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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Frontier Advisors Strategies Turn 4 Years Old!

I want to report on how the models I’ve created for managing client assets have performed now that they’ve established a long enough live history to be relevant. I’m the first to admit that 4 years is still very short in the investment world, and no one knows what the future holds, but I’m happy to say that since Frontier Advisors has been in business, our strategies have done what I hoped and expected they would.

FA model performance 4yr

So what should one take from this performance history? Let me start with what NOT to take from it. First, don’t extrapolate past gains into the future. The last four years have been recovery years for the markets and I doubt we’ll see annualized returns like this going forward. Second, I also don’t know if it’s smart to expect this magnitude of relative outperformance from the equity side of things. While I do expect Frontier’s equity strategy to do better than its broad, global, cap-weighted benchmark over time for several reasons (happy to discuss with anyone interested), we may be looking at a fortuitous time period for performance measurement. It’s important for one to have appropriate expectations.

What I DO hope you will take from this, however, is that beating a global equity benchmark doesn’t require most of what the investment industry tells people it does. It doesn’t require a tactical strategy where a portfolio manager or investment committee decides when to get in and out of certain markets throughout the year only (I have avoided making a single market timing call over the last four years) – the overwhelming majority of evidence shows these strategies don’t work. Beating a benchmark also doesn’t require a time-consuming yet futile effort to find superstar fund managers to control pieces of the strategy, an effort that only serves to drive up costs, turnover, and taxes (I used only low-cost index strategies the entire time, with an average expense ratio well below 0.20% and an irrelevant amount of turnover and tax exposure). By the way, outsourcing parts of the portfolio to others also dramatically reduces a portfolio’s transparency, making it impossible to fully control the sources of risk and return. Finally, beating a benchmark doesn’t require one to buy into the latest investment fads such as dividend- or income-yielding strategies, inflation-protection, hedge funds, etc. Again, all those strategies do is drive up costs, reduce transparency, decrease liquidity, and add stress to an endeavor that is already stressful enough.

What benchmark-beating portfolio management does require is 1) a firm knowledge of how asset classes perform in general and relative to others over time, 2) a focus on keeping all investment costs as low as possible, and 3) the discipline, patience, and perspective to avoid overreacting to the overwhelming amount of noise emanating from the investment marketplace. It’s easier said than done since the hardest thing of all is to avoid our natural inclination to “do something” all of the time, but so far so good…

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A good use of two minutes…

Here might be the most insightful two minutes I’ve heard in a long time.  It’s an  NPR commentary from Bob Reich, a professor at UC Berkeley and the Secretary of Labor under President Clinton.  Basically, he’s saying that both the Democrats and the Republicans have the wrong solution for our job shortage and, therefore, our sluggish economy.  The problem is that the middle class has been languishing for thirty years – their wages have been stagnant or declining in real terms – and they simply can’t spend more, regardless of how much stimulus the government uses to prime the pump via added spending or reduced taxes.  Until we figure out how to get a larger share of GDP going to a broader segment of Americans, our economy will be unable to grow the way we both expect and need it to.  I’d love to see our candidates debate THAT issue.

Incidentally, there are huge investment ramifications to this observation.  A sound middle class is crucial to a healthy economy and therefore healthy markets over the long term.  Those economies structured in a way that maintain a healthy middle class have the best chance for success (all else equal), while those with policies, governments, private sectors, etc. that don’t support a strong middle class are destined for trouble.  Portfolio managers should always include a close evaluation of this issue when making long term strategic investment decisions.

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Knowing what we don’t know

There was an interesting article in the New York Times a few days ago (“Testing What We Think We Know”) that discussed the exorbitant amount we spend on medical procedures that don’t do what we thought they would.  Often times they turn out to be less effective than originally thought, and frequently there are unpredictable negative consequences that result from these procedures.  The article makes the point that we should spend more effort determining if a particular course of action is likely to achieve its intended results before advising to do the procedure.  Doing so could save an incredible amount of money while improving healthcare overall.

So what is the connection to the world of investing, you might ask?  Investment professionals regularly advise courses of action to investors with very little concrete evidence that the particular advice will achieve the intended results.  In fact, often times there is ample evidence that the advice is unlikely to achieve the desired results yet the advice is given anyway, either due to poor judgement, ignorance, or a variety of other less honest reasons. When I see investors flocking to today’s popular strategies: low-volatility, tactical allocation, fundamental indexing, absolute return, inflation-hedging, principal protection, and anything classified as “alternative”, I am amazed at the inability of those investing in these products and strategies to explain what they are, how they work, why they think they should/could/would work, or what evidence there is to support the strategy.  And when you do find support for a particular strategy, it is often one-sided and fails to address the tough and most important questions about it.

Financial engineering today is as significant as it ever has been, and the marketing efforts behind a given strategy are very convincing.  Investors who aren’t appropriately skeptical, knowledgeable, and analytical might easily believe the hope and hype that comes along with each new thing.

So to mimic the author of the NYTimes article, my proposal is that investors adopt a healthy skepticism for any and all “new” strategies that are brought before them and even review what they currently own even if it’s been around a while.  Chasing an investment idea that looks good on paper or sounds good in a sales pitch, even if accompanied by lots of fancy charts and data, should be considered flawed until the support for it is verified independently and all costs of the strategy are taken into account when figuring performance results.

We in the investment industry are in a far more beneficial position than those in the medical industry in that we have ample data and years of history to help us understand whether a particular strategy is likely to deliver the desired results.  We just need to have the intellectual courage coupled with a little analytical capability to identify the difference between reality and marketing hype.  In the end, significant costs can be avoided and portfolio performance improved.

Posted in Investment Philosophy, The Business of Investing | Comments Off on Knowing what we don’t know

Calculating advisory fees fairly for both client and advisor

Most investors who have their portfolios managed by “fee-based” investment managers should wish the second quarter of 2012 ended a day earlier.  Today, the last day of this quarter, the global equity markets are up over 3%.  Since the vast majority of fee-based investment firms calculate quarterly advisory fees off of client balances at market close on the last day of the quarter, many investors just paid their advisors 3% more simply because the last day of this quarter was exceptionally strong.

Of course, the last day of the quarter could just as easily have gone the other way and their advisors would have been paid that much less for the previous quarter’s work, and it sometimes does work out that way.  But since markets tend to go up more than they go down, this arrangement looks to favor the investment firms as far as fee calculations go and it has nothing to do with the skill of the advisor.  It is purely at the whim of the markets.

Consider another issue, client additions and withdrawals.  If all that matters for a fee calculation is the dollar value in accounts at a single point in time, investors should withdraw funds prior to that quarter-end date and only add funds after that quarter-end date to game the system properly.  Conversely, investment managers should not send client funds out of accounts until after that quarter-end date and try and convince clients to add to their accounts before the new quarter starts.  It’s silly gamesmanship that likely doesn’t amount to significant dollars for either clients or advisors, but nevertheless it’s an example of how clients and their investment managers sit on opposite sides of an issue.

But is there a better way?  Of course there is.  Firms could calculate fees based on the average daily balance in client accounts.  This way, the advisory fees charged most accurately reflect every impact of the advisor’s investment decisions as well as properly billing based on cash flows into and out of accounts.

If the advisor bills off of average daily balances it minimizes any incentive either side has to “game” the system.  Clients can then put money in or take money out based on things that actually matter rather than trying to minimize advisory fees paid.  They are likely to put money in sooner and take money out later, as it should be if one wants maximum exposure to global growth.  And advisors can focus on properly managing the assets without feeling the conflict between doing the right thing for their client versus doing the right thing for their paycheck.

So ask your advisor how s/he calculates your fee: is it based on a single point in time or the average daily balance of assets over the billing period?  If it’s the former, ask them why they don’t do it the other way.  It’s easy enough to bill based on the average daily balance, so there really is no reason other than laziness or lack of desire.  In fact, clients should demand it.  It’s the right thing for advisors to do.

Posted in Ethics in Investing, The Business of Investing | Comments Off on Calculating advisory fees fairly for both client and advisor