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How Risk and Uncertainty Affect Stock Returns

bobby — Mon, 05 Dec 2016 09:00:36 +0000

Asset pricing models imply that equity portfolios’ time-varying exposure to the market risk and uncertainty factors carries with it positive risk premiums. Turan Bali and Hao Zhou contribute to the body of literature on this topic through the study “Risk, Uncertainty, and Expected Returns,” which appeared in the June 2016 issue of the Journal of Financial and Quantitative Analysis.

Their study seeks to investigate whether the market price of risk and the market price of uncertainty are significantly positive, and whether they may help explain the cross-sectional and time-series variation in stock returns. According to the authors’ model, the premium on equity is made up of two separate terms. The first term compensates for standard market risk. The second term represents an additional premium for variance risk.

Measures Of Uncertainty

Economic uncertainty is proxied by the variance risk premium (the price of volatility insurance as implied in options prices) in the U.S. equity market. The second set of uncertainty measures that they use is based on the extreme downside risk of financial institutions and is obtained from the left tail of the time-series and cross-sectional distribution of financial firms’ returns.

The third uncertainty variable is related to the general health of the financial sector, and is proxied by the credit default swap index. The final uncertainty variable originates from the aggregate measure of investors’ disagreement about the individual stocks trading at the NYSE, AMEX and Nasdaq. The dispersion in analysts’ earnings forecasts acts as a proxy for the divergence of opinion.

Bali and Zhou’s study covers the period January 1990 to December 2012. Following is a summary of their findings, all of which are intuitive:

The variance risk premium (VRP) is strongly and positively correlated with all the measures of uncertainty considered.
The results indicate a significantly positive market price of uncertainty.
Equity portfolios (individual stocks) that are highly correlated with uncertainty, as proxied by the VRP, carry a significant premium (8% annualized) relative to portfolios (individual stocks) that are either uncorrelated or minimally correlated with VRP.
The results indicate that the VRP can be viewed as a proxy for financial and economic uncertainty.
The results from testing the equality of conditional alphas for the high-return and low-return portfolios provide no evidence of significant alpha for small/big and value/growth portfolios, indicating that the two-factor model proposed in the paper delivers both statistical and economic success in explaining stock market anomalies.

Conclusions

Bali and Zhou found that the difference between the implied and expected variances not only positively covaries with stock returns, but it covaries negatively with future growth rates in GDP.

They explain: “Intuitively, when VRP is high (low), it generally signals a high (low) degree of aggregate economic uncertainty. Consequently agents tend to simultaneously cut (increase) their consumption and investment expenditures and shift their portfolios from more (less) to less (more) risky assets. This in turn results in a rise (decrease) in expected excess returns for stock portfolios that covaries more (less) with the macroeconomic uncertainty, as proxied by VRP.”

Having intuitive explanations for why a premium exists gives us greater confidence that results are not just random outcomes or the result of data mining exercises.

Bali and Zhou’s findings also provide further support for risk-based explanations for the size and value premiums, as small and value firms are more exposed to uncertainty risks, which in turn can lead investors to flee to the stocks of less risky large and growth companies.

This commentary originally appeared November 7 on ETF.com

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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

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“Your Compete Guide to Factor-Based Investing” : A Q&A With Larry Swedroe

bobby — Mon, 05 Dec 2016 09:00:20 +0000

Larry Swedroe discusses his new book, “Your Complete Guide To Factor-Based Investing,” while taking on smart beta, the investment factor “zoo” and how to think differently about diversification in a recent interview with ETF.com’s Drew Voros.

Find it on ETF.com

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The Volatility of Active Management

bobby — Mon, 05 Dec 2016 09:00:15 +0000

S&P Dow Jones Indices has long provided a great service to investors with its semi-annual S&P Indices Versus Active (SPIVA) scorecards. The evidence offered in these reports has shown time and again that, regardless of the asset class, the vast majority of active managers persistently fail to outperform their benchmarks, and that there is little to no persistence of performance beyond the randomly expected.

Thus, while we know that there will almost certainly be some small percentage of active mutual fund managers who will outperform in the future, being unable to use past performance as a predictive metric means there is no reliable way to identify them ahead of time.

S&P Dow Jones Indices recently produced a new study that looks not just at the returns of actively managed funds, but also at their volatility (one measure of risk). One purpose of the study was to test whether past volatility was predictive of future volatility. The following is a summary of the author’s findings:

Typically, active funds offered higher volatility than their category benchmarks, although not always and not in every mutual fund category. An average of 80 percent of U.S. funds and 65 percent of European funds demonstrated greater volatility than their category benchmarks.

While there is no persistence of performance beyond the randomly expected, there is persistence in relative fund volatility, particularly for the most and least volatile funds. About two-thirds of funds in the most volatile quintile in a two-year period remained in that quintile over the next two-year period, and about two-thirds of the least volatile funds in a two-year period remained in the two least volatile quintiles over the next two-year period.

The performance of high-volatility mutual funds appears to stem from a bias toward higher-beta stocks.

The performance of low-volatility mutual funds tends to be driven by large cash allocations (as opposed to a bias toward low-beta stocks). Specifically, researchers concluded that the performance of low-volatility funds could be replicated by holding an 11 percent position in cash.

Funds in the top quintile of volatility produced slightly lower returns than the S&P 500 Index (7.8 percent versus 7.9 percent) and also exhibited higher volatility (17.2 percent versus 14.7 percent). The average exposure of top-quintile funds to market beta was 1.15 versus 1.00 for the S&P 500 Index.

Funds in the lowest quintile of volatility produced lower returns than the S&P 500 Index (7.2 percent versus 7.9 percent) although, as you would expect, they did exhibit a lower volatility (13.2 percent versus 14.7 percent). The average exposure of bottom-quintile funds to market beta was 0.89. However, their correlation of returns with the S&P 500 Index was 0.99. This finding indicates that the lower market beta exposure was the result of holding cash, not of holding low-volatility stocks, whose correlation with the market was about 0.75. As you should also expect, the low-volatility funds underperformed in bull markets and outperformed in bear markets.

Summary

The bottom line is that the evidence shows investors were not able to improve their returns relative to the market either by investing in higher-volatility actively managed funds (taking more risk) or by investing in low-volatility actively managed funds. In other words, the study provides further evidence that active management is a loser’s game; while it’s a game that’s possible to win, the odds of doing so (especially for taxable investors) are too low to make playing a prudent decision.

This commentary originally appeared November 2 on MutualFunds.com

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Bottom-Up Construction Works Best With Multiple Investment Factors

bobby — Mon, 28 Nov 2016 09:00:38 +0000

CAPM was the first formal asset pricing model. Market beta was its sole factor. With the 1992 publication of their paper, “The Cross-Section of Expected Stock Returns,” Eugene Fama and Kenneth French introduced a new-and-improved three-factor model, adding size and value to market beta as factors that not only provided premiums, but helped further explain the differences in returns of diversified portfolios.

But financial innovation didn’t end there. Today the literature contains more than 600 investment factors, a number so great that John Cochrane called it a “zoo of factors.” However, as my co-author Andrew Berkin and I explain in our recently released book, “Your Complete Guide to Factor-Based Investing,” only a small number of exhibits within this factor zoo are required to explain almost all the differences in returns between diversified portfolios.

To be considered worthy of investment, a factor should not only provide a premium and add explanatory power, it should also meet all of the following criteria. It should be:

Persistent: It holds across long periods of time and different economic regimes.
Pervasive: It holds across countries, regions, sectors and even asset classes.
Robust: It holds for various definitions. For example, there is a value premium whether it is measured by price-to-book, earnings, cash flow or sales.
Investable: It holds up after considering trading and other costs.
Intuitive: There are logical risk-based or behavioral-based explanations for the premium, providing a rationale for believing that it should continue to exist.

Factors Aren’t In Lockstep

Academic research has provided investors with a number of factors that meet all the criteria. In addition to market beta, size and value, we can add the equity factors of momentum and profitability/quality. With this knowledge, we can build rules-based portfolios that provide us with systematic exposure to multiple unique factors, each with low correlation to the others.

This low correlation provides diversification benefits, which are important because all factors have experienced long periods of underperformance. However, importantly, they have not all experienced periods of underperformance simultaneously.

A good example of the diversification benefits that factors can provide can be seen by examining value and momentum. From 1964 through 2014, their annual correlation was -0.20. The negative correlation should be expected almost by definition. Consider that when a stock’s price increases, it gains momentum (as long as its price is rising faster than others) while at the same time becoming less “valuey” because it grows more expensive relative to earnings, book value or other fundamental metrics.

Similarly, momentum has been negatively correlated to the size factor. Another example is that profitability/quality has been negatively correlated (-0.27/-0.52) with market beta because investors favor quality in times of uncertainty.

The academic evidence has led to a great increase in interest in constructing portfolios that have exposure to multiple factors. That, in turn, leads to the question of how to best build a portfolio. Is it better to create a portfolio using individual, single-factor components (thinking of them as “building blocks”), or is it better to build a multifactor portfolio from the security level (where scoring or ranking systems are used to select securities)? It should be intuitive that the latter approach, a bottom-up one, is superior.

One reason for this is that, if you use the component approach, you will have one factor-based fund buying a stock (or group of stocks) while another factor-based fund will be selling the same stock (or group of stocks).

For example, if a stock (or an entire sector) is falling in price, it might drop to a level that would cause a value fund to buy it while a momentum fund would be selling the very same security. Investors would thus be paying two management fees and also incurring trading costs twice, without having any impact on the portfolio’s overall holdings.

In Support Of Bottom-Up Approaches

Support for factor-based investing strategies was provided by Antti Ilmanen and Jared Kizer in their 2012 paper, “The Death of Diversification Has Been Greatly Exaggerated.” The paper, which won The Journal of Portfolio Management’s award for the best paper of the year, argued that factor diversification has been more effective at reducing portfolio volatility and market directionality than asset class diversification.

Jennifer Bender and Taie Wang, authors of the 2016 study “Can the Whole Be More Than the Sum of the Parts? Bottom-Up versus Top-Down Multifactor Portfolio Construction,” which appears in a Special QES Issue of The Journal of Portfolio Management, examine which of the two approaches is more efficient.

The authors observe that the bottom-up approach would seem to be a better one because the portfolio weight of each security will depend on how well it ranks on multiple factors simultaneously, while the approach combining single-factor portfolios may miss the effects of cross-sectional interaction between the factors at the security level. The study used the equity factors of value, size, quality, low volatility and momentum, from which the authors built global portfolios from developed markets.

Lower Volatility

Bender and Wang found that the bottom-up portfolio returns were higher than any of the underlying individual component factor returns and higher than the combinations. Additionally, volatility of the bottom-up portfolio was significantly lower.

For example, over the period January 1993 through March 2015, the combination portfolio was able to return 11.14%, versus 12.13% for the bottom-up portfolio, while exhibiting higher volatility (an annual standard deviation of 14.86% versus 13.97%). As a result, the risk-adjusted return increases from 0.73% for the combination portfolio to 0.84% for the bottom-up approach.

They also found that “the bottom-up approach consistently produced better performance over the combination approach in all periods.” Bender and Wang concluded “there are, in fact, beneficial interaction effects among factors that are not captured by the combination approach. Both intuition and empirical evidence favor employing the bottom-up multifactor approach.”

Portfolios that provide exposure to multiple factors allow investors to diversify their holdings in more efficient ways than were previously available. And the theory and evidence demonstrate that the bottom-up approach is the more efficient way to construct a portfolio of factors.

This commentary originally appeared November 4 on ETF.com

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Factor-Based Investing: A Q&A With Larry Swedroe

bobby — Mon, 28 Nov 2016 09:00:16 +0000

Larry Swedroe discusses his new book, “Your Complete Guide To Factor-Based Investing,” as well as the theory behind factor strategies and how investors can achieve their risk and return objectives through them, in a recent Q&A.

Find it on MutualFunds.com

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The Guide to Happy Giving

bobby — Mon, 28 Nov 2016 09:00:01 +0000

The giving season is underway, with the holidays and year-end bearing down on us. So how can we transform one of the more stressful, and sometimes guilt-ridden, elements of the season into something more life-giving?

Whether you’re giving to a family member, a friend or a cause, please consider the following four directives as a guide to happy giving:

1) Give out of impulsion, not compulsion. Compulsion to give can arise from the mountain of expectations, perceived or otherwise, heaped upon us at this time of year. (Those expectations are more often self-imposed, by the way.) Impulsion, on the other hand, comes from within. Give because you want to, not because you have to. And don’t give if you don’t want to.

2) Plan your giving. Just because you’re giving from impulsion doesn’t require that you wait for an epiphany to direct you. Sit down and decide who or what organizations are on this year’s list, and how much you plan to spend. This will help ensure that you are not going to suffer in 2017 for your over-zealous, underfunded generosity in 2016. Stick to your budget.

3) Give creatively. What you give someone and how you give it tells him or her more than the mere fact that you gave. You could give your Goth-inspired nephew a Visa gift card that he can spend on anything. Or, you could target his love of music with an iTunes gift card. Or, you could give him Jack White’s “Ultra LP” on vinyl—it plays from the inside out and has a locked groove on side A. And it also shows that you were paying attention enough to know that he has a record player and would probably like that kind of music. Creativity increases the value of your gift.

4) Give participatively. Yes, I know “participatively” isn’t a word, but perhaps it should be. I encourage you to actively participate in your giving, physically as well as fiscally. Especially when it comes to charitable giving. You can write a check, have a positive impact and feel good about it. But you can also get involved, personally interacting with those receiving your financial gifts. These acts of giving can be life-changing, for the giver and the recipient, and this isn’t simply anecdotal advice. Studies back it up, too: “[S]ocial connection helps turn generous behavior into positive feelings on the part of the donor.”

That ever-popular song says this is the most wonderful time of the year. And while it can be, it’s also one of the most stressful times for far too many. Reframing how we view and practice giving can help transform this central element of the holidays from a burden into a blessing.

A version of this commentary originally appeared December 5, 2014 on Forbes.com

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An Interesting Test of Market Efficiency

bobby — Mon, 14 Nov 2016 09:00:41 +0000

Japan’s Government Pension Investment Fund (GPIF) is the world’s biggest state investor, trumping all other managed government retirement and sovereign wealth funds. Prime Minister Shinzo Abe’s drive to spur the Japanese economy out of its two-decade-and-growing economic slump, known as Abenomics, has pushed the GPIF to plow more money into risky investments, aiming both to stimulate the economy and finance pensions in the world’s most rapidly aging society.

Increased Domestic Investment

For instance, as part of a plan to boost equities to half its assets and shift more money away from Japanese bonds, Bloomberg reported that in the last three months of 2014, the GPIF raised its domestic stock holdings for a fifth-straight quarter, “adding a net 1.73 trillion yen, the most since 2009,” and “almost doubled net sales of Japanese government bonds to 5.56 trillion yen ($46 billion),” at that time “the most in Bank of Japan figures dating back to 1998.”

In addition to increasing its allocation to stocks (both domestic and international), the GPIF also announced in 2015 that it had picked Schroder Investment Management Ltd., Daiwa SB Investments Ltd. and Nomura Asset Management Co. to oversee Japanese traditional active investments and UBS Global Asset Management for its foreign active holdings.

In July, the GPIF unveiled its individual investments for the first time. An analysis from Bloombergrevealed that the pension fund is the top owner of more than 100 Tokyo-listed firms and a top-10 shareholder in about 99% of Japan’s biggest companies, “raising questions about whether GPIF should be less passive in its investments.”

Growing Active Assets

The GPIF’s recent disclosures also show it has been increasing the share of active management represented among its investments. Passive Japanese stock investments fell to 82% of the total at the close of March 2016, compared with 87% a year earlier.

This is an interesting test of the market’s efficiency. Certainly the Japanese government could favor the stocks it owns in the portfolio. And the government could alert its fund managers to changes in policy before making the announcements public. And what’s more, given the size of the GPIF, the government has leverage to negotiate the lowest fees and hire the managers with the best track records.

Unfortunately, despite all of the ostensible advantages, the market appears to be a tough competitor because, at least so far, stock picking hasn’t paid off for the GPIF. Actively managed domestic holdings underperformed its passive strategies by 0.3 percentage points over the past decade.

Despite the evidence as noted above, the pension fund has increased its allocation to actively managed funds. It appears that hope does spring eternal.

This commentary originally appeared October 31 on ETF.com

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“Free Lunch” Investing Takes Time to Cook

bobby — Mon, 14 Nov 2016 09:00:38 +0000

As the director of research for The BAM Alliance, I’ve been getting lots of calls recently from investors questioning their international equity investments. This hasn’t been a surprise, as any time an asset class does poorly, a significant number of investors will question why they own that asset.

One particular inquiry I received addressed the fact that international equities not only had underperformed since 2009, but they crashed in 2008—just when the benefits from diversification were needed most, they failed to materialize. The investor thus questioned the reason for including international equities in his portfolio.

Among the errors discussed in my book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” is one called recency. Recency is the tendency to overweight recent events/trends and ignore long-term evidence. This leads investors to buy after periods of strong performance (when valuations are higher and expected returns are now lower) and sell after periods of poor performance (when prices are lower and expected returns are now higher). This results in the opposite of what a disciplined investor should be doing: rebalancing to maintain their portfolio’s asset allocation.

The problem created by recency is compounded when international stocks underperform, greatly increasing the risk that an investor will commit a mistake. This occurs because of another common error: confusing familiarity with safety, which leads to a home-country bias.

To address the question of where to find the benefits of international investing, we don’t have to go back too far in time. The problem is that investor memories can be very short—often much shorter than is required to be a successful investor.

A Time Of Crisis And Recovery

We’ll begin our analysis by looking at the period that’s caused investors to question their strategy of global diversification: 2008 through September 2016. Over this period, the S&P 500 Index returned 6.9% per year, the MSCI EAFE Index returned -0.3% per year and the MSCI Emerging Markets Index lost 1.2% per year. Given these results, it’s easy to understand why investors are questioning their strategy.

But no one was questioning this strategy during the prior seven-year period: 2001 through 2007. During this period, the S&P 500 Index returned 3.3% per year, the MSCI EAFE Index returned 8.8% per year and, lastly, the MSCI Emerging Markets Index returned 24.0% per year.

For the full period 2001 through September 2016, the S&P 500 Index returned 5.3% per year, the MSCI EAFE Index returned 3.5% per year and the MSCI Emerging Markets Index returned 9.1% per year. A portfolio allocated 60% to the S&P 500, 30% to the MSCI EAFE Index and the remaining 10% to the MSCI Emerging Markets Index (and then rebalanced quarterly) would have returned the very same 5.3% with just slightly higher volatility (15.6%) than the S&P 500 Index (14.8%).

The table below, covering the five-year period 2003 through 2007, presents an even more compelling case for international diversification. You can be sure I wasn’t getting any calls about diversifying internationally during this time, except of course for the ones from investors asking why their allocation to international stocks wasn’t higher! (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Over this particular five-year period, the S&P 500 Index underperformed by anywhere from 8.8 percentage points per year to as much as 32.4 percentage points per year. However, a tree can’t grow to the sky, and such outperformance cannot persist. Inevitably, the high returns produced by international stocks can lead to high valuations and, thus, to lower future returns (and vice versa). And that’s the situation we have today, as the data in the following table demonstrates.

Forward-Looking (Expected) Returns

Many investors are questioning the benefits of international diversification at a time when U.S. equity valuations are now quite a bit higher than international valuations. And because current valuations are the best predictor we have of future returns, international investments now have higher expected returns. At the end of September 2016, the Shiller CAPE 10 ratio for the S&P 500, which uses the last 10 years’ earnings (adjusted for inflation), produced an earnings yield (or E/P, the inverse of the P/E ratio) of about 3.7%.

To adjust for the fact that real earnings grow over time, and for the fact that we are looking at earnings on average five years old, we need to multiply the earnings yield by 1.1, producing a new earnings yield, and a forecast of expected real return, of about 4.1% for the S&P 500. The CAPE 10 ratio for the MSCI EAFE Index produces an earnings yield of about 6.7%, resulting in an expected real return for the stocks in that index of about 7.4%. And the CAPE 10 ratio for the MSCI Emerging Markets Index produces an earnings yield of about 7.3%, resulting in an expected real return for the stocks within that index of approximately 8.0%.

Using this metric, we see that U.S. stocks should be expected to underperform developed markets stocks by 3.3 percentage points and emerging markets stocks by 3.9 percentage points.

Of course, these are just estimates of expected returns. Even though the evidence suggests that this is as good a predictor as we have, the methodology explains only about 40% of actual future returns. The rest comes from unexpected events (earnings grow faster or slower than expected and valuations change).

Thus, we must be very humble about how we think about such forecasts. By that I mean we shouldn’t treat them as single-point estimates. With U.S. stocks, based on the historical evidence, to include all actual subsequent outcomes, you would have to both add and subtract about 8% from the expected real return.

In other words, while the mean expected real return for the S&P 500 Index going forward is 4.1%, potential outcomes range from a real loss of about 4% to a real gain of about 12%. That’s a very wide dispersion of potential outcomes. It also shows how difficult it is to forecast returns.

Before moving on, the table below shows various value metrics for three of Vanguard’s index funds. The historical evidence is that higher valuations forecast lower future returns. The data is from Morningstar as of Aug. 31, 2016.

As you can see, regardless of the value metric we observe, the valuations of U.S. stocks are now much higher than international valuations, especially emerging market valuations. Now, it’s important to understand that this doesn’t necessarily make international investments a better choice. Their higher valuations simply reflect the fact that investors view the United States as a safer place to invest. And there is an inverse relationship between risk and expected returns (at least there should be).

Making The Case For Global Diversification

Diversification has been rightly called the only free lunch in investing—a portfolio of global equity markets should be expected to produce a superior risk-adjusted return to any one country owned in isolation.

However, as we have been discussing, the benefits of global diversification came under attack as a result of the financial crisis of 2008, when all risky assets suffered sharp price drops as their correlations rose toward one. Many investors took the wrong lessons from what happened, wrongly concluding that global diversification doesn’t work because it fails when its benefits are needed most. This is erroneous on two fronts.

First, a critical lesson is that, because the correlations of risky assets tend to rise toward 1 during systemic global crises, the most important diversification is to ensure your portfolio has a sufficiently large allocation to safe bond investments (investments such as U.S. Treasury bonds, FDIC-insured CDs and municipal bonds rated AAA/AA) so that the overall portfolio’s risk is dampened to the level appropriate for your ability, willingness and need to take risk.

During systemic financial crises, the correlations of the safest bonds to stocks, while averaging about zero over the long term, tend to turn sharply negative (when they’re needed most) because they benefit not only from flights to safety, but also from flights to liquidity.

Another wrong lesson investors took from the 2008 financial crisis involves a failure to understand that, while international diversification doesn’t necessarily work in the short term, it does work eventually. This point was the focus of a paper by Clifford Asness, Roni Israelov and John Liew, “International Diversification Works (Eventually),” which appeared in the May/June 2011 edition of Financial Analysts Journal.

Diversification No Refuge In The Short Term

The authors explained that investors focused on the fact that globally diversified portfolios don’t protect them from short, systematic crashes miss the greater point that those with a long-term planning horizon (and it should be, or you shouldn’t be invested in stocks to begin with) should care much more about long, drawn-out bear markets that can be significantly more damaging to wealth.

In their study, which covered the period 1950 through 2008 and 22 developed-market countries, the authors examined the benefits of diversification over a long-term holding period. They found that over the long run, markets don’t exhibit the same tendency to suffer or crash together. Thus, investors shouldn’t allow short-term failures to blind them to long-term benefits.

To demonstrate this point, they decomposed returns into two pieces: (1) a component due to multiple expansions (or contractions); and (2) a component due to economic performance. The authors found that while short-term stock returns tend to be dominated by the first component, long-term stock returns tend to be dominated by the second.

They explained that these results “are consistent with the idea that a sharp decrease in investors’ risk appetite (i.e., a panic) can explain markets crashing at the same time. However, these risk aversion shocks seem to be a short-lived phenomenon. Over the long-run, economic performance drives returns.”

In addition, the authors showed that “countries exhibit significant idiosyncratic variation in long-run economic performance. Thus, country specific (not global) long-run economic performance is the most important determinant of long-run returns.”

For example, in terms of worst-case performances, they found that at a one-month holding period, there was little difference in the performance between home-country portfolios and the global portfolio. As the horizon lengthens, the gap widens. The worst cases for the global portfolio were significantly better (meaning the losses were much smaller) than the worst cases for the local portfolios. The longer the horizon, the wider the gap favoring the global portfolio becomes.

Demonstrating the point that long-term returns are more about a country’s economic performance and that long-term economic performance is quite variable across countries, the authors found that “country-specific economic performance dominates long-term performance, going from explaining about 1% of quarterly returns to 39% of 15-year returns and rising quite linearly in time.”

Summary

The conclusion you should draw is that while global diversification can disappoint over the short term, over the long term, which is far more relevant, it should be expected to be the free (and hearty) lunch that theory and common sense say it should be.

If you require a more specific example of the wisdom of this advice, look to Japan. The poor returns that Japan has experienced since 1990 weren’t a result of systemic global risks. It happened because of Japan’s idiosyncratic problems. And before you make the mistake of confusing the familiar with the safe, you cannot know which country or countries will experience a prolonged period of underperformance. And that uncertainty is what international diversification protects you against.

Finally, the ability to avoid making the twin mistakes of recency and of confusing the familiar with the safe are key aspects to being a successful investor. Warren Buffett offered the following advice, which is related to our discussion: “The most important quality for an investor is temperament, not intellect.” You must be able to ignore short-term performance if you hope to gain long-term benefits. And as we just showed, even seven years is short term when it comes to investing.

This commentary originally appeared October 17 on ETF.com

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Some Alternatives to Big Banks and Their Record-High Fees

bobby — Mon, 31 Oct 2016 09:00:47 +0000

Fees are at an all-time high at the nation’s big banks, while the interest they pay is at an all-time low. Worse yet, evidence recently has come to light of the criminal abuse of a practice common among large banks since the fall of Glass-Steagall: cross-selling.

Cross-selling is rooted in consumer research that large financial institutions tend to salivate over. It shows that customers are more profitable for longer when they own more products. How else could they get us to settle for deposit products for which we pay them? Does this absurdity leave you, the bank customer, wanting to bolt from the big banks?

Fortunately, you have alternatives. Here are some options:

Flee the big brick-and-mortar bank for its younger virtual sibling: the online bank. Online banks, which lack the overhead of their more traditional rivals, can offer higher interest rates, lower fees, free ATM withdrawals and low or no minimum-balance requirements. And they do.

I’ve been using an online bank for several years now and haven’t paid a single ATM fee for that entire time — and I can go to any ATM in the known universe (seriously). In the past year alone, I’ve received more than $200 in ATM fee rebates.

I recommend that you choose an online bank that best serves your needs and lifestyle. Mine, for example, offers unlimited ATM reimbursement, but others will cap the reimbursement amount or restrict you to a (typically large) number of “free” ATMs. Those banks, however, may pay a higher level of interest than my bank. NerdWallet did an excellent job summarizing the best online checking accounts of 2016.

Consider a community or association bank or a credit union. There’s really only one reason I can imagine “needing” a physical bank, and that’s to deposit cash. (For our family, even that is a rarity; if we get a wad of cash, we’ll just use it for expenses anticipated in our budget, such as groceries.)

Beyond daily banking, however, it can still be good to have a relationship with a local bank or credit union, because they also tend to offer higher rates on deposit products and lower rates on loans. You may also want use them for a financial-planning tool that I value very highly for unexpected opportunities or emergencies: an unused home-equity line of credit (preferably with a rate no higher than Prime plus one, no origination fees, no annual fees and no prepayment penalties).

Regardless of whether you use an online or physical bank, the only options you should consider are those with Federal Deposit Insurance Corp. (FDIC) protection.

Consider warehousing your short-term cash through a U.S. Treasury Money Market fund located in your taxable brokerage account.That is, if you’re blessed to have cash in excess of the FDIC limits. As we learned in the financial crisis of 2008–2009, it is indeed possible for a traditional money market account to lose money. Therefore, if safety is your priority, you should find it (and slightly lower interest rates) in a money-market instrument holding only vehicles backed by the full faith and credit of the U.S. government.
Consider good ol’ certificates of deposit with FDIC protection.This is a good strategy if you want to maximize the earning potential of your short-term cash-management strategy without putting that money at risk. You might even create a “CD ladder,” positioning multiple instruments at varying maturities and rates. It means more work and complexity, but it would likely result in higher returns, too.

You can create your CD ladder through traditional, big banks, but it’s likely easier to purchase “brokered CDs” in your taxable accounts, although this strategy certainly requires more skill.

Given these readily available alternatives, are there any good reasons to stay with a big, traditional bank? Not really, unless you’re interested in strengthening the bottom line of banks deemed “too big to fail.”

This commentary originally appeared October 17 on CNBC.com

The post Some Alternatives to Big Banks and Their Record-High Fees appeared first on JMF Capstone Wealth Management.

On the Performance of Long-Serving Active Mutual Fund Managers

bobby — Mon, 31 Oct 2016 09:00:33 +0000

Given its importance to so many investors, it’s not surprising that there has been a tremendous amount of research into the performance of actively managed mutual funds. An overwhelming body of evidence has demonstrated that the vast majority of active funds underperform their appropriate risk-adjusted benchmarks, even before considering the impact of taxes.

In addition, because fewer funds outperform than would be randomly expected, it’s hard to know if the very small percentage of outperformers were able to produce that result based on skill or luck.

For example, Philipp Meyer-Brauns of Dimensional Fund Advisors, author of the August 2016 research paper “Mutual Fund Performance Through a Five-Factor Lens,” found that “there is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.” His study examined 3,870 active funds over the 32-year period from 1984 to 2015. Meyer-Brauns added that “funds do about as well as would be expected from extremely lucky funds in a zero-alpha world. This means that ex-ante, investors could not have expected any outperformance from these top performers.”

The great majority of studies on mutual fund performance have used fund-level data, examining the performance of funds rather than the performance of fund managers. And over any sample period, more than one manager may have been responsible for the management of that fund, particularly as the sample period lengthens. With this in mind, Andrew Clare, author of a September 2016 study, The Performance of Long-Serving Fund Managers explored the performance of tenured fund managers (those with at least 10 years as the sole manager of a fund) to see whether experience favorably impacted performance. It certainly seems like a reasonable hypothesis.

Of course, by restricting the pool to managers with such long experience, we have to be aware of the issue of survivorship bias – managers with poor track records aren’t likely to last 10 years. Clare’s dataset consisted of 357 managers with at least 10 years running a fund as of December 2014.

He found that for long-serving mutual fund managers, the net-of-fee return in excess of the benchmark averaged just less than 0.5 percent per year. And while the benchmark-adjusted performance figures look impressive, as noted earlier, there is an element of survivorship bias here.

Importantly, Clare also found that the excess return was negative over the last four years of the period. In other words, the collective ability of long-tenured managers to outperform their benchmarks waned over the 10-year period. Either that or their luck ran out. When he tested for persistence in performance, Clare found that the winners in one year were unlikely to be winners in the next years, as in six of the nine other years’ excess returns were negative. Within the group of long-serving mutual fund managers he studied, there was no evidence of persistence of performance.

Summary

The bottom line is that even with considerable survivorship bias in how the test was set up, deteriorating performance over the 10-year period and the lack of persistence in performance among long-serving fund managers demonstrates why Charles Ellis called active management a loser’s game. It’s not that you cannot win. It’s just that the odds of doing so are so poor it’s not prudent to try. And despite what most investors believe, it’s clear that even long and successful track records don’t provide much, if any, value for predicting future performance.

This commentary originally appeared October 6 on MutualFunds.com

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