The Investment World According to Harold Evensky
The opening paragraph of this article was modified on October 11, 2018, to indicate that Evensky is retiring from teaching but will remain active in his practice.
I had the bittersweet privilege of attending Harold Evensky’s final presentation on investing. Evensky, who is by far the most decorated member of the advisory industry, is retiring from teaching and has no current plans for public talks. He remains actively involved in his practice, serving on both the investment and management committees and does not plan on retiring from business for many years.
Evensky spoke on September 26 at Bob Veres’ Insiders Forum conference in San Diego.
Nominally, Evensky is the founder of the Florida-based registered investment advisor, Evensky, Foldes and Katz.
But he is much more than that.
As Veres noted in his introduction, the advisory industry is divided by two eras: pre-Harold and post-Harold. The pre-Harold era, which most of today’s practitioners would barely recognize, was characterized by planning practices that relied on now-obsolete rules of thumb and seat-of-the-pants instincts that lead to inferior outcomes for clients.
Evensky changed that.
Early in his career, Evensky delved deeply into the academic literature to identify what makes sense to practitioners. The post-Harold era builds upon that approach. Evensky is singularly responsible for driving the paradigm of research-based and carefully tested planning practices.
His final talk summarized his key insights, accumulated over several decades as a practitioner and curator of research.
Why it’s different this time
There is something significantly different today in the investment world, according to Evensky, and that is the equity risk premium, which he said will deliver investment returns lower than their historical averages. Evensky cited the Shiller CAPE ratio, which is 31.1 versus its historical average of 16.2.
“It’s a very expensive market,” he said.
When the Shiller CAPE is broken into deciles, the returns for the subsequent decades illustrate the correlation. “We’re up near the peak of CAPE ratios,” he said. But he also acknowledged that the CAPE’s predictive ability is only good at long horizons, like 10 years.
In low-return environments, Evensky said, expenses and taxes “mushroom in importance.” He showed data that expenses subtracted 1% from prospective returns and taxes, at a 20% effective rate, will subtract another 1.4%. Investors should optimistically expect returns of 2%, net of expenses, taxes and inflation, he said.
Practitioners need to be thinking in a “three-dimensional world,” Evensky said, focused on expenses, taxes and inflation.
The core-satellite approach
Tax efficiency and manager turnover are correlated, according to Evensky. As trading activity increases, you lose all ability to manage taxes. Advisors should concentrate their core portfolios on funds that are very tax-sensitive, and concentrate their risk in “go-go” managers who are active.
If a manager cuts turnover from 100% to 50%, the marginal reduction in taxes is negligible, Evensky said. Managers need to be closer to 10% turnover to be thought of as tax-efficient.
That is among the observations that led to the core-satellite approach, which Evensky pioneered and popularized. It is a bifurcated approach that concentrates risk in the satellite portion, while the base investments are held in “beta-plus” conservative assets. Around the perimeter of the core is where advisors should look for alpha, Evensky said.
For him the core is 100% passive, with ETFs and index funds. Evensky also uses funds from Dimensional Fund Advisors in core portolios.
Modern portfolio theory is dead?
During the great financial crisis, many observers thought modern portfolio theory (MPT) was dead.
The problem, Evensky said, is that many of those pundits never read Markowitz, whose principal contribution was that risk is proportional to prospective return. Markowitz never said you should look solely at historical returns; investors need to look to the future at expected returns and covariance.
“The criticism of MPT is simply coming from those who never read the paper,” he said. “The problem is with the implementation, not the concept.”
“Our clients don’t need cash flow,” Evensky said. “They need real income.” The problem with dividends is that they are not consistent; interest is also volatile, as bonds are subject to interest rate movements.
“Our clients need reasonably consistent income,” he said.
The problem for advisors is to determine how much income clients need. As clients get older, it’s wrong to assume that they don’t spend less; it may just be that they don’t have as much to spend. When people retire, they have one unique thing: time. Time costs money, Evensky said, and advisors need to construct portfolios that accommodate clients’ spending desires.
As people get older they get frailer, but they don’t stop spending, according to Evensky. He noted that he has seen lots of people on cruise ships with wheelchairs and oxygen tanks.
Another interpretation of spending patterns comes from David Blanchett of Morningstar, who Evensky said is one of three researchers whose work is consistently reliable. Blanchett suggested the concept of the consumption “smile.” As people get older they spend less, according to Blanchett, but as medical expenses go up they spend more, creating a pattern that resembles a curved smile, where spending initially decreases but later accelerates. “That’s another data point that suggests that spending does not go down monotonically,” Evensky said.
Pascal’s wager takes the conjecture that one might assume that there is a 70% chance that God exists, and live his or her life recklessly, knowing that there is only a 30% chance of facing the consequences. But those consequences are severe – spending eternity in fire and brimstone. The lesson from Pascal’s wager is that one must consider the consequences of a decision, not just the probability of expected outcomes.
“According to Pascal’s wager,” Evensky said, “we tend, particularly in planning, to focus on the probability but ignore the consequences. That can be really dangerous in planning.”
If you know the probably of success is 95%, the consequences of failure still matter, he said. We need to plan, for example, for additional longevity of our clients.
Sequence of returns
Two investors can earn the same percentage return over a long time horizon. But if the first-year return for one is lousy, the consequences can be dire and extreme, as Evensky illustrated in an example that would be familiar to readers of this publication.
“We need to communicate the issue of sequence of returns to our clients,” he said.
The two-bucket approach
Evensky developed what he called a “simple two-bucket approach” to managing client assets. The portfolio is split into two components: a cash reserve and long-term investments. The former funds the client’s next five years of cash needs, and the latter holds longer term, higher risk investments. Five years is chosen because it is roughly the length of an economic cycle. This reserve complements Social Security and pension income. A monthly payment is set up from the cash-flow reserve, through a custodian or bank, so the client gets a check – just like a salary – for their income.
Periodically the cash flow reserve is replenished, depending on how the investment portfolio performs.
“Don’t invest if you need the money in less than five years,” he said.
Evensky recalled the success of this approach through multiple market declines. “Nobody was happy after crises, such as 1987, the tech crash or the great recession,” he said. But he didn’t lose any clients after those declines.
“Those clients weren’t happy but they understood they were prepared for the consequences,” Evensky said.
The problem with target-date funds
Target-date funds are inappropriate, according to Evensky. Those funds are typically held in a 401(k), but are only a piece of the client’s assets and are ignorant of the remainder of the clients’ asset allocation.
“It’s a one shoe fits nobody strategy,” he said.
“It’s our job to design strategies” he said, that make target-date funds unnecessary.
The bright future for annuities
Evensky has changed his outlook about annuities, which he once derided as an inappropriate vehicle for his clients.
Single-premium immediate annuities (SPIAs) and deferred-income annuities (DIAs) will be the single most important tool in the coming decade, he said, mostly because their fees have come down.
Evensky said that annuities improve upon traditional investments because they add the mortality return – providing funding for one’s lifetime.
He presented data that showed that SPIAs and DIAs are appropriate when someone reaches age 70. But there are catches. The tax advantages can be significant for DIAs, but there are conflicts for fee-only planners. Research shows that 20% or more of a portfolio should be in SPIAs, he said, but that will cost fee-only advisors 20% or more of their income.
“We’re going to have to suck it up,” he said, “because it is the right thing to do.”
Annuity returns are dependent on 10-year bond rates, and he said he is inclined to wait in most cases until rates go up and annuity returns go up with them.
The rising equity glide path
Michael Kitces and Wade Pfau are the two other researchers Evensky cited. Kites and Pfau have shown that as people get older, they should increase their equity exposure; it leads to better outcomes. Intellectually it works, Evensky said, but practically he is very skeptical.
But, he said, there is no such thing as a conservative investment. It is a matter of balancing investors’ risk tolerance with their financial goals.
The behavioral finance field, pioneered by Daniel Kahneman, showed that people are human, but not necessarily irrational, Evensky said.
“Even though we know something, it doesn’t mean we can see it,” Evensky said.
Investors take mental shortcuts using heuristics, Evensky said, and that can be particularly costly to clients. He provided examples of how advisors can help their clients avoid the biases that stem from behavioral finance.
He asked whether those in the audience thought they were better planners that others in the room. Almost everyone raised their hands, illustrating the “Lake Wobegon” paradox that everyone cannot be above average. This paradox gets investors intro trouble when, for example, they believe they have superior stock-picking ability.
Indeed, Evensky said, research by Terry O’Dean shows that stocks that were sold did better than those that were bought.
Another behavioral bias he discussed was representativeness, which leads people to believe that the recent past predicts the future. This leads to trouble when, for example, investors rely on buying funds with five-star ratings from Morningstar.
Investors perform faulty mental mathematics, according to Evensky. When evaluating the probability of a successful investment in a single stock, they fail to properly account for the sequential steps that must go “right” for the company to succeed.
“We need to help our clients understand the math of investing,” he said, “particularly when taking high risk.”
How you frame a question affects the answer, he said. Consumers prefer a product that is 10% fat-free over one that is 90% non-fat. Advisors should listen to clients who are excited about an investment opportunity, but then ask what could go wrong (rather than telling them that the investment is a bad idea). Advisors need to get clients to frame an opportunity themselves and identify what could go wrong.
“Frame not just the good but the bad consequences,” he said.
David versus Goliath
The steamfitter’s local union in Philadelphia has over $400 million in assets. Clients need to understand that, even with a sizeable $15 million portfolio, they are still very small relative to even the smallest institutional investors.
To ensure that clients get the best outcome in a world where they are the Davids facing the Goliaths of Wall Street, Evensky said that they should ask advisors to sign something that ensures they will act in their best interests.
Evensky showed a sample statement that clients could ask their advisors to sign. It didn’t even mention the word “fiduciary.”
But he doesn’t expect such a document to get the approval from the compliance departments of broker-dealers or wirehouses.
Among his many passions, furthering the fiduciary standard has been paramount over Evensky’s career. Earlier in the conference, he was given an award from the Institute for Fiduciary Standards recognizing him as the Fiduciary of the Year.
Harold Evensky’s legacy will live on through his contributions to the advisory profession. I am personally grateful to him for his guidance and feedback as our team has grown our business. When I was unsure about an issue, whether it was investment- or practice management-related, I could always count on Harold for sound and reliable feedback.