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9 Reasons Investors Love Vanguard & DFA Funds

*** June 2015 article with information worth repeating***

Reposted from pathwayplanning.com

Wow. Vanguard had tremendous growth in 2014. An intake of $214.5 billion last year pushed this fund giant’s total assets to $3.1 trillion as of December 31, 2014. That growth represents a 56% increase for Vanguard compared to 2013. Early this year, they passed State Street Global Advisors as the second-largest exchange-traded fund provider as they close in on the top dog BlackRock.

Dimensional Fund Advisors (Dimensional or DFA funds for short) is another fund company that has been experiencing strong inflows. DFA funds added nearly $28 billion in assets in 2014, which was the third highest dollar amount of inflows last year, trailing only Vanguard and JPMorgan Chase.

That type of growth is doubly impressive because Dimensional Fund Advisors flies under the radar of many investors. Last year’s growth, however (not to mention a relatively steady inflow of assets since its 1981 founding), makes it clear that investors are attracted to DFA. What explains its rising-rock-star appeal, given its (yawn) nerdy tagline, “putting financial science to work”? Maybe it’s the firm’s laser-like focus and steadfast approach to applying academic research into the factors or “dimensions” that are expected to generate long-term wealth – fads and fashions be damned. For this blogger, anyway, it’s hard not to prefer that level of discipline to the usual frenzy involved in active stock picking and reactionary market timing.

Then again, Vanguard’s index and exchange-traded funds are no flashes in the pan either, also built on an investment strategy of substance. Admittedly, it can be confusing at a glance to understand how these two similar, but different fund companies compare. Let’s take a closer look at nine characteristics that help differentiate them from the crowd … and from each other.

 

Reason 1

Both trust the market knows best.

Yes, we are all brilliant, of course. However, when you consider that in 2014 alone there were some 60 million daily worldwide trades representing more than $300 billion dollars, it may be wise to embrace market pricing instead of trying to outguess the market. Vast, real-time, electronic information makes the market a highly effective price-setting machine. Trying to consistently outguess 60 million of your fellow investors is not unlike expecting to find enough single needles to outweigh an entire haystack, and to succeed at it over and over again.

In contrast, if you invested $1 in 1927 in a U.S. large-cap index fund and let it ride, your investment would have grown to $3,955 by 2014. Not bad. Vanguard and Dimensional alike prefer to invest in market “haystacks,” albeit with some procedural differences in how the assets get bailed, so to speak.

Electronic Market

 

Reason 2

Both minimize trading.

Trades cost money, in both overt and clandestine ways. By trading according to plan rather than trying to time the market or jump into “hot” segments, both fund companies are well-positioned to trade less often. Since trading is expensive, we can expect lower costs with reduced drag on performance if we trade less often.

The DFA Difference

Beyond just reducing trades by avoiding market-timing or trend-chasing, DFA’s structured trading strategy is part of its secret sauce. Actually, it’s not such a secret: When it comes to trading, a trader who is in less of a rush to buy or sell can usually command better prices than one who is in a rush or under pressure to trade. By being more patient than an index fund manager can be and a market-timing manager chooses to be, Dimensional has developed a solid track record for minimizing the trading costs involved in capturing the asset class returns they are seeking.

Moreover, DFA takes it one step further and offers its funds through select financial advisors who have demonstrated a similar level of patience. The result? Less frenetic trading and even net inflows during times of market panic. For example, during the 2008-2009 market panic, most funds experienced massive redemptions, which wreaks havoc on a mutual fund management. However, DFA funds actually had net inflows during that time, and was able to put that new cash to work and buy securities at bargain basement prices. (This is a mutual fund manager’s dream!)

Patient Investing

Reason 3

Neither firm tries to guess what asset class will outperform.

Vanguard and DFA offer funds with “style purity.” They invest in the asset class they say they will–small-cap value for example–and stay there. They aren’t making any kind of tactical bets that one asset class will perform better than the other.

The chart below says it all. Each column is the year, and each colored square is a separate asset class. Follow one color, such as “red” (the S&P 500), year by year. Look how much it bounces around! The performance of each asset class each year is anyone’s guess.

 

Callan Periodic Table

Reason 4

They don’t keep betting on the horse that won the last race.

Another common investment mistake is to chase stocks that have been on a recent winning streak and/or abandon recent underdogs. This continues to happen, despite the volume of evidence that past performance does not inform us about future returns.

Both Vanguard and DFA do not make “bets” on individual stock performance. They simply hold a large basket of stocks that fall into their well-defined criteria (in DFA’s case) or follow a published index (in Vanguard’s case).

The DFA Difference

DFA does not invest in public indexes like most of Vanguard’s index funds. The problem with public indexes is, well, they are public; everyone knows when a public index will change (and how it will change). Stocks tend to rise when it’s announced they will be included in a public index, and index funds will buy that stock on the effective date at the higher price.

This forces the index funds to “buy high,” which is exactly the opposite of what investors should do. It’s why Dimensional can afford to trade more patiently, as described above.

Here’s a nice visual to explain the concept:


Index REconstruction

Reason 5

Both firms make “going global” easy.

Only about half of the global market’s capital is in the United States. That leaves a big opportunity set outside our borders. Moreover, many of those other countries respond differently to economic forces, which has many benefits to investors (a portfolio of investments that “zig” while others “zag” can actually increase return and lower risk).

Both firms offer funds that cover broad sectors of foreign markets, so you can easily stay globally diversified.

The DFA Difference

DFA offers foreign funds (and even emerging market funds) with higher “tilts” towards small-cap and value stocks, which have historically been a source of higher long-term returns. They also “tilt” towards companies that have exhibited higher profitability. As an asset class, these stocks also have a history of higher returns.

Global Investment Diversification

Reason 6

They help to manage your emotions.

When you are well diversified, both domestically and in foreign markets, you reduce the risk of any one investment taking a nosedive, which can be unnerving and cause you to panic if you are over-concentrated in that investment. With many of Vanguard and DFA’s funds holding thousands of individual securities, the impact of a few dogs isn’t going to hurt as much. You aren’t as likely to panic sell when you have a global back-up plan.

Take a breath. Talk to your advisor. Don’t react emotionally to a buy high and sell low outcome.

Investor emotions

Reason 7

Both firms help you to see beyond the headlines.

We are bombarded daily with catchy headlines about economic facts that seem to be on the verge of derailing our investment strategy. It’s easy to get swept into the hoopla about rising (or falling) oil prices, currency fluctuations, or political tensions in other countries. By participating in the market according to a disciplined, evidence-based process, turning to fund managers who help you accomplish that, it’s easier to take comfort in the fact that you are a long-term investor with a well-diversified global investment strategy.

Financial News

Reason 8

They help you focus on the real drivers of returns.

Many investors believe the factors that affect their returns are stock picking and market timing. In reality, the bulk of your returns are actually driven by how you decide to split your money between stocks and bonds. (Well, another huge determinant is your ability to stay the course once you build your sensible portfolio, without succumbing to your human behavioral biases, but that’s a subject for another post, such as this one.)

Stocks

  • Stocks have historically offered a higher long-term return compared to bonds, but are more volatile.
  • Smaller companies have historically performed better than larger companies.
  • Value stocks have historically done better than growth companies (think WalMart vs. Groupon).
  • High-profitability companies have historically performed better than low-profitability companies.

Bonds

  • Longer-term bonds have historically had higher yields compared to shorter-term bonds.
  • Lower credit quality (“junkier bonds”) have historically had higher yields compared to higher credit quality bonds.

This is an important decision, so work with your advisor to design a suitable portfolio based on these core drivers of returns.

The DFA Difference

DFA regularly and closely collaborates with academic scholars, some of whom have been awarded Nobel prizes for identifying these factors or “dimensions” of higher expected returns. As such, they have been particularly early, strong and ongoing proponents of this sort of factor-based or evidence-based investing.

DFA Financial Researchers

Reason 9

These firms help you focus on what you can control.

One of the few things you can control in investing is your costs. Both firms offer funds at significantly lower costs than many of their actively managed peers. They also offer a more disciplined approach to knowing what your own fund investments contain, so that it’s easier for you (especially with the support of an evidence-based advisor) to build and maintain a portfolio that you can stick with through thick and thin in your quest to build personal wealth. By minimizing the angst and second-guessing involved when you’re not sure just what is contained within your holdings, your own overall costs can be minimized as well.

You are in the busiest (and most profitable) time of your life. Working long hours. Struggling to figure out the best investments for your retirement. (Time, what time?) Why not work with a financial advisor who can help you clarify your goals and develop and plan to reach those goals?

An advisor will help you focus on factors you control — asset allocation, structuring a portfolio that takes into account the real drivers of expected returns and your ability to handle risk, broad diversification, low expenses, low trading costs and tax minimization.

DFA Financial Control

Summary

Both Vanguard and DFA offer low-fee funds that operate on the principle that the market is an effective, information-processing machine that is nearly impossible to outguess.

DFA takes it one step further with some distinct tactics and also allowing for “tilting” towards areas of higher expected returns like smaller stocks, value stocks and higher profitability stocks.

The growth of these firms shows that investors are waking up to the reality that investment success is about capturing global market returns and keeping costs low, not about hunting down the next “rock star” money managers.

Teresa Staker
Teresa Staker
Administrative Assistant
p // 801-494-6047
Dimensional

LETTER FROM THE CHAIRMAN, 2017

After more than 35 years in the financial services industry,
I have found that having an investment philosophy—one that
is robust and that you can stick with—cannot be overstated.

Just like a personal philosophy can act as a moral compass, an investment philosophy can guide your decisions on how to invest. While this may sound simple, the implications can be significant. People who
put their savings to work in capital markets do so with the expectation of earning a return on their investment, and there is ample evidence to support that long-term investors have been rewarded with such returns. But we also know that investors will encounter times when the results are disappointing. It is in these times that your philosophy will be tested, and being able to stay the course requires trust.
The alternative approach likely consists of moving between different strategies based on past results, which is unlikely to lead to a good outcome.  At Dimensional, our investment philosophy is based on the power of market prices and guided by theoretical and empirical research.

What does that mean?

Markets do an incredible job of incorporating information and aggregate expectations into security prices, so it does not make sense to form an investment strategy that attempts to outguess the market. Our approach focuses on using information contained in prices to identify differences in expected returns. We conduct research to help us organize our thinking, improve our understanding of what drives returns, and gain insights on how to build sensible portfolios. One such insight is looking beyond average returns. By considering the entire distribution of outcomes, we can better understand what investors should be aware of to help them stay invested when results aren’t what they expect.  As an example, the S&P 500 Index has returned about 10% annualized since 1926. But over that time period, there the S&P’s return was within two percentage points of 10%.1 If investors were to adopt a strategy that tracks the S&P 500 Index expecting 10% each year, they need to understand that returns over any given period can look different.

So what does it take to stay the course? Our view is that while there is no silver bullet, there are some basic tenets that can help. Developing an understanding of how markets work and trusting markets is a good starting point. Having an asset allocation that aligns with your risk tolerance and investment goals is also valuable. We believe financial advisors can play a critical role in this determination. Finally, it’s important that the investment manager can be trusted to execute the desired strategy.  In this regard, an index-like approach is useful because of how transparent it is.

It is easy for an investor to examine whether the returns achieved by the manager matched those of the index. This is part of the reason indexing has been a positive development for investors, offering a transparent, low-cost way to access markets. However, index funds prioritize matching an index over potentially achieving higher returns—so we believe they are too mechanical.

So what does it take to stay the course? Our view is that while there is no silver bullet, there are some basic tenets that can help. Developing an understanding of how markets work and trusting markets is a good starting point. Having an asset allocation that aligns with your risk tolerance and investment goals is also valuable. We believe financial advisors can play a critical role in this determination. Finally, it’s important that the investment manager can be trusted to execute the desired strategy.

In this regard, an index-like approach is useful because of how transparent it is.  It is easy for an investor to examine whether the returns achieved by the manager matched those of the index. This is part of the reason indexing has been a positive development for investors, offering a transparent, low-cost way to access markets. However, index funds prioritize matching an index over potentially achieving higher returns—so we believe they are too mechanical.

At Dimensional, we’ve sought to improve upon indexing, taking the best of what it offers and adding the ability to make judgments. Our experience has been that by incorporating a little bit of judgment, you can add a lot of value.

Dimensional began back in 1981 with a new idea: small cap investing. The premise was that many investors didn’t invest in small cap stocks, and that small caps behaved differently than large cap stocks and could offer diversification benefits to investors concentrating in large caps. We found clients who agreed the idea was sensible. Over the next nine years, the performance of small cap stocks was disappointing relative to large caps (at one point the S&P 500 outpaced our portfolio by about 10% annually), so on the surface it may have appeared that both we and our clients had a reason to be nervous. But clients were willing to stick with us because we were clear about our objective—providing a diversified portfolio of small cap stocks—and we delivered on it.2 Having compelling ideas is important, but the implementation of those ideas is what really counts. From the beginning, we focused on developing protocols about how to design and manage portfolios, and 35 years later we have amassed a track record of results that we believe stands out in the industry.

————————————————————————————————————————

1. Past performance is not a guarantee of future results. Indices are not available for direct
investment; therefore, their performance does not reflect the expenses associated with the
management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services
Group.
2. Diversification does not eliminate the risk of market loss. Investing risks include loss of
principal and fluctuating value. Small cap securities are subject to greater volatility than those
in other asset categories. There is no guarantee an investing strategy will be successful.
Consider the investment objectives, risks, and charges and expenses of the Dimensional funds
carefully before investing. For this and other information about the Dimensional funds, please read
the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund
Advisors collect at
(512) 306-7400 or at us.dimensional.com. Dimensional funds are distributed by DFA Securities LLC.

Relative Performance of Equity Funds with More than 15 years of History

While our long-term results show an ability to add value over benchmarks, we still place tremendous value on helping our clients understand why we do what we do. Just like those first years, we have lived through other times when the results have looked disappointing. This is one reason our approach combines our ability to make judgments with the transparency we believe is necessary for clients to understand what they can expect from us. The solutions we provide are meant to help clients achieve their financial goals. We know that a big part of enjoying the expected benefit of long-term returns relies on the ability to stay invested. By clearly articulating what we promise to provide, and delivering on those promises with robust portfolios, our hope is that we can help increase clients’ confidence in their decision to invest with us and provide them with a more successful investment experience.
On behalf of all of us at Dimensional, we want to thank our clients for the trust you have placed in us. We will continue working hard to reinforce the decision you have made. For those of you who may not yet work with us, we look forward to the prospect of serving you in the future.

Letter from the Chairman 2017 Signature

DAVID BOOTH
Founder and Executive Chairman
DIMENSIONAL FUND ADVISORS

LETTER FROM THE CHAIRMAN, 2017

Appendix Letter from the Chairman

award winning trophy shot in black background

DFA Named “Retirement Leader of the Year”

Award presented at 24th Mutual Fund Industry Awards in New York honors firm for developing innovative retirement solutions that positively impact the retirement marketplace

NEWS PROVIDED BY

Dimensional Fund Advisors

25 Apr, 2017, 10:00 ET


AUSTIN, Texas, April 25, 2017 /PRNewswire/ — Dimensional Fund Advisors, a leading global investment management firm that has developed an innovative target date solution designed to reduce uncertainty around the consumption that a plan participant’s savings can support in retirement, is honored to be recognized as “2017 Retirement Leader of the Year” by Fund Intelligence, sponsor of the 24th Mutual Fund Industry Awards.

Presented during a ceremony at Cipriani 42nd Street® in New York City, the award is given to “a firm that has made a key impact on growing retirement assets with unique retirement solutions, marketing campaigns and significant contributions to the retirement industry at large,” according to Fund Intelligence. The judging period was from January 1, 2016, to December 31, 2016.

“We are honored to receive this kind of recognition,” said Eduardo Repetto, Dimensional’s Co-CEO and Co-Chief Investment Officer. “It represents years of dedicated research on life cycle solutions. We have worked closely with Nobel laureate Robert Merton, clients, advisors, consultants, and recordkeepers in order to provide transparent low-cost investment solutions as well as benchmarking and reporting tools designed specifically for participants saving for retirement.”

Dimensional is a well-established leader in the Defined Contribution (“DC”) arena with nearly $47 billion in dedicated DC assets as of December 31, 2016. The firm was also ranked ninth in the 2016 PLANADVISER Retirement Plan Adviser Survey of the top 20 fund families preferred by plan advisers.

Next Generation Retirement Solutions
The main challenge of retirement planning is managing the uncertainty of future income. Dimensional believes a smart income-focused solution should take into account the investment risks that affect retirement income, such as rising inflation and changes in interest rates.

Dimensional’s Target Date Retirement Income Funds are professionally managed mutual funds designed to offer a convenient, long-term solution for investors who expect to retire in or around a particular year. The Funds are diversified across a mix of asset classes that include stocks and bonds, and over time the investment emphasis of the Funds shifts from income growth to income risk management. This shift means more portfolio assets are invested in inflation-protected securities to manage future risks to retirement income.

“If we are going to have progress in the area of investing and finance, the innovation has to come from better and safer financial services,” said David Booth, Dimensional’s founder and Executive Chairman. “That’s what will lift us all up, and that’s exactly what we are trying to do with our retirement solutions. So it’s very gratifying to see our efforts celebrated.”

Measuring Effectiveness
To help measure effectiveness relative to an income-focused goal, Dimensional worked collaboratively with S&P Dow Jones Indices (S&P DJI) to develop the glide path, inflation hedging, and duration hedging techniques used in the S&P Shift To Retirement Income and DEcumulation (STRIDE) Index series, launched in January 2016. This is the first Index to blend the process of wealth creation with the need to mitigate uncertainty of in-retirement consumption. By considering both key retirement risks and post-retirement income needs for an individual in its methodology, the Index series seeks to provide an enhanced target date benchmark for strategies that follow a liability-driven investing philosophy.

About the 24th Annual Mutual Fund Industry Awards
The Mutual Fund Industry Awards recognize and reward the people and organizations whose excellence, achievements, and contributions to the industry have stood out over the past 12 months. Nominations are made by the editorial staff of industry publications Fund Action and Fund Direction, which are part of the Fund Intelligence Group, a provider of financial services sector information products. The 24th Mutual Fund Industry Awards were presented at an evening ceremony and dinner on March 30, 2017.

About Dimensional
Dimensional Fund Advisors is a leading global investment firm that has been translating academic research into practical investment solutions since 1981. Guided by a strong belief in markets, we help investors pursue higher expected returns through advanced portfolio design and careful implementation. With clients around the world, Dimensional has 12 offices in eight countries and global assets under management of $497 billion as of March 31, 2017. Learn more at us.dimensional.com.

Retirement Thought Leadership:
Harvard Business Review: The Crisis in Retirement Planning, by Robert Merton
How Much Should I Save for Retirement, by Dimensional’s Massi De Santis and Marlena Lee

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and charges and expenses of the Dimensional funds carefully before investing. For this and other information about the Dimensional funds, please read the prospectus carefully before investing. Prospectuses are available by calling Dimensional Fund Advisors collect at (512) 306-7400 or at us.dimensional.com. Dimensional funds are distributed by DFA Securities LLC.

Target date funds are designed to target a year in which an investor may withdraw funds for retirement or other purposes. Investments in target date funds are subject to the risks of their underlying funds, and asset allocations are subject to change over time in accordance with each fund’s prospectus. An investment in a retirement income from a target date portfolio is not guaranteed at any time, including on or after the target date. An investment in a target date portfolio does not eliminate the need for investors to decide –before investing and periodically thereafter–whether the portfolio fits their financial situation. For more information, please refer to the prospectus. There is no guarantee this investment strategy will be successful, and it is possible to lose money with this investment. For more information regarding Dimensional’s Target Date Retirement Income Funds, please refer to the prospectus.

Dimensional Fund Advisors LP receives compensation from S&P Dow Jones Indices in connection with licensing rights to S&P STRIDE Indices. Robert Merton provides consulting services to Dimensional Fund Advisors LP.

 

SOURCE Dimensional Fund Advisors

Related Links

http://us.dimensional.com

Interest rates

Investment Shock Absorbers

Ever ridden in a car with worn-out shock absorbers? Every bump is jarring, every corner
stomach-churning, and every red light an excuse to assume the brace position. Owning an
undiversified portfolio can trigger similar reactions.

In a motor vehicle, the suspension system keeps the tires in
contact with the road and provides a smooth ride for passengers
by offsetting the forces of gravity, propulsion, and inertia.
You can drive a car with a broken suspension system, but it
will be an extremely uncomfortable ride and the vehicle will
be much harder to control, particularly in difficult conditions.
Throw in the risk of a breakdown or running off the road
altogether and there’s a real chance you may not reach
your destination.
In the world of investment, a similarly bumpy and
unpredictable ride can await those with concentrated and
undiversified portfolios or those who constantly tinker
with their allocation based on a short-term rough patch in
the markets.
Of course, everyone feels in control when the surface is
straight and smooth, but it’s harder to stay on the road during
sudden turns and ups and downs in the market. And keep in
mind the fix for your portfolio breaking down is unlikely to be
as simple as calling a tow truck.
For that reason, the smart thing to do is to diversify,
spreading your portfolio across different securities, sectors,
and countries. That also means identifying the right mix of
investments (e.g., stocks, bonds, real estate) that aligns with
your risk tolerance, which helps keep you on track toward
your goals.
Using this approach, your returns from year to year may not
match the top performing portfolio, but neither are they likely
to match the worst. More importantly, this is a ride you are
likelier to stick with.

Just as drivers of suspensionless cars change their route to
avoid potholes, people with concentrated portfolios may
resort to market timing and constant trading as they try to
anticipate the top-performing countries, asset classes,
and securities.

Here’s an example to show how tough this is. Among
developed markets, Denmark was number one in US
dollar terms in 2015 with a return of more than 23%. But
a big bet on that country the following year would have
backfired, as Denmark slid to bottom of the table with a
loss of nearly 16%.¹

It’s true that the US stock market (by far the world’s
biggest) has been a strong performer in recent years,
holding the number three position among developed
markets in 2011 and 2013, first in 2014, and sixth in 2016.
But a decade before, in 2004 and 2006, it was the second
worst-performing developed market in the world.¹

Predicting which part of a market will do best over a
given period is also tough. For example, while there is
ample evidence to support why we should expect positive
premiums from small cap, low relative price, and high
profitability stocks, these premiums are not laid out

evenly or predictably across the map. US small cap stocks
were among the top performers in 2016 with a return
of more than 21%. A year before, their results looked
relatively disappointing with a loss of more than 4%.
International small cap stocks had their turn in the sun
in 2015, topping the performance tables with a return
of just below 6%. But the year before that, they were the
second worst with a loss of 5%.²
If you’ve ever taken a long road trip, you’ll know that
conditions along the way can change quickly and
unpredictably, which is why you need a vehicle that’s
ready for the worst roads as well as the best. While
diversification can never completely eliminate the impact
of bumps along your particular investment road, it
does help reduce the potential outsized impact that any
individual investment can have on your journey.
With sufficient diversification, the jarring effects of
performance extremes level out. That, in turn, helps you
stay in your chosen lane and on the road to your
investment destination.
Happy motoring and happy investing.

1. In US dollars. MSCI developed markets country indices (net dividends). MSCI data © MSCI 2017, all rights reserved.
2. In US dollars. US Small Cap is the Russell 2000 Index. Frank Russell Company is the source and owner of the trademarks, service marks, and
copyrights related to the Russell Indexes. International Small Cap is the MSCI World ex USA Small Cap Index (gross dividends). MSCI data
copyright MSCI 2017, all rights reserved.

‘‘Outside the Flags’’ began as a weekly web column on Dimensional Fund Advisors’ website in 2006.
The articles are designed to help fee-only advisors communicate with their clients about the principles
of good investment—working with markets, understanding risk and return, broadly diversifying
and focusing on elements within the investor’s control—including portfolio structure, fees, taxes, and
discipline. Jim’s flags metaphor has been taken up and recognized by Australia’s corporate regulator
in its own investor education program.

Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful. Diversification
does not eliminate the risk of market loss.

Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the
management of an actual portfolio. Frank Russell Company is the source and owner of the trademarks, service marks, and
copyrights related to the Russell Indexes. MSCI data © MSCI 2017, all rights reserved.

All expressions of opinion are subject to change. This article is distributed for informational purposes, and it is not to be construed
as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.
©2017 Dimensional Fund Advisors LP. All rights reserved. Unauthorized copying, reproducing, duplicating, or transmitting of this
material is prohibited.

Larry Swedro

Lessons from 2016

Read it on etf.com

Every year, the market provides us with some important lessons on prudent investment strategy. Many times, the market will offer investors remedial courses, covering lessons that it has already delivered in previous years. That’s why one of my favorite sayings is that there’s nothing new in investing—there’s only investment history you don’t yet know.

Last year gave us nine lessons. As you may note, many of them have appeared before. Unfortunately, many investors fail to learn from them. Rather, they keep repeating the same errors, which is what Albert Einstein called the definition of insanity. We’ll begin with my personal favorite, a lesson the market, if measured properly, teaches each and every year.

Lesson 1: Active Management Is a Loser’s Game

Despite an overwhelming amount of research that demonstrates passive investing is far more likely to allow you to achieve your financial goals, the vast majority of individual investor assets are still invested in active funds. And, unfortunately, investors in active funds continue to pay for their “triumph of hope over wisdom and experience.”

2016 was another year where the large majority of active funds underperformed, despite the great opportunity for active managers to generate alpha in the very large dispersion of returns between the best and worst performers.

For example, while the S&P 500 returned 12.0% for the year, there were 25 stocks in the index that returned at least 45.5%. Oneck Inc. (OKE) returned 132.8%, while Nvidia Corp. (NVDA) returned 223.9%. All an active manager had to do to outperform was to overweight these superperformers.

On the other side of the coin, there were 25 stocks in the index that lost at least 22.9%. Endo International (ENDP) lost 73.1% and First Solar (FSLR) lost 51.4%. To outperform, all an active manager had to do was to underweight, let alone avoid, these “dogs.”

It’s important to note that this wide dispersion of returns is not at all unusual. Yet despite the opportunity, year after year, in aggregate, active managers persistently fail to outperform. The table below shows the percentile rankings for funds from two leading providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard, for both 2016 and the 15-year period ending December 2016. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)

Note that Morningstar’s data contains survivorship bias, as it only considers funds that have survived the full period. And the bias is significant, as about 7% of actively managed funds disappear every year and their returns are buried in the mutual fund graveyard. Thus, the longer the period, the worse the survivorship bias, and at 15 years, it’s quite large.

The results make clear that active management is a strategy we could call fraught with opportunity. Year after year, active managers come up with an excuse to explain why they failed that year and then assert that next year will be different. Of course, it never is.

The good news is that investors are waking up to the reality. In October, The Wall Street Journal reported that, according to Morningstar, “although 66% of mutual-fund and exchange-traded-fund assets are still actively invested … those numbers are down from 84% 10 years ago and are shrinking fast.”

Lesson 2: So Much of Returns Come in Very Short and Unpredictable Bursts

The road to investment “hell” is paved with market-timing efforts, because so much of the long-term returns provided by the market come in short, and totally unpredictable, bursts. Last year provided the following example. From January through October, the DFA Small Value Fund (DFSVX) returned 8.0%. From November through December, it returned 18.8%. For the full year, it returned 28.3%. Two-thirds of the full year’s return happened in the last two months.

These types of results are not at all unusual, For instance, the study “Black Swans and Market Timing: How Not To Generate Alpha,” which covered the 107-year period ending in 2006, found that the best 100 days (out of more than 29,000) accounted for virtually all (99.7%) of returns.

Here’s another example. There are 1,020 months in the 85-year period from 1926 through 2010. The best 85 months, an average of just one month a year (or just 8.3% of the months), provided an average return of 10.7%. The remaining 935 months (or 91.7% of the months) produced virtually no return (just 0.05%).

Peter Lynch offered the following example. He pointed out that an investor who followed a passive investment strategy and stayed fully invested in the S&P 500 over the 40-year period beginning in 1954 would have achieved an 11.4% rate of return.

If that investor missed just the best 10 months (2%), his return dropped 27%, to 8.3%. If the investor missed the best 20 months (4%), the return dropped 54%, to 6.1%. Finally, if the investor missed the best 40 months (8%), the return dropped 76%, all the way to 2.7%.

Do you really believe there is anyone who can pick the best 40 months in a 40-year period? Lynch put it this way: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”

Despite this evidence, investors persist in market-timing efforts. Charles Ellis described the winning strategy in the following way: “Investors would do well to learn from deer hunters and fishermen who know the importance of ‘being there’ and using patient persistence—so they are there when opportunity knocks.”

Lesson 3: Events Occur That No One Predicted

Those who have spent their careers forecasting learn to be very humble about their predictions. The reason is that almost every year, major surprises occur. And by definition, surprises are unpredictable.

That is why, when I’m asked for a forecast, my response is that my crystal ball is always cloudy. That is also why my recommendation is to stop spending time listening to forecasts, which have no value and can cause you to stray from your well-thought-out plan. Instead, spend your time managing risk.

2016 saw at least two major unpredicted events that could have had major negative impacts on financial markets. Yet they did not. The first came in June when Great Britain voted for exiting the European Union—the so-called Brexit, which passed 52% to 48% with a referendum turnout of 72% and votes from more than 30 million people.

The other, of course, was the primary win by Donald Trump and then his election to the presidency. With both Brexit’s and Trump’s victories, the market’s immediate reaction was a dramatic self-off. And then a rapid recovery.

Lesson 4: Ignore All Forecasts; All Crystal Balls Are Cloudy

One of my favorite sayings about the market forecasts of so-called experts is from Jason Zweig, financial columnist for The Wall Street Journal: “Whenever some analyst seems to know what he’s talking about, remember that pigs will fly before he’ll ever release a full list of his past forecasts, including the bloopers.”

You’ll almost never read or hear a review of how the latest forecast from some market “guru” actually worked out. The reason is that accountability would ruin the game—you would cease to “tune in.”

But I believe forecasters should be held accountable. Thus, a favorite pastime of mine is keeping a collection of economic and market forecasts made by media-anointed gurus and then checking back periodically to see if they came to pass. This practice has taught me there are no expert economic and market forecasters.

Here’s a small sample from this year’s collection. I hope they teach you a lesson about ignoring all forecasts, including the ones that happen to agree with your own notions (that’s the deadly condition known as “confirmation bias” at work).

  • In July 2015, Charles Robertson, Renaissance Capital’s global chief economist, predicted that U.S. stocks could crash 50% within the next 12 months.
  • In January 2016, economists at the Royal Bank of Scotland warned that investors faced a “cataclysmic year” in which stock markets could fall by up to 20% and oil could drop to $16 a barrel. The advice was to “sell everything” except safe bonds.
  • In May 2016, legendary investor Carl Icahn warned that “a day of reckoning” was coming for U.S. stock markets unless the federal government stimulated the economy with greater spending. He certainly was putting his money where his mouth was, as shortly before his prediction of a big crash, Icahn Enterprises had announced in SEC filings that it had a net short position of 149%.
  • Also in May 2016, Savita Subramanian, Bank of America Merrill Lynch’s head of U.S. equity and quantitative strategy, appeared on BloombergTV to warn of a “vortex of negative headlines” (doesn’t that sound scary?) coming in the following month that could push the S&P 500 down to 1,850 (a level back near its February lows). The factors she cited to support this prediction were the then-upcoming Brexit vote, the June decision from the Federal Reserve and the U.S. election.
  • Again in May 2016, John Hussman of Hussman Funds wrote: “Prevailing market conditions continue to hold the expected stock market return/risk profile in the most negative classification we identify. That profile reflects not only extreme valuations on the most reliable measures we’ve tested across history, but market internals and other features of market action that remain unfavorable. …. In any event, looking beyond the near-term horizon, I doubt that any shift in market action will meaningfully reduce the likelihood of a 40-55% loss in the S&P 500 over the completion of the current market cycle.”
  • In August 2016, UBS warned of an imminent crash in the S&P 500. The bank predicted there would be a major correction within the next two months.

As poor as the preceding forecasts turned out to be, this one is my personal favorite: Just six weeks into 2016, Goldman Sachs announced that (whoops!) it had abandoned five of its six recommended “top trade” calls for the year, having gotten them wrong.

One might ask: If they got those wrong, why ever would we think they’ll get it right this time? Of course, Goldman Sachs was just as confident of its new trade calls as it was when it made its old forecasts. Overconfidence is an all-too-human trait.

To be fair, there were surely some forecasts that turned out right. The problem is that you can’t know ahead of time which ones to pay attention to and which ones to ignore. What my experience has taught me is that investors tend to pay attention to the forecasts that agree with their preconceived ideas (again, that pesky confirmation bias) while ignoring forecasts that disagree. Being aware of our biases can help us overcome them.

Lesson 5: Even With A Clear Crystal Ball …

Imagine you had a crystal ball that allowed you to foresee the economic and political events of 2016, but not stock prices. Surely that would be of great value in terms of investment decisions—or would it have been?

Would you have been a buyer of stocks if you knew that the first few weeks of 2016 would produce the worst start to a year since the Great Depression? The S&P 500 Index closed 2015 at 2,043. By Jan. 20, it had fallen to 1,859, a drop of just more than 9%.

Would you have been a buyer of stocks knowing that Great Britain would vote to exit the European Union, creating great uncertainty for the global economy and financial markets? Within three days, the S&P 500 Index fell from 2,113 at the close on June 23 to 2,001 on June 27, a drop of more than 5%.

Would you have been a buyer of stocks if you knew that, once again, the economic growth rate would disappoint, with growth failing to reach even a tepid 2%? Most of the world’s developed economies were basically stagnating, bordering on recession.

Finally, would you have been a buyer of stocks knowing that Donald Trump would win the presidential election? Be honest now, especially if you happen to lean Democrat. Within moments of his victory becoming clear, the DJIA fell more than 800 points and S&P futures had sunk more than 5%.

With the benefit of hindsight, we now know that, in each instance, the market recovered, and relatively quickly. The lesson here is that, even with a clear crystal ball (which no one has), it’s very difficult to predict stock markets. Thus, you shouldn’t try. It’s a loser’s game.

Lesson 6: Last Year’s Winners Are Just As Likely To Be This Year’s Dogs

The historical evidence demonstrates that individual investors are performance-chasers—they watch yesterday’s winners, then buy them (after the great performance), and watch yesterday’s losers, then sell them (after the loss has already been incurred).

This causes investors to buy high and sell low, which is not exactly a recipe for investment success. This behavior explains the findings from studies showing that investors actually underperform the very mutual funds in which they invest.

Unfortunately, a good (poor) return in one year doesn’t predict a good (poor) return the next year. In fact, great returns lower future expected returns, and below-average returns raise future expected returns. Thus, the prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well: It adheres to its letter until it reaches its destination.

Similarly, investors should adhere to their investment plan (asset allocation). Sticking with one’s plan doesn’t mean just buying and holding. It actually means buying, holding and rebalancing (the process of restoring your portfolio’s asset allocation to your investment plan’s targeted levels).

Using passive asset class funds from Dimensional Fund Advisors (DFA), the following table compares the returns of various asset classes in 2015 and 2016. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) As you can see, sometimes the winners and losers of 2015 repeated their respective performances, but other times the winners became losers and the losers became winners. For example:

Lesson 7: “Sell in May and Go Away” Is the Financial Equivalent of Astrology

One of the more persistent investment myths is that the winning strategy is to sell stocks in May and wait to buy back into the market until November.

While it’s true that stocks have provided greater returns from November through April than they have from May through October, since 1926, an equity risk premium has still existed in those May-through-October months. From 1927 through 2015, the “Sell in May” strategy returned 8.3% per year, underperforming the S&P 500 by 1.7 percentage points per year. And that’s even before considering any transaction costs, let alone the impact of taxes (with the “Sell in May” strategy, you’d be converting what would otherwise be long-term capital gains into short-term capital gains, which are taxed at the same rate as ordinary income).

How did the “Sell in May and Go Away” strategy work in 2016? The S&P 500 Index’s total return for the period from May through October was 4.1%. Alternatively, during this same period safe, liquid investments would have produced virtually no return. In case you’re wondering, 2011 was the only year in the last eight when the “Sell in May” strategy would have worked.

A basic tenet of finance is that there’s a positive relationship between risk and expected return. To believe that stocks should produce lower returns than Treasury bills from May through October, you have to believe stocks are less risky during those months—a nonsensical argument. Unfortunately, as with many myths, this one seems hard to kill off. And you can bet that, next May, the financial media will be resurrecting it once again.

Lesson 8: Hedge Funds Are Not Investment Vehicles, They Are Compensation Schemes

This lesson has appeared about as regularly as our first lesson, which is that active management is a loser’s game. Hedge funds entered 2016 coming off their seventh-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins.

Unfortunately, the streak has continued into an eighth year, as the HFRX Global Hedge Fund Index returned just 2.5% in 2016, and underperformed the S&P 500 Index by 9.5 percentage points. The table below shows the returns for various equity and fixed income indexes.

As you can see, the hedge fund index underperformed the S&P 500 and eight of the 10 major equity asset classes, but managed to outperform all three of the bond indexes. An all-equity portfolio allocated 50% internationally and 50% domestically, and equally weighted in the asset classes within those broad categories, would have returned 11.0%, outperforming the HFRX index by 8.5 percentage points. A 60% equity and 40% bond portfolio with the same weights for the equity allocation would have returned 6.9% using one-year Treasurys, 7.6% using five-year Treasurys and 7.1% using long-term Treasurys.

Thus, each of these three portfolios would have outperformed the hedge fund index. Given that hedge funds tout their freedom to move across asset classes as their big advantage, one would think that it would have shown up. The problem is that the efficiency of the market, as well as the costs of the effort, turns that supposed advantage into a handicap.

The evidence is even worse over the long term. For the 10-year period from 2007 through 2016, the HFRX Global Hedge Fund Index lost 0.6% per year, underperforming every single equity and bond asset class. As you can see in the following table, hedge fund underperformance ranged from 0.4 percentage points when compared to the MSCI EAFE Value Index, to as much as 8.8 ercentage points when compared to U.S small-cap stocks.

Perhaps even more shocking is that, over this period, the only year the hedge fund index outperformed the S&P 500 was in 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year.

For the 10-year period, an all-equity portfolio allocated 50% internationally and 50% domestically, again equally weighted in the asset classes within those broad categories, would have returned 4.1% per year. A 60% equity and 40% bond portfolio with the same weights for the equity allocation would have returned 3.0% per year using one-year Treasurys, 4.1% per year using five-year Treasurys and 5.1% per year using long-term Treasurys. All three dramatically outperformed the hedge fund index.

The bottom line is that the evidence suggests investors are best served by thinking of hedge funds as compensation schemes, not investment vehicles

Lesson 9: Don’t Let Your Political Views Influence Your Investment Decisions

One of my more important roles as director of research for Buckingham Strategic Wealth is preventing investors from committing what I refer to as “portfolio suicide”—panicked selling that arises from fear, whatever the source of that fear may be. After the election of President Donald Trump, it seemed like the vast majority of times I was called in to help investors stay disciplined and adhere to their financial plans involved anxiety generated by politics.

We often make investment mistakes because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, errors is to become aware of how our choices are impacted by our views, and how those views can influence outcomes.

The 2012 study “Political Climate, Optimism, and Investment Decisions” showed that people’s optimism toward both the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate. Among the authors’ findings were:

  • Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. This leads them to take on more risk, and they overweight riskier stocks. They also trade less frequently. That’s a good thing, because the evidence demonstrates that the more individuals trade, the worse that they tend to do.
  • When the opposite party is in power, individuals’ perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions.

Now, imagine the nervous investor who sold equities based on his views about, or expectations for, a Trump presidency. While those who stayed disciplined have benefited from the rally following the election, investors who panicked and sold not only missed the bull market, but now face the incredibly difficult task of figuring out when it will be once again safe to invest.

I know of many investors with Republican/conservative leanings who were underinvested after President Obama was elected. And now it’s investors with Democratic/liberal leanings who have to face their fears. The December Spectrem Affluent Investor and Millionaire Confidence Index surveys provide evidence of how political biases can impact investment decisions.

Prior to the election, respondents who identified as Democrats showed higher confidence levels than respondents who identified as Republicans or Independents. This completely flipped after the election. Democrat investors registered a confidence reading of -10, while Republican and Independent investors showed confidence readings of +9 and +15, respectively.

What’s important to understand is that if you lose confidence in your plan and sell, there’s never a green flag that will tell you when it’s safe to get back in. Thus, the strategy most likely to allow you to achieve your financial goals is to have a plan that anticipates there will be problems, and to not take more risk than you have the ability, willingness and need to assume. Furthermore, don’t pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.

In conclusion, this year will surely provide investors with more lessons, many of which will be remedial courses. And the market will provide you with opportunities to make investment mistakes. You can avoid them by knowing your financial history and having a well-thought-out plan.

This commentary originally appeared January 27 on ETF.com

Larry Swedroe is the Director of Research for Buckingham Strategic Wealth. He has authored or co-authored more than a dozen books and is regularly published on ETF.com and Advisor Perspectives. He has made appearances on national television shows airing on NBC, CNBC, CNN and Bloomberg Personal Finance. Larry holds an MBA in finance and investment from New York University, and a bachelor’s degree in finance from Baruch College in New York.

bryan_harris

2016 Market Review

Re-posted from Dimensional.com 2016 Market Review January 10, 2016 Market Review

by Bryan Harris, Advisor BylineSenior Editor

In 2016, the US market reached new highs and stocks in a majority of developed and emerging market countries delivered positive returns. The year began with anxiety over China’s stock market and economy, falling oil prices, a potential US recession, and negative interest rates in Japan. US equity markets were in steep decline and had the worst start of any year on record. The markets began improving in mid-February through midyear. Investors also faced uncertainty from the Brexit vote in June and the US election in November.

Many investors may not have expected global stocks and bonds to deliver positive returns in such a tumultuous year. This turnaround story highlights the importance of diversifying across asset groups and regional markets, as well as staying disciplined despite uncertainty. Although not all asset classes had positive returns, a globally diversified, cap-weighted portfolio logged attractive returns in 2016.

Consider that global markets are incredible information-processing machines that incorporate news and expectations into prices. Investors are well served by staying the course with an asset allocation that reflects their needs, risk preferences, and objectives. This can help investors weather uncertainty in all of its forms. The following quote by Eugene Fama describes this view.

“If three or five years of returns are going to change your mind [on an investment], you shouldn’t have been there to begin with.” ―Eugene Fama


The chart above highlights some of the year’s prominent headlines in context of broad US market performance, measured by the Russell 3000 Index. These headlines are not offered to explain market returns. Instead, they serve as a reminder that investors should view daily events from a long-term perspective and avoid making investment decisions based solely on the news.

The chart below offers a snapshot of non-US stock market performance (developed and emerging markets), measured by the MSCI All Country World ex USA Index (in USD, net dividends). The headlines should not be viewed as determinants of the market’s direction but as examples of events that may have tested investor discipline during the year.


World Economy


2016 Year in Review Major World Indices

2016 Market Perspective

Equity Market Highlights

After a rocky start, the US stock market had a strong year. The S&P 500 Index logged an 11.96% total return and small cap stocks, as measured by the Russell 2000 Index, returned 21.31%.

Overall, performance among non-US markets was also positive: The MSCI World ex USA Index, which reflects non-US developed markets, logged a 2.75% return and the MSCI Emerging Markets Index an 11.19% return.1

Global Diversification Impact

Overall, US equities outperformed equities in the developed ex US markets and emerging markets. As a result, a market cap-weighted global equity portfolio would have underperformed a US equity portfolio. Investors generally benefited from emphasizing value stocks around the world, as well as US small cap stocks.

Returns at the country level were dispersed. In developed markets, returns ranged from –24.87% in Israel to +24.56% in Canada. In emerging markets, returns ranged from –12.13% in Greece to +66.24% in Brazil.

Strong performance in the US placed it as the 17th best performing country out of the 46 countries in the MSCI All Country World Index (ACWI), which represents both developed and emerging markets. Although the S&P 500 Index had a positive return in 2016, the year was not in the top half of the index’s historical annual returns.

Brazil offers a noteworthy example of market prices at work and the difficulty of trying to forecast and time markets. Despite a severe recession, Brazil was the top performing emerging market country in 2016. Brazil’s GDP was projected to shrink 3.4% in 2016, according to the OECD in November, yet its equity market logged strong performance. The lesson is that prices incorporate a rich set of information, including expectations about the future. One must beat the aggregate wisdom of market participants in order to identify mispricing. The evidence suggests that this is a very difficult task to do consistently.

Volatility

In 2016, equity market volatility, as measured by the CBOE Volatility Index (VIX),2 was below average. There were, however, several spikes—as you might expect—as new information was incorporated into prices. The high was reached in early February, and spikes occurred following the Brexit vote in June and again in November preceding the US election.

Premium Performance

In 2016, the small cap and value premiums3 were mostly positive across US, developed ex US, and emerging markets, while the profitability premium varied by market segment.4 Though 2016 marked a generally positive year, investors may still be wary following several years of underperformance for value and small cap stocks. Taking a longer-term perspective, the premiums remain persistent over decades and around the globe despite recent years’ headwinds. The small cap and value premiums are well-grounded in financial economics and verified using market data spanning decades, but pursuing those premiums requires a consistent, long-term approach.

US Market

In the US market, small cap stocks outperformed large cap stocks and value stocks outperformed growth stocks. High profitability stocks outperformed low profitability stocks in most market segments.5 Over 2016, the US small cap premium marked the seventh highest annual return difference since 1979 when measured by the Russell 2000 Index minus Russell 1000 Index. Most of the performance for small caps came in the last two months of the year, after the US election on November 8. This illustrates the difficulty of trying to time premiums and the benefit of maintaining consistent exposure. Through October, US small cap stocks had outpaced large company stocks for the year by only 0.35%. By year-end, the small cap premium had increased to 9.25%, as shown below.


US value stocks outperformed growth stocks by 11.01% following an extended period of underperformance. Over the five-year rolling period, the value premium, as measured by the Russell 3000 Value Index minus Russell 3000 Growth Index, moved from negative in 2015 to positive in 2016.

2016 Year in Review Major World Indices

Developed ex US Markets In developed ex US markets, small cap stocks outperformed large cap stocks and value stocks outperformed growth stocks. Over both the five- and 10-year rolling periods, the small cap premium, measured as the MSCI World ex USA Small Cap Index minus the MSCI World ex USA Index, continued to be positive. The five- and 10-year rolling periods for the small cap premium have been positive for the better part of the past decade.

Value stocks outperformed growth stocks by 9.26%, as measured by the MSCI World ex USA Value Index minus the MSCI World ex USA Growth Index. Similarly to US small caps, most of the outperformance occurred in the fourth quarter, reinforcing the importance of consistency in pursuing premiums. Despite a positive year, the value premium remains negative over the five- and 10-year rolling periods.

Emerging Markets In emerging markets, small cap stocks underperformed large cap stocks and value stocks outperformed growth stocks. Despite the underperformance of small cap stocks, small cap value stocks fared better than small cap growth stocks and performed similarly to large cap value stocks. Investors who emphasized small cap value stocks over small cap growth stocks benefited.

Fixed Income

Both US and non-US fixed income markets posted positive returns. The Bloomberg Barclays US Aggregate Bond Index gained 2.65%. The Bloomberg Barclays Global Aggregate Bond Index (hedged to USD) gained 3.95%.

Yield curves6 were generally upwardly sloped in many developed markets, indicating positive expected term premiums. Indeed, realized term premiums were positive in the US and globally as longer-term maturities outperformed their shorter-term counterparts.

Corporate bonds were the best performing sector, returning 6.11% in the US and 6.22% globally, as reflected in the Bloomberg Barclays Global Aggregate Bond Index (hedged to USD). Credit premiums were also positive in the US and globally as lower quality investment grade corporates outperformed their higher quality investment grade counterparts.

While interest rates increased in the US, they generally decreased globally. Major markets such as Japan, Germany, and the United Kingdom all experienced decreases in interest rates. In fact, yields on Japanese and German government bonds with maturities as long as eight years finished the year in negative territory.

In the US, interest rates increased the most on the short end of the yield curve and were relatively unchanged on the long end. The yield on the 3-month US Treasury bill increased 0.35% to end the year at 0.51%. The yield on the 2-year US Treasury note increased 0.14% to 1.20%. The yield on the 10-year US Treasury note closed at a record low of 1.37% in July yet increased 0.18% for the year to end at 2.45%. The yield on the 30-year US Treasury bond increased 0.05% to end the year at 3.06%.

Currencies

The British pound, euro, and Australian dollar declined relative to the US dollar, while the Canadian dollar and Japanese yen appreciated relative to the US dollar. The impact of regional currency differences on returns in the developed equity markets was minor in most cases. US investors in both developed and emerging markets generally benefited from exposure to certain currencies.

“There’s no information in past returns of three to five years. That’s just noise. It really takes very long periods of time, and it takes a lot of stick-to-it-iveness. You have to really decide what your strategy is based on long period of returns, and then stick to it.” ―Eugene Fama


1. All non-US returns are in USD, net dividends.
2. The VIX is a measure of implied volatility using S&P 500 option prices. Source: Bloomberg.
3. The small cap premium is the return difference between small capitalization stocks and large capitalization stocks. The value premium is the return difference between stocks with low relative prices (value) and stocks with high relative prices (growth).
4. Profitability is measured as a company’s operating income before depreciation and amortization minus interest expense scaled by book equity. The profitability premium is the return difference between stocks of companies with high profitability over those with low profitability.
5. Profitability performance is measured as the top half of stocks based on profitability minus the bottom half in the Russell 3000 Index.
6. A yield curve is a graph that plots the interest rates at a specific point in time of bonds with similar credit quality but different maturity dates.

Year-in-review features major headlines, performance data for world indices, and a market perspective for 2016. The text and graphics may be downloaded and adapted for client communication.

Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Dow Jones data provided by Dow Jones Indices. MSCI data © MSCI 2017, all rights reserved. S&P data provided by Standard & Poor’s Index Services Group. The BofA Merrill Lynch Indices are used with permission; © 2017 Merrill Lynch, Pierce, Fenner & Smith Inc.; all rights reserved. Bloomberg Barclays data provided by Bloomberg. Indices are not available for direct investment; their performance does not reflect the expenses associated with the management of an actual portfolio.

Past performance is no guarantee of future results. This information is provided for educational purposes only and should not be considered investment advice or a solicitation to buy or sell securities.

Investing risks include loss of principal and fluctuating value. Small cap securities are subject to greater volatility than those in other asset categories. International investing involves special risks such as currency fluctuation and political instability. Investing in emerging markets may accentuate these risks. Sector-specific investments can also increase these risks.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, liquidity, prepayments, and other factors. REIT risks include changes in real estate values and property taxes, interest rates, cash flow of underlying real estate assets, supply and demand, and the management skill and creditworthiness of the issuer.

Eugene Fama is a member of the Board of Directors for and provides consulting services to Dimensional Fund Advisors LP.

Dimensional Fund Advisors LP is an investment advisor registered with the Securities and Exchange Commission.

Dimensional

Market Timing – Prediction Season

December 2016

The close of each calendar year brings with it the holidays as well as a chance to look forward to the year ahead.

In the coming weeks, investors are likely to be bombarded with predictions about what the future, and specifically the next year, may hold for their portfolios. These outlooks are typically accompanied by recommended investment strategies and actions that are aimed at trying to avoid the next crisis or missing out on the next “great” opportunity. When faced with recommendations of this sort, it would be wise to remember that investors are better served by sticking with a long-term plan rather than changing course in reaction to predictions and short-term calls.

predictions and portfolios

One doesn’t typically see a forecast that says: “Capital markets are expected to continue to function normally,” or “It’s unclear how unknown future events will impact prices.” Predictions about future price movements come in all shapes and sizes, but most of them tempt the investor into playing a game of outguessing the market. Examples of predictions like this might include: “We don’t like energy stocks in 2017,” or “We expect the interest rate environment to remain challenging in the coming year.” Bold predictions may pique interest, but their usefulness in application to an investment plan is less clear. Steve Forbes, the publisher of Forbes Magazine, once remarked, “You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”[1] Definitive recommendations attempting to identify value not currently reflected in market prices may provide investors with a sense of confidence about the future, but how accurate do these predictions have to be in order to be useful?

1. Excerpt from presentation at the Anderson School of Management, University of California, Los Angeles, April 15, 2003.

Consider a simple example where an investor hears a prediction that equities are currently priced “too high,” and now is a better time to hold cash. If we say that the prediction has a 50% chance of being accurate (equities underperform cash over some period of time), does that mean the investor has a 50% chance of being better off? What is crucial to remember is that any market-timing decision is actually two decisions. If the investor decides to change their allocation, selling equities in this case, they have decided to get out of the market, but they also must determine when to get back in. If we assign a 50% probability of the investor getting each decision right, that would give them a one-in-four chance of being better off overall. We can increase the chances of the investor being right to 70% for each decision, and the odds of them being better off are still shy of 50%. Still no better than a coin flip. You can apply this same logic to decisions within asset classes, such as whether to currently be invested in stocks only in your home market vs. those abroad. The lesson here is that the only guarantee for investors making market-timing decisions is that they will incur additional transactions costs due to frequent buying and selling.

The track record of professional money managers attempting to profit from mispricing also suggests that making frequent investment changes based on market calls may be more harmful than helpful. Exhibit 1, which shows S&P’s SPIVA Scorecard from midyear 2016, highlights how managers have fared against a comparative S&P benchmark. The results illustrate that the majority of managers have underperformed over both short and longer horizons.

Exhibit 1. Percentage of US Equity Funds That Underperformed a Benchmark  

Exhibit 1.  Percentage of US Equity Funds

Source: SPIVA US Scorecard, “Percentage of US Equity Funds Outperformed by Benchmarks.” Data as of June 30, 2016.
Past performance is no guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio. The S&P data is provided by Standard & Poor’s Index Services Group.

Rather than relying on forecasts that attempt to outguess market prices, investors can instead rely on the power of the market as an effective information processing machine to help structure their investment portfolios. Financial markets involve the interaction of millions of willing buyers and sellers. The prices they set provide positive expected returns every day. While realized returns may end up being different than expected returns, any such difference is unknown and unpredictable in advance.

Over a long-term horizon, the case for trusting in markets and for discipline in being able to stay invested is clear. Exhibit 2 shows the growth of a US dollar invested in the equity markets from 1970 through 2015 and highlights a sample of several bearish headlines over the same period. Had one reacted negatively to these headlines, they would have potentially missed out on substantial growth over the coming decades.

Exhibit 2.       Markets Have Rewarded Discipline
Growth of a dollar—MSCI World Index (net dividends), 1970–2015

 

Exhibit 2.  Markets Have Rewarded Discipline

In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results. MSCI data © MSCI 2016, all rights reserved.

CONCLUSION

As the end of the year approaches, it is natural to reflect on what has gone well this year and what one may want to improve upon next year. Within the context of an investment plan, it is important to remember that investors are likely better served by trusting the plan they have put in place and focusing on what they can control, such as diversifying broadly, minimizing taxes, and reducing costs and turnover. Those who make changes to a long-term investment strategy based on short-term noise and predictions may be disappointed by the outcome. In the end, the only certain prediction about markets is that the future will remain full of uncertainty. History has shown us, however, that through this uncertainty, markets have rewarded long-term investors who are able to stay the course.

Source: Dimensional Fund Advisors LP.
Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful.
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