by WWM | Jun 13, 2018 | Active vs Passive Management
Do investment analysts provide positive returns for investors? That is, are you better off if you find a top analyst and follow his or her recommendations?
The evidence is not encouraging for those that wish to follow recommendations of analysts.
I think that there are some very good analysts in the business. And I think that the average analyst does a decent job of following the companies in his or her area of expertise. But does that translate into recommending that you find one or more and follow their calls? No.
I shall give you two reasons why I feel this way.
Analysts May Be Too Optimistic
One, analysts may tend to be overly optimistic in their assessments.
There are a variety of explanations as to why analysts tend towards optimism. I am not sure that I fully ascribe to any of them, but I shall point out the common ones quickly.
Existing or potential investment banking relationships between companies and their bankers may result in pressure on that bank’s analysts to provide positive assessments of the company. Usually the pressure comes in the form of employee remuneration or promotion opportunities. In some ways, I can see this occurring, especially when trying to attract new companies as clients for underwriting and other corporate finance work. But investment bankers often separate their finance groups from their research groups to try and maintain an appearance of objectivity.
Brokerage houses make money on investor commissions. Positive research reports may generate increased purchases and greater transaction revenues for the broker. There is some merit in this argument. Maybe I am a little naive, but I am not sure of the long-term benefits in brokers over-hyping stocks. Say I consistently read research reports, bought shares on the recommendations, and then saw under-performance as compared to the recommended share’s target prices. It would not take me long to a) no longer consider the research reports as having any informational value, and b) find a new brokerage house.
The analyst and/or his firm has a financial interest in the company being reported on. Again, this can be a legitimate concern for investors. In many jurisdictions though, there should be statutory disclosure requirements for any potential financial conflicts.
Most relevant professional organizations have ethical requirements concerning this and other issues relating to potential conflicts of interest. For example, the Chartered Financial Analyst “Code of Ethics & Standards of Professional Conduct” has quite detailed standards.
In a word, disclose. When you watch analysts on FOX Business, Business News Network, Bloomberg, etc., there is normally a statement as to whether the analyst, his family, or firm have a financial interest in the securities discussed.
For me, the common reasons as to why analysts are optimistic are a little tenuous.
However, that does not mean analysts are not optimistic in their estimates. In fact, there is evidence to suggest that analysts are indeed too optimistic.
In April of 2010, McKinsey Quarterly wrote that “Equity analysts: Still too bullish”.
“Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.
Alas, a recently completed update of our work only reinforces this view—despite a series of rules and regulations, dating to the last decade, that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest.”
The authors show that the over-optimism is significant as well as consistent.
“… analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent.”
Even though regulatory agencies and professional organizations are working to strengthen analyst objectivity, there still appears to be a bias (intentional or otherwise) towards inflation of expected performance.
While I do not fully support the complaints outlined above, I think that there is a bit of credence to them as to the reason for bias. The weaker the regulatory environment, the greater the probability for problems.
But I believe the key factor for optimism is less sinister. It likely stems from the fact that the analysts spend much of their time listening to the companies they follow. As a result, they hear positive takes on new products, cost cutting measures, and earnings growth.
They also want to keep a good relationship with companies they track. I know of more than a few stories where analysts have been frozen out of companies that they follow because they questioned a company’s data or gave less than glowing assessments. Given that access to the company is crucial when trying to analyze it, this can have an impact on analysts.
How Can You Determine The Best Analysts?
Two, it may be difficult to identify a “top” analyst whose recommendations you can follow.
Analysts tend to specialize in specific industries. Unless you plan to invest in only one or two industries, you will have to determine top analysts in multiple categories.
Also, with many analysts to assess there are many analysts vying for recognition each year. And there may be substantial change in “top” analysts every year.
For example, on August 6, 2012, Business Insider provided readers with, “The 36 Best Analysts On Wall Street”. I am sure an excellent group.
A year later, on August 16, 2013, Business Insider offered 50 names in, “The Best Stock Analysts In America”.
Maybe I missed a name or two in my comparison, but I think only Betsy Graseck made both lists. In one short year, very little concurrence on who are the top analysts.
The shift from year to year is normal within investment categories.
That much change makes it difficult to try and follow specific analysts who you may believe are best in class.
Is Following the Pros a Waste of Time?
I do not think it wise to develop a strategy of following analyst recommendations.
But you should rely on the research reports in your own analysis. The information contained therein is usually pretty good and can help you form your own conclusions. And if you know the limitations and concerns about research reports as described above, you can factor them into your own analysis.
In the future, we will return to this topic. Specifically, how you should utilize research reports in your personal analysis. We will also consider the suitability of attempting to follow the same investment strategies of highly successful investors (e.g., Warren Buffet). But we will save that for a future date.
Next up, a we begin to look at the passive versus active management debate. Also known as, can fund managers beat their benchmarks? And, as we will see, paying a professional to manage your money is often not the wisest strategy.
by WWM | Jun 6, 2018 | Active vs Passive Management
In my last post, I indicated that investors should normally not compete against professionals.
That does not mean you cannot rely on their skills in an attempt to enhance your own portfolio returns. In fact, many investors follow analyst recommendations and/or invest in mutual funds that are actively managed.
Whether this is a prudent investment approach is something we will look at.
As in all walks of life, some analysts and fund managers have better track records than others. If you intend to rely on their advice or investment decisions, you should try to find the ones with proven track records.
Mutual Fund Managers
We covered the key areas of consideration in a couple of previous posts.
Please review “Mutual Funds: Management” for suggestions on assessing fund management.
To try and separate the upper tier managers from the lower tier, I suggest using the recommendations contained in “Mutual Funds: Performance is Relative”.
Keep in mind that past performance is no guarantee of future results. A manager’s prior results may be suggestive of the future, but many other variables can impact the actual results.
Investment Analysts
Assessing an investment or research analyst is quite similar to evaluating a mutual fund manager.
As in “Mutual Funds: Management”, you want to know a little about the analyst you are interested in following.
How long a history does she have as an analyst? What are her technical credentials? Does she have experience in her area of research? For example, the analyst may have 10 years of experience analyzing European bonds. This may be good if she is still rating bonds. But it may not be a good sign if she is now analyzing Australian mining companies.
How has the analyst has performed in both bull and bear markets? When the markets are up, it is relatively simple to see one’s picks rise in value. But how did she do when the market as a whole fell? That may tell a different story.
You might also want to know the analyst’s financial interest in the recommendation. This can be a two-edged sword though. On the one side, it is nice to see the analyst own the securities she recommends and is putting her own money into the investment. On the other side, perhaps there is a conflict of interest if the analyst has a financial stake in the investment. That is, maybe the security is being recommended in the hopes that individuals will read the positive review, put their own money into the security, thereby driving up the price and enhancing profits for the analyst.
And exactly as in “Mutual Funds: Performance is Relative”, how did the analyst perform compared to her peers and any identified benchmarks?
Note that there may not be any associated benchmarks with selections of individual securities. However, that does not mean you cannot create your own as an assessment tool.
I would suggest something simple. For example, if the analyst is rating Swiss equities, the Swiss Market Index (SMI) might be adequate. The SMI holds the 20 largest stocks in the Swiss equity market.
Or you could use a number of other Swiss indices depending on your investment criteria. The SMI Mid (SMIM) that holds the 30 largest Swiss mid-cap equity stocks not included in the SMI. The SMI Expanded includes the 50 stocks that comprise the SMI and SMIM. And the Swiss Performance Index is Switzerland’s overall stock market index. And that is only a few indices from Switzerland. There are others you can use based on your needs.
Definitely not a perfect match as the risk-return profiles may differ. But a good starting point.
Next week, we continue our look at whether you should follow the investment professionals. We will consider whether investment analysts provide positive net returns to investors.
by WWM | May 30, 2018 | Active vs Passive Management, Mutual Funds
Having an investment professional managing your assets is usually perceived as a big positive. In fact, that is the marketing point for many mutual funds.
But should it be?
This is one of the biggest issues for investors. And a prelude to the active versus passive management debate.
I believe that non-professional investors should not normally compete with professionals.
In some ways, I view it as competing against Dustin Johnson or Jason Day on the golf course. Unless you have the same skills, it is difficult.
The professionals have an unfair advantage over the amateurs and it is not wise to try and beat them in picking investments. Professional asset managers have more technical expertise, better tools and data, and better access to information than you at home on your computer.
So it seems pretty straightforward. Go with the pros. Except ….
Two Types of Investment Professionals
I shall quickly differentiate between two types of investment professionals.
The first is the mutual fund manager. The person who makes the investment decisions on behalf of the fund.
The second is the research analyst. The person who prepares the buy and sell recommendations on specific investments.
There are other investment professionals including individuals who invest for their own livelihood. But for discussion purposes here, we will focus on fund managers and analysts.
Advantages of Investment Professionals
Investment Skills and Experience
It is not a simple process to pick individual stocks, bonds, or other investments. Fundamental analysis requires strong quantifiable skills and an understanding of the business, industry, and economic conditions to properly assess the qualifiable considerations. We quickly looked at Quantitative and Qualitative Analysis previously.
Professional fund managers and analysts should have the financial skills and experience to conduct better investment analysis than the average investor.
Better Information and Tools
Investment professional likely have access to better analytical tools and data than you or I.
They also have better access to the corporations that they follow. This includes access to a company’s investor relations staff or management as well as to special conference calls that companies conduct for investors.
These two areas make life difficult for investors such as myself. I would be considered an investment professional given my technical qualifications and experience. But having less timely access to corporate information and other relevant data puts me at a disadvantage to a financial analyst in a large firm or mutual fund. While I may not mind playing Jason Day for money, I want to make sure that I am not using golf clubs from the 1970s when I do so.
Also, funds with significant investments in companies are often able to shift the company’s business agenda. This is usually done at shareholder meetings where funds hold enough shares to pressure companies to follow strategies the funds prefer.
It’s Their Job
Another problem for most individuals is that they are not full-time investors. Fund managers and financial analysts spend their days researching investments. That is their job.
Some of you are students. Others are lawyers, doctors, dentists, plumbers, government employees, and so on. Whatever you do, you put in a full week at your own job. Any time for investing comes at night or on the weekends.
If you had the time and the tools, you might be better able to compete with the professionals. But you do not. This also puts you at a competitive disadvantage.
So many advantages in having professionals manage your money. Except ….
Disadvantages of Investment Professionals
There are a few potential disadvantages to using fund managers or analyst recommendations when investing. I will expand on a couple of these points in subsequent posts.
Some Professionals are Better than Others
As should be expected, some research analysts and fund managers are better than others.
The trick is to find the good ones and to avoid the poor.
Not always a simple thing to do. In fact, often you see rankings that have one analyst or manager perform highly in one period, then less so the next. And vice-versa.
Reviews of peer group performance and category ranking is the main way to assess relative performance. But they are not always a perfect predictor of future results.
Does Active Management Work?
There is great debate as to whether analysts or fund managers can out-perform their relevant benchmarks.
In some select instances, I believe it is possible. But for the most part, I am doubtful as to whether active management can beat a passive approach to investing.
We will look at the arguments for and against active management later in some detail.
Neglected Market Segments
Professional investors focus on specific market segments. The segment may relate to their area of expertise (e.g., an oil and gas analyst focuses on oil and gas companies) or investment style (e.g., a Swiss large-cap equity fund analyzes relevant Swiss companies).
Often there are neglected market segments that analysts do not follow and/or funds do not invest in.
These may be extremely small segments such as micro-cap mining companies in Australia. Or markets where information is scarce so that analysts and managers do not follow the segment closely. Equity investments in Iraq might be a good example. Or perhaps the local market is relatively inefficient and analysts/fund managers cannot match the local expertise. For example, a New York based real estate analyst trying to assess the residential real estate in Tucson, Arizona.
In neglected or inefficient markets, small investors, especially those with specialized knowledge of the market segment, can out-perform the investment professional.
An amateur investor with sophisticated knowledge in 18th Century art may be equally skilled against professional investors who trade in fine art. Or a geologist working in Calgary, Canada who deals with small oil and gas companies on a daily basis may have an advantage over a professional investor who lacks the local knowledge and contacts.
Fund Management Fees
Like anything in life, if you want a service you must pay for it.
For every dollar spent on management fees, that is one less dollar of performance. And one less dollar that can be reinvested to compound over time.
We have previously reviewed mutual fund operating costs and seen that management fees can be a significant component in a mutual fund’s expenses.
Not surprisingly, management fees can be a relative concept.
Top fund managers command greater compensation levels which impacts fund performance. Is it better to choose a fund without a star manager? You may forego potentially better future returns but you will certainly save money on fees.
Or what about funds that require greater amounts of work by the managers. Investing in developing markets typically requires more work (i.e., management time and other costs) than in developed nations. Is it better to pay greater fees and expenses for access to these markets?
Do the Advantages Outweigh the Disadvantages?
I do not think that the typical investor should compete against the professionals. And by competing, I refer to the selecting of individual securities and other assets.
The typical investor lacks the technical skills, investment and economic experience, and time to be a professional investor.
Unless you have specialized expertise or access to better information in an inefficient or neglected market segment, I suggest avoiding selecting specific investments on your own.
That said, do the costs and performance achieved via active management make use of professionals a wise move? Except in specific circumstances, I generally think not.
I shall expand on why I generally think not in coming weeks. As part of the active versus passive management debate.
by WWM | Mar 14, 2018 | Compound Returns
Want to become a millionaire?
Unless you are counting on that big inheritance or playing the lottery every week, your best shot is through investing.
Keys to Compound Return Benefits
The key is to start when you are young. The amount that you invest is somewhat less important than the time frame. If you are not young, start now. You can still benefit from compounding, though to a lesser extent.
Prudently invest on a consistent basis and let the power of compounding do its thing. We will examine what might constitute “prudent” investing in due course.
Utilize tax-free or tax-deferred investment accounts to enhance compounding impact. Look to low-cost investment products to reduce fees and expenses. You want your money to compound on your behalf. Not to enrich the government, investment company, or your friendly financial advisor.
For more detail on these points, please review, “Compound Returns” and “Compound Return Investment Lessons”.
Compound Returns in Real Life
Please consider the story of Nicole and Matt. Not quite an Aesop Fable, but good moral lessons contained within.
The Ant
Nicole is turning 25 years old, has just started a new job, and wants to begin saving for her retirement. She decides to save $300 per month in a tax-deferred retirement account.
Based on historic returns, she expects to earn a net 8% per year in a family of no-load diversified mutual funds that reinvest any income earned back into the funds. We will assume that income compounds semi-annually.
Following this strategy, by age 40, Nicole will have invested $54,000 in total. However her asset value will be worth $104,504 due to the 8% net annual return and compound growth.
If Nicole is wise, she will increase her monthly contributions over time as her salary increases. She will also continue investing until the day she retires.
But at age 40, Nicole decides to set up a separate investment account with her husband and no longer contributes to her first plan. Nicole does not liquidate her initial retirement plan so that $104,504 will continue to grow at 8%.
At age 70, Nicole terminates her individual plan. She is surprised to discover her asset balance has grown to $1.09 million.
For a relatively brief commitment of 15 years and $54,000, she became a millionaire. Not too bad.
And the Grasshopper
Matt is Nicole’s twin brother. Matt has a well-paying job but he always seems to spend as much as he earns. At month end there is nothing left to save, although he does have a nice tan from his recent vacation to Hawaii.
As he turns 40, he notices that Nicole has done quite well from her monthly saving plan. Wanting to copy her success, Matt visits a financial planner.
Matt knows that Nicole has stopped saving. With 30 years to invest, twice the time frame as Nicole had, Matt figures that it will be simple to catch up with her. Maybe he can even do so with less than $300 per month. That would be great.
Matt instructs the financial planner to create an identical investment strategy as Nicole. That is, the same diversified portfolio of low-cost mutual funds netting an 8% annual return with income semi-annually compounding.
Unfortunately, Matt does not understand the concept of compound returns. So he receives quite the shock when he gets the financial planner’s program.
To catch Nicole at 70, Matt must invest $750 monthly for 30 years in an account earning 8%, compounded semi-annually.
Nicole invested $54,000 over a 15 year period.
To match her accumulated $1.09 million in wealth, Matt must contribute $270,000 of his own money over 30 years.
Matt must find more than double the cash that Nicole invested each month and he must do so for twice the time frame. In total, Matt must pull five times the cash out of his own pocket to achieve the same result as his sister.
A lot more sacrifice for Matt to amass the same wealth as Nicole. Smart lady.
Moral of the Story
That is the power of compounding.
Start investing as young as you can. The longer the time frame the better.
The sooner you begin, the less you actually need to invest in total contributions.
Even relatively small investments can grow to large amounts over a long time period.
Return is crucial. Gross returns on the investment itself. But equally so the net returns after fees, costs, and taxes.
Had Matt been able to net 9% annually, rather than 8%, he could achieve almost the same total investing only $600 monthly. If his return was only 7%, he would need to make monthly contributions of $900.
At the 8% return, Matt’s monthly contribution of $750 for 30 years grew to $1.096 million. Now let us say that the mutual fund company he chooses charges a 1.0% annual management fee on the funds. Not a lot as far as most charge. And really, what is 1.0% among friends?
However, that reduces his net return to 7% and his assets only grow to $902,000. A decrease of $194,000 in wealth.
A percentage of return paid to a fund company, bank, or advisor annually, has enormous long term ramifications your wealth. Finance your own retirement, not someone else’s.
by WWM | Mar 7, 2018 | Compound Returns
We compared the investment return concept of simple versus compound in Compound Returns. We saw how compounding may actually result greater asset growth than that from an investment alone.
Today we examine some very important investing lessons resulting from the power of compounding. If you understand and adhere to these lessons, you will improve your investing results and wealth accumulation.
For all the lessons below, we shall use the same basic data from the following example:
You invest $1000 in a bond fund earning a 10% rate of return, compounded annually. Earned interest is automatically reinvested in additional fund units. Changing interest rates, capital gains or losses, taxes, and transaction costs are ignored. After 10 years your investment will be worth $2594 ($1000 initial investment, $1000 interest on your capital; $594 interest on compounded reinvested income).
Assuming all other variables remain unchanged, here are the key investment lessons:
The longer the investment period, the greater the impact of compounding.
Time is a crucial component for compounding.
In our example, after 10 years your initial investment grew to $2594. Not bad. But if you leave that money alone for 50 years, your one time investment of $1000 grows to $117,391. Impressive.
Over that 50 years, you only earned $5000 (50 years X $100 per year interest) in simple return. The rest of the increase is due to compounding. That is, interest earned on interest.
The farther out the year, the greater its impact of compounding.
After 10 years at 10%, you end up with $2594.
If you need the cash after year 9, you only get $2358. Not that bad, but you lose more than just the $100 simple return in year 10. You also lose an extra $136 in interest due to lost compounding. Not great, but not too bad.
However, if you need the money in year 49, you only receive $106,719 versus the $117,391 if you held out until year 50. That lost $10,672 is huge. And almost all of it reflects the compound interest effect over the years.
The longer you can keep money compounding, the greater the incremental impact. Think of that before accessing your tax-free or tax-deferred investment plans.
The higher the rate of return, the greater the impact of compounding.
All else equal, the rate of return has a big influence on performance.
At a 10% compound return, a single $1000 investment grows to $2594 in 10 years and to $117,391 in 50 years.
Had you found an extra percent return, the impact is noticeable. Over 10 years, you end up at $2839, an improvement of 9.5%. Over 50 years, you get $184,565, a change of 57%.
A big concern with investment product fees that reduce net returns. If you own a mutual fund that charges 1.5% annually, that 10% return nets to 8.5%. Your bond fund now will be worth only $2261 in 10 years and $59,086 in 50 years.
Over 10 years that “fee” to the fund company reduces your wealth $333. Over 50 years, $58,305. And that is all based on you investing a mere $1000. Think of the wealth accumulation differential if you invest a $100,000 or more.
That is a lot of money you are giving away to the mutual fund company in exchange, I expect, for “free advice.” Let your wealth compound in your account, not in the fund company’s coffers.
The more periods in a year an investment compounds, the greater the impact of compounding.
The greater the periods, the more times interest will be calculated, the sooner the next round of compounding can begin.
May sound odd, but think of a home mortgage. The more payments made in a year, the quicker the principal falls. Even if the aggregate value of payments in a year is equal.
In our first example, interest was compounded on an annual basis. That gave us the end values of $2594 over 10 years and $117,391 over 50 years.
Compounding monthly, our investment grows to $2707 in 10 years and $145,369 in 50 years.
And daily compounding results in asset values of $2718 in 10 years and $148,312 in 50 years.
Exactly the same investment with the same time frame. Yet just by accelerating the compound periods you are able to increase your overall return.
The less your costs, the greater the impact of compounding.
Costs such as taxes, sales commissions, management fees, and transaction costs, all reduce your monetary return. Less return translates into less money being reinvested. That significantly affects the power of compounding over time. Be very aware of this.
We saw the impact of fund fees above. Taxes are another huge area to try and minimize and/or defer.
Without being too detailed, let’s assume you pay a reasonable 30% tax rate on your earned income. So for each $100 in interest you earn, only $70 can be reinvested. In essence, your annual return has fallen to 7% from 10%.
In our example, your $1000 would only grow over the 10 years to $1967 and not $2594. The government took $300 in taxes, but you also lost $327 in compound interest.
Annoyed? If so, stop reading.
Over 50 years, you only finish with $29,457 and not the $117,391 before tax.
Take advantage of available tax-free and tax-deferred investment accounts.
The same holds true for other costs, such as management fees and transaction costs. Money paid to others will not accumulate on your behalf. 1% fees here or there may seem like nothing. But as we saw above, they can be massive over time.
We will look at ways to minimize costs at a later date.
Conclusion
The younger you begin to invest, the longer the time horizon until retirement. This is great for compounding returns.
Being younger also allows you to take on higher levels of risk in an attempt to earn better returns. Again, something very useful for compounding growth.
The later in life you begin to invest, the more at a disadvantage you will be. But the longest journeys begin with a single step. You just may need to allocate more to your portfolio to offset the lesser compound returns.
Additionally, as you can see from the lessons, minimizing your investment costs is crucial to long term growth. We will look at cost minimization strategies as we go along. But the keys are to avail of tax-free or tax-deferred savings plans and to minimize investment expenses paid to your advisors, fund managers, banks, etc.
Always let your wealth compound on your behalf. Not someone else’s.
I hope this clarifies the concept of compound interest and that you begin to take advantage of it.
Next up, realistic examples on how these compounding lessons impact wealth accumulation.