To draw a parallel, we assembled a few articles that describe how random investment success really is.  For example, if you own actively managed mutual funds, you’ll retire with a lot less money than if you’d just bought, held and rebalanced the boring ETFs others and we recommend.  This is a non-debatable fact that’s been proven over and over again.

But why do so many want to believe something that just isn’t true? Ivy League MBAs who are smart, motivated and work hard must be able to beat a dumb computer managing an ETF or an index, right?  Wrong for two reasons.  First, investment pros charge fees that are an impossible handicap to overcome.  And second, unlike other professions like a surgeon, litigator, race car driver or a pilot where success can be accounted for by how well one manages risk, most professional investors who beat the market one year, are just plain lucky.  They win for short periods of time because of random events, not skill or intelligence. Just luck.  We all became acutely aware of this in 2008 when all the gurus somehow didn’t see it coming.

Consider it likely that the great professional investors may really be no better than the 4 finalists in the 8th round of a 1000 monkey coin-flipping contest.  Yes, there will always be a winner. But why did the winner win?  Did someone know something?

This point is made in an article in The New Yorker:  “Blowing Up” by Malcolm Gladwell author of “The Tipping Point” and “Blink.”  Gladwell interviewed Nassim Taleb, a professional options trader.  Taleb’s book “The Black Swan” describes about how random events in the financial markets are common and unpredictable – essentially dismissing 90% of the value of professional investing.

“Wall Street was dedicated to the principle that skill and insight mattered in investing just as they did in surgery and golf and flying fighter jets….  For Taleb then, the question of why someone was a success in the financial marketplace was vexing.  Taleb could do the arithmetic in his head…”

In another article in Fast Company, called “The Myth of Mutual Funds,”  Chip and Dan Heath the authors of “Made To Stick,” explore why we don’t always want to believe the truth about investing.  “Let’s pull off the Band-Aid quickly. You’ve come to believe that mutual funds are a smart place to put your money. They’re not. That’s the assessment of the smartest minds in finance, supported by a mountain of historical data. So two questions: How can this possibly be true? And why, in gleeful defiance of the data, do more people keep buying mutual funds every year?”

Last, read Moneywatch’s  “Hedge Funds – Case Against, part 2” if you’re considering investing in one. Allan Roth writes some compelling pros and cons for doing so.  He addresses the question:  Are these fund managers lucky or smart?   “If I had a dime for every time I’ve heard that hedge funds provide above market returns with lower risk, I’d be a very rich man. Every time I hear this claim, however, I ask for any evidence that supports it. I have had no takers to date, though maybe this column will change that.  Unless you happen to have a few billion to invest (and give me a ring if you do), I’d steer clear of hedge funds as they provide too much risk with too little return.”

To paraphrase Warren, most investors should “do as I say, not as I do.”  The world’s greatest investor warns us against trying to imitate his stock picking abilities.  His unwavering advice for years has been to buy index funds because:  a) very few people have it in their DNA to be a great investor, and b) those who charge you for their investment expertise can rarely outperform the market due to their onerous fees.

To bring home his advice we’ve pulled together a rare 8 minute Buffett video, evidence a $1 million bet he made, and a fable that he wrote.

A Fable.  Read excerpts from Berkshire Hathaway’s 2005 and 2006 annual reports where Buffett describes what happens to the imaginary Gotrocks family when they begin taking help from Wall Street.

“…imagine for a moment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks… In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.  But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them certain others….  The more that family members trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend, and in a wide variety of ways, they urge it on.”

The $1m Wager. Buffett bet Protégé partners, a fund of hedge funds, $1,000,000 that over a ten-year period commencing on January 1, 2008, and ending on December 31, 2017, the S & P 500 will outperform a portfolio of funds of hedge funds, when performance is measured on a basis net of fees, costs and expenses.  Buffett’s bet is a bet on high fees.  His view:  regardless of how good the money managers are, the hedge fund fee structure is so high, that it will, over 10 years, wipe away any gains achieved from beating the market.

The Lecture. Warren Buffett spoke to a group of students at the University of Florida and answered questions for ninety minutes about his investment philosophy.   Fast forward to the 1:15 minute mark on this great video where he says:

“If you are not a professional investor, if your goal is not to manage money in such a way that you get a significantly better return than world, then I believe in extreme diversification. I believe that 98 or 99 percent – maybe more than 99 percent – of people who invest should extensively diversify and not trade. That leads them to an index fund with very low costs. All they’re going to do is own a part of America. They’ve made a decision that owning a part of America is worthwhile. I don’t quarrel with that at all – that is the way they should approach it.”

Just because you can pick up a golf club doesn’t mean you should bet all your savings on your getting on the PGA tour.  And just because you (or someone in a suit at an investment management firm) can place a trade at an online broker, doesn’t mean you figure out a better strategy than using index funds in an asset allocation strategy for your retirement investing.

Do as I say, not as I do.  Thank you Warren.

Think of the conversations that occur behind closed doors at the White House, corporate boardrooms or U.S. Central Command. We all understand that there are elements of those conversations that are deemed, for whatever reason, unsuitable for public consumption. They are tucked into the classified file, sworn to secrecy and solemn oaths. But every now and again, some of the untold story leaks out – finds its way to the common person. Sometimes the information is so unbelievable, that it is marginalized as ridiculous. Other times it is corroborated with such credibility that all we are left with slack jaws and nodding heads.

Below are three brief but shocking behind-closed-doors accounts about Wall Street and investing that left me stunned.

CEO of a Top Publically Traded Tech Company: Having participated in the Silicon Valley for years and sat on the board of Baidu, I come into contact with a broad network of technology leaders and professionals. Recently, I became part of a stunning conversation with one of the top executives in The Valley.  This individual, while surprising humble, is also profoundly wealthy. For years he used the “top” wealth managers who have access to elite money managers who in turn “outperform” the market to justify their fees. After years of high cost and poor performance and tens of millions lost, this executive was seriously underwhelmed. He pulled his money out, embraced a simple indexing strategy and global diversifications. It takes him only a few hours a year to manage the money himself. He save hundreds of thousands if annual fees and achieves a much better result. Why don’t we ever see that ad during Wimbledon?

Former Banking Firm Top 500 Producer: Imagine being an investment advisor who has built a dream business – over $1B in assets under management (AUM) and a coveted Chairman’s Club member. Making just over 1% a year on AUM, this wealth manager was grossing over $10MM annually in fees. Unfortunately, he had a huge problem – he still had a conscious. The more he study active money management, the more he learned that it not only failed to add value to his customers, but was in fact deleterious.  When he approached management about this problem and sought an indexing approach, he was run out of town. After a legal battle and negotiations, the firm and the manager struck a settlement. He left his customers in the hands of the banking firm and he had to move on. I guess someone is now making money “the old fashion way – earning it.”

$750 An Hour Tax Attorney to the Uber-Wealthy: I was once invited into a private conversation with the uber-wealthy about tax management. The strategy was architected by top legal minds in the country. Profoundly expensive to set-up and maintain, this apparently legal and sophisticated offshore strategy would result in profound tax reduction. Imagine most of your wealth free to compound without tax consequence. These uber-wealthy could invest in the most sophisticated and elite products. When I asked the attorney what the majority of his clients were investing in, he just snickered. Over 60% of their dollars were dedicated to simple and diversified indexing strategies. There was no Wall Street, no active managers, or Jim Cramers – just hundreds of millions, even billions, going into a simple, proven approach used by those in the know.

I hope you are doing the same.

With rapacious accuracy, Rick rips back the covers on Wall Street to expose the true motives in selling this story. Wealth managers are having an increasingly difficult time selling clients on the value of high priced mutual funds that are less tax friendly and have tragically underperformed low cost ETFs.  In light of the giant swooshing sound of clients bailing out of the mutual fund merry-go-round for better constructed and performing ETFs, wealth manager came up with this core and explore pitch to sell manged products for small cap, foreign and emerging market investments. Unfortunately, Ferri points out that there actually is no such creature as an inefficient equity market. As he states:

“Core and Explore would be fine advice if it worked, but it doesn’t. The theory has several flaws. First, how does your adviser know which market is efficient and with is not, or if any market is efficient? The nation’s top academics cannot even agree. Second, why should your adviser suddenly become more skilled in selecting managers in inefficient markets simply because he or she is no longer selecting active managers in efficient markets? Third, there is no unbiased academic evidence to support the notion that active managers outperform in any market.

Two often presumed inefficient markets are U.S. small-cap stocks and emerging markets stocks. According to Core and Explore theory, these are two markets where active managers should have excelled. That has not happened. Data gathered from the S&P Indices Versus Active Funds (SPIVA) Scorecard for the first half of 2009 shows that over 67% of small-cap core funds under performed the S&P 600 index over the trailing five years and about 90% of actively managed emerging markets funds underperformed the S&P/IFCI Emerging Markets Composite index over the same time.

There are no inefficient asset classes where high cost actively managed funds consistently outperform their appropriate benchmarks. This means Core and Explore is about paying for something you do not need and likely will not benefit from. If your adviser has progressed to the point where he concurs with an all index fund portfolio, then you have a good adviser. If he insists that he can select superior funds on the explore side, then perhaps you should do some exploring on your own–for a new adviser.”

I am a big fan of Mr. Ferri’s and strongly agree with his poignant and entertaining expose. I would suggest an important caveat, however. Core and Explore does work, but only if you define the terms quite differently. I have used Core to reflect those assets which are directed at a long-term, reliable and scientifically sound retirement strategy. This Core portfolio should consist of indexes as recommended within the MarketRiders (www.marketriders.com) software. Explore, on the other hand, are the investments outside of my Core retirement portfolio that I am involved with that have a higher risk/return profile. I personally have ownership in a hydroelectric power  company in Chile, oil and gas in the US, a retail store as well as equity in early stage tech companies – for me all part of my Explore strategy that complements the overwhelming majority of my assets in a Core indexed portfolio with MarketRiders.  Even Ferri himself owns land in Texas and has investments outside his index portfolio. I personally like to direct between 10% to 20% of my investible liquid net worth in Explore style investments and see that percentage decreasing rapidly as I move into my 50s and towards retirement.

So, in conclusion, Core does fit with Explore, but when it comes to publicly traded equities, stay true to employing globally diversifed, low cost and tax efficient ETFs.

In 2008 it turns out that asset allocation decisions have everything to do with a portfolio performance.

On MarketRiders, we use our own ETF portfolio builder to track some “Celebrity Portfolios” including the “Lazy Portfolios” (published by Paul B. Farrell at Marketwatch). These portfolios mimic allocations based upon Yale University’s David Swensen, Dr. William Bernstein, Ted Aronson, and Bill Schulthesis who wrote “The Coffeehouse Investor.” Community members also have posted many interesting portfolios with unique asset allocations that have held up well in the last few months.

These portfolios use ETFs without active management and we track weighted average portfolio fees. The component ETF fees range from .08% to .50% and the weighted average portfolio fees are between .12% and .21%.

Comparing and contrasting portfolios with similar asset allocations, shows a lot about how to build solid “all weather” allocations that have held up even in 2008. While some of the variance is surely explained by the allocation in non-equities (Bonds, Treasury Inflation Protected Bonds and Cash), a lot of it is explained by the level of diversification amongst the other asset classes.

There’s quite a variance between some of the portfolios – even when their equity exposures are similar. Two portfolios each with 60% equity exposure have dramatically different results.

For example, Bill Schulthesis, a ex-Salomon Smith Barney broker who wrote The Coffeehouse Investor, designed a portfolio with 40% in an intermediate bond index (BND) and 10% in each of 6 stock funds (Vanguad REIT ETF (VNQ), SPDR S&P 500 ETF (SPY), Vanguard Small-Cap ETF (VB), Vanguard Small-Cap Value ETF (VBR), Vanguard Value ETF (VTV), Vanguard FTSE All World ex-US ETF (VEU)). Dr. William Bernstein wrote the “Intelligent Asset Allocator” and “The Four Pillars of Investing” and proposed the same basic allocation. But high exposure to small cap value US stocks and REITs allowed Coffeehouse’s returns to trump Bernstein by over 2 times.

Here are the results as of last night’s close.  These portfolios and the ETFs in them are posted on MarketRiders.

The Best and the Worst Returns

To better understand where the variances lie, we drill down into each asset class to see where returns (or lack thereof) are coming from. Aronson’s portfolio, is the worst so far, down (16.65%) with 80% equity exposure. Unfortunately, Aronson had no REIT exposure and heavy exposure to Emerging Market (VWO) and Foreign Markets (European (VGK) and Pacific (VPL)) which have both been crushed this year. Aronson’s portfolio has performed very well for 5 years on the backs of these asset classes, but 2008 has been his come-uppance.

The MarketRiders “Low Risk” portfolio is doing the best so far this year – down only (1.83%) – but with 25% exposure to equity and Real Estate (RWR). A strong US allocation (iShares S&P SmallCap 600 Index  (IJR) and SPY) over Foreign Developed and Emerging Markets (VEU) helped dampen the losses.

It’s Time to Rebalance!

Today, we’re rebalancing a few of these portfolios where actual allocations now vary greater than 20% off our targets. The most out of balance portfolio is the one built by John Spense and Rick Ferri on MarketWatch. Emerging Markets, Foreign Markets, TIPs and Small Cap US stocks are all out of whack so this portfolio and others will be brought back to their targets.

Stay tuned.  At the end of the year, we’ll report back and show you how these portfolios did.

Published: March 9,
2008 in the New York Times

INVESTORS collectively spend around
$100 billion a year trying to beat the stock market. That’s the finding of a
rigorous effort to measure the total costs of Americans’ efforts to surpass the
returns they would have received by simply holding a stock index fund. The huge
price tag helps explain why beating a buy-and-hold strategy is so difficult.

The study, “The Cost of Active Investing,” began
circulating earlier this year as an academic working paper. Its author is
Kenneth R. French, a finance professor at Dartmouth; he is known for his
collaboration with Eugene F. Fama, a finance professor at the University of Chicago, in creating the
Fama-French model that is widely used to calculate risk-adjusted performance.

In his new study, Professor French tried to make
his estimate of investment costs as comprehensive as possible. He took into
account the fees and expenses of domestic equity

mutual funds (both open- and
closed-end, including exchange-traded funds), the investment management costs
paid by institutions (both public and private), the fees paid to hedge funds,
and the transactions costs paid by all traders (including commissions and
bid-asked spreads). If a fund or institution was only partly allocated to the domestic
equity market, he counted only that portion in computing its investment costs.

Professor French then deducted what domestic
equity investors collectively would have paid if they instead had simply bought
and held an index fund benchmarked to the overall stock market, like the
Vanguard Total Stock Market Index fund, whose retail version currently has an
annual expense ratio of 0.19 percent.

The difference between those amounts, Professor
French says, is what investors as a group pay to try to beat the market.

In 2006, the last year for which he has
comprehensive data, this total came to $99.2 billion. Assuming that it grew in
2007 at the average rate of the last two decades, the amount for last year was
more than $100 billion. Such a total is noteworthy for its sheer size and its
growth over the years — in 1980, for example, the comparable total was just $7
billion, according to Professor French.

The growth occurred despite many developments
that greatly reduced the cost of trading, like deeply discounted brokerage
commissions, a narrowing in bid-asked spreads, and a big reduction in front-end
loads, or sales charges, paid to mutual fund companies.

These factors notwithstanding, Professor French
found that the portion of stocks’ aggregate market capitalization spent on
trying to beat the market has stayed remarkably constant, near 0.67 percent.
That means the investment industry has found new revenue sources in direct
proportion to the reductions caused by these factors.

What are the investment implications of his
findings? One is that a typical investor can increase his annual return by just
shifting to an index fund and eliminating the expenses involved in trying to
beat the market. Professor French emphasizes that this typical investor is an
average of everyone aiming to outperform the market — including the supposedly
best and brightest who run hedge funds.

Professor French’s study can also be used to show
just how different the investment arena is from a so-called zero-sum game. In
such a game, of course, any one individual’s gains must be matched by equal
losses by other players, and vice versa. Investing would be a zero-sum game if
no costs were associated with trying to beat the market. But with the costs of
that effort totaling around $100 billion a year, active investing is a
significantly negative-sum game. The very act of playing reduces the size of
the pie that is divided among the various players.

Even that, however, underestimates the
difficulties of beating an index fund. Professor French notes that while the
total cost of trying to beat the market has grown over the years, the
percentage of individuals who bear this cost has declined — precisely because
of the growing popularity of index funds.

From 1986 to 2006, according to his calculations,
the proportion of the aggregate market cap that is invested in index funds more
than doubled, to 17.9 percent. As a result, the negative-sum game played by
active investors has grown ever more negative.

The bottom line is this: The best course for the
average investor is to buy and hold an index fund for the long term. Even if
you think you have compelling reasons to believe a particular trade could beat
the market, the odds are still probably against you.

We’ll hear references to the “Goldilocks” economy, a Santa Claus
rally, tigers and tea leaves, bubbles and roller-coasters. A single adjective
in a Fed speech may dominate headlines and drive speculation for two days
running.

This sells newspapers and gets ratings. But the danger is that in
over-simplifying an analysis, it becomes simplistic – almost without
decision-making value.

Today’s round-the-clock news cycle demands a talking-head rationale for
every minor indigestive day in the market. It seems even the slightest 20-point
movement must be attributed to something: obscure remarks by a finance minister
or an after-hours rumor about labor negotiations in Detroit.

In this media environment the Dow, the S & P 500 and other indexes
acquire quasi-human characteristics, as if they were capricious Greek gods.  As you watch television and read the papers, notice how often these
statistical indices are subtly endowed with feelings or moods: the market
“has an appetite” for energy stocks on Monday, the market is
“panicked” by a Labor Department report on Tuesday, the market
“doesn’t like what it heard” in a speech on Capital Hill.

Some of this is journalistic license, of course. But it contributes to and
reflects a “what-is-the-Dow-doing- today” obsession among investors
with actively-managed portfolios, a chronic anxiety level that has sabotaged
many a program.

Often you’ll hear the anthropomorphic mantra “the market is always right.”
This attributes some innate “wisdom” to an index. Even the godfather
of all analysts, Adam Smith, famously coined a metaphorical reference to an
“invisible hand” – an often-misunderstood allusion to macro-economic
forces, not to stocks.

Fact: the stock market is not a person (nor is it a god!).

Personification of the market – resulting so often in the downfall of
investors who try to predict or time its behavior – was superbly satirized by a
man whom many call the father of value investing, the Columbia University
economist Benjamin Graham. He was such a pioneering influence that two of his
most famous disciples, Warren Buffet and Irving Kahn, named sons after him.

It was Graham who invented the bi-polar, emotionally disturbed character he
called “Mr. Market.”

In his allegorical lessons, Graham had the ingratiating Mr. Market arriving
at your door every other day with something new to sell … suddenly becoming
depressed over, say, a slump in the bond market … constantly jumping from
sector to sector … dumping everything one day, buying everything the next …
worrying himself into paralysis over quarterly earnings.

Trying to keep up with the schizophrenic Mr. Market was a recipe for ruin,
said Graham. Focus on the fundamentals. Build your asset allocation on
scientific data. Keep your emotions firmly in check. Diversify. And stay the course.
That was Graham’s advice to all managers (and by extension, all investors).

Set your allocation, said Graham, and establish your rebalancing
methodology. Then, if you really can’t resist the distractive ups-and-downs of
Mr. Market, go and “live in a cave for a few years,” to paraphrase
the Columbia
professor. Just stay away from that addictive stock ticker …

Graham compared the short-term performance of all markets to “voting
machines” in which temporary winners and losers are chosen by popular and often
ill-informed sentiment; whereas long-term returns are sorted out by the
unerring scale of time, which always balances true.

In other words, Graham said, put history on your side.

Think of the markets as a measure, a data base, a colossally efficient repository
of collective daily investment decisions. As the Nobel laureate Friedrich Hayek
pointed out: the market is a mechanism “more immediate and precise than
any system a human has ever devised.”

So in your daily perusal of the business press, watch out for those fairy
tales and amusement-park metaphors … and that unpredictable Mr. Market.

By JACLYNE BADAL
December 3, 2007; Page R1

Today’s
article in the Wall Street Journal attempts to help mutual fund investors
determine what characteristics a mutual fund had before it began an 8 year streak of beating the S&P.

“We started by identifying a group of
mutual funds with the longest winning streak against a well-known measure –
eight straight years of beating the Standard & Poor’s 500-stock index. Only
30 U.S.
stock funds made the cut, out of 1,935 eligible funds tracked by Morningstar
Inc. Then we asked Morningstar to crunch the funds’ data from 1998, as the
streaks were set to begin….Along the way, we also noticed …five of the
seven focused on natural resources, such as oil, that were beaten down in 1998
but have boomed since. The lesson? Be willing to invest in categories that have
been out of favor, since they may be due for a resurgence.

Kudos
for the Wall Street Journal for helping investors attempt to find the 1.3% of mutual
funds that had this kind of streak!  But come on — what a useless bet to
take.  Let’s see, I can:

1.
Try To Beat The Market.  Take my chances that I can identify the 1.3% of
the funds that will beat the S&P .  If I do find one of the funds in
the top 1.3%, I’ll beat the S&P by a few points.   But if I fail
to identify one of those top 1.3% of the funds, I’ll probably lose 2% a year
for 8 years which will deteriorate my capital by 20% over those 8 years compounded.

2.  Buy an index fund or ETF and match the market with 100% probability
without paying much tax.

According
to the article:

“In 1998, the average large-blend fund in Morningstar’s overall
database turned over 62% of its stocks each year. Several of the large-blend funds
on our list came in comfortably under that level. Currently, the average fund
in Morningstar’s large-blend database turns over 72% of its shares annually.
Most of the seven large-blend funds on our list continue to trade less
frequently than their peers.

If
we assume half the normal turnover, the tax bill will eat you alive even if
they do beat the market. Since the study only describes pre-tax returns I’ll bet another 10 – 15 of those funds don’t
beat the S&P.

I think the odds of beating a roulette game by spinning the dice 2000 times
and picking random numbers from the Keno board are better.

To the Wall Street Journal:  Great article.  Wrong
conclusion.  The right conclusion?

Stay away from mutual funds and buy
index funds or ETFs.