March 2008 - Posts

• Lessons From 2007 (Part 4 of 4)

  Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the final installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year. Click here for Part 1 Click here for Part 2 Click here for Part 3 --------------------------------------------------------------------------------- Lesson 6: It's Called Risk Premium for Good Reason From 1927-2006, value stocks provided an annual return about 5 percent above that of growth stocks. However, 2007 was a very different story. The subprime mortgage crisis led to a flight to quality across all financial assets: Treasury bonds outperformed investment grade bonds. Investment grade bonds outperformed junk bonds. Large-cap stocks outperformed small-cap stocks. Growth stocks outperformed value stocks. This type of performance is not unusual. In fact, it is very typical of a financial crisis. Two relatively recent examples are from 1990 and 1998. In 1990, the savings and loan crisis was occurring. While the S&P 500 fell just 3.1 percent that year, small-cap stocks fell by 20 percent and small-cap value stocks fell 22 percent. In 1998, the world was experiencing the Asian Contagion. A crisis in several emerging market countries spilled across borders, and the events eventually led to the spectacular failure of Long Term Capital Management, which was the largest hedge fund in the world at the time. The S&P 500 turned in a good year (up almost 29 percent) that year, but small-cap stocks fell 2.3 percent and small-cap value stocks fell 10 percent. Value stocks are stocks that exhibit characteristics of risky investments. For example, they tend to have high volatility of earnings and dividends, and tend to be more highly leveraged than growth stocks. Also, these companies typically have fewer sources of capital and tend to be cut off from these sources first during crises (like those of 1990, 1998 and 2007). While there are some academics who believe that the value premium is a behavioral story (that is, investors persistently overpay for growth stocks and overestimate the risks of value companies), it seems hard to argue against the risk-based story when value stocks often underperform when there is a financial crisis. There are a few lessons here: Value stocks have a risk premium for a good reason. These are stocks of risky companies and the risks will show up from time to time. The evidence from academic studies suggests there is no way to time the value premium. In other words, a streak of several years of value stocks outperforming tells you basically nothing about what the value premium will be in the next year. Sometimes value stocks outperform for a couple of years, and sometimes they go on long winning streaks. In fact, the streak of value stocks outperforming growth stocks from 2000-2006 was not that unusual. There have been other fairly long streaks: 1961-1965, 1972-1977 and 1940-1948. On the other hand, the longest streak of growth stocks outperforming value stocks has been just three years: 1937-1939, 1978-1980 and 1989-1991. Investors seeking to capture the value risk premium must be prepared to accept that risk and stay the course.     Lesson 7: How Not to Make or Keep Wealth Morningstar dedicates a large amount of resources to identifying the great money managers. It rates about 5,000 mutual funds, giving just 500 its coveted five-star rating. But why settle for the top 500? Why not invest in just the very best in each asset class? In November 2001, Morningstar created its Aggressive Wealth Maker and Wealth Maker portfolios. In May 2002, it added the Wealth Keeper Portfolio. Each portfolio contains less than 10 funds. It's Morningstar's effort to identify the best of the best. How has Morningstar done? In last year's article "Lessons From 2006," it was noted that the three portfolios were trailing their benchmarks. This year is not much different, as all three of the portfolios still trail their benchmark portfolios that consist of simple broad market index funds. From inception through the end of 2007, the Aggressive Wealth Maker trailed its benchmark by 1.4 percent per annum, the Wealth Maker by 1.3 percent per annum and the Wealth Keeper by 1.8 percent per annum. And we should note that the hurdle is actually too low as Morningstar includes small-cap and value oriented funds in its portfolios while the benchmarks contain only total market index funds. Since small-cap and value stocks have outperformed broader market indexes, Morningstar's portfolios had a tail wind at their backs aiding their performance. Unfortunately, it has not been enough. The lesson is that there is a reason the SEC requires that mutual fund advertisements contain the disclaimer about past performance. While investing in actively managed funds does give you the hope of outperformance, the far greater likelihood is that it will lead to underperformance. Summary Like most years, 2007 provided many reminders of the principles of a prudent investment strategy: Build a globally diversified portfolio of passively managed funds that reflects the investor's unique ability, willingness and need to take risk. Formalize that plan by creating an investment policy statement including a rebalancing table. Adhere to that plan. One key to achieving that objective is to ignore all economic and market forecasts, the noise of the market and the emotions that noise can cause. Doing so will also allow you to spend more time on the really important things in life, such as your family, friends and community.    This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Mar 28 2008, 09:18 AM by Jim Cornfeld

• Lessons From 2007 (Part 3 of 4)

  Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the third installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year. Click here for Part 1 Click here for Part 2 --------------------------------------------------------------- Lesson 4: Yesterday's Masters of the Universe, Tomorrow's Cosmic Dust For believers in active management, the equivalent of finding the Holy Grail is identifying a manager who can persistently beat the market. The hero for many had been Bill Miller, manager of the Legg Mason Value Trust (LMVTX). 2005 was the 15th consecutive year his fund beat the S&P 500 - the longest streak on record. To the faithful, surely 15 years was the result of skill and not random luck. On the other hand, perhaps the streak was purely a lucky one. In 2006, the fund returned 5.9 percent, underperforming the S&P 500 by 9.9 percent. Perhaps that was just one bad year, and the market just did not see what Miller saw as real value. Unfortunately, the fund repeated that dubious feat in 2007, losing 6.7 percent and underperforming the S&P 500 by 12.2 percent. The past two years left the fund with a three-year record of underperforming the S&P 500 by 7.3 percent per annum. Was Miller a skillful manager who had just lost his touch? Or was he lucky and Lady Luck had abandoned him? How is an investor to know which is the correct answer? What should an investor in the fund do now? If an investor chooses to stay with the fund, how long should that investor wait before giving up? What if Miller turns the performance around after investors sell the fund? There is even more bad news. Most of Miller's great returns came when the fund was much smaller. The great returns attracted huge cash flows, which kept increasing as his streak continued. The worst performance came when the fund had the most dollars. Thus, the returns actually earned by many investors in the Legg Mason Value Trust are well below the returns reported by the fund. Of course, this is not the fault of the fund. Instead, the fault lies with investors who chose to ignore the evidence from academic studies that there is virtually no persistence of performance beyond the randomly expected, at least among winners. (Losers tend to repeat losing because of high expenses.) As history suggests it would, the fund experienced large outflows in 2007. Investors withdrew almost $10 billion of assets in the third quarter of 2007 from the Legg Mason family of funds. Thus, even if Miller manages to once again outperform, many investors will not be there to benefit. Other Funds It is also worth noting that the domestic fund with the longest current streak of outperforming the S&P 500 also saw its streak end. Cambiar Opportunity (CAMOX), which had beaten the S&P 500 for eight consecutive years, lost 1.9 percent in 2007 and underperformed the S&P 500 by 7.4 percent. The fund's three-year performance trailed the S&P 500 by 1.6 percent per annum. The lesson is that ignoring the SEC's warning about relying on past performance of actively managed funds is the financial equivalent of ignoring the surgeon general's warning about the dangers of smoking.   Lesson 5: The Importance of Portfolio Diversification Insurance plays an important role in managing threats to financial security. People insure against the risks to their homes, cars and personal property. And they insure against premature death (life insurance), medical expenses (health insurance and long-term health care insurance), disability and even longevity (lifetime payout annuities). The same principles of prudent risk management apply to investment portfolios. There are two asset classes - collateralized commodity futures (CCF) and Treasury inflation-protected securities (TIPS) - that provide a form of portfolio insurance because their returns are negatively correlated with the returns of stocks and nominal return bonds (bonds whose returns are not indexed to inflation). When an asset produces higher than average returns, its negatively correlated counterparts tend to produce below average returns. Thus, the addition of negatively correlating assets to a portfolio dampens the volatility of the overall portfolio and reduces volatility's negative impact on compound returns. Both TIPS and CCF provide hedges against inflation risks, and CCF also provides a hedge against some event risks (such as an interruption of oil supplies). Academic research and historical evidence suggest that adding these assets will likely produce less volatile and more efficient portfolios (portfolios with higher risk-adjusted returns). In 2007, both TIPS and CCF produced above average returns. The Vanguard Inflation Protected Securities Fund returned 11.6 percent and the PIMCO CommoditiesRealReturn Fund returned 23.2 percent.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Mar 16 2008, 08:48 PM by Jim Cornfeld

• Lessons From 2007 (Part 2 of 4)

  Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. This is the second installment of Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year. Click here for Part 1 ------------------------------------------------------------------- Lesson 2: Globalization and Diversification One of the more common recent investment themes revolves around globalization. The thought is that the correlation of returns of stocks around the globe is rising with increased globalization, reducing the benefits of international diversification. This train of thought suggests that no one needs to invest internationally. Instead, just invest in U.S. multinational companies, such as those that dominate the S&P 500. Using the passive funds of Dimensional Fund Advisors (DFA), the following table presents the 2007 returns of the four major U.S. equity asset classes and their international counterparts. The returns for the various emerging market asset classes are included. Fund Change From 12/31/06 to 12/31/07 Domestic   DFA US Large +5.4% DFA US Large Value -2.8% DFA US Small -3.1% DFA US Small Value -10.8% International   DFA International Large +12.5% DFA International Large Value +10.2% DFA International Small +5.7% DFA International Small Value +3.0% DFA Emerging Markets +36.0% DFA Emerging Markets Small +38.0% DFA Emerging Markets Value +45.6%  Source: Dimensional Fund Advisors The benefits of global diversification should be obvious. The important lesson is that broad global diversification is part of a prudent strategy.   Lesson 3: Last Year's Winners Just as Likely To Be This Year's Dogs as They Are to Repeat The historical evidence demonstrates that many individual investors are performance chasers - they buy yesterday's winners (after their great performance) and sell yesterday's losers (after the loss has already been incurred). This causes investors to buy high and sell low - not exactly a recipe for investment success. Unfortunately, streaks in asset class returns occur randomly relative to expectations. Such streaks have no more meaning than streaks at the craps table - a good (poor) return in one year does not predict a good (poor) return the next year. In fact, above average returns lower future expected returns, and below average returns raise future expected returns. Thus, the prudent strategy for investors is to act like a postage stamp, which does only one thing, but does it exceedingly well: It adheres to its letter until it reaches its destination. Similarly, investors should adhere to their investment plan. Adhering to one's plan does not mean just buying and holding. It means buying, holding and rebalancing - the process of restoring the portfolio's asset allocation to the plan's targeted levels. Using DFA's passive funds (as well as PIMCO's CommodityRealReturn Fund), the following table compares the returns of various asset classes in 2006 and 2007. As you can see, some 2006 winners repeated, but some became losers. Fund 2006  (Rank) 2007 DFA Emerging Markets Value 37.9% (1)  45.6% (1) DFA Emerging Markets Small 37.3% (2)  38.0% (2) DFA Real Estate 35.3% (3) -18.7% (13) DFA International Value 34.2% (4)  10.2% (6) DFA Emerging Markets 29.2% (5)  36.0% (3) DFA International Small Value 28.4% (6)    3.0% (9) DFA International Large 24.9% (7 tied)  12.5% (5) DFA International Small 24.9% (7 tied)    5.7% (7) DFA U.S. Small Value 21.6% (9) -10.8% (12) DFA U.S. Large Value 20.2% (10) -2.8% (10) DFA U.S. Small 16.6% (11) -3.1% (11) DFA U.S. Large (S&P 500) 15.7% (12)    5.4% (8) PIMCO CommodityRealReturn Fund (Institutional) -3.5% (13)  23.2% (4) Source: Dimensional Fund Advisors It is also worth taking a little longer perspective. From 2003 through 2006, DFA's Real Estate, U.S. Small Value and Emerging Markets funds returned 28.7, 27.2 and 36.7 percent per annum, respectively. In 2007, DFA's Real Estate and U.S. Small Value funds lost 18.7 percent and 10.8 percent, respectively. However, the DFA Emerging Markets Fund once again produced favorable returns, with a return of 36.0 percent. The lessons are that investors need to ignore the emotions that bull (greed and envy) and bear markets (fear and panic) create and that disciplined rebalancing is the winning strategy.   This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455. Posted Mar 07 2008, 06:44 PM by Jim Cornfeld

• Lessons from 2007 (Part 1 of 4)

  Overview: Every year the market provides investors with lessons on the prudent investment strategy. 2007 was no different. The following is Larry Swedroe's annual review of some of the important lessons the capital markets gave us during the previous year. --------------------------------------- Like many years, 2007 was filled with news that might have made investors sell stocks if they had a perfectly clear crystal ball. Let's review some of the bad news. International Events The showdown with Iran over its nuclear weapons program dominated the headlines. And Pakistan, a nuclear power already threatened by terrorism in the region, experienced a political crisis. Commodity Prices The price of a barrel of oil more than doubled to end the year at about $96. The price of many other commodities, including gold and silver, also rose dramatically. This raised the threat of inflation, which is a negative for both the stock and bond markets. The Falling Dollar The dollar collapsed against most major currencies, including the Canadian dollar and the euro. The headlines contained predictions about global investors abandoning the dollar. Financial Mess The U.S. capital markets experienced one of the most significant financial crises in history, fueled by turmoil in the subprime mortgage market. And with globalization, the holdings of subprime debt had spread around the world. The losses from the subprime mortgage meltdown are already in the tens of billions. This led to a general flight to quality, a drying up of liquidity in lending markets (not just mortgage-related lending), and a resulting widening of credit spreads. The central banks of the world had to orchestrate massive efforts to provide liquidity and keep the markets functioning. Housing Recession The U.S. housing market experienced its worst recession since the Great Depression. This created the threat of an overall recession. Hedge Funds Several large hedge funds experienced huge losses due to market volatility.   Lesson 1: Stay the Course One can only wonder how many investors abandoned their investment plans in the face of all this bad news. Despite the bad news, the markets performed well overall. Treasury bond yields fell across the board in spite of rising commodity prices and the threat of a falling dollar. Thus, with the exception of junk bonds (and other risky credits), fixed income investments produced strong returns. Both the S&P 500 Index and Vanguard's Total Stock Market Index Fund produced returns of about 5.5 percent. And with the exception of small-cap and small-cap value and real estate asset classes, most equities around the globe provided good returns as well. The lesson is that not only should investors ignore economic forecasts, but also that even if events were forecast accurately, investors still might make poor investment decisions based on that information. Thus, the prudent strategy is to have the right investment plan in place - one that reflects the investor's ability, willingness and need to take risk. Having such a plan gives investors a much better chance of ignoring the fear and panic caused by bad news.    This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The articles and opinions in this publication are for general information only and are not intended to serve as specific financial, accounting or tax advice. Copyright © 2008, Buckingham Family of Financial Services. All rights reserved. This material may not be copied or distributed (electronically or otherwise) without the written consent of Buckingham Asset Management. The products or services described herein are available to US citizens and residents only and the information contained is intended for such persons only. No information contained herein is an offer to sell. Investors should read the prospectus of a security prior to making any investments. Please contact us if you have any questions at 314.725.0455 Posted Mar 03 2008, 07:10 PM by Jim Cornfeld