What is Survivorship Bias?

Posted On August 15, 2024 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Survivorship bias is the problem that the track record of today’s stocks reflects only the ones that survived. The stocks and funds which failed are no longer part of the performance history of today’s stocks or mutual fund databases. And as we will see, over the years, there have been a lot of stocks that have had bad returns and disappeared. We will also discuss how to invest wisely given the reality of survivorship bias.

Growing up in Rochester NY, my neighbor on the left worked for Eastman Kodak. Our neighbor on the right worked for Kodak. And all three neighbors across the street worked for Kodak. Kodak Park was the largest industrial site in the world, stretching for miles along Ridge Road. Rochester was a company town and there was tremendous pride in Kodak. The stock had done well for employees and residents, the company contributed a lot to the community, and the pension plan provided security to tens of thousands of retirees.

Kodak, the stock, was part of the S&P 500 Index and was one of 30 components of the Dow Jones Industrial Average from 1930 until April 2004. The company actually invented the digital camera in 1975, but thought it would be too impractical to ever have value. The rest, as they say, is history. The company had a long decline into obsolescence and filed for bankruptcy in 2012. The once mighty stock went to zero.

Stock Market 1926 through 2023

A new research paper by Hendrik Bessembinder looks at US stocks from 1926 through 2023, a 98-year period. During this period, there were a total of 29,078 US-listed stocks. Today, there are around 5,000. He looked at the performance of these stocks and it is a remarkable picture of Survivorship Bias.

Only 31 stocks have been in existence for the entire 98 years. The average stock existed only for 11.6 years. Approximately 24,000 companies have disappeared: either bankrupt, merged, acquired, or taken private.
51 percent of the stocks had negative returns over their entire life, with a median compound cumulative return of -7.41%. Most stocks lost money!
Thankfully, the compounding effect of the winning stocks greatly offset the stocks which lost money. The mean performance is much better than the median performance of the 29,078 stocks.
If you randomly select 10 stocks from history, your chance of outperforming the S&P 500 is very small. That is because most of the wealth creation in the market comes from a small percentage of top-performing companies. The majority of stocks under-perform the index.

Idiosyncratic Risk

Eastman Kodak, Lehman Brothers, Enron, and General Motors all went bankrupt and their stocks went to zero. Even though the stock market has done well over the long-term, there are still many individual stocks that get destroyed. We call this Idiosyncratic Risk, or “company specific” risk. Unfortunately, even if you do your homework, investors risk being caught in the next Bear Stearns or Washington Mutual.

What can you do to address Survivorship Bias and reduce the Idiosyncratic Risk of individual stocks?

Diversify extensively with index funds. While single companies do go bankrupt, we have never seen all 500 companies of the S&P 500 index go bankrupt at once. An index fund can greatly spread out your risk. Recognize the difference between speculating on an individual company versus investing in the market as a whole.
Note that index funds are not static. Every year, the S&P 500 Index adds growing companies and drops other companies which are on their way down. Sure, there are still surprises where an S&P 500 company disappears suddenly (like Silicon Valley Bank last year), but you still have 499 other holdings.

Fund Shenanigans

It’s not just individual stocks that exhibit survivorship bias. Mutual Fund companies do the same thing, deliberately getting rid of their worst funds. A fund with a poor track record eventually gets so small that it is unprofitable, and the fund company shuts it down. Even more nefarious, companies create dozens of stock funds and then take the ones with a poor track record and roll them into their funds with better ratings. The crappy fund disappears and now it looks like all their funds are 4-star and 5-star funds!

You might think the solution is to avoid the mutual funds with a poor track record and go with a top ranked actively managed fund. Unfortunately, we know that performance is rarely consistent with actively managed mutual funds. Is that my opinion? No, this is what decades of data shows from the Standard and Poors Persistence Scorecard. For example, there were more than 2000 US stock mutual funds in December 2019. The top quartile (the top 25%) included 529 funds in 2019, but not a single one of those funds remained in the top quartile over the next four years, through December 2023. Past performance (you should know this by heart by now) is no guarantee of future results.

One of the consistent findings of the S&P Persistence Scorecard is that the worst performing funds are the most likely to merge or be shut down. And then you can’t find those one-star funds on Morningstar because they no longer exist. That’s survivorship bias. Our approach: use low-cost index funds from Vanguard, SPDRs, and others. Then we are not chasing performance, looking for the hot fund, sector, or country. And we have been saying for a long time: the vast majority of active managers under-perform their benchmark over time.

Keeping It Simple

The stocks which exist today are different from the ones from 98 years ago. Companies come and go. Survivorship Bias masks the poor track record of the many stocks and funds which have disappeared. When we only see the ones which survived and thrived, investing success looks easier and more inevitable than it really is. Unfortunately, there are stocks and funds out there today which will someday suffer the same fate as Eastman Kodak and thousands of other past stocks. Understanding this history will help you be a better investor in the decades ahead.

How can we reduce Idiosyncratic Risk or Survivorship Bias? Fortunately for investors, this complex question has a simple answer. We can diversify and reduce the importance of any one stock in our portfolio. With index funds, we get broad diversification, with hundreds or thousands of holdings, in a low-cost, tax-efficient vehicle. No doubt an index fund will own some stocks that fail, but one stock out of 500 may only move the index by 0.2% for one day. It often is hardly even noticed. And using index funds also helps keep us out of the worst actively managed funds, which sometimes were the best funds from five years ago. These are time tested strategies and the data keeps proving that this approach remains a wise choice for investors.

When to Sell a Fund

Posted On September 27, 2020 By Scott Stratton, CFP(R), CFA In Portfolio Management /

As part of monitoring your investments, you should have defined reasons when to sell a fund. It is important to distinguish between market timing and valid reasons for selling. Don’t sell an index fund and buy an actively managed fund just because the active fund has outperformed recently. That is performance chasing – and you need to guard against this.

There are a couple of scenarios when you might want to sell a fund, primarily if it is to fix your portfolio. There is probably not a bad time to do this, although investors often agonize over the timing of moves. We cannot predict the future. If you know your portfolio has problems, make those changes and move on.

Three Sales to Fix Your Portfolio

First, if you have narrow funds, such as a sector fund, I would suggest you sell those and get into a broader index fund. If you are up, and have a nice gain, go ahead and sell. Don’t wait until the fund or stock has tanked. If it has tanked, take your loss and learn a lesson. You may hope that it will come back, but hope is not a good investment rationale. While you are waiting for it to come back, perhaps you could be growing your portfolio in an index fund.

I’m not going to recommend that you try to own individual stocks in your portfolio. That is speculative and a distraction for most investors to growing your wealth. I know many millionaires who invest in funds, but not many who got there with individual stocks. The majority of people who are trading stocks have tiny accounts. According to the NY Times, the popular trading app, Robinhood has only an average account of $4,800. Focus on your accumulation and being a market participant, not a speculator. If you’ve had good luck with individual stocks, take your gains and get into index funds.

Second, if you are invested in a fund or product that has high expenses, switch to a low-cost index fund. For example, if you have an actively managed fund, an A-share mutual fund with 12b-1 fees, or a fund in a Variable Insurance product, your expense ratio might be 0.75%, 1.00% or more a year. An index fund might be one-tenth of that, 0.10% or less for many categories. When your goal is long-term growth through market participation, costs are a direct drag on your performance. That’s a good reason to sell.

Interestingly, the average active manager often (slightly) beats their benchmark before fees. It’s just that the drag of a 1% expense ratio, in a market that returns 5% or 10%, eats up all the benefits the managers can create. Over time, low expenses are correlated with better performance.

Third, you may want to sell some of your funds to establish your target asset allocation. Most of your performance is based on your overall asset allocation. I see many younger investors who start out 100% in stocks and as they grow their wealth, eventually realize that they need some bonds. Other investors have some bonds, but no target allocation to use for rebalancing. So, start with your recipe first and adjust your funds to fulfill your target allocation. Otherwise, you end up with a poorly diversified portfolio.

Staying Invested

If you are already invested in a low cost, diversified index fund, why sell it ever? I can think of two good reasons: rebalancing and tax loss harvesting. Outside of that, investors can do quite well by having little or no turnover and sticking with low cost Index funds for not just years, but decades.

What aren’t reasons for a long-term investor to sell? Coronavirus. Elections. Business cycles. News.

Sure, those things can impact stock prices in the short-term. But staying the course in an Index Fund seems to work better than any other strategy. So, yes to selling sector funds, single stocks, and high-expense funds to replace them with an Index Fund. Yes to the occasional sale for rebalancing or tax loss harvesting. Outside of those reasons, try to keep your diversified allocation and stick with your index funds. Now, if you are within five years of retirement and are concerned about risks to your retirement income, let’s talk about how to make sure you are on the right path.

I am posting this because right now volatility seems to be picking up into the election. And over the next two months, I worry that a lot of investors are going to feel spooked. You’re going to hear a lot of opinions about what is going to happen. And markets could, indeed, go down. That’s always a possibility. That’s the inescapable reality of being an investor. But, our approach is to stay the course in turbulent times and be patient. As unique as today’s challenges are, there were unique challenges before. Markets prevailed.

10 Rules for Playing Defense in Investing

Posted On May 31, 2019 By Scott Stratton, CFP(R), CFA In Portfolio Management /

Stocks take the stairs up and the elevator down. When they rise, it is slow and steady, but when they go down it feels like a free-fall. Given the recent market tumult, I wanted to share my top ten rules for defensive investing.
Defense doesn’t mean that you won’t have losses on days when the market goes down. It means that you avoid unnecessary risks that could really blow up your portfolio, so you can have the confidence to stay with the plan.

1. Diversification is the only free lunch in investing. You should be diversified by company, as well as by sector and country. If your employer issues you stock options or has an Employee Stock Purchase Plan, take every opportunity to sell and diversify elsewhere. Most disaster stories I hear are from people who failed to diversify.

2. Index Funds are the antidote to performance chasing. When you pick a concentrated fund, such as a sector fund or single country fund because of its recent track record, you risk buying at the top and experiencing a painful (and much larger than necessary) drop when the winds change direction. While it’s so easy to find actively managed funds that beat the index over the past year, there is a better than 80% chance that those funds will lag the index over the next five or more years. The Index fund is also likely a fraction of the cost and is also more tax-efficient than an actively managed fund.

3. Asset Allocation is the most important decision you make. Start with a carefully measured recipe so you don’t end up with a random collection of funds and stocks you’ve acquired over the years. If you’ve decided that a 60/40 portfolio is the right mix for your needs, that should be for all market environments, not just while stocks are going up.

4. You are going to be tempted to adjust your Asset Allocation. It is very tough to get this right, because humans are wired to make terrible investing decisions. We want to sell a down market and we want to buy when the market is at all-time highs. Obviously, in hindsight, we should buy when things are really ugly and sell at the peaks. Invest with your brain and not your gut-feeling.

5. Rebalance. When you have a target asset allocation, then the process of rebalancing back to your target levels creates a built-in process of selling assets which have shot up in value and buying assets which have temporarily gone out of favor. This works great with Funds, but don’t try this will individual stocks.

6. We buy stocks for growth and bonds for income and safety. When you try to switch those objectives, things seldom go as planned or hoped. Buying stocks for their yield and safety can easily lead to long-term under performance. Many times you will be better off in a plain vanilla index fund than a basket of super-high dividend stocks or supposedly safe stocks. Many high-yielding stocks are very low quality companies with no growth. When they do eventually cut their dividends, the shares plummet.

Similarly, you can find bonds that as quoted, should yield stock-like returns. Stay away. These could be future bankruptcies.

The Persistence Scorecard

Posted On January 3, 2019 By Scott Stratton, CFP(R), CFA In Portfolio Management /

As investors begin reviewing their year-end 2018 statements for their 401(k) and other accounts, I know many will want to change funds after a disappointing year. What do investors do? If they have 15 funds available in their plan, they will often sell out of their lagging fund and put money into whichever funds are performing best.

It seems rational enough to believe that a fund manager who is doing well might have above average skills, work harder, or have a better team than other fund managers. That’s why many investors switch funds – in the assumption that an excellent track record is evidence that strong performance will continue.

You should care about your funds and their managers. But the reality is that switching funds for better performance is not a slam dunk. In December, Standard and Poor’s released their semi-annual Persistence Scorecard. I hope you will read this report. It may change how you invest, how you select funds, and the reasons why you would switch from one fund to another.

In the Scorecard, S&P analyzes returns of over 2,000 US mutual funds, to determine whether high performing funds continue to have strong performance. They evaluate funds by quartile, with data through September 30, 2018. The top 25% of funds would be called first quartile and the worst 25% of funds would be the fourth quartile.

When you buy a fund in the top quartile, what is the likelihood that it will stay a top performer? Let’s go back to September 2016 and track the 550 domestic equity funds that were in the top 25% for the preceding one-year period. Only 21.09% of the top quartile funds stayed in the top quartile in the next year, ending September 2017. And only 7.09% of the 2016 top quartile funds managed to stay in the top quartile for both 2017 and 2018. Of the funds in the top 25% in 2016, only one in thirteen would stay in the top quarter for the next two years.

When you buy this year’s top funds, it is very unlikely that those funds will continue to be the best performers in the subsequent years. Even though we have all heard that “past performance is no guarantee of future results”, everyone still wants to buy the 5-Star fund, even though all that rating tells us is the fund’s most recent performance!

Perhaps you knew better than to put much weight on one year performance. Still, wouldn’t a good manager be able to create a nice long-term track record? The Scorecard also looks at three and five-year returns.

Let’s consider the five-year data:

We will go back to September 2013 and track the 497 funds which were in the top quartile for five-year performance. How did they do over they following five years, through September 2018?

Only 27.16% would stay in the top quartile for another five years. 21.73% would fall to the second quartile, 20.32% would fall to the third quartile, and 21.13% would end up in the bottom quartile. Additionally, 9.46% of the top funds in 2013 would not even exist five years later. Fund companies merge or liquidate their worst performing funds to make their track records disappear. That’s right, when you go on Morningstar and look up funds, what you see is the result of Survivorship Bias. The record has been cleansed of the worst offenders and you only see the survivors. Thankfully, S&P keeps all data and includes deleted funds in its study.

To me this is another reason to use index funds rather than active managers. There is little evidence that when you pick a top performing manager that he or she will persist as a top performer. In fact, there is about only a one-in-four chance a top fund will remain in the top quartile. That’s pretty much a roll of the dice. Switching from one active manager who is underperforming to another active manager who was recently outperforming is very unlikely to be a successful strategy.

Instead of focusing on manager selection and risk chasing performance, we take a more structured approach:

1. Start with the overall asset allocation. Your weighting of stocks and bonds (60/40, 70/30, 50/50, etc.) is the largest determinant of your portfolio risk and return in the long run.

2. Determine how much you want in each category, such as US Large Cap, US Small Cap, US Value, International, Emerging Markets, etc. We base this on correlation, risk and return profiles, and diversification benefits. Then, we adjust the weightings towards categories which we feel are presently undervalued relative to the others.

3. Choose funds which closely reflect those categories. If you are buying a mid-cap fund, it should act like a mid-cap fund.

4. Expenses matter. According to research from Morningstar: “the expense ratio is the most proven predictor of future fund returns.” We prefer funds with low expenses so you can keep more of the performance you are buying.

5. While we could use actively managed funds, we like the track record of index ETFs, along with their low cost, tax efficiency, and transparency. They are great building blocks for a portfolio.

Being diversified means owning a broad basket of holdings. This can be frustrating sometimes, wondering why you own A instead of B, when A is down this year and B is up. But putting all your money into whichever category or fund is doing best at any one point in time is not an effective strategy. That’s not just my opinion – look at the data from Standard and Poor’s Persistence Scorecard and I think you will reach the same conclusion. Bet on the market, not the manager.

Manager Risk: Avoidable and Unnecessary

Posted On May 12, 2018 By Scott Stratton, CFP(R), CFA In Portfolio Management / 1 Comment

You can choose between two funds, A or B. If Fund A has an 85% chance of beating Fund B over five years, would those be good enough odds for you to want to pick Fund B?

More and more investors are realizing that using active equity managers is a bad bet. This is Manager Risk, which is the risk that your portfolio fails to achieve your target returns because of the active managers you selected. When there is a significant probability that a manager lags an index fund and only a small chance that a manager beats that index, taking that risk is going to be a losing proposition for the majority of investors.

Here are three ways Manager Risk can bite you:

1. Performance chasing doesn’t work. Top funds often have a good story about their “disciplined process”, or “fundamental research” approach, but there are so many reasons why today’s leader is often tomorrow’s laggard:

Massive in-flows of cash into popular funds make it more difficult for managers to be nimble and to find enough good investment ideas to execute.
It’s possible that the fund’s specific approach (style, size, sector, country, etc.) was in-favor recently and then goes out of favor.
With thousands of funds, some are going to be randomly lucky and have a period of strong performance that is not repeatable or attributable to skill.

2. The data is clear: over a long-period, the vast majority of funds do not keep up with their index. According to the Standard and Poors Index Versus Active (SPIVA) report: 84.23% of large cap funds failed to keep pace with the S&P 500 Index over the five-years through December 29, 2017.

If 17 out of 20 large cap funds do worse than the S&P 500, why do people bother trying to pick a winning fund, instead of just investing in an Index Fund? I think some of it is that over shorter periods, it can be pretty easy to fund funds that are out-performing and people mistakenly think that recent leaders are going to continue their winning streak.

Consider, amazingly, that nearly 85% of Small Cap Growth funds did better than their benchmark in 2017 according to SPIVA. What a great environment for active managers, right? They must have a lot of skill! But let’s look back further: over the past 15 years, 98.73% of those Small Cap Growth funds lagged their index. That is the worst performance of any investment category in the SPIVA report.

If your odds of outperforming the index over 15 years is only 1 in 100, you’d be crazy to bet on an active manager. It’s a risk that isn’t worth taking.

3. In some categories, there are 10-20% of managers who do outperform the benchmark over five or more years, which means that there might be dozens of funds which have done a nice job for their shareholders. Why not just pick one of those funds?

Standard and Poors also produces The Persistence Scorecard, which evaluates how funds perform in subsequent periods. Let’s look at two five year periods, in other words, the past 10 years. Imagine that five years ago, you looked at the top quartile (the top 25%) of all US Equity funds. How did those top funds do over the next five years (through December 2017)?

25.34% remained in the top quartile
21.56% fell to the 2nd quartile
18.87% fell to the 3rd quartile
23.45% sank to the bottom quartile (the worst 25% of all funds)
10.24% were liquidated or merged, which is the way fund companies make their lousy funds’ track records disappear.

So, if you picked a top quartile fund, you had about only a one-in-four chance (25.34%) that your fund stayed in the top quartile (which is no guarantee that you outperformed the index, by the way). But, you had a one-in-three chance (33.69%) that your fund fell to the bottom quartile or was liquidated and didn’t even exist five years later. Again, those are not odds that are in your favor.

This is why fund companies are required to state, Past performance is no guarantee of future results. We can look backwards at fund history, but that information has no predictive value for how the fund will perform going forward.

It’s an unnecessary risk for investors to use actively managed funds. And that’s why I have moved away from trying to pick 5-star actively managed funds, and have embraced using Index funds.

From time to time, you may hear, “this is a stock picker’s market”, because of volatility, or concentrated returns, or whatever. Don’t believe it. Even when active managers are able to have a good month, quarter, or year, the vast majority remain unable to string together enough good years in a row to beat their benchmark.

There’s enough risk in investing as it is. Let’s reject Manager Risk and instead recognize that an Index Fund is the most likely way to beat 80, 90% or more active funds over the long-term.

Stop Trying to Pick the Best Fund

Posted On July 30, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance /

So much attention is paid to picking “the right fund” or “the best fund” by investors, but in my experience, this question has little bearing on whether or not an investor is successful in achieving their goals. In fact, I don’t even think fund selection is in the top 5 factors for financial success. There are so many more important things to consider first!

1) How much you save. If you contribute $500 a month to your company 401(k) and your colleague contributes $1,000 a month, I would bet that they will have twice as much money as you after 10 years, regardless of your fund selection process. Hot funds turn cold, so most investors just average out over time. Figuring out how to save and invest more each month will get you to the goal line faster than spending your hours trying to find a better fund.

2) Sticking with the plan. Your behavior can have a greater impact than your fund selection. Many investors sold in 2009, incurring heavy losses and then missing out on the rebound in the second half of the year. Trying to time the market is so difficult that investors are better served by staying the course rather than trying to get in and out of the market.

I know that people think they are being rational about their investments, but what usually happens is that we form an opinion emotionally and then find evidence which corroborates our point of view. This is called confirmation bias. Better to remain humble and recognize that we don’t have the ability to determine what the future holds. Buy and Hold works, but only when we don’t screw it up!

3) Starting with an Asset Allocation. People may spend a vast amount of time picking a US large cap fund, but then miss out on the benefits of diversification. Other categories may outperform US large cap stocks. I recently opened an account for a new client, whose previous advisor had him invested in 180 positions – all of which were US large cap and investment grade bonds. No small cap, no international equities, no emerging markets, no floating rate bonds, no municipal bonds, etc.

The most important determinant of your portfolio return is the overall asset allocation, not which fund you chose! Our process begins with you, your goals, timeline, and risk tolerance to first determine a financial plan, including an appropriate asset allocation. The asset allocation is really the portfolio and then the last step is to just plug in funds to each category. Funds in each category perform similarly. If it’s a horrible year, like 2008, in US large cap, that fact is more significant than which large cap fund you chose.

A famous, and controversial, 1995 Study found that 95% of the variability of returns between pension funds was explained by their asset allocation.

4) Not chasing performance. The problem with trying to pick the best fund is that you are always looking through today’s rearview mirror. There will always be one fund that has the best 5, 10, or 15 year returns. There are always funds which are doing better than your fund this year. But if you buy that new fund, you may quickly become disappointed when the subsequent returns fail to match its “perfect” track record.

So then you switch to another new fund. And like a financial Don Juan, the performance chaser is quick to fall in love, but just as quick to move on, creating a tragic, endless cycle of hope and failure. If you are investing for the next 30 years, changing funds 30 times does not improve your chances of success! By the way, if you exclude sector funds, single country funds, and other niche categories from your portfolio, you will be well on your way to avoiding this pitfall.

5) Setting Goals. If you have a goal or large project at work, you probably create a plan which breaks that goals down into a series of smaller steps and objectives. Unfortunately, very few people apply the same kind of discipline, planning, and deliberate process to their finances as they do to their career and other goals. When you begin with the goal in mind, your next steps – how much to save, how to invest, what to do – become clear.

Bonus, 6) Doing what works. Why reinvent the wheel or take on unnecessary risk? We know that 80% or more of actively managed funds lag their benchmarks over five years and longer. With 4 to 1 odds against you choosing a fund that outperforms, why take that risk at all? Even if you get it right once, do you realize how small the possibility is that your choice will outperform for another five years? Better to stick with Index Funds and ETFs. Besides the better chance of performing well, you will also start with very low expenses and excellent tax efficiency. When you use Index funds, it frees up your mind, time, and energy to focus instead on numbers 1-5.

Choose your funds carefully and deliberately because you should plan to live with those funds for many, many years. There are genuinely good reasons for changing investments sometimes and we won’t hesitate to make those trades when necessary. But on the whole, investors trade way too much for their own good. The grass is not always greener in another fund!

Are Smart Beta ETFs Right for You?

Posted On January 25, 2016 By Admin In Portfolio Management /

Over the past several years, you may have heard about “Smart Beta ETFs”. Today, we will look at this concept and share some very important caveats that investors should know before they purchase a Smart Beta ETF for their portfolio. While the name sounds like it would be a sure thing, it is important for investors to understand that there is no guarantee that Smart Beta products will be able to deliver on their promises.

The first ETFs were all index funds, tracking major indices like the S&P 500 or the Dow. As ETFs grew in popularity, investment companies quickly added products representing other indices, sectors, styles, and countries. ETF companies will continue to create hundreds of new products each year to raise new assets and be able to charge more fees. Once every traditional index was replicated in an ETF, companies had to find more creative offerings. Will every product work and be successful? No, but there is such a pronounced first-mover advantage in the industry that many companies are willing to take the risk of launching dozens of new funds hoping that some will be a success.

The knock on traditional index ETFs is that they are weighted by market capitalization. That simply means that each stock is represented according to its total market value. What’s wrong with that? If you went back to 1999, Cisco briefly became the largest stock in the world, trading at over 100 times earnings. At that time, it represented more than 3% of every index fund. And when the stock fell by 90% during the tech crash, every index fund had a large loss. The problem with traditional index funds is that they have too much of the overvalued stocks and too little of the undervalued companies.

Smart Beta ETFs seek to avoid this issue of overweighting the most expensive stocks by using alternative weighting or selection criteria. Like an Index, Smart Beta is a hands-off strategy that is quantitatively driven and passive. There are quite a few different approaches to Smart Beta, including weighting by:
– Dividends (stocks represented by the size of their dividend stream)
– Volatility (emphasizing the Lowest Volatility stocks or combination of stocks)
– Fundamentals (such as book value, sales, or earnings)
– or even, equal weighted, where each company receives the same weight in the fund.

Here are five points you should consider before selecting a Smart Beta ETF.

1) Traditional indexing works well.
While the concern of overweighting expensive stocks sounds legitimate, I’d like to point out that in spite of this supposed flaw, a vast majority of actively managed funds fail to beat their benchmark over five years. According to the S&P Index Versus Active report, as many as 80% of active managers fall short. If it was so easy to pick out the undervalued stocks from the overvalued stocks, wouldn’t more fund managers be able to beat the market cap weighted index?

Everyone is looking for a way to out perform the market, but this remains very difficult to do. It will be interesting in 10 years to see how many of today’s Smart Beta products will have delivered superior returns.

2) Back-tested strategies do not always work as well going forward.
Smart Beta ETFs are created based on academic research looking at factors which would have produced strong returns historically. This is generally done using back-tested data, which gives us another concern. If we looked at stocks from 2000-2015, it was a very unusual period. Will the factors which worked over the past 10 or 15 years continue to generate market beating returns over the next 10 or 15 years? No one knows the answer to that; the future could be quite different than the past and back-tested strategies may not perform as hoped.

3) Smart Beta may be out of favor for extended periods.
The back-tested results look promising, with Smart Beta strategies beating their benchmarks, had the ETFs existed. While the long-term hypothetical returns look good, there can be stretches when this strategy is out of favor. It may have outperformed over 10 years, but it may have lagged in four, five, or even six of those years, only to make it up by strong performance in a couple of years. If you buy a Smart Beta ETF today, will you hold on to it if it lags the market for two years in a row? Three years in a row?

Some Smart Beta strategies correlate strongly with Value and will lag when Growth is in favor. Other strategies are defensive and will trail the market during bull markets and only enhance performance in bear markets. This makes for a difficult decision as to whether or not the current market is the right environment for a particular approach or factor. This creates the potential for market timing errors if investors chase returns by switching from one ETF to another, trying to capture the most advantageous style for any given year.

4) Smart Beta ETFs may be less diversified.
Since Smart Beta funds emphasize certain characteristics such as dividends, the funds may have a high concentration in specific sectors such as utilities, financials, or energy. In the years where those sectors perform poorly, Smart Beta funds could be volatile and disappointing.

5) Costs
Lastly, it’s not certain that the benefits of all Smart Beta funds will accrue to investors once we factor in the expense ratio, trading costs, and taxes. Luckily, ETFs are becoming highly competitive in terms of expenses, so many funds launched in the last two years have extremely low expense ratios. While we know the expense ratio, we don’t know what trading costs are incurred when a Smart Beta strategy buys and sells stocks, which most do on a quarterly or annual basis.

I’ve listed these five concerns about Smart Beta ETFs because I want to dispel the notion that these funds are a sure bet. However, I do think they are interesting and show promise. Perhaps some will deliver results. And this is another conundrum for investors: there are so many flavors of Smart Beta strategies today that we run the risk of picking the wrong one, and we end up with the fund that under performs. So this is not the simple choice of just replacing all of your traditional ETFs with a Smart Beta version and being guaranteed better results.

We’ve spent a lot of time analyzing Smart Beta ETFs and have included several in our clients’ portfolios. If you are looking to hand off your portfolio management to a professional, we are here to help. And while we manage your funds, we also take the time to explain our process, philosophy, and why we own each position.

Why You Need to Drop Your Mutual Funds for ETFs

Posted On October 5, 2015 By Admin In Portfolio Management /

We just finished the third quarter this week and it was a tough one. The market struggled to make new highs all year before it finally ran out of steam during the week ending August 21. The S&P 500 Index traded above 2100 in July, but dropped roughly 10% to 1920 to close the quarter on September 30. Year to date, the index is down 6.75%.

While it was a disappointing quarter, we should remember that we’ve had an exceptionally long run without a correction of any size. Still, no one likes to open their quarterly statements and see that their accounts are down.

One of the myths of active fund management is that managers are able to add value during corrections through their defensive strategies. At least, that’s what we’re told when they lag during a bull market. So how did actively managed funds fare during the third quarter?

According to a report this week by JPMorgan, 67% of active funds performed worse than their benchmark in Q3. Half of those funds (34%) lagged their benchmark by at least 2.50%.

The long-term picture is even worse for active management. The Standard & Poors Index Versus Active (SPIVA) Scorecard was recently updated with data through June 30, 2015. They found that over the past 10 years, 79.59% of all Large Cap funds were outperformed by the S&P 500 Index. Over this period, the index produced an annualized return of 7.89%, versus 7.03% for the average large cap fund.

If you are still using actively managed mutual funds, chances are good that 1) your Q3 returns are even uglier than the overall market, and 2) your long-term performance has suffered significantly. That’s why we use Index Exchange Traded Funds (ETFs) as the core positions in our model portfolios. Investing in an index doesn’t mean “settling” for average returns, it has actually been the most likely and consistent way to ensure your performance is better than the average active fund.

If that isn’t enough to get you to trade in your mutual funds for an ETF portfolio, then read this article from Morningstar on mutual fund capital gains. Morningstar notes that after a 6-year rally, many mutual funds have used up their tax losses and are increasingly likely to distribute capital gains to fund shareholders at the end of this year. If this quarter’s drop causes a large outflow of capital, active fund managers will be forced to liquidate positions, creating a tax bill for the shareholders who remain in December.

It’s entirely possible for an actively managed mutual fund to be down for the year and still create capital gains for shareholders, due to trading within the portfolio. We haven’t seen this scenario in a number of years, but it looks like a distinct possibility for 2015. Index ETFs on the other hand, are extremely tax-efficient; it is quite rare for an equity index ETF to distribute capital gains, thanks to their unique structure.

If you’re a client, thank you for sticking with the plan when the market is down. We know it is frustrating. Corrections are a natural and inevitable part of the market cycle. You can take solace knowing that our Index ETF approach is demonstrating its merit both in its relative performance in Q3 and in its long-term outperformance over actively managed funds.

If you’re not currently a client, please give me a call and we can discuss how our disciplined portfolio management process can help you accomplish your financial goals. While we can’t control what the market is going to do, we can benefit greatly by focusing on what we can control, including tax efficiency, minimizing expenses, diversification, and using a time-tested index methodology.

Behavioral Tricks to Improve Your Finances

Posted On September 28, 2015 By Admin In Behavioral Finance /

I was saddened to hear of Yogi Berra’s passing last week. One of the great quotes attributed to him is “In theory, there is no difference between theory and practice. In practice, there is.” I’ve always thought this quote applied well to personal finance, where the academic expected behavior could differ significantly from the choices people make in real life.

The fact is that we all use our feelings, intuition, and past experience to make our decisions as much, or more, than we rely on logic, research, or an open-minded examination of evidence and data. Many academics take the view that any behavioral deviation from the theoretically optimal decision will lead to poor outcomes. And while that is definitely the case in many situations, my observation as a practitioner is that even the most successful individuals are not immune from this “irrational” behavior.

My point is that when theory and practice do deviate, there can still be good outcomes, in fact, sometimes even improved outcomes. Here are six ways you can use behavioral concepts to improve your financial situation. In theory, these won’t help. In practice, they will.

The 15-year mortgage. In theory, you can make more in stocks than the interest cost of a mortgage, so you should get an interest-only loan and never pay it off. Home values generally appreciate over the long-term, and there is no additional benefit to having equity in your home. Although this is theoretically correct, I suggest that home buyers get a 15-year mortgage instead of a 30-year or interest only note. The reason that the 15-year mortgage benefits buyers is that it will force you to buy a lower priced home to be able to afford the higher monthly payment. If you start your house hunt with a 15-year mortgage in mind, it might mean looking for a $300,000 home instead of a $350,000 home. The lower cost home will have lower property taxes, insurance, utilities, and other costs. More of your monthly payment will go towards principal with the shorter loan, so you will build equity faster, which is very valuable if you should need to move after five or ten years. Having a higher monthly mortgage payment will also force you to save more. By that I mean that if you had a payment that was $500 less, you probably would not save an additional $500 a month; you’d probably save only a small part of this, maybe $100 or $200 a month, and increase your spending by $300 or $400.
Set up your 401(k) contributions as a percentage. People are shockingly lazy with their 401(k) accounts. Many never change funds, and even more never change their contribution level. If you set up a $100 contribution per pay period, chances are good that five years later you are still contributing $100. If, on the other hand, you established a 10% contribution, your dollars contributed would have increased with your raises, promotions, and bonuses. If you can, increase your percentage contribution every year until you make the maximum allowable contribution, $18,000 for 2015.
Make it automatic. We are creatures of habit and momentum and will seldom change established our course. If you give someone $100,000 to invest, they will agonize over the fund choices and try to time their purchases. If the market goes down, they’ll bail out and blame the fund or the manager or something else. It’s better to set your investing on auto-pilot, invest every month into your 401(k), IRA, 529 college savings plan, or other investment vehicle. And then do what is natural for most of us: nothing. Keep investing when the market goes down. Stick with a basic, diversified allocation. That’s why people who have a created a $100,000 account by investing $1000 a month are more likely to stay on course than the investor who puts in a lump sum. Already have your investing on cruise control? Take the next step and make your rebalancing automatic, too!
Pay cash for cars. In theory, there’s nothing wrong with financing or leasing cars. However, if you get in the habit of paying cash for cars it will change your behavior for the better. It is incredibly painful to write a $35,000 check for a vehicle. If you pay cash for cars, it will force you to keep your current car for longer while you save for the next one. It will make you consider a used car or a lower cost vehicle. And it will be a strong incentive to keep your next vehicle for a very long time. Cars are often our second largest expense after housing. Most cars lose 50% of their value in five years, so would you prefer to lose half of $75,000 or half of $30,000? People don’t think this way when all they know is their monthly payment. When you pay cash for a car, you start to think like an owner and not a renter.
Do less research. One of the mental biases facing investors is overconfidence; the more research we do, the more we believe we can predict the outcome of our investing choices. This can lead to people being overweight in their company stock, getting in and out of the market, or making large sector bets. These choices often lead to increased risk taking and quite often to long-term under performance. We’re also likely to suffer from “confirmation bias”, where we cherry pick the data or articles which corroborate our existing point of view and ignore any contradictory evidence. Overconfidence and confirmation bias don’t just affect individual investors, they are significant challenges for professional fund managers. Since the majority of professional managers cannot beat the index, I don’t hold much optimism that an individual can do better. So, cancel your subscription to the Wall Street Journal, turn off CNBC, and buy an index fund.
Use “mental accounting” to your advantage. Money is fungible, meaning $1 is $1 regardless of where it is located. However, people like to divide their money into buckets for retirement, saving, spending, emergency funds, college, vacation, or whatever. In theory, this is meaningless, you’d be equally well off with just one account invested appropriately for your risk tolerance. Even though Academics would like to banish mental accounting, people are enamored with their buckets. While you should look at all your holdings as being slices of one pie, you can use mental accounting to your advantage. You are less likely to touch money when it is in a dedicated account. For example, if you put money in a savings account for emergencies, you may later be tempted to spend that money on a vacation or other splurge. If you instead put that money into a Roth IRA, you’d be much less likely to touch it. But if you did have an emergency, you could access the principal from your Roth, tax-free. The other benefit of buckets is that it may force you to do more saving when you have specific dollar goals for retirement, college, or other purposes. Then if you need to plan for a vacation, you know you will have to do additional saving and cannot touch the buckets allocated for other goals.

Use behavior to your advantage by making sure your choices are helping you get closer to achieving your goals. Investing can be simple; it’s people who choose to make it complicated. Stick to the basics and stay focused on saving and diversification. I’m not sure we can ever completely remove behavioral biases from our decision making process, but the more we are aware of those biases, the easier it is to step back and recognize what exactly is driving our choices.

Should You Hedge Your Foreign Currency Exposure?

Posted On May 25, 2015 By Admin In Portfolio Management /

When you invest in foreign stocks or bonds, you’re really making two transactions. First, you have to exchange your dollars for the foreign currency and only then can you make the purchase of the investment. Over time, your return will consist of two parts: the change in the price of the investment and the change in the value of the currency. In 2014, foreign stocks – as measured by the MSCI EAFE Index – were up 6.4% in their local currency, but because of a strong dollar, the index was actually down by 4.5% in US dollar terms.

This nearly 11% disparity of returns has made for one of the fastest growing investment segments in 2015: currency-hedged Exchange Traded Funds. These new funds invest in a traditional international index, but then hedge the foreign currency, so US investors can receive a similar return to investors in the local currency. Obviously, a currency hedging strategy has worked well over the past year, but is it a good idea going forward?

As you might imagine, there is no free lunch with currency hedging. There are two important caveats for investors to understand. First, when you hedge, you are making a directional bet that the dollar will strengthen. If the dollar weakens instead, a hedged international fund will under perform a non-hedged fund, or even lose money. Hedging adds an additional element to the investment decision making process, which can increase the possibility of under performance. After all, the most appealing time to hedge will be after the currencies have already made a big move, but in many cases, that will also be too late!

Having foreign denominated investments can provide investors with diversification away from the US dollar. If the dollar were to decline, foreign denominated positions would rise. Having that currency diversification could help investors over time by potentially smoothing returns and providing a defensive element. If you hedge your foreign positions, a declining dollar would negatively impact both your domestic and foreign holdings, which means you may have actually increased your portfolio’s correlations and risk.

The second caveat is cost. Currency hedged funds have a higher expense ratio than regular ETFs, and those management costs do not even include the actual cost of purchasing the hedges. If currencies are relatively stable over a longer period, hedged products will likely lag non-hedged funds due to their higher expenses.

Given these two caveats, I have been reluctant to recommend currency hedged ETFs for long-term investors. Today, however, there are some reasons to believe that the US dollar’s strength may continue. If we look at central bank policy, the US Federal Reserve has been discussing when and under what conditions they will begin to raise interest rates. Compare this to Europe or Japan, where the central banks are looking to create new stimulus and quantitative easing programs. The expectation is that the money supply will increase in Europe and Japan, while the US money supply will be more stable. That’s bullish for the dollar for the near term.

We shouldn’t expect 2014’s nearly 11% difference between hedged and un-hedged indices to continue, but currency trends or cycles can last for several years. I will be talking with our investors to discuss hedging a portion of their international exposure, provided they can make those trades in an IRA. We prefer to make the trades in an IRA to avoid any capital gains on a sale today. Also, we consider the currency-hedged funds to be tactical rather than strategic, meaning that at some point in the future, we will probably want to trade back into the traditional, un-hedged index.

There are also currency hedged ETFs for Emerging Market stocks, but we recommend investors steer clear of those funds. The cost of hedging is tied to short-term interest rates in the foreign currency, so it’s very cheap to hedge Euros or Yen today, but fairly expensive to hedge emerging market currencies where interest rates may run 6-8% or more. And that explains why currency hedged Emerging Market funds are not showing the same out performance we see with currency hedged funds in developed markets, even though the dollar has strengthened in both cases.

Have questions on how to implement this in your portfolio? Please don’t hesitate to call me at 214-478-3398 or send me an email to [email protected] for help!