Investment Themes for 2018

Posted On November 26, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning /

Each year, we look closely at trends and valuations to create themes which will be incorporated into our Investment Porfolios. In addition to the Defensive Managers Select portfolio which we highlighted last week, our Premiere Wealth Portfolios are tactical asset allocation models with 10-15 funds or ETFs, at five risk levels: Conservative, with a benchmark of 35% Stocks/65% Bonds, Balanced (50/50), Moderate (60/40), Growth (70/30), and Aggressive (85/15). We are also rolling out a new allocation, Ultra Equity, which will be 100/0.

We will always remain broadly diversified, invested both in Core Assets, which we believe should always be in a portfolio, and in Satellite Assets, which are typically in a more narrow category which we feel offers a benefit to the portfolio at the present time. The Satellite holdings may be changed from year to year, and while the Core funds are “permanent”, their size and weighting in the portfolio will change each year based on their relative valuations and attractiveness of other categories.

We always start with the overall asset allocation in our process, and then choose funds which we think will accurately represent each category. With our themes each year, I think you will see that we are far from being entirely passive. Here are our big picture thoughts for 2018.

1) Foreign over Domestic Stocks. US Equities are quite expensive relative to the rest of the world. The strong performance in 2017 has stretched those valuations even further. We are presently overweight US stocks relative to our benchmark (the MSCI All-Country World Index), but will reduce our weighting to US stocks to an underweight.

2) Overweight Emerging Markets. For 2017, we increased our allocation to Emerging Markets Equities to two-times the level of the index, approximately 17% compared to 8.5%. EM had a phenomenal year in 2017, currently up nearly 30%. When we rebalance, these positions may be trimmed, but please note that we are not reducing our target allocation!

3) Reduce Risk in Fixed Income. While short-term rates rose nicely in 2017, long-term interest rates did not. This was our “low for longer” theme from last year. We sold our high-yield bond ETF over the summer, but will continue to look to reduce the duration of our bond holdings and increase the credit quality. When we do eventually get a correction in the stock portfolio, we want to have high quality bonds to provide support to the portfolio.

4) Increased Volatility. We don’t have a crystal ball and believe that trying to make predictions is not only futile but damaging to your returns. However, we have gone an exceptionally long time without any sort of correction. I don’t know when it will occur, but just as autumn turns to winter, I think investors must not forget that there will be down periods, and be prepared to weather potential storms in 2018 and beyond.

We published Four Investment Themes for 2017 in November of 2016. Click the link if you’d like to see how we did. I think we were generally successful in identifying themes for this year, except that I was expecting Value stocks to take the lead from Growth stocks, which did not occur. However, we saw the gap in valuation between Value and Growth widen in 2017, so I believe that Value offers less risk and potentially a higher long-term return than Growth.

2017 was the first full year to include a 10% allocation to Alternatives within each portfolio. With the stock market producing double digit returns in many categories, our investment in Alternatives was a drag on performance. Still, I think many investors will appreciate that we are looking for more stable sources of returns than just being in stocks and bonds. With high valuations in domestic stocks, and low bonds yields globally, risks remain elevated.

Overall, we will be making only small adjustments to our portfolios for 2018. But compared to two or three years ago, we have already made significant changes to reduce risk and further diversify our portfolios. As always, I am happy to discuss our investing approach in greater detail with anyone who is interested.

Are You Making These 6 Market Timing Mistakes?

Posted On September 10, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management / 1 Comment

Market timing means moving in and out of the market or between assets based on a prediction of what the market will do. Given the extreme difficulty of predicting the future, market timing is frowned upon by most academics. Many studies have shown that the majority of investors who time the market under-perform those who stay invested.

Even though many people know intellectually that market timing is detrimental, it is actually pretty difficult to stay invested and not be influenced by market timing. Even for those who say they don’t time the market, there are a number of ways that investors inadvertently fall into this trap.

1. Being in Cash. “We are going to sit on X% in cash and wait for a buying opportunity.” Seems prudent, right? Except that investors who have been holding out for a 10% or 20% crash for two, three, four years or more have missed out on a huge move up in the market. Yes, there are rational reasons to say that the market is expensive today, but those who have been sitting in cash have definitely under-performed. Will they eventually be proved right? The market certainly has cycles of growth and contraction. This is normal and healthy. So, yes, there will be another bear market. The problem is that trying to predict when this will occur usually makes returns worse rather than better.

2. Greed and Fear. The human inclination is to want to invest when the market has done well and to sell when the market is in the doldrums. I remember investors who insisted in going to cash in November 2008 and March 2009, right at the bottom. In 1999, people were borrowing money to put into tech funds, which had given them returns of 30%, 50%, even 100% in a year. Our natural reaction is to buy high and sell low, the opposite of what we should be doing. It’s only in hindsight that we recognize these trades as mistakes.

3. Performance Chasing. Investors like to switch from Fund A to Fund B when Fund A does better. Who wouldn’t want to be in the better fund? This is why people give up on index funds. Index funds often only beat half of their peers in any given year, so it’s super easy to find a fund that is doing better. However, when we go to a five-year horizon, index funds are winning 80-90% of the time. That’s why switching to a fund with a better recent track record is often a mistake. (And then watch the fund you just sold soar…)

4. Sector and Country funds. Investors want to buy a sector or country fund when it is a standout. This is market timing! You are buying what is hot (expensive) rather than buying what is on sale. I have yet to have any client ever come to me and say “sector X is doing terrible, should we buy?”. Instead, some will ask me about biotech, or India, or some other high flyer. I remember when the ING Russia fund had the best 10-year track record of all mutual funds. If you bought it then, I think you would have regretted it immensely in the following years! When people buy sector or country funds, the decision is almost always a market timing error of extrapolating recent performance into the future, instead of recognizing that today’s leaders become tomorrow’s laggards.

5. Factor Investing. If you haven’t heard of Factor Funds, you will soon! Quantitative analysts look for a set of criteria which they can feed into a computer and it picks the best performing stocks. How do they come up with a winning formula? By back-testing strategies using historical stock prices. This sounds very scientific, and I admit that it looks promising, but there are still some market timing landmines for investors, including:

Historical anomalies. It’s possible that a strategy that worked great over the past 10 years might be a dud over the next 10. It is unknown which factors will perform best going forward and it seems naive to assume that the future will be the same as the past.
Choosing which factor. Low Volatility? Value? Momentum? Quality? Those all sound like good things. There are now so many flavors of factors, you have to have an opinion on the market in order to pick which factor will outperform. And that’s right back to market timing: investing based on your prediction of what the market will do. This isn’t Lake Woebegone, where all the factors are above average. Some factors are bound to do poorly for longer than you are likely to be willing to hold them.
Investor switching. In most single years, a factor does not have very exciting performance. I predict that many investors are going to buy a factor fund, and then switch when they see another factor outperform for a year or two. If you’re really going to buy into the factor philosophy, you need to buy and hold for many, many years. Even in back tests, there are quite a few years of under-performance. It was only over long time periods that factors were able to deliver improved returns.

6. Product development. Asset managers are paid on the assets they manage. It’s a business. They will always be coming out with a new, better product to attract new investors. You are being marketed to every day by companies who want your investment dollar. Many new funds will not survive the test of time and will disappear into financial history. Their poor track records will be erased from Morningstar, which is why we have “survivorship bias”, the fact that we only see the track records of the funds that survive. Please use caution when investing in a new fund. Is this new fund vital to your success as an investor or just a marketing ploy for a company to capitalize on the most recent fad?

At Good Life Wealth Management, we are fans of the tried and true and skeptical when it comes to the “new and improved”. We aim to avoid market timing errors by remaining invested and not trying to predict the future path of the market. We avoid emotional investing decisions, performance chasing, and sector/country funds. For the time being, we are watching factor funds with curiosity but a wait and see attitude.

How then do we choose investments and their weight in our asset allocation? Our tactical models are based on the valuation of each category. This is by its nature contrarian – when large cap becomes expensive, it becomes smaller in our portfolios. When small cap becomes cheap, its weighting is increased. We don’t predict whether those categories will go up or down in the near future, but only tilt towards the areas of better relative value. This is based on reversion to the mean and the unwavering belief that diversification remains our best defense.

If you’d like to talk about your portfolio, I’d welcome the chance to sit down and share our approach and philosophy. What keeps us from the Siren song of market timing is our belief in a disciplined and patient investment strategy.

Bye Bye High Yield Bonds

Posted On August 13, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management / 1 Comment

We’re making a trade in our portfolio models this week and will be selling our high yield bond fund (SPDR Short-Term High Yield ETF, ticker SJNK). The last 18 months have been excellent for high yield bonds; so excellent, in fact, that at this point the now lower yields don’t justify the risks. For those who might be interested in our process behind this decision, please read on.

High Yield, or “Junk”, Bonds are highly cyclical and go through wide swings up and down. They have much higher volatility than other types of bonds, and in spite of their higher yields, have the potential for negative returns to a greater degree than most other types of bonds. Additionally, they have a fairly strong correlation to equities, meaning that when stock markets plunge, high yield bonds – which are issued by lower quality companies – are also likely to drop in value. In times of recession, several percent of high yield issuers will default on their bonds and go bankrupt each year.

How can we determine if high yield bonds are a good value? One of then most common ways is through Credit Spreads. A Credit Spread is the additional amount of yield a high yield bond will provide over a safe bond like a US Treasury.

As recently as January 2016, high yield bonds were paying 6-7 percent over Treasuries. Today, that spread has shrunk into the 3% range, a level which is closer to the lows of the past 20 years. You can see a chart of US Credit Spreads on the website of the Federal Reserve Bank of St. Louis.

Investors today are not being sufficiently compensated for taking the extra risk of high yield bonds, and given the headwinds of higher interest rates and a late-inning stock market, we believe it is time to remove the high yield position from our portfolio. They’ve done their job. While no one can predict if or when these bonds will have their next downturn, we’d rather make the change now.

This is a small trade in most portfolios; our 60/40 model, for example, has only a 4% position in high yield. The proceeds will be reinvested into other bond funds which have lower volatility and also a short duration.

In the future, if yield spreads widen, we might buy back into high yield bonds. When pessimism is at its highest, low prices on high yield bonds can be a great value for patient investors. And that’s the time to be a buyer, not today. Credit spreads are a unique consideration for high yield bonds, but know that we look at each category within our portfolio models closely and will not hesitate to make adjustments after cautious and deliberate study.

If you have any questions about high yield bonds, fixed income, or any other aspect of portfolio construction, please give me a call!

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!

Mid-Year Report: The Return of Irrational Exuberance?

Posted On July 2, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

We’ve passed the mid-year point and the market has had a strong performance in the first half of 2017. Investors should be very pleased with the results of the past six months, although I believe there are reasons to be guarded going forward. Our portfolio models all notched positive returns, but our value oriented approach held back returns relative to our benchmarks.

Looking first at stocks, our global equity benchmark, the MSCI All Country World Index (iShares ticker ACWI) produced a total return of 11.92%. That would be a great return for the whole year, and it’s only July 1 as I write this. US Stocks, such as the Russell 1000 Index (iShares ticker IWB) were up 9.15% in the first half.

Across the board, international stocks were well ahead of US Stocks, with both Developed and Emerging Markets producing 15% returns for the first half. Our International and Emerging small caps did even better, over 17%. Our positions in foreign equities were strong contributors to our portfolio returns. If you are just investing in domestic stocks, you really missed out so far in 2017. And International stocks remain less expensive than US stocks by most measures.

Our holdings in US Value stocks lagged, gaining only 2-4% versus the 9% of the overall market. Last year, Value outperformed both Growth and Core by a wide margin. For 2017, a handful of technology companies are dominating returns, specifically the so-called FAANG stocks: Facebook, Apple, Amazon, Netflix, and Google (now called Alphabet).

While these companies continue to post exciting growth, the price of these stocks is now incomprehensible to me. It feels like 1999 all over again, when there was no price too high for growing tech leaders. While I think that today’s top stocks are bonafide companies with genuine earnings, I still can’t justify the price of the shares.

It smells like a bubble to me, although limited to this small number of stocks. Now that doesn’t mean that we are necessarily on the verge of a collapse. Indices could continue to go higher from here, and even if a few high flyers do get clipped, that doesn’t mean that the rest of the economy will be in trouble.

Our investment process favors patience. We focus our portfolios towards the cheaper segments of the market which have lagged. We look for reversion to the mean, investing as contrarians, rather than chasing momentum. Our value funds and REIT ETF had positive returns, but were detractors from performance, as was our allocation to Alternatives. However, I remain committed to these positions because they are relatively cheap. While they did not beat the market over the past 6 months, our rationale for holding them has only grown more compelling.

In fixed income, the US Aggregate Bond Index (iShares ticker AGG) was up 2.40% year to date. Our fixed income allocations were ahead of AGG by 30 to 80 bps, with higher yields and lower duration. Our position in Emerging Market bonds was a standout performer for the half. I continue to keep a close watch on high yield bonds, but overall think we are well positioned for today’s economy and potential future rate hikes.

I write about the markets twice a year, and not more frequently, to not distract us from sticking to a long-term allocation. We focus on what we know works over time: diversification, keeping costs low, using index funds for core positions, and tilting towards value. Our discipline means that we don’t let short-term events pull us away from our strategy.

Looking at the first half, our fixed income and international equity holdings did quite well. Our value and alternatives holdings have not yet had their day in the sun. However, if the market does eventually realize that the US tech stocks have gotten “irrationally exuberant”, I think we will be glad we have our more defensive positions.

What Are Today’s Projected Returns?

Posted On June 18, 2017 By Scott Stratton, CFP(R), CFA In Financial Planning, Portfolio Management /

One of the reasons I selected the financial planning software we use, MoneyGuidePro, is because it offers the ability to make projections based on historical OR projected returns. Most programs only use historical returns in their calculations, which I think is a grave error today. Historical returns were outstanding, but I fear that portfolio returns going forward will be lower for several reasons, including:

Above-average equity valuations today. Lower dividend yields than in the past.
Slower growth of GDP, labor supply, inflation, and other measures of economic development.
Higher levels of government debt in developed economies will crowd out spending.
Very low interest rates on bonds and cash mean lower returns from those segments.

By using projected returns, we are considering these factors in our financial plans. While no one has a crystal ball to predict the future, we can at least use all available information to try to make a smarter estimate. The projected returns used by MoneyGuidePro were calculated by Harold Evensky, a highly respected financial planner and faculty member at Texas Tech University.

We are going to compare historical and projected returns by asset class and then look at what those differences mean for portfolio returns. Keep in mind that projected returns are still long-term estimates, and not a belief of what will happen in 2017 or any given year. Rather, projected returns are a calculation of average returns that we think might occur over a period of very many years.

Asset Class	Historical Returns	Projected Returns
Cash	4.84%	2.50%
Intermediate Bonds	7.25%	3.50%
Large Cap Value	10.12%	7.20%
Small Cap	12.58%	7.70%
International	9.27%	8.00%
Emerging Markets	8.85%	9.30%

You will notice that most of the expected returns are much lower than historical, with the sole exception of Emerging Markets. For cash and bonds, the projected returns are about half of what was achieved since 1970, and even that reduced cash return of 2.50% is not possible as of 2017.

In order to estimate portfolio returns, we want two other pieces of data: the standard deviation of each asset class (its volatility) and the correlation between each asset class. In those areas, we are seeing that the trend of recent decades has been worse for portfolio construction: volatility is projected to be higher and assets are more correlated. It used to be that International Stocks behaved differently that US Stocks, but in today’s global economy, that difference is shrinking.

This means that our projected portfolios not only have lower returns, but also higher volatility, and that diversification is less beneficial as a defense than it used to be. Let’s consider the historical returns and risks of two portfolios, a Balanced Allocation (54% equities, 46% fixed income), and a Total Return Allocation (72% equities, 28% fixed income)

Portfolio	Historical Return	Standard Deviation	Projected Return	Standard Deviation
Balanced	8.53%	9.34%	5.46%	10.59%
Total Return	9.18%	12.20%	6.27%	14.23%

That’s pretty sobering. If you are planning for a 30-year retirement under the assumption that you will achieve historical returns, but only obtain these projected returns, it is certainly going to have a big impact on your ability to meet your retirement withdrawal needs. This calculation is something we don’t want to get wrong and figure out 10 years into retirement that we have been spending too much and are now projected to run out of money.

As an investor, what can you do in light of lower projected returns? Here are five thoughts:

Use projected returns rather than historical if you want to be conservative in your retirement planning.
Emerging Markets are cheap today and are projected to have the highest total returns going forward. We feel strongly that they belong in a diversified portfolio.
We can invest in bonds for stability, but bonds will not provide the level of return going forward that they achieved in recent decades. It is very unrealistic to assume historical returns for bond holdings today!
Investors focused on long-term growth may want more equities than they needed in the past.
Although projected returns are lower than historical, there may be one bright spot. Inflation is also quite low today. So, achieving a 6% return while inflation is 2% is roughly comparable in preserving your purchasing power as getting an 8% return under 4% inflation. Inflation adjusted returns are called Real Returns, and may not be as dire as the projected returns suggest.

10 Ways to Wreck Your Portfolio

Posted On March 19, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management /

Over the years, I’ve seen hundreds of portfolios and 401(k) accounts, and observed investors make tons of mistakes. Admittedly, I have made many of these errors on my own as well, just to double check! Here’s your chance to learn from others’ losses. But, if you still insist that you want to ruin your rate of return, go ahead and make these 10 mistakes…

1) Rely on Past Performance. You invest with winners, not losers! Just find the top performing fund offered by your 401(k) and put all your money in there. That’s why they say past performance is a guarantee of future returns, or something like that.

2) Don’t diversify. Have you seen that Chinese Small-Cap BioTech fund? Why invest in the whole market when you can bet on one tiny, minuscule sliver?

3) Ignore the fact that 80% of actively managed funds under perform their benchmark over five years. You’re going to pick funds from the other 20%. Indexing is for people who are willing to settle for average.

4) Put as much money as possible into your company stock. It’s beat the S&P 500 for X number of years, therefore you’d be stupid to ever take your money out of company stock or to cash in your options. And since you work there, you know more about this investment than anyone. Just like the employees at Nortel, Worldcom, and Enron.

5) To avoid paying taxes, don’t sell your winners. Don’t rebalance or sell overvalued shares. Later, if the stock is down 40% you can pat yourself on the back: “Thank God I didn’t sell when it was up and have to pay 15% tax on my gains. I dodged that bullet!”

6) Never sell your losers either. The loss isn’t real until you sell, and the most important thing is to protect your ego. If you hold on, eventually, you should get your money back. So what if another fund returns 60% while you are waiting for yours to rebound 30%? (Says the guy who has old General Motors shares that are worthless from when the company filed for bankruptcy and wiped out their stockholders.)

7) Do it yourself. Don’t use funds or ETFs, pick individual stocks yourself! It will be fun and easy. Just look at all those smiling people on the commercials for online brokers, they’re getting rich from their kitchen tables! Anyone can beat those fancy investment managers with their extensive training, huge research departments, and decades of experience. And if you spend all day watching your portfolio, it magically grows faster!

8) You know when to get in and out of the market. It’s not market timing if you know what you’re doing. When the market is down, it’s a bad market, so don’t buy then. Wait until the market goes back up before you make your purchases. You should toss out a detailed 20-year financial plan if your gut tells you. And by gut, of course, we mean CNBC, Fox News, or whatever you watched in the preceding 48 hours.

9) When the market is down, your funds are horrible, the managers incompetent, and the market is rigged. When your portfolio is up, it’s because of your brilliant mind for finance. You are investing for decades, but if your portfolio doesn’t go up every single quarter something is horribly wrong with your approach. Change everything you own when this happens.

10) All the good investments are reserved for the wealthy. You can only become rich by investing in complicated, non-transparent private placements or limited partnerships in oil, real estate, leasing, or something you cannot explain in less than three minutes. And it’s rude to ask how much these programs charge, that’s so gauche. On a related note, you should always buy penny stocks that you hear about through an email.

I know no one really wants to wreck their portfolio, but from my vantage point, a lot of our investment pains appear self-inflicted. I can help you avoid these ten mistakes and many, many others. Even more important than avoiding errors, together we can create a financial plan and investment program that will be tailored to your goals, rather than focusing on what the market might do this month or this year.

Professional advice. Comprehensive financial planning. Evidence-based investment management. Ongoing evaluation, monitoring, and adjustment. Those are our tools to help investors succeed. That doesn’t mean that there won’t be years when the market is down, but it does mean we will be better prepared and much less likely to make the mistakes which can make things worse.

Do Top Performing Funds Persist?

Posted On February 27, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

How do you pick the funds for your 401(k)? I know a lot of people will look at the most recent performance chart and put their money into the funds with the best recent returns. After all, you’d want to be in the top funds, not the worst funds, right? You’d want to invest with the managers who have the most skill, based on their results.

We’ve all heard that “past performance is no guarantee of future results”, and yet our behavior often suggests that we actually believe the opposite: if a fund has out-performed for 1, 3, or 5 years, we believe it is due to manager skill and the fund is indeed more likely to continue to out-perform than other funds.

But is that true? Do better performing funds continue to stay at the top? We know the answer to this question, thanks to the people at S&P Dow Jones Indices, who twice a year publish their Persistence Scorecard (link).

Looking at the entire universe of actively managed mutual funds, they rank fund performance by quartiles, with the 1st quartile being the top performing 25% of funds, and the 4th quartile being the bottom 25% of funds.

Let’s consider the “Five Year Transition Matrix”, which ranks funds over five years and then follows how they perform in the subsequent five year period. For the most recent Persistence Scorecard, published in December 2016, this looks at funds’ five-year performance in September 2011, and then how they ranked five years later in September 2016.

Here’s how the top quartile of all domestic funds fared in the subsequent 5-year period:
20.09% remained in the top quartile
18.93% fell to the second quartile
20.56% fell to the third quartile
27.80% fell to the bottom quartile
10.75% were merged or liquidated, and did not exist five years later

The sad thing is that if you picked a fund in the top quartile, there was only a 20% chance that your fund remained in the top quartile for the next five years. But there was a more than 38% chance that your top performing fund became a worst performing fund or was shut down completely in the next five years.

Another interesting statistic: the percentage of large cap funds that stayed in the top half for five years in a row was 4.47%. If you simply did a coin flip, you’d expect this number to be 6.25%. The number of funds that stayed in the top half is slightly worse than random.

The Persistence Scorecard is a pretty big blow to the notion of picking a fund based on its past performance. And it’s significant evidence that we should not be making investment choices based on Morningstar ratings or advertisements touting funds which were top performers.

Should you do the opposite? I wish it was as simple as buying the bottom-performing funds, but they don’t fare any better. Funds in the bottom quartile had a similarly random distribution into the other three quartiles, but had a much higher chance of being merged or liquidated.

There are a couple of possible explanations for funds’ lack of persistence:

Styles can go out of favor; a “value” manager may out-perform in one period and not the following period. Hence a seemingly perpetual rotation of leaders.
Successful managers may attract large amounts of capital, making them less agile and less likely to out-perform.
There may be more randomness and luck to managers’ returns, rather than skill, than they would like to have us believe.

Unfortunately, the S&P data shows that for whatever reason, there is little evidence for persistence. Investors need a more sophisticated investment approach than picking the funds which had the best performance. The Persistence Scorecard highlights why performance chasing doesn’t work for investors: yesterday’s winners are often tomorrow’s losers.

What to do then? We focus on creating a target asset allocation, using a core of low-cost, tax efficient index ETFs and a satellite component of assets with attractive fundamentals. What we don’t do is change funds every year because another fund performed better than ours. That kind of activity has the potential for being highly damaging to your long-term returns.

I hope you will take the time to read the Persistence Scorecard. It will give you actual data to understand better why we say past performance is no guarantee of future results.

Diversification and Regret

Posted On February 6, 2017 By Scott Stratton, CFP(R), CFA In Behavioral Finance, Portfolio Management / 1 Comment

Diversification is one of the key principles of portfolio management. It can reduce idiosyncratic risks of individual stocks or sectors and can give a smoother performance trajectory, or as financial analysts prefer to say, a “superior risk-adjusted return” over time. Everyone sees the wisdom of not putting all your eggs in one basket, but the reality is that diversification can sometimes be frustrating, too.

Being diversified means holding many different types of investments: stocks and bonds, domestic and international stocks, large cap and small cap, traditional and alternative assets. Not all of those assets are going to perform well at the same time. This leads to a behavioral phenomenon called Tracking Error Regret, which some investors may be feeling today.

When their portfolio lags a popular benchmark, such as the Dow Jones Industrials or the S&P 500, Investors often regret being diversified and think that they should get out of their poorly performing funds and concentrate in those funds which have done better. (Learn about the benchmarks we use here.)

It’s understandable to want to boost performance, but we have to remember that past performance is no guarantee of future results. Many people receive a snapshot from their 401(k) listing their available funds with columns showing annualized performance. Consider these two funds:

	3-year	5-year	10-year	Expense Ratio
S&P 500 ETF (SPY)	11.10%	13.55%	6.88%	0.10%
Emerging Markets ETF (VWO)	2.83%	-0.07%	2.24%	0.15%

Source: Morningstar, as of 2/06/2017

Looking at the performance, there is a clear hands-down winner, right? And if you have owned the Emerging Markets fund, wouldn’t you want to switch to the “better” fund?

These types of charts are so dangerous to investors because they reinforce Performance Chasing and for diversified investors, cause Tracking Error Regret. Instead of looking backwards at what worked over the past 10 years, let’s look at the Fundamentals, at how much these stocks cost today. The same two funds:

	Price/Earnings	Price/Book	Dividend Yield	Cash Flow Growth
S&P 500 ETF (SPY)	18.66	2.65	2.21%	0.33%
Emerging Markets ETF (VWO)	12.34	1.51	3.37%	5.09%

Source: Morningstar, as of 2/06/2017

Now this chart tells a very different story. Emerging Market Stocks (EM) cost about one-third less than US stocks, based on earnings or book value. EM has a 50% higher dividend yield and these companies are growing their cash flow by 5% a year, versus only 0.33% a year for US companies.

I look at the fundamentals when determining portfolio weightings, not past performance. If you only looked at the performance chart, you’d miss seeing that EM stocks are cheap today and US stocks are more expensive. That is no guarantee that EM will beat the S&P 500 over the next 12 months, but it is a pretty good reason to stay diversified and not think that today’s winners are bound to continue their streak forever.

Performance chasing often means buying something which has become expensive, frequently near the top. That’s why I almost never recommend sector funds or single country funds (think Biotech or Korea); the investment decision is too often based on recent performance and those types of funds tend to make us less diversified rather than more diversified.

Staying diversified means that you will own some positions which are not performing as well as others in your portfolio. When the S&P 500 is having a great year, a diversified portfolio often lags that benchmark. But, when the S&P 500 is down 37% like it was in 2008, you may be glad that you own some bonds and other assets.

We use broadly diversified ETFs and mutual funds, with a willingness to rebalance and buy those positions when they are down. We have a value bent to our weightings and are willing to own assets like Emerging Markets, even if they haven’t been among the top performers in recent years. Staying diversified and focusing on the long-term plan means that you have to ignore Tracking Error Regret and Performance Chasing. Just remember that you can’t drive a car forward by looking in the rear-view mirror.

Why We’re Adding Alternatives for 2017

Posted On January 1, 2017 By Scott Stratton, CFP(R), CFA In Portfolio Management /

For 2017, we are adding a 10% allocation to Alternatives to our Premier Wealth Management model portfolios (those over $250,000). The 10% allocation will be taken pro rata from both equity and fixed income categories. A 60/40 portfolio, for example, will have 6% taken from equities and 4% from fixed income, for a new allocation that is 54% Equities, 36% Fixed, and 10% Alternatives. We made some trades in December during our year-end tax reviews, and will make the rest of the trades in the next week.

Why Alternatives? The goal of Alternatives is to provide a positive return without being tied to the stock market or interest rates. Our aim is to diversify your portfolio further with a source of uncorrelated returns. Ideally, this can provide a smoother ride and dampen our portfolio volatility. (See Morningstar on Alternatives: When, Why, and Which Ones?)

That’s the goal, but investing in Alternatives poses its own set of unique challenges. Unlike stocks and bonds, there are many types of “Alternative” investment strategies. Alternatives is a catch-all category that encompasses everything from Real Estate, Gold, Commodities, Futures, Long/Short Equity, Arbitrage, to any other Hedge Fund process. And then there are multi-strategy funds which may combine four, five, or more unrelated strategies or managers.

Even within one category, some funds may do quite well and other funds poorly in the same year. That is a much smaller risk in equities, where, for example, most large cap funds are going to have a positive return when the S&P 500 Index is up and a negative return when the Index is down. In Alternatives, there is a wide dispersion of returns even within a single category.

Our view of Alternatives, then, is that it is a satellite holding that we want to employ tactically, rather than a core strategy that we hold at all times. We think the environment of 2017 could be just such a time to want to include Alternatives.

We enter the year with equities at or near their all-time highs and valuations somewhat above their historical averages. 2016 gave us a very nice return in US stocks: 9.5% in the S&P 500 and 19.4% in the small cap Russell 2000. The maxim that “the market climbs a wall of worry” definitely was the case in 2016. While the market confounds expectations frequently, valuations, not sentiment, are our guide to how we weight segments in our allocation. Valuations today, both relative and absolute, suggest diversifying from US stocks.

In fixed income, we saw a remarkable summer low in interest rates, with the 10-Year Treasury trading at a 1.6% yield. The second half of the year was painful for bondholders, with interest rates rising a full 1% on the 10-Year. It was such a dramatic move that we think it would be a mistake to think that interest rates can continue to increase at a linear projection of the past six months. Still, we may have just seen the end of the 30 year Bull market in bonds and that suggests expected returns going forward will be both lower and more volatile than historic returns.

Our goal within each portfolio is not only to grow your wealth, but to protect and preserve what you already have. Our modelling of adding the 10% allocation to Alternatives suggests that we can potentially reduce portfolio volatility and improve the risk/reward characteristics of our models. While that is no guarantee that returns will be positive in 2017, I want you to know that we are constantly monitoring, studying, and looking for quantifiable ways to better manage your money.

When would you not want Alternatives? If you went back to the lows of March 2009, the start of the current Bull Market, adding Alternatives would have held back your performance. They aren’t aiming to generate double digit returns, which you can sometimes get in equities on a snap-back like 2009. But that’s not where we are in January 2017. Today, with US stocks and bonds looking a bit expensive, we are looking to strengthen our defensive. (ICYMI, our Four Investment Themes for 2017)

As always, I’m happy to chat about your goals, the state of the market, or what we do in our investment management process. Give me a call or drop me a note. One of the reasons why we write about investing in the blog, is to communicate to everyone at the same time and then when we do have our next meeting or call, we can focus 100% on you and not the market.