Navigating Structured Products

by Brian Harris, Senior Editor, Dimensional Fund Advisors

In recent years, structured products have gained favor among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.1 With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

Basic design of structured products

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes.2 The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain. Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.3

The following summarizes a few common characteristics of structured products:

•    Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.

•    Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.

•    Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.

•  Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.

•    Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.

• Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

Who might benefit?
A structured product might help an investor who needs a specific payout at a designated point in the future and who is willing to pay another party to shoulder much of the uncertainty. But this benefit generally comes at the expense of lower yield or limited upside potential.

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock (even though this might mean giving up the upside potential of the stock), and at the same time, provide better-diversified exposure to an equity index, such as the S&P 500.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent. And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.

Endnotes

1 Larry Light, “Twice Shy on Structured Products?” Wall Street Journal, May 28, 2009.

2 A reverse convertible bond is one example of a yield enhancement tool. It pays investors a higher coupon rate than other comparable bonds due to its higher risk. This risk comes in the form of the issuer having the option to pay off the debt with either cash or a predetermined number of common stock shares. The method of payment at time of maturity will depend on the stock price, and the issuer will pay with common stock when it is advantageous to do so. The reverse convertible bond was popular until the last market crisis, when many investors experienced heavy losses when they were paid off with lower-value stock shares.

3 A call option provides the holder the right to buy the underlying security at a given price at a certain time in the future. A put option provides the holder with rights to sell the underlying security at a pre-specified price on maturity date. (American-style options can be exercised before the maturity date, whereas European-style options can be exercised only on the maturity date.) An option holder will exercise the put or call option only if the payoff is positive.

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material on structured products is provided for informational and educational purposes only and should not be considered investment advice or an offer to buy or sell securities.

The following article from Investor’s News is an eye opener. It is so easy to think investing is easy – think again. And, enjoy reading this article and take heed.

Like so many investors in the spring of 2009, Gordon Wolf needed to dig out of a hole.

A 68-year-old psychologist in Napa, California, Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch was suddenly down by more than 50 percent.

The broker had invested much of it in a range of exchange- traded funds, or ETFs, a relatively new financial innovation that was replacing mutual funds in the hearts and portfolios of many investors. An ETF, which can be bought or sold like a stock, attempts to track the price of a particular basket of assets–tech stocks, for instance, or high-yield bonds, or commodities ranging from wheat to gold to oil to natural gas.

The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008 everything fell in tandem. Now it was early 2009, and Wolf was watching oil fall to $34 a barrel. That had to be an opportunity, he figured, so he called his Merrill broker and asked about the U.S. Oil Fund, an ETF designed to track the price of light, sweet crude. “This seems to be something good,” Wolf told the broker, and had him buy about $10,000 of USO.

What happened next didn’t make sense. Wolf watched oil go up as predicted, yet USO kept going down. In February 2009, for example, crude rose 7.4 percent while USO fell 7.4 percent. What was going on?

For the rest of this article, go to Investors in commodity ETFs getting “eaten alive”

Christianity and Capitalism

by Richard Doster

It’s been a rough couple of years for free-market capitalism.

In Business as a Calling: Work and the Examined Life, theologian Michael Novak wonders if capitalism is “spiritually empty and corrosive of virtue.” The evidence, perhaps now more than at any time in the past 70 years, may tilt the scales in that direction.

In response to the recent turmoil, French president Nicolas Sarkozy has said, “Laissez-faire is finished. The all-powerful market that always knows best is finished.” And the Washington Post has declared, “The worst financial crisis since the Great Depression is claiming another casualty: American-style capitalism.”

Such a negative view of capitalism might perplex those in the Reformed-Calvinist community. According to David Hall and Matthew Burton, authors of Calvin and Commerce: The Transforming Power of Calvinism in Market Economies, it was John Calvin himself who laid the foundation for today’s market-based economy.

As Calvin’s theological heirs we know that economic decisions, like those in every category, stem from a worldview. They reflect our values and fundamental view of man, and while the Bible doesn’t prescribe a particular economic system it does, Hall and Burton tell us, provide a moral framework within which to make our choices. As Christians, our challenge is to recognize and—to the extent we’re able—create the system that fits best with what the Bible teaches.

So, in a fallen world that’s populated by sinful people, what realities should an economic system address? What good should it aspire to? And what truths—about God, man, and money—should be brought to bear? The answers could (and do) fill books. For now we’ll glance at six features of a realistic, healthy economic system.

For the rest of this article go to Can Christians Reclaim Capitalism? in byFaith Magazine.

I am linking you to a short presentation that shows how the VAT works. The most important thing about the VAT that is not underlined in this presentation is the fact that the consumer never actually sees that tax that is embedded in the price of everything he will buy under the VAT regimen. I believe this is why some members of Congress like it so much; no visibility.

First, I believe we should be looking like starving hawks for ways to cut spending rather than raising taxes. But that being said, I also believe in full disclosure. There should be no secrets when it comes to government getting into the pockets of American citizens. The VAT does just the opposite, it attempts to hide the tax from the consumer. Oh yes, I know, anyone willing to look into it carefully can know what is being paid in tax, but the reality is that most won’t do that and everyone will eventually get used to the increase in costs and not realize how much of it is a tax. And, of course, once the VAT is in place, it can be slowly increased and, like the frog in the pot, we won’t realize that we are being boiled alive. As you can tell, I don’t like the VAT. But I promised you a link to a demonstration to how it works, so here it is. How Would a VAT Work?

Recent Market Volatility in Perspective

The US stock market has taken investors on a bumpy ride in recent years. This volatility has tested investor discipline and prompted some people to question their commitment to equities. While no one knows the future, looking at the past may help you gain a better view of long-term market performance and put the recent market volatility in perspective.

The above chart shows the historical distribution of US market returns since 1926. The performance years are stacked in ascending order by return range. This chart illustrates that:

•    Market performance over the past two years has been extreme by historical standards. In 2008, US stocks experienced their second-worst calendar return in eighty-four years. Then, in 2009, stocks rebounded strongly to deliver a return in the top quartile of the historical distribution.

•    Over the long term, the market’s positive return years have outnumbered the negative return years. Since 1926, the market has experienced a positive return in almost three-quarters of the calendar years.

•    Not only are the positive years more numerous, the chart shows a larger concentration of performance in the higher ranges of returns.

•    The sequence of calendar returns appears random, suggesting that accurately predicting future performance is a difficult task for any investor or professional manager.

Over time, the market has rewarded investors who can bear the risk of stocks and stay committed through various periods of performance.

This data was provided by Dimensional Fund Advisors.

The content of an investor’s faith includes faith in human nature. Human beings have a natural drive to want to do better for themselves and for the world in which they live. We easily understand the part about bettering ourselves, some would call it greed. For some people, this drive is greed, for others it is an honorable desire to provide for themselves and their loved ones.

The part about bettering the world in which we live may be altruistic or it may simply mean that I want the community in which I live to be more pleasant for my own enjoyment and my own enjoyment is hindered if my neighbors are in poverty and squalor, therefore I want them to do well also. That is part of why people move into “better neighborhoods.”

As an investor, whether I articulate it or not, I am counting on these kinds of forces to continue to be in effect in the corporate world where I invest my money. I count on the fact that the CEO wants to be “a winner” and wants his bonus – either because of his drive to provide for himself and his loved ones or to fulfill his insatiable greed. I also count on the fact that corporate leaders know that in order for their products to sell, they have to be making the community better in some way – or at least it has to be perceived that way, otherwise, consumers will not consume that product.

Economic policies and government programs come and go, but as long as human nature continues to be free to be expressed in commerce, I can invest successfully. This is a basic tenet of the investor’s faith. It doesn’t require religion; it just requires a realistic view of human nature.

This is basic to free market economics and is heresy in the economic theories of socialists or communists. Those economic systems have a different view of human nature.

There are other much more academic parts of the investor’s statement of faith and this magazine is full of those statements that have come from the work of men like Harry Markowitz, Eugene Fama and Ken French and others. Investing is not, in the short run, a sure deal. There are risks (another of the tenets of the investor’s faith) and there are techniques to mitigate risk. Just keep the faith.

There are other good reasons to approach the topic carefully. Market efficiency and its offspring, passive investing, are counterintuitive for many investors. It is human nature to believe that one can beat the market (or identify someone who can) through intelligence, insight, and hard work. This belief is constantly reinforced by Wall Street and most of the mainstream media.

Even though some may characterize Dimensional’s approach as passive, it is only passive with respect to activities that don’t add value—mainly stock picking and market timing. One could argue that Dimensional is very active, however, in managing important considerations such as frictional costs and consistent exposure to targeted risks or asset classes.

Here are some examples of framing:

• We don’t speculate. We invest.Rather than relying on speculation, blind faith, or anecdotal evidence, our philosophy rests on a solid foundation of core principles from the science of investing.
• With capitalism there is always a positive expected return on capital.Capital markets are very competitive due to voluntary exchange between buyers and sellers. There is a buyer for every seller; for markets to clear, prices will adjust to new information and reach a level where there is always a positive expected return to providers of capital. Investors would not risk their capital without the expectation of a positive return. We invest in an approach that strives to capture a fair share of the capital market return based on the risk assumed.
• It is difficult to identify superior investment managers in advance.Capitalism breeds competition, and that makes markets difficult to beat. With millions of participants competing in capital markets, it is hard to identify in advance anyone who can systematically beat the market since past winners may have just been lucky and won’t necessarily win in the future. We eliminate the risk of choosing the wrong manager by following a broadly diversified approach that does not rely on stock picking or market timing.
• Diversification is the only antidote for uncertainty.Although diversification neither assures a profit nor guarantees against loss in a declining market, a properly constructed and well-diversified portfolio is a key component of a successful investment experience. We design portfolios that attempt to capture certain risks and eliminate others, depending on your preference and capacity for various types of risk.
• There is no free lunch. Risk and return are related.Higher expected returns only come from bearing more risk that cannot be diversified away. Much like a football player who chooses to play without a helmet, you should not expect to be paid more for taking risks that can easily be avoided. We focus on eliminating risks that you should not expect a reward for taking, such as concentrating your portfolio in just a few stocks.
• Control what you can.If speculation is futile, and trying to choose winners is more often a loser’s game, what can an investor do? The answer is to concentrate on what can be controlled: managing the transactional costs of investing, reducing the impact of taxes, and taking a long-term view. We implement portfolios in a way that is cost effective, tax efficient, and above all, disciplined.

Market efficiency and the active or passive decision are loaded with misconceptions that can lead to debate and confusion rather than constructive dialogue and understanding. More importantly, it can distract our attention from the most crucial element of all: discipline!

The studies comparing dollar-weighted returns to time-weighted returns are widely known, and behavioral research has documented the propensity for individual investors to skate to where the puck was (instead of where it is going). A decision to invest in an active, indexed, or Dimensional approach can often be differentiated in basis points, while percentage points often gauge the impact of an undisciplined or emotional decision unchecked by an advisor’s sound counsel.

This type of behavior is obviously hazardous to an investor’s wealth; therefore, we should attempt to determine if one of these alternative strategies has been able to mitigate some of these actions.

The charts below show the monthly cash flow into all equity funds (foreign and domestic) in the US , along with the prior twelve-month global equity market return. Cash flow bars that vary with, or more closely follow, the prior year return line could suggest more return chasing behavior among the investors within that universe of funds.

Source: ICI

Source: ICI Index is not available for direct investment; its performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

Source: Dimensional

A simple “eyeball” analysis of this anecdotal data suggests that investors in active mutual funds apparently were more influenced by short-term performance than those who held index funds, and advisors (and clients) who invested in Dimensional funds exhibited the most consistency.

The biggest difference between index funds and Dimensional relating to investor behavior may be the requirement for independent advice from a fee-only advisor. If part of the recipe for a successful investment experience is to stay the course, the advisor is the key ingredient to educating investors and keeping them disciplined through good times and bad.

The comments of Robert Dintzner are greatly appreciated.

Many thanks to Brad Barber for providing the ICI data.

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¹Dimensional cash flow data includes US, Canadian, UK, and Australian domiciled funds.

Dimensional Fund Advisors (“Dimensional”) is an investment adviser registered with the Securities and Exchange Commission.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.

The previous column in this series focused on some theoretical aspects of market efficiency and offered points to help lead investors toward your passive corner. As they begin to march in this direction, however, other questions based on practical, if not emotional, considerations may arise. The following responses may reinforce their conclusion that a passive strategy provides the best odds of success.

Q: If there will be managers who beat the market, who cares if there are no more than would be expected by chance? We only need to pick one!

A: As explained in the previous column, equilibrium accounting presents a dilemma for active managers. We know that for every winner there must be a loser because active management is a zero sum game (before costs) relative to the market. This is due to the adding-up constraint, which infers that market returns must reflect all investors who collectively participate in the market. Therefore, the essence of the active-passive decision is to determine whether one can identify the active management winners in advance.

As I mentioned, there aren’t any more winners in this zero sum game than you would expect by chance, so the real issue is whether you can distinguish luck from skill among the past winners in an attempt to find managers who will win in the future.

There is a large volume of literature on this subject, and the conclusions generally point toward very little persistence in the superior returns of past winners. There may indeed be skillful managers, but the data is too noisy for us to pull them out of the sample that includes a large number who just got lucky. Your assumption should be that ex-ante, the expected alpha (or performance relative to the market return for a given level of risk) of any manager is negative, regardless of past performance.

Here’s another way to think about it. If you find a manager who was in the top quartile in the past, that manager has a 25% chance of being in the top quartile in the future. Unfortunately, so does every other manager, with the exception of those who charge extraordinarily high fees or have extremely high turnover, as research shows that high-cost and high-turnover managers are more likely to persistently underperform the market, net of fees and expenses.

Q: But I just read a report showing how the average manager outperformed in all the prior bear markets! Doesn’t that suggest the zero sum game did not apply in those periods?

A: These types of reports often suffer from two deficiencies. First, they usually fail to adjust for survivorship bias, which would impact the results dramatically. For example, the latest Standard & Poor’s Index versus Active (SPIVA) report indicates that survivorship in the most recent five-year period was 44.9% for Canadian equity funds.¹ If more than half the funds in Canada didn’t survive the last five years, imagine how small the sample of survivors would be today for the 1980-82 bear market. Drawing conclusions from such a small sample of survivors would be like attending a World War II fighter pilot convention and concluding that being a World War II fighter pilot results in longevity because everyone at the convention was over 80 years old. Unfortunately, that conclusion would not account for those who did not survive!

The other problem is the results in these types of reports are often equally weighted rather than asset weighted. Although it is generally instructive to show both, an equally weighted average does not reflect the actual outcome investors experienced. This is analogous to buying ten stocks but putting $91 in one stock and $1 in each of the other nine. An equally weighted return calculation would not fairly reflect the portfolio’s actual performance.

Q: Maybe in aggregate active managers won’t beat the market. But can’t they help protect me on the downside and smooth out the ride?

A: The zero sum game means it is mathematically impossible for active investors to collectively win in a down market, as the adding-up constraint holds regardless of the direction the market takes. As William F. Sharpe states in his article “The Arithmetic of Active Management,” “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”²

It is no coincidence that passive strategies began to attract interest from US institutional investors in the summer of 1975. Many had suffered sharp losses in the 1973-74 bear market, despite employing active managers who claimed to offer capital preservation during difficult markets. The poor performance of actively managed strategies during the recent 2008-09 downturn provides additional evidence that, on average, active managers simply raise costs and do not provide superior performance in bear markets.

Q: An active manager incurs significantly higher costs for things like data sources, model development, research, and company visits. Don’t these added costs justify the higher fees associated with active management?

A: Higher fees cannot be justified because of the higher costs involved with active management unless you apply the logic Patrick Ewing used during the NBA work stoppage. In an interview following a collective bargaining session, he was asked to defend the escalation of player salaries to extraordinary levels, to which he responded, “People got to understand that we make a lot of money, but we spend a lot too!” The question is not are the costs of active management higher to the manager, but are the net benefits of active management higher to the investor? As we’ve discussed, the answer seems to be NO.

Q: ETFs and other passive strategies also charge fees. Wouldn’t these fees guarantee that an investor will underperform the market?

A: All investment strategies have costs, so the gross market return is not achievable for investors. Consequently, costs should be a factor when considering different passive strategies, and just because a strategy is passive doesn’t mean it is cost-effective. However, when you adjust for risk, the net return for the aggregate of all passive portfolios is higher than the net return for the aggregate of all active portfolios by roughly the difference in frictional costs. This is not a theory but a tautology, and it must hold every instant!

So, it is accurate to say that in aggregate passive strategies are guaranteed to underperform the market (even when adjusting for risk) by the amount of their frictional costs. But another way of looking at it is to say that the vast majority of active strategies will underperform by even more. Consequently, the odds are in your favour that the passive strategy beats the active one, even though it is guaranteed to underperform the market.

Q: Passive investing relies on the benefits of diversification. But does diversification even work anymore, given that everything seemed to go down in value at the same time, with passive strategies going along for the ride?

A: Although diversification neither assures a profit nor guarantees against loss in a declining market, it can help eliminate company specific (or unsystematic) risk in a portfolio. However, you cannot diversify away systematic risk, and this is what caused the market decline and drop in value of broadly diversified passive portfolios. Fortunately, systematic (or compensated) risk is the only form of risk you should expect to be rewarded for, and the only way to reduce it is to invest in a portfolio with lower expected returns.

However, contrary to what you may think, diversification has been more important than ever. Company-specific risk has increased significantly recently, and this is risk you can eliminate through diversification. It is also risk that you should not expect a reward for bearing!

When we diversify, we give up the opportunity to concentrate our portfolio in the best-performing investments in return for the assurance of avoiding overexposure to the worst-performing investments. Diversification continued to work during the most recent downturn. Although diversified equity portfolios experienced sizable declines, the losses in many widely held stocks were catastrophic—and in some cases irreversible. In addition, high-quality fixed income securities performed very well during the downturn, illustrating the important role of fixed income as a diversifier in balanced portfolios.

Q: Passive investing is a buy-and-hold approach, but does buy-and-hold really work considering investors didn’t make any money for the last decade if they just bought the whole US equity market and held it?

A: It is true that US equity investors have not been rewarded in the last ten years, but this is the risk you must accept as an equity investor in exchange for higher expected returns relative to less risky alternatives like US Treasury bills. If the risk never materialized, even over long horizons, it would be an arbitrage opportunity and the higher expected returns would not persist.

Investors shouldn’t be happy with the results over this period, but what is the alternative? If the alternative to a buy-and-hold approach is a trading strategy, the results likely would have been worse. Once again, the zero sum game’s adding-up constraint means that the only way to profit from your trading strategy is at someone else’s expense. You may get lucky, but chances are you will simply be adding more risk, higher transaction costs, and higher taxes to your portfolio while increasing uncertainty and broadening the range of possible negative outcomes in the future.

Moreover, if you’re contemplating pursuing stock picking as an alternative to buy-and-hold then you may want to consider Jim Davis’ recent analysis of all US stocks going back to 1926. He concluded that the best-performing stocks each year had a pronounced effect on the overall market return. The compound return on all US stocks from 1926-2008 was 9.4%. If you eliminate the top 10% of performers each year, the compound return drops to only 6%, and if you eliminate the top 25% of performers, your compound return goes down even further to an astonishing -1%.

Simply put, if you excluded the very best performing quartile of stocks each year, you would have lost money investing in equities over a period of more than eighty years! The implications of this finding are daunting for stock pickers, given that when you buy a stock—or continue to hold one you have already bought—there is a 75% chance each year that it will fall outside the universe of winners that accounts for all of the market’s return.

William Bernstein commented on Jim’s finding as follows.

“This may get you thinking: If a small list of securities accounts for the market’s long-term returns, why not avoid all the headaches and losses you’ve suffered recently by carefully choosing these super stocks? Simple: Because a portfolio of ‘carefully chosen’ equities could easily wind up with none of the best-performing stocks in the market—and thus produce flat or negative returns over many years . . . Remember that the point of investing isn’t to aim for the highest possible returns. It’s to make sure you don’t die poor. Yet trying to optimize your performance by seeking out the needles in the haystack is a sure way of becoming, well, poor.”³

Q: Aren’t passive strategies like ETFs best suited for do-it-yourself investors who don’t value expert advice?

A: The premise of passive investing is that no value can be added from stock picking or market timing. Passive investing doesn’t imply there is no value in expert advice. Most fee-based advisors focus on wealth management rather than stock picking or market timing. Wealth management is based on holistic advice revolving around things you can control, such as saving, spending, taxes, costs, risk management, risk budgeting, asset allocation, communication, and reinforcing discipline. The right passive investments fit very nicely in this framework, and the complexity of passive alternatives supports the need for professional advice.

Q: You make some good points, but I don’t fully grasp all of this and I’m not completely convinced. What is the bottom line?

A: Let’s say markets are in fact inefficient, that there are managers who do persist in outperforming, and that you don’t like the idea of indexing. The bottom line is that none of these points would really matter. Here’s why:

• If the market is inefficient, then the aggregate of all investors will still underperform a market rate of return by the amount of frictional costs (fees, trading costs, taxes, etc.). This is due to the adding-up constraint at work in equilibrium accounting.

• If there are superior managers, I have no way to identify them in advance and neither does anyone else.

• If you don’t like the idea of indexing, then let’s invest in passive funds that can address many of the flaws in merely tracking a conventional index.

The only question that matters is whether you, or someone you know, can reliably identify enough superior-performing investments, in advance and after costs, to outperform a market rate of return. The answer is probably NO! So let’s at least put the odds of success in your favor.

Investing is risky enough to begin with. Why add another layer of risk with no expected return?

For the first article in this series go to Active vs Passive: Man vs Market

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The comments of Sam Adams and Weston Wellington are gratefully acknowledged.

¹ Standard & Poors, Index versus Active Funds Scorecard for Canadian Funds, June 4, 2009, 5.

² William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9.

³ William J. Bernstein, “Are Stocks a Loser’s Bet?” CNNMoney.com, May 9, 2009, http://money.cnn.com/2009/05/09/magazines/moneymag/stock-strategies.moneymag/index.htm (accessed July 15, 2009).

James L. Davis, Vice President, Dimensional Fund Advisors

Investors are concerned about inflation, and rightly so. Average annual inflation in the US between 1929 and 2008 was nearly 3.3%. A dollar at the end of 2008 had about the same purchasing power as eight cents did at the beginning of 1929. Protecting the purchasing power of an investment portfolio is a genuine concern.

Inflation is not the only issue for investors, however. An interesting strand of economic research addresses the idea that people do not simply care about their own standard of living; they are also concerned about how their living standards compare to those of other people.¹ If everyone around me is enjoying a higher standard of living over time, I do not want to be left behind in an economic sense. In the language of the papers that have been written on this topic, I want to “keep up with the Joneses.”

Figure 1 shows evidence that this may be a genuine concern for consumers. This chart shows annual observations of per capita real disposable personal income (DPI) and per capita real personal consumption expenditures (PCE) for 1929-2008. The series are in real (2000) dollars, so the upward trend is not caused by inflation. The numbers are per capita, so they do not simply reflect a growing population. Instead, this chart arguably reflects a substantial increase in living standards for US consumers over the past several decades. As a result, it shows why just keeping up with inflation is not enough. Real spending and income levels increased from around $5,000 to more than $27,000 between 1929 and 2008, representing an average increase of more than 2% per year. A consumer who just kept up with inflation would still be at the 1929 levels, while the overall level increased five-fold since then. If all I did was to keep up with inflation, the Joneses would have left me in the dust.

How well have stocks and bonds protected investors against both inflation and rising living standards? Table 1 shows some evidence for 1942-2008.² This table reports average annual returns in excess of both inflation and a measure of changes in living standards. Each year, the excess return for an index is:

R(.) is a return, and ?PCE is the relative change in PCE for the year. Table 1 shows that fixed income securities have generally not done a good job of keeping up with both inflation and the Joneses. In contrast, the average excess returns for the stock indices are reliably above zero and large enough to be economically meaningful.

At this point, the professor in me wants to ask a multiple choice question. In view of the foregoing information, what is the most appropriate response?

1. “Since I want to keep up with both inflation and the Joneses, Table 1 tells me that I’d better put my portfolio in stocks.”
2. “Inflation is all that matters. Those gains in living standards are a thing of the past.”
3. “Historically, stocks have had returns high enough to cover both inflation and living standards. However, stocks are risky (recall 2008). Therefore, like most things in economics, there is a trade-off. The right answer for me depends upon how much risk I am willing to accept. Of course I want to maintain (or increase) my living standards, but I am not willing to take on an amount of risk that will keep me awake at night. My portfolio will contain both stocks and bonds, because that’s good diversification. How much of each depends on my risk tolerance.”
4. “Capitalism is dead. All my money is going into canned goods and ammunition.”

If I am grading the exam, answer (c) gets the points. If you answered (a), I think you are ignoring the risk that went along with those stock returns in Table 1. If you answered (b), I think you are overlooking the source of our increased living standards. The rising income and consumption series in Figure 1 are the result of sustained productivity gains. Productivity increases through technological advances, and technological advances are a natural result of financial rewards for entrepreneurial activity. As long as the economy is allowed to reward innovation, there should be at least the opportunity for continued increases in living standards. If you answered (d), I have to wonder why you’re still reading this.

This discussion ignores the role of labor income in maintaining living standards. Incorporating the interrelationships among labor income, living standards, and asset returns would take the analysis to another level of complexity. Accordingly, that discussion is left for another day.

Improved living standards are a good thing, but people who don’t fully participate in the improvement can start to feel as though they are being left behind. Rising living standards can therefore present a challenge to investors who do not want to be economically worse off than friends, neighbors, and relatives (i.e., the Joneses). While some may see the emphasis on keeping up with others as shallow, those who have experienced a decline in relative living standards probably do not. Because of current fiscal and monetary policies in the US and elsewhere, many investors are focused on inflation. This analysis suggests that we should not myopically focus on inflation to the exclusion of other important factors.
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The helpful comments of Ken French, Inmoo Lee, Marlena Lee, Sunil Wahal, and Weston Wellington are gratefully acknowledged..

1. For example, see John Y. Campbell and John H. Cochrane “By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior.,” Journal of Political Economy 107: 205-251.

2. The PCE data are available back to 1929, but several of the fixed income indices are not available until 1942. The year-end Treasury yield curves for 1941 and 2008 look very similar, so the fixed income excess returns in Table 1 should not be biased by a sustained one-way move in interest rates. The stock index returns may be biased upward, because 1942-1945 were very good years for stocks. Excluding these years produces average excess returns of 5.21% for All Stocks, 9.29% for Value Stocks, and 7.54% for Small Cap Stocks. The corresponding t-statistics are 2.30, 3.41, and 2.43.

Sir John Templeton is quoted as saying, “The best time to invest is when there is blood in the streets.” Of course, he was speaking metaphorically. His statement is very applicable to our circumstances today.

Many would say we are in the trough of this recession. The trough doesn’t mean the “bottom of the market”, but it does mean the time frame around the end of a recession and the beginning of recovery. I won’t get into whether the recession is over and recovery has started – I don’t know. But it does seem to be becoming accepted that we are in the range of either the end or the beginning (of recession or recovery). So, what does that mean to me as an investor?

Many investors assume that stock returns follow the business cycle. According to this view, the stock market offers a higher expected return premium in a strong economy and a lower premium in a weak economy. (The market premium refers to the return of stocks over T-bills.)

In reality, the market premium tends to run counter to the business cycle, as illustrated in the conceptual graph above. The premium is a function of how investors perceive their risk exposure in equities relative to cash, or T-bills. During recessions, as company earnings fall and investors become more risk averse, stock prices adjust downward, which raises expected returns. The possibility of earning higher returns compensates investors for choosing stocks over cash.

Conversely, investors will accept a lower expected return when they regard stocks as less risky relative to cash (i.e., a lower market risk premium). This typically occurs when the economy is expanding and the outlook for company earnings is strong. As more investors choose to hold stocks, market competition drives up stock prices relative to company performance, which reduces expected returns.

Investors should not attempt to time the business cycle. Economic performance is only known after the fact, while stock prices reflect the market’s view of future business performance. As new information becomes public, stock prices adjust to provide equity investors an expected return that matches perceived risk.

Investors are best served by diversifying across many stocks, maintaining a long-term perspective, and applying discipline throughout the business cycle.