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Proactive investing with a global focus The ACTIVE VS. PASSIVE Investing Debate 1-866-JENTNER • www.jentner.com 3677 Embassy Parkway, Akron, Ohio 44333 Executive Summary Those in search of the best investment strategy want to know if active or passive investing yields greater returns. Though it is a commonly debated topic among investment professionals and investors alike, the data show that passive management yields better results over the long term. Active managers underperform their benchmarks: • Of all actively managed U.S. funds, 81% of equity funds and 92% of fixed-income funds failed to outperform their benchmarks over the fifteen years ending December 31, 2014. • Of all of the equity mutual funds that existed from 1965 to 1984, not a single fund generated a statistically significant positive return compared to its benchmark. •Of the domestic equity funds that were in the top quartile for performance as of March 2011, only 0.28% managed to stay in that top quartile after four years. •After five years ending in 2014, nearly one quarter of all domestic equity funds and global and international equity funds could not even manage to survive. Past performance is not an indication of future performance: • Of the top 20 domestic equity mutual funds from 1996 to 2005, during the five subsequent years, two ranked in the zero and second percentiles, with the average ranking in the 66th percentile. • Of all Canadian equity funds, only 45% survived after five years, ending in 2009. Positive returns are based on luck not skill: • Each participant in the market has a 25% chance of being in the top quartile and a 25% chance of being in the bottom quartile. • While a particular manager may have been in the top quartile in the past, they have the same chance as every other participant of being in the top quartile in the future. • If beating the market was due to skill and not luck, more managers would be beating the market. Market predictions are ineffective: • It is improbable that there is one person who will systematically and consistently have more information than the seven billion others to correctly make market predictions. • Missing the 25 best trading days since 1970 would leave an investor with 76% less than if they had remained invested in the market. Short-term investing can miss major gains: • Since 1926, the bull markets in the S&P 500 Index have lasted nearly twice as long as bear markets and have delivered price gains that are disproportionately greater than the bear market losses. Those gains have been nearly three times greater than the losses. • Reactions to short-term market movements can compromise long-term performance. Despite large average intra-year drops of 14.2%, annual returns were positive in 27 of 35 years. Active management is costly: • Active managers typically have higher management fees to cover the cost of research and higher transaction costs because of the high turnover of securities. • The majority of the earnings from actively managed mutual funds were made by the same securities as those held by the passive benchmark index. The remaining actively managed funds earned limited returns while generating significant costs. • Actively managed domestic funds were more than five times more expensive than passive mutual funds, according to a study from 2012. The evidence is clear that active management is a risky investment option that often fails investors. Instead, passive management involves no forecasting, stock picking, or market timing. Passive managers seek to capture the returns of the market either by using index funds to represent an asset class or institutional assetclass funds to hold essentially all of the securities that comprise an asset class. By developing an intelligent plan with a long-range strategy and rebalancing the portfolio to align with the original target allocation, passive managers strive to keep the portfolio on track to pursue long-term goals. 1 Which Yields Better Results — Active Or Passive Investing? The investing public is consistently bombarded with conflicting messages on how to best manage its money. The media and many investment advisors constantly make market predictions and name the hottest stocks. But is this the best way? The debate remains: Does implementing an active or a passive approach yield more lucrative long-term returns? Today, societal pressure calls us to act now, do not just stand by, make things happen. These catch phrases penetrate our everyday decision-making process, which is precisely why it can be so hard for investors to resist interacting with their money on a daily basis. We can feel handicapped when we are not making changes and may believe we are missing out on today’s hot stocks. However, an investor who knows the advantages of a passively engineered portfolio and can ignore societal pressures is more likely to succeed over the long term. Generally, active or tactical management is defined as the art of selecting specific securities and attempting to time the market. Active managers strive to recognize and invest in companies they believe will post above-average returns. They may look for companies with notable sales and profits or innovative new products or one that is poised to make a comeback after a time of poor performance. All active managers, no matter what they look for in an investment, purchase securities based on a forecast of future events. Active management essentially relies on predicting the future. Passive management, however, involves constructing a well-diversified portfolio that represents broad-based financial markets without attempting to identify specific securities that one hopes will be superior performers. This approach can be applied to any asset class, including large-cap, small-cap, value, growth, foreign, or domestic stocks. Unlike active managers, passive managers do not attempt to distinguish superior performing investments. For instance, a passive manager would not decide if Apple is preferable to Microsoft but instead would construct a portfolio that represents a variety of asset classes, using either index funds to represent an asset class or institutional asset-class funds to acquire essentially all of the securities that comprise an asset class. In either case, the resulting passively constructed portfolio would hold hundreds or even thousands of stocks. Furthermore, a passive manager who uses institutional asset-class funds would actually construct a portfolio that holds nearly every publicly traded company. Whether index or assetclass funds are used, the goal is to create a portfolio that closely resembles the performance and, in turn, captures the returns of the global markets. Well-recognized market benchmarks are used to compare returns for each particular asset class, such as the Standard & Poor’s 500 Composite Index for large U.S. companies or the Morgan Stanley EAFE Index for large foreign companies. 2 Playing The Game Of Active Management — The Evidence Many successful wealth managers and market experts agree that using an active management strategy is a lot like a game of Monopoly, winning and losing money each time you play. At the end of the game, you put the surviving pieces of your investment portfolio back in the box, having risked too much, wishing for a different outcome. Here, we will explore the evidence that defends those who prefer investors do anything with their money but play games. Active Managers Underperform Their Benchmarks There is a plethora of data that show active management underperforming the market over the long term. Active managers’ attempts to time the market often leave investors disappointed. Their claims are riddled with marketing spin and often only show good returns over a relatively short period of time. When active managers are put to the test, the data show that most active managers typically fail to add value. And over longer periods of time, they are more likely to underperform their respective benchmark. Figures 1 and 2 offers recent evidence of this, showing the percentage of U.S. equity and fixed-income funds that survived and were able to outperform their benchmark after periods of three, five, ten, and fifteen years, ending December 31, 2014. The size and complexity of the mutual-fund landscape masks the fact that many funds disappear each year, often as a result of poor investment performance. After three Figure 1: Percent of U.S. Equity Funds That Survived and Outperformed Their Benchmarks after 3, 5, 10, and 15 Years, as of Dec. 31, 2014 Data provided by Dimensional Fund Advisors years, 85% of equity funds and 88% of fixed-income funds survived. Over time, fund survival rates dropped sharply. After fifteen years, only 42% of equity funds and 41% of fixed-income funds managed to survive. Investors likely have a more ambitious goal than to just pick a fund that survives. Most people are on a hunt for funds that will provide superior performance. Unfortunately for many investors, after three years, 69% of equity and fixed-income funds failed to outperform their benchmarks. Fund performance results are even worse over longer horizons. After fifteen years, 81% of equity funds and 92% of fixed-income funds failed to outperform their benchmarks. Over both short and long time horizons and for both equities and bonds, the deck is stacked against the investor seeking outperformance. One of the most comprehensive studies of actively managed funds was conducted by Elton, Gruber, Hlavka, and Das. In this study, they examined all equity mutual funds that existed from 1965 to 1984. These funds were compared to the set of index funds that most closely reflected the actual funds’ investment choices, including large stocks, small stocks, and fixed income. Over the 20-year period, the equity funds underperformed the index funds by 159 basis points on average each year. Furthermore, not a single fund generated a statistically significant positive earning. Figure 2: Percent of Fixed-Income Funds That Survived and Outperformed Their Benchmarks after 3, 5, 10, and 15 Years, as of Dec. 31, 2014 Data provided by Dimensional Fund Advisors 3 In another study, Mark Carhart reviewed the performance of 1,892 funds that existed from 1961 to 1993. His extensive analysis showed that the actively managed funds underperformed their benchmark by an average of 1.8% per year. Looking at more recent data, Standard & Poor’s publishes a quarterly analysis called Standard & Poor’s Index Versus Active that shows the performance of active funds versus their benchmarks. The analysis consistently suggests that while active managers may achieve short periods of outperformance, over longer periods of three to five years, they rarely outperform their benchmarks. Whether Standard & Poor’s analyzed funds in broad categories, such as all large-cap U.S. stock funds, or looked at smaller segments, such as New York municipal-bond funds, it found that the vast majority of funds consistently lagged behind their asset-class’s benchmark index, the very index they were attempting to beat. Furthermore, Figures 3 and 4 show the failure of actively managed equity and fixed-income funds over the last five years, as of June 30, 2015. During this time, the vast majority of funds failed to outperform their respective market benchmark. In most equity asset classes, more than 70% of active managers failed, as seen in Figure 3. Additionally, Figure 4 presents the number of fixed-income funds that failed during the same five years. Seven out of ten fixed-income funds failed to beat their benchmark over the last five years in the majority of fixed-income asset classes. Figure 3: Percentage of Equity Funds That Failed to Beat the Index During Prior Five Years, as of June 30, 2015 Data provided by S&P Dow Jones Indices, LLC Figure 4: Percentage of Fixed-Income Funds That Failed to Beat the Index During Prior Five Years, as of June 30, 2015 Data provided by S&P Dow Jones Indices, LLC 4 Additionally, The Wall Street Journal asked Morningstar to evaluate the performance of active managers during the economic slowdown of 2008. During this time, active funds fell behind their benchmarks in six of the nine major categories. Morningstar also discovered that active managers performed worse during this recession than in previous recessions. While many active managers claim they have the knowledge and foresight to time the market to curb losses for their clients, this study suggests that active managers often fail to avoid a market downturn. Relying on their claims and assurances can lead to false hopes. Over and over again, these facts and figures show that active investment managers are failing to beat the market and are being outperformed by the benchmarks they are striving to beat. While there are sporadic periods of aboveaverage results, 50 years of historical data convey that the efforts of active managers to beat the market result in underperformance, and the only consistent performer in any asset class is the market itself. While active managers continually assert that they can outperform, in reality, they are not beating the market, but, rather, the market is beating them. Instead of attempting to beat the market and most likely failing, investors should strive to capture the returns of the market by employing a passively engineered strategy. Past Performance Is Not an Indication of Future Performance Furthermore, a recent Standard & Poor’s Index Versus Active U.S. Scorecard looked at the performance of equity funds over the five-year period ending in 2014. During this time, 24% of both domestic equity funds and global and international equity funds did not survive. If nearly a quarter of equity funds did not survive these five years, how many are likely to survive 10, 20 or even 50 years? Many investment managers boast of their past results in an effort to gain future clients, showing great returns from a previous time period. While a manager may have performed well in the past, it is unlikely that he or she will continue to earn those great returns in the future. History shows that past performance is not an indication of future performance, and this year’s winners may be next year’s biggest losers. Figure 5 shows the performance of the top 25% of domestic equity funds over five consecutive twelve-month periods. Out of the 703 domestic equity funds that were in the top quartile for performance as of March 2011, only 4.69% managed to stay in that top quartile after two years. And after four years, only 0.28% were still in the top quartile. It is important to note that none of the large-, mid-, or small-cap funds managed to stay in the top quartile after four years. While managers may flaunt their past performance, it is no indication of future performance, and history shows their futures will not likely be nearly as bright. Often times, when managers boast of their performance, they remove those dead funds from calculations, skewing the results in their favor. Brad Steiman, director and head of Canadian Financial Advisor Services, said that making claims based on only the small sample of surviving funds “would be like attending a World War II fighter pilot convention and concluding that being a World War II fighter pilot results in longevity because everyone at the convention was over 80 years old.” Those funds that did not survive must also be accounted for, just like the fighter pilots. Data are often twisted in the manager’s favor, and the whole picture is rarely presented. Legendary investor Bernard Baruch said, “Only liars manage to always be out during bad times and in during good times.” Figure 5: Performance Persistence of Domestic Equity Funds Over Five Consecutive Twelve-Month Periods Mutual Fund Category Fund Count at Start (March 2011) March 2012 March 2013 March 2014 March 2015 All Domestic Funds 703 30.87 4.69 1 0.28 Large-Cap Funds 269 30.86 3.72 0 0 Mid-Cap Funds 101 28.71 0 0 0 Small-Cap Funds 148 30.41 6.08 1.35 0 Multi-Cap Funds 185 32.43 7.57 2.7 1.08 Percentage Remaining in Top Quartile Data provided by S&P Dow Jones Indices, LLC 5 Positive Returns Are Based on Luck Not Skill While there is a plethora of investment research, there is not one major published study that effectively proves that managers beat the markets more than one would expect by chance. For the millions of participants in the market, each has a 25% chance of being in the top quartile, as well as a 25% chance of being in the bottom quartile. While a particular manager may have been in the top quartile in the past, that manager has the same chance as every other participant of being in the top quartile in the future, regardless of his or her past performance. Future performance is independent of prior experience. If beating the market was due to skill and not luck, more managers would be outperforming the market. But the data show that the number of managers beating the market is equal to the number who would do so purely by chance. Because past winners may have just been lucky, it is nearly impossible to pinpoint a manager who will beat the market in the future. William Bernstein wrote in The Intelligent Asset Allocator, “There are two kinds of investors, be they large or small: Those who don’t know where the { market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor— the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” In the end, you only have one option: to invest with an investment professional who does not know where the market is headed. So pick a manager who does not pretend to know where it is going. Passive managers admit they do not know what the market will do and, therefore, avoid market predictions. Instead, their strategy is engineered to capture the returns of the market, not gamble on investments they hope will do well. “There are two kinds of investors, be they large or small: Those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor— the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” } -William Bernstein,The Intelligent Asset Allocator 6 Market Predictions Are Ineffective The basis of active management is investing in companies that are predicted to post above-average returns. Much of what active managers do is attempt to gain insight into the future performance of a company. They may look for a company posting significant sales and profits or one that is touting the launch of a new product. However, while a manager is gathering this information, there are thousands of other individuals, analysts, and investment advisors who are also collecting this information. The information they are basing their predictions on is already reflected in the price of the stock because all of the other investors have this information too and are investing with it in mind. For example, if Apple announces that it will be launching the next great device, which will completely alter electronic communication, the price of the stock will quickly increase because there are many investors buying it, hoping that the stock price will continue to rise when the product is launched. The market instantly digests the information and reflects it in stock prices. Therefore, there is no advantage to endlessly seeking information on individual companies as it is unlikely that there is one person who will systematically and consistently have more information than seven billion others. Market timing, the foundation of active management, may seem to offer a seductive prospect, with an active manager boasting of his or her ability to use market predictions to capture only the best-performing days and avoid the worst. But Figure 6 tells the other side of that story. Large gains often come in quick, unpredictable surges. A manager who incorrectly predicts events may leave the market at the wrong time, pulling out before a large surge. By missing only a small fraction of days, especially the best days, a market timer’s portfolio can be destroyed. For example, since 1970, if an investor missed any of the best trading days, his or her annualized compound returns would be significantly less than those of the S&P 500 Index. If an active manager incorrectly predicted and missed those 25 best days, he or she would have 76% less than if the active manager had stayed in. Attempting to forecast which days or weeks will yield good or bad returns is a guessing game that usually proves costly for investors. Figure 6: Performance of the S&P 500 When Its Best Days Have Been Missed, From January 1970 Through August 2014 Data provided by S&P Dow Jones Indices, LLC 7 Short-Term Investing Can Miss Major Gains Active managers often try to time the market to get out before a bear market, a time of decline, strikes. A bear market is identified in hindsight when the market experiences a negative daily return followed by a cumulative loss of at least 20%. The bear market ends at its low point, the day of the greatest negative cumulative return, before the reversal. Since 1926, the bull markets in the S&P 500 Index have lasted nearly twice as long as bear markets and, more importantly, have delivered price gains that are disproportionately greater than the bear-market losses. Those gains have been nearly three times greater than the losses. For those passive managers who stayed in the market the whole time, the losses of the bear markets were negated by the much greater gains. However, when an active manager attempts to time the market and gets out at the wrong time, which happens often, it can be devastating to the manager’s portfolio because he or she may miss the monumental gains. When an investor stays in the market over the long term, he or she is able to endure the downturns because the upturns have historically offset them. Moreover, the passive manager reaps all of the gains of the bull markets, which active managers may be missing. Secondly, bull markets may have short-term dips, and the bear markets may have short-term advances. Figure 7 illustrates the lowest point of the stock market during each calendar year, as shown by the dot, compared to the market’s return for the full year, as shown by the bar. History shows that though the market dips each year, it is clear that the market is capable of recovering from intra-year drops and finishing the year in positive territory. However, it is nearly impossible to determine when the market is in a sustained downturn, hence the difficulty of accurately predicting and timing market cycles. As seen in Figure 7, despite average intra-year drops of 14.2%, annual returns were positive in 27 of 35 years. Thus, it is crucial to maintain a disciplined investment approach that views market events and trends from a long-term perspective. Investors who react to short-term market movements risk making poorly timed decisions that compromise long-term performance. Figure 7: S&P 500 Intra-Year Declines versus Calendar-Year Returns, from 1980 through July 2015 40% 30% 20% 10% 0% -10% -20% -30% -40% -50% -60% 1980 1985 1990 1995 2000 2005 2010 2015 Data provided by J.P. Morgan Asset Management 8 Active Management Is Costly Active managers regularly buy and sell securities in their clients’ portfolios, attempting to select the investments they believe will perform best. With each buy or sell transaction, there is a cost. Comparisons of the cost of active and passive management indicate that active management is the most expensive investment approach. Active managers typically have higher management fees to cover the cost of research and higher transaction costs because of the high turnover of securities from attempting to beat the market. As well, active investment management’s higher security turnover can also increase an investor’s tax burden if the investment turnover results in short-term capital gains, instead of long-term capital gains, which are taxed at lower rates. Additionally, Figures 8 and 9 display the expense ratio for domestic and international mutual funds. This study was conducted using mutual fund expense ratios as of August 21, 2012 and asset weighting based on net assets as of July 31, 2012. The average expense ratios for active funds were more than 50% greater than passive funds. When the weighted average was calculated, the actively managed domestic funds were more than five times more expensive than the passive funds, and the actively managed international funds were more than three times more expensive than the passive funds. Figure 8: Domestic Mutual Fund Expense Ratios The cost of an actively managed portfolio varies greatly and is often masked to clients. Because the total cost is a combination of management fees, transaction fees, the cost of cash, the market impact cost, and taxes, clients of active investment managers often do not know how much they are truly paying. In fact, most actively managed mutual funds actually hold many of the same securities as those held by their passive benchmark. It is those securities that have been found to earn the majority of the mutual funds’ return. But that is only half the story. Measuring the True Cost of Active Management by Mutual Funds by Ross M. Miller goes on to show that the majority of the costs of mutual funds is generated by the securities that are actively managed and are not commonly held by the benchmark index. Miller found that, at the end of 2004, the average expense ratio for the actively managed portion of actively managed large-cap equity mutual funds tracked by Morningstar was 7%, more than six times their published expense ratio of 1.15%. This means that 7% of any gains obtained through active management would automatically be offset to cover expenses. In other words, any enhanced portfolio returns earned as a result of active management must overcome a 7% hurdle before any actual investment gains are realized. So the bulk of the earnings were made by the same securities as those held by the passive benchmark index, and the remaining actively managed funds generated the high costs. Figure 9: International Mutual Fund Expense Ratios Data provided by Morningstar 9 { “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.” - William F. Sharpe, 1990 Nobel Laureate More cost does not equal greater returns, however. Research shows that managers who charge extraordinarily high fees and have extremely high turnover are more likely to persistently underperform the market, net of fees and expenses. Are those odds you would like to play? On the other hand, passive managers recognize and avoid the excessive cost and poor performance of active investment management. Knowing the impact of trading costs on returns and the low probability for success with stock picking and market timing, passive managers offer a less costly alternative. Primarily because of their lowcost structure, passively managed investments typically outperform actively managed funds over the long term. } Active Management Is a Losing Game Active management, while it may sound alluring, is riddled with flaws. As the data show, active managers consistently fail to outperform the very benchmark they are attempting to beat because it is very difficult to regularly predict the market correctly. Active management is also expensive, at times costing clients more than five times what a passively managed fund would. Identifying a manager who will perform well in the future is nearly impossible because past performance does not dictate future performance, and beating the market appears to be based on luck more than skill. The data strongly suggest that active management fails to deliver its promise of superior returns time and again. As a columnist for The Wall Street Journal, Jonathan Clements penned this warning, “Ignore market timers, Wall Street strategists, technical analysts, and bozo journalists who make market predictions ... Admit to your therapist that you can’t beat the market. Investors would also benefit by remembering this simple phrase: Trading is hazardous to your wealth.” 10 Playing It Safe With Passive Management — The Evidence Fortunately for investors, active management is not the only option. Instead of playing the game, the passive investor decides it is better to avoid the game and the endless options. Many successful wealth management firms, investment writers, and, of course, the wealthy employ a passively engineered investment strategy. Let’s look at what makes passive management the prudent choice when selecting a long-term investment strategy. Passive Management Is Not Inactive While passive management may sound sedentary, it is only passive with respect to actions that research suggests do not add value, such as market timing. In reality, passive management is actually quite active and does so to the benefit of its clients. Passive managers systematically construct portfolios to balance risk and returns while executing these strategies patiently and efficiently. This disciplined asset-class approach inherently involves no forecasting, stock picking, or market timing. Passively engineered investment management is based on prudent guidelines, and its benefits can be reaped by those who choose to work with a passive investment manager who implements it. The foundations of passively engineered investment management are asset-class investing and remaining invested through the inevitable ups and downs of market cycles. Asset-class investing can be accomplished by using index funds to represent an asset class or by selecting institutional asset-class funds, which invest in virtually every security that comprises an asset class. Using historical data, passive managers can form reasonable estimates of the overall volatility for a given asset class and can approximate how closely its performance correlates with the performance of other asset classes. Through combinations of asset classes, asset allocations are created. Each allocation has unique estimated risk and expected return characteristics. Each client can find an overall allocation that best matches his or her risk and return tolerances. Finally, the asset allocation can be implemented precisely by investing in those asset classes. The resulting portfolio is easy to explain and understand, verifiable, and highly defendable. Passive Management Is Not a Buy-and-Hold Approach It is a common misconception that passive management is a buy-and-hold strategy, which believes that in the long term, markets produce a good rate of return despite periods of volatility or decline. While passive managers do believe in the futility of attempting to outperform the markets, systematic rebalancing of portfolios without market predictions is crucial to proper implementation of the passive approach. Over time, some assets will appreciate in value while others decline. This causes a portfolio’s allocation to skew, changing the level of risk and return. Eventually, it will drift far enough away from the original allocation that the original objectives are no longer being met. Because the original portfolio was aligned with the investment goals and risk tolerance, its integrity should be preserved. The solution is rebalancing, reducing assets that have risen in value and purchasing assets that have dropped in value. While selling assets that are performing well and buying those that are underperforming may be counterintuitive, one must remember that positive past performance may not continue, and there is no reliable way to predict future returns. Through rebalancing, the portfolio will return to its original target allocation, putting the portfolio back on track to pursue long-term goals. It is prudent to return to the original asset allocation, as it reflects the desired risk and return preferences. It also enables an investor to buy low and sell high without making any market predictions. By using structure, not recent performance, to make investment decisions, rebalancing realigns the portfolio to these priorities. Furthermore, a properly structured portfolio provides a basis for making adjustments when one’s overall financial situation or goals change. Without a quantifiable plan, adjustments are a guessing game. 11 Figure 10: Annualized Long-Term Returns of Equities and Active Managers, Since 1984 S&P 500 Outperforms Active Managers The Quantitative Analysis of Investor Behavior compiles yearly data comparing the performance of the S&P 500 to that of the average investor, who typically employs an active investment strategy. The S&P 500 column in Figure 10 represents a passively managed portfolio. Over the last thirteen years, the average investor has underperformed the S&P 500 by an average of more than 7.5%. While investors often base investment decisions on their market predictions and gut feelings, they do this under the guise of sound judgment and analytical reasoning. But in the end, they fail to outperform a passive investment strategy, as seen in Figure 11. Year S&P 500 Average Equity Fund Investor Difference 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 17.90% 18.01% 16.29% 14.51% 12.22% 12.98% 13.20% 11.90% 11.80% 11.81% 8.35% 8.20% 9.14% 7.81% 8.21% 4.22% 9.85% 7.25% 7.23% 5.32% 4.17% 2.57% 3.51% 3.75% 3.90% 4.30% 4.48% 1.87% 3.17% 3.83% 3.49% 4.25% 5.02% 5.19% -10.65% -10.78% -10.97% -10.34% -9.65% -9.47% -9.50% -8% -7.50% -7.33% -6.48% -5.03% -5.31% -4.32% -3.96% -4.20% 4.66% Data provided by Dalbar, Inc. Figure 11: S&P 500 Versus Average Equity Fund Investor Returns 20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 S&P 500 2009 2010 2011 2012 2013 2014 Average Equity Fund Investor Data provided by Dalbar, Inc. 12 Concentrated Portfolios Are Hazardous Some active managers encourage concentrating a portfolio to hold a small number of different securities that they believe will fare well. For example, a concentrated portfolio might be one that holds a limited number of stocks, one where an individual stock comprises a meaningful percentage of the total portfolio, one that invests heavily in only a few economic regions, or one that has most of its holdings in one or a few asset classes. Regardless of which type of concentration is used, a concentrated portfolio can be hazardous to an investor’s wealth. A concentrated portfolio is like a giant redwood tree towering high above a forest of saplings. When a storm rolls in, which tree is most likely to be struck by lightning? As portfolios become more and more concentrated in a small number of investments, asset classes, or economic regions, they increase their risk of devastation if they are struck. But not only are storms inevitable, they are frequent. Many investors are shocked by the frequency at which lightning strikes occur. A study was conducted in 2011 regarding the percentage of individual companies in the S&P 1500 that underperformed the market. Over the thirteen years in the study, 39% of the 1500 companies underperformed the index by more than 15%, as shown in Figure 12. That is nearly a two-in-five chance that an individual investment gets struck. When the strike occurs on an investment that makes up a significant portion of your portfolio, the results can be catastrophic. Not only can a strike occur on an individual investment, it can also occur on an asset class or on an economic region. While lightning strikes are also likely to occur in a passive broadly diversified portfolio, this type of portfolio is constructed to withstand the hit. Diversification can help eliminate unsystematic risk in a portfolio. In essence, with a diversified portfolio, you are likely to lose only a few small saplings, not the giant redwood, when lightning strikes. Broad diversification can provide investors peace of mind when weathering a financial storm and can help them overcome the impulse to run for shelter at exactly the wrong time. Figure 12: Percentage of S&P 1500 Companies Underperforming by 15% or More Time Period Percentage 2010 18% 2009 31% 2008 30% 2007 58% 2006 34% 2005 42% 2004 33% 2003 34% 2002 31% 2001 32% 2000 45% 1999 45% 1998 71% Average 39% Data provided by Dimensional Fund Advisors 13 Passive Management Outperforms Active Management Investors are presented with a fundamental choice when choosing with whom and how to invest their life savings. But research suggests that passive management yields better returns, as passive managers consistently outperform active managers over the long term. Passive managers construct portfolios that capture the returns of the market, while active managers attempt to predict the future using market timing to beat the market. But in the end, most active managers fail, with more than 80% of all actively managed funds failing to outperform the market over a fifteen-year period. And over the last thirteen years, active investors have underperformed their benchmark by an average of more than 7.5%. Not only are active managers failing, they are failing greatly. Moreover, because future performance is independent of past performance, it is nearly impossible to identify in advance a manager who is likely to perform well. Though active managers may boast, their chances at succeeding over the long term are small. The foundation of active management, market timing, is overcome with drawbacks. Market timing often proves ineffective as active managers can miss the best trading days when they incorrectly predict where the market is headed. If a manager missed only 25 of the market’s best days, the manager’s returns would have decreased by 75%.Yet, missing even only one day can be hazardous to a portfolio’s return. Instead, passive managers choose to remain invested through market cycles to reap the gains of the best days to effectively weather the downturns. Market timing and active management also cost their clients more. From increased management fees to cover endless research to mounting transaction costs for trading securities, actively managed domestic funds are more than five times more expensive than passive funds. Passive management fundamentally involves no forecasting, stock picking, or market timing. Instead, passive managers seek to capture the returns of the market. This can be accomplished either by using index funds to represent an asset class or institutional asset-class funds to hold essentially all of the securities that comprise an asset class. By investing in a combination of asset classes, a passive manager can estimate the risk and expected return of the total portfolio and can find an overall allocation that best matches the preferences of the client. Passive managers use structure, not recent performance, to make investment decisions. By developing an intelligent plan with a longrange strategy and rebalancing the portfolio to align with the original target allocation, passive managers strive to keep the portfolio on track to pursue long-term goals. Jentner Wealth Management is a nationally recognized wealth-management firm based in Akron, Ohio. By providing fee-only comprehensive financial planning, globally diversified investing, and fiduciary advice, Jentner seeks to preserve the financial legacy of clients in Northeast Ohio and across the United States. Founded in 1984, Jentner Wealth Management provides both financial planning and investment management to individuals, families and trusts. Jentner Global Management is a specialized division that provides institutions with investment portfolio management services, including portfolios customized specifically for endowments and foundations. Jentner’s proven, lowcost passively-engineered investment strategy invests broadly in more than 14,000 companies on six continents, seeking to provide steadiness in good times and challenging times to earn meaningful returns over the long term. For more information, please visit www.jentner.com or call 1-866-JENTNER. © 2015 Jentner Wealth Management 14