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Longer form, thoughtful analysis.

Institutional Imperative

Assessing Performance – A Case Study


Great read from Howard Marks in this months Chairman Memo.

“Thus timing – and in particular the selection of the beginning point and end point for studying a performance record – plays an incredibly important role in perceptions of success or failure”

We have been managing clients assets for five years (!) at the end of the month, and we publish our track record for all to see.  In general it has accomplished our objectives, but that is also for a full investment cycle.  We also have a fund that started in Spring 2009, and while it has much much better absolute performance, the relative performance isn’t as good.  It has been really interesting to see the reactions of many investors, professional as well, to essentially the same portfolio, but with different start dates…

I’m in Sydney and Brisbane this week, lots of fun meetings set up including one in the ocean on a board at Bondi Beach!

Norway vs. the Endowment Model

aiCIO is quickly becoming one of my favorite reads.

Here is new article on a white paper examining the Norway pension funds vs. the endowment model popularized by Yale by a few of my favorite authors.

Abstract: The Norwegian Government Pension Fund Global was recently ranked the largest fund on the planet. It is also highly rated for its professional, low-cost, transparent, and socially responsible approach to asset management. Investment professionals increasingly refer to Norway as a model for managing financial assets. We present and evaluate the strategies followed by the Fund, review long-term performance, and describe how it responded to the financial crisis. We conclude with some lessons that investors can draw from Norway’s approach to asset management, contrasting the Norway Model with the Yale Model.

Obama’s Budget Proposal Will Drive Fewer Companies to Pay Dividends

It is often very difficult to determine how geopolitical events will play out in markets.  However, there are some cases where a structural change will have a very logical influence on a market and a substantial impact on investment strategies and outcomes.

Today there is news that in his recent budget proposal Obama outlines taxing dividends for top bracket earners as ordinary income up to 40% from the current 15%.  How will this impact the investment landscape?

One structural change in the stock market is that companies pay out less in cash dividends than they have in the past.  As seen in Figure 1, while companies have historically paid out, on average, 60% of their earnings as dividends, this figure has been declining for the past seventy years.

FIGURE 1 – Dividend Payout Ratio per Decade, 1880-2010.

Source: Shiller, Faber

Likewise, as shown in Figure 2, the number of companies paying dividends has been decreasing, as well.  At one time, nearly all companies in the S&P 500 paid a dividend, but that figure has declined to roughly 70% today.  (The shaded areas represent regimes where dividends were not tax disadvantaged to income.)

FIGURE 2 – Percentage of Companies Paying Dividends, S&P 500.

Source: Standard and Poor’s, Political Calculations blog

The combination of these two forces, less companies paying dividends and companies paying out less of their earnings as dividends, has resulted in the dividend yield on stocks declining to all-time lows levels in the past decade.

When examining any fundamental shift in markets, we must analyze why the change occurred.  Why are fewer companies paying out cash dividends, and why has the amount of earnings paid out as cash dividends decreased?

One of the reasons that companies pay out less in dividends is due to the SEC instituting rule 10b-18 in 1982 – which provided safe harbor for firms conducting repurchases from stock manipulation charges.  A noteworthy paper on trends in corporate payout policy is Dividends, Share Repurchases, and the Substitution Hypothesis (2002) by Grullon and Michaely.  Once the government made it easier for companies to buy back their own stock, Figure 3, below, details how stock buybacks went from nearly nothing to either equaling or surpassing capital that was paid out as dividends in the late 1990s.

FIGURE 3 – Amount of Dividends and Buybacks, All Stocks.


Source:  Damodaran

Why might companies choose to buyback stock rather than payout cash dividends?  While tax rates fluctuate with the political seasons, it has often been the case that dividends taxed as income have had inferior tax treatment to long-term capital gains that are taxed at lower rates.  For over half of the past forty years, dividends have been taxed at higher rates than long-term capital gains, with the exception of 1988-1997, and 2003-present.  While this disadvantage was slightly improved by the recent Bush tax cuts, and while there are some foreign countries that do not have inferior tax treatment for dividends (see table at the end of the post for dividend and tax rates by year), the number of companies paying dividends has, nonetheless, declined from nearly 100% to around 66% for the largest stocks in the U.S.  The percentage of companies remained relatively stable during the shaded areas in Figure 2, representing  the 1988-1997 and the 2003-present periods where dividends were not tax disadvantaged.

Investors shouldn’t care whether their returns come from dividends or capital gains (the so-called Modigliani-Miller theorem).  This approach assumes a tax-neutral investor when, in reality, most investors are highly sensitive to tax treatment.   A recent study finds plenty of empirical support for this argument  (here is also a summary from Cowen at Marginal Revolution, Hat Tip:AF):

Taxation, Dividends and Share Repurchases: Taking Evidence Global by Jacob

We compile a comprehensive international dividend and capital gains tax data set to study tax explanations of corporate payouts for a panel of 6,416 firms from 25 countries for 1990-2008. We find robust evidence that the tax penalty on dividends versus capital gains is statistically significant and negatively related to firms’ propensity to pay dividends, initiate such payments, and the amount of dividends paid. Our analysis further reveals that an increase in the dividend tax penalty raises firms’ likelihood to repurchase shares, initiate such repurchases, and the amount of shares repurchased. This is strong confirming evidence that when listed industrial firms globally design their payout policies, they take into careful consideration the relative tax implications of their payout choices.


How does this impact your investment decisions?  Are dividend stocks going to become more or less relevant?  Stay tuned, lots more to come in a future post soon…

Source: “How Tax Efficient are Equity Styles?” by Israel and Moskowitz.

Lifestyle Companies

Totally unrelated to markets, but lots of interesting lifestyle companies popping up.  I am inherently skeptical about most of these (Groupon and sites like it are my worst nightmare – ie buying more things I don’t want).  However, there are a lot of sites that simply reduce the costs or improve what you are already doing.  A few of my favorites below – I use all of these.

Tripit:  Tracks travel, updates flights, and tracks reward balances.

Taxi Magic:  I don’t have cell service at my house, so this app lets you summon or schedule a cab and pay with credit card info stored on your phone.  Uber is similar for a private driver (but not in LA).

FoundersCard:  I was highly skeptical of this card, as I am for anything that charges a fee ($295) and especially for something that has “exclusive” invites that happens to be open to everyone.  However, it has a few benefits that right off the bat pay for the card and more. I upgraded/booked an enormous hotel room in NYC for a week that probably saved me a few thousand dollars alone.  Other benefits:

10% off AT&T bill, 33% off UPS shipping

Send someone $20 every month through Giftly (for free somehow.  Reminds me of the old X Card Paypal bought)

$40 credit on Gilt

TaskRabbit 15% off and $20 credit (used this last wknd to unclog my sink)

All sorts of benefits on American, Virgin, Quantas, Hertz etc.

Refferral Code:  FCFABER11 (I get reward points if you use my code)

Savored and BlackBoard Eats:  These two are similar and focused on restaurants.  BBEats gives you a code to give the waiter (a pain and has the downside of feeling like you are using a coupon), usually good for 25-33% off food at a restaurant, and they generally have about 2 or so offers per month that expire in a few month’s time.  Savored is a much better offering where they give you 30% off all food AND drink if you book your reservation through the site (read: no coupons or codes to give the waiter, it’s automatic).  That is a big deal if you like wine, etc.  The catch is that it is $10 to make a reservation, but if you are a FoundersCard member they are all free.

Jetsetter and Hotel Tonight (phone app only):  Jetsetter curates hotels and then offers discounts.  Hotel Tonight gives you a choice of a hand full of hotels each nite highly discounted.  In both cases they solve some problems for me – narrowing the list of possible hotels, and then giving a nice discount.  FoundersCard members get a free $50 credit and 15% off Hotel Tonight bookings.

Any other cool sites or apps I’m missing?

Updated with a few readers sent in:

GrubHub:  Online food ordering.

Seamless:  Online group food ordering.

AutoSlash:  Books you with cheapest car and automatically rebooks if fares go down.

Guide to the Markets

Following on the heels of the awesome GIRY download a few posts back, here is a very cool PPT from JPMorgan:

Guide to the Markets, 1Q 2012, Market Insights

Download here.

Highly recommended.


I will be in Australia the week of February 20th, as always if you are around feel free to drop me a line to meetup.  I’ve never been to Australia, so if you have any recs fire them over!

Speaking at the ETF Conference here.

ETF Guide for Investors

Nice PDF from Morningstar on ETFs.

Table of Contents Below:

The ABCs of ETFs

Choosing ETFs the Morningstar ETFInvestor Way

An ETF Primer for Retirees and Conservative Investors 

Avoiding the Dividend Trap 

Create Your Own Bond Portfolio Using ETFs 

Target-Maturity Bond ETFs: The Next Evolution in Fixed-Income Investing 

Indexing’s Hidden Costs 

Indexer? Valuation Still Matters 

What to Watch for When Investing in International ETFs 

An Overview of Broad-Basket Commodity ETFs 

ETFs That Hedge and Diversify 

Warning: Leveraged and Inverse ETFs Kill Portfolios 

How to Analyze a Strategy ETF 

Proactive Tax-Planning Basics With ETFs 

Popular ETF Questions Answered 

Reading the Stars 

ETFInvestor: What’s Inside 

The ETF Numbers That Matter—and Why 

Morningstar ETFInvestor Strategies 




2012 Global Investment Returns Sourcebook

Get it while it’s hot! (HT: Abnormal Returns)

One of my top must reads of the year…

(PS If you are a CSFB client you can get the full/extended version in hardcover.)

Updated: How to Pick Mutual Funds: The Netflix Prize for Improving Morningstar’s Star Rankings

Thought I would update this older post with a few new studies that take a look at active share, and illiquidity and momentum.

While most mutual funds underperform a simple index (and the vast majority underperform after tax), does that mean one cannot build a metric that predicts fund performance better than random?

I was at the Morningstar ETF conference this past summer and learned a pretty amazing statistic: roughly all inflows into mutual funds go into 4/5 star rated funds or new funds.  That was astounding to me.  The Morningstar star ratings (background at the bottom of the post) have been measuring past risk-adjusted performance for over two decades.  What they DO NOT do is offer any clues to future performance.

Don Phillips, President of Fund Research at Morningstar, stated:

“The star rating is a grade on past performance. It’s an achievement test, not an aptitude test…We never claim that they predict the future.”

Morningstar, quite impressively, actually disclosed a few months ago that simply using expense ratios was a better metric for predicting future performance that their star ratings. “Investors should make expense ratios a primary test in fund selection,” Russel Kinnel, director of mutual fund research at Morningstar, said in an article about the study. “They are still the most dependable predictor of performance. Start by focusing on funds in the cheapest or two cheapest quintiles, and you’ll be on the path to success.”  (Older 2007 study here.)

It would be interesting to see Morningstar present this metric on gross and net-of-fee returns to try and isolate the impact of fees (their current ratings are net of fees so naturally include the expense ratio as a factor).

If I was Russ or Don, I would commission a study in house (or possibly with some cheap local U of Chicago PhD’s) or even open it up Netflix style to a competition.  There have been numerous studies that illustrate ways in which one can pick mutual funds (maybe call it SuperStars? ha).

I’m sure there are more (email the papers to me and I’ll add them), and some of these probably overlap (ie high fees and low Morningstar ratings).  A lot of these factors are successful in selecting hedge fund manages on AlphaClone as well.

Most of these links are from the fantastic blog CXO Advisory.  It would be interesting to see a white paper that combines these factors into one metric.


Ways to improve your chances when picking mutual funds:

-Favor funds holding illiquid and high momentum stocks:  ”Using Liquidity and Momentum to Pick Alpha Managers“ - Idzorek

-Favor funds with high active share:  ”Equity Allocations: Thinking Outside of the Box”  Larson

-Favor new funds.  Academic paper here: Performance and Characteristics of Mutual Fund Starts” Karoui and Meier

-Favor cheap funds.  Academic paper herePerformance and Characteristics of Actively Managed Retail Mutual Funds with Diverse Expense Ratios” Haslem, Baker, and Smith

-Favor funds with higher ownership stakes (manager skin in the game).  Academic paper here: Portfolio Manager Ownership and Fund Performance” Khorana, Servaes, and Wedge

-Favor funds with high “Active Share” (holdings very different from the benchmark).  Academic paper here:  How Active is Your Fund Manager? Cremers and Petajisto

-Favor funds with low assets under management.  Academic paper here: How Active is Your Fund Manager? Cremers and Petajisto

-Favor funds with recent momentum.  Academic paper here: How Active is Your Fund Manager? Cremers and Petajisto and here “The 52-Week High, Momentum, and Predicting Mutual Fund Returns” Sapp

-Favor funds with redemption fees.  Academic paper here: “Redemption Fees:  Reward for Punishment” Nanigan, Finke, Waller

-Avoid funds with low Morningstar Stars.  Academic paper here: Selectivity, Market Timing and the Morningstar Star-Rating System” Antypas, Caporale, Kourogenis, and Pittis

-High conviction picks outperform.  Academic paper here:  Best Ideas”  Cohen, Polk, Silli


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