The big players in the investment world continually remind us that it is through their research and expertise that investors will be able to achieve superior investment performance.  We are often reminded of this when we switch on the TV or open the newspaper.  Sadly the result is far from this with the active management approach often not providing the results investors deserve.  (Take a look at Our Research Based Approach report for more details.)

Our goal at A Clear Direction has not only been to work with individual clients to manage their investment portfolios but also provide general educative information about the investment process.  One area we have not yet developed is the provision of multi-media information to assist investors with understanding the best approach to investing.

Index Fund Advisors from the United States are continually developing a website which fills this gap.  For those who prefer to learn visually they have developed a range of videos and podcasts that are freely available on their website - http://www.ifa.com/ .

To keep abreast of their latest offerings you can also subscribe to their free YouTube channel - www.youtube.com/user/IndexFundsAdvisors

One aspect of these presentations is the series 12 Steps for Active Investors which provides 12 clear messages about the problems of an active investment approach.  Here is a list of the 12 steps:

Step 1. Active Investors: Recognize an active investor.
Step 2. Nobel laureates: Recognise that Nobel Prize winners researched the market.
Step 3. Stock Pickers: Accept that stock pickers do not beat the market.
Step 4. Time Pickers: Understand that no one can pick the right time to be in or out of the market.
Step 5. Manager Pickers: Realize that the winning managers were just lucky.
Step 6. Style Drifters: Comprehend active management style drift.
Step 7. Silent Partners: Recognize the partners in your returns.
Step 8. Riskese: Understand how risk, return and time are related.
Step 9. History: Understand the historical risks and returns of indexes.
Step 10. Risk Capacity: Analyze your five dimensions of risk capacity.
Step 11. Risk Exposure: Analyze your five dimensions of risk exposure.
Step 12. Invest and Relax: Invest, relax and stay balanced.

Click here for the full overview - http://www.ifa.com/Book/Book_pdf/overview.pdf

A word of caution, the materials are coming from a US perspective however the general principles are applicable to the Australian context with a few slight adjustments to take into account specific issues here.  I am also not a big fan of the drawings used but if you can get over those two aspects the IFA website and supporting videos and podcasts are well worth a look.

Regards,
Scott Keefer

Earlier in the month I posted an entry looking at the debate going on in Norway about the performance of their sovereign wealth fund.  Today Weston Wellington from Dimensional Fund Advisors in the USA has posted a commentary piece about the fund and the study that has been conducted into its performance over the past 11 years.  The study points out that 99% of the performance of the fund can be explained by the benchmarks (asset allocation) chosen by the fund and not the active management of investments.

The study provides another reminder for all investors, not just those with billions to invest, that you need to focus on the things that really matter - asset allocation.  For this firm that means targetting asset allocations at low costs.

Please take a look at Weston's commentary which has been copied below:

Norwegians have a well-deserved reputation for sound stewardship of their substantial oil wealth, and based on a recent study, they may become further noted for making a significant contribution to the active vs. passive investment debate.

Funded by severance taxes and income from a 67% ownership stake in energy giant Statoil, a government-run petroleum fund (now known as the Government Pension Fund ? Global) was first capitalized in 1996 and has become one of the world's largest sovereign wealth funds, with over NOK 2.5 trillion in assets ($430 billion) as of September 30, 2009. The value of the fund exceeds NOK 1 million per Norwegian household, and the government has given a great deal of thought to the best way to manage this store of wealth for future generations.

The Norwegian Ministry of Finance determines the general investment strategy as well as ethical guidelines for "promoting good governance and safeguarding environmental and social concerns." Norges Bank Investment Management, an affiliate of the Norwegian central bank, carries out the investment mandate using a combination of internal staff and external active money managers. Equity investments were first authorized in 1998, and the current asset allocation target is 60% equity (diversified across 46 countries) and 40% fixed income.

The fund is an unusually sophisticated market participant. With no current distribution requirements and a time horizon measured in generations, the fund is the quintessential patient investor, and with its ample resources, it can afford to hire the best and brightest managers the world has to offer. The fund devotes considerable effort to the process of hiring external money managers, seeking out not just successful organizations but specific individuals within those organizations with desirable characteristics. Combined with the traditional Scandinavian virtues of thrift and thoughtful analysis, the fund appears well-positioned to achieve its ambition, as described by the Ministry of Finance, "to be the best managed fund in the world."

Following a disappointing performance in both absolute and relative terms in 2008 (the fund fell 23.3% for the year, trailing its benchmark by 337 basis points) the Ministry of Finance engaged an international team of experts to "evaluate the experiences in active management in Norges Bank." The resulting 220-page report by Andrew Ang (Columbia Business School), William N. Goetzmann (Yale School of Management), and Stephen M. Schaefer (London Business School) provides an unusually detailed examination of an institution's investment experience for more than eleven years, and the Ministry of Finance deserves credit for encouraging such a detailed independent investigation.

The conclusion? The authors' "key finding" is that despite having an internal staff of 249 and hiring hundreds of external money managers, "to a first approximation, the Fund is actually not an actively managed portfolio" (Ang, Goetzmann, and Schafer 2009). Echoing an earlier performance study by Brinson, Hood, and Beebower (1986), they find that the Fund's results are almost entirely explained by exposure to systematic risk factors rather than active management bets. "By far the most important influence on the performance of the Fund", the authors say, "is the choice of benchmark. This accounts for over 99% of the total variance of the Fund's returns so the contribution of active returns to the overall Fund performance has been small. However, a significant fraction of even the small component of total Fund returns represented by active returns is explained by exposure to a limited number of common factors. The overall behavior of the Fund is therefore very similar to an index fund with a small overlay of exposures to systematic factors such as credit, value-growth, liquidity, volatility, etc."

Based on their finding that the average active return from January 1998 to September 2009 was statistically indistinguishable from zero, the authors suggest that the fund could benefit by targeting various risk factors more explicitly and taking advantage of the fund's unusually long time horizon to earn appropriate returns as compensation for risks that other investors might be unable or unwilling to bear.

Norges Bank Investment Management has responded with a defense of their approach, and it remains to be seen if the report precipitates any significant changes in the overall strategy. Regardless of what the Ministry of Finance decides to do, the exercise provides a compelling illustration of the challenge facing investors in seeking to outperform markets, and, if nothing else, we now have a new standard by which such efforts should be evaluated and impressive documentation that "structure explains performance."

Andrew Ang, William N. Goetzmann, and Stephen M. Schafer, "Evaluation of Active Management of the Norwegian Government Pension Fund ? Global," (research paper, December 2009).

Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, "Determinants of Portfolio Performance,", Financial Analysts Journal, 42, no. 4 (July/August 1986): 39-44.

The research paper "Evaluation of Active Management of the Norwegian Government Pension Fund ? Global" is available at The Norwegian Ministry of Finance website www.regjeringen.no (accessed February 22, 2010).

I came across a simple little slide show on the Investopedia website today - 6 Simple Steps to $1 million.  Even though the site is US based it is definitely applicable to Australians and provides simple starting strategies to build wealth.  The strategies included:

1.Stop sensless spending
2. Fund your retirement plans ASAP
3. Improve tax awareness
4. Own your own home
5. Avoid buying expensive new cars
6. Don't sell yourself short with your work

The final piece of advice from the slideshow is don't rely on luck.

These are the basis for building a significant nest egg to meet the gaols and aspirations you have that require financial funding.  The sooner you get started the better.

From here yo can fine tune your plans by optimising the investments into which your savings are placed.  Take a look at tne building portfolios page of the site for more information on this,

Regards,
Scott Keefer

MSCI Barra, probably best known for the global indices they have developed which are used as the standard benchmark for international investment returns (e.g. MSCI World ex Australia Index), have recently published a report looking at the last 35 years of investment return data to explain what has driven investment returns across the world over that period.

Their findings were that after inflation followed by dividend income were most important in explaining equity returns for the majority of world markets.

Over the period the UK & Australia had the strongest returns and the higher level of dividends.  The report also provided some interest tables setting out the performance of various regions of the world across the 35 year period.

Without wanting to repeat all of this data here I encourage you to take a look at the 7 page report - What Drives Long Term Equity Returns?

For me the report provides a great reminder for long term investors to keep a close eye on the income (dividends) being generated by your investments.  In Australia this is an even easier proposition thanks to the franking credit benefits passed on to shareholders.

Also keep in mind that the Australian market has lagged other world markets (take the 1990s as an example).  For this reason it is still important to keep a good sized allocation of international investments to smooth out volatility and allow the impact of compounding returns provide an overall long term better return.

Regards,

Scott Keefer

Scott Francis in his latest Eureka Report article shines the light on the performance of well known and used active fund managers.  Scott reports that not one of the managers in the sample were able to beat the ASX300 index return for 2009.  He suggests that part of the answer is that managed funds have a number of structural disadvantages that work against them. These include:

• The need to hold some cash for investor redemptions.
• The hidden (market impact) costs of trading.
• The money flow of investor trading.

Scott concludes that not finding one managed fund to beat the average market return in a year is surprising. It certainly brings into question the role of active managed funds in portfolios, especially in comparison with the many low-cost index and ETF products that offer access to different sectors and markets.

Ultimately, investors have to decide whether the structural headwinds of a managed fund such as market impact costs, cash holdings and high fees make them an efficient way to access investment markets - especially when their performance fails even the most basic hurdles.

Please click on the following link to be taken to the article - Australia's biggest losers.

Norway's sovereign wealth funds are well known to have a successful track record and are amongst the largest sovereign wealth management funds in the world.

The Economist magazine has reported an interesting debate playing out with regards the Norwegian Government Pension Fund - Norway's pension fund: Passive aggressive.

The debate has come about following a review ordered by the Norwegian government after poor performance returns through the economic crisis.  The government called on feedback from Mercer, a consultancy, and a report by three business-school academics?Andrew Ang, William Goetzmann and Stephen Schaefer from Columbia, Yale and London respectively.

The 3 academics found that "for all their stock-picking and do-gooding, the fund's managers could just as well have thrown darts at a board.  Taking the crash into account, the fund's performance was essentially indistinguishable from that of a passively managed index fund. "The evidence points to the fact that over time, managers do not provide extra profits,"

The fund's managers have fired back with a 96-page rebuttal of passive investing with the Norwegian parliament to debate the issue in the European Spring.

Yet again there appears to be evidence that the active management approach does not provide superior performance that cannot simply be explained as luck or chance rather than skill.

For me the debate provides further evidence to question the appropriateness of an active management approach and shows the 3 factor model asset class investing approach built around index style funds stands up well.

Regards,
Scott Keefer

Scanning through my financial press summaries today I have come across an interesting report published by Reuters - Study shows why it is so scary to lose money.

The article was based on a study looking at "two women with a rare genetic condition called Urbach-Wiethe disease, which damages the amygdala, the almond-shaped center in the brain that controls fear and certain other acute emotions."

What the study found is:

"A fully functioning amygdala appears to make us more cautious ... We already know that the amygdala is involved in processing fear, and it also appears to make us 'afraid' to risk losing money."

What can we take away from this study?

Apart from the extreme measure of somehow interfering with the amygdala, this simple study provides evidence as to why some of us might be more risk averse than others.  It reminds us that we are all different when it comes to investing and a one size fits all approach does not work.  The important thing is to get as accurate an understanding as possible of our own tolerance to investment risk (and rewards) and structure our portfolios accordingly.

Regards,
Scott Keefer

Last week's decision by the board of the Reserve Bank of Australia to keep official interest rates on hold surprised many including economists, market commentators, forecasters and even betting agencies.  The decision provides a reminder of the uncertanties of finance and investment markets and that care should be taken making decisions around what is widely seen as a sure thing.

Jim Parker from Dimensional Fund Advisors has written a commentary piece on this in his Outside the Flags column on the Dimensional website.  I have included a copy of Jim's article below.

Regards,
Scott Keefer

Rate Expectations

Bookmakers sometimes refuse to offer odds on a particular horse if it's seen as a sure thing. So it was recently when a betting agency declined to take bets on the Reserve Bank of Australia raising official interest rates because the outcome was "as close to a guaranteed certainty as possible".¹

Media commentary ahead of the first meeting for 2010 of the central bank's policy-making board was also unequivocal. "RBA to Lift Interest Rates", trumpeted ABC Radio; "Rates Almost Certain to Rise", said The Sydney Morning Herald, while The Australian Financial Review chose to look even further into the future to ask whether retail banks would move more aggressively than the anticipated quarter percentage point rise.

To be fair to the reporters, they merely were reflecting what the market was saying. All 20 economists in a Reuters poll had forecast a 25 basis point increase in the cash rate to 4 per cent, the fourth such move since September and making Australian rates among the highest in the developed world.²

The economists' confidence was also reflected in the futures market, where bill traders put the odds of a rate rise at almost 80 per cent.

So the market professionals, the economists, the journalists and even the bookmakers were speaking as one ? this was a done deal, a sure thing, a short-odds favourite and as good as money in the bank.

Which is why there was a lot of scraping of egg off faces on the afternoon of February 2, 2010 when the RBA announced that it had in fact decided to leave its benchmark lending rate at 3.75 per cent.

The "surprise" outcome of the bank's monthly policy meeting had an immediate and dramatic market impact, with the Australian dollar dropping by a full cent against the US dollar and yields on short-dated bonds tumbling.³ The local share market also rose strongly after the announcement, ending up 1.8% on the day and near its highs for the session.

Naturally enough, some economists lined up to provide ex-post rationalisations for the on-hold decision, despite many of them having offered just hours before equally confident sounding explanations of why rates were almost certainly going up. Others, obviously feeling aggrieved at being made to look silly, took another tack and accused the bank of making a mistake. A third group just took it on the chin and admitted they got it wrong.

Suffice to say, it is a tough job being a market commentator. You have to make every market event ? no matter how surprising ? seem quite logical and part of a coherent, pre-ordained narrative. So when events change, you have little choice but to change the narrative without it seeming too obvious.

What does this mean in understanding how markets work? If the market on the morning ahead of the announcement was fully priced for a rate increase, did that make the pricing wrong in retrospect?

No, because the pricing in share, bond and currency markets before the RBA statement reflected the best estimate of market participants based on the information available at that time. When the information changed, the pricing changed.

Is there a case, then, for investors second guessing the market if they suspect it has got it wrong and seeking to make a profit from those mistakes? A brave individual could have attempted to make a profit by betting against the consensus, but this essentially would have been a speculative bet. If they got it right, all well and good, but this is no different to betting on a horse.

An alternative way of looking at is to say that if the people who are paid to analyse interest rate movements, who obsessively parse central bank statements and who crunch numbers for a living can't get these calls right, what chance has the individual?

Better to accept that it is extremely difficult, if not impossible, to accurately forecast future events in a consistent way. Market pricing is only ever a best guess of the future based on current information. It incorporates the opinions of millions of individual investors and changes as events change.

The media in the prior week to the RBA decision was full of speculation about the outcome of the meeting and the likely consequences of another credit tightening. Many reporters were looking ahead to what would happen after the "inevitable" rate rise.

But then when the predicted event didn't occur, the slate was wiped clean and the story became "what does the Reserve Bank know that we don't? Maybe the economic outlook is worse than they are letting on?"

Essentially, the pundits are trying to build coherent narratives for their readers and customers out of unpredictable and haphazard events. Their running game analysis makes for entertaining reading. But at the end of the day, it's just noise and it's not something to base an investment strategy on.

¹'Rate Rise a Guaranteed Certainty: Centrebet', ABC news, Feb 2, 2010

²"Aussie Up Ahead of Rate Call", Reuters, Feb 2, 2010

³'Australian Dollar Drops After Central Bank Leaves Rates on Hold', Bloomberg, Feb 2, 2010

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 January 2010.

Commentary:

The graphs show a pull back in returns over the month for the Australian share asset classes with international share investments relatively flat for the month with Emerging Markets experiencing a fall.

Over the long run, the graphs continue to clearly show the existence of the risk premiums (small, value and emerging markets) that the research tells us should exist:

Australian Share Trusts - 7 Year returns

International Share Trusts - 7 Year returns

NB - These numbers are average annual returns for the 7 year period which are slightly higher than the annualised returns.

Please click on the following link to be taken to the graphs - Dimensional Fund Performance Graphs.

For anyone new to our website, it is important to point out that we build investment portfolios for clients based on the best available academic research.  Take a look at our Building Portfolios and Our Research Based Approach pages for more details.  In our view, this research compels us to use the three factor model developed by Fama and French.  In Australia, the most effective method of investing using this model is through trusts implemented by Dimensional Fund Advisors (www.dfaau.com).  We do not receive any form of commission or payment from Dimensional for using their trusts.  We use them because they provide the returns clients are entitled to from share markets.

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.

Two recent reports have focussed attention on the adequacy of the superannuation system in Australia to prepare Australians financially for their life in retirement.  The federal government's intergenerational report and Rice Warner Actuaries' Retirement Savings Gap report (840k PDF) both show the pending stresses on the nation if the current system is allowed to continue.

A lot of the focus has been on whether the 9% standard employer contribution level is enough.  This looks at the money going into the system.  Unfortunately not enough seems to be made of the flows out of the system, most importantly the fees being charged.

The average fee for managing superannuation is currently 1.2%.  Unfortunately many are being charged much more than this to maintain a superannuation account.  The mantra being applied by these higher cost funds is that the investor need not worry about the level of fees but rather the net return after fees which of course is correct.  Unfortunately what they forget to mention is that once we accumulate all investor returns the average return is the market return.  So if everyone gets the average gross market return the distinction between one investor and the next is the evel of fees paid to get that average return.

For this firm the preferred approach for superannuation account holders is to focus on the key determinant of investment returns - asset allocation - and then make sure you are getting your optimum asset allocation (given your risk preference) at the lowest cost.

If you can apply this approach over the life of a superannuation holding you can be confident that you will have a much better than average result in retirement.

Regards,
Scott Keefer

An article in Monday's edition of The Australian newspaper written by Geoffrey Newman highlighted the projected deficiency between the amount the average Australian will save for their retirement and the amount needed - Superannuation gap blows out by hundreds of billions.  The numbers are indeed sobering.

The article referred to a report conducted by Rice Warner which suggested that we needed to contribute 18-20 per cent of our incomes into retirement savings each year to allow for an adequate retirement income.

There is pressure on the governemnt to increase the 9% of income that compulsorily goes into superannuation each year.  Even if the government comes to the party some way it will still require some significant extra contributions by individuals to reach the necessary funds required for an adequate retirement.

So what are the alternatives?

We can rely on the government to look after us in our twilight years.  This, for most no matter what side of politics, seems to be taking a big risk.

Alternatively, we can start putting aside extra savings each year.  This does not mean that we need to pump these extra savings into superannuation.  There are other alternatives though maybe less tax effective provide a lot more of flexibility and some might say certainty compared to the superannuation system.

An easy way of looking at the benefits of this extra saving is using the magic 5% rule.  If you invest your assets prudently you should expect to be able to draw 5% of income from your savings each year while allowing the capital value of these assets to grow in line with inflation so that he $5 of income grows each year in line with the growth in the costs of goods and services.  This means that if you save an extra $100 this year that corresponds to an extra $5 of income per year for the rest of your life.

Now if you don't spend that income and rather reinvest it, after 10 years that $100 of savings will be able to generate $8.15 of income each year for the remainder of your life, after 20 years $13.25 and the numbers get more compelling the longer you are able to refrain from using the income.

It would be great if the government could step in to help build everyone's retirement savings for the future but most would agree we should not be relying on that to happen.  The more we can each afford to save each year will definietly help towards a much more comfortable existence later in life.

Regards,
Scott Keefer