January 5, 2010
Help us help you
This commentary incorporates several innovations that you can use right now in this important annual reporting season, including:
• Surz Style Pure® Indexes
• StokTrib holdings-based style analysis and attribution that gets the benchmark right
• Portfolio Opportunity Distributions
Surz Style Pure® indexes are available for free on a number of platforms including Evestment Alliance, MPI, Zephyr, Factset, Informa, SunGard, Pertrac, Morningstar, and others. Please use them, especially for returns-based style analysis because they meet Dr. William F. Sharpe’s recommendation to use a style palette that is mutually exclusive (no stock is in more than one style) and exhaustive (the collection of indexes comprise the entire market). The good news is that Surz Style Pure® indexes are free – a free upgrade is just mouse clicks away. Get the most out of your returns-based style analysis investment; compare and contrast your index choices.
We’ve invited the service bureaus above and others to incorporate our advanced attribution and universe approaches, and most agree that ours are important and meaningful innovations, but there is little business motivation for these vendors because their clients are not requesting these services. So here’s how you can help us help you. Please ask your service providers to add these tools to your toolbox. It costs nothing to ask, and the rewards are more informed decision making that will set you apart. The old tools, namely indexes and peer groups, are incapable of performing the basic task of separating winners from losers. And attribution analysis that uses the wrong benchmark leads us to mistaken inferences about the reasons for success or failure. If the benchmark is wrong, all of the analytics are wrong, wasting our time, energy and money.
Far worse, we make bad decisions.
These shortcomings open the door for creative salespeople to turn mold into gold right before our eyes. The Madoff mess was made possible by complacency and laziness in manager due diligence.
Please ask your service providers to add these important innovations, and let us know how we can help you help yourself in this endeavor. Thanks.
A word about the old folks
Many retirees, as well as those who are saving for retirement, have invested in target date funds. Target date funds start out aggressively when the target date is distant and then become more conservative as the target date draws near. The target date fund (TDF) industry is growing rapidly. Currently encompassing $310 Billion, this industry is forecast to grow above $2.5 Trillion in the next 10 years [see Casey, Quirk 2009], primarily because it has become the preferred qualified default investment alternative (QDIA) under the Pension Protection Act of 2006.
TDFs are a reasonably good idea, but suffer from pathetic execution, at least so far. This is due in large part to the fact that most TDFs are currently designed to serve beneficiaries beyond the target date, to death, instead of to their presumed target – the retirement date. Such funds have come to be known as “THROUGH” funds, as contrasted to “TO” funds which are designed to end at the target date. A secondary issue with TO funds is the amount of equities that should be held at the target date; we believe zero is the correct answer because savings are most dear as retirement draws near.
2008 was disastrous for TDFs, with the typical 2010 fund losing 25%, because it held 45% in equities. 2010 funds are intended for those retiring between 2005 and 2015. We should have learned a lesson from 2008, but little has changed other than it is likely that the SEC and DoL will require fuller disclosure, especially about the meaning of the date in target date fund names. Perhaps THROUGH funds will have to be called target death funds.
With the recovery in 2009, some have begun to argue that even TO funds should have higher, rather than lower, equity allocations at target date because participants will be richer. For example, [Basu 2009] argues that a glide path that increases equity exposure through time dominates the traditional glide path, which has decreasing equity exposures. According to Basu, this “Contrarian” path delivers greater ending wealth 90% of the time, with about the same risk, leading to a characterization called “Almost Stochastic Dominance” (ASD). ASD means the Contrarian path is better most of the time in both risk and reward. The flaw in this perception is that risk is measured without regard to account size, so losing 10% of a $10 portfolio early on in the glide path is no different than losing $100,000 on a $million portfolio as the glide path matures. We correct this mistake in this commentary, and reach a totally different conclusion. There is no free lunch in target date investing. After all, who would advise their clients to be entirely in equities as they enter retirement?
An important question for fiduciaries is what are the risk and reward trade-offs of “through versus to” TDF paths. To answer this, we have measured ending wealth and risk for all 40-year glide paths going back to 1926. Importantly, the risk measure is dollar-weighted downside deviation, which we call “risk of ruin.” The rationale for this measure of risk is provided in [Surz 2009]. The following graph summarizes the results.
As you can see, the reward-to-risk is about the same for the complete 40-year glide path, but TO funds dominate over the critical last 10 years of the path. So now you know the risk and reward considerations in your choice between TO and THROUGH – although both provide roughly the same reward-to-risk profiles over the full 40 years, “TO” funds are much safer over the final 10-year period as the target date approaches.
Conclusion
Returns in 2009 were good year, but it was one of only three good years in the past decade. U.S investors broke even on average during this decrepit decade, unless you were concentrated in the growth stock segment of the market, where most losses occurred. Even though growth outperformed value in 2009, it underperformed for the full decade, losing 8% per year while value stocks grew at 7% per year. This will make it difficult for growth stock managers to retain business because investors routinely confuse style with skill, and academics assert intrinsic superiority to value investing. It wasn’t that long ago that growth stock managers benefitted from investors’ style-skill dyslexia as the growth bubble inflated. What goes around comes around. Do not confuse style with skill; custom benchmarks can help. Style rotation is a separate and distinct decision from the active-passive decision.
Diversifying outside the U.S. has helped, with every country except Japan outperforming the U.S. in the past decade. Some will say diversification has “worked” because exposure to foreign markets improved returns, but that is not the promise of diversification. In theory, diversification improves the reward per unit of risk – it smoothes out the ride.
Defined contribution plan fiduciaries have come to believe that any target date fund will suffice because all target date funds are qualified default investment alternatives (QDIAs). But there are huge differences among target date funds, especially near the target date, so this generic belief is false. Fiduciaries have the responsibility to select and monitor good target date funds. In particular, convenience and familiarity are foolish reasons for entrusting employee savings to the plan’s recordkeeper.
Ron Surz is President of PPCA Inc at www.ppca-inc.com and its subsidiary Target Date Solutions at www.TargetDateSolutions.com
REFERENCES
Basu, Anup and Michael Drew, “Portfolio Size Effects in Retirement Accounts: What Does it Imply for Lifecycle Asset Allocation.” Journal of Portfolio Management, April 2009
Casey, Quirk & Associates, “Target Date Retirement Funds: The New Defined-Contribution Battleground”. November 2009 Research Paper
Siegel, Laurence B. 2003. Benchmarks and Investment Management. Research Foundation of CFA Institute, Charlottesville, Va. Available online as a free download at http://www.cfapubs.org/doi/pdf/10.2470/rf.v2003.n1.3922
Statman, Meir. “What Do Investors Want?” Journal of Portfolio Management, 30th Anniversary Edition 2004, pp. 153-161
Surz, Ronald J., “Should Investors Hold More Equities Near Retirement, or Less?” Advisor Perspectives, August 2009. Available on line as a free download at http://www.advisorperspectives.com/newsletters09/Should_Investors_Hold_More_Equities_Near_Retirement.php
-------------,”The New Trust but Verify.” PPCA White Paper, November 2009. Available for free download at http://www.ppca-inc.com/pdf/Trust-But-Verify-20091123.pdf
APPENDIX: Surz Style Pure® Indexes
Style groupings are based on data provided by Compustat. Two security databases are used. The U.S. database covers more than 6000 firms, with total capitalization exceeding $18 trillion. The non-U.S. database coverage exceeds 15,000 firms, 20 countries, and $31 trillion -- substantially broader than EAFE.
To construct style groupings, we first break the Compustat database for the region into size groups based on market capitalization, calculated by multiplying shares outstanding by price per share. There are 3 regions maintained in our system: U.S., Foreign and Global. Beginning with the largest capitalization company, we add companies until 65% of the entire capitalization of the region is covered. This group of stocks is then categorized as "large cap" (capitalization). There are generally about 200 companies in this group for U.S., 800 for Foreign, and 1000 for Global. The second size group represents the next 25% of market capitalization and is called "mid cap". There are generally about 1000 companies in this group for U.S., 2700 for Foreign, and 3500 for Global. Finally, the bottom 10% is called "small cap". There are generally 5000 U.S. securities in this group, 10,000 Foreign, and 15,000 Global.
Then, within each size group, a further breakout is made on the basis of orientation. Value, core, and growth stock groupings within each size category are defined by establishing an aggressiveness measure. Aggressiveness is a proprietary measure that combines dividend yield and price/earnings ratio. The top 40% (by count) of stocks in aggressiveness are designated as "growth," while the bottom 40% are called "value," with the 20% in the middle falling into "core."
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