How You Can Reap Extraordinary Returns

Systematic Investing

The year 2013 saw the end of the long bull market in bonds that began in 1980. Led by Fed policy, expectations of higher interest rates have driven down bond prices.

In the face of low bond prices, individuals have increasingly turned to individual common stocks, as well as equity mutual funds and ETFs in their efforts to build wealth. But to do so, they have had to overcome the negative psychology growing out of the financial panic of 2008.

As a result, far too many waited on the sidelines after the recovery began in March 2009, and they missed much of the enormous run-up we’ve seen over the past five years. In fact, equity mutual funds only started seeing net in-flows of capital in 2013 and, as of year-end, those funds still showed substantial net asset withdrawals versus 2008.

A significant percentage of investors manage their own portfolios, making trades via brokerage firms. However, the shock of the 2008 crisis wiped out the assets and the confidence of a lot of these independent investors.

So, rather than manage their own portfolios, even more individual investors are investing in traditional mutual funds or ETFs.

Today, about 20 percent of equity mutual fund assets reside in so-called “index funds,” These vehicles passively mimic an index; and the mutual funds charge annual fees that average roughly 13 basis points for doing so.
While still relatively small, since the late ‘90s, the proportion of money invested in the index funds has been growing rapidly. Index funds are popular largely because a growing share of investors consciously or unconsciously subscribes to the so-called “efficient market hypothesis,” or EMH. EMH argues that with so much attention being paid to stocks, the opportunity to out-perform the market is virtually non-existent because all information is always priced into the market.

When combined with advantages of lower fees and relatively infrequent trading, selecting an index fund seems like a “no-brainer” to many. However, research and active real-world investing experience confirms that the EMH is a myth that investors would do well to avoid.

And ironically, the accelerating in-flow of assets to index funds, especially those that track the S&P 500, is making the market less efficient and creating even more opportunities for outperforming the indexes. Why?

Because index funds are mechanical constructs: They simply purchase a capitalization-weighted basket of stocks when they receive money from investors. They only change their selection and weighting when the index is updated.

As such, they add no information to the system. This means that an increasingly small number of active investors are actually setting the prices, which are then simply accepted by the indexes.

So, it’s not surprising that the remaining 80 percent of equity mutual fund assets remain invested in so-called “actively managed funds.” Because they are managed by smart humans these funds should theoretically perform better than index funds even after charging, on average, roughly 92 basis points per year in fees.

So, does this mean you should invest in actively-managed mutual funds and ETFs? Well, the evidence certainly doesn’t support investing in the “average” fund managed by the “average” fund manager. Why?

Over the past five years, roughly 80 percent of large-cap mutual funds under-performed the S&P 500, and that result is consistent with performance generated over the past 60+ years.

That’s mostly because active investors, whether amateur or professional, tend to be inconsistent in their approach to investing, as well as less than rigorous in their approach to stock selection. When coupled with the higher fees that active managers charge, you have a recipe for giving clients a poor deal.

That goes for genuine gurus, as well as run-of-the-mill fund managers. Consider the example of Harry S. Dent, Jr. Dent first came to the attention of the general public with the publication of The Great Boom Ahead in 1993; his 2014 book is titled The Demographic Cliff.

Obviously, he is very smart: He graduated in the top 5 percent of his class at Harvard Business School and went on to work for the premier consultancy, Bain & Company. Like the Strategic Wealth Advisor Editors, Dent focuses heavily on demography and combines it with his understanding of technology and human behavior. And to his credit, The Great Boom Ahead predicted the ‘90s tech boom quite accurately.

However, Dent’s subsequent advice was not nearly so useful to investors. For example:

• During the “up markets” between 2004 and 2006, Dent said the Dow would rise as high as 40,000 by 2009.
• During that period, he was running a mutual fund known as the AIM Dent Demographic Trends Fund; it once had $2 billion in assets. However, by the time it was merged into another, now-extinct mutual fund 80 percent of the assets were gone. Dent says that the poor performance was due to the fund not taking all of his advice, but that makes little sense because the fund was managed by his team at HS Dent Investment Management.
• Later, on Sept. 9, 2009, Dent launched an ETF as part of the AdvisorShares family. Through July 30, 2012, the fund lost 12.9 percent and was subsequently closed. By contrast, the Vanguard Total Stock Index Fund gained 42.7 percent over that period. In that same time frame, the stocks identified by the Strategic Wealth Advisor Premier strategy delivered a 66.4 percent gain.
• Despite Dent’s astoundingly poor back-to-back performance, his website still describes the so-called “Dent method of investing” as "the ultimate economic forecasting tool for asset protection and growth."
• Notably, Dent’s new book, released on January 7, 2014, is selling well. It predicts that the Dow will fall to under 4,000 in the coming decade. Hopefully, that forecast will prove even less accurate than his forecast of 40,000 for 2009.

What can we learn from Dent’s story? First, investors have a strong “confirmation bias” when it comes to financial matters. And second, they hate uncertainty. Dent, like other fund managers and newsletter publishers who promise “too good to be true” gains, is almost always telling people just what they want to hear.

Consequently, in good times, his books and newsletters predict more good times. In bad times, he predicts things will only get worse. And predictably investors readily buy into such arguments with which they already agree. As a result, confirmation bias blinds them. So much so, that few even do a routine Google search to see what kind of track record their “flavor-of-the-month market guru” actually has.

To review:

First, contrary to the Efficient Market Hypothesis, the indexes can be consistently beaten with the right strategy.

Second, most actively-managed funds perform worse than the passive index funds, because few managers are analytically rigorous in formulating their models or consistently disciplined in applying them. On top of that, the high fees charged by active managers negate the net benefits of marginal outperformance.

Third, market gurus who promise “too-good-to-be-true returns” may perform well for short periods, as Dent did in the ‘90s. But, they almost always “crash and burn” over the long haul.

In the mid-‘90s, our editors set out to validate and exploit these three observations. The work started with a careful examination of the investment strategies formulated by highly successful and methodical investment professionals like William O’Neil, James O’Shaughnessy, and Nobel Laureate Eugene Fama. The hallmark of these strategies was that they could be:

• Objectively assessed
• Validated in real-time
• Thoroughly back-tested

he objective was to identify a very small, but powerful, set of strategies that would enable us to comfortably beat the major indexes year-after-year without taking excessive risk or incurring wealth-sapping fees and commissions. And, that goal was fully achieved!

To understand, consider what we call the SWA Premier strategy: It started with our summary of James P. O’Shaughnessy’s first book, Invest Like the Best, in which he laid out his research into the predictive value of a wide-range of market-related variables. He later wrote What Works on Wall Street that introduced what has become his firm’s Market Leaders Value Strategy. O’Shaughnessy’s methodology was shown to outperform the S&P 500 index from 1963 to 2013 by over five percent per year compounded. And, it also outperformed it in all but one three-year rolling period since 1963.

More importantly, in live real-time trading over the past 12 years, it performed nearly twice as well as the Russell 1000 or the S&P 500 indexes. As a result, every $100,000 invested in this strategy at the beginning of 2002 grew to $439,502 by the end of 2013. By comparison, the same amount invested in the S&P 500 only grew to $205,136. And notably, the strategy beat the index with lower risk than the index funds.

Our editors have refined and implemented this as the SWA Premier Strategy. As mentioned earlier, a key weakness of the passive index funds is using market capitalization as their sole criterion for stock selection and weighting. Research shows that size alone is not a particularly useful way to select and weight stocks in a portfolio.

To replace market capitalization in the selection and weighting process, index-beating strategies employ the stock selection criteria that have been shown to be the most predictive of strong future returns across U.S.-listed large capitalization stocks.

The resulting Premier Strategy model, featured in our Strategic Wealth Advisor newsletter, favors companies with attractive valuations and strong yields, while avoiding companies with bloated and unsustainable balance sheets, poor earnings quality, and poor recent earnings growth trends. Fortunately, each of these criteria can be objectively measured using publicly available data, and then applied with the same rigor and consistency that passive index funds use. This eliminates the emotional element from the trading process.

Here’s how the SWA Premier Strategy five-step evaluation and selection process works:

1. Focusing on large- and mid-cap stocks, evaluate earnings based on both profitability and quality of earnings.
2. Use balance sheet data to avoid companies that are highly leveraged, borrowing at an excessive pace, or have insufficient operating cash flows to service the interest on their debt.
3. Evaluate the yield on each stock, combining dividend yield and the rate of share re-purchases over the prior 12 months.
4. Focus on the most important factor: valuation. To do so, use metrics like price-to-earnings, price-to-sales, and price-to-book. Research clearly shows that stocks that look cheap based on all of these valuation metrics produce the strongest future returns.
5. Once the “best” stocks are selected, allocate the investment in each of them equally, instead of weighting them by market capitalization, as the major indexes do.

O’Shaughnessy’s firm implements the Market Leaders Value strategy for high net worth clients via managed accounts with broker fees, which eat into realized gains. That’s the price you pay to have one of the few great money managers, who has beaten the markets year-after-year, manage your money.

We launched Strategic Wealth Advisor to give subscribers access to the carefully researched strategies that have beaten the indexes year-after-year, so anyone can execute them, at or below the cost of an index fund. Most importantly, adhering to the Strategic Wealth Advisor strategies eliminates stress and anxiety, because it clearly tells investor using a particular strategy what to do and when to do it, based on solid, empirical evidence.

So, there’s no more worrying about short-term swings in the market. Trying to “time the markets” becomes a thing of the past, because you stay invested in the stocks that perform best through both up and down markets.

What’s the bottom line? Between now and 2033, the Dow is likely to soar to over 75,000, while the S&P 500 is expected to rise to well over 9,000.
Those who avoid the “too-good-to-be-true charlatans” and simply invest in passive index funds like those offered by Vanguard have a chance to earn a 500 percent cumulative return over the next 20 years.

Meanwhile, those who adopt the kind of well-considered active strategy found in the Strategic Wealth Advisor newsletter could turn that 500 percent rise in the market indexes into a return of 800 percent, 1,000 percent, or even more. While past performance is no guarantee of future returns, consistently applying a strategy that has outperformed the indexes for over 50 years is likely to produce superior results in the years ahead, during both bull markets and bear markets.