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THE BLUE MONEY REPORT.
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The Blue Money Report
"The future is an opaque mirror. Anyone who tries to look into it sees nothing but the dim outlines of an old and worried face."
~ Jim Bishop
New York Journal-American, March 14, 1959
Welcome to the Blue Money Report
Today's Commentary: 04.10.03 Note from the Editor:Special thanks to Larry Swedroe for his contributions in today's column. The opinions and observations expressed here are Larry's and we thank him for his insight.
The Association of Investment Management and Research (AIMR) is the world's leading society of investment analysts, covering more than fifty thousand investment practitioners and educators in over one hundred countries. Founded in January 1990, AIMR was created from the merger of the Financial Analysts Federation (FAF) and the Institute of Chartered Financial Analysts (ICFA). The FAF was originally established in 1947 as a service organization for investment professionals in its societies and chapters. The ICFA was founded in 1959 to examine candidates and award the Chartered Financial Analyst (CFA) designation. AIMR's members are employed as securities analysts, portfolio managers, strategists, consultants, educators, and other investment specialists.
These professionals practice in a variety of fields, including investment counseling and management, banking, insurance, and investment banking and brokerage firms. AIMR's mission is to serve its members and investors as a global leader in educating and examining investment managers and analysts and sustaining high standards of professional conduct. Part of AIMR's mission is to examine candidates and award the Chartered Financial Analyst (CFA) designation. According to its website, as of August 2002, AIMR had almost $80 million of assets in its investment portfolio. The AIMR Board of Governors sets the investment policy for its portfolio. Interestingly, the Board has chosen to adopt a passive investment strategy "to avoid conflict that might arise from implicit endorsement of a particular style." Since there are only two choices, active or passive, choosing a passive strategy certainly seems to us like a strong endorsement of passive investing - especially in light of the fact that so many of the society's members are security analysts and portfolio managers whose very existence depends on a belief in active management as the winning strategy. With so much brainpower in the organization, one might think AIMR would invest at least some of its assets with active managers with proven track records. And if they were not endorsing a particular style, would they not have invested half their assets in each of the two strategies?
Part Two
For equity investors the answer is that effective diversification is best achieved by owning all the stocks (or at least a very large percent of the market-cap weighting) of an asset class. The reason that so many stocks are needed is that the correlation of returns of individual stocks, even within the same asset class and/or industry, is low. Since the correlation of returns between stocks has fallen in recent years, as individual stocks have become more volatile, the need for broad diversification of equity investments has increased in importance.
Through the use of passive asset class/index funds and/or ETFs effective diversification can be achieved in a low-cost and tax-efficient manner. For fixed-income investors the answer is different, and varies depending on credit quality. U.S. Treasury instruments carry the full faith and credit of the U.S. government. Since they entail no credit risk, there is no need for diversification of this particular risk (though you may want to diversify maturity risk). The most cost effective way to invest in these instruments is to buy them individually instead of by purchasing a mutual fund that invests in these instruments.
The reason is that the main benefit of mutual funds is they are the most effective way to achieve diversification; and none is needed when buying instruments with no credit risk. Government bond funds that try to add value by forecasting interest rates should be avoided, as there is no evidence of any persistent ability to do so. Thus the operating expense ratio of the fund is likely to only serve as a drag on returns.
Funds like those of Dimensional Fund Advisors (DFA) that attempt to add value through the use of what is called a shifting maturity approach are worth considering. The shifting maturity approach is based on academic research that has demonstrated that the best forecast of future yield curves is today's yield curve. DFA has used this knowledge to implement a strategy that has delivered above benchmark returns.
The only other reason to consider owning a fund is for convenience purposes. This is especially true for investors with smaller portfolios that are making regular contributions to their fixed-income allocations. If this is the case then the lowest cost funds should be used.
As investors move down the credit quality chain from AAA to junk bonds they begin to take on more and more credit risk. As they do so, they are taking on equity-like risks. The higher the credit rating, the greater the correlation of returns will be with government guaranteed debt. However, the lower the credit rating, the greater the correlation of returns is with the equity of the issuing company.
Since the prudent strategy for equity investors is broad diversification, as investors seek the greater returns from lower credit quality bonds, the need for diversification increases. For example, investors in securities of what are known as GSEs (government sponsored agencies) such as Fannie Mae and Freddie Mac need to be concerned about diversification of risk far less than investors in CCC-rated bonds. Thus investors in the highest-grade investment quality bonds‹AAA and AA‹can build effective portfolios on their own because they have a limited need to own securities of different issuers.
However, investors in lower-rated bonds have a far greater need for the benefits of diversification. Therefore, if one is willing to accept the greater credit risk of lower-rated bonds the prudent way to do so is through mutual funds.
The problem then is that you have to pay to obtain this benefit, giving away part of the reward for accepting the credit risk. Since the overwhelming body of evidence demonstrates that there is a lack of persistent ability of fund managers to add value by security selection or interest rate forecasting, the lowest cost investment vehicle should be chosen. Investors should also note that as they move down in credit rating, the risk of default does not increase in an arithmetic manner. Instead, the increase is more geometric in nature.
This is why it is suggested that once an investor moves below the AA level, mutual funds become the preferred investment strategy. At the U.S. government and AAA/AA level, investors with large enough portfolios to build their own structured (or laddered) portfolio are probably best served by owning individual securities.
There is one caveat of which investors should be aware. Unless they are either buying directly from the government or only new issues they are susceptible to paying large "commissions" to the seller. While a nominal (typically $25 or $50) transaction fee, or even no transaction fee, will appear on the trade confirmation, it is not uncommon for a broker-dealer to add from 1 percent to as much as 5 percent to the inter-dealer price on municipal or corporate bonds. The reason investment firms are able to add spreads that are this large is that the price of municipal and corporate bonds is unlikely to be available in the financial press for investors to check (as it is with government bonds and stocks).
Unless either buying directly from the government or buying only new issues, working with a fee-only advisor that puts the purchase out to competitive bid to many broker-dealers is the best way to ensure that the best price is obtained.
Larry Swedroe is the author of "What Wall Street Doesnąt Want You to Know," "The Only Guide To A Winning Investment Strategy You Will Ever Need," and "Rational Investing In Irrational Times, How to Avoid the Costly Mistakes Even Smart People Make Today," was published in June by St. Martins Press. Larry is also the Director of Research for and a Principal of both Buckingham Asset Management, Inc. and BAM Advisor Services in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management or BAM Advisor Services.
Today's Commentary: 04.06.03
Or you could get a group of politicians on the Beltway that feel as though the economy needs their thoughtful and insightful relief to get the economy back on track. These folks want taxes cut, and with them the services that the many Americans have come to expect from the federal, state and county governments; they want a return to deficits, borrowing against a future that will not be witnessed by any of the current players nor will it effect their economic future. In this scenario, Alan will still come out ahead.
He will sit back and watch the current administration drive the economy into the ground in a good intentioned effort to save it and the election next year. He will not need to lower interest rates again when the FOMC meets in May nor will he need to increase the money supply. He will simply point to the false hope that the President offers in his tax package and wonder how folks could be so gullible. Then he will be pleased when he discovers that they are not.
I believe that Alan recognizes a new breed of investor. This wholly new animal is an evolutionary marvel. They are skeptical as they admit they always should have been. They have become discerning and critical, when they hear what sounds like a pitch. Those pitches, coming from the very folks who led these investors down the road to prosperity and shrugged their collective shoulders as the road ended, sound hollow to this new breed. These folks are firmly behind the President, peppering their arguments with patriotism, as they see any tax cut as nothing but a return to trade commissions.
Mr. Greenspan spoke his peace and received a stern reprimand from the White House and the Congress. Alan smiled as if amused as the rabble called for his head. He looks as if he is pleased at the history he has written and, in some way, realizes that he once again has exerted his influence over the fate of yet another Bush administration. Pre-mature? Not if the investor refuses to heed the quick knee jerk reaction that many predict will take place immediately when the war ends and the budget passes.
So what does this new investor know? They are working. Those that are not know why. They know that the economy has jettisoned them with the over capacity of earlier exuberance. The unemployed workers, for the sake of this argument, don't matter in this scenario. They are the hybrid version of the this new investor. They are not only skeptical and disbelieving, but they are no longer players in the game in any active way. They can only hope that when the recovery comes, it is sustainable and lengthy.
The new investor knows that their employers are still concerned about the way their businesses are being run. More work is being offered to those that are still on the payrolls. This is a way of showing increased productivity without increased revenues. They also know that if all of those talking heads are proved incorrect, and somehow when they talk in chorus they tend to be, and the market merely pops and then retreats, those jobs that have been hanging in the balance will no longer exist. Alan knows that CEOs listen and are using these jobs like a bank of hours. Ready when they need to become the old "just in time" company they thought they wanted to be and easy to extract from the bottom line should the scales tip in the opposite direction.
The new investor understands this. We are students of Alan's way of thinking. Cautious, perceptive and aware of the nuances of financial bull droppings. No matter who scatters them about, we can't be convinced that they are less fertilizer and more flowers unrealized.
The economy is about to tip. The direction is easier to predict than anyone wants to admit. There are only two people who know the direction. Alan and the new investor.
The Week Ahead/The Week Behind The consistent bounce up and then down; the sideways drift is apt to continue even if the war ends soon. Should investors be concerned. Not really. Investors, including the new ones I spoke of earlier are looking for the big picture. Right now, they are getting it one pixel at a time.
The Week Ahead/The Week Behind Traders believe that the numbers have either been built into the markets or are reported without considering the lowered geopolitical risks. Housing remains a risky venture but not to such a degree that it will effect the market. The Bush budget looks as if it will pass almost totally intact. History lends us an eye on the outcome of this incredible push to rid the government of a surplus it doesn't have. before the decade is out, taxes will need to increase. Perhaps that is part of the plan. It certainly won't be the President's problem. He will be long retired to his ranch hoping that history is kind to his presidency.
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