Managers vs. Markets

Proponents of active management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction. While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active managers do not consistently deliver on this promise, according to research provided by Standard & Poor's.

S&P Indices publishes a semi-annual scorecard that compares the performance of actively managed mutual funds to S&P benchmarks. Known as the SPIVA scorecard¹, the report analyzes the returns of US-based equity and fixed income managers investing in the US, international, and emerging markets. The managers' returns come from the CRSP Survivor-Bias-Free US Mutual Fund Database, and the managers are grouped according to their Lipper style categories.²

The graph below features fund categories from the most recent SPIVA scorecard—all US equity funds, international funds, emerging market funds, and global fixed income funds—and shows the percentage of active managers that were outperformed by the respective S&P Indices in one-, three-, and five-year periods. These are only four of thirty-five equity and fixed income fund categories. But a deeper analysis confirms that the active manager universe usually fails to beat the market benchmarks over longer time horizons. Underperformance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.

Over the last five years, about 60% of actively managed large cap US equity funds have failed to beat the S&P 500; 77% of mid cap funds have failed to beat the S&P 400; and two-thirds of the small cap manager universe have failed to outperform the S&P Small Cap 600 Index. Furthermore, across the thirteen fixed income fund categories, all but one experienced at least a 70% rate of underperformance over five years.

In 2009, active funds experienced more success over a one-year period, and proponents typically highlight those results in the SPIVA scorecard. However, one-year results are not consistently strong from year to year, and investors should not draw conclusions from short-term results. Over three- and five-year periods, most fund categories have not outperformed their respective benchmarks.

This poor track record appears in other research, as indicated in the graph below. This study compared the same actively managed funds in the CRSP database to the Russell benchmarks and showed similar results over the three- and five-year periods. Over the past five years, about 65% of all US equity managers failed to outperform their respective Russell Indexes, and 84% of fixed income managers failed to beat their respective Barclays Capital Indices.

Of course, the results of these studies will fluctuate over time, and a majority of funds in a given category might outperform over the short term. But the message is clear: As a group, actively managed funds often struggle to add value relative to an appropriate benchmark—and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.

The Secret Your Estate Planning Lawyer Wont Tell You

By Daniel Solin

No one wants to confront their own mortality. That’s why so many Americans die without a will, which is the worst possible estate planning. For those who act responsibly and retain the services of an estate planning lawyer, a hidden danger lurks.

The standard estate planning advice is geared (as it should be) around minimizing estate taxes and avoiding probate, where appropriate. That’s all well and good. However, a critical area of concern is ignored by every estate planner I have encountered: the management of your assets after death.

Estate planning lawyers receive referrals from major brokerage firms and traditional institutional trustees. The best way to keep these referrals flowing is to refer business back to the source. It all sounds innocuous enough until you understand the devastating consequences of this common practice.

The real money in trust administration is not in the administration fees. It’s in the advisory fees generated by the arm of the trustee that manages the assets in the trust. Well in excess of 90% of institutional trustees also manage trust assets. Not only does this create a conflict of interest (how carefully is one division of the trust administrator really going to review the conduct of another division?), but it practically insures under performance of trust assets.

Notwithstanding the overwhelming evidence demonstrating the superiority of passive management, I know of no trust administrator who follows this Nobel Prize winning investment strategy. Instead, they increase the costs to the trust by engaging in active management, in a usually futile attempt to “beat the markets.” It’s sad that investors who, during their lives, take such care to invest prudently, fall into this trap by following the standard advice of their estate planners.

There is a way to avoid having your assets mismanaged after your death, but don’t expect your estate planner to tell you about it.

Insist that your trust be managed by a “directed trustee.” These are professional trust administrators who only administer trusts. They do not manage money. The leading directed trustees are Advisory Trust of Delaware, Santa Fe Trust, Charles Schwab Trust Services and Wealth Advisors Trust Company.

You will need to give your directed trustee guidance about the kind of financial adviser it should appoint. Here’s language I inserted in my trust:

“The Investment Manager shall be guided by the basic principle known as Modern Portfolio Theory. The Investment Manager should make no effort to “beat the markets.”

The Investment Manager shall focus on the asset allocation of the portfolio. The portfolio shall be globally diversified, using low cost stock and bond index funds, exchange traded funds or passively managed funds. The investment manager shall be guided by the principles set forth in The Intelligent Asset Allocator, by William Bernstein, A Random Walk Down Wall Street, by Burton Malkiel., The Little Book of Common Sense Investing, by John Bogle and The Smartest Investment Book You’ll Ever Read, by Daniel R. Solin”

With the appointment of a directed trustee and the insertion of this (or similar) language in your trust document, you have now protected your assets from being plundered after your death. Based on historical data, the returns of your trust assets could be as much as 300% higher than the historical returns of the average equity investor over the past twenty years.

Of course, you should be following the same investment advice while you are alive. Why should your heirs be the only beneficiaries of Smart Investing?

Solin, Danielle. "The Secret Your Estate Planning Lawyer Wont Tell You." Index Funds Advisors Blog. Word Press, 7/18/2010. Web. 7/20/2010. .

Grading Your Employers 401k Plan!

By Mark Hebner

“The typical fund company services [401k plan] participants in the same way that Baby Face Nelson serviced banks.” William Berstein seems to agree, "The 401(k) is likely to turn out to be a defined-chaos retirement plan."

So, grade your 401k and help you and your fellow colleagues, it might just happen that your 401k is not as dazzling as it may seem.

When you head out each morning to work, you have an expectation that your employer is providing a safe environment. There is no heavy object loosely dangling above your desk and the coffee in the break room uses water that has gone through some filtration system. Your employer provides this safe environment at work because while at work they have a responsibility to the well-being of their employees. This responsibility extends beyond your physical and mental health. If they decide to offer you benefits such as a retirement plan, they must place your interests above all else, otherwise known as a fiduciary responsibility. The law has provided some guidance as to what constitutes fiduciary prudence in regards to employer sponsored retirement plans. These are laid out in the Employee Retirement Income Security Act, or ERISA.

A Little History

Gone are the good ole days of your parents’ pension plan. Funding your retirement was so much easier back in the day. Each paycheck, your employer would take out a portion of your earnings and, along with a little extra money from their own pockets, invest the funds for you and your colleagues. At retirement, the pension fund would begin sending you a paycheck every month calculated using a formula that included your years of service and salary. You should notice one important thing missing in that calculation — Investment Return!!! Investment returns were solely the responsibility of your employer. Whether the investments in the fund performed well or poorly, your monthly retirement check calculation would stay the same. Poor investment performance just meant that your employer had to make up the short fall to cover their obligation to you. This did not sit well with employers; they did not want to assume the risk of poor market performance. So, that risk was transferred to the employees utilizing a long standing yet little used section of the code known as the 401(k).

An Employers’ Duty

Now the 401(k) is the norm, and the pension plan is, for the most part, non-existent in private industry. Instituting a 401(k) plan may have transferred investment risk to the employees, but the responsibility to act in the best interest of the employee, or fiduciary prudence, still lies with the employer. The 401(k) plan must provide a reasonable process for selecting investments. Which begs the question, what is a reasonable process? Well, the Uniform Prudent Investor Act spells out that the reasonable process must be rooted in Modern Portfolio Theory. This means the process must take into account three important factors:

the trade-off between risk and return
offer investment products which provide broad diversification both within and across asset classes
charge fees appropriate relative to service
Unfortunately, it seems as though employers have misinterpreted their transfer of investment risk to the employee to also mean a transfer of fiduciary prudence. Too many employer-sponsored 401(k) plans violate nearly all three of the above factors. Investments are chosen based on recent outperformance (which has been proven overtime to be no indication of future performance) while ignoring risk, investment options are narrow and often ignore many asset classes, and fees are excessively large and many times hidden. The silver lining here is that employees are beginning to fight back. Lawsuits against prominent companies are mounting. Names like Wal-Mart, Caterpillar, Unisys, United Technologies, Honda, Boeing, etc. are all seeing their fiduciary prudence being questioned. To be fair, each of these companies has been sued but not all have received a judgment against them. That being said, the accusations tend to include the terms excessive fees, limited options, and even active management without similar passive options.

Grading Your 401(k)

Here are some important questions to research in your plan documents:

Do your fund expenses exceed the following:

0.20% for US Large
0.40% for US Small
0.50% for Real Estate
0.50% for International Large
0.80% for International Small
0.80% for Emerging Markets
0.20% for Fixed Income
Do the expenses include 12b-1 Fees (which are paid to the plan provider but only serve to lower your return)?

Is your plan missing one or more of the above asset classes?
Are you forced to choose from a menu of expensive actively managed funds without index fund alternatives?
Do funds tend to last only for a couple years in the plan, entering after recent good performance then leaving when they cannot replicate the performance?
Are you given little to no guidance on how to put together a risk appropriate portfolio using the fund selections available?

As a plan participant, employees should be unequivocally concerned with the asset allocation of their retirement plan. As an employee, if your retirement plan is unknown to you or poorly performing, a visit to your HR department is in order. You should seek passively managed options through index funds with a low cost structure.

If you should need help composing a letter or communicating with your HR department call Arianna Capital Management and we will help you through the necessary steps.

Hebner, Mark. "Grading Your Employers 401k Plan!." Index Funds Advisors Blog. Word Press, 07/18/2010. Web. 07/20/2010. .

Ask the Octopus

By Jim Parker

A “psychic” octopus correctly predicted Germany’s path through the soccer World Cup and Spain’s victory in the final over the Netherlands. If only there were such prescient creatures in the financial markets.

“Paul” the Octopus made his successful picks by choosing between glass boxes containing mussels and carrying the flags of the combatant countries.1

So maybe former US President Harry Truman came up with the wrong solution to bad economic forecasts when he said that what he really needed was a one-handed economist. Eight hands might have been better.

But, seriously, the attribution of the power of divination to a cephalopod, however ridiculous, is not that different to how many people attribute to economists the power to accurately and consistently forecast the paths of stocks, interest rates and currencies.

The only difference is that our eight-armed soccer-following underwater friend seems to get it right more often than his two-armed land-loving brethren!

Economists can deal with the professional hazard of inaccurate predictions in a number of ways – by making forecasts continuously to give themselves the flexibility to change their minds, by making forecasts so far into the future that no-one can remember what they said or, more sensibly, by pointing out that their predictions are really just assumptions subject to significant variation.

Fortunately, in this internet age, we can trace back to discover what the various experts were saying about the outlook this time last year. (By the way, it’s a good opportunity to make these comparisons in Australia, because our financial year ended on June 30 and media outlets are currently jammed with sage-sounding forecasts for the coming 12 months.)

Take for instance, the economists polled a year ago by The Australian Financial Review. They tipped that the Reserve Bank of Australia, having cut benchmark interest rates to historic lows in April, 2009, would most likely sit on its hands for the rest of that year and possibly even cut rates further.2

As it turned out, not only did the RBA fail to cut interest rates again in the financial year just passed, it began raising them from October and did so another five times in the ensuing seven months.

So what about the equity market forecasts? The AFR asked a panel of six strategists their projections for the Australian share market’s benchmark S&P/ASX 200 index by the end of June 2010. The consensus was a gain of 21.4 per cent over 12 months. As it turned out, the index rose only 8.8 per cent and all but one of the expert panel was too optimistic.

One could legitimately ask that if analysts are so off in their broad market forecasts, how they can possibly pick individual stocks with any accuracy. But that clearly doesn’t stop them from trying.

Business Review Weekly magazine3 at the end of the 2008/09 financial year asked “some of Australia’s largest and best performing investors” for some “blue chip stock picks” for the coming 12 months.

They came up with a list of 10 stocks – Asciano, Australian Securities Exchange, BHP Billiton, CSL, Harvey Norman, Rio Tinto, Toll Holdings, Westpac, Woodside Petroleum and Woolworths. These, we were told, were “attractively priced shares for the new financial year”.

But maybe they weren’t priced attractively enough, because only two of those stocks – Rio Tinto and Asciano – beat the wider market on a total return basis. Another two performed broadly in line with the market (BHP, Westpac), four delivered single digit returns (Woolworths, Harvey Norman, CSL and Woodside) and a couple posted negative returns over the year (Toll Holdings and the ASX). The median return of the 10-stock portfolio was 6.7 per cent, just over half the total market return of 13.1 per cent.

One has to feel for economists and bottom-up share analysts. It’s a tough business making forecasts. As smart and as well qualified as they are, there are just so many ways their assumptions can go awry.

The great mystery is why, despite their patchy overall record, these end-of-financial-year supplements and features turn up in the media year after year and people go on buying them and reading them.

Maybe go ask the octopus.

1.‘Sucker for Soccer: Octopus Predicts World Cup Finalist’, The Guardian, July 8, 2010
2. ‘Economists Don’t See Rises on the Cards’, Australian Financial Review, July 3, 2009
3. ‘Smart Investing in Tough Times, BRW magazine, July 1, 2009

Buffett's Advice For Families

Recent market events have led individuals to reflect on their own financial health. Hear what Warren Buffett has to say - "Don't listen to the media, avoid debt, buy and hold index funds, and don't time the market." Sound familiar? Take a peek at this 2min video!

http://news.yahoo.com/video#video=20768089