Given the market environment of the last few years, it is completely understandable that investors would be searching for products that may offer greater peace of mind or higher levels of income. Unfortunately for investors, the financial services industry recognizes this all too well.

Many financial firms drive profits by creating products that cater to whatever emotion investors are feeling at the time – playing to investor fear or greed is a tried and true strategy for selling financial products. While the promise of such products can be enticing, investors must evaluate if the potential benefits are more than offset by greater complexity and higher costs (increased complexity carries a major advantage for financial service firms: it provides justification for higher fees).

A current example of this increased complexity is structured products. Investment banks promote these manufactured securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

While a structured product might help an investor who desires a specific payout at a designated point in the future and is willing to pay another party to shoulder much of the financial market uncertainty, this benefit often comes at a high price. The following summarizes a few common characteristics of structured products:

• Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes.

• Substantial cost:  These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.

• Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. There is no free lunch in the risk-return tradeoff – to pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.

• Credit and liquidity risks: Investors are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver (during the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt). Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market.

Perhaps most important, investors who are considering a structured product or any other financial product should consider what the appeal may be and whether the same objective can be achieved by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk.

Mr. Ellis was recently the featured guest on the television show Consuelo Mack WealthTrack. Below is a sampling of his words of wisdom for investors from that interview.

On index investing:

“Well, let me give a little bit of personal history because I’ve been in this game for 50 years, and when I first got started, I was absolutely determined I was going to find the stocks that we should buy at the price and make some real money. And I remember calling and telling my dad, ‘Dad, this is something you really ought to do.’ And I would talk to my friends, ‘Don’t you think we ought to do this?’ And over the years – and I don’t say this with any kind of pride, no kind of satisfaction, it’s in fact a very sad story – over the years, most of my friends have been triumphant and then not. And over time, their records individually across a wide spectrum – and I’ve worked with people as a consultant on investing in the United Kingdom, in Germany, in Canada, in Australia, New Zealand, in Japan, and all over the United States – and I can tell you with very few exceptions, they all would have been better off if they had indexed. And I say very few exceptions. Yes, Warren Buffett is one of the exceptions.”

“If I’ve spent fifty years looking all over the world for really good investors, and I found one or two, and that’s it, and I found lots who looked fabulous and then they didn’t, instead of getting all grumpy about it, I just said, okay, all these smart people had a problem. What was the problem? They were surrounded with and competing with brilliantly talented people also. Everybody else works all day, works all night, studies things, has their own Bloomberg system, really cares a lot, really trying hard – they all are working hard, but they cancel each other out. It’s like having 5,000 people on one end of a rope and 5,000 people on another end of the rope and saying, tug-of-war, and see which of the 5,000 can pull the rope farther against the other 5,000? It’s a complete waste of time.”

Consuelo Mack: “It’s so interesting that even you, Charley Ellis, are indexing. You’re basically, you’re following your own advice.”

Charles Ellis: “Very strongly.”

On asset allocation:

“But there is real value to asset allocation by type of asset. For most individuals, that is stocks and bonds, period. They should not get into hedge funds. They should not get into private equity. They should not get in venture capital because those are areas in which if you’re really good at it, you’ll get customers so fast that you’ll have more money than you can manage, so you close the doors.”

“Commodities are not an investment. They’re a speculation. You’re speculating that the price will be changed and that somebody else will want to pay more. Sometimes that works. There are lots of times when people say, look, it did work, retrospectively. But the long-term record of investing – of commodity speculation – cannot be considered investing because it doesn’t have any economic productivity to it. Now you can buy a painting and the painting can be higher in price later or lower in price. You can buy gold, and it could be higher or lower. But over long periods of time, it doesn’t pay off.”

On the biggest risks to investors:

“Well, the biggest blunder that we have seen in the last couple of years is very clear: November, December, January, February, March last year, it was really horrible. People were scared. Now what they were experiencing was a short-term severe pain, and they could convert that into a long-term severe pain by a very simple action: sell that stuff. Let’s get out of the market. And then the market goes vooop, and they’re not there. And that loss went from temporary, short-term, small part of your time period, diversification over time, to a forever big loss.”

“Panic selling’s the worst. Optimistic buying is the second worst – chasing things. ‘I heard him; I’m sure it’s going to work.’ And borrowing money to do that is the worst of the worst on the upside. So if you take those two out of your life system and you say, if it ever is true that the things that I own are going way down, way down, way down, I’m not going to sell, I’m going to actually buy more.”

“First thing is anybody who is in retirement should recognize is that the biggest risk they have is living longer than the money will last.”

As outlined in our September 2009 commentary, the financial reform bill presented an opportunity for Congress to universally apply the fiduciary standard to anyone who offers investment advice. As you may recall, only Registered Investment Advisors (such as Truepoint) are currently required to act as fiduciaries, which means always placing the client’s interests first. In contrast, stockbrokers and sales representatives of banks and insurance companies are held to the much less stringent “suitability” standard.

Unfortunately for investors, the fierce lobbying efforts of the brokerage and insurance industries ultimately deterred Congress from mandating the fiduciary standard in the financial reform bill. Instead the bill instructs the Securities and Exchange Commission (SEC) to conduct a six-month study analyzing the differences between the fiduciary duty and the suitability standard.

The prospects of such a study led Barbara Roper, director of investor protection at the Consumer Federation of America, to state: “If we wait to study again an issue that the SEC has been studying for years, unsophisticated investors will continue to be duped into believing they are in a relationship of trust by brokers who masquerade as financial advisors but refuse to acknowledge any obligation to act in their customers’ best interests.”

Understandably, investors find this issue confusing and few recognize the stark difference between the investment advisors’ fiduciary standard and the brokers’ suitability standard. In practice, this distinction often separates the professionals who serve their clients from those who sell to their clients. In a telling study, analysts estimated that if brokers were held to a fiduciary standard, brokerage firms could face a 4% to 10% decline in profitability per broker. Opponents of the fiduciary standard argue that it would undermine the broker-dealer business model and limit the products brokers would be willing to sell to clients (good for clients, bad for business!).

Despite the failure to include the fiduciary standard in the financial reform bill, a major step is included: upon completion of the prescribed study, the SEC is empowered to write regulation requiring brokers to act in the best interests of their clients and to reveal any conflicts of interest when providing investment advice. Now the consumer and industry groups that have battled for the ear of Congress on this issue will turn their attention to the SEC. While the stage has been set for real reform, it remains uncertain whether investor protection will prevail.

First, it’s worth noting that while the stock allocation of Truepoint-managed portfolios includes approximately a one-third allocation to foreign markets, the widely diversified holdings do not represent excessive exposure to Greece or any other European country with a tenuous fiscal outlook. This is reflected in the fact that Greece is a minor contributor to the global marketplace, representing only about 2% of the European Union’s Gross Domestic Product (GDP).

However, in a globally interconnected economy, a fiscal crisis in one country can impact many countries. Since Greek debt is held throughout the world, a Greek default could reverberate widely. As a result, there is legitimate concern for the potential domino default effect throughout Europe and elsewhere. Particularly because some of the countries potentially impacted are already battling fiscal issues of their own (though of a much smaller scale than that faced by Greece). 

There has been a concerted international commitment to keep this crisis from spreading. On May 10th, Europe’s finance ministers announced a €750 billion ($940 billion) rescue package which was initially positively received by investors throughout the world. While the rescue package does not solve the fiscal problems in Greece, it does buy the government time to get its fiscal house in order. Unfortunately, the volatility of global markets over the last 10 days reflects investor concern as to whether Greece will make the difficult policy decisions necessary to shore up its balance sheet and give investors confidence that Greek debt will be repaid in full.

Painful change rarely occurs in the absence of crisis. Examples of such change could be civil servants throughout Europe pushing retirement off to the age of 65 instead of 55 or 60; or, in Greece, requiring citizens to pay all of their taxes instead of just some of their taxes. While change in this region may be difficult, don’t underestimate the potential for change to occur. Just last week, Spain’s Socialist Prime Minister, Jose Luis Rodriguez Zapatero, abandoned his vision of an expanding welfare state and announced spending cuts of €15 billion ($19 billion) over two years. The cuts will impact civil service pay, social programs and pensions. While this move represents a drop in the bucket, it is nonetheless a step in the right direction. Ultimately, the only way for countries both large and small to work their way out of a high debt-to-GDP crisis is through a combination of fiscal austerity and economic growth. Finding the balance between these two imperatives will be challenging but attainable. One such example of success is the United States after World War II.

Dissimilar to the global financial crisis of recent years, the European debt crisis is taking place during a time when the global economy is expanding as opposed to contracting. And unlike two years ago, governments throughout the world are better equipped to deal with financial crises today. However, no one knows for certain how and when this crisis will end or whether we will see further signs of global contagion. What we do know is, as with past market crises, the resulting volatility creates rebalancing opportunities for the long-term investor. We will continue to capitalize on this volatility by making incremental purchases of depressed asset classes in order to benefit from a future recovery. While the timing of such a recovery is never clear in foresight, disciplined investors can remain confident in their eventual participation.

Investigations into what exactly caused this momentary plunge of stock prices are already underway. It seems clear, however, that a contributing factor was the cascading effect of high frequency trading – the rapid automated buying and selling of stocks driven by computer algorithms.

For example, in an attempt to protect against further losses, the computers may be programmed to sell as stock prices fall to certain levels. This can lead a quick market decline to be self-perpetuating as stock sales are continually triggered with each incremental drop in prices.

The great danger of this type of trading strategy is the danger inherent to all forms of market timing: it only proves successful if the investor is subsequently able to re-enter the market at even lower levels. This proved especially costly to many such traders yesterday as large stock sales were automatically triggered by the abrupt market decline only to see prices then reverse suddenly and dramatically.

It will be interesting to learn the conclusions of investigators into yesterday’s chain of events. However, while the sources of the intraday volatility may be unique, investors should recognize that the volatility itself is not. Though fortunately infrequent, history shows that the market will experience days such as yesterday.

As the European debt crisis unfolds, uncertainty in the global markets may well result in continued volatility and price declines. As investors, it’s critically important to separate what we can control from what is beyond our control. While we cannot control whether or not the market decline will continue, we can control how we respond. And it is our response in the face of short-term market events that will drive long-term portfolio results.

Our historical measure of stock market returns is the annual performance of the S&P 500 Index since 1930. The measure for government spending is the annual budget deficit/surplus since 1930 as a percentage of GDP (as reported by the Office of Management and Budget).

Performing a mathematical regression of the S&P 500 returns against the federal budget as a percentage GDP produces this accompanying chart. The R2 statistic displayed is a measure of “goodness-of-fit” for the regression equation on the data, or more specifically, how closely the blue data points surround the bold black line ranging from left to right. This statistic details the percentage of the variation in stock market returns that can be explained by the variation in the federal budget as a percentage of GDP.

Interestingly, the analysis shows that just 3.8% of the variation in stock market returns is explained by the annual variation in the federal budget. This suggests little to no direct relationship between the level of government spending and equity returns in any given year.

Taking a different perspective, we can examine average equity returns in the years immediately prior to and following federal budget decisions to further understand the relationship of stocks returns and government spending.

The second accompanying chart divides the past 80 years of government spending into deciles and examines the average market return in each of three years: the same year of the budget deficit or surplus, the year prior and the year following. Perhaps surprisingly, we find that stock market returns on average are higher in the years corresponding to and surrounding large budget deficits. For instance, the eight largest annual deficits on record ranged from 5.9% of GDP in 1934 to 30.3% of GDP in 1943 (including 9.9% of GDP in 2009). For this top decile of largest deficits, the average annual return of the S&P 500 Index in the same year is 18.9%, 18.1% in the year following and 22.4% in the year prior – impressive results considering the average annual return on the S&P 500 is 11.4% through the end of 2009.

On the opposite end of the spectrum, the eight smallest deficits (including surpluses) reflected in the tenth decile are associated with average annual market returns of 9.9% in the same year, 5.7% in the year following and 8.4% in the year prior. This data might suggest that budget deficits actually lead stock market returns, perhaps supporting famous British Economist John Maynard Keynes’ theory for deficit spending during recessionary cycles to increase business output, incomes and consumer spending.

In conclusion, though the long-term economic costs of an unsustainable budget deficit are real, it does not necessarily follow that the federal budget explains near-term stock market returns with any significance. Future government policy and economic growth are unknowable and investors should be hesitant to adjust their portfolio allocation in the face of projected political or fiscal events. A disciplined reliance on a globally diversified portfolio continues to be the best defense against this inherent uncertainty.

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Two of the most prominent researchers in this field are Eugene Fama, professor of finance at the Booth School of Business at the University of Chicago, and Kenneth French, professor of finance at Dartmouth College’s Tuck School of Business. Their most recent study, “Luck versus Skill in the Cross Section of Mutual Fund Returns,” analyzed 10,000 performance simulations to evaluate the presence of skill among active managers. The study data is based on the actual returns of 3,156 U.S. stock mutual funds from 1984 to 2006.

While about 70% of actively managed funds underperformed the market, the analysis suggests that most of the funds achieving some level of outperformance did so simply due to chance rather than skill. In fact, the professors conclude that only zero to 3% of active managers exhibit the skill sufficient to outperform a comparable efficiently managed passive fund.

The fact that up to 3% of active fund managers may possess the skill necessary to overcome their costs suggests that it is possible to select a manager with the ability to outperform the market. However, there’s a catch: according to the professors, the very few highly skilled managers are indistinguishable from those managers who do extraordinarily well by chance. Therefore, attempting to identify a truly exceptional active manager ends up being a matter of very low-probability guesswork. And those investing with a top-performing active manager run the risk of being around when the luck runs out.

Professors Fama and French explain that going forward they expect a portfolio of low-cost index funds to perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe. In an interview with MarketWatch, Fama suggested that the continued faith in active management is due to both the mutual fund industry’s marketing efforts and the complicity of mutual fund rating agencies, whose existence is based on the assumption they can identify the best funds.

The conclusions of this study are consistent with that of many prior academic studies favoring the use of low-cost, passively managed funds. Ongoing, rigorous research such as this further strengthens the underlying rationale for our investment philosophy and process. However, we are committed to regularly reviewing the latest in financial market and investor research, and if new evidence ever points to a superior approach, we will adjust our strategy accordingly.

This is a complex topic on which opinions are quite divided. Adopting a stance in stark contrast to Zweig’s is John Bogle, founder and former Chairman of Vanguard. Bogle has long maintained that no foreign stock allocation is necessary given that nearly half of the revenues of large domestic companies are already generated outside of the U.S. And, he contends, if a foreign stock allocation is included, it should represent no more than 20% of the portfolio. Meanwhile, in a departure from its founder, Vanguard’s research suggests that a 20% foreign stock allocation represents a reasonable starting point.

As with any investment decision, the rationale for an allocation to foreign equities should be rooted in economic logic and sound portfolio theory. In this case, history has shown that foreign stock exposure in a portfolio can enhance diversification and even increase expected return. However, in determining an appropriate allocation, the potential future benefit must be weighed against the additional risk and cost that may be associated with foreign investing. Below are a few of the key considerations:

• Higher costs: Transaction and investment costs are generally higher in foreign markets than in the U.S. This is primarily a result of liquidity differences and relatively lower market participation. For example, bid-ask spreads tend to be wider, and management fees and frictional costs (such as trading commissions, market-impact costs and tax costs) tend to be higher for foreign investments.

• Currency risk: Over time, currency movements contribute to the diversification benefit of foreign holdings. However, unless you live abroad, you will be spending mainly U.S. Dollars in retirement. As a result, it may be imprudent to rely on a long-term stock portfolio in which the U.S. Dollar occupies a minority position.

• Other risks: In addition to unpredictable currency fluctuations, additional risks of foreign investing may include liquidity risks and the potential for political unrest or changes in government policy that can weaken a country’s or region’s securities markets.

• Varying correlations: If the foreign exposure consists only of large-cap stocks in developed markets, the benefits may be minimal. Since its introduction in 1970, Morgan Stanley’s Europe, Australasia, Far East (EAFE) Index has returned 10.0% while the S&P 500 Index has returned 9.8%. And over the past decade, the correlation of returns between the two indexes has been very high at 0.88. Factor in the higher costs of investment and the EAFE Index can resemble an expensive S&P 500 fund. However, greater diversification benefit can be found in foreign value and small cap stocks as the companies in these categories generally conduct much more of their commerce locally than globally.

Weighing these practical concerns against the diversification opportunity suggests that some level of a “home bias” (i.e., allocating more to domestic stocks than their world market weighting would suggest) is warranted. In fact, Vanguard’s research indicates that exceeding a 40% foreign allocation has not historically added significant additional diversification benefit, particularly in light of the additional costs.

We concur with Vanguard’s findings and advocate a foreign allocation of 30-40% of the stock portfolio. Additionally, both our foreign developed and emerging market holdings are tilted to value and small cap stocks to enhance the expected return and diversification benefit. Our recommendation will evolve as the world equity markets do, but the objective will remain to adopt an allocation that substantially and efficiently captures the benefit of foreign equity exposure while remaining sensitive to the associated risks and costs.

*Postscript: A discussion with Jason Zweig subsequent to this posting clarified his position and finds us much more in alignment: he believes that the world equity allocation should serve as the baseline from which investors increase or decrease their domestic allocation based on personal circumstances.

While it’s hard to argue with the “lost decade” headlines, a minority of individual investors (including our clients) actually found the decade to be a productive one. These investors followed a time-tested and academically proven investment strategy that can be boiled down to the following steps: Buy and hold. Diversify. Rebalance. Though the strategy is simple, adhering to it is not easy.

Despite being frequently questioned in the wake of 2008, the merits of diversifying across asset classes are demonstrated in the table below. As you can see, not all equity categories performed poorly over the past ten years. In fact, foreign emerging markets and real estate both produced quite attractive returns.

The data also shows why staying the course can be so difficult. While bonds provide crucial portfolio stability, the best and worst 12 month returns reflect the wild volatility experienced by each of the equity categories. A disciplined investor must not only be willing to maintain these investments, but also add to them (i.e., rebalance) throughout the fear-inducing declines. It is telling to note that the two best performing categories for the decade also posted the two worst 12-month slides.

While the logic of opportunistic rebalancing (buy low, sell high) is clear, disciplined execution is rare among individual investors because of the psychological challenge it poses. For example, buying stocks amid the bursting of the dot-com bubble or the more recent financial meltdown was uncomfortable, to say the least. However, the comfort generated by avoiding stocks comes at a very high price. Never was this more evident than in the final nine-plus months of 2009 as stocks surged nearly 70% while record levels of cash earned next-to-nothing on the sideline. 

Despite enduring the single worst calendar decade in the history of the U.S. stock market, an investor whose portfolio was reasonably diversified across the categories displayed above, and who adhered to a disciplined rebalancing strategy, likely achieved a portfolio gain in the neighborhood of 50% for the decade – obviously a dramatic advantage over the -9% produced by the S&P 500 Index. 

Additionally, it bears noting that 10 years is not a particularly long time horizon; it’s the lifetime results that are important. The danger in the recent focus on the past decade’s performance is that it could lead investors to misguided decisions regarding their future investment strategy.

During 2009, there was great focus on the investment lessons learned from 2008. However, it is just as important to review the lessons learned from 2009 and the decade as a whole. Though dismal, the past decade clearly demonstrates that if you are broadly diversified, maintain an appropriate asset allocation, and have the discipline to stay the course, almost any storm can be weathered.