Newsletter May 2009 In This Issue
I hope this Spring finds you healthy and reinvigorated. Below I share my thoughts on a few key principles. Please let me know if you need help with your financial spring cleaning.
Mark Sladkus
Spring Blooming? The global economy experienced continued weakness through the first quarter of 2009. Despite this fact, as of this writing (May 20, 2009), we have seen a widespread stock market rally with short-term strength that has rarely been witnessed in such a period of time. We have to ask, is this an augur for an improved financial outlook?
1st Quarter Review
There was plenty of bad economic news to digest during the last quarter, as unemployment reached a 25-year high. Adding to the economic malaise, 4th quarter revised GDP numbers presented the largest fall since the 1982 recession. During the beginning of the quarter, the US stock market fell below its lows of November 2008 before making a substantial recovery by the end of the quarter. As shown below, the US and other developed market equities ended the quarter lower, while emerging markets closed flat.
As future inflation became a greater concern, the value of TIPS (Treasury Inflation Protected Securities) rose, as investors welcomed the inflation hedge that these securities offer. Longer-term bonds performed poorly reflecting the increased fear of inflation. At Red Lighthouse we generally advise clients to avoid bonds with longer maturities as they usually do not offer a good risk/return relationship. In the current environment of historically low interest rates, our reticence regarding these longer-term bonds has only increased. Other things equal, the longer the maturity of a bond the more sensitive it is to interest rates. In an environment with interest rates potentially increasing, longer maturity bonds would fall the greatest amount.
Equities
First Quarter 2009*
April, 2009*
US – Russell 3000
-10.81 %
10.52%
Developed Markets (excl. US) – EAFE Net
-13.94 %
12.80%
Emerging Markets – MSCI EM Net
.95 %
16.64%
Bonds
US Govt. Inter. Bonds – Merrill Lynch US Treas./
Agency Index 1-5 Years
.16 %
-0.23%
US TIPS – Barclays Capital Index
5.52 %
-1.87%
Municipal Bonds – Barcap Muni 10 Year
3.41 %
1.83%
Int’l. Bonds – Citi World Bond 1-3 Yr. Hedged
0.77 %
0.07%
“Alternatives”
Commodities – DJ AIG Commodity Index
-6.31 %
0.73%
US REITs – DJ Wilshire Index
-33.92 %
32.81%
* Source: Morningstar, DFA
Cause for Celebration?
Having said all of the above, what a difference a month can make. As of the date of this newsletter, the US equity market, as measured by the Wilshire 5000, is up almost 36% from its March 9th low. We do not know, nor can anyone know, whether the bottom for this cycle has been reached. Only the future will inform us.
But we do know a few things. First, the stock market is a leading indicator. In most cases, the stock market turns higher, often sharply so, in advance of the economic statistics pointing to a recovery. This is quite logical as prices are set by future expectations, not by current conditions.
Second, we also know that on average the bulk of the performance in a recovery is “front loaded.” That is, much of the increase comes in the earliest portion of a bull market. The first month of a bull market (bull markets have historically lasted from one to ten years) has accounted for almost 15% of the entire bull market’s return. The first six months of a bull market have accounted for almost a third of the entire bull market. Investors (usually in cash) who wait on the sidelines for the climate to improve risk missing a significant portion of the upside.
This recent rally may yet turn out to be short-lived, and new lows could come. Yet the rally since March 9th provides a glimpse of the potential surge that is possible even in an environment of dispiriting news. Such a rally leaves market-timers frustrated as they attempt to determine their entry point.
A globally balanced portfolio, tailored to your requirements, continues to provide the best assurance for meeting your long-term investment goals.
Less is More? The Index Funds Win Again. Such was the title of a recent article in the New York Times by Mark Hulbert. The article reported on yet another study that found “it is the extremely rare actively managed fund or hedge fund that does better than a simple index fund.” The author of that study, Mark Kritzman, simulated the after tax returns, net of all fees, for an index fund, an active Mutual fund and a hedge fund. In a taxable account, he concluded that, net of all fees, a mutual fund must annually outperform an index fund by 4% to be better off. A hedge fund would have had to outperform by 10%! This assumed an investment horizon of 10 years. The picture is worse the longer the investment horizon. The study assumed a federal tax rate of 35% and a state tax rate of 6.85%, applicable for example in New York. Even if your tax rates are lower, the hurdle is quite high. No doubt, one can find active funds or hedge funds that outperform index funds by these large thresholds. By sheer chance you would expect to find some, given the many thousands of funds to choose from. The question investors need to honestly ask themselves is: “Are you likely to identify a manager who can outperform an index fund by such a margin?” Contact us for a copy of the study.
Mr. Kritzman also cited a new study by Laurent Barras, Olivier Scaillet, and Russ Wermers (BSW) entitled “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas.” BSW tried to estimate the percent of managers who add “alpha1” due to skill and not luck. After examining 2,076 active mutual funds that existed at any time between 1975 and 2006 they concluded:
- 75.4% of all funds had zero alpha. No value added after expenses.
- 24.0% had negative alpha.
- Only 0.6% exhibited truly positive alphas.
- The number of funds adding alpha have declined significantly over the period studied.
With so few managers able to add value one should be very humble in expecting to identify such a manager.
1. Alpha is a financial term that measures the risk adjusted active return. It is often used to quantify the value added of a manager above a “market” return.
The battle continues between salespeople such as brokers who work for Wall Street firms or insurance companies vs. fiduciaries such as Registered Investment Advisors. The difference between the two is important to understand. Brokers, even if they are called financial planners or advisors, are not required to act as a fiduciary. They are typically compensated based on the products that they sell, causing an inherent conflict of interest. In contrast, a fiduciary is required by law to put their clients’ interests first.
A broker’s first interest is not to his/her client. Brokers are paid commissions for selling you stocks, bonds, mutual funds and other financial products. No matter how nice they may be, they are paid by their employer, and, therefore, beholden to their employer. Their financial incentives are not aligned with those of their clients. Because they are not necessarily acting in your best interest, the SEC requires them to add the following language to client agreements:
“Your account is a brokerage account and not an advisory account. Our interests may not always be the same as yours. Please ask us questions to make sure you understand your rights and our obligations to you, including the extent of our obligations to disclose conflicts of interest and to act in your best interest. We are paid both by you and, sometimes, by people who compensate us based on what you buy. Therefore, our profits, and our salespersons’ compensation, may vary by product and over time.”
Does this seem to be to be the type of relationship that is in your best interest?
By contrast, Registered Investment Advisors are required to act in their clients’ interests. For an interesting discussion of the differences in fiduciary responsibility, fees and regulatory structure see The Fight Over Who Will Guard Your Nest Egg by Jason Zweig. Among the quotes:
“Let’s say you tell your broker that you want to simplify your stock portfolio into an index fund. He then tells you that his firm manages an S&P-500 Index fund that is “suitable’ for you. He is under no obligation to tell you that the annual expenses that his firm charges on the fund are 10 times higher than an essentially identical fund from Vanguard. An adviser acting under fiduciary duty would have to disclose the conflict of interest and tell you that cheaper alternatives are available.
If brokers had to take cost and conflicts of interest into account in order to honor a fiduciary duty to their clients, their firms might hesitate before producing the kind of garbage that has blighted the portfolios of investors over the years.”
A fee-only Registered Investment Advisor, such as Red Lighthouse Investment Management, places clients’ interests first. We bill our fees directly to you. And these fees are our only source of revenue. In doing so, we avoid any and all conflicts of interest. We invest in what we believe is the best choice for YOU.
Disclaimer: This newsletter is for information purposes only. Past performance is no guarantee of future results. While the information and data contained herein is believed to be reliable, we do not represent it as accurate. Any opinions expressed herein are subject to change without notice. Nothing contained herein should be considered a recommendation to buy or sell any security or fund.
Red Lighthouse Investment Management, LLC is a fee-only registered investment advisory firm based in New York City.
Red Lighthouse Investment Management - 212.799.3532 - www.redlighthouseinvestment.com
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