It's a problem for institutional investors too!

In three previous posts (here are the first one, second one, and third one) we have been building the case that the rise of a class of "financial advisors" who do not manage money themselves (they do not actually make the buy-and-sell decisions on individual stocks and individual bonds) but rather "pick managers" (selecting mutual funds or portfolios that are managed by someone else) may well have led to lower long-term returns for their clients.

We have suggested that the reason for this may be that these manager-pickers "churn" managers, not out of an underhanded desire to make commissions (the financial advisors are usually paid an annual fee rather than commissions, although many can receive commissions as well) but rather out of a desire to be doing something to earn their fee, as well as out of a desire to replace under-performing managers with better-performing ones.

We believe that the data in several years of the Dalbar Quantitative Analysis of Investor Behavior support this conclusion.

Now a Boston University professor of finance has published a study which indicates that institutional investors may be doing the same thing! A recent article in Advisor Perspectives entitled "Maybe Smart Money . . . Isn't So Smart" describes the research done by Scott Stewart, a former institutional fund manager and now finance professor, using data from Effron PSN.

As the graph above demonstrates, in the words of the article, "Stewart's data show convincingly that plan sponsors destroy value when shifting assets." They typically shift money into managers whose portfolios have recently outperformed, resulting in significant under-performance going forward.

Stewart himself states that: "the effort that plan sponsors are putting towards hiring and firing managers is not just a waste of time. It is actually hurting them."

In other words, data shows that the institutional investment community, which is dominated by institutional "investment management consultants" who (like the "financial advisors" dominating the retail investment world) are not money managers themselves but rather help institutional investors "pick managers" and shift from one manager to the next, is being harmed by the same phenomenon we have been discussing. The data seem to suggest that the intermediary between the investor and the money manager is not adding value but may well be destroying value.

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Can your advisor answer this question?

Previously, we discussed research showing that the average equity investor (measured by the largest data pool available, which is the money in equity mutual funds) has a twenty-year performance record which is barely ahead of inflation, and which is far below the record of many index funds and actively-managed funds over the same twenty-year period. You can read our analysis of this problem here and here.

Today, we offer another angle on this issue: In light of this research, do investors ask potential advisors what the long-term rate of return experienced by their clients has been?

Can an advisor even tell you what the long-term rate of return experienced by his clients has been? He should be able to, but can he?

It is very easy to pull out a track record of a fund or a manager that his clients own right now, and show the twenty-year record (or shorter time period, if the record doesn't go back that far) of that particular fund or manager, but as we have pointed out before, the advisor's clients may very well have just entered that fund or portfolio and thus the history before that time does not reflect returns that the clients themselves experienced.

And, unless that advisor has a very consistent system for all of his clients, it is very possible that some of his clients don't own that particular manager's fund or portfolio at all, and that those who do own that manager's fund or portfolio entered it at very different points in time.

Based on the results of research studies like the Dalbar studies, as well as our own experience in the financial world, we would suggest that most advisors you encounter are not able to tell you what the twenty-year rate of return experienced by their clients has been. If they have not been in the business for twenty years, then we would likewise assert that they are not able to tell you what the fifteen-year, or ten-year, or five-year rate of return of their clients has been (or whatever period of time is appropriate for their time in the business).

The reason for this inability is that most advisors today do not actively manage assets themselves, but rather select managers who do the actual management of the assets. While it is easy to find the record of those third-party managers, it is harder to find the record of the advisor who spends his time moving clients in and out of those managers. And that makes it very hard to know the record that the client (who may have had several managers at one time, and dozens of different managers over the course of twenty years) experienced over the same period of time. And, unless the advisor has a very systematic process which he has used consistently for all his clients as he goes about "picking managers" over the years, he will not be able to tell you what the twenty-year record of his clients was.

The results in the graph above suggest that this is a very important question! It is especially significant in light of the data discussed earlier which suggest that a large percentage of the investors whose data is reflected in the chart above are using professional advisors!

A likely rebuttal from an advisor who is not able to show what all of his clients experienced in returns over the past twenty years might be, "But every one of my clients is different, so of course I cannot tell you what the rate of return everyone received over that period of time! Each one may have had different managers, because each one has a unique situation."

Of course it is true that each investor has different needs based on different time horizons and different specific situations, but is it really true that each needs a completely different system for the equity portion of their investments? Do they need a completely different system for their bond investments? How about for their cash investments?

We would argue that while the allocations of equities and bonds and cash differ from client to client, and even account to account for one client or client family, it does not follow that clients should each have a different process governing the portion of their market assets which are allocated to equities (or to bonds either). To do so makes it impossible for an advisor to see what kind of twenty-year returns his clients have experienced.

And it is the long-term returns that are clearly the problem for investors, as you can see in the graph above. A family's wealth is not determined by its one-year rate of return, but by the rate of return experienced over decades.

for later posts dealing with this same topic, see also:

• "Investor Behavior or Advisor Behavior -- 2009" 06/26/2009.

• "The financial services timeline, 1977 to present, and what it means to you" 03/18/2010.

• "Investors fleeing equity funds for bond funds" 08/25/2010.

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Say "tax rate cuts," not "tax cuts"

For years we have argued that the real issue with respect to taxes is not "cutting taxes" but rather cutting the tax rates! In other words, the goal is not to necessarily take in less money overall (which is the way many politicians as well as their echo, the media, frame the issue when they say things like "how will we pay for this tax cut?").

That's why you should insist on the more precise phrase "tax rate cuts" rather than "tax cuts," because cutting tax rates -- especially in the highest income tax brackets -- has an immediate and powerful effect on productive behavior, leading to higher tax revenue.

In our opinion, nobody can explain this as well as economist Art Laffer, whose name is synonymous with this concept and with the "Laffer Curve" which illustrates its effect. He explains in a piece published in today's Wall Street Journal (and available to all, subscriber or not, in the new no-subscription-required Wall Street Journal Editorial Page) that tells the story better than we can.

For readers who may not be completely familiar with the concept of "marginal" tax rates, you can refer to the diagram at the top of this post. Think of your taxable income as water that is poured into a giant barrel that looks something like the diagram at the top of this blog post.

Your taxable income is taxed at a different rate as it fills up the barrel -- from the bottom rate for the first $8,000 or so of your taxable income (for a single filing status, and the bottom $16,000 or so if you are married filing jointly), which will be taxed at the lowest rate of 10%, all the way up to the very top of your income stream. That last part -- the part that is at the top of your particular income tax barrel -- is called your marginal income. That is the part that Art Laffer is talking about in his article. He states, "It's the marginal tax rate that elicits the supply-side response."

People whose income streams go all the way up to the highest bracket (which goes on forever, as indicated by the arrows in the diagram) are the ones who (logically) make the most changes to their behavior when their marginal tax rates are raised or lowered by the government.

As indicated in Art's article, history demonstrates that lowering the rate on the highest bracket has a tremendous positive effect on job creation and economic production, which in turn helps everyone else including those in lower marginal brackets (those whose marginal or top rate is in a lower bracket than the top bracket).

This assertion is very closely related to one that we posted here last week, in the fourth paragraph from the bottom of the entry.

Tax rates may seem like a political issue, but they are immediately and profoundly important in their economic impact.

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For later posts on this same subject, see also:

• "The 'wealthiest' rates matter to everyone" 12/03/2010.

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A twenty-year perspective for the recent market turbulence

Another powerful insight -- particularly in light of the recent market turbulence -- from the most-recently published Dalbar Quantitative Analysis of Investor Behavior (QAIB) is the fact that the average investor underperformance is greatest over long periods.

In a previous post, we discussed Dalbar's research which has consistently shown that most investors achieve unsatisfactory returns over long periods of time, which the Dalbar studies themselves say is due to the fact that "investor behavior erodes the returns on even the best performing fund."

The graph above includes not only those 20-year results which were shown in the previous post, but adds the perspective of short-term returns. The Dalbar study reveals that for short periods, such as one year, the average investor achieves comparable returns to the market. It is over long periods that investors sabotage their own performance by making mistakes driven by fear and other emotions, and particularly (the study notes) the mistake of selling during downturns.

The lesson of the study is often said to be that investors need professional advisors to help them, but as we noted, the people who provide the data for these Dalbar studies state that their research has indicated that about 80% of mutual fund investors (the source of the data) seek professional advice in their mutual fund decisions outside of retirement plans at work. So this problem is not at all limited to those without advisors but may well be caused in part by advisors!

The lesson of the study is also not simply that everyone should "just index." It is not the vehicle itself that is the problem, but the behavior. As Dalbar says, "investor behavior erodes the returns on even the best performing fund." Bailing out of an index fund when the market drops 20% will hurt you just as badly as bailing out of an actively-managed fund. And, we have argued elsewhere why we do not buy into the current index-fund bandwagon.

The lesson of the terrible long-term performance shown in the graph above is that the average investor (and the average advisor, according to our understanding of the data) is fairly capable at picking short-term performers, but does not have the consistency required to achieve long-term success.

If you look around at the panic taking place right now, and count the voices advising you from all angles to "take action" in order to "recession-proof" your portfolio or otherwise make changes to your investment process in light of the market's behavior, you can see why long-term success is so elusive.

It is easy to jump on something that has done well (which is why the average investor has a decent one-year track record) but it is much harder to stay true to a long-term process. Many investors (and many advisors) have no real consistent long-term process beyond finding what has done well lately and switching into that every couple of years.

We advise readers that the first critical requirement is to have a consistent discipline that is based on successful fundamental principles. The second is to realize that, if your allocations of capital are currently set in accordance with your various time horizons and cash-flow needs, then you don't need to panic and make wild changes during market turbulence. Those kinds of wild changes lead to the results in the graph above, and you don't want to go there.

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A few lessons from 2002

Here's a picture of what it looks like when things get ugly in the stock market.

This is a chart of the Dow Jones Industrial Average during the last bear market, which stretched from January of 2000 through October 2002.

Note the three different bottoms, marked by red arrows on this chart (these three successive bottoms are also visible in the chart we posted in this previous blog entry).

One lesson from this chart is that it is very difficult to predict the real bottom in any significant correction. The third arrow marks the actual low for the bear market of 2000 - 2002, which occurred in October, 2002 for both the Dow and the S&P 500. Investors who were waiting for another bottom after that one may well have missed the strong rally that began in March, 2003. Overall in 2003, the Dow was up 25.3%.

Also, this type of diving three or even more times as the market tests for the final bottom is not unique to the chart above -- you can see it in other significant corrections, for example between the dates of January 1, 1981 and December 31, 1982.

Another lesson from the above chart is that, if you have cash available and your financial assets include an equity strategy as part of your long-term growth component (based on a time horizon of more than five years), you should add to your equity strategy during market corrections. Remembering the three arrows in the chart above, you should be willing to add and then add again later during corrections (if your cash-flow situation makes that possible).

Many investors (even wealthy investors and supposedly "sophisticated" investors) did not do that during the period covered in the chart above, and therefore missed the opportunity to add to equity positions during periods of lower prices.

The chart below shows that investors were pulling money out of equities and pouring money into bonds at greater and greater rates right up until the market bottom in the fall of 2002. The chart depicts net fund flows into equity mutual funds minus net fund flows into bond mutual funds. When the red line is above zero, flows into equity funds outweighed flows into bond funds. When the red line is below zero, flows into bond funds outweighed flows into stock funds.

Clearly, bond fund inflows were peaking at the very bottom of the equity market (second yellow circle). In fact, you can see the three bottoms from the first chart (the ones marked with red arrows) reflected in this chart as well.

Most investors will make similar mistakes in the current correction, and in future corrections, because adding money to equity positions during market drops takes intestinal fortitude and far-sightedness, and because the conventional wisdom is shouting that it is time to head for bonds and take cover. In fact, a Wall Street Journal article from this past Friday states that "Traders said it appears investors are shuffling money directly from stocks into bonds."

However, investors with historical perspective should be adding now, if possible, and remain prepared to add more in future months, knowing that drops like the one we are experiencing are opportunities.

For later posts dealing with this same topic, see also:

• "Invest like Mr. Howell" 05/18/2009.
  

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