Full and Fair Disclosure

During these troubling economic times, many in our business are scrambling to explain (or justify) recommendations they made or opinions they expressed that haven’t turned out well.  Many are also anxiously trying to market themselves and their services in the current environment. Those two categories often overlap.  In that context I have seen a number of assertions repeated over and over again that, while not false, are not quite true either.  Full and fair disclosure (Principle 4 of the Financial Planning Association‘s Standard of Care) requires more and better with respect to these assertions than I have typically seen.  I will deal with three of these claims below.

1. The “Lost Decade”

This past decade has hardly been a good one for investors.  But it wasn’t been as bad as many tout and was not necessarily the “lost decade” that so many claim. 

A typical argument about the “lost decade” merely asserts that the S&P 500 index averaged an annual return of -0.73% from 2001-2010.  That’s true, but it’s only part of the story and therefore deceptive. That index return only calculates price appreciation (or depreciation).  Returns can also be generated through income, obviously.  Accordingly, when dividend reinvestment is included for 2001-2010, the S&P 500 index return is a still poor 1.15% annually, but it is at least in positive territory. 

When mutual fund companies compare their returns to those of a stock index, they are required by the Securities and Exchange Commission to include dividend income in the performance of the index. Money managers abiding by voluntary guidelines known as the Global Investment Performance Standards must do the same.  But financial advisers and others in the business are not always required to follow those rules, which can make a true “apples-to-apples” comparison difficult and can leave individual investors deceived.

Perhaps more significantly, and as Carl Richards pointed out in his Bucks blog recently, the S&P 500 should not be used as a proxy for our collective investment experience.  As Richards demonstrates, a portfolio of 60% equities (evenly divided among large cap, small cap, REIT, international stock and emerging market stock indices) and 40% bonds (the Barclays U.S. government intermediate-term index) returned nearly 8% annually1 over the “lost decade.”  Obviously, one can’t invest directly in an index and there is a bit of data mining at work (20% equity allocations to REITs and emerging markets seem high), the point is still made that the “lost decade” was not as lost as is commonly assumed.   

2. Diversification without Stocks and Bonds

As further evidenced by some extreme market volatility over the past few weeks following a two-year rally, we remain mired in the throes of a secular bear market, prone to major swings in both directions. How much longer it will last is impossible to tell. But make no mistake, the economy needs to de-leverage and stocks need to return to fairer value. Bonds, the traditional safe haven in times of market uncertainty, have performed spectacularly, but only to this point. Their run appears to be all but over, Fed prospective rate promises notwithstanding.

Traditional diversification strategies failed miserably during the financial crisis of 2008-09 as nearly all correlations seemed to move toward one.  In such an environment, investors need better alternatives than they have typically had available to them in order to achieve their goals. As a consequence, advisors and money managers of various types have increasingly used “alternative” investments (which for these purposes I will define as investments which are generally non-correlated to the traditional stock and bond markets) so as to reduce portfolio risk and to provide opportunities for outperformance in this challenging times, inspired by the so-called “endowment portfolio” strategy begun and exemplified by Yale’s David Swensen.

Comprehensively understood and carefully managed, alternative investments and strategies can indeed offer better ways for advisors to manage risk and to achieve better diversification within their client portfolios.  However, some advocates of such an approach seem to define such diversification so as to exclude traditional asset classes.  Doing so is extremely dangerous.  For example, investors not in the stock market from March, 2009-March, 2011 missed a massive rally. Diversification does not imply attempting to time the market so as to avoid market drops, and we should be careful to say so.

3. The Answer to the “Lost Decade” is Active Management

Even the strongest advocates of active management must concede that, as a matter of simple arithmetic, the universe of active managers will underperform the universe of passive managers.  Costs matter and passive management is a much cheaper endeavor.  As Morningstar discovered, in every single time period and data point tested, low-cost funds beat high-cost funds. Factor in the added tax efficiency of passive investing (much longer holding periods and far fewer transactions in general) and it is clear that active management bears a difficult burden in the contest to earn the trust and business of investors.  Perhaps even more tellingly, active managers generally fail to beat their benchmark indices.  Indeed, in 2010, only about 25% of active managers outperformed.  And those few that do have a very hard time keeping up the good work.  Indeed, active management underperformance overall is entirely predictable on account of higher fees and closet-indexing.

Please don’t misunderstand me – active management can be a very effective investment tool.  Active management indeed has the opportunity to outperform.  But doing so can be very difficult and active managers take advantage of that opportunity far too infrequently and inconsistently.  Some would suggest that a simple move to active (or adaptive, or strategic, or or or) management will cure the ills of a bear market. It just ain’t so, and full and fair disclosure demands that we admit it.


1 Ron Lieber used a more realistic allocation to measure returns in the decade from 2000-2009 for The New York Times.  For that decade, a portfolio of 50% stocks (evenly split between domestic and international stocks) and 50% bonds (the Vanguard’s Total Bond Market Index Fund) yielded an annual return of 4.56%.  That’s nothing to write home about, but it isn’t a disaster either. While I grant that the so-called “lost decade” was not as bad as it is commonly portrayed – especially if you have a diversified portfolio – nobody can argue that times have been good.  On a holistic level, active funds can offer greater degrees of diversification, as certain funds are not correlated to the broad market and therefore can reduce portfolio volatility

3 thoughts on “Full and Fair Disclosure

  1. Pingback: Financial Predictions That Never Look Silly » Andrew Hallam

  2. Pingback: 2008 All Over Again? | Above the Market

  3. Pingback: Alternative Realities | Above the Market

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