Those who are not persuaded by this argument should carefully consider the data on returns received by post-IPO investors. According to an article¹ in the Journal of Finance, for 6,249 IPOs from 1980 to 2001, the average total return for the three years subsequent to the IPO lagged the overall market by 23.4%. Most of this lag is attributable to the fact that a large number of IPO companies belong to the category of small cap growth which has shown the worst performance of all the different combinations of size and value.

Dimensional Fund Advisors (DFA), the company that operates the mutual funds that IFA advises its investors to use, has a longstanding policy of excluding recent IPOs from all their equity strategies.  The reasons cited include the “lock-up” period after which insiders can flood the market with shares that they were previously barred from selling. Furthermore, it is not uncommon for the underwriting bank to intervene in the market to support the price above a certain level, and once that support is terminated, the price can drop precipitously. DFA also excludes companies that fall into the extreme small growth category.

While we at IFA fully accept the concept of market efficiency, we acknowledge that there are situations where the market price may not reflect an unbiased estimate of what the future holds for the company. Stocks within the first year after their IPO are one such situation, and our best advice is to avoid it.

¹Ritter, J. R. and Welch, I. (2002), A Review of IPO Activity, Pricing, and Allocations. The Journal of Finance, 57: 1795–1828.

Quiz Question: What do these companies have in common—Whitbread of the United Kingdom, Molson Coors of North America, Qantas of Australia, Honda of Japan, and Adidas of Germany?

Yes, they all deliver consumer products and services. Whitbread is in hospitality, Molson Coors is in brewing, Qantas is in airline transportation, Honda is in automotive products, and Adidas is in sportswear.

But that’s not all these companies have in common. Have you guessed yet?

Yes, they are all well established and have internationally recognized brand names.

• Whitbread has been around since 1750, when Samuel Whitbread started the first mass production brewery in the UK. The company now employs more than 40,000 people worldwide and serves more than 19,000 customers per month.
• Brewing conglomerate Molson Coors has a history going back to 1774 in England, 1786 in Canada, and 1873 in the US. It now employs 15,000 people, services 30 countries, and boasts more than 65 individual brands.
• International airline Qantas was founded in outback Australia in 1920 as “Queensland and Northern Territorial Aerial Services,” operating fragile biplanes. It now employs 35,000 and is one of the most recognized airlines in the world.
• Honda’s roots go back to 1937 when a young mechanic named Soichiro Honda started a business making piston rings. Honda is now the seventh-largest automaker in the world with 180,000 employees and nearly 500 subsidiaries.
• Adidas, renowned for sports apparel, has a history dating back to the mid-1930s when it was a single, small factory run by a humble shoemaker Adi Dassler. The company now employs 47,000 people and sells its products around the world.

Have you guessed yet? Yes, these are all consumer products companies. They all have long histories and humble beginnings. They all operate internationally. They all employ thousands of staff. And their products are globally recognized.

But that’s still not all. Give up yet?

The answer is that these companies all operate in the capital markets. They have grown from humble beginnings, partly because they have issued equity and tapped the savings of millions of investors, who in turn have shared in their successes.

It is worth keeping this in mind when you hear grim stories about the future of equity investment and the global economy.

It is true that we have been through and continue to feel the effects of a global financial crisis. This crisis caused strains in the banking system of many developed economies and continues to cause knock-on effects today, particularly in Europe.

But think about this. For all its troubles, the world economy is still growing. The International Monetary Fund estimates global economic growth this year of about 3.5%, accelerating to 4% in 2013. For emerging and developing economies, the growth assumptions are about twice that.¹

Economic growth means an increase in the world’s output of goods and services. This increased productive effort is derived from a number of inputs—namely labor, materials, energy, intellectual capital, and financial capital.

So at Honda, for instance, researchers might be working on new technology for a zero-carbon emission electric vehicle. To do this, it will hire skilled labor, bring together the raw materials, apply its intellectual capital, and raise funds by issuing shares.

As an investor, your role is to supply the final element—the financial capital. In doing so, you take a risk. But you also get to share in the profits of this endeavor.

So, unless you think the people of the world are going to stop buying cars, stop taking holidays, stop eating at restaurants, and stop playing sports, it seems foolish to assume that companies’ demand for capital will not continue.

That capital is not free. It costs companies to tap the savings of others. And that cost is your expected return as an investor. That return is not there every day, every week, every month, or even every year. But over time, there is a return on capital for those who are patient and who diversify away risks they don’t need to take.

If there were no return, there would be no capitalism. This is not a perfect system by any means. There are questions by some about its efficiency and by others about its equity. But it’s the system we have and that most of us work under.

So to no longer participate in the equity market is to deny yourself a share of the wealth that these companies create—companies that provide livelihoods to millions and products to millions more.

Sharing the wealth means owning shares. Quiz over.

1. “World Economic Outlook,” International Monetary Fund, April 2012

On rare occasions, a change so profound and significant occurs in the financial world that it is given the “big bang” designation. Examples include the 1975 abolition of the fixed rate commission system in the U.S. and the drastic deregulation of the London Stock Market in 1986 under Margaret Thatcher.

In the past few months, a great deal of coverage in the financial media has been given to the 8/30/2012 Department of Labor deadline for 401(k) plan administrators to disclose all fees to plan participants. At Index Funds Advisors, Inc. we have always maintained that transparency is essential to successful investing, especially regarding fees and other expenses, so we strongly support these new requirements, as can be plainly seen in this video.

IFA.tv Show 10 Fee Transparency click to Watch

When an advisor agrees to accept fiduciary responsibility for a retirement plan, she is required to fulfill the traditional duties of a fiduciary which include diversification of the investments and controlling costs to a justifiable level. The one type of investment that inarguably meets these requirements is a low-cost index fund. Retirement expert Mary Beth Franklin (no relation) observes that many providers who previously focused on actively-managed funds are now adding new product offerings with lower-cost index funds. The Department of Labor has indicated its agreement with this approach, much to the chagrin of brokers and active managers. An especially bizarre complaint was voiced by Paul R. D’Aiutolo, vice president of investments, advisory, and brokerage services at UBS Institutional Consulting.

“The purpose is to keep people engaged in their plans. While index funds may perform well over the long term, it’s often the ups and downs of actively managed funds that keep plan participants paying attention.”

Memo to Mr. D’Aiutolo: Investing for retirement is not intended to be a source of entertainment.  As one of our favorite Nobel Laureate economists Paul Samuelson said, “I tell people [investing] should be dull. It shouldn’t be exciting. Investing should be more like watching paint dry or watching grass grow. If you want excitement, take $800 and go to Las Vegas.”

IFA will continue to closely monitor the situation regarding fee disclosure requirements, and we will make every attempt to keep investors informed. For further informative video discussions on this and many other important subjects, please visit www.ifa.tv.

-Standard & Poors Indices versus Active Funds (SPIVA ®) Scorecard¹

SPIVA Fixed Income Bar Chart 2011

This past March, we published an overview of S&P’s year-end 2011 scorecard which illustrated the continuing dismal performance of active managers, as seen in the table below:

Percentage of Active Funds Outperformed by Benchmark

We also showed how the SPIVA study debunks the myths that small cap managers are more likely to outperform their benchmark than large cap managers and active managers achieve higher performance than index funds in bear markets. Although a glance at the table above would suggest otherwise, there is a persistent popular belief that the concept of market efficiency applies to equities only and not to fixed income. The table below shows the subpar performance in every category of fixed income that was analyzed in SPIVA.

Percentage of Active Funds Outperformed by Benchmark

With odds like these, one has to wonder why anybody would purchase an actively managed bond fund. To make matters worse, these numbers exclude the impact of sales loads and deferred loads. According to Morningstar, the average front-end load of their largest category of bond funds (Intermediate-Term) is 3.84% (Class A shares only). This amount is comparable to an entire year’s worth of expected return. While this might be a wonderful arrangement for the fund company and the commission-collecting broker, the hapless investor who is taking 100% of the risk does not fare well.

The reason behind the sorry numbers shown above is not difficult to understand. Management fees plus the hidden costs of running an active fund represent an insurmountably high hurdle. With bonds, essentially one of two things can happen: either they pay what was promised or they default. Unlike equities, there is little possibility for a manager to get lucky and beat his benchmark. In the few instances where it did happen, it is commonly a result of the manager taking on a different risk profile (either term risk or default risk) than his assigned benchmark.

As we have said on many occasions, manager-picking is a mug’s game. When it comes to fixed income, however, we may have been too generous.

¹http://www.standardandpoors.com/indices/spiva/en/us

The President has nothing on Barton Biggs. Mr. Biggs has been “big” in the world of securities prognosticators for many years. He was the formerly the head strategist at Morgan Stanley where he was reportedly responsible for the formation of its investment management business. He is the author of Hedgehogging, an insider’s look at the hedge fund industry and the founder of Traxis Partners, a hedge fund.

Here’s what Smart Money had to say about his expertise: “As the global investment strategist for Morgan Stanley, Barton Biggs is without question the premier prognosticator on the international scene and a mover of markets from Argentina to Hong Kong. It wouldn’t be a stretch to say Biggs wrote the book on emerging-market investing.”

Like most prognosticators (premier and otherwise), sometimes he was right and sometimes he was wrong. Perhaps the most notable time when his crystal ball failed him was in July, 1993 when he appeared on the cover of Forbes Magazine, dressed in a bear costume, imploring readers to sell U.S. stocks and buy emerging markets. According to Yahoo Finance, on July 1, 1993, the SP 500 Index was at 449. Just three years later, on the same date, it closed at 675. What about emerging markets? According to an article by Daniel Wheeler of Dimensional Fund Advisors, emerging markets performed “terribly” in the ensuing three year period.

Given this background, I read with interest Biggs’ views on those who attempt to predict the future of the market. They are set forth in his 2009 book, Wealth, War Wisdom.

Biggs noted the “increasing evidence” that relying on expert opinion for advice is “a loser’s game.” He set forth with approval studies showing expert opinions on various subjects, including business, should be ignored “as random blather.” He correctly observed “… that pundits who appear regularly on television are particularly unreliable… because they become obsessed with showmanship.” Their focus is not on accuracy but “on their entertainment shock value.”

He is, in my view, spot on with these observations, although I suspect Jim Cramer might take issue with them. Yet, there is an irony that a “premier prognosticator”, who runs a hedge fund, would caution investors to ignore those who purport to have the ability to predict the twists and turns of the market.

Maybe the final phase of his evolving views will be a recognition that trying to beat the market is also a loser’s game. The main beneficiaries of actively managed mutual and hedge funds are typically those who run them. Those who invest in them are often not so fortunate.

Follow Dan Solin on Twitter:

www.twitter.com/DanSolin

Jamie Dimon, the Chief Executive of JP Morgan, called the trades “flawed, complex, poorly reviewed, poorly executed and poorly monitored.” Mr. Dimon was nonplussed by this event, adding, “We will admit it, we will fix it and move on.”

If you are a shareholder in JP Morgan, you are not “moving on” so quickly. According to Reuters, the bank lost $15 billion in market value since this announcement. Standard Poors revised its outlook on the bank from stable to negative, while affirming its A/A-1 issuer credit rating.

In an odd coincidence, the state of New York announced the appointment of JP Morgan as the new advisor for its $2-billion adviser-sold 529 plan, marking its entry into the college savings market. JP Morgan’s “Global Multi-Asset Group” will handle the new business. It manages $74.6 billion in assets.

Mr. Dimon was right. JP Morgan is “moving on.” The question is whether investors in this 529 Plan, and other clients whose assets are managed by this bank, are doing the same. The massive loss suffered by the bank is yet another indication of the inability of this huge institution (or anyone else) to predict the direction of the markets. Yet, the entire securities industry is premised on the false assumption that its members can add value by stock picking, market timing, and fund-manager picking.

The real skill of these “wealth managers” lies in their ability to convince you they have an expertise that doesn’t exist. This latest debacle is one more example demonstrating the irrefutable fact that these investment gurus are emperors with no clothes, representing a significant, little-understood peril to your financial security.

Here’s the hidden message: You would likely be better off without them. Read The Smartest Investment Book You’ll Ever Read, The Little Book of Common Sense Investing and Index Funds: The 12-Step Recovery Program for Active Investors.

You can’t fight this system, but you don’t have to be part of it.

Dimensional Fund Advisors Ltd. is authorised and regulated in the United Kingdom by the Financial Services Authority (FRN: 150100), is registered in England and Wales under Company No. 02569601 and VAT No. 577327607. The registered office address of Dimensional Fund Advisors Ltd. is 7 Down Street, London, W1J 7AJ, United Kingdom. Dimensional Fund Advisors Ltd. is a subsidiary of Dimensional Fund Advisors.

By Eugene F. Fama and Kenneth R. French

Understanding volatility is crucial for informed investment decisions. Our paper explores the volatility of the market, size, and value premiums of the Fama-French three-factor model for US equity returns.

Volatility and Premiums in US Equity Returns (PDF)

Here are two stories that appeared in the financial media one day apart.

The first story was very good news for UBS, AG, Switzerland’s biggest bank. It attracted $12 billion in new assets from wealthy clients in the first quarter of 2012.  This impressive influx of funds beat analysts’ estimates and sent the stock soaring.  It was up 5.5% on May 2, 2012 when the news hit the business wire.  UBS is understandably optimistic about its future.  Its CEO and Chairman said “… we believe our wealth management businesses as a whole will continue to attract net new money, as our clients recognize our efforts and continue to entrust us with their assets.”

The reference to “entrust us with their assets” is significant.  It seems obvious that trusting the integrity of the firm managing your wealth is the most important criterion governing your selection of a financial advisor.

But is it?  That brings us to the second story. On May 1, 2012, the SEC reported that UBS AG will pay $26.6 million to resolve claims its Puerto Rico-based brokerage unit sold shares in its closed end  mutual funds without disclosing that it was propping up the price of the funds in the secondary market.  UBS had allegedly solicited thousands of investors to invest in these funds by representing there was a liquid and competitive secondary market for the funds.

UBS allegedly bought shares into its own inventory from customers who wanted to exit the market and then sold 75 percent of its closed-end fund inventory to unsuspecting investors.

According to SEC Enforcement Director Robert Khuzami, this conduct deprived these investors of “accurate price and liquidity information” and “UBS Puerto Rico denied its closed-end fund customers what they were entitled to under the law — accurate price and liquidity information, and “a trading desk that did not advantage UBS’s trades over those of its customers.” The $26.6 million will be placed into a fund for investors harmed by this conduct. Although UBS consented to this settlement, it did not admit that it engaged in any wrongdoing.

In October 25, 2011, UBS agreed to pay a fine of $12 million to settle accusations it failed to oversee millions of short sale trades over a five year period. Allegedly, it permitted its employees and some of its clients to sell short without verifying that its traders could actually produce the underlying shares.  UBS also denied any wrongdoing in this matter.

On April 11, 2011, UBS was ordered to pay nearly $11 million in connection with charges it misled its customers about the safety of principal-protected notes issued by Lehman Brothers in the months prior to its bankruptcy.  It is alleged to have failed to emphasize to its customers that these notes were unsecured and payment of principal was not guaranteed.  Without admitting to any wrongdoing (sound familiar?), UBS agreed to pay a $2.5 million fine and to reimburse customers an additional $8.5 million.  FINRA’s enforcement chief commented that UBS brokers “did not even understand the complex products they were selling.”

While UBS’ regulatory woes are probably no greater than those of its competitors, its conduct  should be a source of concern to investors.  Yet, this is clearly not the case.  You have to wonder whether the confidence investors are placing in UBS is misplaced.

Dan Solin is a senior vice president of Index Funds Advisors. He is the New York Times bestselling author of “The Smartest Investment Book You’ll Ever Read,” “The Smartest 401(k) Book You’ll Ever Read,” “The Smartest Retirement Book You’ll Ever Read” and “The Smartest Portfolio You’ll Ever Own.” His new book is “The Smartest Money Book You’ll Ever Read.” The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.