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May-03-17

Looking For “Alpha” In All The Wrong Places

If I had to select one factor that causes investors to underperform market returns (that anyone could easily obtain), it would be the quest for “alpha.” As indicated in this excellent white paper from Vanguard, most investors define “alpha” as the ability to outperform a designated benchmark, like the S&P 500 index. However, this definition doesn’t account for the amount of risk the fund manager is taking.

However you define “alpha, the underlying assumption of many investors — and the primary reason they rely on brokers — is the lure of earning outsized returns. The securities industry preys on the greed of investors and entices them with misleading claims about its ability to “guide” them in accomplishing this goal. The end result is often a combination of low returns, high fees and the transfer of wealth from investors to those who “manage” their money.

Poor returns

One study looked at 10-year annualized returns of mutual fund investors in actively managed funds for the period 2004-2013. During that time, the S&P 500 index had an annualized return of 7.4 percent. While you can’t buy the index, you can purchase an index fund that tracks the index for a cost as low as 0.05 percent.

The average investor in a blended portfolio of stocks and fixed-income actively managed mutual funds had a net average return of only 2.6 percent during that period. The results over longer terms were even more dismal. The 20-year annualized return was a puny 2.5 percent. The 30-year annualized return was even worse, coming in at 1.9 percent.

For these investors, the quest for alpha generated “negative alpha.”

Metrics that matter

This data should discourage you from succumbing to the allure of capturing “alpha”. Unfortunately, the reality is that the combination of massive advertising by the securities industry and a stream of misleading financial news is likely to continue to tempt the majority of investors to engage is this high risk strategy.

If you must pursue this rocky road, you should be aware of the metrics that matter and those that don’t.

The Vanguard study found the expense ratio of actively managed funds (the amount the fund charges as a management fee) was the most significant factor by far in trying to predict which actively managed mutual funds are likely to outperform. The lower the cost, the more likely the fund was to outperform.

A cautionary note

Although buying low management fee actively managed funds increases the likelihood of outperformance, let’s put this in context. Lower cost funds don’t always generate higher returns. In addition, the majority of actively managed funds don’t generate “alpha”, even when low cost is taken into consideration. Over the 20 year period ended Decemnber 31, 2013, only 35 percent of actively managed stock funds in the least expense quartile outperformed, compared to 17 percent of funds in the most expensive quartile.

A better way

Fortunately, there’s a better, more responsible way to invest. Fire your broker. If you need an advisor, use a registered investment advisor who focuses on putting together a globally diversified portfolio of low management fee index funds, passively managed funds or exchange-traded-funds in an asset allocation suitable for you. If you don’t need an advisor, you can purchase these funds directly from low cost fund families like Vanguard, Fidelity or Schwab.

If you can’t resist seeking alpha, recognize the fact that the odds are against you. You can increase those odds by purchasing the lowest cost actively managed funds.

Looking For “Alpha” In All The Wrong Places blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read and his latest, The Smartest Sales Book You’ll Ever Read. He is a wealth advisor with Buckingham and Director of Investor Advocacy for The BAM ALLIANCE.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments
March-28-17

A Tale of Two Brokers

Brokers can be like sharks. They circle the waters looking for the weak and vulnerable. Then they pounce.

I receive many inquires from readers of my books asking my advice about recommendations they receive from their broker. Typically, these recommendations are in the best interest of the broker and his employer. They are rarely suitable for the investor. Here are two recent examples.

Broker #1: Deceptive advice about “risk free” investments

An investor had an FDIC insured Certificate of Deposit mature and wanted to invest the proceeds in something “equally safe and liquid.” He told his broker he might need access to the funds at any time within the next two years.

The broker recommended the Lord Abbett Short Duration Income Fund (LALDX). Not only did he assert that it was “like a CD”, but also that he “was paid by the fund”, so there was no charge.

The facts are quite different. Over 50% of the holdings of the fund are rated BBB (36.5%) or below (14.1%). These bonds face more solvency risk than higher rated bonds in the event of an economic decline. My reader’s CD is backed by the full faith and credit of the U.S. Government. There’s no credit parity between these two investments.

The Lord Abbett fund has a high expense ratio of 0.60%. It also has a front end sales charge of 2.25%, of which 2.00% is designated as a “dealer’s concession.”

My advice

I advised him to consider Vanguard’s Prime Money Market Fund (VMMXX) instead. It’s one of the most conservative investment options offered by Vanguard. It has an expense ratio of only 0.16%. There’s no sales charge. According to Investopedia, “This fund is suitable for conservative investors whose tolerance for risk is low or who may need quick access to the funds on a daily basis.” That’s the precise requirement of this reader.

An objective broker — one not motivated by fees — would have recommended the Vanguard fund and not the Lord Abbett fund.

Broker #2: Deceptive advice about bonds

Investors are seeking higher yields from bonds, motivated by historically low current yields. These investors often don’t understand the evidence indicating they would be better off taking no risk with the bond portion of their portfolio. Instead, they could increase expected returns by allocating more of their portfolio to stocks, and viewing their bond portfolio as a ballast that serves to mitigate market volatility.

Many also don’t understand that higher yields than the risk free rate of return (which is generally considered to be the interest rate on a three-month U.S. Treasury bill) typically means accepting a higher level of risk.

Broker #2 recommended J.P. Morgan’s Efficiente Plus DS 5 Index (Net ER) as a replacement for a low risk bond index fund. This is a complex product that seeks to generate returns from investing in ETFs and a cash index “to provide exposure to a universe of diverse assets based on the efficient frontier portfolio analysis approach.”

A look at the disclosed conflicts of interest should scare away most investors. Here are some of the most glaring ones:

The CD’s don’t pay interest.

Investors don’t receive dividends or other distributions on the underlying securities.

J.P. Morgan’s economic interests “are potentially adverse to your interests as an investor in the CDs.”

A fee of 0.85% per annum will be deducted daily!

My personal favorite is this one:

J.P. Morgan and its affiliates “MAY HAVE PUBLISHED RESEARCH, EXPRESSED OPINIONS OR PROVIDED RECOMMENDATIONS THAT ARE INCONSISTENT WITH INVESTING IN OR HOLDING THE CDs, AND MAY DO SO IN THE FUTURE” (All caps is in the Prospectus).

My advice

I suggested the investor consider iShares Barclays Short Treasury Bond ETV (SHV). This fund has an expense ratio of only 0.13%. It seeks to track the investment results of the U.S. Treasury Short Bond Index. It invests 95% of its assets in U.S. government bonds.

Another option would be Vanguard’s Bond Market Index Fund (VBMFX). It’s expense ratio is only 0.15%. It’s designed to track the performance of the Bloomberg Barclays U.S. Aggregate Float Adjusted Index, which is a broad, market-weighted bond index. It holds a mix of U.S. Treasury Notes and investment-grade, taxable, corporate and international dollar denominated bonds, mortgage-backed and asset securities. This fund is often used as the core bond holding of investors.

Either fund would serve as a low risk portion of a portfolio, designed to mitigate stock market volatility.

The J.P. Morgan fund would not be suitable for this purpose.

A pattern

As in these two cases, brokers tend to recommend expensive, actively managed funds. They also frequently prefer complex investments, and don’t fully explain the risks.

All of this begs the central question: Why would you rely on anyone for investment advice who won’t confirm in writing they will always put your interest above theirs?

A Tale of Two Brokers blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read and his latest, The Smartest Sales Book You’ll Ever Read. He is a wealth advisor with Buckingham and Director of Investor Advocacy for The BAM ALLIANCE.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments
March-21-17

A Massive Bargain in Stocks

The financial media encourages you to buy individual stocks that a self-professed “guru” believes are underpriced. These entreaties appeal to the understandable desire of investors to make “a killing” by uncovering the next Facebook or Microsoft. The real reason for the stock picking focus by the media and the securities industry is more insidious. Buying and selling stocks generates revenues. More revenues means more profit for them, and lower expected returns for you.

The folly of stock picking

The perils of stock picking are well documented. As one commentator accurately noted: “But because investors are not rewarded by the markets with higher expected returns for taking uncompensated risk—risk that is easily diversified away—the rational strategy is not to buy individual stocks.”

The odds of picking an individual stock that will outperform the index to which it belongs is small (around one-in-three).

Those who tell you they have the ability to pick outperforming stocks have rarely demonstrated the ability to do so. One comprehensive study looked at the performance of 2076 actively managed mutual funds (where the fund managers engage in stock picking in an effort to “beat the market”) from 1975-2006. The study found 99.4 percent of these fund managers demonstrated no evidence of stock picking ability. The balance of 0.6% were lucky, with no evidence of skill either.

One of the co-authors of the study stated he had “generally been positive about the existence of fund manager ability,” but found this data to be a “real shocker.”

Dismal performance of hedge funds

What about hedge funds? Certainly those super managers who charge obscene fees to wealthy clients must have the ability to pick outperforming stocks, right?

According to an article in Bloomberg, more hedge funds closed in 2016 than at any time since the 2008 crisis. The article noted, “The average fund hasn’t beat the S&P 500 Total Return Index, a measure that includes reinvested dividends, since 2008.”

It’s not surprising that investors pulled over $70 billion from these funds in 2016. Why anyone invests in them is a mystery.

A real bargain

Trying to find a mispriced stock is like looking for a blue sweater in your size that’s on sale at your favorite department store. But there’s good news your broker doesn’t want you to know. Because of a price war among major fund families, all stocks are on sale and can be purchased at a bargain price. There’s no need to hunt for the sweater you want. Every item in the department store is yours for a fraction of its prior cost.

You can own Vanguard’s Total World Stock ETF (VT), which gives you a share of the domestic and foreign stock markets, for an expense ratio of only 0.11 percent which is 91% lower than the average expense ratio of funds with similar holdings, according to Vanguard. This fund holds 7651 stocks, with a median market cap of $36.9 billion.

For the five year period ending February 28, 2017, VT had average annual returns of 8.77 percent. Since inception on June 24, 2008, it returned 5.22 percent.

Not to be outdone, Schwab recently announced reductions in the expense ratios of its S&P 500 Index Fund (SWPPX) and its Small-Cap Index Fund (SWSSX) which it lowered to 0.03% and 0.06%, respectively. Its U.S. Aggregate Bond ETF (SCHZ) has an expense ratio of only 0.05 percent.

The cost of owning a globally diversified portfolio of stocks, and a portfolio of bonds that track the Barclays U.S. Aggregate Bond Index is now minuscule. It’s less than half the cost of the fee for a low cost robo-advisor, although robo-advisors offer other services that may make it prudent to consider them.

There’s a clear link between fees and performance. Morningstar found funds with high fees have below average performance and those with high fees have “a higher likelihood of above average performance”, although that’s not a guarantee.

Instead of succumbing to the snake oil pitch of TV pundits pretending to have a stock picking expertise that doesn’t exist, take advantage of the low prices for owning the entire stock and bond markets. There’s never been a better time to do so.

A Massive Bargain in Stocks blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read and his latest, The Smartest Sales Book You’ll Ever Read. He is a wealth advisor with Buckingham and Director of Investor Advocacy for The BAM ALLIANCE.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments
March-14-17

A $2 Trillion Mistake

If you’re like most investors, your primary goal is to maximize your returns for a given level of risk. A new report from Morningstar is bad news for investors who tried to accomplish this goal in actively managed funds holding over $2 trillion in assets.

Factors to consider

The report notes investors who are considering an actively managed fund should focus on these two factors:

1. The annual management fee charged by the fund; and

2. The potential of the fund to generate returns before fees in excess of its benchmark index.

It’s easy to determine the management fee of any fund. It’s referred to as its “expense ratio” and is set forth in the prospectus and on financial web sites, like Yahoo Finance.

Study results

The study analyzed 6,708 U.S. stock funds. It concluded that 4,635 (two-thirds of them) were projected to underperform their benchmark, net of fees. This underperformance was due to the amount of fees charged by these funds. The report found: “At their current price, and assuming those estimates approximate actual pre-fee excess returns in the future, these funds would have no prayer of beating their benchmarks after fees.”

The reality, as found by the study, is that “most active U.S. stock funds are too expensive to succeed.” Even the actively managed funds with lower fees, and projected excess returns, have “little margin of error”, making their outperformance far less than a sure thing.

The one silver lining for investors in actively managed funds was small cap funds “where it appears fees are still below estimated future pre-fee excess returns.”

The report had this advice for active fund managers (which is unlikely to be heeded): Slash fees or mothball the funds.

The active share myth

Actively managed fund families are not taking all this negative publicity in stride. They are fighting back with purported ways savvy investors can prospectively identify actively managed funds likely to outperform. One of the most publicized of these tools is “active share.” This theory holds that fund managers who’s holdings deviate the most from their benchmark index (measured by “active share”), “are well positioned to outperform their benchmarks before and after fees.”

If this was true, all you would have to do is purchase actively managed funds with the highest active share, and you could be confident of achieving returns in excess of its benchmark index.

If only it were that easy.

Vanguard reviewed the data in this analysis. Initially, it found funds with a high active share score had at least as much downside as upside, meaning that you would need to hold on to these funds for the long term and withstand periods of underperformance.

It then identified actively managed U.S. stock funds that ended 2009 with a high active share score of at least 80 percent. It compared the returns of these funds during the five-year period from 2005-1009 and then calculated the returns for the ensuing five-year period from 2010-2014.

It found that funds with a high active share score in 2009, that performed in the top quartiles during the prior five-year period, turned into underperformers in the next five years.

Clearly, high active share was not a predictor of future outperformance.

A better way

Don’t be enticed by the hype about achieving outsized returns using actively managed funds. There’s no reliable way to select outperforming funds prospectively, even by using active share as a measurement. As the Morningstar report illustrates, most actively managed funds are priced to fail. Even those that aren’t have little room for error.

Your expected returns will likely be higher if you refuse to play a game that primarily enriches mutual fund families and brokers. Instead, confine your investments to low management fee target date funds, LifeStrategy funds from Vanguard, index funds and exchange-traded funds.

It’s time to focus on your retirement instead of transferring your money to those who “manage” it.

A $2 Trillion Mistake blog was originally posted on The Huffington Post website.

 

2014-04-01-Hiresfrontbookcover.jpgDan Solin is a New York Times bestselling author of the Smartest series of books, including The Smartest Investment Book You’ll Ever Read, The Smartest Retirement Book You’ll Ever Read, The Smartest 401(k) Book You’ll Ever Read and his latest, The Smartest Sales Book You’ll Ever Read. He is a wealth advisor with Buckingham and Director of Investor Advocacy for The BAM ALLIANCE.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.

 

 

By: Dan Solin | 0 comments