Download How the Market Works… and What It Means for Your Portfolio

How the Market Works…
and What It Means for Your Portfolio
April 2010
Bradley A. Reed, CFA
S tt M.
Scott
M Keller
K ll
4901 Hunt Road | Suite 200 | Cincinnati, OH | 45242 | 513.792.6648 PH | 513.792.6644 FX | TruepointInc.com
Today’s Agenda
ƒ What is Conventional Investment Wisdom
ƒ How the Market Works
ƒ What It Means for Your Portfolio
2
Conventional Investment Wisdom
Conventional investment wisdom suggests that smart people, working diligently, can
discover which stocks are mispriced
p
by
y the market. Conventional wisdom also says
y
that these informed investors can time the market. This is what the practice of active
management is all about - stock picking and market timing.
ƒ Th
The success off stock-picking
t k i ki and
d market
k t titiming
i are myths
th perpetuated
t t db
by th
those
who stand to profit from them the most – Wall Street and the media
ƒ Wall Street and the media uphold the myth that investing should be exciting and
d
dynamic
i
ƒ Rational voices advocating prudent investment practices receive very little
attention in world of entertainment masquerading as advice
3
How the Market Works
Who is “The Market”
Today 90% of all New York Stock Exchange trades are made by investment
p
professionals
ƒ The market is considered “efficient” – not perfect, but sufficiently efficient that
wise investors will recognize they cannot expect to regularly exploit mispricings
ƒ Everything currently knowable is already incorporated into prices - stock prices
move only in response to new information
unexpected, movements in stocks,
stocks and
ƒ Since surprises are by definition unexpected
movements in the stock market overall cannot be identified in advance
ƒ It’s been said that there are only two kinds of people in the world – those who
don’tt know where the market is headed
don
headed, and those who don’t
don t know that they
don’t know
“Trading individual stocks is like playing tennis against an invisible opponent; what you
d ’t realize
don’t
li iis th
thatt you are volleying
ll i with
ith th
the Willi
Williams sisters.”
i t
”
– William Bernstein, PhD, MD, Financial Author and Theorist
4
How the Market Works
Implications
p
for Active Management
g
ƒ The basic assumption that most investment managers can outperform the
market is false – these investment managers are the market
ƒ Given the cost of active management, three quarters of investment managers
have and will continue over the long
have,
long-term,
term to underperform the overall market
ƒ To achieve better than average active management results, a manager must
discover and exploit the mistakes of other investment managers
ƒ As a result of the efficiency of the market and the high cost associated with
active investing, active management has become a “loser’s game”
5
How the Markets Work
The Benefits of Passive Management
g
“After costs, the return on the average actively managed dollar will be less than the
return on the average passively managed dollar for any time period.
period ”
—William F. Sharpe, 1990 Nobel Laureate
Domestic Mutual Fund Expense Ratios
International Mutual Fund Expense Ratios
1.59%
1.45%
1.01%
0.91%
0.94%
0.73%
0.26%
0.16%
Average of
Weighted Average,
All Funds Based on Fund Assets
Average of
Weighted Average,
All Funds Based on Fund Assets
Active
Passive
Average of
Weighted Average,
All Funds Based on Fund Assets
Active
William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9.
Mutual fund expense ratios as of February 6, 2009. Asset weighting based on net assets as of December 31, 2008. Data provided by Morningstar, Inc.
Average of
Weighted Average,
All Funds Based on Fund Assets
Passive
6
How the Market Works
Daniel Kahneman
“What’s
What s really quite remarkable in the investment world is that people are
playing a game which, in some sense, cannot be played. There are so many
people out there in the market; the idea that any single individual without
extra information or extra market power can beat the market is
extraordinarily unlikely. Yet the market is full of people who think they can do
it and full of other people who believe them. This is one of the great
mysteries of finance: Why do people believe they can do the
impossible? And why do other people believe them?”
– Daniel Kahneman, 2002 Nobel Laureate and Behavioral Economics Expert
7
How the Markets Work
The Failure of Active Management
g
Percentage of Active Public Equity Funds That Failed to Beat the Index
July 2004-June 2009
% of Active
e Funds Thatt Failed
to Outpe
erform Bench
hmark
100%
80%
70%
90%
87%
90%
73%
71%
68%
63%
60%
60%
50%
40%
30%
20%
10%
0%
US Large
Cap
US Mid
Cap
US Small
Cap
Global
International
International
Small
Emerging
Markets
Equity Fund Category
Source: Standard & Poor’s Indices Versus Active Funds Scorecard, August 20, 2009. Index used for comparison: US Large Cap—S&P 500 Index; US Mid Cap—S&P MidCap 400
Index; US Small Cap—S&P SmallCap 600 Index; Global Funds—S&P Global 1200 Index; International—S&P 700 Index; International Small—S&P Developed ex. US SmallCap8
Index; Emerging Markets—S&P IFCI Composite. Data for the SPIVA study is from the CRSP Survivor-Bias-Free US Mutual Fund Database.
How the Markets Work
Non-Surviving
g Active Equity
q y Funds 2004-2008
28.5%
Total Universe of
3 662 Funds in 2004
3,662
Percentage of Cumulative
Non-Survivors
ƒ
On average, 5.7% of the
actively managed equity
fund universe disappeared
each year.
ƒ
During 2004, 6.8% of the
fund universe disappeared.
By the fifth year, 28.5% of
the fund universe (1,043
funds) had disappeared.
ƒ
Reasons for non-survival
likely include closure due
to poor investment results.
24.0%
18.1%
12.5%
6.8%
2004
2005
2006
2007
2008
Data provided by CRSP Survivor-Bias-Free US Mutual Fund Database. Sample includes mutual funds existing as of 12/2003. Returns analyzed for the five-year period from 2004-2008.
For funds with multiple share classes, only the share class with the most assets at the beginning of the sample (12/2003) is included. Index funds, inverse funds, and leveraged funds
are excluded.
9
How the Markets Work
Few Consistent Active Equity
q y Winners 2004-2008
ƒ
Surviving funds did not
outperform their respective
category benchmark in most
years or over the entire
five-year period.
ƒ
Only about one-third (33.2%) of
actively managed US equity
funds outperformed their
benchmark in 2004.
ƒ
Five years later, only 1.4% of
th surviving
the
i i ffunds
d (38 outt off
2,619) had outperformed the
benchmark every year.
33.2%
Surviving
equity funds
that beat their
category
benchmark
consistently.
23.3%
5.9%
4.1%
1.4%
2004
2005
2006
2007
2008
Data provided by CRSP Survivor-Bias-Free US Mutual Fund Database. Sample includes mutual funds existing as of 12/2003. Returns analyzed for the five-year period from 2004-2008.
For funds with multiple share classes, only the share class with the most assets at the beginning of the sample (12/2003) is included. Index funds, inverse funds, and leveraged funds
are excluded.
10
What It Means for Your Portfolio
Prudent Process for Portfolio Construction
Winning a loser’s game means avoiding error and protecting against serious,
permanent loss
p
ƒ Poor asset allocation, ill-considered active management, and perverse markettiming lead the list of damaging errors made by individual investors
ƒ The appeal of security-trading and the allure of market-timing leads investors to
focus on unproductive and expensive portfolio activities
ƒ The real opportunity to achieve superior investment results lies not in attempting
to outperform the market, but in establishing and adhering to an appropriate
long-term investment strategy
11
What It Means for Your Portfolio
Prudent Process for Portfolio Construction and Management
g
Investment wisdom begins with the recognition of two key principles:
ƒ Risk and return are inextricably related – investors cannot earn attractive returns
without taking risks, and expected returns can only be increased by assuming
additional
dditi
l risk
i k
ƒ Long-term returns are the only returns that matter
12
What It Means for Your Portfolio
Long-Term
g
Objectives
j
The key to success is to determine what long-term investment policy will have the best
chance of producing the desired result. Thoughtful policy targets, carefully
implemented and steadfastly maintained, create the foundation for investment
success.
Step 1. Determine Risk and Return Objectives
ƒ Time horizon and cash flow expectations are the most important factors in
determining long-term
long term portfolio objectives
ƒ Need, ability, and willingness to take risk should be analyzed
13
What It Means for Your Portfolio
Optimal
p
Asset Mix
Portfolio management is investment engineering - good portfolio design eliminates
avoidable and unintended risk and maximizes expected returns
Step 2. Determine the Appropriate Asset Allocation
ƒ In constructing a portfolio, the focus should not be on rate of return but on the
managementt off risk
i k
ƒ Determining the appropriate balance between stocks and bonds allows an
investment plan to address three key financial risks:
− Market risk – the risk that stock prices will decline
− Inflation risk – the risk of losing long-term purchasing power
− Longevity risk – the risk of completely depleting the portfolio
ƒ The essence of portfolio construction is to combine assets that occasionally
move in different directions
14
What It Means for Your Portfolio
The Importance
p
of Market Diversification
World Market Capitalization - $28.6 Trillion
In US dollars. Map reflects countries in the MSCI Provisional All Country World Index, MSCI All Country World Small Cap Index, and MSCI Frontier Markets Index. Market cap data is free-float adjusted. MSCI
data copyright MSCI 2009, all rights reserved. Vietnam data provided by MFMI. Many small nations not displayed. Totals may not equal 100% due to rounding. Dimensional makes case-by-case determinations
15
about the suitability of investing in each emerging market, making considerations that include local market accessibility, government stability, and property rights, before making investments. For educational
purposes; should not be used as investment advice.
What It Means for Your Portfolio
Select Specific
p
Investment Vehicles
Step 3
3. Investment
est e t Vehicle
e c e Se
Selection
ect o
ƒ Most investors concentrate their attention on stock selection rather than focusing
on the much more important allocation decisions
ƒ Passive investors accept market returns by investing in index funds and their
similar, but more sophisticated, versions known as passive asset class funds
ƒ In an efficient market, no additional return can be expected over the market rate
of return by assuming unnecessary individual-stock risk
16
What It Means for Your Portfolio
The Benefits of Diversification
ƒ Strong performance among a
few stocks accounts for much
of the market’s return each
year.
Compound Average Annual Returns: 1926-2008
All US Stocks
Excluding the Top 10%
of Performers
Each Year
Excluding the Top 25%
of Performers
Each Year
9.4%
ƒ There is no evidence that
managers can identify these
stocks in advance—and
attempting to pick them may
result
lt iin missed
i
d opportunity.
t it
6.0%
ƒ Investors should diversify
broadly
y and stay
y fully
y invested
to capture expected returns.
-1.0%
17
Results based on the CRSP 1-10 Index. CRSP data provided by the Center for Research in Security Prices, University of Chicago.
What It Means for Your Portfolio
Maintain Discipline
p
and Consistently
y Rebalance the Portfolio
Rebalancing to long-term policy targets plays a central role in the portfolio
management process
Step 4. Make modifications and adjustments to ensure maintenance of originally
stated objectives
ƒ Disciplined rebalancing manages portfolio risk by ensuring that the portfolio does
not deviate significantly from the thoughtfully developed long-term allocation
targets
ƒ Real-time rebalancing (as opposed to calendar-based) directly links the
frequency of rebalancing to market volatility - as a result, real-time rebalancing
creates a buy
buy-low
low and sell-high
sell high opportunity each time the market exhibits
volatility
18
What It Means for Your Portfolio
Maintain Discipline
p
and Consistently
y Rebalance the Portfolio
Maintaining discipline plays a critical role in portfolio success
ƒ While representing supremely rational behavior, rebalancing forces the investor
to move in a direction opposite that of the crowd
ƒ The hardest work in investing is not intellectual; it’s emotional
ƒ It is the ability to ignore our instinctive responses of fear and greed that
determines, as much as anything else, which investors end up with the highest
returns
19
What It Means for Your Portfolio
Summaryy
ƒ By investing in passively managed funds and adopting a simple buy, hold and
rebalance strategy, you are guaranteed to not only earn the market rates of
return, but you will do so in a low-cost and relatively tax-efficient manner
ƒ You are also virtually guaranteed to outperform the majority of professional and
individual investors.
ƒ Our role as advisors is to help each client identify
identify, understand
understand, and commit
consistently to long-term investment objectives that are both realistic and
appropriate
20