I recently read an article in Investment News talking about the merits and progress of the equity indexed annuity business. For those of you unfamiliar with these vehicles, they are insurance products that credits a client’s account with an interest rate that is tied to some movement of an index. In addition, they guarantee principal protection. So, they offer some return of an index with no risk of loss. What’s not to like? Unfortunately, a lot.
The article referenced above talks about the 10/10/8 rule. These annuities should have surrender periods no longer than 10 years, surrender charges capped at 10%, and no more than 8% commission to the broker. These are huge fees and commitments that the client has to make in order to invest in these products. The question is whether the cost and restrictions are worth it. Research says no.
In 2009, an article titled “Financial Analysis of Equity-Indexed Annuities” appeared in the CFA Digest. The findings were pretty damning for equity indexed annuities. To quote the article:
In the author’s analysis, all 13 equity-indexed annuities produced returns below returns available on risk-free Treasury bills and substantially below returns available from rolling over six-month certificates of deposit (CDs) and buying five-year Treasury securities. On the basis of the Sharpe ratios, none of the equity-indexed annuity contracts produced risk-adjusted returns that were competitive with returns available on Treasury bills, CDs, or Treasury notes. The alphas for the 13 annuity contracts were all statistically significantly negative at the 5 percent level, implying that the equity-indexed annuities underperformed the market on a risk-adjusted basis by at least 1.73 percent per year, with an average underperformance of about 2.9 percent per year.
The article points out that these annuities have historically underperformed risk-free investments by a substantial margin. I see no justification to pay exorbitant fees in order to lock up your money for 10 years just to underperform a risk-free investment. Now, maybe these returns will change in the future, but until they do, investors should run, not walk, away from these products.
Morningstar came out with a research piece showing the difference between mutual fund returns and investor returns. To clarify, the mutual fund returns are those that would be experienced if you bought the fund at the beginning of the period and held it all the way to the end. Investor returns actually account for inflows and outflows. If investors buy more shares when the price is high and sell when the price is low they could lower their investor return (conversely, they can increase it by buying low and selling high). Basically investor returns are more real life and account for behavioral issues we tend to find with investors. Here is a chart of the actual fund returns versus investor returns over the past 10 years:
So, investors are losing between 1.6 and 3% per year in returns due to their behavior. This may not sound like much but use this example as a cautionary tale. Investor A with $1 million earns buys an equity fund and never makes any changes, earning an 8% return. In 10 years he will have $2,158,925. Investor B starts with the same $1 million but makes changes over that time (that mirror what an average investor does) and therefore earns 6% per year. These changes could be switching from a poor performing fund to a better performing one, or reallocating more to safe assets when the market becomes volatile. In 10 years he will have $1,790,847, a difference of $368,077 (17% less)!
Behavior is one of the most important factors in creating a successful investment experience. Next time you plan on making an investment change, please remember this article. The idea that you should be doing “something” is usually overrated and can be destructive to your wealth.
There is a great new article by Morgan Housel at the Motley Fool about luck versus skill. This is something that we continue to write about. Housel has a great comment about how we should think about managers that outperform:
What do you do in this situation? How do you know which investor to follow, to idolize, to learn from, in a world where it’s hard to tell who has been successful and who has been lucky?
The key to identifying talent versus luck comes down to understanding the difference between process and outcome.
He argues that most people just look at outcomes (investment results) and believe this is the most important determinant in selecting an investment manager. The problem with this approach is that it doesn’t separate out those who have been lucky. And unfortunately the majority of those that outperform are lucky. Here is an excerpt:
Not realizing the difference between luck and skill puts you on a road to ruin. When returns are the result of luck, the person who earned them is going to assume whatever absurd technique he or she used is pure skill, and is likely to keep using that technique with a false sense of confidence. That’s dangerous, because luck quickly reverts to the mean — if I kept my Excel model running long enough, Richard will eventually come crashing back to Earth.
Housel argues that process is much more important. The only problem with his argument is whether an investor can determine who has good process versus bad process. If an investment manager has been outperforming his benchmark for 10 years, whatever his story is may sound like a good process. Let me give my own two cents on elements of process that must be present for it to be considered good:
- Simple- if the process is complex with regards to trading strategies, asset rotation, or some other sort of strange model, I would be weary. It should be fairly simple and easy to understand why it produces returns. Some examples would be rebalancing a portfolio when it becomes overweight in a certain area or diversification to reduce risk.
- Not manager dependent- any strategy that requires the specific knowledge of a manager to be successful is most likely based on luck. We try to avoid any strategy that requires a manager’s knowledge of what the future will hold since we believe it is unsustainable.
- Rigorous- if the process works, the outcomes should also be present. We prefer this to be statistically significant and thoroughly researched before we commit any of our client’s capital to this type of strategy. A 10 year track record by a fund manager does not fit this test. One example we have used to describe this rigor is the idea that value companies tend to outperform growth. Academic research has found this to be true over very long periods AND have found this phenomenon to happen in many other free markets beside the US throughout time. This is the type of rigor that is important for a process to be thoroughly vetted.
If you follow these three elements I think you will find very few managers that have outperformed are truly skillful. It is healthy to be skeptical of any outperformance by investment managers and not let your emotions overtake the logic that these results could very well be due to luck.
Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.