Larry Swedroe calls it the Holy Grail—the search for managers who can deliver returns that beat the appropriate risk-adjusted benchmarks. And it’s “a fool’s errand,” he adds; he spends much of his new book, The Quest for Alpha (John Wiley & Sons), reviewing the evidence for that view. Swedroe is a principal and director of research at Buckingham Asset Management in St. Louis, Mo., an RIA with $3.1 billion in assets; he’s also principal at BAM Advisor Services, a turnkey asset management program with more than $11 billion in assets, serving 130 RIAs. Swedroe says passive investing strategies —selecting asset allocations and rebalancing annually—are superior in the long run to techniques that involve picking stocks and timing markets. And he believes Buckingham has the record that supports its philosophy. “We’ve been doing this for 15 years. Our annual (client) turnover rate is about 1 percent. Clearly our clients think we’re adding great value,” he says. In this interview, condensed and edited for space, he talks about how advisors can make their case to skeptical investors.
Registered Rep.: If passive investing strategies are the way to go, how does a financial advisor add value?
Larry Swedroe: I think it’s that question that causes many advisors concern. “If I adopt a passive strategy, why will my clients feel they need to pay me? I’m not doing much, if anything.” I’d say, “You’re absolutely right, but if you’re a fiduciary advisor, you should do what’s in the client’s interest.”
RR: So what’s wrong with a client having an investment plan without an advisor?
LS: You could have the best investment plan of all, but the plan can blow up for reasons that have nothing to do with investing. A young guy gets married, dies, and his plan blew up because he didn’t have term insurance. We see people create great estate plans and pay big fees to attorneys, and then they don’t fund the trust properly or put the right type of assets in them. A very smart investor recently asked us to review his plan and assets. It turns out the guy was sitting with huge 2009 tax losses from his business. We said, “Convert your IRA to a Roth and you’ll pay no tax.” But nobody thought of that because he has an attorney and an accountant who aren’t his investment advisors, and there’s no one coordinating those things.
Rule number one is, the advisor has to have a well-thought-out investment plan that identifies your client’s ability, willingness, and need to take risk. Make sure the asset allocation is right, and you have to integrate this with well-thought-out estate, tax and risk management, meaning all kinds of insurance. You need to be doing all of those things and acting like a quarterback. It doesn’t mean you have to write their estate planning documents if you’re not an attorney. We don’t do their taxes, but we coordinate with their CPA to make sure we’re doing the most efficient things.
Number two, within the equity side you’ve got to decide how to asset allocate properly. We, for example, run Monte Carlo simulations for clients and do it every few years or whenever conditions change to make sure the asset allocations still make sense. And every quarterly meeting we review with them all the assumptions that went into the plan to see if anything’s changed. We ask, “Has there been a death in the family? Divorce? Did you change jobs?” Plans should be living documents.
Having a well-thought-out investment plan is only the necessary condition for investment success. You also must have the discipline to stay the course, meaning you have to rebalance as you go along, and that’s very hard if not impossible for most investors to do. In bull markets they get greedy and they tend to take on more risk and they don’t rebalance. “I don’t want to rebalance because I’ll pay taxes.” And on the downside they can’t rebalance because fear and envy take over; in most cases they even panic and sell. The advisor’s role, throughout the process, is to remind them why they had a plan, why they developed a passive strategy.
RR: What do you say to critics who, following the financial crash, argue that buy-and-hold strategies don’t work?
LS: A passive strategy does not mean buy, hold and do nothing. The whole idea of “buy and hold is dead” is nonsensical, because it never was buy and hold. An active investor is one who’s trying to manage returns. They do it either through stockpicking, market-timing or some combination of those things. Passive investors say, “I can’t manage returns because there are no good forecasters. While it’s possible to beat the market, it’s not likely I’ll do it. The risk-adjusted odds on an after-tax basis are close to zero. I don’t want to play the game.” What do I focus on? I passively accept whatever the market returns by the asset classes I chose to invest in. Then I rebalance my portfolio whenever the asset allocation exceeds my targets. You want to do it in the most tax-efficient way, so we tell people, don’t realize short-term capital gains unless they’re small.
RR: It’s very difficult for an investor to stand pat when the markets are tumbling.
LS: That’s how you add great value. You have to be an educator. Before you even accept your client’s money, you must educate the prospect on the history of investing, showing them what asset allocations like the one you’re proposing for them have done year by year, showing them what the worst one, two three years have been, and remind them that you cannot protect them from bear markets, and no one else can, either.
On an ongoing basis you have to be communicating with your client, and talking sort of counter to whatever the market is doing. So when the market is doing well, you need to be reminding them, “We’re going to have bad periods and that’s why we’re rebalancing now, we’re taking some of those chips off the table. And when it comes, we’re going to remind you that we’re going to need to buy stocks.”
We had a lot more chips off the table by the time 2008 came. Our clients were a lot better off. Many of our clients, those who started at 70-30, some of them were down to 20, 30 percent equities by the time 2008 came because they had done so well that they didn’t need the risk anymore.
What we tell people is, “An investment policy statement is a contract between you and you. You’re going to have to live with it. Our job is to be the enforcer, the sheriff. We’re going to try to do our best, but ultimately the choice is up to you, whether you stay the course.”
RR: Given the big run-up in stocks in the past two years, should investors be getting into equities now?
LS: Absolutely. We have a huge increase from extremely low valuations, and earnings have skyrocketed. Current PEs are actually at about historical averages. In 1999, one might have argued that the S&P 500 was overvalued, and you wouldn’t have gotten an argument from me. But it’s a very slippery slope. Because, remember, (former Fed Chairman Alan) Greenspan and (economist Robert) Shiller and others were saying it was overvalued in ’94; you would have missed the next six great years.
Most stock returns are caused by surprises. Did anyone forecast these rolling revolutions in the Middle East, or did anyone forecast the earthquake and tsunami and nuclear disaster in Japan? Trying to forecast or manage returns is the fool’s errand. You should focus instead on what you actually can control, which is the amount of risk you take, the types of risks you take, and then focus on controlling costs, and tax efficiency. That gives you the best chance of achieving your goals.
RR: How should advisors approach commodities?
LS: What people forget is commodities tend to go through decade- or decades-long periods of terrible returns. Prices are down for a long time; no new supply comes on the market. Mines don’t get started and oil wells don’t get drilled when you have $8 a barrel oil. Over 10 or 20 years, demand catches up and there’s no supply, and boom, prices start to take off over a relatively short period. And then something happens, like the Fed tightens under Volcker, and prices collapse. In 1980, gold hit $850 an ounce. Fifteen months or so later, it was down to like $330. Silver went from almost 50 an ounce to under $5 and stayed there for 20 years.
I don’t have crystal balls, I can’t tell you what’s going to happen with gold or silver, but it sure looks like a bubble to me because the prices are way above the marginal cost of production. And one of the things people forget is, unlike oil, which is a depleting asset, all the gold and silver that’s ever been mined is available for sale, pretty much. I think it’s perfectly fine to have a small allocation as an investment, a form of insurance, of gold or silver or commodities in general in your portfolio. And then just rebalance. But if you’re a speculator trying to time it, you’re crazy.