Larry Swedroe, Director of Research, The BAM ALLIANCE

Harry Markowitz received the Nobel Prize in Economic Sciences in 1990 for his contributions to the body of work known as “modern portfolio theory.” Probably his greatest contribution was to turn the focus away from analyzing the risk and expected return of individual investments to considering how its addition impacts the risk and expected return of the overall portfolio.

Markowitz showed it was possible to add risky assets (with low or negative correlation) to a portfolio, increasing the expected return without increasing overall risk. He also demonstrated the importance of diversification of risk.

Today most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one in which no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio).

Working with the efficient frontier, investment advisors tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.

Managing Financial, Not Just Investment, Risks

When developing an overall financial plan, there are risks—other than investment risks—that are important to consider. Not integrating the management of these risks into an overall financial plan can cause even the most carefully considered and well-thought-out investment plans to fail. Among the other risks that should be considered are human capital (wage-earning) risk, mortality risk and longevity risk. Let’s consider how these risks should be integrated into an overall financial plan.

Human Capital Risk

We can define human capital as the present value of future income derived from labor. It’s an asset that doesn’t appear on any balance sheet. It’s also an asset that is not tradable like a stock or a bond. Thus, it’s often ignored, at potentially great risk to the individual’s financial goals. How should human capital impact investment decisions?

The first point to consider is that, when we are young, human capital is at its highest point. It’s also often the largest asset young individuals have. As we age and accumulate financial assets, and our time remaining in the labor force decreases, the amount of human capital relative to financial assets shrinks. This shift over time should be considered in terms of the asset allocation decision.

The second point is that we need to not only consider the magnitude of our human capital but also its volatility. Some people (such as tenured professors, doctors and government employees) have stable jobs, and thus their labor income is almost like an inflation-indexed annuity. In other words, it acts very much like a bond. Other people (such as commissioned salespeople and construction workers) have labor income that is more volatile, and thus acts more like equities. Financial advice should incorporate these differences.

For example, for people with safer labor income, it might be appropriate to invest more aggressively—with a higher allocation to equities overall and perhaps higher allocations to riskier small and value stocks. Those with riskier labor income should consider holding less aggressive portfolios (those with higher bond allocations).

This gets to the heart of Markowitz’s work on portfolio theory: An asset shouldn’t be considered in isolation. Note there may be times when the riskiness of one’s human capital changes (after a career change, for example). If the riskiness of the human capital increases, one should consider reducing the riskiness of the other assets in the portfolio, and vice versa.

A related issue is the significance of human capital as a percentage of total assets. If human capital is a small percentage of the total portfolio (because there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.

Correlation, Health And Mortality

The third point we need to consider involves one of the most basic principles of investing—don’t put too many eggs in one basket. Individuals should avoid investing in assets that have a high correlation with their human capital. Unfortunately, far too many people follow Peter Lynch’s advice to “buy what you know.” The result is that they invest heavily in the stocks of their employers.

This is a mistake on two fronts. The first is that it’s a highly undiversified investment. The second is that the investment is likely to have a high correlation with the person’s human capital. Employees of such companies as Enron and WorldCom found out how costly a mistake that can be.

The fourth point to consider is that human capital can be lost due to two risks that need to be addressed by means other than through investments. The first is the risk of disability. This risk can be addressed by the purchase of disability insurance. Thus, the risk of disability and how to address it should be part of the overall financial plan. The other risk is that of mortality. That issue can be addressed by the purchase of life insurance (we will discuss that in more detail).

There are still other points to consider. All else being equal, people with a high earning capability have a greater ability to take more financial risk because they can more easily recover from losses. However, they also have a lower need to take risk. All else being equal, the higher their earnings, the lower the rate of return they need from their investment portfolio to achieve their financial goals—they can choose less risky investments and still achieve them.

Risk Tolerance And Adaptability

Another factor is investors’ willingness to take risk—their risk tolerance. It’s important that investors don’t take more financial risk than their stomachs can handle. The reason is that, when the inevitable bear markets arrive, they might be more inclined to panic-sell, and the best laid plans would end up in the trash heap of emotions.

Even if they were not driven to panic, life is just too short not to enjoy it. One should be able to “sleep well” with his or her investments. Thus, a high earnings capability, or even a high need to take risk, shouldn’t necessarily result in an aggressive investment portfolio.

Yet another factor to consider is the ability to adjust your “supply” of human capital. Consider the following: You develop a financial plan that allows you to retire at age 65. However, the market’s rate of return falls below the expected return you built into your plan, or you weren’t able to save as much as you had expected. Now you will need to work longer.

Can you continue in the labor force? What level of income can you generate? Will the market allow you to sell your skills, and at what price? Younger workers typically have more ability to adjust their supply of human capital. In addition, those with a variety of skill sets also have a greater ability to adjust their supply to economic conditions.

We’ll revisit this discussion later in the week to consider additional risk factors, including mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.

This commentary originally appeared April 12 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post Understanding Different Types of Risks appeared first on JMF Capstone Wealth Management.

Earlier this week, we looked at the importance of incorporating different types of risk—specifically, human capital risk—into an overall financial plan. Today I will focus on mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.

Mortality Risk

For those families whose human capital makes up a substantial portion of their total assets, protecting that capital via the purchase of life insurance should be part of the overall financial plan. Life insurance is the perfect hedge for mortality risk because its return is 100% negatively correlated with the human capital asset.

The younger the investor (the higher the human capital), the greater the need for life insurance. The amount of insurance required can be determined through what’s called a “needs analysis.” It can also be related to bequeathal motivations.

It’s important to note that life insurance can be used for purposes other than to hedge mortality risk. For example, it may be the most effective way to pay estate taxes. It can also be useful in terms of business continuity risks. Thus, while the individual’s need for insurance to hedge the risks of human capital falls as he or she ages, the need for life insurance might actually increase.

Longevity Risk

Longevity risk is the risk that you will outlive the ability of your portfolio to support your desired lifestyle. This risk has increased for much of the population with the decline of defined benefit plans (which, like social security, pay out for a lifetime) in favor of defined contribution plans. Also, advances in medical science continue to expand life expectancy. Longevity risk can be addressed by the purchase of lifetime payout annuities.

While the academic literature demonstrates that many investors would benefit greatly from the purchase of immediate annuities or deferred income annuities (because of “mortality credits” built into the product—in effect, people who die earlier than expected subsidize those who live longer than expected), very few are purchased.

The main reason seems to be that people are risk averse, in the sense that they don’t want to risk giving up their assets and then dying soon. The fear is that the assets would no longer be available for their heirs. But this is only true if they live a shorter-than-average life span. By definition, half will live longer. And for them, buying a payout annuity preserves any remaining assets for the estate.

The academic literature suggests that deferred income annuities are superior to immediate annuities for the purpose of protecting against longevity risk. Deferred income annuities can be purchased in an investor’s mid-60’s, with income beginning at age 85. Investors should begin to consider purchasing immediate annuities during their mid-70’s and buy them before they reach age 85.

Since the payouts from annuities are dependent on the level of interest rates (among other things), a recommended strategy is to diversify the interest rate risk by purchasing various annuity contracts over time instead of all at once. This strategy also preserves liquidity for some period. Monte Carlo simulations help analyze the benefits of annuitization. It’s also important to understand that delaying social security benefits as long as possible provides longevity insurance.

Another risk is also related to longevity. As we age, the risk of needing some form of long-term health care increases. It’s estimated that at least 60% of people over age 65 will require some long-term care services at some point in their lives. And contrary to what many people believe, Medicare and private health insurance programs do not pay for the majority of long-term care services most people need—help with activities of daily living, such as dressing or using the bathroom.

Thus, when investors develop an overall financial plan, they should consider the purchase of long-term care insurance. Again, the use of Monte Carlo simulations can help analyze how the purchase of long-term health insurance impacts the odds of achieving one’s goals.

These examples demonstrate why having a well-developed investment plan isn’t sufficient for financial planning purposes. Other important risks also exist. We need to consider another broad category called wealth protection.

Wealth Protection Insurance

Financial plans can fail in several ways because we don’t have sufficient insurance. A well-developed plan covers not only longevity and mortality risks, but disability.

Sufficient coverage should also be in place for all types of property and casualty risks, as well as the all-too-often overlooked personal liability risks covered by umbrella policies that protect against claims from lawsuits. Because needs change over time, incorporating a regular, thorough review of your overall insurance needs is an important part of the financial planning process.

In addition to integrating into an overall financial plan the management of the risks we have discussed, integration of strategies that add “tax alpha” can significantly improve the odds of achieving your financial goals.

Tax Alpha

Tax Alpha refers to the additional performance benefit gained from your investments through tax savings. Following are just two ways tax alpha can improve results:

1. You can take advantage of a lower tax bracket between retirement and the time that required minimum distributions (RMD) start to reduce the size of IRAs. Taking income at a low bracket early can lead to avoiding paying tax at a higher bracket later.

2. You can achieve proper asset location, holding lower returning assets (such as bonds) in a traditional IRA while holding higher returning assets (such as stocks) in a Roth IRA to keep future RMDs as low as possible.

Summary

Having a well-thought-out investment plan is a critical part of the financial planning process. However, it’s only the necessary condition for likely success. The sufficient condition is to integrate the investment plan into an overall financial plan that also addresses the risk management issues discussed above. Even then, other issues may need to be considered.

For example, for those with charitable intent, there are more, and less, efficient ways to make donations. The same is true for the transfer of wealth, whether through lifetime gifts, leaving a legacy or both. A well-thought-out financial plan helps to ensure that transfers to loved ones or to charity are made in the most tax-efficient manner, in a way that maintains the donors’ financial independence during their lifetime and meets their nonmonetary objectives.

If your planning doesn’t address each of these issues, I hope this serves as a wakeup call. It’s not too late to act—until it is.

This commentary originally appeared April 14 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post An Integrated Investment Plan Is Key appeared first on JMF Capstone Wealth Management.

Eugene Fama and Kenneth French’s 1992 paper, “The Cross-Section of Expected Stock Returns,” resulted in the development of the Fama–French three-factor model. This model added the size and value factors to the market beta factor.

As my co-author, Andrew Berkin, and I demonstrate in “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” the value premium has been persistent across long periods of time and different economic regions, and pervasive across the globe and even asset classes (cheap assets have outperformed expensive assets).

And while the most common metric used to define value has been the book-to-market (BtM) ratio (as in Fama and French), it has been robust in other definitions. For example, in the United States for the period 1952 through 2015, the annualized value premium was 4.1% (t-stat = 2.4) as measured by BtM, 4.7% (t-stat = 2.9) as measured by the cash flow-to-price ratio, and 6.3% (t-stat = 3.4) as measured by the earnings-to-price ratio.

Measuring Value

Ray Ball, Joseph Gerakos, Juhani T. Linnainmaa and Valeri Nikolaev contribute to the literature on the value premium in their February 2017 paper, “Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns.” Their study, using Center for Research in Security Prices and Compustat data, covers the period July 1963 through December 2015. The sample excluded the bottom 20% of stocks (microcap stocks) as ranked by NYSE market capitalizations, as well as financials.

Note that excluding these financials is typical in academic papers. Omitting the smallest stocks is done so that these stocks don’t dominate results—they make up more than half the number of stocks but have much less market-cap weight. It’s also important to note that, typically, one sees stronger results for factors in these smaller-cap stocks. For example, using BtM, the value premium is much larger in small stocks than in large stocks.

Ball, Gerakos, Linnainmaa and Nikolaev begin by noting that book value of equity consists of two main parts: retained earnings (earnings less dividends) and contributed capital (the value of subsequent net share issuance). Following is a summary of their findings:

• Retained earnings-to-market subsumes book-to-market’s predictive power in the cross section of stock returns despite comprising, on average, only 42% of the book value of equity (book-to-market predicts the cross section of returns only because it contains retained earnings).
• The accumulated dividends component of retained earnings is uninformative of the cross section of average returns (another example of dividend policy not being relevant to expected returns). The authors state: “This result is consistent with book-to-market’s explanatory power arising only because it provides a good proxy for expected earnings yield.”
• Retained earnings-to-market is a significant predictor of future earnings yield, and thus returns, while contributed capital has no predictive power.
• The value premium (the return on the high minus low portfolio) is greater using retained earnings-to-market than using book-to-market (43 versus 35 basis points per month) and has stronger statistical significance. Using only contributed capital, the value premium falls to 7 basis points per month and is no longer statistically significant (t-stat = 0.54).
• Retained earnings predicts the cross section of stock returns out to seven years, while book-to-market predicts returns only as far out as three years.

Conclusions

Relative to the value premium, this last finding provides an argument against the mispricing (behavioral-based) theory, and for the risk-based theory. As the authors point out: “Why would the correction of mispricing occur gradually over a horizon that extends at least as far as seven years, especially bearing in mind that all this accounting information is made publicly accessible at essentially zero cost for all firms and all years?”

Finally, the fact that book-to-market’s explanatory power comes from the earnings component highlights the potential importance of including price-to-earnings and cash flow metrics instead of just BtM (as some investment firms do, such as Bridgeway Capital Management and AQR).

Another alternative is to include the new profitability factor in construction of value portfolios (as Dimensional Fund Advisors does), as retained earnings contain information about future expected earnings/profitability. It will be interesting to see if these findings will be incorporated into portfolio construction rules of funds that seek to capture the value premium.

This commentary originally appeared March 29 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post A More Complex View On Value appeared first on JMF Capstone Wealth Management.

Role reversal: If you have aging parents, they may need help sorting out their finances. Stuart Vick Smith lays out some steps you can take to help them feel in control of their financial life.

Find it on KVUE.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post How to Help Aging Parents With Their Finances appeared first on JMF Capstone Wealth Management.

The term “private equity” is used to describe various types (e.g., buyout funds and venture capital funds) of privately placed (nonpublicly traded) investments. Even though buyout (BO) funds and venture capital (VC) funds have similar organizational and compensation structures, they are distinguished by the types of investments they make and the way those investments are financed.

BO funds generally acquire 100% of the target firm (which can be public or private) and use leverage. VC funds take minority positions in private businesses and do not use debt financing. Today BO funds account for about three-fourths of private equity deals.

Private equity (PE) excites many investors, offering the opportunity for spectacular returns (although, as with most investments, we generally hear only the stories with happy endings). Even the term conveys an exclusive nature, especially for investors who yearn to be “players.”

Capital committed to PE funds worldwide has risen substantially in the past two decades, thanks largely to U.S. pension funds searching for alternatives to public equity markets that might help them meet their return objectives. Endowments seeking to replicate the successes of the Yale Endowment have also contributed to the growth of PE funds. And it is reasonable to assume that high-risk, illiquid investments are priced by investors to deliver higher expected returns than publicly traded securities to compensate for the greater risk.

The Historical Evidence

Steven Kaplan and Berk Sensoy contributed to the literature on the performance of PE funds through an extensive survey of current research on the performance of private equity. Following is a summary of the findings from their October 2014 paper, “Private Equity Performance: A Survey”:

• BO funds have outperformed the S&P 500 net of fees by about 20%, on average, over the life of the fund.
• VC funds raised in the 1990s outperformed the S&P 500, while those raised in the 2000s have not.
• Before the 2000s, buyout and VC fund performance showed strong evidence of persistence.
• Since 2000, there is little evidence of BO fund persistence (with the exception of persistence among those in the bottom quartile, the worst performers), while VC fund persistence has remained strong.

Unfortunately, the returns data presented by Kaplan and Sensoy isn’t risk-adjusted. Private equity is really much riskier than an investment in a publicly traded S&P 500 Index fund, making it a wholly inappropriate benchmark. For example …

• Companies in the S&P 500 are typically among the largest and strongest companies, while VC typically invests in smaller and early-stage companies with far less financial strength. Studies have estimated betas for BO funds at about 1.3 and for VC funds at 1.6 to 2.5. Adjusting for the higher betas alone would have erased any evidence of outperformance. Similarly risky but also publicly available small value stocks have also outperformed the S&P 500 by a wide margin—from 1927 through 2016, the S&P 500 returned 10.0%, while the Fama-French Small Value Index (ex utilities) returned 13.6%.
• Investors in private equity forgo the benefits of daily liquidity. It’s well-documented in the literature that investors will demand a premium for investing in illiquid assets, especially those that perform poorly in bad times (like PE). There’s no adjustment in the returns data for the risk of illiquidity. In addition to the lack of liquidity relative to investments in mutual funds, private equity investors also forgo the benefits of transparency and broad diversification (and for individuals, the ability to harvest losses for tax purposes).
• The median return of PE is much lower than the mean (the arithmetic average) return. PE’s relatively high average return reflects the small possibility of a truly outstanding return, combined with the much larger probability of a more modest or negative return. In effect, PE investments are like options (or lottery tickets). They tend to provide a small chance of a huge payout but a much larger chance of a below-average return. And it’s difficult, especially for individual investors, to diversify this risk.
• The standard deviation of private equity exceeds 100%, in comparison to standard deviations of about 20% for the S&P 500 and about 35% for small value stocks.

In their survey, Kaplan and Sensoy observed that the authors of the 2013 study, “Limited Partner Performance and the Maturing of the Private Equity Industry,” found that, in the more recent sample of PE funds raised between 1999 and 2006, there was no evidence that endowments outperform other limited partner types or display any superior skill at selecting general partners.

According to Kaplan and Sensoy, this study (which Sensoy also co-authored) concluded that “the disappearing endowment advantage is consistent with other secular trends in the industry, particularly the decline in VC performance since the late 1990s and the decline in performance persistence in BO firms.”

Latest Evidence

Reiner Braun, Tim Jenkinson and Ingo Stoff contribute to the literature on private equity performance and its persistence with their study, “How Persistent is Private Equity Performance? Evidence from Deal-Level Data,” which was published in the February 2017 issue of the Journal of Financial Economics.

Their findings were consistent with those of Kaplan and Sensoy. Their study covered timed cash-flow data at the deal level for 13,523 investments made by 865 buyout funds (not VC funds) run by 269 general partners (GPs). The investments were split roughly equally between the U.S. and Europe, with a few in other regions, and span the period 1974 to 2012. This is important, as most other studies examined only U.S. data.

The authors noted: “As well as being extensive and detailed, for the vast majority of the GPs in our sample we have their complete investment history. This is clearly critical when analysing performance persistence, and lack of completeness is a problem that has plagued earlier analyses. We source the data from three fund-of-fund managers who required all GPs who sought capital to provide this detailed deal-level information in a standardized format. Importantly, the sample includes all the GPs upon which the fund-of-fund managers performed due diligence, whether or not they actually chose to invest.” They also partitioned the data sample into an early period up to the end of 2000 and a later period from 2001 onward.

Following is a summary of their findings …

• While there was evidence of performance persistence in the early period, it was weaker than performance persistence found in previous studies and has largely disappeared in recent years. The authors stated: “This is consistent with the PE sector maturing, with financial engineering and valuation techniques becoming commoditized, professionals moving between or forming new GPs, and the ways to create operational improvements to portfolio companies becoming assimilated across firms.”
• Competition has clearly increased in recent years, but not evenly over time or by region. When a large amount of capital chases deals, persistence tends to be lower.
• There is significant evidence of top-quartile performance persistence but only in low competition states. On the other hand, GPs who make bad deals tend to repeat, irrespective of the state of competition.

Braun, Jenkinson and Stoff concluded: “Overall, the evidence we present suggests that performance persistence has largely disappeared as the PE market has matured and become more competitive.”

They add: “Those Limited Partners (LPs) who were early investors in PE—such as endowments—established relationships with successful GPs which were valuable when the market was developing. However, those relationships, and access to funds—at least on the buyout side—are now much less valuable and are no longer a source of LP out-performance.”

For investors, the research has an important implication: If past performance provides little guidance on the choice of GPs, how can one identify the future top performers

Swensen On Private Equity

If you’re considering investing in PE or sit on the board of a committee that is doing so, be sure to consider these sage words of advice from David Swensen, chief investment officer of the Yale Endowment: “Understanding the difficulty of identifying superior hedge fund, venture capital, and leverage buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results.”

In his book, “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen offered the following observation on BO funds: “Investors in buyout partnerships received miserable risk-adjusted returns over the past two decades. Since the only material differences between privately owned buyouts and publicly traded companies lie in the nature of the ownership (private vs. public) and character of capital structure (highly leveraged vs. less highly leveraged), comparing buyout returns to public market returns makes sense as a starting point. But because the riskier, more leveraged buyout positions ought to generate higher returns, sensible investors recoil at the buyout industry’s deficit relative to public market alternatives. On a risk-adjusted basis, market equities win in a landslide.”

Swensen also cited a Yale Investments Office study that provides some insight into the additional return required to compensate for the risk in leveraged buyout transactions. He writes: “Examination of 542 buyout deals initiated and concluded between 1987 and 1998 showed gross returns of 48% per annum, significantly above the 17% return that would have resulted from comparably timed and comparably sized investments in the S&P 500. On the surface, buyouts beat stocks by a wide margin. Adjustment for management fees and general partners’ profit participation bring the estimated buyout result to 36% per year, still comfortably ahead of the marketable security alternative…. Because buyout transactions by their very nature involve higher-than-market levels of leverage, the basic buyout-fund-to marketable-security comparison fails the apples-to-apples standard. To produce a risk-neutral comparison, consider the impact of applying leverage to public market investments. Comparably timed, comparably sized, and comparably leveraged investments in the S&P 500 produced an astonishing 86% annual return. The risk-adjusted marketable security result exceeded the buyout result of 36% per year by an astounding 50%age points per year.”

Summary

The bottom line is that if you’re willing, able and have the need to take more risk in search of higher returns, the most likely to place to find that is not in PE, but rather in publicly available small value stocks. And you can access these higher expected returns through low-cost, passively managed and tax-efficient funds. You can globally diversify their risks as well. In addition, you’ll have all the benefits of daily liquidity and transparency.

This commentary originally appeared March 27 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post Private Equity Adds Risk, Little Return appeared first on JMF Capstone Wealth Management.

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness, it was the epoch of belief, it was the epoch of incredulity, it was the season of Light, it was the season of Darkness, it was the spring of hope, it was the winter of despair, we had everything before us, we had nothing before us.”

These words, from the opening of Charles Dickens’ “A Tale of Two Cities,” are among the most famous in all of English literature. Today they could easily apply to how investors view the outlook for the U.S. economy and our stock market.

Politics Affect Investors’ Market Perceptions

Whether you view the outlook for our economy and stock market as entering the best of times or the worst of times is highly dependent on your political perspective. Research on investor behavior has found that individuals become more optimistic and perceive the markets to be less risky and more undervalued when the party they favor is in power.

This leads them to take on more risk. They also trade less frequently, which is a good thing, because the evidence demonstrates that the more individuals trade, the worse they tend to do. But when the opposite party is in power, investors’ perceived uncertainty levels increase, and they exhibit stronger behavioral biases, leading to poor investment decisions.

You can observe just how strong the impact of these biases can be in the Spectrem Group’s December 2016 Affluent Investor and Millionaire Investor Confidence survey. Prior to the presidential election in November, survey respondents who identified as Democrats showed higher confidence than those who identified as Republicans or Independents. This completely flipped following the election, when Democrats registered a confidence reading of -10 while Republicans and Independents showed confidence readings of +9 and +15, respectively.

The February 2017 University of Michigan survey of consumer confidence provides further evidence. It showed Republican confidence sentiment at 120. This figure hadn’t topped 112 since 1952. For Democrats, the confidence reading was just 55.5, a level not seen since the last recession, when the economy was shedding 2 million jobs a month. Echoing Dickens’ now famous words, Republicans apparently think it’s the best economy in the postwar era, while Democrats seem to think it’s the worst since the financial crisis.

Here’s one more example. Before the 2000 election results were announced, Democrats were slightly more optimistic than Republicans. However, after the announcement of George W. Bush’s win, that changed dramatically. Roughly 62% of Democrats were optimistic about the stock market before the election, but that figure fell to just 36% in early 2001. The optimism about the overall economy was similarly affected.

The Problem Of Political Bias

Political biases create problems for investors, causing them to stray from even well-thought-out financial plans. Imagine the nervous investor who sold equities based on his views of a Trump presidency. While those who stayed disciplined have benefited from the rally, those who panicked and sold not only missed the bull market, they now face the incredibly difficult task of figuring out when it will once again be safe to invest.

It may also be worth noting that Warren Buffett’s Berkshire Hathaway has been persistently buying since the election, despite his having supported Hillary Clinton. Buffett doesn’t let his biases impact his investment decisions, which should be a clue as to whether you should allow your biases to do so.

I know of many investors with Republican/conservative leanings who were underinvested after President Obama was elected. Now it is investors with Democrat/liberal leanings who must face their fears.

It’s important to understand that, if you sell, unfortunately, there’s never a green flag that will tell you when it is safe to get back in. Never. Thus, the strategy most likely to allow you to achieve your goals is to have a plan that anticipates that there will be problems, and to not take more risk than you have the ability, willingness and need to take. Lastly, don’t pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.

Summary

There’s strong evidence that the political climate impacts investors’ views of the economy and the stock market, and that it affects their investment behavior. Specifically, individual investors’ returns improve when the political regime favors their political party, and vice versa.

This result is due to two factors. When their party is in favor, investors tend to increase their exposure to systematic risk and, thus, earn higher returns. They also tend to use more passive strategies, reducing costs.

Unfortunately, investors often make mistakes with their money because they aren’t aware of how decisions can be influenced by their beliefs and biases. The first step to eliminating—or at least minimizing—mistakes is to become cognizant of how our financial decisions are affected by our views, and then how those views can influence outcomes. Being aware of your biases and acting accordingly can help you make better investment decisions.

The bottom line is that, just as you shouldn’t let the latest economic news cause you to abandon a well-developed financial plan and shift your asset allocation, you shouldn’t let the political climate do so either. As the “Oracle of Omaha” Warren Buffett stated in Berkshire Hathaway’s 1996 annual report, “Inactivity strikes us as intelligent behavior.”

This commentary originally appeared March 13 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

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The typical hedge fund fee structure includes a management fee, calculated as a fixed percentage of a fund’s net asset value, plus an incentive fee, calculated as a percentage of its trading profits.

Some hedge funds use both hurdle rates and a high-water-mark (HWM) provision—the historical peak of the fund’s net asset value—in the calculation of incentive fees. These features are sold as a way to protect investors because the incentive fee is paid only on the portion of the gains that exceed either the hurdle rate and/or HWM.

Although hedge funds in managed futures, called commodity trading advisors (CTAs), typically don’t employ hurdle rates, they do generally still comply with the HWM provision that requires the fund manager to make up past deficits prior to earning the incentive fee.

The HWM feature is highly asymmetric and can be expressed as a long call-option position with a strike at the HWM. Therefore, hedge fund managers face a moral hazard issue because they have an incentive to increase risk when their previous performance has been disappointing.

For example, Stephen Brown, William Goetzmann and James Park, authors of the 2001 study “Careers and Survival: Competition and Risk in the Hedge Fund and CTA Industry,” found that poorly performing funds tended to increase risks due to the incentive fee and HWM provisions. This can create an unequal field in terms of incentives (agency risk), leading to the propensity to double-down on bets and take extreme risks when the incentive compensation is “out-of-the-money.”

Therefore, characteristics that appear “investor friendly” on the surface can, in fact, lead to increased risk. In addition, the HWM provision increases the likelihood of a fund terminating its existence and creating a new fund when it is “out-of-the-money” in terms of incentive compensation.

A Moral Hazard Problem

Li Cai, Chris (Cheng) Jiang and Marat Molyboga contribute to the literature on the agency risks of hedge funds with their study, “The Moral Hazard Problem in Hedge Funds: A Study of Commodity Trading Advisors,” which was published in the Winter 2017 issue of The Journal of Portfolio Management. By focusing on CTAs, the authors were able to classify the funds as discretionary or systematic (where trading is based on algorithms, not opinions), an important distinction. Their study covered the period 1994 through 2014.

They hypothesized that a manager “who systematically follows a trading methodology is more immune to the moral hazard problem than a discretionary manager who lacks the formulaic discipline of systematic trading.”

Cai, Jiang and Molyboga found that discretionary fund managers exhibit a significantly higher degree of risk-shifting than systematic fund managers. They also found that “tournament behavior is at work as evidenced by the relatively large increase in risk taking among the poorer performing funds.”

In other words, “discretionary managers who are underwater at midyear tend to increase their risk taking in the second half of the year.” Importantly, they found that “in most years, the impact on investors’ risk-adjusted performance has been negative, with investors getting exposed to greater risk without a corresponding increase in returns.” The impact of risk-shifting behavior was a 4.5% relative reduction in the Sharpe ratio.

A finding of interest was that a “subperiod analysis revealed that the difference in behavior is particularly strong during favorable market environments. By contrast, during unfavorable market environments, the difference in behavior is not significant because both types of fund managers avoid risk.”

Cai, Jiang and Molyboga explained that this is consistent with prior research that has found in negative market environments managers tend to be more concerned with career risk and thus engage in less risk-shifting. When fund mortality is high, survivorship is difficult and thus managerial career concern dominates. In contrast, when mortality is low and survivorship is easy, career concern is minimal.

The authors concluded that “fund managers care more about incentive fee income in good market environments but care more about survival in bad market environments. Thus, fund investors should be most worried about the moral hazard problem when the market environment is positive for fund managers.”

These findings have important implications for investors. Not only do features of the hurdle rate and HWM provisions—which supposedly are designed to protect investors—create an increased moral hazard environment, they have negative impacts on risk-adjusted returns, at least for discretionary fund managers. If you happen to be considering a hedge fund, or, specifically, a CTA, at the very least, you should be aware of the moral hazards—hazards that can be avoided, or at least minimized, when choosing a fund that invests systematically.

Discretionary Versus Systematic Funds

This strike against discretionary fund managers relative to systematic fund managers, in terms of the moral hazard risk, isn’t their only disadvantage. The other is that very strong evidence shows that the systematic approach to investing has delivered superior returns. Campbell Harvey, Sandy Rattray, Andrew Sinclair and Otto Van Hemert address this subject in the December 2016 paper “Man vs. Machine: Comparing Discretionary and Systematic Hedge Fund Performance.”

They analyzed and contrasted the performance of systematic hedge funds, which use rules‐based strategies involving little or no daily intervention by humans, with the performance of discretionary hedge funds, which rely on human skills to interpret new information and make the day‐to‐day investment decisions. The study covered the period 1996 through 2014 and included data on more than 9,000 macro and equity hedge funds. To adjust returns for exposure to common factors, they used stock factors (beta, size, value and momentum) and bond factors (term and credit), as well as FX carry and volatility.

Investors have a clear preference for discretionary funds, given that they make up about 70% of the hedge fund universe and control approximately 75% of the assets under management. However, the authors found no evidence to support such a preference. For equity hedge funds, they found both that, after adjusting for exposure to well‐known risk factors, risk‐adjusted performances were similar and that for discretionary funds (in aggregate), more of the average return and volatility of returns can be explained by risk factors.

In addition, when looking at what they called the “appraisal ratio” (the ratio of the average risk‐adjusted return to its volatility), the authors found that systematic funds outperformed 0.35 to 0.25. For macro funds, they found systematic funds outperformed discretionary funds both on an unadjusted and on a risk‐adjusted basis. The appraisal ratios were 0.44 for systematic funds and just 0.31 for discretionary funds. They concluded “the lack of confidence in systematic funds is not justified.”

The Advantages Of Objectivity

In their excellent book, “Quantitative Value,” Wes Gray and Tobias Carlisle provide further support for the power found in systematic, quantitative investing. They write that the objectiveness of the approach acts as a shield, protecting us against our own biases, while also acting as a sword, allowing us to exploit the cognitive biases of others.

To make this point, they presented the following example from Joel Greenblatt. Greenblatt’s firm, Gotham Capital, had compounded at a phenomenal rate of 40% annually, before fees, for the 10 years from Gotham’s formation in 1985 to its return of outside capital to investors in 1995.

In his own book, “The Little Book That Beats the Market,” Greenblatt describes an experiment he conducted in 2002. Greenblatt wanted to know if Warren Buffett’s investment strategy could be quantified. He studied Buffett’s annual shareholder letters and developed his “magic formula,” which he published. Gray and Carlisle show that study after study has found “the model is the ceiling of performance from which the expert detracts, rather than the floor to which the expert adds. Even Greenblatt has said the he cannot outperform the Magic Formula.”

We can perform another test in the ongoing battle of “machine (systematic) versus man (discretionary)” by examining the relative performances of two leading providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

The following table shows the Morningstar percentile rankings, adjusted for survivorship bias, for the 15-year period ending in 2016:

As you can see, Vanguard’s systematic approach outperformed 79% of actively managed funds and DFA’s systematic approach outperformed 90%. Given that the largest cost of active management in taxable accounts typically is taxes, these figures likely understate the advantage of systematic approaches for taxable investors.

The aforementioned evidence should lead you to conclude that, when you invest, it should be with a fund that uses a systematic approach to gaining exposure to markets, asset classes or factors.

This commentary originally appeared March 8 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post Moral Hazard In Hedge Fund Fees appeared first on JMF Capstone Wealth Management.

The best financial relationships occur when your wealth advisor is interested not just in investing your money, but in investing in your life. Manisha Thakor on helping clients achieve financial clarity, calm and confidence through the process of true wealth management.

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post Financial Calm and Confidence appeared first on JMF Capstone Wealth Management.

It’s old news that we’re busy and that we wear our busyness as a badge of honor. But a new study found that Americans, in particular, are actually buying it. Specifically, the study concluded that Americans who always say they’re “busy” are actually seen as more important. Unfortunately, it’s all a charade.

Numerous studies have shown that busyness isn’t actually good business, and here’s the big reason why: It makes us less productive. We’re all susceptible to it, but If I’m saying to myself (and I have), “Woo, I’m busy; really busy,” I’m likely being distracted from the most important, most productive work that I could be doing. I may feel like I’m doing more, but the net result is actually less. And it often feels like it.

But not everyone wears busyness as a status symbol. In response to the research and their own well-informed gut feelings, many are finding enjoyment in more productive work at a less busy pace. I wanted to know how these people recognize when they’re devolving into busyness and what they do to stop the downward spiral, so I asked 12 thought leaders who’ve inspired me two simple questions:

• How do you know when you’ve gotten too busy?
• What is a technique that you use to “unbusy” yourself?

Here’s what they had to say:

Chris Guillebeau, Art of Non-Conformity blogger, Side Hustle School podcaster and author of Born For This, knows he’s too busy when:

I don’t mind working hard and taking on lots of projects–in fact, I wouldn’t have it any other way—but when I have no time to think, then I feel too busy.

He unbusys himself by:

It can be hard to dig myself out of a busyness tunnel. However, one tactic I use is to look through my upcoming calendar and cancel anything that doesn’t seem essential. It’s likely I’ll still have a number of commitments to see through, but even a little relief can help to restore order.

Laura Vanderkam, time management guru and bestselling author of I Know How She Does It, knows she’s too busy when:

You find yourself dreading lots of tasks on your calendar or you don’t have the energy for things you normally like to do. And if you have a lot of activities in your life that you feel like you’d pay good money to offload—that’s probably a sign too!

She unbusys herself by:

Sometimes our calendars need a radical makeover. People had been talking about decluttering for years, but Marie Kondo changed the conversation by flipping it from getting rid of stuff you don’t like to only keeping stuff that “sparks joy.” This is an interesting thought for a schedule. What would it be like to only have activities in your life that “sparked joy?” It’s probably unworkable in practice, but it’s a goal to keep in mind as you evaluate your schedule.

Jon Acuff, career expert and author of the book Do Over, knows he’s too busy when:

My eyelid starts to twitch from the raw amounts of caffeine I’m using and coffee no longer touches the tiredness. My inbox is also a canary in the coal mine. When it’s out of control, I usually am too.

He unbusys himself by:

I exercise. It’s hard to multitask when you’re running or swimming. I also turn my phone off. It’s a distraction buffet.  

Ryan Carson, CEO and Co-Founder of Treehouse and Naive Optimist blogger, knows he’s too busy when:

My day has started and I haven’t taken time to write down my 5-6 high-priority to-dos.

He unbusys himself by:

Put down my phone, close my laptop and pull out my daily written to-do list and re-center myself.

Jean Chatzky, Financial Editor of NBC’s TODAY Show and co-author of the new book AgeProof, knows she’s too busy when:

My perceived level of stress is on the rise. You can feel it physically (headaches, stomachaches, backaches) but your sleep often suffers as a result and you’re unable to focus as well as normal.   As we write in AgeProof, you can’t deep breathe away this type of stress, you have to attack it at its source.

She unbusys herself by:

I slow myself down. That doesn’t exactly move things off my plate, but it does make sure that I do them correctly the first time which means I don’t have to re-do them.

Ryder Carroll, digital product designer and inventor of the Bullet Journal, knows he’s too busy when:

You stop appreciating what you’ve achieved. If you can’t take a moment to enjoy the fruit of your labor, then what’s the point?!

He unbusys himself by:

Marking the occasion. Be it a dinner with friends, or a better cup of coffee, celebrate your accomplishments. It’s not only about patting yourself on the back, it’s about having a moment of closure to catch your breath and regroup. It’s a critical pause that allows you to take a step back to get perspective and reconnect with your purpose. If your heart is in it, then your mind will follow. Working intelligently is not about being busy, it’s about being productive.

Carl Richards, New York Times Sketch Guy, podcaster and author of The One-Page Financial Plan, knows he’s too busy when:

It’s a feeling, and the key (for me) is learning to notice it instead of drifting through life letting IT dictate how you live and interact with the people around you.

Some clues for me are feeling rushed, holding my breathe a little bit while completing tasks, impatience with people I love, faultfinding with others’ work, and a sense of self-centeredness or self-importance.

He unbusys himself by:

First test: Go hang out with a two- or three-year-old. If you find yourself rushed, you fail.

Second test: Are you responding to “How are you?” using either “So busy!” or “Busy man…but it’s better than the alternative”? Another fail.

Solutions: First, acknowledge you failed the test—you’re either too busy, or acting too busy. Second, start paying attention, and finally, follow your breath.

Jonathan Fields, inspirational blogger, speaker and author of How to Live a Good Life, knows he’s too busy when:

Busyness, alone, isn’t the problem. The loss of intentionality—being “reactively busy”—is. Manically crossing off to-dos without regard to who put them on your list and whether they matter to you is when things fall apart. What’s the big tell? If you find yourself at the end of a breathlessly packed day, having accomplished very little that truly mattered to you, it’s time for an intervention.

He unbusys himself by:

It starts with awareness. You can’t choose differently until you become aware of what you’re doing in the moment. Set “awareness triggers” on your mobile device to vibrate in a distinct pattern and let you know it is time to pause for a moment, consider what you’re working on and whether you’re investing your energy in something with intention and purpose, or simply defaulting to the compounding agendas of others.

Michael Kitces, educator to the most educated financial planners and the prolific publisher of the Nerd’s Eye View blog, is often asked how he does it all. He knows he’s too busy when:

You find you don’t have the time to spend with friends. Or with your spouse and children. Or when you don’t have time to take a vacation. Or when you just feel exhausted from running too hard for too long.

He unbusys himself by:

Saying “no” more often. Greg McKeown’s Essentialism makes this point incredibly well. As I wrote on the blog, most of us get stuck thinking that we have to accept every opportunity that comes our way, and over-busy ourselves. It’s entirely a mental challenge we inflict upon ourselves. Which I say as someone who’s heavily self-inflicted this many times over the years.

Manisha Thakor, my colleague and Director of Wealth Strategies for Women at The BAM Alliance, author and podcaster, knows she’s too busy when:

An additional piece of interesting work lands on my plate and instead of being excited for the opportunity I feel my whole body tensing up.

She unbusys herself by:

I either do a 20-minute, high-intensity cardio workout (alternating 60 seconds of all-out effort with 60 seconds of recovery) when I can or I will take 20 very looong, slow deep breaths. Both have the physiological effect of “rebooting” me.

Michael Hyatt, one of the country’s most sought after top leadership gurus and the co-author of Living Forward, knows he’s too busy when:

You look at your calendar and feel dread.

He unbusys himself by:

First, triage your calendar. Then, learn to say No with grace. If you can’t start saying No, you will end up right where you are now.

Michael Evans, long-time commodities trader and most recently the founder of wealth management firm Cogent Advisor, knows he’s too busy when:

No matter what entrepreneurs like me are doing, we can easily be distracted by something else, leading us to not be fully present no matter where we are or who they’re with. When an opportunity does come along, when something big and exciting could be launched or decided, we’re not conscious enough of the opportunity to take advantage.

He unbusys himself by:

Avoiding the “too-busy” trap. I take scheduled free days where I do no work-related thinking or activities for 24 hours to completely detach myself from my business. No emails, no reading and no talking to others about work. While counterintuitive, it’s so rejuvenating to return energized, creative and present.

The most convincing proof that these thought leaders are doing what they wrote? All of these apparently busy people had time to answer my two questions within several hours of my asking them.

How might your life and work look different if you followed the footsteps of these wise men and women who’ve found joy in rejecting busyness as a badge of honor?

This commentary originally appeared March 11 on Forbes.com

image courtesy of Flickr.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post Why Busyness Isn’t Good Business appeared first on JMF Capstone Wealth Management.

The Trump administration’s move to delay implementation of the Department of Labor’s fiduciary rule has inspired me to delay implementation of my commitment to remain silent on matters of public policy and politics. It’s that important.

It seems pretty obvious that those in the financial establishment who oppose the rule do so primarily out of self-interest. After all, it’s estimated that they will lose billions in profits if the final rule goes into effect. I get it.

But I was fascinated recently when a member of the media wondered aloud if my advocacy for a wider fiduciary standard was also simply an outgrowth of my own bias.

Indeed, who’s to say I’m not just grinding my own axe on this issue? Maybe I’m in favor of all financial advisors being held to a fiduciary standard because I’m a fiduciary financial advisor and part of a national community of financial advisors that supports the fiduciary standard.

That would be a convenient rebuttal from the anti-fiduciary community, but here’s the (huge) problem with that rationale:

While those in the financial services industry opposed to the rule understandably don’t want it because it cuts into their profits, the fiduciary community as it currently stands actually loses a clear competitive advantage if everyone has to be a fiduciary. Why? Apparently informed consumers actually like the idea that their advisor has to do what’s best for them. Imagine that!

Here’s how financial industry maverick Jack Bogle put it in his recent New York Times Op-Ed:

It simply doesn’t seem like a good business practice for Wall Street to tell its client-investors, ‘We put your interests second, after our firm’s, but it’s close.’

It’s bad business to be publicly against your clients’ best interest—and it’s good business if your competition takes such a stance.

Perhaps, then, fiduciary advisors are for the fiduciary rule simply because they’re, uh, fiduciaries.

This commentary originally appeared February 24 on Forbes.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

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.

© 2017, The BAM ALLIANCE

The post The Ironic Conflict Of Interest of the Fiduciary Financial Advisor appeared first on JMF Capstone Wealth Management.