Reposted from USA TODAY
When one of the world’s richest men provides free money tips, it’s worthwhile to pay attention.
Warren Buffett does so in the chairman’s letter contained in Berkshire Hathaway’s latest annual report, offering a strong vote of confidence for a blue-collar investment vehicle.
As with past Buffett essays, his most recent narrative, penned Feb. 25, provides valuable insights mixed with a prosaic discussion of Berkshire Hathaway’s operations. That’s part of Buffett’s literary style — spin yarns, go off on tangents, keep it simple.
Buried deep in the 27-page letter, Buffett recounted how he initiated a long-term wager nearly a decade ago and now has nine years of performance data that will determine who wins the bet.
Back then, he staked $500,000 to support his view that a mutual fund holding stocks in the Standard & Poor’s 500 index would beat a representative sampling of hedge funds. Only one hedge fund proponent, an investment manager named Ted Seides, took him up on it on the wager, choosing five portfolios that each invested in 20-plus hedge funds.
All performance results, the two agreed, would be measured net of fees, as is standard practice.
This was a blue-collar vs. white-collar proposition, a contest pitting a mainstream investment against portfolios reserved for the wealthy. Index mutual funds, open to anyone with a couple thousand dollars or less, are designed for the masses. Hedge funds, by contrast, are reserved for “accredited” investors — basically, people with incomes of $200,000 and up or net worths exceeding $1 million — and run by some of Wall Street’s sharpest minds. With one year to go, barring a market meltdown, Buffett’s bet looks like a winner.
Over the prior nine years, from 2008 through 2016, the blue-collar S&P 500 index fund appreciated 85.4% including reinvested dividends, beating all five funds that Seides selected (each was a portfolio investing in 20 or more individual hedge funds, as noted). The best hedge fund-of-fund rival was up 62.8% over the nine years, according to Buffett’s accounting, giving the latter a commanding lead.
Hedge fund managers have a lot more tools at their disposal than mainstream mutual funds. They typically can buy stocks long or sell them short, invest in currencies, commodities or other assets, trade options or — in short — seek out opportunities wherever they spot them. Index funds do just one thing — buy and hold the same stocks represented in the market index or basket that they track.
So why have the hedge funds lagged so badly? In part, it’s because their managers do try to outperform the market and often mess up, Buffett noted. In addition, the funds typically charge lofty expenses that include a fairly standard 2% annual bite plus 20% of any profits realized. A typical index fund, in comparison, charges around 0.2%, possibly a bit less, and the fund’s management team doesn’t take a slice of the shareholders’ capital gains.
As part of the bet, Buffett agreed not to disclose the names of the funds or the hedge funds they held, so we have to take his word that the performance numbers are accurate (he indicated he gets to view the audited results). Of significance, Buffett structured the bet by pitting his S&P index fund against the average results from multiple hedge funds. That was an important condition because it minimized the possibility that one hot hedge fund, by itself, could hit paydirt and win the wager. Rather, this was a bet comparing multiple hedge funds against the overall stock market, as represented by the 500 or so largest corporations.
The comparative results say a lot about the eroding effects that expenses can exert and the futility of active portfolio management. “When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients,” he observed.
Buffett’s hedge fund competition has deeper significance, as it says a lot about human behavior and psychology. In many respects, as Buffett acknowledged, the wealthy do receive the best products and services. But this isn’t necessarily the case when it comes to investing. In fact, this expectation of superiority can work against the rich.
“The financial elites — wealthy individuals, pension funds, college endowments and the like — have great trouble meekly signing up for a financial product or service that is available as well to people investing only a few thousand dollars,” he wrote. “The wealthy are accustomed to feeling that it is their lot in life to get the best food, schooling, entertainment, housing, plastic surgery, sports ticket — you name it.”
But it isn’t necessarily so in the investment world, Buffett argued, pointing to the hedge fund contest as evidence. If anything, he cautioned upscale individual and institutional investors to beware the many advisers and consultants who play to these presumptions.
Buffett recounted that many people have asked him for investment advice over the years, to which he has regularly recommended low-cost index funds such as those holding stocks in the S&P 500.
“To their credit, my friends who possess only modest means have usually followed my suggestion,” he said. “I believe, however, that none of the megarich individuals, institutions or pension funds has followed that same advice when I’ve given it to them.”
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 will 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 that there are no expert economic and market forecasters.
Thanks to research compiled by the team at InterTrader, we can examine the 2015 stock market recommendations from 16 leading investment banking firms. They produced what they called the Gurudex.
How The Gurudex Works
InterTrader’s prediction data was sourced from The Motley Fool website for the period from Jan. 1, 2015 through Dec. 31, 2015. They collected the date of the prediction, the starting and ending prices, and the prediction itself (buy or sell). Because almost all the predictions did not specify a “time frame” for the investment, they provided results for 30-, 90- and 180-day investment periods, though all positions were closed out at the end of the year.
A guru’s prediction was deemed accurate if the sell price was higher than the buy price for the selected investment period—a very low bar. When reviewing the results, keep in mind that they do not account for transaction costs. The following is a summary of their findings:
- For the 30-day investment period, 55 percent of the recommendations produced a gain. The total return of all the forecasts was just 0.8 percent, less even than the return one could have earned using an FDIC-insured deposit account from an online bank. It’s also less than the 1.3 percent return of Vanguard’s 500 Index Fund (VFINX), which does include all costs. Nine of the 16 investment banking firms posted accuracy percentages above the 50 percent mark, and six came in below. The highest accuracy rate was 74 percent for Barclays. However, the total gain of the firm’s predictions, before trading costs, was just 2.5 percent. The lowest accuracy rate was 33 percent for Mizuho. And that firm’s total return was an ugly -11.2 percent.
- For the 90-day investment period, 49 percent of the recommendations produced a gain, with the aggregate average loss being 1.5 percent. Now, just seven of the 16 firms had an accuracy rate above 50 percent, and seven had an accuracy rate below 50 percent. Nomura posted the highest accuracy rate with 70 percent. However, the total return of the firm’s predictions, even before expenses, was -2.3 percent. Citicorp now had the worst accuracy rate at 14 percent. Its total return was -14.1 percent.
- For the 180-day investment period, just 42 percent of the recommendations produced a gain, with the aggregate average loss being 3.7 percent. Only three of the 16 firms had an accuracy rate greater than 50 percent, while 10 of them had an accuracy rate below 50 percent. BMO Capital Markets had the highest accuracy rate at 58 percent, but its predictions produced a total gain, before expenses, of just 0.8 percent. Amazingly, Canaccord Genuity put up a 0 percent accuracy rate. I don’t think you could get a score of zero if you actually tried to do that. Its predictions produced a total return of -12.9 percent.
- Using the end of the year, 43 percent of the recommendations produced a gain, with the aggregate average loss being 4.8 percent, pre expenses. Just four firms had accuracy rates above 50 percent, while 10 had rates below that figure. Nomura’s 60 percent accuracy rate was the highest, although its total gain, before expenses, was just 2.8 percent. Citicorp’s 14 percent accuracy rate was the lowest, and its recommendations earned a total return of -3.1 percent.
The preceding data serves as a reminder of the wisdom in Warren Buffett’s words of advice on the subject of the value of stock market forecasters: “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
Swedroe: Irrelevance Of Dividends | ETF.com
Research has established that dividend policy should be irrelevant to stock returns, yet investors have long demonstrated an irrational preference for them. Mutual fund providers are well-aware of this fact.
Earlier this week, we reviewed a pair of studies showing that mutual fund managers exploit investors’ well-documented preference for cash dividends to attract assets by artificially “juicing” the dividend yield, and that they use dividend-chasing behavior strategically to benefit themselves at the expense of fund investors. Today we’ll tackle some possible explanations for investors’ anomalous behavior.
Attempting To Explain The Preference For Dividends
Hersh Shefrin and Meir Statman, two leaders in the field of behavioral finance, attempted to explain the preference for the cash dividends anomaly in their 1984 paper, “Explaining Investor Preference for Cash Dividends.” They offered the following explanations.
First, in terms of their ability to control spending, investors may recognize they have problems with the inability to delay gratification. To address this problem, they adapt a “cash flow” approach to spending, meaning they limit their spending only to the interest and dividends from their investment portfolio.
A “total return” approach that used self-created dividends would not address the conflict created by the individual who wishes to deny himself or herself a present indulgence, yet is unable to resist the temptation. While the preference for dividends might not be optimal (for tax reasons), by addressing the behavioral issue, it could be said to be rational. In other words, the investor has a desire to defer spending, but knows he doesn’t have the will, so he creates a situation that limits his opportunities and, thus, reduces the temptations.
The second explanation is based on “prospect theory” (also referred to as loss aversion), which states that investors value gains and losses differently. As such, they will base decisions on perceived gains rather than on perceived losses.
So, if someone were given two equal choices, one expressed in terms of possible gains and the other in terms of possible losses, people would choose the former. Because taking dividends doesn’t involve the sale of stock, it’s preferred to a total-return approach that may require self-created dividends through sales. Sales might involve the realization of losses, which are too painful for people to accept (they exhibit loss aversion).
What they fail to realize is that a cash dividend is the perfect substitute for the sale of an equal amount of stock, whether the market is up or down, or whether the stock is sold at a gain or a loss. It makes absolutely no difference. It’s just a matter of how the problem is framed. It’s essentially form over substance.
Whether you take the cash dividend or sell the equivalent dollar amount of the company’s stock, you’ll end up with the same amount invested in the stock. With the dividend, you own more shares but at a lower price (by the amount of the dividend), while with the self-dividend, you own fewer shares but at a higher price (because no dividend was paid).
Shefrin and Statman write: “By purchasing shares that pay good dividends, most investors persuade themselves of their prudence, based on the expected income. They feel the gain potential is a super added benefit. Should the stock fall in value from their purchase level, they console themselves that the dividend provides a return on their cost.”
They point out that if the sale involves a gain, the investor frames it as “super added benefit.” However, if the investor incurs a loss, he frames it as a silver lining with which he can “console himself.” Because losses loom much larger in investors’ minds, and because they wish to avoid them, they prefer to take the cash dividend, avoiding the realization of a loss.
Shefrin and Statman offer yet a third explanation: regret avoidance. They ask you to consider two cases:
1) You take $600 received as dividends and use it to buy a television set.
2) You sell $600 worth of stock and use it to buy a television set.
After the purchase, the price of the stock increases significantly. Would you feel more regret in case one or in case two? Since cash dividends and self-dividends are substitutes for each other, you should feel no more regret in the second case than in the first case. However, evidence from studies on behavior demonstrates that, for many people, the sale of stock causes more regret. Thus, investors who exhibit aversion to regret have a preference for cash dividends.
Shefrin and Statman go on to explain that people suffer more regret when behaviors are taken than when behaviors are avoided. When selling stock to create the homemade dividend, a decision must be made to raise the cash. When spending comes from the dividend, no action is taken; thus, less regret is felt. Again, this helps explain the preference for cash dividends.
The authors also explain how a preference for dividends might change over an investor’s life cycle. As mentioned previously, a theory incorporating self-control is used to justify spending only from a portfolio’s cash flow, never touching the principal.
Younger investors, who generate income from their labor capital, might prefer a portfolio with low dividends, as a high-dividend strategy might encourage dis-savings (spending from capital). On the other hand, retired investors with no labor income would prefer a high-dividend strategy for the same reasons, to discourage dis-savings. A study of brokerage accounts found that a strong and positive relationship between age and the preference for dividends did in fact exist.
While the preference for cash dividends is an anomaly that cannot be explained by classical economic theory (which is based on investors making “rational” decisions), investors who face self-control issues (such as a weakness for impulse buying) may find that, while there are some costs involved, the benefits provided by avoiding behavioral problems may make a cash dividend strategy a rational one.
Before summarizing, we have one more important point to cover. It involves how popularity drives down returns.
The Curse Of Popularity
The Federal Reserve’s zero-rate policy has led many investors to search for incremental yield, replacing safe bonds with riskier assets. Dividend-paying stocks are among the beneficiaries of these cash flows. That increased demand has impacted valuations, which are the best predictors of future returns. Higher valuations predict lower future returns. Until recently, dividend-paying strategies—specifically high-dividend strategies—called for the purchase of value stocks. Increased demand, however, has changed that.
The table below shows three value metrics—price-to-earnings (P/E), price-to-book value (P/B) and price-to-cash flow (P/CF)—for two of the market’s most popular dividend strategies: the SPDR S&P Dividend ETF (SDY), with more than $14 billion in assets under management (AUM), and the Vanguard Dividend Appreciation ETF (VIG), with more than $22 billion in AUM. Data is as of July 13, 2016. VIG buys the stocks of companies with rapid growth in their dividends.
The table also shows the two large-cap value ETFs with the most AUM, the iShares Russell 1000 Value ETF (IWD) and the Vanguard Value ETF (VTV). Finally, I’ll compare the value metrics of these funds with that of the SPDR S&P 500 ETF (SPY). As you review the data, remember that the lower the price metric, the higher the expected return. Data is from Morningstar.
The above data makes clear that the popularity of the two dividend strategies (SDY and VIG) has led to a rise in the prices of these stocks and reduced their expected returns. No matter which value metric we look at, the expected returns for both SDY and VIG are now well below the expected returns of the two large value strategies, and also below that of the S&P 500 ETF. It’s an example of the curse of popularity, and what happens when a trade gets “crowded.” Forewarned is forearmed.
It seems that investors all over the world are prone to the same behavioral mistakes, mistakes that lead them into a preference for dividends. While Shefrin and Statman showed that at least some investors may derive some benefit (such as help in controlling spending), the preference is irrational from a financial economist’s perspective. It can lead to reduced diversification benefits and higher tax costs. And it can lead at least some investors to fall prey to mutual funds seeking to exploit the typical retail investor’s lack of financial knowledge.
For the past 20 years, the workhorse model in finance has been the Fama-French four-factor model—the four factors being beta, size, value and momentum. The model explains the vast majority (about 95%) of the differences in returns of diversified portfolios.
Newer asset pricing models, which include the profitability, quality and investment factors, have added further explanatory power. Yet none of them include dividends as a factor. If dividends played an important role in determining returns, these models wouldn’t work as well as they do.
In other words, if dividends added explanatory power beyond that of the factors I just mentioned, we would have a model that included dividends as one of the factors. But we don’t. The reason is that stocks with the same “loading,” or exposure, to these common factors have the same expected return regardless of the dividend policy. This has important implications, because about 60% of U.S. stocks and about 40% of international stocks don’t pay dividends.
Any screen for dividend stocks results in portfolios that are far less diversified than they could be if dividends were not included in the portfolio design. Less diversified portfolios are less efficient, as they have a higher potential dispersion of returns without any compensation in the form of higher expected returns (assuming exposures to the factors are the same).
Additionally, you have seen how the preference for dividend stocks has driven dividend strategy valuations to levels well above the valuations of value strategies and the overall market. This should raise concerns about future returns.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.