Would you buy this fund?

Let's go back to the early part of this decade, to the year 2000. Let's consider the experience of a well-known value oriented mutual fund. Providing this example, gives us further evidence of our investment philosophy and the frustrations that investors who try to identify "the best mutual funds" continually face.

In the year 2000, the dot.com bubble was bursting and funds such as this were clearly out of favor. The hot funds were growth funds. Everyone wanted tech funds. Many investors were withdrawing money from this fund. So while the fund was experiencing massive investor withdrawals in 2000 and 2001, the fund returned approximately 26% in each of those two years, far outperforming the S&P 500 by 35% and 38% respectively.

So, in early 2002, if you'd gone to an adviser, he may have looked at the recent track record and advised you to invest in this fund, based on its past few years performance. The fund was considered a mid cap value fund, and was one of the tops in its category.

Great decision, right? In 2002, the fund was in the 48th percentile and exceeded its category benchmark by 2%. Things get worse. For the next five years, the fund underperformed its benchmark during every year between 2003 until 2007. Its category percentile rankings, starting in 2003, were 70%, 83%, 60% and 62% (1% being the best). And finally in 2007, the fund's performance was in the 99th percentile of its category. So much for that great strategy in early 2002 to jump right in.

So by the end of 2007, when the S&P made approximately 5%, and this fund lost 14%, I'm sure that you and your advisor, along with many other investors, were heading for the hills and withdrawing your money to look for the next great fund. How much underperformance can you take? Isn't five years enough to show that this fund doesn't have what it takes?

But then in 2008, the fund loses approximately the same as the S&P 500, around 36%. However, that puts it in the 28th percentile of its new "large blend" category. Then in 2009 it earns over 52%, while the S&P 500 only earned approximately 26%. The fund was in the top 2 percentile of its category for the year. So if you jumped ship and pulled money out after its poor performance in 2007, now must be the time to get back in, right? How can you possibly know?

Through this volatile decade, even with five straight years of significant "underperformance," the fund is ranked in the top 2 percentile for large blend funds, for the past 10 years, as of the end of 2009. Incredible?

Reviewing this shows the challenges of trying to identify the best actively managed funds out of the thousands of funds that are available. How can an investor know in advance, which fund will outperform others? Answer: you can't! And that is why we don't even try to play this game.

We would rather utilize a strategy that relies on investing in specific asset classes, rather than relying on the judgment of a mutual fund manager, which may go in and out of favor.

The fund in this illustration is actually the Oakmark Select fund, which I had personally invested in during the 1990s, prior to entering this business. I highly respect its manager, Bill Nygren, and their firm's value investment philosophy. I still learn a great amount from reading his quarterly investment commentaries. They diligently adhere to their strategy, but it has resulted in a roller coaster, in terms of annual performance, when tracked against comparable funds.

For our clients, we feel that purchasing mutual funds that do not make huge bets on specific companies or industries, will in the long run, provide them with a better investment experience. We would rather build a globally diversified portfolio that is not reliant on the judgment of a few individuals, as we cannot predict how successful they will be. And I don't think that you can predict that either.

Source: Morningstar.com

Firm News: New Credentials

We are pleased to announce that both Brad Wasserman and Keith Rybak received designations as Personal Financial Specialists (PFS), during March 2010.

This designation, which can only be acquired by CPAs, requires a minimum of 3,000 hours of financial planning experience, in addition to extensive continuing education requirements and passing a rigorous examination. As CPAs, this credential represents the highest professional standard of any financial planning credential and sets the PFS holder apart from other financial planners.

The PFS credential was established for CPAs who specialize in personal financial planning, and is awarded exclusively to AICPA members who demonstrate considerable experience and expertise in this area. Currently, the AICPA has granted only 3,800 PFS designations throughout the country.

We are proud to have earned this new designation, as it reflects our extensive experience, which has benefited and will continue to benefit our clients in the future.


Source: AICPA.org

Goldman Sachs Lawsuit: Understanding and Implications

On Friday, Goldman Sachs was accused of wrongdoing in a SEC civil lawsuit of fraud. Let me explain, by way of an analogy, what is alleged in the SEC suit. Please note, this is not intended to be a full analysis of lawsuit, only a general explanation intended to help readers of this blog understand some of the issues of this case. These are allegations only and no parties have been proven guilty at this time.

Let's say the general manager of a baseball team wanted to place a bet in Las Vegas on a baseball game (not legal, but assume it is and follow along). The GM, John Peters, wanted to place a bet against his own team, the Phoenix Mortgages. He went to his manager, A. Choosy, who was preparing the line up. Peters worked with Choosy to put forth the least desirable team of his 25 ball players. Choosy benched the starters for that day and turned in his line up card. Choosy, with Peters' assistance, started the worst pitcher on the Mortgages for this game.

Peters then went to Las Vegas. He bet $1 Billion that his team, the Phoenix Mortgages would lose the game. When placing the bet, Peters did not disclosure to the casino (professionals at what they do, which is accept bets and wagers) that Peters had helped to select the players involved in the game. However, the casino are professionals and are supposed to be experts at these type of transactions.

You know the outcome. The Phoenix Mortgages lost the game, as the worst players were selected to participate in the game. The casino lost their $1 Billion. Peters however, made out very well, winning $1 Billion.

How does this relate to the Goldman Sachs SEC lawsuit? A hedge fund investor, John Paulson (ie John Peters) thought that the subprime mortgage market was going to do poorly. He went to Goldman in 2007 and requested their assistance in preparing a pool of mortgages, so he could "bet" against them. The suit alleges that Paulson helped to select the mortgages, and tried to find the worst quality ones he could find. Thus, he helped to prepare the lineup card he was going to bet against.

Goldman, per the SEC lawsuit, then went to other experienced, professional institutional investors (not individuals) and sold them the $1 Billion + pool of mortgages, without disclosing that Paulson helped to structure and select the mortgages. They also did not disclose to the investors of the mortgage securities that Paulson was placing a bet against them (or in my example, Peters did not tell the casino that he had been involved in selecting the players for the game). The institutional investors who purchased the pool of mortgages were provided with details of the mortgages, and one of the major investors was also involved in the selection of the mortgages (as a casino would be involved and study a baseball team, before it sets the "spread" of a given game).

In my analogy, the baseball game was over quickly and the bet was won in no time. In the real world, Paulson's bet was won pretty quickly as well. This deal closed on April 26, 2007. Paulson's hedge fund paid Goldman $15 million to structure "Abacus" (the name of the pool of mortgage securities). By October 24, 2007, 83% of the mortgages had been downgraded and by January 28, 2008, 99% of the portfolio were downgraded. Investors in Abacus had lost $1 Billion and Paulson's hedge fund was ahead by $1 Billion.

As investors, this is again a reminder of many concepts. As your financial advisors, we have a fiduciary responsibility to act only in your interest (our interests are aligned with yours). We feel it is important to understand what you are investing in. We do not invest in hedge funds or exotic investment products. We understand the philosophy of the mutual funds that we utilize and they are very transparent about their holdings and actions.

Sources: Wall Street Journal, April 16, 2010; SEC Complaint filed April 16, 2010

Note: this post was updated on 4/19/10, based on Goldman Sachs' third statement regarding this matter, particularly noting that the investors in this transaction were "two professional institutional investors." Source: Goldman Sachs statement dated April 19, 2010

Putting Volatility into Perspective: It's better than you think

The US stock market has seen two very dramatically different years in 2008 and 2009, as 2008 was the worst second worst calendar year in 84 years and then 2009 was one of the best years.

As we base our investment decisions on academic data, principles and discipline, and not predictions of the future, the data below is very helpful to gain a long-term view of market performance and put recent market volatility in perspective.

The following is a review of the total US stock market (defined as all stocks on US stock market exchanges, but not international markets) from 1926 to 2009. The data below shows the number of years that each investment return occurred, for the overall US stock market:

Loss 50% to 40%:........ 1
Loss 40% to 30%......... 2 (including 2008)
Loss 30% to 20%......... 3
Loss 20% to 10%......... 8
Loss 10% to 0%........... 8

Gain 0% to 10%.......... 15
Gain 10% to 20%........ 13
Gain 20% to 30%........ 19 (including 2009)
Gain 30% to 40%........ 11
Gain 40% to 50%.......... 3
Gain 50% to 60%.......... 1 (1933, just in case you were wondering!)

Observations:

Positive v. negative years: There were 62 positive years and 22 negative years. Thus, 74% of the calendar years were positive.

Not just positive, but better: Not only were there many more positive years, but the positive years were concentrated with performance in the higher ranges of returns.

Randomness: I have not presented the year by year data in this blog, but the returns have no sequential pattern. Thus, the ability to predict future performance by an investor or mutual fund manager would not be assisted by this data.

Staying the course: Over time, investors have been rewarded by remaining invested in the US stock market. They will have to endure down years or periods of years, but should be rewarded for remaining committed and disciplined through those down years.

We work with our clients to educate them, so they can remain disciplined in bad and good markets. Establishing an asset allocation of stocks that is in line with your risk tolerance will lead to the ability to stay the course, remain invested as appropriate for you and your family, and which will hopefully provide you with positive stock market returns that occur over the long term.

Note: The above information is based on US stock market performance. We generally recommend that a significant portion of our clients' stock investments be allocated to foreign markets, which is not included in the above information. We think the conclusions as stated above would be the same, if they were to include foreign stock market data. Further, adding foreign investments generally results in improved diversification, which lessons the volatility of an overall investment portfolio, which would lead to increased returns over time.


Source: Center for Research in Security Prices (CRSP), University of Chicago

Wealthy Thoughts - 1

Collection of thoughts and ideas about various things....


Apple stock "started at Outperform" This was the headline in the Wall Street Journal online edition on 3/31/10, citing a stock recommendation by a French brokerage firm, Exane BNP Paribas. Everyday, brokerage firms make recommendations like this. It caught my eye, as Apple stock has risen incredibly over the past year, from the $80s to $235 per share. So after this terrific rise in the share price, why are they predicting it to outperform now?

Apple certainly has great prospects and is a great company, but wouldn't this have been a lot more helpful at $80 or $150 per share? This is why we find little value in brokerage firm recommendations. It is hard to accurately predict the future, and very few, if anyone can do it accurately over a long period of time. That is why we follow a different investment philosophy, which is not founded in brokerage firm "predictions" about the future.

Record Retention: There was an excellent article in the New York Times, dated 3/31/10, which accurately provided guidelines for record retention rules for tax and other documents. If you have any questions on this topic, please contact us. The article is: "Retain your Records No Longer Than You Must," by Jennifer Saranow Schultz (see nytimes.com)


Vanity Fair Magazine: This magazine has become a must read for me, as during the past years they have added a number of terrific financial writers, particularly Michael Lewis, who have provided excellent analysis of world economic events, major individual players in Washington and New York, as well as prominent book excerpts on these topics. If you want more in depth information about these topics, I highly recommend you review this magazine. I'll leave it up to you if you want to pay attention to the numerous fashion ads.

"Bonds Cap Epic Comeback" This was the leading headline that blared on the top of the 3/31/10 Wall Street Journal. But the much more important question, which I've written about extensively, is what will the future hold for bond fund investments?

The article states that investors "poured a record $375.4 billion into bond mutual funds during 2009, while pulling out $8.7 billion from stock funds, according to data compiled by the Investment Company Institute." (a mutual fund trade organization)

We think this is a huge error by investors, as when interest rates rise (which they will do eventually), these investors will face dramatic losses in these bond fund investments.

Our advice to you is as follows: If you have significant bond fund holdings, please contact us immediately and we would be pleased to review these investments, to discuss why this is a bad strategy and what we would advise as a solid alternative.

If you know someone else who has large bond fund investments, do them a favor for which they will be very grateful and have them contact us, and we will review their holdings and advise them appropriately.

This is the next big mistake in the financial world. This is not an if, but a when.

Truly Free Credit Reports and Gift Card Law Change

Free Credit Reports and Why You Should Do This (at least annually)

The only truly free website to obtain a free credit report is: http://www.annualcreditreport.com/. This site is governed by the Federal Trade Commission (FTC). You may also call 877-322-8228.
Beginning April 1, 2010, other websites offering credit reports must clearly indicate in a box the above information. This site will provide you with a link to get your credit report and you will need to answer a number of personal questions, for identification purposes.

The Fair Credit Reporting Act guarantees consumers access to their credit report information from each of the three credit reporting companies, once per year, for free. The best and only way to ensure that you are getting this information for free is to use the above website, http://www.annualcreditreport.com/.

The 3 major credit reporting agencies are Experian, Equifax and TransUnion. Using the above website, you are entitled to one report from each company every 12 months. You can obtain a free report from all three at one time, or order them one at a time, at various times during a 12 month period.

There are many companies that offer credit reporting services and most will charge various fees, along with the "free credit report." You should be careful of such services. While they may provide you with valuable services, you should not have to pay for the above credit report. Note that this free credit report is not your "credit score," which is the basis for most lending, such as mortgages and credit cards.

We recommend that you request your free credit report information from each of the 3 companies at different times during the year, not all 3 at once. This is recommended to monitor if the information maintained is accurate and to spot identify theft. You have the right to inform the agencies if you note any errors.

If you want to purchase an additional credit report, for up to $10.50, you can contact each agency as follows:
Equifax: equifax.com, 800-685-1111
Experian: experian.com, 888-397-3742
TransUnion: transunion.com, 800-916-8800

Source: Federal Trade Commission, www.ftc.gov/freereports


New Gift Card Rules: The purpose of the new rules is to prevent service fees on gift cards unless the consumer has not used the card (or gift certificate) for more than one year. The consumer cannot be charged with more than one fee per month and the fees must be clearly disclosed.The Federal Reserve released the rules on March 25, 2010, which go into effect on August 22, 2010.

Expiration dates for gift cards must be at least 5 years after issuance, or five years after funds were last loaded. These rules are for retail gift cards or network branded cards, like Visa gift cards.

The new federal laws will override any state laws that are not as beneficial to the consumer.

Source: Journal of Accountancy, March 25, 2010, "Fed Issues Final Rules on Gift Card Fees, Expiration Dates"

Fiduciary Standard: Why this matters so much

We make a great effort when working with our clients that they understand their investments and the rationale that supports our investment philosophy. We feel this education is important and a vital part of our relationship.

In some discussions, we are asked how are we different than the "typical broker," such as Merrill Lynch or Smith Barney. There are many answers to this question. In this post, I want to focus on an important distinction that is based in law, but I think really comes into practice regularly and has significant consequences to investors.

We are legally established as a "Registered Investment Advisor" and must adhere to a "fiduciary responsibility." Brokers are subject to a lesser standard, called a "suitability rule." This topic was addressed in a New York Times article dated February 28, 2010, which I will use to explain these differences.

"Registered financial advisers...adhere to a higher standard - "fiduciary responsibility," an ethical and legal requirement that the investor's best interest comes first, not the adviser's own financial gain...Rooted in trust law, that standard means that an advisor has to act impartially and solely for the benefit of the client, avoiding conflicts of interest and self-dealing."

"Brokers are governed by the suitability rule, which requires them to have "reasonable grounds for believing that the recommendation is suitable, according..." to industry standards. "They are not obligated to get you the best price for what they advise you to buy or sell - or even to be free of conflicts."

"What may matter more than the array of services is the mind-set of the adviser. When a broker tells a client to buy or sell something, the suitability rule does not mean the broker has to be free of conflicts of interest. After all, the broker's salary is ultimately paid by the brokerage firm, which has various products to sell. But brokerage firms say they are trying to eradicate that appearance of conflict."

We take this obligation very seriously and it is the core foundation of our firm. We will only act in our client's interest.

As an example, we recently reviewed a statement on behalf of a client, who also has some investments with a major Wall Street firm. The other broker sold a high quality municipal bond, which was to mature in a year, and purchased a bond that was rated as much riskier, based on the rating agency's credit rating. Upon further research, the new bond that was purchased was underwritten by the same Wall Street firm. Thus, it appears that the only reason for the sale and purchase was to support the firm's bond underwriting efforts. Was this broker acting in the client's best interest or his firm's best interest?


Source: New York Times, "Broker? Adviser? And What's the Difference?", February 28, 2010