TH€INV€$TM€NTI££U$IONandFixinga Flawedbusiness model

By Marius Kerdeland Jolmer Schukken

“Investing is simple, but not easy”

This White Paper is provided for discussion purposes only and does not constitute fi nancial or other advice. The authors do not

accept any responsibility for any loss or damage which may arise from reliance on information contained herein.

The information contained in this White Paper is, unless other-wise stated, the copyright work of the authors.  It may not be

used for any purpose whatsoever without obtaining the authors’ explicit written permission in advance.

This is the 2nd edition, published in November 2010

The 1st edition was published in December 2009

Contents3 Introduction

5 The Investment Illusion7 1.1 Stock picking: the investor’s favorite game9 1.2 Fund Picking: the advisor’s favorite game13 1.3 Market Timing: the fortuneteller’s game16 1.4 Conclusion

17 The Investment Solution17 2.1 Simple Truth 1: Discipline and taming the beast: you!22 2.2 Simple Truth 2: ‘Going Dutch’ works wonders27 2.3 Simple Truth 3: Manage risk, don’t chase return30 2.4 Conclusion

31 A Flawed business model31 3.1 Flaw 1: The confl ict of interest32 3.2 Flaw 2: The revenue model

35 Fixing the Flaw35 4.1 The fee-only advisor36 4.2 The customer owned fi rm

39 Summary

41 Epilogue

43 Appendices43 Appendix 1: From Berkshire Hathaway’s 2005 Investment Letter45 Appendix 2: Academic research49 Appendix 3: Warren Buffet as a hedge fund50 Appendix 4: Market timing - The story of Quincy & Caroline by Dalbar Inc.51 Appendix 5: The Arithmetic of Active Management54 Appendix 6: Example of a balanced No-Nonsense Portfolio56 The authors: Marius Kerdel and Jolmer Schukken

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IntroductionWe, the authors of this White Paper, have been active investors for the better part of our lives. After spending all this time playing and studying the market we had hoped to learn what works and what doesn’t. We had imagined we’d fi nd a way to pick the right invest-ments and time the market. Like so many gurus, we would have loved to write about how that is done. The truth is that our results brought more questions than answers. In fact, after many years of investing we were probably more confused than when we started.

And we are not alone. Most people around us, family, friends, but also colleagues from the fi nancial industry, are confused. Con-fused about how to invest, what advice to follow and whom to trust. Since investing plays, or will play, a crucial role in most of our lives we decided to look for answers. We have come to a sur-prising conclusion: investing wisely is easier and cheaper than ever!

Why, then, are most investors confused? Humans in general are not wired to make decisions under uncertainty and most of us are not well educated in fi nance and investing. It would seem logical that the asset management industry would educate us and help us deal with the uncertainty. Unfortunately this is not in its best interest, and instead of providing investors with a solution, the industry has created the illusion that with their help you can beat the market. The cost of participating in this illusion has been increasing for years and as a consequence investors have lost out. If the situation does not improve many of us will face increasing problems in funding our retirement.

In Chapter 1 we will analyze the Investment Illusion and show that it does not yield long-term results. In Chapter 2 we present a simple solution. This solution is not something we invented, it is not new and it is not unique. In fact it has been around for de-cades, has been well researched and is supported by a wide range of respected investors and lauded academics. In Chapter 3 we discuss the asset management industry’s core problem: the confl ict of in-terest between the investment ‘professionals’ and their clients and how this inevitably leads to a fl awed business model. In Chapter 4 we share our thoughts on how to ‘Fix the Flaw’: a confl ict-free business model that implements the investment solution and edu-cates society on investing.

The evidence presented in this white paper is based on indepen-dent academic research from, amongst others, nine winners of the

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Nobel Memorial Prize in Economic Sciences1. With a couple of ex-ceptions, all the investment giants of our time agree with and sup-port the conclusions. In other words, we did not make this up, but are reiterating an important message, which unfortunately is too often hidden or ignored. We hope that doing this will help reduce confusion amongst individual investors and that it will encourage potential partners to join us to bring change to a malfunctioning industry.

1 Daniel Kahneman, Robert Merton, Myron Scholes, Harry Markowitz, Merton Miller, William F. Sharpe, Franco Modigliani, James Tobin and Paul Samuelson.

The Investment IllusionThe asset management community has moved from investing to speculating. From focusing on reliable long-term returns from re-sidual income and economic growth, to chasing short-term price fl uctuations in unpredictable markets. This move has created a lot of ‘fi nancial’ activity that is detrimental to the return for the ulti-mate investors.

The math is simple: corporations generate profi ts, which in principle are available directly to their investors. However, a whole layer of brokers, fund managers and advisors, or ‘helpers’2 has emerged to reroute and redistribute these profi ts, even though the ultimate group of investors has not changed. All costs incurred by these parties are deducted from the corporate profi ts before they reach the ultimate owners, the investors. The group of ‘helpers’ and their income has been growing continuously. Unfortunately, the more the asset management industry takes, the less the inves-tor makes.

Costs of investing vary between brokers, funds and countries and depend on the liquidity of the security involved. This makes it challenging to determine the exact level of costs ‘in general’, but reasonable estimates can be made. To the average investor the cost of ‘intermediation’ may not look signifi cant on an annual basis, but compounded over a longer period the impact can be devastating. For a European investor who works with an advisor, the average annual costs are estimated to be around 3%3 of the assets under management. The average gross income on stocks (dividends plus capital appreciation) between 1900 and 2009 was 8.6% globally.4 The average investor starts saving about 40 years before retiring. A sum of $1,000 invested at the global historical rate will grow

2 The story of the Gotrocks family and their Helpers from Berkshire Hathaway’s annual letter is attached in Appendix 1. It is a must-read for every investor serious about preserving his savings.

3 See Chapter 2.2.

4 US$ return: Global Investment Returns Yearbook 2010.

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to $27,100 over this period. However, deducting the annual cost of 3% reduces the sum to $8,800, just 33% of the market return. Comparing results to the market is not completely fair, as some level of frictional costs to purchase and hold a diversifi ed portfolio of stocks is inevitable. However, 3% is not just ‘some level’. It is a value-destroying amount that should and can be avoided. As John Bogle puts it: “the wonderful magic of compounding returns is overwhelmed by the powerful tyranny of compounding costs.”

Of course costs to the investor equals revenues for the asset management industry. Herein lies the core of the problem. It is in the industry’s interest to promote as much activity as possible, as this allows them to charge the investor the maximum amount, both for the high level of transactions and for their perceived ‘added’ value. After all, why pay someone who doesn’t do anything? That is why the whole marketing machine of the industry is focused on spawning more investor activity. The industry is supported in this endeavor by the fi nancial media, and the biggest advertisers in fi nancial media are? … exactly.

The core message of the asset management industry is that we, the individual investors, can use them, the managers of assets, to outsmart and outperform the other investors. In convincing us that this is possible, most ‘advisors’ focus on three investment ac-tivities, or games, as we will call them:

1) stock picking,

2) fund picking, and

3) market timing.

The notion that you can beat the market by participating in these games is what we call the “Investment Illusion”. Since billions of marketing dollars and countless media hours are spent on promot-ing this illusion, it takes a wise person to resist. Unfortunately most of us end up playing along and the harm to our fi nancial wealth can be signifi cant.

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1.1 Stock picking: the investor’s favorite game

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is actually a third type of investor - the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.” - William Bernstein, The Intelligent Asset Allocator

The assumption behind stock picking is simple: “I am smarter than the market, and not once but continuously.” Is this possible? In order to answer this question, we fi rst need to understand whom we are trying to outsmart: Who is the market?

Charles Ellis, author of ‘Winning the Loser’s Game’ put it this way: “Before the seventies 90% of the market participants were individual investors and only 10% were what we have come to call professional investors. The 90:10 ratio has now been completely reversed and the consequences are profound. Today, 90% of all trades are done by professionals. In fact, 75% of all trades are done by professionals at the 100 largest and most active institutions.

What a crowd of professionals they are! Top of their class at graduate school, they are the best and the brightest, supplied with extraordinary information, disciplined and highly ambitious. The fact is that these professionals, as a group, are not beating the mar-ket! Why? Because they are the market and they cannot beat them-selves.”

But surely within these ranks of professionals, there are some who are better than others? Or maybe there is still the odd indi-vidual investor, who sees things that the professionals don’t see? Before we look at the facts it is important to distinguish skill and luck. What we attribute to skill with hindsight, might simply be luck, or put differently, statistical probability. Imagine a universe with only one thousand investors. Simply by chance 50% of them will beat the market in a given year and the other 50% will not. Straightforward statistics dictate that over a 10-year period one of these thousand investors will, simply by luck, beat the market ten years in a row. In our own ‘universe’, there are millions of inves-tors, so inevitably there will be many that have unbelievable, mar-ket beating, track records. When these chance results are explained and rationalized in retrospect it is easy to believe the performance was achieved due to skill. Unfortunately 50 years of independent academic research do not support this.

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Let’s fi rst look at individual, or what some call, amateur inves-tors. Individual investors are disastrous at picking stocks. Various studies have analyzed how active individual investors fare and they reach the same conclusion: on average individuals materially un-derperform the professionals and therefore the market. A recent Dutch academic study5 of 68,000 active investors showed that the average individual investor underperformed the benchmark index by 60% between 2000 and 2006. Only 10% of the indivi-dual investors earned cumulative net returns that were close to the benchmark index. The other 90% underperformed the index and 80% also underperformed the average benchmark mutual fund. A landmark US study6 found that, between 1991 and 1996, the average individual investors underperformed the market index by 18%, or 3.7% per annum. It also showed that the 20% most ac-tive investors earned net annual returns that were 5.5% per year lower than that of the least active 20%. According to the study, there is no statistically signifi cant evidence of any market-beating skill among individual investors. This is not to say they always picked the wrong stocks, but the average individual investor trades frequently and activity leads to costs, which over a longer period almost inevitably leads to underperformance of the index.

As we shall see, ‘professionals’ are only fractionally better at stock picking, but they have the disadvantage of charging for their ‘services’ before passing on the gains to the fi nal investors. And therefore their net returns to investors are sometimes even worse. This will be discussed in more detail in the next chapter.

These facts go against our intuition, maybe because we are overwhelmed by billions of dollars of marketing spin and endless success stories from the media telling us, with hindsight, that in-vestors everywhere are correctly picking the winning stocks and making millions in the process. And if they can do it, why can’t we? Of course it is possible. It is just highly unlikely because the odds are stacked against us. It is like playing the casino continu-ously and persistently. If you play long enough, the probabilities of consistently beating the house become infi nitely small.

What the industry should tell you is that if you want to do bet-

5 “The Performance and Persistence of Individual Investors: Rational Agents or Tulip Maniacs?”, Rob Bauer, Mathijs Cosemans and Piet Eichholtz (Maastricht Univer-sity), February 2007

6 “Trading is Hazardous to Wealth: The Common Investment Performance of Indi-vidual Investors”, Brad Barber and Terrance Odean, The Journal of Finance, April 2000

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ter than the market average, they can help you to take more risk. But taking risk shouldn’t be confused with market-beating skills. Unfortunately the fl ipside of the risk coin is that you also have a bigger chance of doing worse, especially after paying the costs of all those ‘value-adding’ helpers.

1.2 Fund Picking: the advisor’s favorite game

“Why pay people to gamble with your money?” - William Sharpe, Nobel Prize winner 1990

We have moved from a world of direct investing in stocks and own-ing part of a corporation to indirect investing through investment funds. Investing via a fund can make a lot of sense. The economies of scale achieved by pooling investments can give investors access to broadly diversifi ed portfolios,7 which would not be practical or cost-effective for them to build individually. However the average costs of investing in funds have risen steadily over the last 50 years, even though the operational cost of investing has continued to fall. The average US equity fund now charges around 2.0% in total expenses per year and the average European equity fund charges 2.7%, both excluding transaction costs, which could add another 0.8% on average.8 This suggests sharing costs is no longer the funds’ raison d’être. Instead funds have become one of the favored tools of the fi nancial industry to make money for themselves and their shareholders. Unfortunately they usually don’t do the same for their clients.

The high level of profi ts has made this a very attractive business to be in. Today the number of available funds is larger than the number of available stocks. Globally there were 45,358 companies with a stock market listing at the end of 2009 and almost 47,0009 mutual funds trying to fi sh the best out of this pool. As described in the previous chapter, with so many funds competing and deal-ing amongst themselves, how can they all outperform each other?

7 As we shall see in chapter 2.2, diversifi cation – investing in many different compa-nies – is essential to managing the risk of your portfolio.

8 See chapter 2.2.

9 World Federation of Exchanges, annual report and statistics 2009 and “Mutual Funds Fees Around the World”, Khorana (Georgia Tech), Servaes (LBS) and Tufano (HBS), February 10, 2006. Dutch Association for Investors (VEB) and the World Federation of Exchanges (an association of 56 regulated exchanges around the world).

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But we read about fund managers with market-beating track records all the time so surely they exist, right? Of course! Simple coin fl ipping tells us that on average 50% of these 50,000 funds will outperform the market in a given year. This means that statisti-cally over 1,500 of them can be expected to outperform the market fi ve years in a row. If we allow them at least one year in which they underperform, this number increases dramatically. Morningstar and many other fund rating companies are in business to provide an overview of these best performing funds over the years to ea-ger investors. Magazines and newspapers will write exciting stories about these top performers and many investors will use this infor-mation to make investment decisions.

The important question to ask is: Are there funds that, other than by luck, consistently outperform the market? The simple an-swer is NO. In a given year the best performing funds tend to out-perform due to the market favoring a particular industry or ‘style’ of investment. Examples of styles are technology stocks in the late nineties or emerging markets and commodity related companies over the last decade. Unfortunately the world changes, so styles go out of favor and performance doesn’t persist. Even fund managers who do possess unique skills or knowledge in certain niche areas have not been able to sustain their performance. In a way they become the victims of their own success. Their strategy may have worked in a small market for a small fund, but once they become successful and attract a lot of capital, it usually turns out that their strategy cannot be replicated at this larger scale or other funds have started to copy their tactics, thereby neutralizing the opportunity. Unfortunately most investors will start to invest once the fund has already passed its prime. Therefore investors in these funds will, on a net returns basis, actually underperform the market due to untimely entries and because the funds charge the investor for their ‘services’.10

Once again the math is simple. As the average gross return of all funds is approximately equal to the average market return, the average net return will obviously be the average minus these costs, often more than 3%. So if the average fund underperforms the market by such a signifi cant amount, how likely is it that we can outperform the market by picking the best funds? Extremely un-likely!

10 There is an abundance of research on this topic. Appendices 2.1 and 2.2 give an overview of the most reputable studies about mutual fund performance.

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If this is so straightforward, why has there been such an infl ow of capital into funds?11 One of the reasons is that the fi nancial mar-keting machine is particularly good at marketing and selling funds. As a potential investor you will only be shown funds which can boast impressive market beating performances. Underperforming funds are closed down or merged with other funds, and in many cases their track records are erased from public sources to preserve the fund company’s or the issuing bank’s reputation. In fact many companies will start multiple funds every year, often with their own money. The ones that happen to perform well are subsequent-ly marketed, using this attractive, retrospectively selected track re-cord. The losers are closed down without ever becoming public. Analysis of public data therefore overstates the performance of funds signifi cantly due to survivorship bias: it only takes the sur-viving funds into account and not those which are closed down or don’t even make it into the public space to begin with.12

These facts have not kept investment advisory fi rms from in-creasingly pursuing the game of fund picking for their clients. The main reason for this is simple: larger profi ts. Most advisors get paid by the client for managing their savings and by the fund ma-nagers for investing those savings in their fund. One wonders what the likelihood is that their advice is objective.13

The latest trend: investing with the stars! Over the last decade the most successful, or luckiest, mutual fund managers have star ted their own hedge funds,14 mainly for one reason: the enormous amounts of money they could earn. In 2008 the top ten high-

11 As explained above, there is a very good reason to invest in funds: it allows individual investors to share costs, thereby enabling diversifi cation. However the infl ow of capital has in a large part been driven by funds who claim to beat the competition by employing active and ‘expensive’ strategies, and who charge signifi cant fees for their efforts to accomplish this.

12 The CRSP Survivor-Bias-Free US Mutual Fund Database for the period from 2005-2009 for example showed more than 30% of active equity mutual funds did not survive this 5-year period. For Bond funds, the number was 28.5%.

13 See chapter 3.2.

14 A hedge fund is allowed to use investment strategies unavailable to mutual funds, including selling short and using leverage and derivatives. Hedge funds are exempt from many rules and regulations governing other mutual funds. They are restricted by law to a limited number of ‘professional’ investors. As the name implies, hedge funds often seek to offset potential losses but the term ‘hedge fund’ has come to be applied to many funds that do not actually hedge their invest-ments, but to funds using alternative methods to increase rather than reduce risk, with the hope of increasing return.

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est paid managers of hedge funds together earned an unbelievable $16.1 billion. It took an annual income of $210 million to make the top 25.15

On average hedge funds charge a management fee of 1.63%, take 17.21% of the profi ts earned and have other operational costs that are estimated at 2%.16 Since over 56%17 of hedge fund assets are invested through fund of funds, an additional average of ma-nagement fee of 1.26% and performance fee of 10.60% should be added for the majority of investors. Alle these costs need to be paid for by the exceptional performance that these ‘stars’ pro mise to deliver by capturing market ineffi ciencies, or alpha.18 However, the rapid increase in the number of funds trying to capture alpha has greatly reduced the ineffi ciencies. If historical market returns of around 8.4% continue, the average hedge fund has to beat the market by around 7% to deliver the same net return. The only way for hedge funds to do this is by taking more risk. If things go well they will reap huge incentive fees. Unfortunately if things go wrong the investor pays the bill.

Hedge fund success stories make wonderful headlines. Rarely mentioned is the enormous number of hedge funds that fail.19 For investors it is practically impossible to pick the winners in advance and due to the outrageous cost, the average hedge fund investor will underperform the market considerably in the long run.20

15 Alpha magazine by institutional investor.

16 “Hedge Fund Terms & Conditions Survey”, Preqin, July 2009, “A fee frenzy at Hedge Funds”, Business Week 2005. Operational cost calculations by LJH Global Investments.

17 Results of 2008 PerTrac Hedge Fund Database Study, April 2009.

18 A measure of a fund’s risk and return relative to the overall market. It refl ects the difference between a fund’s actual performance and the performance expected based on risk level taken by the fund manager. A positive Alpha shows that the manager produced a return greater than expected for the risk taken.

19 The median life of a hedge fund is only 31 months. Fewer than 15 percent of hedge funds last longer than six years, and 60 percent of them disappear in less than three years. King, M.R., and Maier, P., 2009, “Hedge funds and fi nancial stability: Regulating Prime Brokers will Mitigate Systemic Risks,” Journal of Finan-cial Stability, 5 p.285.

20 Appendix 3 provides an interesting perspective on return for investors in hedge funds.

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1.3 Market Timing: the fortuneteller’s game

“If I have noticed anything over these 60 years on Wall Street, it is that people do not succeed in forecasting what’s going to happen to the stock market.” - Benjamin Graham, legendary investor, Warren Buffet’s mentor and author of the investment bible “Security Analysis”, 1934

Since the start of public markets, stocks have seen tremendous growth. Over the long term this growth has largely been mirrored by the growth in earnings and dividends of the underlying com-panies. To put it in the industry’s terms: the ratio between stock Prices and companies’ Earnings (the P/E ratio), has tended to re-vert to the mean.21 This means that over time return on stocks is not dependent on all the short-term movements of the markets that the world is so obsessed about. It has come almost exclusively from dividends and earnings growth: fundamental investment re-turns driven by real earnings generated by real companies that fl ow to real investors. As we have seen, global return on stocks between 1900-2009 was 8.6%, or 5.2% in real terms. Only 0.36% of the real return was due to change in the P/E ratio. The other 4.8% of return came from dividends and earnings growth.22

Figure 1: Long term 10 year normalized P/E ratio S&P 500

21 The P/E ratio is usually calculated based on 10 year ‘normalized’ historical earn-ings: the average earnings over the last 10 years. The historical average mean P/E ratio in the US has been around 16 for instance, as estimated by a combina-tion of sources such as Capital Economics, The Bogle Financial Markets Research Center, Standard and Poors, Global Investment Returns Yearbook 2009. Similar ratios can be seen around the world.

22 Global Investment Returns Yearbook 2009.

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In the short run however, stock prices, earnings and the P/E ratio can change quite dramatically. For example, the S&P 500 index was trading at a normalized P/E ratio of around 7 in 1982, in-creased to 43 in 2000, before commencing a bumpy ride back down to 12 in March 2009.23 With these fl uctuations comes the opportunity of substantial gains and unfortunately the risk of pain-ful losses.

The assumption behind market timing is that these short-term movements of the market are predictable and that an investor can make money by selling or buying in anticipation of these moves. It is important to remember that if one party is selling at the right time, another party must get it wrong. After all market timing is a zero sum game: what is gained by one investor is lost by another on the opposite side of the trade.

Why would anyone choose to be on the ‘wrong side’ of a trade? Presumably because his expectations were different from what ac-tually happened. In other words, there was some unexpected news. Unexpected is the crucial term here, because if it was expected it would have already been incorporated in the current market price, and the ‘news’ would not have led to price changes. Market timing therefore only adds value if your prediction is correct and differ-ent from the rest of the market’s. In short, you have to predict the unexpected. There is another profession which claims to be able to do this …. it is called fortune-telling.

Of course you can get lucky. The real problem here is that you not only have to be right or lucky once, you have to be right almost continuously. After all the goal of the market timer is to capture the upswings and avoid the downswings. So you have to know when to get out of the market, but also when to get back in. When you are out of the market you are not exposed to risk. This may sound like an advantage, but risk is the source of an investor’s return. If you are not exposed you will not benefi t from the fundamental in-vestment returns: dividends and earnings growth. And every time you execute a trade in line with your market timing strategy, you will incur transaction costs. So in order to be successful at market timing, you need to be right when the rest of the world is wrong and your success rate in doing so needs to be substantially higher than 50% to make up for times when you are not exposed and to recoup your transaction costs.

23 Based on 10 year average real earnings. Data from www.econ.yale.edu/~shiller.

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Putting some numbers behind this: SEI Corp24 conducted a study over the period 1901-1990. To match the US stock market return of 9.5% over this period a market timer needed to correctly predict about 70% of the ups and downs of the market. The study also showed that if the market timer correctly called 100% of the declining markets and a full 50% of the rising markets, they still were not able to exceed the average market return over this period.

Research done in 15 international equity markets, incorporat-ing over 160,000 daily equity market returns furthermore indi-cates that a very small number of exceptional days have a massive impact on long-term performance.25 On average across all 15 mar-kets, missing the best 10 days resulted in portfolios which were 50.8% less valuable than a passive market investment. Given that those 10 days represent less than 0.1% of the days considered, the odds against successful market timing are staggering.

An annual study by Dalbar26 most clearly illustrates the impact of trying to time the market. It compares the long-term returns of the market with that of the net return earned by the average mu-tual fund investor. Between 1989 and 2009 the US market offered annual returns of 8.20% for equities and 7.01% for bonds. The average fund investor however earned just 3.17% on his equity investments and 1.02% on his bond investments primarily due to untimely entries by investing in funds near the peak of their per-formance cycle.27

But if the evidence is so clear-cut, why are we as investors so addicted to market timing? Maybe it is because the success sto-ries are so appealing and in hindsight it all sounds so incredibly logical. How could all of us not have predicted the fall of the fi -nancial industry in 2008 or the bursting of the internet bubble in 2000? Wasn’t it completely obvious? With hindsight it certainly was. However, using the lessons of the past to predict the next ‘big event’ is not easy. It assumes that past events will be repeated under

24 A leading information technology solution provider to the fi nancial industry since 1968.

25 “Black Swans and Market Timing: How Not to Generate Alpha”, J. Estrada at IESE business school, 2008.

26 “Quantitative Analysis of Investor Behavior 2008”, by Dalbar, an independent company committed to raising the standards of excellence in the fi nancial-services industry, founded in 1976.

27 For most funds there is a big difference between time-weighted returns that are reported and dollar-weighted returns earned by the average investor in the fund. This is primarily due to the fact that funds which had a good run are heavily mar-keted and attract most money at their peak.

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similar circumstances in the future. The reality is that history is determined by a few important events that are rare and unpredict-able. These events will seem obvious after the fact, but in reality few see them coming before they occur.28

In summary, you can get lucky, but almost without exception, investors do not possess market-timing skills. Independent aca-demic research supports this. In fact most of the studies indicate a negative timing ability. In other words, we tend to buy high and sell low as the Dalbar study above illustrates. This might be the only lesson that we can take from market timing. As Warren Buffet famously stated: “If investors insist on trying to time their partici-pation in the market, they should try to be fearful when others are greedy and greedy only when others are fearful.” Unfortunately most of us do exactly the opposite.29

1.4 Conclusion

Many of us are trapped in the Investment Illusion. We think that by investing actively we can outsmart the market and capture more than our fair share of profi ts that companies generate.

The asset management industry profi ts from this activity. There-fore their relentless marketing is focused on convincing investors to stay active by playing their three favorite games: stock picking, fund picking and market timing.

The cost of these games to the investors is income to the asset management industry. The costs reduce the returns available to investors by an equivalent amount, thereby changing active invest-ing from a zero-sum to a loser’s game.

Avoiding these games, and the costs that come with it, is a cru-cial step in successfully managing, growing and preserving your wealth.

28 Nicholas Taleb describes the human tendency to explain random outcomes as non-random in his books Fooled by Randomness (2001) and The Black Swan (2007). Taleb’s point is that the past frequently tells us nothing at all about the future, even though many of us believe it does and make investments accordingly.

29 As illustrated by a ‘typical market timing story’ in Appendix 4.

The Investment SolutionInvesting wisely is less complicated and cheaper than ever. If prop-erly implemented, the three simple truths below should help every investor to beat the majority of the ‘smart’ competition by a wide margin over time.

2.1 Simple Truth 1: Discipline and taming the beast: you!

“The investor’s chief problem, and even his worst enemy, is likely to be himself.” – Benjamin Graham

The main reason for mediocre investment performance is likely to be the person you see in the mirror. We think of ourselves as rational beings, but most of the time we are not. We are driven by emotion in all facets of our lives, but few things awaken the beast in us more than when we are investing.30 As a consequence, we often do not act in our own best interest when making investment decisions.

The lack of fi nancial education drives a lot of bad fi nancial deci-sions, but people with the proper knowledge, also make a lot of bad investment calls. Fear and greed drive many of our invest-ment decisions. It is why we tend to sell our investments when everybody is pessimistic and markets are down and we buy when everyone is elated and markets have gone up. This is called the emotional cycle of investing and can lead to disastrous investment results.

30 Daniel Kahneman won a Nobel Prize for his pioneering work with respect to behavioral fi nance, the fi rst psychologist ever.

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Figure 2: illustration of the emotional cycle of investing31

OPTIMISTIC

GREEDY

NERVOUS

FEARFUL

OPTIMISTIC

Lowest expected return

Highest expected return

The annual Dalbar study mentioned in Chapter 1.3 perfectly il-lustrates the damage of the emotional cycle. It showed that the average fund investor underperforms the market by more than 5% annually, and the average fund by around 2.5%, over the last 20 years because we buy after prices have risen and sell after prices have gone down.

The fi nancial media are partly to blame as they feed our emo-tions of optimism in good times and pessimism in bad times, but they only stimulate that which is inherently human. Below are oth-er examples of behavioral inclinations which cause smart people to make big investment mistakes.

Overconfi dence is a very common infl iction. Most people are overconfi dent about their abilities and they overestimate the pre-cision of what they know.32 On average, people who claim to be 100% certain, turn out to be right around 85% of the time. 70% of us think we are better drivers than the average person. For an in-vestor, overconfi dence is the biggest return-killer. Overconfi dence makes us think we know better than everyone else. It is why we try to time the market, pick stocks and funds, and subscribe for an IPO of a company we don’t understand. Empirical research is con-clusive: the more active an individual investor the worse his per-formance. If you think, “sure, that must be true for most people, but I am different from the rest”, you are likely suffering from an overconfi dence syndrome and could harm yourself fi nancially. If you are a man, next time you make an investment decision, talk to your wife, your girlfriend or your mother. Women are less over-

31 Adapted from “The Investment Answer” with permission from the authors Daniel C. Goldie and Gordon S. Murray, 2010.

32 E.g. Alpert and Raiffa (1982), Griffi n and Tversky (1992).

19

confi dent and are proven to be better investors.33 To paraphrase Zsa Zsa Gabor: “Macho is not the same as Mucho”.34

Familiarity bias. We hold onto or buy only those investments that we are familiar with instead of spreading our eggs over dif-ferent asset classes and securities to lower our risk for a similar expected return. Dutch investors generally look at and pick the majority of their stocks from the AEX index, although there are only 25 companies in that index, many of which have disappeared over the years. Another example of this bias is that employees of public and private companies all over the world tend to invest the majority of their retirement savings in their own company’s stock. They often unknowingly double up on the risk of their own com-pany by counting on its success both for their salary and future in-vestment income. Most of these people incorrectly think that their company is really better managed, more diversifi ed or safer than the rest. Too much concentration in an investment portfolio is one of the main reasons for investment failure and in some instances total collapse. Why would you want to increase your risk if you don’t need to? Greed and overconfi dence are a main cause, but the familiarity bias often also plays a role.

Another reason for diversifying too little is recency bias. In psychology, the recency effect is the tendency to remember recent events or observations more vividly and give recent information more weight than other information. Be careful! Past performance can mostly be explained by company, sector, country or style spe-cifi c factors. The future of specifi c companies is determined by unexpected events and the ubiquitous “past performance is no guarantee of future success” really is one of the best pieces of in-vestment advice around.

An interesting question related to our behavioral defects is the following: assume you are around 40 years old, currently have a small amount invested and will invest your annual savings or ex-cess cash until your retirement. If you had a choice, ceteris paribus, which would you prefer?

33 Barber and Odean (2001). Psychological evidence has proven that men are gener-ally more overconfi dent about their fi nancial decision-making ability than women. This overconfi dence leads overtrading, which is costly and leads to underperfor-mance. A new study by Hedge Fund Research found that, from January 2000 through May 31, 2009, hedge funds run by women delivered nearly double the investment performance of those managed by men.

34 The American-Hungarian actress knows what she is talking about: she married eight times.

20

A. Stocks go up by quite a lot and stay up for many years.B. Stocks go down by quite a lot and stay down for many years.

What did you choose? If you chose A you are not in bad company, the majority of professional investors did the same. It’s not the right choice. If you are a buyer of stocks you buy a right to divi-dends and earnings growth. If stocks are cheap, the dividends and earnings growth potential you buy with every dollar are higher. Many of us are net buyers of stocks for the foreseeable future and we should therefore want stock prices to go down and stay down so we can accumulate more at lower prices. However, most of us feel good about buying stocks in markets that have been rising, while the future return embedded in our purchases must be lower at these higher prices.

The fear of being average is a common trait amongst highly educated people, who are used to being the ‘smartest guys in the room’. Average can be a dirty word to them, as they tend to see it as a failure to live up to their capabilities. This makes some people hesitant to use passive funds to track the market. After all, that ba-sically ensures average returns, right? Actually it doesn’t. Investors who on a net basis have managed to match market returns with their portfolio over the last 25 years, have outperformed 90% of professional fund managers. Passive investing is not equal to ac-cepting average returns. In fact the opposite is true: sticking to the simple truths will secure your place amongst the best.

Financial negligence is the last common behavioral affl iction we will discuss. We work 40 hours a week for 40 years to save for a sound fi nancial future but spend more time buying a television, car or booking a holiday than we spend managing our investments. Excuses we give ourselves often include that we are too busy, mon-ey is not that important, or that it must be too complicated for us. These are indeed excuses. Investing wisely maybe challenging, but it is not complicated and should not take up a lot of time.

Understanding that our emotions can get in the way of a sound investment strategy is the fi rst and most important step to long-term investment success. Discipline is the medicine to implement it. A good way to enforce discipline and avoid falling into these behavioral traps is to make a sound long-term Investment Plan (IP). An IP can be seen as a ‘contract’ between the investor or investors and their fi nancial worth. It provides the general goals and objectives of the investor and describes the strategy to achieve

21

them. It should include an overview of the investor’s current fi nan-cial situation, liquidity needs and his willingness, ability and need to take risk. Putting everything on paper is a good start, but you may need some support. Sharing your IP with family members or an independent advisor has proven to help investors keep a cool head when everybody else is losing theirs. It will enable you to ig-nore the daily ‘noise’ thrown at you by the fi nancial marketing ma-chines, journalists and investment gurus convincing you that this is the time to buy, sell, short or long your way to fi nancial prosperity.

If part of you cannot live with the fact that investing with a strict investment plan is not exciting and fun, but boring and beau-tiful, it might be wise to establish a separate ‘casino’ account in which you put a small portion of your wealth and from which you can continue to invest actively. If you are lucky you will lose money often enough to resist the urge of converting all your assets into a game of chance.

In addition to giving us the discipline to focus on our long-term investment goals, a sound IP enables us to experience the beauty of rebalancing. Rebalancing means selling those assets whose relative value has increased and buying the ones that went down. The aim is to bring the relative weights of the assets back to their original levels, thereby ensuring the risk of the overall portfolio remains the same.35 Making this an automatic and periodic exercise ensures that you continually move against market sentiment and will sell high and buy low. Periodic rebalancing is especially powerful if combined with a portfolio of asset classes with limited correlation (see chapter 2.3). It also gives us the opportunity to profi t from the market’s behavioral defects, rather than to suffer from them by joining the crowds.

Truth 1: The hardest, but most important part of investing is not intellectual but emotional. Being rational in an emotional environ-ment is not easy, but awareness of the emotional traps and hav-ing the discipline to stick to a sound, long-term investment plan should help you achieve it.

35 To illustrate rebalancing with a simple example: say you start with a portfolio with $50 in stocks and $50 in bonds. Stocks have a very good year and go up by 20%, whilst bonds stay the same. Your overall portfolio will now be worth $110 and consist of $60 in stocks (55% of the portfolio) with bonds still at $40 (45%). To rebalance back to the 50/50 portfolio you need to sell $5 in stocks and use the money to purchase $5 in bonds. If stocks had gone down instead of up, you would have had to sell bonds to buy stock. This is what is meant by being forced to ‘sell high and buy low’.

22

2.2 Simple Truth 2: ‘Going Dutch’ works wonders

“Let me assure you, many fi nancial services companies make every effort to obscure the total costs you are actually paying. Every extra dollar of expenses you pay is skimmed from your investment capital. The only fac-tor reliably linked to future fund performance are the expenses charged by the fund.” - Burton Malkiel, professor at Princeton and author of the classic fi nance book ‘A Random Walk Down Wall Street’.

Most industries are built on a straightforward principle: “the more you pay, the more you get”. Unfortunately this doesn’t apply to investing. Every penny we pay in costs is a penny less from our in-vested capital and the average investor pays a lot of pennies. Keep-ing costs low is critical to our investment success!

What are the Total Costs of Investing (“TCI”) that are gener-ally incurred? Investors who invest directly in stocks pay custody costs to the bank holding their investment account and transaction costs in the form of explicit brokerage commissions and implicit spread and market impact costs.36

Investors who invest through funds pay management fees, plus the operational and marketing costs of the fund, which are charged separately. The management fee usually includes a charge for kickbacks, or “distribution fees” as the industry likes to call them. Kickbacks are a commission paid to advisors as an incentive to invest their clients’ money in a particular fund. Kickbacks are not separately disclosed, but simply included in the overall man-agement fee. This means retail investors who do not use advisors end up paying them regardless. In that case it presents incremental profi ts for the fund.37 The management fees (including the kick-backs) plus the operational costs are together called the Total Ex-pense Ratio (TER) of a fund. This name is misleading as the TER does not include direct transaction costs, called purchase and re-demption costs or ‘loads’, which fund investors generally incur to buy or sell participations in the fund. It also does not include the transaction costs incurred when the fund itself purchases and sells the underlying securities of its investment portfolio. These transac-

36 Market impact is the effect that a market participant has on the price of the asset when it buys or sells an asset. If the amount of money being moved is large rela-tive to the turnover of the asset in question, then the market impact can be several percentage points. For funds market impact cost can be substantial, especially if they trade in mid- and small-cap stocks.

37 Kickbacks are described in more detail in chapter 3.2

23

tion costs ‘within the fund’ are not published anywhere, but can be estimated based on a fund’s turnover.38

Finally, many investors use an advisor to whom they pay an-other layer of fees.

An overview of the TCI for a typical European investor with 50% of his asset invested in actively managed funds, and 50% invested directly in stocks and bonds, might look something like this:3940

Direct Investments

Investments in funds

Average (50/50 split)

Fees to advisor (Incl. VAT)40 0,89% 0,89% 0,89%

- Management Fees 1,00% 0,50%

- Kickbacks 0,56% 0,28%

- Operating expenses 0,50%  0,25%

TER underlying funds 0,00% 2,06% 1,03%

- Direct transaction costs 0,40% 0,75%  0,58%

- Transaction costs within funds 0.80% 0.40%

Transaction costs 0,40% 1,55% 0,98%

- Bank and custody costs 0,10% 0,10% 0,10%

Total Cost of Investing (“TCI”) 1,39% 4,60% 3,00%

38 The turnover is the percentage of securities in the portfolio that are bought and sold in a year. The average actively managed fund replaces 100% of the value of its stocks in a year. This means it fi rst sells 100% of its stocks, and subsequently repurchases the same amount to replace them. Costs are incurred in both the sale and the purchase. Confusingly in the US this is called a turnover of 100% (only either the purchase or sales side is counted), but in Europe this is called a turnover of 200% (both sides are counted). As a rule of thumb, the transaction costs ‘within the fund’ can be estimated by multiplying the fund’s total value of transaction by 0.4%. For the average active fund this means 0.4%*200% (100% sales + 100% purchases) = 0.8% in transaction costs per year.

39 Fee to advisor is an estimate based on market research. The kickbacks, manage-ment fees and operational costs are estimated based on “Analysis of distribution fees in Europe”, Lipper, October 2007, “Mutual Funds Fees Around the World”, Khorana (Georgia Tech), Servaes (LBS) and Tufano (HBS), 2006; average trad-ing based upon the following research: Edelen, Evans & Kadlec (2007), Plexus Group (2007), Karceski (2004), SEC (2003), Hussman (2003), Bernstein (2001), Sharkansky (2001), Keim & Madhaven (1997), Cahart (1997), Bogle (1994). The direct annual transaction costs for the fund investor (loads) are estimated from “Analysis of distribution fees in Europe”, Lipper, October 2007, by taking the difference between the ‘normal’ retail funds share class with loads and the ‘CDSC’ share class, where the loads are incorporated in the annual management fee.

40 As the advisor also receives kickbacks, the actual income to advisors is actually 1.45% (advisor fee plus kickback).

24

On an annual basis these costs of 3% may still seem reasonable, but bear in mind that they represent more than 34% of the annual his-torical nominal market return. They can have a very material im-pact, especially when compounded over longer periods: an initial sum of $1 million invested over the last 40 years in a global basket of equities would have grown to around $28 million by the end of 2009.41 The reason behind the growth is simple. It is about equal to the aggregate dividends plus growth in earnings of the compa-nies that make up the global economy over this period. Subtract-ing the 3% in costs would have decreased the resulting sum to of $8.9 million, a mere 32% of the portfolio with the market return. No wonder we are facing a tremendous retirement problem!

Figure 3: The tyranny of costs over 40 years (MSCI world total historical compounded returns, incl. gross dividends, in $ ‘000)

0

5,000

10,000

15,000

20,000

25,000

30,000

35,000

40,000

1969 1974 1979 1984 1989 1994 1999 2004 2009

Gross stock returns (8.7%)

Net of 1% annual costs

Net of 3% costs for typical investor

So what can you do? The cheapest solution is to buy only a few stocks and hold them for a long time. This can be risky however, as one ‘Enron’ in your portfolio could ruin your retirement plans. A more sensible solution would be to buy and hold a well-diversi-fi ed portfolio. This will inevitably bring some costs, but they should not be unreasonable. In fact, for about 1%,42 you could be

41 Grown at 9.53% per year, the average rate of return of the MSCI World Index in US$, including reinvested net dividends.

42 This includes management fees and operational costs of standard MSCI world index funds (0.50%) plus transaction, custody and “Indexing” costs (see explana-tion in this chapter)

25

the owner of a global dream team:43 Warren Buffet, George Soros, the leading hedge funds managers, Goldman Sachs; the list goes on and on. All these professionals together are the market, and you can own their portfolio at about 1/4 of the cost of owning the av-erage actively managed mutual fund. Subtracting 1% in costs per year would have left the passive dream team owner with a sum of $19.1 million after 40 years, more than double that of the active investor who paid 3% on average.

How can you buy the market? The simplest way is by buying a passively managed index fund. Passively managed funds follow a pre-determined investment strategy that requires as few portfolio decisions as possible in order to minimize costs. In the case of an index fund the strategy is simply to hold every listed stock in exactly the same ratio as the benchmark index. Index funds beat actively managed funds in the long run for several reasons. They only charge a fraction of the management fees and operational costs, since little management and basically no research is needed to follow a benchmark index. In addition index funds usually don’t charge extra costs for kickbacks and little to nothing for purchases and redemptions. The turnover and therefore the transaction costs are also much lower. Together these differences result in a rela-tive cost advantage of 2.7%.44 Finally, index funds barely hold any cash while actively managed funds, believing that they can time the market, hold signifi cant cash reserves. The long-term return on cash is lower than the return on equity, and why pay somebody to hold cash for you?

Unfortunately buying an inexpensive index fund is easier said than done, especially when, like most European investors, you are a client of a large fi nancial institution. Index funds are relatively rare in Europe, but the development of Exchange Traded Funds (ETF’s) or ‘trackers’, such as iShares, has been a huge boost to investors who aim to passively track a market.

A downside of these trackers is that by their nature they are forced to exactly replicate their benchmark index. The composi-tion of that index is adjusted periodically based on specifi c criteria. Unpopular stocks are removed and replaced with stocks that are

43 “Winning the loser’s game”, Charles D. Ellis, 1998.

44 Management fees and operational cost (1%), kickbacks (0,56%), subscription/ redemption costs (0.75%) and transaction costs (0.4%)

26

more popular.45 After these readjustments are announced, all of the investment vehicles that track that specifi c index trade in and out of the same stocks at the same time. As a consequence, the price of the companies who join the index will go up, just as the index fund needs to buy them. And of course the stocks they need to sell will typically have lost some value. The result is buying relatively high and selling low, which affects the long-term returns.

Another disadvantage of most mainstream index funds is that they track the companies with the highest market cap within a spe-cifi c market. They therefore tend to miss the embedded premium in small caps and value stocks.46 Passively managed funds holding a more balanced portfolio including small and value stocks could offer a higher return per unit of risk than a ‘fl agship’ index fund. This is especially the case for funds, which are not forced to exactly replicate a public index, but can passively and fl exibly follow an entire asset class. These funds could furthermore avoid excessive exposure to certain sectors in times of exuberance - think Japan in the 80s and technology in the 90s. However, countless studies have shown that costs are the only reliable indicator of a fund’s expected return versus its appropriate benchmark. Therefore low-cost index funds, despite their shortcomings, consistently outper-form in excess of 80% of their active counterparts.47

Truth 2: A rigorous focus on controlling the total cost of invest-ing will dramatically increase your long-term performance. It is best achieved by investing in passively managed funds that capture the entire market, not just the mainstream part of it. Standard in-dex funds however are a good and more readily available alterna-tive.

45 These criteria (market capitalization, traded volume etc.) differ per index and can be set somewhat arbitrarily. High volatility in the market can lead to signifi cant changes in the composition of an index. During the tech/internet crash from early 2000 through end 2002 for example, the Nasdaq 100 index replaced 80 of the 100 stocks in the index

46 Small company stocks and value stocks (stocks whose market price is low rela-tive to the value of their accounting book-value) have shown about 1.5% higher return than the market average since 1927. The economists Fama and French fi rst discovered this in 1964. The thesis still holds true today. However these stocks are also relatively risky, as they are more vulnerable in economic downturns.

47 In fact, the average index fund will always outperform its actively managed counter-part. This has not only been concluded by countless empirical studies, it is an arithmetic certainty (see Appendix 5).

27

2.3 Simple Truth 3: Manage risk, don’t chase return

“It is the part of a wise man to keep himself today for tomorrow, and not venture all his eggs in one basket.” – Miguel de Cervantes (1547-1616)

Risk management is the art of constructing an investment portfo-lio which (1) optimizes the trade-off between risk and return, and (2) is appropriate for the individual investor’s risk profi le.

Optimizing the risk/return trade-off is another way of saying that you should try to minimize your risk, given a certain level of expected return. This is best accomplished by investing in a port-folio which is broadly diversifi ed between and within asset classes. An asset class can be defi ned as a group of securities, which share similar risk characteristics, and differ in those characteristics from other groups of securities. The two primary asset classes are stocks and bonds. The other most commonly used asset classes are real estate, commodities and cash. Each asset class has risk and return patterns, which have limited correlation to other asset classes. In layman’s terms: when one moves up, the other tends to move in another direction. An investment portfolio consisting of a num-ber of different asset classes will therefore show less fl uctuation in return than a focused single asset investment. The lower the cor-relation between asset classes, the bigger this effect becomes. This principle of diversifi cation between asset classes is illustrated in the graph below.

Figure 4: Diversifi ed pool of asset classes, compounded return from Dec 1971 – Jun 2009:

0

500

1,000

1,500

2,000

2,500

3,000

3,500

1971 1976 1981 1986 1991 1996 2001 2006

US equities

Gold

50/50 annually rebalanced portfolio

28

Even though the correlation between securities within an asset class is much higher (they tend to move up and down in tandem), the correlation is not perfect and therefore the same principles of diversifi cation still hold. Therefore, the more diversifi ed you are also within an asset class (the more securities you add to your port-folio), the better the risk/return ratio becomes.

Asset class allocation is also the tool to establish an investment portfolio that is appropriate for an individual investor’s risk pro-fi le, as different asset classes have different risk profi les. Stocks, for example, are a relatively risky asset, as the return on equity shows a high level of volatility.48 In capitalism risk is rewarded, so in the long run, stocks should provide relatively high returns. The high volatility however implies that returns can be low and even nega-tive for prolonged periods of time. Bonds - government or cor-porate - are less risky49 and should therefore be expected to show stable, but lower returns. Bonds act as a portfolio stabilizer and can offer relatively attractive returns, especially when risky assets are underperforming. But the fi xed nature of their return means bonds tend to lag in performance during times of infl ation. Where possible investors will want to minimize risk, but there is of course a trade-off: without taking real risks, real returns will be negligible.

How is the optimal mix determined? Individual investors have different goals, means, time horizons and levels of willingness and ability to take risk. As a result, there is not one optimal portfolio for all investors, but the goal is to establish an asset allocation that has a high probability of achieving an individual investor’s goals under a wide range of possible future economic and market sce-narios.

The fi rst step in constructing the right portfolio is determining what level of risk is appropriate for your investment horizon and risk profi le. Your investment horizon is the time between today and the day you plan to start liquidating some of your investments. For most people this is when they retire, but it can also be when the kids go to college or when you want to start a business or buy

48 The volatility of an investment is given by the statistical measure known as the standard deviation of the return rate, which is the variation with which the yearly return fl uctuates around the average. Stocks have a standard deviation of about 15%; a standard deviation of zero would mean an investment has a return rate that never varies, like a deposit paying interest at a guaranteed rate.

49 The volatility of bonds depends on the maturity date and the risk of the issuer. Short- and medium-term government and investment-grade bonds pose low risks with a standard deviation of below 5%.

29

a new house. It can also be a much longer timeframe, for instance if you are saving for the next generation. The appropriate risk for you as an investor depends on the minimum return required dur-ing this period, whilst taking into account the maximum loss you can afford. For example, if you plan to retire in ten years you may want to look at the maximum loss you can sustain without giving up a certain lifestyle both before and after retirement. The shorter the timeframe, the less time you have to adjust, for instance by spending less and saving more before you retire, and therefore the lower the risk you should take.

Equity returns revert to the mean over time, so an investor with a longer time horizon can afford to invest a larger portion of his portfolio in equities and should not be worried about short-term fl uctuations in the stock market. Risk appetite also plays an impor-tant role. If you can afford a high-risk portfolio, but the fl uctua-tions in your investment portfolio keep you awake at night, a less risky portfolio will be more appropriate.

Once you have an idea of the appropriate level of risk, how can you translate this to a concrete portfolio? There are a number of statistical methods,50 which use historical return, volatility and correlation data to maximize expected returns for a certain level of risk. These methods can be useful, especially to investigate the im-pact of correlation effects on a portfolio, which can sometimes be counterintuitive.51 However, since they depend on historical data, they are not necessarily a good predictor of the future.

An alternative is to use a rule-of-thumb approach. Examples of such approaches are an equal weighting of all asset classes ap-proach that excludes return estimates altogether, or the popular mix of 80% equities and 20% bonds for a high risk/return or growth portfolio; 50% equities and 50% bonds for a moderate risk or balanced portfolio; and 20% equities and 80% bonds for a low risk or conservative portfolio. These rules of thumb are of-ten derived from statistical methods, and research concludes that many ‘intuitive’ or ‘rule-of-thumb’ portfolios are often within the

50 The most common examples are 1) Mean/Variance Optimization, which aims to construct different combinations of portfolios that maximize return per unit of risk along the “effi cient frontier” and 2) Simulation Optimization, which simulates future return scenarios through Monte Carlo analysis.

51 Precious metals, such as gold, are a good example. This asset class tends to have poor results for long periods and is very volatile. However, it has shown negative correlation with other asset classes as it tends to do well when nothing else does. Precious metals can therefore increase the return of an overall portfolio per unit of risk.

30

effi cient region of statistically equivalent portfolios calculated by those methods themselves.

Although the basic concept of risk management is not diffi cult, successful execution is as much an art as a science. This is another area where an investment advisor can be helpful. They can do this by allocating the assets across different asset classes in line with your risk profi le and investment horizon. They should focus on managing risk, not chase returns, whilst keeping in mind the two other investment truths.

Truth 3: Risk management, or building a portfolio that maximi-zes the chances of meeting your investment goals, given a certain level of risk that matches your profi le as an investor, is a central element of investing wisely. Diversifi cation and asset allocation are the tools to accomplish this. Asset allocation is not an exact sci-ence, but also depends on common sense judgment.

2.4 Conclusion

Most people in the asset management industry would fi nd it hard to make a living if they weren’t pretending to beat the market. Whose problem is that: theirs or yours?

Don’t fall into the trap of trying to be smart. Be wise and stick to the three simple investment truths:

1) Control your emotions by having the discipline to stick with your investment plan at all times

2) Minimize costs

3) Manage risks through diversifi cation and allo-cating assets across asset classes

The knowledge that one can’t, and therefore doesn’t need to know, which stock or fund to pick or when to enter or exit the market is the ultimate investment wisdom. It will enable you to ignore all the fi nancial nonsense thrown at you and in the process you will outperform nearly every other investor in the long run. And to an investor, the long run should be all that matters.

Do not expect it to be easy. There are too many people whose income depends on telling you otherwise!

A Flawed business model “It is diffi cult to get a man to understand something, when his salary depends upon his not understanding it.” - Upton Sinclair

What we have described in the previous chapters is not new, it is not revolutionary and it is supported by the best in the industry. So why has the asset management industry not adopted this philoso-phy, and is in fact doing its utmost to convince the average private investor to do the opposite? Why do they encourage you to chase the illusion and be an active investor, or to let them manage your assets actively for you, when it has been proven time and again that in the long-term this leads to value destruction for you as an investor?

3.1 Flaw 1: The confl ict of interest

The answer to this question is pretty simple: for the industry ac-tivity equals revenue and therefore they will want to see more of it rather than less. Unfortunately revenue to them is a cost to you and the more you pay the less you get. What asset management fi rms should be doing is managing their clients’ risk, helping them stick to their investment plans and explaining the merits of mini-mizing costs. Particularly the latter is not in their interest, so it is hard for the industry to promote this, or even accept it as a fact.

The bottom-line is that there is a confl ict of interest between the asset management fi rm and its clients. Nowhere is this clearer than with hedge funds, where incentive fees are paid over gains, but losses are absorbed by the investor: “heads I win, tails you lose”. When you think about it, it is almost incomprehensible how a business model that provides such incentives to take risks with cli-ents’ money, has grown to be a dominant force in the capital mar-kets. With its dominance, the average profi t margin of the fi nancial

32

industry increased gradually to 40% in 2007.52 Fierce competition would normally eliminate such profi t margins, but asset managers have somehow been able to convince investors to continue to pay for the illusion of superior performance.

3.2 Flaw 2: The revenue model

Imagine you are running a large manufacturing conglomerate. You have decided that you need to totally revamp the IT systems in your organization. This is a critical process that can determine the future of your company. You decide to hire a topnotch consultancy fi rm to evaluate all the available options and recommend which system you should buy. How would you feel if you found out that this consultant, whom you hired to give you an objective and informed opinion, was receiving a commission from one of the IT companies trying to sell their system to you? Not too happy prob-ably. Outraged is another possibility. Luckily in the ‘real world’ this would never happen, right?

Strangely enough, this is how much of the wealth management industry works: investment funds pay annual kickback fees to ad-visors and managers to invest your money in their fund. ‘Advi-sors’ give the impression that they only charge a seemingly reason-able management fee. In reality they make a lot more ‘through the backdoor’, which you are paying for. The problem is not only that this process is opaque and disguises the real costs of invest-ment. But, since different funds pay different levels of kickbacks, the objectivity of the advisor or manager is compromised. In fact, they should not be called advisors, but dealers or agents. They are merely distributing products for which they receive a commission. Perhaps the strangest thing about it is that on top of those com-missions, they charge you for their ‘objective’ advice as well.

Given the points above, it is not surprising that most asset man-agers do not invest their own money along with their clients’. In Adam Smith’s words “managers of other people’s money rarely watch over it with the same anxious vigilance with which they watch over their own; they very easily give themselves a dispensa-tion.”

52 “The growth dilemma”, Global Asset Management Report, the Boston Consulting Group (2007)

33

What is surprising is that despite the fact that individuals see money as one of the most important factors in their wellbeing, after health and relationships, managers of money require little for-mal education and often lack the knowledge of investment theory and history to make the best investment choices. Imagine that a doctor with no formal education would treat you based upon what he had learned over the years from the popular press and others like him. Fortunately the majority of medical advice is based on science and not on personal opinion. Surprisingly, the majority of investment advice is based personal opinion and the science of investing is largely ignored.

34

Fixing the Flaw4.1 The fee-only advisor

How would you deal with the problem of the IT consultant de-scribed in the previous chapter? You’d likely fi re the guy who was taking commissions and hire a new one, with whom you’d agree that he or she cannot accept payments from anyone else but you. This ‘fee-only’ model is slowly starting to get some traction in the wealth management industry. In the US a small but rapidly grow-ing number of advisors are now fee-based. Australia has gone as far as to make it illegal for advisors to work with commissions, so luckily for Aussies, fee-only is now the only option available there. Unfortunately for those of us in continental Europe, the fee-only model is still very much the exception to the ‘commission’ rule.

The fi rst obstacle for this seemingly straightforward solution is that few investors are aware of kickback fees as they are gen-erally not disclosed to the client. For years European regulators have tried to stand up against these practices by demanding more transparency. It seems that the crisis of 2008 and the resulting disil-lusionment of many investors has fi nally brought some progress. Advisors, wealth managers and private banks in several European countries are now obligated to disclose the levels of kickbacks they receive. If you work with one of these parties and are invested in funds, ask your relationship manager to disclose the information. It might be a struggle to get the data, but eventually they will have to give it to you.

The second obstacle is related to the fi rst. If you don’t real-ize you are paying commissions, the fee-only advisor can actually seem more expensive. After all, they only make money from what you pay them and don’t receive commission income through the backdoor. The fact is that most fee-only advisors offer much lower overall costs of investing because those who have chosen to be transparent about how they make their money can also be trans-parent about the Investment Illusion and its associated costs. They

36

can choose to work with passive fund managers53 and other low cost investment partners, who share their philosophy of discipline, low cost and risk management.

4.2 The customer owned fi rm

The fee-only advisor or manager is a big step in the right direction. However, the core confl ict of interest - costs to the client equal revenues to the manager - still causes tension in this model. The advisor could still be tempted to look for complicated solutions that justify higher fees. A way to avoid this confl ict is to ensure that investors not only become clients, but the actual owners of the wealth management or investment fi rm. After all it is the cli-ent’s money that is put at risk, and only a fraction of their capital would be needed to pay for the set-up costs of an investment fi rm. Shouldn’t they control how their ‘equity’ is put to work?

Such a customer-owned fi rm should have good performance-based incentives for its employees to enhance the focus of the fi rms’ efforts and attract quality and loyal employees. This incen-tive plan should focus on the key drivers of the fi rm’s success, such as cost advantage relative to the competition, client satisfaction and growth of assets under management. It should be primarily based on the collective efforts of the fi rm, not on individual per-formance. To ensure maximum alignment of interest, managers should be obligated to put their money where their mouth is and invest their own money alongside their clients’.

This straightforward, but profound governance change would greatly reduce the value-destroying behavior of the asset manage-ment industry. Robeco, traditionally the premier and for a long time the only major Dutch mutual fund company, used to be a client-owned ‘cooperative’ and an excellent example of what align-ment of interests can achieve. Founded in 1929, it grew to be the largest mutual fund in Europe by 1969. As the profi ts of the own-ers were translated into fee reductions for its clients (in fact, the very same people), it should be no surprise that the Robeco funds were competitively priced. Up until the early nineties the total ex-pense ratio for most Robeco funds was around 0.30% per year and the fi rm consistently showed excellent investment results.

53 Most passive funds do not pay kickbacks. The ‘active’ advisor will therefore be reluctant to use them, not only because it goes against his belief that activity adds value, but also because his business is dependent on the commission income.

37

Unfortunately Robeco is also a case study of what a confl ict of interest can do. In 1993 it changed its ownership structure, even-tually leading to a sale of the management company to Rabobank in 1996. With the change came the split between clients and own-ership and therefore the start of a confl ict of interests. The unfor-tunate consequence has been that Robeco’s management fees have steadily increased ever since, even though the funds under manage-ment continued to grow. The total expense ratio of their fl agship ‘Robeco Fund’ now stands at 1.14%, an almost fourfold increase from the 0.30% in 1990. With funds under management of close to EUR 4 billion, this means they are generating almost EUR 45 million in revenues per year to actively ‘track’ the MSCI world in-dex, their self-proclaimed benchmark. Unfortunately for Robeco, a large part of this revenue was paid in kickbacks to banks for selling the fund and in 2009 the fi rm actually lost money for the fi rst time in its existence. Unfortunately for the investors the increased costs have resulted in a relative underperformance of almost 1% per year compared to the benchmark since the take-over was completed.54

It is also unfortunate that the client-owned model is practically extinct these days, with only a few exceptions. Family offi ces and to some extent endowments have such a corporate governance structure. Other leading asset management organizations such as Vanguard,55 and Berkshire Hathaway,56 have been built on a simi-lar governance structure. Their continued success is built on prin-ciples of co-ownership, alignment of interests and low costs.

The takeaway from this chapter does not need to be that you should avoid working with investment funds, advisors and wealth manag-ers. As we have seen, investing in low-cost funds can actually make a lot of sense and for most people a well-diversifi ed portfolio is hard to achieve without them. Advisors and wealth managers can also play an important role. Research has shown that the majority of investors would benefi t from working with an advisor, as most of us lack the necessary knowledge and especially the discipline to stand tall against the challenges posted by the behavioral defects discussed in Chapter 2.1. A wealth manager can furthermore pro-vide access to low-cost institutional investment vehicles that might

54 Source for performance and fi nancial results: www.robeco.nl

55 A provider of low cost index funds

56 A mix between an investment fi rm, a private equity fund and an insurance busi-ness.

38

not be accessible to individual investors and they can help you manage your assets in a tax-effective manner.

What you can take away is that if you do decide to work with an advisor or manager, you should look for one who sticks to the three simple investment truths, is fully transparent about her business and has minimal confl icts of interests with you, the cli-ent. However, if you are well informed and have the discipline to consistently follow a sound investment plan, it is possible to do well without having to pay someone for it. You may still consider consulting an expert periodically to establish an investment plan and evaluate your portfolio. Appendix 6 provides an example of a straightforward portfolio that may help you to get some ideas if you decide you want to ‘do it yourself ’.

Summary“Rule 4: He who wishes to become rich from this game must have both money and patience”. - From the masterpiece “Confusion of Confu-sions”, the oldest book ever written on the stock exchange business by Joseph de la Vega, successful merchant, poet, and philanthro-pist residing in 17th century Amsterdam.

The entire industry of investing has been built on an illusion: that by investing actively it is possible to beat the market. Financial fi rms spend billions in marketing to keep this illusion alive, and make more billions as a result.

The reality is as simple as this: our economy is made up of profi t-generating companies. In the long run the growth in profi ts of all companies across the globe can be expected to increase in line with world GDP. The profi ts of these companies are for the benefi t of the investors. The asset management industry stands in between the profi ts and the investors. Any revenue to the asset management industry is deducted from the profi t of investors.

So what to do? Recognize that trying to become rich by stock picking, fund picking and market timing is the same as trying to become rich in a casino. If somebody promises market beating returns they can only do this by taking more risk or hoping to get lucky. The chances of getting lucky after deducting cost are negli-gible in the long run. The best route to a sound fi nancial future is to have patience and stick to the three simple investment truths:

1) Control your emotions by having the discipline to stick with your investment plan at all times

2) Minimize costs

3) Manage risks trough diversifi cation and allo-cating assets across asset classes

These truths are timeless and based on objective, scientifi c research of what actually works. They are shared by the most respected in-vestment professionals and academics of our time.

40

If you fi nd it hard to do it on your own, or simply don’t want to spend the time, fi nd an advisor or wealth management fi rm with few confl icts of interest that provides its clients with a common sense investment solution instead of selling them an investment illusion.

Happy investing!

Yours truly,

Marius Kerdel and Jolmer Schukken

Amsterdam, November 2010

EpilogueIn this paper we have focused on public markets since that is where the majority of investment activity takes place, especially for indi-vidual investors. In principal the same fundamental dynamics ap-ply to the private markets, although in certain areas an edge can still be achieved through superior knowledge and skill. In general, the more illiquid and specialized an area is, the more skill, know-ledge and connections can make a difference. In evaluating the investment results in these markets, one should take into account the illiquidity of the investment, which increases risk and therefore explains some of the difference in return.

Outperformance has been provided to and by the top quartile of knowledgeable insiders in alternative investments, such as pri-vate equity and hedge funds, over the last decades. Unfortunately this is an exclusive club for investors with large available funds and therefore usually not available to the average investor. The bottom 50% of ‘alternative’ investors have actually underperformed public markets signifi cantly on a risk-adjusted basis, mainly because of the enormous fees involved in investing in that industry.57 Further-more, considering the growth of and competition within the alter-native investment industry, outperformance will be more diffi cult to achieve.

57 Private Wealth Management, Wharton Executive Education 2008.

42

AppendicesAppendix 1: From Berkshire Hathaway’s 2005 Investment Letter

“…The explanation of how this is happening begins with a funda-mental truth: With unimportant exceptions, such as bankruptcies in which some of a company’s losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn. True, by buying and selling that is clever or lucky, investor A may take more than his share of the pie at the expense of investor B. And, yes, all inves-tors feel richer when stocks soar. But an owner can exit only by having someone take his place. If one investor sells high, another must buy high. For owners as a whole, there is simply no magic – no shower of money from outer space – that will enable them to extract wealth from their companies beyond that created by the companies themselves. Indeed, owners must earn less than their businesses earn because of “frictional” costs. And that’s my point: These costs are now being incurred in amounts that will cause shareholders to earn far less than they historically have.

To understand how this toll has ballooned, imagine for a mo-ment that all American corporations are, and always will be, owned by a single family. We’ll call them the Gotrocks. This fa mily – gen-eration after generation – becomes richer by the aggregate amount earned by its companies. Today that amount is about $700 bil-lion annually. Naturally, the family spends some of these dollars. But the portion it saves steadily compounds for its benefi t. In the Gotrocks household everyone grows wealthier at the same pace, and all is harmonious.

But let’s now assume that a few fast-talking Helpers approach the family and persuade each of its members to try to outsmart his relatives by buying certain of their holdings and selling them cer-tain others. The Helpers – for a fee, of course – obligingly agree to handle these transactions. The Gotrocks still own all of corporate America; the trades just rearrange who owns what. So the family’s annual gain in wealth diminishes, equaling the earnings of Ameri-can business minus commissions paid. The more that family mem-bers trade, the smaller their share of the pie and the larger the slice received by the Helpers. This fact is not lost upon these broker-Helpers: Activity is their friend and, in a wide variety of ways, they urge it on. After a while, most of the family members realize that

44

they are not doing so well at this new “beat my- brother” game. Enter another set of Helpers. These newcomers explain to each member of the Gotrocks clan that by himself he’ll never outsmart the rest of the family. The suggested cure: “Hire a manager – yes, us – and get the job done professionally.” These manager-Helpers continue to use the broker-Helpers to execute trades; the mana-gers may even increase their activity so as to permit the brokers to prosper still more. Overall, a bigger slice of the pie now goes to the two classes of Helpers. The family’s disappointment grows. Each of its members is now employing professionals. Yet overall, the group’s fi nances have taken a turn for the worse. The solution? More help, of course. It arrives in the form of fi nancial planners and institutional consultants, who weigh in to advise the Gotro-cks on selecting manager-Helpers. The befuddled family welcomes this assistance. By now its members know they can pick neither the right stocks nor the right stock-pickers. Why, one might ask, should they expect success in picking the right consultant? But this question does not occur to the Gotrocks, and the consultant-Helpers certainly don’t suggest it to them. The Gotrocks, now supporting three classes of expensive Helpers, fi nd that their re-sults get worse, and they sink into despair. But just as hope seems lost, a fourth group – we’ll call them the hyper-Helpers – appears. These friendly folk explain to the Gotrocks that their unsatisfactory results are occurring because the existing Helpers – brokers, man-agers, consultants – are not suffi ciently motivated and are simply going through the motions. “What,” the new Helpers ask, “can you expect from such a bunch of zombies?”

The new arrivals offer a breathtakingly simple solution: Pay more money. Brimming with self-confi dence, the hyper-Helpers as-sert that huge contingent payments – in addition to stiff fi xed fees – are what each family member must fork over in order to really outmaneuver his relatives. The more observant members of the family see that some of the hyper-Helpers are really just manag-er-Helpers wearing new uniforms, bearing sewn-on sexy names like HEDGE FUND or PRIVATE EQUITY. The new Helpers, however, assure the Gotrocks that this change of clothing is all-im-portant, bestowing on its wearers magical powers similar to those acquired by mild-mannered Clark Kent when he changed into his Superman costume. Calmed by this explanation, the family de-cides to pay up. And that’s where we are today: A record portion of the earnings that would go in their entirety to owners – if they all just stayed in their rocking chairs – is now going to a swelling

45

army of Helpers. Particularly expensive is the recent pandemic of profi t arrangements under which Helpers receive large portions of the winnings when they are smart or lucky, and leave family members with all of the losses – and large fi xed fees to boot – when the Helpers are dumb or unlucky (or occasionally crooked). A suf-fi cient number of arrangements like this – heads, the Helper takes much of the winnings; tails, the Gotrocks lose and pay dearly for the privilege of doing so – may make it more accurate to call the family the Hadrocks. Today, in fact, the family’s frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying Helpers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.”

Appendix 2: Academic research

A) Academic research on mutual fund performance

“The Performance of Mutual Funds in the Period 1945-1964”, Jensen, M.C., The Journal of Finance, Volume 23, May 1968. Among the fi rst groundbreaking mutual fund performance stud-ies. The verdict: The evidence on mutual fund performance indi-cates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do signifi cantly better than that which we expected from mere random chance. It is also im-portant to note that these conclusions hold even when we measure the fund returns gross of management expenses (assuming their bookkeeping, research, and other expenses except brokerage com-missions were obtained free).

“The Arithmetic of Active Management”, William Sharpe, winner of the 1990 Nobel Memorial Prize in Economic Sciences 1991 ar-ticle in the Financial Analysts Journal. He concludes that on a net of expense basis, in the aggregate, fund and institutional managers will tend to underperform the market by an amount equal to the fees that they charge for managing the portfolio, plus associated costs. Quote: “Empirical analyses that appear to refute this prin-ciple are guilty of improper measurement”.

“False Discoveries in Mutual Fund Performance: Measuring Luck

46

in Estimated Alphas”, Barras (London), Scaillet (Geneva), Werm-ers (Maryland), 2008. After studying the returns of 2,076 domes-tic actively managed mutual funds in the US over the period 1975 to 2006, they conclude that 0.6% exhibit truly positive alphas. They do fi nd a higher proportion of skilled fund managers before 1990 and fi nd that 9.6% outperform when they examine alphas before expenses (not including trading costs). They conclude that the large growth in the number of actively managed funds has re-sulted in a much lower proportion of truly skilled funds and that the large number of actively managed funds has not resulted in a competitive level of fund fees and expenses.

“Luck versus Skill in the Cross Section of Mutual Fund Alpha Es-timates”, Eugene F. Fama and Kenneth R. French, Feb 2009. The aggregate portfolio of U.S. equity mutual funds is close to the market portfolio, but the high costs of active management show up intact as lower returns to investors. Bootstrap simulations pro-duce no evidence that any managers have enough skill to cover the costs they impose on investors. If we add back costs, there is some evidence of inferior and superior performance (non-zero true al-pha) in the extreme tails of the cross section of mutual fund esti-mates. The evidence for performance is, however, weak, especially for successful funds, and we cannot reject the hypothesis that no fund managers have skill that enhances expected returns. Equilibri-um accounting tells us, however, that if anybody produces positive alpha due to skill, there must be other actively managed segments of the investment industry that pay for hedge fund winnings, dol-lar for dollar, with negative alpha.

“Strategy: The global going gets tough.” In “The Competitive Edge”, Morgan Stanley Dean Witter, 1999. The professional shortfall is found in international markets as well. The average un-derperformance of international mutual funds is 340 basis points.

Mark Kritzman, president and CEO of Windham Capital Manage-ment of Boston and professor at MIT did a study to accurately mea-sure the long-term impact of all the expenses involved in investing in a mutual fund or hedge fund. Those include transaction costs, taxes and management and performance fees. Results were presented in Feb 2009 issue of Economics & Portfolio Strategy. He concludes that to break even with the index fund, net of all expen-ses, the ac-tively managed fund would have to outperform it by an average of

47

4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.A study by Barksdale and Green of 144 institutional equity portfo-lios over the rolling 10 year periods between January 1, 1975 and December 31, 1989 showed that portfolios that fi nished the fi rst fi ve years in the top quintile were actually the least likely to fi nish in the top half over the next fi ve years. The results were entirely random. That meant that what might have beaten the market for a certain period of time had little consistency in doing so in the near future.

“Beating Index Funds Takes Rare Luck or Genius”, Jeff Brown. Morningstar research showed that over a 10-year period only 2.4% of funds beat their benchmark (2004).

Jenke ter Horst, Proefschrift: Longitudinal Analysis of Mutual Fund Performance, November 1998.

“Returns from Investing in Equity Mutual Funds 1971 to 1991”, Burton Malkiel, The Journal of Finance, Volume 50, Issue 2, June 1995, p 549 - 572.

“Performance of UK Equity unit trusts”, Quigley & Sinquefi eld, Journal of Asset Management, Vol 1, Feb 2000.

“Mutual Fund Performance”, William Sharpe, Journal of Business, 39, 1966.

“The Arithmetic of Active Management” William Sharpe, The Fi-nancial Analysts’ Journal Vol. 47, No. 1, January/February 1991.

“Is it a search for the Holy Grail?”, Larry Swedroe, Journal of Ac-countancy, January 2000.

B) Academic research on mutual fund performance persistence

“On persistence in mutual fund performance”, by Mark Carhart. Published in 1997 Journal of Finance. Considered by many to be the defi nitive paper on the subject of mutual fund persistence at that time, or the ability of funds to repeat their performance year after year. Carhart analysis of 1,892 funds over 32 years does not

48

support the existence of skilled or informed mutual fund portfolio managers. On average actively managed funds underperform the proper benchmark by 1.8%. Cahart currently works for Goldman Sachs.

“Mutual Fund Performance”, 2008, Paper by Fama & French, University of Chicago and Tuck School of Business. Conclusion: In aggregate mutual funds produce a portfolio close to the market portfolio but with high costs of active management that show up intact as lower returns. Persistence is weak to nonexistent on ave-rage return, and it largely disappears after 1992.

“The Predictive Performance of Morningstar’s Mutual Fund Rat-ings”, Kraeussl and Sandelowsky, 2007, University of Amsterdam, concludes that the predictive performances of the different rating systems used by Morningstar do not beat a random walk.

“The Persistence of Mutual Fund Performance”, Grinblatt & Tit-man, Journal of Finance, December 1992.

“Hot Hands in Mutual Funds: Short-run Persistence of Perfor-mance”, Hendricks, Patel & Zeckhauser, Journal of Finance, Maart 1993.

“Performance Persistence”, Brown & Goetzmann, Journal of Fi-nance, vol 52, Juni 1995.

“Returns from Investing in Equity Mutual Funds 1971-1991”, Burton Malkiel, Journal of Finance, Vol. 50, 1995

“Do Winners Repeat?”, Goetzmann & Ibbotson, Journal of Port-folio Management, 1994

C) Academic research on determinants of portfolio performance

“Determinants of Portfolio Performance”, Brinson, Hood, and Beebower, Financial Analysts Journal, 1986. A classic and fre-quently cited empirical study updated in “Determinants of Per-formance II: An Update,” Financial Analysts Journal 1991. The 1991 study analyzed data for 82 pension plans over the 10-year period ending 1987, similarly reaching the conclusion that invest-

49

ment policy accounted for 91.5% of performance.

Blake, Lehmann, and Timmermann (1999) investigated asset al-location in the United Kingdom. Examining more than 300 medi-um-sized to large actively managed U.K. defi ned-benefi t pension schemes for the period 1986–94. They concluded that asset alloca-tion accounted for approximately 99.5 percent of the vari ation in plan total returns.

“Does Asset Allocation Policy Explain 40%, 90%, or 100% of Performance?” Ibbotson and Kaplan, (working paper, 1999). They concluded that, 1) asset allocation explained 40% of the variation of returns across funds, and 2) it explained virtu-ally 100% of the level of fund returns. Selected fi ndings of this study are also reviewed in Surz, Stevens and Wimer, “Investment Policy Explains All,” The Journal of Performance Measurement, Fall 1999 and The Importance of Investment Policy: A Simple Answer To A Contentious Question. Surz, Stevens, Wimer, http://www.ppca-inc.com/Articles/ioip.html

“The Contribution of Asset Allocation Policy to Portfolio Per-formance”, Drobetz (University of Basel) and Friederike Köhler (University of St. Gallen), 2002. They analyzed German and Swiss balanced mutual fund data and found that more than 80 percent of the variability in returns of a typical fund over time is explained by asset allocation policy, roughly 60 percent of the variation among funds is explained by policy, and more than 130 percent of the return level is explained, on average, by the policy (asset class) return level.

Appendix 3: Warren Buffet as a hedge fund

FT, 12 March 2008, by JOHN KAY

Albert Einstein supposedly observed that the most powerful force in the universe is compound interest, and Mr Buffett’s frugality has enabled compound interest to work its magic. During Mr Buffett’s tenure at Berkshire Hathaway, the S&P 500 index has produced an average total return of 10%. That return reinvested over 42 years will multiply your stake 67 times. But if your investments yield twice as much as that - as Mr Buffett’s have done - your wealth increases not by twice 67, but 67 squared, a factor of 4,500. That

50

arithmetic makes Mr Buffett the richest man in the world. The calculation illustrates a more subtle point. Mr Buffett’s for-

tune has come not through growing an investment management business, but from his own share in the value of the funds he man-ages. Suppose he had adopted a more conventional investment management structure, charging the 2% management fee and 20% of performance common in private equity and hedge funds. How much of his $62bn would have been the property of Buffett the manager - Buffett Investment Management - and Buffett the inves-tor - the Buffett Foundation?

The answer is astonishing. At “2 and 20”, the split is $57bn for Buffett Investment Management and $5bn to the Buffett Founda-tion. The effect of compounding at 14%, rather than at 20%, is to reduce the accumulated pot by over 90%. You might argue that the seemingly disproportionate share of Buffett Investment Man-agement is reasonable: after all, Buffett Investment Management is very good. So rework the sum on the assumption that Mr Buffett was mediocre and performed in line with the 10% return on the S&P. That would have reduced his wealth to $930mn, below cut-off for the Forbes rich list. But only $170mn of that more modest sum belongs to investors: Buffett Investment Ma nagement would still have the lions’ share, at $760mn.

Worse still, suppose Mr Buffett had been no good at all. If re-turns had averaged 5% a year, then the Buffett Foundation would have a miserly $32mn to pass to Bill Gates’ charities. However, inept but thrifty Buffett Investment Management would still have accumulated $82mn.

The results of these calculations are as puzzling as they are remarkable.

Appendix 4: Market timing - The story of Quincy & Caroline by Dalbar Inc.

Quincy and his wife Caroline inherited $20,000 in 1985. Quincy heard that mutual funds were the best way to put money away and he and Caroline decided that they would put their windfall into mutual funds. They decided that they would split the money and each put $10,000 in their own account. They both selected the same stock mutual fund and put their money in on the fi rst busi-ness day in January, 1986.

In the twenty years since that time, Quincy has stayed on top of the market, checking on how his investment was doing every

51

month. Caroline in the meanwhile was more concerned about rais-ing their kids and would listen to Quincy talk about how much he was making and occasionally, how much he had lost.

A year later Quincy was very happy with his decision, the in-vestment was now worth $12,000 and so was Caroline’s.

After two years, at the end of 1987, Quincy was very worried about all the news of the market crash in that happened in October. When he checked on his investment it had fallen from $12,000 a year earlier to $9,600. He decided to limit any further loss and withdrew half of his investment and put $4,800 in his checking ac-count. He wanted Caroline to do the same thing with her $9,600, but she talked it over with her friend and decided against doing anything. Her friend, who was a fi nancial advisor, assured her that the market would bounce back.

By the August of the next year, Caroline’s account was back up to $12,000 level but Quincy still had $4,800 in his checking ac-count, that did not increase when the market did. Quincy regained his courage by the end of 1988 and put the money back into his mutual fund. By this time Caroline’s account was worth $15,000 and Quincy’s was only worth $12,300.

In the intervening years Caroline simply let her nest egg grow but Quincy moved money in and out of the market. He would read the stock market reports and talk with friends to fi nd out what they were doing. When he became worried about losing his money he would withdraw some and when his confi dence was restored he would invest it again.

By the end of 2005, Quincy had built his initial $10,000 in-vestment up to a whopping $21,422. Caroline had not touched her investment so it suffered during times of market declines and recovered when the market did. By the end of 2005 Caroline’s ac-count was worth... $94,555.

Appendix 5: The Arithmetic of Active Management

By William F. Sharpe, The Financial Analysts’ Journal Vol. 47, No. 1, January/February 1991. pp. 7-9

“Today’s fad is index funds that track the Standard and Poor’s 500. True, the average soundly beat most stock funds over the past decade. But is this an eternal truth or a transitory one?”

“In small stocks, especially, you’re probably better off with an active

52

manager than buying the market.”

“The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets.”

“Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle.”

Statements such as these are made with alarming frequency by investment professionals. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justifi ed by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue ca-reers as active managers. If “active” and “passive” management styles are defi ned in sensible ways, it must be the case that:

1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and

2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollar

These assertions will hold for any time period. Moreover, they de-pend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.

Of course, certain defi nitions of the key terms are necessary. First a market must be selected - the stocks in the S&P 500, for example, or a set of “small” stocks. Then each investor who holds securities from the market must be classifi ed as either active or passive.

• A passive investor always holds every security from the market, with each represented in the same manner as in the market. Thus if security X represents 3 per cent of the value of the secu-rities in the market, a passive investor’s portfolio will have 3 per cent of its value invested in X. Equivalently, a passive manager will hold the same percentage of the total outstanding amount of each security in the market.

• An active investor is one who is not passive. His or her port-folio will differ from that of the passive managers at some or

53

all times. Because active managers usually act on perceptions of mispricing, and because such misperceptions change rela-tively frequently, such managers tend to trade fairly frequently -- hence the term “active.”

Over any specifi ed time period, the market return will be a weight-ed average of the returns on the securities within the market, using beginning market values as weights. Each passive manager will ob-tain precisely the market return, before costs. From this, it follows (as the night from the day) that the return on the average actively managed dollar must equal the market return. Why? Because the market return must equal a weighted average of the returns on the passive and active segments of the market. If the fi rst two returns are the same, the third must be also.

This proves assertion number 1. Note that only simple prin-ciples of arithmetic were used in the process. To be sure, we have seriously belabored the obvious, but the ubiquity of statements such as those quoted earlier suggests that such labor is not in vain.

To prove assertion number 2, we need only rely on the fact that the costs of actively managing a given number of dollars will exceed those of passive management. Active managers must pay for more research and must pay more for trading. Security analysis (e.g. the graduates of prestigious business schools) must eat, and so must brokers, traders, specialists and other market-makers.

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

This proves assertion number 2. Once again, the proof is em-barrassingly simple and uses only the most rudimentary notions of simple arithmetic.

54

Appendix 6: Example of a balanced No-Nonsense Portfolio

This is a simple example portfolio of passive vehicles (“trackers”) that a do-it-yourself investor could use when implementing the simple truths of this paper. It covers the core asset classes of an in-vestment portfolio. Please note that this portfolio is for illustration purposes only. It does not constitute a recommendation from the authors to buy these specifi c funds.

Equity   Description Expense ratio

Developed iShares / Vanguard MSCI World

Broad representation of over 1,600 large cap companies in the world 0.50%

EmergingiShares / Vanguard MSCI Emerging Markets

Aims to cover the largest listed compa-nies in over 20 of the largest emerging markets (700 companies)

0.75%

Bonds    

Government iShares € Govern-ment Bond 1-3

Provides exposure to a diversifi ed basket of € government bonds with maturities from 1.25 – 3.25y

0.20%

Cash Savings account Capped at €100,000 per person 0.00%Real estate    

  iShares European Property Yield

Exposure to higher yielding stocks within the universe of the FTSE EPRA/NAREIT Developed Europe ex UK Index

0.40%

Commodities    

Precious metals RBS Physical Gold tracker

Provides direct exposure to gold price and is backed by physical allocated gold held by the custodian

0.29%

Comment: for Dutch investors there are some small fi scal inef-fi ciencies in this portfolio, which unfortunately cannot easily be solved by individual investors at the moment.

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The authors: Marius Kerdel and Jolmer Schukken

The authors are the founders of Triple Partners (www.triplepart-ners.com), a company dedicated to implementing the Investment Solution in a transparent and cost-effective way. They are both in their late 30’s hold masters degrees in Economics and MBAs from IESE, with Marius adding a CFA designation. They also share an interest in investment history, and boring academic studies about investing.

Marius worked at Rabobank International until July 2009. He joined the bank in 1998 and was a member of Europe’s leading Food and Agriculture mergers & acquisition team until 2002. Be-tween 2003 and 2008 he cofounded and subsequently led the US structured products group in New York.

Marius is a non-executive board member of International Partners, a private investment company founded in 1969 with $200 million under management. He is the executive producer of three movies and has been actively involved in starting up several businesses. He is married, has fi ve-year-old twins and is a fanatic skier and golfer.

Marius can be contacted at marius@investmentillusion.com

Jolmer started his career at General Electric in 1997, where he held various fi nancial management positions in Asia and Europe. From 2005 until April 2010 he worked for Fortis Bank where he was an investment manager for private equity investments in the commodity and renewable energy sectors.

Jolmer is the statutory director of the investment company hold-ing his family’s strategic investments and has been a consultant to and private investor in various start-up companies in Europe. He is married, has a fi ve-year-old daughter and a three-year old son. He is also a keen skier, loves cycling (both on and off the road) and other endurance sports. Jolmer cycled the entire Tour de France for charity in 2010, one day ahead of the professionals (see www.tourforkika.org).

Jolmer can be contacted at jolmer@investmentillusion.com

www.investmentillusion.com