Index funds, by contrast, are more tax friendly by nature.   As there is no manager darting in and out of stocks based on market forecasts, trading activity is reduced.  Fewer trades help keep a lid on transaction costs, and also minimize realized capital gains.  By simply tracking the market, index funds ensure the lion’s share of return lands in investors’ pockets. 

Consider Vanguard’s Total U.S. Stock Market Fund (symbol VTI).  The fund, which invests in all publicly-traded U.S. stocks, returned 1% in 2011.  Taxes on dividends reduced that by 0.3%, resulting in an after-tax return of 0.7%.  That may not seem like much.  But in 2011, it was nearly 5% more than what the average fund investor took home.

Longer term, the story is much the same.  From 2001 through 2010, Vanguard’s Total U.S. Stock Market Fund earned 3.75%.  With a tax burden of just 0.31% per year, 3.44% made its way to investors’ bottom lines.  Actively-managed large cap stock funds earned 3.22%, on average, before tax.  Taxes ate 0.73%, leaving only 2.49% for investors.

How much do taxes matter?  For every $1,000,000 invested, the difference between 3.44% and 2.49%, compounded annually over ten years, is $123,600.

Beyond making the tax-savvy decision to favor index funds, a few additional strategies Vista employs help ensure taxes don’t take too big a bite out of our clients’ returns:

• Asset Location—Place highly-taxed assets (e.g. bonds and REITs) in tax-deferred accounts and favor more lightly-taxed stocks in taxable accounts.
• Tax Loss Harvesting—Trim positions trading at a loss, immediately replace them with a similar investment, and use the realized (“harvested”) losses to wipe out future gains.
• Municipal Bonds—Favoring tax-free over taxable bonds often has appeal for clients in higher tax brackets.  A muni bond yielding 3% delivers the same income as a 4.5% taxable bond.

We recognize how boring these strategies may appear relative to the dizzying complexity peddled by Wall Street.  And therein lies their appeal:  simple, sensible and quietly effective.  It sure beats salt in the wounds.

This new fund invests in top-rated, non-U.S. government bonds.  These bonds complement our existing holdings in high-quality U.S. Treasury Bonds, Treasury Inflation Protected Securities (TIPS), and tax-free municipal bonds.  When investing in bonds, our primary objective is safety and capital preservation during periods of stock market distress.  High-quality international government bonds help fulfill this objective.^[1]

¹ International Bonds are represented here as the weighted average of the following countries’ 1-5 Yr hedged government bonds: Japan—20%; France—15%; UK—15%; Germany—14%; and 4% each of Austria, Canada, Denmark, Finland, Netherlands, New Zealand, Norway and Sweden. U.S. Bonds: Barclays Capital Treasury Bond Index 1-5 Years. U.S. Stocks: S&P 500 Index. Average Return is 1995-2011. Great Recession is 11/2007-02/2009. Tech Bubble Burst is 04/2000-03/2003. All returns annualized.

Why?  It’s all a game.  A charade.  A ploy to sell more magazines and line Wall Street’s pocket with fees.  So, with this year’s stock market guides now hitting stores, we think a review of last year’s predictions might provide investors with the necessary caution:

Fortune Magazine assembled a team of Wall Street pros to share its “Ten Best Stocks for 2011”.  Unfortunately for readers, six of the ten stocks plunged an average of 37%.  (The S&P 500 Index returned 2%).^[1]  Transocean declined 40%, Royal Caribbean fell nearly 50%, and Entropic Communications plummeted 60%.  The average return for all of Fortune’s “Ten Best”?  A total bust—down 20%.

SmartMoney published its own “Where to Invest” guide, in which it shared the stock picks of fund managers from the likes of T. Rowe Price, Legg Mason, and Morgan Stanley.^[2]  These experts, hinted SmartMoney, had a track record of making “the boldest moves in dark times.”  How did these gallant Wall Street pros fare?  Not so well.  Their daring picks turned out to be nothing more than duds. The average return for the 13 stocks listed, from recommendation date through year-end, was a whopping zero percent.   

Barron’s assembled ten of the industry’s most “estimable” investors—the likes of Abby Joseph Cohen, Bill Gross , and Mario Gabelli—to share their insights for the year ahead.^[3]   Most of the pros warned against Treasury bonds (up 13% in 2011), favoring instead commodities (-12%), gold (+14%) and stocks in high-growth emerging markets (-18%).  Eight of these “market mavens” provided stock tips; only two selected stocks which collectively delivered positive returns.  The average return of all eight experts’ picks?   Minus 3%—five percentage points less than the S&P 500 Index. 

The Wall Street Journal proclaimed “the stage is set for stock-pickers to shine”, yet cautioned readers against picking just any active fund manager.^[4]  Most managers, claimed the WSJ, are really “closet indexers”, meaning they claim to pick and choose stocks but in fact seek to closely track their benchmark index, such as the S&P 500.  The WSJ suggested investors try a different approach:  favor only those managers willing to make big active bets and deviate significantly from the index by holding concentrated portfolios of just their best stock ideas.  The WSJ identified four such managers willing to “chart their own course.” And chart their own course they did.  While the S&P 500 Index returned 2%, three of the four funds ran aground—underperforming the S&P 500 Index by at least 5% each.   

Longtime Forbes columnist and money manager Ken Fisher peered into his crystal ball and declared 2011 would be “an easy one for stock pickers”.^[5]  He then recommended five stocks readers must buy.  From the January recommendation date through December 30th, Fisher’s five recommendations tumbled an average of 20%.  Oops.

What’s the takeaway for investors?  Instead of seeking to predict the unpredictable, investors should focus on the things they can control—asset allocation, minimizing costs and taxes, and staying disciplined.  After all, reading an expert’s view of the future is entertaining, but following that advice sure can prove costly.

Employees cited, as an example, Ameriprise’s diversified bond fund offering—which costs 0.78% per year—as “some 71 basis points more than a comparable offering from Vanguard.”  Plaintiffs say Ameriprise selected such funds as a way to earn more in fees, despite the fact such fees directly eat into investor returns.  Employees allege they collectively lost more than $20 million related to high fund costs.

As long-time champions of low-cost investing, we can empathize with these employees’ frustration.  But we believe there’s another story here which has gone unreported:

A little digging on Ameriprise’s website reveals that of all US taxable bond funds available to customers of the firm, the average cost is 1.08%^[2].  That’s 50% higher than the cost of the fund referenced in the lawsuit, and 15-times higher than the comparable Vanguard fund to which Ameriprise employees presumably wish they themselves had access.

This begs the question: When do customers of Ameriprise get to file their suit?

¹ Mercado, Darla.  “Ameriprise workers sue over company’s own 401(k) funds.”  Investment News.  September 29, 2011.

² Ameriprise Financial Mutual Fund Finder.  Average expense ratio for all no-load, Domestic Taxable bond funds.

For those unfamiliar with the nation’s debt ceiling history, it has almost always been this way—contentious, dramatic, and down-to-the-wire.  Since the aggregate debt limit was created back in 1939, it has been lifted almost 100 times.^[1] Many of these incidents were preceded by similar political posturing and predictions of financial disaster.

On each of these past occasions, however, a deal was reached to raise the debt limit and pull our government from the brink—often at the eleventh hour.  Just as in this instance, The U.S. Treasury has repeatedly been forced to use financial maneuvers to buy time while Congress and the President negotiate a deal.  To illustrate just how close we have cut it in the past, consider 1979 when the resolution of the debt limit issue was so late the payment schedule on a portion of short-dated Treasury Bills was missed.^[2] The incident was quickly resolved, but technically speaking, represented a default.

Despite the historical drama and confronting “this time is different” scenarios numerous times, the U.S. has enjoyed its coveted AAA credit rating for the past 70 years.  Notice from ratings agencies, Standard & Poor’s and Moody’s, on the potential for credit downgrades should provide added incentive for decision makers to reach a deal and make progress towards putting the country’s finances on a stronger footing.  One thing participants in this negotiation seem to agree on is the interest rate increase that would result from a credit rating downgrade would make paying down the debt and solving this problem even harder than it is now.

Use of the term “default” as it relates to Treasury Bonds also deserves a little more explanation than it is receiving in some of the press.  Some people might worry U.S. Treasury Bond holders will be left with nothing if the debt limit isn’t raised right away.  Our inability to issue more debt would not immediately result in existing debt going into default.  Actually, U.S. government revenue is still more than 5 ½ times the amount needed to make interest payments.  To be sure, the Treasury would have to make some excruciating choices about what to cut, but would likely prioritize interest payments, Social Security, Medicare, and “essential defense” payments over other types of spending.

Markets appear to be anticipating yet another last-minute debt limit deal.  Stock and bond prices are actually higher now, as the deadline nears, than they were earlier in the year.  The information conveyed by millions of investors with real money at stake is more reliable than the politically charged statements coming out of Washington.

Of course, no one can say with certainty what the short-term future holds.  We do believe, however, that a prudent investment strategy should be based—in part—on lessons learned from periods of past turmoil and not based on pure speculation about the future.  With that in mind, we continue to believe a diversified portfolio consisting of nearly every publicly-traded stock and real estate investment around the globe, complemented with Treasury bonds issued by the largest and most productive economy in the world, is the most effective protection against uncertainty.  That, and a healthy dose of discipline.

¹ Kirchgaessner, Stephanie, Richard McGregor and James Politi.  “US Debt Crunch: A Nation Taken To The Limit.”  Financial Times, July 14, 2011.

² Ibid.

Sharp increases in gross domestic product (GDP), however, do not automatically translate into bigger market gains.  Take China for example: The Wall Street Journal recently reported that between 1993 and 2010, China’s GDP grew by an inflation-adjusted average rate of 9.5%.^[1] The Chinese stock market, however, gained just 2.2% per year.

In fact, studies show the historical relationship between GDP and stock returns around the globe has often been the opposite of what one might expect—on average, low-growth countries have had slightly higher market returns than high-growth countries.  This was the finding of a recent MSCI Barra research bulletin that compared developed markets from 1958 to 2008.^[2] The experience in emerging markets has been the same.

Market expectations may partially explain these surprising results.   Expectations in high-growth countries can get overblown, pushing prices to levels that set the market up for disappointment.  In contrast, prices in low-growth countries can remain relatively cheap, leaving plenty of room for appreciation when low expectations are even slightly exceeded.

A few other considerations are worth keeping in mind, too, when thinking about the link between GDP growth and market returns.  First, the fruits of a country’s economic growth are not enjoyed exclusively by its publicly-traded companies and their shareholders.  Workers, governments, private companies, and multinational companies based in other countries also take their share of the benefits.  Second, companies must convert economic growth into profits in order to sustain stock prices and drive market returns.

Economic growth can form the foundation for a country’s market advances, but by itself, it is not an indicator of investment returns.  Prudent investors look beyond headline GDP figures and invest in globally-diversified portfolios, with country weights based on their relative size within the broader world market.

¹ Stein, Peter.  “Why Stocks Don’t Always Boom With the Economy.”  Wall Street Journal, February 21, 2011.

² ”Is There a Link Between GDP Growth and Equity Returns?”  MSCI Barra Research Bulletin, May 2010.

As far back as 2005, Robert Rodriguez bemoaned the “investment foolishness” in the market, noted the “financial strains” at Fannie Mae, Freddie Mac and identified problems in the real estate market.^[1] In June of 2007, Rodriguez delivered a speech to a group of financial analysts in which he outlined how the stock, bond, private-equity and hedge-fund markets were all caught up in “a speculative bubble”.  In December 2007, Rodriguez was so worried the credit crunch would cause a severe recession, he temporarily halted all stock purchases in his fund.  By March 2008, cash had swelled to more than 40% of the stock fund’s total assets.^[2]

For these spot-on predictions, Money Magazine declared Rodriguez to be “the best fund manager of our time.”^[3] How were FPA Capital Fund shareholders rewarded for Rodriquez’ prophetic calls?  Unfortunately, not so well.  The fund lost 35% in 2008.  Perhaps not the result investors had hoped for from someone who predicted the future.

The financial media’s praise of Rodriguez may take second fiddle, however, to the buzz surrounding Peter Schiff, president of brokerage firm Euro Pacific Capital.  He gained attention on major television networks in 2006 and 2007 with his bold forecast of over-leveraged American consumers leading the U.S. economy into recession.

In 2007 Schiff authored a book, Crash Proof:  How to Profit from the Coming Economic Collapse, in which he recommended investors pile into gold, commodities and high-dividend paying foreign stocks.  As conditions in the U.S. economy and the markets deteriorated, his predictions brought him fame as an economic guru who could help shelter investors from the storm. Nervous investors poured money into accounts with Schiff’s firm.

Sadly, for investors hoping to profit from Schiff’s advice, 2008 made mincemeat of their portfolios.^[4] Many Euro Pacific customers attested to losing 50% or more, much worse than the 37% drop in the U.S. market.  This was due, in part, to Schiff’s expectation that the weakening U.S. economy would cause the U.S. dollar to depreciate rapidly, providing an extra boost to shares of international investments.  Instead, the dollar advanced, magnifying the already steep losses in the international markets into which Schiff so aggressively steered his clients.

These examples highlight the difficulty of a market-timing strategy even for the smartest (or luckiest) of investors and provide a lesson for the rest of us:  When it comes to trying to beat the market, even correctly predicting the future may not be enough.

¹ Gullapalli, Diya.  “Manager Foresaw Crisis—but Didn’t Avoid Big Losses.”  Wall Street Journal, January 5, 2009.

² Annual Report, March 31, 2008.  FPA Capital Fund, Inc.

³ Zweig, Jason.  “The best fund manager of our time.”  Money, April 8, 2008.

⁴ Patterson, Scott, Joanna Slater and Craig Karmin.  “Right Forecast by Schiff, Wrong Plan?”  The Wall Street Journal, January 30, 2009.

Less attention, however, has been paid to how portfolio moves by large institutional plan sponsors—pension funds, endowments and foundations—have impacted those funds’ performance. Plan sponsors collectively control billions of dollars, are managed by professional fiduciaries devoting considerable time and resources to selecting managers, and have access to consultants who are paid specifically to help their portfolios outperform.  In other words, plan sponsors should know what they’re doing.  For this, they are labeled the “smart money.”

Just before the stock market began its swift decent in October 2007, a team of researchers headed by Boston University professor of finance Scott Stewart looked into whether the smart money makes better decisions than the individual investor.  Specifically, they wanted to determine if plan sponsors make or lose money when they hire and fire money managers.

The conclusions of Stewart’s research may surprise you.  The study found plan sponsors actually destroy value when shifting assets among managers.  Fired managers outperformed those hired by 3% in the year following the hiring/firing decision.  Over the subsequent five years, “fired” managers beat “hired” managers by 1% per year.

In dollar terms, these figures are staggering.  The opportunity cost of plan sponsors’ decisions, on average, amounts to $20 billion in the twelve months immediately following a decision to change managers.  Over one five-year period, as much as $77 billion was lost due to firing managers who subsequently outperformed and hiring managers who proceeded to underperform.

Professor Stewart concludes, “The effort that plan sponsors are putting towards hiring and firing managers is not just a waste of time.  It is actually hurting them.”^[1] It seems the “smart money” may not be so smart, after all.

¹ Heisler, Jeffrey, Christopher Knittel, John Neumann and Scott Stewart.  “Destruction of Value:  An Analysis of Manager Selection Decisions by Institutional Plan Sponsors.”  Working Paper, September 2007.

In spite of the overwhelming academic evidence supporting an index approach, most money is still invested with active managers who are paid to outperform the market.  One such fund is the Norwegian Government Pension Fund, one of the world’s largest professionally managed portfolios.  With over $430 billion in assets, the fund employs a staff of 249 to research and hire the best money managers.  Norway’s Ministry of Finance says the Fund’s mission is simple, “to be the best managed fund in the world”.  Given its ample resources, long time horizon and its unusual level of sophistication, it is hard to think of a fund more likely to succeed.

Norway recently engaged an international team of experts to evaluate whether or not they were accomplishing their mission.  The result was a 220-page report produced by three highly-regarded academics – Andrew Ang (Columbia Business School), William N. Goetzmann (Yale School of Management) and Stephen M. Schaefer (London Business School).  The report’s conclusion?  “The three professors found that for all their stock picking and do-gooding, the fund’s managers could just as well have thrown darts at a board….the fund’s performance was essentially indistinguishable from that of a passively managed index fund.”^[1]

Let’s review the immense factors working in the Norwegian fund’s favor.  The Fund is run by a team of 249 highly-skilled investment professionals who work day and night to select the world’s best money managers.  The Fund then benefits from huge economies of scale that allow it to negotiate ultra-low management fees and trading costs (they pay their managers .07% on average vs. the average mutual fund fee that’s well in excess of 1.0%!).  Finally, the Fund pays no taxes.  Given all of these advantages, if the Norwegian Government Pension Fund can’t beat the market, what chance do the rest of us have?

¹ “Passive Aggressive.” The Economist. February 4, 2010.

Mr. Kritzman devised a method to accurately measure the long-term impact of all the expenses associated with investing in a mutual fund or hedge fund.  He calculated average returns over a 20-year period for three hypothetical investments:  A stock index fund with an annualized return of 10%, an actively managed mutual fund with an annualized return of 13.5% and a hedge fund with an annualized return of 19%.  From these rates of return, Kritzman deducted the fees, expenses and tax costs associated with each type of fund to determine the return likely to end up in an investor’s pocket.

Mr. Kritzman found that, net of all expenses, including federal and state taxes, the index fund delivered the highest return at 8.5% per year.  The actively managed fund would have to outperform the index fund by an average of 4.3% per year just to deliver equal performance, net of all expenses.  For the hedge fund, that margin would have to be an astounding 10%.

That kind of outperformance is tough to find.  Of the 452 domestic stock funds in Morningstar’s database which have been around for 20 years, only 13 outpaced the S&P 500 index by an average of four percentage points per year or more.^[2] And these winners are only visible now with the benefit of hindsight.  Identifying, in advance, the small minority of funds that will outperform during the next 20 years is like trying to find a needle in a haystack.  In his study, Mr. Kritzman wrote, “It is very hard, if not impossible, to justify active management for most taxable investors, if their goal is to grow wealth.”

¹ Hulbert, Mark. “The Index Funds Win Again.” The New York Times. February 22, 2009.

² Ibid.