By Kennon Grose

“I don’t trust the so-called financial experts anymore. I am just leaving things alone. When I claw back some of my money, I am out of there.” This comment tells us a lot about how people are feeling. First, they have realized that no one cares as much about their money as they do. Second, they are applying the homily “Fool me once, shame on you. Fool me twice, shame on me.” Millions of people have now learned enough to know the difference between quality advice and a quality sales pitch.

Trust means to have confidence or faith: “In God we trust”; “bank on your education”; “rely on your friends”. You have faith that the advisor managing your money will provide some kind of value added – usually a return advantage for you.

Mutually Rewarding Relationship

The trust you have in your advisor is grounded in a mutually rewarding relationship – you are willing to pay advisor fees to receive the value added result. Putting this in a formula might look something like this;

Value added result plus fees equals mutually rewarding relationship

Coming off one of the worst market downturns in our lifetime has brought much needed scrutiny to the financial advisory relationship. The question, which Wall Street never answers reasonably, is whether all of the fees associated with managing your money have resulted in any value added. The answer is “rarely.”

Value Added Result

A value added result doesn’t mean you should expect your account hold its value no matter what. Virtually everyone has lost significant money in the last year. It can simply mean losing less money than other portfolios that took the same level of risk. Needless to say, it’s one thing to have this idea in your head. It’s quite another to understand it when your feelings are at the panic stage. The typical measure of valued added is the amount by which advisor selections beat their appointed asset class benchmark. As you know, investors are likely to be disappointed about 70 percent of the time.

The AssetBuilder approach is different. Rather than chase index beating returns, we accept market returns knowing those allow us to do better than 70 percent of all managed portfolios. Instead, we focus on maximizing return relative to risk. Our expectation is that our portfolios will, over time, provide higher returns for the amount of risk that was taken. That’s value added.

Let me give you a concrete example. Recently we did a portfolio analysis for a prospective client. He was unusual in that he was already using a Dimensional Funds advisor. We found that our model portfolio that had a virtually identical level of risk as his provided an annualized return that was 1.69 percent higher than his current adviser over a long period¹. The advantage held short term, as well. In the first 5 months of this year his portfolio had provided a return of 9.80 percent (period return). Our comparable risk portfolio (Portfolio 9) had provided a return of 12.5 percent (period return) over the same period. That’s quite a difference.

Similarly, measured against all “moderate allocation” mutual funds in the Morningstar database, our portfolio 9 was in the top 3 percent over the same period, well ahead of the category average of 6.12 percent. This was done at a slightly higher level of risk (13.13 percent vs.11.61 percent standard deviation). This could, of course, be a statistical fluke. But we don’t think so. We think it is our value added— more return for a given level of risk. It’s something that can be seen on the upside, but it is psychologically invisible on the downside.

Fees

Since fees are guaranteed and return is not, discriminating investors are taking a hard look. Fees can take a significant bite out of an already dwindling account balance.

Financial advisor fees vary, but can be grouped by fee-only or fee-based. A Fee-only advisor is compensated entirely by the investor. A Fee-only advisor typically pays close attention to the long-term cost of what he/she is recommending. A Fee-based advisor may be partially paid by fees but is also paid commissions. These commissions are part of the food chain for the legacy investment services industry. Sometimes, the commission drives an investment strategy contrary to investors’ best interests.

AssetBuilder Difference

Guided by Nobel Prize-winning research, we offer our clients a menu of pre-constructed portfolios that make choosing and implementing a personal investment strategy relatively simple. We believe simplicity is a virtue. It’s also a powerful tool for controlling expenses. We are committed to adding value to – and subtracting cost from – your investment decisions.

As a fee-only advisor, we believe real value is delivered not in trying to outperform the market, but in constructing portfolios that capitalize on the market’s long-term returns. That’s what AssetBuilder portfolios are built to do – at lower cost than traditional financial services firms can deliver.²

Sources:

1. The return figures used are net AssetBuilder’s advisory fee and Schwab transaction fee of 70 basis points (.70%) per year. (Calculation based on average fee impact on $50,000 invested in AssetBuilder Model Portfolio 06 rebalanced annually for 5 years. Return figures calculated using Morningstar® EnCorr® software from Ibbotson Associates

2. According to the 2008 Moss-Adams survey titled Financial Performance Study of Advisory Firms.

By Kennon Grose

I would like to offer my personal thanks to those of you who have become AssetBuilder clients during the past year. We reached our second anniversary at the end of May, and we continue to grow. Even during these tough economic times. Thanks to you and your referrals, we have attracted more than 500 clients across 34 states, representing $173 million in invested assets.

The secret to our success continues to be YOU!

We believe the current global financial crisis will reshape the financial services industry in terms of competition, government regulation and investors’ taste for financial products. Now more than ever, you understand the only guaranteed part of the return is the fees you pay.

If you’re like most AssetBuilder clients, you came to us because you were tired of doing business with Wall Street brokers, their high-risk stock pickers and overpriced middlemen. You told us you didn’t want to invest based on fear, uncertainty and doubt. And we listened.

We stripped out the unnecessary costs and risks and built an investment firm that puts you first. We offered a science-based system of diversified index investing designed to capitalize on the market’s long-term growth, rather than playing stock-picking games. We cleared away Wall Street’s smoke and mirrors in favor of an open and honest relationship with our clients – one that respects your intelligence.

The question we ask ourselves every day. Do we have the right investment strategy? Are the models performing the way we expected them to?

All of our model portfolios are recovering from the current market low set March 9, 2009 – measured by the S&P 500 total return. The science of investing is holding up STRONG against the fear, uncertainty and doubt of the market. While we focus on diversification, it is nice when our investment strategy is holding two of the best performing Dimensional Fund Advisors (DFA) funds YTD. Both emerging markets; DEMSX 45.66% and DFEVX 43.13%.

Word is certainly spreading. AssetBuilder’s Web site – a wealth of valuable information and a repository for Scott’s writings – is averaging more than 1,600 visitors per day. Recently, we have seen as much viewer interest in information about AssetBuilder as we have seen with Scott’s Couch Potato information. The AssetBuilder “our portfolios” page is the third most viewed page on our site.

We were recently featured in a NY Times article “Stirring Up the Right Investment Mix” by Ron Liber. Mr. Liber focused on our use of DFA funds – available only through registered investment advisors. He further notes, “AssetBuilder, in Plano, Tex., is charging its clients less in management fees (and allowing portfolios of much smaller sizes) than just about anyone else offering DFA funds.”

Thank you again for making all of this possible, through your confidence in us, your loyalty and your referrals. Empowered by your trust, AssetBuilder will continue this journey to make our clients’ investing simple – and their futures smart.

By Kennon Grose

You got the call in the morning. By noon everyone in your unit had been laid off, including you. After years of good work, you are suddenly unemployed.

What do you do?

First, you remind yourself that your most valuable asset is yourself— your human capital. It’s the stock of knowledge and skills that you built through years of study and work. Job One is to re-engage that human capital.

After that, you make a list with the title “Important Details.”

Some of your human capital has already been converted into financial assets— the investments that have accumulated in the 401(k) plan of your former employer. Networking with others, you are surprised to learn many left their 401(k) behind. In fact, some left a trail of 401(k) s, like bread crumbs that matched their resume entries.

Being passive about your financial assets isn’t a good idea. For many former 401(k) plan participants leaving a company is a major opportunity to reduce investment fees and share less of your return with the financial services industry. Remember, fees are the only guaranteed part of your plan.

What do these companies have in common?

When we think about ultimate 401(k) plans, we think about household names like Bechtel, Boeing, Caterpillar, Deere & Co., Excelon, Fidelity, General Dynamics, International Paper, Principal Life Insurance, Wal-Mart. These are just a few of the companies being litigated right now. The lawsuits claim the fee structure imposed by third-party administrators, record keepers, investment managers, and other 401(k) service providers ( the food chain servicing the 401k) is excessive, undisclosed, illegal and may contain prohibited transactions.

Fidelity, the largest 401(k) provider, is facing litigation on a number of fronts: Alleged excessive fees, indirect fees hidden in the plan structure, undisclosed revenue sharing and failure to inform participants of a “long-standing agreement” with Fidelity to only choose Fidelity funds.

USA Today reports: “The fees charged 401(k) plans are all but invisible to investors who don’t know where to look. Making matters more confusing are complex fee arrangements – common in retirement plans – that often lump together administrative and fund-management fees.”

Recent Congressional hearings examined requiring 401(k) plans to be more transparent on fees. Plan costs were broken down into four categories: administrative, investment management, transaction, and “other”. The real win, however, is a requirement to offer plan participants at least one inexpensive index fund.

Roll Your 401(k)

Now that you are no longer with your former employer, there is no match to help cover plan costs. So you bear all the fees. A little time and energy spent to move your 401(k) to an individual retirement account (IRA) can dramatically reduce the fees you pay and, in turn, allow your retirement savings to grow faster, possibly a lot faster.

A 401(k) Rollover Checklist

A 401(k) rollover is the process of moving your 401(k) plan from a former employer into an IRA – individual retirement account – or another qualified plan. The reason to take advantage of the rollover is simple: Reduce the fees and expenses that can take a significant bite out of your future value. The following is a list of things to think about in the transition;

• Do you have any of your employer stock in your 401(k) account? If so, you’ll want to seek the assistance of a tax professional who can determine if you should to take advantage of net unrealized appreciation – NUA. NUA allows you to pay current income tax on the average cost of the shares – cost basis. The shares are then held in a taxable account. When the shares are sold, the difference between the cost basis and the market value (also called NUA) is taxed at the long-term capital gains rate. This can result in significant tax savings. It gets still more interesting if you pass the stock along to your heirs. Their tax liability is based on the appreciation of the stock while it was held in the employee’s 401(k) account.
• An IRA Rollover is a tax-free transfer from a 401(k) plan, to a traditional IRA. Tactically, there are two ways this is accomplished; Direct Rollover and Indirect Rollover.x
  1. In a direct rollover – also called a “plan-to-plan transfer,” – the eligible rollover distribution is transferred directly by the 401(k) plan administrator to the individual IRA rollover account.
  2. Under the indirect rollover, the 401(k) plan administrator writes a distribution check to the individual. You then have 60 days to transfer the entire amount received to an IRA rollover account. The distribution is not taxable if the transfer occurs within 60 days. A direct rollover is preferred.

How to Invest Your IRA Rollover

You can use the do-it-yourself Couch Potato plan for investing. Or you can use AssetBuilder to manage your IRA Rollover for you. At AssetBuilder, we construct portfolios to provide the highest return with a defined level of risk. We use a technique called mean variance optimization and a broad mix of asset classes to maximize diversification and minimize risk relative to expected return.

By Kennon Grose

The first Capital Gains article was about the term FUD – for Fear, Uncertainty and Doubt. However, the new term of the day is Fearmongering. Fearmongering is the use of fear to influence the opinions and actions of others towards some specific end. Often times the feared object or subject is exaggerated and the pattern is repetitious. The outcome often times becomes a vicious cycle.

The seed of fear is the excess of recent years – whether on Wall Street, in real estate, or in consumer credit. The bill presented in 2008 and the first part of 2009 was far larger than the darkest pessimists expected.

The inherent turbulence on Wall Street is being fanned by so many who have turned fearmongering into an art form. Unfortunately, we can’t avoid loss simply by avoiding the object of our fear – Wall Street. We have to apply simple main street principles to our investment process.

Three Big Questions

There have been worse times for investors. But not many: You can count more dismal periods on a few fingers. If we politely measure by whole years, 2008 produced a 37 percent declines for large cap domestic stocks. If we measure from October 2007 peak to what we hope was the March 2009 bottom, large cap stocks fell more than 55 percent. However, you slice it, we’ve just experienced one of the worst stock markets in history.

So it’s not surprising that we’ve all got questions.

• “Should I sell and wait this one out?”
• “Have I taken too much risk?”
• “Did anyone know it was going to get this bad?”

The answer to the first question is easy to say, but harder to do. This is not the time to be in cash. The last thing you want to be is a late-blooming market timer. That’s what going to cash amounts to if you do it today. It’s also helpful to consider how stocks have performed after other major declines. Toughing it out was a good thing in the past. We expect it will be a good thing in the future.

The best example we can think of it the 1973-1974 market crash that followed the OPEC embargo and oil price increase. Many thought it was the end of Western civilization. At the market low, the New York Times calculated that Saudi Arabia could buy the entire U.S. stock market in only a few years with their ever-growing horde of petro-dollars.

That didn’t happen.

Instead, large domestic stocks returned 325 percent over the following years. Few noticed this, however, because many people were selling. Equity mutual funds, for instance, were in net redemption until the early 1980s. This means millions of investors didn’t get to participate in the recovery. Stand pat and you’ll participate in this recovery.

The answer to the second question requires some understanding of how the market has changed. At AssetBuilder we measure risk by volatility – the amount of price movement in an asset class or portfolio as measured by standard deviation. Most of our sense of risk has been conditioned by periods of much lower market volatility. Typically, for instance, only one day in five sees market moves of 1 percent or more. Only one day in 25 sees market moves of 2 percent or more. And only one day in a hundred sees market moves of 3 percent or more.

But last year, every other day saw a move of 1 percent or more. One day in three saw market moves of 3 percent or more. January saw more of the same. The prospect is for this new level of price volatility to continue for some time. It’s a bit like thinking we were good for the junior roller coaster but found ourselves on the monster roller coaster.

The answer to the third question is problematic. Few subjects have received more ink than the incredible boom in residential real estate prices and how easy it was to borrow money. When mortgages are called “liar loans” or nicknamed “NINJAs” (for no income, no job, and no assets) you’ve got to have a clue about future foreclosures. There was even some attention to the growing volume of obscure derivatives, although it was limited to publications like Barron’s and an occasional comment in the Wall Street Journal.

But while there was broad expectation that the party would end and losses would be suffered, we can’t recall a single analyst who expected we would have a financial implosion that would virtually wipe out the equity of the entire domestic financial system. And that’s what we’re dealing with.

Recovering from a Financial Collapse

Now that we know this, we may also have a better idea of what’s coming our way in 2009 and later. Research on earlier financial wipe-outs tells us that we won’t have a V-shaped recovery. It tells us that recovery will be long and slow relative to the recoveries we’ve experienced from the run-of-the-mill economic cycles. So we’ll have to expect a lot of public-handwringing, fearmongering, and disappointment over the next two years. We believe this works well for the basic value-tilt of our AssetBuilder Model Portfolios.

A Very Important Question

The question we ask ourselves every day. Do we have the right investment strategy? Are the models performing the way we expected them to?

Our basic premise has always been very simple. Take Couch Potato investing to the next level. Do index investing. Provide the broadest diversification possible. Add value by building risk-efficient portfolios. Do our best to earn a higher return for any given level of risk. Give Investors a choice of risk level. And charge as though we were providing a humble service like laundry folding or dry-cleaning rather than acting like we have the only crystal ball in town.

Back-testing showed that we were on to something. It appeared that we had a very good shot at providing a higher return for any given level of risk. It made us confident that we were on track to do something rare in financial services – add real value for what we charged.

We still believe that is the case. And there is evidence to prove it, if you can get past the fact that we’ve lost money like everyone else.

By Kennon Grose

I would like to offer my personal thanks to those of you who have become AssetBuilder clients during the past year. We reached our first anniversary at the end of May, and our growth has been nothing short of phenomenal. Thanks to you and your referrals, we have attracted more than 300 clients across 24 states, representing $124 million in invested assets. We are currently adding more than one new client every day.

What’s our secret? YOU, of course.

If you’re like most AssetBuilder clients, you came to us because you were tired of doing business with Wall Street brokers, their high-risk stock pickers and overpriced middlemen. You told us you wanted a simpler way to invest – an alternative. And we listened.

We stripped out the unnecessary costs and risks and built an investment firm that puts you first. We offered a science-based system of diversified index investing designed to capitalize on the market’s long-term growth, rather than playing stock-picking games. We cleared away Wall Street’s smoke and mirrors in favor of an open and honest relationship with our clients – one that respects your intelligence.

And we achieved this with a very low fee structure. In fact, our business model has our professional fees positioned at half the published industry average of one percent.

Together, we are on a journey – a mission to challenge Wall Street’s entrenched system of unnecessary costs, risks and complexity. We’re well on our way.

Word is certainly spreading.  AssetBuilder’s Web site – a wealth of valuable information and a repository for Scott’s writings – is averaging more than 1,600 visitors per day.  Propelling us well ahead of our competitors. 

Scott is continuing his focus on writing, investor education and the research necessary to be our Chief Investment Strategist.  Scott will be a busy person while promoting his new book, Spend ‘Til the End, which hit the shelves on June 10.  In May and June alone, Scott has appeared on 19 radio broadcasts from coast to coast.  In media markets such as New York, Los Angeles, Chicago, Boston, Denver and Seattle.

Thank you again for making all of this possible, through your confidence in us, your loyalty and your referrals. Empowered by your trust, AssetBuilder will continue this journey to make our clients’ investing simple – and their futures smart.

By Kennon Grose

We’re sure it isn’t news to you that we’re in a global financial crisis. What we’d like to do is distill some signal out of all the noise.

One thing is very clear: The current global decline is major. It will rank among the very worst. Today, it still isn’t as bad as 1973–1974 or 2000–2002, but it could be before it is over. We simply don’t know. But after talking with clients, we thought we could offer some useful observations.

The first is that we are in this with you. Most of my personal wealth is invested in the markets through the same investment strategies we employ at AssetBuilder. Ditto Scott. We understand the discomfort you are feeling as markets react to one headline after another. We deeply appreciate the confidence you have expressed in AssetBuilder by making us your investment advisor.

The second is that we’re in a period of extreme behavior. Jim Cramer says, “Sell stocks if you need the money within the next 5 years”. At the other extreme the Oracle of Omaha, Warren Buffett, has been committing billions with recent investments in GE, Goldman Sachs, Constellation Energy and others.

Our investment strategy is closer to Buffett than Cramer. We call our strategy “Main Street vs. Wall Street.” We believe investing is a process–over–time, not a decision for a moment–in–time. Like Buffett, we believe the best holding period is “forever.” Because of that, our investment strategy is based on efficient asset class index funds, high diversification, and a tilt toward value stocks and small cap stocks. We take as little risk as possible in the fixed income markets, saving our risk budget for the higher long term payoff of equities. Our shorter term fixed income positions mean you have more low risk access to cash than you would have in portfolios that take longer term fixed income positions.

A third observation is that this market is not unique. We have had periods of excessive credit before this. Recall Michael Milken and the junk bond era. Recall risky lending to REITs in the late 70s. Recall the S&L lending binge of the early 80s.

Like today’s market, what they all share is a sense of doom.

So let’s ask a crucial question. Could you have escaped the misery with clever selling? Answer: Not likely. Good market timing requires two near–perfect decisions. One is when to sell. The other is when to buy. In our experience, the few that get the first decision right never make it to the second decision and miss the recovery.

The risk of not doing so is highlighted in the tables below. They show the growth of a dollar’s investment from January 1980 through August 2008 for four broad indices. You would have realized about half the value if you missed the six best individual months in that period. Keep in mind, six months represents 1.8 percent of the period we are looking at.

Significant market uncertainty has put “risk” in a personal context … one that every investor has taken measure of. Please review my Capital Gains article on the website; “How to Survive the Market Ride?”

I hope this perspective on the current situation is helpful, but please contact us if you would like additional help. We are here for you!

By Kennon Grose

In December of 2007, we launched a change in our model portfolios which included a commodity asset class. We use the model portfolios as a way to meet our client’s investment goals for risk, expected return and investment horizon.

The following contributed to our decision making and model changes;

• Dimensional closed two funds (DFSVX – small cap value fund, DFSCX – micro cap fund).
• We were intrigued by the diversification and reductions in volatility commodities offer the model portfolios.
• Annually we review our model portfolios.

We published our thoughts in the article post – Changes in 2008(http://assetbuilder.com/blogs/capital_gains/archive/2008
/01/09/changes-in-2008.aspx).

Our decision has landed us in the middle of the pro vs. con battle for using commodities as an asset class. We have already had to ban a known competitor for multiple username registrations and attacking other members on our website.

In many ways, this reminds me of the battle between MS Word and WordPerfect. We can never explain/tell to the satisfaction of someone’s personal bent. It is like trying to explain the merits of MS Word vs. WordPerfect.

The value proposition for commodities;

• Commodities tend to be negatively correlated against stocks and bonds.
• Based on the study by Gorton and Rouwenhorst there is a definable risk premium benefit. (http://ssrn.com/abstract=560042)
• Risk (defined by standard deviation) is similar to that of large cap US stocks.

Risk Premium of Commodity Futures, Stocks and Bonds

Annualized Monthly Returns 1959/7 – 2004/12

Data provided page 12 (http://ssrn.com/abstract=560042)

t-statistic — is the confidence that can be placed in judgments made from data samples.

Sharpe ratio — is the measure of return per unit of risk; used to measure the efficiency of a portfolios return.

The entire debate around commodities can be summed up in one statement; “Is there a risk premium benefit?” Risk premium is the reward – additional return – for holding a risky investment rather than a risk-free one. The Pro side believes there “is” and the Con side believes there “is not”.

We are taking a middle of the road approach in this argument, which says; Commodities do not offer a consistent risk premium. The uncontroverted fact is that commodities reduce the risk (volatility) in a portfolio. The problem is without adjustment in the portfolio to accommodate the inconsistent risk premium; the expected return is also affected. Therefore, if there is no risk premium, the expected return of the portfolio will trend down. If there is a risk premium, the expected return of the portfolio will trend up.

Hopefully keeping this at an understandable level – we then dial the expected risk (volatility) up to compensate for the thought that commodities might not have a risk premium. However, now some would say we are trying to “cherry pick” our historical returns because when there is a risk premium, the historical returns look spectacular.

Some would say, “Why even bother if you believe the risk premium is inconsistent?” One other interesting characteristic of commodities is they tend to move in the opposite direction of stocks and bonds. This goes to our thought introduced in Changes in 2008. We want to inoculate our investment strategy with a “tilt” that assumes future inflation.

One additional thought that leads us to believe there might be a risk premium for commodities is the supply side problem. Commodities can’t be mined, grown or drilled quickly to offset the increasing demand.

Once you get over the hurdle of including commodities as an asset class – picking an index is the next challenge. Without driving through the wandering road of all the decisions, we selected the Duetsche Bank Liquid Commodity Index – Optimal Yield. We liked the idea of the mathematical process behind trading the contracts and the limited focus on six commodities.

By Kennon Grose

Couch potato investing started in 1987 when Scott wanted to create the idea of an "all weather portfolio" – a portfolio that would be less vulnerable to declines. The All Weather Portfolio morphed into the Couch Potato Portfolios.

As soon as a column on "the Couch Potato Portfolio" appeared, readers called and wrote. "OK", they seemed to be saying, "I’ve done my part. I hit the Mute button. Now will you tell me EXACTLY how to do this?"

In case you missed it, if you had divided your money in half and invested one portion in the Standard and Poors’ 500 Index and the other portion in the Shearson/Lehman Intermediate Bond Index, you would have done very well.

The Couch Potato investment strategy is based on three basic concepts;

• Control the cost – settled on Vanguard as the lowest cost index fund choice.
• Use index funds versus managed funds – index funds will usually outperform actively managed funds.
• Use simple diversification techniques – use index funds that provide access to US, international and emerging markets.

"Home Cooking"

Scott published his Couch Potato Portfolios years ago and they have stood the test of time – especially against the many investment options supported by Wall Street. However, since we started AssetBuilder, we have seen many variants of the Couch Potato investment philosophy that have been "good cooking". Therefore, if you choose the do-it-yourself route, don’t be afraid to experiment. The only caveat is the original three basic concepts.

The Couch Potato Portfolios

The directions for all of the following Couch Potato Portfolios is the same. Select the Couch Potato Portfolio of choice. Then add the funds in equal parts to the portfolio. The result of this simple recipe is the Couch Potato investment strategy of choice.

Couch Potato

• 1/2 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/2 – Vanguard Total Stock Mkt Idx (VTSMX)

Margarita

• 1/3 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/3 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/3 – Vanguard Total Intl Stock Index (VGTSX)

Four Square

• 1/4 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/4 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/4 – Vanguard Total Intl Stock Index (VGTSX)
• 1/4 – American Century International Bond (BEGBX)

Five Fold

• 1/5 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/5 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/5 – Vanguard Total Intl Stock Index (VGTSX)
• 1/5 – American Century International Bond (BEGBX)
• 1/5 – Vanguard REIT Index (VGSIX)

Six Ways from Sunday

• 1/6 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/6 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/6 – Vanguard Total Intl Stock Index (VGTSX)
• 1/6 – American Century International Bond (BEGBX)
• 1/6 – Vanguard REIT Index (VGSIX)
• 1/6 – Vanguard Energy (VGENX)

Seven Value

• 1/7 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/7 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/7 – Vanguard Total Intl Stock Index (VGTSX)
• 1/7 – American Century International Bond (BEGBX)
• 1/7 – Vanguard REIT Index (VGSIX)
• 1/7 – Vanguard Energy (VGENX)
• 1/7 – Vanguard Value Index (VIVAX)

Seven Value 2

• 1/8 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/8 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/8 – Vanguard Total Intl Stock Index (VGTSX)
• 1/8 – American Century International Bond (BEGBX)
• 1/8 – Vanguard REIT Index (VGSIX)
• 1/8 – Vanguard Energy (VGENX)
• 1/8 – Vanguard Value Index (VIVAX)
• 1/8 – Vanguard Small Cap Value Index (VISVX)

Nine Emerging

• 1/9 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/9 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/9 – Vanguard Total Intl Stock Index (VGTSX)
• 1/9 – American Century International Bond (BEGBX)
• 1/9 – Vanguard REIT Index (VGSIX)
• 1/9 – Vanguard Energy (VGENX)
• 1/9 – Vanguard Value Index (VIVAX)
• 1/9 – Vanguard Small Cap Value Index (VISVX)
• 1/9 – Vanguard Emerging Mkts Stock (VEIEX)

10 Speed

• 1/10 – Vanguard Inflation-Protected Securities (VIPSX)
• 1/10 – Vanguard Total Stock Mkt Idx (VTSMX)
• 1/10 – Vanguard Total Intl Stock Index (VGTSX)
• 1/10 – American Century International Bond (BEGBX)
• 1/10 – Vanguard REIT Index (VGSIX)
• 1/10 – Vanguard Energy (VGENX)
• 1/10 – Vanguard Value Index (VIVAX)
• 1/10 – Vanguard Small Cap Value Index (VISVX)
• 1/10 – Vanguard Emerging Mkts Stock (VEIEX)
• 1/10 – Vanguard International Value (VTRIX)

by Kennon Grose

Chief Investment Strategist

Before I expand on the evolution of AssetBuilder, let me tell you about our Chief Investment Strategist – Scott Burns.  Scott is an amazing person of knowledge and experience.  He has been investing, researching and writing for 40 years.  His first book on personal finance and investing was published in 1972.  His most recent book was published by MIT Press in 2004 and was endorsed by 4 Nobel laureates.  In fact, he has been dealing with personal finance and investing longer than many advisors have been alive.

Many of you also know Scott because you have been reading him all these many years.  Scott has a unique gift in his ability to give time-stressed readers what they wanted – easy to read stories that didn’t sacrifice depth, context and meaning.  You also know him from a personal perspective because he has shared many personal trials and tribulations through the years.

Couch Potato Investing

Couch potato investing started in 1987 when Scott wanted to create the idea of an “all weather portfolio” – a portfolio that would be less vulnerable to declines.  The All Weather Portfolio morphed into the Couch Potato Portfolios.  The basic drivers were (1) low cost index funds, (2) “naïve” asset allocation, and (3) smart indexing ala Fama/French.

Scott hoped the portfolios would be easy enough to implement that virtually anyone could do it on their own.  In a recent article Scott outlines the results of the Couch Potato Portfolios.

The Birth of AssetBuilder

Scott and I share a mission – “Help the weary investor who has been taken advantage of by the legacy financial system”.  We spend a considerable amount of time and effort constructing our portfolios to embody our investment strategy, which is also our vision – “Simple Investing, Smart Future”.  The foundation started by putting into practice the basic investment principles Scott has been evangelizing since 1988 – low cost, index vs. managed funds, and diversification.

We provide value by constructing portfolios designed to provide the highest return given a measured level of risk.  That doesn’t mean we are the only shop to give risk serious attention.  It just means that most of the portfolios we see are poorly designed from a risk management perspective.  We use a technique called mean variance optimization, which won its creator, Harry Markowitz, a Nobel Prize in 1990.  If you want to understand your investment risk, use our portfolio review.

The reason we have such confidence in our models is we didn’t just optimize funds; we optimized the Fama/French research indexes. These research indexes provide us data we could make clear analytical decisions with – not influenced by anomalies; (REITs), survivor bias, etc… We then replaced funds with the indexes we optimized. Tweaked the models again with the actual funds, but were able to have the more complete historical impact beyond the length of the actual funds.

DFA funds are superior to Vanguard funds when you want the best vehicles to pursue the return benefits of small cap investing or value investing because they follow the Fama/French research rigorously. The Vanguard funds primarily follow market capitalization. Follow this link for a return benefit comparison.

We employ a disciplined investment strategy that is a process over time, not a decision for a moment in time.  While many people “get it” when it comes to index investing, there are dozens of ways they could miss the boat for putting it to work.  We put the idea to work.  We make it happen.  We take responsibility for all the details.  Equally important, we know it will cost far less than the legacy financial system.

Our Business Model

There is the “do-it-yourself” decision versus the “let-the-staff-do-it” decision.  Many people choose to manage their own portfolios simply because they don’t want to give up 100 to 200 basis points of annual return to traditional management firms.  We think that’s a very reasonable choice.  Scott has written about expense reduction for decades – it is the SINGLE most direct act we can take to increase our investment returns. We’ve built our business model with the goal of lowering the cost enough that the ONLY reason you would wander the do-it-yourself path was that you needed a time-consuming hobby. With a fee schedule that ranges from 50 basis points down to 25 basis points, this is half the average Registered Investment Advisor fee schedule of 100 basis points (1%).

Our business model has many in the industry calling us the “low-cost provider”.  However, we view ourselves as customer advocates for your financial future.  We believe it is possible to declare independence from the expensive legacy financial system, to embrace the idea of indexing, and to make a decision to have someone do it for you at a very reasonable cost.  We’re that someone.

As a registered investment advisor we have a fiduciary standard of care for clients, placing their interests first.  The standard of care we provide our clients is outlined in our Code of Ethics.

The typical payment scheme in the legacy financial system is based on commission.  Commissions foster an “eat what you kill mentality” and is not customer friendly.

Unlike the legacy financial system, everyone at AssetBuilder is an owner in the company and no one is on commission.  This makes all employees task and service oriented.  We don’t see our customers as the basis for making our fortunes.  We see our customers as a way for us to be useful human beings, and that’s a great satisfaction. 

Impacting the Legacy Financial System

AssetBuilder is gaining traction. While we may be a start-up company we have very strong institutional connections. Schwab is the custodian for all assets and we are using Dimensional Fund Advisors for funds.  With Schwab, our customers have access to all the tools and conveniences offered by Schwab. We think this is a very nice mix of brick and mortar offices and electronic convenience.

Thanks to you, our web exposure has also grown very rapidly. Six months ago our www.alexa.com rating was over 500,000.  As of last week we are at 251,240.  This is leagues ahead of similar registered investment advisors.  We are also in the ballpark with the institutions of the legacy financial system.

Our low pricing dictates we have a lot of assets under management.  We have already grown larger than the average registered investment advisor. The key is using the internet as a way to gain customers who are interested in our common sense approach to investing. 

by Kennon Grose

The AssetBuilder investment strategy is represented by our nine Model Portfolios.  We match client investment goals for risk, expected return and investment horizon with these portfolios.

We are not market timers. We believe deeply in our index investing strategy.  However, we want to inoculate our investment strategy with a “tilt” that assumes future inflation.  The inflation tilt we are going to give our Model Portfolios is a weighting in commodities.  This will add an additional asset class to our already highly diversified Model Portfolios.

In a recent article (http://assetbuilder.com/blogs/scott_burns/archive/2007/12/14/the-art-and-benefit-of-the-steady-eddy-portfolio.aspx), Scott outlined some of our thoughts about the value of commodities in an investment strategy.  We have been intrigued by the increased diversification. More important, we like the reduction in volatility commodities offer the Model Portfolios.

Why No Treasury Inflation Protection Securities (TIPS)

We use mean variance optimization to construct our Model Portfolios.   Under the simple construction of the Couch Potato Portfolios, TIPS act as a hedge against expected future inflation. But when you are developing optimized portfolios there are good reasons to exclude TIPS.

In our optimized portfolio construction our "glue" -- the stuff that influences how we put portfolios together -- is the level of risk in any given asset class. Because of the long average maturity of the TIPS indexes (including DFA), they provide relatively little return for the amount of risk taken. The risk factor argues for short fixed income maturities, not long maturities. That’s why our portfolios tend to hold one, two and five-year fixed income funds.

Putting our fixed income dollars at that maturity level allows us to "buy" more portfolio return by holding a variety of equity asset classes that have higher standard deviations--- but disproportionately higher expected returns.

This works to benefit portfolios in rising markets. But it looks rather lame in this particular down market. Since the equity markets rise more than they fall, holding short-term fixed income so we can own more equity will continue to be a better long term strategy.

Why No Energy Sector

Energy is an equity sector. It is not an asset class.  When you start making “sector bets”, over and underweighting them in a portfolio, you are stepping on a slippery slope.  This action will reverse the level of engineering that went into the construction of our Model Portfolios. 

Scott introduced energy in his Six Ways from Sunday couch potato portfolio as a currency and inflation hedge.  Without dredging up the long history, he realizes, in order to apply the "rocket science" to the modeling process we had to engineer the portfolios with asset classes and exclude sector indexes.

Because energy has been such a hot sector recently, the Six Ways from Sunday portfolio has done very well.  However, the better way to get at the advantages of energy without investing in companies is to use commodities.

Commodity as a New Asset Class

There are three major indexes which track the commodities market.  The S&P Goldman Sachs commodity index (S&P GSCI), the Dow Jones-AIG commodity index (Dow Jones - AIG) and the Deutsche Bank Liquid Commodity Index (DBLCI).  In our analysis, DBLCI was the most effective index. It has the following characteristics;

• Comprised of six commodities: West Texas Intermediate (WTI) crude oil, heating oil, aluminum, gold, corn and wheat.
• Constant weighting which reflect world production and inventory, providing a diverse and balanced commodity exposure.
• A rule-based and transparent calculation methodology. Energy contracts are rolled monthly, metal and grain contracts annually.
• Historically measured from December 1, 1988.

The security which tracks this benchmark is the Powershares DB Commodity Index Tracking Fund (DBC). The downside is the lack of history associated with this exchange-traded-fund -- started in March 2006.  However, with the history of DBLCI, we can garner the necessary data to make prudent inclusion of the asset in the Model Portfolios.

An in-depth discussion of commodity indices can be found on the Deutsche Bank website - http://dbfunds.db.com/Pdfs/dbindexguide2007.pdf.

How Do Commodities Help our Investment Strategy/Model Portfolios?

We don’t want to time the market. We don’t want to take a “the sky is falling” approach.  But our investment strategy will assume higher inflation in the future--- higher than we are living with today.  Because commodity prices usually rise when inflation is accelerating, commodities offer protection from the effects of inflation.  

Adding commodities--- particular DBLCI--- increased diversification. More important, it reduced volatility in the Model Portfolios.The diversification comes from another asset class.  It avoids overweighting an equity sector.  The reduction in portfolio volatility is the result of the low correlation of commodities to equity.  Commodities tend to move in the opposite direction as equity.

New vs. Old Model Portfolios

One of the key modeling principles we apply in our portfolios is based on the incremental return benefits of small cap and value, per the Fama/French research.  In 2007, the subprime shakeout negatively affected the value and REIT market, which ultimately affected our investment strategy.

New Model Portfolios

Old Model Portfolios

Individual Security Performance

Our new Model Portfolios can be accessed by the following links;

Model Portfolio 06
Model Portfolio 07
Model Portfolio 08
Model Portfolio 09
Model Portfolio 10
Model Portfolio 11
Model Portfolio 12
Model Portfolio 13
Model Portfolio 14

The AssetBuilder (AB) constructed portfolios - Model Portfolios - have been developed based on historical performance of the standard asset classes (stocks, bonds and cash) and of representative market index fund measures.  Since this is a Model Portfolio (fiction), there can be no assurance that an AB client would have achieved similar rates of return over the time frame.  In addition, since the time period in question is a historical one, there can be no assurance that future results achieved by AB clients will in any way resemble those represented by the model portfolio

The Performance Table above is representative of a compilation of the selected funds to achieve a probabilistic return for a measured level of risk.  The portfolio was assumed to have been rebalanced every year on March 1.  The returns are net of selected fund fees, but don’t include deduction of AB’s Advisory Service fees. The commodity measure represented in the Model Portfolio is the PowerShares DBC security (net of fund fees) from March 2006.  To gain additional history, DBLCI was appended back in time net of fund fees ( .83%, 83 basis points per year).

by Kennon Grose

     The warning label on most mutual funds at this time of year should read – be careful about “buying a tax liability” with late year distributions. Mutual funds periodically distribute to the fund’s shareholders any gains or losses the fund achieves from buying and selling stock. These are called dividends or distributions, and the shareholder must pay taxes on this gain.

      Distributions are in the form of dividends, short-term capital gains and long-term capital gains. Both dividends and short-term capital gains are taxed at ordinary income tax rates. Long-term capital gains are currently taxed at 15 percent.

       Most experts point to the use of either tax-managed funds or index funds as a way to minimize taxes – tax friendly. Index funds don’t trade much which helps keep capital gain distributions in check. Tax managed funds are run with an eye to after-tax returns. Unlike tax friendly funds, most mutual funds are managed without regard to taxes.

       Tax friendly funds play a pivotal role in enhancing your wealth through tax mitigation. For example, if you invest $20,000 in a fund that produced a 10% pre-tax annual return for 20 years; with an after tax return of 7 percent you would have $77,394. However, if the after tax return had been 9 percent, then you would end up with $112,088.

       While it is subject to change, it is a pretty good indication that you can buy now without stepping into a “tax cow-pie”.

DFA Tax Distribution Schedule

       The following table provides an estimate for the distribution in December of DFA funds.

Record Date: 12/18/2007 – The date on which DFA looks at its record to see which shareholders will receive a distribution.
Ex-Date: 12/19/2007 – On this date the DFA funds trade at the price minus the distributions.
Pay Date: 12/24/2007 – The date DFA will make the distributions to the shareholders account.

by Kennon Grose 

       What is sold using fear tactics and pays the maximum benefit upon death?  

      
       The VARIABLE ANNUITY – a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you.  There is no other investment description on the Securities and Exchange Commission website (http://www.sec.gov/investor/pubs/varannty.htm) that has a highlighted warning label.

 Caution!

-  "Other investment vehicles, such as IRAs and employer-sponsored 401(k) plans, also may provide you with tax-deferred growth and other tax advantages.  For most investors, it will be advantageous to make the maximum allowable contributions to IRAs and 401(k) plans before investing in a variable annuity.

In addition, if you are investing in a variable annuity through a tax-advantaged retirement plan (such as a 401(k) plan or IRA), you will get no additional tax advantage from the variable annuity."

        Scott has written a number of very good articles about the variable annuity and normally, I would not feel the need to add one.  (http://assetbuilder.com/blogs/scott_burns/archive/2005/07/12/Answering-the-Variable-Annuity-Industry.aspx)  However, in conducting our many portfolio assessments, we are encountering a lot of investment holdings with variable annuities.  The story is always the same; the weary investor was sold through misleading sales techniques and inadequate disclosure. 

        Therefore, we have chosen to take a closer look at the variable annuity as an investment.  One of the big selling points used to entice our client was the quality of the underlying mutual funds.  (NOTE: it might be helpful to read the article, “The Ingredients of the Portfolio Assessment”, to understand definitions. http://assetbuilder.com/blogs/capital_gains/archive/2007/10/29/the-ingredients-of-the-portfolio-assessment.aspx)

Variable Annuity

The Director Plus – The Hartford
Current Value - $433,557.46
Surrender Charges

Annual Insurance Charge – 1.60%
Front-end Load (Commission) – 5% to 7%

The Assessment
The following funds are the underlying investment for The Director Plus.

Observations:

1. The front end load – sales commission – five to seven percent.  This represents a pretty good pay day for the Broker ($20,000 – $28,000) assuming $400,000 initial investment.


2. The 12b-1 fee will be used to further compensate all of the “servicing” agents.


3. Per the representation of the Broker, these funds have good Morningstar Overall Star Ratings.


4. The estimated portfolio gross operating expense is below the average and therefore is a plus for this portfolio.

The comparative AssetBuilder Building Block Portfolio 13.

Projecting performance of this Broker recommended variable annuity back in time to 12/2003 provides the following historical results

Definitions:

Geometric mean – represents the real growth of your dollar. For example, if a stock fell 50 percent in the first year, and rose 50 percent in the second year, then it would be incorrect to report its “average” increase per year over this two year period as the arithmetic mean (-50% + 50%)/2 = 0%. According to this measure, you would still have your dollar. The correct calculation is the geometric mean which yields an average loss per year of 13.4 percent. Correctly reflecting the true value of your dollar at 75 cents.

Standard deviation – is a measure used to determine how much something fluctuates. The S&P 500 Index has a standard deviation of 19.6 percent. This means that it will provide its long-term average return, about 10 percent, in any year plus or minus 19.6 percent. It will do this two-thirds of the time. So it will return somewhere between 30.6 percent and minus 9.6 percent (10% +/- 19.6%) in most years. The return will be greater, or smaller, the remaining one third of the time. The greater the standard deviation of an asset, the greater our risk.

N Periods – number of months we can go back in time to review historical returns and standard deviation. From 1/1999 to 9/2007 is 105 months.

The comparative AssetBuilder Building Block 13.

The historical result is AssetBuilder Building Block 13 delivers 4.54 percent per year additional return with less risk. Adding the annual insurance premium further reduces the investor’s return.

Even with “good” funds, the high costs of the compensation schemes, fees and expenses make the variable annuity a “poor” investment choice.

The Performance Table above is representative of a compilation of the selected funds to achieve a probabilistic return for a measured level of risk. The portfolio was assumed to have been rebalanced every year on March 1. The returns are net of selected fund fees, but don’t include deduction of Advisory Service fees.

by Kennon S. Grose

     In six months we have conducted more than 200 portfolio assessments – the systematic basis for making inferences about one’s investment strategy. Using the measurement of risk as the common factor, we benchmark the appropriate AssetBuilder portfolio against your portfolio.

     Why the focus on risk? We feel our added value is in packaging investment risk. Our goal is to construct portfolios in such an efficient way, that we provide an optimal return for a measured risk. The alternative is market timing and we feel this is a futile exercise.

     Our second focus is on cost. The more costs we can take out of the process, the higher the return. As a fee-only advisor, there are only three costs associated with doing business with us. One cost is the management fee we charge. The second cost is the trading fee Charles Schwab charges. The third cost is the gross operating expense of Dimensional Funds.

     Why the focus on cost?  Fees and expenses are an important consideration because any costs lower your returns. Even small differences in fees can translate into large differences over time. For example, if you invest $10,000 in a fund that produced a 10% annual return for 20 years before expenses; with an operating expense of 1.5% you would have $49,725. However, if the fund had expenses of only 0.5%, then you would end up with $60,858.(http://assetbuilder.com/investing/assetbuilder_fees.aspx)

Our third focus is on diversification. Many investors hold many funds (or individual securities) but few have real diversification in asset classes. In fact, many are surprised by their lack of diversification.

Why the focus on diversification? In a word, “Dot-com bomb” – the well experienced horror story of investors too heavily weighted in one asset class (growth stocks). If you invested $1.00 on March 23, 2000 in the Russell 1000 growth index – measures the performance of the high price-to-book companies in the market’s 1,000 largest firms – on December 31st, 2006 that $1.00 would be 0.64 cents. However, if you invest $1.00 on March 23, 2000 in the Russell 2000 value index – measures the performance of the low price-to-book companies in the market’s 2,000 smallest firms – on December 31st, 2006 that $1.00 would be $2.73.

The Assessment

The following portfolio is the recommendation by a well-known brokerage firm.

Observations:

1. The front end load – sales commission – does scale down and will be waived for invested assets over $1 million. Used to compensate the Broker.
2. The Broker said, “Won’t charge you any fees for buying and selling these funds”. The Broker uses 12b-1 fees to cover trade costs. Used to compensate broker/dealer part of the firm.
3. The excess 12b-1 fee will be used to further compensate the Broker.
4. Little to no targeted investment in other asset classes; US small, international small & emerging markets.
5. The estimated portfolio gross operating expense is below the average and therefore is a plus for this portfolio.
6. Needs additional fixed income.

The comparative AssetBuilder Building Block Portfolio 11.

Projecting performance of this Broker recommended portfolio back in time to 1/1/1999 provides the following historical results.

Definitions:

1. Geometric mean – represents the real growth of your dollar. For example, if a stock fell 50 percent in the first year, and rose 50 percent in the second year, then it would be incorrect to report its “average” increase per year over this two year period as the arithmetic mean (-50% + 50%)/2 = 0%. According to this measure, you would still have your dollar. The correct calculation is the geometric mean which yields an average loss per year of 13.4 percent. Correctly reflecting the true value of your dollar at 75 cents.
2. Standard deviation – is a measure used to determine how much something fluctuates. The S&P 500 Index has a standard deviation of 19.6 percent. This means that it will provide its long-term average return, about 10 percent, in any year plus or minus 19.6 percent. It will do this two-thirds of the time. So it will return somewhere between 30.6 percent and minus 9.6 percent (10% +/- 19.6%) in most years. The return will be greater, or smaller, the remaining one third of the time. The greater the standard deviation of an asset, the greater our risk.
3. N Periods – number of months we can go back in time to review historical returns and standard deviation. From 1/1999 to 9/2007 is 105 months.

The comparative AssetBuilder Building Block Portfolio 11.

One key design goal of an optimal portfolio is to have a long-term historical standard deviation less than the long-term annualized return. The Broker Portfolio has a standard deviation of 11.86 percent. The Geometric Mean is 10.16 percent. The following table shows the fluctuations in returns based on the standard deviation.

The reason risk is such an important design goal is to support the portfolio in withdrawal mode and its long term survivability.

The final component is the expected return. Since we are looking back in time, these figures represent past performance. The graph assumptions include dividend reinvest, annual rebalance, include mutual fund fees, but don’t include trading costs and management fees. The following graph compares the growth of a dollar invested in the S&P 500, Broker Portfolio, and AssetBuilder Building Blocks 11.

One of the most common questions we get; “The returns on my portfolio have not been as good as what you are showing me. Why?” The answer – management fees! Scott’s latest article, How Much Do You Pay For Financial Services? is just one of many devoted to this important topic.
http://assetbuilder.com/blogs/scott_burns/archive/2007/10/19/how-much-do-you-pay-for-financial-services.aspx

Our Value Proposition

The foundation of AssetBuilder started by putting into practice the basic investment principles Scott has been evangelizing since 1988 – low cost, index vs. managed funds, and diversification. We felt we could put a business around these concepts and use the internet to get our message out.

Click Here to let us review your portfolio!

The graphs are not sufficient to formulate an investment decision.

The AssetBuilder (AB) Building Blocks constructed portfolios have been developed based on historical performance of the standard asset classes (stocks, bonds and cash) and of representative index fund products,including Dimensional Fund Advisors (DFA) funds, as well as other concepts of Modern Portfolio Theory.

The graphs above are representative of a compilation of DFA funds to achieve a probabilistic return for a measured level of risk. 

by Kennon S. Grose 

Record breaking is the only way to describe this wild ride!  Did you make it back or did you get off along the way?

    Market volatility – risk – is a way to describe the ups and downs of the market.  Market uncertainty is the emotional measure.  Significant market uncertainty has put “risk” in a personal context …one that every investor has taken measure of. 

    The million dollar question is; “Did you react to market uncertainty and change your investment holdings?”

    If you did, you weren’t alone.  New York Stock Exchange daily share volume – number of shares that are traded – not only broke the four billion share record, it also broke the five billion share record.  This means a whole lot of decisions were made during market uncertainty.

    Investors need to think about investing as a process over time.  Not a decision that needs to be made at some moment in time.  A mistake that most investors make is in reaction to volatility.  They think it creates an investment “to-do” item. 

    The best way to avoid hasty decisions is with a highly diversified investment approach.  We call this approach smart asset allocation.  It is constructing a portfolio that gives you the highest return with the least risk.  It can be done with a technique called mean variance optimization, which is close enough to rocket science to have won its creator, Harry Markowitz, a Nobel Prize in 1990.

    The basic concept of Mr. Markowitz’s study was to combine assets with low correlation – when one asset is up, the other is down – into an investment portfolio.  Treasury bonds – fixed income – are considered less risky than stock – equity.  Yet equity has the potential for higher gain. 

    The result of the basic concept is not so intuitive.  Combining a little equity with fixed income, results in the potential for higher return with less risk.  However, as equity becomes a greater percentage of the investment, the risk is higher and the potential return higher.





    Mean variance optimization is the process of combining asset classes – equities and fixed income – in an optimal amount to achieve an expected return for a mathematically measured level of risk – standard deviation.  The resulting optimal investment portfolios are defined along a risk/reward curve – efficient frontier.

    We have developed portfolios that represent this knowledge – AB Building Block Portfolios.  Building Block Portfolio 6 has 66% fixed income and would be at the “low risk/low return” end of the efficient frontier.  Building Block 14 has 92% equity and would be at the “high risk/high return” end of the efficient frontier.






    One of the key benefits of this method is the investor determines the “ride”.  Since we have experienced a high degree of market uncertainty this year, it has brought more focus on risk.  We have a tool which provides a historical perspective and is a great pictorial of the “ride”.  AB Building Block Portfolio 6 is very smooth, as opposed to AB Building Block Portfolio 14 which is more volatile.  http://assetbuilder.com/swf/growthofwealth/assetbuildergrowthofwealth.html

NO REACTIVE DECISIONS REQUIRED is the label for this smart buy-and-hold investment method. 

The graphs are not sufficient to formulate an investment decision.

The AssetBuilder (AB) Building Blocks constructed portfolios have been developed based on historical performance of the standard asset classes (stocks, bonds and cash) and of representative index fund products,including Dimensional Fund Advisors (DFA) funds, as well as other concepts of Modern Portfolio Theory.

The graphs above are representative of a compilation of DFA funds to achieve a probabilistic return for a measured level of risk. 

by Kennon S. Grose

  Wrap accounts, the most rapidly growing form of asset management, were recently declared illegal March 30, 2007.  This decision is set to go in effect October 1, 2007.

    Wrap accounts allow unlimited trading, with an annual fee of 1 to 3 percent, but charge no brokerage commissions.  Reuters reported; “This court ruling affects an estimated 1 million brokerage accounts that hold a combined $300 billion in assets.”


    Substituting an annual fee for brokerage commissions creates an illusory shared interest between the broker and his customer. In a commission based relationship the customer often worries (quite rightly) whether transactions are being proposed for his benefit or the benefit of the broker. In theory, a fee based relationship puts broker and customer “on the same side of the table.”

    In fact, the broker has only converted an irregular income stream into a regular income stream. The brokers’ primary loyalty is still to his or her firm. The customer’s interest can still be sacrificed to the business interests of the firm.  Brokers do not have the same loyalty and obligation to the investor as investment advisors.  Penn, Schoen & Berland Associates released a study about brokers with the following results;

• 58 percent of customers incorrectly believe brokers are required to act in the investor’s best interests in all aspects of the financial relationship;
• 63 percent of customers incorrectly believe brokers are required to disclose all conflicts of interest prior to providing financial advice.

     Legally, brokers are not fiduciaries. They don’t have the obligation of a fiduciary, which is to put the customer’s interest first.   Instead, brokers have what the legal world terms as an “arm’s-length” relationship. This allows them to downplay conflicts of interest with simple statements, such as: “Our interests may not always be the same as yours.”

    Like hidden compensation schemes, undisclosed conflicts of interest are part of the financial service industry’s dirty laundry.  For example; proprietary funds, house owned bond issues, house owned securities, etc.  
   
    A new press release issued September 19th by the Securities and Exchange Commission (SEC) will most likely halt those brokers complying with the court ruling.  The SEC will allow fee-based accounts to remain in place for now.  Under the temporary fix, brokers may continue to offer the accounts – provided they inform account holders about potential conflicts of interest.

    The sad thing about this entire court case is the SEC’s position.  The SEC, a government organization specifically created to protect investors, granted fee-based brokers an exemption to disclosing conflicts of interest.  The SEC is in the odd position of fighting legal battles to protect this exemption.  At AssetBuilder, we believe this is wrong.  

Customer friendly financial relationships are built on full disclosure.   Here is our full disclosure:

• We act in the investor’s best interest in all aspects of the financial relationship.  
• The fee we charge our investment customers is our only source of compensation.  
• We accept no fees or commissions from Dimensional funds, Charles Schwab, or any other third party.  
• We also don’t have a sister company or division that receives any monetary benefit from our investment decisions.

Chronology

September 20, 2007 – The Securities and Exchange Commission (SEC) issues temporary rules for wrap accounts.  The SEC’s stop-gap rule is silent on what investors and brokerage firms should do, but gives brokers limited relief.  The relief is based on more complete disclosure. http://www.sec.gov/news/press/2007/2007-193.htm


May 14, 2007 – The Securities and Exchange Commission (SEC) said it would not appeal the March 30 federal court decision.  The SEC asked for a stay of the court’s decision until October 1, 2007. http://www.sec.gov/news/press/2007/2007-95.htm


March 30, 2007 – the U.S. Court of Appeals for the D.C. Circuit found the Securities and Exchange Commission had exceeded its authority by promulgating Rule 202(a)(11)-1, which exempts broker-dealers offering fee-based brokerage accounts from registering as advisers.    http://pacer.cadc.uscourts.gov/docs/common/opinions/200703/04-1242a.pdf

On the Web

Kim, Jane J. “Moving Past ‘Fee-Based’ Accounts” Wall Street Journal, 22 Sep 2007:

Opeila, Nancy. “Paving the way: Court ruling and new standards a good start for consumers – but only the beginning” Journal Financial Planning, September 2007 Issue:

Burns, Judith. “SEC OKs Temporary Rules for Fee-Based Brokerage Accounts” Morningstar - Dow Jones Newswires, 19 Sep. 2007: 

Giannone, Joseph A. “Wall St. scrambles as court bans fee-based accounts” Reuters, 17 May 2007: 

“Morgan Stanley To Roll Out New Fee-Based Advisory Program” Financial Advisor – Dow Jones Newswires, 16 May 2007: 

Coleman, Murray. “Brokers to push special fee-based account status” Market Watch, 15 May 2007: 

Wutkowski, Karey. “US SEC won’t appeal fee-based accounts ruling” Reuters, 14 May 2007: