General Questions

Financial Theory

U.S. Equities

Fixed Income

Balanced Strategies

Financial Fraud

Additional Question


General Questions

I took the IFA Risk Capacity Survey, and I know from your Website what an appropriate portfolio for me would look like, so would I not be better off investing on my own through Vanguard or using ETFs?

While you could avoid paying an investment advisory fee by being a “do-it-yourselfer”, the question you should ask yourself is whether or not you would have a higher net return (after all expenses). Careful introspection will lead most people to the conclusion that they are better off using the services of a passively-oriented advisor. The reason for this is that even if one has the investment knowledge and the quantitative skills necessary to manage a globally diversified portfolio, it is unlikely that he or she will be able to overcome the behavioral impediments that lead to sub-optimal decision-making. For example, investors have a strong tendency to overweight the importance of recent events and thereby assume that recent trends will continue into the future. This leads to performance-chasing which is one of the quickest and surest ways to destroy wealth. Furthermore, to achieve the returns that are available for your level of risk, it will be necessary at times to buy the worst-performing asset class. This can be extremely difficult, even for the most experienced investors. The objectivity of a fee-only advisor is invaluable in these situations. In an attempt to quantify how advised DFA investors have fared relative to non-advised index investors, Morningstar did a study of investor returns vs. total returns for the two groups. They found that advised DFA investors received 109% of the available returns of the various DFA funds (by buying low and selling high) while unadvised investors received only 82% of the available returns of their funds (by doing the opposite of the advised DFA investors). All of this is besides the point that as a “do-it-yourselfer”, you will not have access to DFA funds which have shown a clear advantage over traditional index funds through a combination of their stronger tilt towards small cap and value stocks as well as their opportunistic approach to trading which is the very opposite of how traditional index funds all place the same trades simultaneously, incurring high costs for their shareholders. See more on this topic HERE.



We have created this chart to summarize the above studies.

1. Bogle, John C. The Little Book of Common Sense Investing: the Only Way to Guarantee Your Fair Share of Market Returns. Hoboken, NJ: John Wiley & Sons, 2007. 56. Print.
2. Dalbar. "Helping Investors Change Behavior to Capture Alpha." Quantitative Analysis of Investor Behavior. 25 Mar. 2011. Web. 14 Nov. 2011. 3. <http://www.qaib.com/>.
3. Zweig, Jason. "What Fund Investors Really Need To Know. OUR EXCLUSIVE STUDY OF MUTUAL FUND RETURNS SHOWS WHICH ONES REALLY MADE MONEY FOR INVESTORS AND WHICH ONES TOOK SHAREHOLDERS FOR A COSTLY RIDE." CNNMoney - Business, Financial and Personal Finance News. June 1, 2002. Web. 14 Nov. 2011. 10. <http://money.cnn.com/magazines/moneymag/moneymag_archive/2002/06/01/323312/index.htm>.
4. Bogle, John C. "Bogle Financial Markets Research Center." Vanguard - Mutual Funds, IRAs, ETFs, 401(k) Plans, and More. 8 Jan. 2010. Web. 14 Nov. 2011. <http://vanguard.com/bogle_site/sp20071015.html>.
5. Dalbar. "Helping Investors Change Behavior to Capture Alpha." Quantitative Analysis of Investor Behavior. 25 Mar. 2011. Web. 14 Nov. 2011. 3. <http://www.qaib.com/>.
6. Kinnel, Russell. "Bad Timing Eats Away at Investor Returns." Morningstar. 15 Feb. 2010. Web. 14 Nov. 2011. <http://news.morningstar.com/articlenet/article.aspx?id=325664>.
7. Bogle, John C. Common Sense on Mutual Funds. Hoboken, NJ: Wiley, 2010. 331. Print.
8. Bogle, John C. The Little Book of Common Sense Investing: the Only Way to Guarantee Your Fair Share of Market Returns. Hoboken, NJ: John Wiley & Sons, 2007. 51. Print.
9. Bogle, John C. The Little Book of Common Sense Investing: the Only Way to Guarantee Your Fair Share of Market Returns. Hoboken, NJ: John Wiley & Sons, 2007. 56. Print.
10. Morningstar. "Morningstar Index Yearbook 2005." Morningstar, 12 May 2006. Web. 14 Nov. 2011. 3. <http://indexes.morningstar.com/Index/PDF/MorningstarIndexesYearbook2005.pdf>.
11. Bogle, John C. The Little Book of Common Sense Investing: the Only Way to Guarantee Your Fair Share of Market Returns. Hoboken, NJ: John Wiley & Sons, 2007. 51. Print.
12. Morningstar. "Morningstar Index Yearbook 2005." Morningstar, 12 May 2006. Web. 14 Nov. 2011. 3. <http://indexes.morningstar.com/Index/PDF/MorningstarIndexesYearbook2005.pdf>.
 

What is the meaning of the number that is assigned to each of the IFA Index Portfolios?

The number for each IFA Index Portfolio represents the percentage of equities (including real estate investment trusts) that is held in the portfolio. For example, IFA Index Portfolio 60 is 60% equities and 40% fixed income.

What are the important dates surrounding a dividend or distribution?

A shareholder must own shares on the record date in order to be entitled to distributions. The following business day is the ex-dividend date, when distributions or capital gains are deducted from the fund's assets or set aside to be paid to the shareholder. On this day, the fund's net asset value decreases by the amount of distribution to be paid out, plus or minus any market activity. The distributions are actually scheduled to be paid on the payable date.

It is important to recognize that the payment of a distribution by a mutual fund does not increase the value of the holding. Assuming the dividend is reinvested, the investor ends up owning more shares at a lower net asset value. It is also important to know that payment of a distribution is a taxable event. Therefore, a responsible mutual fund company will do everything it can to minimize distributions.

Why do the IFA portfolios not include an allocation to commodities or commodity futures?

When deciding whether or not to include an asset class in a portfolio, the most basic and fundamental test should be, "Does this asset class offer a positive real expected return?" In the case of commodities (which includes gold), the answer is no. Purchasing a commodity in the hope that down the road someone else will pay you more than you paid for it is not investing but speculation, and the expected return from speculation is zero before costs and negative after costs.

Risk is the other side of the equation, and the risk of commodities is substantial. From inception of 1/1/1991 through 11/30/2012, the Dow Jones UBS Commodity index has had a standard deviation of 15%, almost the same as the S&P 500. Unfortunately, the return for the commodity index has lagged the S&P by 3.2% per year. Over the entire period, the growth of a dollar invested in the commodity index is 34% lower than the growth of a dollar invested in the S&P 500. Furthermore, the majority of the return of the commodity index has derived from the fixed income investments that are held as collateral for futures contracts. A fixed income return can be obtained for about one-third of the risk.

It is worth noting that in a diversified equity portfolio, an investor would already have a substantial exposure to commodities via oil companies, mining companies, agricultural companies, etc. There simply is no compelling reason to double down on this exposure.

For further information on commodities, visit here.


 

Financial Theory

If everyone followed an indexing strategy would markets still be efficient?

 
Rex Sinquefield
   

This question has come up repeatedly ever since indexed strategies first appeared in the mid 1970s. Critics of indexing assert that markets would be less efficient if all investors adopted a market-fund investment approach. One can accept this theoretical viewpoint and still embrace indexing with enthusiasm.

If the adoption of indexed strategies became so pervasive that market efficiency were impaired, it would be a self-correcting process. Mispriced securities would create opportunities for investors to earn profits in excess of their research costs, and their activity would drive prices back to equilibrium levels. We will never know how much information and liquidity are required for an efficient market. Markets for consumer durables such as homes or autos appear to be at least reasonably efficient, despite very poor liquidity, high search costs, and the absence of perfectly fungible assets. This behavior suggests a shift to passive investing would have to be very pronounced to have any effect on market efficiency.

Even if all professional investment managers adopted a passive approach, other market participants would continue to provide price-setting information. Sources of such information could include corporate stock buybacks, acquisitions, and the investment activities of officers, employees, competitors, and suppliers. 

Despite the impressive commercial success of indexed investing strategies over the last twenty-five years, they still represent only a fraction of total stock market wealth.

Isn’t the success of indexing in recent years mostly due to a “self-fulfilling prophecy”? Index funds appear to push up prices of a handful of big company stocks simply because they’re included in the S&P 500 index.

Some critics of indexing assert that mechanical buying from index funds creates a “self-reinforcing trend” in a handful of large company stocks and that their price behavior is dictated by cash inflows to index managers, not fundamental business conditions at the underlying companies.

Evidence to support this assertion is difficult to find. A more plausible explanation of pricing suggests it is the active money managers who dictate prices to indexers, not the other way around. As an example, an analysis of trading activity in General Electric Corp. stock* (the largest component of the S&P 500 index) found that programmed buying from index funds in January 1997 accounted for approximately 1.3% of total GE monthly trading volume. The notion that 1.3% of trading attributable to passive investors possessing no useful information determines the price-discovery process for the remaining 98.7% of market participants is far-fetched.

Advocates of the “self-fulfilling” viewpoint must also confront a wide disparity in performance of individual issues. If the behavior of large company stocks is primarily attributable to passive investors buying without regard to fundamental developments, it is difficult to explain why Coca-Cola shares appreciated only 0.5% in 1998 while Wal-Mart Stores soared 106.5%.

*Strategic Insight Mutual Fund Overview February 1997

What is CRSP?

CRSP (“crisp”) is an acronym for the Center for Research in Security Prices at the University of Chicago. Established in 1960 with a grant from Merrill Lynch & Co., the center undertook a massive data-gathering project to answer the question “how have stocks performed over the long term?” Under the direction of James Lorie, Ph.D., a professor of business administration, and Lawrence Fisher, associate professor of finance, a database of both price and dividend information was compiled for all common stocks listed on the NYSE beginning in 1926. Over two million bits of information were entered onto magnetic tape, and the commercial computers then becoming available calculated total returns. The results were published in a landmark article in the Journal of Business in January 1964. The center continues to add data on a regular basis, and with a $180,000 grant from Dimensional Fund Advisors in 1984, added data from NASDAQ markets starting in January 1972. The CRSP data files have been an essential tool in the study of capital markets by an entire generation of financial economists.

Why and how is Modern Portfolio Theory still relevant in today's Black Swan world?

A black swan is defined by investopedia as an event or occurrence that deviates beyond what is normally expected of a situation and that would be extremely difficult to predict. It was popularized by Nassim Nicholas Taleb, a finance professor and hedge fund manager. Another common characterization is the term “fat tails” (i.e., more outliers than would be expected in a normal distribution).

Fat tails have always been a part of the investment landscape. They were first identified by Benoit Mandelbrot and Eugene Fama over forty years ago. The real question is whether the existence of fat tails should impact the way we form portfolios, based on Modern Portfolio Theory which tells us to maximize diversification while keeping our risk exposure to an acceptable level. The answer, quite simply, is no. We just need to recognize that from time-to-time, we will have returns that are outside the bounds of our expectations, but this will happen on both the positive and the negative side. Over the long-term, the black swans become less and less important as the portfolio’s expected return becomes the dominant factor in the determination of performance.

Another common criticism of MPT is that during a financial crisis, correlations increase (i.e., everything moves down together, rendering diversification meaningless). The funny thing is that nobody seems to complain when correlations increase during a strong bull market (like what occurred from March 9th through the end of 2010). One answer to this is that diversification between stocks and high quality bonds worked exactly the way it was supposed to in 2008. A more general answer is that returns are a function of a security’s beta, which is a measure of its sensitivity to the overall market. During a financial crisis, the beta term dominates in the determination of returns, and the other part of the return that depends on differences in correlations is overshadowed. This is all predicted by Modern Portfolio Theory, which is why investors would be foolish to abandon it.

One of the primary examples touted regarding the non-normality of returns is Black Monday of 1987 (October 19th) when the S&P 500 dropped by 20.5%, about 20 standard deviations below the mean. In a normal distribution of daily returns, we would not expect to have seen  this large of a drop even if stocks had been trading from the time the universe began (14.6 billion years ago). Sobering numbers indeed! However, if we look at every possible 5 year period that contains Black Monday, the lowest annualized return received by an investor in the S&P 500 was  8.27%, which is only a little under the long-term historical average of 9.5%. Five years is well below the recommended minimum holding period for equities, so any reasonable investor who experienced this black swan would not have been wiped out by it.

 

U.S. Equities

Why does Dimensional use a ratio of book value to market value to construct portfolios for the value strategies? Book value appears to be increasingly unimportant in assessing stocks as investors attach greater significance to off-balance sheet assets such as technological expertise or brand recognition.

The goal is to distinguish between companies with high and low investor expectations; using market price relative to some fundamental economic measure effectively captures these differences. There is no magic associated with book value; research shows that screening on other fundamental measures such as cash flow, earnings, or dividends produces similar results. Book value appears to do the best job in explaining differences in average returns over time between growth and value stocks, but the current reliance on book value does not preclude future refinements in screening techniques.

Dimensional’s small company strategies employ a “patient buyer” trading strategy to purchase blocks of thinly-traded stocks at a discount. What happens if Dimensional gets a large redemption? Won’t it face the same transaction cost problem trying to sell these stocks?

It would be difficult to manage our small cap portfolios cost-effectively if they were subject to large and unexpected redemptions. Unlike conventional mutual funds accessible by the general public, Dimensional strategies have been developed exclusively for a limited number of professional investors such as corporate pension plans, state governments and registered investment advisors. We work closely with clients to identify significant cash inflows or outflows in advance in order to minimize overall portfolio transaction costs. Although it has never occurred, the Portfolios are permitted to make redemption payments by a distribution of portfolio securities in lieu of cash (see DFA Investment Dimensions Group Inc. prospectus dated March 30, 1999, page 54). 

What is a reasonable expectation for portfolio turnover in the various strategies?

A portfolio such as U.S. Large Company will have relatively low turnover since companies in the S&P 500 index which it attempts to track are replaced infrequently. Turnover is generally higher for strategies focusing on the small capitalization or value dimensions of the equity market. In order to maintain the desired small cap or value characteristics, stocks are sold as they move out of a pre-determined buy/hold range.

Annual Portfolio Turnover as of 10/31/2009
(from Morningstar ®)
U.S. Large Company 6%
U.S. Large Cap Value 19%
U.S. Small Cap 27%
U.S. Targeted Value 20%

Fixed Income

Why do Dimensional fixed income funds have annual portfolio turnover of 100% - 200% in some years? This appears inconsistent with a passive strategy.

Dimensional’s fixed income approach is “passive” in one sense – it involves no interest rate or economic forecasting – but is “active” in implementation. Research conducted by Eugene Fama at the University of Chicago suggests a shifting-maturity strategy that targets segments of the yield curve with the highest expected return can add value relative to a conventional indexed approach. The optimal maturity targets are constantly reviewed using information provided in the yield curve, and transactions are made if the increase in expected return exceeds the cost of making the trade. Annual portfolio turnover in excess of 100% is not unusual. An important element of the shifting maturity strategy is a focus exclusively on short-term instruments with the highest credit quality. These issues are very liquid, and can be traded at very low cost.

Why does Dimensional offer a global fixed income strategy but no international-only fixed income strategy? Shouldn’t the allocation decision between domestic and international fixed income be made by the advisor?

Dimensional’s global fixed income strategy reflects our view that the sole purpose of fixed income in a balanced account is to dampen the volatility of equities. Returns for a U.S. investor in non-dollar denominated securities are determined by a combination of changes in foreign currency exchange rates and the return on the underlying fixed income securities. The return component attributable to fluctuating exchange rates frequently exceeds that of the fixed income securities by a wide margin. The additional volatility attributable to the currency fluctuations defeats the purpose of holding fixed income securities.

If one could predict future changes in foreign exchange rates, it would be possible to engage in selective hedging activity in an effort to improve the reward-to-volatility characteristics. There is little evidence, however, that active managers are able to extract excess returns from foreign exchange trading with any consistency.

As a result, Dimensional employs foreign currency forward contracts to hedge exchange rate risk at all times. High-grade securities from eight major international bond markets (Australia, Canada, Denmark, Euro, Japan, Sweden, U.K. and U.S.) are placed in competition with each other. Non-dollar denominated assets are purchased only when their expected returns (net of all hedging costs) exceed those of comparable U.S. instruments. No more than 30% of portfolio assets can be invested in any single country outside the U.S. It is not unusual for the portfolio to own issues from major multinationals such as G.E., Hewlett-Packard, or McDonald’s in several different currencies.

By eliminating both the potential profit and loss from currency movements, the strategy eliminates the greatest source of risk in a global bond portfolio. The increased diversification provided by owning securities in multiple bond markets suggests it is appropriate to consider using Dimensional’s global strategy as a substitute, not just a companion, for a U.S-only approach. 

Why doesn’t Dimensional offer portfolios investing in mortgage-backed securities, convertible bonds, or high yield debt?

Dimensional believes that five factors explain the vast majority of returns in diversified portfolios (market, size, and value for equities; term risk and default risk for fixed income). They also appear to explain the behavior of hybrid asset classes such as high yield bonds or convertible securities. In general, the behavior of these asset classes can be captured more reliably and at lower cost by using some combination of structured equity strategies combined with high-grade short-term fixed income securities.


Why are TIPS (Treasury Inflation-Protected Securities) excluded from IFA’s traditional 20 Index Portfolios?

It is important to understand that investors are normally paid for bearing inflation risk. If they wish to be protected from the risk of unexpected inflation, they should have to pay for this privilege. It is the classic economic trade-off of risk for reward. As always, there are no free lunches. A good way to mitigate inflation risk without sacrificing the inflation risk premium is to use short-term fixed income. The maximum maturity in the IFA Index Portfolios is five years. The reason short-term fixed income works well as an inflation hedge is that once the market anticipates high inflation, it is immediately reflected in short-term interest rates, so as bonds mature, they can be re-invested at the higher interest rates. Holders of long-duration fixed income could be stuck with their low yields for many years, and the decreased market price of their bonds will reflect this. This brings up another problem with TIPS, which is that they can carry a high degree of term risk which could potentially overshadow the boost in return resulting from high unexpected inflation. This scenario would present a bitter disappointment to TIPS investors if they had been anticipating complete protection from inflation.


Balanced Strategies

If academic research demonstrates that small cap/value stocks have higher returns than large cap/growth stocks over time, why not put 100% of the equity allocation into small cap and value stocks?

For investors who define risk solely as the variability of returns, such a strategy might be appropriate. Whether such investors actually exist is debatable. Most investors are probably sensitive to the risk of being different from the market, even if overall variability is no higher. Small cap and value stocks do not outperform market portfolios regularly or predictably - if they did, they would not be riskier. To the extent an investor is likely to be disappointed with performance that differs from a market portfolio, a tilt toward small cap and value stocks should be undertaken cautiously. Source: DFA

Financial Fraud

How can I be certain that IFA is not running a Ponzi scheme?

Index Fund Advisors, Inc is an investment advisor registered with the SEC. An investor gives us the authority to invest his or her money; however, the custody of the money is given to a reputable custodian (i.e., Fidelity or Charles Schwab). In fact, assets are sent directly to the custodian. We do not accept assets directed towards IFA.

  • This separation is very important. With many hedge funds, as in the Madoff case, both the custodian (entity responsible for the safe-keeping of your money) and the person given authority to invest your money are one in the same. Having a custodian independent of your advisor gives an investor the ability to monitor his or her portfolio using independent statements from the custodian. Bernard Madoff supplied his investors with his own statements. In addition to the separation of custody and decision-making, there are a few other items that distinguish IFA from Madoff-like schemes:

  • IFA does not implement a “black box” strategy. IFA’s investment strategy is fully transparent and makes use of marketable securities that are fully liquid. At any time, you can view the holdings in your account by simply logging into the site of the third-party custodian that holds all of the assets.

    IFA’s investors earn returns that are the result of the acceptance of the amount of risk that is appropriately matched to their risk capacity. IFA’s returns will fluctuate in the short term as do markets. Fraudulent schemes frequently deliver the allure of consistent and smooth returns that are high, and seemingly arise without risk. Such allure is fraudulent however. Risk is the source of returns, and risk brings volatility. If it were painless all the time, why would you expect to earn a return?

  • Madoff refused to allow individuals to invest in his strategy if they pressed him for details about the investments or his “strategy.” IFA advisors are never too busy to answer your questions, and with the comprehensive website at ifa.com, more than likely all questions can be answered there. An unwillingness to answer questions often means there is something to hide.

How can I be certain that the funds that IFA invests in are not themselves Ponzi schemes?

The infamous Ponzi schemes over the last few years have rightfully alarmed investors. Bernard Madoff and Stanford Financial were able to defraud clients by avoiding safeguards that are essential requirements of registered investment companies (i.e., mutual funds). The following safeguards under the law are required of mutual funds and not of hedge funds:

  • Mutual funds are registered with the SEC as an investment company under the Investment Act of 1940

  • A mutual fund can only be advised (and sub-advised) by an investment advisor registered with the SEC pursuant to the Investment Advisers Act of 1940

  • The shares issued by a mutual fund are generally securities themselves registered with the SEC pursuant to the Securities Act of 1933 and regulated per the Securities and Exchange Act of 1934

  • Mutual funds must have a majority of directors who are independent of the manager, charged with obligations for oversight of the fund audit process, nomination of other independent directors, and fee approval.

  • Audited financial statements are required annually

  • Mutual funds must keep assets at custody banks in segregated accounts marked as “client accounts”, not subject to the banks’ own assets. This can be compared with some hedge funds that have had their assets caught up in the Lehman Brothers bankruptcy and must wait along with the other creditors for bankruptcy trustees to review their claims and return client assets
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