Understanding The Financial Crisis

Understanding The Financial Crisis

By Larry Swedroe The 10th anniversary of the Great Financial Crisis is the subject of lots of articles and media coverage. As a result, I’ve been getting many questions about what caused that crisis and what, if any, lessons we can take away from it to help prepare for the almost inevitable next one. I’ll begin with a brief review of the main causes. (Entire books have been written on the subject.) Unfortunately, while the media often focuses on the failure of financial models, the real causes can be found elsewhere. Origin Story The origin of the crisis stemmed from the political objective of increasing home ownership, beginning with FDR and including Reagan, Clinton and George W. Bush. This goal was aided by the enactment of the Community Reinvestment Act (CRA) of 1977. The CRA’s intent was noble—to encourage depository institutions to help meet the credit needs of the communities in which they operate and to eliminate “redlining” (not lending to anyone in certain neighborhoods) and discrimination. Next up was the Housing and Community Development Act of 1992, which established an “affordable housing” loan purchase mandate for Fannie Mae and Freddie Mac. That mandate was to be regulated by HUD. Initially, the 1992 legislation required that 30% or more of Fannie’s and Freddie’s loan purchases be related to “affordable housing” (borrowers who were below normal lending standards). However, HUD was given the power to set future requirements, and HUD persistently increased the mandates, which encouraged “subprime” mortgages. By 2007, the goal had reached 55%. In other words, more than half the loans originated were “affordable housing” loans. Like many well-intentioned...
Portfolio Pain and the Difficulties of Discipline

Portfolio Pain and the Difficulties of Discipline

By Larry Swedroe Earlier this week, I discussed why it’s so hard to be a disciplined investor, which generally is a prerequisite for being a successful one. Building on this theme, the “Factor Views” section of J.P. Morgan Asset Management’s third-quarter 2018 review provides another example of why successful investing is simple, but not easy. Value Investing Has Been Painful Over the last 10 calendar years, Fama-French data from Dimensional Fund Advisors shows that the value premium in the U.S. was slightly negative, at -0.8%. The value premium (HML, or high minus low) is the annual average return on high book-to-market ratio (value) stocks minus the annual average return on low book-to-market ratio (growth) stocks. Such long periods of underperformance will test the discipline of even those with a strong belief in the value factor. Compounding this issue is that, as the J.P. Morgan Asset Management report points out, since the beginning of 2017, the value factor has posted losses of nearly 15%. Furthermore, the second quarter of 2018 was the value factor’s second worst since 1990. The result, the report states, is that “the factor is now mired in the second worst drawdown since 1990 (eclipsed only by the dot-com bubble).” The value premium’s poor performance was not confined to the U.S. The report’s authors also write that “the current drawdown is worse in Europe (-20%) and Japan (-21%) than it is in the U.S. (-17%).” Importantly, the report’s authors offered this perspective: “In our view, this underscores that we are experiencing a natural sell-off of a factor whose performance is always cyclical.” All risky assets and factors can...
Mutual Fund Benchmark Discrepancies Can Fool Investors

Mutual Fund Benchmark Discrepancies Can Fool Investors

By Larry Swedroe Evaluating the performance of actively managed mutual funds generally involves comparing a product’s results with some passive benchmark (the SEC requires that funds select a benchmark for comparison purposes) that follows the same investment “style” as the fund’s portfolio (such as the S&P 500 for large-cap stocks, the S&P MidCap 400 for midcap stocks and the S&P SmallCap 600 for small-cap stocks). This practice can create problems, as funds can choose benchmarks with less exposure than they do to factors that historically have provided premiums (such as market beta, size, value, momentum, profitability and quality). Thus, the benchmarks have lower expected returns. This misleading practice is important because, as Berk Sensoy’s study, “Performance Evaluation and Self-Designated Benchmark Indexes in the Mutual Fund Industry,” which appeared in the April 2009 issue of the Journal of Financial Economics, shows, “almost one-third of actively managed, diversified U.S. equity mutual funds specify a size and value/growth benchmark index in the fund prospectus that does not match the fund’s actual style.” Unfortunately, the same research also shows that when allocating capital, individual investors emphasize comparisons relative to the mutual fund’s self-selected benchmark, not its true, risk-adjusted benchmark. It’s clear that fund companies strategically choose a benchmark that will drive fund flows. Recent Research Martijn Cremers, Jon Fulkerson and Timothy Riley contribute to the literature on mutual fund performance relative to self-selected benchmarks with their May 2018 study, “Benchmark Discrepancies and Mutual Fund Performance Evaluation.” They used a holdings-based procedure to determine whether an actively managed fund has a “benchmark discrepancy”; that is, a benchmark other than the prospectus benchmark that better...
Making Harmony with Money

Making Harmony with Money

By Tad Gray Dear Erika and Johannes, There’s a saying that goes, “The cobbler’s children have no shoes.” It means that we parents don’t always share our professional know-how with our own children. But now that you’re on the cusp of your careers, I would be remiss not to provide you with some financial guidance. Over the years I’ve been proud to watch you two grow to a remarkable level of artistry, and it has reminded me of all the joy I got from making music when I was younger. I’ve loved watching you from the audience just as I’ve loved the opportunities we’ve had to make music as a family. You’ve each demonstrated so much discipline in the pursuit of your craft. And I want you to know that that same discipline is all you need to manage the more practical sides of your artistic careers. As you know, I stopped pursuing music professionally when I was 23 – not much older than you are now – in favor of focusing on business. While I don’t regret that decision, financial concerns were an important part of it, so I’m sensitive to the challenges you’ll face. And since your mom continued her own musical career, I have remained connected to the economic reality of a musician’s life. If there’s one thing I’ve learned during my career in finance, it’s that your mindset is one of your most important tools. You know this is true for music, too. Just as our performance improves when we become more aware of our full selves, so does our relationship with money. With the right...
Know Your Risk Inclinations and Investor Personality

Know Your Risk Inclinations and Investor Personality

By Larry Swedroe In my book, “The Only Guide You’ll Ever Need for the Right Financial Plan,” there’s a detailed discussion on how investors can choose the right asset allocation for them, with the focus being on determining one’s ability (capacity), willingness (tolerance) and need (the rate of return required to achieve a goal) to take risk. To help with issues surrounding the willingness to take risk, risk tolerance questionnaires have become a very popular. Unfortunately, as Joachim Klement showed in his article, “Investor Risk Profiling: An Overview,” published in the June 2018 CFA Institute Research Foundation brief “Risk Profiling and Tolerance: Insights for the Private Wealth Manager,” the “current standard process of risk profiling through questionnaires is found to be highly unreliable and typically explains less than 15% of the variation in risky assets between investors. The cause is primarily the design of the questionnaires, which focus on socioeconomic variables and hypothetical scenarios to elicit the investor’s behavior.” He went on to explain that there are three problems questionnaires typically fail to address: Our genetic predisposition affects our willingness to take on financial risks, the people we interact with shape our views, and the circumstances we experience in our lifetimes—in particular, during the period psychologists call the formative years—influence our outlook. Being aware of biases at least gives us a chance of addressing them, either on our own or with the help of a financial advisor. Michael Pompian provides guidance on behavioral biases in his article, “Risk Profiling Through a Behavioral Finance Lens,” for the aforementioned CFA Institute Research Foundation brief. (Pompian also is the author of the 2012...
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