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Closet Indexers Will Go The Way Of The Buggy And The Whip

“The decade long run of money moving out of actively managed mutual funds in favor of passive indexes and exchange-traded products speaks volumes about investors’ palate for active management these days,” according to a recent article in Investment News. The piece touches on how to identify active managers who are not simply hugging the benchmark in an overly cautious effort not to get beat by it. The key is to be selective, according to the article, but this can be challenging due to the large number of funds and fund classes available. Professor Martijn Cremers of Notre Dame says benchmark-huggers virtually guarantee failure, saying “The more holdings a fund has that are different from the benchmark, the more potential the fund has for performance that is different from that benchmark.” Cremers launched a website ActiveShare.info aimed at uncovering the most active of active managers, using a simple equation dividing the funds expense ratio by the index overlap. President of Touchstone Investment, Steve Graziano, is critical of benchmark huggers that are charging active-management fees. “We manage active funds because you have to be different from the benchmark in order to survive… We’re right at the intersection of where closet indexers will go the way of the buggy and the whip.”

When Is A "7% Return" Not A 7% Return? Answer: Most Of The Time

By Gregg S. Fisher Let’s say you make a $100,000 investment in stocks that compounds at 7% per year (which is not far from what US equities have historically returned), and you hold onto that portfolio for 25 years without adding or withdrawing funds. For the sake of argument, let’s assume the return is constant, never deviating from 7% every year. As the Constant 7% line in Exhibit 1 demonstrates, at the end of a quarter-century holding period, the value of that $100,000 sum would have more than quintupled to $542,700. For most investors, this would be a very satisfying outcome. Click to enlarge The catch, of course, is that the assumptions we have made above are unrealistic. Aside from certain cash equivalents, no investment will grow at exactly the same rate every year, and the riskier the asset (e.g., stocks), the greater the volatility. To simulate the real world, we ran five randomized trials (all depicted in Exhibit 1), all with an “average return” of 7% a year, but now adding the additional element of 14% per year volatility, or standard deviation, which is also close to the historical experience for a stock proxy such as the S&P 500 Index. Since 14% volatility, or risk, can manifest itself in many different patterns, that “average 7% return” can take vastly different paths with entirely different outcomes. Allow me to explain what I mean. Terminal Value of $900,000, $500,000, or $200,000? How can the ending portfolio value after 25 years vary from a little more than $200,000 to almost $900,000? It’s because volatility can be the investor’s friend or foe, depending on when , and how many , losses and gains occur. For instance, if large losses are encountered early in an investment’s lifecycle (as in Trial 1, where the ending value is just $228,000), they pull down the amount of funds available for growth in later years. This scenario reminds me, in a slightly different context, of a retiree led to believe that there’s little risk in the sustainability of a 4% portfolio withdrawal rate in retirement. If the investment portfolio suffers significant losses in his first few years of retirement, then he’s behind the eight ball if he intends to keep pulling out 4% of initial portfolio value (adjusted for inflation) each year to meet his cost of living. On the other hand, if large gains build up early on, there’s that much more money to compound and to absorb future losses. Trial 2 shows such a case, with a final portfolio value of $869,000 that significantly outperforms the 7% compound return. In the three other trials, two outcomes significantly underperformed the 7% compound return (Trials 3 and 4), and one (Trial 5), despite some wicked cycles, ended with almost identical wealth. The point is that the total amount of an investor’s gains and losses can vary widely since that 14% volatility, which can dramatically affect the compounding rate, can move returns either up or down (remember, in theory volatility can work in an investor’s favor every year, just as it can also work against you). Thus, a “7% average annual return” doesn’t mean much when it comes to measuring actual long-term investment returns. Harry Markowitz, a Nobel Prize winner who’s considered the father of modern portfolio theory, suggested a rule-of-thumb method to evaluate the relationship between average performance and compound return: compound returns equal the average return minus half of the variance, and that increasing the variance of returns without increasing the average return will hurt investment performance. How Much Risk Can You Tolerate? Let’s shift gears now and apply the implications of the math that I’ve just described to real-life investment portfolios. I have worked with investors now for nearly a quarter of a century. From that vantage point, I can say that there are some investors out there who would be comfortable with a portfolio comprised entirely of high-risk assets, hoping for that $900,000 outcome described in Trial 2. But I can also state that such intrepid investors are relatively few. For the great majority of our clients at Gerstein Fisher, fear of a dismal outcome overwhelms the hope for a spectacular one. Most would be content with a smooth ride that achieves the constant 7% result, rather than reaching for the $900,000 outcome fraught with risk. We understand and respect this mindset, which is why we make risk mitigation front and center for most of the portfolios that we manage. Probably the most important such strategy-a classic-is diversification . Since many different asset classes tend to move up and down at different times, holding a collection of them tends to smooth the ride for a portfolio (i.e., reduces volatility). That’s why for most investors it’s an advantage to own both stocks and bonds, both US and international stocks, both bargain-priced “value” stocks and high-flying “growth” stocks, as well as some alternative asset classes such as REITs (we prefer both domestic and foreign ones), and perhaps some gold and commodity futures. The market movements in 2016 are a case in point. For example, year-to-date through May 2, while both domestic and international large growth stocks were down nearly 1%, value stocks and bonds were up, and global REITs and gold jumped 8% and 21%, respectively. Of course, there’s a limit to how far you should take diversification, since if you owned every investable asset on earth, the returns would probably cancel one another out and you’d be left with zero. But few investors have to worry about excessive diversification; in our experience, most are not diversified enough . How much diversification you should strive for, and with what assets, very much depends on your individual financial goals (both long- and short-term), time horizon, and ability to live through trying investment times without being tempted to bail out of the markets. If you work with an investment advisor such as Gerstein Fisher, we can help you construct such an individually tailored, diversified portfolio, and coach you through the inevitable market cycles. Conclusion Long-term portfolios with the same average annual return can produce astonishingly different final wealth sums due to volatility and differing patterns of gains and losses along the way. A well-diversified global portfolio can help to reduce volatility levels and make for a smoother ride for investors. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Gerstein, Fisher & Associates, Inc.), or any non-investment related content, made reference to directly or indirectly in this blog will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from Gerstein, Fisher & Associates, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Gerstein, Fisher & Associates, Inc. is neither a law firm nor a certified public accounting firm and no portion of the blog content should be construed as legal or accounting advice. A copy of the Gerstein, Fisher & Associates, Inc.’s current written disclosure statement discussing our advisory services and fees is available for review upon request.

Upbeat Industrial Q1 Results Fail To Lift ETFs

Most of the industrial bellwethers have beaten on earnings in the first quarter of 2016. However, it’s not surprising given the low estimates, which had fallen ahead of this reporting cycle. Among other factors, a recent pullback in the greenback and encouraging manufacturing trends could have played a role in the beat. A strong dollar impacts most industrial bigwigs adversely as most of these companies have significant international exposure. However, the earnings beat came largely on the back of lowered expectations (read: ETFs to Watch on U.S. Manufacturing Revival ). Meanwhile, revenue weakness in the sector remains thanks to reduced spending, volatility in oil prices and lackluster global growth. Below we have highlighted in greater detail earnings of some of the major industrial companies which really drive this sector’s outlook. Industrial Earnings in Focus General Electric Company (NYSE: GE ) Diversified industrial conglomerate General Electric posted mixed first quarter results as it reported in line earnings but missed on revenues. The company’s earnings came in at 21 cents per share, in line with the Zacks Consensus Estimate but up 5% from the year-ago quarter. Shares of the company fell slightly after the earnings release. Revenues were up 6% to $27.8 billion, missing the Zacks Consensus Estimate of $29 billion. The revenue miss was due to a weak global economy and an oil price slide that hurt the renewable and oil and gas segments. For 2016, the company reaffirmed its earnings per share guidance of $1.45-$1.55 (read: Industrial ETFs in Focus on Mixed GE Q1 Performance ). 3M Company (NYSE: MMM ) Another major conglomerate, 3M Company reported earnings of $2.05 per share in first-quarter 2016, beating the Zacks Consensus Estimate of $1.92. Net sales during the quarter were $7.4 billion, down 2.2% year over year but ahead of the Zacks Consensus Estimate of $7.3 billion. The year-over-year decrease in sales was largely due to a significantly negative foreign currency translation impact. 3M shares fell on the day of its earnings release. Honeywell International Inc. (NYSE: HON ) Honeywell International’s earnings per share of $1.53 in the reported quarter beat the Zacks Consensus Estimate of $1.50. Revenues in first-quarter 2016 were up 3% year over year to $9.5 billion, ahead the Zacks Consensus Estimate $9.4 billion. Based on favorable business conditions, Honeywell narrowed its 2016 guidance. The company anticipates earnings in the range of $6.55 to $6.70 per share on revenues of $40.3 billion and $40.9 billion. Shares of the company rose slightly on the day of its earnings release. Union Pacific Corporation (NYSE: UNP ) The rail transportation operator, Union Pacific reported first-quarter 2016 earnings of $1.16 per share, which beat the Zacks Consensus Estimate of $1.09. Earnings declined 11% on a year-over-year basis. Revenues decreased 14% year over year to $4.8 billion in the first quarter, falling short of the Zacks Consensus Estimate of $4.9 billion. A 14% decline in freight revenues hurt the top line. Declining coal shipments weighed on the railroad operator’s results yet again. The stock gained after reporting results. ETF Impact Despite reporting encouraging earnings, most of the industrial stocks failed to hold up gains over the past 10 days, sending the related ETFs into rocky territory. This has put the spotlight on industrial ETFs. Below we discuss four of these ETFs having a sizeable exposure to the above stocks. Industrial Select Sector SPDR Fund (NYSEARCA: XLI ) This product tracks the Industrial Select Sector Index. General Electric occupies the top spot with 11.2% allocation, while 3M, Honeywell and Union Pacific have a combined exposure of roughly 14.7% in the fund. XLI has garnered $7.2 billion in assets and trades in a heavy volume of 13.2 million shares per day. It has a low expense ratio of 0.14%. The fund has the highest exposure to Aerospace & Defense (26%), followed by Industrial Conglomerates (21%). The product gained 0.3% in the past 10 days and currently has a Zacks ETF Rank #4 or ‘Sell’ rating with a Medium risk outlook. Vanguard Industrials ETF (NYSEARCA: VIS ) This fund follows the MSCI US IMI Industrials 25/50 index and holds about 342 securities in its basket. Of these firms, GE occupies the top position with 12.7% share, while 3M, Honeywell and Union Pacific together comprise almost 10.7% of the fund’s assets. The fund manages nearly $2.1 billion in its asset base and charges only 10 bps in annual fees. From an industry perspective, the fund has the highest exposure to Aerospace & Defense (21.7%), followed by Industrial Conglomerates (20.6%). Volume is moderate as it exchanges roughly 112,000 shares a day on average. The product lost 0.1% in the past 10 days and currently has a Zacks ETF Rank #3 or ‘Hold’ rating with a Medium risk outlook. iShares U.S. Industrials ETF (NYSEARCA: IYJ ) IYJ tracks the Dow Jones U.S. Industrials Index to provide exposure to 214 U.S. companies that produce goods used in construction and manufacturing. General Electric occupies the top spot in the fund with almost 11% share while 3M, Honeywell and Union Pacific have a combined exposure of more than 10%. The ETF manages an asset base of $737.6 million and trades in an average volume of 75,000 shares. The fund has top exposure to Capital Goods (58.9%) and Software & Services (12.7%) and Transportation (11.7%) have double-digit exposure each. The fund is slightly expensive with 45 basis points as fees. It rose almost 0.4% in the last 10 days and currently has a Zacks ETF Rank #3 with a Medium risk outlook. Fidelity MSCI Industrials Index ETF (NYSEARCA: FIDU ) This fund tracks the MSCI USA IMI Industrials Index, holding 342 stocks in its basket. General Electric takes the top spot at 12.7% share while 3M, Honeywell and Union Pacific have a combined exposure of almost 11.5%. The product has amassed $161.2 million in its asset base while it trades in moderate volume of nearly 115,000 shares a day on average. The fund has top exposure to Aerospace & Defense (23.4%) and Industrial Conglomerates (20.9%). It is one of the low cost choices in the space charging 12 bps in annual fees from investors. The fund gained 0.5 % in the last 10 days and currently has a Zacks ETF Rank #3 with a Medium risk outlook. Link to the original post on Zacks.com