A Gadfly column I wrote last week arguing that financial advisers are subject to inadequate professional standards generated passionate responses from readers who agreed with the thesis and those who did not (including advisers, of course).
Because interest in the column was so intense, I wanted to share some of the critical comments I received from readers, and to explore those comments further.
“Financial advisers are often perceived as dishonest, and consistently rank among the least trustworthy professionals.” So proclaims the Capital Ideas Blog of the University of Chicago’s Booth School of Business in a post about a new study that finds that 7 percent of advisers have been disciplined for misconduct.
My Bloomberg colleague Barry Ritholtz rightly calls this an astonishingly high number, but the business of financial advice suffers from an even more astonishing problem: Precious little is required to become a financial adviser.
Want to be a financial adviser in the U.S.? All you have to do is pass the Uniform Investment Adviser Law Examination, a three hour exam that covers a variety of law and investment-related subjects. Just pay the $165 exam fee and answer 72 percent of the questions correctly — a feat that realistically requires several weeks of study — and you’re in.
Despite some recent and minor market rebounds, oil and the broader energy sector remain down-and-out. Contrarian-minded investors are no doubt preparing to pounce, and some may have their eyes on Master Limited Partnerships (MLPs) — publicly-traded partnerships that largely own energy infrastructure in the U.S.
But investors who view MLPs as a proxy for energy are making a big mistake (and as my Gadfly colleague Liam Denning has already noted, investors who also used to think of certain MLPs as reliable, utility-like havens have “realized their mistake”).
The recent movements of oil and MLPs, for example, are instructive. The price of oil tumbled 55 percent from July 2014 to August 2015, but the Alerian MLP Index declined just 37 percent over the same period.
You know what you do with your portfolio when the stock market behaves badly? You move to those timeless stores of value: cash, gold and real estate.
Or at least that’s what some investment strategists are suggesting in response to market malaise. They certainly aren’t not alone. Just search on Google for advice about the wisdom of investing in cash, gold or real estate and you’ll find a chorus of voices singing the praises of those traditional safe havens.
Despite such popularity, my guess is that few sophisticated portfolio managers actually attempt to sidestep the market’s vagaries by hiding in cash, gold or real estate — and for good reason.
Consider that the simplest 60/40 diversified portfolio made up of the S&P 500 Index and long-term government bonds has returned 9.9 percent annually from 1972 to 2015 (the longest period for which data is available for all investments referenced in this column; those returns include dividends).
Cash, as represented by 30-day Treasuries, returned 4.9 percent annually over the same period. Gold returned 7.5 percent annually over the same period. And real estate, as represented by the FTSE NAREIT U.S. Real Estate Index, returned 9.7 percent annually over the same period.
On a risk-adjusted basis, gold and real estate fared even worse. The 60/40 portfolio has a Sharpe Ratio of 0.48, whereas gold and real estate have Sharpe Ratios of 0.13 and 0.27, respectively. (The Sharpe Ratio gauges risk-adjusted returns, with a higher ratio indicating that investors are more adequately compensated for volatility. The Sharpe Ratio of cash is zero because the Sharpe Ratio measures the excess risk-adjusted return over cash.)
So cash, gold and real estate have been no match for a simple diversified portfolio over the long haul. But here’s the more crucial twist: They also haven’t even been a sure-fire hiding place during market routs.
There were four ugly multi-year episodes for U.S. stocks between 1972 and 2015, as measured by changes in the value of the S&P 500. The first episode was the Nifty Fifty crash of the early 1970s. The 60/40 portfolio declined 29.6 percent from December 1972 to September 1974, but real estate investors were less fortunate, suffering a decline of 52.6 percent over the same period.
The second episode was the stagflation recession of the early 1980s. The 60/40 portfolio declined 3.7 percent from November 1980 to July 1982, but this time it was gold investors’ turn to get hammered with a decline of 44.7 percent over the same period.
The third episode was the post-tech bubble collapse of the early 2000s. The 60/40 portfolio declined 21.2 percent from August 2000 to September 2002, and this time investors got what they came for – cash, gold and real estate all appreciated in value.
The fourth and most recent episode, of course, was the 2008 financial crisis. The 60/40 portfolio declined 29.7 percent from October 2007 to February 2009, but real estate investors were left poorer yet again, suffering a decline of 63.2 percent over the same period.
Given that cash, gold and real estate appear to be less than perfectly correlated, you may be wondering whether a combination of the three would have been the silver bullet. No dice there either. An equally weighted portfolio of the three would have declined in two of the four bear markets – by 8.5 percent from November 1980 to July 1982, and by 20 percent from October 2007 to February 2009.
All of this means that investors who are hell-bent on sidestepping bear markets have a near-impossible mission. For starters, they have to time their market exit and re-entry to near perfection, which is famously difficult to do.
But that’s just the beginning. Investors also then have to predict which of their desired ports of call –- cash, gold or real estate –- will actually hold up in a storm. Granted, cash should always hold up (and if it doesn’t, heaven help us all), but it also inflicts the most severe penalty for mistiming the market, as it will fall farthest behind over time.
So investors shouldn’t look longingly at cash, gold or real estate right now, even if their portfolios seem shaky. They should just stay the course, because sometimes a port in the storm is much more dangerous than it appears to be.
And yet, and yet. The monstrous volatility that has visited global stock markets over the last two decades has given rise to an alternative investing mantra: buy-and-adjust.
As my Bloomberg colleague Mohamed El-Erian noted, a more flexible approach to asset allocation may allow investors to exploit volatility by tilting their portfolios to cheaper assets during market selloffs and to higher quality assets during booms.
Which begs the question: Has a flexible (tactical) approach to asset allocation — in which an investor opportunistically adds value plays to her portfolio when markets are whipsawing — beaten a static (buy-and-hold) approach to asset allocation?
A lot of folks are scratching their heads about the recent high correlation between stocks and oil, and it has inspired some high profile musing. Ben Bernanke posits that both stocks and oil are reacting to slowing global growth. Howard Marks recently told my Bloomberg<GO> colleagues on television that any correlation between stocks and oil is proof that investors simply don’t understand the relationship between the two.
But the focus on the recent waltz of stocks and oil misses a larger concern: a multi-decade shift in correlations across risk assets that threatens to crack the foundation of portfolio theory.
In the abstract, a high correlation between stocks and oil — and commodities generally — should be the exception, not the rule. Lower commodity prices translate into lower costs and higher earnings for all but commodity producers, and higher earnings translate into higher stock prices. An obvious exception is a slow-growth environment that threatens both commodity prices and sales, but that would be cyclical by definition and any resulting spike in correlation between stocks and commodities should be fleeting.
Go ahead, invest 100 percent of everything you have in stocks. Or, even better, please don’t.
A recent New York Times column suggesting that investors allocate 100 percent to stocks clearly disagreed with that point of view, using a relatively non-controversial argument: Stocks have a higher expected return than bonds, and the longer your investment period, the greater the probability of capturing that higher return.
Ergo, buy stocks, hang on, and collect your prize.
The problem, of course, is that investors fail to hang on. You wouldn’t know it by looking at mutual fund returns because those returns ignore the timing of investors’ buy and sell decisions, and assume instead that investors bought and held their fund shares for the entire period. But if you’ve ever looked at a fund’s performance and thought, “That’s not the return I got,” you know that the actual return depends on when you bought and sold the fund.
To bridge the gap between a fund’s return and the return investors actually achieved, Morningstar compiles “Investor Return” data for funds, which takes into account the impact of inflows and outflows. I looked at mutual funds in Morningstar’s U.S. large cap category and compared the average fund return with the average Morningstar investor return.
Bill Miller’s 30-year tenure as manager of the Legg Mason Value Trust is one of the most celebrated runs by a mutual fund manager in investing history, and for good reason. From May 1982 to April 2012, the Value Trust outpaced the S&P 500 Index by an average of 1.3 percent annually (including dividends). And the Value Trust famously beat the S&P 500 for 15 consecutive years from 1991 to 2005.
But there’s a catch. As one of Miller’s former colleagues puts it, the downside of Miller’s approach is the potential for “big mistakes.”
The Value Trust declined 55 percent in 2008, while the S&P 500 declined 37 percent that year. This was no fluke – the Value Trust’s standard deviation was 23 percent higher than that of the S&P 500 during the Miller era — which means investors had to have the stomachs for enduring very bumpy rides when they traveled with Miller.
For at least two decades, the “value premium” – the hallowed expectation that value stocks beat growth stocks – has been a mainstay of financial theory. But the value premium has failed to show up in recent years and disappointed investors are pulling billions of dollars from once irreproachable value managers.
So have we seen the last of the value premium?
The argument between growth and value investors, one of the oldest in finance, can be reduced to one question: What is a better bet, high growth stocks or low valuation stocks?
No, you can’t have both, but thanks for asking.
In the dark decades before the widespread availability of market data and the computing power to process it, that debate raged without a victor. But by the mid-1990s a consensus emerged: value trumps growth. Not always, but most of the time, and value’s win percentage climbs as the investment period grows.
If you had looked two decades ago at data compiled by finance researchers Eugene Fama and Ken French, you would have seen that the cheapest 30 percent of U.S. stocks by price-to-book had returned 13.7 percent annually to investors from July 1926 to December 1995, whereas the most expensive 30 percent of U.S. stocks had returned 9.6 percent over the same period. You would have also seen that the cheapest stocks had beaten the most expensive stocks 91 percent of the time over rolling ten-year periods.
You might then have wondered whether value’s best days were in the history books. Surely investors would begin to chase previously unloved value stocks and thereby diminish the valuation gap between value and growth – which, of course, had been the very source of value’s edge over growth.
Well, something funny happened on the way to value’s coronation – investors went on an epic growth binge, shunning value stocks in favor of fast growing Internet and technology companies. The S&P 500 Growth Index beat the S&P 500 Value Index for four consecutive years from 1996 to 1999, a margin of 12.9 percent annually in favor of growth during the period.
Investor’s abandonment of value in favor of growth from 1996 to 1999 only served to widen the valuation gap between value and growth.
One way to measure this valuation gap is to calculate the spread in earnings yield between value and growth. The average spread in earnings yield between S&P 500 Value and S&P 500 Growth has been 1.4 percent since 1998, with a standard deviation of 0.7 percent (calculated using five-year trailing average earnings from inception of the data). In 1999, that spread had climbed to 3 percent, implying that value was exceedingly cheap relative to growth at the time.
Armed with a deep valuation advantage, value investing was then positioned for a run of its own. In that round, S&P 500 Value beat S&P 500 Growth for seven consecutive years (from 2000 to 2006) — a margin of 8.5 percent annually in favor of value during the period.
Value’s newfound popularity squeezed the valuation gap between value and growth, and the spread in earnings yield between S&P 500 Value and S&P 500 Growth was a paltry 0.6 percent in 2006.
Then came round three and our melodrama took yet another turn. This time, presumably motivated by fear of a wounded economy rather than by dreams of high tech riches, investors chased growth yet again.
S&P 500 Growth beat S&P 500 Value seven out of nine years from 2007 to 2015, including the last three years, a margin of 4.2 percent annually in favor of growth during the period. The spread in earnings yield between S&P 500 Value and S&P 500 Growth now stands at 2.1 percent.
I leave it to you to decide what the next turn brings. But I think the unmistakable takeaway from the last two decades is that, despite the value premium’s widespread recognition and acceptance, the feud between growth and value is as hot-blooded as ever.
My guess is that investors will always find reasons to fear some corners of the market or to chase others, and as long as they do the value premium will persist. If you doubt that assertion, just look at distressed energy stocks, beaten down emerging markets or galloping unicorns.
A lot of people are worried about corporate leverage. Years of cheap credit have encouraged corporate borrowing, and credit spreads have widened recently on fears of a global slowdown — all of which makes for a potentially explosive cocktail. By one measure — the debt-to-earnings ratio — corporate leverage is at a 12-year high.
But other measures of corporate leverage suggest that fears of a corporate debt binge are overdone. According to Bloomberg data, the debt-to-Ebitda, debt-to-equity, and debt-to-assets ratios for the S&P 500 Index are all well below their historical averages since 1990. The U.S. is not alone. All three ratios for the MSCI ACWI ex-USA Index are also well below their historical averages since 1995 (for both the S&P 500 and ACWI ex-USA, the first year for which data is available).