Equifax: What You Need to Know

On September 7, 2017, Equifax, one of the major credit reporting bureaus, issued a press release announcing that on July 29 it had discovered “unauthorized access” to data belonging to as many as 143 million U.S. consumers. We have compiled some information that we hope may help you understand what happened and what to do next. As always, please don’t hesitate to reach out to us if you have specific questions. (more…)

Financial Spring Cleaning: Life Insurance Audit

So much of the maintenance of our personal finances falls into the category of “boring, but important.” But when it comes to life insurance, our subconscious resistance to the topic is further compounded because, unlike retirement or career planning, your pot of gold at the end of the life insurance rainbow is actually a headstone. (more…)

Following Up On 2017’s ‘Sure Things’

At the start of each year, Larry Swedroe (Director of Research at The BAM Alliance) put together a list of predictions gurus make for the upcoming year—sort of a consensus of “sure things.” We keep track of the sure things with a review at the end of each quarter.

With March behind us, it’s time for our first review. As is our practice, we give a positive score for a forecast that came true, a negative score for one that was wrong and a zero for one that was basically a tie.

The Predictions

Here, then, are the first-quarter results. Each sure thing is followed by what actually happened, and the score.

  1. The Federal Reserve will continue to raise interest rates in 2017. That leads many to recommend that investors limit their bond holdings to the shortest maturities. Economist Jeremy Siegel even warned that bonds are “dangerous.” On March 15, 2017, the Federal Reserve did raise interest rates by 0.25%. However, despite the prediction of rising rates actually occurring, through March 31, 2017, the Vanguard Long-Term Bond ETF (BLV)returned 1.78%, outperforming its Short-Term Bond ETF (BSV), which returned 0.56%; and its Intermediate-Term Bond ETF (BIV), which returned 1.26%. Score -1.
  2. Given the large amount of fiscal and monetary stimulus we have experienced and the anticipation of a large infrastructure spending program, the inflation rate will rise significantly. On March 15, 2017, the Bureau of Labor Statistics reported that the Consumer Price Index for All Urban Consumers increased 0.1% in February on a seasonally adjusted basis. It also reported that the index for all items less food and energy rose 2.2% over the last 12 months; this was the 15th-straight month the 12-month change remained in the range of 2.1-2.3%. The February increase was the smallest one-month rise in the seasonally adjusted all-items index since July 2016. However, in January, the index rose 0.6%, and the all-items index rose 2.7% for the 12 months ending February; the 12-month increase has been trending upward since a July 2016 trough of 0.8%. We’ll call this one a draw. Score 0.
  3. With the aforementioned stimulus, anticipated tax cuts and a reduction in regulatory burdens, the growth rate of real GNP will accelerate, reaching 2.2% this year. We’ll have to wait to get the first quarter figures to make a call on this one. Score 0.
  4. Our fourth sure thing follows from the first two. With the Fed tightening monetary policy and our economy improving—and with the economies of European and other developed nations still struggling to generate growth and their central banks still pursuing very easy monetary policies—the dollar will strengthen. The U.S. Dollar Index (DXY) ended 2016 at 102.38. The index closed the first quarter at 100.35. Score -1.
  5. With concern mounting over the potential for trade wars, emerging markets should be avoided. Despite those mounting concerns, through March 31, 2017, the Vanguard FTSE Emerging Markets ETF (VWO) returned 10.87%, outperforming the S&P 500 Index, which returned 6.07%. Score -1.
  6. With the Shiller cyclically adjusted price-to-earnings ratio at 27.7 as we entered the year (66% above its long-term average), domestic stocks are overvalued. Compounding the issue with valuations is that rising interest rates make bonds more competitive with stocks. Thus, U.S. stocks are likely to have mediocre returns in 2017. A group of 15 Wall Street strategists expect the S&P 500, on average, to close the year at 2,356. That’s good for a total return of about 7%. As noted above, the S&P 500 Index returned 6.07% in the first quarter. Score -1.
  7. Given their relative valuations, U.S. small-cap stocks will underperform U.S. large-cap stocks this year. Morningstar data shows that at the end of 2016, the prospective price-to-earnings (P/E) ratio of the Vanguard Small-Cap ETF (VB) stood at 21.4, while the P/E ratio of the Vanguard S&P 500 Index ETF (VOO) stood at 19.4. Through March 31, 2017, VB returned 3.74%, underperforming VOO, which returned 6.05%. Score +1.
  8. With non-U.S. developed and emerging market economies generally growing at a slower pace than the U.S. economy (and with many emerging markets hurt by weak commodity prices, slower growth in China’s economy, the Federal Reserve tightening monetary policy and a rising dollar), international developed-market stocks will underperform U.S. stocks this year. Through March 31, 2017, the Vanguard FTSE Developed Markets ETF (VEA)returned 7.81%, outperforming VOO, which returned 6.05%. Score -1.

Analysis Of Results

Our final tally shows that five sure things failed to occur, while just one sure thing actually happened. We also had one draw and one too early to call. We’ll report again at the end of the second quarter.

The table shows the historical record since I began this series in 2010:

Only about 25% of sure things actually occurred. Keep these results in mind the next time you hear a guru’s forecast.

This commentary originally appeared April 10,2017 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

Lauterbach Financial Advisors Voted “Best Investment Firm”

Thank you El Paso!

Lauterbach Financial Advisors was voted by readers of El Paso Times and the community at large as the “Best Investment Firm” at Best of the Border 2016 awards.

We’re thankful and proud for this recognition and look forward to continuing our commitment to help our clients Live Financially Confident.

 

Save Social Security for Later, When You Need It Most

I think we’ve been looking at Social Security retirement benefits all wrong. In the long-running debate about when to take Social Security — as early as age 62 or as late as age 70 — the focus has been on timing your claim to get the most money, in total, out of the social safety net.

This is a circular argument that will never be fully decided until the Social Security recipient in question dies. So let’s shift the focus from the question “How do we get the most out of Social Security?” to “How do we get Social Security when we need it most?”

Simply put, you’re more likely to run out of money at the end of retirement than at the beginning.

Behavioral science explains why we are all so prone to preferring money today over tomorrow. It’s called “hyperbolic discounting,” and behavioral economists plead that we meaningfully overvalue money now, unfairly discounting money later.

But the risk of making less money in your early retirement years is dwarfed in comparison to the risks of longevity and inflation in the latter stages of retirement. And the probability you will outlive your money meaningfully decreases if you wait to take Social Security.

Prove it!

Let me show you through an example that, while hypothetical, is no doubt close to reality for many.

We’ll consider three couples, the Earlies, the Fullers and the Laters. Each couple:

  • Retires with $1 million in tax-deferred retirement savings.
  • Has an identical 50 percent equity, 50 percent fixed-income portfolio.
  • Has a pretax retirement income need of $90,000 per year.
  • Will supplement their Social Security income with the retirement savings necessary to fulfill their income needs.
  • Includes one household member who will receive the maximum in Social Security benefits and one who will receive 50 percent of the maximum.

The only difference is that the Earlies retire and begin taking Social Security retirement benefits at 62, the Fullers at 67 and the Laters at 70.

This hypothetical case study is designed to result in an academic probability that each couple will not run out of money, and applies more than 3,000 iterations of randomized historical market returns for the respective retirees’ portfolio allocations.

Then, we show the likelihood that each couple will have at least one dollar left in retirement savings at the end of four different time periods — 20, 25, 30 and 35 years into retirement.

Therefore, if you see a result of 47 percent in the 25-year column of the table below, it means the couple represented still had at least one dollar left in their retirement savings at the end of that period in nearly half of the thousands of iterations run. In other words, that couple had a 47 percent chance of not running out of money 25 years into retirement. Statistically, a probability of 85 percent or better is favorable.

The findings

What did we find? If you die early enough — within 20 years of your retirement date — you have a reasonably good chance to outlive your money regardless of when you take Social Security. The Earlies hit the golf course fully five years before the Fullers, but it’s not clear that they’ve suffered for it at the 20-year mark.

At 25 years, however, there’s a greater than 50 percent chance the Earlies have run out of money and now must ask their kids to pay their greens fees. At 30 years their probability of solvency has dropped to 30 percent, and at 35 years they’re likely relying on their reduced Social Security benefit for all of their income.

Why do the Earlies fail? Because in order to meet their income needs with a reduced Social Security benefit, they put too much pressure on their portfolio to pick up the tab. They were forced to take an effective withdrawal rate of 5.62 percent in their first year of retirement.

How do the Fullers look? Pretty good. Buoyed by a Full Retirement Age (FRA) Social Security benefit and beginning with a reasonable 4 percent effective rate of withdrawal from their portfolio, at 20 and 25 years into retirement, they’re in the 90 percent-plus range. But if they plan on seeing their faces on a Smucker’s jar, their probability of success declines to 67 percent when they’re 35 years into retirement.

As you’d guess, the Laters are solid. Because of their increased Social Security benefit, they require only a 3.26 percent portfolio withdrawal rate in year one. Statistically, they ride off into the sunset and should have the funds to test the boundaries of science in their pursuit of longevity.

If you suspect you’ll die early — and have lineal or medical justification for that belief — you might justify taking Social Security as early as you can (although a lesser-earning spouse could still benefit from your higher benefit when you’re gone). And please forgive the inherent insensitivity in this analysis, which presumes the Earlies, Fullers and Laters all have a choice in taking their benefits at various points in time. Many retirees don’t, and if you need to retire and take early Social Security for any number of valid reasons, of course you should do just that.

But if you hope to have a longer retirement — 30 or 35 years, especially — your chances of not outliving your retirement savings improve greatly if you delay Social Security. Waiting is like purchasing longevity and inflation insurance for what will hopefully be a long and prosperous retirement.

This commentary originally appeared January 1 on CNBC.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

The Dangerous Education Gap

A large body of research on the behavior of individual investors has demonstrated that low levels of financial knowledge, in addition to biases in the selection and processing of information, drive suboptimal financial choices.

Among the findings from the literature are:

  • Men tend to be more financially literate than women, independent of country of residence, marital status, educational level, age, income and their possible role as decision-makers.
  • Women tend to be less confident than men, though they are more aware of their own limits. This is a positive finding, because overconfidence, which may lead to excessive risk taking, excessive trading and lack of diversification, is negatively related to performance. The result is that women outperform men. Note that it has been found that higher levels of education may lead to higher levels of overconfidence. (Any financial advisor who has worked with doctors would confirm this!)
  • Degree of financial knowledge tends to be positively correlated with education and wealth.
  • Individuals with a high degree of financial literacy tend to exhibit a higher risk tolerance and a higher degree of patience, as well as greater willingness to spend time acquiring financial knowledge.
  • Financial experience, as measured through the ownership of financial instruments and the holding period length of risky assets, is positively associated with financial knowledge.
  • Regret aversion (coupled with low literacy) may deter the demand for professional help if individuals anticipate the possibility that advisors will highlight mistakes in their previous decisions.

Monica Gentile, Nadia Linciano and Paola Soccorso contribute to the literature on investor education and behavior with their March 2016 working paper, “Financial Advice Seeking, Financial Knowledge and Overconfidence: Evidence from the Italian Market.”

The authors write: “The effectiveness of both investor education and financial advice may be challenged by individuals’ behaviours and reactions. Unbiased financial advice can substitute for financial competence only if unsophisticated investors seek the support of professional advisors. Furthermore, advice may not reach overconfident investors deciding on their own on the basis of self-assessed rather than actual capability. Conventional financial education initiatives may exacerbate overconfidence and/or other biases distorting further investors’ decision-making process.”

Drawing on data from more than 1,000 Italian households, the authors analyzed the relationship between investors’ propensity to seek professional investment advice, financial knowledge and self-confidence, as well as the determinants of financial knowledge and self-confidence.

Following is a summary of their findings:

  • The majority of individuals exhibited a very low degree of financial literacy. For example, almost half of respondents weren’t able to describe inflation, 55% incorrectly defined risk diversification, 57% did not correctly define the risk/return relationship, 72% were not able to compare investment options across expected returns and 67% showed insufficient understanding of simple interest rates.
  • Nearly 45% of investors preferred informal advice (that is, consulting relatives, friends and colleagues) to professional advice.
  • The authors, in general, found a lower level of financial knowledge among women, resulting in a gender gap.
  • Loss aversion was quite widespread. Overall, 55% of respondents weren’t willing to take financial risk, implying a chance of loss and 17% would disinvest after even a very little loss. However, financial knowledge is positively related to risk aversion. The more financial knowledge someone has, the less risk averse that investor tends to be.
  • Financial literacy positively affected financial advice seeking. The higher the level of financial literacy, the more likely it is that professional advice will be sought.
  • Financial knowledge was negatively related to high levels of investor self-confidence. Less knowledgeable investors were more confident of their skill (skill they do not, in fact, have). Overconfidence, in turn, discourages demand for advice (by the very people who need it the most).
  • Overconfidence was prevalent. For example, among individuals reporting an understanding of basic financial products equal or higher than the average person, 30% weren’t able to correctly define inflation and 44% couldn’t solve a simple-interest problem.
  • Financial advice acts as a complement rather than as a substitute of financial capabilities.

Gentile, Linciano and Soccorso concluded that their results confirm “concerns about regulation of financial advice being not enough to protect investors who need it most.”

They continue: “Additionally, our findings suggest that investor education programmes may be beneficial not only directly, i.e. by raising financial capabilities, but also indirectly, i.e. by enhancing people’s awareness of their financial capability and by hindering overconfident behaviours and behavioural biases. This latter outcome mitigates the worries about financial education fueling confidence without improving competence, thus leading to worse decisions.”

Summary

One of the great tragedies is that most Americans, having taken a biology course in high school, know more about amoebas than they do about investing. Despite its obvious importance to every individual, our education system almost totally ignores the field of finance and investments. This remains true unless you attend an undergraduate business school or pursue an MBA in finance. Without a basic understanding of finance and markets, there’s simply no way for investors to make prudent decisions.

Making matters worse is that far too many investors think they know how markets work, when the reality is quite different. As humorist Josh Billings noted: “It ain’t what a man don’t know as makes him a fool, but what he does know as ain’t so.”

The result is that individuals make investments without the basic knowledge required to understand the implications of their decisions. It’s as if they took a trip to a place they have never been with neither a road map nor directions. Lacking formal education in finance, most investors make decisions based on accepted conventional wisdom—ideas that have become so ingrained that few individuals question them.

And some spend far more time watching reality TV shows than they do investing in their own financial literacy. Given the important role that financial literacy plays in achieving financial goals, this is dangerous behavior.

 

 

This commentary originally appeared September 26 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

How Fantasy Ruins Football (and Investing)

It’s that time of year again, where the heat of summer recedes, sweatshirts make a comeback and businesses lose billions in flagging productivity due to fantasy football. But it’s not just businesses losing out—fans and players come up short as well.

How, after all, can I truly dedicate myself to rooting fully for my beloved Baltimore Ravens if I took Le’Veon Bell—who, for those not acquainted with the best rivalry in football, plays running back for the Steelers—second in the fantasy draft? It can’t be done. It’s just wrong.

I’m kidding, right?

Partly. But there are more serious personal and financial implications to embracing fantasy (sports or otherwise). The danger in fantasy is its distance from reality. It’s “betting on a future that is not likely to happen,” according to Psychology Today.

Our fantasies tend to sensationalize what we’d prefer to imagine while ignoring what we’d prefer to not. Then, when our actual spouse, child, parent, friend or co-worker falls short of the impossibly high bar we’ve set for them, we—and often, they—are crushed.

“Emotional suffering is created in the moment we don’t accept what is,” says Eckhart Tolle, who, perhaps unintentionally, delivers a potent dose of truth that especially informs us in our personal dealings with money.

Here are a handful of financial fantasies, followed by their unvarnished truths:

Fantasy: The market has made 10% per year, so I should expect to make 10% per year.

Truth: The market almost never makes 10%. In fact, in the past 88 years, only thrice has the S&P 500 ended the year with a positive return between the numbers 9 and 11! The market’s only consistent trait is its inconsistency, and while the market has actually returned an approximate annual average of 12%, you should expect to be surprised. Every. Single. Year.

Fantasy: Gold is a good hedge against inflation. (Or a good hedge against currency risk, or a good investment. Just take your pick.)

Truth: Of the many traits often attributed to gold as an investment, the only one that really holds up is that the precious metal historically has risen in price when stocks are in deep decline. People tend to buy gold when they are scared (and sell it when they aren’t). But good luck shaving off some of your bullion for bread when the Hunger Games start (or when any dystopian tween books series becomes a reality).

Fantasy: “Wow, they have a big house. They must be rich!” (That’s an actual quote from my 10-year-old son. I know. We’re working on it.)

Truth: They might be “rich.” Or they may just have a very big mortgage. Regardless, The Millionaire Next Door taught us that appearances can—and often are—deceiving.

Fantasy: Money is power. Everything would be better if I had more of it.

Truth: Literally (since 1971) and figuratively (forever), money has no value other than that which we attribute to it. Most of us have a tendency to over-value money, and in so doing, diminishing what has true power in our lives—relationships. But when we see money as the neutral tool that it is, it can be used very effectively, especially when in the service of enhancing relationships.

Fantasy isn’t all bad. Expanding our imaginations often leads to the conception—and eventually, the accomplishment—of endeavors formerly relegated to the realm of impossibility. Perhaps the key, then, is to ensure our fantasy only enhances our reality.

Fantasy football provides a great example. It can be a great way to have fun with friends, to enhance your knowledge of the game and to learn more broadly about its players. But as clutch NFL kicker Justin Tucker reminds us, “If you’re going to take it so seriously, then you’re an idiot.”

This commentary originally appeared September 3 on Forbes.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

Research on Luck versus Skill in Mutual Fund Performance Highlights Active Management’s Shortcomings

In many walks of life, trying to discern the lucky from the skilled can be a difficult task. For example, it seems like every time a professional sports draft occurs, debate again flares up over whether the evaluation of college (or even high school) athletes is an exercise in skill or in luck.

Were the Portland Trail Blazers unskilled in the 1984 NBA draft when they selected Sam Bowie with the second overall pick, just ahead of Michael Jordan? Or were they just unlucky? (Bowie went on to an uneventful and injury-plagued career, while Jordan led the Chicago Bulls to six championships and is considered by many to be the greatest basketball player ever.)

The point is that sometimes it’s not easy to distinguish luck from skill. This difficulty extends to the evaluation of active mutual fund managers. With that in mind, we’ll review the academic literature on the subject of luck versus skill in mutual fund performance. We will examine the results of five studies. The first is by Bradford Cornell.

Skill Vs. Serendipity

Cornell, who contributed to the literature with his study “Luck, Skill, and Investment Performance,” which was published in the Winter 2009 issue of The Journal of Portfolio Management, noted: “Successful investing, like most activities in life, is based on a combination of skill and serendipity. Distinguishing between the two is critical for forward-looking decision-making because skill is relatively permanent while serendipity, or luck, by definition is not. An investment manager who is skillful this year presumably will be skillful next year. An investment manager who was lucky this year is no more likely to be lucky next year than any other manager.” The problem is that skill and luck are not independently observable.

Because this is the case, we are left with observing performance. However, we can apply standard statistical analysis to help differentiate the two, which is precisely what Cornell did. He used Morningstar’s 2004 database of mutual fund performance to analyze a homogenous sample of 1,034 funds that invest in large-cap value stocks.

Cornell’s findings are consistent with the previous research. The great majority (about 92%) of the cross-sectional variation in fund performance is due to random noise. This result demonstrates that “most of the annual variation in performance is due to luck, not skill.” Cornell concluded: “The analysis also provides further support for the view that annual rankings of fund performance provide almost no information regarding management skill.”

French & Fama Weigh In

Our second study is by Eugene Fama and Kenneth French, who contributed to the literature with their study, “Luck versus Skill in the Cross-Section of Mutual Fund Returns,” which was published in the October 2010 issue of The Journal of Finance. They found fewer active managers (about 2%) were able to outperform their three-factor (beta, size and value)-model benchmark than would be expected by chance.

Stated differently, the very-best-performing traditional active managers have delivered returns in excess of the Fama-French three-factor model. However, their returns have not been high enough to conclude they have enough skill to cover their costs, or that their good returns were due to skill rather than luck.

Fama and French concluded: “For (active) fund investors the simulation results are disheartening.” They did concede their results appear better when looking at gross returns (the returns without the expense ratio included). But gross returns are irrelevant to investors unless they can find an active manager willing to work for free.

Increasing Difficulty

Our third study is “Conviction in Equity Investing” by Mike Sebastian and Sudhakar Attaluri, which appears in the Summer 2014 issue of The Journal of Portfolio Management. Their study is of interest because it showed a declining ability to generate alpha. The authors found:

  • Since 1989, the percentage of managers who evidenced enough skill to basically match their costs (showed no net alpha) has ranged from about 70% to as high as about 90%, and by 2011, was at about 82%.
  • The percentage of unskilled managers has ranged from about 10% to about 20%, and by 2011, was at about 16%.
  • The percentage of skilled managers, those showing net alphas (demonstrating enough skill to more than cover their costs), began the period at about 10%, rose to as high as about 20% in 1993, and by 2011 had fallen to just 1.6%, virtually matching the results of the aforementioned paper by Fama and French.

Our fourth study is “Scale and Skill in Active Management,” which appeared in the April 2015 issue of the Journal of Financial Economics. The authors, Lubos Pastor, Robert Stambaugh and Lucian Taylor, provided further insight into why the hurdles to generating alpha have been growing. Their study covered the period 1979 to 2011 and more than 3,000 mutual funds. They concluded that fund managers have become more skillful over time.

They write: “We find that the average fund’s skill has increased substantially over time, from -5 basis points (bp) per month in 1979 to +13 bp per month in 2011.” However, they also found that the higher skill level has not been translated into better performance.

They reconcile the upward trend in skill with no trend in performance by noting: “Growing industry size makes it harder for fund managers to outperform despite their improving skill. The active management industry today is bigger and more competitive than it was 30 years ago, so it takes more skill just to keep up with the rest of the pack.”

Pastor, Stambaugh and Taylor came to another interesting conclusion: The rising skill level they observed was not due to increasing skill within firms. Instead, they found that “the new funds entering the industry are more skilled on average than the existing funds. Consistent with this interpretation, we find that younger funds outperform older funds in a typical month.” For example, the authors found that “funds aged up to three years outperform those aged more than 10 years by a statistically significant 0.9% per year.”

They hypothesized this is the result of newer funds having managers who are better educated or better acquainted with new technology, though they provide no evidence to support that thesis. They also found all fund performance deteriorates with age, as industry growth creates decreasing returns to scale, and newer, and more skilled, funds create more competition.

A Factor-Based Analysis

Our fifth and final study is “Mutual Fund Performance through a Five-Factor Lens,” an August 2016 research paper by Philipp Meyer-Brauns of Dimensional Fund Advisors. His sample contained 3,870 active funds over the 32-year period 1984 to 2015.

Benchmarking their returns against the newer Fama-French five-factor model (which adds profitability and investment to beta, size and value), he found an average negative monthly alpha of -0.06% (with a t-stat of 2.3). He also found that about 2.4% of the funds had alpha t-stats of 2 or greater, which is slightly fewer than what we would expect by chance (2.9%).

Meyer-Brauns also found that the distribution of actual alpha t-stats had shifted to the left of what would be expected from chance if all managers were able to produce excess returns over the five-factor model sufficient to cover their costs.

He concluded: “There is strong evidence that the vast majority of active managers are unable to produce excess returns that cover their costs.” He added that “funds do about as well as would be expected from extremely lucky funds in a zero-alpha world. This means that ex-ante, investors could not have expected any outperformance from these top performers.”

Summary

In 1998, at a time when about 20% of actively managed mutual funds were outperforming their risk-adjusted benchmarks, Charles Ellis called active management a loser’s game. What he meant was that, while it certainly was possible to win the game by selecting funds that would outperform, the odds of doing so were so poor that it wasn’t prudent to try.

Today the combination of academics having converted what once was alpha into beta (a common factor explaining returns)—thus eliminating potential sources of alpha—and that increasingly skilled competition has raised the hurdles, now only about 2% of actively managed mutual funds are generating statistically significant alpha. And that’s even before the impact of taxes on taxable investors.

The choice is yours. You could try to beat overwhelming odds and attempt to find one of the few active mutual funds that will deliver future alpha. Or you could accept market returns by investing passively in the factors to which you desire exposure. The academic research shows that investing in passively managed funds is playing the winner’s game.

This commentary originally appeared August 22 on ETF.com

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2016, The BAM ALLIANCE

When should TIPS be used in a client’s portfolio?

The short answer to this common fixed income question: It depends on the client. If the client’s lifestyle could be greatly affected by an unexpected spike in inflation, or if the client is generally fearful of inflation, then a higher allocation to TIPS would be warranted regardless of how “inexpensive/expensive” they appear in the market. But let’s examine this question from the wider perspective of a client who is neutral in regards to inflation protection.

First, let’s look at the market’s expectation for inflation going forward. The easiest and most effective way to determine this is to look at the break-even inflation rate, which is calculated by subtracting the yield on a TIPS bond from its nominal Treasury counterpart. For example, if a five-year TIPS bond is trading at 1.00 percent and a five-year Treasury is trading at 4.00, then the 3.00 percent difference between the two yields is roughly the market’s expectation for inflation over the next five years. The advantage of using the break-even inflation rate is it is easily observable and uses real-time, forward-looking market data. Now that we know the market’s five-year inflation expectation, we have our baseline measurement.

Traditionally, BAM’s Fixed Income Desk has not purchased nominal Treasury bonds for our client portfolios because there are better-yielding options with similar credit risk, such as U.S. agency bonds or FDIC-insured brokered CDs, and a similar break-even inflation number can be computed for these other options. For example, if evaluating the purchase of a five-year brokered CD at 5.00 percent, subtract the 1.00 percent real yield on the TIPS bond from our previous example for a break-even inflation number of 4.00 percent. Compare that number to market break-even inflation in order to make a judgment about the best product to purchase. In the example above, the break-even inflation rate on the brokered CD is
4.00 percent while the market break-even inflation rate is only 3.00 percent. Inflation would have to be 100 basis points, or 1.00 percent, higher than what the markets are currently expecting for the TIPS bond to provide the same nominal yield as the brokered CD. This same math can be applied to other fixed income securities such as U.S. agencies and taxable and tax-exempt municipal bonds. Given that large difference of 100 basis points, BAM would recommend purchasing the brokered CD as opposed to the TIPS bond.

The next logical question: What is the cutoff for when TIPS would be recommended as opposed to another nominal bond option? BAM’s rule of thumb is roughly 25 to 30 basis points. So if the difference between the break-even inflation rates is less than 25 to 30 basis points, TIPS bonds are recommended because the small yield give-up is worthwhile because of the inflation risk that is taken off the table.

When evaluating the use of TIPS, the break-even inflation rate for the nominal security and the market break-even inflation are critical. If the difference is greater than 25 to 30 basis points, then the nominal option will likely be the better solution. If the difference is less, then TIPS are the preferred solution. Remember, though, that this evaluation can vary client to client depending on sensitivity to inflation. ___________________________________________________________________________________________

Copyright © 2016, The BAM ALLIANCE. This material and any opinions contained are derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. To be distributed only by a Registered Investment Advisor firm.
Information regarding references to third-party sites: Referenced third-party sites are not under our control, and we are not responsible for the contents of any linked site or any link contained in a linked site, or any changes or updates to such sites. Any link provided to you is only as a convenience, and the inclusion of any link does not imply our endorsement of the site.

What are the differences between fixed income and stock trades?

The bond market is less transparent in pricing and trades less frequently than equity markets. Blerina Hysi explains how a trusted advisor can help navigate these market inefficiencies and prevent you from suffering excessive mark-ups.

Featured photo by Rick Tap.

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