Should You Hire a Financial Advisor? Jeff Speakes. Copy write Table of Contents

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1 Should You Hire a Financial Advisor? Jeff Speakes Copy write 2015 Table of Contents 1. Can a Novice Beat a Pro? 2. Vanguard 3. Asset Pricing Theory 4. Wealthfront 5. Fundamental Indexing (and other market beating strategies) 1. Can a Novice Beat a Pro? In general, we expect that a beginner or novice in a field is likely to be out-performed by a seasoned veteran. We would be surprised if a beginner could build a better house than a skilled carpenter, or if an amateur boxer could knock out a pro. Yet, something like this may be true in the investment field. In his book The Gone Fishing Portfolio author Alexander Green argues that the average individual investor, even if not trained in investments, should manage his or her own portfolio instead of turning it over to a professional investment manager. The basis for this counter-intuitive advice is twofold: first, since investment management is an extremely competitive industry and the financial markets are highly efficient, the average professional investor is likely to produce net investment returns (i.e., returns after deducting management fees) that fall short of market averages. Second, the financial services industry has produced a great product, the so-called index fund, that can come very close to replicating market returns at very low cost. Thus, Green asserts, the typical investor can obtain a greater return (net of fees) by passively investing directly in index funds. The steps that Green lays out are as follows: first, select a set of asset classes including US and international equities, real estate and various types of bond funds, along with an investment vehicle that represents each class; second, determine appropriate weights for each class (Green s recommendation is generic); and third, adopt an adjustment or rebalancing strategy. Green s partly tongue-in-cheek adjustment strategy is to review the portfolio once a year, and conduct trades to move the current allocation back to the target allocation, if necessary. This should take less than one hour, and then you can go fishing. If you can follow Green s simple program, then you should be able to achieve reasonable portfolio returns.

2 Table 1. Green s Program (the Investment Vehicles are broadly diversified low-cost Exchange Traded Funds) Asset Class Investment Vehicle Allocation US Value Stocks VTI 15% US Small Stocks VB 15% European Stocks VEO 10% Pacific Rim Stocks VPL 10% Emerging Market Stocks VWO 10% High Grade Bonds BND 10% Inflation-Indexed Bonds TIP 10% High Yield Bonds HYG 10% Real Estate VNQ 5% Gold GDX 5% Not many individual investors follow the Green approach (less than 20% of retail investor funds are passively invested in index funds), even though it would almost surely improve realized performance. Studies show that actual performance of retail investors falls dramatically short of market returns. For example, Jack Bogle, the founder of Vanguard, shows that retail equity investors have lagged market returns by hundreds of basis points (one hundred basis points is one percent). Over time, this adds up. Bogle s decomposition of the sources of this massive performance shortfall includes a) high fees and commissions, b) excessive trading, and c) miserable timing (buying at the top and selling at the bottom). It is not certain why individual investors do so poorly on their own, but one possibility is a variety of psychological biases that impair clear thinking. Another factor is that some gullible investors fall prey to hustlers and are sold high-cost inappropriate strategies. The key step to improving portfolio returns is clear: stop making these mistakes. Surely professional advisors are aware of the mistakes people make and the reasons for them. A great benefit of hiring a professional may be to keep you from hurting yourself. Another potential source of value added for the professional manager is to tailor a portfolio to your specific risk tolerance and situation. For example, someone employed in a cyclical industry like construction might be well-advised to avoid concentrating his investment portfolio in cyclical stocks. The reason is to avoid a major drop in portfolio value at the same time that his earned income or human capital is being impaired. Finally, you may be able to find a manager that provides market beating returns. To summarize, there is a simple strategy that the novice investor can deploy to realize market-like returns, if he/she has the confidence and interest to implement the strategy. Alternatively, there are a variety of potential benefits accruing to hiring a pro. Which is best for you? I think the answer is: it depends. In subsequent posts we will explore the issues more carefully.

3 2. Vanguard John C. (Jack) Bogle graduated from Princeton University in 1951 and founded The Vanguard Group, Inc. in In 1975, Vanguard introduced the first so-called Index Fund based on the Standard and Poor 500 (S&P500) stock index. The S&P500 is a market capitalization weighted average of 500 of the largest stocks that trade on the New York Stock Exchange or NASDAQ. Since the total market capitalization of these 500 stocks represents more than 95 percent of the entire market value of stocks traded on American exchanges, the index return is a good proxy for the overall market return. The purpose of the fund is to come as close as possible to emulating the return on the index. This is accomplished by purchasing and passively holding a portfolio of S&P500 stocks. Since there is no effort made to time the market or to pick winners and losers, there is no need to hire expensive economists or security analysts. The strategy can be deployed by a single manager equipped with a smart computer. Thus, the expenses of running the index fund are quite small. In fact, Vanguard s annual fee today for running the fund is six basis points (that is,.06 percent) of fund assets. This compares to approximately 150 basis points for the average actively managed stock funds. The rationale for creating the index fund was a growing suspicion or awareness that actively managed equity funds produce returns before fees that were no greater on average than market returns. Naturally, in this case the return after fees (the net return to the investor) would lag behind the market return (by, roughly, the amount of the fee). Thus, Bogle identified an opportunity to create a product that should be very appealing to the typical investor getting market returns at very low expense. Surely, this was an important financial innovation. Less well known is Bogle s innovation in corporate governance. Vanguard is the only mutual fund company that is truly mutual in that they are owned by the investors in the funds, rather than by a separate investment management company with its own shareholders. Thus, profits from management fees are used to further reduce fund expenses. Bogle has been preaching the benefits of passive index fund investing, and the mutual form of governance for mutual funds, for more than forty years. He has produced dozens of books and articles on the subject. His argument rests both on the Efficient Market Hypothesis (EMH) that says that it is very difficult for active investors to beat the market, and the Cost Matters Hypothesis (CMH) that says that the net return on a fund is a negative function of the expense ratio of the fund. Bogle has conducted numerous studies of the variables that drive fund performance, and he finds that the single best predictor of return is the cost of running the fund (including the expense ratio mentioned above plus the sales load or commission, if any). Low cost funds do better than high cost funds. In one sense he has been extremely successful; Vanguard is now the largest mutual fund company in the world with assets under management of nearly $3 trillion. The driving force behind this extraordinary growth is undoubtedly Vanguard s success at producing market returns at extremely low cost.

4 Yet in another sense, based on actual realized returns of retail (non-professional) investors, he has been an abysmal failure. Most individual investors have remained oblivious to the Bogle message and Vanguard opportunity. Instead of matching the overall market, or lagging behind by a few basis points, the average realized returns of retail investors lag the overall market by literally hundreds of basis points. Obviously, most people are not taking advantage of Bogle s brilliant innovation. The reasons for the awful performance are many, including high expenses, excessive trading, and really poor timing. In one study, Bogle estimated the costs as follows: average expense ratio 150 basis points, average trading commissions 75 basis points, plus another 200 basis points of underperformance due to poor timing selling low and buying high. This rough breakdown accumulates to 419 basis points of under-performance (150 plus 75 plus 200 minus index fund expenses of 6). Returns: Historical and Expected Four hundred and nineteen basis points per year is a gigantic reduction in potential return. The longterm historical return on the US stock market is approximately 10%. Thus, the typical retail investor suffers a forty percent reduction in annual return, and it gets a lot worse with compounding. Over a forty-year period, compounding at 10% takes $1 to $45, while compounding at 6% (10%-4%) takes $1 to $10. The average investor has given up almost 80% of the potential wealth gain. Looking forward over the next ten or twenty years, many people argue that future returns will be lower than historical returns. This is due to lower expected economic growth, lower real rates of interest, and relatively elevated equity prices today. Suppose expected returns on the overall equity market are 6% looking forward, instead of the realized history of 10%. If the cost of mistakes remains the same at 400 basis points, this means fully two-thirds of the potential annual return is lost. Recommendation Bogle s recommendation for the retail investor is very simple, even simpler than the Gone Fishing portfolio described last month. You only need to worry about two funds: an overall stock market index fund (Vanguard s exchange traded fund VT (global stocks) or VTI (US stocks) would fit the bill) and an overall bond market index fund (like Vanguards exchange traded fund BND). The overall market value of stocks is about 150% of the value of bonds, so the market weighting between these two funds would be about 60% VTI and 40% BND. If you are more risk averse than the average investor, you should lower your target VTI allocation, and if you are less risk averse you should raise it. Finally, Bogle makes the argument that you should gradually reduce your stock allocation as you get older. Other than that, there is not much you have to do with your portfolio. Bogle s advice is consistent with the financial theory that was being created around the time frame that he started Vanguard. The key ideas in this theory are the value of diversification, the Capital Asset Pricing Model which says that you only get paid for taking on systematic risk and the primary (sole) source of systematic risk is volatility in the overall stock market, and the Efficient Market Hypothesis

5 described above. Since the 1980s, however, further developments in financial theory challenge portions of this theory, particularly the notion that there is just one source of systematic risk. We will discuss this theory and the implications for portfolio management in the next posting. 3. Asset Pricing Theory John Cochrane is professor of finance at the Booth School of Business at the University of Chicago and is an expert on the theory of asset pricing. You can take (or audit) his free online course through Coursera ( In this course he starts out by briefly summarizing the state of the art in asset management back in the 1970s. The key ideas at the time were Modern Portfolio Theory (MPT), the Capital Asset Pricing Model (CAPM) and the Efficient Markets Hypothesis (EMH). The main authors of these theories were all awarded Nobel Prizes in economics. Basically, the MPT showed that you could reduce risk by diversifying across multiple investment vehicles, the CAPM argued that you only got paid for taking on systematic or market risk, and the EMH argued that market prices reflect all available information. The combination of these ideas argued strongly for investing in two assets: a risk-free asset (the closest thing to this in the real world is probably inflationindexed Treasury bonds) and a market portfolio that includes all stocks in proportion to their individual market values. These theories provided intellectual support for John Bogle s introduction of the first index fund, the Vanguard 500, as discussed in a previous blog. Recent Research Since the 1970s a lot has changed. First, the CAPM has not stood up to testing. In the CAPM, the expected return on an asset (an individual stock, or a portfolio of stocks) is a positive function of the beta of the asset, which is a measure of the sensitivity of the asset s return relative to the return on the market portfolio (the source of systematic risk). Thus beta has come to mean the return from taking on market risk. Any realized return above the predicted return is called alpha and represents non-systematic return. The theory is that alpha should be zero on average. However, in exhaustive tests conducted in the 1980s and 1990s it was discovered that certain classes of stocks, in particular small stocks and value stocks tended to have returns greater than you would have expected from their betas (that is, they exhibited positive alpha). Value stocks mean stocks that have depressed prices relative to earnings, dividends or book value. Thus, the ratio of earnings to price or dividend to price is high for a value stock. The fact that value stocks seem to do better than growth stocks prompted people to contemplate predicting future return by using these ratios. In particular, Cochrane discusses at length a model that explains return simply by using the dividend yield (ratio of dividend to price, or D/P). He finds that this model works well high D/P predicts high return and low D/P predicts low return, particularly over relatively long horizons (like five years or so). In other words, long-term equity returns are (at least somewhat) predictable!

6 And not just stock market returns. Studies have also shown that bond returns are predictable (extremely steep yield curves predict higher returns for longer term bonds), foreign exchange returns are predictable (extremely high interest rates on a particular currency predict higher returns on a strategy that is long the currency with high rates and short the currency with low rates), and similarly for credit markets and commodity markets. To summarize this research, researchers now believe that there are numerous sources of excess return or risk premiums including the overall equity risk premium, the value stock premium, the small stock premium, the term premium, the credit premium, and so on. Implications for Portfolio Management In order to determine if you should orient your portfolio so as to bet on these various sources of excess return, you have to make a judgment about why they exist in the historical data, and whether they are likely to persist in the future. Those authors that continue to support the EMH, like its chief creator Chicago Business School professor Eugene Fama, argue that the value, size and other effects are reflections of underlying deeper sources of risk. Other economists, like Yale economist Robert Shiller, argue that findings of positive risk premiums suggest that the markets are not efficient, perhaps because investors are not totally rational. It is interesting to note that Fama and Shiller (along with another Chicago finance professor Lars Hansen) shared the 2014 Nobel Prize in Economics, even though they come down on opposite sides of this major issue. If Fama is correct then it is likely that risk premiums will persist, but you are indeed taking on greater risk. If Shiller is correct, the historical excess return has been a free lunch, but who knows if it will continue. Notwithstanding this debate, many investment management companies have sprung up over the past two decades based on the academic research mentioned above. Once of these is Dimensional Funds Advisors (DFA) founded in 1981 by Chicago Business School alum David Booth. DFA offers a number of investment funds that are constructed so as to capture the size effect, the value effect, the term effect, the credit effect, and so on. DFA has been quite successful (so much so that business school at Chicago is now known as the Booth School in honor of his significant financial contribution). Should you invest in DFA funds instead of Vanguard? Well, you can t, at least not easily. DFA only sells its funds through selected investment advisors. You have to sign up with one of the approved investment advisors and pay their fee plus the DFA fee. The question then becomes, once you pay the double set of fees, have you lost the benefit of low cost passively managed funds? Meanwhile, the vendors of passively managed index funds (like Vanguard) have responded to the new research by offering passive funds that tilt toward small stocks (ticker symbol VB), or value stocks (VTV), or other possible sources of excess return. Indeed, these are the types of funds that comprise the Gone Fishing portfolio described in a previous posting. While it makes sense to me that stock prices (and other asset prices) are subject to psychological waves of optimism and pessimism, I think Fama s idea that there are other sources of risk besides correlation

7 with the market portfolio also makes sense. One deeper source of risk may simply be the probability of failure. Small stocks are more likely to fail in a tough economic scenario due to less staying power. Likewise for value stocks (an operational definition of value is where the price is low relative to earnings, dividends or book value). Thus, the additional return for investing in small stocks or value stocks is associated with additional risk. Alternatively, you could achieve higher expected return simply by increasing your allocation to the overall stock market. Careful analysis by scholars and quantitative fund managers suggests that it may be more efficient to seek greater risk by diversifying into value or size (or other potential areas of greater risk and return like term, credit, carry, liquidity, etc.), instead of simply increasing the overall equity allocation. Indeed, a common strategy for quantitative hedge funds is to optimize their portfolios by allocating risk to various areas until the marginal additional return per unit risk is the same in each area. The expertise and analysis required to do this effectively comes with a high price (giant hedge fund fees) and may or may not provide a net benefit after fees. Data suggests that the after-fee gain is small or negative. It is not feasible for the individual investor to follow this hedge fund strategy. But the do-it-yourself investor does have a number of feasible ways to go. You can use the Bogle recommended two fund strategy (one overall stock fund and one overall bond fund). You can use the ten fund Gone Fishing strategy (which is partially based on the academic findings discussed above). Either way, you will achieve net returns close to overall market returns, which is dramatically better than the historical performance of individual investors. Still, lots of people (perhaps a majority) are not comfortable with going it alone and would prefer to seek expert guidance. Unfortunately, this expertise generally comes at a high cost. Recently, another alternative has appeared on the scene. This is the robo-advisor where financial theory and technology link up to offer a managed fund process at very low cost. In the next posting, I ll profile one of these services; a very successful recent IPO (i.e., a company that recently sold stock to the public for the first time) called Wealth Front. 4. Wealthfront We have shown in prior blogs how do-it-yourself investors can achieve reasonable investment returns through the use of low-cost highly diversified passively managed funds. How can non-do-it-yourselfers obtain these same benefits? There are financial advisors who specialize in these services, but often not at an acceptable level of cost. Recently, a marriage of technology and financial theory has resulted in a number of online wealth management services that provide automated, algorithm-based portfolio management advice at very low cost (these services are known as Automated Investment Services or AIS). One of these is Wealthfront, a company started just two years ago and already managing nearly $3 billion in assets. The founders include technologists and financial economists.

8 Wealthfront is targeting the tech-savvy millennial generation; people who grew up with technology and arguably would be more comfortable with turning their portfolios over to an automated process. The company offers a set of diversified portfolios, each using low-cost passively managed index funds (in the form of Exchange Traded Funds). The funds represent major asset classes including US equity, international equity, emerging markets, dividend stocks, corporate bonds, municipal bonds, inflationindexed bonds, real estate and precious metals. A recommended allocation across these asset classes is derived from user answers to a brief set of queries that are aimed at assessing a client s tolerance for risk and investment horizon. The company offers a very competitive fee structure: zero percent on the first $10,000 and then 25 basis points (.25%) on the remaining balance. This fee is in addition to the expense ratio on the funds (roughly 10 basis points). For large accounts (greater than $1 million), Wealthfront will create a personalized index fund consisting of a portfolio of individual stocks designed to match market indexes. The benefit of this service is that you save the 10 basis point fund fee (and only pay the 25 basis point Wealthfront fee). In return for their fee, Wealthfront takes over management of your portfolio. The portfolio is automatically rebalanced at no cost in order to maintain the desired asset allocation. Capital losses are automatically harvested (realized) in order to optimize tax efficiency (to offset realized gains and maximize deductible losses), again at zero cost. The Wealth Front website claims their process offers a total value added of roughly 300 basis points (3%) of return per year, based on their low fee structure and the benefits of rebalancing and tax loss harvesting. Not only that, but by turning your portfolio over to an automated process, you are at least partially prevented from making monumentally bad timing decisions. This might be the biggest benefit of all. The website is very user friendly, even for an aging baby boomer. The risk tolerance measure is on a scale of 0.5 (very low risk tolerance) to 10.0 (huge risk tolerance). You can toggle the measure and see instantly changes to the recommended portfolio. The total allocation to equities is 90% for the 10.0 risk lover and 33% for the 0.5 risk hater. There is a screen showing projected portfolio performance over a five year period, based on the recommended asset allocation. You can see the range of probable values of the portfolio in five years, and the probability that it declines in value. What is the downside to AIS? One potential downside is for some reason (perhaps a decline in the overall stock market) you lose confidence in the process and decide to intervene. That is, you still have the opportunity to make monumentally bad timing decisions. Second, portfolios are tailored to the individual customer only in a fairly coarse way. The series of questions put to a client are aimed at assessing the client s tolerance for risk and investment horizon, but do not attempt to assess the client s overall financial position. For most people who are not in or near retirement, the amount of financial wealth they have is small relative to their human capital or the present value of future earnings. Ideally, the nature of this earnings stream should be taken into account when determining the financial portfolio. For example, a tenured college professor has an income stream which is very safe, like a Treasury bond. It would be appropriate for the college professor to concentrate her financial portfolio in riskier assets, like equities. On the other hand, a serial entrepreneur has an extremely volatile

9 earnings stream and should concentrate her financial portfolio in less volatile assets, like bonds. It is possible that a financial advisor would take these factors into account and come up with more appropriate portfolios. I see three broad groups of investors. First are the people that are comfortable with handling their own portfolios. Financial theory and innovations have provided this group with the tools to obtain market returns at very low cost so that do-it-yourself is a viable strategy. The second group consists of people who are comfortable with turning their portfolios over to an automated process. This is the target market for AIS, but to this point does not comprise a large portion of the total market. Of an estimated $27 trillion of financial wealth being managed by somebody, the share of AIS is a fraction of one percent. Wealthfront s bet is that a large portion of young people will eventually fall into this second bucket. As described above, the AIS approach offers the benefits of low cost funds along with further benefits of automated rebalancing and tax loss harvesting. Do these benefits more than offset the (modest) AIS fee? I don t know the answer, but surely the AIS approach is also a viable strategy. The third group, comprised of people who demand a personal touch, is today by far the largest group. It encompasses a wide variety of different types of relationships from fee-only financial planner to discount broker, full-service broker, active mutual fund manager, separate account manager, etc. It is certainly possible that an advisor can add value through developing a customized plan or a market beating portfolio. In the next blog, the final chapter in this series, we ll review some specific strategies aimed at achieving market-beating returns. 5. Fundamental Indexing (and other market beating strategies) Asset management is an extremely competitive industry that offers extraordinary wealth building opportunities to those managers who are successful in generating market beating returns, or at least in bringing in large amounts of assets to manage. This opportunity draws lots of really smart people to the business. The problem is that the average performance of these really talented people is likely to be near market average returns before subtracting fees, and below market returns net of fees. Meanwhile, individual investors can achieve something very close to market returns by investing in low-cost passively managed index funds. This apparent paradox, that an amateur can outperform the average pro, is due to the fact that tremendous competition makes it extremely difficult to consistently beat the market. Active managers resist this theory. They point to examples of investors that have consistently outperformed the overall market for years (Warren Buffett being one example). Besides, if there were no gains to be achieved through market analysis and security analysis, why do so many people pursue these activities? Cynics might respond that these activities are pursued in part because customers are easily duped into paying large fees for them, even if they do not on average produce value.

10 Behavioral finance says that the academic theory of the Efficient Markets Hypothesis (EMH) is wrong because people are not rational. They are subject to waves of optimism and pessimism, they are overconfident, they extrapolate recent results, they tend to hold onto losing investments too long and sell winning investments too soon. These errors of judgement lead to terrible investment performance by individual investors. On its face, this theory suggests the opportunity for active management to take the other side to the losing trades of the individual investor, or at least to help the individual out by keeping him from making mistakes. Of course, in order to add value the active manager must not be susceptible to these well documented errors and biases. Even without assuming superior ability to outwit the market, one implication of behavioral finance is to question the efficiency of traditional indexes of market return. Most indexes, like the SP500, are socalled market capitalization weighted indexes. This means that the share of each stock in the index is its proportionate value weighting (i.e., the weight for Apple is the market value of Apple divided by the sum of the market values of all SP 500 stocks). Market capitalization (or market cap ) weights are prescribed by traditional financial theory. The market portfolio is a market cap weighted index of all traded stocks. But if stock prices do not fully reflect available information as assumed by the EMH, then we can conclude that stocks are, at times, either over- or under-valued. The effect of market cap weights is to concentrate too much weight on over-valued stocks and place too little weight on undervalued stocks. The consequence is that you will be more susceptible to asset price bubbles and will tend to underperform indexes that are not based on market cap. To avoid this source of underperformance, you might want to use other methods to build indexes and index funds. The simplest is equal weight where each of N stocks has weight 1/N. Alternatively, you can build portfolios by weighting fundamentals like company sales, or profits or book value. This is called fundamental indexing. Notice that the theory does not assume that the asset manager can identify which stocks are over and under-valued, just that market cap weightings are not efficient. One of the leading proponents of fundamental indexing is Robert Arnott who has conducted research studies to show that fundamentally indexed portfolios have out-performed market cap weighted portfolios. Arnott is also a financial entrepreneur who has introduced the RAFI (Research Affiliates Fundamental Indexes) set of fundamentally indexed funds. Perhaps not surprisingly, one critic of fundamental indexing is John Bogle. He points out that financial theory supports market cap weighting and claims that fundamental indexing is simply another version of tilting your portfolio toward value stocks or small stocks, and that any additional return that you may achieve is balanced by greater riskiness of the portfolio. It turns out that this dynamic identification of a market beating strategy, and then realization that it entails heightened risk seems to come up a lot. Researchers have identified historical market beating

11 returns in small stocks, in value stocks, in momentum strategies (buying stocks that have been moving up and selling those that have been moving down), by using leverage, in selling liquidity (buying illiquid securities and selling liquid securities), in being short options (selling volatility) and numerous other strategies. Generally, the flip side of the higher average return is that the potential downside risk of the strategy in a difficult environment may be extremely large. This is one of the fundamental lessons of financial economics. Bottom line So what should you do? Take a deep breath and try to focus on the important stuff. The first step is to develop an overall financial plan, featuring a feasible spending plan given your current income, likely future income, current age, desired retirement age and current financial wealth. The second step is to manage your investment portfolio in a coherent way. Keeping it simple, you should have three objectives. First, take advantage of the equity risk premium by holding broad equity exposure. Second, maintain a safety net in the form of a low-risk bond portfolio. Third, take advantage of any special skills or talent that you might have (this talent could be security analysis and selection, or market forecasting and time, or manager selection). The first two objectives can be achieved through a core portfolio consisting of broadly diversified stock and bond funds. The percentage in equities should depend on your tolerance for risk. The third objective is to increase return by using your special skill; that is, if you have a special skill. You can do this by running an active portfolio in addition to the core portfolio. The size of the active portfolio relative to the core portfolio should depend on the confidence that you have in your special skill. For most of us, the active portfolio percentage should be very small. Can you do this by yourself? Sure you can. But most people will probably decide to employ outside expertise in one or more of these steps. Just be sure to keep an eye on the fees.

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