Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.
Miller's most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron's included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as "one of the greatest investors of our time." A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to "think about thinking" suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.
Miller's bold and concentrated investment style would never be confused with a "closet index" approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller's overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?
Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.
Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund's expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund's performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion's share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.
To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.
Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.
Commentators have said that Miller has "lost his touch" or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.
Where does this leave investors seeking the best strategy to grow their savings?
When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, "As William James would say, we can't really draw any final conclusions about anything." Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.
REFERENCES
Weston Wellington, VP, Dimensional
Andy Serwer, "Will the Streak Be Unbroken," Fortune, November 27, 2006.
Edward Wyatt, "To Beat the Market, Hire a Philosopher," New York Times, January 10, 1999.
Tom Sullivan, "It's Miller Time," Barron's, October 12, 2009.
Diana B. Henriques, "Legg Mason Luminary Shifts Role," New York Times, November 18, 2011.
Standard & Poor's
Morningstar Inc.
Wednesday, November 30, 2011
Wednesday, November 2, 2011
What's in Your View Finder?
Below is a very intriguing article written by Weston Wellington, VP, Dimensional. I thought it was worth sharing and I hope you find wisdom in reading it.
A restless college dropout, he founded a wildly successful company whose innovative products touched millions of lives. He was a brilliant, dictatorial, and cantankerous leader, relentlessly pushing his staff to solve one impossible problem after another. He had no use for conventional market research, and trusted his own vision to create products with little detectable demand that flew off the shelves upon introduction. He zealously guarded his personal privacy but reveled in his role as a master magician on stage when introducing his firm's latest innovations to eager crowds of industry followers. Stockholders wore big smiles as the shares vaulted to one new high after another. In many ways, he was the antithesis of the conventional corporate chieftain, and despite his demanding persona, he was revered by employees, customers, and even competitors to a greater extent than almost any other chief executive in recent memory.
A tribute to the late Steve Jobs? No—to Edwin Land of Polaroid.
The son of a scrap metal dealer, Land dropped out of Harvard to pursue his own research at the New York Public Library on polarized light filters. He founded Land-Wheelwright Laboratories in 1934 with his former physics professor, and his low-cost polarizing filters proved useful in products ranging from sunglasses to army tank telescopes and gunsights. After the war, he turned his attention to photography and introduced the Polaroid-Land instant camera in 1948. Despite a stiff price tag of $89.75 the first shipment of 57 cameras sold out in a matter of hours at a Boston department store, and the firm never looked back.
Numerous improvements followed, and sales boomed as the cameras and film became smaller, lighter, easier to use, and less expensive. The stock price did likewise, and Polaroid became a bellwether "glamour" stock during the postwar bull market, soaring tenfold in just five years from 1963 to 1967.
When a cover story in Time appeared in June 1972, Polaroid seemed all but unstoppable. Land's inventive genius had resulted in an astonishing new industry with technology protected by a wall of over 1,000 patents. (Land himself held 535 patents, second only to Thomas Edison.) Eastman Kodak offered only token competition in instant photography, and was eventually vanquished in both the marketplace and the courtroom. Kodak was forced to pay Polaroid nearly $1 billion to settle a patent infringement suit and withdrew from the instant camera business. Polaroid shares reached an all-time high of $149.50 in mid-1972, amid intense excitement over the ingenious new SX-70 single lens reflex color camera and rumors of an instant movie product. Government surveys at the time identified photography as one of the fastest-growing industries in the country, and Polaroid appeared to be a key beneficiary: In the premium category (cameras selling for $50 or more), Polaroid was not only the undisputed leader but outsold all other global competitors combined.
Land was one of Steve Jobs' heroes, and the youthful computer tinkerer from California felt almost a mystical connection with the Cambridge scientist forty-six years his senior. Both were impatient perfectionists, often driving themselves even harder than their overworked employees. Land was infamous for wearing out staff members, who rotated in shifts while he focused on knotty problems. During one marathon research session, Land wore the same clothes for eighteen straight days. When Jobs had the opportunity to meet Land personally, he found that he and Land shared a peculiar characteristic: Both believed that new products were not invented so much as discovered. Both could visualize a product that did not yet exist down to its smallest details, and the task of development was thus akin to Michelangelo's description of sculpture: The artist's task was to remove the unnecessary material to reveal the beauty already contained within the stone.
Alas, Time's cover story marked the beginning of the end. The instant movie project ("Polavision") turned out to be a costly failure and led to Land's resignation in 1980. Jobs was dismayed when Land was pressured to leave the firm he had founded, calling him a "national treasure." Jobs would suffer a similar fate after a losing boardroom battle in 1985.
Although Polaroid products continued to sell well, the shift to digital photography caught the firm unprepared and slowly hollowed out the highly profitable film business. Polaroid filed for bankruptcy in October 2001. The research labs and film factories were shuttered, although the brand name, traded from one sharp-elbowed financier to another, survives as a ghostly reminder of its illustrious past. The years have been kinder to Eastman Kodak, but not by much. Founded long before Polaroid in 1888, it has outlived its former adversary but now struggles to avoid a similar fate.
What is the message for investors?
As we observed in a previous note, the forces of competition are relentless, and today's astonishing innovation may be tomorrow's commodity—or garage sale castoff. We have no reason to believe that Apple has anything but a bright future, but those of us tempted to concentrate our investment capital in a handful of exciting industry leaders should consider the fate of Polaroid before declaring, "It can't happen here."
Securities Research Company, SRC Green Book, 1993 edition.
"Polaroid's Big Gamble on Small Cameras," Time, June 26, 1972.
"The Story of Polaroid Inventor Edwin Land, One of Steve Jobs' Biggest Heroes," 37signals www.37signals.com, accessed October 14, 2011.
Friday, August 19, 2011
Scare Tactics
Front page Yahoo headline for Friday, August 19, 2011:
Wall Street Sees Worst Four-Week Drop Since March 2009
As a great radio broadcaster used to say: "The rest of the story..."
The US Total Stock Market Index for the year end 2009:
A whopping gain of 29.1%!
Moral of the story? Don't believe all the hype nor believe in all the fear. If we all traded on our emotions, we would all be in trouble.
Fine print: this is no way saying the markets are going to end the year in a great upward swing, nor is it saying the market is going to continue to drop. My crystal ball is as cloudy as yours. But what I do know, that with time, the markets have a good history of working everything out.
Wall Street Sees Worst Four-Week Drop Since March 2009
As a great radio broadcaster used to say: "The rest of the story..."
The US Total Stock Market Index for the year end 2009:
A whopping gain of 29.1%!
Moral of the story? Don't believe all the hype nor believe in all the fear. If we all traded on our emotions, we would all be in trouble.
Fine print: this is no way saying the markets are going to end the year in a great upward swing, nor is it saying the market is going to continue to drop. My crystal ball is as cloudy as yours. But what I do know, that with time, the markets have a good history of working everything out.
Monday, August 15, 2011
Discipline: Your Secret Weapon
Working with markets, understanding risk and return, diversifying and portfolio structure—we've heard the lessons of sound investing over and over. But so often the most important factor between success and failure is ourselves.
The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.
What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.
This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.
The survey found 40 percent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.
"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."
This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.
In a speech in Sydney, Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.
"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."
Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.
These behavioral issues and the impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.
Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behavior has been shown to be more prevalent in men than in women.
A study quoted in The Wall Street Journal showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.
The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behavior by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualized returns of just 3.8 percent, well below the 9.1 percent delivered by the market index, the S&P 500.
What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.
So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.
An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.
Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.
The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.
What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.
This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.
The survey found 40 percent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.
"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."
This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.
In a speech in Sydney, Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.
"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."
Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.
These behavioral issues and the impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.
Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behavior has been shown to be more prevalent in men than in women.
A study quoted in The Wall Street Journal showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.
The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behavior by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualized returns of just 3.8 percent, well below the 9.1 percent delivered by the market index, the S&P 500.
What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.
So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.
An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.
Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.
Seven Headlines to Beat the Gloom
Debt crises, sovereign risks, double dips and banking strains: Page One headlines can make for depressing reading these days. But being a smart news consumer—and smart investor—means keeping an eye on the lesser headlines. Here are seven you may not have seen:
Australia, for instance, is enjoying its best terms of trade in more than 50 years. An unprecedented investment boom in mining is injecting extraordinary wealth into the economy and has helped to push the Australian dollar to levels not seen since it was floated in the early 1980s. Likewise, China, India and much of South-East Asia are seeing strong investment flows and worrying more about over-heating than anything.
This is not to say that all is right with the world. The aftermath of the global financial crisis has created severe problems, particularly in terms of public sector debt and deficits. But we know that that news is in the price. Meanwhile, economic activity in much of the world is thriving.
For equity investors, that means opportunities for wealth building are increasing, not decreasing. Moreover, the global economy is becoming multi-polar, rather than overly dependent on the US, which means the potential benefits from broad diversification are even greater. That's why focusing too much on the day-to-day headlines with the US debt ceiling or European sovereign issues risks missing many of the good stories out there.
Sometimes, the best advice is to read the newspaper from the inside out.
- Robust Growth in Germany Pushes Prices—Analysts see a strong chance that German inflation will head towards 3 per cent by the end of the year against a backdrop of robust growth in Europe's biggest economy. (Reuters, July, 27, 2011)
- Brazil Domestic Demand Still Strong—The Economist Intelligence Unit says economic growth in Brazil surprisingly picked up speed in the first quarter, challenging the government’s efforts to cool the expansion. (EIU, July 6, 2011)
- Japan Retail Sales Top Estimates—Japan's retail sales rose 1.1 per cent in June, exceeding all economists' forecasts and adding to signs the economy is bouncing back from an initial post-disaster plunge. (Bloomberg, July 28, 2011)
- No Fear in China—Traders betting on gains in China's biggest companies are pushing options prices to the most bullish level in two years. The Chinese economy is projected to grow by 9.4 per cent in 2011. (Bloomberg, July 28, 2011)
- Southeast Asia Booms—Southeast Asian markets are the world's top performers in 2011 thanks to strong economic and corporate fundamentals. Thailand's index hit a 15-year high in July and Indonesia's a record high. (Reuters, July 22, 2011)
- Australian Boom Keeps Rate Rise on the Agenda—The Australian dollar hit its highest level in 30 years in late July as traders looked to the prospect of another rise in interest rates on the back of a resource investment boom. (WSJ, July 27, 2011)
- NZ Bounces Back—The New Zealand economy has grown more strongly than expected after the Christchurch earthquake, helped by improving terms of trade. The Reserve Bank signals it may raise interest rates soon. (Bloomberg, July 28, 2011)
Australia, for instance, is enjoying its best terms of trade in more than 50 years. An unprecedented investment boom in mining is injecting extraordinary wealth into the economy and has helped to push the Australian dollar to levels not seen since it was floated in the early 1980s. Likewise, China, India and much of South-East Asia are seeing strong investment flows and worrying more about over-heating than anything.
This is not to say that all is right with the world. The aftermath of the global financial crisis has created severe problems, particularly in terms of public sector debt and deficits. But we know that that news is in the price. Meanwhile, economic activity in much of the world is thriving.
For equity investors, that means opportunities for wealth building are increasing, not decreasing. Moreover, the global economy is becoming multi-polar, rather than overly dependent on the US, which means the potential benefits from broad diversification are even greater. That's why focusing too much on the day-to-day headlines with the US debt ceiling or European sovereign issues risks missing many of the good stories out there.
Sometimes, the best advice is to read the newspaper from the inside out.
The Current Market Aftershock
Using an illustrated timeline, David Booth (Chairman and Co-Chief Executive Officer, Dimensional Fund Advisors) chronicles US stock market performance in four periods since World War II. His review suggests prevailing market sentiment is often wrong and that investors must stay disciplined through all market environments to pursue their long-term goals.
click to play
Recent Market Volatility
The current renewed volatility in financial markets is reviving unwelcome feelings among many investors—feelings of anxiety, fear, and a sense of powerlessness. These are completely natural responses. Acting on those emotions, though, can end up doing us more harm than good. At base, the increase in market volatility is an expression of uncertainty. The sovereign debt strains in the US and Europe, together with renewed worries over financial institutions and fears of another recession, are leading market participants to apply a higher discount to risky assets. So, developed world equities, oil and industrial commodities, emerging markets, and commodity-related currencies are weakening as risk aversion drives investors to the perceived safe havens of government bonds, gold, and other commodity type investments.
Over the past two weeks, we’ve seen events reminiscent of 2008, when the collapse of Lehman Brothers and the sub-prime mortgage crisis triggered a global market correction. This time, however, the focus of concern has turned from private-sector to public-sector balance sheets. In this email, I want to try to address a few points and summarize my thoughts on what has been happening. As to what happens next, no one knows for sure. That is the nature of risk. But here are a few points all investors need to keep in mind to make living with this volatility more bearable:
- Remember that markets are unpredictable and do not always react the way the experts predict they will. The recent downgrade by Standard & Poor's of the US government's credit rating, following protracted and painful negotiations on extending its debt ceiling, actually led to a strengthening in Treasury bonds.
- Quitting the equity market at a time like this is like running away from a sale. While prices have been discounted to reflect higher risk, that's another way of saying expected returns are higher. And while the media headlines proclaim that "investors are dumping stocks," remember someone is buying them. Those people are often the long-term investors.
- Market recoveries can come just as quickly and just as violently as the prior correction. For instance, in March 2009—when market sentiment was last this bad—the S&P 500 turned and put in seven consecutive months of gains totaling almost 80 percent. This is not to predict that a similarly vertically shaped recovery is in the cards this time, but it is a reminder of the dangers for long-term investors of turning paper losses into real ones and paying for the risk without waiting around for the recovery.
- Never forget the power of diversification. While equity markets have had a rocky time in 2011, fixed income markets have flourished—making the overall losses to balanced fund investors a little more bearable. Diversification spreads risk and can lessen the bumps in the road. This is why portfolios at Arcon Wealth Management consists of over 10,000 stock holdings spread across separate asset classes in over 40 countries around the world.
- Markets and economies are different things. The world economy is forever changing, and new forces are replacing old ones. As the IMF noted recently, while advanced economies seek to repair public and financial balance sheets, emerging market economies are thriving. A globally diversified portfolio takes account of these shifts.
- Nothing lasts forever. Just as smart investors temper their enthusiasm in booms, they keep a reserve of optimism during busts. And just as loading up on risk when prices are high can leave you exposed to a correction, dumping risk altogether when prices are low means you can miss the turn when it comes. As always in life, moderation is a good policy. So too is a well developed plan that takes risks and volatility into consideration. Thus the reason our financial plans are built around both very good times as well as very bad economic times. Anything else is just not prudent planning.
Thursday, July 28, 2011
Sovereign Debt and the Equity Investor
Last week I came across an "Economic and Policy Watch" update prepared by a major investment bank that reviewed recent government proposals to address the nation's funding crisis. Titled "It Just Gets Worse," the report chided policymakers for actions that "look like a poor cover for loose money, rising inflation, and fiscal problems," and warned that "government financing needs are corrupting monetary policy." As a result of these ill-advised tactics, the bank had turned "more negative" on the outlook for financial stability and saw "little hope of improvement in the inflation/currency mix."
Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. I found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.
Indonesia's sovereign debt rating at that time placed it firmly in the "junk" (non-investment grade) category: B3 from Moody's and single-B from Standard & Poor's. Although Moody's upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.
What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.
Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.
For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country's troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.
I am not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor am I suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.
Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation's improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. My point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a "junk" rating is no assurance of failure. A diversified strategy will have exposure to both.
-by Weston Wellington, VP, Dimensional Fund Advisors
Amidst the barrage of news coverage from dozens of sources probing the US debt/default/downgrade issue, such a conclusion might seem unremarkable. I found it of interest because the focus of the report was not the US Treasury but the government of Indonesia, and it appeared over a decade ago, on July 16, 2001.
Indonesia's sovereign debt rating at that time placed it firmly in the "junk" (non-investment grade) category: B3 from Moody's and single-B from Standard & Poor's. Although Moody's upgraded Indonesia to a B2 rating in 2003 and to Ba1 in early 2011, at no time over the past decade was Indonesia deemed to merit an investment grade rating.
What has been the experience of equity investors in Indonesia since this report was published? The Jakarta Composite Index closed at 415.09 on January 16, 2001, while the Dow Jones Industrial Average finished that day at 10,652.66. On Wednesday, the Jakarta Composite closed at 4,087.09 and the Dow at 12,592.80. If the Dow Jones Average had kept pace with Indonesian stocks over the past decade, it would be over 104,000 today.
Investors in Indonesia have had their share of ups and downs over the years, and markets fell even harder than the US during the financial crisis, with a peak-to-trough loss of nearly 60%. But the recovery was sharper as well: The Jakarta Composite recouped all of its losses by April 2010, and the all-time high on July 22 this year was 45% above the high-water mark of early 2008.
For the ten-year period ending June 30, 2011, total return as computed by MSCI was 29% per year in local currency and 33% in US dollar terms. At no point throughout this period did Indonesia have an investment grade rating for its sovereign debt, and outside observers continue to find fault with the country's troublesome level of corruption, primitive infrastructure, and unpredictable regulatory apparatus.
I am not suggesting that investors should dismiss the effects of a US government credit downgrade. US Treasury securities are so widely held around the world that any potentially destabilizing event is worrisome. Nor am I suggesting that investors focus solely on countries with low credit ratings. Just as a broadly diversified portfolio includes companies with high and low credit quality, investing in countries with both high and low ratings is equally sensible.
Some might say the strong performance of Indonesian stocks over the past decade was at least partly attributable to the nation's improving credit profile, even if it remained at a relatively low level. The US, in contrast, appears to be deteriorating. My point is that a low credit rating in and of itself is not necessarily a death sentence for equity investors. Citizens of triple-A countries behave much like those living in single-B territory—they eat, drink, shop, get stuck in traffic jams, chatter on mobile phones, and check their Facebook pages. (Indonesia claims the second-largest number of members in the world.) Companies doing business in either location generate cash flows, and investors do their best to evaluate what those cash flows are worth. A triple-A sovereign debt rating is no guarantee of superior equity market returns, and a "junk" rating is no assurance of failure. A diversified strategy will have exposure to both.
-by Weston Wellington, VP, Dimensional Fund Advisors
Friday, July 22, 2011
Thoughts on the Debt Ceiling Debate
In recent weeks, the pending concern of the US debt limit has garnered lots of attention. This crisis creates the potential for another financial “meltdown,” especially when we consider that there’s a similar crisis on the other side of the Atlantic – a crisis in Greece that has the potential to rapidly spread to Ireland, Portugal, Spain and even Italy.
The risks are clearly great if we don’t get an agreement. The problem is that we don’t know what will happen. The crisis could be resolved, or we could see a default. We could also see defaults in Greece and other defaults might follow, and we might also see the end of the Euro, and who knows what else.
It’s interesting to note that the stock market has risen in the past month despite these problems. On June 15, the S&P 500 Index closed at 1,265, despite:
• The failure to resolve the US debt ceiling problem
• No resolution on the Greek crisis
• Weakening economic data
• Rising unemployment
• The end of QE2 (which some gurus were predicting would lead to major problems for the bond and stock market alike)
• The failure to resolve the US debt ceiling problem
• No resolution on the Greek crisis
• Weakening economic data
• Rising unemployment
• The end of QE2 (which some gurus were predicting would lead to major problems for the bond and stock market alike)
On July 14, the S&P 500 closed at 1,308, up more than 3 percent. And despite Moody’s warning of a downgrade of Treasury debt, the 10-year Treasury rate was unchanged at 2.98 percent. I doubt many would have predicted that outcome.
So that brings us to what YOU should do about the situation. I can tell you what I am doing as your advisor. I’m not making any adjustments to client portfolios in response to the debt ceiling debate. The market is well aware of the fact that the debt ceiling discussions are ongoing and U.S. Treasury rates are still very low, indicating the market believes the debt ceiling will be increased and that financial market disruptions are unlikely. I believe that efforts to try to move in or out of the stock or bond markets in anticipation of what will happen aren’t productive. As I have noted before, the reason why we create well-developed plans for our clients, is that it will have anticipated crisis (which by definition aren't predictable or we would avoid them) and incorporated the virtual certainty that they'll occur. This should allow us all to sleep easier at night. If you aren't and your stomach is tossing and turning, then you either don't have a well-developed plan or you were overconfident about your ability to deal with bad economic times.
Even if the worst case scenario materialized and the U.S. debt ceiling isn’t raised, it’s seems likely that it would be raised quickly if there were any subsequent disruptions in the financial markets. Also keep in mind that this is a political technicality more than anything and not an issue with the capacity of the U.S. government to pay its debts.
And if you are reading this late at night because you can't sleep over worrying about the financial pornography shot out at you from all directions, then you should immediately develop a plan, rewrite your plan and permanently lower your equity allocation because this likely won't be the last crisis we have to deal with, or watch and listen to less of the media hype.
Tuesday, June 28, 2011
The Best of Times, the Worst of Times
For the twelve-month period ending May 31, 2011, equity investors around the world enjoyed the equivalent of blue skies and bright sunshine while the economic news was partly cloudy at best. Among forty-five developed and emerging-country stock markets tracked by MSCI, all but four had double-digit total returns (in US dollar terms), and twenty-six had returns of 30% or more.
If someone had told us a year ago that global markets would stage such a broad-based rally, we would have been inclined to think that trends in employment, housing, and financial distress were about to take a pronounced turn for the better. It seems hard to argue they have done anything of the sort. Somehow, despite gloomy financial page news that keeps repeating itself, equity prices marched substantially higher.
The moral of the story? Investors should be skeptical of their ability to predict future events and even more skeptical of their ability to predict how other investors will react to them.
Past performance is no guarantee of future results.
If someone had told us a year ago that global markets would stage such a broad-based rally, we would have been inclined to think that trends in employment, housing, and financial distress were about to take a pronounced turn for the better. It seems hard to argue they have done anything of the sort. Somehow, despite gloomy financial page news that keeps repeating itself, equity prices marched substantially higher.
The moral of the story? Investors should be skeptical of their ability to predict future events and even more skeptical of their ability to predict how other investors will react to them.
| Last Year's Headlines | This Year's Headlines |
|---|---|
"Europe Crisis Deepens as Chaos Grips Greece" Sebastian Moffett and Alkman Granitsas. Wall Street Journal, May 6, 2010 | "Greek Woes Fuel Fresh Fears" Marcus Walker and Hannah Benjamin. Wall Street Journal, May 10, 2011 |
"Fearful Investors Are Pulling Out" Adam Shell. USA Today, May 20, 2010 | "Fear Wins: Stocks Resume Long Slide" Adam Shell. USA Today, June 16, 2011 |
"Housing Prices Remain Weak" Sara Murray. Wall Street Journal, May 26, 2010 | "Home Market Takes a Tumble" Nick Timiraos and Dawn Wotapka. Wall Street Journal, May 9, 2011 |
"Fear Returns—How to Avoid a Double-Dip Recession" Cover story. Economist, May 29, 2010 | "The World Economy—Sticky Patch or Meltdown?" Cover story. Economist, June 18, 2011 |
"Spill Tops Valdez Disaster—Deep Trouble: There Was 'Nobody in Charge'" J. Weisman, G. Chazan and S. Power. Wall Street Journal, May 28, 2010 | "Japanese Nuclear Crisis Is Ranked at the Level of Chernobyl" Mitsuru Obe.Wall Street Journal, April 12, 2011 |
"Discouraging Job Growth Batters Stocks" Don Lee. Los Angeles Times, June 5, 2010 | "Jobs Data Stoke US Recovery Fears" Robin Harding, S. Bond and M. Mackenzie. Financial Times, June 4, 2011 |
"Economic Outlook Darkens" Jonathan Cheng and Justin Lahart. Wall Street Journal, June 2, 2010 | "Stocks Plunge Amid Fears That Global Economy is Slowing" Christina Hauser. New York Times, June 11, 2011 |
"Bond Fund Managers See Signs of a Bubble" Sam Mamudi. Wall Street Journal, June 8, 2010 | "Why Are Investors Still Lining Up for Bonds?" Jeff Sommer. New York Times, May 29, 2011 |
"Rapid Declines Rattle Even Optimists" E.S. Browning. Wall Street Journal, June 14, 2010 | "Investors Shaken by the Fear Factor" James Mackintosh. Financial Times, June 18, 2011 |
Thursday, June 23, 2011
A Few FAQs
In layman's terms, what is the Efficient Market Hypothesis?
The Efficient Market Hypothesis says that market prices are fair: they fully reflect all available information. This does not mean that prices are perfect; some prices may be too high and some too low, but there is no reliable way to tell. In an efficient market, investors cannot expect to earn above-average profits without assuming above-average risks. Market efficiency does not suggest that investors can't "win." Over any period of time, some investors will beat the market, but the number of investors who do so will be no greater than expected by chance.Can any single industry—for example, the high-tech sector—assure investors above-average returns?
Detailed research into the sources of investment returns (Fama, Eugene F. and Kenneth R. French. "Industry Costs of Equity." Journal of Financial Economics 43 (1997), 153-93.) concludes that industries, or companies' products, are not a factor in expected stock returns. Industry effects can influence prices, but in a seemingly random, short-term way that can be mitigated in a diversified strategy. Therefore, industry effects, though they pose risks that are worth taking into account, are not a primary variable on which to sort securities for investment purposes.
Firms developing new technologies have no assurance of earning above-average long-run profits. The competitive forces in a free market work constantly to disperse the benefits of innovation throughout the economy. The retailer using new high-speed computers to cut inventory costs, for example, may reap greater economic rewards than the company who developed them. And if competition pressures the retailer to pass the resulting savings along in the form of lower prices, the ultimate beneficiary is the consumer. Even if one could correctly predict technological trends, identifying the winners from an investment standpoint becomes an elusive exercise.
Consider the birth of the personal computer industry in the early 1980s and its subsequent explosive growth. Industry pioneers IBM and Apple Computer were responsible for many innovations, yet shares of both firms have lagged the broad stock market: total return for the 20-year period ending December 2001 was 333% for Apple Computer, 1360% for IBM, and 1606% for the S&P 500 index (Center for Research in Security Prices, University of Chicago; Ibbotson Associates).
Arcon Wealth Management, LLC does not believe in "picking stocks," so how do you decide which stocks to buy?
Buying stocks inside the funds is a detailed process but can be described in general terms. An eligible universe of all traded stocks of real operating companies is created. Filters are then applied to exclude stocks that do not fit the asset class of the fund or that have specific pricing or trading concerns. The remaining stocks are eligible for purchase and are subject to rough market-capitalization target weights. Trading in the market place is regularly monitored with real-time checks for current news that may impact prices, such as a looming takeover. Other than that, we're generally indifferent among the stocks in the eligible universe, which allows us to trade opportunistically and take advantage of liquidity premiums that benefit client returns. For additional information regarding the investment strategies of each fund, please read each fund's prospectus and statement of additional information carefully.
Isn't the success of indexing in recent years mostly due to a "self-fulfilling prophecy"? Index funds appear to push up prices of a handful of big company stocks simply because they're included in the S&P 500 index.
Some critics of indexing assert that mechanical buying from index funds creates a "self-reinforcing trend" in a handful of large company stocks and that their price behavior is dictated by cash inflows to index managers, not fundamental business conditions at the underlying companies. Evidence to support this assertion is difficult to find. Arcon Wealth Management, LLC believes a more plausible explanation of pricing suggests it is the active money managers who dictate prices to indexers, not the other way around. As an example, an analysis of trading activity in General Electric Corp. stock (the largest component of the S&P 500 index) found that programmed buying from index funds in January 1997 accounted for approximately 1.3% of total GE monthly trading volume (Strategic Insight Mutual Fund Overview, February 1997). The notion that 1.3% of trading attributable to passive investors possessing no useful information determines the price-discovery process for the remaining 98.7% of market participants is far-fetched.
Advocates of the "self-fulfilling" viewpoint must also confront a wide disparity in performance of individual issues. If the behavior of large company stocks is primarily attributable to passive investors buying without regard to fundamental developments, it is difficult to explain why Coca-Cola shares appreciated only 1.3% in 1998 while Wal-Mart Stores soared 108.0% (Standard & Poor's "Stock Guide," January 1999).
If everyone followed an indexing strategy, would markets still be efficient?
This question has come up repeatedly ever since indexed strategies first appeared in the mid 1970s. Critics of indexing assert that markets would be less efficient if all investors adopted a market-fund investment approach. One can accept this theoretical viewpoint and still embrace indexing with enthusiasm.If the adoption of indexed strategies became so pervasive that market efficiency were impaired, Arcon Wealth Management, LLC believes it would be a self-correcting process. Mispriced securities would create opportunities for investors to earn profits in excess of their research costs, and their activity would drive prices back to equilibrium levels. We will never know how much information and liquidity are required for an efficient market. Markets for consumer durables such as homes or autos appear to be at least reasonably efficient, despite very poor liquidity, high search costs, and the absence of perfectly fungible assets. This behavior suggests a shift to passive investing would have to be very pronounced to have any effect on market efficiency.
Even if all professional investment managers adopted a passive approach, other market participants would continue to provide price-setting information. Sources of such information could include corporate stock buybacks, acquisitions, and the investment activities of officers, employees, competitors, and suppliers.
Despite the impressive commercial success of indexed investing strategies over the last twenty-five years, they still represent only a small percentage of total stock market wealth. The assets of all US equity index mutual funds* were approximately $695 billion as of December 31, 2010, or roughly 5% of the nation's total stock market value.
*US-domiciled equity index funds in Morningstar database, and which reported fund assets for December 31, 2010.
If academic research demonstrates that value stocks have higher returns than growth stocks or market portfolios over time, why not put 100% of the equity allocation in value stocks?
For investors who define risk solely as the variability of returns, such a strategy might be appropriate. Whether such investors actually exist is debatable. Most investors are probably sensitive to the risk of being different from the market, even if overall variability is no higher. Value stocks do not outperform market portfolios regularly or predictably—if they did, they would not be riskier. To the extent an investor is likely to be disappointed with performance that differs from a market portfolio, a tilt toward value stocks should be undertaken cautiously!
Tuesday, June 14, 2011
The Advice Remains the Same: Defensive Strategies Won't Protect You
(Note: This item is part three of a series on why you shouldn’t alter your investment strategy during booms or busts.)
If the perception of risks are high, which they are during bear [or weeks of down] markets, so must be the expected return. And the historical evidence is that investors persistently demonstrate a pattern of buying high and selling low when acting on their own. This destructive behavior is evidenced by the fact that investors typically underperform the very mutual funds in which they invest.
“Defensive” strategies
Investing history is filled with examples of strategies that try to benefit from observable patterns of past market performance. Unfortunately, the realized returns haven’t matched the promise.
In their article “Noisy Signals: A Challenge to Tactical Strategies,” Joseph Davis and Christopher Philips of Vanguard examined the performance of several different signals based on “conventional wisdom” to see if they actually translated into better risk-adjusted returns.
For example, they examined selling in the presence of an inverted yield curve (short-term interest rates exceeding long-term rates), which is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is “noisy.” For the period 1952 through 2006, the yield curve inverted 19 times, but the U.S. economy lapsed into recession only nine times.
While the historical record shows that various sectors tend to outperform during tough times, Vanguard reached the conclusion that, “Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments.”
Summary
Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.” Thus, my advice will continue to be the same, unless compelling evidence, published in peer reviewed academic journals, demonstrates that there is a superior alternative strategy. Until then, my advice remains the same: buy [the market, diversify systematically, minimize taxes and turnover, think long-term, apply discipline, hold low-cost funds and maintain asset allocation].
Article by Larry Swedroe, Wise Investing, April 13, 2009. Used today by Matt McKinney because the same needs to be said after every downturn in the market and the pessimism (or noise) in the media that follows.
If the perception of risks are high, which they are during bear [or weeks of down] markets, so must be the expected return. And the historical evidence is that investors persistently demonstrate a pattern of buying high and selling low when acting on their own. This destructive behavior is evidenced by the fact that investors typically underperform the very mutual funds in which they invest.
“Defensive” strategies
Investing history is filled with examples of strategies that try to benefit from observable patterns of past market performance. Unfortunately, the realized returns haven’t matched the promise.
In their article “Noisy Signals: A Challenge to Tactical Strategies,” Joseph Davis and Christopher Philips of Vanguard examined the performance of several different signals based on “conventional wisdom” to see if they actually translated into better risk-adjusted returns.
For example, they examined selling in the presence of an inverted yield curve (short-term interest rates exceeding long-term rates), which is a well-documented leading indicator of recessions. Vanguard found that the yield curve signal is “noisy.” For the period 1952 through 2006, the yield curve inverted 19 times, but the U.S. economy lapsed into recession only nine times.
While the historical record shows that various sectors tend to outperform during tough times, Vanguard reached the conclusion that, “Even the most reliable indicators have low predictive power when used to execute real-time strategies. Investors seeking to mitigate equity market risks are better served with a strategic allocation to fixed income investments.”
Summary
Noted author Peter Bernstein provided this insight: “Even the most brilliant of mathematical geniuses will never be able to tell us what the future holds. In the end, what matters is the quality of our decisions in the face of uncertainty.” Thus, my advice will continue to be the same, unless compelling evidence, published in peer reviewed academic journals, demonstrates that there is a superior alternative strategy. Until then, my advice remains the same: buy [the market, diversify systematically, minimize taxes and turnover, think long-term, apply discipline, hold low-cost funds and maintain asset allocation].
Article by Larry Swedroe, Wise Investing, April 13, 2009. Used today by Matt McKinney because the same needs to be said after every downturn in the market and the pessimism (or noise) in the media that follows.
Monday, June 13, 2011
The Advice Remains the Same: Adventures in Market Timing
(Note: This item is part two of a series on why you shouldn’t alter your investment strategy during booms or busts.)
My previous post discussed market efficiency. Now I want to address the fallacy of market timing and why information is not enough for making investment decisions.
As to trying to time the market, take a look at the historical evidence. If you are thinking about getting out until things are clear again, consider that the evidence on market timing is even worse than on stock selection. Mark Hulbert of the Hulbert Financial Digest says his data backs up his 80/20 rule: 80 percent of market timers fail over any reasonable period of time. I don’t like those odds. Neither should you.
One reason that market timing fails is that so much of the market’s return occurs during very brief and unpredictable periods. Another reason is that you have to be right not once, but twice. Deciding to get out is easy compared to deciding when to get back in. If you go to cash, you may be “whipsawed.” You risk getting out after a severe drop, missing a big rally and jumping back in only to experience another severe loss. You would end up worse than if you had simply stayed the course. That is why I believe going to cash is not a winning strategy.
The difference between information and wisdom
Information can be defined as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess — above market — profits. When I ask investors why they are so willing to abandon their well-designed plan, they say something like: “Isn’t it obvious that the situation is terrible?” The question they fail to ask is this: If it is in fact obvious, isn’t the bad news already built into prices? After all, that is why prices have already gone down.
They also fail to understand the following: If things are so bad, that must mean the market is perceived as risky. If the market is risky, expected returns are now higher. Why would investors decide to sell now when expected returns are higher than when they originally bought?
If you feel the need to sell, consider that there is a “universe of risk.” Since all stocks must be owned by someone, someone must hold the market risk. For everyone who wants to sell, someone else must be willing to buy at the same price. And they will only buy in a time of distress if they believe the market price fully reflects the high risks.
In my next post, I will conclude by talking about the lack of success of defensive strategies employed by some to ride out the investing roller-coaster.
Article by Larry Swedroe, Wise Investing, April 10, 2009. Used today by Matt McKinney because the same needs to be said after every downturn in the market and the pessimism (or noise) in the media that follows.
My previous post discussed market efficiency. Now I want to address the fallacy of market timing and why information is not enough for making investment decisions.
As to trying to time the market, take a look at the historical evidence. If you are thinking about getting out until things are clear again, consider that the evidence on market timing is even worse than on stock selection. Mark Hulbert of the Hulbert Financial Digest says his data backs up his 80/20 rule: 80 percent of market timers fail over any reasonable period of time. I don’t like those odds. Neither should you.
One reason that market timing fails is that so much of the market’s return occurs during very brief and unpredictable periods. Another reason is that you have to be right not once, but twice. Deciding to get out is easy compared to deciding when to get back in. If you go to cash, you may be “whipsawed.” You risk getting out after a severe drop, missing a big rally and jumping back in only to experience another severe loss. You would end up worse than if you had simply stayed the course. That is why I believe going to cash is not a winning strategy.
The difference between information and wisdom
Information can be defined as facts or opinions. In terms of investing, wisdom is information that can be exploited to generate excess — above market — profits. When I ask investors why they are so willing to abandon their well-designed plan, they say something like: “Isn’t it obvious that the situation is terrible?” The question they fail to ask is this: If it is in fact obvious, isn’t the bad news already built into prices? After all, that is why prices have already gone down.
They also fail to understand the following: If things are so bad, that must mean the market is perceived as risky. If the market is risky, expected returns are now higher. Why would investors decide to sell now when expected returns are higher than when they originally bought?
If you feel the need to sell, consider that there is a “universe of risk.” Since all stocks must be owned by someone, someone must hold the market risk. For everyone who wants to sell, someone else must be willing to buy at the same price. And they will only buy in a time of distress if they believe the market price fully reflects the high risks.
In my next post, I will conclude by talking about the lack of success of defensive strategies employed by some to ride out the investing roller-coaster.
Article by Larry Swedroe, Wise Investing, April 10, 2009. Used today by Matt McKinney because the same needs to be said after every downturn in the market and the pessimism (or noise) in the media that follows.
Sunday, June 12, 2011
The Advice Remains the Same: Markets Are Efficient
(Note: This item is part one of a series on why you shouldn’t alter your investment strategy during booms or busts.)
Whether the market has gone up (as it has during the past two years) or down (as it has during the past several weeks), my investing advice has not changed: [buy the market, diversify systematically, minimize taxes and turnover, think long-term, apply discipline, hold low-cost funds and maintain asset allocation].
A common refrain from investors has gone something like this: “Yes, that advice has worked in the past. However, this time is different. It obviously isn’t working now! The market just keeps going down and down. There must be a better alternative than to sit and do nothing.”
In the next few posts, I want to explain why my investing advice has not changed, even though many others may believe “this time is different.”
Market efficiency
For us to believe that we should abandon a long-term, buy-and-hold strategy, we would have to be first convinced that markets were no longer efficient. In other words, the market was now mispricing assets and was slow to react to new information.
It is hard to imagine that markets have gotten slower at reacting to news. In fact, markets incorporate news into prices almost instantaneously. After Treasury Secretary Timothy Geithner unveiled the Treasury Department’s plan to clean up toxic assets, the market reacted immediately, as evidenced by several indexes leaping to their highest one-day gains since last fall.
We see no evidence that active managers were able to predict (the then) bear market. In fact, while there was a wide dispersion in individual stock returns (some stocks, like Wal-Mart were actually up), almost every single diversified mutual fund produced large losses. This would not be the case if markets were somehow inefficient. It is also important to note that evidence shows that active managers fail to outperform during bear markets.
We believe that the market was and continues to be highly efficient. It is just that the news has been persistently worse than expected, causing prices to fall. This is what causes bear markets.
In my next posts, I’ll give further explanation of why my investing advice is still valid, including a discussion of market timing.
Article by Larry Swedroe, Wise Investing, April 9, 2009. Used today by Matt McKinney (italics his) because the same could be said during most if not every downturn in the market and the pessimism (or noise) in the media that follows.
Whether the market has gone up (as it has during the past two years) or down (as it has during the past several weeks), my investing advice has not changed: [buy the market, diversify systematically, minimize taxes and turnover, think long-term, apply discipline, hold low-cost funds and maintain asset allocation].
A common refrain from investors has gone something like this: “Yes, that advice has worked in the past. However, this time is different. It obviously isn’t working now! The market just keeps going down and down. There must be a better alternative than to sit and do nothing.”
In the next few posts, I want to explain why my investing advice has not changed, even though many others may believe “this time is different.”
Market efficiency
For us to believe that we should abandon a long-term, buy-and-hold strategy, we would have to be first convinced that markets were no longer efficient. In other words, the market was now mispricing assets and was slow to react to new information.
It is hard to imagine that markets have gotten slower at reacting to news. In fact, markets incorporate news into prices almost instantaneously. After Treasury Secretary Timothy Geithner unveiled the Treasury Department’s plan to clean up toxic assets, the market reacted immediately, as evidenced by several indexes leaping to their highest one-day gains since last fall.
We see no evidence that active managers were able to predict (the then) bear market. In fact, while there was a wide dispersion in individual stock returns (some stocks, like Wal-Mart were actually up), almost every single diversified mutual fund produced large losses. This would not be the case if markets were somehow inefficient. It is also important to note that evidence shows that active managers fail to outperform during bear markets.
We believe that the market was and continues to be highly efficient. It is just that the news has been persistently worse than expected, causing prices to fall. This is what causes bear markets.
In my next posts, I’ll give further explanation of why my investing advice is still valid, including a discussion of market timing.
Article by Larry Swedroe, Wise Investing, April 9, 2009. Used today by Matt McKinney (italics his) because the same could be said during most if not every downturn in the market and the pessimism (or noise) in the media that follows.
Tuesday, May 17, 2011
How to overcome 2 & 20...no this isn't about football.
Here's a great article I read recently that shares my view on hedge funds. Remember, things are not always what they seem...
Why I won’t invest in hedge funds
Commentary: As in Vegas, the percentages are never in your favor
By Brett Arends, MarketWatch
LAS VEGAS (MarketWatch) — The rich and powerful of the hedge-fund world flew in here last week for a big confab. Nearly 2,000 managers, investors, advisers and hangers-on took over the Bellagio for three days. George W. Bush stopped by. So did Colin Powell, TV historian Niall Ferguson, SAC billionaire Steve A. Cohen, and former British prime minister Gordon Brown.I didn’t make the poolside party on the first night, but it must have been quite an event. People looked pretty wobbly the next morning.
For all the big-name plenary sessions in the grand ballroom, the real action took place in side rooms, where investors and money managers talked dollars. Investors came in droves to meet new funds and try to find the manager who’s going to make them rich. I wish them luck. But as I mingled with the money mavens, I did some thinking.
Your typical (hedge) fund manager takes 2% of your money off the top each year, just for showing up. Then he takes 20% of your profits — if any. So your returns are going to be net of these costs. They’re also net of any trading costs. To beat a basic index fund, a hedge fund has got to earn a lot more.
How much more? Do the math. According to data from the New York University’s Stern school of business, over the past 80 or so years U.S. stocks have produced an average annualized return of 9.3%, and bonds 5%. So a portfolio of, say, two-thirds stocks, one-third bonds, would have earned an average return of about 7.9% a year.
Over an investment horizon of about 30 years, that’s enough to turn an initial stake of $1,000 into $9,800. But after 2%-and-20% fees, you’d only keep 4.7% a year (It would probably be even less, because profits are uneven, and in a down year the manager doesn’t hand back 20% of the losses).
At that rate, you’d only finish with $4,000. In other words, the manager would have eaten two-thirds of your profits!
But that’s not a fair comparison, say the fund managers, because we’ll earn a higher investment return than the market. OK, some will. But how much more? If the market on its own earns 7.9% a year, a hedge fund with a 2%-and-20% fee structure has to earn 11.85%, gross, just to keep up. In other words it has to earn 50% more than the market each year. How likely is that? In these days of lower nominal returns, the challenge is even greater. And how much more do hedge funds really earn anyway? Some studies in the past have put the figure as high as 3% to 5% a year. But research just published in the Journal of Financial Economics blows this out of the water.
Professor Ilia Dichev at Emory University and Gwen Yu at Harvard Business School studied investors’ returns for nearly 11,000 hedge funds over 28 years, from 1980 to 2008. Their main finding: Actual “dollar-weighted returns” — in other words, what investors really earned — were far lower than previously thought. That’s because we only tend to hear about the funds that do well. And because investors typically jumped into the good funds just after they had done well (and got out again after they had done badly).
Over the entire period, they found, hedge funds appeared to earn an average return of 12.6% a year. But investors really only made about 6%. That, they note, was a lot less even than the 10.9% you could have earned in the Standard & Poor’s 500 stock index over the same period. Indeed it wasn’t that much more than the 5.6% your grandma earned in U.S. government bonds. They also found that the volatility of returns was greater.
In other words, hedge-fund outperformance was largely a myth. And “the risk-return trade-off for hedge fund investors is much worse than previously thought,” they say.
And here’s a final thought from Sin City.
If a benchmark portfolio earns a typical 7.9% a year, then a hedge fund manager charging 2%-and-20% basically skims 3.2% of your money each year. As I listened to George Bush wow the audience, it occurred to me that the casino just down the corridor only took 2.7% on the spin of a roulette wheel. And if you played craps or blackjack, the house’s take is under 1%. Next year, the Vegas casino operators should hold their annual conference in Greenwich, Conn., the house of the hedge funds. They could learn a thing or two from these guys.
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