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January 28, 2015

Dear Clients and Friends,
 

Financial guidance is most effective when integrated and coordinated with all areas of financial planning. This approach drives our efforts to assist clients in managing cash flow, debts, investments, insurance, income taxation, retirement, and estate planning. The subject that receives the most attention and fills the most media content is investments. It is also an area that we spend a lot of time discussing, researching, and evaluating. 

Our job as advisors is to develop, in an unemotional setting, a carefully thought-out investment strategy that utilizes the benefits of value-driven diversification and to encourage clients to stay the course. This approach has proven its worth since our advisory services started in 1983. 

Our objective in this newsletter is to shed light on some important areas within investment management that, when understood, will reinforce or increase your confidence in our approach in helping you manage your financial resources.  We encourage anyone with questions, concerns, or who would benefit from a discussion, to schedule a meeting or a call. 

To begin, we will discuss the two major types of investment management: passive and active.

 



Passive Management

What does the “market” mean to an investor? It is often the most widely quoted index in one’s home country.   The S&P 500 and the Dow Jones Industrial Average, or Dow, are the two most widely known in the U.S. The “market” could mean the FTSE in the United Kingdom, the DAX in Germany, the CAC 40 in France, or the Nikkei in Japan. Each index is designed to act as a representative sample of a larger universe of securities.

Passively managed strategies, most commonly represented by index funds, are designed for investors who want to inexpensively replicate a market or market segment. The benefits of passive strategies are 1) they are inexpensive, 2) there are no performance surprises versus the index, and 3) they are fairly tax efficient.

Investing in passive strategies is a reasonable option for investors. In our experience, however, investors want to substantially match market returns on the upside, but are not so willing to accept downside participation in steep market declines such as 2008, when the S&P and international markets dropped 37% and 47%, respectively. In up markets, investors desire good relative performance, but in down markets, absolute performance is their primary concern. "Prospect Theory", originally described by Daniel Kahneman and Amos Tversky, suggests that individuals are more upset by prospective losses than pleased by equivalent gains. Empirical studies show that this ratio is almost 2 to 1, which validates our personal, “get me out of the market” experiences with clients over the years.

Passive strategies often gain popularity during bull markets, such as the current run for U.S. stocks, as investors erroneously anticipate that past performance will translate into future performance. For those who believe the U.S. market will permanently outperform others, and has disconnected from the rest of the world, consider the Morningstar chart below that shows U.S. versus international market returns dating back to 1970. How often have we heard that “this time is different”, only to realize that it really wasn’t.

Active Management

Active management, by definition, is all strategies that are not managed passively. There are many different ways to “actively” manage. Ultimately, it means holding securities, sectors, and regions in different proportions versus any particular index. This can also mean not being fully invested when markets or specific investments are not attractively priced. Traditionally, active managers are measured (or “benchmarked”) against a particular passive index. This creates the potential for a conflict of interest as explained by Jeremy Grantham of GMO, a highly respected institutional manager:

 

“The central truth of the investment business is that investment behavior is driven by career risk. In the professional investment business we are all agents, managing other peoples’ money. The prime directive, as Keynes knew so well, is first and last to keep your job. To do this, he explained that you must never, ever be wrong on your own. To prevent this calamity, professional investors pay ruthless attention to what other investors in general are doing. The great majority “go with the flow,” either completely or partially. This creates herding, or momentum, which drives prices far above or far below fair price.” 

 
 
As a result of benchmarking, many managers elect to “hug” the benchmark by holding many of the same securities. Yale University did a study on index hugging, which led to the term “active share”. It measures how similar a fund is to its benchmark index. An active share of 0 means a fund is equivalent to the benchmark index and 100 means it is completely dissimilar. Funds that have an active share of 60 or less are considered closet indexers, meaning, they substantially mimic a market index, while still charging higher fees.

The Yale study concluded: 1) Funds with high active share have a greater chance of outperforming and 2) Investing in actively managed funds with low active share is similar to buying an index fund with a high price tag, something to avoid. 

High Active Share

Funds that have an active share of over 90 are true active managers. These managers, who invest in a manner that is substantially different from an index, are the exception. High active managers can have successive years of outperformance and underperformance versus its benchmark. While benchmarking is an idea with good intentions, it has often resulted in negative consequences for the vast majority of investors. Financial pundits emphasize making short-term comparisons of the market to the performance of high active share managers. Their job is to capture an audience and encourage action. Short-term comparisons creep into an investor’s psyche, patience wanes, and action is triggered. The cost of this action is represented in the chart below prepared by Vanguard that shows the average annual difference between investorreturns and fund returns by category:
 
 
Instead of focusing on the market, as the financial pundits would have you do, think about the alternative. Say you have a certain amount of capital to invest. You hire someone to go out and invest that capital when there are good opportunities, but you do not force them to put all your cash to work all of the time. Instead you tell them to put cash to work when they find prudent opportunities, but to hold cash, or safe alternatives, when they do not. You do not constrain their ideas to just opportunities in the U.S., but give them carte blanch to invest in whatever companies represent the best opportunities. Does this sound reasonable? We certainly think so. Okay, now here’s the catch. If the investments they make on your behalf underperform the market over a three or five year period, will you be able to resist the suffering from performance envy and stay the course? Successful investing often rewards such patience.

From Jean Marie Evelliard, Founder of First Eagle Global Fund:

If you lag in the first year, your clients are okay with it; if you lag again in the second year, they get nervous; and if you lag in the third year, they are gone! Our fund had total assets of around $6 billion in 1997, but by 2000 it was down to $2 billion. I was unhappy, but I constantly reminded myself that I was acting in the best long-term interests of our investors, so I had to do the right thing. When the mania was over, investors came back and praised our discipline. The fund [the First Eagle Global Fund] today has a size of close to $30 billion.”

[In November 2000.] An investor who buys a building or an entire corporation gives a great deal of attention to the price to be paid for the asset. So does the buyer of a car or even a bathing suit. They all seek value. What's so different with equities? Are they just pieces of paper to be traded in and out of on the basis of psychology, sentiment, herd instinct? Doesn't financial history teach any lessons? After all, many individuals' savings have been repeatedly wiped out-yes, wiped out-in the past half-century of economic expansion, most recently with Internet stocks. My point here is that both closet indexing and shooting for the stars are exposing financial planners' clients to undue risk. Both are a result of benchmark tyranny.”

Grantham has the same take. Despite acknowledging the career risk associated with ignoring the crowd, GMO created a fund called the Benchmark Free Allocation Fund in 2003 because he was able to demonstrate internally, that by ignoring the market (aka benchmark), they were able to produce much better results than GMO’s other diversified stratgies. In naming the fund “Benchmark Free”, the hope was to buy a few extra years of investor patience in case of performance lag.   Grantham has admitted that GMO does their heavy lifting, achieving better relative performance, in down markets.

Below are graphs prepared using Morningstar Advisor Workstation SM that show the following:

1 – A comparison of one of our actively managed funds, Jean Marie Evelliard’s First Eagle Global Fund, versus the S&P 500 since the fund’s inception.

2 – A comparison of GMO’s Benchmark Free Allocation Fund, First Eagle Global Fund, and the S&P 500 for the longest time period available (2003- 2014) - the long-term view.

3 – A comparison of the two funds and the S&P index during the last five years – the short-term view. 

  

 

The graphs show the attractiveness of the passive (S&P 500) investment during the recent five-year bull market and the benefits of being patient with value-driven active managers through a more complete market cycle.




Risk

We humans take mental shortcuts all of the time. It has been necessary for our survival. However, in the investment world, these shortcuts can do harm.   Focusing on annual returns (or annualized returns) at the expense of other data is the result of availability bias. We focus on what is in our view, and what is in our view is often determined by others. Pick up a financial magazine, turn on CNBC, access a financial website, and you will readily see numbers with up or down arrows, color coded in red or green, with all of the necessary buzzwords that draw you in to emphasize one thing, RETURN.

Imagine you are approaching retirement. You anticipate that you will need to withdraw $40,000 a year from a $1 million portfolio for a period of 10 years. As your advisor, we have two portfolios to offer you and miraculously know the 10-year return of each portfolio in advance. Your choices are: 1) a portfolio that will have a compounded annualized return of 6% or 2) a portfolio that will earn a compounded annualized return of 4%. Which one suits you? It could not be more obvious, right? Return is the only thing that matters, or based on the attention it receives, at least it is the most important thing.

 

Case 1

Year 1

2

3

4

5

6

7

8

9

10

 

 

 

 

 

 

 

 

 

 

 

Return

-30%

-20%

-10%

30%

25%

12%

35%

9%

15%

15%

Loss/Gain

        (300,000)

     (132,000)

       (48,800)

      119,760

          119,740

            67,044

      207,353

         67,779

      117,131

      128,963

Withdrawal

            (40,000)

       (40,000)

       (40,000)

      (40,000)

          (40,000)

          (40,000)

      (40,000)

      (40,000)

      (40,000)

      (40,000)

Ending

          660,000

       488,000

       399,200

      478,960

          558,700

          585,744

      753,097

      780,876

      858,008

      946,970

                     

 

 

Case 2

Year 1

2

3

4

5

6

7

8

9

10

 

Return

4%

4%

4%

4%

4%

4%

4%

4%

4%

4%

Loss/Gain

             40,000

          40,000

          40,000

         40,000

            40,000

            40,000

         40,000

         40,000

         40,000

         40,000

Withdrawal

          (40,000)

       (40,000)

       (40,000)

      (40,000)

          (40,000)

          (40,000)

      (40,000)

      (40,000)

      (40,000)

      (40,000)

Ending

       1,000,000

    1,000,000

    1,000,000

   1,000,000

      1,000,000

      1,000,000

   1,000,000

   1,000,000

   1,000,000

   1,000,000

 

Case 2, with a 4% average return, ends the 10-year period with $53,000 (or 5.6%) more in value than Case 1 that had an average return of 6%. The difference has to do with the variability of annual returns (risk), which, in statistical terms, is referred to as standard deviation. The point of the example above is to show that there are trade-offs between risk and return, and that they both impact outcomes, even though the return metric is what stays consistently in the spotlight. It is our job to make sure all relevant factors are considered.
 
 
 
Summary
 

·         The two broad types of investment management are active and passive.

·         Passive management, also known as indexing, mimics a particular index.

·         Active is everything else but passive management. There are various types of active management.

·         There are strategies that promote themselves as active, but substantially mimic the index while charging much higher fees than passive. These strategies should be avoided.

·         True active managers, those with high “active shares”, can deviate from any particular index for consecutive years. These managers are not concerned about relative performance, but absolute performance over long periods.

·         Investors want to be in relative performance strategies in up markets and absolute return strategies in down markets. No one has figured out how to successfully execute this.

·         Investors look at recent performance and extract it into the future, which causes them to switch out of absolute and into relative strategies or vice versa at the worst possible times. Empirical evidence shows these moves cost investors dearly. 

·         Committing to an investment strategy takes discipline and patience. Financial pundits and the plethora of information in print, on TV, and on the web have exacerbated impatience.

·         Prospect Theory of behavior finance shows that people feel the pain of financial loss twice as much as the pleasure of financial gain. This “loss aversion” frequently leads investors to abandon a perfectly prudent investment plan.

·         While return is the most widely publicized metric, risk is vastly underappreciated and has a significant impact on the ability for investors to reach their goals. There is a tradeoff between risk and return that all investors must consider.

·         High active value managers at First Eagle, Yacktman, and Mutual Series funds have consistently demonstrated a good risk/return tradeoff. They have the conviction to ride out waves of investor redemptions stemming from performance envy. To quote Evelliard again, “I would rather lose half my shareholders than lose half my shareholders’ money.” This is our sentiment as well.

 

Annual Net Worth Statements

We are in the process of preparing personal Net Worth Statements as of December 31, 2014. Taking an accurate picture of assets and liabilities on an annual basis is an important financial planning tool that improves our ability to serve you. These statements allow us to answer these questions: 

 

·         Should any existing financial accounts be consolidated in the interest of simplification?

·         Should there be any changes in asset ownership that will minimize income taxes?

·         Should there be any changes in asset ownership that will minimize estate taxes or probate expenses?

·         What is the nature of any current debt? Should any debt be paid off or refinanced? Was personal spending supplemented by an increase in debt, which could impact retirement feasibility or retirement security? 

·         Have there been any additions to personal property requiring insurance coordination? 

·         Were there any purchases, sales or gifts of real estate interests? 

·         Were there any changes in asset ownership not communicated to us? Ownership changes impact insurance, taxes and estate planning.

 

Please respond promptly to our request for this information.

 

Information for Tax Return Preparation

It is time to begin gathering the information needed to prepare 2014 tax returns. It is a good idea to keep a current year tax file and fill it with any documents you know will be needed to prepare your returns, such as charitable contribution receipts, property tax bills, and copies of estimated tax payments made. Financial institutions, including Fidelity, will be sending out Form 1099s with information on dividends and capital gains. You should assume that Fidelity’s 1099s are accurate, unless we notify you otherwise and provide you with a more accurate statement of the year’s gains and losses from our system. We have sent out statements of planning fees paid in 2014 from taxable accounts. Note that fees paid from IRAs have already provided a tax break, since payments are not treated as taxable withdrawals. Therefore, they are not deductible on Schedule A of your Form 1040. 

 

Annual Delivery of Privacy Statement
 
We are committed to maintaining the confidentiality, integrity, and security of the personal information entrusted to us. The SEC requires delivery of the enclosed copy of our Privacy Statement on an annual basis.  
 
 
Information Filing - Securities and Exchange Commission (SEC)
 
The Securities and Exchange Commission requires all registered investment advisors to update the information on file with the agency on Form ADV within 90 days of year end, or March 30. We intend to revise the form and post it on our website by that date. If you do not have access to our website and desire a copy of that form, please contact us.

 

2015 Annual Tax Planning Limits

A summary of key tax planning limits for the current year is attached for your reference.

 

In The News

Vincent was recently interviewed for an article on retirement planning that appeared in the December 16thissue of Delaware Business Times. The article can be found at:   http://www.delawarebusinesstimes.com/the-correct-first-steps-lead-to-comfortable-retirement/

 

We continue to work daily to earn your trust and confidence.

 

 

Best Regards,

                               

Vincent A. Schiavi, CFP®, CPA/ PFS                  Ravi P. Dattani, CFP®, CPA

President                                                          Vice President  

 

 
 

 

SCHIAVI + DATTANI

 

 

 

 

 

PRIVACY STATEMENT

 

 

Schiavi + Dattani and its employees understand the importance of maintaining the confidentiality, integrity and security of the personal information entrusted to us.

 

The categories of nonpublic information that we collect from you may include information about your personal finances, information about your health to the extent that it is needed for the financial planning process, information about transactions between you and third parties, and information from consumer reporting agencies, e.g., credit reports. We use this information to help you meet your personal financial goals.

 

With your permission, we disclose limited information to attorneys, accountants, mortgage lenders and other professionals with whom you have established a relationship. You may opt out from our sharing information with these nonaffiliated third parties by notifying us at any time by telephone, mail, fax, email, or in person. With your permission, we share a limited amount of information about you with your brokerage firm in order to execute securities transactions on your behalf.

 

We maintain a secure office to ensure that your information is not placed at unreasonable risk. We employ a firewall barrier, secure data encryption techniques and authentication procedures in our computer environment.

 

We do not provide your personal information to mailing list vendors or solicitors.

 

We require strict confidentiality in our agreements with unaffiliated third parties that require access to your personal information, including financial service companies, consultants, and auditors. Federal and state securities regulators may review our Company records and your personal records as permitted by law.

 

Personally identifiable information about you will be maintained while you are a client, and for the required period thereafter that records are required to be maintained by federal and state securities laws. After that time, information may be destroyed.

 

We will notify you in advance if our privacy policy is expected to change. We are required by law to deliver this Privacy Statement to you annually, in writing.

 

 

 

 

 



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