November 25, 2019

#Schwabitrade - Charles Schwab announces the purchase of TD Ameritrade.

Investing, Finance

Charles Schwab announced the acquisition of TD Ameritrade this morning.  Consolidation in the discount brokerage industry is no surprise since trading commissions have now fallen all the way to zero.  However, this merger should give Charles Schwab the size and scale needed to continue to find innovative ways to reduce investing costs while remaining a healthy and profitable firm.  I expect the process will be slow and the first major hurdle will be for the deal to get regulatory approval. If approved by regulators the merger will create a massive brokerage firm with $5T in assets, 24 million brokerage accounts and custody services provided to approximately 14,000 investment advisers. 

CNBC:  Charles Schwab to buy TD Ameritrade in a $26 billion all-stock deal

Details at this early stage are rather sparse but the deal is not meant to close until the second half of 2020 and full integration will take a further 18-36 months.  I anticipate that there will be no perceptible changes for at least 2 years.

For Stone Lake Wealth Management, which uses both firms to custody client assets, the impact can be split into 2 categories:

1. Impact on clients
2. Impact on SLWM operations

Impact on Clients

Once again, no details have been published at this point in time but I think we can use TD Ameritrade’s acquisition of Scottrade in September of 2017 as a rough template for what to expect.  Ultimately client accounts will be merged onto one system.  Which system that will be is unclear at this point but if done well the transition should be relatively smooth.  I hope they will be able to do it without requiring new paperwork.  Clients whose accounts are eventually migrated may have to engage in some minor activities such as re-linking bank accounts, setting up new login IDs and passwords to view their accounts and receiving dual statements for a short period of time. 

Impact on SLWM Operations

I am excited about the potential of this merger from an operational point of view.  I currently deal with two back end systems and while this is not too cumbersome, I look forward to a single system once all client accounts are transitioned.  Charles Schwab, which has been a pioneer in driving down the cost of investing since its founding, has a much more extensive physical branch network.  TD Ameritrade’s back end systems, especially their powerful portfolio trading software iRebal, are much more streamlined and easy to integrate with for third party services.  If the merger is done well Charles Schwab will be able to combine the best parts of both firms.

 I will keep all clients informed as more details are released in the months ahead.

Kind regards,

May 6, 2019

NPR Life Kit Money Podcast: Should You Pay for Financial Advice

I recently listened to this podcast published by NPR’s Life Kit Money series on December 15, 2018 and felt very proud of the fact that Stone Lake Wealth Management fit ALL of the criteria that they recommended an investor should look for when hiring an advisor.

1. We are a FEE ONLY and not a fee based or commission based advisor.  We are solely paid by our clients and no one else. 
2. We use low cost, non-commission index funds and ETFs as our primary investment vehicles.
3. Our fees are completely transparent.  Stone Lake Wealth Management will directly send invoice receipts to clients every time fees are deducted from the accounts.

We agree that many people don’t need to pay for financial advice or would do just fine with a robo-advisor.  However, if you are searching for a highly qualified advisor whom you can connect with, who can work with non-cookie cutter situations and who is held to a fiduciary standard we hope you will consider Stone Lake Wealth Management.  We will always work for your best interests. 

March 26, 2018

Benefits of Diversification Elegantly Quantified

Time horizon, diversification and a portfolio allocation that balances risk tolerance and financial goals are the three basic pillars to long term investing success. The benefits of diversification were quantified and understood in 1952 when Modern Portfolio Theory was developed by Dr. Harry Markowitz, work for which he was awarded the Nobel Prize in Economics in 1990. Since then, diversification has become fundamental to the practice of responsible professional investment management. 

Conceptually diversification has been around for centuries and is easy to understand. We have all heard the old saying 'Don't put all your eggs in one basket'. Concretely demonstrating the actual benefits of diversification is more difficult due to the complexity of the mathematics involved.  The table presented below elegantly solves this problem by showing the results of a basic, dual asset portfolio constructed with different allocations of US Large Stocks and US Long-term Government Bonds from 1926 to 2016. 

Geometric Mean = Compounded Annual Rate of Return
Arithmetic Mean = Average Annual Rate of Return
Standard Deviation = Volatility or 'Riskiness' of the Annual Return

At first glance the table confirms conventional wisdom, that stocks have higher returns than bonds and greater risk. As you add more bonds to the portfolio the levels of risk, and consequently return, are reduced. The two go hand in hand.  The stunning insight, however, is that a portfolio comprised solely of bonds is actually more risky and has a lower return than the portfolio with a 30% allocation to stocks. Effectively, diversification can make the riskiness of the overall portfolio lower than the risk of its least risky component. 

If we were solely optimizing the portfolio for the lowest risk the choice would be 30% Stocks/70% Bonds. In reality risk tolerance and time horizon also influence the choice of asset allocation. For investors with aggressive risk tolerance or long time horizons a higher risk, higher return portfolio would be more suitable. Conversely, someone in retirement living on the cash flow from the portfolio would choose even less risky, shorter term bonds. In all cases mathematical theory, decades of hard data and common sense all tell us that a key component to long term investment success is diversification. 

2017 Stocks, Bonds, Bills and Inflation Yearbook published by Duff and Phelps (1926-2016)
Exhibit 2.11: Portfolio Summary Statistics of Annual Returns

(Always Rebalanced) (% per annum)

March 21, 2018

ACTIVE MANAGERS UNDERPERFORM AGAIN

S&P released its semi-annual Index vs. Active Scorecard (SPIVA) for year end 2017 and it confirms yet again what academics and honest practitioners of investment management have known for decades.  Active management underperforms index investing over any appreciable timeframe, during bull or bear markets, in transparent and liquid developed markets or in opaque and illiquid emerging markets .  The report is extensive but I wanted to highlight some of the salient points made by its authors. 

Quotes and data taken from SPIVA US Scorecard Year End 2017

“While results over the short term were favorable, the majority of active equity funds underperformed over the longer-term investment horizons. Over the five-year period, 84.23% of large-cap managers, 85.06% of mid-cap managers, and 91.17% of small-cap managers lagged their respective benchmarks.

Similarly, over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis.

Percentage of US Equity Funds OUTPERFORMED by Benchmarks (as of Dec 29, 2017)

Percentage of International Equity Funds OUTPERFORMED by Benchmarks (as of Dec 29, 2017)

Active managers continue to sell investors the promise of 'beating the market' but ultimately the data speaks for itself. At Stone Lake Wealth Management we listen to it carefully, ignore the hype and slick marketing, and focus on serving clients for the long run. 

For further discussion of the virtues of index investing please refer to my previous post

For further discussion of the virtues of index investing please refer to my previous post The Reasoning Behind Our Approach and Investment Philosophy.

Source:https://us.spindices.com/spiva/#/reports

Tagged: index investing, active management, investing, investment managers, investment advisor, stocks

October 26, 2017

The Reasoning Behind Our Approach and Investment Philosophy

WE SAVE AND INVEST TO ACHIEVE GOALS

People typically have many different types of goals.  They can revolve around health, family and friends, careers, retirement or charitable causes just to name a few.  Some goals are immediate and others can take decades to realize.  Attaining any goal, regardless of its nature, requires a combination of time, effort and finances.  

• Saving is the act of accumulating capital in order to address a goal’s financial requirements.  
• Investing is the application of an appropriate amount of risk to savings to increase its chances of meeting a goal’s financial requirements via returns.   

HOW TO INVEST: DIVERSIFICATION

Predicting which asset classes will perform best or even trying to forecast their short term performance at all has been proven to be a fool’s errand.  Large of amounts of time and money have been devoted to this endeavor and the problem of uncertainty remains.  For example, speculators who used to apply technical analysis to price charts manually now use algorithms, machine learning and AI.  The results haven't changed.  In the end markets remain uncertain and unpredictable.  

Diversification is the act of distributing a portfolio across a broad swath of asset classes.  If done properly, it has been shown to add incremental return while at the same time reducing the overall risk in the portfolio.  By mixing and matching asset classes that behave independently we can tailor the risk/reward trade off for the unique individual and their goals.  In a broadly diversified portfolio no one decision can derail the portfolio’s performance.  Diversification and time are the two most important inputs to a portfolio’s long term performance.  The more of both, the better.

BEST WAY TO DIVERSIFY: INDEX FUNDS

Mutual funds or ETFs based on broad indexes representing different asset classes are the most cost effective and operationally efficient way to construct a diversified portfolio.  

Indexing eliminates the problem of manager selection. Time and money must be devoted to identifying criteria that predict their future performance.  Academic research using decades of data has been unable to consistently identify such traits.  Similar to trying to predict short term market behavior, identifying superior managers a priori has proven to be impossible.   

Once selected, managers must be continuously monitored to ensure that their investment style does not drift over time.  Managers are under constant pressure to outperform their benchmarks, especially during bull markets.  Eventually they are forced to chase performance by buying the investment choices with the highest momentum, which means the highest levels of risk.  Without careful monitoring the asset allocation of a portfolio could change surreptitiously and with serious consequences.  Indexing completely removes the need to select and monitor managers and reduces the time, energy and resources needed to manage an investment portfolio.  

Indexing also eliminates direct and indirect costs.  Fees charged by index products are usually extremely small, mostly less than 0.1% per year.  Additionally, indexed portfolios typically turnover only 5-10% of their portfolios each year vs. active managers who range from 60-80%.  This reduces both transaction costs and capital gains taxes which can sap the performance of the portfolio behind the scenes.  Indexing virtually eliminates two additional layers of fees for an investor working with a financial advisor.   

PERFORMANCE: INDEX VS. ACTIVE MANAGEMENT

The most important reason to use index funds is performance.  Decades of data have shown that active managers struggle to outperform their benchmark indexes over both short and long time horizons.  The S&P Dow Jones SPIVA Scorecard is published semi-annually and tracks how active managers are performing.  The following data is taken from the Year End 2016 report.

Table 1: Percentage of U.S. Equity Funds Outperformed by Benchmarks

Table 2: Percentage of International Equity Funds Outperformed by Benchmarks

Table 3: Percentage of Fixed Income Funds Outperformed by Benchmarks

REASONS BEHIND ACTIVE MANAGER UNDERPERFORMANCE

The most obvious reason for underperformance by active managers is fees.  In a highly competitive, highly efficient market managers start off behind an index fund every year by charging fees 10 to 20 times higher.  This difference compounds with time, making the manager’s challenge of beating their index benchmark harder as time goes on.  

Market structure has also changed significantly over the past 50 years.  According to Charles D. Ellis in The Index Revolution, decades ago 90% of the trading on the NYSE was done by individual investors.  These people were typically non-financial professionals investing their savings with long time horizons.  Today 98% of trading is done by institutions and high frequency traders.  Active managers are no longer trading against amateurs, but rather sophisticated professionals like themselves.

Finally, in 2000 'Regulation FD' was implemented.  It requires that all material information regarding a company be released to the entire public at the same time.  Analysts or portfolio managers could no longer develop an information advantage through relationships with company management, site visits or other informal, back channel means.  Full public disclosure combined with algorithmic trading has now made the market react to new information faster than any human analyst or portfolio manager can.  

IMPACT OF WALL STREET MARKETING

Wall Street banks and brokers’ basic business model involves selling investments to collect fees or commissions.  Like any sales operation, Wall Street employs marketing in order to reach consumers and influence demand for their products.  In the 60s, when commissions were the base model for revenue, the Street came up with terms such as the 'nifty fifty' or 'one decision stocks' in order to entice people into a transaction.  Later they discovered that rather than transaction based commissions, annual fees based on assets under management was a much steadier stream of income.  In the 80’s and 90’s, mutual funds with star managers charging high annual management fees, front end loads (effectively commissions) and 12b-1 distribution fees became the investment vehicle of choice for most brokers.  All through these phases, however, the classic definition of diversification never changed.

As the impact of competition, discount brokers and the continuously expanding data sets showing poor active manager performance made high cost mutual funds harder to sell, Wall Street realized that something needed to change.  Slowly and subtly they started to change the definition of diversification from investing in different asset classes to investing via different investment vehicles.  High cost mutual funds with star managers were replaced with higher cost hedge fund and private equity products that had gunslinger managers who could beat the markets due to some unknown secret sauce and skill.  A diversified portfolio changed from having allocations to US stocks, emerging markets, fixed income, commodities and real estate to including allocations to alternative investment vehicles.  In the end private equity is still equity, so having an allocation to both is simply a means for part of the portfolio to generate high fees, a piece of which is collected by the broker.  The investor ends up with a non-diversified portfolio generating sub-par performance and containing high hidden fees.  

ROBO-ADVISORS vs. HUMANS

We end with a word on the latest innovation in investment management, the robo-advisor.  Modern portfolio theory implemented through technology has allowed for this new, low cost, automated means of obtaining an efficient portfolio constructed based roughly on your risk tolerances and basic, quantifiable investment goals.  This is a perfectly acceptable approach for the do it yourselfer who has the time and inclination to educate themselves on the basics of investing.  It also is great for people with modest portfolios and very simple finances, i.e. the young and single.  In addition to portfolio construction, a human advisor can offer services and comprehensive advice a robo-advisor can not.  These include:

1. Understanding your unquantifiable needs and financial goals.
2. Advising on your unique, complete financial situation.
3. Continuous coaching and discipline to adhere to long term plans.
4. Adapt to major life events and changes.
5. Understand that the market’s past and the future may not look the same.  
6. Collaborate, explain and discuss all recommendations.

Typical robo-advisor fees range from 0.25-0.4%.  Choosing the right option means making a decision on what types of services you need and want.  

September 27, 2017

Equifax Data Breach - Here Is What To Do

As you may have heard Equifax, one of the three major credit reporting agencies, experienced a massive hack in which they lost the critical identification information of 143mm Americans. It is safe to assume your data was probably in that group. While there is no perfect way to protect yourself I am going to outline what I recommend based on what I have read.

1. The best thing to do is to place a FREEZE on your credit report at each of the 3 major credit agencies, Transunion, Equifax and Experian. This will cost $5-10 per person per agency but it’s the best thing to do. Each agency will issue you a pin that will be required to ‘unfreeze’ your report. Keep these safe. In the future if you apply for a loan or credit card you will have to call each agency, give them your pin and unlock your report for a short period of time. 
2. Alternatively you can place a fraud alert on your credit report. This is free and lasts for 90 days. You only need to place it with one agency since the other 2 agencies will automatically pick it up. You can renew it for free after 90 days.

The best way to take action is online with each agency. I tried calling their hotlines but the systems are really terrible and frustrating. Equifax, as you can imagine, is experiencing such heavy volume that I could not get through online or on the phone. So in order to at least get some protection for that report I recommend putting on a fraud alert with one of the other agencies as well as freezing the reports. The fraud alert should automatically get picked up by Equifax. By the time 90 days runs out hopefully the traffic has died down and you can place the freeze on Equifax as well. 

In a month or so I recommend pulling your complete credit report, which consists of all 3 agencies, and making sure no unfamiliar accounts are on it. The law mandates each person is allowed a free copy of their credit report annually so it should not cost you anything. For more information you can check the Consumer Financial Protection Bureau’s website: https://www.consumerfinance.gov

It's going to feel painful and take about an hour to do this but I highly recommend taking these actions. They are not perfect but will significantly reduce the chances of someone using your data.