Journal of Financial Planning: July 2013
Harold Evensky, CFP®, AIF®, is chairman of Evensky & Katz in Coral Gables, Florida, and Lubbock, Texas. He is an internationally recognized speaker on investment and financial planning issues and is the author of Wealth Management and co-editor of The Investment Think Tank: Theory, Strategy, and Practice for Advisers.
Good news, lots of interesting papers so far this year. I’m becoming encouraged that there is an increasing quantity of applied research related to the concerns of practicing financial planners. Here are a few I found of particular interest.
“A Broader Framework for Determining an Efficient Frontier for Retirement Income,” by Wade D. Pfau, Ph.D., CFA (Journal of Financial Planning, February 2013)
It would be hard not to include a paper by Wade Pfau, because he is consistently one of the most prolific and on-target academics writing about issues of importance to practitioners, so I don’t even try. This recent contribution is an excellent example. Pfau begins his work by noting, “The idea that retirees should focus on finding a spending strategy that maintains a rather low failure rate using a diversified portfolio over a fixed retirement period, as is standard with safe withdrawal rate studies, is not adequate. Problems abound, including …”
- Not considering the retiree’s entire balance sheet
- Failure rates ignore products designed to provide lifetime income (e.g., immediate annuities)
- Ignoring the lost potential of spending more in early retirement
- Ignoring the magnitude and severity of “failure”
- Studies are based too heavily on the U.S. historical markets record
Although I would debate the assumption that practitioners ignore these issues in their planning process, that debate is for another time. I believe the most important contribution of this paper is his analysis of a retirement solution considering allocations between four different products/strategies—systematic withdrawal from a total return portfolio, single premium immediate annuities (SPIAs), inflation adjusted SPIAs, and VAs with a guaranteed life withdrawal benefit rider. Using an example of a 65-year-old couple with a net (after Social Security) 4 percent withdrawal need, he develops an efficient frontier and finds that a combination of stocks and fixed SPIAs dominate all solutions. For many practitioners, the wake-up call in this paper is the need to consider products designed to provide lifetime income.
“When to Claim Social Security Benefits,” by David M. Blanchett, CFP®, CLU®, AIFA®, CFA (Journal of Personal Finance, Volume 11, Issue 2, 2012)
Blanchett is head of retirement research at Morningstar (and a Ph.D. student at Texas Tech). He, along with Wade Pfau and Moshe Milevsky, make up the triumvirate of must-read authors in the field of retirement planning. For anyone who has not been following the research on the optimization of Social Security, this current contribution is an excellent introductory overview. To emphasize the importance, he notes that his research found “the optimal Social Security claiming decision can generate 9.15 percent more income for a hypothetical retired married couple … .”
“Dividend Investing: A Value Tilt in Disguise?” by Gregg S. Fisher, CFP®, CFA (Journal of Financial Planning, April 2013)
As Fisher notes in his introduction, “The notion that the high dividend-yielding stocks outperform the markets is widely accepted by investors.” This issue particularly resonated with me. Recently, a member of the investment committee of an institution I’d prepared an investment plan for was concerned that I had not recommended any high dividend managers. I explained that we overweight value, not dividends, so Fisher’s study was most timely. The focus of the study was to investigate the factors contributing to higher returns.
Covering a 33-year period from August 1, 1979, through July 31, 2012, the research divided the Russell 3000 Index into 10 deciles. It then created two portfolios, updated monthly, for comparison. A market portfolio was composed of all of the stocks in the index, and a second “high-dividend-yield” portfolio was composed of the highest yielding 10 percent of stocks.
Fisher found that “… by focusing on high-yield-dividend stocks, investors unwittingly tilted their portfolios to value stocks. The dividend yield factor is subsumed in the value and earnings yield factors.” The final conclusion of the research is that “… outperformance of high-yielding-dividend stocks can be explained by the value factor … outperformance returns appear to arise from value factors rather than as a result of dividend yield.”
One very surprising finding was that “… the dividend yield factor had a negative contribution to return in 231 months and a positive contribution in 170 months. Not only was the dividend yield factor’s contribution to return negative more often than it was positive, but the average downside was larger than the average upside ... as a result, the overall contribution of the dividend yield factor was negative.”
In conclusion the author suggests that investors seeking long-term outperformance of a broad market return should employ a portfolio value and high-earnings yield tilt.
These last three I would put in the must-read category.
"Shedding Light on ‘Invisible’ Costs: Trading Costs and Mutual Fund Performance,” by Roger Edelen, Richard Evans, and Gregory Kadlec (Financial Analysts Journal, January/February 2013)
Although research has repeatedly demonstrated that a fund’s expense ratio is one of the few reliable predictors of fund performance, it captures “only the ‘visible’ (reported) costs of mutual funds. What is missing is the costs associated with commissions, spreads, and price impact.” The common method of accounting for these costs is to use fund turnover. This study not only incorporates these costs—most important from a practitioner’s perspective—it also develops an accurate but computationally simple trading-cost proxy.
The study found, “… that funds’ annual expenditures on trading costs (aggregate trading costs) were comparable in magnitude to the expense ratio (1.44 percent versus 1.19, percent respectively).” In addition, “… aggregate trading costs displayed consistently more cross-sectional variation than did expense ratios. For example, the difference in average expense ratio for small cap growth and large cap value funds was 0.32 percent ... whereas the difference in average aggregate trading costs for the same funds was 2.33 percent.”
Most important, although the study found no consistent predictive value in using turnover, expense ratio, or total net assets, it did find a strong negative relation between aggregate trading costs and fund return performance.
The paper concludes, “Contrary to the literature, our results suggest that invisible trading costs have a detrimental effect on fund performance that is at least as material as that of the (visible) expense ratio. However, the commonly used proxy of turnover fails to identify this effect statistically reliably because it does not jointly consider trading volume and per unit costs.”
The detailed analysis was based on a comprehensive quarterly analysis on a stock-by-stock basis, referred to as “Aggregate Trading Cost (Fastidiously Measured)” and concludes that this approach results in recognizing that the substantial data and computational requirements of this process is an unrealistic standard for practitioners. The authors developed a much simpler metric they call the “Position-Adjusted Turnover.” It is determined by:
- Computing the average dollar value of each portfolio holding by dividing the fund’s total net assets by the number of stocks in the portfolio (the fund quarter’s “position size”).
- Computing the percentile rank of the fund’s average position size relative to all other funds in a given market-cap category.
- Taking the product of the percentile rank times the fund quarter’s turnover.
The authors report that this easily calculated Position-Adjusted Turnover is an effective alternative to the Fastidiously Measured alternative, and one I will be looking to potentially implement in our practice.
“The Arithmetic of Investment Expenses,” by William F. Sharpe (Financial Analysts Journal, March/April 2013)
In a perfect follow up to the prior paper, Sharpe proposes a new strategy for evaluating the impact of expenses, a metric he calls the Terminal Wealth Ratio (TWR). His paper considers two alternative portfolios—one with high and one with low expenses in two settings—a single initial lump sum investment and a second with recurring investments over many years. Based on a series of Monte Carlo simulations, Sharpe finds that “… the results I obtained for the expense ratios considered [0.06 percent low-cost and 1.12 percent high-cost] are dramatic. Whether one is investing a lump-sum amount or a series of periodic amounts, the arithmetic of investment expenses is compelling … . Managers with extraordinary skills may exist, but as I argued in this publication many years ago (Sharpe 1991), another exercise in arithmetic indicates that such managers are in the minority. And as Ellis has reminded us, they are very hard indeed to identify in advance. Caveat emptor.”
“Adding ‘Value’ to Sustainable Post-Retirement Portfolios,” by Neeraj J. Gupta, Robert Pavlik, and Wonhi Synn (Financial Services Review, spring 2012)
Of all the papers I’ve reviewed, this one may have the most significant influence on our practice. I’ve been a long-time skeptic regarding the use of a tactical overlay to a strategic portfolio, not because I don’t believe in the concept, but because I had not seen a credible strategy. This research has me rethinking my position.
The paper compared the performance of a traditional, annually rebalanced balanced fund to a “valuation-based” balanced fund according to the mean reverting properties of financial metrics (price-earnings, price-to-book, and price-dividend). The strategy is built on an initial allocation that is modified according to well-defined, valuation-based decision rules that, when exceeded, trigger annual changes in the initial portfolio allocations.
In considering alternative valuation triggers, the authors evaluated the following adaptive strategies:
- P-E10: if the S&P’s normalized P/E ratio is less (greater) than its historical mean plus (minus) one-half its standard deviation, the stock allocation in the rebalanced portfolio is decreased (increased) to 25 percent below (above) the baseline allocation
- P-B: similar adjustment based on the stock market’s normalized P/B ratio
- P-DIV10: similar adjustment based on the stock market’s normalized price-to-dividend ratio
The analysis was based on Shiller’s 10-year period.
Recognizing that “although a high allocation to stocks is normally the preferred option when designing sustainable retirement portfolios, the evidence in favor of mean reversion suggests that high allocations to stocks may not be appropriate when stocks are trading at much higher than normal valuations.” The conclusion of the study, using both rolling period and bootstrapping simulations, is that adaptive P-E10 strategies “clearly outperform all other strategies.”
At this stage I’m not prepared to adopt this strategy; however, I will continue to investigate this strategy and will be discussing it with my practitioner and academic friends for their feedback. If you find this of interest and have thoughts, pro or con, I look forward to hearing from you (Harold@Evensky.com).
As always, I hope you enjoyed this month’s column, and I hope you find elements in these papers that help you improve the quality of the advice you provide to your clients.