldman as a “great vampire squid wrapped around the face of humanity.”

Since Mr. Smith has essentially transformed himself into a toxic asset as far as Wall Street is concerned, we suggest that he find a career where he is actually providing valuable goods and services to society. If, however, he intends to stay in the financial services industry, then he should try sitting on the same side of the table as his clients for a change by becoming a fee-only registered investment advisor. As for Goldman’s clients, we suggest that they follow Smith’s example and sever their ties immediately, unless of course, they enjoy being viewed as muppets with pockets ripe for the picking.

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Active vs. Passive: The View from Standard & Poors

Posted on March 14, 2012 by Jay Franklin
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“The only consistent data point we have observed over a five-year horizon is that a majority of active equity and bond managers in most categories lag comparable benchmark indices.”

-Standard & Poors Indices versus Active Funds (SPIVA ®) Scorecard1

 

S&P recently published its eagerly awaited year-end 2011 scorecard, and the story for actively managed funds continues to remain dismal, as seen in the table below.

Percentage of Active Funds Outperformed by Benchmark
Calendar Year 2011 5 Years Ending 12/31/2011
Domestic Equity Funds 80.5 71.6
Real Estate Funds 76.2 70.2
International Equity Funds 63.8 70.8
Fixed Income Funds 74.6 81.9

The true numbers are actually worse because the returns evaluated by S&P are not adjusted for loads. Since its ultimate source of data is the Mutual Fund Database from the Center for Research in Security Prices, SPIVA accurately accounts for funds that failed to survive the period due to merger or liquidation. The well-known commercially-used fund databases suffer from this survivorship bias which causes active managers as a group to appear to have better returns than is actually the case. Another helpful aspect of SPIVA is its tracking of style consistency among active funds. For the five years ending 12/31/2011, only 49.3% of all active domestic equity funds both survived the period and maintained the same style. For investors who are concerned with maintaining a consistent asset allocation, actively managed funds are poor vehicles.

At this point, we will review some of the myths that are busted by SPIVA.

Myth:  Indexing is fine for large-caps, but since the small-cap market is inefficient, an active manager can take advantage of those inefficiencies and thus outperform a small cap index.

Fact:  “Over the last decade, SPIVA has consistently shown that indexing works as well for U.S. small-caps as it does for U.S. large-caps.” The table below provides the numbers.

Percentage of Active Funds Outperformed by Benchmark
Calendar Year 2011 5 Years Ending 12/31/2011
Large-Cap Domestic Equity Funds 78.3 61.6
Mid-Cap Domestic Equity Funds 69.2 86.0
Small-Cap Domestic Equity Funds 88.4 74.4

 

Myth: Active managers do better in bear markets than index funds because they can make defensive moves while the index funds are forced to ride the market down.

Fact: “In the two true bear markets the SPIVA scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.” The table below provides the numbers.

Percentage of Active Funds Outperformed by Benchmark in Bear Markets
2008 2000 to 2002
Large Cap Domestic Equity Funds 54.3 53.5
Mid-Cap Domestic Equity Funds 74.7 77.3
Small-Cap Domestic Equity Funds 83.8 71.6

Of course, a naïve reader of SPIVA could argue that it does not apply to him because he will find the rare manager who can consistently outperform his peer group. SPIVA’s companion report, The S&P Persistence Scorecard belies this claim. It shows that year after year, the number of managers who remain in the top half of their peer group is either equal to or less than 50% (what we would expect from chance). Even if an investor thinks he has found a manager who has outperformed his benchmark over a long period, a statistical test such as the t-test will often show that luck cannot be ruled out as the explanation. To summarize, would-be manager-pickers would do well to read the SPIVA report along with the S&P Persistence Scorecard and take their lessons to heart.

1http://www.standardandpoors.com/indices/spiva/en/us

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An Investor Protection Plan

Posted on March 13, 2012 by Dan Solin
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It is sickening to witness the continued fleecing of investors. If you are using a retail broker, or relying on much of the financial media, you may be a victim. Protect yourself.

Insist on Peer-Reviewed Data

There is data and then there is peer-reviewed data. Much of the data you receive from brokers and hear or read in the financial media is not peer-reviewed. While peer review does not guarantee accuracy or reliability, it means the information being disseminated has gone through an evaluative process to determine whether or not it is suitable for publication. You can find an extensive list of leading financial journals here.

The next time you get a stock picking, market timing or manager picking recommendation (which is the daily grist of many brokers), ask the person giving you this advice to provide a peer reviewed article indicating that he is following a methodology with a demonstrated history of success. You won’t receive one, but the deer in the headlights look will at least make this exercise entertaining.

Don’t Fall for Cherry Picked Portfolios

Everyone knows that past performance is not predictive. Why then do brokers so often rely on the short term past performance of fund managers as the basis for making recommendations? A very common trick used by brokers is to recommend a portfolio of stocks, bonds and mutual funds (or a combination) which has outperformed relevant benchmarks over a designated period of time. A few minutes with the right software can easily produce a portfolio with stellar returns. When confronted with this type of proposal, ask your broker to represent in writing that this portfolio was actually in his clients’ portfolios for the entire period of time for which the returns are illustrated. Don’t bother checking your inbox for a response.

Focus on Risk

Every investor should be concerned with the risk of their portfolio. Yet, in my experience, few are. Whenever I use the words “standard deviation,” which is a measure of risk, I can see a glazed look come over my prospective client. Here’s a simple guide everyone can follow. The calculations are based on the annualized standard deviation of monthly returns for Index Portfolios over 84 years from Jan. 1, 1928 to Dec. 30, 2011:

  • Very aggressive investors (100 percent stocks) should have a standard deviation that does not exceed 23 percent;
  • Moderate investors (60 percent stocks/40 percent bonds) should have a standard deviation that does not exceed 13 percent
  • Conservative investors (Up to 35 percent stocks/ 65 percent or more bonds) should have a standard deviation that does not exceed 8 percent.

Debunk Their “Expertise”

A broker who loses a client to index funds typically responds with a dismissive statement indicating that he and his firm have the ability to select “market beating” fund managers. As discussed above, ask him to show you a peer reviewed article demonstrating the reliability of his methodology. In addition, ask him to provide you with a long term (10 years or more) analysis comparing the returns of the proprietary mutual funds of his firm (funds that have the name of the firm as part of the name of the fund) with their Morningstar assigned benchmark. After all, if they can pick superior managers, wouldn’t those managers be running their branded mutual funds? This is another report you are unlikely to receive.

There is an easier way to avoid becoming a victim. Don’t use any retail broker or adviser who tells you they have the ability to “beat the markets”.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of “The Smartest Investment Book You’ll Ever Read,” “The Smartest 401(k) Book You’ll Ever Read,” “The Smartest Retirement Book You’ll Ever Read” and “The Smartest Portfolio You’ll Ever Own.” His new book, “The Smartest Money Book You’ll Ever Read,” was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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An Open Letter to Jim Beard, Atlanta’s CFO

Posted on March 7, 2012 by Dan Solin
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Dear Mr. Beard:

I read with interest an article in the Atlanta Journal-Constitution outlining the woes of your city’s three big pension plans for police, firefighters, and other employees. These plans have assets of approximately $2 billion. I understand that investments in these plans are overseen by boards of trustees who retain investment advisers to give them investment advice. According to the article these advisers were paid $8.5 million in 2011.

My guess is these advisers told you how they could add “alpha” by selecting fund managers who could “beat the markets.” I am sure the quality of their charts and graphs were outstanding. Their presentation was no doubt stellar. Did it focus on the past performance of the managers they were recommending? It usually does.

It doesn’t seem like this process is working out too well for the hard working city employees. Last year, the returns of the three funds ranged from 1.02 percent to 2.80 percent. Over the past decade, they ranged from an annual average of 5.02 percent to 5.52 percent. In order to make up for devastating losses in 2007-2008, these plans need to achieve an annual investment return of 7.75 percent-8 percent over the next 30 years.

I have to admit that I was pretty surprised by your take on this dismal situation. You are quoted as noting that the plans need “… to assume more risk” to make up for lost ground. Despite evidence that the relatively small percentage of pension assets in index funds appear to be outperforming comparable actively managed funds in the plans, you still favor using “a mix” of index funds and actively managed funds. Your reasoning is revealing: “If I think I have a fleet of [active] managers that outperform… it may be worth paying to get that.”

I believe you are barking up the wrong tree. The data on the ability of pension administrators to select outperforming active fund managers is pretty depressing. A 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 both money and time. The study looked at the ten-year period from 1994 through 2003, and examined hiring and firing decisions by consultants and boards at 3,400 plans. It found that hiring fund managers with superior past performance on average yielded post hiring excess returns of “zero.” Even worse, when these managers were fired, post firing excess returns were frequently positive and “… sometimes statistically significant.” You should read this conclusion of the authors of the study: “Our sample of round-trips shows that if plan sponsors had stayed with fired investment managers, their excess returns would be no different than those actually delivered by newly hired managers.”

Frankly, it is beyond me why you believe you have the ability to buck these odds.

I have a bold proposal for you, but first I want to acquaint you with additional data.

Your best plan annualized return was 5.52 percent over the past decade. If you had invested in a globally diversified portfolio of all passively managed funds (using no actively managed funds), in an asset allocation of 60 percent stocks and 40 percent bonds, rebalanced at the beginning of each year, your returns would have been 6.02 percent annualized return for the period ending Dec. 31, 2011. No need to take unnecessary risks by over allocating to stocks.

Your goal is to achieve a return of 8 percent for your plans over the next 30 years. The simulated index portfolio mentioned above achieved an annualized return of 9.82 percent over the past 30 years and 9.55 percent over the past 50 years.. The composition, risk and returns of that portfolio can be found here. Sources, updates and disclosures can be found here.

Atlanta General Employees Pension Plan: Growth of $1 Billion

Here’s my proposal:

Fire all of your active managers. Abandon the notion that you have the ability to pick “market-beating” fund managers. You’ll be in good company. The Thrift Savings Plan, which is for government employees, has over $270 billion under management. It is all indexed. Our congressional representatives are participants in this plan. That should tell you something!

You can dismantle the huge infrastructure you have for picking new funds and eliminating losers. It’s really just a charade. I know the active managers will howl in protest. Here are some questions you can ask them:

1. Can you show me a peer reviewed study where a methodology for picking out performing active managers has been actually implemented and demonstrated to work over a long period of time?

2. If you really had the ability to select these managers, why haven’t you done so for our plans in the past with any consistency?

3. Can you show me the returns versus Morningstar Assigned Benchmark for all of your proprietary mutual funds? Logically all, or most of them, should be outperforming their benchmark since I assume your superior manager picking skills would start with the funds that carry your brand.

You really need to focus on the data. There’s no shortage of it. You will find it summarized in my books, and in books authored by John Bogle, William Bernstein, Burton Malkiel, Mark Heber and many others. Your police and firefighters put their lives on the line for the protection of the citizens of Atlanta. At the very least, you could educate yourself on basic principles of investing and enable them to retire with dignity.

Sincerely,
Dan Solin

 

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of “The Smartest Investment Book You’ll Ever Read,” “The Smartest 401(k) Book You’ll Ever Read,” “The Smartest Retirement Book You’ll Ever Read” and “The Smartest Portfolio You’ll Ever Own.” His new book, “The Smartest Money Book You’ll Ever Read,” was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated.

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Surprising Investing Myths

Posted on March 1, 2012 by Dan Solin
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How you invest your hard earned money is critically important. It can determine whether you can retire with dignity or be dependent on friends and family in your “golden years.” With so much at stake, you would think most investors would have a pretty good handle on how to avoid financial pitfalls. Unfortunately, this is not the case.

To help guide you through the mine field of investing traps, I have compiled some little-known investing myths. If you pay attention to them, you will be well on your way to improving your expected returns.

Most Investors Have Goals

I have advised many investors. When I ask them for their goals (“What do you want to achieve with your investments?”), I usually get a long pause on the other end of the line. Without a map, you can’t get to a destination. You need a goal.

Establishing an Investment Goal Is Difficult

It’s actually quite easy. I typically ask this question: “Would an acceptable goal be to come up with a plan that will maximize the possibility that you and your spouse (or partner) will not run out money during your lives, and which will permit you to maintain your quality of life?” Every time I ask that question, I get an enthusiastic “yes” in response.

Running the Report to Determine if My Goal Is Realistic Is Too Complex

The report you need is called a “Monte Carlo Simulation.” It’s not perfect because it is based on many assumptions. But it’s based on long term historical data and it will be a good starting point for you to determine if you are on the right track. It requires relatively few inputs and you can run it yourself here.

The Biggest Decision I Need to Make Is What Broker or Adviser I Should Use

Initially, the biggest decision you need to make is whether you will engage in active management (where you and your broker attempt to “beat the market”) or you will engage in index based investing, where you seek to capture the global returns of the marketplace, using a diversified portfolio of low management fee stock and bond index funds. This is a watershed decision and it is where most individual investors make a huge mistake. They are persuaded by the financial media, hundreds of millions of dollars of advertising money and the entreaties of brokers and active advisers to try to beat the market by stock picking, fund manager picking and market timing. The overwhelming data supports index based investing. You will find a helpful chart comparing active with index based investing here.

Once you decide to become an index-based investor, choosing a broker or adviser is quite easy. You will need to eliminate almost all brokers from consideration, since they tend to be proponents of active management. Most advisers fit into the same category. Only a relatively small group of advisers strictly adhere to the principles of index based investing.

Stellar Past Performance Is a Good Measure of Investment Skill

Every year, another fund manager is anointed as the “next investment guru” based on his recent past performance. It’s more likely he was just lucky rather than skillful. It can take a very long period of time (often 20 years or more) to determine whether the performance of a fund manager was luck instead of skill. Relatively few fund managers stick around that long.

If Only I Qualified for a Hedge Fund Investment

Be thankful you don’t. If you do, avoid the temptation. In his new book, The Hedge Fund Mirage: The Illusion of Big Money and Why It’s Too Good to Be True, Simon Lack concludes that hedge fund investors as a group would have been better off if they had simply invested in Treasury Bills. Lack bases his conclusion on publicly available data from Hedge Fund Research, Inc. Hedge funds are great investments for those who run successful ones, because of the excessive fees they charge: commonly 2 percent of assets and 20 percent of profits. This fee structure motivates them to take very high risks… with your money!

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of “The Smartest Investment Book You’ll Ever Read,” “The Smartest 401(k) Book You’ll Ever Read,” “The Smartest Retirement Book You’ll Ever Read” and “The Smartest Portfolio You’ll Ever Own.” His new book, “The Smartest Money Book You’ll Ever Read,” was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated.

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The Greater Fool Theory and Investing

Posted on February 29, 2012 by Dan Solin
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The greater fool theory (GFT) refers to those who buy an investment based on the premise they will be able to sell it at a profit to a “greater fool.” Many investors subscribe to this theory, but don’t know they are engaging in it. In an ironic twist, they become the “greater fool,” and are left holding the bag when the investment falls and they either can’t find a buyer or they have to sell at a loss. Here are some examples of “greater fool” investments. See if you recognize yourself in any of these scenarios:

You Overweight Your Portfolio in Gold

It’s clear to you that the world is headed towards a financial crisis that will dwarf the Great Depression. Sovereign debt is out of control. Greece and other European countries are on the brink of bankruptcy. The deficit of the U.S. is at record levels. Something has to give and you believe it will precipitate a world-wide financial meltdown. What’s the solution? Buy gold, of course.

You are hoping the price of gold will continue to increase. It better. While you are holding it, it pays no dividends. Gold engages in no productive activity. It is not manufacturing goods or providing services. You should understand that loading up on gold is premised on the GFT. You are assuming that you will be able to sell it in the future to someone whose fear about the state of the world economy is greater than yours. Of course, that’s possible. But who was the person or entity that sold you the gold you purchased? They obviously didn’t share your world view. Which of you was the greater fool?

You are Picking Stocks

Picking stocks refers to both the practice of buying individual stocks because you believe they are mispriced, or purchasing actively managed stock mutual funds, where the fund manager attempts to beat a designated benchmark. If you are engaging in either of these activities, you are a participant in the GFT.

Individual and institutional stock pickers assume they can find mispriced (typically underpriced) stocks, hold them and sell them at a profit. If anyone could do this, you would think it would be Bruce Berkowitz, the much lauded manager of the Fairholme Fund. With much fanfare, on Jan. 12, 2010, Morningstar issued a press release naming him the “Domestic-Stock Fund Manager of the Decade.” It noted this was a new award recognizing fund managers who have achieved superior risk-adjusted results over the past 10 years and have an established record of serving shareholders well.”

How did the “Domestic Fund Manager of the Decade” perform in 2011? According to data provided by Morningstar Direct, his fund suffered a staggering loss of 32.4 percent!

Greater fools thought that Berkowitz had the Midas touch that would continue indefinitely. They assumed there would always be buyers at a higher price for stocks picked by him. They were wrong.

If you purchase any actively managed mutual fund, you are engaging in the GFT. One study (reported here) showed the Vanguard Index fund beat 75 percent of designated mutual funds before taxes for the period 1982-1991. The same study found that its after tax return beat 65 out of 71 mutual funds. When you buy these actively managed funds, you are the greater fool.

You Buy a Private Equity Deal

Private equity deals are wonderful profit opportunities for those who manage them. According to the Financial Times, from 2001 to 2010, U.S. pension plans made on average 4.5 percent a year, after fees, from investments in private equity. What percent of gross investment performance was paid in fees to those who managed the funds? Would you believe 70 percent? That’s the view of Professor Martijn Cremers of Yale, who was quoted in the Financial Times article.

What if these pension plans dismantled the expensive infrastructure they have in place to evaluate these deals and just invested in passively managed (index) funds, using a balanced portfolio of 60 percent stocks and 40 percent bonds? For the same period of time (Jan. 1, 2001-Dec. 31, 2010), the annualized return of this index portfolio would have been 6.61 percent. You can run your own calculations for the returns of index portfolios for any time period by using this calculator. Use it to compare the returns of your portfolio to an index portfolio of comparable risk.

It will help you determine who is the greater fool.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of The Smartest Investment Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read and The Smartest Portfolio You’ll Ever Own. His new book, The Smartest Money Book You’ll Ever Read, was published December 27, 2011.The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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The Sizzle or the Steak: Exotic Market-Linked CDs

Posted on February 28, 2012 by Roger Trinwith
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By Roger Trinwith

With investors scouring the metaphorical earth and turning over its rocks for “safe” investments that provide yields in excess of inflation, it comes as no surprise that Investment Banks have started selling record numbers of exotic market linked Certificates of Deposit (CDs), a market where annual sales may total $25 billion per year.1 Rather than paying a fixed amount of interest, these CDs pay a variable amount of interest tied to the returns associated with anything from a stock index, or currency, to gold.  According to a recent Financial Advisor Magazine article, the Financial Industry Regulatory Authority (FINRA) has started looking into whether the buyers of these products understand their risks and lack of liquidity. After all, the last time investment banks starting packaging products of which nobody understood the risks, nobody got hurt, right?

FDIC insured market linked CDs may not be the toxic paper that collateralized debt obligations, pre-packaged tranches of subprime mortgages, and credit default swaps have been.  Nevertheless, we are becoming increasingly convinced that somewhere on Wall Street a banner exists with the words, “It is better to ask for forgiveness than permission.”

All of the problems outlined above are only the symptoms of the underlying issue- that investors think they can get something for nothing (returns without risk).  These exotic products can often be replicated with combinations of bonds and options. Investors are not receiving a free lunch but in fact are paying a hefty sum to the salesman as evidenced by the brokerage commissions of 6% or more.1

For most investors, it can be assumed that the more exotic of a product they purchase, the less likely they are to do well. From one of our favorite authors, William Bernstein, “Understand that in investing, there is an inverse correlation between the sizzle and the steak – the most exciting assets tend to have the lowest long-term returns, and the dullest ones tend to have the highest….”.2

If you’ve been fortunate enough to have a healthy amount of disposable income and have elected to spend on an exotic product (luxury car, house, club memberships & etc), you derive more utility from it, even if the cost is higher. A highly recognized status symbol such as a Mercedes is more than a means of getting you from point-A to point-B (consider the dual zone climate control, heated leather seats, and safety for your family).

When it comes to investing, I have yet to see somebody valet park his market linked CD at the local country club and drop the jaws of his peers or protect his family in a head-on collision.  An investment’s sole purpose should be to maximize the investor’s wealth for any given amount of risk. Do yourself a favor. If you want a CD, buy a CD. If you want some stock market exposure at the same time, buy a small portion of a stock index mutual fund. Buying a hybrid product of the two is equivalent to paying a lot of money for the sizzle when it’s pretty easy to have the steak.

1http://www.fa-mag.com/fa-news/10014-market-linked-cds-under-scrutiny-while-luring-yield-starved-investors.html

2William J. Bernstein, The Four Pillars of Investing, (The McGraw-Hill Companies, 2010), pg. 183.

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Can You Pay an Active Manager to Beat the Market for You?

Posted on February 28, 2012 by Jay Franklin
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Question: When was the last time you walked into Wal-Mart and found $20 bills on sale for $10? I am guessing never. It might not occur to you that your hope of finding a manager with true skill (i.e., the ability to deliver a consistently higher return than the market) who is willing to make you the financial beneficiary of her skill is the intellectual equivalent of expecting something for nothing. The reason why the potential financial benefit of true skill rightfully belongs to the manager derives from the field of labor economics: The scarce resource captures the rent. For those readers who don’t understand what that means or are still unconvinced that the quest for alpha is an exercise in futility, we step into the realm of theoretical physics and present the following thought experiment.

The key players in our thought experiment will be the venerable Warren Buffett and his son, Howard Buffett, who has been designated as the future chairman of the board of Berkshire Hathaway. Let’s suppose that as preparation for his future position, Howard decides to start an investment company where he will accept a maximum of $1 billion from new investors. Warren is so excited by his son’s initiative that he publicly announces that he will personally guarantee that Howard’s fund will achieve a return for the following year equivalent to the return of the S&P 500 Index plus 2%. Specifically, if the return from Howard’s investments falls short of this goal next year, Warren will make up the difference. Likewise, if Howard proves to be the investment genius that his father expects, Warren will keep any excess beyond the guaranteed S&P 500 plus 2%.

So we have now conjured up an investment that is guaranteed to return 2% above the S&P 500, but there is one catch–Howard’s salary will be paid by his investors, so their return will be the S&P 500 plus 2% minus Howard’s salary.

Here is the question to contemplate: What is the fair value for Howard’s salary?

A few moments of careful consideration will lead you to the unavoidable conclusion that his salary should be the value of the guaranteed return above the S&P 500, or about 2% of $1 billion (i.e., $20 million). To see why, suppose that Howard decided to be content with a 1% fee (i.e., $10 million).

This would provide an opportunity for managers who are only obligated to only deliver the S&P 500 return to their shareholders, like passive managers of S&P 500 index funds. They could invest their whole $1 billion with Howard, pay him $10 million and keep for themselves the remaining $10 million as a windfall gain, because Howard (and Warren) guaranteed a 2% additional return.

Since there are many such managers, they would compete with each other to get into Howard’s fund. Their offers to Howard would become increasingly generous until they reach the value of his service, which is $20 million. 

The scarce resource collects the rent. In this case, the scarce resource is not investor capital but the guaranteed ability to beat a benchmark by 2%.

While there might be a parallel universe where an altruistic Wal-Mart sells $20 bills for $10, it will never happen in ours. Likewise, we should not expect to find altruistic active managers who offer above S&P 500 Index returns for salaries that are less than that value. A competitive market does not serve up free lunches.

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Who Has the Midas Touch?

Posted on February 23, 2012 by Mark Hebner
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Weston WellingtonOver the course of a lengthy and illustrious business career, Warren Buffett has offered thoughtful opinions on a wide variety of investment-related issues—executive compensation, accounting standards, high-yield bonds, derivatives, stock options, and so on.

In regard to gold and its investment merits, however, Buffett has had little to say—at least in the pages of his annual shareholder letter. We searched through 34 years’ worth of Berkshire Hathaway annual reports and were hard-pressed to find any mention of the subject whatsoever. The closest we came was a rueful acknowledgement from Buffett in early 1980 that Berkshire’s book value, when expressed in gold bullion terms, had shown no increase from year-end 1964 to year-end 1979.

Buffett appeared vexed that his diligent efforts to grow Berkshire’s business value over a fifteen-year period had been matched stride for stride by a lump of shiny metal requiring no business acumen at all. He promised his shareholders he would continue to do his best but warned, “You should understand that external conditions affecting the stability of currency may very well be the most important factor in determining whether there are any real rewards from your investment in Berkshire Hathaway.”

As it turned out, the ink was barely dry on this gloomy assessment when gold began a lengthy period of decline that tested the conviction of even its most fervent devotees. Fifteen years later, gold prices were 25% lower, and even after twenty-one years (1980–2010), had failed to keep pace with rising consumer prices. By year-end 2011, gold’s appreciation over twenty-two years finally exceeded the rate of inflation (205% vs. 195%) but still trailed well behind the total return on one-month Treasury bills (398%).

Perhaps to compensate for his past reticence on the subject, Buffett has devoted a considerable portion of his forthcoming shareholder letter (usually released in mid-March) to the merits of gold.

With his customary gift for explaining complex issues in the simplest manner, Buffett deftly presents a two-pronged argument. Like a sympathetic talk show host, he quickly acknowledges the darkest fears among gold enthusiasts—the prospect of currency manipulation and persistent inflation. He points out that the US dollar has lost 86% of its value since he took control of Berkshire Hathaway in 1965 and states unequivocally, “I do not like currency-based investments.”

But where gold advocates see a safe harbor, Buffett sees just a different set of rocks to crash into. Since gold generates no return, the only source of appreciation for today’s anxious purchaser is the buyer of tomorrow who is even more fearful.

Buffett completes the argument by asking the reader to compare the long-run potential of two portfolios. The first holds all the gold in the world (worth roughly $9.6 trillion) while the second owns all the cropland in America plus the equivalent of sixteen ExxonMobils plus $1 trillion for “walking around money.” Brushing aside the squabbles over monetary theory, Buffett calmly points out that the first portfolio will produce absolutely nothing over the next century while the second will generate a river of corn, cotton, and petroleum products. People will exchange their labor for these goods regardless of whether the currency is “gold, seashells, or shark’s teeth.” (Nobel laureate Milton Friedman has pointed out that Yap Islanders got along very well with a currency consisting of enormous stone wheels that were rarely moved.)

When Buffett assumed control of Berkshire Hathaway in 1965, the book value was $19 per share, or roughly half an ounce of gold. Using the cash flow from existing businesses and reinvesting in new ones, Berkshire has grown into a substantial enterprise with a book value at year-end 2010 of $95,453 per share. The half-ounce of gold is still a half-ounce and has never generated a dime that could have been invested in more gold.

Few of us can hope to duplicate Buffett’s record of business success, but the underlying principles of reinvestment and compound interest require no special knowledge. Every financial professional can point to individuals who have accumulated substantial real wealth from investment in farms, businesses, or real estate, and sometimes the success stories turn up in unlikely places. (See “The Millionaire Next Door.”)

Where are the fortunes created from gold?

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