/Strategy

6 Ideas for Lump Sum Investing

You’ve just received a lump sum of cash. Perhaps it was from a rollover retirement account, the sale of assets, or an inheritance. Now what do you do?

Your first thought may be to spend it. That’s always an option – and probably the most fun option. The less-fun decision is to invest it. This is especially less fun if you’re unfamiliar with how to invest a lump sum. It’s no wonder one of the most frequent questions I am asked.

One of the first decisions to make is whether to invest the proceeds all at once or over time using dollar-cost averaging (DCA). This is a strategy where you invest equal parts over time based on planned intervals. There are advantages and disadvantages to both. 

Here are four simple questions to ask yourself, to help you decide which strategy or combination of strategies may be right for you.

  1. What is the size of the cash lump sum relative to your existing savings? If it is relatively small, regardless of where it came from, I suggest investing it all at once and being done with it. My rule of thumb is 20 percent of your current savings. If a lump sum is 20 percent or less of the amount you already have, then invest the entire amount in your existing asset allocation and don’t think anything more about it. For example, if you already have $1 million in savings and you inherit another $200,000, just put it all in at one time.
  2. What if the lump sum is greater than 20 percent of your savings? The answer is more complex. Different factors will determine whether you should put it all in or DCA. Consider the following questions.   
  3. Was this money from an employer pension plan? If the answer is yes, then the cash was most likely recently invested in stock and bond investments, which means it probably is best invested right back into the same. For example, if your 401(k) was recently invested in stock and bond funds or a balanced fund before it was liquidated to cash for the distribution, then the cash should go right back into a stock and bond allocation that’s right for your long-term retirement needs. If you’re not sure about your allocation, the distribution may serve as an excellent time to be in touch with an objective investment adviser, to help you determine where you stand, big-picture.
  4. Was the money from the sale of a business or property? If the answer is yes, then there was a previous business risk attached to that money, even though it wasn’t direct stock market risk. In this case, consider investing a portion of the money in an allocation of stocks and bonds based on your needs and DCA the remaining over a period of time, perhaps two years. This spreads out the entry-point risk into the markets. If your timeframe and risk tolerance are such that you can calmly stay the course through volatile markets, then you could put the entire amount to work for you as soon as possible, to give it more time to earn the market’s expected long-term returns.
  5. Was the money inherited, won, or from another source where you had no previous ownership? Here is where DCA can again work well for many investors. You might consider investing a portion of the funds now and DCA the rest over a few years. For example, imagine you won $1 million after-tax in a lottery. By investing $400,000 this year and $200,000 per year for the next three years, you can spread out your entry-point risk.

The guide above provides some ideas for the timing of lump-sum investing, but it doesn’t address where to invest it. That depends on your financial situation — although receiving a lump sum often changes that. Here are a couple of guides to help with investment decisions:

  1. If the lump sum is 20 percent or less of your current savings as described in #1, then your asset allocation shouldn’t be affected, at least not by the new cash in and of itself. Simply invest according to your current investment policy (or establish one if you’ve not yet got one).
  2. If the lump sum is more than 20 percent of your current savings, then you should consider reviewing and revising your overall investment strategy. You may be able to do this on your own by reading investment books, or you can get help from a trusted investment adviser. Another idea is to visit www.Bogleheads.org and learn from this free online community of individual investors.

Receiving a lump-sum distribution doesn’t need to be overly daunting. It can even serve as a good time to take a fresh look at your financial goals and dreams, and fine tune your strategy accordingly. The points above can help you get started. Continued education and investment advice as warranted can keep you on course from there.

By |2018-08-10T14:19:51+00:00August 10th, 2018|Investments, Strategy|Comments Off on 6 Ideas for Lump Sum Investing

Fund Managers and the Illusion of Skill

Mutual fund rating services divide mutual funds into categories based on their investment style. This helps investors compare the performance of one style to another and helps them compare the performance of individual funds in a particular style. While useful in many ways, this methodology can also create the illusion of superior performance when none exists.

Among the most familiar investment style tools is the Morningstar Style Box, a nine-square grid that provides a graphical representation of a fund’s investment style. For stock funds, it classifies funds according to primary market capitalization (large, mid and small) and investment style (growth, core and value). Morningstar tracks the performance of securities in the nine style boxes, creates style indices, and then compares fund performance to these indices.

According to Morningstar magazine, the average actively managed US equity fund performance has fallen short of its comparable style box index in all nine categories over the past five years ending in June 2015. However, there are times when a majority of active managers appear to perform better than a style box index. Over the past three years, surviving large-cap value managers have fallen into this category by outperforming their benchmark index 62.7% of the time. See Figure 1 below.

Outperformance by a majority of managers in a particular style is often followed by calls from the fund community to use active management in that style. There are those who begin to argue that the market is inefficient in certain areas. They say indexing doesn’t work in these styles and that active management works better.

Don’t take these periods of active manager outperformance at face value. It is an illusion that is expected to fade over time. What’s actually occurring is the difference between pure style index returns and messy active manager returns.

Style indices represent a pure selection of securities driven strictly by empirical measurements, while fund managers are often messy in their portfolio constructions. For example, the only securities you’ll find in a small-cap value index are small-cap value stocks. In a small-cap value fund, a manager may choose to extend into other style boxes by drifting outside of the pure style. (The fine print in the fund prospectus typically allows for this.) A fund with messy style drift often compares favorably to the style it is benchmarked against when the benchmark is lagging other styles.

When enough fund managers in a category are messy in their stock selection, and the benchmark style performs poorly relative to adjacent styles, it creates a period when active style-drifting managers appear to be a better option for investors. This is a temporary illusion of superiority that is not expected to persist.

Figure 1 compares the three-year performance of Morningstar Style Box returns to the percentage of managers outperforming their style index benchmark. The X-axis represents the three-year annualized Morningstar style index return and the Y-axis represents the percentage of managed funds that outperformed each style.

Figure 1: Morningstar Style Box Performance and Percentage of Managers that Outperformed. Three years ending June 30, 2015.


Source: Morningstar magazine, August/September 2015, chart and regression by R. Ferri

Figure 1 graphically illustrates the relationship between style performance and the ability of active fund managers to outperform the style. Mid-cap Value (MV) earned 20.7% annually and outperformed all other styles; MV managers had a very difficult time outperforming this index and succeeded only about 9% of the time. In contrast, Large-cap Value (LV) earned 14.1% annually and was the worst-performing style index; LV managers had an easier time outperforming, winning about 63% of the time.

The regression is close to 85%. This means the percentage of managers who outperformed in each style is highly correlated with the relative performance of the style index. The greater a style index outperforms adjacent styles, the fewer managers outperformed in that style and vice versa.

This observation isn’t new in mutual fund analysis. William Bernstein wrote about the phenomenon in 2001 article, Dunn’s Law Review: The Life and Times of “Core and Explore,” in which he noted, “[T]he fortunes of indexing a particular asset class depend on its performance relative to other asset classes.”

The concept was expanded by William Thatcher in a 2009 article, When Indexing Works and When It Doesn’t in U.S. Equities: The Purity Hypothesis. Both articles indicate an inverse relationship between a style’s relative performance to other styles and active management’s ability to outperform in style.

This brings us to a couple of important questions. First, when do a majority of active managers outperform a poor-performing style? Second, can managers time styles and position their portfolios accordingly and make it worth investing in messy active funds?

Tables 1, 2 and 3 help answer the first question: When do a majority of active managers outperform a poor performing style? The yellow box with the red numbers in each table represents the percentage of managers that outperformed that style over a three-year period ending in June 2015. The red box represents the performance of the Morningstar style index for that category. The green box represents the performance of surrounding Morningstar style indices.

Table 1 indicates Large Cap Value (LV) managers had a great run over the three-year period ending June 2015. Almost 63% of active manager beat the Morningstar Large Value Index return of 14.1%. It’s easy to see why. The green areas in Table 1 represent the performance of adjacent styles indices: Large Core (18.3%), Mid Core (19.9%), and Mid Value (20.7%). All three had notably superior performance to Large Value. Any messy LV managers who invested outside of, but near the LV style index constituents would have added performance to their portfolio.

Table 2 shows the opposite story for Mid Cap Value (MV) managers. Only 9.0% outperformed their style index. MV was the highest-performing style of the nine style boxes, so any messiness on the part of MV managers would have hurt their performance relative to the style index – and it did.

Table 3 represents Small Cap Value (SV) managers, 33.6% of whom outperformed the Small Cap style index. Although the index performed satisfactorily at 17.0%, it underperformed the adjacent style indices, but not by as wide a margin as LV in Table 1. Accordingly, there was some benefit to active SV manages, but not enough to increase their win rate over 33.6%.

This latest evidence substantiates what Bernstein and Thatcher have indicated in the past: It appears there is no truth to the cliché that the market is inefficient in one style and not another. It’s about style performance relative to adjacent styles, and how messy managers are about remaining within a style in their equity selection.

Active fund managers look superior when their benchmark style performs poorly relative to adjacent styles, and they look bad when their benchmark style outperforms adjacent styles by a meaningful amount. Eventually, this all comes out in the wash. Active managers in every style have underperformed by about the same percentage. Please see The Power of Passive Investing for more analysis on this topic.

The second question is easier to answer: Can active managers time styles and position their portfolios accordingly? They cannot. If they could, today’s Morningstar active versus passive results would show improvement since the time Bernstein wrote about it. But it has not. Managers do not appear to have persistent skill in timing investment styles.

Mutual fund rating services help investors compare the performance of one style to another by creating style indices, and they help investors compare the performance of funds within a particular style. But raw data can create the illusion of superior performance when none exists. You’ll need to dig deeper into a manager’s performance to determine if he or she truly has ongoing skill or if it’s just an illusion.

By |2018-05-18T12:06:35+00:00May 18th, 2018|Investments, Strategy|0 Comments

Passive Investing Is Power Investing

The Feds may or may not raise interest rates again in 2018. Europe’s economy may or may not recover anytime soon. A correction may come that causes some investors to panic and others to benefit from the dip. It’s business as usual in the markets, with the usual mixed messages tempting individual investors into trying to time interest rates, predicting global economies, or forecasting the market’s next turn.

Is it really worth risking your retirement savings playing a timing game? The temptation to time the market or pick the next winning investment is best avoided. The more often you play this active management game, the more investment horsepower you tend to sacrifice.

Instead, empower yourself and your portfolio with passive investing. “Passive” is actually a bit of a misnomer; it’s not about doing nothing, but rather it’s about reaching your goals through deliberate action. Creating the right portfolio allocation from the start, participating in the markets cheaply through index and exchange-traded funds, and not speculating on the near-term future of the markets by trying to time your trades. By helping you stay on course and keep your money otherwise wasted on unnecessary investment expenses, I believe that passive investing can help you reach your financial goals.

I published The Power of Passive Investing to encourage this preferred strategy for all investors to follow. Packed with academic studies, this book shows the hard facts about the failure of active management and the fund companies who profit while their investors do not. It cuts through Wall Street hype and exposes those whose only interest is to make money from you, not for you. John Bogle, the founder of the Vanguard Group, graciously wrote the book’s foreword, and the Bogle Financial Markets Research Center generously provided mutual fund research used in a portion of the book.

While the particulars in the book may have changed – with new crises du jour to trouble us and the latest hot stock tips to tempt us – the book’s lessons remain as relevant today as they’ve ever been. This seems like as good a time as any to share some of the most powerful excerpts from The Power of Passive Investing:

Investors should select the best way to manage their portfolio so as to have the highest probability for success.

Finding an actively managed mutual fund that delivers alpha is a challenge for any investor. Trying to select a portfolio of active funds that outperforms a portfolio of index funds is another matter entirely. The odds of a portfolio using actively managed funds outperforming an all index fund portfolio is much lower than a single fund, and the odds drop with each additional active fund added to a portfolio, and the longer the funds are held.

Active fund investors have strong headwinds against them. The probability of selecting a winning fund is low; the average payout for those winning funds does not compensate them enough for the shortfall from being wrong; the addition of several active funds in a portfolio reduces the probability of success; and the longer that portfolio is held, the odds drop even more. That’s a lot of headwind!

(Note: for more information on index fund portfolios verses active fund portfolios, see “A Case For Index Fund Portfolios”, A White Paper by Rick Ferri, CFA, Portfolio Solutions® and Alex Benke, CFP®, Betterment, and winner of the S&P Dow Jones Indices Third Annual SPIVA Award for excellence in research on the topic of index-related applications).

Investors who are seeking alpha are looking for skilled managers, and this assumes skill is identifiable. Is it? About one-third of [surviving] managers beat the market over a five-year period, but are all these managers skillful? Are any skillful? Perhaps the winning managers just got lucky.

Often a manager has one or two big winning years and then their performance fizzles out. Where there’s no consistency, there’s no talent. It should be no surprise that most winning active managers don’t have consistency, which means they don’t have skill. They just got lucky.

If it’s possible, as some claim, to select skilled fund managers in advance, then what’s the methodology for doing so? It certainly would have been revealed in academic studies by now. Do such studies exist? If so, what’s the secret?

By far, the two most popular factors used in fund selection by the public are past performance and fund ratings. Other factors are fee analysis, the amount of assets in a fund, and qualitative factors such as where the manager went to college. Unfortunately, I was unsuccessful in identifying any comprehensive study on mutual fund selection that provided evidence that a successful fund selection method exists.

There were a few studies that suggested ways of narrowing down the field by eliminating funds that had certain characteristics such as the highest fees, or only including funds that had certain qualitative features such as a large personal stake in the fund by the manager, but no single factor worked consistently.

Recall that the very reason academics began studying mutual funds in the 1960s was to discover managers who had skill. Their efforts were unsuccessful back then and new efforts remain unsuccessful today. If the Ph.D.s can’t figure out how to pick winning managers, then it’s not likely that an individual investor or investment advisor is going to do it.

As one Amazon reviewer put it, The Power of Passive Investing is a comprehensive study that “sticks a fork in active investing starting in Chapter 1 and by the end of the book it’s a virtual blood bath. … While I had heard many of the arguments before, I’ve never read such a concise summary of the debate. And at the end it really crystallized my understanding of the market and how active funds underperform the market relative to their costs.”

If you’ve not yet read The Power of Passive Investing and “A Case for Index Fund Portfolios”, you may find it perennially helpful to your investing. If you have read it, a refresher may help your thinking stay on the right track.

By |2018-05-09T14:13:49+00:00May 9th, 2018|Markets, Strategy|0 Comments

Six Rules to Disciplined Investing

Investment discipline isn’t easy. Despite best intentions and claims to the contrary, many investors chase performance, react emotionally to market moods, and generally incur far more trading costs than good discipline would suggest. Even when there is a long-term plan in place, if it’s not followed, the plan is useless. Over the years, I’ve seen good intentions go by the wayside time and again because discipline was not followed.

These observations aren’t limited to individual investors. I’ve seen similar conduct from investment advisers who claim to have a disciplined strategy, only to add that they’ll “adapt to changing market conditions” when warranted. This loophole leaves an ample opening for ever-shifting adjustments based on what seems to be the right move at the time. It’s particularly common in bear markets when clients become anxious and hint that they may be looking to take their business elsewhere. Loopholes in discipline statements may allow an adviser to retain skittish clients, but lack of discipline is rarely in a client’s best long-term interest.

I’ve put together six rules to disciplined investing. They will help you (and perhaps your adviser) make better long-term decisions:

  1. Have a long-term investment philosophy.
  2. Form a prudent asset allocation based on this philosophy.
  3. Select low-cost funds to represent asset classes in the allocation.
  4. Maintain this portfolio through all market conditions.
  5. Don’t change the asset allocation due to recent market activity.
  6. Don’t hold back on new investments while waiting for market clarity.

Have a long-term investment philosophy: There are two investment philosophies in the world. You either believe you have a high probability of beating the markets or you don’t. I decided a long time ago that the markets are more efficient at pricing securities than I could ever hope to be. I do not have enough skill to consistently add value to a portfolio by picking mispriced stocks, bonds, industry sectors, countries, or entire markets. So I don’t try. Market returns are all I need to achieve my long-term financial goal.

Form a prudent asset allocation based on this philosophy: Asset allocation is how a portfolio is diversified among asset classes. A prudent asset allocation should be based on each person’s own long-term financial goals. This gives you a personalized beacon to follow through turbulent market conditions. The allocation should be in fixed percentages that you plan to stick with over time, rather than floating or tactical reactions to the ongoing turbulence.

Select low-cost funds to represent asset classes in the allocation: Implement the asset allocation using an appropriate mix of index funds and exchange-traded funds (ETFs). These products provide broad diversification within an asset class for a very low cost. Building a select portfolio of index funds and ETFs that tracks the markets  will help you receive your fair share of the markets’ returns.

Maintain this portfolio through all market conditions: Markets do not remain at their current levels for long, yet a portfolio should be maintained at roughly the same asset allocation through all market conditions. Rebalancing helps control the portfolio allocation. An annual rebalancing can serve as the method to maintain a portfolio. Cash contributions and withdrawals also provide an occasion to rebalance.

Don’t change the asset allocation due to recent market activity: Since a portfolio is based on long-term needs, it should be maintained for the long-term. If you’re not willing to hold an asset class or fund for the next 10 years, then you shouldn’t own it now. It doesn’t matter what’s going on in the markets today; build and hold your portfolio for the long haul, giving it the greatest chance to fulfill its intended purpose.

Don’t hold back on new investments while waiting for market clarity: It’s not easy to invest new money in a portfolio that has recently lost money, but that’s what you have to do. If your plan is to invest every month, then invest every month regardless of recent market activity. Discipline in investing is about forming good habits and then doing them consistently.

By |2018-05-04T16:30:34+00:00May 4th, 2018|Strategy|0 Comments