Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection.

Miller’s most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron’s included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as “one of the greatest investors of our time.” A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to “think about thinking” suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.

Miller’s bold and concentrated investment style would never be confused with a “closet index” approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller’s overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?

Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.

Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund’s expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund’s performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion’s share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.

To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.

Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.

Commentators have said that Miller has “lost his touch” or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.

Where does this leave investors seeking the best strategy to grow their savings?

When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, “As William James would say, we can’t really draw any final conclusions about anything.” Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.

Author Weston Wellington is a Vice President with Dimensional Fund Advisors

REFERENCES

Andy Serwer, “Will the Streak Be Unbroken,” Fortune, November 27, 2006.

Edward Wyatt, “To Beat the Market, Hire a Philosopher,” New York Times, January 10, 1999.

Tom Sullivan, “It’s Miller Time,” Barron’s, October 12, 2009.

Diana B. Henriques, “Legg Mason Luminary Shifts Role,” New York Times, November 18, 2011.

Standard & Poor’s

Morningstar Inc.

We’re passionate about the process of developing financial plans for long term investors. The secret to doing well in the market is not in buying fad stocks or over-hyped investment products, it’s about developing a long term financial plan and sticking to it. That’s why we are a little frustrated to hear about the federal government’s latest scheme to help out middle class investors.

The US Treasury Department recently unveiled plans to offer guidance to retirees on how to invest their retirement funds into income-yielding investments like annuities. Worried that individuals may outlive their investments, the Obama administration wants to encourage retirees to consider income investment products with guaranteed life payouts.

“By emphasizing investment choices over the planning process, the federal government is doing a disservice to seniors who are looking for guidance on how to make their retirement years as comfortable and stress-free as possible.”

Ted Toal, CFP® –Senior Partner, Rockwood Wealth Management

The good news is that the feds are concerned about every day investors. The bad news is that they think they can help retirees with magic bullet investment products. What good are new investment options without a plan? Picking investments without a process in place is like trying to buy a new car blindfolded.

Investment products are only part of an investment plan. The most important part is the financial planning process, in which a long term plan is developed for each investor. Outliving  savings is a real concern for retirees, who are living longer than ever. However, by emphasizing investment choices over the planning process, the federal government is doing a disservice to seniors who are looking for guidance on how to make their retirement years as comfortable and stress-free as possible.

We believe that financial planners are best suited to helping working investors and retirees plan for retirement. The planning process that we execute is designed to help investors develop financial goals, evaluate their current financial status, and develop a road map for long-term financial stability. Most importantly, our clients get independent advice that’s not tainted by affiliation with one investment product or another. We want what’s best for each client and develop tailored financial advice based on each client’s goals, financial position, and personality.

Do you have any questions about how the government’s new pay-out options will affect your retirement plans? Let us know in the comments!

Or, schedule a no-obligation financial consultation with us.

For those who find making Investment New Year resolutions useful, here are ten investment-related resolutions, courtesy of Brad Steiman, Director, Head of Canadian Financial Advisor Services and Vice President, Dimensional Fund Advisors Canada ULC, that will hopefully result in better long-term wealth:

1. I will not confuse entertainment with advice. I will acknowledge that the financial media is in the entertainment business and their message can compromise my long-term focus and discipline, leading me to make poor investment decisions. If necessary I will turn off CNBC and turn on ESPN.
2. I will stop searching for tomorrow’s star money manager, as there are no gurus. Capitalism will be my guru because with capitalism there is a positive expected return on capital, and it is there for the taking. And for me to succeed, someone else doesn’t have to fail.
3. I will not invest based on a forecast—whether it is mine or anyone else’s. I will recognize that the urge to form an opinion will never go away, but I won’t act on it because no one can repeatedly predict the future. It is, by definition, uncertain.
4. I will keep a long-term perspective and appropriately consider my investment horizon (i.e., how long my portfolio is to be invested) when determining my performance horizon (i.e., the time frame I use to evaluate results).
5. I will continue to invest new capital and work my plan because it is time in the market—and not timing the market—that matters.
6. I will adhere to my plan and continue to rebalance (i.e., systematically buying more of what hasn’t done well recently) rather than “unbalance” (i.e., buying more of what’s hot).
7. I will not focus my portfolio in a few securities, or even a few asset classes, as diversification remains the closest thing to a free lunch.
8. I will ensure my portfolio is appropriate for my goals and objectives while only taking risks worth taking.
9. I will manage my emotions by learning about and acknowledging the biases and cognitive errors that influence my behavior.
10. I will keep my cost of investing reasonable.

Most of us find it hard to follow a sensible diet or a sensible investment strategy 100% of the time. If you must stray when managing your wealth or well-being, moderation is the key. Chocolate cake is OK, as long as it’s not for dinner every night. Speculating on a stock or two is all right as well, as long as you don’t do it with your investment capital.

Finally, just as successful athletes rely on coaches and trainers to help them achieve their goals, most investors can probably benefit from having a “financial coach” to remind them about their New Year’s resolutions and keep them on track toward a more prosperous future.

I wish you and your clients good health and good wealth in 2011.

The comments of Weston Wellington are gratefully acknowledged.

Many investors understand the need for portfolio management.

Unfortunately, most investment professionals work very hard to make their portfolio management extremely confusing.

• They have a vested interest in creating investor confusion.
• They use jargon designed to intimidate you and make it difficult for you to understand.

But portfolio management is actually not that complicated if you stick to five key concepts for portfolio management success.

Concept One: Utilize Diversification Effectively to Reduce Risk

Most people understand the basic concept of diversification: Don’t put all your eggs in one basket. However, no matter how sophisticated you are, it’s easy to get caught in a trap. Proper diversification is a major key to successful portfolio management.

Concept Two: Dissimilar Price Movement, Diversification Enhances Returns

If you have two investment portfolios with the same average or arithmetic return, the portfolio with less volatility will have a greater compound rate of return. You want to design your portfolio so that it has as little volatility as necessary to achieve your goals.

Concept Three: Employ Asset Class Investing

Many investors feel that they could have executed better than they did during the last few years.

Unfortunately, most investors are using the wrong tools and put themselves at a significant disadvantage to institutional investors. The average investor who uses actively managed mutual funds is trying to fix a sink with a screwdriver, when they really need a pipe wrench. You need the right tools.

Almost all investors would benefit by using institutional asset classes due to:

1. Lower operating expenses
2. Lower turnover resulting in lower costs
3. Lower turnover resulting in lower taxes
4. Consistently maintained market segments

Concept Four: Global Diversification Reduces Risk

We’ve all read about the concept of a “global village”—that we’re getting closer and closer together.

Technology is creating a new paradigm in which businesses around the world are tied together, just as markets are now tied together. International investments should be a part of your portfolio.

Concept Five: Design Portfolios That Are Efficient

The process of developing a strategic portfolio using Modern Portfolio Theory is mathematical in nature and can appear daunting.  This concept boils down to one simple point: for every
level of risk, there is some optimum combination of investments that will give you the highest rate of return.

Given today’s market volatility, one of the most important things you can do as an investor is to ensure that your investment plan is current. Your plan should examine where you are now and where you need to go to
realize your financial goals, and should also identify the gaps you need to overcome.

In recent years, structured products have gained favor among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.

With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

Basic design

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula.

Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes. The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it.

Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain.

Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.

A few common characteristics of structured products are:

• 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. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.
• 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.
• Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.
• 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. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk.
• Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also 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. 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.
• Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

Who might benefit?

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent.

And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.

Proponents of active investment management believe that skilled managers can outperform the financial markets through security selection, market timing, and other efforts based on prediction.

While the promise of above-market returns is alluring, investors must face the reality that as a group, US-based active investment managers do not consistently deliver on this promise, according to research provided by Standard & Poor’s .

S&P Indices publishes a semi-annual scorecard that compares the performance of actively managed mutual funds to S&P benchmarks.

The report analyzes the returns of US-based stock and fixed income managers investing in the US, international, and emerging markets.

Over the last five years:

• About 60% of actively managed large cap US stock funds did not beat the S&P 500
• 77% of mid cap funds did not beat the S&P 400
• two-thirds of the small cap manager universe did not outperform the S&P Small Cap 600 Index
• Underperformance of active strategies is particularly strong in the international and emerging markets, where trading costs and other market frictions tend to be higher.

Furthermore, across the thirteen fixed income fund categories, all but one manager experienced at least a 70% rate of underperformance over five years.

Proponents of active investment management will simply say buy managers who can outperform the market. Of course, a couple problems occur with this strategy:

• It is impossible to identify managers who will outperform the markets in the future.
• Most managers who have outperformed the markets cannot consistently do so in the future.

The message is clear: As a group, actively managed funds often struggle to add value relative to an appropriate benchmark—and the longer the time horizon, the greater the challenge for active managers to maintain a winning track record.

With the dawn of a new decade arrives the financial media’s recommended investments.

Articles with attention grabbing titles such as “10 Stock Investments for the Next Ten Years” entice readers with promises of market beating returns.

But should you follow media’s investment recommendations? Consider the following articles published ten years ago.

In August, 2000, a Fortune magazine article presented “10 Stocks to Last The Decade.”

How would these ten stocks have performed if you spread your investments equally among each pick versus the market and a fully diversified portfolio*?

• Fortune’s 10 Stock Investments:  -44.21%
• S&P 500:  -7.26%
• Diversified Portfolio: +81.04%

Time period – August, 2000 through November, 2009.

Fortune’s stock picks drastically underperformed both the market and a fully diversified portfolio.

A second article by The New York Times asked for Buy and Hold picks from “10 very smart, very successful investment professionals…”

So how did these stock picks fair versus the market and a fully diversified portfolio?

• New York Times:  +25.17%
• S&P 500: -4.29%
• Diversified Portfolio:  +84.35%

Time period – February, 2000 through November, 2009

The New York Time’s picks beat the market but it seems a passively managed diversified portfolio drastically outperformed these “very smart, very successful investment professionals…”

Think twice before rushing out and investing your money in any of the media’s picks for the next ten years!

Having a financial plan and a fully diversified portfolio based on this plan is the best bet when investing for your goals and future.

*Fully Diversified Portfolio:
Dimensional US Adjusted Market 2 Index: 30%
DFA Equally Weighted Emerging Markets Index: 5%
Five-Year US Treasury Notes: 40%
Dimensional International Market Index: 25%
Rebalanced annually

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From the January, 2000 Smart Money Magazine:

“The Underachiever’s Club – Thanks for Nothing: Sixteen mutual funds reopened to new investors in 1999. But returns for these three make you wonder why they bothered.”

The three mutual funds highlighted in Smart Money’s “Underachiever’s Club” were:

• Lord Abbett Small-Cap Value
• Neuberger Berman Genesis
• Vanguard Windsor

The Smart Money article focused on each fund’s market underperformance since reopening – a period of only six months! Six months is hardly enough time to judge an investment or investment strategy.

Of course, it’s easy to find winners and losers using hindsight. The problem was, this article highlighted these funds as losers although they were on the verge of outperformance.

Look at the subsequent five-year (2000-2005) compound returns for each of Smart Money’s “underachievers” versus the general market.

• Lord Abbett Small-Cap Value: 17.05%
• Neuberger Berman Genesis: 17.44%
• Vanguard Windsor: 7.62%
• S&P 500: -1.13%

Investing based on tips from the financial media is dangerous to your wealth and will not help achieve your goals.

Finding an advisor you trust and developing a plan with that advisor will!

*This article does not represent a recommendation to buy or sell the mentioned funds. Past performance does not guarantee future results!

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