ASCEND INVESTING An Evidence-Based Investment Approach
A White Paper by:
Letter from the President Because I believe that informed investors are better investors, I’m very pleased to present Ascend Investing to clients and prospective clients of Ascend Wealth Management. This White Paper provides an introduction to our investment approach—and a basic roadmap—to construct highly efficient portfolios designed to grow and preserve wealth. Our investment strategy is based on a career dedicated to investment research and decades of empirical and academic studies, much of it the subject of Nobel Prize-winning research. The benefits of this approach are deeply rooted in scientific evidence, rather than Wall Street’s marketing hype. As a fee-only, independent wealth management firm, we strongly believe that all investors deserve a fiduciary level of care when putting their hard-earned money to work in the capital markets. We know that investing should be rewarding and the best investments are bought, not sold. For that reason, Ascend Wealth Management does not rely on transactions, nor do we accept commissions. Our choice of investments is based solely on the quality of the offering. Our focus is on real wealth creation for you and your family. As your trusted financial advisor, our passion is helping you make smarter investment decisions. We hope you enjoy learning about our investment approach, and we stand ready to help you achieve your goals. Sincerely,
Mark Bourguignon President Ascend Wealth Management Inc.
700 Larkspur Landing Circle, Suite 199, Larkspur, CA 94939 ph: 415-569-7909 email: firstname.lastname@example.org www.ascendwealth.com
Table of Contents Letter from the President..............................4
1 Introduction...........................................................................5 2 The Markets Work.....................................................6 3 Reduce Your Investment Costs..............9 4 Focus on Asset Allocation..............................10 5 Achieve Proper Diversification..............13 6 Always Pay Attention to Taxes...............17 7 Rebalance When Necessary......................17 8 Stay The Course............................................................18 9 Conclusion...............................................................................20 About The Author.........................................................20 Ascend Wealth Management.....................21 Data Appendix...................................................................21
1 Introduction When investing in the capital markets, the majority of investors experience disappointing results. This can be attributed to a variety of factors including high costs, lack of discipline, or confusion about what really matters—or all of the above—in order to achieve superior investment returns. At Ascend Wealth Management, we believe that there’s a better way to invest. We practice a disciplined, evidence-based approach to investing that is based on rigorous academic research and Nobel Prize-winning investment strategies. By applying financial science across globally diversified investment portfolios, we seek to build wealth without speculating or taking unnecessary risks. Instead, we focus on what we can control—asset allocation, risk mitigation, cost reduction, portfolio structure, diversification, tax efficiency, and rebalancing—in order to deliver a better personal experience and better investment outcomes for you. The Ascend Wealth Management investment approach embraces these cornerstones: 1. We customize and manage risk-appropriate investment portfolios so you can maintain consistent exposure to the markets. 2. We minimize your investment costs, including fees, commissions and taxes. 3. We structure your portfolio to target areas of the market that have higher expected returns. 4. We utilize broad and global diversification among uncorrelated assets to minimize underperformance and risk. 5. We maintain a total-return discipline to minimize taxes and increase what’s available to invest. 6. We adhere to a systematic rebalancing strategy in order to control risk and capture higher return opportunities. 7. We deliver our services in a transparent, conflict-free manner that keeps you informed and invested for the long term.
2 The Markets Work Every day, the capital markets facilitate an average of more than 100 million trades on over $500 billion worth of capital; each trade has a distinct buyer and a seller competing for the most attractive returns. This means that for every professional investor seeking a low enough price to buy a security, there is another professional investor seeking a high enough price to sell that same security. This level of competition, which reflects all available information and expectations of the future, has the effect of quickly driving security prices towards fair and intrinsic values.
peer review, won the Nobel Prize in 2013 for his groundbreaking work on EMH. The implications of Fama’s work are that no individual can reliably “beat the market” by predicting the future direction of stock prices. Of course, short-term mispricings do occur but, as we’ll demonstrate in this White Paper, not in a predictable pattern that would allow you to consistently outperform the markets.
A market that is quick to aggregate new information from willing buyers and sellers every day and does not This concept of a market where current prices reflect allow any individual to consistently earn abnormal all available information is referred to as the Efficient returns is a sign that the markets indeed “work”. Market Hypothesis (EMH)1. It was initially proposed in the mid-1960s by Professor Eugene Fama, who, Despite the overwhelming evidence against the ability of after five decades of empirical evidence and extensive professional investors to consistently outperform, much
What Happens to the Underperformers? Investors might be surprised by how many mutual funds actually fail to survive. It’s virtually undetected in a highly competitive, sales-driven industry where poor performing funds are often quietly merged into better performing funds, and new funds crop up to take their place. On average, 5-7% of US equity and fixed income mutual funds “disappear” each year. Even among the universe of index funds and ETFs, the growth of new funds and strategies has brought about an increase in fund liquidations that investors should be aware of. This high rate of closure among poor performing funds leads to “survivorship bias” in mutual fund research and marketing. Studies that look at past performance inevitably focus on the funds that survived, and those funds usually have stronger performance. In order to eliminate this significant bias, we use the CRSP Survivorship-Bias-Free Mutual Fund Database to conduct our research.
EMH is often misrepresented as a statement or belief that financial markets can forecast the future perfectly. This is, of course, not possible. What EMH does propose is that the market knows more than any individual because prevailing security prices incorporate all available information. Certainly, in today’s world with greater access to information, better/quicker technology, and new disclosure regulations, these findings are even more evident today. 1
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Exhibit 1. Equity Funds - Low Rates of Survivorship and Outperformance Performance periods ending December 31, 2015 Beginners
3,550 funds at beginning
3,711 funds at beginning
2,730 funds at beginning
2,758 funds at beginning
17% 43% Survive Outperform
Beginning sample include funds as of the beginning of the three-, five-, 10- and 15-year periods ending December 31, 2015. The number of beginners is indicated below the period label. Survivors are funds that were still in existence as of December 31, 2015. Non-survivors include funds that were either liquidated or merged. Outperformers (winners) are funds that survived and beat their respective benchmarks over the period. Past performance is no guarantee of future results. See Data appendix for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security prices, University of Chicago.
of the investment industry is built upon this unfulfilled promise. What we can say for sure is that strategies that attempt to capitalize on short-term mispricings2 are characterized by high fees, greater risk, and more taxes.
For the 15-year period, only 43% of all funds survived and, even worse, only 17% beat their benchmark. In other words, investing in mutual funds provided much lower odds of success than merely flipping a coin.
Exhibit 1 looks at the performance of these investment professionals. The large blue boxes represent the total number of equity mutual funds that existed over the past 3, 5, 10 and 15 years. The striped area reflects how many funds were still in business at the end of each period (the “survivors”) and the smallest orange box represents funds that managed to survive and beat their benchmark. Notably, the rates of outperformance are relatively low regardless of the period studied, and exhibit a consistent decline as time periods expand.
PAST PERFORMANCE HAS LITTLE PREDICTIVE POWER Investors often try to overcome poor performance among professional managers by analyzing their historical track records in the hopes of selecting funds that are likely to outperform in the future. They rationalize that not all stock pickers are as savvy as others, and the ones that survived and outperformed in the past are more likely to outperform in the future.
The reason we say that professional investors are trying to capitalize on short-term mispricings is because they themselves must believe that over the long-term there are no mispricings. That’s what allows them to buy below intrinsic value and sell, at a later date, at intrinsic value. In other words, they believe that markets are inefficient when buying and efficient when selling. 2
Exhibit 2. Equity Funds – Do Winners Keep Winning?
Past performance vs. subsequent performance
65% Losers 2011-2015
Only 35% of the 931 winning funds continued to win
67% Losers 2011-2015
Only 33% of the 731 winning funds continued to win
63% Losers 2011-2015
Only 37% of the 541 winning funds continued to win
2008-2010 (3 years) 2,730
27% Winners 73% Losers
2006-2010 (5 years) 2,758
20% Winners 80% Winners
2001-2010 (10 years)
The sample includes funds at the beginning of the three-, five-, and 10-year periods, ending in December 2010. The graph shows the proportion of funds that outperformed and underperformed their respective benchmarks (i.e., winners and losers) during the initial periods. Winning funds were re-evaluated in the subsequent period from 2011 through 2015, with the graph showing the proportion of outperformance and underperformance among past winners. (Fund counts and percentages may not correspond due to rounding.) Past performance is no guarantee of future results. See Data appendix for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.
But do the odds of success improve if you only choose among managers with “winning” track records? To determine if this is a viable strategy, we analyze the persistency of mutual fund outperformance in Exhibit 2 to determine if focusing on only the “smartest” investors increases the odds of success.
proportion of funds—only 33%—outperformed in the subsequent five years. This indicates that past performance alone provides little insight into a fund’s ability to outperform in the future. It also shows that there’s a less than 10% chance [27% x 33% = 8.9%] of picking a fund that outperformed in the two consecutive periods from 2006-2010 and 2011-2015.
We start by looking at the performance of mutual funds over 3-, 5- and 10-year periods leading up to 2010. The ALWAYS FOCUS ON WHAT YOU CAN CONTROL left side of the graph shows the proportion of funds that The generally poor results and lack of persistency outperformed (blue) and underperformed (grey) their among winning professional fund managers reflect a respective benchmarks during the initial period. market that works, meaning no individual investor has the ability to consistently outperform other investors. For example, only 27% (738 of 2,730 funds) of mutual funds outperformed their benchmark for the 5-year Once we accept that the capital markets work and period from 2006-2010, which is very close to the 29% success rate for the different 5-year period (2011-2015) recognize their mercurial nature, we can avoid spending our efforts making unreliable predictions (speculating) examined in Exhibit 1. about the future—such as picking the next hot stock or Next, we analyze only the outperformers from the riding the coattails of a successful investment manager initial period to see if these funds had a greater rate of —and instead focus on the predictable and repeatable outperformance in the subsequent 5-year period from investment choices that are within our control. After all, 2011 to 2015. Again, a similar and underwhelming the effects of compounding one smart decision after 8
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Exhibit 3. Equity Funds – Performance and Investment Costs Are Negatively Correlated
Outperformers vs. underperformers based on expense ratios 15 Years
5 Years 40%
The sample includes funds at the beginning of the five-, 10-, and 15-year periods ending December 31, 2015. Funds are ranked by quartiles based on average expense ratio over the sample period, and performance is compared to their respective benchmarks. The chart shows the percentage of winner and loser funds within each expense ratio quartile. Past performance is no guarantee of future results. See Data appendix for more information. US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago.
PERFORMANCE AND INVESTMENT COSTS ARE NEGATIVELY CORROLATED Our process begins by selecting among asset class funds To determine the effect of costs on fund performance, that avoid the perils of forecasting and instead seek to Exhibit 3 examines the relationship between expense capture the returns of entire asset classes. This is known ratios and mutual fund performance over the past 5-, as asset class investing. The benefits of this approach are 10- and 15-year periods. Funds are ranked into quartiles deeply rooted in scientific evidence rather than in Wall based on their expense ratios. Among each quartile, the vertical bars show the percentage of outperformers Street’s marketing hype. (the blue portion) and underperformers (grey portion) relative to their benchmark. For example, in the 3 5-year period, funds in the lowest expense quartile Since markets are efficient and security prices reflect had a 40% rate of outperformance and a 60% rate of a fair and intrinsic value, aren’t all investors on a level underperformance. These low odds of success were the playing field without much chance for divergence in best among all time periods and expense ratio quartiles results? And if so, why do so many investors fall short? —it only gets worse from there. The most obvious reason, yet not always the most detrimental, is the drag created by costs, notably a The wide range of mutual fund expense ratios shown fund’s expense ratio. Unless investors are selecting their in this exhibit reflects a variety of investment styles. own individual securities in a highly-concentrated The poor performance across the board and systematic portfolio, these costs are largely unavoidable, yet they decline as costs rise are further evidence of a highly should be reasonable and reflect the value added by a efficient market that works, regardless of the strategy professional’s decisions. another can have a significant impact on your ability to generate wealth and preserve it.
Reduce Your Investment Costs
employed. It is also worth considering that we have not included the additional negative impact of higher taxes associated with these funds. If we were to assume the higher tax rates, the already low rates of outperformance would further decrease. INVESTMENT COSTS COME IN MANY FORMS Higher expense ratios are associated with funds that seek to outperform the markets, but evidence shows that these funds do not offer greater value (returns). While expense ratios are the most readily observable cost, they offer only a vague approximation of the total costs incurred by investors. Additional expenses can include brokerage/trading fees, taxes, cash drag3 and sales charges that further contribute to lower (net) returns. Even among seemingly similar index funds and ETFs, certain characteristics, such as fund construction rules, factor exposure, trading acumen, securities lending policy, spread costs, premium/ discount volatility, and liquidity can all cause significant differences in performance. Our investment process seeks to eliminate all unnecessary costs and scrutinizes other relevant factors in order to find the most suitable investments. Our preferred investments are low-cost, institutional asset class funds that apply a consistent and effective approach to generating shareholder returns.
4 Focus on Asset Allocation Just because markets are generally efficient—making it difficult to predict which stocks will outperform in any given year—does not mean that all securities are priced to generate the same returns. These differences in return are called “premiums” and they are determined primarily by risk “factors”. Risk and return are inextricably linked, so it makes sense that an investor
seeking a higher return must be willing to accept a greater amount of risk. However, not all sources of risk are equal and some do not adequately compensate investors for taking them. INDENTIFYING THE SOURCES OF HIGHER RETURN Decades of academic research have identified which risk factors have provided higher returns over time4. In order to have confidence in these factors and to protect against the dangers of data mining (i.e., making inferences from what might have been a chance outcome), it is imperative that each factor is intuitive (it has a logical, economic rationale why it works and will likely continue); is persistent (it occurs throughout various time periods); is pervasive (it is evident across industries and geographies); and is robust5 (it is tested to alternative specifications). The factors that produce higher expected returns (premiums) include: 1. Market: Stocks have higher expected returns than bonds. 2. Size: Smaller company stocks have higher expected returns than large company stocks. 3. Price: Lower-priced (“value”) stocks have higher expected returns than higher-priced (“growth”) stocks. 4. Profitability: Higher profitability stocks have higher expected returns than lower profitability stocks. In general, factors can be thought of as any characteristic that defines a group of securities and is influential in explaining their expected risk and return. For instance, the first factor is the market—also known as the “equity risk premium”—and it represents the higher return that most investors know they can expect from investing in stocks (equity securities) rather than bonds (fixed income securities).
Cash drag is the cost of holding cash. Many mutual funds consistently carry cash in the range of 5% of assets, which is a drag on returns, whereas passively managed funds (that eschew stock picking) are typically fully invested. If we assume an annual long-term equity premium for stocks over cash of 8%, there would be an additional 0.40% drag on active fund returns. 4 The foremost academic piece on this subject was written in a 1992 paper “The Cross-Section of Expected Returns,” by Eugene Fama and Kenneth French. Their model, known as the Fama-French three-factor model, identified which factors have predictive powers for returns, and it is considered the standard for academic studies of investment returns. In 2012, additional research by Robert Novy-Marx and Fama/ French identified profitability as a fourth factor responsible for delivering higher expected returns. This 20-year gap between identified factors highlights the importance of being open to new ideas while also holding a high bar for what constitutes a reliable premium. 5 Reliable data needs to be robust. In the case of factor investing, this would mean that each factor has validity when tested under alternative specifications. For example, the value factor could be tested by using price-to-earnings (P/E), price-to-book (P/B), or price-to-cash flow (P/CF) and produce similar results. Likewise, the profitability factor could utilize gross margin (GM), return on equity (ROE), return on assets (ROA), cash flow over assets (CFOA), etc. 3
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Exhibit 4. Performance of the Premiums
Historical premiums and returns (annualized): US, Developed ex US, and Emerging Markets US Stocks
Developed ex US Markets Stocks
Emerging Markets Stocks
12.00 2.28 Small minus Large
Small minus Large
Value minus Growth
Annualized Returns 1975-2015
3.44 Value minus Growth
11.78 2.25 Small minus Large
Value minus Growth
High Prof. High Prof. Low Prof. minus Low Prof. Annualized Returns
Annualized Returns 1989-2015
Annualized Returns 1996-2015
High Prof. High Prof. Low Prof. minus Low Prof. Annualized Returns
High Prof. High Prof. Low Prof. minus Low Prof. Annualized Returns
Indices not available for direct investment. Performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.Index returns are not representative of actual portfolios and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. See “Index Descriptions” for descriptions of Dimensional and Fama/French index data. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. The S&P data is provided by Standard & Poor’s Index Services Group. MSCI data. © MSCI 2016, all rights reserved.
WHAT IS THE PERFORMANCE OF THE PREMIUMS? Exhibit 4 shows the other factors of size, price, and profitability—and their return premiums. For example, the first box (upper left) shows the size factor. The grey bars reflect the average returns among small cap stocks (12.00%) and large cap stocks (9.72%) in the US going back to 1928, while the blue bars to the left show the small cap premium – the excess return for investing in small cap stocks.
HOW MUCH EXPOSURE CAN YOU TOLERATE? While the premiums of size, price and profitability are evident over time, they do not occur every year, and it can be tough for investors to stick with these investments when they are out of favor. Think back to the late 90s’ tech bubble, when large cap growth stocks, especially tech stocks, handily outperformed small cap and value stocks. This caused many investors to abandon their small cap and value funds altogether. But In this case, an investor would have received 2.28% markets swiftly changed in 2000: tech stocks crashed, greater annual returns for allocating capital to small and investors who stuck with their small cap and value cap stocks versus large cap stocks. In the next column, funds were generously rewarded. which looks at non-US developed market stocks, we find an even greater small cap premium of 5.03%. This Invariably, there will be periods of time when these is repeated among each of the factors and across the factors do not produce higher returns. This is why it three major geographic investment regions going back is important for investors to consider how much expoas far is data is available. As you can see, there is strong sure they can tolerate. evidence that the premiums have been persistent across time and pervasive across markets. www.ascendwealth.com
Exhibit 5. Performance of the Premiums Over Rolling Periods MARKET beat T-BILLS
Overlapping Periods: January 1928–December 2015 15-Year 10-Year 5-Year 1-Year
96% of the time 85% of the time 78% of the time 69% of the time
Market is Fama/French Total US Market Index. T-Bills is One-Month US Treasury Bills. There are 877 overlapping 15-year periods, 937 overlapping 10-year periods, 997 overlapping 5-year periods, and 1,045 overlapping 1-year periods.
SMALL beat LARGE
Overlapping Periods: January 1928–December 2015 15-Year 10-Year 5-Year 1-Year
82% of the time 72% of the time 64% of the time 57% of the time
Small is Dimensional US Small Cap Index. Large is S&P 500 Index. There are 877 overlapping 15-year periods, 937 overlapping 10-year periods, 997 overlapping 5-year periods, and 1,045 overlapping 1-year periods.
VALUE beat GROWTH
Overlapping Periods: January 1928–December 2015 15-Year 10-Year 5-Year 1-Year
97% of the time 88% of the time 77% of the time 61% of the time
Value is Fama/French US Value Index. Growth is Fama/French US Growth Index. There are 877 overlapping 15-year periods, 937 overlapping 10-year periods, 997 overlapping 5-year periods, and 1,045 overlapping 1-year periods.
HIGH PROFITABILITY1 beat LOW PROFITABILITY Overlapping Periods: July 1963–December 2015 15-Year 10-Year 5-Year 1-Year
100% of the time 100% of the time 92% of the time 71% of the time
High is Dimensional US High Profitability Index. Low is Dimensional US Low Profitability Index. There are 451 overlapping 15-year periods, 511 overlapping 10-year periods, 571 overlapping 5-year periods, and 619 overlapping 1-year periods.
Indices not available for direct investment. Past performance is no guarantee of future results. Profitability is a measure based on information from individual companies’ income statements. Based on rolling annualized returns using monthly data. Rolling multiyear periods overlap and are not independent. This statistical dependence must be considered when assessing the reliability of long-horizon return differences. Dimensional Index data compiled by Dimensional. Fama/French data provided by Fama/French. The S&P data is provided by Standard & Poor’s Index Services Group. The information shown here is derived from such indices. Index descriptions available upon request. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP.
THE PROBABILITY OF SUCCESS INCREASES OVER TIME In Exhibit 5, we examine the probability of achieving higher returns among each factor over different rolling periods of time. This allows us to look past any shortterm “noise” and include periods that span both strong and weak markets.
a strategy that starts with good odds that continue to improve over time. This begins with keeping your costs down and avoiding the urge to speculate on the future direction of stock prices.
From there, we diligently structure broadly diversified In each case, the odds of success start at statistically portfolios that pursue higher expected returns by high levels and continue to improve as time periods increasing the allocation to smaller, undervalued and lengthen. For example, over 5-year rolling periods going higher profitability stocks. We often use institutional back to 1928 (each month begins a period, so there funds that provide the purest exposure to each of these are 997 instances), value stocks outperformed growth factors in every part of the world without the constraints of typical index funds and ETFs. stocks 77% of the time. These odds improve to 97% of the time over all of the 15-year periods (877 instances). BALLAST YOUR PORTFOLIO WITH FIXED INCOME This stands in stark contrast to the performance of Another significant component of asset allocation is professional fund managers whose odds of success start fixed income. While equities are the higher risk (and the at a low level and steadily decline over time. potential reward) portion of your portfolio, fixed income securities are there to reduce volatility and provide a To achieve investment success, it is prudent to follow more stable source of returns. There are many important 12
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Index Fund Shortcomings
The poor performance among professional investors has made indexing a popular investment choice, yet index funds have inherent weaknesses as well. Index funds were designed with a singular purpose: to mimic (or “track”) the performance of a commercial index, e.g., the S&P 500 Index. This means that index funds must hold the same securities in the same quantities as their benchmark index. These rigid construction rules cause index funds to incur a number of implicit costs that affect returns. Because index funds must hold the same securities as a commercial index, they often miss an opportunity to apply simple, sensible screens to exclude certain securities that exhibit poor riskadjusted returns, such as stocks with insufficient float or liquidity, small stocks with low profitability, merger and acquisition targets, stocks in bankruptcy, recent IPOs, and low priced (“penny”) stocks. The result is poor risk selection. Another consequence of strictly adhering to an index is the hidden trading costs that result from the forced buying/selling of securities as they are added/deleted from an index. Arbitrageurs and liquidity providers are able to front run these well-telegraphed trades (changes to an index are typically announced weeks before these changes are made) causing index funds to pay a premium when buying securities and receive a discount when selling. Finally, index funds are exposed to an undesirable style drift that occurs as a result of their infrequent—typically once a year—reconstitution. Because stocks can move in/out of an asset class at any time (e.g., small cap stocks can grow into mid or large cap stocks), you can typically achieve greater returns by having the flexibility to trade throughout the year in order to gain more consistent exposure to those stocks that produce higher returns.
characteristics to examine when selecting the amount and type of fixed income securities to purchase, such as the issuer, credit, term, liquidity, and taxation of the securities. We advocate using high quality, short- to intermediateterm bonds in order to manage risk, stabilize returns and create a more balanced portfolio. Shorter duration bonds have lower correlation to equities compared to longerterm bonds, and they are less sensitive to interest rate movements. There has also been no evidence of a reliable return premium for extending maturities into longer term bonds. Meanwhile, higher credit quality bonds have been shown to provide less volatility and offer greater safety of principal during times of market distress.
5 Achieve Proper Diversification Diversification is perhaps the most misunderstood and underutilized component of a successful investment strategy. In its simplest form, it involves using multiple securities to ensure that no single investment causes significant harm to your overall portfolio. Effective diversification, however, requires a more comprehensive approach, where large-, medium- and small-sized companies, growth and value companies, domestic and international stocks, and fixed income and real estate securities are all properly represented. THERE ARE MANY BENEFITS OF DIVERSIFICATION A well-diversified portfolio constructed of different asset classes that do not move in sync provides many valuable benefits, including: • Improving risk-adjusted returns. • Eliminating guesswork about which asset classes will outperform. • Reducing loss and volatility. • Capturing return opportunities wherever they occur. • Minimizing unsystematic risks.
LOWER RISK WITHOUT SACRIFICING RETURNS Changing market conditions affect asset classes differently (i.e., some zig while others zag). By owning multiple uncorrelated asset classes at the same time, you can reduce risk without sacrificing much in the way of returns. The benefits of diversification can be clearly identified when asset classes are mapped according to their risk and return.
Exhibit 6. The Benefits of Diversification 16%
10% 8% 6%
Small Cap Stocks U.S. Total Market Diversified S&P 500 Portfolio International Corporate Bond Government Bond
4% 2% 0%
Risk (Standard Deviation)
Exhibit 6 shows the risk and return of various stock and bond asset classes, as well as a diversified portfolio that is a combination of all asset classes. As you can see, the diversified portfolio experiences much lower volatility (x-axis) than any of the individual equity classes, yet it achieved equity-like returns (y-axis)6. This is the result of combining thousands of securities that don’t always move in tandem, thereby limiting exposure to any one particular asset class that will undoubtedly experience periods of underperformance. Since the goal of investing is to maximize returns per unit of risk7, diversification among uncorrelated assets is highly desirable.
Diversification and Factor Investing—A Powerful Combination Proper diversification is about more than just getting exposure to every asset class. Each asset class has different risk and return characteristics that should be considered when determining an appropriate amount of exposure.
to achieve positive net exposure, you must further tilt your portfolio towards these desirable factors.
Furthermore, if you hope to target the premiums of size, price, and profitability, you must recognize that exposure to these premiums is a net consideration. For example, the price factor is the return of value stocks minus the return of growth stocks. In other words, value stocks provide a positive exposure to the price effect, and growth stocks provide a negative exposure to it.
There are additional benefits that come from targeting multiple factors at the same time (e.g., a small cap value fund that excludes low profitability securities) due to their low historical correlation to one another—their outperformance does not always occur at the same time. This is important because the benefits of diversification depend more on how assets perform relative to one another (correlation) than on the number of different asset classes in a portfolio.
This means that a highly diversified fund that holds all parts of the market (e.g., a “total market” fund like VTI, the Vanguard Total Stock Market ETF) has, by definition, no net exposure to these factors. This is because in addition to holding small cap stocks and value stocks, it also owns offsetting negative exposure to the same factors of size and value by owning large cap and growth stocks. In order
Therefore, combining factors can be a particularly effective investment strategy. By tilting a portfolio toward multiple factors at the same time, we expect to lower the risk of underperformance while preserving—or even increasing—the likelihood of outperformance. In effect, combining factors makes the whole of the portfolio more effective than the sum of its parts.
The diversified portfolio in Exhibit 6 is split evenly among the seven asset classes (14.29% each). Compared to a 100% all equity investment (S&P 500 Index), this diversified portfolio has similar returns (11.9%) and 25% less risk (standard deviation goes from 15.1% down to 11.4%). 7 Maximizing returns per unit of risk is the framework for Modern Portfolio Theory (MPT), which was first put forward by Dr. Harry Markowitz in a 1952 paper called “Portfolio Selection”. Prior to MPT, investors focused entirely on selecting individual stocks that they believed offered the best value without regard to their effects on the portfolio as a whole. While many individuals continue to invest this way, large institutional investors have entirely changed the way they invest as a result of Markowitz’s work. Similar to Fama’s work on EMH, the framework for MPT has been extensively peer reviewed and has stood the test of time. Markowitz won the Nobel Prize 38 years later (1990) for his work on MPT. 6
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Exhibit 7. Volatility=Less Lower Volatility = Less Stress & Greater Wealth Lower Stress Beginning Balance
Security A (High Volatility) Annual Return Wealth
Security B (Low Volatility) Annual Return Wealth
little volatility as possible in order to achieve your investment goals. Selecting individual stocks or failing to properly diversify among uncorrelated asset classes will leave you exposed to unnecessary volatility and risk. Proper diversification is especially valuable during market downturns, where higher returns are required To see this in practice, consider two securities (Exhibit in order to fully recover from market bottoms. In our 7) with the same average returns but different volatility. hypothetical example, it took a 25% gain in year 3 to Given matching average returns, you might expect overcome a 20% loss in year 2. both securities to produce the same amount of wealth. However, it’s a mathematical fact that the one with lower ARE YOU PROPERLY DIVERSIFIED? volatility will produce a greater compounded (geometric) Investors often feel they have achieved proper diversireturn, which is the true measure of wealth creation. fication because they own many funds with different In this case, the more volatile security (A) experienced objectives. Upon closer examination, however, we often a very strong gain (35%) in the first year and had find their portfolio is fairly undiversified for a number three years of solid performance, yet the less volatile of common reasons: security (B) generated 1.8% greater annual returns • Closet indexing: Mutual funds with low active share8 over a 5-year period. that have similar (but don’t need to be identical) benchmarks generally own many of the same securities. Furthermore, lower volatility also drastically lowers the emotional anxiety that often causes investors to • Coattail investing: Many investment managers sell their investments at exactly the wrong time. If you copy the investment choices of the perceived “smart sold security A in year 4 after its disappointing returns money”, which results in a diverse group of funds and missed the final year of average performance, your that own similar holdings. compounded return would fall another 2% for an annual • High concentration: Actively managed funds are underperformance of 3.8%, or 19% less total return. expected to conduct due diligence on each individual security, which limits the amount of companies they have time to research and own. Ideally, you want to position your portfolio with as LOWER VOLATILITY= LESS STRESS & HIGHER RETURNS Combining uncorrelated assets in a portfolio not only reduces risk, but by virtue of lower volatility, can also increase returns.
Active share is the percent of a fund’s securities that do not overlap with the benchmark. Investors pay attention to this because they are paying the manager to beat the benchmark, not own it. A study from Yale University titled “How Active Is Your Fund Manager” (2009), estimated an industry average active share ratio of only 60%. Subsequent research has suggested that active share has steadily declined since that period. A fund with only 60% active share means that 40% of the holdings are the same as a comparable index fund and so the fund is relying on only 60% of its holdings to beat the benchmark and cover its higher costs. 8
The Value of Global Diversification Today, the US represents 52% of the world’s market capitalization, which means that nearly half of the wealth creating opportunities among equities is located outside the US. While some home bias is appropriate in order to reduce exposure to currency risk and increase the correlation of your investment performance to the cost of living in your own country, there is an opportunity cost of failing to properly diversify outside the US. This is readily apparent when we examine the period from 2000-2009, which became known as the “lost decade” in the US. During this period, the S&P 500 recorded it worst 10-year performance ever with a cumulative return of -9.10%. When we look beyond US large cap equities, however, we find that conditions were considerably better for global equity investors during this same period:
Global Index Returns vs. S&P 500 S&P 500 Index MSCI World ex US Index MSCI World ex US Value Index MSCI World ex US Small Index MSCI World ex US Small Value MSCI Emerging Markets Index MSCI Emerging Markets Value Index MSCI Emerging Markets Small Index
Total Return ‘00-’09
-9.10% 30.70% 48.71% 94.33% 145.75% 154.28% 212.72% 176.71%
Source: Morningstar Office
In fact, if we expand beyond this period and look at performance for each of the past 11 decades starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and underperformed in the other six. This reinforces the idea that investors should construct sound, globally diversified portfolios, designed to reduce risk and capture higher return opportunities wherever and whenever they occur. Knowing that diversification is a panacea for volatility, there is a similar benefit to seeking global diversification among fixed income securities, where volatility is an even greater concern. After hedging against currency risk, bond markets around the world have only modest correlations. As a result, a bond portfolio that hedges currency risk should exhibit lower volatility than a single-country portfolio and offer the opportunity to seek higher returns across multiple yield curves.
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BROAD DIVERSIFICATION IS YOUR NEW BEST FRIEND •Financial planning: We may coordinate with your We believe that a properly diversified portfolio is the CPA or accountant to achieve additional tax benefits. most effective way to lower risk and capture the long- •Loss harvesting: We may take advantage of market term expected returns available throughout global capital swings to generate tax credits while keeping your markets. Our portfolios are broadly diversified among money 100% invested. more than 10,000 equity securities across over 35 countries. •Tax lot optimization: We avoid short-term capital We further diversify by including real estate stocks (REITs) gains when trading and sell high cost shares first in and high-quality, short- to intermediate-term fixed income order to minimize capital gains. securities that have low correlation with stocks to balance your portfolio(s) and further reduce risk.
6 Always Pay Attention to Taxes
7 Rebalance When Necessary
Portfolio rebalancing is another critical component of proper wealth management. Since securities will inevitably drift away from their initial target allocation, it is necessary to occasionally rebalance a portfolio by selling overweighted securities and buying underweighted securities in order to prevent an unnecessary increase in risk exposure.
Managing your investments to a lower tax rate is yet another way to improve your returns. But taxes are often an afterthought for many investors, because they may feel that the tax impact of their choices is either too complex to understand, insignificant to returns or just not interrelated because taxes aren’t paid when investA knock-on effect of rebalancing is that it can capture ment decisions are made. buy low and sell high opportunities, which can further Being tax efficient with your investments requires improve your returns. These opportunities for higher paying attention to various aspects of the wealth returns are improved when the number of uncorrelated management process in order to limit taxes and asset classes held in a portfolio and the volatility of increase what’s available to invest. We focus on the those assets increases. following opportunities to reduce your taxes: Investors traditionally rebalance on a semiannual •Investment selection: We use asset class funds with or annual basis (if at all), but we do not recommend low turnover to avoid incurring short-term gains, and this approach. Rigid time-based rebalancing can be we use a unique set of tax-managed funds that seek ad- unnecessarily expensive and it may miss episodic ditional opportunities to maximize after-tax returns9. market events that present attractive buy or sell •Asset location optimization: We emphasize placing tax opportunities. We carefully review accounts every few inefficient assets in qualified (tax deferred and tax free) weeks to look for rebalancing opportunities, and we always make sure that the benefits outweigh the costs. accounts and tax efficient assets in taxable accounts. We also use rebalance thresholds11 and tolerance bands •Tax efficient rebalancing: We use tolerance bands to minimize unnecessary costs, such as trading fees and 10 and new fund flows to avoid incurring unnecessary taxes. Additional rebalancing may also occur as a result capital gains. of a shift in risk tolerance or change in life events.
Mutual funds are required to distribute at least 98% of capital gains each year. That means mutual funds that trade often are subjecting investors to the higher ordinary income tax rate, rather than the much lower long-term capital gains tax rate. In addition, there are certain classes of tax-managed funds available that take advantage of other tax efficient opportunities for its shareholders. 9
Tolerance bands provide a permissible range in which asset classes may float, which alleviates the need to rebalance all securities back to an initial target. Fund Flows are the movement of cash in and out of an account. Utilizing each of these strategies eliminates unnecessary taxes and trading costs. 10
Thresholds are the absolute amount in which an asset class is allowed to stray from its initial target. Once a threshold is reached, an asset is rebalanced. (Tolerance bands are a smaller subset of the threshold.) 11
Exhibit 8. Missing Days Can Hurt Performance
Performanceofofthe theS&P S&P 500 Performance 500Index, Index1970-2015 (1970-2015)
Growth of $100,000
Annualized Compound Return
$5,828,514 $3,374,751 $2,125,041 $918,943 Total Period
Missed 1 Best Day
Missed 5 Best Single Days
Missed 15 Best Single Days
Missed 25 Best Single Days
One-Month US T-Bills
Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. In US dollars. Indices not available for direct investment. Their performance does not reflect the expenses associated with the management of Past performance isannot a portfolio. guarantee of futureisresults. Not to be construed as investment advice. Returns ofprovided modelbyportfolios are based on back-tested actual Past performance not a guarantee of future results. Performance data for January 1970–August 2008 CRSP; performance data with for September 2008–December 2015 provided by Bloomberg. S&P dataactual provided investment by Standard & Poor’s Index Services Group. model allocation mixes designed the benefit of hindsight and do not represent performance. Bonds, T-bills, and inflation data provided by Morningstar.
8 Stay the Course Ignoring short-term market fluctuations may be the biggest challenge an investor faces, yet it can also be the most valuable component of achieving superior longterm returns—even more so than selecting the right security or minimizing investment costs and taxes.
index produced an average annual return of 10.35% over the past 30 years (1986-2015), equity mutual fund investors earned only 3.66% on average–a 35% capture rate–over that same time period12.
Why? It’s because investors fail to stay the course and Too often, investors struggle to separate their emotions respond emotionally to changing market conditions. As a from their investment decisions, and end up following result, they often miss out on the best days in the market. a counterproductive cycle of extreme optimism (buying when prices are high) followed by extreme MISSING JUST A FEW DAYS CAN BE VERY COSTLY fear (selling when prices are low). What is the result of missing days in the market? Exhibit 8 illustrates the effect of missing just a few of the best MARKET TIMING RESULTS IN LOWER RETURNS days in the market over the past 45 years. In this case, An annual study by the research firm Dalbar, which missing the top five days—or only one day every nine factors in the cash flows from mutual fund purchases years—lowered annual returns by 1%. and sales, offers some insight into the significant lost opportunity that occurs when investors rely on their Due to the power of compounding interest, that emotions in an attempt to time the markets. Dalbar’s difference between earning 9.24% and 10.27% on a most recent report suggests that while the S&P 500 $100,000 portfolio over 45 years amounts to $3,146,585. Dalbar, Inc., 22nd Annual “Quantitative Analysis of Investor Behavior” (2015). For the year 2015, Dalbar shows that while the S&P 500 returned 1.38%, the average mutual fund investor earned a -2.28% return. While similar in outcome to the 30-year period, the longer-term figures have greater validity since there is more return and net asset history available, and these periods span a variety of market conditions. Notably, these results would be worse if the higher costs/commissions and taxes associated with such an active strategy were included in the analysis. For a copy of Dalbar’s most recent report, please contact us. 12
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Exhibit 9. The Market’s Response to Crisis
Cumulative total return of a balanced strategy (60% stocks / 40% bonds) After 1 year
October 1987: Stock Market Crash
After 3 years
August 1989: US Savings and Loan Crisis
After 5 years
September 1998: Asian Contagion Russian Crisis
March 2000: Dot-Com Crash
September 2001: Terrorist Attack 84%
September 2008: Bankruptcy of Lehman Brothers
20% 11% -1%
-1% -3% In US dollars. Balanced Strategy: 7.5% each S&P 500 Index, CRSP 6-10 Index, US Small Value Index, US Large Value Index; 15% each International Value Index, International Small Index; 40% BofA Merrill Lynch One-Year US Treasury Note Index.The S&P data is provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2016 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. CRSP data provided by the Center for Research in Security Prices, University of Chicago. US Small Value Index and US Large Value Index provided by Fama/French. International Value Index provided by Fama/French. International Small Cap Index compiled by Dimensional from StyleResearch securities data; includes securities of MSCI EAFE countries in the bottom 10% of market capitalization, excluding the bottom 1%; market-cap weighted; each country capped at 50%; rebalanced monthly.
This shows that over the short term, the impact of making a mistake may seem small, but over the long run, it can have a dramatic impact on your results—and your ultimate standard of living. EMBRACE VOLATILITY Investors often fail to stay invested over the long term because of volatility. However, volatility is an inevitable and even essential component of investing. Market swings reflect a properly functioning market that is quick to incorporate new information; i.e., the markets work. The most extreme examples of volatility occur when unexpected events cause many investors to panic and sell at the same time. This sudden increase in selling leads markets to correct more than events would suggest is necessary. MARKETS REWARD DISCIPLINE Unfortunately, for those investors that sell, the markets’ best performance usually follows these periods of extreme selling. Exhibit 9 examines the six most notable periods of market distress during the past 30 years. During each of these events, there was no shortage of news stories that www.ascendwealth.com
Are The Professionals Any Better at Market Timing? Not even professional investors can properly time market entry and exit points. Consider the poor performance among actively managed mutual funds, which we shed light on earlier. Not only do these professional stock pickers attempt to beat the market by picking individual stocks, but they also have the flexibility to time the markets by selling stocks and holding cash instead. In other words, they will sell stocks when they feel the markets are about to go down or perhaps they will sell once the markets have started to correct thinking that the worst is yet to come. If they are right, holding cash will be a much better investment than holding falling stocks. Meanwhile, the benchmark indexes, which these funds are measured against, have no such flexibility and are fully invested at all times. If the markets go down, they have nowhere to hide. The poor performance among actively managed funds shows there has been little benefit from trying to time the markets, even among professional investors. 19
advised investors to sell stocks and wait for a better time to invest. These type of bold predictions are often meant to create viewership for the media and commissions for Wall Street, but they often don’t work out as well for investors.
We strive to provide our services in a refreshingly transparent and intelligent manner. This provides a better personal experience and more consistent investment outcomes.
When you make the right choices with your money, you can significantly improve your standard of living and that of your heirs. As your wealth manager, we can help you achieve financial independence and the peace of mind that comes from knowing that your money is Meanwhile, many investors heed these warnings and being managed with expert care. exit the markets near the bottom, which proves to be a mistake. Investors who maintained a long-term focus To discuss the investment philosophy found in this were rewarded with extremely strong performance White Paper, please contact Mark Bourguignon, Presfive years after these events. This reminds us that being ident, Ascend Wealth Management at 415-569-7909 or disciplined and looking beyond the headlines of today visit www.AscendWealth.com. can help you achieve better long-term returns. Steve Forbes, the Publisher of Forbes Magazine once said, “You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”
HAVE A PLAN YOU CAN STICK WITH Knowing that emotional reactions can have a negative effect on investment success, we begin the investment planning process with a thorough assessment of your unique risk tolerance. We can show you the historical downside of a particular strategy, so you clearly understand the type of risks you’re taking. This forms the basis for building a customized investment plan that you can live with through good times and bad. The capital markets can be rewarding, but it takes a well-constructed investment plan, a comprehensive assessment of the risks, and the discipline to stay invested in order to eliminate the significant performance gap that so many investors experience.
About the Author Mark Bourguignon has dedicated his career to conducting securities research and implementing investment strategies designed to meet the distinct needs of individual investors. He brings a proven commitment to investment excellence and is passionate about helping others achieve their financial goals so they can spend more of their time following their own life’s passions.
Prior to founding Ascend Wealth Management, Mark spent 12 years as a Director and Senior Portfolio Analyst 9 for Clearbridge Investments. While at Clearbridge, Many investors experience disappointing returns for Mark provided the research and investment selection putting their money to work in the capital markets. This for the firm’s mutual fund and separate account is often the result of high costs and an undisciplined products, including small cap, income-oriented and and/or non-scientific investment approach that is prac- value strategies with more than $20 billion of assets ticed by or sold to investors by firms that have dual under management. (conflicting) interests. Moreover, any strategy that relies on instincts or projections is completely unpredictable Previously, Mark served as the Director of Research for the private equity fund, Option Advantage Partners L.P. and must be constantly updated. The fund was the first of its kind to offer entrepreneurs At Ascend Wealth Management, we believe there is the ability to tax-efficiently exercise their stock options a better way to invest. We follow an unemotional, using private funding. Mark began his career in the highly diversified investment strategy based on sound, investment research departments of Donaldson, evidence-based fundamentals that have been proven to Lufkin and Jenrette and Thomas Weisel Partners. influence investment success.
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Mark Bourguignon earned a Bachelor of Science degree in Finance from Marquette University. He was also a scholar of Pan-European Economics at The University of Antwerp, Belgium.
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Benchmark data provided by Barclays, MSCI, Russell, Citigroup, BofA Merrill Lynch, and S&P. Barclays data provided by Barclays Bank PLC. MSCI data © MSCI 2016, all rights reserved. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Citigroup bond indices © 2016 by Citigroup. The BofA Merrill Lynch index is used with permission; © 2016 Merrill Lynch, Pierce, Fenner & Smith Incorporated; all rights reserved. Merrill Lynch, Pierce, Fenner & Smith Incorporated is a wholly owned subsidiary of Bank of America Corporation. The S&P data is provided by Standard & Poor’s Index Services Group.
Ascend Wealth Management is an independent, fee-only wealth management firm that works with individuals and families. We provide the highest standard of care and ethics in the investment industry—a fiduciary standard—which means that our advice as your trusted Benchmark indices are not available for direct investment. advisor always serves a single purpose: to build financial Their performance does not reflect the expenses associated security and wealth for you and your family. with the management of an actual portfolio. We work closely with our clients in order to understand their unique needs, goals and risk tolerance. We then develop customized investment portfolios of institutional class funds designed specifically for longterm investors who are seeking an alternative to what is commonly available among the investment industry. Our strategy is based on sound, time-tested principles that have been confirmed by decades of academic and empirical evidence. Our commitment is to manage your assets with an unwavering dedication to academic rigor, discipline and transparency in order to achieve better investment outcomes while minimizing your costs, your risks, and your tax burden. We welcome the opportunity to meet with you and discuss how a sensible, evidence-based investment approach may provide you with greater prosperity and peace of mind.
US-domiciled mutual fund data is from the CRSP Survivor-Bias-Free US Mutual Fund Database, provided by the Center for Research in Security Prices, University of Chicago. Funds are identified using Lipper fund classification codes. Correlation coefficients are computed for each fund with respect to diversified benchmark indices using all return data available between January 1, 2001, and December 31, 2015. The index most highly correlated with a fund is assigned as its benchmark. Winner funds are those whose cumulative return over the period exceeded that of their respective benchmark. Loser funds are funds that did not survive the period or whose cumulative return did not exceed their respective benchmark. www.ascendwealth.com
Expense ratio ranges: The ranges of expense ratios for equity funds over the five-, 10-, and 15-year periods are 0.01% to 4.90%, 0.01% to 4.72%, and 0.07% to 4.44%, respectively. For fixed income funds, ranges over the same periods are 0.02% to 3.09%, 0.06% to 2.67%, and 0.03% to 3.66%, respectively.
US size premium: Dimensional US Small Cap Index minus S&P 500 Index. US relative price premium: Fama/French US Value Index minus Fama/French US Growth Index. US profitability premium: Dimensional US High Profitability Index minus Dimensional US Low Profitability Index. Dev. ex US size premium: Dimensional Intl. Small Cap Index minus MSCI World ex USA Index (gross div.). Dev. ex US relative price premium: Fama/French International Value index minus Fama/French International Growth Index. Dev. ex US profitability premium: Dimensional International High Profitability Index minus Dimensional International Low Profitability Index. Emerging Markets size premium: Dimensional Emerging Markets Small Cap Index minus MSCI Emerging Markets Index (gross div.). Emerging Markets relative price premium: Fama/French Emerging Markets Value Index minus Fama/ French Emerging Markets Growth Index. Emerging Markets profitability premium: Dimensional Emerging Markets High Profitability Index minus Dimensional Emerging Markets Low Profitability Index. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. Ascend Wealth Management Inc. is a Registered Investment Adviser. This White Paper is solely for informational purposes. Advisory services are only offered to clients or prospective clients where Ascend Wealth Management Inc. and its representatives are properly licensed or exempt from licensure. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Ascend Wealth Management Inc. unless a client service agreement is in place. 21
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