Clear Money Blog™

Running to Stand Still

roberts@clearfa-llc.com (Robert Schmansky) — Tue, 02 Apr 2013 07:51:48 PDT

The following article is provided by Jim Parker, Vice President of Dimensional Fund Advisors, on the lack of value added by advisors and investors in guessing the direction of the markets, and especially in a common speculating strategy known as Tactical Asset Allocation.

Trying to correctly time your entry point to the market is never easy. Just ask the experts.

In early February, strategists at a global investment bank were becoming alarmed at political events in Europe, the sequestration “crisis” in the US Congress, and what they saw as an unseemly rush into equities.

The word went out to their clients to put a tactical alert on stock investing for the next one to six months.

A month later, however, the bank strategists¹ decided to reverse course. The problems in Europe, they now discerned, were not systemic, and the likelihood was that continuing easy monetary policy would support investor sentiment globally.

As a result, the experts told clients to cautiously re-enter the market over a number of months.

That’s a shame for the clients, because at time of writing, the Global MSCI was up by 8.6% in US dollar terms this calendar year. The US S&P 500 was up 10.7%, the FTSE-100 9.9%, and Australia’s S&P/ASX 300 10.7% in local currency terms.

The investment bank was not alone in changing its view.

In December 2011, the veteran US newsletter writer Richard Russell, author of the Dow Theory Letters, told his clients in unequivocal terms to “get out of stocks.”

“I believe we’re going to see a brutal stock market that will shock the Fed and the bulls and the public—and all who insist on remaining in this bear market,” he said.²

But 15 months later, Russell has changed his tune, telling his clients to buy stocks after a rally that has taken the broad US market to more than double the levels prevailing at its bottom in March 2009.

“Yes, I know that this market is uncorrected during its long rise from the 2009 low, and I know that there are risks in buying an uncorrected advance that is becoming uncomfortably long in the tooth, but my suggestion is that my subscribers should take a chance (after all, Columbus took a chance),” Russell said in March 2013.³

This sort of commentary isn’t just happening in the US.

In Australia, one of the most recognized market gurus, writer Alan Kohler, issued an ominous warning to his subscribers in a regular note in December 2011:

“The conditions are in place for a panic sell-off,” he said. “It is not certain that it will happen … but the risk is now such that you must take action. I will be significantly reducing my already reduced exposure to equities, possibly to zero.”⁴

Explaining his mistake later, Kohler said he had not foreseen the extent to which central banks would continue to pump cheap money into the financial system.

That’s all very well. But the fact is anyone who followed his advice and went to term deposits missed a rally in the Australian share market of more than 20%.

Providing reliable investment advice based on macroeconomic, technical, and political news is a tough gig. Having once worked for a newspaper, this writer knows well the dangers of splashing a front page story about markets that events overtake.

After a bleak session on Wall Street one Thursday, the Australian paper I worked on covered Friday’s local session and then went forward in the Saturday edition with a doom-laden headline, trusting that US markets would stay down overnight.

Unfortunately, for us at least, Wall Street bounced back on Friday, recovering all of the previous day’s losses and more. Our Saturday splash, along the lines of “No Respite from the Bears,” now looked a trifle silly, if not plain wrong.

For the everyday investor, the lesson is that the closer you are to media and market noise, the harder it is for you to pay attention to the bigger picture.

Markets are moving constantly as news and information is built into prices. Sentiment is buffeted one way, then the other. Millions of participants make buy and sell decisions based on news or their individual requirements.

The job of media and market analysts frequently boils down to creating plausible narratives around disconnected events so that it all appears seamless. The next day, you start all over again.

As a broker or a journalist, whose horizons are in minutes, this approach to markets makes sense. But for investors with long-term horizons, second- and third-guessing money decisions based on the news of the day is unlikely to deliver sound results.

A better approach is to work with a trusted advisor on building a diversified portfolio of assets tailored for your needs and risk appetite. The portfolio is rebalanced regularly to match your requirements, not according to what is happening in the markets.

Tactical asset allocation can sound tempting, but there is always a risk that the news will overtake you. Then you are left having to change everything all over again.

As a wise man once said, running inside a moving bus won’t get you to your destination any quicker.

Expensive Mistakes

roberts@clearfa-llc.com (Robert Schmansky) — Fri, 15 Mar 2013 17:19:06 PDT

The following article by Jim Parker, Vice President of Dimensional Fund Advisors, discusses common, but expensive mistakes that many investors make.

This material may refer to resident trusts offered by DFA Australia Limited. These resident trusts are only available in Australia. Nothing in this material is an offer or solicitation to invest in these resident trusts or any other financial products or securities. All figures in this material are in Australian dollars unless otherwise stated.

There are two ways of learning: You can be taught how to do something correctly, or you can be shown the consequences of doing it wrong. In the world of investment, it’s a lot cheaper to learn from others’ mistakes.

A recent edition of a television current affairs program¹ detailed how elderly Australians, many of them with only modest nest eggs, had lost up to $15 billion in recent years through dubious investment schemes.

Most of these schemes involved the provision of high-risk finance to property ventures, some involving speculative residential projects. Yet, the program found, these investments were often promoted as safe, secure, and bank-like.

In some cases, the promoters of the schemes extracted high fees (as much as 5%) from the vehicles, and engineered related-party transactions that cost the elderly clients millions—without giving them any say in the matter.

The program found that end investors often had their entire life savings in a single investment product, which meant there was no safeguard when things went wrong. On top of all this, the schemes were promoted by financial “advisors,” who earned commissions on their sales.

The wonder is that these dubious schemes continue to fleece thousands of people five years after the financial crisis exposed the folly of structured and highly conflicted mortgage finance vehicles and securities firms masquerading as banks.

In one heartbreaking moment in the program, a widow with an autistic son told how she lost $330,000 in compensation from the death of her husband after she was advised to put the money into a fund linked to a finance company that later failed.

The woman is now unable to afford the special education the boy needs and has called on her in-laws to provide emergency childcare while she works full time.

New regulations in Australia are about improving disclosure to investors and removing conflicts of interest around advice. But they have clearly come too late to help the thousands of people hurt by these collapses.

So, barring a further change in the law to protect against fraud, how can individual investors protect themselves? First, understand risk and return. If someone is offering a “low-risk” investment with a regular return well above the risk-free rate, alarm bells should go off. Return rarely comes without risk, but not all risks are worth taking. So always ensure you understand what you are investing in.

Second, diversify. It is the only free lunch you will get as an investor. Sinking your life savings into a single property scheme or mortgage fund is not diversification. That is taking a massive, speculative bet on a single asset.

It is far better for your long-term wealth if you spread your risk across a range of asset classes—domestic and developed market equities, emerging markets, local and global bonds, listed property, and cash. And within each of those asset classes, you should diversify as much as possible.

Third, fees matter. The difference made by a 1%, 2%, or 3% fee can run into hundreds of thousands of dollars over the years. Time after time, we see the rewards in these heavily marketed schemes going not to the end investors but to the promoters.

Finally, and most importantly, get truly independent advice. That means avoiding the recommendations of someone who is receiving a financial or other incentive from the provider whose product he is promoting.

A good advisor will work for you. That means understanding your risk appetites, your situation, and your investment and lifestyle goals. It means structuring a diversified portfolio that reflects your needs, not what a product provider has to sell.

The losses suffered by Australians in these schemes are tragic. Liquidators interviewed by the program had little hope that people would get much of their money back, if any. Questions were raised about the adequacy of regulation.

Ordinary investors can’t control those outcomes. But they can learn from these lessons and steer clear of anything that smells of conflicted advice, promises of high returns and low risk, lack of diversification, high fees, and slick marketing.

If we don’t learn these lessons from the experiences of others, we risk having them taught to us directly. And in those cases, the tuition bills can be substantial.

1. “A Betrayal of Trust,” Four Corners, Australian Broadcasting Corp. Television, March 4, 2013.

Short-Sighted

roberts@clearfa-llc.com (Robert Schmansky) — Thu, 07 Mar 2013 16:37:57 PST

The following article is provided by Brad Steiman, Vice President of Dimensional Fund Advisors, discussing the movement of the markets and how returns are based on changing expectations rather than current experiences.

Not long ago, fatigued investors were feeling the cumulative weight of two severe financial crises, periods of heightened stock market volatility, and an endless supply of bad economic news. Investors who extrapolated recent market experience were losing faith in equities and looking for alternatives.

Equity strategies that can short became more popular for investors who embraced the idea that making money in a "sideways market" required stock picking unconstrained by a long-only approach. As usual, the investment industry was quick to capitalize on and foster this popular theme by rolling out new products to meet the demand of retail clients looking for market-neutral investments.

Traditional equity managers also started moving in this direction. One prominent Canadian mutual fund company allowed most of its managers to short sell in their portfolios following an industry-wide amendment that permitted mutual funds to short up to 20% of a fund's net asset value. The company noted: "Our portfolio managers are constantly researching securities of all types. Often, they find overvalued securities that they believe are set to decline in value, but previously there wasn’t a direct way for our investors to benefit from this research."

This approach illustrates that removing the constraint on shorting amplifies stock picking and, in a sense, puts traditional active management on steroids. Removing constraints can be desirable, but only if the underlying process adds value. To the contrary, a large body of literature documents that traditional active management—or, in this case, stock picking—fails to add value after fees and expenses. This conclusion challenges the assertion that magnifying the impact of stock picking by removing the short selling constraint can provide a tangible benefit to investors.

Studies of traditional active management mostly have been limited to long-only mutual funds because the data set is larger and far more reliable than data for alternative investments.¹ However, the long-only constraint should not diminish the relevance of these findings to managers who also go short.

One of the main reasons for removing the short selling constraint is to capitalize on identifying over-valued securities. But if this ability were reliable and systematic, you would expect to see it in the multitude of tests on the long-only universe of mutual funds. Although managers in this universe cannot short the stocks "they believe are set to decline in value," they can choose not to own them, which would result in persistent outperformance relative to their long-only benchmarks.

In very simple terms, being able to short stocks may double the stock picking opportunity set, but this offers no benefit if traditional stock picking doesn't work to begin with. Zero multiplied by two is still zero!

As there is no value from simply increasing the range of stock picking opportunities by allowing managers to short, a market-neutral strategy will have an expected return of T-bills minus fees and expenses, where the standard is "two and 20," unless the portfolio is long another dimension of expected return that is persistent and pervasive—such as size, relative price, or direct profitability. In the event that a market-neutral strategy with systematic exposure to one or more of these dimensions is included in a portfolio that already has market beta, the client would be better off reducing the "two and 20" and eliminating the cost of shorting by combining market beta with the desired exposure to other dimensions of expected return in one long-only strategy.

We have already addressed the flaw of assuming good stock picks are the answer, but there is a bigger problem with adopting a market-neutral approach as a solution for the sideways market, or one where the expected return is zero. The whole notion is a fallacy because there is always a positive expected return on capital.

That doesn't mean your return is guaranteed to be positive, but it is always expected to be. No return is guaranteed because the market can only know what is knowable—and unknowable information is, by definition, new information. If the information were considered bad news, or if risk or risk aversion were to increase and investors were to require higher expected returns, prices would drop.

The market mechanism works to bring prices to equilibrium where, based on the new information, the expected return on capital remains positive and commensurate with the level of risk or risk aversion in the market. The opposite would be true if the new information were considered good news, or if risk or risk aversion were to decline. This is how well-functioning capital markets result in expected returns always being positive. In other words, investors shouldn't expect a sideways market ex-ante.

Good and bad news also have to be defined relative to expectations rather than in absolute terms. The new information could be considered bad news in an absolute sense—for example, unemployment increased to 9%. But this information could be received as good news in a relative sense if market prices reflected expectations of an increase to 10% unemployment.

The table below is a simple illustration of how new information relative to expectations can influence security prices and returns.

New Information	Relative to Expectations	Result
Good news	Better than expected	↑	Above normal return
Good news	As expected	–	Normal return
Good news	Worse than expected	↓	Below normal return
Bad news	Better than expected	↑	Above normal return
Bad news	As expected	–	Normal return
Bad news	Worse than expected	↓	Below normal return

Investors betting on a sideways market are obviously expecting a below-normal return on equities. They aren’t betting on the future being good or bad, but worse than expected.

Nobel laureate Friedrich Hayek described the market as a communication mechanism that "garners, comprehends, and disseminates widely dispersed information better and faster than any system man has deliberately designed."

When you consider that expectations are already embedded in prices, betting against them is, well, short-sighted!

1. Data for hedge funds and other alternative investments can lack integrity because of voluntary reporting that results in survivorship bias, self-selection bias, and backfill bias.