14 Weeks of Summer, Week 7: Advice worth listening to?

I think one of the hardest issues to tackle with respect to investing is where to go for advice.  I’ve long struggled with how to guide people on this issue since what needs saying is often hard to hear or believe.  Unless you’ve spent years in the industry AND worked in many capacities across the various silos and business units, it’s truly impossible to fully understand how the sausage is made and therefore which sausage is worth eating.  The industry cranks out a LOT of sausage and very little of it is worth consuming, so I want to try and help save readers from at least indigestion, if not terminal food poisoning.

The thing about this industry’s sausage, to keep with the metaphor, is that it always looks so tasty, filling, and nutritious.  Unfortunately, the vast majority of it is downright toxic and should be treated the same as biohazard.  The industry is all about pumping out facts, figures, studies, opinions, strategies and using very smart, well-spoken, impeccably dressed people to deliver it.  They know your hot buttons and push them incessantly to get you to buy or sell whatever they want you to buy or sell.  So let’s get down to those individuals who actually deliver the messaging…

Let’s start with all those chief strategists, chief economists, and overall financial gurus we see paraded on CNBC and the other financial news outlets.  Did you know that most of them aren’t actual economists (not that being an economist helps anyone predict the future either)?  If they have a bachelor’s degree in economics they are leading the pack.  Most don’t even have that.  They are where they are because they are good communicators and they don’t question the fact that practically all their advice is pulled directly from their keesters.  The results of their advice?  Just what you’d expect…horrible.  Studies that track the predictions of the Wall Street chief strategists have shown that their predictions are mostly wrong.  Larry Swedroe, director of research of the BAM Alliance, follows the “sure thing” predictions of these gurus and finds that they are only right about 25% of the time – and that’s when discussing sure things!!  Better to throw darts or flip a coin, not take the advice of chief strategists or anointed gurus.

How about that portfolio manager who spoke at the last client event?  “It was the portfolio manager…in person.  Didn’t s/he sound really smart?”  Guess what…they all sound really smart and they are all really convincing.  It’s amazingly easy to sound smart when you speak a totally different language, and it’s amazing how “convincing” someone can be when you give them the title Portfolio Manager.  But the undisclosed truth is that many of these so-called portfolio managers don’t actually manage any money!  They are paid to travel around with the sales folks and sound smart while the real portfolio managers are kept behind closed doors at headquarters and do the actual work of underperforming (see my post from Week 4).  There is simply not enough time in the day to manage a typical investment strategy AND travel around and tell people about it.  There isn’t a single portfolio manager who would ever meet with you who actually manages the portfolio they are talking about.  Don’t be scammed.

What about all the stuff firms send around about various investment strategies?  The first thing you need to find out is who is publishing it and why.  If it’s internal research supporting their own strategy, you should always discard it as biased.  While it might be true, most likely it’s the result of overly mined data that has been flogged until it tells the story they want it to tell.  And if it’s coming from one of the big shot Wall Street firms, you can be assured it’s part of a marketing effort to sell a product so they can get commissions, ongoing asset management fees, or both.  The entire industry is geared around creating sales pitches about various investment theses that tap into either our fears or our greed, supported by compelling back-tests and analyses, but after a few years of live performance investors realize the whole idea was bunk and now they’re out fees, commissions, and relative performance.  If they’re lucky they also have a tax bill when they need to switch to the next great thing since even bad strategies can go up over time (just not as much as everything else).  Don’t be hoodwinked.

“Yes, but I trust my advisor.  S/he has been in the business for years and has lots of designations.  Plus, they couldn’t work at [insert name brand Wall Street firm here] if they weren’t well-vetted and above board.”  Hmmm, really?  Here’s the truth.  Barriers to entry for “advisors” in this industry are ridiculously low.  Licensing only requires regulatory and procedural knowledge and very little investment knowledge.  Most firms’ in-house training is sales training, nothing more.

Those letters after one’s name?  There are 175 different investment designations according to FINRA and a high number of them are from online self-study programs that one can complete in a weekend.  If it’s not the CFA designation for investing or the CFP designation for financial planning, pay it no mind (you can research investment advisor designations here).

And oversight?  The SEC is overworked, under-staffed, under-budgeted, and simply doesn’t have the resources to adequately supervise all firms and advisors.  Audits of firms are few and far between, and sometimes don’t come at all at the SEC level.  Also, the auditors usually don’t have the training, knowledge, or experience to identify wrongdoing even if they came across it except in the most obvious circumstances.  Heck, Bernie Madoff avoided scrutiny for years even with folks writing letters to the SEC about his Ponzi scheme!  At the state level things can be even worse since every state supervises investment firms differently.  And a recent study by three university professors found there is an uncomfortably high occurrence of misconduct and fraud in the advisory industry and many of those found guilty of something continue to work in the industry, often at the same firm.

So don’t trust your advisor because they sound smart, are likeable, have a bunch of letters after their name, work at a big firm, or have been around a long time.  Those things can all be good, of course, but look brokers up in brokercheck and investment advisors up on the SEC site to see if they’ve had to disclose anything.  Ask them tough, probing questions about their education, experience, and knowledge.  And definitely don’t let them wine and dine you to buy your appreciation of them.

Finally, take the recommendations of friends, family, and other professionals, but do your own vetting.  What might have worked for them may not work for you.  Finding a capable advisor requires effort, but this is your life savings we’re talking about so you need to do the up front work!

For those needing more specific guidance on choosing an advisor/advisory firm, I’ve written a shortpaper you should find useful.  It tells you what to look for and why, and even gives you one-page framework at the end to use in your search so you don’t forget anything.  Happy hunting!

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14 Weeks of Summer, Week 6: The Scourge of Investment Costs

Several years ago I wrote a paper on the various costs of investing, how controllable they are for investors and how important this issue is to your long term wealth.  While I encourage you to read the paper in its entirety (click here for the paper), let me give you a few of the highlights and then move on to a few additional observations.

Investment costs generally fall into four categories: advisory fees, expense ratios, trading costs/commissions, and taxes.  The first two categories can eat up 2-3% of your portfolio annually, trading costs can shave another 0.5-1% (or more, by some accounts), and the tax you pay is its own beast specific to your individual situation and requiring separate attention.  Conservatively speaking, I’d say most investors easily pay 2.5-3.5% of their total portfolio in fees/costs each and every year before taxes.  Most importantly, however, these costs can and should be under 1% total for every investor and we demonstrate how easy it is at Frontier Advisors, where we are able to reduce these costs by over 70%.  Every dollar not taken is a dollar saved to be spent elsewhere or, even better, kept in one’s portfolio to grow and compound over time, resulting in immensely more wealth over the years.

While I think the paper stands on its own as a comprehensive explanation of the costs investors bear, I’d like to make three additional points.  First is a bit of good news in that the pressure for costs to come down has been increasing.  The fiduciary rule that went into effect in June has brought much needed attention to this issue that won’t subside just because they revoke the rule.  Also, competition for investment dollars between active and passive and then within the active and passive philosophies themselves is creating pricing pressure.  Prices haven’t dropped as much as they should have in the active space given their abysmal performance, but in the passive world costs have come down considerably over the last several years.  At Frontier, the expense ratios of the passive tools we use in our portfolios have dropped by about a third since 2009!  In addition to expense ratios, trading costs are also decreasing.  Our clients pay around half of what they use to for equity trades!  I can’t speak to how trading costs may have changed at full service brokerages (my guess is that they are all still ridiculously expensive), but in the discount brokerage world, already nominal trading fees have gone way down.

Second, fee transparency is increasing.  The Department of Labor has added transparency requirements within the 401k world and all retirement assets should become more transparent if the fiduciary standard that took effect in June stays in place.  It’s important to remember, however, that the these transparency improvements only apply to retirement accounts (IRAs, 401ks, etc.) and NOT taxable accounts.  The SEC has yet to act at all in this regard, so most investment assets are as they were, but investors are at least becoming aware that something’s amiss in the investment world.

This leads me to my third and most important point.  Investors are woefully unaware of how much they pay and the industry continues to do all it can to make sure investors remain ignorant.  A 2017 survey by consulting firm Cerulli Associates found that about half of investors don’t know what they pay and half of those thought they didn’t pay anything at all.  I’ve encountered many advisors who can’t accurately explain the fees their clients pay and many who simply have no idea.  I have yet to encounter an advisor who thinks they or their firm should make less than they currently do!

For those investors who truly want to figure out what they pay, it’s incredibly difficult due to the lack of disclosure, the overall ignorance within the industry (can’t get a convincing answer to questions), the complexity of fee arrangements, and the lack of true honesty among many investment professionals who have a strong incentive to keep comprehensive cost information hidden.  There was a very eye-opening article recently in The Wall Street Journal by an investigative reporter who had an incredibly frustrating time trying to figure out what her own investment accounts cost her.  In the end, she couldn’t get a written answer indicating her actual fees (“What’s My Investing Fee?  A Frustrating Quest,” by Andrea Fuller, The Wall Street Journal, May 17, 2017).

And without a fiduciary rule requiring advisors to keep the best interests of clients in mind, ridiculously expensive products will continue to proliferate the market.  Examples are loaded mutual funds that take 4-6% off the top when purchased, private real estate investment trusts with their average 13% up-front fee, hedge funds with their 2% fee and 20% of profits structures, and variable annuities with their contingent deferred sales charges and loads of hidden fees within the products.

So consider yourself forewarned in case you didn’t already know that a huge problem exists around this issue.  And while there is pressure to reduce fees to some degree, I’m also seeing a growing movement to broaden service offerings to justify higher advisory fees or at least keep them from coming down.  So when you are presented with a long list of all the things a firm will do for you all for their li’l ‘ole 1% fee, know that most of it is bunk.  They are charging you an ongoing fee for one-time services that ought to be part of what they do anyway (planning discussions, review meetings) or actually fall to other, more appropriate professionals (tax and estate advising that should be done by CPAs and attorneys).  Instead, flip the question on them and ask them to justify in dollar terms the total cost of your investment portfolio and each and every service they  think you’ll need.  That exercise should be enlightening for both sides.

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14 Weeks of Summer, Week 5: Moving Beyond the Active vs. Passive Debate

As previously discussed, the evidence is overwhelming that passive tools are superior to their active counterparts.  But after we accept that truth we then need to ask: is it possible to maintain a thoroughly passive portfolio?  Is it even desirable?  The answer to both is a resounding no.

Let’s start by quickly tackling why it’s impossible to maintain a thoroughly passive portfolio.  The main reason is that we have no consensus on what that purely passive portfolio looks like.  Reasonable people can and likely will disagree about which asset classes should be included, how to properly define each asset class’s universe, which index most accurately represents each asset class, and even how far a portfolio can drift from “market” weights before we need to rebalance.  Each of these issues (and surely many more) involves active decisions, and so a purely passive portfolio is a mythical ideal.

Understanding that the purely passive portfolio is a myth, should we mourn our inability to achieve it?  No!  In fact, we should cheer that realization!  Being unable to produce a true representation of the market portfolio means we can devote our efforts to understanding the best way to put our passive tools to work while being true to what we know about why passive beats active.

Active decisions are always about risks – how much and what kind we want to take.  The risks we were debating in the active/passive discussion are the unsystematic ones, those that can be diversified away.  The passive side of the argument (and decades of financial literature) says that since you can diversify away all of them and are compensated for none of them, why take them at all?!?  But once in the passive realm, we are talking about the systematic risks…those at the market level, that can’t be diversified away, and that you DO get compensated for.  These are the risks we should be spending the vast majority of our time debating.  Even among these risks, some make sense and some don’t, but this is definitely the discussion worth having.

Examples of useful active questions are whether to tilt the portfolio toward smaller company stocks, whether to favor the value stock universe over growth, and which sectors of the bond market to include.  At the asset class level, one might consider commodities, precious metals, private equity, or real estate…all markets that could or could not be part of the “market portfolio” depending on how you look at it.  These discussions can be immensely stimulating and the literature is short on answers.  At Frontier Advisors we have our own answers to all these questions and more, and I’m happy to share those thoughts with anyone interested if you drop me a line.

So you can see that it’s not so much about active vs. passive but which active within passive, and what you decide can significantly affect your results.  Those who spend all their efforts on the active decisions that are clearly a waste of time and little to none on the ones that have the potential to add value are making a big mistake.  Be on the correct side of that line.

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14 Weeks of Summer, Week 4: Active vs. Passive Investing

This is the first of two posts on this subject.  Here I want to tackle why understanding this debate is not just relevant but crucial to all investors.  In the follow-on post I will ask you to rethink whether active vs. passive is really the debate we should be having!

Executive summary:  The only people who should be paying for actively managed strategies is…no one.  The likelihood that you will perform well enough to cover costs is so low it’s not worth trying, and the opportunity cost of doing so makes the gamble nonsensical.  Be smart and invest using passive tools.


For those who may not have an ear to this debate, the discussion about whether active investing (trying to beat the market via smart security selection) is superior to passive investing (trying to mimic the market return by investing in index-based strategies) is becoming deafeningly loud.  The flow of assets out of actively managed strategies is accelerating at the same time passive strategies are gaining more and more market share.  It seems every day there is another article in the mainstream media about this subject, with folks on either side of the debate arguing their case with an almost religious fervor.

Clearly there’s a lot at stake for both sides.  From an economic standpoint, active management has billions to lose annually if investors decide their approach is worthless.  The amount of money made by those on the active side is jaw-dropping and that all goes away if the wizard no longer has any clothes.  Well, folks, I’m here to tell you that the wizard better be wearing sunscreen, because he’s naked as a jaybird.  And if the wizard is as unclothed as I’m saying, why then do we need all those folks doing all that “work” that serves no purpose?  Quite simply, we don’t, and so they’ve dug in and are fighting tooth and nail to save their precious jobs and massive incomes.

Don’t worry, I won’t take you through the mountain of research that undresses the wizard of active management.  It’s out there for all to see in the dozens of books, hundreds of peer-reviewed research papers, and thousands of articles dating back many years and if you are truly interested I’m happy to direct you to the best of it.  But I do want to offer a few bits of information for the doubters to chew on so that perhaps they might begin to rethink what they’ve taken for granted all these years:

  • In each of the last 1, 3, 5, 10, and 15 year periods, well over half of actively managed funds failed to beat their appropriate indices (SPIVA U.S. Year-End 2016 Scorecard);
  • Most compelling are the 15 year numbers where in some categories of US stock funds, practically ALL (99.43% of small-cap growth) funds were beaten by their index and the best performing category saw only 21% of its funds able to beat the index (large-cap value);
  • Underperformance is pervasive across asset classes and geographies, so the argument that there are certain “inefficient” markets in which active does better is simply not true;
  • More than half of most active fund categories are either merged with another fund or liquidated (usually due to poor performance, lack of investor interest, or both) into another fund by the 15th year, meaning it’s a coin flip as to whether the active funds you hold today will be around later;
  • It’s been shown that true investment skill is extremely rare – most of the limited outperformance over any period is due to luck.  A famous paper from 2010 showed that only managers in the top two percentiles of performance evidenced a statistically significant amount of skill;
  • Outperformance that we do observe in one period is highly unlikely to persist into the next period…less likely than one would expect by chance alone (S&P Persistence Scorecard);
  • Because active managers as a whole have such poor performance numbers, the more active strategies in a portfolio the lower its chance to match the broad market.  One study by Larry Martin of State Street Global Advisors and highlighted in Rick Ferri’s book, The Power of Passive Investing, shows that a portfolio with 5 active strategies in it has only a 4% chance of outperforming after 10 years and only a 1% chance after 20 years…more strategies and those numbers go lower;
  • And while I’m not one to tout the opinions of gurus, it’s hard to ignore a few experts who know a thing or two and have come out in favor of passive: Nobel laureates such as Gene Fama, Dan Kahneman, Bob Merton, Myron Scholes, and Bill Sharpe; notable active investors such as Yale’s endowment chief David Swensen, Fidelity Magellan superstar Peter Lynch, and the king of active investing himself, Warren Buffett.

To me it all comes down to siding with the evidence rather than with the self-interested investment folks who are trying to keep their gravy train alive.  As Upton Sinclair once said, “It’s difficult to get a man to understand something when his salary depends on his not understanding it.”  I can’t understand why those who have heard these facts, and independently confirmed their truth, would ever invest any other way…unless, of course, their well-heeled lifestyles depend upon it!

The implications for investors are huge.  By one estimate, only 15% of regular investors’ assets are invested in passive strategies, so a whopping 85% are still focused on what has been called “the loser’s game.”  So not only are those assets invested in strategies that have a scary low chance of keeping up with the broad markets, those investors continue to pay those managers for underperforming.  The opportunity cost to investors is estimated to be in the tens of billions of dollars annually.

I’m not saying you should run out and sell your actively managed strategies, but you should definitely consider it after factoring in the tax costs of changing.  And I’m not saying you should fire the “advisor” who put you in all that junk, as you may be as much to blame as s/he is, but you should definitely question whether it makes sense to pay someone who either faces serious conflicts of interest, is ignorant of reality, or both.  And I’m not saying you should just give all your money to Vanguard to manage as there are shortcomings to that idea, too, but you could certainly do much worse.

Before you do anything, though, read my next post where I will discuss why active vs. passive is a false dichotomy.

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14 Weeks of Summer, Week 3: ETFs vs. Mutual Funds…Which is Better?

To keep this post reasonably short yet useful, I’m not going to spend time on defining or explaining the exchange traded fund (ETF).  If you want to learn more, a great place to start is ETF University at etf.com, or read The ETF Book, by Rick Ferri.

And for those who want the executive summary, here it is.  ETFs are better than mutual funds and should be the main tool for portfolio construction.  Criticisms of ETFs, even by the great John Bogle, are easily dismissed, and many criticisms are based on pure ignorance.  So, if you’re not using ETFs in a major way, you’re doing yourself a disservice.


ETFs seem to be getting a bit of bad press these days.  First is the question of ETFs vs. mutual funds and which is better for building a portfolio.  Then there are those who say that ETFs are an accident waiting to happen, or that they are going to be the undoing of the capital markets altogether.  I want to use this post to clear the air a little bit while giving folks some free advice.  Let me start by throwing this grenade: ETFs are in no way inferior to mutual funds and in many ways superior to them.  In fact, ETFs may be the best piece of financial engineering since the first mutual fund was created back in 1924.

Relative to mutual funds, ETFs are cheaper, more tax-efficient, more easily traded, and more transparent.  There are a few reasons one might want a mutual fund over an ETF (some asset classes, such as bonds, are better suited for mutual funds, a point I’ll leave for another day), but for the most part, ETFs should be an investor’s tool of choice for portfolio construction.

Cheaper.  The average ETF fee is about a third of the average mutual fund fee.  Much of that price difference is because ETFs are primarily passive vehicles while mutual funds cover both the active and passive investing worlds (I will tackle the active-passive debate in my next post).  If comparing an ETF with its comparable mutual fund then the fees are quite similar, but ETFs are most definitely not more expensive so overall they get the nod on the all-important price issue.

More tax-efficient.  Because of their unique structure (again, for a full explanation see the previously mentioned sources) ETFs are able to pass any internally-generated capital gains on to others, leaving investors fully in control of their own capital gains when they sell.  Mutual funds, on the other hand, are structured so that capital gains created from redemption activity by fund sellers must be passed on to current holders, creating capital gains and losses for which they were not responsible.  In the worst years, mutual fund holders pay taxes on capital gains without ever selling and when the price of their fund has dropped significantly!

More easily traded.  ETFs trade like stocks, so you can buy or sell throughout the day and you always know the price you are getting.  Mutual funds, on the other hand, are only bought/sold at the end of the day at the end-of-day net asset value, which is impossible to know when you place your trade order.  For mutual funds, it’s entirely possible that you buy or sell at a price very different from what you expected if the market moves significantly from when you placed your order.  Added to that, the mutual fund industry has been caught playing games around end-of-day pricing that significantly favored a few at the expense of the many (for more information, click here).  You can’t play those games with ETFs.

More transparent.  ETFs are required to publish their holdings daily.  Mutual funds, on the other hand, are not, and in most cases you will not know exactly what is in a mutual fund on a given day for at least a month.  So, when you buy your mutual fund you can only know what was in it thirty days ago rather than when you buy it, and you will only find out what was in it when you bought it thirty days later.  Rule number one in investing is to know what you’re buying, which is in some sense impossible with mutual funds.  Now try constructing a portfolio of several funds when you really don’t know what’s in any of them!  With ETFs you have no doubt what’s in it or whether its holdings conflict with others in your portfolio.

Yet there are critics of ETFs.  Perhaps the most famous is Jack Bogle, founder of Vanguard and champion of small investors everywhere.  While I agree with Jack on most everything, I do part ways with him on this issue although I understand his point.  His criticism is that ETFs are open to misuse because of the ease with which they can be traded.  While I don’t dispute that point, I contend that it is an easily overcome issue…don’t trade your ETFs.  Just because they offer that flexibility, it doesn’t mean you have to use it.  Consider antibiotics – overuse is a dangerous thing but we most definitely want them around!

The rest of the criticisms of ETFs seem focused on one of two things: pricing efficiency concerns arising from the massive flows from mutual funds into ETFs (driven by a collapse in confidence of active investing which again, I’ll address next time), or of trading glitches we’ve encountered a couple of times already in 2010 and 2015.  While these concerns are worth considering, in the end they are much ado about nothing.

The pricing efficiency critique is an interesting one.  The argument is that the ton of money flowing into these passive vehicles creates a false demand on all the underlying securities and pushes their prices up to speculative levels.  Simply put, a bunch of buy orders will drive prices up, creating a bubble that will eventually pop.  This is a variation of the concern that as the popularity of active investing wanes, there won’t be an adequate amount of price discovery in the markets and we will no longer know what the real price of anything is since nothing trades on their fundamantals anymore.  While all of this is fun to ponder, the bottom line is that there remains a more than adequate amount of price discovery out there and while things are shifting from active to passive, there are still plenty of active investors waiting to capitalize on any pricing discrepancies they find.  The number of trading strategies have never been higher, and so the tug of war for the price of any individual security is very robust.  Prices are as accurate as all the various opinions can make them, so those who worry about a “bubble” from the recent popularity of ETFs to me just shows their ignorance of how markets, and specifically, ETFs work.

With respect to the trading glitches the ETF system has encountered over the years, the only thing to say is that we are imperfect beings striving to be more perfect, working in imperfect markets that we are trying to make more perfect.  Stuff happens, and while I am quite confident glitches will continue to happen in the coming years as we uncover new ways markets can screw up, those who are smart and responsible actors who don’t overreact or get greedy in those rare moments when things go momentarily haywire have little to worry about.  In each “flash crash”, things corrected very quickly and the only folks who got hurt were the irresponsible or ignorant traders trying to take advantage of the situation.  The rest of us moved right through it as though nothing had happened and the industry then examined the situation and made improvements where necessary.  Beware the Chicken Littles screaming of a falling sky.

So, I encourage all investors to make ETFs their primary tool in portfolio construction.  They allow you to build extremely robust investment portfolios for almost nothing, with great liquidity, transparency, and tax-efficiency.  But one needs to do proper research, since only a small fraction of the over 2000 ETFs are worth investing in.  The vast majority are a combination of gimmicky algorithms, perhaps leveraged and risky or narrowly focused, or simply pointed at an inferior index.  It’s important to be very thoughtful if you want the best results, and above all else…be an investor rather than a trader.

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14 Weeks of Summer, Week 2: Diversified or Di-WORSE-ifed?

Diversification is an investment term most are familiar with, and it’s an issue all investors must confront.  Most simply, it’s the act of spreading risks out with the goal of improving one’s overall risk/reward ratio.  But in an effort to do just that, many investors end up “di-worse-ifying” (thank you Peter Lynch, famed portfolio manager of the Magellan Fund in the 1980s, for coining the term) their portfolios and hurting their risk/reward profile.  Scary thought: I have yet to encounter a prospective client portfolio who wasn’t diworsified in one way or another.  So what am I talking about?  Below I identify four of the most often seen mistakes made by professionals and non-professionals alike.

  1. Too many funds/strategies with a similar focus. Why does a portfolio need three US large cap value mutual funds in it?  At that point you probably own so much of the large cap value market you should just buy an index fund and be done with it.  Research shows that owning more funds within a market segment actually reduces the likelihood that you will outperform in that space.  The only time this diversification technique makes sense is if your goal is to transfer your wealth to as many different firms as possible.  Instead, you or your advisor figure out what focus areas you want in your portfolio, do the research up front to find the strategy that you have the most conviction in, and commit to it.  Anything else is lazy, indecisive, and ignorant.
  2. Diversifying with funds of funds or separately managed accounts. This strategy is the previous mistake on steroids.  Not only are you giving up all control of your portfolio by outsourcing allocation, security selection, and manager selection to third and fourth parties, you are also adding in a layer of fees.  Funds of funds are by definition lacking in any direction or overall wisdom since each manager within the fund of funds is singing his or her own tune.  There’s even a chance that they all end up owning a whole bucket of the same thing, so instead of diversifying you may actually be concentrating your portfolio in unintended ways.  And since they each charge a fee, and then the fund cobbling all the sub-advised funds together gets its fee, you pay twice for the freedom to give up your freedom.  And don’t be fooled by the sales pitch of getting “access” to great managers under one strategy – if they were so great they wouldn’t need to be part of a fund of funds and, in reality, they’d be closed to outside investors anyway.  Plus, access to managers isn’t the problem folks make it out to be.  So avoid this marketing gimmick unless, again, your goal is to enrich others.
  3. Diversifying across several advisors. It seems rational to avoid putting your nest egg in one basket by diversifying across a few different portfolio management firms.  However, doing so is just a way of avoiding the un-enjoyable work of figuring out who is actually the best at what they do and/or executes a strategy that makes the most sense to you.  It doesn’t actually reduce your risk, but instead it increases complexity, anxiety, confusion, and costs.  Finding the best portfolio manager for you is tough even for folks who understand this business, but it’s not impossible and it’s incredibly important to make the effort up front.  I will discuss investment manager selection in a later post, but for now I’ll just say do the work, commit to someONE (even if it’s yourself), and you and your portfolio will be glad you did.
  4. Diversifying across too many asset classes. I saved the best (worst?) for last.  The most frequent, but contentious, mistake I see in others’ portfolios is the attempt to diversify a portfolio across WAY too many investment categories.  No kidding, I once saw a portfolio that invested across over thirty different mutual funds with only minimal duplication (the first mistake I mentioned)!  Few in this industry will admit that the majority of what are termed “asset classes” are not at all helpful for most investment portfolios.  The truth is that you can do a fine job investing in as few as two very broad asset classes, and arguably better with just a small handful of perhaps 6-8 more finely tuned asset classes.  The usual asset classes to avoid include: commodities, currencies, most categories of bonds, all hedge funds (which are not even an asset class),  private equity, venture capital, and I’d argue even the growth and value categories of stocks (stocks are great, it’s the distinction between growth and value that is unhelpful).  So if your entire portfolio has a list of securities that requires more than a fraction of a page to list, you are probably diworsified.

The really disappointing thing is that there are plenty of investor portfolios out there making all four of the above diworsifying mistakes.  They own what I call a “kitchen sink” portfolio and when you have a little of everything, you get a lot of nothing.  No, that’s not true…what you get is a lot of expense, complication, friction, and headache if you are even aware of the monster that was created.  So if you are diworsified, do yourself a favor and pare down your portfolio to only those investments that serve a specific, intended, research-supported purpose, that are inexpensive and transparent, and are predictable and manageable.  And make sure they are stocks (blended rather than growth vs. value), certain types of high quality bonds, or cash.  You really can properly diversify your portfolio across thousands of non-overlapping securities in productive global markets with just a few holdings and for practically nothing.  Such a portfolio diversifies all diversifiable risks so that what’s left are the well-chosen risks you intended and that hopefully will reward you over time.  That kind of portfolio, I argue, has a far better chance of achieving one’s investment goals with far less stress than any diworsified portfolio might.

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14 Weeks of Summer, Week 1: Some Perspective on the Upcoming Fiduciary Rule

On June 9, 2017, the Department of Labor’s Fiduciary Rule goes into effect.  In short, it requires that anyone providing advice to tax-deferred or tax-free retirement accounts for a fee must put the investor’s interests before their own.  While the rule falls short of what’s still necessary, it’s a long overdue step in the right direction for investors.

Specifically, I expect the rule will eventually reduce (not eliminate, unfortunately) the conflicts of interest out there as the newly required disclosure will shine a blinding light on some very egregious practices.  It should also reduce costs as people become aware of the ridiculous fees they’ve been burdened with yet never knew (revenue sharing agreements, sales charges, high commission rates, and added costs from portfolio churn are but a few to pay attention to).  Lastly, I expect investors will have a better investment menu before them as the worst products and strategies will evaporate once people see them for what they are – yes, fixed-index and variable annuities, I’m talking about you!  When the salespeople have to justify a product’s costs to people who have the proper information in front of them, it will become obvious just how little value those products add.  The worst of them will fade away and what should remain are fairly reasonable strategies that have a chance of helping retirement investors.

But as absolutely necessary as this rule is, there is a lot of money being spent trying to bury it.  I’m actually surprised it’s going into effect on June 9, and its long term survival is far from certain.  The main opponents of the rule are the brokerage and insurance industries, as they have vested interests in keeping the status quo.  The rule will clearly impinge on how they do business, increasing their compliance costs, decreasing their profit margins, and exposing them to new legal liabilities.  They’d much rather keep their respective worlds opaque, their clients ignorant, and their margins high.  To do so, they are arguing that the new rule will increase investor costs, decrease or even eliminate access to advice for many, and reduce investor choices.  While there may be a strain of twisted truth to some of their claims, investors win across the board.  Costs will not increase relative to what investors currently pay unless investors are insensitive to price, but that’s not realistic.  Access to advice won’t be denied to investors who want and need it, although perhaps it will in the brokerage industry, but who cares?!  There will always be investment advisory firms willing to help, so I just can’t see that argument at all.  And choices may be reduced, but only by those products and strategies that never should have been around in the first place.  So don’t let their fear mongering sidetrack you from the truth.

The only complaints we should be hearing are 1) the rule doesn’t go far enough since it only covers retirement assets and 2) we should have had a fiduciary rule all along.  The fact that some investment advisors aren’t upheld to a fiduciary standard across the investment universe is unconscionable (fact: every fee-based Registered Investment Advisory firm is held to a fiduciary standard in all aspects of what they do).  But no sense crying over spilled milk.  This is progress in the right direction, so we should cheer this development while working to get the SEC to expand the fiduciary standard across the board.  The politics will be difficult, however…

Want more perspective on this and other important matters?  Read John Bogle’s book, Enough.  In it the Vanguard founder and former chairman shares his timeless insights on money/investing, business, and life.  He packs a ton of great insights into a short but essential read.

As always, feel free to send any questions or comments directly to me at rlesan@frontieradvisorsllc.com.  I’m happy to hear any feedback, good, bad, or otherwise, and I’m open to having my mind changed on this topic or any other.

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In case of emergency, walk, don’t run…or better yet, don’t go anywhere

Oil lower by over 50%.  Greece possibly leaving the Eurozone.  Hints of global deflation, especially in Europe.  Russia continuing to cause problems in Eastern Ukraine.  China feeling a slowdown coupled with concerns about its enormous shadow banking sector.  ISIL causing trouble in the Middle East.  Terrorist attacks in Paris.  Those are just a few of the reasons for folks to be worried these days.  It is no secret that I have concerns about the heights to which the markets have climbed without a significant pullback over the last several years.  Volatility since last October makes these concerns a daily preoccupation and the obvious question is what will I do when markets have a sustained sell off…will Frontier clients ride the markets down or will we jump to the sidelines?

Most answer this question in vague terms – saying something about evaluating risks, considering all variables, and standing ready to take action when things begin to go south.  While all that is good and well it avoids answering the question while implying that one will be able to correctly sell assets in front of a market drop.  I’d rather be very clear and very direct, despite the discomfort it may cause.  In short, I am not reducing exposure to stocks in the current environment and have no intention of going to cash if/when the markets take another nose-dive.  Predicting when markets are going to sell off is impossible, and predicting when they will recover is, too.  Attempting to do so and acting on such guesses with client assets is not investment management, it’s speculation management, and that’s irresponsible.

So yes, in a horrible market we will feel the pain while avoiding the temptation to sell.  But when markets recover, like they always have, we will fully enjoy that recovery rather than watching from the sidelines.  The mistake most investors make, and the mistake I refuse to make on behalf of Frontier clients, is to sell during a fire sale and then try to figure out when to get back in.  It is the clearest recipe for portfolio disaster there is, so it’s best to know now that I intend to avoid that mistake with any assets for which I have a discretionary mandate.

And by the way, a sharp drop in the markets is by no means preordained.  There are many folks out there who are amazingly optimistic about the future.  The US continues to recover from the financial crisis and is in decent shape by many measures.  Europe could actually change for the better if it figures out how to agree on a fiscal and monetary structure that actually makes sense, and Abenomics offers more hope for Japan than it’s had in years.  Yes, oil’s collapse will hurt the oil exporting emerging markets, but there are plenty of oil importing emerging markets that should hugely benefit from today’s low prices (India, for example).  So remain optimistic, but understand that when things hit the proverbial fan, we won’t react with fearful trading.

One final note.  This is not to say that I won’t rebalance client portfolios along the way.  Rebalancing is a key component of portfolio management.  I establish size limits around each holding, and when those limits are breached I do what is necessary to reestablish the portfolio weights.  In a down market it means I will sell some of any asset that has done relatively well and is above its target threshold to raise cash and buy more of any asset that is below its target threshold.  Maintaining one’s risk/reward objective is imperative during all market environments.

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What Frontier’s strategy is…and is not

This is probably no surprise, but I thoroughly enjoy talking about investing strategies with people.  I’ve realized over the years, however, that most don’t share this interest.  In fact, most are happy to know as little as possible about the strategy(ies) employed within their own portfolio and prefer to find someone they trust to deal with all of it on their behalf.  I respect that, and I truly appreciate it when I fill that role on behalf of Frontier clients, but I feel very strongly that all investors should have at least a general understanding of their investment strategy(ies).  Doing so will help one maintain confidence in it over time and hopefully be a check on the portfolio manager, to the degree that’s necessary.  So in that vein, I wanted to offer a short reminder of what Frontier’s strategy is and is not, hopefully buttressing your confidence after a year where your portfolio may have fallen short of its benchmark.

What the Frontier investment strategy is:

  • Low turnover – I put a lot of thought into portfolio positioning and will only change holdings for three reasons: the global economy is demonstrably evolving in a new direction, a necessary and superlative investment tool becomes available, or I’ve made a mistake. All three are rare, so changes in Frontier portfolios occur at a glacial pace.  The benefit of low turnover is a more predictable, transparent, and less costly portfolio.  It can be unsettling for those who think successful investing is all about doing something, but the truth is that successful investing is more about doing as little as possible for as long as possible.
  • Tax efficient – Frontier portfolios are built primarily with exchange-traded funds (ETFs), which are extremely tax-efficient due to their creation/redemption structure. I won’t go into how this works here, but ETFs are far more tax-efficient than mutual funds, which tend to pass along unwanted capital gains each year whether an investor has sold anything or not.  The flagship fund of one of my former employers just distributed $10.13/share, over 20% of the fund’s value, at the end of 2014…in a year where it underperformed it’s benchmark by over 8%!!  Mutual fund analysts expect last year to be one of the worst on record for capital gains distributions by mutual funds.  Frontier’s portfolios are insulated from this unwanted tax event and the ETFs in which we invest have yet to distribute any realized capital gains to shareholders.
  • Growth-oriented – our portfolios are designed to grow client assets. That can be a bad thing if you are only looking for capital preservation because it means you are taking on a certain level of risk that you may not desire.  But I have that discussion with clients before they become clients so there are no surprises.  The benefit is that we target the risks that are most likely to result in asset appreciation over time.  We diversify broadly so we minimize individual security/business risk, but we embrace the markets that have demonstrated (and where we believe they will continue to demonstrate) stronger growth than others.  If successful, clients and their beneficiaries will see much greater wealth in the future but with no more risk than necessary.
  • Transparent – again because of the ETF structure, Frontier clients know exactly what is in their portfolio every single day. ETFs have to disclose their holdings daily, whereas mutual funds only have to disclose quarterly, and even then with a 30-45 day lag.  Not only does this pose a problem from a risk perspective, it also makes it impossible to avoid overlap within the portfolio.  Frontier portfolios have zero overlap across asset classes, so we are fully in control of the risks we are taking on behalf of our clients.  Full transparency also eliminates concerns that a portfolio manager is engaging in “window dressing”, or moving securities in/out of the portfolio in order to look better to investors at the end of a quarter when holdings are disclosed.  If nothing is hidden, all is known, as it should be.
  • Mostly passive – while the Frontier strategy itself is by definition active, which is to say a Frontier portfolio looks different from the overall market due to portfolio manager decisions, we are building the portfolio using passive tools. That means the underlying pieces will get their respective markets’ returns, no more, no less.  But since two-thirds of those attempting to beat their market actually underperform (last year it was closer to 80%!), this is a much better way to construct global portfolios.  It’s been shown over and over again that the way most folks manage money is ineffective and damaging relative to a passive approach, and I can attest to that fact from experience, so why engage in what doesn’t work?
  • Inexpensive – because of the efficiency of the ETF structures used to build the portfolio, the cost of a Frontier portfolio is a small fraction of the industry average. The underlying expense ratio of a Frontier portfolio is less than 0.18% and shrinking every year.  That means more of your money remains in the portfolio working for you and compounding with the markets.
  • Elegantly simple. I’m a big believer in the beauty of simplicity.  Einstein used to say, “as simple as possible, but no simpler.”  Smart guy.

What the Frontier strategy is not:

  • Speculative – in my opinion this describes most strategies out there. They bett on short term predictions that have as much a chance of being wrong as right, and after costs they have a far greater chance of detracting value.  And it gets even worse as a typical portfolio manager outsources most of the portfolio to other portfolio managers, which turns it into what I call a speculation-squared strategy.  Not a good way to manage other people’s assets.
  • The kitchen sink – the portfolios that come to me usually have 15-30 various funds in them. It’s an attempt to cover all bases and expose the investor to everything under the sun.  They are described as “diversified”, but it’s quite the opposite.  The reality is that there tends to be considerable overlap from fund to fund, so what was meant to be diversifying actually increases risk.  Additionally, much of this “diversification” is nothing but low-growth, which eliminates the purpose in this portfolio manager’s opinion.
  • Short-term – we don’t get overly concerned with all the short term issues that preoccupy most money managers.  Basically anything mentioned on CNBC, Bloomberg, or Fox Business News can be ignored since it’s either speculative or short-term, or both.  What we care about are things that affect the long-term direction of asset classes and their interrelationships.  Short of that, the news is just noise.
  • Worrisome – the idea of full transparency, long-term thinking, and elegant simplicity is to remove the stress that normally accompanies a growth-oriented portfolio. Investing doesn’t have to be gut wrenching, but unfortunately for most that’s exactly what it is.  Hopefully  not for Frontier clients.
  • Composed of anything on FINRA’s watch list – FINRA, the brokerage world’s regulatory body, maintains a watch list of troubling strategies. On the list currently: smart beta, alternative mutual funds, variable annuities, non-traded REITs, structured products, and floating-rate bank loan funds.  None of those make investment sense and never had a shot of getting into the Frontier strategy, yet millions of investors are invested in them.  Why?  Because these kinds of products are sold, not bought.

While that doesn’t explain everything, I think it hits the high points.  Keep this piece handy if you ever forget what we’re trying to accomplish.  And don’t hesitate to get in touch if you’d like me to elaborate on anything in here.

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2015 Predictions

“Prediction is very difficult, especially about the future” – Unknown

Every time the calendar year rolls over, investment pundits scramble to explain last year and predict the next.  I spend the first couple weeks of each new year looking over these explanations and predictions as they come in, curious if any of them offer even a hint of usefulness to their audiences.  Some get a lot of attention from the media and the investing public, driving conversation and even investment action, for better or worse.  The truth is, it’s mostly for the worse.

Jason Zweig, the thoughtful author of “The Intelligent Investor” column for The Wall Street Journal (his column is always worth a read) had a good article on the subject on the last day of 2014.  It’s titled “Lessons From Year of Market Surprises,” and in it he recounts how poorly recent predictions have turned out.  He reminds us that interest rates were supposed to rise sharply in 2014 (they fell), oil prices were supposed to increase (they’ve been cut in half), and the stock market sell-off in October was supposed to be the beginning of a major correction (we’ve seen new highs since then, and the S&P 500 finished 2014 up over 13% including dividends).  Practically all the industry strategists predicted similar things, and they all got it wrong last year.

What about those portfolio managers who make a living off “forecasting” markets as part of their investment process?  They got pummeled last year by the very indices they were supposed to beat.  A lot of that is simply bad stock picking, but a good portion of it is also the result of forecasts that didn’t come true.  And 2014 wasn’t a fluke…actively managed strategies regularly fail to beat their appropriate indices.

Academics know how bad forecasters are.  Brad Barber of the University of California at Davis has thoroughly studied the subject and maintains that there is no evidence that analyst estimates or forecasts add any value.  Even folks whose job it is to issue forecasts don’t believe they are accurate.  Ed Lazear, a professor at Stanford’s business school and former chair of the Council of Economic advisors, has commented on how unreliable forecasts from the Office of Management and Budget, the Council of Economic Advisors, the Congressional Budget Office, and the Department of the Treasury are and that “government forecasters might as well use a Ouija board.”  Data reveals that the investment industry is no better at it.

My own personal experience with forecasting supports the research.  At every previous firm for which I’ve worked, we always had our own forecasts.  It’s a core part of what any typical investment firm does, and it tends to drive portfolio strategy at firms with centralized money management.  What’s more, if done rigorously, it drives analyst research on individual securities when the firm’s forecasts are used as inputs for each analyst’s modeling efforts.  Predictions over the short and medium term have a considerable impact on asset allocation decisions and security selection.  The dirty secret, though, is that the forecasts driving our models and portfolios were often incorrect.  There was always some curve ball thrown at us during the year for which we had not accounted, significantly impacting returns.

Those return effects were sometimes positive and sometimes negative.  But it didn’t matter because our marketing group always figured out a way to explain our missed forecasts so we didn’t look as clueless as we actually had been in the case of negative impacts, or we looked smarter than we actually were when events helped out our portfolios.  Clients were never the wiser…while the industry is lousy at forecasting the future, it’s very good at making folks believe it can.

As you can probably tell by now, the title of this piece is somewhat misleading…I’m not about to make any projections for 2015.  Knowing the impossibility of doing it accurately, it seems a foolish exercise and a general waste of time, yours and mine.  Unfortunately, the rest of the industry doesn’t feel the same way.  Pundits are all cranking out their predictions as if they know something everyone else doesn’t, and they are juggling their portfolios based upon their crystal ball.  Rather than investment portfolios, most investment managers create speculation portfolios, and that is immensely troublesome.

The reality, however, is that responsible portfolio managers do need to look out into the future and consider how the world might evolve.  But that means well into the future…5/10/15 years out, and think about the really big things that change glacially, not what might happen over the next 6-18 months.  It’s those longer term issues that we can have a better idea about since they change slowly and require an incredible amount of variables factoring into their development.  Over time we can watch things evolve and gain a level of confidence that our strategy is positioned to benefit from those developments.  And if things begin to go in a different direction, because of the sheer number of variables involved we can have a certain amount of confidence that the game has changed and we need to change with it.

Realize, too, that it’s unlikely that we’ll be ahead of it all (unless we get lucky, which does happen from time to time), but I don’t think that’s the job of a responsible portfolio manager.  Portfolio managers should be making every effort to get his/her clients their fair share of global growth, not gambling with their clients’ assets by trying to predict the unpredictable.  And besides, the data is clear that those who try the latter always lose over the long run.  And so do their clients.

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