Stock Picker to Indexer

Recently, Jason Zweig, in his Intelligent Investor column, discussed data mining and proprietary trading on Wall Street, and the unreliability most of these strategies have on predicting the future.

If you watch just 30 minutes of CNBC commercials or peek at web banner ads, there is a big push for companies selling their investment strategies. One company claims their strategy called the “top of the market” in 2007 and the massive sell off last fall. Another has a foolproof system to back test your technical strategy. Amazingly, some of these folks believe they are reasonable. I think most people and financial advisors can see through this sales pitch, but how many people do you know think they personally have an above average investment strategy?

I think it is in our human nature, or at least in the nature of financial professionals, to believe that we can be winners. Thus, we believe that we can beat the market over the long term.

As an advisor, it is always interesting to see the portfolios when they are first transferred. Most of our assets seem to come in from brokerage houses, thus we see clients in A Funds,  all in the same fund family. The fees are typically high and most are lacking in a lot of ways compared to their benchmark and mutual fund peers.

Throughout 2008 and 2009, we have been reading that buy and hold is dead. I agree that if you bought and held just the S&P 500, this could be the case. However, applying even just your college basics of investing 101, we know not to do that. By simply using the long term standard deviation and correlation of several asset classes and the S&P 500 as the benchmark, one can add treasuries, high yield bonds, emerging market bonds, international treasuries, the US Bond market, commodities, small cap, mid cap, large cap, developed international, international small cap and emerging markets to a portfolio. The right allocation can hold up in bull and bear markets with overall less risk and usually a greater return than the S&P 500 and even an asset allocation benchmark. It is, of course, not a perfect system, but it seems by mixing asset classes, a portfolio can become very above average.

I know this from experience; since I took my firm to all indexing in 2004, this has been the case. If you back test the same portfolios 10 years, we see the same results. Prior to 2004 and my ownership of the company, Wiser Wealth was a stock picking firm. The stock picking did okay during those years, however, after capital gain taxes and transaction fees, clients fell behind the mark. After switching to ETFs and a passive strategy, the capital gain tax bills shrank and our clients liked the reduction in trade confirmations!

After reading thoroughly through the Journal of Indexes, two publications of Active vs. Passive and the University of Maryland Study that shows that less than 1% of active managers have beat their benchmarks net of fees from 1975 to 2007, I don’t see how advisors can chose active management over passive. At least they should admit passive is better for everyone but themselves, right?

10 Year Risk Reward Chart – Source – Morningstar Office Edition

Index 10 yr BlotterIs buy-and-hold dead? No way. Passively investing broad-based index funds throughout the globe works, and that strategy has no tricks to it or special systems.  The above scatter plot shows the risk/reward for various asset classes over the last 10 years as of 9/31/2009.  As seen above, different asset classes had very different risk and return characteristics over the last 10 years. Bonds and Treasury Inflation Protected Securities had an annualized average return of 6.8% and 7.1%, even with inflation at historically low rates, to which the bonds are linked. Emerging Markets with an annualized 10 year return of 12% took on more risk, but it paid off with its above average return.

As more advisors become independent and get away from the old commission system and take on fiduciary responsibility, buy and hold indexing will thrive. Diversifying a portfolio throughout global asset classes makes a difference. And even in times of crisis, it tends to lessen the affects of even a global recession, where investors fled stocks to invest in government bonds, pulling money from global investments to the US, increasing the value of the US Dollar (temporarily) and US Treasury Bonds.

The cost of indexing is minimal compared to an actively trading mutual fund manager. As more conflicts of interest are revealed with the mutual fund world and commission brokers, the brighter the indexing option will shine. After all, with all the turmoil of 2008, ETFs actually increased in usage and size.

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