Why Passive Investing Makes Sense

The debate about active versus passive management is endless in investment management circles, but here are a few simple facts in favor of passive management.

1. Missing opportunity? Strong performance among a few stocks accounts for much of the market’s return each year. There is no evidence that active managers can identify these stocks in advance and attempting to pick them may result in missed opportunities.
   
   For all U.S. stocks from 1926 thru 2011, the compound average annual return was 9.6%.
   
   If you didn't own the top 10% best stocks each year, your return was 6.2%. A huge difference!
   
   If you didn't own the top 25% best stocks each year, your return was -0.7%. Ouch!
2. The majority of active public equity funds do not beat their respective index. According to Standard & Poor's, the following percentage of actively managed funds did not beat their respective index for the five-year period ending December 2011:
   
   • 62% U.S. large-cap funds
   • 80% U.S. mid-cap funds
   • 73% U.S. small-cap funds
   • 63% Global funds
   • 78% International funds
   • 26% International small fund
   • 83% Emerging markets funds
3. Superior performance is not persistent. Of the top 25% U.S. stock funds from 2002 to 2006, for the following five-year period from 2007 to 2011:
   
   • Only 8% remained in the top 25%.
   • Only 18% remained in the top 50%.
   • 21% fell to the third quartile of performers (51% to 75% range)
   • 46% fell to the bottom 25% of performers.
   • 15% didn’t survive (the fund was merged or closed)

Passively managed funds have a very high relative predictability to match their benchmarks and not underperform.

These few simple facts lead to a successful long-term investment strategy.

About Bruce J. Berno, CFP^®

Bruce J. Berno, CFP^®is the founder of Berno Financial Management, Inc. a fee-only comprehensive personal financial planning and investment advisory firm headquartered in Cincinnati, Ohio. Since 1993, Berno Financial Management has been helping individuals and families achieve financial peace of mind. For more information about Berno Financial Management, visit http://www.bernofinmgt.com/.

Tax Fairness Isn't Simple

There is no better time than an election year to "spin" some income tax statistics. Getting the facts from reliable sources will help you decide which candidates are telling the truth and hopefully help you decide how to cast your vote.
Who are these "1%" people anyway? What percentile do I fall in?

According to the Tax Foundation and based on 2009 income tax returns, taxpayers were categorized according to their federal tax return Adjusted Gross Income (AGI) as follows:

• Top 1%: $344,000+
• Top 5%: $172,000+
• Top 10%: $112,000+
• Top 25%: $66,000+
• Top 50%: $32,000+

What proportion of total personal income taxes does each group pay?

• The top 1% of taxpayers pay about 37% of the total of all personal income taxes.
• The top 5% pay almost 60%.
• The top 10% pay about 70%.
• The top 25% pay about 87%.
• The top 50% pay about 98%.
• The bottom 50% pay about 2%.

Nonetheless, no matter how you spin it, our tax system is relatively proportional and somewhat progressive (progressive in that higher income people pay a higher percentage of their income in taxes).

According to the Institute on Taxation and Economic Policy, the share of total taxes paid (including federal, state and local taxes, sales taxes, and excise taxes) roughly matches the share of total income for each income group.

For instance:

• The lowest income group paid 2.1% of taxes and earned 3.4% of total income.
• The top 1% income group paid about 22% of total taxes and earned 21% of total income.

Clearly, there are many different ways to analyze tax policies and spin the statistics. One thing is for sure; it isn't as simple and clear cut as the politicians want to make it sound. Know the facts and vote accordingly!

About Bruce J. Berno, CFP^®

Bruce J. Berno, CFP^®is the founder of Berno Financial Management, Inc. a fee-only comprehensive personal financial planning and investment advisory firm headquartered in Cincinnati, Ohio. Since 1993, Berno Financial Management has been helping individuals and families achieve financial peace of mind. For more information about Berno Financial Management, visit http://www.bernofinmgt.com/.

Do Your Friends A Favor: Show Them There's a Better Way!

Help your friends understand the difference between a broker and an independent advisor. 

On March 14, the New York Times published an Opinion-Editorial by Greg Smith, a Goldman Sachs Executive Director. In the piece, Smith explained that he was resigning from the one of the world's largest and most important investment banks due to the conflict between the best interests of the clients and the culture of Goldman Sachs.

While your friend's individual broker may be an honest and ethical person, most investors do not realize or understand the conflict of interest that a broker faces. (Brokers include representatives of the major brokerage firms as well as anyone whose business card or letterhead says "Investments offered thru XYZ Securities.")

Bob Veres is a journalist who has decades of experience covering the personal financial planning industry. He is an independent journalist and well-respected authority on the industry.

Veres recently published the following article for independent advisors on the conflicts that brokers face, particularly in compensation plans, which I share with you verbatim per his suggestion. My only request is that you consider forwarding it to a friend who you know uses a broker and would be better served by an independent, fee-only firm like ours that acts in a fiduciary capacity in the best interest of you, our valued client.

The Difference Between a Broker and an Independent Advisor
By Bob Veres

The financial advisory profession has recently created two pretty good videos that illustrate the conflicts of the agency/brokerage/wirehouse advice model. One, produced by Hightower Securities (which actively recruits brokerage teams) compares brokers to butchers and fiduciaries to dieticians; the one sells you a choice cut of meat, the latter sells advice on a healthy diet. Don't ever ask the butcher if you really need a juicy pork chop in your diet. (You can find the video here)

The other video was produced by Greenspring, which is a fee-compensated advisory firm I probably should be familiar with, but am not. The video explains certain conflicts built into the brokerage compensation model, and why they provide incentives for a broker to make recommendations that may not be in the customer's best interests. You can find the video here, and tables showing various brokerage compensation structures (fascinating reading in their own right) can be found here. Be sure to scroll to the bottom, where the magazine provides the actual payout grids, plus interesting tidbits like the fact that Merrill brokers won't get paid for advising any accounts under $250,000 in size unless at least 80% of their accounts are that large or larger, at which point they can be compensated for servicing customers who bring in those measly $100,000 accounts.

You also see the quota system on sales: Morgan Stanley brokers who have been with the firm for nine or more years have to produce at least $300,000 in sales or they're put on probation. A company spokesperson says that the firm's previous $250,000 quota was lower than the industry average, so the firm decided to come inline with everybody else.

As the Greenspring video makes clear, the system is most conflict-ridden when an advisor is close to reaching a higher payout level―when, say, the Merrill Lynch advisor has made $280,000 in commissionable transactions or brought in asset management dollars that generate this level of total compensation (gross dealer concessions) as of mid-December. At that production level, he stands to make 35% of the total, which comes to $98,000, while the firm takes the rest for overhead, expenses and those amazing executive bonus pools. But if that broker can get another sale, or bring in more assets to generate $20,000 more in gross production/sales, it would bring him up to the $300,000 threshold. At that level, he'll earn 38% on the total amount for the year, plus a potential long-term productivity bonus of 2.5%. That $20,000 sale could mean an increase in yearly compensation of $23,500. Do you think that broker isn't calling his customers in the latter half of December looking for something―anything―they might be willing to buy?

You can see a more straightforward conflict of interest in the Walls Fargo Advisors payout grid, where brokers, agents and financial advisors are paid additional bonus percentages if they can sell certain noninvestment products―which are coyly not named directly, but appear to be related to gathering assets the firm will manage (Net Asset Flow Award = 2.5% in additional payout) or getting customers to take out loans (Lending and Banking Award = .5%-1.5% depending on production). The customer may not need to refinance a home mortgage through Wells Fargo, but if it means an additional payout that raises the broker's entire compensation structure, hey, why not give it a pitch?

About Bruce J. Berno, CFP^®

Bruce J. Berno, CFP^® is the founder of Berno Financial Management, Inc. a fee-only comprehensive personal financial planning and investment advisory firm headquartered in Cincinnati, Ohio. Since 1993, Berno Financial Management has been helping individuals and families achieve financial peace of mind. For more information about Berno Financial Management, visit http://www.bernofinmgt.com/.

Do You Have Too Much in International Stocks?

The financial press has jumped on the bandwagon yelling, "Sell, sell, sell!" for international stocks, especially in Europe. So our clients ask:

• How much should I have invested internationally?
• How about Europe?
• How does Berno Financial Management decide how much to invest internationally?
• What do other large advisors do?

At Berno Financial Management, we use a multi-asset class strategy for broad diversification. A truly global stock portfolio would be invested about 45% in U.S. stocks and about 55% in international stocks, including about 23% in Europe. Few U.S. investors have that much in international stocks, primarily due to currency and political risk. Our current model portfolio asset allocation includes 30% of the stock portfolio being invested in international stocks. This is our subjective target based on a balancing act to achieve optimum returns within a reasonable risk level. Our core international stock funds have slightly less than 45% of their assets invested in Europe, so a typical client's European investments are about 10% to 15% of their total stock investments (and even less of their total portfolio when including bonds and cash).

What do the big boys do? We cite two examples.

First is TIAA-CREF, which is a large private pension plan available primarily to employees of non-profit groups like universities and hospitals. Being academically minded, they have the best of resources available to them. The CREF Fund (College Retirement Equities Fund), which has about $100 billion in assets and is one of the largest private pension funds in the country, is invested 70% in U.S. stocks and 30% in international stocks. For the record, and this is the truth, we discovered this after we had set our model allocation. We are not copycats!

Second is The Vanguard Group, one of the largest providers of mutual funds for retirement plans. Their Target Date Retirement Funds and Lifestrategy Funds are very popular in 401(k)s and IRAs and have about $118 billion in assets. Their stock allocation likewise is 70% U.S. stocks and 30% international. They actually just increased the international allocation to 30% within the past few years, so we were ahead of them!

So rest easy and sleep well. Broad diversification is your friend. Remember a few years ago when investors were questioning Real Estate Investment Trusts (REITs)? They have turned out to be among the best asset classes after many investors bailed out.

If over $200 billion in assets at two of the largest retirement plan providers in the country have 30% of stocks in international investments, we think you can rest assured that this is a reasonable strategy for you as well!


About Bruce J. Berno, CFP^®
Bruce J. Berno, CFP^® is the founder of Berno Financial Management, Inc. a fee-only comprehensive personal financial planning and investment advisory firm headquartered in Cincinnati, Ohio. Since 1993, Berno Financial Management has been helping individuals and families achieve financial peace of mind. For more information about Berno Financial Management, visit http://www.bernofinmgt.com/.