Investment Strategies

Transcription

1 Index Investment Strategies July 2018 Investor Education Investor Education is Critical to reach your Financial Goals Wealth gives you Freedom and Control of your Life Setup an Auto-Investment Plan to Invest on a Regular Basis in Bull and Bear Markets Create a Diversified Portfolio with the Proper Asset Allocation Purchase Quality Investments Manage your Portfolio Properly PDM Investment Services, LLC A Registered Investment Advisor 5131 Standish Drive, Troy, Michigan * * info@fginvestor.com For complete disclosure see our website Portfolio Performance Contributors Page 2 Adding Value Page 3 Investment Strategy Elements Page 5 Tactical Asset Allocation Page 6 Basic Asset Allocation Strategic Asset Allocation Strategic Sector Allocation Enhanced Security Selection Low-Cost strategy Fundamental Analysis Momentum, Technical Analysis Valuation Analysis Investor Psychology Growth Trends Market Cycle Indicator Cycles & Seasonality Low Turnover Concentrated Strategy Management Ownership Sector Rotation Momentum Strategies Page 11 Risky Investment Strategy Elements Page 13 Investment Vehicles Page 14 Common Stocks Mutual Funds (Open End) Mutual Funds (Closed End) Bear Market Funds Page 15 Passive Mutual Funds (ETF s) Page 16 Smart Beta Funds Page 19 Active Mutual Funds Page 20 PDM Strategy Page 26 Strategy Examples Page 27 Investment Strategy History Page 29 Future Returns Page 30 1

2 Portfolio Performance Contributors 2

3 Define your Strategy Define your investment philosophy, strategy and discipline to guide you in implementation and management of your investments. Over the long term, stocks historically have been the best investment over bonds and cash. Corrections create buying opportunities and recession bear markets set you back. Corrections are not predictable and recession bear markets are very difficult to predict consistently. Selecting the best asset classes to invest in each year is difficult. By the time you identify the leading asset classes and invest in them, they change. Your best chance is to invest in a broadly diversified portfolio covering several asset classes. A diversified portfolio typically performs in the middle of all the asset classes each year. Adding Value Howard Marks from Oaktree Capital Management believes in second level thinking with deep analysis of market cycles and each investment. He looks at fundamental, value, risk, technical and investor psychology. He buys growth at a reasonable price. How much of your performance was due to skill and how much comes from luck? Luck can often be a huge factor in strong investment returns. Luck often runs out in a bear market. Luck is less repeatable then skill. You know less about investing than you think. Don t overtrade. Most investment forecasts miss their mark. 66% of analyst earnings estimates are wrong. Events that look very uncertain before they happened seem very obvious after the fact. Example: You owned three aggressive funds during the bull market and performed very well. Was this by design or by luck? Are you skilled enough to reduce your risk level before the next bear market? Luck, a chance combination of circumstance or conditions operating for or against you, is another consideration. For each good or bad investment decision, ask yourself how much did luck and how much did skill play in the outcome? Your strategy will move in and out of favor. Luck is less repeatable than skill. It takes skill to produce consistent strong performance. An aggressive investor with skill will produce market returns in a bull and not fall as much as the market in a bear market. A defensive investor with skill will produce some of the market returns in a bull and fall less in a bear market. Both of these strategies would produce above market returns over a long period of time. Passive Investors produce market returns with market risk. Anyone can do this by buying an index fund. Most underperform the market. Active Investors attempt to improve on the passive strategy. Produce better returns than the market, with less risk. Active Investor tools: Raise and lower risk through the market cycle. Deviate from the index asset classes considering asset correlation. Buy only the better stocks in the index. Must be able to value an investment s worth and buy it at a discount. Is the discount related to the market, sector, a earnings miss or irrational behavior? Buying opportunities exist because perception understates reality. Use active mutual funds. Use individual stocks. 3

4 Avoid big mistakes because they are hard to recover from Greed, fear, ego and envy can cause investor mistakes. Thinking you know everything about investing is dangerous. This time is not going to be different. Have an offense and a defense plan. Target winners and avoid losers. Sound decisions about a stock selection can be unsuccessful if the market acts irrational. Defense against loss Deep analysis, Lower valuation buys for a margin of safety. Diversification of assets of different correlations. A diversified portfolio of mutual funds for your risk level. (The bond and cash element are your defense) Use bonds and cash. not gold as your defense. Consider the full range of outcomes and consequences. Consider the outliers on a bell curve and the what if. Market bubbles have a parabolic rise and high PE ratios. Hulbert Financial Digest Last Issue (February 2016) The Hulbert Financial Digest was the primary newsletter that rated the performance of investment newsletters. The newsletter discontinued service in Here are some final notes from the last issue. Use the following guidelines when tracking newsletter performance on your own Does the newsletter report their performance? Most of the good newsletters we follow track performance. See the following list. Investment Advisory Service, Dow Theory Forecasts, Fidelity Monitor & Insight, Investech, Hays Advisory, and AAII Stock Superstars) Does the advisor maintain a specific portfolio with exact investments and the allocation of each to track? Is performance based on an actual cash account (only accurate way) or a hypothetical portfolio (not very useful)? Is the reported performance monitored by an independent service? Do not use average performance of holdings in a portfolio because they can be misleading. Advisors may select a timeframe that they performed the best to display. Look close at the detail of the assumptions used in the performance calculation. Look close at the outperforming year and understand why and if repeatable. Past results often are not repeated going forward. If the newsletter is outperforming its benchmark annually by more than 4%, it may be to good to be true. Lessons from 36 years of newsletter performance monitoring 1. It is very difficult to beat the market over the long term. Fewer than 10% of advisors followed beat the market over the past 36 years. The best performing newsletter monitored over the past 36 year beat the buy-and-hold benchmark by 3.7% annually. 2. If you cannot resist trying to beat the market, create a small fun money account and actively manage your timing, fund selection and stock selection. Track your performance each year and compare to your Permanent Portfolio. The best you can hope for is beating the stock market by an annualized average of just a few percentage points. The few points may not be worth your time. 3. In your large primary account, create a well-diversified index fund Permanent Portfolio for your risk level and let it ride. 4. Short term performance is mostly noise and random luck. Focus on performance over the long term. 4

5 Investment Strategy Elements Buy Fundamentally sound Undervalued companies trading at strong Support levels? Buy Fundamentally sound Overvalued momentum leaders at High levels? A combination of strategies may work best. The world stock market, asset allocation, security selection, portfolio management and advisor structure all affect a portfolio s performance each year. The world stock market is the key contributor to your portfolio performance. The second key contributor is asset allocation, third is security selection and forth is portfolio management and advisor structure. The greatest investors of all-time like Benjamin Graham, Philip Fisher and Warren Buffett used fundamental analysis and deep research to select investments, not momentum, derivatives or complex computer-driven trading models, like many investors use today. Warren Buffet used cheap leverage form insurance operations and bought stocks that are safe, cheap, high-quality and large. Their strategies worked well in the past and will continue to work well in the future, unlike many of the hedge funds that use risky derivatives. We employ fundamental analysis and do not use risky strategies that fall out of favor, no margin, no shorting, no leverage, no derivatives and no penny stocks. Simple investment vehicles like individual stocks, no-load mutual funds and ETFs are used because they are easier to understand. Strategy past performance should be measured over at least a 10-year period covering a complete economic cycle. Past performance of a strategy is only valuable for future periods with similar characteristics. It is very difficult to identify the best strategy for each period and actively change your strategy. Sound Investment Strategy Elements Basic Asset Allocation Strategic Asset Allocation Strategic Sector Allocation Enhanced Security Selection Low Cost Strategy Fundamental Analysis Momentum, Technical Analysis Valuation Analysis Investor Psychology Growth Trends Market Cycle Indicator Active Managed Investments Passive Managed Investments Low turnover Concentrated Strategy Management Ownership Other Investment Strategy Elements Tactical Asset Allocation Cycle & Seasonality Momentum Strategies Risky Investment Strategy Elements Short-Term Trading Derivatives Margin Options Short Selling Leveraged Funds Penny Stocks Hedge Funds 5

6 Investment Strategy Elements Investment strategies based on time-tested strategies like Modern Portfolio Theory, asset allocation, enhanced security selection, low cost investments, fundamental analysis, technical analysis, valuation analysis, investor psychology and cycles & seasonality typically produce better returns. Sound management and a low cost advisor structure also help performance. The only way to get rich is to use the best timetested investment strategies and stick with them. There are no get-rich schemes that work long-term. The strategies used in the technology bubble, housing bubble and mortgage-backed security crisis ended badly. Some of the stronger performing strategies over the long term have higher drawdowns in bear markets. To create a portfolio that will outperform its benchmark requires luck and skill. Luck is needed to overcome all the variables we have no control over like the economy, world markets and company manager decisions. Skill comes from analytics, behavioral understanding and sticking with a solid investment plan. Tactical Asset Allocation & Risk Management (Long-Term Timing) Tactical asset allocation actively varies the allocation in equities, bonds and cash depending on market conditions. Being in the market at the right time can help avoid bear markets and control risk. We do not try to time corrections because they are impossible to time consistently. No mutual fund or newsletter has consistently had success in short-term timing. Short-term timing can be costly due to transaction fees and taxes. The markets are positive 70% of the years, so we only focus on timing major bear and bull markets. The elements of our tactical asset allocation model are listed below. Low Inflation allows the Federal Reserve to keep Interest Rates low. Low interest rates make money easier to borrow driving Economic Growth. Economic growth drives corporate Earnings higher. Earnings growth drives Stock Prices higher until market Valuations are high. Cycles & Seasonality can influence stock prices. Market Sentiment can influence stock prices. Global Crisis, Fiscal Policy and Geopolitical concerns can influence stock prices. Tactical asset allocation is rarely successful It takes a different mindset to buy at the bottom then it does to sell at the top. The strategy typically underperforms during bull markets and outperforms during bear markets. Very few indicators have predictive powers and are less than 50% correlated to the market. Market timing systems have a way of breaking down if not constantly evaluated and adjusted for changing world economic and investment conditions. The world continues to evolve and flatten and new investment methods and systems are added. A better strategy for most is to build a portfolio that you can live with through the market s ups and downs. Even if you had the holy grail of a timing system, you may not act properly on the sell and buy signals due to your emotions. Based on Timer Digest, Hulbert Financial Digest and Morningstar less than 5% of newsletters and mutual funds that use long-term market timing outperform. Tactical Asset Allocation is hard (Strategies that make frequent shifts around asset classes and sectors) Mutual Funds in the Morningstar Tactical Allocation Category continue to underperform the market and asset allocation funds. Consider using Bear Market Funds like ProShares Short S&P 500 ETF (SH) to reduce equity exposure preparing for a bear market. This method is easier than reducing your holdings in many asset classes. 6

7 Basic Asset Allocation Asset allocation is a systematic way of diversifying a portfolio and spreading investments among a variety of asset classes that are not perfectly correlated with one another. The process produces consistent long-term returns if executed properly by managing risk-reward tradeoffs and re-balancing. Asset allocation determines the mix of asset classes and sectors used to create a portfolio to meet its specified goals and risk level. The most common asset classes are large cap growth, large cap value, mid cap blend, small cap growth, small cap value, international, sectors, bonds and cash. You should always keep a well-diversified portfolio with a good mix of asset classes. The cure for over-confidence is diversification. Diversification reduces risk. Having more than 10% of your portfolio in one security is risky. Stock portfolios should have at least 25 positions. Based on Modern Portfolio Theory, a diversified asset allocation portfolio with equities and bonds should outperform the S&P 500 in down markets and over longer periods of time, but may underperform in up markets. Bonds and cash will add some downside protection in the next bear market. Strategic Asset Allocation Strategic asset allocation is a systematic way of diversifying a portfolio and spreading investments among a variety of asset classes that are not perfectly correlated with one another. The process produces consistent long-term returns if executed properly by managing risk-reward tradeoffs and re-balancing. Asset allocation determines the mix of asset classes and sectors used to create a portfolio to meet its specified goals and risk level. We actively manage the percent of assets in each asset class and sector based on our asset class-rating model. The most common asset classes are large cap growth, large cap value, mid cap growth, mid cap value, small cap growth, small cap value, international, sectors, bonds and cash. Simple Passive Portfolio Design Vanguard Total Stock Market Index Fund (VTSMX) 34% Vanguard Total International Stock Index Fund (VGTSX) 33% Vanguard Total Bond Market Index Fund (VBTLX) 33% Positives Low cost, simple and diversified number of stocks and bonds. Negatives Could have tax legacy if you sell previous portfolio, missing the following investments. Individual sectors, CD s, international bonds, sector funds, active funds, smart beta funds, alternative funds and low high yield bonds. Not a fun portfolio. 7

8 Strategic Sector Allocation Strategic sector allocation is the active management of the percent of assets in each sector. We actively manage the percent of assets in each sector based on our sector-rating model. Investing in high-growth sectors can enhance returns. Some sectors perform better in some parts of the economic cycle and worse in other parts. Our portfolios invest in high growth sectors like technology, healthcare, financial and Asia. Why invest in the S&P 500 and mutual funds that contain all sectors, including the slow growth ones. Top performing sector mutual funds and stocks are used for each sector to further enhance performance. In sector mutual funds, you get the best managers for each sector compared to one manager that knows a little about each sector in a diversified fund. Enhanced Security Selection Enhanced security selection is used to select the best investments in each asset class. We invest in mutual funds, ETFs and stocks with high performance (alpha), consistent performance, high risk-adjusted returns (sharp ratio) and the best strategies. Our stock and mutual fund rating systems tell us the best stocks and mutual funds to select in each asset class. Stocks and mutual funds are selected based on deep research, not a star rating and last year s performance. Growth strategy, fundamentals, management, performance, performance consistency, risk, valuation, sentiment and technical strength are considered when selecting stocks and mutual funds. We look for growth companies with strong and consistent revenue and earnings growth, an expanding or steady pretax profit margin and a return-on-equity that is steady or growing. Companies are purchased at a reasonable price and at a favorable reward-risk ratio. Low-Cost Strategy Invest in low cost strategies using a discount broker as custodian, purchase ETFs and no-load mutual funds with low transaction costs and pay reasonable management fees to drive higher performance. Passive managed portfolios with passive ETFs are a good low-cost strategy. Fundamental Analysis (What to Buy) Fundamental analysis is an approach that is primarily concerned with earnings, revenue and cash flow. This approach examines factors that try to determine a firm s expected future earnings. Some of the key fundamental indicators to consider are consistent revenue and earnings growth, earnings surprises, earnings expectations, cash flow, valuation and a fundamental price target. Momentum, Technical Analysis (When to Buy) Technical analysis is an approach that tries to predict the future direction of equities based on past price, current price and volume changes. The assumption is that equities follow a pattern. Some of the key technical indicators are trend lines, moving averages, support and resistance lines and momentum oscillators. Trend lines show support and resistance for the stock price. Technical Analysis is used to identify the health of the primary trend. It does not necessarily predict price action, but indicates where and when a trend is likely to resume its path. ishares Edge MSCI USA Momentum Factor ETF (MTUM) LCG Valuation Analysis (When to Buy) Value analysis involves investing in equities you believe are undervalued using the price-to-earnings ratio, price-to-book ratio and price-tocash flow analysis. 8

9 Investor Psychology Investor psychology shows the mood of investors. Investor psychology can help determine stock market peaks and valleys. At market bottoms, investor psychology is at extreme low levels. At market tops, investor psychology is high. Some of the investor psychology indicators are the High/Low Logic Index, Investor Intelligence, Volatility, Insiders, Smart Money, Sentiment and the Overbought Indicator. Growth Trends Getting in and out of an explosive growth trend can enhance your portfolio returns substantially. Identify new disruptive technologies and the dominant players to invest in as the growth trend takes off. Once the growth trend matures, exit the trend. Some of the most significant growth trends of the past were the personal computer, cell phone, internet, biotechnology, the mutual fund, hand held GPS and smart phones. How would you like to have invested in the market dominators in these industries when their prices were low? You could have bought Apple, Microsoft, Qualcomm, EMC, Cognizant, Google, Amgen and T. Rowe Price just as they started their huge rise. Market Cycle Indicator Economic cycles follow similar patterns. Like John Templeton once said: Bull markets are born from pessimism, grow on skepticism, mature on optimism and die on euphoria. In secular bull markets, cycles are longer and in secular bear markets they are shorter. They start with a recovery, seeing a sharp increases in stock prices off the oversold recession bottom. Next comes the transition phase where the market consolidates. Next comes the capital goods phase where the economy is growing strong. Then the cycle ends in recession. It is common to see corrections during a cycle. See the chart below of the typical market cycle that started in 2008 and will end in recession. 9

10 Cycles and Seasonality There are distinct cycles that tend to affect the stock market. The market moves in long-term secular cycles creating and removing excess. The market cycle indicator is used to determine the stage of the economic cycle. The decade cycle shows the years within the decade the stock market tends to perform best. During the four-year election cycle, some years have better stock market performance than others. There are time periods like October through April that the stock market tends to outperform. Some months outperform other months during the year. A positive January often leads to a positive year. Time of Year Cycle Strong Period: November 1 st thru April 30 th In the strong period from 1960 to 2015 the S&P 500 with dividends reinvested produced a 6.9% annual return. 76% of the years this period saw a positive return. 65% of the years this period did better than the weak period. Weak Period: May 1 st thru Oct 31 st In the weak period from 1960 to 2015 the S&P 500 with dividends reinvested produced a.9% annual return. 63% of the years this period saw a positive return. 35% of the years this period did better than the weak period. Since this period still produced a positive return and outperformed the strong period 35% of the time, you should stay invested in the weak period. A 1% annual return is still better than a 0% cash return. Source: Investech Research Low turnover Strategies with low turnover tend to outperform high-frequency trading strategies. Higher fees, transaction costs, taxes and poor judgment cause high-frequency trading strategies to underperform most of the time. Concentrated Strategy Strategies with less-than fifty stocks offer a greater chance of outperforming their benchmark. Over-diversified strategies tend to perform at or below their benchmark. Management Ownership Strategies with high insider and manager ownership tend to outperform their benchmarks. Managers that believe in their strategy will invest their own money in it. 10

11 Sector Rotation (Momentum Relative Strength Strategies) Momentum strategies are based on relative strength relative to other asset classes or relative to a benchmark. Score starts at 0 with the lowest RS and goes to 100 with the highest RS. Relative strength reveals nothing about the direction. A high RS on a falling stock mean means the stock is falling less than its peers. RS looks back at strength over 1, 3, 6 or 12 months or all periods. Human nature wants us to invest in the strongest sectors only to see them change. Stocks or sectors with high relative strength tend to outperform until the dynamics change. Momentum strategies rotate into the strongest equities or asset classes until they weaken, then they sell. You identify an up cycle and invest in it until the cycle ends. You miss the gains in the beginning of the cycle and see some losses after the cycle ends before you get out. For this strategy to work, you have to get in early. Momentum investors aim to buy high and sell higher. Mutual Funds: The Morningstar Tactical Allocation Category continue to underperform the market and asset allocation funds. Good Harbor U.S. Tactical Core Strategy (GHUIX) and F-Squared AlphaSector Premium had winning years but are underperforming now. Virtus Equity Trend (VAPAX) Alpha -7%, Virtus Sector Trend Fund (VARIX) Alpha = -2%, Virtus Multi-Asset Trend Fund (VAISX) Alpha = - 2%. Innealta Capital Sector Rotation Fund (ICSIX) Moderate Allocation. Horizon Active Asset Allocation (HASIX) 5-star TAC fund. Alpha=3. Newsletters: The only sector rotation newsletter that performs well on paper is the Sector GPS for $800 per year and Harloff s The Intelligent Fund Investor for $279 per year. (Based on Hulbert Financial Digest and Timer Digest) Asset Rotation Book: Matthew P Erickson. MPT will no longer work with record low interest rates. Tactical and strategic asset rotation with ETF s beat S&P 500 over many periods based on past information. Software: Sector Surfer (SumGrowth Strategies) claims to do well based on a few of its first strategies still running. Actual performance in an account with real trades will likely perform worse due to trading fees and trading timing. These strategies work well in secular bull markets and in years where sector leadership stays the same for long periods. They do not work when sectors jump from the top to the bottom and back to the top month to month. Smoothed relative strength works better than month to month performance. In theory, momentum strategies should offer some protection in bear markets, but this tends not to be the case. Momentum strategies do not work well in trendless markets and corrections when buys and sells come often. Momentum strategies tend to hold overvalued stocks and buy the asset classes and equities with the strongest 3 to 6-month relative strength. Sector Rotation often lags because it is difficult to consistently make additive market-timing calls. Because so many investors try sector rotation it makes it more difficult to add value. We have yet to see strong evidence that a momentum strategy is superior to a Buy fundamentally sound stocks at a reasonable price strategy. Only a few momentum strategy mutual funds and newsletter outperform the market over a 10-year period by more than 2% annually. A Morningstar study of Fundamental Stock-Picker funds and Sector-Rotator funds show the stock pickers outperform. AAII Article 2016 (Top performing money managers (Strong 5-year, 10-year performance). By chasing performance, investors fall into an ongoing pattern of buying after share prices have risen considerably and selling after they have dropped. The top managers make up lost ground and add excess return following periods of weakness. Investors with the patience to stick with top managers through trying times are likely to reap greater rewards than those who chase the latest winner. Even the best investment managers see periods of underperformance with their strategy due to changes in market environment. Approximately 85% of top managers had at least one three-year period in which they underperformed their style benchmark by 1%, 50% by 3% and 25% by 5%. No strategy works all the time in all phases of the market cycle. Management or strategy changes can warrant selling of the fund. 11

12 AAII Article 2016 Momentum works because investors anchor to improved earnings expectations and herding behavior. Buying sectors or stocks based on RS only is not a diversified strategy. Using multiple strategies can increase diversification and reduce volatility. Adding fundamentals, valuation, volatility and size to momentum can also help. Trends tend to last 4 to 12 months. Momentum does not have staying power on an aggregate. Momentum has higher turnover rates driving higher costs. Momentum strategies can crash. There are long periods where momentum investing does not work. The strategies tend to perform best in bull markets in years with small corrections. They do not perform well in years with large corrections and bear markets because leadership/sentiment changes at these times. A momentum portfolio that is long winners and short losers has significant negative market exposure near the end of a bear market. During the first year of recovery from a bear market, momentum strategies tend to underperform, as the biggest winners in the first year are the biggest losers of the past year. These are called momentum crashes. During the period of March through May of 2009, stocks ranking in the bottom 20% for past performance, low relative strength, gained 163%. Stocks in the top 20%, high relative strength, gained just 8%. Buying stocks with a strong 3-month return and weak 12-month return works best because the stocks tend to be undervalued. A strategy based on momentum works best if you only select equities that are fundamentally sound and are not overvalued. Asset Rotation (Matthew P Erickson) 2015 Modern Portfolio Theory with 60% equities/40% bonds will no longer work with record low interest rates. Stocks are growing at a slow rate and are fairly valued. Bonds are expensive and will lose value as interest rates rise off of record lows. Active managed mutual funds are underperforming passive managed ETF s. Stock pickers are underperforming the S&P 500. Exchange Traded Funds seem to be the best performing strategy these days with their low costs. Portfolio managers are struggling to produce after fee returns in this low growth environment. Their Tactical Strategic Asset Rotation Model with ETF s beat the S&P 500 with lower volatility and higher risk adjusted returns over many periods based on past information. Rotating 5 asset classes can produce a lot of trading each month so ETF s must be used. Sector Type: Select the 10 S&P Sectors and one Bond ETF or the asset class ETF s (LCG, LCV, MCG, MCV, SCG, SCV, INT) and bond ETF. Number of Holdings and Weight: Typically use around 5 ETF s with 20% in each. Trigger: Strongest relative strength (30 is under owned, 70 is over owned or 1-month return. Review Period: Rebalance each month. Strategies must be tested thru complete market cycles. The Credit Swiss Hedge Fund Index is a benchmark to be considered. Rising Market (2009, 2013, 2014) Positive Will miss beginning of trend. Good under normal market conditions. Falling Market (2008) Positive Will fall until trend established. TAC will help. Sideways Market (2011) Positive Works if pick up on the trend. Sideways Volatile Market (2015, 2016) Negative Whipsaw trading hurts performance. 12

13 Risky Investment Strategy Elements Stocks with a higher level of information uncertainty create the potential for momentum profits, like small caps. Short-term trading, derivatives, options, short selling, leverage, margin and penny stocks are risky investment strategies. They may work well in some periods, but often fail in other periods. Over the long-term they tend to underperform. Derivatives A derivative is a financial instrument that has a value based on the expected price movements of assets to which it is linked. The most common derivatives are options, futures and swaps. They are seen as alternative investments. Derivatives are most often used by hedge funds. They can be used to reduce risk like in market-neutral funds or increase risk like in collateralized debt obligations in mortgages that took down the financial and housing market in Options Call Options: If you buy a call option, you are paying a premium now for the right to buy the stock in the future at the strike price, before it expires. If the stock rises above the strike price, a gain will be created. Your maximum gain would be the stock rise over the strike price minus the premium. If the stock falls below the strike price, there will be no gain and your only loss will be the premium. Companies often purchase call options for employees and pay the premium to incent them to drive the stock price higher. If you sell a call option, you are betting against the stock. Your maximum loss is the rise in stock price above the strike price minus the premium. Your maximum gain is the premium. Options can magnify the gains and losses by as much as ten times leverage. Put options: The opposite of call options. If you buy a put option, you are paying a premium now for the right to sell the stock in the future, at the strike price, before it expires. Options can magnify the gains and losses by as much as ten times leverage. Short Selling In a short sale, you are benefiting from the stock falling. A short sale is when you borrow money to sell high, buy the stock back later at a low price and cash in the difference. The maximum loss is the gain of the stock, which could be over 100%. The maximum gain is 100% if the stock falls to $0/share. Margin Brokerage accounts consist of cash accounts and margin accounts. In cash accounts, investors hold stocks, mutual funds and cash. Margin accounts are a way to gain leverage by borrowing against your cash account to buy marginable stocks. The most you can borrow is 50% of the cash account value. If your stocks drop and you do not meet the margin requirement, you will get a margin call requiring you to add more money or sell stocks. Margin amplifies your gains and losses. 13

14 Investment Vehicles The most common investment vehicles are mutual funds, ETFs and common stocks. For most investors, portfolios with mutual funds and ETFs will perform the best. Individual stock portfolios require a high level of skill and time to perform well. Small portfolios should start with a diversified mix of ETFs, then as the portfolio gets larger add active mutual funds and eventually some individual stocks. Common Stocks A basic form of equity ownership in a business that provides voting rights and a claim on earnings and dividends. Low-cost Higher upside and downside potential More flexibility to find good opportunities at market bottoms and overbought markets Portfolios are more difficult to manage More difficult to get diversification More difficult to research The stock market is often irrational for long periods of time giving no respect to individual stock fundamentals and valuations It is difficult to find companies to invest in for the long-term No professional management Higher risk Self-managed portfolio more likely to underperform Individual stock picking success rate is less-than 65% More difficult tax records Potential for lower taxes Mutual Funds (Open End) The most common type of mutual fund that the number of shares in the fund vary and it is priced at the end of each trading day. A mutual fund is a fund that pools the money of its investors to buy a variety of securities. Most mutual funds are diversified and are classified by large, small, growth and value stocks. Higher cost Portfolios are easier to manage Easier to get diversification Easier to research Professional management Lower risk Moderate upside and downside potential Self-managed portfolio more likely to outperform Easier tax records Harder to participate in buy low. At bottoms funds are selling to pay redemptions 14

15 Mutual Funds (Closed End) Closed ended funds have a fixed number of shares and trade like a stock based on supply and demand. The NAV is the value of the fund based on its investments. The Price trades above and below the NAV at a premium or discount which can create supply and demand leverage. It is better to buy the fund when it trades below its 3 and 5 year premium/discount average. The percent difference between the Price and NAV equals the Premium or Discount. Before buying a closed end fund, look where the distribution money is coming from each year, leverage ratio and premium/discount. Closed end funds set a distribution rate each year and return capital, dividend income and stock appreciation to shareholders to make up this rate. A normal year for a dividend stock fund would distribute 3% from income and 5% from capital gains, returning no capital. In years that stocks are down, they distribute capital and dividend income, reducing the value of the NAV and the value of your investment. In good years, they distribute dividend income and capital gains, not diluting the NAV. Capital distributions are less destructive when the price trades at a discount. Think of it as a retirement fund you take an 8% distribution from each year. In bad years you have to sell some of your base investment to continue receiving the 8% return, eroding your base investment. Bear Market Funds (InvesTech Research) Consider using a Bear Market or Reverse Fund to reduce equity exposure preparing for a bear market. Easier and faster than reducing your holdings in many asset classes to reduce equity exposure. Allows you to keep a higher diversification. Tax efficient. Reduce capital gains in a taxable account. Use an index that is closest to your portfolio. An index fund is efficient, low cost, faster and a better representation of an index than an active inverse fund. Bear market funds should only be used to neutralize portfolio risk, not as a trading investment. Do not use leveraged inverse funds. Gradually implement a bear market position as bear probability increases. Could use for the first few 5% steps (75% to 70% to 65%) than reduce high risk sectors next. Example: 73% long funds, 8% bear fund and 19% cash. Net long is 75% -10% = 65% net long. ProShares Short S&P 500 ETF (SH) Large inverse fund ($1.7 billion), since 2006, very liquid (no issues in flash crashes yet) Low ETF fee structure. Grizzly Short Fund (GRZZX) Goal is to outperform the inverse fund. Shorts the S&P 500 and 100 stocks. 1.55% management fee. $10k minimum. Alpha over index is = -47%, 2010= -23%, 2011= -2%, 2012= -21%, 2013= -27%, 2014= -11%, 2015= 4%. A fast market surge off the bottom may hurt you. Inverse funds are based on daily activity. The index drop over time will not march the funds gain to 2010: S&P %, SH +92% S&P %, SH -44% Another method is removing the low RS sectors. Lowering all sectors than raising all may not be feasible. 15

16 Passive Mutual Funds (ETF s and Index Funds that mimic a market cap index, unmanaged, low fees around 0.3%) Strategic/Smart Beta (ETF s that apply rule based active screening to index, computer managed, moderate fees around 0.5%) Active Mutual Funds (Mutual Funds that apply human judgement, managed, use a market view, higher fees around 0.8%) Passive Managed Funds (ETF s and Index Funds) Passive mutual funds are often exchange-traded funds (ETF) that trade like stocks and can be bought and sold within the day. The funds typically represent market indexes, sectors and asset classes. ETFs are easier to research, easier to trade, more efficient, are more likely to outperform and have lower costs than active-managed funds. It is difficult to find good active funds that consistently outperform their index. Portfolios with ETFs are easier to implement and manage. Unless you have the tools and skills to identify superior active funds, you are better off investing with ETFs in most asset classes. Based on the whole universe of funds, passive funds outperform active ones for most individuals and portfolio managers most of the time. Passive ETF s outperform in bull markets because they have lower fees than active funds. A passive ETF has an average fee of 0.2% where an active fund is around 0.7%. Passive index funds typically underperform a true index by the 0.2% management fee and 0.3% cost of adjusting to changes in the index. They are on the wrong side of the announcement a stock will be added or removed from the index. Small cap index funds see an even higher drag on performance. There is no management ownership in an ETF like an individual stock or mutual fund. The Active SPIVA Scorecard measures the performance of active and passive mutual funds annually. Since you cannot purchase an index, compare your active managed funds to passive index funds. Passive index funds are a bucket of good and bad quality stocks with high and low valuations that mimic an index like the S&P 500. Index funds do not care about a company quality, fundamentals or valuation, like active managed funds do. They do not hold cash like active managed funds do for downside protection. The market will care about quality, fundamentals and valuation in the long term and during the next bear market. In the next bear market, index funds will likely come tumbling down and money will flow back into active managed funds. Index funds typically underperform in bear markets and corrections. Passive index fund mania occurred in the later stages of the last three bull markets. Passive and active move in and out of favor in different stages of the market cycle. Active managed funds typically outperform in flat and bear markets and index funds outperform in bull markets. Indexing does not offer much risk management. It does guarantee you will perform at the index benchmark in a bull market and you will fall 100% of the index in a bear market. Active funds may not rise as much in a bull run, but may offer more protection in a bear. Over the complete cycle active management often outperforms a passive index. Liquidity Risk ETF s cannot have more liquidity than their underlying investments in a selling panic. If an ETF cannot sell equities fast enough to keep up with redemptions, trading halts or assets are sold at a discount further reducing its share price. The morning of 8/24/15 the Dow fell 1000 points on the open, similar to the flash crash of May The 5-minute trading halts implemented in 2010 for stocks may have caused undue volatility in the ETF markets, causing some ETF s to plummet over 30% briefly. Look at the sharp spikes down in the stock charts of ETF s. (IVV, JNK and SPLV charts) The ETF s were falling faster than the stocks they owned. The halts stopped the arbitrage traders from fixing the discrepancy, causing the spike down. Active managed funds do not have this problem since they are priced at day end. It is best if you trade ETF s between 10:30 AM and 3:00 PM for maximum liquidity. It is dangerous to use stop loss orders with ETF s because a sell may be triggered at 30% down and then the ETF recovers an hour later. Only purchase larger established ETFs like ishares, SPDR and Vanguard. Many ETFs close in the first few years making it difficult to get a good sell price. Make sure AUM are greater than $5 million and average daily volume for a given month is more than $100,000 and cash reserves in risky ETF s. Look close at underlying securities, the ETF sponsor and liquidity. Some ETFs, like REITs, commodities and hedge funds may trade at a price higher or lower than the funds NAV. When you buy or sell be aware of the premium or discount. 16

17 Passive Mutual Funds (ETF s, Index Funds) Passive Performed Well in 2011, 2014, High correlation/low dispersion/high efficient market, stock picking does not work, low volatility, low inflation, low interest rates, diversification fails (-V,S), high momentum stocks with risk on/risk off, late in economic cycle, low to moderate growth and high active fund outflows. More monitory policy driven market where all companies benefit. Lower management costs. (One of the main predictors of fund performance) (Average expense ratio is 0.4%) Lower purchase costs with no loads. (Brokerage transaction costs range from $7 to $20 per trade) Low minimum purchase cost for small portfolios. (Better for small portfolios, 1 share minimum. Active funds minimum >$1000) Tax costs for equity ETF s are generally lower in taxable accounts. (Exceptions are bond, commodity, currency hedged and high dividend ETFs) Lower turnover from less trading because they track an index. They change hands in the marketplace with no capital gains. Active funds need to raise cash and distribute capital gains for redemptions. You won t see large 10% year-end capital gain distributions. ETF s distribute dividends but little capital gains distributions. Massive movement out of active funds too passive in the past 7 years due to better performance and lower fees. The inflows help the performance of passive and hurt the performance of active funds. New DOL fiduciary rule driving lower fees will support passive. Over time markets have become more efficient making it more difficult for stock picking and active management. Passive funds are not affected by large cash inflows or outflows like active funds are. On average 75% of passive funds outperform active funds by 1% each year in their category. Passive funds perform better in strong markets, growth, large cap and mid cap. Easier to research, select and trade ETF funds. Good for small simple portfolios. Eliminates risk of picking the wrong security. Portfolios are easier to manage due to greater flexibility. Can trade within the day. Warren Buffett is endorsing passive; he has advised his trustees to put 90% of his estate in low-cost S&P 500 index funds. ETF s can run into trouble in stressed markets (market panics) when their holdings are not trading because of market circuit breakers. Flash crash 8/25/2016 Roughly 20% of all ETF s fell more than 20%, while just 5% of individual stocks declined as much. August 2010 Flash Crash. Stock and ETF exchanges must fine tune how they stop and start trading again. (See above) ETF s with less liquid investments could fall sharper in a down market due to liquidity and indirect sale thru brokers. Many companies will unfairly benefit from being a part of an index in the short term. Long term this should correct itself. Your returns will closely follow the category performance, but not beat it. When small-cap is outperforming large-cap, passive funds tend to underperform. The massive size of ETF s work some in the next downturn or flash-crash. Easier and cheaper to trade may increase redemptions. Ned Davis Research 2017 (Passive investment bubble) Index investors just buy and hold the market, the good and the bad stocks. They don t worry about market timing, valuation and fundamentals. The way people are investing is creating a market of dislocations. Counter: Active works if you can pick the winning stocks and time the market which very few can. 17

18 Passive Mutual Fund Analysis (Exchange Traded Funds) Below is a table of leading ETF fund companies and ticker symbols in various asset classes. Guggenheim are mostly equal weight or smart beta (pure growth screen and pure value screen) and the others are mostly market cap weight. Analysis is based on our analysis of Morningstar data in July Vanguard BlackRock ishares State Street SPDRs Schwab Guggenheim Large Cap Growth VUG JKE, IWF SPYG SCHG RPG (pg), RSP (ew) LCB, OEW (ew) LCG Large Cap VOO Large Cap Value VTV JKF, IWD SPYV SCHV RPV (pv) Mid Cap VO Mid Cap Growth VOT JKH, IWP MDYG RFG (pg) Mid Cap Value VOE JKI, IWS MDYV RFV (pv), EWMC (ew) Small Cap VB Small Cap Growth VBK JKK, IWO SLYG RZG (pg), EWSC (ew) Small Cap Value VBR JKL, IWN SLYV RZV (pv) International VEU ACWX GWL SCHF Emerging Markets VWO EEM GMM SCHE EWEM (ew) Asia VPL EPP GMF Technology VGT IYW XLK RYT (ew) Financial VFH IYF XLF RYF (ew) Healthcare VHT IYH XLV RYH (ew) Performance A B- B+ B B Management Fees A B+ B+ A B- Management Tenure B- B B B B Morningstar Stars 3.6 ave 3.2 ave 3.8 ave 3.5 ave 3.7 ave Liquidity AUM Large Large Medium Medium Medium Tax Efficiency (Turn) Highest High Medium Highest Higher Turnover 18

19 Strategic/Smart Beta Funds (Smart Index Funds, Smart Beta, Strategic Beta, Enhanced Indexing, Fundamental Indexing) Smart beta is an attractive option for investors who want to own products in the middle of active managed funds and passive managed ETFs. They have a lower minimum purchase, are tax efficient and their cost structure is low closer to ETF s than active managed funds. Smart Beta funds may have higher fees and be less tax efficient than pure index funds. Many smart beta funds are designed using the factors that produced strong past returns and do not take into account reversion to the mean for the future. Most fail to outperform in the past 1 and 3 years. Creating a fund based on past performance is money chasing. Past performance does not guarantee future results. Smart Beta funds are ETF s based on an index with a rule set (factors) filter applied. These factors help explain the differences in portfolio returns. Each year growth or value leads, large or small leads. A portfolio over weighted in leading factors will outperform. The goal is to beat the market by screening stocks based on a variety of factors. Active managed funds use a combination of factors but have higher fees that eat away at performance. Smart beta funds use the factors, are quantitative computer driven with lower fees. The top 6 factors that have provided alpha in the past are listed below. Many are also equal-weighted funds, not market-cap weighted. Large or Small Growth or Value (valuation) Quality Fundamentals (earnings and revenue quality) Momentum Volatility (Market beta and standard deviation) Dividends Their value is yet to be determined since they have only been available since Active Managed ETF s with the same holdings as active version are starting to come out in Small cap value with quality have shown the best performance in the past. In 2016 and 2017 many Smart Beta ETF s have performed close to their indexes like QUS, JHML, ROUS, TILT, DEUS, JPUS, LRGF, SCIU and GSLC. Most index funds are market-cap weighted with the large companies having more weight than the small companies. do poorly in the future. Equal weight funds use the same weight for all companies, larger or small. Some smart beta funds do not attract money and are closed. Look for ones that are larger with more liquidity. A Wharton School of the University of Pennsylvania study of 164 smart beta ETFs between 2003 and 2014 found that 60% of the smart beat ETF s beat their raw passive benchmarks. Many are designed based on a screen that worked in the past so it looks attractive only to find it Search: Morningstar, More, ETFs, ETF Returns, Show complete list, Sort Name. First Trust AlphaDEX (G,V), Guggenheim (EW,G,V), ishares Edge (low volatility), Powershares (Q), Doubleline, SPDR. Fidelity Factor ETFs (Launched in 2017) 2017 YTD 1H S&P 500 Base (SPY) 9.2% Momentum (FDMO) 10.0% Quality (FQAL) 9.8% Dividend for Rising Rates (FDRR) 8.3% Low Volatility (FDLO) 8.3% Value (FVAL) 7.7% Core Dividend (FDVV) 4.3% 19

20 Active Managed Mutual Funds Traditional mutual funds are active managed funds managed by a portfolio manager. It is very difficult to find investment managers who consistently add value relative to the appropriate benchmark. About 25% of active funds outperform passive funds each year in their category and 5% of active funds outperform passive funds consistently each year. Finding these 5% is a difficult and ongoing process. A consistency over 70% would be considered good. There are good funds in the active and passive category. Active and passive perform different in different periods. 70% of active funds are closet indexers and generally fail to beat their benchmark after fees and portfolio taxes. All the manager skill and alpha is gone after fees and portfolio taxes. Look close at fund strategy, management, expense ratio, makeup, number of stocks in portfolio, amount of active share and correlation (R2). A fund must be different than its benchmark to beat it. Look close at the style box to see whole picture. Focus and smaller funds typically perform better. PRIMECAP Odyssey Growth, Mairs & Power Growth, Oakmark Fund and Akre Focus are examples of active funds that outperform their category most years. They all use fundamental and valuation analysis, have low expense ratios, low turnover, control risk, have ownership in the fund and have been managed by the same manager for a long time. Active funds have higher costs, but provide the opportunity to outperform their benchmark. Portfolios with active funds are more difficult to implement and manage than passive fund portfolios. Past performance is a poor predictor of future performance because the performance is often due to pure chance or period specific characteristics. In 2014, less than 20% of active fund managers outperformed passive indexes. This was the worst showing for active managers since Portfolio managers were hurt by positions in high-yield bonds, natural resources and international stocks. Asset allocation hurt portfolios due to the divergence in asset class performance and the flood of money from overseas into U.S. large cap index funds. The sharp rise in the U.S. Dollar normally hurts large multi-national companies, but not this time. The market rewarded slow predictable dividend growth and punished high growth stocks. The dispersion index was at the low end of its range. Low dispersion means the index components performed alike, making it difficult for stock picking. Only 20% of Large Cap funds outperformed the S&P 500 in In % of active Large Cap funds outperformed the S&P 500. Did the individual stock performance drive this or did the massive flow in index funds drive the low dispersion? Dispersion: In seeking alternatives to correlation (R2), a simple starting point is the degree of variation in the returns of a portfolio s components (measured, for example, by the cross-sectional standard deviation of asset performances during the relevant time period). This provides a direct measure of diversity by measuring how differently individual assets perform compared to the average. This is fine for an equal-weighted portfolio, but since most portfolios are not equal-weighted, we can obtain a more accurate measure of portfolio dispersion by weighting the summands in a standard deviation calculation. Dispersion has some correlation to volatility. The dispersion of asset classes in the S&P 500 index also show the opportunity for active management. Active manager stock pickers had more opportunity to outperform other portfolio managers in (Tech and LCG bear), 2003 (recovery year), 2008 (bear), 2009 (recovery year), 2011 (correction year). The Active SPIVA Scorecard measures the performance of active and passive mutual funds each year. According to a Morningstar study of 15 years ending July 31, 2014 on U.S. diversified stock funds, Vanguard active funds outperformed Vanguard passive, other cheap active and expensive active funds. Expensive active did the worst. Vanguard active allocation funds performed the same as passive ones. Vanguard active international outperformed passive international. Vanguard active taxable-bond outperformed passive. 20

21 Trends working against Active Management The hurdles to generate alpha are getting higher as competition is increasing and the pool of underperforming individual stock pickers is falling. Active mutual fund management adds value on a risk-adjusted basis and produced an average of 0.7% alpha, which is eaten away with fees producing less than 0% alpha after fees. Passive index funds and ETF s have lower management fees than active managed funds creating an alpha close to 0. Incredible Shrinking Alpha: Swedroe & Berkin Individual stock investment has fallen from 48% in 1980 to 20% in Now the pool to exploit is smaller, making it difficult to outperform. Individual investors underperform active manages funds. In the past, active managers exploited individual stock investors to gain alpha. Alpha is a zero-sum game. You need losers to have winners. Institutional traders are now doing as much as 90% of the daily trading volume. The rise in passive index funds and ETF s that target matching the index is growing exponentially at the expense of active mutual funds. As less-skilled investors abandon active strategies, the level of competition among the remaining participants will increase. The remaining ones are more skilled. This rise in passive funds further reduces the pool of poor performers to exploit. The increase in competition for a limited amount of alpha reduces the ability of any given fund to outperform. The increase in hedge funds has also been competition for active fund managers. An increasing number of highly talented young investment professionals have entered the competition. The talent is increasing with analytic tools and fast information. The markets are becoming more efficient. The shear increase of volume in passive ETF funds has contributed to outperformance. The volume drop in active funds has hurt performance. The goal of actively managed funds is to generate alpha returns above an appropriate benchmark. The only way to create alpha is to hold a different, less-diversified portfolio than the benchmark. Alpha is created by investing in the strong asset classes and selecting the best investments in each asset class. The number of areas to find alpha is shrinking. The level of competition is getting tougher as ever more skilled active managers employ better data and technology. The trend toward index ETF funds is making passive investing perform better and alpha harder to find. There are less poor performers to exploit alpha from and the money flow into passive strategies help drive them higher. Benjamin Graham (1960 s) I think the most important reason why the investor should not be led to emphasize his selection of individual stocks, and to neglect the general level of the stock market is the fact there is no indication that the investor can do better than the market averages by making his own selections or by taking expert advice This advice includes active managed mutual funds. He was implying index funds would be better but they did not exist to invest yet. Growth stocks can be overpriced and value stocks can be difficult to evaluate. Warren Buffett believes most investors would be better off buying a low-cost S&P 500 Index Fund and Short Term Treasury Fund for a 30- year time horizon. 21

22 Active Mutual Funds Active Performed Well in 2012, 2013, Low correlation/high dispersion/less efficient market, stock picking works, higher volatility (investor behavior inefficiencies), rising inflation, rising interest rates (S), diversification works (+V,S), low momentum stocks with risk on/risk off, early in economic cycle, stronger growth and low active fund outflows. More fiscal policy driven market where some companies benefit. Pricing inefficiencies will always exist due to irrational investor behavior helping active managers. Better chance to control risk. Risk management strategies in active funds can help reduce market and security risk. Active funds that perform to the index, offer better downside protection than its index fund. Offers a chance to outperform the indexes. Active funds participate in most of the market gains and less of the market losses. Active management aligns with investor psychology to control emotions. Provides the opportunity to outperform the major indexes, especially in bear markets and when investors start paying attention to fundamentals. When the Fed starts reducing its asset purchase program active may perform better. When small-cap is outperforming large-cap, active funds tend to perform better. Active funds perform better in flat and bear markets, less-efficient, less-liquid, more volatile, weak sectors, small cap, international, emerging markets, technology, financial, healthcare, alternatives and bond sectors. Active small caps outperform passive small cap because quality small cap is superior. International active managers can avoid weak markets like Japan and gain more exposure to emerging markets than index ETFs. Better in sideways markets, weak markets, when investors are paying less attention to falling interest rates and more to earnings. May perform better in rising interest rate environment. On average, only 25% of active funds outperform passive funds each year in their category. Is it worth the bother? Most of the time the 25% outperformers are different each year. 5% of top quartile funds outperform the next year. A small group of active funds outperform the market with a high level of consistency each year. Higher costs are the largest drag on active managed funds. (The main drag on performance) (Average expense ratio is 1.0%) Higher purchase costs. (Brokerage transaction costs range from $0 to $75 per trade) Tax costs are generally higher. A Smart Beta Fund is an index fund with some defined screens and has better tax management. Active managed funds pay higher dividends and capital gains distributions. Massive cash outflows into passive funds and bond funds hurt active fund returns from 2010 to 2016 except % drag (M.S.). Active funds are negatively affected by large cash inflows or outflows especially in less liquid sectors like small-cap, mid-cap and foreign securities. Trading costs rise, capital gains costs rise and extra cash can drag down returns. Large inflows can cause managers to hold more cash or invest in second tier stocks. Morningstar studies suggest large outflows have reduced returns by about 2% and large inflows by about 0.5%. More than $211 billion (2%) has poured out of active managed U.S. stock mutual funds over the past year ending August The money has moved to passive managed mutual funds and bond funds. It takes more time and it is more difficult to research and select funds that will outperform in the future. 22

23 Summary of Active and Passive Funds The Bottom Line: A mix of active and passive funds in a portfolio is best with more passive in large, mid and small cap and more active in value, international, sectors and bonds. The amount of active depends upon the persons ability to pick above-average active managers, cost and investors risk tolerance. Passive typically outperform early in the cycle when correlation is high and passive late and in down markets where correlation falls. Based on the whole universe of funds, passive funds outperform active funds for most individuals and portfolio managers about 75% of the time. Active management has been underperforming since the 2008 financial crisis in this ultra-low interest rate environment. From 2006 thru 2016 we saw a massive shift from active to passive managed funds. Active outperformed 80% of the years on average and the total mix went from 15% passive to 34% active funds. William Priest Book: This low interest rate low growth environment is driving the outperformance of low-quality, low growth and higher yielding stocks driving up valuations in passive fund investments. The higher correlation between stocks is also helping passive management. Active managers invest in higher growth, higher quality, correlation discrepancies and modest valuation companies. The near zero percent return of money market investments in active managed funds is a 0.4% drag on performance plus the 0.5% higher fees. The performance gap is driving active management to shorten their investment horizons and hug the indexes. Both active and passive management will survive. If all investors were passive and no managers were researching company fundamentals, mispricing and inefficiencies would rise, creating opportunities in active investing. Pricing inefficiencies will always exist due to human behavior supporting active managed funds. The following type of active managed funds will survive: Small mutual fund families with only a few funds like Mairs & Power, PRIMECAP, Oakmark, Akre, and FMI. Specialty funds in sectors and small cap will survive. Alternative mutual funds like market neutral, long-short, arbitrage, and absolute return. Smart Beta active ETF funds. Active funds perform better in flat and bear markets, less-efficient, less-liquid, more volatile, weak sectors, small cap, international, emerging markets, technology, value, financial, healthcare, alternatives and bond sectors. Passive funds perform better in strong markets, growth, large cap and mid cap. Bond Index Funds are structured according to company s appetite to borrow rather than the ability to service debt. Active Bond Funds have more control over bond yield, bond quality and duration. AAII Daniel Crosby 2016 An S&P 500 Index Fund is not really a passive managed fund at all. It is a basket of 500 stocks that reflects the broader U.S. economy by including leading companies in leading industries. It s an actively managed portfolio selected by a committee. The index has a fundamental growth bias selecting companies that are growing and has a momentum tilt toward companies with strong stock performance. Indexes are a product of active management intervention and are prone to all of the human behavioral biases (committee) that beset regular managers. The committee allowed for the addition of popular but unprofitable companies like American Online during the tech bubble. Since the index is market cap-weighted, it demonstrates a momentum based strategy where investors buy high and buy more at a higher price. This does not follow the buy low sell high theory. As stocks get more expensive and less attractive to buy, its weight in the index grows. The S&P 500 Index held nearly 50% in tech stocks in the tech bubble of 2000 and 40% in financials before the housing collapse in The index saw an over 40% drop after the bubbles popped. Sounds like the same behavioral bias mistakes many other investors make. Behavioral bias can be eliminated by an automated stock selection process like smart beta funds are trying to do. They apply rule based active screening to an index, are computer managed and have moderate fees of around 0.5%. 23

24 Summary of Active and Passive Funds Investment strategies that tend to outperform have low fees, diversification, low turnover, manage behavioral bias and risk management. Passive Low fee Diversified Low turnover Rule Based Low fee Diversified Low turnover Manages bias Risk management Potential outperformance Active Diversified Risk management Potential outperformance Mutual Fund Industry (Barron s July 11, 2016) Since passive managed ETF s outperform active managed mutual funds about 75% of the time in many asset classes. Investors have been aggressively selling active funds and buying passive ETF funds. For non-professional individual investors, ETF portfolios are easier to design and manage, ETF s are easier to trade, have lower internal fees and better performance. There has been a massive movement of cash flowing out of active managed funds to passive managed ETF funds due to the lower costs and better performance. When the market was flat from mid-2015 to mid-2016 investors pulled $308 billion out of active funds and poured $375 billion into passive funds. The huge outflows in active funds also take a toll on their performance. The 2016 DOL law will even put more pressure on high fee active managed funds. Active funds also have a confusing number of share types all with different fee structures. 1-Year Net Flow Total Fund Assets Market Share Fund Types Vanguard $223 billion $3,096 billion 22% Passive & Low cost Active American $6 billion $1,213 billion 9% Active & Passive Fidelity -$15 billion $1,200 billion 8% Active & Passive BlackRock ishares $86 billion $853 billion 6% Passive ETF s T. Rowe Price $-2 billion $485 billion 3% Active State Street SPDR $20 billion $435 billion 3% Passive ETF s Franklin Templeton $-$44 billion $387 billion 3% Active Dimensional $25 billion $283 billion 2% Passive Largest active 1-year outflows: PIMCO, Franklin Templeton, Ivy, Fidelity, Goldman Sachs, Oppenheimer, Columbia and Wells Fargo. 24

25 Summary of Active and Passive Funds Variables that effect active or passive leadership (Active Mutual Fund verses Passive ETF) Dunn s Law Active fund variation from index mostly comes from differences in asset class/sector allocation. An active fund may have more growth/value or small/large than the index fund driving a different performance. Security Selection In a stock pickers market active performs better. More prominent in sector funds, international and value funds. Cash Balance In a down market active can perform better because of its larger cash balance. Correlation The direction of returns of a portfolio s components (asset classes and stocks) Dispersion The degree of variation in returns of a portfolio s components (asset classes and stocks) If stocks and sectors act largely in concert (low dispersion), active investors will find it more difficult to construct an index-beating portfolio. High dispersion: 1998, 1999, 2000, 2001, 2002, 2003: 2007, 2008, 2009: Low dispersion: 2004, 2005, 2006: 2010: 2012, 2013, 2014, 2015, 2016 (0) 25