Learn How to Spot Investment Pitfalls

Don’t be Too Smart for Your Own Good

As we near the end of 2014, the stock market has resumed its upward trajectory. Once again, the Strategic Wealth Advisor strategies have soundly beaten the S&P 500.

Obviously that means that those who have been emulating these strategies continue to beat the key indexes. And more surprisingly, trounce the net returns of all but a few of the best managed mutual funds, hedge funds and money managers, all without margin, options or penny stocks.

However you might ask, “Isn’t the truly smart money at the big endowments and pension funds moving away from ordinary equities and bonds to invest in alternative investments?” Yes they are. And most of them are none too happy.

As reported recently in the Wall Street Journal, “corporate pension funds and university endowments in the U.S. have missed out on much of the rally for stocks since 2009, following a push to diversify into other investments that have had disappointing performances.”

The institutions, ranging from large corporations such as General Motors Corp. to big universities such as Harvard, have been shifting to hedge funds, private equity and venture capital. But while these alternative investments outpaced stocks during 2008's market meltdown and are seen as potentially less volatile, they have badly lagged behind the S&P 500 since 2009, a period in which U.S. stock indexes have more than doubled and the SWA strategies have quadrupled.

Diversifying away from stocks could still work out, since many of these institutions enjoy very long investment horizons and won't need to spend the bulk of their assets until decades into the future. And obviously, averages don’t tell the whole story. A small fraction of alternative investments, especially private-equity firms, have done even better than the indexes. But don’t forget, hedge funds, venture funds and private-equity firms typically charge investors much higher fees than mutual funds and other traditional investments; this includes management fees of as much as 2% of assets plus a sizeable share of any gross returns.

So it’s important for any individual investor to ask himself whether he would  have been wise enough to invest in specific market-beating funds. If you were, you’d be smarter than the brilliant money managers at Harvard, Yale and Stanford:

• Harvard, with the world's largest endowment at $32.7 billion, had an average annual return of 10.5% over the three years, ending in June 2013.
• Yale, with an endowment of $20.8 billion, had a return of 12.8%. And,
• Stanford, with $21.9 billion, had a return of 11.5%.

Compare this with an average annual return of 18.45% for the S&P 500, including dividends, over that same period.

To make this point even clearer, consider just the year 2013. Those who simply bought the S&P 500 index were clearly wiser than the U.S. companies with the largest defined-benefit pension plans. These plans posted an average return of 9.9%, according to a survey of 100 large firms by Milliman, an actuarial services firm. Meanwhile, the S&P 500 returned 32% in 2013, including dividends, and the SWA strategies averaged 43.5%.

As the chart below shows, the last decade witnessed a mass migration from equities to alternative investments:

Strategy Shift

Consider the facts. Between January 1, 2009, when the market began rallying, and Mid-June 2014, the S&P 500 climbed 137%, including dividends. Meanwhile, the average hedge fund was up 48%, according to research firm HFR Inc.; the average equity hedge fund rose 57%. Over that same period, according to Cambridge Associates, private-equity funds climbed 109% on average, while venture-capital funds rose 81%. Meanwhile, the SWA strategies rose 247%.

It’s worth noting that the long-term results of alternative investments are somewhat better. Over the past 10 years, the S&P 500 climbed 114%, including dividends. Obviously that beats the 75% gain of the average hedge fund, as well as the average 68% return of stock-focused hedge funds. But, according to Cambridge Associates, it falls short of venture-capital funds which climbed 153%, over the 10-year period.

Far more important to Strategic Wealth Advisor readers is that only private-equity funds (the best-performing of all investment classes) with an average 10-year cumulative return of 304%, out-performed the return of the SWA strategies, at 236%.

But, don’t forget that private equity funds typically require seven-figure minimum investments, only accept money from those with a net worth of $5+ million, impose stringent liquidity constraints that make them inappropriate for most investors, and only grew at about half the rate of the SWA strategies over the most recent 5-years.

What can we learn from the recent performance of the big endowment and pensions funds? First, don’t chase returns; just because something did well in the recent doesn’t mean it will continue to out-perform. Second, don’t follow the herd; if all of your friends are going one way, you may want to consider going the other way. And finally, don’t confuse “being smart” with “being wise”; if good judgment was simply a matter of high-IQ, the funds at Harvard, Yale and Stanford would always deliver stellar returns.

Interested in finding out more?

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