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On The “Sioux And The Buffalo”

My recent piece, “The New Wolves Of Wall Street,” struck a nerve. I think it taps into both advisers’ insecurities and investors’ worries about not getting what they pay for. Good. That’s what I was going for.

Before I follow up on that piece, though, let me make a couple of things clear. First, there are some truly wonderful advisers out there. My experience, however, tells me they are more the exception than the rule. As WSJ’s Jason Zweig tweeted this morning many, “treat clients like Sioux treated the buffalo.”

Second, I’m not criticizing either the RIA model or index funds right now (though these aren’t without their own problems). All in all, they are a net positive for individual investors because they reduce conflicts of interest and bring down costs. I’m focused on the problems that arise when you put the two together.

Ultimately, this discussion is focused on the massive underperformance individual investors experience in their own portfolios on a consistent basis:

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Most pundits like to blame this on the fact that individual investors are just “dumb money.” Indeed, there is a “behavior gap” that causes investors to become euphoric with the crowd and buy at the wrong time and then panic in the midst of a bear market and sell at precisely the wrong time. This is human nature.

What the wolf doesn’t want you to know, however, is that he’s just as much to blame for your underperformance as your caveman brain is (see “Where’s Wall Street’s Blame In The Buy High Sell Low Game?“). In fact, even if he does a perfect job managing your natural instincts along with his own, he’s going to cost you big time – like half of all of your profits over the long run, big time.

So the problem as I see it two-fold. Both the “behavior gap” and obscene fees are significant contributors to the problem of massive underperformance. Addressing the first part is a good start. But ignoring the second part or – even worse – pretending, as an adviser, to pursue a low-cost approach while charging predatory fees is counterproductive, at best.

In fact, I’ll take it a step further. An adviser who is recommending passive index funds should not charge a “management fee” at all. Management fees are just that – fees for managing investments. If you’re not managing investments – you’re just overseeing a passive portfolio – you don’t deserve a management fee. Period.

Investment advice like this is valuable, though. Investors deserve to be educated about how their biases screw up their investment plans. And I think there’s a huge opportunity for advisers interested in doing this the right way.

Investment advice like this should be compensated just like all the other “advice” given by professionals out there – attorneys, accountants, therapists, etc. – on an hourly rate. Get paid for the advice you’re giving. Nothing more – nothing less. What would you say to your CPA if, instead of his hourly rate, he asked you for 2% of all your money every year for the rest of your life just for doing your taxes?

Too many “advisers” simply gather assets, charge their management fee for a one-time recommendation and then just ride the gravy train. And can you blame them? Under a management fee structure this is the overwhelming financial incentive. They maximize their profits by bringing in as much money as possible to charge a perpetual management fee on and then do as little management or advising as possible.

If advisers were compensated for the time they spent actually advising rather than the amount of assets they gathered then that’s how they would spend their time. This would much better align investor needs with adviser incentives. And it would also help keep human advisers relevant in the era of the robo-adviser. Somebody’s going to see the light here and seize this opportunity, I’m sure.

Still, I believe that the vast majority of investors are capable of overcoming the “behavior gap” on their own. They certainly don’t need pay an annual tithe to have it managed for them. My hope is that this helps inspire them to help themselves. And there are some wonderful role models out there like Stephanie Mucha.

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The New Wolves Of Wall Street

Wall Street is in the midst of some pretty massive change right now. And I’m talking about Wall Street as it relates to Main Street. I’m talking about how individual investors are being courted (hunted) and cared for (killed) by the new wolves of Wall Street.

Brokers have now become an endangered species as the model has been attacked on two sides by fee-only investment advisers (aka, RIAs) and discount brokers advocating a DIY approach. And now there’s a third entrant attacking both the brokers and RIAs: robo-advisers. All in all this evolution is good for investors as it ultimately brings down costs.

But don’t underestimate greed’s resilience and its willingness and ability to adapt. As they say, “the more things change, the more the stay the same.” Many brokers are making the switch to RIAs. In fact, they’re doing it in droves (witness the growth of the likes of LPL Financial). Changing your title and even your business plan, however, won’t magically turn a wolf into a sheep but it does make him harder to identify.

Make no mistake. There are plenty of wolves left on Wall Street. They just don’t call themselves wolves anymore. In fact, they do everything in their power to look like innocent, cuddly sheep. They setup as RIAs now. Many even preach a low-cost, passive or index-based approach to investing, aligning themselves with the likes of Burton Malkiel, Warren Buffett and Jack Bogle, some of the most respected names in the business.

It’s the ultimate hypocrisy. You see, while they preach a low-cost approach and may actually use low-cost products like index ETFs, they’ll charge you an arm and leg for the privilege – as much as 2% per year. As Meb Faber put it, “you’re a predator if you’re charging 2% commissions and or 2%+ fees for doing nothing.” I’m sure the wolves, who normally brag about ‘eating what they kill,’ would take this as a compliment. Meb continues,

Anything more than 0.5% or so on top of fund fees is either paid a) out of ignorance, which is not always the investor’s fault or b) as a tax for being irresponsible.  For the latter I mean a fee to keep you out of your own way of chasing returns and doing something stupid, much in the same way someone pays Weight Watchers or any other diet advice program when you know what you should be doing (eat less, exercise more).

I’d say that anything more than 0.25% for “managing” a passive portfolio of index ETFs these days is obscene (it’s not even really “managing” if it’s passive – more like “overseeing”). And there are plenty of advisers charging nearly ten times that amount. And what’s the money for? What are you paying these fees for year after year? Because if the funds themselves do all the work and merely need to be rebalanced a couple of times it might take 15 minutes per year.

At the end of the day, you’re paying for the pleasure of their company. And that 2% fee might not seem like much but it really adds up over time. As Albert Einstein famously said, “compound interest is the eighth wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Over 40 years, on $100,000 initial investment, that 2% fee you’re paying compounds into roughly $2 million. Even Kate Upton‘s company is not worth that much.

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That chart above shows the growth of $100,000 over 40 years assuming a rate of return of 9.68% for the index fund (the return over the past 40 years) and 7.68% for the investor paying 2% to his adviser. The DIY guy ends up with a little over $4 million and the guy with the wolf, I mean adviser, ends up with a little less than $2 million. That’s right, the wolf ends up eating over half of your profits.

So when I call these fees “predatory” or “obscene” this is why. Wolves preaching a low-cost, passive approach and charging these fees represent the height of hypocrisy – or the height of greed – take your pick.

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Where’s Wall Street’s Blame In The Buy High Sell Low Game?

The chart above is making the rounds today. The dumb money can’t catch a break. Everybody’s laughing at the poor retail investor. But what I’m wondering is how many of these mutual fund investors are actually being directed by advisers? I’d wager it’s a fair number.

Yes, I know that individual investors are famous for buying high and selling low but advisers are subject to the very same biases and emotions. And their layers upon layers of fees alone can be the cause of significant underperformance.

I’ve seen advisers buy, for their clients – never with their own money, mutual funds that pay themselves fat front-end loads (upfront commissions). Then they turn around a while later and recommend selling the underperforming fund (destined to fail due to its high fee structure) to buy one just like it, paying another fat commission (aka, churning).

Where does this show up in the data and how can we blame individual investors for this sort of behavior?

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5 Quotes From Financial Wizards To Help You Understand The Current Asset Bubble

Fed policy “makes no sense from a risk/reward perspective” and it will “end badly.” -Stan Druckenmiller

Druckenmiller went on to say, “every ounce of intuition in my body is that the potential costs have crossed the potential benefits in Fed policies.” I think what he is referring to here is that the tools available to the Fed are not precision tools. They are blunt instruments that are not very effective in their mission and their use comes with all sorts of side effects and consequences. I wrote a bit about this yesterday. We’re seeing the majority of the effects ZIRP and QE appear in stock and bond prices rather than in employment and wages. But so what?

“We are taking a greater chance of having another crash at a time when the world is less capable of bearing the cost.” -Raghuram Rajan

When you push up asset prices in an effort to stimulate the economy you also subject the economy and financial markets to the risk of asset bubbles – which, when they eventually pop (as they all do sooner or later), can undo all the work the policies or tools did in the first place. Anyone remember the financial crisis? We were well on our way to the Great Depression, part deux, as the Fed would have us believe. But have we reached “bubble” levels yet?

“Yellen’s comments suggest, and I agree, that we are in an asset bubble.” -Carl Icahn

Carl sure thinks so and evidently believes the Fed is doing it consciously. But how can we determine if we’re in a bubble?

Corporate bonds and junk bonds “have never been more over-valued in history.” -Jeff Gundlach

Oh, that’s how. Junk bonds valuations are sky high (not to mention other asset classes like stocks, farmland or office towers)…

“It is worrisome that covenant-lite lending has continued its meteoric revival and has even surpassed its 2007 highs.” -Richard Fisher

…and the riskiest sort of bonds are being issued at a record pace. Didn’t we learn our lesson after the financial crisis? That this sort of thing is not a fix at all but just exacerbates the problem? Will we ever learn?

Maybe somebody ought to teach the Fed Albert Einstein’s definition of insanity: ‘doing the same thing over and over again and expecting different results.’

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Don’t Buy The Buy-And-Hold Line Of BS

“Far more money has been lost by investors preparing for corrections, or trying to anticipate corrections, than has been lost in corrections themselves.” – Peter Lynch

This quote has been making the rounds since the market’s 2% decline last Thursday. It’s a great quote; I’m a huge Peter Lynch fan. I’ve read each of his books at least twice and recommend them enthusiastically.

However, I think there’s an important point to be made here. Peter Lynch managed money professionally from 1977 to 1990 putting up an amazing track record: 29% average annual returns. No doubt this places him in a very elite class of the most skilled investors ever. But he also had a massive tailwind to work with as the stock market was very attractively valued during his entire career.

Below is a chart of the total stock market value relative to GDP (via Doug Short). I’ve circled the area that represents Lynch’s career in red:

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Over the past couple of decades there was maybe only a single month, at the very bottom of the financial crisis, during which stock market valuations neared the levels that Peter Lynch had to work with. And even then those levels, of about 60% market cap to GDP – that we considered cheap, during his career represented the month just before the 1987 crash!

Considering what investors have gone through since Lynch retired, the aftermath of the internet bubble, housing bubble and financial crisis, I think it would be very difficult to make the case that they lost far more money over the past couple of decades trying to sidestep these debacles than the money lost by those who didn’t sidestep them.

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When Treasury Bonds far outperform stocks over a 15 year period, I’d say sidestepping the madness of these markets has paid off fairly well. And considering the fact that stocks are now, once again overvalued to the point that an investor can expect roughly a 0% return over the coming decade, I’d say it will probably pay to sidestep it once again.

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Investing, Posts

The Creative Destruction of Wall Street

I was taking a look at the different robo-advisors today and I’m just amazed at how fast technology is revolutionizing the investment industry. It’s a f***ing awesome thing to witness. I’m not specifically recommending any one of these companies but WealthFront now charges just 0.25% per year to do what most advisers charge at least 4 times as much for. Betterment charges just 0.15%. And WiseBanyan is FREE – yes, FREE. The robo-advisor price war is officially getting bloody.

It’s still very early in the game but what we are witnessing is nothing less than the creative destruction of Wall Street via Silicon Valley and it’s about time. WealthFront is the largest and fastest growing of the group and has nearly cracked $1 billion under management mainly because it’s become so popular with the tech community. As it expands outside of those early adopters into the general population it’s growth will only accelerate. The big Wall Street firms, Merrill Lynch, Morgan Stanley, etc. along with most independent investment advisers must be s****ing themselves watching this unfold. I don’t think there’s ever been a threat of this magnitude to their businesses.

I finally got around to watching The Wolf of Wall Street last night and, as a Wall Street insider, I have to say it really resonated with my personal experience (what I witnessed, not what I did, LOL). I spent just under a year at Bear Stearns before I migrated to the hedge fund world but I can tell you that that early scene movie, when Jordan Belfort first lands on Wall Street, absolutely nails it. The Matthew McConaughey character is spot on: “Fuck the clients…. The name of the game: move the money from your client’s pocket into your pocket.”

Robo-advisors now have the power to change the game entirely. Jack Bogle has been fighting this battle for decades and has surely made massive inroads in the world of investment products. In just the past ten years we’ve seen the explosion of ETFs that give investors access to every kind of index and sector at the lowest possible price. The price war between Vanguard and Schwab has now pushed the annual cost of owning the entire US stock market to just 0.04%. That’s insanely cheap!

Still, the gatekeepers, the brokers and advisers of the world, were the one thing separating the general public from these fantastic, low-cost products. They don’t make any money selling them so their clients just haven’t heard about them. It’s taken Silicon Valley stepping in to shake up the services side of the business so that Joe Retail investor can actually access these super-low-cost products. And it’s so cool to see it finally happening. Granted, there are some serious drawbacks (read this and this) but for 90% of investors robo-advisors are simply heaven sent. Do yourself a favor and look into them.

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Less Than Zero

That’s the return investors should now expect from the stock market over the next decade… according to Warren Buffett’s favorite valuation measure: total stock market capitalization relative to GDP.

wmc140407cChart via John Hussman

The chart above shows the correlation between this valuation measure (blue line) and subsequent 10-year year returns (red line) and it’s pretty damn tight. I think the only possible argument one can make against “less than zero” returns over the next decade is something along the lines of, ‘companies are much more profitable now than they have ever been. For this reason, investors will be willing to pay higher valuations in the future so this correlation will break down.’ In other words, ‘its different this time.’ To those of us who have been around the block these are the four most dangerous words in the investment game. (See my thoughts on profit margins here.)

If investors are guaranteed to achieve nothing over the next ten years why would anyone in their right mind put money into the stock market right now? Or even keep a significant chunk invested right now? I keep asking myself this question because it just doesn’t make any sense to me.

I think there are two reasons. First, individual investors are deathly afraid to miss out on future profits EVEN if they understand that those profits are almost sure to be given back (and maybe they get off on the roller coaster ride). They just can’t stand to see their friends make money, even temporarily, and leave them behind. Second, professional investors are deathly afraid of underperforming because it may mean they get fired – even if they absolutely believe that the risk of owning stocks far outweighs the potential reward. They would rather lose money along with everyone else than forgo profits on their own.

It’s just very, very hard to put rational analysis above our natural “herding” instincts. In fact, for most people it’s nearly impossible which is why markets will never be efficient and we will always have booms and busts.

There’s only one reason I can think of for investors to keep money invested right now and to keep putting new money to work in stocks: you’ve got a time frame longer than 10 years AND you don’t have the time or wherewithal to pay attention to even the most basic investment merits of stocks as an asset class. In this case, dollar cost average into an index fund and put more into it every single month, without fail. Over 10, 20, 30 years you should do very well – the longer your time frame, the better.

Those who have a time frame less than 10 years or who can understand and pay attention to the investment merits of stocks as an asset class, however, have no excuse. There’s just no good reason to have undue exposure to stocks right now that I can think of.

Ultimately, the stock market right now is flying as high as Robert Downey, Jr.’s character in the movie that shares a title with this blog post. And now that the Fed is taking away its heroin (QE) it’s inevitably going to go through some painful withdrawals. And even if it doesn’t, you’d do better to put your money under the mattress.

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