Unconventional success from an investment strategy leads to failure for most investors. The excess gains earned by the early adopters of a new investment idea quickly dissipate as growing crowds become increasingly unsophisticated and push down returns. It doesn’t take long before the average return from the strategy falls well below a simple portfolio of index funds.

A recent example of unconventional failure is the Yale Model, also referred to as the Endowment Model.  This strategy, which combines traditional stock and bond investments with alternative investments such as hedge funds and private equity, was popularized by the success of the Yale Endowment Fund in the early 2000s.

From July 2000 through June 2003, the S&P 500 fell 33% while the Yale Endowment fund gained 20%. That’s all it took for a revolution to occur in the way large and small institutions managed their endowments and public pension funds.

David F. Swensen, chief investment officer of Yale University, fanned the flames of enthusiasm in his bestselling book, Pioneering Portfolio Management [Free Press, 2000]. The book provided a blueprint for people who wished to implement this new way of investing.

To his credit, Swensen repeatedly warned in the book that only a handful of the largest organizations have the depth of knowledge to successfully implement such a strategy. That was a nice suggestion by Mr. Swensen, but it was about as useful as telling a freshman college student to avoid parties where alcohol is being served.

Data compiled from 831 U.S. colleges and universities that manage over $400 billion in aggregate have not performed well using the Yale model. National Association of College and University Business Officers (NACUBO) data for the most recent fiscal year ending in June 2012 shows that large, medium and small endowments have all fallen well short of investments that are less complex and less costly.

I compared the average endowment fund performance reported by NACUBO to two index fund strategies. The first was a Core-4 portfolio and the second was a single balanced index fund available through Vanguard.

The Core-4 is a simple yet popular strategy used by many individual investors. It’s comprised of four index funds shown in Table 1. The average asset allocation of the endowments was approximately 30% in fixed income and cash, and 70% in U.S. and foreign equity and alternative investments (of which 7% was in real estate). I replicated this allocation as closely as possible using the Core-4 fund strategy and rebalanced once per year on June 30.

Table 1: Core-4 Portfolio with a Typical Endowment Asset Allocation

Source: Vanguard.com, Bogleheads.org Wiki

The second strategy was a single balanced index fund. The Vanguard Balanced Index Fund Investor Shares (VBINX, ER .24%) seeks to track 60% of the investment performance of overall U.S. stock market and 40% of the investment performance of a broad, market-weighted bond index. There isn’t a separate allocation to foreign stocks or real estate.

Most Vanguard index funds are available in three share classes: Investor Shares, which have a low investment minimum; Admiral Shares, which have a slightly higher minimum; and ETFs, which have no minimum investment. To be as fair to the endowments as possible, I used the highest cost Investor Shares in the analysis. Table 2 highlights the results.

Table 2: Comparison of Three Strategies through June 2012

Source: Vanguard, NACUBO data

The numbers speak for themselves. Despite hundreds of millions of dollars spent on consultants, management fees, and incentive fees for alternative investment gains, endowment fund portfolios did not keep up with these simple index fund strategies. To add insult to injury, I looked at this same comparison for an article I wrote on this topic last year (The Curse of the Yale Model) and endowment performance has become worse.

John Maynard Keynes wrote in The General Theory of Employment, Interest and Money, “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” When unconventional thinking becomes conventional thinking, failing is imminent. That’s where most endowments and public pension funds are. The trustees who oversee these funds are failing their beneficiaries by intentionally ignoring the obvious.

I don’t think this will ever change. There are too many reputations and too many jobs at stake for trustees to do the right thing for fund beneficiaries. The obvious right thing is to cut most consultants, cut most active managers, cut alternative investment funds, cut the burgeoning internal staff needed to track the quagmire, and convert to all index funds.

About Rick Ferri and the Portfolio Solutions Blog:

Richard (Rick) A. Ferri, CFA is the founder of Portfolio Solutions, the low-fee investment management firm he founded in 1999, which currently manages more than $1.2 billion in assets. He is the author of six investing-related books, and shares his insights as a frequent news commentator, Forbes columnist, media contributor and public speaker. Rick holds a Master of Science degree in finance from Michigan’s Walsh College, where he has served as an adjunct professor. Prior to entering the financial industry, Rick served as a U.S. Marine Corps officer and fighter pilot before retiring from the reserves in 2001 with twenty years of service. You can read more insights from Rick at www.RickFerri.com/blog.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Madison Avenue Securities is not affiliated with FOLIOfn or The Portfolioist.

Related Links:

• Parsing the Drop in the Japanese Stock Market
• Harvard Endowment: Less Bonds, More Foreign Stock
• The Pension Dilemma

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Over the last five sessions, the iShares MSCI Index ETF, EWJ, has dropped by almost 10% (see chart below).

Source: Yahoo! Finance

How could the market’s perception of the value of the world’s 3^rd largest economy have dropped so much, so fast, in the absence of some kind of catastrophe or the emergence of some incredible revelation or change in outlook with regards to Japan’s economy.

The value of a stock, bond, or index of stocks or bonds, is determined by the market’s consensus view as to the value of future income that the investment provides.  What has changed so dramatically in the last week or so is a shift in the consensus view rather than in some meaningful change in concrete measures of the Japanese market.

We may contrast this situation to the market decline after Japan suffered a catastrophic hit by a tsunami and earthquake in 2011.  The impacts of this catastrophe included damage to nuclear power plants and other infrastructure, such that long-term economic impacts were unclear.  In the first full day of trading after the tsunami, the Nikkei 225 dropped 6.2%.  In this situation, the prospects for Japan’s economy were substantially impacted by an external event.

One plausible narrative in explaining the substantial and sudden drop in the Nikkei is based on exchange rates (see chart below).  Japan’s economy depends heavily on exporting its goods, so a weakening currency will drive stock prices up because the country’s products are cheaper for its foreign consumers with a weak Yen.

Source: FRED

EWJ rose 22.7% from the start of 2013 through May 21, as the Yen fell and then dropped dramatically in parallel with a sharp increase in the Yen on May 22.  The drop in the Nikkei is out of all proportion to the increase in the Yen exchange rate, however.

To a large extent, I conclude that the sudden decline in the Japanese stock market is largely a result of behavioral effects and, perhaps, program trading that responds to notable volume levels.  Market participants took an unusual drop in the Nikkei as a selling trigger, just as they amplified the gains in the Nikkei early in the year.  In other words, we are seeing market participants trying to exploit momentum in both up and down directions speculating that the trend will continue.

The big picture lesson from the recent rapid drops in the Nikkei is that massive changes in price of even entire stock indexes, representing large portions of the global economy, can happen with startling speed, even in the absence of a clear driver when speculators play a large role in setting prices.  Even as we look for causes of a big decline (or gain), we must recognize that major market moves can simply occur due to a confluence of behavioral drivers that may, in fact, have little demonstrable connection to fundamentals.  Seeing the value of the world’s 3^rd largest economy drop by almost 10% over five days, in the absence of a fundamental driver, should serve as a vivid warning as to how quickly the market’s “animal spirits” can shift.

Related Links:

• The Cost of Performance Chasing
• Being a Weather Contrarian
• Understanding France’s Credit Rating Downgrade

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Through the end of April of 2013, we no longer hear about the ‘lost decade’ because the trailing ten-year annualized return for the S&P500 is almost 8%.  Not bad.  The ‘market’ has delivered a substantial return, albeit with some big bumps.  But how have investors actually fared over recent years?  A great way to get a sense of how investors time their purchases and sales is to look at Morningstar’s investor return data.  These return numbers are the asset weighted returns for mutual funds.  If investor returns are notably less than a fund’s returns, this means that investors added or removed money to the fund at the wrong times.  Most often, this occurs for one of two reasons. One way that investors tend to lag fund returns is by jumping into or out of the market at the wrong times, with subsequent returns that are worse than simply buying and holding an index fund.  The second common driver of under-performance is that investors tend to ‘discover’ a new manager after a period of out-performance, and add money to his or her funds.  There is often surprisingly little persistence in the ability of a manager to out-perform, so investors flow into funds after great performance and just in time for worse performance.  For this reason, the actual investor returns may be poor even though fund returns are high.

Let’s start our exploration of investor decisions with Vanguard’s S&P500 index fund (VFINX).

Source: Morningstar

According to Morningstar, investors in VFINX have under-performed the fund by 1.11% per year over the fifteen year period, out-performed the fund by 0.37% per year over the ten year period, and under-performed the fund by 3.34% per year over the most recent five year period.  How could investors have performed so poorly even as the market has recovered in recent years?  The data suggest that investors must have pulled money out during the decline, missed a substantial part of the early recovery, and then put money back in.  The evidence that money has flowed back in is that the three year period shows a more modest (but still substantial) 2.07% per year of under-performance.  This is an example of the first effect in action: bad timing.

Now let’s look at the problem of investors putting their money with a manager after he has gotten a lot of media attention for a string of past high returns.  Consider the Fairholme Fund (FAIRX).  The fund’s manager has received plenty of media coverage, including being named Morningstar’s fund manager of the year for 2009.  FAIRX has an admirable ten-year track record, with annualized returns of 11.37% per year.

Source: Morningstar

The data on investor returns shows, however, that investors in Fairholme fund have achieved a paltry 3.77% per year over this ten-year period.  This enormous disparity between the fund returns and investor returns is the hallmark of a fund that achieves high returns early on, attracts lots of new investors, and then performs far worse than it did in its early years.  Perhaps most intriguing here is that this under-performance is not just due to Fairholme’s early years.  Even over the most recent three years, investors in this fund have averaged -1.54% per year while the fund has returned an average of 3.37% per year.  This level of under-performance is stunning, not least because an S&P500 index fund (VFINX) has returned an average of 12.64% per year over the same period.

The long-term cost of investors’ bad timing choices is nothing short of catastrophic in terms of long-term wealth accumulation and retirement planning.  Average investors are jumping in and out of the market and specific funds based on emotion, reactions to the media, or other factors and are severely reducing the returns that simple index funds, purchased with a consistent investment discipline, have provided.

In summary, the lessons are straightforward.  Putting money into stocks because they have performed well in recent years (or taking money out after a big decline) is truly like shutting the barn door after the horse is gone.  Investors need to look at risky assets on their own merits and decide whether the expected returns justify the potential for loss.  Giving money to a manager after he or she has generated substantial returns is trickier.  It is natural to want to see evidence that a manager can build an out-performing portfolio.  The question is whether anyone has the ability to determine whether out-performance will continue.  In most cases, the track record of investor returns suggest that we might just as well bet on horse races as try to predict which managers will out-perform in the future.  The losses that investors have, on average, sustained by chasing performance in the market or with active managers can be so large as to make investing remarkably unprofitable.

Related Links:

• REIT Yield as a Predictor of Future Returns
• Retirement: Is Consistent Saving More Important Than How Much We Withdraw?
• Are We Hard-Wired To Make Bad Financial Choices?

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In an interesting twist on this type of analysis, Bill Bernstein recently noted that yields on equity REITs appear to have substantial value in predicting future real returns.  I was not surprised by his findings overall, but his analysis is very compelling and suggests that the relationship between REIT yields and future returns is, in fact, even more robust than I would have imagined.  I was so struck by his analysis that I asked if I might reproduce his chart in a blog post and he kindly gave me permission.  Here is his chart:

U.S. Equity REIT dividend yield vs. subsequent annualized five-year real return (Source: Bill Bernstein)

This chart uses monthly data, from the end of 1971 through August of 2012, so each point compares the yield on equity REITs to the total return over the next five years, net of inflation.  The inflation measure is the CPI (Consumer Price Index).  These data suggest that the current yield on equity REITs explains 40% of the future variability in total return (R^2 of the trend line is 40%).

Using this relationship, Bernstein concludes that even in the rosiest outcome, we should expect REITs to deliver no more than 1.4% per year, net of inflation, over the next five years.  Given that REITs have historical volatility levels not much below equities, this low a return is not at all attractive.  This type of projection is, of course, subject to a vast range of uncertainties but it is certainly food for thought.

Even without going beyond the data explicitly reflected in the chart, there is a lot to think through.  There are a number of ETFs and index funds that track U.S. equity REIT indexes, including VNQ (Vanguard), ICF (iShares), and a range of others.  The trailing 12-month yield for VNQ is currently 3.15% and for ICF the corresponding yield is 2.67%.  Based on the 41-year data sample in Bernstein’s chart, it is very hard to see how we could end up with positive real returns over the next five years, given these yields.

Perhaps the largest lesson to draw from this chart, as well as from other studies that show a persistent relationship between yield and future returns on various asset classes, is simply that markets swing broadly around fundamental relationships.  It is hard to be a contrarian.  The last real estate bubble should be vivid enough to remind us to consider the lessons of both history and fundamentals, but apparently this is not the case.  In the last bubble, people convinced themselves that real estate was a good bet because this asset class had delivered outsized returns for a number of years.  The recent run-up in real estate prices is more the result of Fed policy and investors seeking yield in a low-rate environment.  The fundamental drivers, however, remain the same.  The past, as they say, does not repeat, but it does rhyme.  The implication of current REIT yields is that expected future return is low.

Related Links:

• The Meaning of the New Highs in the S&P500
• What Happens in A Nation of Renters?
• Managing Your Portfolio’s Exposure to Interest Rates

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When you buy a share in an S&P500 fund, you are getting two things.  First, you are getting rights to future dividends, which are the distributed earnings of the firms that make up the S&P500.  Second, you are purchasing an asset that may or may not be worth more in the future.  Hulbert’s point is that while the dollar value of a share in an S&P500 fund has now exceeded its previous all-time high, you will be able to buy 24% less goods and services with the money from selling that share than you could in 2000.  Hulbert notes that an investor who used all dividends to buy more shares of the S&P500 would have considerably more in terms of actual purchasing power, but that even this investor would have assets that were worth less in real terms than they were worth in 2000.

Let’s frame this situation in simpler terms.  Imagine that instead of buying shares in the S&P500, you bought a rental property in 2000 for $100,000.  The rent that you collect is the equivalent of dividends.  Imagine that you had reinvested all of the rent that you have gotten over the years in maintaining the property, paying property taxes, and making improvements to your property.  You decide to sell your property this year, and you find that after paying the realtor, you will pocket $135,000.  Have you done well or not?

I chose the $135,000 figure because this how much money you need today to match the purchasing power of $100,000 in 2000.  So, you have taken risk and invested for thirteen years and, at the end of it all, you have the same purchasing power as you did back in 2000.  Hulbert demonstrates that investors in the S&P500 have actually done a bit worse than this.  Even with reinvested dividends, the S&P500 is worth less today than it was in 2000 in real terms.

In inflation-adjusted terms, you can buy a share of the S&P500 today for about the same price as you could in 1997.  What this means, in turn, is that the index as a whole has not generated a net-of-inflation return for investors (beyond dividends) from 1997 to today.  What has happened to all of the reported earnings that have not been paid to investors via dividends?  In terms of the current market values, these net earnings have not generated value for shareholders and this is perhaps the most significant conclusion.  The current market levels suggest that the value of the economy, as measured in terms of the value of the companies represented by the S&P500, is about where it was in 1997.  This is not terrible news, but neither is it reason for celebration.

Related Links:

• Explaining the Value Premium
• Financial Literacy: State of the Union in 2013
• The Hidden Costs of Index Funds

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

Value has persistently outperformed over the long-term.  Why is that?

In the most general terms, growth stocks are those with growing positive attributes – like price, sales, earnings, profits, and return on equity.  Value stocks, on the other hand, are stocks that are underpriced when compared to some measure of their relative value – like price to earnings, price to book, and dividend yield. Thus growth stocks trade at higher prices relative to various fundamental measures of their value because (at least in theory) the market is pricing in the potential for future earnings growth. Over relatively long periods of time, each of these investing classes can and do outperform the other.  For example, growth investing dominated the 1990s while value investing has outperformed since. But value wins over the long haul.

To be fair, we are not talking about exact categorizations here. As Warren Buffett emphasized in his 2000 letter to shareholders, those “who glibly refer to growth and value styles as contrasting approaches to investment are displaying their ignorance, not their sophistication.”  Buffett would have investors rely on a company’s intrinsic value to determine whether or not it is fairly priced. That measure is largely determined by value considerations, but also includes growth characteristics in the overall mix.  However, whether cash flow (for example) is growing at any particular time doesn’t really matter; what matters are the totality of future cash flows.  Obviously, this process is very difficult and highly subjective. The bottom line is that we should value businesses by estimating how much cash an investor can expect to take out of them over their remaining lives. And those considerations are largely value-oriented.

These broad distinctions have led to the famous Morningstar” style box” (shown below).

Morningstar’s value calculus is one-half price/projected-earnings ratio (forward P/E) with the other half evenly divided among price/book ratio, price/sales, price/cash flow, and dividend yield. On the other hand, its growth calculus is one-half long-term projected earnings growth with the other half evenly divided among historical earnings growth, sales growth, cash flow growth, and book value growth.  Morningstar designates the largest 250 U.S. stocks (based upon market capitalization) as large cap, the next largest 750 stocks as mid cap, and the remaining stocks as small cap.  Others think of large cap as companies with a market cap in excess of $10 billion, mid cap as $2-10 billion, and small as under $2 billion. That’s how these categories are typically delineated.

Since, in general, nobody leaves a $100 bill lying on the sidewalk unclaimed, there is good reason to be skeptical of any proposed winning strategy, including value. It is axiomatic in the investment universe that good trades get copied to death, crowding out excess returns.  However, value has significantly outperformed growth over the long haul in a persistent way.  For example, the Russell 3000 Value Index has returned 8.87 percent annualized from its inception to date while the Russell 3000 Growth Index has returned 7.08 percent annualized over the same period. That outperformance exists in each and every category over the long-term. A comprehensive listing is provided by the addendum below.

Since value outperformance has persisted, the obvious and necessary question is: “Why?” One traditional answer is that value stocks are riskier in some way.  At market extremes in particular, value stocks can get beaten up pretty badly, so this risk hypothesis isn’t totally nuts.  But since growth investing projects increasing growth into an unknown future, it seems to me that growth probably bears more risk in the aggregate. In any event, there is no clear data-driven basis to conclude that value is riskier. Moreover, since low volatility and low beta strategies have outperformed persistently, the intuitive idea that higher risk correlates to higher return does not necessarily follow either.

I think the better answer lies in our behavioral and cognitive biases.  Jack Bogle (among others) has emphasized that while value beats growth persistently on an index basis, when the data examined is real mutual fund returns, the advantage tends to disappear. In other words, we screw things up.

As Bill Simmons recently noted in the context of NBA player evaluation:  “Fans always gravitate toward unlimited potential over known commodities.”  And that’s why — in a nutshell — the value premium persists.  Baseball presents a similar phenomenon, though it clearly reaches into the management suite there.  Major League GMs once got great value by trading for minor league prospects.  But the landscape has changed such that prospects now tend to be over-valued.  Accordingly, teams part with solid major-leaguers in exchange for untested prospects with a slightly higher ceiling potential to their detriment.  As Rany Jazayerli has shown (in The MLB Prospect Bubble): “Increasingly, teams have decided that they’d rather bet on that ceiling than take the guaranteed return.”  Once again, value beats growth, but we refuse to act on it.  Here’s my explanation/hypothesis why that is so (with illustrative over-the-top videos).

1. We choose ideology over facts and stories over data. We all develop ideologies as intellectual strategies for categorizing and navigating the world. Psychological research increasingly shows that these ideologies reflect our unconscious goals and motivations rather than reflecting anything like independent and unbiased thinking.  This reality fits conveniently together with the narrative fallacy, which is our tendency to look backward and construct a story that explains what happened along with what caused it to happen.  We all like to think that our outlooks and decision-making are rationally based processes — that we examine the evidence and only after careful evaluation come to a reasoned conclusion as to what the evidence suggests or shows. But we don’t. Rather, we spend our time searching for that which we can exploit to support our pre-conceived commitments, which act as pre-packaged means of interpreting the world.  We like to think we’re judges of a sort, carefully weighing the alternatives and possibilities before reaching a just and true verdict.  Instead, we’re much more like lawyers, looking for anything – true or not – that we think might help to make our case and looking for ways to suppress that which hurts it. We inherently prefer words to numbers and narrative to data — often to the immense detriment of our understanding.  Indeed, we know from neurobiology that when presented with evidence that our worldviews are patently false, we tend to refuse to engage our prefrontal cortex, the very part of the brain we need most to make sense of the new.  This aspect of our make-up is potentially damaging to every decision we make, and especially in investing.  It’s why we concoct silly conspiracy theories. We see what we want to see and act accordingly.

2. We love status. Our preferred stories cast us as heroes – figuring out what lesser mortals cannot. Simon Lack, a hedge fund insider from his long tenure at JPMorgan Chase, raised a ruckus last year with his book, The Hedge Fund Mirage, in which he argued that the hedge fund industry as a whole lost more money in 2008 than it had made in the previous 10 years. Even worse, “[i]f all the money that’s ever been invested in hedge funds had been put in Treasury bills instead, the results would have been twice as good,” especially since nearly all the hedge funds’ gains had gone to managers rather than clients.  In 2012, the HFRX Global Hedge Fund Index, reflective of industry returns, gained just 3.5 percent and has returned just 1.7 percent over the past 10 years.  Thus the S&P 500 has outperformed the HFRX for ten straight years, with the exception of 2008 when both fell sharply. More significantly, a standard 60/40 portfolio has delivered returns of more than 90 percent over the past decade, compared with a meager 17 percent after fees for hedge funds.  Despite these facts, hedge funds continue to sell big. I think it’s because of status.  Status also explains why the lowest-ranked equity slices of the most toxic CDOs during the mortgage crisis were said not to go to institutions, but to “some high-net-worth clients.” We tend to want what the richest and the best have to establish our standing high up in the pecking order.  Mundane facts are singularly unsatisfying.

3. We’re overconfident about our skills and overly optimistic about expected results.  We insist that we are anything but average, facts notwithstanding.  We suffer from a well-established bias in which our subjective confidence in our judgments is reliably greater than their objective accuracy. Consider Wing Chau, the hapless fund manager profiled by Michael Lewis in The Big Short. According to Lewis, Chau controlled roughly $15 billion in toxic subprime CDOs and thanked Steve Eisman for shorting that market because his doing so provided him with more garbage to buy. We all know how that turned out.  But it’s also true that Chau was hardly alone.  As he stressed: “Many investors that chose to purchase the bonds [CDOs] were among the most sophisticated in the world, including the proprietary trading desks of investment banks as well as large insurance companies.” He insists that he wasn’t as foolish as he seems since “more than 80 firms” participated in that market.  We wear rose-colored glasses – that’s why fully 94% of college professors believe they have above-average teaching skills (anyone who has gone to college will no doubt disagree with that) and 80% of drivers say that their driving skills are above average.  Thus sitting in class or driving on the freeway provide obvious reasons why we fail to act upon the value premium.

4. We like to win and win big.  The 1930 classic, Watch Your Margin, insists that people don’t invest just to make money.  They also play the markets for the thrill – especially the thrill of getting something for nothing.  If we invest consistent with the “tried and true,” we aren’t winning. We want to win and win big.  We don’t want the mundane.  We don’t want average.  We want flow.  That’s why (for example), final eBay bids tend to exceed available fixed price offerings and, surprisingly, the most experienced participants are most likely to bid sub-optimally.  The effects of our biases are amplified by our participation in the markets.  We want to roll-the-dice and win big.  How do you think those lavish casinos get built, anyway?

5. We routinely exaggerate our ability to shape the future. This is what Nobel laureate Daniel Kahneman takes care to describe as the “planning fallacy.” It is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.  It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect.  It’s why the results we achieve aren’t as good as we expect. And I think it’s why we ignore simple investment truths to chase nonsense.

We may “know” that a bird in the hand is worth two in the bush, but we still tend to go running into the bushes anyway.

_____________________________

ADDENDUM: Other value/growth comparisons (from their inception to date):  Russell 1000 Value/Growth 9.08/8.06; Russell 2000 Value/Growth 10.50/6.74; Russell 2500 Value/Growth 5.91/5.84; Russell Asia ex-Japan Value/Growth 5.28/2.09; Russell Asia Pacific Value/Growth 4.14/1.73; Russell BRIC Value/Growth 11.67/7.19; Russell Developed Europe ex-UK Value/Growth 7.35/6.55; Russell Developed Europe Value/Growth 7.08/6.26; Russell Developed Eurozone Value/Growth 6.78/6.24; Russell Developed ex-Japan Value/Growth 7.75/5.76; Russell Developed ex-North America Value/Growth 5.87/4.55; Russell Developed ex-U.S. Value/Growth 6.23/4.48; Russell Developed ex-U.S. Large Cap Value/Growth 6.15/4.62; Russell Developed ex-U.S. Small Cap Value/Growth 7.15/3.83; Russell Developed Value/Growth 6.98/5.07; Russell Developed Large Cap Value/Growth 6.91/5.20; Russell Developed Pacific Basin Value/Growth 3.63/1.39; Russell Developed Small Cap Value/Growth 8.07/4.19; Russell Emerging Asia Value/Growth 4.17/1.02; Russell Emerging EMEA Value/Growth 10.74/5.46; Russell Emerging Europe Value/Growth 12.54/7.66; Russell Emerging Markets Value/Growth 9.12/3.02; Russell Emerging Markets Large Cap Value/Growth 9.69/2.99; Russell Emerging Markets Small Cap Value/Growth 8.13/3.26; Russell Europe ex-UK Value/Growth 7.49/6.26; Russell Europe Value/Growth 7.17/6.08; Russell Eurozone Value/Growth 6.76/6.21; Russell Global 1000 Value/Growth 3.35/2.79; Russell Global 2000 Value/Growth 6.78/4.85; Russell Global 2000 ex-U.S. Value/Growth 8.27/6.17; Russell Global 3000 ex-U.S. Value/Growth 4.17/4.00; Russell Global ex-Japan Value/Growth 7.90/5.71; Russell Global ex-North America Value/Growth 6.32/4.58; Russell Global ex-U.S. ex-Japan Value/Growth 8.12/5.92; Russell Global ex-U.S. Value/Growth 6.62/4.54; Russell Global ex-U.S. Large Cap Value/Growth 6.53/4.66; Russell Global ex-U.S. Small Cap Value/Growth 7.39/4.01; Russell Global ex-UK Value/Growth 7.22/5.01; Russell Global Value/Growth 7.16/5.06; Russell Global Large Cap Value/Growth 7.07/5.19; Russell Global Small Cap Value/Growth 8.18/4.29; Russell Global SMID Value/Growth 8.77/6.10; Russell Greater China Value/Growth 4.64/2.74; Russell Latin America Value/Growth 14.69/10.57; Russell Microcap Value/Growth 6.83/1.61; Russell Midcap Value/Growth 11.00/8.68; Russell Small Cap Completeness Value/Growth 6.66/3.89; Russell Top 200 Value 7.97/6.96.

Similar measures find the same thing.  The S&P GIVI (Global Intrinsic Value Index) is a rules-based, global equity strategy index designed to capture the low-volatility and value anomalies and has outperformed across each of the nine regions studied: global, developed markets, emerging markets, U.S., Europe, U.K., Japan, emerging Asia Pacific, and Pan Asia ex-Japan, Australia and New Zealand.

About Robert Seawright and the Above the Market Blog:

Above the Market is the blog of Robert P. Seawright, the Chief Investment & Information Officer for Madison Avenue Securities, a broker-dealer and investment advisory firm headquartered in San Diego, California. Its focus is the capital markets, economics and personal finance from a data-driven perspective. His About Me profile is available here.

Disclosure:

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Madison Avenue Securities is not affiliated with FOLIOfn or The Portfolioist.

Related Links:

• What Happens in A Nation of Renters?
• Top Ten Ways to Deal with Behavioral Biases
• Gaming the Numb3rs

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

The Time article explores the major elements of this shift.  First, lending standards have tightened after gradually loosening in the decade up to the real estate crash.  Lack of lending standards appears to have been a major player in driving the real estate market to ridiculous extremes.  Lenders had little incentive to ensure that borrowers would actually repay their loans because the lenders simply packaged up bundles of mortgages and sold them to investors, rather than retaining the loans on their own books.  In addition, potential first-time homebuyers are often fairly recent college graduates who are facing a tough job market and historically high college debt.  These people are less likely than luckier generational cohorts to buy homes.

I am not going to weigh in on the debate as to policy issues, but rather explore some of the investment implications of having fewer owner-occupied homes.

First, this shift is not good news for businesses that sell home improvement products and services direct to individuals.  Companies like Home Depot (HD) and Lowes (LOW) will take a hit if people spend less money on landscaping and a range of do-it-yourself upgrades.  I doubt that people will spend the same time and effort on the yards of houses they are renting as compared to those that they own.  It also seems to me that renters will spend less money on a range of interior products such as furnishings for houses they rent.  Who will buy nicer drapes for a rental?  I see companies like Bed, Bath and Beyond (BBBY) suffering and companies like IKEA benefiting here.  IKEA products are famously easy to disassemble and move.  The broader market for upscale interiors is also likely to experience a malaise.  I seriously doubt that many property management firms will be adding granite countertops or Viking appliances in rental houses.

Renters should be investing more heavily than homeowners precisely because they don’t have homes that they can treat as a source of retirement assets.  I know many people who, during the real estate bubble, splurged on their homes and home improvements with the rationale that they were ‘investing’ in their homes and that this would be a potential source of retirement funds in the future.  Though this rationale was weak, I believe that it was a key driver to justify expensive home improvement projects.  Even for more conservative homeowners, a house is an asset that can be sold if need be.  Where will the growing population of renters put their extra cash?  One possibility is that they will spend more money on discretionary items such as automobiles or vacations.  A more hopeful scenario is that they will save more in retirement accounts and in other taxable investment accounts.  In a perfect world, the new generation renters will seek out investments that do a good job of keeping up with inflation.  Home owners are or have pre-paid for future cost of shelter.  Renters remain exposed to inflation in housing costs.

A large-scale shift from home ownership to renting has led to the emergence of a new sub-asset class: publicly-traded firms that manage large numbers of single-family homes as rentals.  One business model in this space is single-family real estate investment trusts (REITs) such as Silver Bay Realty (SBY) and Two Harbors Investment Corporation (TWO).  Blackstone Group (BX), a publicly-traded private equity firm is also buying single-family homes at an aggressive rate.  Blackstone is the largest owner of residential real estate in the United States.  Whether or not this turns out to be an attractive investment remains to be seen.

Becoming a landlord is also an option for investors to cash in on the trend towards a larger population of renters.  This alternative has the benefits that the business model is straightforward and historically-low interest rates make it remarkably cheap for credit-worthy borrowers to raise money.  Direct ownership of investment property also has some unique challenges of course.  If a pipe bursts at four in the morning, you get the call.  If your tenant leaves, you have to find a new one.  Perhaps most significant, however, is liquidity risk.  If you need to get out of your investment, this can take considerable time and effort, not to mention costs associated with selling.

As the fraction of Americans who own their homes declines, there will be impacts across the investment landscape and I have tried to identify a few of these.  Over the longer-term, the effects are unclear.  The largest wildcard in this shift is that home equity remains the single largest source for wealth for median-wealth households.  If fewer people have the enforced saving discipline imposed by a mortgage, will they save less?  On the other hand, will the increased mobility afforded to workers who are not bound by a home mortgage enable people to obtain higher wages?  There is little question that trends in homeownership have the potential for substantial socioeconomic shifts.  Until the larger impacts become clearer, we will have to make do with trying to identify near-term effects.

Related Links:

• Being a Weather Contrarian
• Yale’s Goetzmann on Real Estate in the 2000s and the 1920s
• Implications of Robust Corporate Profits and Stagnant Wages

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Unusual seasonal weather conditions impact many businesses.  Canadian National Railway Company (CNI) management points to a harsh winter as the cause of a major year-on-year drop in profits.   Relatively colder conditions for the first quarter of 2013 have negatively impacted McDonalds restaurant sales.  Air Canada, Canada’s largest airline, also just reported operating income well below expectations due largely to adverse weather conditions.   The company’s stock price collapsed 12% after the announcement.

Even Caterpillar’s recent earnings surprise has been blamed partly on the colder winter.

Utilities are the companies with the most direct connection between earnings and weather.  Colder winters and warmer summers lead to higher energy demand by consumers and tend to boost utility earnings.  Similarly, weather can have a big impact on companies in the agricultural sector, including food producers and their suppliers, although the amount of a food commodity in storage can mute the response of commodity prices to weather.

Property and casualty (P&C) insurers also experience a direct connection between weather and their earnings.  Travelers (TRV), for example, paid out far less for covered natural disasters in Q1 of 2013 than the company paid in same period of last year, which directly helped their bottom line.  TRV’s stock price jumped 3.9% after earnings were announced.

I have observed this pattern over and over again through the years.  It makes sense that lower-than-expected earnings announcements tend to drive a stock’s price down because investors interpret low earnings as due to either worsening conditions for the business as a whole or poor management.  Either way, this is bad news.  What makes weather-driven earnings surprises unusual, however, is that they are most often due to chance and are not more likely to recur on the basis of the previous period.  Selling a stock because adverse weather drove down earnings in the previous quarter is truly like closing the barn door after the horse is gone.  For this reason, I am something of a weather contrarian: I tend to buy stocks after their prices have declined due to weather-driven earnings surprises.

There are important caveats to a contrarian weather strategy.  First, even though an earnings surprise is attributed to the weather, this true impact of weather is hard to parse out.  As a manager, I’d much prefer to blame bad weather than poor executive decision making for a bad quarter.  Second, there are weather anomalies that do persist so simply betting that things will return to normal is not a good idea.  Droughts, for example, tend to persist for long periods of time and drought conditions often correspond to persistent hot weather.  As the ground dries out, there is less evaporative cooling.  Similarly, weather anomalies caused by El Nino can persist for extended periods of time.

Being a weather contrarian simply means that you recognize the transient nature of weather-driven earnings surprises.  The fact that a mild hurricane season causes a surprise increase in the earnings of a property and casualty insurer does not make me think that the company’s management or business model is superior.  Low earnings from a utility due to a warm winter has no impact on my long view of the attractiveness of the company.  My overall thesis with regard to weather is simply that weather-driven earnings anomalies are often one-off events as opposed to more systemic earnings drivers.  Long-term investors will do well to distinguish between the two.  When a company comes out with lower-than-expected earnings due to extreme weather, this is a buying signal for weather contrarians.  Conversely, weather contrarians will avoid buying stocks in the aftermath of a positive earnings surprise that is largely due to fortuitous weather.

Related Links:

• Financial Literacy: State of the Union in 2013
• Sector Watch: Spotlight on Utilities
• The Yield Paradox

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

It is well understood that someone who is illiterate in the traditional sense (reading, writing) is severely handicapped in terms of work and opportunities available to them.  The person who cannot read or write is likely to be taken advantage of at every turn.  He will miss opportunities for improving his life as well, because the ways that we find new opportunities and avoid choosing the wrong paths often come in the form of text.  It goes without saying that not being able to read and write essentially guarantees that you will be poor.

I believe that being financially illiterate is almost as bad as being illiterate in the traditional sense.  People who are financially illiterate have almost no chance of financial stability, much less success.  Financial illiteracy also poses huge problems for society.  People who don’t understand the importance of saving, for example, are far more likely to end up on the public dole.  People who take on massive levels of expensive and unsupportable college debt pose a problem for society as a whole.

Financial literacy is having the knowledge and know-how to understand and function in a modern financial system.  Obviously this entails basic math skills, but there is far more involved.  To function in a modern society, people need to understand how to (1) manage a bank account, (2) manage and pay taxes, (3) determine how much debt they can reasonably assume, (4) determine how much they need to save, and (5) choose how to invest these savings.  These five categories are the absolute minimum and of course there are different levels of sophistication required in each, but particularly in number five.

The State of Financial Literacy

A 2012 study by the SEC concluded that the level of financial literacy in the U.S. is dangerously low.  The SEC’s report concludes that

“studies show consistently that American investors lack basic financial literacy. For example, studies have found that investors do not understand the most elementary financial concepts, such as compound interest and inflation. Studies have also found that many investors do not understand other key financial concepts, such as diversification or the differences between stocks and bonds, and are not fully aware of investment costs and their impact on investment returns. Moreover, based on studies cited in the Library of Congress Report, investors lack critical knowledge about investment fraud.”

The problem is massive and widespread.  I have had many conversations with many people who are well-educated in the traditional sense who are largely financially illiterate in terms of being able to make decisions about their financial lives that would be considered reasonable by most financial professionals.  Studies of financial literacy confirm that even wealthy and well-educated people lack financial literacy.  Many people are unaware of (1) how much they pay in expenses to their various providers of investment services, and (2) whether the people giving them advice are legally required to give them advice that is in their best interests (e.g. have fiduciary responsibility).

A 2012 survey found that the majority of participants in 401(k) plans did not understand the fees that they were paying.  Related research finds that investors do not properly take mutual fund fees into account when choosing a fund.  Nobel Laureate Bill Sharpe has a new paper that shows that bad choices among mutual funds can reduce your lifetime wealth accumulation by 30%.  A variety of other calculations come up with consistent results.

The largest of all financial literacy issues revolves around savings.  The data consistently show that people have little idea of how much they need to save and save far less than they need to.

The Future

A generation or two ago, the average American worker or retiree did not need to worry so much about financial literacy.  If you had useful skills and could hold down a job, your employer took care of health insurance and a pension in retirement.  Employers determined how much they needed to take out of each paycheck to provide for retirement, and promised to provide for lifetime income in retirement.  Today, with the shift from traditional pensions to self-directed plans (e.g. 401(k) plans) and shorter tenure with employers, individuals shoulder the responsibility for making the most crucial financial decisions in their lives, such as how much to save and how to invest these savings.  We have also seen shifts in levels of individual debt.  As college costs have risen far faster than inflation, more people take on substantial levels of debt to pay for education before they ever enter the workforce.

An excellent survey of the state of financial literacy and the effectiveness of financial education concludes that there is very limited evidence that financial education programs to date have been effective at actually raising levels of financial literacy.  For this reason, it is unclear that we, as a nation, know how to proceed.  Given our current situation, the best that we can hope for is increased awareness and focus on the problem of financial literacy.

In practical terms, on an individual basis, there is a great deal that people can accomplish even if large-scale programs appear marginally effective.  There are a number of very good books that are invaluable in educating yourself.  I recommend starting with Your Money Ratios by Charles Farrell and The Bogleheads Guide to Retirement Planning by Taylor Larimore et al.  For younger readers, I suggest Debt-Free U by Zac Bissonette and I Will Teach You to Be Rich by Ramit Sethi.

Related Links:

• Review of The Affluent Investor by Phil DeMuth
• Financial Literacy is the Issue of the Month? Try Issue of the Century.
• Are We Hard-Wired To Make Bad Financial Choices?

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

I have known Phil DeMuth for a number of years and I admire his common sense and views on many topics.  Phil authored the recently-published book The Affluent Investor that fills a need in the crowded shelves of investment books.  As a financial advisor to high-net-worth families, Phil brings valuable perspective to investors who have built substantial portfolios and seek to protect and grow their wealth effectively.

The motivation for this book was that there appeared to be an odd lack of books aimed at people who range from reasonably well-off to very wealthy, who are good at handling money in general, but who are not entirely confident of the best path for preserving and growing their assets.  There are many good books that direct people to pay off their credit card loans and not to buy a more expensive car than they can really afford.  Phil’s new book is not aimed at that audience.  The Affluent Investor is aimed at people who don’t need help balancing their checkbooks, who don’t have credit card debt, and who know how to earn money.  We are talking about executives, business owners, doctors, lawyers, engineers, and other professionals.  These are not the people who call in to Suze Orman to ask whether they can afford the vacation they have been wanting to take.

This book is nominally aimed at people with at least $100,000 and as much as $10,000,000 in their investment portfolios.  This is an enormous range in terms of wealth levels, of course, but I get where Phil is coming from here.  Someone on the higher end of this range may put a chunk of her portfolio into hedge funds and someone on the low end is more likely to be concerned about brokerage costs, but there are some sensible core strategies that can form the foundation of a portfolio for investors over much of this spectrum of wealth levels.  It is this common ground that the book seeks to explore.

The book starts with a review of some of the basics of how people become affluent in the first place.  If you are already affluent, this section simply serves to demonstrate that there are some similarities among members of the audience at whom this book is aimed.   Many people in this population became affluent by developing their human capital and doing high-value work, whether starting a business or working in a profession.  These people also save a substantial portion of their income.  Affluent investors are also likely to pay considerable attention to managing their assets and planning for the future.

The question of how best to invest a body of wealth is the focus of much of the book.  Phil lays out a helpful hierarchy of the investment process.  The first step is building a portfolio out of low-cost index mutual funds or ETFs.  This would include domestic and international stocks and bonds and might hold as few as three funds.  Investors who want to go beyond the simplest low-cost asset allocation can seek to boost returns by allocating to specific styles of stocks such as small-cap stocks, value stocks, and low-beta stocks.  These three types of portfolio ‘tilts’ are well-researched and have historically added to portfolio return.  The additional return gained from small cap and value stocks is well-documented in the research by Eugene Fama and Kenneth French.  The value of low-beta stocks has  been documented in considerable research over the past few years.

Dividend-paying stocks also receive some well-deserved attention as a special class of equities that investors may want to emphasize.  A subsequent chapter deals more deeply with the specifics of income investing, a topic about which Phil and Ben Stein wrote a good book a number of years ago.

There is a useful chapter that deals with lifecycle investing and how your investments should change through your life.  The following chapter explores how to refine this concept, depending upon your primary source of income.  If the income from your job is entirely safe and not correlated to the stock market (if you are a tenured professor or a Federal employee, for example), you can afford to take on more stock market risk than a commissioned salesperson whose income is highly correlated with economic variability.  Phil ties this idea to the peril of being among the high beta rich.

One of the over-arching themes of this book is that affluent investors need to be vigilant about all of the financial products and ‘opportunities’ that will come their way.  There are many ways that you can risk your hard-earned wealth in the hopes of earning great riches.  If you are already affluent, you have almost certainly experienced the onslaught of people who want to help you manage your investments.  Some are probably good.  Others, not so much.  Phil provides a series of examples of how you may be parted from your wealth.  Ultimately, he makes a compelling case that a key element of becoming affluent and remaining that way is to commit to being engaged in the appropriate stewardship of your wealth, whether or not you hire an advisor.

If you have accumulated a substantial portfolio and want a sensible and compact guide on how to proceed, this book provides a solid foundation.  I recommend it.

Related Links:

• Implications of Robust Corporate Profits and Stagnant Wages
• From the Portfolioist Book Shelf: Yes, You Can Be a Successful Income Investor by Ben Stein and Phil DeMuth
• From the Portfolioist Book Shelf: Your Money Ratios

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.