Sunday, May 16, 2010

How Unusual Was 2008 and Should I Be Timid of Recent Volatility?

Through the sparkle-clean viewing glass of hindsight vision it does appear that 2008 was unusual yet not unprecedented. And, it appears that there is little reason to be timid over the long-term. Let us work through this summary in an attempt to provide substance for these answers.

Fama and French explains that the only year of the 1927-2008 period that produces a market return below -38.31% is 1931 (-44.36%). Three additional years have returns close to or below -30%: 1930 (-28.83%), 1937 (-34.61%) and 1974 (-27.95%). If one considers successive years of negative market returns, the cumulative return for the three-year period 1929-1931 is -66.35%, the return for 1973-1974 is -41.47%, and the return for 2000-2002 is -37.54%. On the plus side, the annual market return is greater than 30% for 15 individual calendar years of 1927-2008. In short, extreme stock returns are common. Fortunately, extreme positives outnumber extreme negatives.

Figure 1: Annual Market Returns 1927 - 2008

It seems apparent that, although difficult to stomach, extreme fluctuations happen and just as often to the plus side. Now let us work through one more point about investing for the long term that should help you rid yourself of this timid feeling so that sleep is more amenable the next time the market nose dives.

Treasury Bills are known for being relatively risk free. If we had moved from the riskier S&P index to the treasury bills in the boxed chart bellow, we would have missed out on the returns experienced in the other times of the chart. That being said, it is important that your portfolio is properly allocated and your risk appropriately assessed for you so that you can meet your goals.

To summarize, markets do fall and the necessity for good emotional management and proper risk assessment is critical for an investor. With the proper portfolio in place for the individual investor long term goals may be met so that it matters little if the market is bullish or bearish.

Thursday, May 6, 2010

Alternatives: Private Equity, Venture Capital, Hedge Funds, International Small - Which is Best?

The poor performance of public equity markets in recent times has lead investors to emphasize closer examination of alternative investments. The benefits would include high expected returns, low volatility, and low correlation with public equity markets - an investor's dream!

Often times investors are lured by high-flying returns produced by hedge funds, private equity, and venture capital. Itching to get their fair share of these juicy returns, investors tend to glance over what it really takes to be part of the "parade". Of all of the alternative investment managers claiming they can add value for you, how are you going to pick which managers which will outperform the others? Will it be past performance? Academic studies show, with great confidence, that past performance has no predictive validity. Maybe, you will go to the one with the highest education or most enticing models? Probably not a good idea either, seeing as literally a monkey throwing darts at a financial newspaper can outperform the professionals. Now you're stuck...let's look at the numbers to give us a better idea as to whether these flashy funds are with it.

Venture Capital
A paper by Chicago finance professor John Cochrane examined the results of 7,765 venture capital projects (not venture funds) between January 1987 and June 2000. By surveying the entire range of venture capital projects—not just the winners—the study avoided selection bias. The June 2000 termination date of the survey excludes the subsequent poor performance of many venture projects. Cochrane finds that venture projects have option-like characteristics; a small number have the chance of a huge payoff. Among successful projects—those with a new financing round, IPO, or acquisition—the arithmetic average return to IPO or acquisition is 698%, but with enormous standard deviation of 3,282%! Compound return is 108%. Accounting for selection bias by examining all projects (not just winners) lowers these numbers dramatically to a mean return of 57% and a compound return of 15%.

A second study shows similar results. A study by Peng Chen, Gary Baierl and Paul Kaplan examined the record of pooled venture capital funds from the Venture Economics database over the January 1960-June 1999 period. The absence of a liquid market for VC investments means there is no return history to analyze, so the authors restrict their study to 148 funds (among over 900) that have been liquidated. Chen et al. also report very high mean returns for venture capital fund investments over the 1960-1999 period: 45%. By comparison, mean return was 13.3% for the S&P 500 and 17.2% for US small company stocks over this period. The variance in VC returns was so high (standard deviation of 116%) that the compound return shrank to 13.4%, 120 basis points higher than the S&P 500 over this period but 90 basis points per year below US small company stocks.

Investors in venture capital do not necessarily capture the behavior of the entire asset class. Moving on...

Private Equity
A forthcoming study by Moskowitz and Vissing-Jorgensen examines the results over 5 million private businesses (proprietorships, partnerships, S corporations and C corporations), with estimated value of $6 trillion, using data from the Federal Reserve, Internal Revenue Service, Securities Data Corp., and the Center for Research in Securities Prices. Based on Federal Reserve survey data (whose results are not available to the IRS), the authors report the annual compound return of all private equity over the 1990-1998 period to be 13.9% vs. 17.9% for the S&P 500. Using Federal Reserve Flow of Funds data for the 1963-1999 period, the authors report compound return to book value of 13.2% for all private equity vs. 15.6% for public equities.

The results show that private equity does not offer a reliable improvement to a portfolio of public equities. Next.

Hedge Funds
Hedge fund manager Clifford Asness et al. studied the CFSB/Tremont database of hedge funds over the January 1994-September 2000 period. Funds were limited to those with assets over $10 million, audited financial statements, and those that met CFSB/Tremont reporting requirements. There were 656 funds as of November 15, 2000. Initial results suggested the average fund did well relative to a market model: beta was 0.37 and annualized alpha was 2.6% (net of fees). But hedge funds often hold securities that trade infrequently or are difficult to value, such as over-the-counter convertible bonds. If managers are slow to re-value securities, the presence of stale prices can artificially reduce reported volatility and create the illusion of low correlation with traditional benchmarks. Against a lagged market model, hedge fund results looked much less appealing: beta rose from 0.37 to 0.84 and annualized alpha went from 2.6% to -4.5%.

As we can see, all three alternatives require do not exactly fit our intended goal. Fortunately, there is an asset class which has shown to provide exactly what our portfolio of public equity needs - international small stocks.

International Small Stocks

With high expected returns and low correlation with US large cap stocks, international small stocks can play a useful role as diversifiers.

Annualized data 1970-2002
Compound Return / Standard Deviation
International Small 15.0 / 30.1
MSCI EAFE (net div.) 9.3 / 22.5
S&P500 10.8 / 17.5

Correlation of international small stocks with:

S&P 500 0.29
US Small 0.28

Although the volatility of international small stocks was appreciably greater than the S&P 500 Index (30.1 vs. 17.5), the low correlation suggests significant diversifying power. Using the same time period, a 100%S&P 500 portfolio could be revised to 70% S&P 500 and 30% international small with no increase in overall volatility, but a 200 basis point enhancement in realized return.

Low correlation with US large cap stocks and superior liquidity relative to venture capital, private equity, or hedge funds makes international small stocks an appealing choice for investors seeking alternative investments.

Thanks to Rex Sinquefield for compiling this research and introducing the topic.

Wednesday, May 5, 2010

Investors' Average Equity Returns Over the Past 20 Years.

Mutual fund firms love to quote plush returns for their prospects. Of course, usually these returns do not include expenses and costs, which dramatically lower the return, especially for actively managed funds. Don't you ever wonder, if, and how many people actually earn those tasty returns?

If there is anything that will give us insight as to what the returns were for the average investor, it is the Dalbar study of QAIB (Quantative Analysis on Investment Behavior) for 2010. The research compiles results of investor's actual returns in equity, fixed income, and asset allocation funds.

What the results showed was quite disheartening. For the 20-year period dating back to 1990, the average equity investor garnered a weak 3.17% annualized return. Contrasted with the S&P 500 achieving a 8.20% return over the same time frame.

Why aren't investors achieving higher returns? The 3.17% average equity return highlights investors' lack of investment discipline. Why don't they buy and hold? Simple, because they are impatient.

A 20-year analysis displays that equity investors only retained their mutual fund holdings for an average of 3.22 years. Investors' time horizons are long-term, so why don't their holdings show this? Easy, investors tend to fixate on the present moment instead of the future.

During uncertain markets, investors flee equities - panicking. Fleeing equities and evacuating your long-term goals will certainly hinder your performance and ultimately effect the achievement of your goals. Short-term market movements lead to emotional mistakes that must be avoided in order to reach your expectations, rather staying disciplined and focused on the future will result in satisfactory results.

Which group were you in? We'd be glad to take a second look at your current financial position to make sure you aren't receiving sub-par investment solutions.

Retirement, Risk, and Return

One Fools Fall In...Managed Funds?

By Jonathan Clements
September, 2002

Santa Claus and the Easter Bunny should take a few pointers from the mutual-fund industry.

All three are trying to pull off elaborate hoaxes. But while Santa and the bunny suffer the derision of eight year olds everywhere, actively-managed stock funds still have an ardent following among otherwise clear-thinking adults.

This continued loyalty amazes me. Reams of statistics prove that most of the fund industry's stock pickers fail to beat the market. For instance, over the 10 years through 2001, U.S. stock funds returned 12.4% a year, vs. 12.9% for the Standard & Poor's 500 stock index.

Moreover, fund performance is even worse than statistics like this suggest. How lousy are the results of actively-managed stock funds? Let us count the ways:

Mercy Killings

Almost all fund statistics suffer from what's called survivorship bias. Fund companies regularly kill off rotten stock funds, typically merging them into other funds with better records. That means these rotten performers disappear from the fund averages, thus making actively-managed funds look like a better bet than they really are.

For proof, consider some numbers from Vanguard Group in Malvern, Pa. Using the Lipper mutual-fund database, Vanguard calculates that U.S. stock funds returned 12.5% a year over the 31 years through year end 2001, compared with 12.3% for the S&P 500.

A clear victory for active management? Not quite. That 12.5% excludes all the funds that were liquidated or merged out of existence over the 31 years. If you add these funds back, you find U.S. stock funds returned 11% annually, or 1.3 percentage points a year less than the S&P 500.

The solution is to ditch actively-managed funds and buy market-tracking index funds instead. True, that means giving up any chance of beating the market. But with a low-cost index fund, you can be sure of garnering the market's result, minus maybe 0.2 percentage point a year because of the index fund's expenses.

Click here for more of the article.

Do Past Mutual Fund Winners Repeat?

Anyone, from a second grader to a 401(k) consultant can pick the best performing funds for the past 1, 3, 5, and 10 years. The problem is no one can pick which funds will perform the best 10 years from now. We cannot predict the future. The phrase “past performance is not an indicator of future outcomes” is a common fine print line found in all mutual fund literature. Yet due to either force of habit or conviction, both investors and advisors consider past performance and related metrics to be important factors in fund selection (which is not a valid consideration).

So, just for fun let's look at the S&P Persistence Scorecard. "The semi-annual S&P Persistence Scorecard seeks to track the consistency of top performers over three- and five-consecutive year periods, and measure performance persistence through transition matrices for three- and five-year non-overlapping holding periods."

The results:

Very few funds manage to consistently repeat top-half or top-quartile performance. Over the five years ending September 2009, only 4.27% large-cap funds, 3.98% mid-cap funds, and 9.13% small-cap funds maintained a top-half ranking over the five consecutive 12-month periods. No large- or mid-cap funds, and only one small-cap fund maintained a top quartile ranking over the same period.

Based on this data and extrapolation, if we picked a top-half ranked large-cap fund, today, we could be strongly confident five years from now that the same fund will have roughly a 4.27% chance of being in the top-half of performers and roughly a 0% chance of being in the top quartile. Odds that I would not like to place my investment savings in.

The Failure of Active Management

Over the years we have encountered many people who question our thoughts on the "failure of active management". Some reply with, "Well, how come Wall St. exists?" or "So, you are telling me Wall St. has it all wrong?". In which we reply with a resounding "Yes!". At Arianna Capital we hold the believe that stock picking and timing the markets does not bode well for most investors. Rather, suggesting that the average investor would fare better with a simple index fund, taking advantage of market returns preventing one from making emotional mistakes such as stock picking and timing the market.

Thankfully, there exists an institution to keep "score" on how these active funds perform relative to a simple index. "The S&P Indices Versus Active Funds (SPIVA) Scorecard reports performance comparisons corrected for survivorship bias, shows equal- and asset-weighted peer averages, and provides measures of style consistency for actively managed U.S. equity, international equity, and fixed income mutual funds." An apples-to-apples comparison of active vs passive management. Let's check out the results:

Over the last five years, the S&P 500 has outperformed 60.8% of actively managed large-cap U.S. equity funds; the S&P MidCap 400 has outperformed 77.2% of mid-cap funds; and the S&P SmallCap 600 has outperformed 66.6% of small-cap funds.

The five-year data results are similar for actively managed fixed income funds. Across all categories, with the exception of emerging market debt, more than 70% of active managers have failed to beat benchmarks.

On average, academics tell us that roughly 75% of actively managed funds will under-perform relative to their benchmark. Looks as if the the SPIVA scorecard bolsters this statistic. If the professional money managers who spend night and day trying to outsmart the millions of market participants cannot seem to consistently accomplish their goal, which is to provide value ontop of the benchmark, what makes you think you can or your broker/advisor at Morgan Stanley, Merrill Lynch, UBS, or Citi/SmithBarney can? If that's not enough to convince you:

The turmoil of the past five years saw 29% of domestic equity funds, 21% of international equity funds, and 10% of fixed income funds merge or liquidate.

This statistic tells us that funds managed by professionals either liquidated or merged due to poor results. Why else would they merge or liquidate? To conceal the failure of active management.

Don't fall into Wall Street's gimmicks, just look at the numbers. Next time you talk to a salesman at Edward Jones, Merrill Lynch, or Raymond James show him/her the SPIVA scorecard and ask him how he/she can provide value. He/she will probably tell you that they can help you stay away from these under-performing funds or identify the "better" ones. Ask them how. If they have an answer, you know they are a charlatan or mountebank.

Monday, May 3, 2010

Arianna Capital - New Beginnings

Welcome to the NEW blog! The main purpose of this blog was to expand the arms of Arianna Capital Management past the news page on our website. Visit our website for the majority of our updated articles and content to see what we can do for your goals. A little bit about us is included below. -- --

Arianna Capital is an investment atelier that offers a level of personal service and investment solution unmatched in the industry.

We strive to build a lasting relationship with you, our client—to understand your needs and empower you to accomplish your life goals. We believe this strong relationship is the key to aligning your wealth with your values and providing the financial solutions you need to realize your vision.

Arianna was first born as an idea.

Our founders saw there was a problem—a rash of malpractice in the financial realm and a breakdown of trust. The needs of the affluent were not being met; they too often had to choose between trust and expertise when selecting an advisor.

We realized there was only one solution—a strong, trust-based relationship between client and advisor. What creates this trust? The things that make Arianna unique: unbiased advice, a handpicked team of seasoned experts, a scientific investment approach, a fine-tuned consulting process, and strategic alliances with world-class experts.

That’s the Arianna solution—one that empowers you and improves your life.