Hedge Funds: Actual Investor Returns Less Than Advertised

When a mutual fund or hedge fund lists their historical returns, the industry standard is to use time-weighted returns that assume you buy at the beginning of the time period and hold until the end. However, what often happens is that a fund will start out small and have great returns for a while, gradually start attracting lots of investor money, and then the subsequent returns are not so hot. Whatever special inefficiency or investment idea the fund managers had initially is either wiped out by market forces over time or simply hindered by asset bloat. In such a case, the actual returns experienced by investors is less than what is listed under fund return data, even though things like 5-year trailing returns still look quite good.

Via Abnormal Returns, Ben Lorica of The Verisi Data Studio took an academic paper by Dichev and Yu [pdf] in the Journal of Financial Economics and made a nice visualization of the hunk of data presented about hedge funds:

click to enlarge

From the paper’s conclusions:

Using a comprehensive sample, the main finding is that dollar-weighted investor returns are about 3% to 7% lower than fund returns, depending on specification and time period examined. This difference is economically large, and it is enough to reverse the conclusions of existing studies which show outperformance in hedge fund returns. In addition, the estimated dollar-weighted returns are rather modest in absolute magnitude; for example, they are reliably lower than the returns of broad-based indexes like the S&P 500 and only marginally higher than risk-free rates of return.

Most of us can’t invest in hedge funds even if we wanted to, so this is best taken as a larger lesson to be careful when chasing hot returns by any money manager. You don’t want to be the last money in. Morningstar also tracks “investor returns” (dollar-weighted) separately from “total returns” (traditional, time-weighted) in their mutual fund listings.

Posted in Investing | 5 Comments »

Correlation Between Age Demographics and Stock Market Prices?

While perusing this early retirement reading list for more books to read, I ran across an interesting fellow named Harry S. Dent, Jr. His primary theory is that age demographics are strongly correlated with the economy and thus stock market prices.

In particular, the number of households headed by 46-50 year-olds are the best indicator because they are shown to have the highest spending. This makes sense, as around age 50 is also when peak income occurs while you also have spending pressure from grown-up kids and college tuition. After that, the kids move out, things slow down, and average income drops. Here are some charts from the HS Dent Foundation website:

Source:HS Dent Foundation

By looking at birth rates and adjusting for immigration, you can basically predict how many 46-50 year-olds there will be well into the future. Here’s how the shifted birthrate data corresponds to the Dow Jones stock index adjusted for inflation:

Source:HS Dent Foundation

According to the birthrate data, we are looking at depressed prices for another 10-15 years or so, but things will pick back up after that. While I think there may be something to this concept on a long timescale, I would be careful with trying to profit with it in the short-term.

I’m actually look at Mr. Dent himself here – a quick look around shows that he is trying everything under the sun to make money from this simple theory – writing a new book every few years with mostly the same content (2011, 2009, 2006), selling $1,500 seminars to “Demographics School”, and even starting his own Dent Tactical ETF (ticker symbol: DENT) with poor performance since inception and a bloated 1.65% expense ratio. Potential investors should know that he already started a mutual fund previously that failed:

In 1999, the AIM Dent Demographics Trends Fund was launched, based on the demographic economic and lifestyle trends identified by Dent. Unfortunately, the fund’s results were miserable. From 2000 through 2004, the fund lost more than 11 percent per year and underperformed the S&P 500 Index by almost 9 percent per year. In 2005, its sponsor put investors out of their misery by merging it into the AIM Weingarten Fund.

Over the years, he has made many predictions. Some of them came true, more or less. For example, he predicted that the slowdown in Japan economy would coincide with the end of the end of their peak number of 46-50 year-olds in 1990-1994. Some of them did not, like in 2006 when he predicted the Dow Jones would reach 32,000-40,000 in the year 2010 (the highest ever close was 14,164 in 2007).

The last prediction I could find was Dow 4,000 to 6,800 somewhere around 2012. That’s over a 50% drop from today’s prices. I think I’ll add this demographics theory to my investing consciousness, but I’ll leave the bold predictions behind.

Posted in Investing | 9 Comments »

How To Retire Early and Live Well With Less Than A Million Dollars [Book Review]

I enjoy reading older books about early retirement; I seek to learn from their experiences, but I also look for ways in that their perspective is colored by their own time period. For instance, a book written in the 80s¹ – an era of high inflation – would likely assumed that interest rates would be moderately high forever, at least in the 5% range. The tendency to extend recent trends into the future is unavoidable, and something you should consider when reading or making forecasts today.

This is a review of How To Retire Early and Live Well With Less Than A Million Dollars by Gillette Edmunds, a book published in 2000 that was recommended to me by a reader. Edmunds was a former tax attorney and financial journalist who retired in 1981 at age 29.

Unreasonably High Expected Returns
Remember that for both the 1980s and the 1990s, the average annualized total return of the S&P 500 for both decades was around 18% a year. Imagine two decades of such returns, all before the dot-com bust and the housing bust. Edmunds retiring in 1981 turned out to be some of the luckiest timing possible. As a result, a major criticism of this book is the continued expectation of high stock returns going forward. The quoted excerpts below are taken verbatim from the book:

• Can you retire today? His answer is that “most middle-class Americans, including me, could live comfortably on the investment returns from $500,000.” Perhaps, but with currently-accepted safe withdrawal rates of 3-4%, this would only create $15,000 to $20,000 a year in income. Instead, the book promotes withdrawals rate of 8-10%, which would have left many nest eggs completely wiped out from 2000 to 2010.
• “An average, educated, experienced investor can reasonably expect to make 10% a year for life.”
• “Anyone should be able to produce a 7.75% return.”

I bet these assumptions sounded reasonable, perhaps even conservative, in 2000 but they are just bad jokes today.

Owning Non-Correlated Asset Classes
Edmunds tells us not to time the markets, ride out temporary market drops, and to maintain low investment costs. He advises you to hold a variety of “non-correlated” asset classes such as:

• Real Estate
• Foreign Stocks
• US Large Stocks
• US Small Stocks
• Emerging Markets Stocks

Edmunds believes that these asset classes are on different business cycles. When one is going up, the other is going down. However, I don’t like the term “non-correlated”, as very few asset classes have negative correlations these days. Low or minimally correlated is a better term. As we saw in the recent financial crisis, when the poo hits the fan correlations can go back to 1 (everything goes down together). However, I agree with the general asset allocation advice of holding different asset classes with minimal correlations. He counts as an early proponent of not holding too much in US stocks (no more than 1/3rd of total portfolio), and an equal amount in foreign stocks (also use for 1/3rd of your portfolio).

I did have an issue with the lack of supporting evidence as to why these assets and not others, as we only get weak arguments like “after owning bonds for about five years, I realized that a portfolio of five different high-return asset classes that excluded bonds had both high predictability and high returns”. I’m sorry, but making a conclusion to stop holding bonds after 5 years of data is just plain bad advice and makes him come off as egotistical.

He ends the book with a philosophical epilogue with the usual “money isn’t everything, enjoy life with family and friends” material. I don’t mean to belittle the importance of this factor, just that I didn’t really learn anything new from it. He does come off as well-intentioned and talks about the effect of his divorce. Despite its flaws, I found this book worth the read as it encompasses the overall philosophy of one person who had been successfully retired for 20 years. Just remember he had a very strong tailwind of high returns, and adjust your own expectations accordingly.

Other “early retirement” books that I’ve reviewed:

• ¹Cashing in on the American Dream: How To Retire at 35
• Early Retirement Extreme
• Your Money or Your Life
• The 4 Hour Workweek

Posted in Book Reviews, Investing | 7 Comments »

The Overnight Rule For Managing Your Portfolio

Recently, I came across an investment tip called the Overnight Rule from Carl Richards via the NYT Bucks Blog:

Imagine that all your investment holdings were sold overnight by accident.

Would you buy back everything you owned previously again at their current prices? If not, why are you holding them now?

I think this provides a fresh look at your portfolio, as many times we hold investments for irrational reasons. For example, there is the well-documented trait of loss aversion (even though readers of this blog may be immune), where investors really hate selling at a loss, even more than they love selling with a gain.

Perhaps you bought the stock at $20 a share, and it is now at $15 a share. You want to get rid of it “just as soon as it gets back to $20 a share”, so that so you can say you didn’t lose money on it. It’s better to admit the mistake and put your money in something better.

Then there is regret aversion. Perhaps you bought it at $50 a share and now it’s at $400 a share. You get to tell your friends how you bought Apple at $50 a share. You’re afraid it’s overpriced, but you don’t want to miss out if it rises some more. You sit on your gains and choose inaction instead of having to make a hard decision even though your money could be better deployed elsewhere.

Maybe it is company stock from your job, or shares that you inherited from a beloved family member. Whether is it some form of sentimental attachment, inertia, or plain laziness – you may want to consider your reasons for holding them.

There is a small exception to this rule if you are sitting on large capital gains in a taxable account and don’t want to realize them and get hit with the tax bill, especially if the alternative investment is also very similar (ex. mutual funds with similar holdings). However, even in this scenario you want to make sure that you’re not holding a poor investment just to put off a tax bill.

I did not come up with this myself, but read about this rule somewhere online within the last month. I’ve searched for the source but can’t find it, so please let me know if you do. Found it, thanks!

Posted in Behavioral Economics, Investing | 22 Comments »

Historical Bond Yields vs. S&P 500 Dividend Yield

Here’s a chart from a Morninstar article on dividend stock ETFs that caught my eye. It shows the historical relationship between the yield on 10-year US Treasury bonds and the dividend yield on the S&P 500. I am not convinced that this means one should overweight dividend stocks over bonds, but it does provide some historical perspective. The last time the yield differential was around zero was in the 1950s.

Click to enlarge. Source: Morningstar Analysts

Since we are talking about such long time periods, let me throw in this chart showing (ready for this?) the rolling 10-year average annual inflation adjusted total return for the S&P 500 from 1926 through the end of 2011. Credit to Quant Monitor.

Click to enlarge.

Posted in Investing | 5 Comments »

The (Next) Big Short: Current Investments of Michael Burry and Steve Eisman

I’ve read parts of The Big Short by Michael Lewis before, but finally re-read the entire thing over the weekend. If you are unfamiliar with this bestseller, it tells the story of the housing bubble through the viewpoint of investors who saw the crisis coming and bet big money on the collapse of subprime mortgages. Lewis portrays these guys as almost heroes, courageous individuals from smaller hedge funds that went against the commonly-held beliefs of the big firms on Wall Street.

Instead of writing the 8,449th review of this book, my question was – what are these characters betting against now? Now, this doesn’t necessarily mean I think they’ll be right, but I’m still curious.

Michael Burry, Scion Capital
Burry no longer accepts money from outside investors (he doesn’t need to), but still invests at Scion Capital using his own money. He doesn’t write a blog or release his recent letters to shareholders to the public, except for a few old ones. He did make a April 2011 lecture at his alma mater Vanderbilt University entitled Missteps to Mayhem where he sees continued problems with the government printing too much money and not tackling our current fiscal problems.

The government’s borrowing of money for the purpose of injecting cash into society, bailing out banks, brokers, and consumers, is a short-sighted, easy decision for a population that has not yet learned that short-sighted and easy strategies are the route to long-term ruin.

He ends his speech with the ominous advice “All that said, I might suggest opening a retail banking account in Canada.” I’m not even sure that’s possible to do as a U.S. citizen… is it?

From this complete transcript of a September 2010 interview with Bloomberg, he states that he believes that “productive agricultural land with water on site is — will be very valuable in the future”, he is bullish on gold due to currency debasement, but he doesn’t have a good feel for the timing of things as it could take a while to play out.

Steve Eisman, FrontPoint Partners
Eisman left FrontPoint in June 2011 and is reported to start his own hedge fund Emrys Partners in 2012. He has gotten the most publicity in recent years for shorting the stocks of certain for-profit colleges taking advantage of easy credit from government student loans. Basically, people who can’t get into traditional colleges are pitched a great future and convinced to take out large amounts of debt that they can’t pay back, all so these pseudo-accredited colleges can profit. Sound familiar? From a 2010 conference speech:

Until recently, I thought that there would never again be an opportunity to be involved with an industry as socially destructive and morally bankrupt as the subprime mortgage industry. I was wrong. The for-profit education industry has proven equal to the task. [...] This is similar to the subprime mortgage sector in that the subprime originators bore far less risk than the investors in their mortgage paper.

I also looked for information on Charles Ledley and James Mai of Cornwall Capital, but really didn’t come up with much. They have a website, but there is nothing to see for the public.

Posted in Book Reviews, Investing | 4 Comments »

Estimate Your 2011 Portfolio Rate of Return – Calculator

Some of you may be wondering how well your specific portfolio performed last year. Let’s say you started the year with $10,000 and put in another $5,000 throughout the year, and ended up with $16,000. What was your rate of return? Your main goal is simply to separate the effect of new deposits (or withdrawals) and your actual return from investments.

Figuring out your exact personal rate of return requires you to know the exact dates of all your deposits and withdrawals, along with a financial calculator or software program with an IRR function. However, for an simple and quick estimate of your returns, try this calculator instead:

Instructions

1. Get your initial balance. This is probably from your brokerage statements. Try January of last year.
2. Tally up any deposits or withdrawals. For example, maybe you put $3,000 in your Roth IRA and also put in 5% of your $40,000 salary into a 401(k). That would be $3,000 + $2,000 = $5,000. If you paid a lot in fees or commissions, include those. No need to worry about the dates.
3. Get your final balance. Your December statement is probably available already.
4. Find the time elapsed (in years) between your initial and final balances.
5. Hit Calculate. An estimate of your annualized return is instantly given.

How Good Is This Estimate?
The calculator assumes that the inflows and outflows are spread evenly around the middle of the year. I originally saw this method in The Four Pillars of Investing (review). However, unless the deposits and withdrawals are very large as compared to the initial balance, the estimates are actually pretty good.

For example, let’s say that you start with $100,000 on 1/1/11, and end up with $120,000 on 1/1/11. If you had net deposits of $10,000 during the year, the calculator above would estimate your return at 9.52%. If the $10,000 was actually deposited all at once on one of these specific days, you would get the following exact returns:

I Want Exact Numbers Too!
For everything you ever wanted to know about rate of return and then some, see Gummy Stuff. I must warn you that it’s very math intensive. If you just want to know how to figure out the numbers, see his XIRR page. You’ll need the exact dates of all your fees, commissions, deposits, and withdrawals.

Like this tool? Check out the rest of my Tools and Calculators. I hope they are useful.

Updated and revised for 2012.

Posted in Investing, Tools & Calculators | 14 Comments »

Active Mutual Funds, Passive ETFs, & Tax Efficiency

When looking at your investment returns, it’s important to calculate your return after the impact of taxes and expenses (management fees, commissions, bid/ask spreads). That number is what you really end up with, but it’s never shown on any year-end statements. ETF provider iShares put out a Managing Tax Challenges brochure that shows the average annualized tax cost for actively-managed mutual funds over the last 10 years. Via Abnormal Returns and Mebane Faber.

(Click to enlarge)

Many actively managed mutual fund managers have had difficulty delivering benchmark-beating, after-tax returns. Figure 1 shows the 10-year average tax cost for active funds and top quartile active funds. What’s striking is that in every case except for mid cap blend and small cap value, top quartile funds’ tax costs (as indicated with a white dot) were equal to or greater than those of the category average (black dot). Even worse, after taking taxes and fees into consideration, the average active fund underperformed its benchmark.

The takeaway is that expenses and tax-efficiency both matter greatly to the bottom line, and passively-managed ETFs are much more tax-efficient than actively-managed mutual funds, possibly enough to counter the performance benefit of active management. For one, being passively-managed on its own means lower turnover (less buying and selling) and thus less taxable events. Second, the ETF structure itself has inherent advantages over open-ended mutual funds. Neither of these traits are specific to iShares, by the way, although they do have some of the most popular index ETFs out there.

I should note that many Vanguard ETFs are simply different share classes of open-ended mutual funds (Example: VTI and VTSMX). Theoretically, this extends the tax-advantages of ETFs to the mutual fund shareholders, as described in Vanguard’s ETF brochure:

Tax advantage. Like other ETF providers, Vanguard can push low-cost-basis shares out of the portfolio through the in-kind redemption process. Our patented share-class system provides an additional benefit. To meet cash redemption requests from non-ETF shareholders, Vanguard can sell high-cost-basis securities to generate a capital loss. These losses offset any current taxable gains and, if not exhausted, can be carried forward to offset future capital gains—a recycling that is not likely within stand-alone ETFs. Theoretically, cash redemptions could trigger a gain instead of a loss; however, Vanguard’s deep tax-lot structure has allowed us to select high-costbasis shares in both good markets and bad, resulting in a high degree of tax efficiency.

As a result, in many cases if I can own Admiral shares of Vanguard index funds that have the same low expenses as the ETF version, I’d rather just own the mutual fund version for the sake of simplicity. For instance, I like making dollar-based transactions at net-asset value (NAV) instead of having to place a market order (potential loss due to bid/ask spread) and also worrying about NAV discount/premiums. It also keeps me from doing silly things like trying to time the market intraday.

Posted in Investing, Taxes | 9 Comments »

ShareBuilder Promotion Codes: Free Automatic Trades (Updated 2012)

Update January 2012: There are a few new codes that give you automatic investment credits, and also two new codes that will give you $50 and $25 bonuses respectively if you make a $25+ transfer over (each) to ShareBuilder with no trades required. Thanks to readers ML, Will, George, BR, and MBR for the most recent updates.

Here are some promotion codes for existing ShareBuilder accounts. ShareBuilder is a discount brokerage now owned by the same folks behind ING Direct. They give out codes for various promotions, and they often work in your account even if you weren’t given the code directly.

Don’t have an account yet? Grab this $50 opening bonus first, all you have to do is deposit $50 before 3/31/12, and then add the promo codes below afterward. You can usually double-dip on codes if you have both a individual account and joint account. Got kids? Get even more by opening up custodial accounts for each of them.

How To Use
To enter the codes into your account, first log in to ShareBuilder, and then go to the Accounts tab > Overview > Profile & Settings > Enter Promotion tab shown below.

In the marked box, enter a code. If it works, you should see a confirmation that says something like:

Thank you for referring ShareBuilder to your friends! Your 2 real-time trades have been credited to your account and are available to use immediately.

How To Verify
To see how many free automatic trades you have, click on the top Trade > Automatic Investing and look for “You have XX Automatic Investment credits”. If you click on it, you’ll note that these may have different expiration dates. Here’s what I see:

Active Codes

BDAY12JY (1 free automatic investments, expire 3/31/2012)
12AIP (12 free automatic investments, expire 3/31/2012)
SK483GXM2BU9 (5 free automatic investments, expire 12/31/2014)
START50 ($50 bonus with electronic deposit of $25+, enter this code before the code below)
INVEST122111 ($25 bonus with electronic deposit of $25+)
3AIP
3AIP*GEJZOH (try if above doesn’t work)

Expired Codes
TAF5ANL*073t0C TAF2RA*2VvUQt TAF2RD*c48Ugc TAF5AR*2AsFg5 TAF5AW*1FkJgR TAF2RG*2VvUQt TAF5AC*2AsFg5 TAF2RM*2VvUQt TAF5AZ*2AsFg5 TAF5AA*t9sUKs BDAY11NV

Posted in Deals & Offers, Investing | 107 Comments »

Jack Bogle’s Personal Investment Portfolio

While poking around doing research on municipal bond funds, I ran across this 2010 Marketwatch article about the personal portfolio of Jack Bogle, founder of Vanguard.

The 81-year-old Bogle said that for his personal portfolio he follows an age-based formula. The founder of the Vanguard Group has 81% of his personal assets, including his retirement plan, in bonds and 19% in stocks. [...] “I’ve always had in the back of my mind this incredibly simplistic idea, that your bond position should have something to do with your age,” he said.

[...] In his retirement portfolio today, he’s got two-thirds of his bond portfolio in the Vanguard Total Bond Index fund and one-third in the Short-Term Investment Grade bond fund. In his personal portfolio, Bogle’s got two-thirds of his bond portfolio in the Vanguard Intermediate-Term Tax-Exempt bond fund and one-third in the Vanguard Limited-Term Tax-Exempt bond fund.

Now, you have to remember that Bogle is 81 and even though he didn’t take the Goldman Sachs private yacht route, it’s safe to say he doesn’t worry about wringing every last penny out of his investment returns. Of course, I don’t think he’d want to own something that would tank in price, either. I’m sure he thinks of his portfolio as more of a lesson to other investors than anything else. As such, here are my takeaways:

Age in bonds. Bogle said age in bonds, not bet the house on bonds as the article seems to suggest. If you’re 25, that’s just 25% in bonds which provide some needed stability to your portfolio. Look at 2011 year-end returns as just one example. At age 65, that’s 65% in bonds. Even if you think the stock market is going to outperform bonds, do you really want to expose yourself to 70% or 80% stocks in retirement? Even if you don’t follow this rule exactly, it can serve as a rough guide.

(As for the 19% stocks, you can reference this older 2006 Morningstar article where he lists the Vanguard Total Stock Market Index fund as well as some active holdings in Wellington, Wellesley, Windsor, and Explorer. These are sentimental holdings – he was once Chairman of Wellington Management before founding Vanguard – which aren’t index funds but are still very low-cost.)

What kind of bonds? In tax-deferred accounts, he holds the Total Bond index fund (mix of Treasuries, GNMAs, corporates) and some short-term high-quality corporate bonds. In taxable accounts, he holds intermediate to short-term municipal bonds. The Vanguard muni bond funds are actively-managed to maintain diversification across states and counties, and all maintain relatively high credit ratings. I currently hold the same muni bond funds (limited and intermediate). I also own TIPS, which is not mentioned in this article but was in his portfolio as of 2006.

Now, he is obviously pro-Vanguard but an important thing with bonds is low-cost. With Treasuries and TIPS, the credit risk is all the same so you could technically buy them directly yourself. Otherwise, low-cost funds and ETFs are the only thing I hold. Bogle also doesn’t extend his average bond duration very long in any case, which protects you somewhat in the event of rising interest rates. I also gather from this that he does not fear widespread defaults in the muni bond arena. I don’t know where Bogle lives (I think Pennsylvania) but he chooses not to use any state-specific muni bond funds.

Posted in Investing | 8 Comments »

2011 Year-End Investment Returns by Asset Class

I’ve been waiting for some good graphics about the performance of various asset classes for 2011. Got any? I’d try and make one myself, but I’m exhausted from year-end festivities. Below is one from Scotty Barber of Reuters (click to enlarge):

I also saved as a PDF the performance data from all Vanguard mutual funds after the close of the last trading day of 2011 (download link). Selected funds:

As a reminder that being this year’s best performing asset class is no guarantee of for future years, here’s the Periodic Table of Investment Returns from Callan that shows the relative performance of 8 major asset classes over the last 20 years (1991-2010, click to view PDF).

Any predictions for 2012?

Posted in Investing | 7 Comments »

Larry Swedroe Personal Portfolio: Small Value Stock Premium Revisited

I’ve written a little bit in the past about including small-value stocks to your investment portfolio. “Small” means companies with a relatively smaller market cap (total market value) – definitions vary from being the bottom 10% by capitalization or being worth less than $1 billion. “Value” stocks are those that tend to trade at a lower price relative to others when measured against markers like earnings, dividend yield, sales, or book value.

This NYTimes article on the portfolio of investment advisor and author Larry Swedroe included some concise examples of how significant this small-value premium has been in the past. For one, small-value stocks outperformed the S&P 500 by about 4% annually from 1927-2010.

Put another way, by making a portfolio using small-value stocks and US Treasury bonds, you could have gotten similar performance to the S&P 500 with much lower risk. Specifically, you could have held 1/3rd small-value and 2/3rd Treasury bonds and had close to the same return as the S&P 500 over a 40-year period from 1970-2010. This chart summarizes:

Source: Buckingham Asset Management, New York Times

Will this “small-value premium” continue to persist? There are a few theories out there. One is behavioral, where small-value companies tend to be the more ignored and unpopular companies and thus are consistently underpriced. Another is based on the fact that small-value companies are simply riskier, and thus investors demand a higher return for holding them.

I happen to believe that there is something enduring about small-value stocks, but the size of my bet on that belief is relatively small – only about 5% of my target stock allocation. But I also know that you need to hold a very strong belief in whatever internal explanation you have for the outperformance. Otherwise, when small-value is the dumps for a while relative to the Current Hot Thing – and it will be, one day – you’ll sell and lose any potential edge.

Posted in Investing | 6 Comments »