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Review: Return of the Active Manager

Active portfolio management is dead, killed by the superior performance of cheaper stock index funds.

Or is it?

In Return if the Active Manager, C. Thomas Howard and Jason Apollo Voss make the case that active management may actually be on the verge of a major comeback.

As recently as 2009, active mutual funds enjoyed a market share of over 75%, with passive index funds making up less than 25%. In 2018, active and passive funds reached parity, with each taking about 50%. It’s safe to assume that, once the numbers are tallied, passive funds will overtake active funds in 2019. Howard and Voss eventually expect the split the stabilize at roughly 70% passive index funds and 30% actively managed funds.

It’s not hard to understand why. As Howard and Voss explain it, the fund industry is structured to force active managers into being closet indexers, which is a battle they can’t win. They can’t beat the index if, in the authors’ words, “active managers are being asked, not just to beat the index, but to do so with the same securities, the same industry weightings, no tracking error, no style drift, the same volatility, with lower expenses,” etc.

The authors make a compelling case that Morningstar and its style boxes are to blame. While Morningstar intended for their style boxes to describe and evaluate funds after the fact, instead they became a straightjacket of investment constraints before the fact.

Because of the need to fit within a Morningstar style box, managers get forced into a game they can never win. The only way to beat an index is to do something fundamentally different, which means “style drift” or “tracking error.”  

As Howard and Voss explain it, the unintentional outcome was “the bland sameness in investment management strategies, leading to consistent underperformance of closet indexers…”

If the situation looks bleak for active management, the good news is that its destruction brings opportunities. As others, such as Mike Burry and Bill Ackman, have noted, indexing only works when there are active managers whose informed trading forces prices into a state of efficiency (or something close to it). If there are no more active managers, then passive investing stops working effectively.

As Howard and Voss explain, “As stocks are increasingly held by index funds, which simply respond to investor flows rather than fundamental  company information, stocks become increasingly mispriced… The implication is that as investors flee closet indexers and move their money into low-cost index funds, stock picking opportunities improve.” Hence the return of the active manager.

This brings Howard and Voss to the core of their argument. They see the future of active management being one in which Morningstar style boxes are irrelevant, as are all performance metrics that depend on the CAPM or the Efficient Market Hypothesis. Instead, active managers will focus on exploiting the stock picking opportunities created by excessive indexing.

This behavioral finance approach takes it as given that market prices are driven mainly by emotional crowds, and that investors are not rational. By understanding this – and by managing your own emotions – you can take advantage of market anomalies.

In evaluating active managers, Howard and Voss offer a few suggestions. First, look for managers that are pursuing a “narrowly defined strategy with consistently and conviction.” You’re looking for a specialist, not a generalist. Secondly, look for smaller managers with less than $1 billion in any single strategy. And finally, look for low correlations. Howard and Voss suggest looking for funds with R-squared values (a common measure of the degree to which a fund tracks an index) of below 0.80.

As active managers specializing in behavioral finance, Howard and Voss clearly have an interest in investors following their advice here. But their analysis is solid, and investors would be wise to take it seriously.

My compliments to the authors.  

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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The Smartest Investor You’ve Never Heard Of And the Crisis No One Sees Coming

Mike Burry is the smartest investor you’ve never heard of.

Well, I say that. If you saw the movie The Big Short, you’ve heard of him. Burry was the eccentric hedge fund manager played by Christian Bale and one of the select few people that both saw the 2008 mortgage crisis coming and managed to profit from it.

But despite his stellar returns – generating 697% gross returns between 2000 and the first quarter of 2008 at a time when the S&P 500 barely returned 5% — Burry lacks the name recognition of some of his higher-profile peers.  Warren Buffett can’t sneeze without CNBC reporting it, whereas you have to actively search for comments by Burry.

But when he speaks, you’d be wise to listen. And Burry has quite a bit to say these days about the index funds making up your 401(k). In fact, he considers stock and bond index funds and ETFs to be as risky today as exotic mortgage derivatives before the 2008 meltdown.

In a normal, functioning market, informed buyers and sellers reach an agreement on price. This is true of stocks but equally true of houses, cars, cups of coffee or velvet Elvis paintings. The push and pull of buyers and sellers towards a fair price is what economists call “price discovery.”

Of course, central bank tinkering has effectively destroyed price discovery in the bond market. You need look no further than the $17 trillion in negative-yielding bonds as proof of this. But, as Burry explains, “now passive investing has removed price discovery from the equity markets” because it doesn’t “require the security-level analysis that is required for true price discovery.”

In other words, no one bothers to do actual stock research anymore. Passive index investors buy stocks based on their market caps and nothing else. Valuation, earnings quality, forward projections… none of these things matter.

Burry compares this to the collateralized debt obligations (CDOs) he made a fortune betting against in 2008. No one bothered to do actual security-level research then either. Pricing was determined by models dreamt up in a lab by quants in white coats rather than by actual buyers and sellers. And we know how that ended.

Equally scary is the lack of liquidity. As Burry points out, more than half the stocks in the S&P 500 have less than $150 million in daily trading volume. “That sounds like a lot,” Burry says, “but trillions of dollars in assets globally are indexed to these stocks. The theater keeps getting more crowded, but the exit door is the same as it always was.”

Over the past few decades, low-cost index funds have outperformed most active managers. But ironically, this doesn’t mean that active investors are bad at their jobs. The exact opposite is true. Indexing works because talented active managers push the market towards efficiency. Price discovery is the work of active traders and investors. But if everyone indexes, the whole thing falls apart. Someone has to do the fundamental research that keeps this dog and pony show afloat. (Bill Ackman made similar comments about three years ago, and they’re worth revisiting today.)

This probably won’t end well. But it’s not all doom and gloom. As Burry notes, “the bubble in passive investing through ETFs and index funds… has orphaned smaller value-type securities globally.”

As a value investor, that’s music to my ears. An unloved orphan stock is a cheap stock and one that’s off the radar of most investors.

Will the years ahead be good ones for small-cap value investors? Only time will tell. But all bubbles (and busts) create opportunities, and small-cap value stocks may be the ultimate winner in the indexing bubble.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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Maxing Out Your 401(k)? Try This.

If you’re on track to max out your 401(k) this year, congratulations! You’re building your next egg while sticking it to the tax man. Pat yourself on the back!

But before I go any further, let’s make sure we’re on the same page. I’ve chatted with dozens of people who told me with a straight face that they were maxing out their 401(k) plans every year… except they weren’t. In fact, they weren’t even close.

They weren’t lying, of course. They legitimately thought they were maxing out their retirement plans. But there’s a lot of competing terms here, and it’s easy to get them confused. So, today, we’re going to sort this out. You’ll want to pay attention because this can potentially save you thousands of dollars a year in taxes and hundreds of thousands over the course of your investing life.

Your employer might match your 401(k) contributions up to 3% to 5% of your salary. You should always contribute at least enough to take advantage of the matching. But “matching” and “maxing” are not the same thing.

You can contribute up to $19,000 to your 401(k) this year or $25,000 if you’re 50 or older. This is the maximum you can put in, not including your employer matching or any profit sharing.

Let’s play with the numbers. Let’s say you earn an even $100,000 per year and that you make it your goal to max out your 401(k) plan for the year. Let’s also say that your employer offers 5% matching. This is how that would shake out:

                You contribute:                                 $19,000

                Your company contributes:          $5,000 ($100,000 * 5%)

                Total going into your plan:            $24,000

Ok. Let’s say you’re as fanatical as I am about saving and you’ve managed to max out the full $19,000. But now you’ve caught the saver’s bug and you want to save even more.

If your health insurance plan includes them, you can consider using a Health Savings Account as an “extra” retirement plan.

This requires a little explaining. HSAs are not designed to be retirement plans. They’re designed to help you save for health expenses by giving you a tax break. As with IRAs or 401(k) plans, any money you put into an HSA gives you an immediate tax deduction. A dollar invested in an HSA lowers your taxable income by a dollar. And you can take cash out of an HSA at any time tax and penalty free if you use it to pay for qualifying medical expenses.

But here’s where it gets fun. No one says you have to spend the money. You can leave the cash in the HSA account and invest it in stocks, bonds and other investments. Once you turn 65, you can take the funds out for non-medical purposes penalty free.

You’d still owe taxes on it, but the same would be true of any cash taken out of an IRA or 401(k) plan.

So, you can effectively use an HSA as a “spillover” IRA for extra cash you want to invest tax deferred.

And here’s another fun little kicker. Unlike IRAs and 401(k) plans, HSAs don’t have required minimum distributions (RMDs). In normal retirement accounts, the IRS forces you to pull a certain amount out of your account every year after you hit the age of 70 ½. HSAs don’t have that requirement, meaning you can let your funds grow and compound tax-free well into your golden years.

In order to use an HSA you have to also have a high-deductible health plan. Those with individual plans can contribute up to $3,500 per year (or $4,500 if you’re 55 or older). Those with family plans can contribute up to $7,000 per year (or $8,000 if you’re 55 or older).

If you’re already over the age of 65 and on Medicare, you generally can’t add new money to an HSA plan. But if you’re under the age of 65 and are looking to lower your tax bill and turbocharge your retirement savings,  the HSA can be a great way to do both.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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25 Stocks Every Retiree Should Own

The following first appeared on Kiplinger’s as 25 Stocks Every Retiree Should Own.

Retirement is a major life milestone, eclipsed only by marriage or the birth of your first child in terms of financial impact. For many, it’s an exhilarating leap into the unknown. In your working years, you can take investing setbacks in stride, as portfolio losses can be offset by new savings or working an extra year or two.

But once retired, you no longer have that luxury. Your portfolio must last for the the rest of your life, and that of your spouse as well. So, the decision of what retirement stocks you should include your portfolio is an important one.

An ideal retirement stock will pay a healthy dividend. As Sonia Joao, president of Houston-based RIA Robertson Wealth Management, explains, “Four out of five of our clients are in or near retirement, and essentially all of them tell us the same thing. They want safe, secure streams of income to meet their living expenses and replace their paychecks.”

While a good dividend is probably the most important characteristic to look for, it’s certainly not the only one. Yields across most asset classes are lower today than in years past, and retirees need growth to stay ahead of inflation. So, while a retirement portfolio should have a large share of income stocks, it also will include some growth names for balance.

The following are 25 stocks every retiree should own. This group of retirement stocks includes both pure income plays and growth companies, with a focus on very-long-term performance and durability.

Public Storage

Self-storage REIT Public Storage (PSA) may be the single least sexy stock in the entire Standard & Poor’s 500-stock index. If you mention it at a cocktail party, don’t expect to be the center of attention.

But the boringness is exactly what makes Public Storage such an ideal retirement stock. Self-storage is one of the most recession-proof investments you’re ever likely to find. In fact, recessions are often good for the self-storage industry, as they force people to downsize and move into smaller homes or even move in with parents or other family – and their stuff has to go somewhere.

With the economy looking a little wobbly these days, that’s something to consider. But there’s another angle to this story as well. According to Ari Rastegar – founder of Rastegar Equity Partners, a real estate private equity firm with expertise in the self-storage sector – changes to the broader economy are at work.

“Despite unemployment being exceptionally low, wages haven’t kept pace with rising prices,” Rastegar explains. “This has led to the rise of micro apartments and the general trend of smaller units closer to city centers. All of this bodes very well for the future of the self-storage sector. Your apartment might be shrinking, but you still need to put your personal belongings somewhere.”

Public Storage has a diversified portfolio of nearly 2,500 properties spread across 38 states and additionally has a significant presence in Europe. While the REIT has kept its dividend constant at $2 per quarter for the past two years, it historically has been a dividend-raising machine. Over the past 20 years, Public Storage has raised its dividend by nearly 10-fold.

At current prices, Public Storage yields 3.4%. That’s not an exceptionally high yield by any stretch, but it’s still better than what you’re able to get in the bond market these days – at least not without taking significantly more risk.

To continue reading, please see 25 Stocks Every Retiree Should Own.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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11 Stocks to Buy That Prove Boring Is Beautiful

The following first appeared on Kiplinger’s as 11 Stocks to Buy That Prove Boring Is Beautiful.

Stocks aren’t all that different than cars, in some ways. Sure, the Ferrari is a lot of fun to drive, and you look cool sitting behind the wheel. But it’s also going to cost you a fortune, and high-performance cars spend a lot of time at the mechanic’s shop.

Now, compare that to a Honda Civic. You never really notice a Honda Civic on the road. It’s utterly forgettable. But it’s also just about indestructible, requires virtually no attention from you, and it quietly and efficiently does its job.

Consider that mentality when you’re tracking down stocks to buy. A highflying growth pick can be a lot of fun to own. You look smart owning it, and it’s fun to talk about at parties. But when the market’s mood swings the other way, you’re often left with some nasty losses and a bruised ego. Meanwhile, that dividend-paying value stock in your portfolio might not be particularly interesting. But over the long haul, it’s a lot less likely to give you problems. Like that Honda Civic, it will quietly do its job with no stress and no drama.

“Some of our most profitable trades over the years have been some of our most boring,” explains Chase Robertson, principal of Houston-based RIA Robertson Wealth Management. “We’ve done well for our clients by mostly avoiding the trendy sectors and focusing instead on value and income.”

Here are 11 boring but beautiful dividend stocks to buy now. They might not be much to look at, but they’re likely to get the job done over the long term. And when you need them most – in retirement – they’ll be less likely to break down on you.

AT&T

AT&T (T) has been a boring play for many years now. Even its seemingly transformative recent buyout of Time Warner (which owns HBO, Cinemax, TBS and TNT) was a drawn-out affair that got bogged down in court battles.

It seems almost silly now, but in the late 1990s and early 2000s, AT&T was a bubble stock. Investors couldn’t get enough of everything related to telecommunications, and AT&T delivered the goods. But when the bubble burst, AT&T crashed hard. Today, nearly 20 years after the peak of the internet mania, T shares still are more than 40% below their old highs.

Of course, 20 years later, AT&T is a very different company. Its mobile and home internet businesses are mature, and its paid TV business is actually shrinking, albeit slowly. AT&T is essentially a utility stock. But T belongs on any short list of boring stocks to buy now given its current pricing.

AT&T took a tumble in 2018 that brought it to its most attractive prices in recent memory. The stock has recovered somewhat, but not completely, and still offers a value at less than 10 times analysts’ expectations for future profits, and a fat dividend yield of 5.9%.

Are you going to get monster growth from AT&T? Of course not. But modest capital appreciation and high levels of income should deliver a very respectable total return.

To continue reading, please see 11 Stocks to Buy That Prove Boring Is Beautiful.

Disclaimer: This material is provided for informational purposes only, as of the date hereof, and is subject to change without notice. This material may not be suitable for all investors and is not intended to be an offer, or the solicitation of any offer, to buy or sell any securities nor is it intended to be investment advice. You should speak to a financial advisor before attempting to implement any of the strategies discussed in this material. There is risk in any investment in traded securities, and all investment strategies discussed in this material have the possibility of loss. Past performance is no guarantee of future results. The author of the material or a related party will often have an interest in the securities discussed. Please see Full Disclaimer for a full disclaimer.

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