Sadly, it was no surprise to learn the Goldman Sachs threw their clients “under the bus” by deceitfully selling them mortgage securities while at the same time making a killing on shorting the housing market.  Their slogan, “Helping clients build and preserve their financial wealth” needs a minor adjustment. “Helping clients build and preserve OUR financial wealth.” This is a paragon of the Wall Street ethic – make money (hmmm – a lot of money) even if you must trample your client under foot. When you manage your own diversified portfolio of ETFs through a MarketRiders account, you truly get Wall Street out of your pocketbook by removing the intermediaries.

The Wall Street gurus seem to have a closet full of tricks to help investors outperform the market. Unfortunately, most of this advice is unproven and ineffective. In this MoneyWatch article, James Picerno points out one of the ONLY scientifically proven secrets to boost portfolio returns year-upon-year – disciplined rebalancing. Mr. Picerno underscores that rebalancing can deliver a 0.5 to 1.0 percentage point annual bonus compared to what you’d earn on the same portfolio that’s left alone. Our research shows that by using MarketRiders’ advanced rebalancing algorithms rather than a simple calendar based approach, investors add up to 2% additional growth in some portfolios and market conditions. We have more on this topic here: “How Often Do I Need to Rebalance?”.

When it comes to retirement investing, remember that you don’t have as many friends in the financial services industry as you think. By taking the time to learn the virtues of low cost indexing, global diversification and disciplined rebalancing, you will truly build and preserve YOUR wealth.

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.

Second, according to the NY Times, if you want to be considered “in the know”, just start talking about ETFs at your next party.  The wave is sweeping the investment landscape and investing in them might soon be considered “cool.”  ”Average investors haven’t really latched onto perhaps the biggest investing innovation of the past two decades.  Despite being low-cost, tax-efficient and easy to buy or sell at a moment’s notice, exchange-traded funds remain largely the domain of institutional investors and stock-market aficionados.  ‘Main Street still barely knows what they are,’ acknowledges ETF expert Matt Hougan of IndexUniverse, an independent Web site on exchange-traded and other index funds. That may soon change.”

Third, one of our Experts at MarketRiders is John Bogle, the founder of Vanguard.  When he writes in the Wall Street Journal, we listen.  There’s a group of investors so enamored with him, that they host a popular and growing website dedicated to following his investment theories: www.bogleheads.org. Jane Bryant Quinn lists this site as her favorite. Bogle’s editorial is well worth reading.  He writes:

“(At the end of 2009) I concluded that ‘the faith of investors has been betrayed.’ How so? Because the returns generated by our corporate stewards have often been illusory, created by so-called financial engineering and produced only by the assumption of massive risks. What’s more, too many of our professional money managers have failed to act as vigilant stewards of the money that we investors entrusted to them.”

We can’t emphasize it enough — maintain an asset allocation that’s good for you so that you have diversification, and own ETFs in each asset class.

“If it sounds too good to be true, it probably is.”  Instead, I encourage serious retirement investors to stick with the strategy used by the world’s best investors.  Focus on asset allocation, globally diversify, keep fees down with indexing, and rebalance to stay the course.  For many that have gotten caught up in a Ponzi scheme or know of friends that have, now might be the perfect time to take matters into your own hands and start to manage your own investments.  Many of the tools available today will guide you on how to invest your money with the goal of generating the most returns for retirement, accounting for risk and time frame, at a low cost.  Try reading several Investing 101 articles that are out there as they are loaded with lots of great tips on finding the best investment vehicle for you.

As stated by Dolan, “just under 6% of fund managers invest $1 million or more of their own money in their funds. Also, of the 4,383 funds tracked for manager ownership levels over the past five years, a paltry 51% of fund managers owned no stake at all. Having a stake in a mutual fund means that managers have their interests truly aligned with shareholders. The best managers that we’ve followed and respect a lot tout the fact that they’re investing alongside investors. They find their funds the most attractive place to invest their own money.”

Ms. Dolan has uncovered the stark reality that mutual fund managers, on the average, do not invest in their funds. They are quite happy, however, to sell their products to you, and for a handsome profit to their firm and their retail investment adviser partners. When it comes to mutual funds, the lesson seems to be the same – watch out! ETFs offer a much lower cost and more tax efficient option for long-term retirement investors.

In academic financial research, there’s a concept called “agency risk.” You incur this risk when someone who is acting as your “agent” has a set of interests that conflict with yours.  We’re surprised at how little investors appreciate the magnitude of agency risk.  Whether you invest in a hedge fund, a mutual fund, a public company, a private investment partnership, a venture fund, or your friend’s yogurt store – you are exposing yourself to agency risk.  Managing your own diversified portfolio of ETFs dramatically reduces agency risk. 

Investment fraud and agency risk is rampant.  Small mistakes can cost you dearly.  Over the holidays, think about your investments and who really has control of your money.  Ponder the risks you might be assuming with having “agents”.

I’d like to point out the immense irony here. General Motors, Ford, and Chrysler are currently struggling significantly against Japanese and other foreign manufacturers who have spent the last many years improving fuel efficiency and developing hybrid and other alternative technologies. If Detroit had spent as much time, money, and effort in research and development as they did lobbying Congress to keep fuel mileage standards low, and made competitive non-gas guzzling vehicles, I would venture a guess these loans wouldn’t be necessary.

I believe that most people understand a mortgage bailout was necessary. I’m not so sure that I understand how the failure of Detroit could cripple the United States economy. There are plenty of foreign auto manufacturers with operations in the United States – Toyota, Honda, and Nissan – who could easily pick up the slack. Their vehicles are outselling American automobiles. They are building plants in places like East Liberty, OH and Lincoln, AL, providing jobs for people displaced by the failure of Detroit.

Jim Press, Vice Chairman of Chrysler said that this loan package will reduce America’s dependence on foreign oil. Given that other manufacturers are already well at work on these technologies without the need for this money, I find his statement hard to swallow. Chrysler Chairman Bob Nardelli was quoted as saying this money “…is not a bailout.” This is simply not true. Detroit was relegated to borrowing from the government because the private capital markets are shut off to it due to bad credit ratings and history of financial losses.

I, for one, am outraged at this loan package. It is anti-competitive to startup companies like Tesla Motors who are investing their own money in alternative technologies like battery power. $25 billion is a lot of money. Detroit should not be able to argue for 30 years against improved fuel mileage and better technology, and then come back to the same government they persuaded into facilitating their failure, for a bailout.

I’m not sure I can blame them for disliking the so-called Paulson Plan. Let’s consider the most recent set of facts:

• Are we really going to rely on the same people who led us into this mess to get us out? It is entirely possible that had Fannie Mae and Freddie Mac reform legislation been passed two years ago, the scale of the current economic mess would be greatly reduced.
• I’ve heard a number of financial experts talking today about how the taxpayers will make money on their $700 billion investment. Here’s why I disagree. Investing in bad mortgages is not like investing in distressed companies. If you invest in a distressed company, the company can right itself and provide a good return. If you invest in a second mortgage that was written on a house valued at twice what its currently worth, the odds are slim you will ever see a positive return on that investment.
• Secretary Paulson’s plan would entitle him to purchase assets from any financial institution. When asked if this would allow him to purchase from pension plans, he said yes. How does purchasing from a pension plan help the homeowner facing foreclosure or the bank who can’t afford to lend any money?
• From what I can tell, the plan does not differentiate between the types of loans that the government can purchase. There is a big difference between purchasing a first mortgage on a property and purchasing a no-documentation loan or home equity line of credit. We may have a chance of recouping money on the first mortgage; we have little to no chance on the others.
• Where are the details? Three pages aren’t enough for me to feel comfortable spending this kind of money.

What if we don’t do anything at all? What if we let the market sort this out on its own? Isn’t this socialism at its worst? As much as I believe in free markets ability to self-regulate, I no longer believe nothing is an option. The United States cannot afford to lose credibility with foreign investors while we’re $9.6 trillion in debt. It would be disastrous if foreign countries no longer purchased our debt because they didn’t trust the United States financial markets. If we let this linger, retirement investment accounts and pensions could be seriously impaired.

How do we know that a $700 billion bailout will work? Haven’t we already pumped hundreds of billions of dollars into the economy? How can we claim that this money is working when the nation’s largest thrift, Washington Mutual, just failed tonight? There is no simple answer to this. The fact is nobody knows the right number. It’s simply a guess.

So what should happen? Here are some things that I believe are critical when a bailout plan eventually gets finalized.

• Phased approach. There is no reason to spend all the money up front. It makes sense to invest a portion, watch what happens, and evaluate how successful the strategy is.
• Once the government purchases assets, it must be ready to work out these loans to prevent further foreclosures. If we can stem the tide of foreclosures, we can stop this meltdown dead in its tracks.
• Oversight. The Treasury must be accountable for what it purchases. A plan with no or little oversight asks for corruption, preferential treatment to certain institutions, and the like.
• Taxpayers first. This bailout is to protect the taxpayer. Any proceeds from this bailout should go to pay back the money we borrowed and to lower the deficit, not into the pockets of Wall Street bankers who aided in creating this mess.

I wish us all luck in the coming days, and hope that Washington is able to set aside both partisan and Presidential politics in order to put together a plan that has a chance of succeeding in a timely fashion.

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.