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June 2018 Newsletter

Dear Clients and Friends,

We have recently had some great conversations with clients concerning investments and have concluded that several important points from these conversations need to be shared with all clients.

Fidelity Information

Please note that the “Total Gain/Loss” on Fidelity.com or the “Unrealized Gain/Loss” on your Fidelity statements does not equal performance for a particular position.  This value does not account for cash received by the position in the form of dividends, interest or capital gain distributions.   Cash distributions can have a material impact on the percentage displayed.  This has been a source of confusion for several clients.

Low-cost Versus High-cost Funds

Competitive forces have driven down the cost of investing in equities and bonds considerably.  However, if a fund’s expense ratio was the sole attribute in deciding whether or not to include a particular fund in a prudently diversified portfolio, it would be fairly easy to use that filter.  We are not suggesting that costs do not matter, but that they must be taken into context with the fund’s overall strategy and size.  Factors to consider:

  • Funds that provide exposure to more liquid1 markets (i.e. large U.S. multinational companies, Treasury bonds, etc.) will generally be less expensive than less liquid markets (i.e. small and/or international and emerging market companies).
  • Larger funds (large amounts of invested dollars) will generally be less expensive than smaller funds (i.e. economies of scale).
  • Funds that are managed more or less by a computer using algorithms with little to no human intervention will generally be less expensive than those that are not.
  • Alternative funds, which represent a much smaller subset of mutual funds in existence, are much pricier than funds that allocate to traditional investments such as stocks and bonds.  In many cases, alternative funds contain strategies that traditionally have existed only in the hedge fund space.  While these funds are more expensive on a relative basis, they are less than their hedge fund counterparts. 

We research and conclude on what we believe is worth paying for and what is not with no conflict of interest to influence our recommendations.

Valuation Concerns

All fundamental research we have reviewed suggests that developed2 market equities are overvalued with U.S. equities being substantially overvalued.  We included a chart from Star Capital that uses two data points on valuation to demonstrate how various countries or regions compare from a valuation perspective.

If we looked at the valuation of the S&P 500 as measured by the cyclically adjusted price-to-earnings ratio (CAPE)3 and divided all of the historical data into 10 deciles from most undervalued to most overvalued, the current valuation of the market is in the most expensive 10% of all measurable periods since 1928.  The most expensive decile is represented by the 90-100% in the table below.  This table illustrates the average prospective returns from 1 to 10 years out.  Historically, the most expensive decile averaged 3.1% annualized over a 10-year basis, and was basically flat over a 5-year basis. 

 This is not to suggest that a positive 10-year return is not possible.  The next two tables illustrate the best and worst returns from 1-10 years at each respective decile of valuation. 


What is expensive can certainly get more expensive, as witnessed in the late ‘90s.  The current ascent of the S&P 500 has shown this as well.  Below is a graph of how values moved from the ‘90s bull run through the ultimate market low (12/31/1997 – 2/28/2009).   The ‘90s bull market continued to run until the latter half of 2000, and then gave back all of the gains within two years, and then repeated a climb and then collapse, bottoming out in February 2009.


Professional Dilemma – Do I Protect My Career At The Expense Of My Clients? 

Investment advisors/managers have always had to deal with the fear of being wrong, in isolation.  It is always better to be wrong with a lot of company, than to be wrong alone (in the near term).

James Montier4of GMO, a well-respected member of the investment community, explains why professional investors continue to hold overvalued stocks:

“This is what I’ve described as this kind of cynical bubble (in the U.S.) where people (professional investors) know they shouldn’t be investing and they say, “Yes, we agree. U.S. equities are expensive.”  I had a bizarre meeting earlier this year on the West Coast of the States with a well-known endowment, and we spent 20 minutes running through all the valuations and they were nodding away and I was like, “Oh, this meeting is going really quite well.” And then we go to the end where we talk about, “What are you going to do? So, how are your positions?” They’re like, “Well, our Chief Investment Officer is screaming at us because we got 6% cash and meant to have 3. So we’re going to go and buy S&P 500 futures.” And this was not some individual investor who had no idea. This was a very sophisticated endowment and here they were behaving in exactly the way that we talked about here was cynical.  

So I think this is a very fragile market where you have this cynical career risk dominated behavior where everyone is saying, “I’m gonna own equities, either because I think they’re going up more or because…” And this is, I think, a big influence on a lot of the professional investors, “I don’t want to look wrong in the short term. It’s not that we don’t think they are over-valued, we do. It’s just that all of my peers are holding this stuff and if I’m the only one who isn’t, and they do well again, I’m gonna look really stupid and I’d get fired.” And that’s why we often talk about career risk being such a dominant force in market behavior because it is one of those things that forces people to do strange things like owning overvalued equities, which they know they’re doing, but they’re doing it because the fear of missing out is just so great. And that makes me nervous because it’s in essence you’re playing a greater fool game. You know, you abandoned the principles of investment. You should no longer call yourself an investor. You’re welcome to call yourself a speculator.” (Meb Faber Research May 23, 2018) 

We have always taken a hard stance in this area.  Our job is to make sure you reach your goals, which mainly consists of helping you create or build toward a sustainable cash flow stream.  Investing an outsized portion of a portfolio into richly valued stocks, which has historically punished investors severely, is not something we could do in good conscious.   We would rather have the uncomfortable conversation of not participating in an expensive market that gets more expensive than risk your sustainable livelihood.   This investment management discipline is precisely what we get paid to do. 


Return and Risk

We can all easily understand risk unrelated to investing.  There is the risk of dying young, the risk of being disabled, the risk of someone getting hurt on our property, the risk of losing our job, etc.  However, from an investment standpoint, risk is a nebulous concept.  The financial community uses risk interchangeably with the statistical measure known as standard deviation, which is basically a measure of variability around the average return of an investment.   What exactly does that mean?  We all know that returns do not happen evenly.   For example, if an investment earns an 8% annualized return over a 10-year period that will not mean that the yearly return was 8% every year.  There will be years where the return is well over 8% (i.e. 25%) and years where the return will be well under 8% (i.e. -15%).   The greater the magnitude of returns both up and down, the greater the risk (standard deviation).   In other words, if you graphed two investments that had the same returns, the lower risk investment would have smaller peaks and valleys.   What are the implications?  Below are the results of a simulation of 2 portfolios with the same return, same withdrawal rate, but different risk levels: 

Portfolio 1: 6% return, 14% standard deviation

Portfolio 2: 6% return, 10% standard deviation

Each portfolio experiences a 4% annual withdrawal, adjusted for inflation, to meet cash flow needs.

The chart shows the probability of success (balance not going to $0) over a 30-year time frame for each portfolio.   


The effect of building a portfolio that has lower peaks and valleys increases the success rate of a sustainable cash flow stream.  Keep in mind that an investor must be willing to give up some years of high performance in return for less significant declines.  There is no silver bullet that allows one to participate in the peaks and not the valleys.  

Owning A Portfolio That Acts Differently From Your Neighbors

We hope that we have made the case as to why it makes sense to allocate to alternative investments other than stocks and bonds: valuation concerns and minimizing portfolio risk (peaks and valleys).  What are alternatives?  Alternatives are a catch-all bucket for anything that does not fit neatly into the stock or bond category.   Our primary criteria for choosing alternative investments is that they perform independently of economic and interest rate risk, both of which are key drivers of returns for stocks and bonds.   Additionally, there must be a solid fundamental reason why these strategies make money over time.   The Stone Ridge All Asset Risk Premium Fund (AVRPX), Stone Ridge Reinsurance Interval Fund (SRRIX) and both merger arbitrage funds meet this criteria.   These investments will not track anything you see on TV or read about in financial publications.  Including these strategies in your portfolio will undoubtedly cause you some performance envy from lack of upside participation in environments where stocks and bonds are doing well.  However, once you realize that including alternatives increases the odds of a sustainable cash flow stream, this envy can be kept in perspective.

The last negative year for bonds was 2013 with a return of -2.02%.  In that year, the return from merger arbitration strategies, as represented by the Barclay Merger Arbitrage Index, was +3.91%.  Merger arbitrage, with its low risk profile, is the exposure we use as an alternative to bonds.

The last negative year for the stocks, as represented by the S&P 500 index, was 2008 when in the midst of the financial crisis the index declined 37%.  In that year, catastrophe bonds, as represented by the Swiss Re Global Cat Bond Index retuned a positive 2.45%. 


Creating a sustainable cash flow stream requires that an investor pay attention to both return and risk.   Minimization of risk requires adding assets that do not correlate or “track” each other.  Although the inclusion of these assets can cause discomfort when traditional assets are performing well, the benefit of reducing large portfolio declines is worth it.  Given a 40-year declining interest rate environment in combination with lofty stock valuations across the globe, we do not believe that traditional asset classes (stocks and bonds) will provide a sufficient risk/return tradeoff necessary for most to achieve their retirement goals.

The concepts presented here are of such importance that we want to make sure that all clients understand them.  In order for us to be confident that this material was understood, we are asking all of you to contact us by phone or email to confirm your understanding. We will reach out to anyone we have not heard from in the affirmative in the coming weeks. 

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  


1A liquid market is a market with many bids and offers, low spreads, and low volatility. In a liquid market, it is easy to execute a trade quickly and at a desirable price because there are numerous buyers and sellers. In a liquid market, changes in supply and demand have a relatively small impact on price .  (Investopedia)

2Developed market economies are recognized to be the most developed, sophisticated, and stable.  These economies are thought to be less risky for investment compared to developing markets.  The United States, Germany, Japan, Canada, and the United Kingdom are considered developed markets.  (investorguide.com)

3The CAPE ratio is a valuation measure that uses real earnings per share (EPS) over a 10-year period to smooth out fluctuations in corporate profits that occur over different periods of a business cycle. (Investopedia)  

4James Montier. James is a member of GMO’s Asset Allocation team. Prior to joining GMO in 2009, he was co-head of Global Strategy at Société Générale. He is the author of several books including “Behavioural Investing: A Practitioner’s Guide to Applying Behavioural Finance”; “Value Investing: Tools and Techniques for Intelligent Investment”; and “The Little Book of Behavioural Investing”.