I am not sure what our fascination about predictions are all about. Whether it is political elections, sports, or the financial markets, everyone seems to be willing to stop and listen to someone who is willing to make a prediction. Rarely do we ever go back to evaluate how those predictions pan out. With regards to investment predictions, every once and a while I like to go back and check the accuracy of those prognosticators against the investment markets to see how they have held up. One of the most famous is Jeremy Grantham, founder of GMO, a multi-billion dollar asset management company. He periodically publishes a 7 year market prediction and gained quite a bit of notoriety for accurately predicting much of the investment returns in the early part of the 1990s. As we approach the end of his 7 year forecast from June 30, 2008, I thought it would be helpful to evaluate his predictions (caveat- the index returns go through 5/31 while the GMO forecast is through 6/30):
|Asset Class||Index||GMO Forecast||Actual Return|
|US Large Cap Stocks||S&P 500||3.2%||9.85%|
|US Small Cap Stocks||Russell 2000||2.1%||10.46%|
|Int'l Large Cap Stocks||MSCI EAFE||5.8%||2.42%|
|Int'l Small Cap Stocks||MSCI EAFE Small||6.2%||5.69%|
|US REITs||DJ Select REIT||2.7%||8.4%|
|Emerging Mkt Stocks||MSCI Emerging Mkts||6.8%||1.25%|
So, if you had taken GMO's advice and overweighted the areas they predicted would perform the best, you would have put most of your money in emerging market stocks and international stocks. The asset classes where they predicted the worst performance (US stocks and REITs) have been the best places to invest. The point is, no one has a crystal ball. Those that have been right in the past have no better chance of being right in the future. Once you realize this, you'll be a much better investor, immune from the siren song of predictions.
David Swenson, the chief investment officer of the Yale endowment fund, has gained notoriety over the past several decades for his management of the Yale endowment fund. In the early 1990s he decided to place a gigantic chunk of the endowment into alternative assets like real estate, hedge funds and private equity. The results were spectacular. From 2000 to 2012 Yale's endowment returned about 12% annually while US stocks averaged 2% during the same period. Not only have other institutions followed suit, but so have individual investors. Retail mutual funds investing in alternative strategies have exploded, aided in part by the success of endowment funds like Harvard and Yale. Instead of being some fringe investment strategy, alternatives have become mainstream, with over $300 billion in these products.
While Yale has focused on alternatives, Norway has gone the opposite direction. Here is an article from 2013 in the WSJ:
Does anything sound familiar here? Extremely broad diversification, focus on small and value companies, low cost. This approach is the one touted by Greenspring on behalf of its clients. In fact, the nearly $1 trillion Norway Pension Fund is invested almost identically to Greenspring clients. It is somewhat comforting to us to know that the largest institution in the world has adopted the same approach. I thought it would be interesting to go back and see how things have fared for both institutions since the financial crisis and ensuing recovering. From the period of June 30, 2007 to June 30, 2014 the Yale Endowment has averaged 5.71% per year. During that same period, the Norway fund has averaged 5.23%. A nearly identical return, but the Yale endowment has experienced 34% more volatility than the Norway Fund.
Before you take this data and assume that you can't hurt yourself by investing in alternatives, please remember that Yale has $24 billion in assets and an investment office of 28 professionals working on this fund. That gives them significant access and leverage in pricing. Two factors that will be working against you. In addition, there is a train of thought that Yale's outperformance will be difficult to continue. Because so many institutions have followed their lead, the opportunities available to them will not be as favorable due to other organizations competing for the same deals. Conversely, it is not that hard to invest like Norway. It can be done through mutual funds or ETFs and at a very reasonable cost. We believe Norway's approach, which is certainly less sexy than Yale's, will be the best alternative for investors in the future.
Have you ever had an advisor or consultant recommend a fund or investment to you because he thought the manager of that investment had a "good story" for future outperformance? It could be that the manager has a certain investment philosophy, risk management strategy or track record that warrants investing money with them. If part of your advisor's value is helping you select these investments, I am here to tell you they probably can't do it, and therefore, you shouldn't be paying for it. Professors from the University of Oxford and the University of Connecticut have released a research study that covers approximately 90% of the market share of investment consultants worldwide during the period 1999 to 2011. Here is an excerpt from the study:
Starting with returns relative to benchmark, on a value-weighted basis we find no evidence that recommended products significantly outperform other products. However, on an equally-weighted basis, we find that average returns of recommended products are actually around 1% lower than those of other products. This result is confirmed using one-, three- and four-factor pricing models, and the differences using returns against benchmark and factor models are in every case statistically significant. We also measure the performance of products in the one- and two-year period after they have experienced a net increase or decrease in the number of recommendations they receive; we do so in order to test for the possibility that consultants’ recommendations add value in the short term, but then become stale and fail to make a contribution. However, there is no evidence that the net increase or decrease in the number of recommendations predicts superior or inferior performance respectively.
Let me put this in more plain English: The smartest, highest paid professionals, working at firms with vast resources, were not able to add any value (and on average detracted from value) when making recommendations on which funds the largest pensions and endowments should select for their portfolios. These were recommendations were made to clients with hundreds of millions of dollars. If you believe that your advisor has some uncanny ability to select winning funds or investments you are probably wrong.
So if advisors can't consistently beat the market by picking winning investments, what should you be paying them for? Good question. We think there are several services advisors can provide which are hugely valuable to clients:
- Diversification and Portfolio Structure- given your goals, time horizon and risk, how much of your portfolio should be in small US companies, real estate, bonds, etc? How you structure your portfolio is a major determinant of your risk and return
- Discipline- investors are their own worst enemy. A good advisor will help a client from inflicting harm upon themselves
- Cost containment- advisors who have a laser focus on wringing every unnecessary cost out of the portfolio can help investors keep more of what they earn
- Tax minimization- designing a portfolio that minimizes income taxes can add tremendous value over time by increasing the investor's after-tax return
- Financial planning- how much should you be saving each year, which goals should take priorities, how can you budget more effectively, how should your estate be set up to accomplish your wealth transfer goals? These are just a few of the questions a good advisor can answer.
As investors and academics start to understand the value an advisor brings, the entire industry will begin to change. Those advisors who are doing business in the future the same way they have always done will be dinosaurs in the not too distant future.
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.