“(One of) The Most Powerful Ideas in Investing”

active-vs-passive-investing-300x166 4In the last fifteen months, $215 billion has moved out of actively managed mutual funds into passively managed index funds and Exchange-Traded Funds (“ETFs”).  It’s possible another $2.5 trillion will migrate out of actively managed funds in the next decade.  Noah Smith in Bloomberg View last week suggested this transition may be “the biggest story in the finance industry during the past decade; larger than the 2008 financial crisis.”  In fact, Mr. Smith titled his article “The Rise of the Most Powerful Idea in investing.”

There are five major reasons astute investors use passive investments for mature markets, such as most equity and fixed income asset classes:

  • The “Efficient Market Hypothesis,” an investment theory for which Eugene Fama won a Nobel Prize, states that it is impossible to “beat the market” because stock market efficiency causes existing share prices to always incorporate and reflect all relevant information. As a result, it should be impossible to “outperform” the overall market through expert stock selection or market timing.
  • Modern technology allows index mutual and ETFs to construct portfolios that track indices closely and inexpensively. Some index funds have an operating expense ratio of .05% or less.
  • In general, actively managed funds over time have underperformed. It’s pretty simple math. Investors in actively managed funds are paying higher operating fees and sometimes front-end loads and marketing fees as well.  All in all, some actively traded funds have expenses over 1.5% per year, while a similar exposure in the markets using passive funds could cost .35% or less.  People trying to beat the market are likely to lose, since they tend to be trading on stale information, while paying higher fees at the same time. On average, the 1% or more of costs result in underperformance of a similar magnitude.  Over time, this has a huge negative impact on wealth creation.
  • Low interest rates are producing lower returns which make investment costs more noticeable and painful, pushing people toward low-fee passive investment vehicles.
  • The new “Fiduciary Rule” issued by the Department of Labor has brought more public awareness to the difference between brokers and Registered Investment Advisers (“RIAs”) like DWM.  Many investors previously thought that any financial advisor was a fiduciary and hopefully looking out for the clients’ best interests.  When, in fact, some brokers were looking out for their own best interests, selling actively managed funds that produced more income for the broker, while reducing the potential performance for the investor.

We may now have hit a real “tipping point” in the “debate” over actively managed vs. passively managed investing.  In the latest sign of the change, yesterday Charles Schwab & Co. announced it is taking mutual funds with sales loads off its shelves.   These “Class A Load Shares” have become a
“tiny fraction of Schwab’s mutual fund business overall” according to A Company spokesman.

To conclude, while some, such as Mr. Smith, would say that the migration from actively managed investing to passive investing is the “most powerful idea in investing”, we at DWM see this “idea” as just one of the key building blocks of sound investment management.  You regular DWM blog readers and seminar attendees hopefully can recite with us the remaining factors by rote:

  • Creation of an investment plan to fit your needs and risk tolerance
  • Identifying an appropriate asset allocation
  • Structuring a diversified portfolio
  • Reducing expenses and turnover (including use of passive investments for mature markets)
  • Minimizing Taxes
  • Monitoring (by comparison to benchmarks) and rebalancing regularly
  • Staying invested

All of these controllable activities are powerful ideas that can assist you, with the help of your wealth manager if you desire, to add significant value to the management of your investment portfolio and enhance the ability to protect and grow your assets.

Three Point Shots and RIAs: More in Common than You Think

s curry 1Hats are off to the Golden Warriors for a fantastic season with 73 victories.  Of course, this eclipsed the record 72-win season that Michael Jordan and the Bulls had 20 years ago.   Steph Curry had a huge season, averaging 30 points a game, including making 402 three point shots, breaking his 3-point record total last year by 116.

These days, the best teams shoot lots of 3s.  It wasn’t always that way.  Larry Bird, whose best 3-point season was 87-88 when he made 98, puts it this way:  “I thought little of the shot when it came into the league (in 1979).”  That first year, the entire NBA averaged 2 attempts per game.  Of course, many coaching staffs and their owners were slow to accept change.  It took 15 years before the league averaged 10 three-point attempts per game.  This year the average was 25 per game with Golden State averaging 32.

Just 10 years ago, NBA defenses focused on protecting the paint.  Now they know they need to protect the perimeter as well.  The math is pretty simple.  A three-point shot is worth 1.5 times that of a 2-pointer.  And, if you can make them 45% of your attempts, as Steph Curry does, that’s huge.  But even a three at 33% accuracy (NBA’s overall rate was 35% this year), yields the same points as shooting 50% from 2-point range.

A similar sea change is happening in the wealth management world.  Registered Investment Advisors (“RIAs”) like DWM continue to draw assets from the big banks, wire-houses and other brokerage segments at an impressive pace.  Since the 2008-09 financial crisis, there has been a big movement to RIAs.  RIAs managed 19% of assets in 2010, 25% now and Cerulli Associates of Boston estimates the number will be 28% by 2018.

Again, the math is pretty simple.  The world has changed.  Double digit equity returns in the 80s and 90s, fueled by higher economic growth and inflation, are gone.  Actively managed mutual funds have been shown to underperform over time.  Families are looking for more than “big-name” investment management.  They are looking for an experienced, competent wealth manager to help them in all aspects of their financial life. People are demanding more value for their money.

They are also looking for a financial advisor that is committed to putting their interests first.  RIAs, by law, are required to follow a fiduciary standard.  Brett and I have signed an oath demonstrating that commitment and also are Accredited Investment Fiduciary (AIF®) certificants. But not every advisor has been adhering to the same standard. So the Department of Labor (“DOL”) has taken action.

Just last week, the DOL issued its new rule requiring advisors to adhere to fiduciary rules with respect to most of the $23 trillion U.S. retirement market.  As we reported in our February 18, 2016 blog “Fiduciary Standard Closing in on Reps and Brokers” http://www.dwmgmt.com/fiduciary-standard-closing-in-on-reps-and-brokers/, the new rules should eliminate the large front-end loads and high average annual expense ratios on most retirement accounts.  This will save individual investors billions of dollars each year.  Investors will continue to demand more fair-dealing with their money.

Of course, not all RIAs are the same and not all NBA players are Steph Curry.  His success is a combination of a number of factors, including his own “special sauce.”  Certainly Steph has exceptional hand-eye coordination, a quick release and great repetition.  It’s more than that.   Curry is shooting as he is jumping.  The result is a sharp arc and steeper shot which provides a wider opening into the rim.  Hence, his huge accuracy.

Steph had to work hard to get here.  He was often the smallest guy on the court growing up and had to find a way to get the ball over the taller boys and keep up with the bigger and better players.  Curry had to develop his own unique offering which is extremely successful and a delight to watch.

Similarly, there are lots of excellent RIAs, but we feel very few with a “special sauce.”  DWM is one of those few.  We were “late to the party,” starting in 2000; experiencing tough markets for us and our clients from day one.  We had to work harder: our investment management offering needed to be focused on finding better ways to protect and grow assets.  And, we needed to add lots more value than simply managing money.  We do this with a proactive, proprietary process focused on “Increasing Family Wealth by Adding Value” every day, week and month of the year in every aspect of our clients’ financial lives.   For us, that’s just like hitting a 3-point buzzer beater.


What’s Trending?

trend_watching1We are certainly living in an exciting time.  The world is facing many political, economic, demographic and technological shifts and it is fascinating to observe and participate in the changes. In 2016 especially, we are inundated with political polls and national statistics.  Often, these statistics or polls are reported to best suit a particular agenda.  It can be worrisome and makes many decisions, including those regarding our personal financial management, fraught with anxiety.  As Americans, we watch these trends and polls and try to put our world in perspective.

It is really fun to watch the technological advances!  These trends now come so quickly we can hardly imagine things before they are a reality.  A car that drives itself? Drones that deliver goods to your doorstep? A watch that contains your phone, internet service and monitors your health?  I have a personal example of the impact of new technology.  My grandfather, George Crowley, was an inventor and, as a boy, looked for ways to use electricity to better the world around him.  He rigged his mother’s curtains to open and close with the flip of a switch and made a dining room door that moved automatically.  As a Navy engineer assigned to GE, he used his talents during WWII to create heated flight suits that allowed the American bomber pilots to fly above the German anti-aircraft weapons, an ability that is noted in the Smithsonian Air & Space Museum as helping to turn the tide of the war.  That also led to a GE patent for the modern electric blanket, which, if you live in colder climates, is a wonderful luxury even now!  At the 1964 World’s Fair, my grandfather contributed to a GE film exhibit about a “House of the Future”.  In the imagination of the creators, there was a medical bed on which you would lay down each morning and receive a report on all your vitals – a quick health check-up.  We can now do this on most home exercise machines or health apps.  Everything in the 1964 smart house was voice activated or electronic in some way…video cameras in the baby’s room with monitors for the parents around the house; lights, music and security systems that were voice activated; kitchen appliances that allowed for “instant” cooking or multifunctional chores like today’s microwave ovens or food processors.  Amazing innovations in the 1950’s and 60’s and taken for granted nowadays.

It is also interesting to look back in history and see which economic and political predictions have been accurate.  John Naisbitt, who wrote “Megatrends” in 1982, outlined some of the challenges that lay ahead because of the economic shift from the industrial age to a more global information-based economy.  The issues of population increases, environmental stresses, militant religious forces and an explosion in the increase of information technology are trends discussed in the book.  They seem obvious now, but were certainly less so when originally written.  Our economy has had to adjust, rapidly at times, to these economic and political shifts and certainly impacts our life in this century!

Americans are facing some significant demographic changes ahead.  By 2055, the U.S. will not have one single ethnic or racial majority, according to the Pew Research Center (www.pewresearch.org) in the latest report on their population findings.  In this political year, with much focus on immigration issues, Asia has replaced Latin America as the biggest source of new immigrants to the U.S.  In fact, the Pew Research Center found that between 2009 and 2014, more Mexicans returned to Mexico than arrived in the USA.  Americans, it continued, are more likely to embrace our country’s diversity than consider it a burden.  The demographic group called Millenials, young adults born after 1980, are the generation to watch.  Millenials are more racially and ethnically diverse than any previous generation.  They also tend to consider themselves more politically independent than their elders and are optimistic about their financial future, despite the burdens of student debt and a weak job market.  And this is no surprise, but we have changes in our families, too.  Marriage rates and two-parent households are dropping and, with more women in the workforce than ever before, at least half of the traditional two-parent families have both parents working full-time.  Whatever these trends portend, Americans seem to take them in stride.

So we sit back and watch the technological genius and demographic, economic and political changes with fascination and perhaps, at times, with trepidation.  At DWM, we embrace change and strive to help navigate and make sense of at least some of these trends for you.

My stand-up desk converter should be here any day… they say sitting is the new smoking, so this may be a trend that is here to stay.  My grandfather would have loved it.

DWM 1Q16 Market Commentary: Are You Getting Enough Sleep?

satisfying sleep2It’s all perspective: If you had fallen into a deep sleep on December 31 and woken up March 31 and looked up your portfolio balance, it was like nothing really happened. Maybe up one or two percent. Decent start to the year…

But for those of us that woke up every day and are required to watch along closely, you know that 1Q16 was anything but tame.

January and the start of February were downright ugly for the stock markets with the Dow Jones having its worst start ever and the S&P500 torpedoing into correction status. But things turned on a dime in mid-February and markets rallied. The big catalysts being: monetary easing by central banks, firming of oil prices & other commodities, a healthy US labor market and a weakening dollar.

Let’s take a look at the scoreboard:

Equities: The MSCI AC World Equity Index registered +0.2%, essentially unchanged (or “unched” in trader lingo). Value lead growth for the first time in a while. In another show of turning tides, the S&P500 didn’t take top billing this time, up a modest +1.3%. Mid Cap stocks as represented by the S&P MidCap 400 Index fared quite well, up 3.8%. The equity markets abroad were rather mixed: more developed international equities had a rough showing, -3.0% as represented by the MSCI EAFE Index; while emerging markets proved to the big winner, up 5.0% as represented by the MSCI Emerging Markets Investable Market Index.

Alternatives: The big standout in alts: Gold – as represented by the iShares Gold Trust ETF, up 16.1% – had its best quarterly gain in three decades. Then again, some absolute return strategies were challenged by the whipsaw and fell into the red. In general, as a group, alternatives were also about “unched” using the Credit Suisse Liquid Alt Beta Index, -0.6%, as a proxy. More importantly, they played their role this quarter: They did a decent job protecting the first several weeks of the quarter when the equity markets were swooning. From empirical studies, we know that by minimizing the overall portfolio’s downside during times like these, the portfolio can sooner recover and achieve new highs that much quicker.

Fixed Income: We saved the strongest asset class on the quarter for last. Fixed income powered by dovish central bankers and declining yields had a pretty remarkable quarter. The Barclays US Aggregate Bond Index, the most popular bond benchmark, was up 3.0%. And like with equities, emerging markets stood out as evidenced by the JPMorgan Emerging Markets Bond Index, +5.3%. Fixed Income really hasn’t been the first pick from the litter for many asset managers in a long while, but this quarters shows why it deserves a place in everyone’s portfolio, even if it’s just a small allocation.

Here are some general comments looking forward denoted by negative (“-“) or positive (“+”) influence:

  • (-) Economies around the globe remain sluggish.
  • (-) Some areas within equities seem expensive. For example, the S&P500’s TTM P/E is 18.2, higher than its 10-year average of 15.8. Other areas, particularly emerging markets are the opposite – they’re downright cheap even after this quarter’s rally.
  • (+) The U.S. Fed in this quarter communicated that they are dialing back their pace of raising rates, which the markets definitely welcomed. Probably only one more, if any, tightening this year.
  • (+) Energy has bounced off lows. The market has already beaten up those companies that rely on higher oil prices. All the while, the consumer still is enjoying this “gasoline holiday”.
  • (?) Upcoming Presidential election hasn’t seemed to scare the market much so far, but volatility could increase as time marches on and uncertainty remains.

Probably the biggest thing is the change in tone: there is a much better tone of the markets than when we wrote our last market commentary. There’s hardly any recession talk now compared to a lot of it then. However, we still have a lot of the same uncertainty. And our markets are more correlated – meaning they move more in tandem – than ever. One big geopolitical or some strange unforeseen event or maybe an altercation of a current event can switch the tone immediately…at least for the short term. And, folks, anything can happen in the short-term.

So for those that like action, strap on the seat belt and enjoy the ride. Or for those that would rather relax, enjoy a nice long sleep and check your portfolio account balance next quarter. You may just sigh another breath of healthy fresh air and go back to bed. Sorry, long-term disciplined investing can be quite boring, but can be quite profitable.

To finish – and in another sign of positivity – Go Cubs! This is the year!