The Evolution of Investing

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1 Bringing the Best of Academic Research to Real-World Investment Strategies

2 The Science of Investing from the Halls of Academia An enormous Industry has developed over the years that s very familiar to all of us. It s called Wall Street. This whole industry is based mainly on the notion that somebody can peddle investment advice to people that predicts the future. In addition, numerous magazine articles and books on investing have been written over the years, and cable TV investing programs have been created all of which in one way or another, attempt to divine the future. As unusual as it seems, this has always been the conventional approach to investment advice. However, over the years, an entirely new approach to investing has been developing not at Wall Street firms, not at banks or insurance companies, not at pension funds, but instead, in the halls of academia at places like the University of Chicago, Dartmouth, Stanford, Yale and MIT. The academic body of knowledge developed at these universities has taught us some very interesting things about investment markets, and has made some assertions that, when first put forth, were ridiculed dismissed as total nonsense by the so-called investment experts of the day. Today, however, these ideas have become more powerful and much more difficult to refute And the reason is this: the academics have developed an approach to investing that s based not on speculation, and attempting to predict the future but rather on decades of research, and on the science of capital markets a strategy that has been trial-tested in academic labs and time-tested in actual portfolios. The ultimate goal of this research: to deliver the performance of capital markets, and increase returns through state-of-the-art portfolio design and trading. To this day, thanks to ongoing research in the academic community, the model continues to evolve.

3 Modern Portfolio Theory and the Capital Asset Pricing Model During the 60 s, a trio of young graduate students at the University of Chicago (Harry Markowitz, Merton Miller and William Sharpe) wrote their PhD dissertations on the subject of the stock market. From their work came what is known today as Modern Portfolio Theory and won for them Nobel Laureates in Economics. Willliam Sharpe shared this award for his pioneering contribution to asset pricing theory. His model sought to explain how risky assets would be priced in equilibrium. Employing a number of simplifying assumptions, the Capital Asset Pricing Model he developed proposed that a stock s expected return was a function of its volatility relative to the volatility of the universe of risky assets, and that the most efficient portfolio was the entire universe of risky assets. The CAPM provides the intellectual foundation for the totalmarket index fund. Equity risk is a combination of systematic and unsystematic risk: Systematic risk includes macroeconomic conditions affecting all companies in the stock market. Systematic risk cannot be diversified away. Unsystematic risk includes company and industry developments specific to individual securities. The effect of these can be reduced through sufficient diversification. Investors should not expect markets to reward them for taking on risks that can be diversified away. They should expect compensation only for bearing systematic risk.

4 The Three-Factor Model Another study, conducted by two of the leading academics in the world of finance, Eugene Fama and Ken French (both former students of the aforementioned Nobel laureates), was even more groundbreaking in nature. Their study, called the Three- Factor Model, teaches us that equity market returns can be summarized in three dimensions. The first is that stocks are riskier than bonds and consequently have greater expected returns. Next, among stocks, relative performance is largely driven by the two remaining dimensions: small cap stocks vs. large cap stocks and value stocks vs. growth stocks. Many economists believe small cap and value stocks outperform their large and growth counterparts because the market rationally discounts their prices to reflect underlying risk. The lower prices give investors greater upside as compensation for bearing this risk. More specifically, just as the S&P 500 has much higher historical returns than T-Bills (no surprise there it s really just payment for taking on the risk of owning equities) the data shows that the same holds true for small stocks vs. large stocks and for value (financially distressed) stocks vs. growth (financially sound) stocks. In each case, owning the riskier stocks (small and value) must reward the investor over time, in order to attract investor money and to compensate the investor for taking the additional risk. (The caveat here is that while the data shows that small and value do outperform over time, the data also shows us that they don t outperform all the time.) This is a truly seminal study grounded in academic research, supported by intellectual underpinnings and backed by historical pricing data from the 1920 s the Three Factor Model has changed the way we think about investing.

5 From Academic Theory to Real-World Strategies At Plancorp, we are strong advocates of Modern Portfolio Theory, the Capital Asset Pricing Model (CAPM), and the Three Factor Model and derive our investment strategies from the most current academic thinking and research. Much of this body of research points to the fact that there is actually little to no value-added derived from the traditional stock picking and market timing approaches favored by most investment professionals today. Academic research instead indicates that portfolio performance is primarily the result of the asset allocation decision made. Portfolio construction begins with the goal of attempting to capture the return that the various markets give us, with the ultimate goal of generating returns that add incremental value over and above the return of the overall market. We do this by owning the market investing in various asset classes around the world and then into subsets of those asset classes. This broad diversification strategy addresses both the risk issue as well as the return expectation. We attempt to add value on the return side by overweighting in those areas of the market that have historically shown to produce the best returns. This investment approach borrows from groundbreaking research performed by some of the leading academics in the world of finance, and it forms the cornerstone of our investment philosophy. It also provides us with the intellectual underpinnings that allow us to bring some rationale to the investment markets. Finally, since we are strong proponents of the efficient market theory (which states that at any given point in time, the actual price of a security is a good estimate of its intrinsic value), we take a more academic-based, passive approach to the investment process, as opposed to the more traditional active approach favored by most money managers today. We find that there are many advantages to the passive approach to investing, especially in the areas of cost, performance, style drift, cash drag, and fiduciary responsibility. Understanding the Keys to Investing Markets Work Capital markets do a good job of fairly pricing all available information and investor expectations about publicly traded securities. Diversification is Key Comprehensive, global asset allocation can neutralize the risks specific to individual securities. Risk and Return are Related The investor s compensation for taking on increased levels of risk is the potential to earn greater returns. Portfolio Structure Explains Performance The asset classes that comprise a portfolio and the risk levels of those asset classes are responsible for most of the variability of portfolio returns.

6 Key Investment Principle #1 Markets Work Rather than trying to outguess the market, let it work for you Markets throughout the world have a history of rewarding investors for the capital they supply. Companies compete with each other for investment capital, and millions of investors compete with each other to find the most attractive investment opportunities. This competition quickly drives prices to fair value, ensuring that no investor can expect greater returns without bearing greater risk. Investing vs. Speculating Traditional investment managers strive to beat the market by taking advantage of pricing mistakes and attempting to predict the future. Too often this proves costly and futile. Predictions go awry and managers miss the strong returns that markets provide by holding the wrong stocks at the wrong time. When the investor rejects costly speculation and guesswork, investing becomes a matter of separating the risks that investors are compensated for (market risk) from the risk where they receive no compensation (individual company risk, industry risk, single country risk, etc). It s then a question of determining how much of these risks to undertake. Financial science identifies the sources of investment returns, and we provide the tools and experience to achieve them. Gaining Clarity In an efficient market, at any point in time the actual price of a security will be a good estimate of its intrinsic value. Eugene F. Fama Random Walks in Stock Market Prices, Financial Analysts Journal, Jan/Feb 1995 Early recognition and understanding of the efficient market theory can direct investors to a passive investment approach saving them from below-market returns and the additional costs associated with active management.

7 Key Investment Principle #2 Diversification, Diversification, Diversification Significant research has been performed over the years to determine what impact diversification can have on the risk and return dimensions of a portfolio. Capital markets are composed of many classes of securities, including stocks and bonds, both domestic and international. A group of securities with shared economic traits is commonly referred to as an asset class. There are numerous asset classes both in the U.S. and abroad, each with historical price movements that tend to be distinct from one another. In addition, in today s changing global landscape, the use of international investing (both in developed and emerging markets) has taken on increased importance. Research shows that investor portfolio s are best served from a risk and return standpoint by being diversified across all asset classes as well as within each of those asset classes. Examples of different asset classes include, among others: large cap stocks, small cap stocks, value stocks and growth stocks in both U.S. and foreign markets. (Sector companies such as the communications industry or the health care industry, as well as single foreign countries, are not considered asset classes.) Because the asset classes play different roles in a portfolio, the whole is often greater than the sum of its parts. As a result, investors have the opportunity to achieve greater expected returns over time with lower standard deviations (volatility) than they would in a less comprehensive portfolio. In the end, the goal of diversification is to provide the investor with global investment solutions that attempt to maximize returns at a reduced level of risk.

8 Key Investment Principle #3 Risk and Return are Related When it comes to investing, the academics have identified what really matters. Evidence from practicing investors and academics alike points to an undeniable conclusion when it comes to investing: Returns come from risk. Gains in the marketplace are rarely accomplished without taking risks, but the caveat is that not all risks carry a reliable reward. Fortunately, thanks to the academic community, over the last fifty years financial science has brought us to a powerful understanding of both the risks that are worth taking, and those that are not. Avoidable risks include holding too few securities, betting on single countries or industries, following market predictions and speculating on information from rating services. To all of these, diversification is the antidote. It wipes away the random fortunes of individual stocks and positions your portfolio to capture the returns of the broad market. Structuring a strategy around compensated and uncompensated risk factors gives purpose to an investor s portfolio. Rather than analyzing individual securities, the more relevant decision becomes one of how much stock to hold versus bonds, and how much small and value tilt those stocks should have. By focusing on these issues, rather than on the noise coming from Wall Street, we focus on the things that really matter in developing a responsible, successful investment strategy.

9 Key Investment Principle #4 Portfolio Structure Explains Performance One of the questions that the academic community spent a great deal of time researching over the years was this: Of all the decisions that are made regarding the way we manage an investment portfolio, what is it in the decisionmaking process that can most enhance the performance of a portfolio? The answer was found in a 1986 ground-breaking research study by Gary Brinson of Brinson, Hood and Beebower titled Determination of Portfolio Performance. His study analyzed the reasons for performance variations between securities portfolios with the goal of trying to understand what it was that added the most value to a portfolio over time. The issues involved were: Asset Class Selection (how assets are allocated in a portfolio i.e. how much in stocks, how much in bonds and how much in cash), Market Timing (shifting portfolio assets in and out of the market or between asset classes), and Stock Selection (finding the best stocks, bonds or mutual funds to own). The study s somewhat surprising conclusion was that the asset allocation decision was by far the most significant determinant of portfolio performance accounting for over 90% of the variation of portfolio returns, with market timing and stock selection accounting for the remainder of the variation. More recent studies have come up with different variations of the original study, but all agree that asset allocation plays a dominant role in determining the variability of performance. These findings were quite extraordinary, and they served to reinforce the notion that an academic-based investment approach that focuses on asset allocation is truly the antithesis of the more traditional star system employed by most institutional portfolios.

10 The Next Frontier the Core Equity Strategies The academic model of investing developed by a select group of academicians continues to evolve with the latest manifestation found in the advancement of a more integrated solution called the core equity strategies. These strategies target expected return, along with the reduction of portfolio friction (costs) which so often impedes effective investment planning. Core strategies are integrated portfolios that hold a wide range of equity securities. Across this range, each core strategy is designed to achieve a progressively stronger exposure to the greater expected returns of small cap and value stocks. Yet, in achieving these exposures, each core portfolio manages to contain virtually every stock in the market. US Applied Core Equity Applied Core 1, Applied Core 2 Market-wide strategies Higher expected return than the market and the S&P 500 by: Underweighting large growth companies Overweighting small and value companies Using these core strategies with their strategic tilts helps capture the same expected return as the more traditional component strategy (which is composed of individual investment pieces for each separate asset class), but with a significant reduction in the usual costs. This cost savings occurs, in part, because in the component strategy, transactions are forced by the buy and sell rules required to maintain the integrity of each particular asset class. When a transaction takes place, the investor bears the cost of the trading which, in the end, does nothing more than move a stock from one asset class to another. It s like absorbing commission costs, price impact, and tax costs just to move money from one pocket to another. In addition to these savings from transaction costs, there can be significant tax savings resulting from the potential reduction of capital gains distributions. Capturing the compensated dimensions of returns while minimizing needless risks and costs is what the core equity strategies are all about and represents the next logical step in the evolution of an idea.

11 Minimizing the Routine Costs of Asset Allocation Component strategies provide sharp exposure to limited segments of the market. Applied core strategies capture the benefits of traditional component investing with smoother market exposure at a lower cost While Capturing the Compensated (Small and Value) Dimensions of Returns A Plan for the Future In the final analysis, at Plancorp we see markets as an ally, not an adversary. Rather than trying to take advantage of the ways markets are mistaken, we take advantage of the ways they are right the ways they compensate investors. We design portfolios to capture what the market offers in all its dimensions. However, the work is never complete. The final chapter will never be written. But a process grounded in academic science can only improve the odds of financial success. The peace of mind and clarity of such an approach is, in itself, reward enough for most investors its long history of documented performance only adds to its allure. By applying modern financial principles to wealth management, Plancorp remains ahead of the industry and stands ready to assist you in addressing your investment needs.for information on the fiduciary responsibilities of the institutional trustee, see the following page