Skip to content

A Better Mousetrap

by Dan Tolomay, CFA

A little over a year ago, I wrote a blog post, “Value Stocks: Lessons from the Produce Aisle”. In that writing, I touched on ways to invest in an attractively-priced segment of the stock market: active management (trying to outwit the market), indexing (trying to match the market), and evidence-based (trying to outperform the market). That discussion showed that active management and indexing have resulted in lower performance. In this piece, I’d like to highlight some other pitfalls in those strategies and highlight how an evidence-based tactic avoids them.

When targeting a specific market segment, consistency is critical. In an effort to add to a fund’s return, an active manager may deviate from the mandate or let their holdings run. Such actions result in “style drift” and can cause a portfolio to behave differently than what the investor needs or wants.

The Standard & Poor’s Index Versus Active (SPIVA) report analyzes this effect via a metric known as Style Consistency. This calculation shows the percentage of funds that had the same style classification at the end of a time period as at the beginning. As the graphic below shows, many active managers are prone to this phenomenon.

Whereas a wandering focus may be the result of deliberate action on the part of an active manager, index funds are not immune. Such funds seek to track a benchmark with little variance. As a result, the fund’s holdings will mirror those of its target index. Changes are made to the benchmark index periodically in a process known as reconstitution. But what happens between reconstitutions?

Let’s say, for example, that a fund is targeting small value companies. If the market is rising (and small value firms with it), the names in the benchmark may drift from small to mid-sized firms or from value to core holdings on a valuation basis. For an investor seeking exposure to small value names, the fund may not purely provide it between reconstitutions.

An evidence-based approach corrects for these drawbacks. By following an objective, investment process rather than a subjective, manager’s directions, the portfolio stays focused on its goal and uses disciplined buying and selling to prevent drift and maintain consistent exposure. Unlike an index fund, the goal is not to track the index but to routinely position the portfolio to the pieces of the market with the highest expected returns. This may result in short-term “noise” around the benchmark return. However, as is shown below, over the long-term, the difference narrows, and value has been added by pursuing more rewarding market attributes.

The impact on an investor’s portfolio may be reduced diversification. If a fund fails to “stay in its lane”, it could lead to holdings overlap. The result is that an investor may end up overexposed to an area of the market during a selloff or underexposed to an area of the market that rallies. If a gap is left in the portfolio, it’s not just a return story but a risk one, too. By not having broad exposure, the portfolio may move together more, resulting in greater volatility.

The second limitation of active and indexed approaches has to do with rigidity. A stock picker, by definition, seeks specific names for the portfolio. He or she wants to buy those companies deemed desirable and sell those dubbed inferior. Such a manager adds and removes holdings at self-identified optimal times. Being rigid on what names to trade and when makes the manager subject to prices set by the market. An active manager may pay up for a “good” stock or accept a lower price to get out of a “bad” stock.

Now consider an index fund during reconstitution. It’s not a manager dictating the names and times but a third-party. For example, when changes to the Russell 2000 are announced, an index fund springs into action. In an effort to minimize the noise around the benchmark’s return, the manager buys and sells to match it. The amounts that are paid and the proceeds that are received are based on prices set by the market. Reconstitutions are announced to the public in advance. Not only are index providers placing the same trades, but traders on the other side know that they must make the trade to achieve their goal.

A flexible, evidence-based approach removes these impediments. By being agnostic on individual names and knowing that research shows that attributes of stocks explain returns, companies can be viewed as substitutes. If a stock picker or an index fund has to buy/sell a specific name, the flexible manager can oblige and choose to hold a different stock instead. If stocks with similar characteristics are perceived as equivalent, the one commanding the highest price can be sold while a lower priced option can be bought.

There is a price to this malleable approach. When comparing the results to a benchmark, there will likely be a difference. It may be negative in the short run. Longer-term, though, the flexible manager has added positions at more attractive levels and has a portfolio better built for the future. Over time, the noise fades and superior results emerge.

How does average ten year outperformance of 0.97% for large value and 1.52% for small value compare to the alternatives? Again, using SPIVA data, we see that over the 10 years ended June 30, 2020, 86% of active large value and 90% of active small value managers failed to perform better than their Standard and Poor’s benchmark.

An index fund would be expected to trail its benchmark by the expense ratio. This reliable result can be comforting. But a detail can be lost when returns are reported in their standard, annualized format. That aspect is the cumulative impact of relative performance and fees.

For example, consider the 10 years ended 9/30/20. DFA US Large Cap Value posted an annualized return of 10.09% vs. 9.95% for the Russell 1000 Value. If we look at this result on a cumulative (de-annualized) basis, we see that the performance was 161.50% vs. 158.20% or 3.30% greater return. An index fund charging a low expense ratio, say 0.07%, would return 9.88% (the benchmark return less the expense ratio). The cumulative return of the index fund is 156.56% vs. 158.20% or 1.64% less than the benchmark.

The SPIVA study shows that the average large value fund returned 9.08% for this 10 year period. It’s been established that this is a sub-par result. But, what’s the cumulative effect? Earning 9.08% per year versus 9.95% for the benchmark accumulates to 19.72% performance lag!

Lastly, it is difficult for a fund to outperform if it disappears before the evaluation period ends. This occurs if a fund is liquidated or merged into another fund. How common is it for a fund to not survive? SPIVA tells us this story, too. As time goes on, active funds become fewer and fewer.

The prolonged lag in the performance of value stocks relative to growth stocks has been frustrating. However, it also offers an opportunity to position a portfolio to benefit from an inevitable value rebound. In addition to what to pursue, how to seek the exposure must be considered. An evidence-based approach provides a consistent experience. Flexible implementation can cause short-term noise but has also led to long-term outperformance. These superior results compound in a favorable way, which contrasts with the impact of active underperformance or fee drag from index funds. Working with an established partner that has a disciplined approach, means the fund knows how to and will be around to deliver.

As Chief Investment Officer, Dan is responsible for developing Trust Company’s investment strategy and managing client portfolios.

Weather Ahead

by William Smith, CFP®

Flying blind

Inside a dense layer of clouds, I couldn’t see anything outside the plane.  The pilot tried to prepare me for this, but his coaching hadn’t helped in the moment.  It’s difficult to simulate what we were experiencing, instrument flight conditions, at least it was 30 years ago.  In a series of rapid fire instructions, air traffic control finally directed us, “Baron one seven niner romeo papa turn left heading two seven zero, descend and maintain three thousand, join the localizer, cleared for the ILS two three approach, contact Greensboro tower now on one nineteen point one.”

I watched the pilot maneuver the airplane, never once taking his eyes off the instrument panel, checking gauges, following a disciplined process — he remained calm throughout.  Despite my anxiety about this environment: the noisy clamor from the radios, constant terrifying turbulence, and falling forward 200 mph toward our destination with zero visibility — I trusted the pilot.  Scanning the gauges, I found what I thought was the altimeter.  It was spinning counter-clockwise, 3000 feet, down to 2000 feet, 1500 feet and suddenly, we broke through the clouds, several hundred feet above ground, magically aligned toward runway 23.  Once safely on the ground at Piedmont Triad International Airport – I had never felt more relieved yet inspired.

On that day in the summer of 1988, I realized I wanted to learn to fly.  The entire program appealed to me:  the challenge of planning a flight, navigating, communicating, coping with weather, responding to pressure situations – managing my and possibly my passengers’ emotions.  Little did I know that the experience of becoming a private pilot proved to be the perfect training ground for my future career as a financial advisor.


Planning your trip

Independent advisors, like my colleagues at Trust Company, serve our clients in a fiduciary capacity, meaning our interests are aligned with yours — we’re in the plane with you.

Much like a pilot, at the beginning of our journey together, we gather details and chart a course to your desired destination.  While the pilot is concerned about fuel needed for the trip, wind speeds and direction, and any restricted airspace along the route, your advisor requires details about your current assets, tax situation, spending needs, charitable and legacy goals.  Do you hold concentrated stock positions?  These are like nasty weather events we can avoid altogether by diversifying.  How have you responded to past bear markets?  They happen with unfortunate frequency (about once every five years since WWII) and best practice suggests we endure through these turbulent patches, trust our process and appreciate that eventually, all bear markets come to an end.

Weather ahead

Inevitably, circumstances may force us to change course enroute.  Sometimes we can navigate around the event, other times we must grit our teeth and fly through the turbulence.  The pilot may encounter different winds than forecast, icing at the requested altitude or even worse.  On the ground, your advisor responds to your life events as they occur: job loss, incapacity, birth of a grandchild, an unexpected inheritance – all of these may require a modification to the original plan.  In the midst of the storm, an advisor, just like the pilot, slows down, maintains a level attitude, assesses the data and focuses on the factors he or she can control:  can we rebalance the portfolio, harvest any unrealized losses, or deploy available cash at discounted prices?

Both pilots and advisors operate in a setting that’s highly volatile, and if not managed properly can have life-altering consequences.  We approach that environment by formulating a plan, avoiding unnecessary risks, and executing that plan with discipline and focus.

Handling turbulence

Regardless of how much coaching you’ve received, bear markets are scary, just like flying through the clouds on an instrument approach for the first time.  Sometimes they’re severe but brief like the market crash in October 1987 or the most recent episode in March 2020.  Other times conditions gradually erode and the environment goes from bad to worse over several years like the Dot-Com bust of the early 2000s.  In all cases however, the most prudent path forward is to remain calm, stay in your seat and trust that the markets will recover.  Every past market decline has been temporary, while the advance is permanent.

For additional valuable perspective on tuning out the noise associated with stock market events, take 2 minutes to listen to this fantastic piece from Dimensional Fund Advisors –  Tuning out the Noise.

Bill serves as President and Chief Executive Officer of the firm as well as Chairman of the Board.  Based in the Greensboro office, he oversees client relationships, assists in new business development efforts, and works directly with many of Trust Company’s not-for-profit clients.

Coronavirus: Views on Volatility through a Historic Lens

by Dan Tolomay, CFA

Inboxes have been especially full lately. The contents are not e-mails from worried clients but from other members of the financial services industry. Everyone, it seems, has thoughts on the Coronavirus and market volatility. And this is not new. After the crisis in 2008, any blip in the markets generates a frenzy of commentary.

Such reactions set a tough precedent. Reacting to every decline runs the risk of “crying wolf” and having the message passed over. Sporadic publications may cause readers to wonder if one event is more or less serious than another. Lastly, failure to address each price decline may be perceived as being dismissive or aloof.

Hopefully, the commentary below provides some perspective on recent events. We do not (nor does anyone else) possess any unique insight that will tell us how long this will last or what the magnitude will be. What we do know is that we expect volatility from equity markets. Higher risk equates to higher expected returns. We are aware of the situation and view it as a normal component of investing in stocks.

The headlines pertaining to the spread of the Coronavirus around the globe and the increase in the number of infected are unsettling. Of primary concern is the health and well-being of people around the world. We remain hopeful that coordinated global containment efforts and common sense precautions will slow and eventually cease the outbreak.

Of secondary concern is the impact the epidemic is having on financial markets. Is it different this time? Yes, this time it’s Coronavirus. Last time it was Ebola. Before that Zika. The following graphic from The Wall Street Journal summarizes market reactions to recent epidemics.

It is not our intent to diminish any of these events. Rather, we seek to highlight the fact that this type of event has happened before and markets reacted the same way – by processing information. The recent volatility can be unnerving, but it proves that markets are working. Declines occur when market participants reassess their views of the future. Governments, companies, and individuals are all trying to figure out what is next. These reviews translate into uncertainty.

Unknowns are risky. Consider, for example, that you are buying a used car. Despite your diligent research, there is still an element of uncertainty. What if it looks, sounds, and drives fine but there is an unseen issue? You may build in a margin of safety (via paying a lower price) to allow for something to go wrong (i.e. a needed repair). The same concept applies to stocks. When risk increases, higher returns are required for investors to bear that risk. Higher returns are achieved by paying lower prices for “risky” assets like stocks. Prices will settle at a level that provides a positive expected return for exposure to the perceived hazard.

Every market stress is different in its duration and magnitude. But, looking at past events, we see that markets have rewarded investors for bearing risk.

Perspective on historical volatility may help put the recent selloff in context. The chart below looks at the S&P 500 from 1980 through the end of February 2020 on an annual basis. Over that time, the average annual return (blue bars) has been about 10%. There has been quite a bit of variance around that average.

However, within any year the noise is louder but common. On average, the S&P saw an intra-year decline of -14%. And, to the upside, the average intra-year advance was +23%.

It may be tempting to try to miss those declines and capture those increases. Again, the data paints a sobering picture.

As we’ve seen in the past few weeks, volatility – both down and up – tend to occur together. So, an attempt to avoid big losses may very well mean missing big gains, too. And missing a few of those can be devastating.

Times like these can be stressful and you may feel helpless. So, what can you do?

1. Ask yourself if anything has changed with your personal situation that would merit a change to your asset allocation. If so, discuss with your advisor. If not, stay the course.

2. Avoid the risks that you can. For example, diversify your portfolio.

3. Control the controllable. Keep your investment costs down and more will stay in your pocket.

4. Have faith in markets to set prices at a fair level and provide a return commensurate with the risk being borne.

Please stay healthy and safe. If you have any questions, please let us know.


Late November Reflections

by Dan Tolomay, CFA

As the fourth Thursday of November draws near, it’s time to stop and reflect on the important things – like the best sales on Black Friday. While I never have participated in the early morning rush to beat the crowds to get the best deal, some interesting observations can be made from this annual event. What if we apply the approach to our portfolios, specifically growth and value stocks?

Whether it’s a new television or shares of a company, a good starting point in assessing the opportunity is the price. For the purposes of this analysis, we’ll assess the “price” of a stock as its price-to-book (PtB) ratio, which is a common metric in finance to assess how expensive/attractive a stock is. At the end of October 2019, growth stocks (represented by the Russell 1000 Growth Index) traded at a PtB of 8.07 while value stocks (using the Russell 1000 Value Index as a proxy) stood at a PtB of 2.04. It is common for growth to trade at a higher PtB than value, so don’t read too much into this…yet.

How does the current price compare to its history? Available data, that goes back about twenty-five years, shows that growth and value stocks have averaged PtBs of 5.08 and 2.06, respectively. Put another way, growth is 59% more pricey and value is 1% less expensive than their long-term averages. One percent isn’t a sale to fight crowds over, but no one is going to get up early for a nearly 60% mark up!

Another lens that can be used to view the current versus historical prices is to look at the distribution of price observations. A PtB of 8.00 to 9.00 has only occurred 7% of the time for growth stocks whereas a PtB of 2.00 to 2.25 was noted most frequently (38% of the time) with value shares.

Paying more than historical averages doesn’t just sting in that you’re not getting a deal; it can lead to serious buyer’s remorse. There is an inverse relationship between the price you pay and your subsequent investment experience. The graphs below compare different starting valuation levels with the subsequent ten year annualized returns.

The current valuations are consistent with ten year returns of -3.60% for growth and +7.53% for value. Indeed, the last time the PtB crossed 8.0 for growth stocks was June 30, 1999. From there, the annual return was -4.18% per year for the next decade. Value looks priced to deliver a more satisfying experience for the purchaser. On average, growth trades at 147% of value’s PtB. At the end of October, that metric was 296%.

Setting aside bargain hunting, there are reasons to be thankful. One reason is diversification. Research shows that value stocks perform better over long time periods. Owning a diversified portfolio that also includes growth stocks helps in the inevitable (and unforeseeable) times that value is out of favor.

And while much has been made of how value has underperformed growth recently, some perspective is helpful. For the ten years ended June 30, 2019, value delivered 12.9% on average versus its long-term average of 12.7%. Over the same period, growth provided 16.3% against a historical backdrop of 9.7%.

Hypothetically, what would the next ten years look like for both sets of stocks to return to their long-term trends? Value would return 12.49% per year while growth would turn in 1.99%.

A second reason to give thanks is that we don’t engage in market timing. Valuations and mean reversion suggest that the returns through 2029 may favor value. This supports our strategic value tilt and has led us to make tactical shifts to best position our portfolios for the future. Making drastic moves to try to precisely time a growth to value shift is futile in our opinion. Consider the above example of June 30, 1999. With perfect hindsight, growth was expensive and had a bad next ten years. But the index kept rising and was up another 31% from that point through August 31, 2000.

A final reason for gratitude is that there are pockets of opportunity in a seemingly stretched market. The media reports every time the broad markets hit a new closing high. This has led many investors to ask if returns must then be lower in the future. There is no crystal ball, but there is data that suggests that maintaining exposure to more attractively priced areas of the market will provide stronger, more equity-like returns going forward.

And so, whether you enjoy the rush of bargain hunting on Black Friday or simply pausing to give thanks on Turkey Day, there are reasons to appreciate both in your portfolio. Happy Thanksgiving from Trust Company of the South!

Value Stocks: Lessons from the Produce Aisle

by Dan Tolomay, CFA

With US value stocks experiencing one of the longest and largest periods of underperformance relative to US growth stocks, we consider whether the value premium will continue into the future and, if so, how best to position a stock portfolio to realize this premium.

Key Findings

  • US value stocks have outperformed US growth stocks by 3.30% annualized since 1928.
  • US value stocks have outperformed US growth stocks in 84% of all 10-year periods since 1928.
  • Not since the Great Depression have US value stocks underperformed US growth stocks by a similar degree.
  • A careful look at stock market history offers comparable time periods where the value premium was declared dead only to recover dramatically.


Savvy shoppers know how to get the most for their money. If you could buy 10 apples for $1.00 or 15 apples for $1.25, what’s the better deal? It’s the latter, as the cost per unit (apples in this case) is lower. You don’t know in advance if one option will lead to a better result (taste). You assume the same outcome and look for the better deal. This is basically the value premium at work.

Markets are mostly efficient, which means that all relevant information is reflected in a stock’s price. As new data becomes available, investors digest it and move the price to a fair level. From a company’s exciting opportunities to its concerning threats, the price should reflect its prospects. Trying to outsmart the collective knowledge of global investors is not a game that is easily and consistently won.

If we assume that two stocks are priced fairly to reflect their possible futures, how do we decide which we prefer? First, as the future is unknowable, we don’t pick one. We own them both. But, we use the same approach as we did with apples to improve our odds. A valuation measure compares stocks using a common metric. For example, the price-to-book ratio compares two stocks’ price per unit of book value. Where is the better deal? Assuming the same outcome, the lower per unit price is the answer.

Why Do We Pursue the Value Premium?

A tenet of Trust Company of the South’s investment philosophy is to pursue compensated risks. In practice, this means to deviate from the market’s composition and hold stocks at different weights. By overweighting stocks with higher expected returns and underweighting names with lower expectations, the portfolio is positioned differently. This makes sense as, to outperform the market, the portfolio has to differ from the market. This deviation may or not payoff (the risk).

One of the sources of higher expected return is targeting stocks with lower valuations (aka “value” stocks) as described above. The value concept is not just theoretical. Looking at the longest available return data sets for the U.S., International Developed, and International Emerging markets, there is an observable return premium. Value stocks have bested growth stocks in these markets by annual averages of 3.30%, 5.01%, and 3.66%, respectively as shown in Exhibit 1.

Over long periods of time, the numbers are impressive but not constant nor guaranteed. I often explain to clients that if the value premium was available for the taking every year, it would not exist. Investors would pour money into value stocks and bid prices up to a point where the higher return disappeared. While we expect higher returns every day, we don’t realize them every day.

The exhibits below illustrate how the value premium is observable but less consistent on a year-to-year basis (Exhibit 2); however, over longer periods, the value premium increases in consistency (Exhibit 3).

We cannot know when the value premium will appear, for how long, and to what extent. So, the best approach is to have a disciplined investment strategy. Historically, short-term pain (underperformance) has been rewarded with long-term gain (index beating returns after expenses) the majority of the time as illustrated in Exhibit 4.

Will the Value Premium Reappear Soon?

Recently, value has underperformed growth even for recent 10-year periods. This is not unexpected. It has happened before and will happen again. Despite the 83% success rate of value over growth, there is the other 16%. And things can change fast.

Consider year end 1998. Growth had bested value over 1, 3, 5, 10, and 20 year periods. Then came 1999 when growth beat value by 27%. Surely, the value premium was dead or at least not worth pursuing. By February 28, 2001, a mere 14 months later, value was beating growth over all of the aforementioned time periods.

Exhibit 5 below illustrates this dramatic reversal of value’s performance over growth’s performance around the time of the tech bubble.

Now, for argument’s sake, let’s assume there is no value premium going forward. How should a portfolio be invested? Growth stocks have outperformed value stocks. A basic investing axiom is to buy low and sell high. Rebalancing a portfolio would mean selling outperformers (growth) and buying underperformers (value).

A look at valuations, which are a good indicator of long-term returns, makes a similar case. Growth stocks are not only expensive relative to value stocks but relative to their own history. Selling expensive names and reinvesting in cheaper stocks increases the portfolio’s expected return.

Most of the comparisons so far have been value versus growth. The options are not mutually exclusive, though. A tilt toward value increases the potential gain, but it is not an “all-in” bet. A diversified fund with a low cost that leans toward value will produce a solid result even if the value premium ceases to exist.

What is the Best Way to Implement a Value Tilt?

Regardless of whether one is strategically pursuing the value premium or tactically positioning to reflect recent market moves and current valuations, what is the best method for investing in value? There are three main paths.

In the first, conventional active management attempts to provide benchmark-topping returns. The manager will try to outsmart other investors. As a result, there will be variance around the benchmark’s return. Some positive, some negative. Unfortunately, over long periods of time, there’s much more negative. This can be observed by looking at the Morningstar category average returns (Exhibits 6 & 7) for the large value and small value groupings.


This is, unfortunately, a typical result for stock pickers trying to beat a benchmark. Standard & Poor’s Index Versus Active (SPIVA) study, which is produced semi-annually, shows the percentage of stock pickers that trailed their benchmarks as shown in Exhibit 8.

While these odds are bad, the story gets worse. You would have had to identify one of the minority of winners in advance. Picking a past winner is no guarantee of future success as a small number go on to repeat as victors. Lastly, “beating the benchmark” doesn’t capture magnitude. A return over the benchmark of, say, 2.00% sounds great. But, beating it by 0.01% also counts as outperformance!

In the second approach to investing in value, index funds seek to minimize variations with the benchmark’s return. As such, there will be little difference between the fund’s return and its target. This predictability is nice, but it comes at a cost. Index funds will always trail the benchmark because of their expense ratio. Take, for example, two iShares funds as of 7/31/19 in Exhibits 9 and 10.

For the third method to value investing, an evidence-based approach uses research to construct a portfolio. Rather than try to outsmart the market, it harnesses the power of markets. Using the information reflected in where investors -in aggregate- have set prices, the portfolio can be structured to maximize return instead of minimizing noise around a benchmark.

Building a portfolio that is different than the market leads to returns that are not the same as the market. In shorter periods of time, this can be significant; however, the noise fades over time and the approach triumphs.

Over 1 year periods, DFA Large Cap Value has trailed its benchmark by as much as -10.5% and beat it by up to +20.3%. The range shrinks over time: 3 year periods (-5.8% to +6.2%), 5 years (-4.5% to + 5.2%), and 10 years (-0.4% to +2.7%).

The story is the same for DFA Small Cap Value. 1 year periods (-13.8% to +21.3%), 3 years (-4.3% to +8.2%), 5 years (-2.3% to +5.6%), and 10 years (-0.1% to +3.1%).

This information is displayed in Exhibit 11 below.

The odds of a benchmark-topping return (after fees) also increase with time as shown in Exhibit 12.


It has been frustrating to be a value investor as of late. However, whether it is apples or stocks, you receive more when you pay less. Short-term underperformance and noise around the benchmark are the costs for the benefit of higher long-term returns. History shows that the odds favor the value investor but there will be challenges along the way.

So, this fall, sit back and enjoy an apple. Current valuations point to better days ahead for value stocks. Having the gumption to stick to plan and capture these returns is critical. Peace of mind is further provided knowing that an evidence-based approach is the most probable road to success.

Is the Past Prologue?

by Dan Tolomay, CFA

With the Standard & Poor’s 500 trading near all-time highs and bond yields remaining low, a natural question is, “what is the implication for future returns?”. Let’s take a look at: what has occurred in the past, what’s happening in markets now, and what we should expect and why.

From 1926-2017 U.S. bonds returned 5.35%, and U.S. stocks delivered 10.27% on average. During the same period, inflation averaged 2.91%. As a result, an investor in these assets would have earned between 5.35% and 10.27% in nominal (pre-inflation) terms or 2.44% to 7.36% on a real (inflation-adjusted) basis. A “balanced” portfolio of 60% stocks and 40% bonds (common among investors trying to fund a spending need and maintain purchasing power) would have provided 8.30% and 5.39% in pre- and post-inflation scenarios, respectively. The 5.39% real return would have allowed for withdrawals and covered all related costs.

None of us know the future, but we can use data to see what may play out over the next decade. While not a perfect predictor, looking at how expensive stocks are can be a good indicator of future long-term returns. Using historical data, U.S. equities are trading at a valuation level that implied a roughly 5.52% annual pre-inflation return over the next decade. Bonds, too, have a useful rule of thumb for estimating forward returns. There has historically been a close relationship between the ten-year Treasury note yield and the subsequent ten year return of the broad bond market. The 10-year yielded 2.51% at the end of April. The last piece of the puzzle is inflation. Breakeven inflation, which is the inflation rate that is priced in by the market where Treasury and Inflation-Protected Treasury notes provide the same real return, is 1.95%.

Looking ahead, then, an all bond portfolio might provide 2.51% pre-inflation return and an all stock portfolio could produce 5.52% of pre-inflation return. After inflation, the numbers drop to 0.56% and 3.57%, respectively. A 60/40 portfolio delivers 4.32% before inflation and 2.37% after inflation. Obviously, these implied returns provide less for portfolio draws and cost coverage.

What’s an investor to do?

Confirm asset allocation. A comparison of an account’s present value to its desired future value combined with a time horizon allows for a return goal to be defined. By comparing the required return to the expected return, tweaks may be necessary to a portfolio’s asset mix to reconcile the two. It is critical that risk is considered as well as return. Higher returns come with more volatility. If the portfolio is unable to tolerate the swings or if volatility causes the investor to deviate from plan, then risk is too high.

Focus on controllable factors. The account’s asset allocation will determine its return. And, while the current value cannot be changed, other levers can be pulled. The future value is one. The original goal may be too lofty and may require revision. A review of future spending plans is a healthy exercise. Alternatively, the goal may be left as is and the time horizon extended. Allowing funds more time to grow before use can offset lower potential returns. Lastly, the account can be funded at higher levels. More money growing at a lower rate can achieve the same goal as less money grown at a higher percentage.

Think bigger. The analysis thus far has focused on the U.S. only. However, nearly half of the global stock market lies beyond the borders. Those markets are trading at lower valuations and have higher expected returns than American shares. Diversifying globally increases the expected return on stocks. Similarly, the majority of the taxable bond market exists internationally. By not exposing all fixed income exposure to the United States’ yield curve and inflation environment, volatility can be lowered and returns can be potentially enhanced.

Think smaller. Looking at valuations and implied returns across the globe is helpful, and so is looking within markets. In the United States and developed international markets, the better buys (and, thus, higher implied results) lie in smaller companies and value stocks. Both have greater expected returns than their broad market measures.

Eliminate unfavorable odds. Harry Markowitz (Nobel Laureate) called diversification “the only free lunch in finance”. Holding a portfolio of only one or just a few stocks yields higher risk than potential reward.  This type of concentration risk is easily diversified away. Further, research shows that the vast majority of conventional active managers fail to outperform their benchmarks after cost. Trying to outsmart the collective market tilts the odds away from your favor. Lastly, there is a clear relationship between costs and returns. The more you pay, the less you keep.  Thus, keep costs low.

We cannot know what the future holds. What we can do is look at what’s happened historically and at what might occur based on current market fundamentals. Setting and sticking to a plan based on portfolio-specific circumstances and adapting as necessary is a key first step. Diversifying across and within markets, targeting higher expected returns is next. And, lastly, by avoiding unnecessary risks and minimizing costs, more return – whatever it ends up being – accrues to your bottom line.

Why Should You Diversify Globally?

by Chase Reid, CFA, CFP

With US stocks outperforming non-US stocks in recent years, some investors have again turned their attention towards the role that global diversification plays in their portfolios.

For the five-year period ending March 31, 2019, the S&P 500 Index had an annualized return of 10.91% while the MSCI World ex USA Index returned 2.20%, and the MSCI Emerging Markets Index returned 3.68%. As US stocks have outperformed international and emerging markets stocks over the last several years, some investors might be reconsidering the benefits of investing outside the US. While there are many reasons why a US-based investor may prefer a degree of home bias in their equity allocation, using return differences over a relatively short period as the sole input into this decision may result in missing opportunities that global markets offer.

Although international and emerging markets stocks have delivered disappointing returns relative to the US over the last five years, we will show that historical data support global diversification and that the human brain may be playing tricks on domestic investors all over the world.

The global equity market is large and represents a world of investment opportunities. As shown in Exhibit 1 below, nearly half of the investment opportunities in global equity markets lie outside the US. Non-US stocks, including developed and emerging markets, account for 48% of world market capitalization and represent thousands of companies in countries all over the world. A portfolio investing solely within the US would not be exposed to the performance of those markets.

Exhibit 1: World Equity Market Capitalization

At Trust Company, we retain a slight home bias. Our neutral US to International equity mix is 65% US and 35% International. This positioning largely stems from a thorough study performed by Vanguard. The analysis looked at the minimum variance (i.e. greatest risk reduction) point between US and international stocks for an investor based in the US. The researchers at Vanguard found that a range between 30% and 40% invested internationally saw the most benefit. This study was updated in February 2019 with similar findings.

We can examine the potential opportunity cost associated with failing to diversify globally by reflecting on the period in global markets from 2000–2009. During this period, often called the “lost decade” by US investors, the S&P 500 Index recorded its worst ever 10-year performance with a total cumulative return of –9.1%. However, looking beyond US large cap equities, conditions were more favorable for global equity investors as most equity asset classes outside the US generated positive returns over the course of the decade (See Exhibit 2 below). Expanding beyond this period and looking at performance for each of the 11 decades starting in 1900 and ending in 2010, the US market outperformed the world market in five decades and underperformed in the other six. This further reinforces why an investor pursuing the equity premium should consider a global allocation.  By holding a globally diversified portfolio, investors are positioned to capture returns wherever they occur.

Exhibit 2: Global Index Returns, January 2000 – December 2009

Over long periods of time, investors may benefit from consistent exposure in their portfolios to both US and non US equities. While both asset classes offer the potential to earn positive expected returns in the long run, they may perform quite differently over short periods. While the performance of different countries and asset classes will vary over time, there is no reliable evidence that this performance can be predicted in advance. An approach to equity investing that uses the global opportunity set available to investors can provide diversification benefits as well as potentially higher expected returns.

Our partners at Dimensional Fund Advisors (DFA) provided a study of a globally balanced portfolio compared to the S&P 500 which goes back to 1970. The globally balanced portfolio is a 70/30 split between US stocks and international stocks with tilts to value and small companies. Exhibits 3 and 4 below compare the long-term success of the globally balanced portfolio (Exhibit 3) relative to the S&P 500 with the recent short-term outperformance of the S&P 500 (Exhibit 4).

Exhibit 3: Long-term (January 1970 – December 2017)

Exhibit 4:  Short-term (January 2010 – December 2017)

One of the most common investment conversations we have had with clients over the past decade has been our US to International weighting. Even with our underweight position to International equities, many clients have questioned the benefits of having International equity exposure at all. The data found in this piece provide a clear answer. Still, the questions continue and, in fact, are quite natural.

The field of behavior finance has exploded in recent years with many insights into humanity’s inherently flawed brains. The human brain is remarkably complex and able to perform great feats. Little children learn to speak and understand language within months of being born. We have built upon knowledge over centuries to spur new technologies such as the printing press, the automobile, computers, and today’s smart phones. The extents of our brains’ potential is still not fully known. Yet, we regularly call our kids by the wrong name, lose our keys, and struggle to remember what day it is. Maybe this is just this writer’s experience, but all of us can likely point to something quite simple that we simply cannot get right.

In his seminal work Thinking Fast and Slow, Daniel Kahneman describes two systems in our brain: system 1, which governs about 90% of what our body does every day and system 2, which does all our strong computing and analysis. Our system 2 is quite good and is responsible for humanity’s great triumphs. Our system 1 is quite bad, and in many cases, it is worse than animal brains. Our system 1 is quick to form error prone thinking habits without our even realizing it. Outlined below are a handful of common system 1 flaws that have very likely influenced investors in the debate regarding the optimal US to International equity mix.

If you are wondering if you have flawed thinking about your US to International equity mix, then reflect upon the arguments presented in this research piece. If the facts discussed herein leave you unconvinced about the necessity of diversification to international equities, then maybe one of the below biases is at work in your mind.

Recency Bias: Easily remembering something that has happened recently, compared to remembering something that may have occurred a while back.

  • Example: Say you live in upstate New York. During the last two winters, this part of the country has received less than a foot of snowfall each year. Despite a long-term average of snowfall of 80 inches per year, you focus on recent winters and decide to forgo the all-wheel drive in your new car purchase.
  • Application: The S&P 500 has outperformed recently. Despite data showing global diversification as a superior strategy over a long time period, your brain incorrectly thinks that international equity does not warrant a place in your portfolio.

Familiarity Bias: Preference for familiar or well-known investments despite the seemingly obvious gains from diversification.

  • Example: Say you are a banker. Working as a banker for decades, you develop an expertise in what drives success and creates value for banks. Using this expertise, you invest all your assets in bank stocks in an effort to outperform the market. Little did you know, interest rates were about to move in a way that was extremely harmful for banks. This event was unknowable and completely outside of your area of expertise, so this unexpected interest rate movement created massive losses in your portfolio, even if you owned the best bank stocks.
  • Application: Investors across the globe show a strong home bias. In 2018, Charles Schwab performed a study on the UK’s home bias. The study revealed that 74% of UK investors hold a majority of their equity exposure in UK stocks. The UK is less than 5% of the global market. On top of that, 71% of UK investors believed that their country would be the top performer in 2019 despite Brexit and numerous unknowns surrounding this impending event. This same phenomenon takes place all over the world, not just in the US and UK. As a starting point, it’s far more likely that any investor is below the optimal allocation to international stocks rather than above it.

Confirmation Bias: Tendency to seek out and interpret any new evidence as confirmation of one’s existing beliefs or theories.

  • Example: Consider a Presidential election cycle. A majority of Americans will make up their minds about candidates in advance then reinforce these views through their interpretation of facts. Moreover, many media outlets disseminating these facts are biased themselves.
  • Application: Financial media in the US focus almost entirely on the US. This is not surprising. This is where their viewers reside. Financial media outlets are not in the business of financial advice; they are in the business of financial entertainment. Consider 2017, when the S&P 500 was up 22%. International stocks were up 27% with the emerging markets subset up 37%. This divergence in performance made little news and caused even less concern among US investors. Why did this go unnoticed? It was not widely reported, and when it was, the information was automatically minimized in the brain of a US investor. Since this fact does not support a naturally occurring home bias, it is quickly dismissed by the brain.

As the field of behavior finance continues to expand, many lessons will be learned. It is still not entirely clear what happens inside our brains that causes these flaws in our thinking, and it very well may be different for each individual.

To offer an amateur theory, we would point to a desire for control or certainty which are both fueled by fear. Most clients we work with have seized control of their careers, companies, and lives in general to meet goals. Generally, this proactive approach has led to much success. Unfortunately, markets do not work this way. You cannot manufacture returns in the way you can manufacture widgets. You cannot try harder to make the market go up. We have zero control over the market. We can only control our positioning relative to it, since we do control portfolio allocation, portfolio costs, and our reactions to portfolio volatility.

Thus, investing requires a release of control, a view of the long-term, and (of course) a globally diversified portfolio with an optimal mix of US to international stocks.

Markets in 2018: A Preliminary Review

by Dan Tolomay, CFA and Chase Reid, CFA, CFP

Given recent investor behavior, we wanted to provide a commentary on diversification, particularly relative to the often highlighted S&P 500 index.  Our piece is broken into two sections.  The first portion looks at the investor psyche during periods when the S&P 500 appears to be king and diversification seems to be better identified as di-worse-sification.  The second portion of our commentary analyzes portfolio construction step-by-step to illustrate why performance of a diversified 60% /40% portfolio has deviated from the S&P 500 this year.  We hope you enjoy.

Investor Psyche About The S&P 500: You Were Always On My Mind

Global equity markets have seen resurgent volatility after an uncharacteristically quiet year for stocks in 2017.  This year, US stock investors had to wait almost nine months to break previous all-time market highs set back in January 2018, only to see markets fall back below all-time highs this October.

2017, on the other hand, saw new all-time S&P 500 highs reached on 67 trading days.  This is just over 25% of all trading days in US markets for a calendar year.  Another way to think about it is the S&P 500 averaged a new all-time high about once a week or five times per month.  With no significant drawdowns, 2017 proved to be a delightful year for investors, both US and international.

The quilt chart below is no doubt familiar.  It illustrates various global stock market categories.  You will notice common themes.  No portion of the equity market clearly outperforms over time, and no portion of the equity market clearly underperforms over time.  Finally, the gray global equity box is often in the middle experiencing a smoother average ride.

Simply put, diversification works.

In fact, most investors agree that diversification works.  This is not a controversial statement in investing.  It’s quite the opposite.

So, why do investors consistently measure their diversified portfolio against the S&P 500’s performance?

A well-diversified portfolio, like those we manage at Trust Company, is a globally allocated mix of stocks and bonds.  Referring back to the quilt chart, it is clear that US stocks, particularly large cap stocks as measured by the S&P 500 (green boxes), have performed better in recent years.  Further, US financial media and news outlets reinforce this information by rarely quoting any index outside of the big three US indices: S&P 500 Index, Dow Jones Industrial Average, and Nasdaq Composite.

This creates a well-researched phenomenon of how we instinctively view things in our brain.  It is called the availability bias.  This bias is simply defined as the human tendency to think that examples of things that readily come to mind are more representative than is actually the case.

In truth, this bias is hardly avoidable.  What do you imagine the ratings of financial media programs would be if pundits only discussed how a diversified portfolio performed?

When the S&P 500 is up some level more than a US investor’s diversified portfolio, the question naturally arises: why am I underperforming?  Unsurprisingly, it does not work the other way.  In 2017, few – if any – US investors were likely to ask the question: why was I not up 37% like emerging markets?

2017 saw global diversification work in a big way with both developed and emerging international stocks beating the S&P 500.  But based on what we know of the availability bias and financial media, this largely went unnoticed.  It is critical to fight our natural urges to only see what is right in front of us.  Instead, we must dig deeper into the complete story of global markets before making observations about portfolio performance.

One key takeaway from this discussion is that diversification works.  It has often been said that diversification does not work every time, instead it works over time.  The other key message is that we must always fight our biases.  As the great investor Benjamin Graham once said, “The investor’s chief problem – even his worst enemy – is likely to be himself”.

In the next section, we walk through an example 60% stock/40% bond portfolio to illustrate how its performance has differed from the S&P 500 in 2018 and why.

Diversified 60/40 Versus S&P 500 in 2018

To properly consider a globally diversified 60/40 portfolio, we will show in a number of steps how we arrive at the ultimate allocation.  Along the way, you will notice how a diversified portfolio differs from the S&P 500 and the reasons why it should.

Let’s start with a look at the S&P 500 versus a portfolio consisting of 60% global equities and 40% global fixed income.  In each step we will use well recognized market benchmarks for performance representation.

Right away, we see a major disparity in how our example global portfolio has performed year-to-date versus the S&P 500.  The other aspect to note is that we are comparing the S&P 500 which is 100% equity to a portfolio that has 40% of its allocation in bonds.  This is like comparing a basket of apples to a basket of apples and oranges.  This is a common error when investors analyze performance differences.

We will now add further allocation details similar to how Trust Company allocates its global stock and bond portfolios.  This will provide a window into how different parts of the market have performed this year.

Trust Company retains a slight home bias in its equity allocation relative to global markets which is roughly 50% US and 50% international.  This thinking is principled in a study performed by Vanguard which looked back over decades of data to determine the optimal mix of US and International stocks.  The range of preference was determined to be 30%-40% of a US investor’s equity exposure invested abroad.  Trust Company settled at the midpoint of 35%.

Within fixed income, the US is a much smaller component of global markets, around one-third of global fixed income.  In this asset category, there are a variety of reasons to retain a larger home bias, such as: costs associated with currency hedging, lower exposure to US Treasuries which are a safe haven in times of crisis, and lower transparency in some international bond markets. Thus Trust Company’s fixed income is divided 70% US/30% International across our bond portfolios.

Finally, let’s consider how Trust Company invests in equities relative to market weights.  Rigorous research illustrates that a tilt toward value stocks and smaller firms generates excess return over time.  Below are these two risk premiums over time in different markets.

The data show that these risk premiums do not go unrewarded over time.  That being said, they do not show themselves every day or every year.  In 2018, US Value stocks have underperformed the S&P 500 by 4.71% and smaller firms have underperformed the S&P 500 by 3.4%, as measured by the Russell 1000 value index and the Russell 2000 index respectively.

These measurements are taken at the index level, but investors cannot invest directly into an index.  So, it is worth considering how these numbers may differ at the fund level.

At the fund level, research shows that most active managers underperform over time.  Indexed funds may track more closely to their benchmark but will still underperform by their expense ratio over time.  Our core fund manager, Dimensional Fund Advisors (DFA), has proven to add value over most benchmarks in the long run.  This is partially due to DFA’s low cost structure but also due to their superior techniques for tilting to value and size premiums.

Taking all aspects into account, a diversified 60/40 portfolio has underperformed the S&P 500 in 2018 for three main reasons.

  • The S&P 500 is an all equity index while a diversified 60/40 has a large amount in fixed income.
  • International equities have performed worse in 2018 than US stocks.
  • Value and small stocks have underperformed.

As disheartening as all this information may appear for 2018, remember that diversification works over time.  Below is a look at the same comparison, but instead of looking only at 2018, we broaden the timeframe to 15 years.  As long-term investors, this is a much more appropriate time period to use when determining a proper long-term allocation.

The final, and most often overlooked, key in this analysis is the amount of risk required to earn these returns.  Money does not grow for free.  It requires payment in the form of risk.  Risk is a necessity in order to receive returns like those listed above.  It cannot be avoided, but it can – and by all means should be – minimized through diversification.

To that point, the S&P 500 returned 9.65% over the past 15 years by taking on 13.19% in risk, as measured by standard deviation.  Said another way, for every 1 unit of risk taken the S&P 500 earned .73% in return.  The Diversified 60/40 portfolio returned 7.49% over the past 15 years.  Its risk, as measured by standard deviation, was 8.94% over the same time.  Thus, the diversified portfolio earned .84% in return for every 1 unit of risk taken.  These calculations show that diversification helps investors use risk more efficiently to smooth their ride and target their goals with a greater degree of confidence.

2018 is a year where the diversified portfolio will likely be marginalized by financial pundits and US investors.  It will be questioned, criticized, and thrown out by some.  How quickly we forget why we diversify.  It was not that long ago that the S&P 500 returned 0% for a 10 year period.  Referred to as “The Lost Decade” for the S&P 500, those who diversified globally over the same time period saw a positive outcome.


If It Was Easy, Everyone Would Do It

by Dan Tolomay, CFA

Wouldn’t it be great if we were all in perfect shape and successful? I would argue no. At least we wouldn’t think it was great. The reason, I believe, that we value these attributes is scarcity. If everyone had a perfect body and was accomplished, it would be no big deal. It would be common and, as a result, its value would disappear.

While these end results are desirable, the effort to achieve these goals also commands respect. A good physique is the outcome, but it requires hours of effort and discipline to attain. Similarly, success – be it professional or personal – comes only after pouring time and energy into an effort. The same can be said of investing in the equity markets. Why do some investors stand out? The end result (higher returns) and effort (discipline) sets them apart. Higher returns can be sought through active management (stock picking and market timing); but, studies show that the higher costs that come along with this approach lead to sub-par results. Holding a concentrated portfolio of a few stocks may lead to outsized gains, but it may also leave you penniless.

Based on the above, one could argue for an indexing approach. Indexing avoids the losing bet of active management and diversifies a portfolio. Additionally, it keeps costs low. However, it has flaws. The return achieved will closely track the gain/loss on a benchmark. This benchmark, which is maintained by a third-party, defines the investment strategy. The strategy is not necessarily based on fundamentals, but on index rules. The focus of replicating the benchmark can lead to forced transactions and costs. Lastly, the changes that the index must make can distort prices of securities being added or removed.

Dimensional Fund Advisors (DFA) engages in asset class investing. This approach retains the benefits of indexing (low turnover, diversification, low costs). But, unlike indexing, the return sought is that of the asset class, not a commercial benchmark, and investment decisions are based on the return dimensions of stocks, not index rules. This technique means increased flexibility on transaction timing and better management of trading costs. Also, by avoiding securities that are part of an index change, mispriced securities can be evaded.

On top of these operational efficiencies, DFA targets factors (low valuation, small company size, and higher profitability) that have historically provided higher returns. But, these higher returns are not free. Return and risk are directly related – to achieve higher returns, higher risk must be borne. And, like fitness and success, if it was easy to achieve higher returns, everyone would follow the approach and achieve the better result.

Just as there are days that you may not want to go to the gym or spend another hour working on a task, there will be times in asset class investing where you’ll want to throw in the towel. Higher risk leads to the possibility of short-term underperformance. But, those who have the discipline to persevere and focus on the long-term goal will be rewarded with an outcome that is rare and desirable.

Dan is responsible for developing investment strategy and managing client portfolios for Trust Company. Prior to joining the firm in 2008, Dan was a vice president at Smith Breeden Associates in Chapel Hill. His focus was on performance measurement and, earlier, he performed analyses for the firm’s Financial Institutions Consulting Group. His career began as a financial analyst in the Business Process Outsourcing (BPO) unit of PriceWaterhouseCoopers.