Month: December 2018

Pay attention to asset classes, not returns

Link Joshua VanDykeLeave a comment

When people think about deciding between investment advisors, or mutual funds, or even stocks, the temptation is to look at past performance. That’s the default. And it seems basic, you’re looking for returns, what else would you look at? What else could you even look at?

The problem is the past performance we see is short term. You’ll see three to five year histories on your account statements, Morningstar defaults at a ten year history (if the fund has been around that long), and the news rarely talks about anything further back than the last year. Those are relatively short periods of time, especially when we’re talking about market returns. Instead of comparing past performance in advisors and mutual funds over the past ten years, we should be looking at long-term historical returns of asset classes.

An asset class is a group of similar securities that tend to move together. The main general asset classes are equities (stocks), fixed income (bonds), and cash. Each of these, but especially the equities group, can be broken down further. In equities, we see large vs small, value vs growth, U.S. vs international. For an example, a very popular asset class is U.S. Large Growth, which is basically the S&P 500. We have returns data on these asset classes all the way back to the early 20th century. That information can tell us much more than the past ten years. We can see which asset classes tend to outperform others, we can see how the different asset classes correlate to each other, and we can know what returns and risk a fund or portfolio can expect over long periods of time. A ten-year history of returns is almost irrelevant. Over ten years any asset class could outperform any other, but we don’t know when or which. So to look backward at the performance of a fund is not only unhelpful, it’s more often hurtful. A good ten-year history on a fund, or even an asset class, deceives us into thinking the performance will continue in the future. The short-term history the only information we know to use, and besides that, it seems to make sense. But that’s the opposite of a good investing strategy. Instead, let’s analyze the asset class data going back as far as it goes, understand where returns come from, and diversify our portfolio’s in a way that’s consistent with the data. Then we let the market perform and deliver results. Our balanced diversified portfolio won’t always be the big winner year by year, but over the long haul, it will outperform anyone trying to predict market movements based on ten-year histories, or any other material information.

You should know something about ETFs

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First things first, if you’re unsure what an ETF (exchange-traded fund) is, let me explain broadly. An ETF is something you can invest money into, it’s an investment vehicle. Like mutual funds, ETFs provide a way for investors to own multiple companies through one fund. You might even have some money invested in ETFs through your 401k or other investment accounts.

ETFs have quickly become a very popular investment option in the US. We hear a lot about robo-advisors these days, their offerings consist almost exclusively of ETFs. In 2016, seven of the top ten traded securities in the US market were ETFs. Assets deposited and held within ETFs have grown substantially within the last 15 years:

Besides all that, ETFs are cool. They’re based on algorithms, you can buy and track them through really nice apps, they’re usually super cheap, the list goes on. They’re the perfect investment for this generation. I’ll admit, they appeal to my millennial preferences too. But, there are a few important things to understand about ETFs before making any investment decisions, and there’s a reason we don’t recommend them.

Now let’s define ETF a little more specifically. The easiest way to explain them is by a comparison with mutual funds. Mutual funds have been around for much longer, they’re a little simpler, and probably a little more familiar. We’ll look at two distinguishing characteristics between mutual funds and ETFs:

1) Ownership.

A mutual fund owns shares of different companies. So if you buy one share of a mutual fund, you’re actually investing in each of the different companies that the mutual fund owns. Different mutual funds make different decisions on which companies they own. Some are actively managed, meaning there’s a manager buying and selling different shares within the mutual fund; some are passively managed, meaning they own a group of companies that are chosen based on a set of rules and the companies don’t change too much; some are index funds (which is a type of passive fund), which means they own the same companies that an index tracks (like the S&P 500); there’s no shortage to the type of mutual fund you can own, there are lots of them, and they’ve been a very popular investment vehicle for a long time. The thing to remember is that the value of a mutual fund is the value of the stocks it owns. Mutual funds actually own stock shares.

ETFs also invests in different companies, and different ETFs have different criteria for the companies or sectors they invest in (the most popular ETFs track with the S&P 500). However, ETFs don’t actually own stock shares in those companies. Instead, they own pledged assets, which are contracts to provide shares. Essentially, ETFs own rights to shares. This brings benefits like low expense ratios within ETFs (no fees for buying and selling stocks since the only things that trade within an ETF are contracts) and occasional tax savings (if you have a taxable account).

2) Fund type.

Mutual funds are their own separate type of investment, they’re not like stocks. Mutual funds are only valued once per day, after the close of market. Then all the stocks and investments within the fund are added up and the value of the mutual fund is determined anew. Because of this, you can only buy and sell mutual funds once per day, when the value has been calculated. Mutual funds are a longer type of investment by design. That doesn’t mean the holdings within the mutual fund are long term, a mutual fund manager could be making trades inside the mutual fund at any time, but the mutual fund itself can’t be day-traded or hedged or anything you might do with stock holdings.

ETFs however, are traded on an exchange, which means they act like a stock. You can make inter-day trades, the value is moving whenever the market is open, you can hedge and short and order stops, and engage in all sorts of risky stock market things. It also means there’s a fee for each trade, which isn’t necessarily a problem, but you wouldn’t want to be executing lots of ETF trades. This extra trad-ability makes mutual funds appealing for many. The trade costs are a bit of a deterrent, but you can actually day-trade with ETFs.

So that’s what ETFs are. The rise of ETFs in one of the most significant changes in the world of investing over the last 20 years and many people are excited about the opportunity. Here are a few reasons why I’m less excited, and why we don’t recommend ETFs for our investors.

Regulation surrounding ETFs has proven insufficient. I’m usually not a big proponent for the increase of regulation, but when it comes to ETFs, the lack of regulation is a real problem. There currently isn’t even an official legal definition for ETFs so they’re regulated individually, fund by fund, under mutual fund rules. As you’ve seen above, ETFs differ from mutual funds in significant ways, and mutual fund regulations simply can’t account for the discrepancies.

Since ETFs own contracts for shares instead of actual shares, the value of an ETF is tied to the viability of its contracts to perform, its arbitrage mechanism. Theoretically, the value of an ETF should be the value of the promised shares (like mutual funds are valued based on the shares they own), and usually, it is, but not always. When the price diverges, the arbitrage mechanism has to kick in to bring it back. So there’s a whole new type of risk involved, the reliability of the arbitrage mechanism, which can also dramatically affect the price. The fact is, when the market is stressed, the arbitrage mechanism can fail, causing massive swings in the pricing of ETFs, unrelated to the underlying stock assignments. That’s not just a hypothetical, it has happened, and continues to happen. August 24, 2015, is one specifically egregious example. It’s not entirely clear how or why these things happen from a market perspective, and the differing regulations (even between funds with the same pledged assets) only cause more uncertainty. The whole system is shrouded. What we know is that the inconsistent regulation, the cloudy definitions, and the unreliable arbitrage mechanisms have created more risk for ETFs. Unfortunately, it’s impossible to quantify the additional risk in any meaningful way because there are still too many unknowns. Investopedia even admits in reference to ETFs, ‘the perceived increase in volatility needs further research.’ In its current state of affairs, the ETF market is simply not reliable enough to recommend as a vehicle for a person’s life savings. There seems to be increasing support for research and regulation surrounding ETFs so the issue is certainly not over-with, perhaps we could even end up recommending ETFs to all of our investors in the future, but for now, stick with some good old mutual funds.

 

Sources:

Financial Times: The $5tn ETF market balances precariously on outdated rules

Financial Times: Market turbulence revives fears over ETF structural issues

Evanson Asset Management® – Are DFA Strategies Superior?

Why I switched back to physical books

Link Joshua VanDyke3 Comments

For the last three years or so I have been ravenously building and reading my Kindle library. I love reading and I love iPads, and I really loved putting the two together. But, the title gives it away, I’m switching back to normal physical books. Here are some quick pros and cons to Kindle books, and why I decided to go back.

 

Pros:

  • Convenience. The fact that one portable device can store thousands of books, literally an entire library, is compelling, and super convenient. My iPad, or at least my iPhone, is always with me so the books are always available. No packing, remembering, planning, nothing. They’re all always with me.
  • Not physical. The books are electronic, which means no maintenance. I never worry about spilling coffee on a book (although that might have been worse on an iPad), ripping a page, drool from my children, or any other thing that would ruin a book. Their general well-being is never a concern, they’re always in mint condition. An iPad can obviously sustain some serious damage too, but even if my iPad was destroyed or lost, the books would still be there to download on the next device.
  • Easy to organize. The direct sync between Kindle and Goodreads is a helpful feature. My Goodreads profile and book tracking is always up to date without ever logging in to Goodreads. Kindle also uses Collections, which basically function like tags, and I love tags.

 

Cons:

  • Progress as a percentage. I found myself constantly tracking that stupid number. I’ll admit, it could be a personal problem, maybe you can ignore the numbers, but they’re pasted right on the cover of each book. I can’t stop paying attention to them. I get immersed so much more easily in a physical book.
  • It’s distracting to read on a device. The percentages are distracting, but that’s only where the distractions begin. If you’re reading on any type of tablet or phone there’s a pull to check email, look something up online, or get a quick game in. I would suddenly remember something in the middle of reading and, since a little computer was in my hands, I would just switch over to quickly take care of the thing I forgot. Even if every notification and connection setting is turned off, you still can’t turn off the capability. The counter-point to this is to use an e-reader of some sort because they don’t have all that capability. While they seem to be a great solution for many people, I have found them lacking for a few reasons. 1) They have small screens, six inches is too small. 2) The e-ink flashes every time a page turns, talk about distracting. 3) Books lose any distinguishing characteristics, even more so than in the Kindle app. 4) They’re made of plastic. 5) They’re boring! If I’m going to read books on a device, give me an iPad with all the capability it comes with, distracting as it may be.
  • What happens if Amazon goes out of business? This could be stupid, but I get a little nervous that someday my library won’t be accessible. Companies go out of business all the time. There would probably still be some way for people to keep their electronic copies, but I, for one, am not interested in watching it play out.
  • I missed seeing my whole library. It’s exciting to scan an entire shelf of books and pick one out. When a Kindle library grows the only option to find books is to type titles in the search bar or get scrolling. The library feels hidden.
  • The human element. I’m human, I like to touch and feel and see and smell things. iPads and e-readers are great, but they make every book feel and look and read the same. Books lose some of their personality that way. You can develop a sort of connection with a physical book that isn’t possible when you read it on a device. I guess my point is that books are personal, and that’s important.
  • I have young kids. Studies have shown that households with books raise more literate and successful children. Interestingly, this specific study found that 350 books in a household is a kind of threshold. The benefit for children rose with the number of books in their house until they hit 350, then the benefit leveled off. 350 books appears to be enough to saturate the home, there will be books lying around on end tables and shelves, they’ll be in each person’s room, they’ll be visible all over. I started reading normal books again before coming across this article, but you can bet I counted right away to ensure we had over 350. Besides the study, I’ve noticed an interesting change in my own house since I recommitted to physical books about three months ago. The kids have begun to read more. When they saw me on an iPad they had no idea if I was reading a book or playing a game or whatever, they just wanted to play on an iPad too. There’s something about a Dad’s example that seems to inspire kids, they watch and copy. It’s not like rules changed three months ago, but the example changed, and it has made a noticeable difference.

All told I have no regrets returning to a library of physical books. What I miss most about using a Kindle library is the convenience, it’s a bit of an adjustment carrying books around again, but the advantages have far outweighed the extra weight in my bag.

What’s going on inside your investment portfolio?

Link Joshua VanDykeLeave a comment

Part of my job is to analyze customer portfolios. The gist is that we dig into the different investments, usually contained within different mutual funds, to figure out what people actually own in their portfolios. For many of us, it’s tough to know what’s going on behind the scenes in our portfolio because the quarterly statements only show pie charts and weird mutual fund names. So, I help to figure out what the actual stock holdings are, then organize the information by asset classes to see how many different asset classes people are invested in and what percentage of their money is allocated to each. Essentially it’s a determination of diversification, which, as we know, is the single most important component of a portfolio (check out Where do returns come from?). It’s a fun exercise, and helpful for clients. The results tend to be a little more sobering.

I estimate that about 95% of portfolios we analyze are not diversified like they should be, and about 75% of portfolios are heavily bent toward one asset class: US Large Growth (S&P 500). Those are estimates, the point is that the large majority of portfolios we see are diversified poorly or hardly at all. There are two problems here: 1) diversification is lacking, 2) the most popular asset class to load up in is US Large Growth.

The first problem has to do with the Modern Portfolio Theory. Lacking diversification means that the portfolio is subject to more risk (volatility) and will expect less return over time than an efficiently diversified portfolio. Many people think that they’re pretty well diversified because of the number of mutual fund names they see on their statement. However, we find that those mutual funds typically have significant overlap with each other. The large majority of portfolios are loaded up in US Large Growth companies because the mutual funds they own are loaded up in US Large Growth companies. Just because there are a bunch of different mutual funds doesn’t mean there are a bunch of different asset classes represented within them. Seldom do we find small companies or value companies within these mutual funds, and we almost never see small value companies. These portfolios also infrequently own anything internationally, which makes up about half of the global stock market (in 2017, the US accounted for 51.3% of the global market, leaving 48.7% often untapped). These asset classes are largely ignored in favor of US Large Growth.

The second problem has to do with the US Large Growth asset class. If US Large Growth was the best performing asset class, a lack of diversification in your portfolio would have at least some defense. The risk would still be higher than it should be, but at least you could expect some decent returns. Unfortunately, that’s not the case. Going back as far as we have air-tight data on the stock market (almost 100 years), US Large Growth has been one of the worst performing asset classes in the world. That’s not to say US Large Growth a total waste, the asset class still provides good returns, and it’s valuable as a piece of a well-diversified account, but the lean towards these companies has a handicapping effect on portfolios. You simply won’t be able to expect the same level of return as you would in an efficiently diversified portfolio. Here’s a snapshot of average asset class returns over the years:

Why do most portfolios lean toward the S&P 500 despite the evidence? It seems that there are a few reasons. 1) The S&P 500 is the popular companies, the ones you’ve heard of, like Apple and Google and Amazon. They’re also all we hear about in the news. The S&P 500, the Dow Jones, and the Nasdaq are all categories of Large US companies. The news cycle is constantly spinning stories about them. They’re familiar companies, and we like to think we know them better. 2) The US Large Growth asset class is cheap to trade in. There is so much trading activity going on with these stocks, they’re always in demand, there’s always a market for them. Since much of the industry is still actively trading in an attempt to beat the market, they have to trade where the trades are cheaper. If they were actively making trades in an account with small value companies, the trading costs alone would submarine any return expectations.

When we see these disappointing results in a client’s portfolio we offer them a few things. 1) For the money they can move, we offer a well-diversified portfolio which will take advantage of returns offered from higher performing asset classes while simultaneously reducing risk. 2) If the money is locked up in a 401k with a current employer, we help them analyze their options within the 401k to get as close to an efficiently diversified portfolio as possible.