This is the approach we take at my firm, Buckingham Strategic Wealth. Because the equity mutual funds we utilize exclude REITs in their design, the allocation (typically about 3 percent) to REITs is accomplished through a separate allocation to a passively managed REIT fund, such as VGSIX. With that said, given the evidence, and the increase in correlations to both stocks and bonds, investors more concerned about downside risk should consider a reduced allocation to this asset class. This is especially true for investors with limited space in their tax-advantaged accounts, in which case REITs might crowd out investments with superior diversification benefits.
In closing, investors need to recognize that, over the long term, real growth in REIT dividends has been about -0.7 percent. While no one knows what the future holds for REIT returns, at the very least, REIT investors should be aware of the nature of these changes and their implications. Thus, when forecasting future real expected returns to REITs, you should subtract 0.7 percentage points from the current yield.
Appendix D: How to Evaluate Index and Passive Funds
For evidence-based investors, selecting an investment vehicle is much simpler than it is for active investors because the universe of funds from which to choose is much smaller. However, even for evidence-based investors, the decision is not as simple as looking at the expense ratios of the various options within each asset class and choosing the cheapest fund. The reason is that not all “index” funds are created equal.
While expense ratio is an important consideration, it should not be the only one. In practice, a more expensive fund manager can add value in several ways that have nothing to do with “active” investing. (Active investing is defined as the use of either technical or fundamental analysis to identify specific securities to either overweight or underweight). Let’s explore some of the ways a fund can add value in terms of portfolio construction, tax management and/or trading strategies.
1. Choice of Benchmark Index or How a Fund Defines its Investment Universe
This decision affects returns in several important ways:
Turnover, which impacts trading costs and tax efficiency. Some indices have higher turnover than others. And some indices/funds have added hold ranges (the index/fund will no longer buy additional shares, but it will not sell existing holdings) designed to reduce the negative impact of turnover (both on transaction costs and tax efficiency).
Exposure to the size and value risk factors. The greater the exposure, the higher the risk and expected return of the fund.
As an example, let us look at two such funds: the DFA U.S. Small Cap Value Portfolio (DFSVX) and the Vanguard Small-Cap Value Index Fund (VISVX). The table shows their expense ratios and degree of exposure to the market beta, size and value premiums for the period from June 1998 (VISVX’s inception date) through December 2016. The data comes from the regression tool available at Portfolio Visualizer (www.portfoliovisualizer.com).
The point is not to say that one fund is necessarily better than the other. The lesson is that not all passive funds are created equal, and you should not simply look at expense ratios and end your evaluation there. Instead, determine how much exposure you need to the market beta, size and value premiums, and then find the least expensive way of getting that exposure. Remember, the more exposure you have to the size and value premiums, the less equity risk you need to hold to achieve the same expected return.
Now, resuming our list of ways that a fund’s benchmark index or investment universe can affect returns:
Correlation of the fund to other portfolio assets (the lower the correlation, the more effective the diversification).
Some indices are more opaque than others, preventing actively managed funds from exploiting the “forced turnover” created when indices reconstitute (typically annually). A lack of opaqueness historically has created problems for index funds that replicate the Russell 2000 Index.
A fund can add value through incorporating the momentum effect by temporarily delaying the purchase of stocks exhibiting negative momentum and by temporarily delaying the sale of stocks exhibiting positive momentum. It can also add value by incorporating the profitability factor.
A fund can screen out certain securities (even if they are within the defined index) with characteristics that have demonstrated poor risk/return profiles (such as stocks in bankruptcy, very low-priced stocks, IPOs and extreme small growth stocks). For example, while utilities and real estate stocks typically have high book-to-market ratios (and, therefore, are found in most value indices) they also have very low market betas (exposure to equity risk). Including them in value indices that use book-to-market ratio as the screen creates a drag on returns. In addition, including real estate in value funds will make the fund less tax efficient (because the dividends from REITs are non-qualified and thus taxed as ordinary income).
How often an index reconstitutes can impact returns. Most indices (such as the Russell and RAFI Fundamental Indices) reconstitute annually. A lack of frequent reconstitution can create significant style drift. For example, from 1990 through 2006, the percentage of stocks in the Russell 2000 in June that would leave the index when it reconstituted at the end of the month was 20 percent. For the Russell 2000 Value Index, the figure was 28 percent. Over the course of the year, a small-cap index fund based on the Russell 2000 would have seen its exposure to the size factor drift lower. For small value funds based on the Russell 2000 Value Index, exposure to both the size and value premiums would have drifted lower. Drift toward lower factor exposure results in lower expected returns, as well as less factor diversification.
2. Patient Trading
If a fund’s goal is to replicate an index, it must trade when stocks enter or exit that index. It must also hold the exact weighting of each security in the index. A fund whose goal is to earn the return of the asset class, and that is willing to live with some random tracking error relative to its benchmark index, can be more patient in its trading strategy, using market orders and block trading to take advantage of discounts offered by active managers looking to quickly sell large blocks of stock. Patient trading reduces transaction costs and block trading can even create negative trading costs in some cases.
3. Tax Management
While indexing is a relatively tax efficient strategy (due to relatively low turnover), strategies can be employed that improve tax efficiency:
Harvest losses whenever they are significant.
Eliminate any unintentional short-term capital gains (those not the result of acquisitions).
Create wider buy and hold ranges to reduce turnover.
Preserve qualified dividends, which are taxed at lower rates. A fund must own stock that earns dividends for more than 60 days of a prescribed 121-day period. That period begins 60 days prior to the ex-dividend date.
Limit securities lending revenue to the expense ratio.
4. Multiple Value Screens
Academic research on stock returns has documented that value stocks historically have outperformed growth stocks. We see the higher returns to value stocks in almost all countries. Not only has value outperformed growth, but the persistence of its outperformance has been greater than the persistence of stocks outperforming bonds.
Many different metrics can be used in implementing a value strategy. Among the most common are price-to-earnings ratio, price-to-sales ratio, price-to-book value ratio, price-to-dividends ratio and price-to-cash flow ratio. The various metrics all produce results showing that value stocks have had higher returns than growth stocks. And the various measures produce similar results (with the weakest results coming from the price-to-dividend ratio).
Given the similarity in results, price-to-book ratio has been the most widely used because book value is more stable over time than the other metrics. That helps keep portfolio turnover down, which in turn helps keeps trading costs down and tax efficiency higher. Recently, some passively managed funds have moved away from a single-screen metric because research indicates that using mul
tiple screens produces better results. Part of the reasoning is that price-to-book ratio can work well as a value metric in some industries/sectors, but not in others. With this in mind, it could make sense to use multiple value metrics instead of sorting exclusively by price-to-book. Another reason is that different value metrics (such as price-to-earnings, price-to-cash flow and price-to-EBITDA), while highly correlated, are not perfectly correlated. Thus, the use of multiple value metrics provides a diversification benefit. A third benefit of multiple metrics is that value measures such as price-to-cash flow offer more exposure to the profitability and quality factors, increasing factor diversification and helping to avoid “value traps” (stocks that may look cheap on a price-to-book ratio basis, but could be overvalued).
5. Securities Lending
Securities lending refers to the lending of securities by one party to another. Securities are often borrowed with the intent to sell them short. In the international markets, another reason for securities lending has to do with exploiting the foreign tax credit. Thus, the opportunities to add value are greater in foreign markets. As payment for the loan of the security, parties negotiate a fee. Some mutual funds are more aggressive than others in this area.
The following example demonstrates why it is a mistake to only look at a fund’s operating expense ratio. Let us assume that Fund A has an expense ratio of 55 basis points and generates 40 basis points in securities lending fees that are credited to the fund (not the fund manager). Thus, we might consider the fund’s “net” expenses to be 15 basis points. Fund B in the same asset class has a significantly lower expense ratio at 35 basis points. However, it generates just 12 basis points in securities lending fees. Thus, its “net” expenses of 23 basis points exceed Fund A’s “net” expenses of 15 basis points. Securities lending revenue data is available in the mutual funds’ annual reports.
6. Core Funds
Core funds combine multiple asset classes into a single fund. Fund managers developed the core approach because it is the most efficient way to hold multiple asset classes, especially for taxable accounts. The following example will demonstrate why this is the case.
The Russell 3000 can be broken down into four components: the stocks that make up the Russell 1000 Growth Index, the stocks that make up the Russell 1000 Value Index, the stocks that make up the Russell 2000 Growth Index and the stocks that make up the Russell 2000 Value Index. We have seen institutions hold all four components in exactly the same market-cap weighting that the Russell 3000 holds them. In other words, they owned the same stocks, in the very same proportions, as the Russell 3000—only in four funds instead of one. This makes no sense because when the indices reconstitute each June, each of the four component index funds will have to sell the stocks that leave its index and buy the stocks that enter its index. That incurs transaction costs, which can be particularly large when the entire market knows you have to trade, and especially large for small-cap stocks. In addition, if a stock moves asset classes from value to growth or vice versa, this could mean that one component index fund you own sells the stock only to have another component index fund you own buy it. The benefits of owning the single fund are obvious.
Now consider an investor who owns four component U.S. index funds, a large company fund, a small company fund, a large value fund and a small value fund. A single fund that held the same stocks, in the same proportions, would be a more efficient approach. Dimensional Fund Advisors (DFA) has created core funds with various degrees of “tilt” (meaning they depart from market-cap weightings) to small-cap and value stocks. The benefits are reduced turnover—which reduces transaction costs and the realization of capital gains—and the minimization of the need for investors to rebalance. (The fund itself rebalances using dividends and cash flows.) Each of these can provide significant benefits, especially for taxable accounts.
Another example of a core fund is the Vanguard Total International Stock Index Fund (VGTSX), which combines holdings in developed and emerging markets. This is a significant improvement for investors who previously would have had to hold the two components separately. A single fund will avoid having to sell and buy stocks from a country that migrates from an emerging to a developed market, as Israel did recently and South Korea and Taiwan are expected to do. This not only minimizes transaction costs in markets where they can be quite high, but it also avoids, or at least minimizes, the realization of capital gains. It also eliminates the need for investors to rebalance the portfolio, yet again helping them to avoid trading costs and the realization of capital gains. The fund itself rebalances with “other people’s money,” using cash flows and dividends.
Core funds are just another example of how financial engineering can add value through structuring portfolios, without trying to add value (with low odds of success) by generating alpha from stock-picking or market-timing strategies.
Summary
As author John Ruskin explained: “Not only is there but one way of doing things rightly, but there is only one way of seeing them, and that is, seeing the whole of them.” While certain funds may be the cheapest in terms of expense ratios, when evaluating similar passively managed mutual funds, it is important to consider not only the operating expense ratio, but also all the ways a fund can add value. A little bit of extra homework can pay significant dividends.
Appendix E: Enough
To know you have enough is to be rich.
—The Tao Te Ching
Author Kurt Vonnegut related this story about fellow author Joseph Heller: “Heller and I were at a party given by a billionaire on Shelter Island. I said, ‘Joe, how does it make you feel to know that our host only yesterday may have made more money than your novel Catch-22 has earned in its entire history?’ Joe said, ‘I’ve got something he can never have.’ And I said, ‘What on earth could that be, Joe?’ And Joe said, ‘The knowledge that I’ve got enough.’”
What Heller was saying was that you are rich when you know you have enough. Of course, everyone’s definition of “enough” is different. From the perspective of an investment plan, how you define enough is of great importance because it defines your need to take risk—the rate of return you require to achieve your financial goals. The more you convert desires (what might be called “nice-to-haves”) into needs (“must-haves”), the larger the portfolio you will need to support that lifestyle. And the more risk you will need to take to achieve that goal.
Those with sufficient wealth to meet all their needs should consider that the strategy to get rich is entirely different from the strategy to stay rich. The strategy to get rich is to take risks, and concentrate them, typically in one’s own business. However, the strategy to stay rich is to minimize risk, diversify the risks you do take, and to avoid spending too much. In other words, if you have already won the game—meaning you have a large enough portfolio to meet all your needs—it is time to change your strategy and develop a new investment plan. The new plan should be based on the fact that the inconvenience of going from having enough to not having enough is unthinkable.
When deciding on the appropriate asset allocation, investors should consider their marginal utility of wealth—how much any potential incremental gain in wealth is worth relative to the risk that must be accepted to achieve a greater expected return. While more money is always better than less, at some point many people achieve a lifestyle with which they are very comfortable. At that point, taking on incremental risk to achieve a higher net worth no longer makes sense: The potential damage of an unexpected negative outcome far exceeds the potential benefit gained from incremental wealth. The utility curve in the following chart illustrates this point.
Each investor needs to decide at what level of wealth their unique utility of wealth curve starts flattening out and bending sharply to the right. In the preceding example, that point is about $10 million. For you, it might be $500,000 or $1 million. There is no one right answer. Just an answer that is right for each individual. However, whether the figure is $1 m
illion or $50 million, beyond this point there is little reason to take incremental risk to achieve a higher expected return. Many wealthy investors have experienced devastating losses (does the name Madoff ring a bell?) that could easily have been avoided if they had the wisdom to know what author Joseph Heller understood.
A lesson about knowing when enough is enough can be gleaned from the following incident. In early 2003, Larry met with a 71-year-old couple with financial assets of $3 million. Three years earlier, their portfolio had been worth $13 million. The only way they could have experienced that kind of loss was if they had held a portfolio almost all in equities and heavily concentrated in U.S. large-cap growth stocks, especially technology stocks. They confirmed this. They then told him they had been working with a financial advisor during this period—demonstrating that while good advice does not have to be expensive, bad advice almost always costs you dearly.
Larry asked the couple whether any meaningful change in the quality of their lives would have occurred if, instead of their portfolio having fallen almost 80 percent, it had doubled to $26 million. The response was a definitive no. Larry then noted that the experience of watching $13 million shrink to $3 million must have been very painful, and that they probably had spent many sleepless nights. They agreed. He then asked why they had taken the risks they did, knowing the potential benefit was not going to change their lives very much, but a negative outcome like the one they experienced would be so painful. The wife turned to the husband and punched him, exclaiming, “I told you so!”
Some risks are not worth taking. Prudent investors do not assume more risk than they have the ability, willingness or need to take. The important question to ask yourself is: If you’ve already won the game, why are you still playing?
Reducing the Risk of Black Swans Page 13