It’s About Time II

I have shared with many of you, stories of my brief experience as a stockbroker for a major wire house back in the mid 80’s.  My experience was brief because it was apparent, from day one, that the lack of ethics and the exploitation of investors were ingrained in the firm’s culture.  My favorite “take away” from the many “sales meetings” was:  “if you can’t sell it with a clear conscience, we will find someone who can.”  (By the way, these sales meetings were always held in the basement far from the ears of customers.)  There were other cultural rules to be followed but the message was always clear, I was there to make money for the firm.  I was not there to provide investment advice, even if that was the advertised role of the broker.  It was apparent investors needed an alternative.

Fortunately investors do have a better alternative today, the “fee-only advisor.”  Being a part of the development of this new profession I came to know a great number of this new breed and many of them were “converts” from the “dark side” as I love to call it.  This conversion was easy because they had a conscience and wanted to work with a “clear conscience.”  As the years went by, I would hear stories about their experiences on the “dark side,” and they would always tell me that their experiences were similar to mine even if it was 10, 15, 20 years later.  In other words, nothing has really changed.

Thanks to research conducted by some folks at the University of Notre Dame you don’t have to take my anecdotal evidence that the Wall Street culture has not changed.  I came across this from a New York Times article yesterday summarizing the research.  Over 1400 Wall Street employees participated in the confidential survey.

You can and should read the survey but here are a couple of highlights:

1.    Of those earning more than $500,000 annually, 34% have witnessed, or had first hand knowledge of, wrongdoing in the workplace.

2.    51% of these folks believe their competitors are engaged in unethical or illegal activities to gain an edge in the market.

3.    32% of employees with less than 10 years experience would likely use non-public information to make a guaranteed $10 million if there was no chance of getting arrested for insider trading.  So much for a new breed of stockbroker.

4.    Nearly one third of respondents believe the compensation structure could incentivize employees to compromise ethics or violate the law.

There is more but you get the idea.  But here’s the kicker, the reporter writing the article was trying to make the point that Wall Street has not learned its lesson, even after the last recession.  I disagree; Wall Street learned its lesson decades ago.  Keep politicians, who make the laws, beholden to you while they are in office, and reward them, after they leave office.  Wall Street has no incentive to change the culture.  There is too much money to be made.  No one ever goes to jail and the billions in fines are insignificant relative to their bottom line.

Note:  nytimesdealbookmay182015

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It’s About Time

The death of “conflicted investment advice” may be at hand.  When commissions were banned in both the U.K. and Australia, I applauded their Regulators, who took a stand for investors against the Financial Industries in their respective countries.  It was a long time coming but it is now a reality.

Having witnessed these developments I began to speculate whether or not such a ban could ever be implemented in the U.S.  Being aware of the strong financial ties between Wall Street and politicians of both parties, I have been skeptical that such reforms could ever become law in the U.S.

However the debate has begun.  The arguments against banning commissions are twofold:

1.    “The small investor will be left out of the advice market.”  Excuse me?  That should be one of the main objectives of any legislation.  Small investors are exploited more than others because they are sold the products with the highest commissions.  Otherwise it is not worth the sales person’s time.  Once people realize they are being ripped off, they will be motivated to invest some time learning how to invest their savings.  I used to say, if people would spend as much time making investment decisions as they do when making decisions about which car to buy, they would have a much better investment experience.

2.    “Thousands of jobs will be lost in the Financial Services Industry.”  This brings back memories of when I would write about “conflicted advice” in Investment Advisor Magazine.  I would get emails (maybe it was “hate mail”) accusing me of destroying the sender’s career.  My response would be, “if your career is based on ripping people off, perhaps a new career may be needed.”

Both of these arguments are what I would expect.  They put the Financial Services Industry’s interest ahead of the investors’ interest.  Wall Street is not going to roll over without a fight.  There is too much money at stake.  Rather than simply ban commissions, they will likely settle for a slight tightening of the rules regarding their fiduciary responsibility that requires them to put the investors interest first and no doubt the training syllabus for new brokers will include a course on “how to comply with the law while still maximizing commission income.”  If that is all the reform does, enforcing such a rule will be cumbersome and expensive.

Simply banning commission would be a much more effective way to protect investors and be a lot less expensive to all parties involved.

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Hedge Funds

One of the supposed benefits of investing in a Hedge Fund, is the opportunity to make money in both up and down markets.  This goal is appealing to two types of investors.  First, those who do not have the discipline to stick with a “buy and hold” strategy and secondly, it’s alluring to those who believe in “magic.”

With Hedge Funds, transparency is limited, but this lack of transparency is widely accepted by Hedge Fund investors.  Perhaps it’s because it’s hard to believe in “magic” if the data shows that there is no “magic.”  There is however, enough data to show that the collective performance of hedge funds over the past 10 years, falls short of market rates of return that are easily earned with index funds and other passive strategies.

The standard pricing structure of a Hedge Fund, that is 2% per annum, plus 20% of any gain, seems to be acceptable to those using Hedge Funds.  Do the math:  An investment of $1 billion in a Fund that earned 10% would yield a fee of $40 million.  It’s absolutely ludicrous.  But in spite of this fee structure, the Hedge Fund industry continues to grow, as does the wealth of the Hedge Fund managers.  It is not unusual for a successful Hedge Fund manager to take home over a billion dollars in one year.

So are these Hedge Fund billionaires bad guys?  Not really, there are just very good at moving other people’s money into their own pocket.  And who are these “other people?”  Hedge Fund investors fall into three groups:  Wealthy individuals, Pension Plan sponsors, and those managing University Endowments.

It may be foolish to invest in Hedge Funds but wealthy investors can do whatever they like.  After all, it is their money.  But the last two, Pension Plan sponsors and Endowment committees, are managing “other peoples money.”  The money in Pension Plans belongs to current and former employees, not those making investment decisions, and if Endowment Funds underperform, students and others will be asked to make up the difference.

My former colleague, Rex Sinquefield, once said that Hedge Funds are “Mutual Funds for stupid people.”  That’s a bit harsh, but perhaps Pension Plan sponsors and members of the Investment Committee of Endowment Funds are not stupid, they just fail to understand and/or they refuse to accept the Fiduciary responsibility they have when investing other people’s money.  It may not be their money but it must be quite an ego trip to have control over how the money is invested.

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Looking For Feedback

When working at DFA I always surrounded myself with individuals who shared my passion for moving investors away from active management and for creating an advisor/investor relationship sans the conflict of interest.  You advisors know most of these individuals, including Sam Adams, who led the “charge,” so to speak, in both Europe and Australia.

Sam, along with many advisors and their clients, is passionate about “sustainability.”  He left DFA recently with a goal of creating a family of “sustainable funds” that advisors could use to deliver the capital market rates of return across different asset classes.  Sam has done a lot of work on how to accomplish this but it is more than I can spell out with this post.

Currently, the market is dominated by expensive, actively managed funds, with multiple “social goals” making proper diversification a challenge for advisors and their clients.  And I agree with Sam that the “environmentalist movement” has the investment message all wrong.  The doom and gloom story is not the way to go.  Market forces and technology will create the solutions.

So here is what I am asking.  Let Sam and/or me know what you think.  We believe it’s a win/win for investors and the environment and we are trying to determine whether or not the demand is strong enough to make the funds themselves “sustainable.”

You can email Sam at: sam@vertasset.com

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Shooting Par

I have commented in the past about my passion for golf and how simple it is to be a successful investor versus the challenges of being a successful golfer. As those of you who play golf know, very few non-professional golfers are able to shoot par. It is extremely difficult. You’ve all heard the expression “that’s par for the course” used to describe a common expectation about virtually any endeavor or situation we might experience. But, when it actually comes to golf, expectations are far less than par. If I went to my golf lesson today and my instructor told me he had discovered a simple way to shoot par, I would be ecstatic and embrace his advice immediately. Unfortunately I know that’s not going to happen.

When it comes to investing however, it’s a different story. For me “par” is the “market rate of return.”  And unlike golf professionals, “professional money managers” find it very difficult to “shoot par.”  Fortunately, you as an investor, can easily shoot par. If you’re not convinced, find an advisor that is “shooting par” and they will teach you.

Before accepting “passive investing” and realizing it would make me a “par investor,” I shot way too many “bogies” using active management. But “Wall Street” wants you to believe they can shoot par (or better) but unfortunately, they are like the weekend golfer, who will continue to shoot bogies no matter how hard they try to make par. Your golf bogies may create a great deal of frustration as they show up on your golf scorecard. But it is nice to know that the “professional money manager’s” bogies are not going to show up on your “investment scorecard.”

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Diversification—“Fidelity’s Buddy”

Over the years I have often quoted Nobel Laureate, Merton Miller, stating that the only thing we know for certain about investing is that “diversification is your buddy,” valuable insight for every investor.  However, diversification can also be used in a manner that can be very harmful to investors.

Last week there was a full-page ad in Bloomberg Businessweek extolling the great long-term performance of their Fidelity Low Priced Stock Fund.  There is no question that an investor in this fund would have done very well.  Hence, Fidelity will invest their advertising dollars to promote the results.

This is where Fidelity’s “diversification strategy” comes into play.  Fidelity manages and offers 185 different funds.  They have funds representing virtually every  “sector” (asset class) of the market.  In other words, they are well diversified with their offerings.  No matter which sector of the market does well, Fidelity has a fund with great performance numbers.

This makes the advertising decisions at Fidelity very simple, “push” the winners.  And, if you have that many funds you will, by definition, have great performing funds to push.  I have to admit it’s a very clever strategy.

It reminds me of the advice I used to give my clients for “cocktail party investment talk.”  When someone starts to boast about owning this or that hot stock, they could always respond with “I own it too.”  Why?  My clients were diversified to the point of owning an interest in virtually every publically traded company around the globe.  All the winners!  (But also, all the losers.  No need to disclose that to anyone.)  So don’t expect Fidelity to spend any advertising dollars pushing their poor performing funds.

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The “Experts” Have No Clothes

I hope you had a great “holiday season!”  No complaints here as we head into 2015 without a clue as to where the market is headed.  I have an opinion regarding such matters but as I always say, “god forbid that I would ever make an investment decision based on that opinion.”  But being clueless doesn’t stop the “experts” who make a living, gazing at their crystal ball.

Once again, they are riding into the new year, wearing no clothes.  It’s the same story every year, but for many investors, the fairy tale about successful active management, never gets old.  For them, the future is simply too scary, without a forecast.

For the past 25 years I have been documenting the failure of these experts and teaching people the “good news” that an accurate forecast is not required to have a successful investment experience.  Back in the beginning I would simply make xerox copies of the annual December articles publishing the experts’ forecasts for the coming year. Twelve months later, usually at our annual holiday party, we would look at the results.  It was a great way to debunk the myth, of successful active management, and to celebrate the superior returns of a simple diversified and disciplined strategy.

Most advisors I know use their own version of this annual ritual to drive the message home and thanks to all the advances in technology, gathering the data is so much easier.  In the past, I had to save copies of all the December issues of each publication in order to document the results each year.  But now there is a very inexpensive app that enables anyone to download past issues.  It’s called Next Issue.  Reading the “Where to Invest In the Coming Year” 12 months after they were published is not only entertaining, it’s very enlightening.

And for those of you who still have faith in the experts to make an accurate forecast, check out what has happened this past few months to the price of oil.   Now go back to the beginning of last year and see what the experts were forecasting.  It doesn’t mean these experts are dumb, it simply shows how difficult it is to know the future.  That is what creates so much uncertainty for investors, and the only way I know to deal with that uncertainty is to be as diversified as possible and to stay disciplined.  It really is that simple.

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