In a recent public gathering of well-known portfolio managers sponsored by Bloomberg, Bogle criticized ETFs as “the best trading innovation of the 21st century” while castigating the entire class of securities as harmful to long term investors because they encourage frequent trading and because there are too many lousy choices on the market.

I fervently support his philosophy against frequent trading and agree wholeheartedly that there are far more lousy ETFs on the market than good ones.  Having said that, I will argue as loudly has he argues his points that ETFs are empirically a better investment vehicle than any other and should be an investor’s first choice when getting exposure to most markets.  In fact, I challenge him or any other to show me one way that the ETF structure is inferior to the beloved mutual fund.  It can’t be done.

ETFs offer more transparency, more liquidity, more tradeability (can be a double-edged sword, but all in all is an advantage for prudent investors), more tax-efficiency, and more flexibility for the same or less expense than one can get through mutual funds.  It’s empirical and unequivocal and frankly, isn’t worth even arguing about although I’m happy to any time!

But Mr. Bogle is harping so loudly about how ETFs can be and often are misused by the investment industry and the public that I am concerned he is steering many in the wrong direction instead of objectively educating them on how to use ETFs correctly.  Yes, if used ignorantly ETFs enable many to speculate in ways they couldn’t before, and in a rush to gather assets the industry is pumping out incredibly ridiculous products that appeal to whatever the trend of the day is.  But the cliche “guns don’t kill people, people kill people” always comes to mind as the proper retort when he starts talking about all the ways one can misuse an otherwise smart and efficient structure.  We should not broadly denounce ETFs any more than we should denounce firearms.  Yes, the ETF stockpile has its own form of fully automatic weapons that have no logical use for rationally-intended investors, but we shouldn’t throw the baby out with the bathwater.  Just like with firearms, we should preach and teach safe-handling and their merits while educating about how to avoid misuse and the consequences thereof.

After a long career in the investment industry, I have first hand experience in all the ways the industry fleeces investors and how misguided the vast majority of both professional and non-professional investors are and can be when putting money to work in the public markets.  But I am as big an advocate of ETFs as there is because they are, to date, the smartest way for anyone to access the markets when looking to do so in a diversified, transparent, and low-cost way (which, incidentally, is how we should all be looking to get market access).

I will not deny, however, that investing in ETFs is like investing in anything and requires knowledge and perspective to avoid making costly mistakes.  The industry is constantly working against investors by adding complexity and creating impediments to lower costs as best it can, and investors have to remain vigilant while understanding how the game is played.  The investment industry is NOT on the side of investors, no matter how much money it spends on marketing messages that say otherwise, but that doesn’t mean investors can’t find a tool or two that gives them at least a fair chance at achieving their objectives.

In terms of the valuation issue, let me go on record as saying that if someone from Morgan Stanley (the lead underwriter of the offering) showed up and offered me shares of FB during the IPO at today’s valuation, I’d tell him or her to take a hike.  At the risk of being criticized for not “getting” the whole social media revolution thing, I think it’s far more prudent to proceed cautiously with regard to the impact the social media movement will have on the sale of goods and services.

Don’t get me wrong, I think Facebook is revolutionizing communication and information transfer, and a certain portion of that will benefit sales and marketing.  But I also think that a good portion of the advertising dollars beating down Mr. Zuckerberg’s door is unlikely to have the desired effect of moving more product or selling more services.  According to the aforementioned article, the value of Facebook is its platform’s ability for users to reach out to others about something they like or don’t like.  While I wholeheartedly agree with that observation, that kind of grass roots advertising is very different from the kind of advertising a company can control and might actually pay for.  Grassroots advertising happens when the quality and utility of a good or service is so great (or poor) that people are moved to tell others about it.  So why then are these companies spending their resources on Facebook advertising instead of efforts to improve the goods and services they offer?

Were firms to shift their Facebook advertising budget to R&D, or anywhere else that improves the quality and delivery of their goods and services, not only would they likely get more mileage out of the Facebook platform, but perhaps we would see positive changes on a broader scale.  Doing so might increase the availability of high quality jobs we’re looking for in this country (and elsewhere), it might improve the quality, availability, and choice of goods and services broadly, and it might actually add value to the global economy in a measurable way.  Of course, such a view means Facebook’s valuation should be far lower than its current estimates, but I think Mr. Zuckerberg and others will get along just fine.

So is there anything wrong with that logic?  For starters, many of the companies in the high dividend category are there because their stock price is so depressed that any dividend will be a larger percentage of its stock price than it normally would (dividend yield, the measure used to compare one stock’s dividend to another, is calculated by dividing its annual dividend by its current stock price).  That’s not necessarily bad if the stock price is irrationally oversold, but what if it’s not?  This is the inherent risk of value investing, that the stock price is low for a reason and likely to stay that way.  If it’s low because the company is truly in trouble, not only will the stock price stay low or go lower, but the company may very well cut its dividend as it tries to fix the company.  Hopefully, good research can help avoid that outcome, but many have tried and failed disastrously.

What about the idea that high dividend companies are more stable and better managed than others?  This is simply one of those statements that is overly broad and unjustified.  While many of the high dividend firms are quite stable and well managed, there is certainly no evidence that it is the case for all or even a significant number of them.  And even if it were, things change all the time so that there is no way of knowing whether that will be the case a year from now – companies change, management changes, stock prices change, dividends change, etc.  And large, stable companies, while sounding great in a volatile stock market environment, don’t necessarily offer the longer term growth that most stock investors desire.  They have a much harder time consistently offering the double-digit growth that many want and need if they expect their portfolios to give them the retirement nest egg they want to have.  Consider a company with $100 billion in market capitalization…how likely is it to grow another $10 billion next year (a 10% gain), and then $11 billion the next (another 10% gain), accelerating each year just to offer similar percentage gains in stock price?

As for the logic behind replacing yield from investors’ bond portfolios, that might work for a little while, but eventually bond yields will normalize and when that happens, money will likely flow back into bonds, creating downward pressure on those stock prices as it moves from one to the other.  The income one receives in dividends over their holding period could very easily be given back in capital losses down the road.  Using stocks to replace yield in bonds is a dangerous notion and one that investors should seriously consider before doing so.

Finally, those managers who are building portfolios out of those large and supposedly stable high dividend stocks are doing so from a very limited universe.  Of the nearly 5,000 non-real estate, US-domiciled stocks trading on the NYSE/AMEX/NASDAQ, only 53 have dividend yields of 3% or greater as of this writing.  Again, that may not be a bad thing, but concentrated portfolios are considered riskier than diversified ones, which is contrary to the logic behind dividend investing.

So, before you get too excited about the latest idea from investment “professionals”, think about all the angles.  I doubt most of those “pros” have.

So what advice did he offer?  In short, he said we should maintain well-diversified portfolios that are invested in undervalued, high quality companies with good fundamentals, strong cash flows, great balance sheets, good management, and a global footprint.  And for an added measure of safety, tilt your equity portfolio heavily toward companies that have large and growing dividends.

Really?!?  That’s it?!  So, investors aren’t supposed to look for overpriced stocks of low quality, poorly managed companies that are heavily indebted and generate no cash?  And if they offer no dividend then that makes them an extra good find?  Really?!

He should have just saved us all some time and said: “Invest in things that go up.”

But as lame as his advice was (and by the way, he also droned on about what his company’s predictions for various asset class benchmarks would be at the end of 2012 – and this kind of advice is particularly ridiculous and never reliable), the worst part of the whole thing was the lack of pushback from those in the room.  I didn’t criticize in the meeting because I wanted to play nice since I used to work with the guy, but there were half a dozen other people in the room who certainly could have pointed out the silliness of it all.  And yet, no one did.

I guess this speaks to why the vast majority of investors seriously underperform the broad market: they listen to lousy advice and don’t think enough about it to recognize just how lousy it is.  Until investors start thinking, and forcing those they hire to manage their money to start thinking, they shouldn’t expect anything different.

We’ll see what comes of this, perhaps not much, but I support anything that brings more transparency to the events of the last several years and requires those responsible to admit their role in it all.  I hope Judge Rakoff’s decision moves things in the direction of bringing about responsible, fair, and adequate settlements that add transparency to all that has happened.  And, when people learn more about what these firms have done, maybe they’ll begin to vote with their feet and checkbooks and take their business elsewhere as I did earlier this year when I dusted Bank of America off the bottom of my family’s and my firm’s shoes and gave my business to a firm I can trust and respect.

In the meantime, cheers for Judge Rakoff!  And boos for Citigroup and the SEC.

But is managing your own assets really the right choice for you?  It’s a very important question and one that few people spend enough time thinking about.  First, there are ways to discern good asset managers from bad so you don’t have to suffer unethical or incompetent management (see our shortpaper on Evaluating Investment Firms).  Second, and perhaps most relevant, is that managing money requires significant time and know-how if you are to do it properly.  It isn’t something to take lightly, especially if your asset base is significant.

Our latest shortpaper discusses the issues involved with do-it-yourself investing.  It is not our opinion that investors should always hire a portfolio advisor.  It is our opinion, however, that investors need to know what they are getting into before taking on DIY responsibilities.  Too much is on the line, and it’s far too easy to make mistakes that can cost dearly.  Armed with an understanding of what properly managing a portfolio entails, investors can make the right decision for themselves and their assets.

To read our shortpaper on the subject, click on this link:  DIY Investing

Here is a brief shortpaper, Measuring Performance (also available in the Research section of the Frontier Advisors website), that addresses the most important issues on the topic.  Hopefully there won’t be anything in there you didn’t already know, but I don’t expect that to be the case for most.  If your portfolio is managed by others, you can use the information in this shortpaper to press your investment advisors on their own measurement processes.  Ask them directly if they follow industry standards for performance measurement, and have them justify the benchmark(s) they use for comparison.

Only by properly measuring performance will you be able to accurately identify areas for improvement, either within the portfolio itself or perhaps even with the person or team overseeing your portfolio.  Measure, adjust, and then measure again, over time.  It’s an ongoing process that is absolutely critical for any successful investment process.

Here is a case in point.  I’ll pick on Richard Bernstein because both his 2010 predictions and his 2011 predictions are readily available.  Richard Bernstein, by the way, was the Chief Investment Strategist at Merrill Lynch, so it was in his job description to publish a list of annual predictions, and he continues making them to this day.  To his credit, he does call his predictions “guesses” and so that earns him points in my book, but I’d rather he didn’t publicly “guess” at all.

Looking over his predictions for 2010 he was only about 50/50, and that is if I give him credit for a few of his predictions that my dog could have gotten right.  The first on his list, for example, was that “stock and bond market returns will again be positive.”  Since the S&P 500 and Barclays Aggregate Bond indices have been positive in 79% and 94%, respectively, of their full calendar years since 1976 (that’s as far back as the Barclays/Lehman Aggregate data goes), it’s easy money to say they’re likely to go up in any subsequent year and so this probably shouldn’t even count as a prediction.

In another he predicted that “treasuries will probably underperform stocks.”  This one, too, seems like a lock since 1) most assume that stocks usually trump treasuries and 2) every market guru has been predicting an imminent crash in treasuries for over a year now (see my previous post entitled “Beware geniuses”).  But, giving him the benefit of the doubt that he was referring to long treasuries (they have the best chance of outperforming stocks in any given year) since he didn’t specify, the S&P 500 only beats a long treasury bond index a little more than 50% of the time on a calendar year basis (55.6% to be exact).  Interestingly enough, Mr. Bernstein’s prediction only came true because of December’s extremely strong stock market performance coupled with a hammering in treasuries.  Through November, long treasuries were ahead of S&P 500 stocks in 2010!

While he got a few of the easy ones right, he got some of the ones I feel are most important exactly wrong.  He predicted a significant flattening of the yield curve as short term rates rise and long rates come down, and he got the fine print on how it would happen exactly backwards, too (he expected inflation to push up the long end in the first half and Fed tightening to bring sanity to the bond market in the second half).  He predicted that employment in the US would improve, but we are still waiting for that to happen.  He also predicted that the Dems would have a better showing in November than everyone thought they would, expanding the prediction to say, “investors will look back on the year and realize that monetary and fiscal policy stimulus still works.”  Oops.

So, here are some predictions I think people should go forward with:

• US ingenuity, hard work, and capacity to perform when push comes to shove will help us overcome our current problems and keep our markets and our economy the envy of the world for some time to come.
• Europe’s desire to maintain the European Union and its common currency, as well as a fear of what might happen should it all unwind, will help it overcome its current problems.
• Developing countries will continue to gain strength and influence in the global economy, an evolution that developed countries should embrace, not fear, since it will likely lead to greater global stability, greater wealth, more investment opportunities, and higher standards of living for all.
• Speculators and investors alike will continue to be overly optimistic in good times and overly pessimistic in bad times.  Investors who recognize the real battle is against their own emotions and the temptation to be influenced by the “noise” of the markets will be most likely to win that battle in the long-run.
• The financial industry will continue to do whatever it can get away with, morality be damned, since all they have learned from recent events is that society and the government lack both the understanding and the will to properly oversee and regulate them.
• The investment industry as a whole will continue to serve itself and fleece investors by marketing products, services, and strategies that do not benefit the investor, all the while overcharging for all of it.

You’ll notice that my predictions are very different from what you’ll find in the financial press.  And it might not be obvious, but they offer actionable advice: 1) maintain exposure to equities since they give you a direct stake in global productivity; 2) keep your exposure global and free from an irrational home-country bias; 3) give your investments time to work and don’t trade your portfolio (other than to rebalance) because things are going up strongly or things are going down strongly; 4) ignore any short term noise in the market, no matter how loud; and 5) be skeptical and critical of every actor in the finance and investment industries and ask the tough questions before buying anything – you most likely don’t need it.

For my predictions at the end of next year I’ll simply post a link to this blog and say “ditto”.

As trite as the phrase “past performance is no predictor of future performance” is, investors and advisors alike tend to select active managers based almost entirely on past performance.  To some degree, it makes perfect sense to pick managers this way.  Why would anyone select a fund that was among the worst performers over the last five years?  We all like to go with a proven winner, and mutual fund investing follows the same logic.  However, the Persistence Scorecard shows just how big a mistake this seemingly intuitive approach to manager selection can be.

In the most recent study (November 2010), it shows that of the 155 domestic large cap mutual funds that were ranked in the top quartile of their category for the year ending in September 2005, only 14.2% were still in the top quartile five years later (statistically we would expect 25% to remain in the top quartile after a fifth year).  If we broaden the universe to the top half of large cap mutual funds (310 funds), only 32.6% – less than a third of them, were able to maintain their position in the top half of large cap mutual funds at the end of five years!  These results are relatively similar for domestic mid- and small-cap funds, too.

It is no wonder that investors and their advisors tend to chase their own tails as they try to create portfolios with “best of breed” money managers.  All they end up doing is running from one fund to the next as each fund they choose tends to migrate lower in the rankings over time.  They get into the fund after it has done well, only to see it begin to underperform while they are invested in it, and practically every investor and advisor continues to make this mistake over and over and over.

The SPIVA report combined with the Persistence Scorecard should provide enough convincing evidence to investors that continuing to invest by giving your money to various “best of breed” active managers is unlikely to yield the desired results.  Much better results can be found by avoiding the active manager decision altogether and focusing on things that actually matter such as asset allocation and long term investment themes.  Use passive investments to wisely allocate your portfolio across various markets and asset classes after considering historical relationships among them, risks in the current environment, and expected long term themes for global economic and market expansion.  By denying active managers your business, you cut your investment costs considerably and create a structurally tax-efficient portfolio that has a much better chance of meeting your investment needs and expectations.  A new frontier for investors has finally evolved, and those who do not consider this better way of investing will eventually regret it.

There is a tremendous amount being written on a number of what I consider to be short term or “trader” issues these days, and all days for that matter, so let me use a few of these issues to help you understand how these things do and do not influence the Frontier investment process.

One of the most talked about issues these days is the Fed’s recently announced monetary stimulus package, dubbed QE2.  Economists roundly disparage the $600 billion stimulus as either unnecessary, ineffective, economically damaging, or any combination of the above, and governments around the world are angry about it because of what it does to relative exchange rates and their own plans for export-led growth.  On the other side of the argument is Fed Chairman Ben Bernanke, the Obama administration, and the US markets themselves (demonstrated by strong moves upward prior to and around the announcement) arguing that deflation is the bigger concern and that this stimulus is absolutely necessary to keep deflation at bay and to help support employment.  While it does disadvantage other exchange rates for the time being, Bernanke argues that that is an unfortunate side-effect, not the target of the policy, and that these foreign markets would be disadvantaged even more by US deflation.

Around this issue, traders have to decide many things across the various asset classes in their portfolios.  Should they increase or decrease exposure to US equities based on their view of QE2 being helpful or harmful to our economy, respectively?  What to do about their foreign equity exposure – does a favorable US economy cause problems for all others and how do currency fluctuations figure in?  The current environment could be a significant boon or bust for emerging economies so will assets flee the US market for these rapidly growing areas or are we expecting emerging markets to experience major headwinds when significant pricing pressure in commodities reverberates throughout the developing world?  How should they play bonds since interest rates will have to go up at some point but for now rates are depressingly low at the short end of the yield curve?  Being long commodities seems like a sure thing given all the inflation we’re expecting, but what if growth does slow in emerging markets and demand for commodities also slows?  And what is the best way to play commodities?  So many of the futures markets are in contango right now, do commodities futures make any sense and how do we invest in them directly if that is our choice?

Now figure in the other issues of the day.  Just to name a few: real estate bubbles in China; sovereign debt concerns in Greece, Ireland, Spain, Portugal, Italy, and possibly a few others; municipal bond defaults across the US; the likelihood of significant political battles in the US over unemployment insurance, tax rates, health care, discretionary spending, entitlements, and many others over the next two years.  And that’s only at the macro level without even considering individual sectors or companies.

At any point in time there are hundreds, if not thousands, of variables to factor in to any single trade, and every decision has an effect on all others.  Getting those decisions right on a regular basis is a ridiculously impossible task, yet that is the game most investors play either directly or indirectly.  If they aren’t doing it themselves as a day trader, they are paying some else to trade for them.  Most commonly investors pay some else to pay someone else to trade for them by hiring a broker or perhaps a “wealth manager” to pick other money managers to actively trade in various markets.  At Frontier, paying someone to pay someone to engage in an impossible task is perfectly nonsensical.

That is not to say the proper course is to ignore all of these issues, market weight a portfolio of various asset classes and forget about it.  It is important to stay on top of all the previously mentioned issues because they create the mosaic that drives the long-term evolution of the global economy and therefore the global markets.  Understanding today’s developments helps us gain a sense of where things might be five or ten years from now, and seeing how things change week to week and month to month helps us either confirm or deny the long-term theses around which we do actually build our portfolios.

And since we do use historical relationships between asset classes to inform today’s portfolio construction, the issues of the day help us determine how accurate those historical relationships continue to be or whether they will or won’t hold down the road.  For example, understanding what is driving growth and creating risk in today’s emerging markets helps us think about the relationship between the emerging and developed markets over the last ten and twenty years as we try to think about that relationship today and what we expect it to be ten and twenty years forward.

The bottom line is that all information matters, but what is crucial is how we use that information when making investment decisions and building portfolios to weather the longer term.  I would argue that most investors, whether individual or professional, put too much significance on the day-to-day and let it crowd out their thinking on the far more important longer term.  For those who recognize this, they open themselves up to a new frontier of investing.  One in which day to day anxieties over the multitude of variables affecting their portfolio are significantly reduced (they never go away completely, nor should they), the cost of portfolio management goes down considerably, and the performance of their portfolio is likely to go up as the risks remain largely the same but the cost drag facing most portfolios is no longer there.  And, to the extent that the long-term decisions for their portfolio become clearer and result in better positioning, portfolio growth over time could be significantly better than those portfolios without the proper perspective.  But it all depends on that one crucial component…perspective.