29 Oct 2010 Winning
One of the most compelling human instincts is to excel at whatever we do, to be the best we can be, to win. No matter what endeavor we pursue, our careers, our hobbies, the games we play – all are more exciting when we compete to win.With investing, however, the instinct to win can cause untold harm in our lives if it is not properly channeled. Most would agree that it would be foolish to speculate wildly with hard-earned savings earmarked for long-term goals. Yet, millions speculate every day with their IRAs, 401ks, and investment accounts with little or no knowledge they are doing so. By engaging an active money manager of mutual funds or managed accounts we ask him to make bets with our money to provide market-superior returns. There is a globally pervasive view that beating the market is an absolute must if we are to accomplish our goals, when in fact few have even thought about what their goals are.
Mutual fund companies and separate account managers understand the urge to win all too well and they effectively market to it. Here are but a few:
• “We seek to buy securities at reasonable prices relative to their prospects and hold them for the long term.” – American Funds
• “Our research is committed to uncovering the most promising opportunities for our investors.” – Janus Funds
• “Our seasoned portfolio managers seek superior results over time, backed by original, fundamental research on a global scale.” – Putnam Funds
• “PIMCO’s innovative products and strategies employ the firm’s proven investment process to help our clients capture the best opportunities in all market environments. Our macroeconomic forecasting, authoritative sector and security analysis and rigorous risk management address the challenges of a rapidly changing world.”
(Italics added for emphasis)
These fund providers imply they can win for their clients by predicting the future better than any of their competitors. If investors truly buy this myth, they select a road to mediocrity, not to winning. There are volumes of studies available to show how miserably the average investor competes in the ‘investment game.’
Take another look at the quotes above and you will notice that they really say nothing about the investor. There is no mention of his goals or his priorities. Actually, there is no reason for such mention. Money managers are just that – MONEY MANAGERS. They have no idea of what goals are uniquely important to the people who buy their shares. Beating the market is what they are paid to do and they go about it as best they can within their published parameters to accomplish it.
It is the financial advisor’s job to intimately understand his client’s goals and priorities and with that knowledge to design and monitor a plan that will with confidence and as little risk as possible accomplish every goal he or she values. In short, the advisor should focus on his or her client and not the client’s money.
But too many financial advisors are incented to focus on selling to them. They are not fiduciaries focused solely on what is best for their clients, but salesmen, rewarded according to their production. Banks, brokerages, and insurance companies represent the largest customers of travel agencies and resort hotels as they reward the winners in their sales forces with expensive trips and cruises.
If plans are involved at all, they are used to sell and are usually primarily focused on the product du jour, not the client’s life plan. As a result clients can wind up with mutual funds, annuities, CDs, insurance or even collateralized debt obligations that have no place in their portfolios. They are left largely on their own, without plans and at the mercy of the best product marketing machine in the world.
Let’s look more closely at the issue of stealth speculation that is inherent in actively managed mutual funds. As stated earlier, fund managers are charged with bettering market returns; it’s how they justify higher costs. By definition, when a manager holds anything less than a fully diversified investment position he speculates that his idea will result in returns superior to those of the market in which he operates. Since all actively managed mutual funds take concentrated positions they all actively speculate. Further, the investors who engage them speculate that the manager will continue to replicate his compelling track record in the future.
Here’s the problem: A market-beating performance number does not guarantee greater wealth than the markets themselves, it only guarantees greater uncertainty. Let’s take a real-world example. The largest actively managed growth fund in the US according to Wall Street Journal Market Watch is the Growth Fund of America (GFA). It is one of the best actively managed funds in the US according to Morningstar and other rating services.
In our example we compared GFA to our Aggressive Growth model, not the S&P 500 as the fund company does. GFA has a 16% exposure to international stocks, similar to our AG model which has 15% exposure to foreign companies. The S&P 500 is a 100% domestic index. In our comparison we used GFA’s A shares which carry a 5.75% up front sales load. We loaded our model with internal costs of the index exchange traded funds that comprise them which come to .097% annually. We also added an estimate for commission costs required for monthly rebalancing.
For our example we did not factor in the cost of taxes, but they can be huge. GFA’s long term return is reduced by a full 2% when federal taxes on distributions are accounted for at the highest current federal bracket. State taxes reduce returns further. Most ETFs do not distribute unwanted taxable gains.
Please understand that the following example is for illustrative purposes only. The returns shown are actual, but are presented hypothetically. The data comes from Morningstar and was analyzed using the Morningstar Advisor Workstation.
In our case a hypothetical investor in two portfolios holds, spends $1,000, and adds $1,000 annually for 10 years beginning January 1, 2001 through September 30, 2010. The illustration represents a specific time frame selected to demonstrate a point. As will be demonstrated later, there are other timeframes which more favorably present the performance of GFA.
The table below compares what would be the actual results under the most common three scenarios of investing; holding, spending, and saving. At the bottom left you can see that the GFA and AG portfolios performed similarly over the past ten years. As you compare the two columns of returns under “Avg An Return” you can see some rather dramatic differences. Active managers increase uncertainty beyond that of the capital markets.
Next, look at the returns across the bottom. Notice how much they vary as the money is held, spent, or saved. The investment returns were the same, but the timing and direction of the cash flows have significant impact of the average annual return calculation. The fund reports 1.22%, but you might get -1.91% or 2.52% depending upon your cash flow requirements.
Now, here’s the main point. You don’t accomplish financial goals with the numbers 1.22% or 2.52%. You accomplish goals with money – wealth. In every year and in each scenario presented, the AG model, and efficient representation of the equity markets, produced more wealth than the GFA did. It didn’t matter if our investor held, spent or saved. He had more money in each year during the decade and at the end.
As stated earlier, it is important to be fair to GFA and American Funds. There are plenty of periods where GFA fared better than the market. For instance, if we took a 10-year period that started just one year earlier in January of 2000, we find that GFA beats our AG model 1.73% to (.37%). However, there were still a few years where AG provided greater wealth.
We do not mean to imply that funds do not beat the market, but simply that it is not necessary to do so and that it absolutely adds greater uncertainty to the mix. You cannot know when your manager will underperform and how greatly that underperformance will impact your wealth.
A far better use of our time and their money is to keep our clients goals in balance, avoid unnecessary risk, and provide for a reasonable probability of achieving their goals. We regularly check to determine that their plans are properly funded adjusting when necessary, according to their priorities, not only their portfolio risk, but components just as important to lifestyle including longevity of work, savings, giving, and the timing of major cash flows and goals.
To win at anything, it is important to control as much possible and plan well for what cannot be controlled to adapt quickly and efficiently to the unexpected. For our clients it means controlling costs, taxes, and under market performance through the use of efficient index ETFs and intelligent portfolio design and management. It means planning for the inevitable uncertainty and volatility of markets by employing a sophisticated Monte Carlo-based probability model that continually stress-tests our clients’ plans for adequate confidence in meeting every one of their important goals. We believe that’s a winning combination for any investor.