Tag Archives: financial

The Leap Year Approach To Investing

This year (2016) marks another special year for those who happened to have a significant event, like a birthday or wedding anniversary, fall on February 29th. The Leap Year, which is that extra day that we get every 4 years to help align our calendar year with an actual solar year (which happens to be 365.25 days), is upon us yet again. While many of us might just see this as just “another day,” there are some real advantages to having four-year intervals in our lives. We propose that one of them is looking at your investment performance, assuming you are in a target date fund or have a passive advisor handling rebalancing, tax-loss harvesting and a glide path strategy for you. Now this might sound a bit loony, but there is some real truth into what we are proposing. First of all, it allows investors to drown out the daily “noise” that the prognosticators, the “professionals,” and the entertainers are delivering across the many media outlets. These outlets have become experts in delivering second by second accounts of random news stories and extrapolating them into “advice” with an overlay of overconfidence, as if their ability to estimate market values and future events has the same precision as a Swiss watch. Unfortunately, many soothsayers are more often wrong than they are right , but the short-term attention and amnesia that affects all of us humans allows us to forget and repeat. Once we take a big step back from the second by second clutter, we are able to take a deep breath and really see the irrelevance of it all. A Leap Year approach to investing is the embracing of this emancipation. Now there is nothing unique to this approach in which we are trying to find some long-term market-timing trend that will allow you to outperform the market. Quite the contrary! This is about resetting your internal investment clock to be thinking in years — many years, that is — instead of seconds. It could have easily been the 10-Year High Reunion approach to investing or a welcome to a new decade approach to investing. But let’s be reasonable. At the end of the day, what we are really talking about is the benefit of time diversification. So what does this actually look like? Let’s assume that an investor decided to start investing back on March 1, 1928 and made an agreement with their investment advisor to not discuss nor look at any performance figures until February 29th of the next Leap Year. May seem very unrealistic, but not as much as one would think. Unless something dramatic changes in somebody’s financial situation (this does not include fear due to a short-term downturn in the market), then it doesn’t seem so unrealistic that a 4-year window to chat and reassess could be practical. There may be things going on in the background like rebalancing and tax-loss harvesting, but we are just talking about looking at performance and reassessing financial goals. Using historical performance data for IFA Index Portfolio 100 from March 1, 1928 through February 29, 2016, we have 22 independent 4-year time periods ending on a Leap Year (see table below). We know that past performance is no guarantee of future results, but we are going to be speaking more about the overall trend versus specific numbers. For example, over all 22 4-year periods, the average 4-year annualized return was 11.50%. The lowest 4-year period was during the Great Depression (1928-1931) where we saw an annualized return of -23.50%, or a painful total loss for the 4 years of 65.74%. This was subsequently followed by the highest 4-year annualized return (1932-1936), where we saw a 32.48% annualized return, which amounts to a total return of 208.06%. This would have gotten an investor back to the original investment amount from March 1, 1928 (8 years earlier). The third lowest Leap Year annualized return ended on February 29, 2012, which included the global financial crisis of 2008-2009, but still ended up with a 12.6% total return for the period. Let’s digress on this just a little bit. If we were to focus on the day-to-day news stories and volatility during that time, which included the fall of Bear Stearns and Lehman Brothers as well as the bailout of the biggest financial institutions in the world, like AIG, and the economy had lost 800,000 jobs per month, we would have expected a much different story. It was a warzone. But once we expand our view, even during a very distressing time like 2008, it was just a blip. Out of the 22 independent Leap Year periods, there were only 2 (9%) that had negative returns (both in the 1928 to 1940 period) and no negative Leap Year period returns since 1940. Leap Year Returns of IFA Index Portfolio 100 88 Years (1/1/1928 to 12/31/2015) 22 Leap Years 4-Year Leap Year Periods Annualized Return Total Return March 1, 2012 – February 29, 2016 6.18% 27.09% March 1, 2008 – February 29, 2012 3.02% 12.64% March 1, 2004 – February 29, 2008 10.54% 49.33% March 1, 2000 – February 29, 2004 9.82% 45.43% March 1, 1996 – February 29, 2000 12.12% 58.04% March 1, 1992 – February 29, 1996 13.92% 68.44% March 1, 1988 – February 29, 1992 13.82% 67.81% March 1, 1984 – February 29, 1988 22.54% 125.46% March 1, 1980 – February 29, 1984 18.49% 97.09% March 1, 1976 – February 29, 1980 21.46% 117.63% March 1, 1972 – February 29, 1976 3.23% 13.56% March 1, 1968 – February 29, 1972 9.55% 44.05% March 1, 1964 – February 29, 1968 18.29% 95.77% March 1, 1960 – February 29, 1964 9.09% 41.65% March 1, 1956 – February 29, 1960 10.39% 48.49% March 1, 1952 – February 29, 1956 19.22% 101.99% March 1, 1948 – February 29, 1952 18.44% 96.78% March 1, 1944 – February 29, 1948 13.81% 67.77% March 1, 1940 – February 29, 1944 13.32% 64.88% March 1, 1936 – February 29, 1940 -3.14% -11.98% March 1, 1932 – February 29, 1936 32.48% 208.06% March 1, 1928 – February 29, 1932 -23.5% -65.74% Source: ifacalc.com , ifabt.com , Index Fund Advisors, Inc. We could also take a look at the monthly rolling 4-year returns from 1928 to 2015. This would include 1,009 4-year monthly rolling periods. The median annualized return across all 1,009 4-year periods was 13.42%. The lowest 4-year period was 06/1928 to 05/1932, where we saw an annualized return of -36.73%. Similarly to our observation before, the highest 4-year return came soon thereafter (03/1933 – 02/1937) where we saw a 56.22% annualized return. Click to enlarge Click to see the full interactive chart on IFA.com . The Leap Year Review approach to investing is our way of resetting our investors’ internal investment clocks. Investing is not about thinking in seconds, minutes, hours, days, weeks, months, or even 4 years. There is too much randomness to extract anything of benefit from these types of time periods. Having a broader focus allows investors to tune out the irrelevant. This will help to protect investors from becoming victims of their own emotions. We have shown using historical data the benefits of time diversification . Of course this doesn’t mean that the future will be so bright, but remember, from 1928 to 2016 there have been multiple wars, conflicts, economic booms and busts, stagflation, and differing economic policies (think FDR versus Ronald Reagan). Through all of this, markets have rewarded the patient investor. Believing that somehow this is going to change in the future is pure speculation. Happy Leap Year! 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.

The MFS "Active Advantage"… Really?

For those of you who like to peruse CNBC every once in a while, there is a very high chance that you have seen commercials from an outfit called MFS Investment Management. They are very well scripted and highlight some of the typical selling points active managers like to make when speaking to investors about topics such as risk management, downside protection, alpha, and a globally informed perspective through a network of analysts that have boots on the ground at different locations around the world. It is a very compelling story that speaks to a lot of the fears investors have when broaching the topic of investing for the future. The biggest selling point and overall message from these commercials is the fact that MFS Investments are being active in the sense they are not just sitting back and letting things happen. This is often one of the issues we have as advisors when talking about the difference between an active and passive approach to investing in that passive insinuates this idea of not taking action and letting things like large market swings or problems in China just happen. In other words, we are not being proactive in controlling the outcomes these events have on the wealth of our clients. And it is completely understandable. How many times in our daily life do we just sit back idly and wait? It is not the American way or the American spirit. We are supposed to take control of our day and our future. Our outcomes at work and other personal goals such as fitness or relationships are a direct reflection of the actions we take or do not take. Therefore, the same should apply when it comes to investment outcomes, right? This is the unfortunate paradox that traps many investors into believing that the same active approach we take in other areas of our life also applies to that of the financial markets. The reality is that an individual investor has very little control over the day-to-day fluctuations of the market. Furthermore, nobody has enough foresight to know what is going to happen to the markets that somebody else doesn’t already know; at least not with a high degree of certainty. What an investor does have control over is the long-term growth of wealth, which is dependent upon their individual savings rate and amount of risk taken within their portfolio. Legendary investor and mentor to Warren Buffett, Benjamin Graham, famously stated in Security Analysis , “in the short run the stock market is a voting machine, but in the long run it is a weighing machine.” Now, even though we have laid out a line of thinking that seems reasonable, it still wouldn’t be a robust argument without empirical support. Let’s take a look at the individual claims that MFS Investment Management makes in their commercial and the corresponding peer-reviewed academic support for their statements. This is not intended to highlight the merits of MFS Investment Management individually since their claims are very common amongst the active investment community. Claim #1: Active management tends to perform well during market transitions, particularly more difficult markets, providing value in risk management and reducing downside volatility. This is a classic argument active management proponents like to use. It assumes that based on current information they know exactly where we are at in a market cycle. In terms of the academic literature, there has been no conclusive evidence that demonstrates that this claim is true. Active management tends to perform similarly during down markets and up markets. We have already written articles before on the topic of active management providing protection during down markets here . We referenced a paper from the Fall 2012 edition of the Journal of Investing called Modern Fool’s Gold: Alpha in Recessions , which concluded that there is very weak persistence in a manager’s ability to provide superior outperformance during subsequent recessions or expansions. So while it sounds very comforting to say we reduce downside volatility but fully embrace upside volatility, managers usually do not know when each is going to occur, and by the time they act on their premonitions, the market has already moved on. Claim #2: Focus on security selection is such that no systematic component of risk drives performance and offsets everything we are trying to do. Let’s dissect this sentence since there is a lot of fluff. No systematic component of risk refers to either overall market risk, size risk, or relative-price risk. These are more formally known as the different dimensions of risk, which were comprehensively introduced in 1992 in Eugene Fama and Ken French’s seminal paper, The Cross Section of Expected Returns . So if we don’t want one single component of these risk factors driving the performance of the overall strategy, then what we are really saying is that we want to be very well diversified. We want large stocks, small stocks, growth stocks, and value stocks across all different sectors and regions. The problem with this approach is the more and more diversified you get, the more and more you look like the overall market (i.e., index fund). As we will show later, this seems to be an issue MFS Investment Management is running into with a lot of their seasoned strategies. From a security selection standpoint, most active managers have a really tough time distinguishing the next winners from the next losers. In Fama and French’s paper, Luck versus Skill in the Cross-Section of Mutual Fund Returns , they looked at the performance of 819 different mutual funds over the 22 years ending in 2006. They found that the vast majority (97%) didn’t beat their respective benchmark (produce positive alpha), and the small amount that did is indistinguishable from just choosing stocks at random. Click to enlarge Claim #3: From a philosophical standpoint we look to take risk where we think we will be compensated and budget risk for where we have the most skill and ability to consistently deliver alpha. This claim is very similar to that of Claim #2. We already know where investors should be expected to earn a return for risk taken; that would be in stocks that are smaller in size and value-oriented. Anything beyond these factors is assuming the pricing mechanism inherent in the market is not functioning properly. In other words, current stock prices do not properly reflect future expectations of a particular company, which is just complete nonsense. To look at a price and say it is currently mispriced means that your ability to estimate the fundamentals of a particular company or your ability to predict the future are superior to that of the other few million professionals in the world. It’s their collective estimate of a company versus yours. That is quite a claim to say you know something they do not. And the law of large numbers is stacking the odds against you. We can once again cite the paper by Eugene Fama and Ken French on Luck versus Skill . The vast majority cannot consistently deliver alpha across multiple asset classes and time horizons. What is so special about MFS Investment Management that they believe they can deliver it? To say they have a global operation that believes in collaboration and sharing of information is nothing special. Most of the big asset managers have global operations and are promoting the exact same thing. Claim #4: We like to tell clients to arbitrage the time horizon and have a long-term view. This is just fancy speak for staying diversified and having a long-term focus, which is something we also promote. Because nobody can accurately predict what is going to happen in the future, it is best to “arbitrage the time horizon” by buying low-cost index funds and rebalancing when necessary. The market, not one particular individual, knows best. Cold, Hard Facts Let’s look at the cold, hard facts. We examined the performance of all 87 different mutual funds that MFS Investment manages to see if their integrated research platform around the world that promotes the sharing of information, protecting investors from downside volatility, taking risk where they expect to be compensated, and budgeting risk for where they think they can provide alpha has worked out well for them. We first looked at all of their US-based strategies that had at least 10 years of performance history to see if they were able to deliver outperformance over a medium time horizon. Of the 14 funds that were US-based strategies and had at least 10 years of data, not a single one produced a positive alpha that was statistically significant to a high degree of certainty (95% confidence level) once we adjusted for the known dimensions of expected return using the Fama/French 3 Factor Model . See chart below. Click to enlarge As you can see, most of the funds hug the dashed line that represents zero annualized alpha. This is what we would expect to see not only in an efficient market , but also for someone who is tracking the overall market, which is the point we made under Claim #2. The second thing we looked at was the performance of all 87 mutual funds against their Morningstar assigned benchmark, since inception, to see if there were any funds that produced a statistically significant alpha. Here is what we found: 53 (61% of all funds) displayed a NEGATIVE alpha compared to their Morningstar assigned benchmark since inception Only 1 fund (1.15% of all funds) displayed a POSITIVE alpha that was statistically significant at the 95% confidence level compared to its Morningstar assigned benchmark 27 (31%) displayed a POSITIVE alpha compared to their Morningstar assigned benchmark 7 (8%) of the funds had no alpha to report since they had been around for less than 1 year. It is important to note that these performance figures do not take into account the front-load fees that are associated with these funds. The average maximum front load-fee as of 10/31/2015 across all MFS Investment strategies is 5.16%. These fees may or may not be paid by investors based on broker recommendation or custodial and/or broker platforms. The table below lists the fees for all MFS funds. Readers can find a more in-depth analysis and illustration of the costs associated with strategies from MFS Global Management here . So the vast majority (61%) of their funds displayed negative alpha and only 1 strategy had a positive alpha that was statistically significant at the 95% confidence level . Which was the only fund whose performance may have been attributable to skill? It is the MFS International New Discovery A (MUTF: MIDAX ) coming in with an annualized alpha of 4.96% and a t-statistic of 2.02. Below is its alpha chart showing the performance comparison against the MSCI All Country World ex US Index. Click to enlarge Does this necessarily mean that we would concede that investors should reliably expect to be better off investing in MIDAX versus a comparable index fund or mix of index funds? Absolutely not! There are key reasons why, although MIDAX has historically produced a statistically significant alpha, that investors should still stick with a passively managed index fund instead: First has to do with the Morningstar assigned benchmark, which happens to be the MSCI All Country World ex US Index. The Index has a 99% developed and 1% emerging market makeup, while MIDAX has consistently had 10-15% allocated to emerging markets, which we know has experienced a higher historical return than that of its developed counterpart. We cannot control for the overall size and value tilts in this particular strategy like we can with US-based companies since we do not have independent size and value factors for a global ex US portfolio of stocks. As we showed with the 14 US-based strategies, the alpha is diminished down to nothing once we have controlled for known dimensions of expected return. A lot of the alpha seems to have happened during the first 4 years (very tall green bars) of the fund’s history, but since then, results have been mixed. This means the statistical significance might be subject to in-sample bias. As we have mentioned before in this article , the best way to control for in-sample bias is to look at two independent time periods to see if the statistically significant alpha persists. Although the alpha for the strategy is statistically significant at the 95% confidence level, there is still a 5% chance that the outperformance was due to random luck. Our opinion that it’s random luck is bolstered by the very weak performance for the remaining 79 funds in the MFS Investment lineup. The policies, procedures, and systems in place in terms of hiring professional staff, gathering and analyzing information, and implementing investment strategies would seem consistent across the business. Unfortunately, this has not translated into an overwhelming success story across all of their strategies. Unless they applied a process, which was unique to MIDAX, it may seem reasonable to believe that just by random chance 1 out of their 87 strategies would have success. There is nothing distinguishing about MFS Investment Management’s process that would give us confidence they could deliver future outperformance. As we have said before in other articles that examine the performance of major mutual fund lineups (see Fidelity Funds Part 1 , and Part 2 , American Funds , Lord Abbett Funds , JP Morgan Funds , Hedge Funds , Olstein All-Cap ), this in no way is supposed to critique the level of intelligence and competence of the individuals in these organizations. They are the very brightest and most knowledgeable in our industry. Their reason for their lackluster performance has to do with the environment in which they operate. The free market that allows for the continuous sharing of information and exchanges that have the ability to aggregate that information are the ultimate culprits for the existence of the manager who can consistently deliver “alpha.” No single individual is more powerful than the overall market and no single individual will ever have all the information at their finger-tips about a particular company and its future earnings potential. All individuals are subject to estimation error when it comes to analyzing financial information and future growth prospects, and the aggregating of these estimation errors by the markets allows the price to be the single best estimation at any given time. Some active managers may be right at times at the expense of other active managers, but that is what we would expect. Unfortunately, the persistence of any manager’s outperformance comes down to either better estimation faculties, quicker access to information, or illegal insider information. In today’s overwhelmingly competitive markets, the latter or blind luck seems to be the biggest reason why most managers have experienced long-term success. Below are a few examples of the alpha charts we do in our analysis based on Morningstar assigned benchmarks. Click to enlarge Click to enlarge Click to enlarge You can find alpha comparisons across all 87 MFS strategies in the original article here . 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.

Fear Of A ‘Black Swan’ Event Is Worse Than The Actual Event Itself, Study Shows

Originally posted on May 3, 2016 Are investors more frightened of freak market crashes than the reality of such crises? Sometimes fear of a freak, outlier event can be a lot worse than the event itself, at least when it comes to the markets. Most of us are aware of the now famous credit crisis book by Nassim Nicholas Taleb , “The Black Swan: The Impact of the Highly Improbable.” The central thesis of the book is of course that black swans , or freak market events, are more common than we expect in life, and in particular, in complex systems such as economics. The credit crisis was, therefore, no great surprise, and such crises can be expected to occur in one form or another on a fairly regular basis. Well, that was Taleb’s thesis. But it was also a thesis written at the height of negative market sentiment. Subsequent serious academic work reported by Bloomberg by William Goetzmann, Dasol Kim and Robert Shiller looked at 26 years of survey data to test Taleb’s thesis. They found that people consistently expect things such as stock market crashes and earthquakes to happen more frequently than they really do. In other words, there may be black swans out there, but more important perhaps than their occurrence is our exaggerated fear of their occurrence. There are indeed periods of irrational exuberance when we forget about the possibility of black swans. But certainly since the credit crisis , it seems that there has indeed been an exaggerated angst that has gripped the global investing community. It is as if the crisis was sufficiently intense that it set off a type of Post-Traumatic Stress Disorder among investors, leading to everyone seeing specters around every corner. This overarching sense of angst has had very significant effects since the credit crisis. Although there has been modest growth in gross domestic product in the United States ever since 2009, the recovery hasn’t felt like a recovery. We continue to suffer what economist Joseph Stiglitz calls the “great malaise,” a lack of those animal commercial spirits. Shiller himself sees this anxiety as driving this very low rate environment as most investors and banks keep the bulk of their assets in low-return fixed-income assets, which itself further lowers the yield on said assets. This has also driven excess regulation. No one can say that the credit crisis didn’t merit a significant re-think of various parts of the U.S. financial regulatory architecture. But it is now becoming equally clear that the Dodd-Frank Act was a behemoth of a piece of legislation, 848 pages long, most of it with half-baked concepts that were left to be developed over time by sub-legislation. Many now expect the very framework of large chunks of Dodd-Frank to require major re-engineering, given its excessively controlling and complex features. The idea, for example, of bank living wills was probably a non-starter from day one. The concept was that banks must put in place plans for their orderly wind down in the event of financial failure, ones that didn’t rely on government support. But this was immediately a bizarre exercise for all financial institutions because it involved making up totally theoretical failure scenarios, some concatenation of events that is unlikely to have any bearing on the actual features of any next crisis. After all how on Earth could we predict what that crisis will really entail? The Federal Deposit Insurance Corp. and the Federal Reserve made all the banks write their living wills twice, on the basis that they were too loosely drafted the first time, but more granularity here doesn’t solve the conceptual problem. The situations conceived are so hypothetical that these living will models are often the case of garbage in garbage out. In addition, for those institutions that matter – the systemically important financial institutions – living wills are a particularly absurd exercise because, by definition, these large financial institutions are simply not sustainable during periods of acute illiquidity without government support. It seems, in other words, that Dodd-Frank itself was premised on their being black swans everywhere. And the capital requirements it imposes on banks, the compliance burden, the business line restrictions and high levels of liquidity buffers all mean that banks simply haven’t been meeting much of even the legitimate credit demand in the United States. The result, of course, has been huge growth since the crisis of the shadow lending market, which is legitimate lending done by non-depositary institutions. The shadow lending market has gone through a total re-birth since the crisis, as multiple research papers demonstrate. There can be dangers of an excessively large non-bank lending sector, but again Dodd-Frank has embedded within it another mechanism for seeing black swans in this sector also. That is the Consumer Financial Protection Bureau . The role of the CFPB in supposedly protecting borrowers from predatory lending is only just being defined now by the regulator. But there is already considerable confusion about the CFPB’s ambit, and, indeed, even a recent court hearing indicated that the bureau may be acting outside the scope of the Constitution. Meanwhile, the U.S. economy struggles to get above 2% GDP per annum, consumer inflation is negligible and growth is so anemic that the Fed’s attempt to raise short rates and normalize monetary policy is materially struggling. So it is back to Shiller and Stiglitz, just too much fear in the system to allow growth really to ignite. And so what does such economic neurosis really amount to? It isn’t necessarily the product of there being too many black swans but the product of an irrational belief that there may be too many black swans. And the big question then is when will it all end? When does the anxiety end, when is the neurosis cured and how? Disclosure: Jeremy Josse is the author of Dinosaur Derivatives and Other Trades , an alternative take on financial philosophy and theory (published by Wiley & Co). He is also a managing director and head of the financial institutions group at Sterne Agee CRT in New York. Josse is a visiting researcher in finance at Sy Syms business school in New York. The views and opinions expressed herein are those of the author and don’t necessarily reflect the views of CRT Capital Group, its affiliates or its employees. Josse has no position in the stocks mentioned in this article.