In the latest edition of Sound Investing podcast, published by FundAdvice.com, Paul, Tom and Don share their insights into a range of topics including hedge funds, emerging markets and the importance of staying calm.  They also interviewed Bob Deere, Dimensional's Investment Director and Senior Portfolio Manager.

One warning, the radio show is 51 minutes in length and will suck up 23MB of download.  If this is not an issue for you I highly recommend you take a look at the latest podcast - Sound Investing - June 27, 2008

For those who have limited time and/or download capability the following is a brief summary of the material covered:

Hedge Funds

The key question to ask is do you understand how they work and the internal risk involved with the strategy.  They looked at a particular example where a hedge fund set up by Nobel Laureates lost 4.6 billion dollars for their investors.

Bob Deere - Dimensional's Investment Director and Senior Portfolio Manager

Bob discussed the main advantages of the Dimensional approach - low level of transactions and transaction costs, very highly diversified portfolios, portfolios are tilted to the dimensions of risk which provide slightly higher returns.  He also discussed the definition of a value stock as being a low price relative to something. E.g. earnings, cash flow, adjusted book value.  Bob also explained why he thought Dimensional funds are better structured than ETFs to capture the dimensions of risk and return particularly in the more exotic parts of the market where the higher returns can be found.

Frontier / Emerging Markets

Paul, Tom & Don looked at he recent performance of frontier markets with some performing strongly like the Bangladesh and Bulgaria markets while others have gone poorly like Vietnam and China.  The key to investing in this area of the world is to be extremely well diversified.  Just like individual stocks can "blow up", so too individual national markets can blow up.  However, emerging markets as a whole are likely to have the highest returns over the next 20+ years. The reason why - they are riskier investments.

Regards,

Scott Keefer

Robin Bowerman, Principal and Head of Retail at Vanguard, has written a recent article for Vanguard's Smart Investing e-newsletter - Playing defence: can it work in tough markets.  In the article Bowerman refers to a Vanguard study looking at whether investors would be better off using economic / market signals to move portfolios into a more defensive asset allocation ahead of market downturns.  This is extremely relevant to those who have asked themselves whether they should have moved more of their portfolios into cash and fixed interest earlier in the year.

The article firstly concluded that economic or market signals were not necessarily good predictors of future downturns.  However, if the signals were used, the end results were at best a small out-performance against continuing to hold your assets.  The authors of the Vanguard study concluded that the excess results were not statistically different from zero.  So basically the conclusion was that investors would be no better off trying to move their portfolio into a more defensive position.

Bowerman suggests that a better strategy is to incorporate defensive assets into a portfolio.

An interesting article well worth a read.

Regards,

Scott Keefer

Each week the Eureka Report publish the best letter to the editor for the week along with a reply from the author.  In this week's Eureka Report the letter was directed at Scott's recent article - Credit crunch's silver lining.

The letter questioned whether "the high rates offered by online bank accounts offered by BankWest and Rabobank and term deposits offer returns far in excess of index funds at present and show attractive and better than share returns, at least for the next year or maybe more?"

In his reply Scott pointed out that BankWest and Rabobank were both owned by overseas banks and in his conservative style noted that this might see investors holding more"institutional risk" compared to similar investments held with an Australian owned bank.

Scott also reminded readers of the difficulty of predicting future movements in share markets and knowing whether cash style investments will indeed provide better returns compared to index funds.

Click on the following link to be taken to the letter and Scott's reply - Reply to letter of the week.

Users of our website, through our User Voice feedback forum, have requested that we regularly update the graphs outlining the performance of the Dimensional trusts that we use in building portfolios for clients.  In response to this feedback we have updated these graphs to reflect performance up to the end of May 2008.

The graphs show positive returns in the Australian market over May with the small and value premium kicking in nicely.  Returns from the global funds were basically flat for the month except for the Global Small Company Trust which saw some positive movement.

Overall, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist.  Please click on the following link to be taken to the graphs - Dimensional Fund Performance Graphs.

However, academic theory is nothing if it can not be implemented and provide the returns that are promised by the research.  Therefore, we like to provide the historical returns of the funds that we use to build investment portfolios.

Please let us know if you have any feedback regarding these graphs by using the Request for More Information form to the right or via our User Voice feedback forum.

Regards,
Scott Keefer

We receive regular commentary from Weston Wellington in his "Down to the Wire" postings on Dimensional's secured site. Weston is a Vice President of Dimensional Fund Advisors in the US.  His latest offering "How Not to Retire Rich" provides a stark example of how stock picking is not the best way to go.  Please find following Weston's comments:

The most recent copy of Fortune landed on our desk last week with an eye-catching cover?a prosperous-looking couple gazing serenely across sunlit ocean waters from what appeared to be the deck of an expensive yacht (presumably their yacht). Although the ambiance of comfortable wealth suggested by the photo seemed clear enough, Fortune editors took no chances?the typeface for the "Retire Rich" cover headline was so large that abundant future wealth appeared to be not just a possibility but a foregone conclusion.

Inside this annual Retirement Guide issue, readers could find advice on housing bargains (try Las Vegas, Miami, or Phoenix); second career possibilities (executive matchmaker, animal rescue squad member, alpaca rancher); and where to obtain the best "executive" physical exam (Johns Hopkins, the Mayo Clinic). Of course, no self-respecting retirement guide is complete without investment recommendations, and Fortune suggested forty stocks - eight from each of five separate categories: "growth and income," "bargain growth," "deep value," "small wonders," and "foreign value." According to the article, the Fortune 40 portfolios were introduced in 2002 and have outperformed the S&P 500® Index by a significant margin (annualized return of 15% vs. 11%), although the precise time period was not specified.

Fortune has published an annual Retirement Guide issue for many years, and it seems plausible that the introduction of the Fortune 40 strategy in 2002 was at least partly motivated by the erratic performance of stock recommendations in prior years. The retirement issue appearing in mid 1999, for example, followed a more concentrated approach and suggested only ten stocks. Relying on both outside experts and in-house quantitative analysis, Fortune at that time assembled a collection of firms "with the size, stability, and earnings power to carry investors through whatever the market throws their way in the decades to come."

Although Fortune undoubtedly worked hard to select companies with "the right business plan and the right management," time has not been kind to most of their recommendations. Nine of the ten stocks have underperformed the S&P 500® Index, including two whose shares have been declared worthless in bankruptcy court. Between Fortune's quoting date of July 13, 1999 and Friday, June 13, 2008, the Fortune 10 stocks fell 46.1%, on average, while the S&P 500® Index (price-only) declined 2.4%.

The table below presents the basis for Fortune's recommendations in 1999 along with a summary of more recent events:

Stock Price Change
July 13, 1999-June 13, 2008
Adjusted for Splits and Spinoffs

Our motivation in writing this column is not to skewer the stock-picking skills of Fortune editors. Many of these stocks were also recommended by some of the world's most prominent analysts and money managers. Fortune editors in 1999 were well aware that many investors were fixated on internet stocks and emphasized the importance of holding a diversified list of proven companies. Considering the widespread conviction at the time that growth stocks in general and technology stocks in particular were destined to outperform for the indefinite future, Fortune's choices, drawn from a wide array of industries, looked quite sensible. But time and time again, market participants are blindsided by unexpected events. Even today, it's difficult to find fault with the reasoning behind the various recommendations.

Judging by their most recent advice, Fortune editors appear to have recognized that even a carefully researched portfolio of ten stocks is still very risky. (We have not run the numbers, but a list of "Ten Stocks to Last the Decade" appearing in the 2000 Retirement Guide issue included stinkers such as Enron, Broadcom, and Nortel Networks, and therefore appears to have fared even worse.) They should be applauded for recommending a more diversified approach such as the Fortune 40. But why stop with this limited number when there are thousands to buy? As Dartmouth professor and Dimensional director Ken French has observed, "Diversification is the closest thing to a free lunch. You might as well eat a lot of it."¹

Especially if you aim to retire rich.

1. Kenneth R. French is director, consultant and head of investment policy at Dimensional Fund Advisors.

Berenson, Alex. "Tyco's Embattled Chief Calls It Quits." New York Times, June 3, 2002.

Carey, Susan, and Mitchell Pacelle. "UAL Files for Creditor Protection." Wall Street Journal, December 9, 2002.

Glater, Jonathan D. "With Shares Battered, A.I.G. Ousts Leader." New York Times, June 16, 2008.

Grynbaum, Michael M. "Bad Investments and a $7.8 Billion Loss at A.I.G." New York Times, May 9, 2008.

Harris, Gardiner. "Will the Pain Ever Let Up at Bristol-Myers?" New York Times, May 18, 2003.

La Monica, Paul R., and Katie Bener. "The Fortune 40 Best Stocks to Retire On." Fortune, June 23, 2008.

Latour, Almar. "Ebbers Is Convicted in Massive Fraud." New York Times, March 16, 2005.

Morse, Dan. "Home Depot Is Struggling to Adjust to New Blueprint." Wall Street Journal, January 17, 2003.

Reuters. "GM, Auto Shares Tumble as Outlook Darkens." New York Times, June 18, 2008.

Rynecki, David. "Ten Stocks to Last the Decade." Fortune, August 14, 2000.

Saul, Stephanie. "Drug Maker Fires Chief of Five Years." New York Times, September 13, 2006.

Schwartz, Nelson D., and Julie Creswell. "Stocks to Grow With." Fortune, August 16, 1999.

Yahoo! Inc. Yahoo! Finance. In https://my.dimensional.com/r/?u=http://finance.yahoo.com, accessed June 17, 2008.

Young, Shawn. "MCI to Emerge from Bankruptcy." Wall Street Journal, April 20, 2004.

You might have expected that the headline of the Weekend Australian Financial Review's lead article would have put a shiver down the spines of financial advisors like ourselves - "Spotlight on Financial Planners - High Price for Advice".  To be frank, I was a touch hesitant at first in reading the article but on reflection found that there were a range of comments made in the article that highlighted in a positive light the services of some financial advisors.  I wanted to address a few of these points.

1) The key problem is that financial planners have been paid in trail commissions from fund managers and not their clients.

Trailing commissions are payments by fund managers to financial planners for directing the planner's clients to invest in the fund - basically a reward to financial planners for using their product.  The article quotes a study from the Industry Superannuation Network (ISN) that suggests four fifths of people believed commissions compromised independent financial advice.  (Of course the ISN have their own bias in that their super funds do not pay commissions to advisors)

There is some truth to this argument.  We are clear in acknowledging on our website and when communicating to current and prospective clients that we do not accept commissions from fund managers.  There is actually a cash fund in our recommended portfolio for non super and pension clients that requires us to receive a commission.  Every three months we return this commission to client accounts in full.

The reason for taking this stance is that we do not want to even be accused of providing clients with advice that is biased in any way.

That being said, we actually believe there are some grounds where financial planners using a trailing commission fee model can provide a really great service for clients, particularly those with smaller funds to invest, as long as they are not encouraged to recommend particular investment because of the commission.  Commissions can make financial advice affordable.

The key point, as mentioned in the article, is that the investments / products that are recommended are done so with the client's best interests in mind.

2) There is a confusion amongst investors about payments that are received by financial advisors.

This is for us the key issue.  A financial advisor must be providing clients with all of the information about payments they are making, or the product that they are using is making to advisors.  Clearly showing the dollar value of these fees along with the percentage fee is really crucial.

A fee that is very rarely mentioned is what are called volume rebates.

Volume rebates are where a financial product provider "rewards" a financial advisor for directing their clients to a particular product or service by providing them a volume rebate.  The level of the rebate increases as the amount of funds directed to the product provider increases.

We utilise an administration service for clients.  Our group of financial advisory firms receives a significant rebate from the service because of the large amount of assets which are invested with the service.  A financial advisor has three basic choices here, keep the rebate for themselves or pass it back to clients, or a combination of the two.  We choose to pass the rebate back in full to our clients and in doing so significantly reduce the administration service fee by almost half.

3) Are asset based fee models the same as trail commissions?

There is a clear distinction between the two.  A financial advisor using a trailing commission fee model is being paid for recommending particular investments whereas an assets under management fee model advisor is being paid based on the total amount of assets the client wants managed by them.  The second are free to recommend investments they prefer for clients without being biased by commissions from a particular product.

The article suggests that another problem with trailing commissions or asset based fees is that investors do not understand how the payments grow over the years.  This is a fair point.  The usual reason for seeking advice in the first place is to grow your level of investments.  Under a trailing commission or asset based fee arrangement, the dollar amount of fees grows as the value of the investment grows.

The asset based fee model is sound as long as fees are capped, i.e, they do not grow without limit.  We place a $4,400 cap (GST inclusive) on our client portfolios.  This means that no client will ever pay us more than $4,400 (less GST) per annum.  Thereby clients can be absolutely sure of the outer limits of the fees that are payable to the advisor.

4) Getting out of a relationship with a financial advisor is difficult

The article also implies that under the commission fee structure, clients can stop having an ongoing relationship with an advisor but continue to pay the trailing commission fees.  This is a problem with trailing commissions.  Advisors set clients up into particular investments and can do nothing ever again while still receive ongoing payments into their accounts.

We are open with our clients that they can choose to cease ongoing advice whenever they want to.  From that point onwards no more advisor fees will be paid into our account.

We also do not charge upfront fees for this very reason.  We do not want to place barriers in the way of clients to get in or get out of our advisory services.  Payment of an upfront or annual fee paid once per year can make clients feel like they have to keep using the service to get their money's worth.  We feel it is much healthier for clients to know that they can move to another financial advisor should they feel the need.

Concluding remarks

The article particularly targets financial planners that use trailing commissions on the basis that this type of fee structure causes planners to be biased in their choice of investments and thereby not working in their client's best interests.

There is some validity in this argument - take the Westpoint disaster as an example.  However, investors should not be put off looking for good quality, unbiased advice because of this.  Look for a financial advisor who can clearly identify the costs involved with their advice and who are not biased because of their fee structure or because of who "owns" them.

Regards,

Scott Keefer

In his latest article written for Alan Kohler's Eureka Report, Scott looks at Suncorp's convertible prefernce share offering.

He looks at the upside yield assessment while also clearly stating the potential risks.  Scott concludes that the offering is well worth considering with the rewards on offer reasonable compensation for the underlying risk.

Click on the following link to read Scott's article - Suncorp offering with a bonus.

A client of ours has referred to us an excellent website from the US - FundAdvice.com .  The site is published by Merriman Berkman Next, a registered investment advisor based in Seattle.  After only listening to their most recent podcast published on the 20^th June I am already a big fan.  The podcast is a weekly radio program hosted by Tom Cock, Paul Merriman and Don McDonald and actually broadcast on a number of US radio stations.  The presenters are entertaining and keep the discussion flowing nicely while providing really useful general investment advice.  Listeners do need to be careful in that the show is obviously very USA centric but much of the commentary is totally relevant to Australia.  Click on the following link to listen to the most recent podcast - Sound Investing Radio Show

Apart from the weekly podcasts, the website also includes a question & answer page based on questions posed by visitors of the site or listeners to their radio show.  There is also a page covering a range of articles.

One particular article on the website that took my immediate attention was "Ten ways to crash proof your investments."  The article briefly set out 10 strategies to avoid permanent losses and crash-proof your portfolio:

1.                   Diversify among many shares

2.                   Diversify across many sectors

3.                   Spread your portfolio across asset classes

4.                   Spread your investments geographically

5.                   Include fixed interest securities

6.                   Consider using a mechanical defensive strategy to limit the size of losses and if you do this be disciplined but don't get into market timing

7.                   Avoid paying unnecessary expenses

8.                   Avoid paying unnecessary taxes

9.                   Don't panic

10.               Don't think you can avoid all risk

We would fully subscribe to all of these strategies except point 6.  We believe it is very difficult, and dangerous, to time markets even using a mechanical method.  A mechanical method is to implement a process whereby you invest in an asset when it is rising and switch to cash when it is falling.  The risk with this method is when assets are falling in price and then being out of the market after an asset turns up again in price. We prefer to recommend holding assets and continue regularly investing over time (often referred to as dollar cost averaging).

That being said the article provides a snapshot of the type of quality commentary being provided on the website.  Well worth a look.

Regards,

Scott Keefer

In his latest article written for Alan Kohler's Eureka Report, Scott looks at how to analyse the value or otherwise of term deposit offerings.

He looks at the nuts and bolts of investing in term deposits including credit quality, interest rates, institutional risk and diversification and tax considerations.

Click on the following link to read Scott's article - Credit crunch's silver lining.

Two pieces of reading came to my attention over the past week that both give some prudent insights into why it pays for investors to get "good quality" financial advice.  The first was an article in the Australian's Wealth supplement that is published every Wednesday.  The lead story for this week started with the following phrase:

"Investors who use qualified financial planners tend to have a lower casualty rate"

In his article, Tony Kaye quotes some research commissioned by he Financial Planning Association of Australia.  As you would expect, otherwise the FPA wouldn't have released the findings, the study found that investors who use financial planners have been receiving much lower rates of margin calls (only 5%) compared to those who do not utilise a financial planner.  This is a good result given the carnage on the markets especially in February.  A 2nd point from the article was that something like 95% of all investors using the services of a financial planner feel in better control of their finances and they feel much better prepared for retirement.  Both suggesting the raltionship is extremely valuable.

A third statistic quoted by the FPA suggested that 77% of Australians who use financial planners are more likely to sit tight and ride out the current volatility than those who don't.  Some may think that this statistic is not as flattering as it might suggest that financial planners are just sitting on their hands doing nothing.

Well, in fact, sitting and doing nothing is a pretty good strategy during tough times and this brings me to the 2^nd piece of information I have looked at this week - the Quantitative Analysis of Investor Behaviour 2008.  This publication is produced by Dalbar and is based on US data.  Each year these studies are consistently finding that investors are not achieving the returns they deserve from the share market.  The latest results look at the past 20 years of returns up to the 31^st December, 2007.  What it finds is that the average equity fund investor has achieved an annualised return of just 4.48% underperforming the S&P500 by more than 7% and only beating inflation by 1.44%.

So why is this happening?

A conclusion made by Dalbar is that the reason behind the discrepancy lies in investors frequently timing their investments and redemptions unsuccessfully.  It concludes that this poor timing is worse during market declines.  Basically what they are saying is that many investors are buying at high prices, selling at low prices and in the process destroying value.

A financial planner worth their salt will be able to "coach" their clients into understanding the reality of how markets work and keep them calm both in times of downturn as well as booms.  Keeping them to the strategy that will see them do much better over the long term rather than trying to time markets.

Is it time you found such a financial advisor?

Regards,

Scott Keefer