Are Smart Beta ETFs Right for You?


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.

Exchange Traded Funds Gain in Popularity


According to a report from Blackrock this week, investors poured $347 Billion in Exchange Traded Funds (ETFs) in 2015. In recent years we have seen the shift from mutual funds to ETFs continue and even accelerate. While we don’t have numbers for mutual funds for 2015 quite yet, according to the Investment Company Institute, investors had already pulled $47 Billion from mutual funds as of November 30, 2015.

Even though ETFs continue to take market share from mutual funds, I find that many folks who have invested primarily in a 401(k) still aren’t very familiar with ETFs. Here are some of the reasons we are big fans of ETFs.

  • ETFs generally use passive strategies, such as tracking an index, or selecting stocks based on specific criteria. Since the majority of active managers fail to beat their benchmark over five years, passive strategies are a logical choice.
  • ETFs are very low cost, since passive strategies don’t require a large research staff or highly paid managers. And in a low return world, it can be very difficult for an actively managed fund with 1.10% in expenses to beat a passive ETF which has expenses of 0.10%.
  • ETFs are typically more tax efficient than mutual funds. Quite a few mutual funds distributed capital gains at the end of 2015. If you held those funds in a taxable account, you’d owe taxes, even though you didn’t sell any of your shares. If you had ETFs in your taxable account, your tax bill may have been much, much lower, or even zero.
  • ETFs offer diversification, transparent holdings, and style consistency. That’s why they make great building blocks to construct an efficient portfolio.

Wonder how your mutual funds stack up against ETFs? Call me for a free portfolio review and we will be happy to take a look and share our recommendations.

Why You Need to Drop Your Mutual Funds for ETFs


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.

6 Ways to Reduce Stock Market Risk


We had a roller coaster ride this past week in the market. Last Monday, the Dow dropped nearly 1000 points as investors spooked from the previous Friday’s sell-off sold positions en masse. By Friday, however, the major indices recouped their losses and several even finished slightly ahead for the week. Anyone who sold during Monday’s mayhem locked in their losses and lost out on the subsequent rebound.

No one can predict what the stock market will do in the future, so I genuinely believe it is futile to respond to this week’s activity by making trades. The media has detailed the concerns which “caused” the market to drop this week, but there are always going to be reasons which drive the short-term gyrations of markets. This noise can distract investors from staying focused on their financial goals.

After an extended period of low volatility, a tough week often raises questions about how much risk is in your portfolio and how a downturn might impact your ability to fulfill your financial objectives like retirement. Before we invest, we have all our clients take the FinaMetrica risk assessment to better understand your personal beliefs and comfort with taking risk. Given the choice, we’d all prefer to have less risk in our portfolios. The reality, however, is that the reason stocks outperform other asset classes is that stocks provide a risk premium – that is a higher rate of return – in exchange for the volatility and unpredictable path of their results.

I am always interested in ways of reducing risk. While I think investors will have the highest long-term return by embracing risk intelligently with a diversified, index allocation, the most important factor is actually each investor’s behavior. If you aren’t willing to stay invested through the inevitable ups and downs of the market cycle, you are likely to greatly hurt your performance. The most important part of my job is educating investors and encouraging them to stick with the plan.

Investors want options and we are happy to suggest ways to reduce risk. Below are six ideas to reduce price volatility in your equity portfolio. Just bear in mind that “there is no such thing as a free lunch.” While each of these approaches can reduce risk, some may reduce your return as well. The first three strategies can be applied to a traditional portfolio; the second three options are slightly more unusual and may be unfamiliar to most investors.

  1. Diversify. This is the most basic step, but forgetting this can be a big mistake. If you are investing in individual stocks, you are taking on specific risks that those positions could implode. This is an uncompensated risk which we can avoid entirely by investing broadly across the whole market. Over time, the majority of stock pickers fail to outperform the index. We prefer to invest in index exchange traded funds (ETFs). Diversification doesn’t always work quite as planned, but having non-correlated holdings improves the likelihood that when one category is down that other categories can offset or reduce those losses.
  2. Increase your bond allocation. The biggest impact you can have on your overall portfolio risk is by changing your asset allocation. We run five model portfolios: Conservative (35% equities/65% fixed income), Balanced (50%/50%), Moderate (60%/40%), Growth (70%/30%), and Aggressive (85%/15%). If you want to shift to an allocation with less risk, the best time to change would be when the market is up. Be careful, because you are most likely to want to change at a market bottom, which is exactly the wrong time to become more conservative!
  3. Consider Low Volatility ETFs. I’ve written about these previously. A Low Volatility ETF selects stocks from an index, but instead of weighting the positions by market capitalization, it weights the positions to emphasize the stocks with the lowest volatility. Historically, this process can produce a similar long-term return as a regular index, but with a somewhat less bumpy ride. How have they done recently? Over the past month, the iShares USA Minimum Volatility ETF (USMV) is down 2.72%, versus the iShares S&P 500 (IVV), which is down 4.80%. Year to date, USMV is up 0.83% versus IVV which is down 2.08%. In this time frame, the low volatility fund has been more defensive. However, you should expect a low vol strategy to under perform a traditional index fund in a bull market. For example, over the past three years, USMV’s annualized return of 13.59% has lagged IVV’s return of 14.50%. (Source: as of August 28, 2015)
  4. Bond + Options. Instead of buying an ETF that invests in the market, we can buy an option on the ETF or index. If you had $100,000 to invest in the S&P 500, we would purchase a zero coupon bond that would mature at $100,000 in several years. This bond would trade at a discount, say for $93,000. With the remaining $7,000, we would purchase an option on the S&P 500. At the end of the term, if the market was down, the option would expire worthless. However, you’d still get $100,000 back from the maturity of the bond and not lose any money. That’s a lot better than if you had put your $100,000 into an ETF, in which case, you could be down 30% or more. If the market was up, you’d receive the $100,000 from the bond and a gain from option on the index. While I love the simple elegance of this approach, there are three important considerations: i. With today’s low interest rates, the cost of bonds is quite high, leaving very little money to purchase an option. As a result, your option may not provide the same return as investing directly in the market. In other words, if the market was up 10%, your options may not return $10,000. ii. While this strategy eliminates stock market risk, it does introduce credit risk that the issuer of the bond defaults. iii. The option’s return will include price appreciation, but not dividends, so you will miss out on approximately 2% of yield that you would receive from investing in an ETF.
  5. Equity-Linked CD. This is an FDIC insured CD, but instead of paying a fixed rate of return (like 2%), the return is based on the performance of an equity index, such as the S&P 500. If the market goes down, you are guaranteed to get your original principal back. Even if the bank goes bust, your CD is insured by the FDIC like a regular CD. Before you get too excited about this option, let me explain that you do not get the full start-to-finish return of the index. Rather they have a formula to calculate the CD return. For example, a common approach for a 5-year CD is to add up the 20 quarterly returns of the S&P 500, subject to a cap of 5% per quarter. This sounds good, but there are three caveats: i. If the market is up 20% in a quarter, you only get credit for 5%. But if the market is down 20%, that is a minus 20% counted towards the sum. ii. Since this approach adds quarterly returns instead of multiplying, you miss out on compounding. iii. Again, no dividends. An Equity-Linked CD is not redeemable during the term, so your return is not guaranteed if you do not hold to maturity.
  6. Equity Indexed Annuity (EIA). Unlike the CD above where the return is unknown until the end of the term, most EIAs post a return annually using a “point to point” method. Typically this includes a cap on the annual return, and a floor of zero, so there are no negative years. These can be even more confusing than the CDs, however, because to access those returns and receive your money there may be withdrawal restrictions, surrender charges, and other complex rules. An annuity may work for someone who is close to retirement or in retirement and needing income with less market risk. For a younger investor, an annuity may not be the best fit.

The longer your time horizon, the less you should be concerned about short-term market volatility. We can implement any of these approaches for our investors and we’re happy to help you weigh your options to make the right choice for you. However, we don’t usually recommend numbers 4 through 6, because they’re likely to have a lower return. Let’s say that over 5 years, the market returns 8% a year, but one of these defensive strategies might only return 5%, because of no dividends (-2%) and because of caps or other weighting mechanisms (-1%). And over 5 years, that 3% difference in return on a $100,000 portfolio would make the difference between growing to $127,628 versus $146,923. What seems like just a small trade-off in performance becomes significant over time.

Risk may be a four-letter word, but you may be better served to think of risk as opportunity. This past week was a reminder that stock prices do go up and down, often randomly and sometimes quite painfully. This part of being an investor is challenging and frustrating, but also largely unimportant over time and out of our control. We are wiser to focus on the things we can control, including our saving, being diversified, and keeping costs and taxes to a minimum.

Fixed Income: Four Ways to Invest


Fixed Income is an essential piece of our portfolio construction, a component which can provide cash flow, stability, and diversification to balance out the risk on the equity side of the portfolio. Although fixed income investing might seem dull compared to the excitement of the stock market, there are actually many different categories of fixed income and ways to invest. As an overview, we’re going to briefly introduce the various tools we use in our fixed income allocations.

1) Mutual Funds. Funds provide diversification, which is vitally important in categories with elevated risks such as high yield bonds, emerging market debt, or floating rate loans. In those riskier areas, we want to avoid individual securities and will instead choose a fund which offers investors access to hundreds of different bonds. A good manager may be able to add value through security selection or yield curve positioning.

While we largely prefer index investing in equities, the evidence for indexing is not as conclusive in fixed income. According to the Standard & Poor’s Index Versus Active (SPIVA) Scorecard, only 41% of Intermediate Investment Grade bond funds failed to beat their index over the five years through 12/31/2014. Compare that to the 81% of domestic equity funds which lagged their benchmark over the same five year period, and you can see there may still be an argument for active management in fixed income.

2) Individual Bonds. We can buy individual bonds for select portfolios, but restrict our purchases to investment grade bonds from government, corporate, and municipal issuers. The advantage of an individual bond is that we have a set coupon and a known yield, if held to maturity. While there will still be price fluctuation in a bond, investors take comfort in knowing that even if the price drops to 90 today, the bond will still mature at 100. It’s difficult for a fund manager to outperform individual bonds today if their fund has a high expense ratio. You cannot have a 1% expense ratio, invest in 3% and 4% bonds, and not have a drag on performance.

Those are the advantages of individual bonds, but there are disadvantages compared to funds, including liquidity, poor pricing for individual investors, and the inability to easily reinvest your interest payments. Most importantly, an investor in individual bonds will have default risk if we should happen to own the next Lehman Brothers, Enron, or Detroit. Bankruptcies can occur, and that’s why we only use individual bonds in larger portfolios where we can keep position sizes small.

3) Exchange Traded Funds (ETFs). ETFs offer diversified exposure to a fixed income category, but often with a much lower expense ratio than actively managed funds. ETFs can allow us to track a broad benchmark or to pinpoint our exposure to a more narrow category, with strict consistency. Fixed income ETFs  have lagged behind equity ETFs in terms of development and adoption, but there is no doubt that bond ETFs are gaining in popularity and use each year.

4) Closed End Funds (CEFs). CEFs have been around for decades, but are not well known to many investors. Closed End Funds have a manager, like a mutual fund, but issue a fixed number of shares which trade on a stock exchange. The result is a pool of assets which the fund can manage without worry about inflows or redemptions, giving them a more beneficial long-term approach. With this structure, however, CEFs can trade at a premium or a discount to their Net Asset Value (NAV). When we can find a quality fund trading at a steep discount, it can be a good opportunity for an investor to make a purchase. Unfortunately, CEFs tend to have higher volatility than other fixed income vehicles, which can be disconcerting. We don’t currently have any CEF holdings as core positions in our portfolio models, but do make purchases for some clients who have a higher risk tolerance.

Where fixed income investing can become complicated is that within each category (such as municipal bond, high yield, international bond, etc), you also have to compare these four very different ways of investing: mutual funds, individual bonds, ETFs, or CEFs. They each have advantages and risks, so it’s not as easy as simply choosing the one with the highest yield or the strongest past performance. And that’s where we dive in to each option to examine holdings, concentrations, duration, pricing and costs.

There are other ways to invest in fixed income, such as CDs, or annuities, and we can help with those, too. But most of our fixed income investing will be done with mutual funds and ETFs. In larger portfolios, we may have some individual bonds, but will always have funds or ETFs for riskier categories.

Investors want three things from fixed income: high yield, safety, and liquidity. Unfortunately, no investment offers all three; you only get to pick two. Where we aim to create value is through a highly diversified allocation that is tactical in looking for the best risk/reward categories within fixed income.

Get Off the Sidelines: 3 Ways to Put Cash to Work


I know there are many investors who have a lot of cash on the sidelines. They may have raised cash fearing a pullback in 2014. Or maybe they made contributions to their IRA and didn’t invest the money because the market was at or near a high. Others sold positions once they reached their price targets and have been sitting in cash ever since.

Looking at today’s valuations, it’s a lot tougher to find bargains that seemed plentiful a few years ago. Unfortunately, holding cash cost investors plenty last year, when the S&P 500 Index was up more than 13%. And that’s the problem with trying to time the market with your purchases: you can miss a lot of upside by being on the sidelines, even if you’re out for a relatively short period.

If you have a significant level of cash in your portfolio that will not be needed in the next couple of years, it probably makes sense to put your cash to work. And while there’s no guarantee (ever) that the market will be higher in a month or a year from now, that’s the uncertainty that we have to accept in order to make more than the risk-free rate over time.

I can understand that putting a lot of cash to work at once is daunting when the market is up like it is today. So rather than thinking in black and white terms of all-in or all-out, let’s consider three strategies to help you get that excess cash invested prudently.

1. Dollar Cost Average. We invest in three tranches, 90 days apart, investing 1/3 of the cash position each time. This gives us the advantage of getting an average price over time. If prices drop, we can pick up more shares at a lower price.

Dollar Cost Averaging worked well in the second half of 2014, as we had cash to invest in October when the market was down 7%. Of course, there are also times when the market rises, and the lowest prices were available at the first trade date. In that case, Dollar Cost Averaging can increase your average cost basis.

2. ETF Limit Orders. One of the advantages of Exchange Traded Funds (ETFs) compared to Mutual Funds is the ability to use limit orders. If you believe there might be a pullback in 2015, place a limit order to buy ETFs at a set price or percentage below the current values.

For example, if you think there might be an 8% correction, we could set limit orders that are 8% below the current price of each ETF. This way we have a plan in place that will automatically invest cash if the market does in fact drop. Even though there is no guarantee we will have such a drop, this is still a much better plan than saying “Let’s wait and see what happens”, because when the market is down, people don’t feel good about making purchases. And recently, any corrections in the market have been short-lived, so there has been only a small window of opportunity.

3. Use “Low Volatility” ETFs. If the primary concern is market volatility, there are Low Volatility products can help reduce that risk today. These are funds which quantitatively select stocks from a broader index, choosing only the stocks which are exhibiting a lower level of fluctuations and risk. Low volatility funds are available in most core categories today, such as large cap, small cap, foreign stock, and emerging markets.

Over time, a Low Volatility index may be able to offer  similar returns to a traditional index, but with measurably lower standard deviation of returns. These ETFs have been available for only a couple of years, so this belief is largely based on back testing, and there’s no guarantee this strategy will work in the immediate future.

We should also note that a Low Volatility strategy is likely under perform in Bull Markets (think late 90’s, or 2009), and could lag other strategies for an extended period of time. Additionally, Low Volatility does not prevent losses, so the strategy could certainly lose money like any other equity investment in a bear market.

With those caveats in mind, I am happy to use Low Volatility funds if they give an investor some more comfort with their equity positions and the willingness to put cash to work. Time will tell if these funds are successful in achieving their stated objectives, but in my opinion, Low Volatility funds are among the more compelling ideas offered to investors in the past several years.

Each of these three strategies has advantages and disadvantages, and there is no magic solution to the conundrum of how to get cash off the sidelines today. My role is to work with each investor to find the best individual solution to move forward and have a plan to accomplish your personal goals. Luckily, we have a number of tools and techniques available to help address your concerns.

Three Studies for Smart Investors

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Over the last several years, my investment approach has become more systematic and disciplined.  In place of stock picking or manager selection, I believe clients are better served by a focus on strategic asset allocation. Today, we offer investors a series of 5 portfolio models, using ETFs (Exchange Traded Funds) and mutual funds. This approach offers a number of benefits, including diversification, low cost, transparency, and tax efficiency.

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This evolution in approach occurred gradually as a result of continued research, personal experience, and pursuing the goal of a consistent client experience.  In my previous position, I managed $375 million in client portfolios, performing investment research, designing asset allocation models, rebalancing and implementing trades.  I am grateful for having this experience and want to share the reasons why I believe investors are best served by the approach we’re using today.

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My investment approach is underpinned by three academic studies.  These studies look at long-term investment performance, are updated annually, and offer great insight into what is actually working or not working for investors. As an analyst, I am very interested in what data tells us, and how this may differ from what we think will work or what should work in theory.  But even if you aren’t a numbers geek like me, these studies instruct us about investor behavior and where you should focus your efforts and energy.  I’m going to give a very brief summary of each study and include a link if you’d like to read more.

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Published semi-annually, SPIVA looks at all actively managed mutual funds and calculates how many active managers outperform their benchmarks. The long-term results are consistently disappointing.  As of December 31, 2013, 72.72% of all large cap funds lagged the S&P 500 Index over the previous five years.
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Sometimes, I hear that Small Cap or Emerging Market funds are better suited for active management because they invest in smaller, less efficient markets.  This sounds plausible, but the numbers do not confirm this.  The data from SPIVA shows that 66.77% of small cap funds lagged their benchmark and 80.00% (!) of Emerging Market funds under performed over the past five years.

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The lesson from SPIVA is that using an index fund or ETF to track a benchmark is a sensible long-term approach.  Indexing may not be exciting or produce the best performance in any given year, but it has produced good results over time and reduces the risk that we select the wrong fund or manager.  Our approach is to use Index funds as a core component to our portfolio models.

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The other conclusion I draw from SPIVA is that if large mutual fund companies, with hundreds of analysts, cannot consistently beat the benchmark, it would be foolish to think that a lone financial advisor picking individual stocks could do better.

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After looking at SPIVA, it may occur to investors that 20-35% of funds actually did beat their benchmarks over 5 years.  Why not just pick those funds?  Why settle for average when you can be in a top-performing fund?
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The S&P Persistence Scorecard looks at mutual funds over the past 10 years.  At the 5-year mark, the scorecard ranks funds in quartiles by performance and looks at how the funds’ returns were in the subsequent five years. This tells us if a top performing fund is likely to remain a leader.

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Looking at all US Equity funds, we start with the funds which were in the top quartile in September 2008. Below is breakdown of how those top quartile funds ranked in the subsequent five years, through September 30, 2013:


1st Quartile:  22.43%
2nd Quartile  27.92%
3rd Quartile:  20.53%
4th Quartile:  16.71%
Merged/Liquidated:  12.41%
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Of the funds in the 1st Quartile in 2008, only 22% remained in the top category in the following 5 years.  29%, however, fell to the bottom quartile or were merged or liquidated in the following 5 years.  So, if your method is to go to Morningstar and find the best performing fund, please be warned,past performance is no guarantee of future results.  In fact, the Persistence Scorecard tells us that not only is past performance not a guarantee, it isn’t even a good indicator of future results.  The results above aren’t much different than a random chance of 1 in 4 (25%).  Albeit disappointing and counter-intuitive, the reality is that past performance offers virtually no predictive information.

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Now in its 20th year, QAIB compares mutual fund returns to investor returns.  The reason why they differ is because of the timing of investors’ contributions and withdrawals from mutual funds.  For example, people may think that it is safer to invest when the market is doing well and they buy at a high.  Or, investors chase last year’s hot sector and sell out of a fund that is at a low and just about to turn around.  Investor decisions are consistently so poor that we can actually measure the gap between the average investor’s return and the benchmark.  You might want to sit down for this one – over the 20 year period through 2013, the S&P 500 Index returned 9.22% annually, but the average investor return from equity mutual funds was only 5.02%.  The behavior gap cost investors 4.20% a year over two decades.
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I draw three very important conclusions from QAIB:
– We should avoid trying to time the market (buy/sell);
– Chasing performance is more likely to hurt returns than improve returns;
– Without a disciplined approach, including a target asset allocation and monitoring/rebalancing process, what may feel like a good investment decision at the time may ultimately prove to be a poor choice in hindsight.
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These three studies are so important that I carry excerpts from the reports with me to discuss with investors. They’re fundamental to my investment approach, and hopefully, their significance can easily be grasped and appreciated by all our clients.

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While we’ve focused exclusively on investment philosophy in this post, I would be remiss to not add that the benefits of working with a CFP(R) practitioner are not limited to portfolio management.  A comprehensive financial plan includes many elements, such as savings/debt analysis, risk management, tax strategies, and estate planning.  The investment management component tends to get the greatest attention, but the other elements of a personal financial plan are equally important in creating a foundation for your financial security.

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