The Pitfalls of Income Investing

The Pitfalls of Income Investing

 

LUTZ BUSINESS INSIGHTS

 

The Pitfalls of Income Investing

the pitfalls of income investing

josh jenkins, cfa, senior portfolio manager & head of research

 

As people advance toward retirement, their investment objectives inevitably shift. During their working years, the goal is to build wealth. By forgoing some consumption today, investors accumulate future spending power in the form of a portfolio of assets. When the time comes to leave the workforce, those assets must step in and replace earned income.

There are a variety of approaches a retiree can use to turn their portfolios into spending power. We will discuss a couple of common methods here. Before we get to that, it may first be helpful to understand how portfolio returns are generated:

Appreciation + Income = Total Return

In the equation above, appreciation refers to changes in the asset’s price, while income generally consists of dividends and interest. ‘Total return’ is simply the combination of the two.

The Income Approach

A common strategy to fund retirement spending focuses specifically on the income component of return. With this approach, the retiree lives off the dividends and interest generated by the investments. This is a very attractive proposition for many investors, particularly those with an aversion to dipping into principal. While this seems like a great idea in theory, in practice, it doesn’t work well for a variety of reasons.

To start, the idea that dividends allow you to bypass a reduction in principal is not true. A dividend does not represent value created out of thin air. Before being distributed to investors, it was cash on the balance sheet and comprised some part of the company’s value. When a firm decides to pay a dividend, its value is reduced by that amount. However, the direct impact on the stock is difficult to observe, given the myriad of other factors that cause day-to-day fluctuations in price. Dividends are not a free lunch. Whether it is the company distributing capital to shareholders or investors selling shares in their portfolio, there is a reduction in principal.

Another weakness of the income approach relates to the current market environment. Let’s assume that a typical retiree spends about 4% of their portfolio’s value per year. Thirty years ago, stocks and bonds could have easily handled that need, but that has since changed. As the chart below illustrates, a decline in yields (particularly for bonds) means a traditional portfolio would not be able to satisfy that spending rate.

Source: Morningstar Direct. Data from December 1987 through June 2020. Popular Vanguard funds (VFINX for the S&P 500 Index and VBMFX for the Total Bond Market) were used instead of the actual indices due to data availability. 

If the income from a traditional portfolio is no longer sufficient, how do retirees make up the difference? One option would be to take more risk in the bond allocation. This can be accomplished by buying either longer-term or lower-quality bonds. Each option has material drawbacks.

Bond prices have an inverse relationship with interest rates (when rates rise, bond prices decline), and that relationship grows stronger as the time to maturity stretches longer. With yields near historic lows, relatively small increases could cause the value of longer-term bonds to decline by more than the interest payments they receive. On the other hand, lower-quality bonds carry an increased risk of default, which can cause them to behave more like stocks than high-quality bonds. When the market becomes volatile, low-quality bonds can experience dramatic equity-like price declines.

Increasing the risk of the bond allocation could potentially help reach a specific income target, but in doing so, the principal value of the portfolio is put at risk. As famed investor Howard Marks once observed, “If riskier investments could be counted on to produce higher returns, they wouldn’t be riskier.”

Another option for increasing portfolio income is to focus the equity allocation on areas that produce high dividends. Again, doing this has some profound drawbacks. For starters, the really high dividend companies are generally concentrated in a few sectors (including energy, utilities, and REITs) and represent a small subset of the overall market. To really emphasize them, an investor must embrace a more concentrated portfolio. Additionally, stocks that share a similar feature, such as a high dividend yield, may also share a sensitivity to certain macro risk factors. An example here would be rising interest rates. The end result is a less diversified portfolio, which is thus taking on more risk than necessary.

Taxes represent another important consideration, as income strategies are generally less tax-efficient than alternatives. While 100% of a dividend is taxed, only the portion representing a gain is taxed when selling stock. The rate the dividend is taxed at could also be less favorable. While most traditional stocks pay qualified dividends, which are taxed at the long-term gains rate, others get classified as ordinary dividends and are subject to the higher ordinary income rate. Finally, an investor has no control over the timing of when a dividend is received but does have the flexibility to manage stock sales around actual spending needs. At the end of the day, the spending power of a taxable account will depend on the after-tax return, which is typically lower on high-income strategies.

 

A Better Solution

An alternative to the income strategy for funding retirement spending is the ‘total return’ approach. This method embraces both components of return rather than focusing on just the income piece. In practical terms, this involves holding a diversified portfolio of traditional stocks and bonds. The income generated is tapped to pay expenses, and the difference is covered by selling shares. By focusing sales in the portfolio areas that have recently done the best, the benefit of rebalancing is captured. During periods of strong market returns, some gains are taken off the table in the stock allocation. When the market is under pressure, bonds are sold to allow the stocks time to recover. This leads to a consistent practice of “selling high.”

The income-based approach is very common, in part because of how intuitive it is. In theory, the idea of protecting your portfolio by never dipping into the principal is very enticing. While doing this efficiently was an option a few decades ago, declining yields mean it’s no longer possible without adding avoidable risks. At Lutz Financial, we instead advocate the total return approach. This hybrid method can take advantage of both components of return while avoiding the pitfalls of yield chasing.

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA® + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is the Senior Portfolio Manager and Head of Research at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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P: 402.462.4154

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Portfolio Management for Retirees During a Financial Crisis

Portfolio Management for Retirees During a Financial Crisis

 

LUTZ BUSINESS INSIGHTS

 

portfolio management for retirees during a financial crisis

joe hefflinger, director and investment adviser

 

The impact of COVID-19 on the financial markets has been nothing short of dramatic. From its all-time high on February 19th, the S&P 500 fell 34% over just a few weeks before rallying off those lows recently. While the impact of the current crisis on our everyday lives is certainly unprecedented in many ways, market drops of this size and speed are not. Bear markets (drops of 20% or more from a recent peak) happen frequently enough (on average, once every six years) that their possibility should be considered in every financial plan.

Obviously, nobody enjoys seeing their net worth take such a hit in such a short period of time. However, for those with many years to go before retirement, they can generally keep adding to their retirement accounts (at discounted share prices) and remain aggressive with their investment allocation as they won’t be tapping into these funds for a long time. On the other hand, for those already in or approaching retirement, managing their portfolio during a financial crisis is far more complex. Times like these demonstrate the vital importance of having a comprehensive financial plan in place that is tailored to your personal needs. Part of any good plan is constructing your portfolio in a manner that takes into account that the markets can and will pull back materially at different points over any sizable period of time.

Keep in mind, however, that retirees could have two to three decades in retirement to invest their money. So there needs to be the appropriate balance between the need for current cash flow and the need for additional growth to protect against outliving your assets.  One way to accomplish this is to hold some of your assets in conservative bonds and cash, which provide some cushion against the risk of falling stock prices.

For those approaching or in retirement, we advise following the three-bucket approach in constructing your portfolio. Figure out what you’d like to spend each year. Say this number is $150,000 a year all-in (including taxes, out-of-pocket healthcare costs, etc.). Now figure out what amount of non-portfolio income you have coming in each year (e.g., social security, any pension or deferred compensation, etc.). Say that totals $50,000. That tells us your annual need from the portfolio (your shortfall) is $100,000 a year.

Let’s further say your total portfolio (401k, IRAs, taxable accounts, etc.) is $3,000,000. We advise putting one year of your shortfall needs in cash at the bank ($100k here). We typically like to see another ten years or so of your shortfall needs ($1M here) outside of the stock market, with a large portion of that in a diversified bond portfolio.

The remainder of the portfolio ($1.9M here) could be allocated to equities or some mix of equities and bonds depending on your ultimate goals, objectives and comfort level. The resulting overall allocation, in this case, would land somewhere between 63-37 (stocks to bonds/cash) and say 50-50, again depending on the amount of cushion the client is most comfortable with.

An illustrative example of this three-bucket approach is set forth below.

 

 

In a sense, this model takes asset allocation from the theoretical to the practical. Refilling each bucket over time can be adjusted as necessary as conditions warrant. For example, as markets fluctuate, you can evaluate options to potentially re-balance the portfolio as needed to get back to your desired targets.

It’s important to analyze your specific situation within the confines of a comprehensive financial plan. If you run your numbers and you aren’t comfortable with the result, you may be faced with some of the following questions:

  • If I’m still working, do I need to push back the age I plan to retire or increase my savings rate?
  • Do I need to find ways to reduce the amount I plan on spending annually in retirement (at least until the markets have recovered)?
  • If you’re already retired and had planned on delaying social security benefits to age 70, should you consider starting benefits earlier to avoid having to sell stocks at depressed prices to fund your living expenses?
  • Do I need to accept more risk (meaning own more stocks) in order to achieve my financial goals?

Some of these adjustments could make sense for you, but it depends on your facts and circumstances. It’s advisable to work with an experienced financial planner to help you analyze the specifics of your situation.

The benefit of the three-bucket model is that you wouldn’t need to touch the funds you have in stocks for over ten years. It’s easier to emotionally handle market pullbacks like we’ve seen when you can look at your portfolio through this lens, making it far more likely that you will stay the course. The key to all of this is not having to sell your stocks at an inopportune time. Currently, for clients that need funds from their portfolio, we will typically be selling their bonds and holding onto their stocks so they can participate in the ultimate recovery. And while it’s true that bonds can be volatile at times as well, historically they have been much less so than stocks. In times like these, having a solid financial plan in place (and sticking to it) is essential to maintaining a successful portfolio over the entirety of your retirement years.

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.827.2300

jhefflinger@lutzfinancial.com

LINKEDIN

JOE HEFFLINGER, JD, CFP®, CAP® + DIRECTOR & INVESTMENT ADVISER

Joe Hefflinger is an Investment Adviser and Director at Lutz Financial. With 15+ years of relevant experience, he specializes in comprehensive financial planning and investment advisory services for professionals, business owners, and retirees. He lives in Omaha, NE, with his wife Kim, and daughters Lily and Jolie.

AREAS OF FOCUS
  • Retirement Cash Flow Planning
  • Insurance Planning
  • Estate Planning
  • Business Owner Exit Planning
  • Charitable Planning
  • Tax Planning
AFFILIATIONS AND CREDENTIALS
  • National Association of Personal  Financial Advisors, Member
  • Financial Planning Association, Member
  • Nebraska State Bar Association, Member
  • Omaha Estate Planning Council, Member
  • CERTIFIED FINANCIAL PLANNER™
  • Chartered Advisor in Philanthropy®
EDUCATIONAL BACKGROUND
  • JD, Creighton University School of Law, Omaha, NE
  • BS in Economics, Santa Clara University, Santa Clara, CA
COMMUNITY SERVICE
  • Partnership 4 Kids - Past Board Member
  • Omaha Venture Group, Member
  • Christ the King Sports Club, Member

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OMAHA

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Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

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Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

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Grand Island, NE 68803

P: 308.382.7850

Being Too Conservative Can Be a Risky Strategy

Being Too Conservative Can Be a Risky Strategy

 

LUTZ BUSINESS INSIGHTS

 

being too conservative can be a risky strategy

josh jenkins, cfa, senior portfolio manager & head of research

 

It is generally accepted that when it comes to investing, there is a relationship between risk and returns. When done intelligently, increasing portfolio risk provides a corresponding increase to expected return. Conversely, by accepting a lower expected return, an investor can reduce their investment risk. By combining a risky asset class (stocks) that carry a high expected return, with lower risk assets like cash and bonds, investors can position themselves on the risk-return spectrum where they feel most comfortable.

The link between risk and return tends to break down at the extremes. On one hand, investors could take large and imprudent risks that are unlikely to be rewarded. On the other hand, they could become so conservative in their investments that they inadvertently amplify a different type of risk within their portfolio. The latter scenario is the focus of this post.

The primary goal of a typical conservative investor is the preservation of capital. They are willing to accept a low expected return to avoid losses. To do this, they may eliminate riskier assets (like stocks) altogether. The chart below illustrates the efficacy of this approach. Going back to the 1920s, there has never been a ten year period where a portfolio of cash investments or bonds have experienced a decline.

Source: Morningstar Direct. Analysis form 1/1/1926 – 12/31/2019. Includes all 10-year periods using monthly returns. “Rolling” means all 10 year periods calculated in 120 month increments. Returns are annualized. Cash is represented by the IA SBBI US 30 Day T-bill TR USD Index, bonds represented by the IA SBBI US IT Govt TR USD Index.

This may appear to be a slam dunk, but the simple analysis is omitting a critical factor: inflation. Inflation measures the rate of price change for a basket of goods and services over time. Historically, inflation has been positive, meaning prices tend to rise over time. The portfolio’s dollar value is, therefore, only half the equation, the future cost of goods and services is equally important. For long term investors, what really matters is the preservation of buying power, NOT the preservation of capital. 

This reality raises the bar for what a conservative portfolio must accomplish. Instead of merely staying above a 0.0% return, it needs to remain above the rate of inflation. The previous rolling return chart can be revised to include the impact of inflation. Doing this transforms the nominal (non-adjusted) returns into real (inflation-adjusted) returns. While conservative investments like cash and bonds stayed positive in nominal terms, the chart below illustrates that there have been long periods of time where they have lagged inflation – the result: a decline in purchasing power.

 

Source: Morningstar Direct. Analysis form 1/1/1926 – 12/31/2019. Includes all 10-year periods using monthly returns. “Rolling” means all 10 year periods calculated in 120 month increments. Returns are annualized and inflation-adjusted (real). Cash is represented by the IA SBBI US 30 Day T-bill Inf Adj TR USD Index, bonds represented by the IA SBBI US IT Govt Infl Adj TR USD Index.

These drawdowns in purchasing power are pretty dramatic, even when compared to an all stock portfolio. The worst 10-year period for cash investments saw a decline in purchasing power of 42.1%! Meanwhile, bonds logged a decline of 36.5% in their worst period. That is a devastating outcome for an investor who thinks they are in a low-risk strategy. The worst 10-year period for an all stock portfolio saw a decline of 45.3%, just a touch worse than cash!

Source: Morningstar Direct. Analysis form 1/1/1926 – 12/31/2019. Includes all 10-year periods using monthly returns. “Rolling” means all 10 year periods calculated in 120 month increments. Returns are annualized and inflation-adjusted (real). Stocks are represented by the IA SBBI US Large Stock Inf Adj TR USD Ext Index.

Not only were the declines for cash investments and bonds surprisingly high, they were also relatively more frequent. Of the roughly 1,000 ten-year rolling return periods in the analysis, stocks declined 140 times. Bonds declined nearly twice as frequently (254), while cash declined more than three times more often (429).

Source: Morningstar Direct. Analysis form 1/1/1926 – 12/31/2019. Includes all 10-year periods using monthly returns. “Rolling” means all 10-year periods calculated in 120 month increments. Returns are annualized and inflation-adjusted (real). Stocks are represented by the IA SBBI US Large Stock Inf Adj TR USD Ext Index, cash is represented by the IA SBBI US 30 Day T-bill Inf Adj TR USD Index, bonds represented by the IA SBBI US IT Govt Infl Adj TR USD Index. The 60/40 portfolio is 60% stocks and 40% bonds, rebalanced monthly. 

Fortunately for investors, there is a relatively simple approach to balance the risk of short-term stock market volatility and long-term loss of purchasing power. Diversification! Diversification allows you to own bonds to dampen short term fluctuations in the stock market, while also owning stocks to help the portfolio keep up with (and hopefully exceed) the pace of inflation over time. As the table above illustrates, a balanced portfolio of 60% stocks and 40% bonds has historically offered a variety of benefits relative to owning any single asset class. Note: We chose the 60/40 portfolio for this example, but other combinations of stocks and bonds could have similar benefits.

Based on historical experience, the 60/40 portfolio has:

  • Achieved a higher real return than an all-cash and/or bond portfolio
  • Experienced a drawdown in fewer periods than any of the asset classes on a stand-alone basis
  • Lost less in periods of decline
  • Lost less in the worst 10-year period

There is obvious appeal in trying to protect your portfolio from price fluctuations, as it’s painful for most people to see their balance decline. While concentrating your assets in “safe” short-term cash and bond investments is a way to prevent red ink from spilling on your portfolio statement, doing so may be simply trading one risk for another. There have been long periods in history where the rate of inflation has exceeded the return on cash and bonds. This less observable risk carries with it the same end result: a loss in the future purchasing power of the portfolio. A better approach for a conservative long-term investor could be a diversified mix of asset classes. A balanced portfolio can help toe the line between dampening short-term price swings, and protecting against the threat of inflation.

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

LINKEDIN

JOSH JENKINS, CFA® + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is the Senior Portfolio Manager and Head of Research at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

SIGN UP FOR OUR NEWSLETTERS!

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Toll-Free: 866.577.0780  |  Privacy Policy

All content © Lutz & Company, PC

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850

Is Value Investing Dead?

Is Value Investing Dead?

 

LUTZ BUSINESS INSIGHTS

 

is value investing dead?

Josh Jenkins, cfa, senior portfolio manager & head of research

 

Value investing has been around for nearly a century, developing a devout group of followers over time. Some of the world’s most prominent investors employ a variation of the strategy, including Omaha’s Warren Buffett. It’s not just the practitioners filling the ranks of the believers, the approach is also supported by academic research. Value investing has a strong track record with sound economic rationale to back why it has worked in the past, and why it should work in the future.

None of this changes the fact that recently the relative performance of value investing has stunk (please excuse the technical jargon). For over a decade it has lagged behind the broad market, causing some investors and pundits to lose the faith. Here at Lutz, however, we still believe. To understand why, let’s explore what value investing is, how it has performed in the past, and why we are optimistic about its future.

What is Value?

“Long ago, Ben Graham taught me that ‘Price is what you pay, value is what you get.’ Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” – Warren Buffett, 2008 Berkshire Hathaway Shareholder Letter

The above quote illustrates an important distinction that is confusing to many investors. How can you tell if a stock, or a broad market index like the S&P 500, is cheap or expensive? The obvious answer would be to look at its price. This approach feels natural, as many of us do it on a daily basis as we walk through a store or click around Amazon, but it can be misleading. The chart below illustrates the price index for the S&P 500 going back to 1928. If you tried to evaluate its merits based solely on price, you might reasonably conclude it was extremely cheap from the late 1920’s to the 1970’s. Aside from a few painful drawdowns in the 1990’s and 2000’s, the market appears to become more expensive year after year. The question is: If prices are always going higher, can stocks ever be cheap again?

S&P 500 Price Index

Source: MorningstarDirect. The S&P 500 is represented by the S&P 500 PR Index, using monthly data from 1/1/1928 to 6/30/2019. 

This is where Buffett’s quote comes into play. It is evident we have paid more for stocks over time, but has anything changed in what we receive for our money? The answer, of course, is “yes”. Decades of companies reinvesting their profits to expand and develop new technologies has resulted in businesses that are larger, more efficient, and more profitable than ever.

There are many variations of the value approach employed by the investment community. A simple one seeks to evaluate how many dollars you must pay to purchase one dollar of some fundamental metric of a company or market index. Commonly used metrics include sales, earnings (think of earnings as profits), cash flow, or book value. The value approach is centered on making sure the price you pay is reasonable relative to what you get in return. When it comes to buying stocks, what you ultimately get is an ownership stake in a company (the book value), and the right to participate in its operations (its sales, profits, and cash flows). The intuition behind using earnings (profits) as an example, is that returns will increase as you decrease the price paid for the same level of profits.

From here on “value stocks”, or simply just “value”, will refer to the subset of companies where the price paid per unit of the above fundamentals is low, relative to other stocks. If value stocks are those with the lowest price, the flip side of the coin would be growth stocks, or just “growth”. While it may seem counterintuitive to intentionally purchase the most expensive companies available, it’s actually a very popular strategy. The high flying “FANG” stocks (Facebook, Amazon, Netflix and Google), fall into this category. As their name implies, these firms are typically growing at a much faster rate than their value counterparts, and investors are willing to pay more for that future growth. The price may appear high today, but it could ultimately become a cheap purchase if the expected growth comes to fruition. The problem is investors tend to overestimate growth.

The Performance of Value

“In Theory there is no difference between theory and practice. In practice there is.” – Yogi Berra

The idea behind value investing is simple enough, but has it actually worked? To find out, we can compare the historical returns of value versus growth. Using data going back 91 years, the results clearly favor value, which outperformed the more expensive growth stocks by an average of 3.10% per year. While value has delivered higher returns over the long term, it has struggled notably in recent years. Over the last decade, the leadership has reversed with growth outperforming value by 3.44% per year. It is impossible to say precisely what has caused this change, but the massive returns from a small subset of firms (including the FANG stocks) have certainly contributed.

Historical Performance of Value vs Growth

Source: The Kenneth French Data Library; https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Value is represented by the Fama/French US Value Research Index, growth is represented by the Fama/French US Growth Research Index. The indices are not available for direct investment, do not include costs/fees, and are not representative of actual portfolios. Returns are annualized, based on monthly data from 1/1/1927 – 5/31/1927.  

After an extended period of underperformance investors will invariably begin to question whether things have changed to the point the strategy is obsolete. While no one can say for certain if or when value will make its comeback, it is important to recognize the current bout of poor relative performance is not unprecedented. There have been several other notable periods where value has struggled.

Looking at the chart below, value has outperformed on a ten year basis during the majority of the evaluation period, as evidenced by the green line fluctuating above the grey bar marking 0.0%. When the line is blue and below the grey bar (as it is today), it signifies growth has outperformed value. The aftermath of the Great Depression (1930’s), and the run-up of the internet boom (late 1990’s) provide two stark examples of past rough patches for value.

10 Year Rolling Performance - Valus vs Growth

Source: The Kenneth French Data Library; https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html. Value is represented by the Fama/French US Value Research Index, growth is represented by the Fama/French US Growth Research Index. The indices are not available for direct investment, do not include costs/fees, and are not representative of actual portfolios. Returns are annualized, based on monthly data from 1/1/1927 – 5/31/1927.  

Alas, no strategy works all the time. Value investing, like many other phenomena in the markets, is cyclical. Investors may shun certain companies for extended periods of time. This in turn makes them cheaper, and may set them up to perform better in the future. Conversely, people can get overly excited about the prospects of certain companies. As more investors buy into the ever-rising growth expectations, the price could rise too far, setting the company up to underperform. Even a wonderfully successful company can be a subpar investment by merely delivering great results when the market was expecting perfection.

 

Value Going Forward

“There is no way that we can predict the weather six months ahead beyond giving the seasonal average.” – Stephen Hawking, Black Holes and Baby Universes

Despite its struggles, there is a good reason to expect brighter days ahead for value. Given how well growth has done recently (particularly FANG stocks discussed above), the discount paid for value stocks is currently larger than normal. The chart below illustrates the discount for value companies (large and small) relative to the broad market. The middle grey bar in each section represents the average cost historically, while the green lines represent the current cost over time. The lower the green line moves, the cheaper value stocks are relative to the rest of the market.

Large and Small Cap Values

Source: Morningstar Direct. Valuations are based on an equally weighted composite of price/book value, price/earnings, price/sales, and price/cash flow of each value index relative to the broad market. Large cap value is represented by the S&P 500 Value Index, while small cap value is represented by the S&P 600 Value Index. The broad market was represented by the Russell 3000 index. Data from 1/2001 to 6/2019.

As you can see from the chart, not only are value companies trading at a larger discount than average relative to the rest of the market, they are the cheapest they have been since the early 2000’s! Unfortunately being a better deal than usual is not a guarantee that value stocks are poised to outperform in the near, or even intermediate term. Over time, however, the price paid has been shown to be one of the best predictors of future returns. Generally speaking the cheaper you can purchase stocks, the higher the returns you can reasonably expect (all else equal).

Wrapping Up

While the critics continue to debate whether or not value investing is dead, we believe those investors who are patient will be rewarded. The strategy has weathered many market cycles over the decades and endured other periods of extended underperformance. The opportunity to buy these already cheap companies at a larger than normal discount gives us a good reason for optimism.

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA® + SENIOR PORTFOLIO MANAGER & HEAD OF RESEARCH

Josh Jenkins is the Senior Portfolio Manager and Head of Research at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst (CFA)
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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Socially Responsible and Environmentally Sustainable Portfolios

Socially Responsible and Environmentally Sustainable Portfolios

 

LUTZ BUSINESS INSIGHTS

 

socially responsible and environmentally sustainable portfolios

jim boulay, lutz financial investment adviser & managing member

 

An increasing number of investors are looking for ways to align investment decisions with their own values and philosophies. As a citizen, you can express your political preferences around sustainability and other social issues through the ballot box. As an investor, you can express your preferences through participation in global capital markets. Socially Responsible Investing or “SRI,” is an investment strategy that allocates your dollars consistent with your beliefs and ideals.

SRI considers investors’ tastes and preferences about social issues in the design of an investment portfolio. There are a few different types of SRI investments, those that are environmentally conscious, those that are socially responsible and those that are may be consistent with religious beliefs. While some of these philosophies can be isolated, many are now combined into a general investment category called “ESG” investing. This combines social, environment and governance investing into one.

 

Who Practices SRI/ESG?

Several trends have driven SRI/ESG over the past decade. These include rising institutional and investor demand, legislative mandates for public funds, regulatory developments, the rise in environmentally themed offerings, increased shareholder advocacy, and the growth of community investing.

SRI/ESG is an investment approach available to anyone who wants to align their principles and beliefs with their financial future. If you seek a financial gain coupled with the opportunity to leave a positive mark on the environment or valued organizations, this strategy will suit your investing needs. With many financial institutions globally beginning to offer these services, it’s becoming a widely acceptable and even preferred way for investors to manage their money.

 

How Does Lutz Financial Offer SRI/ESG Services?

At Lutz Financial, we partner with Dimensional Fund Advisors to offer two types of portfolio styles to accommodate investor preference. The first are Social Core Equity portfolios, both domestically and internationally. These portfolios offer broadly diversified equity market portfolios that exclude companies that have a certain percentage of business in the following:

  • Abortion
  • Adult Entertainment
  • Alcohol
  • Child Labor
  • Contraceptives
  • Gambling
  • Stem Cell
  • Tobacco
  • Landmines
  • Companies with Businesses in Sudan

Even with the exclusions, these funds offer a broadly diversified portfolio amongst many different types and sizes of equities. As of June 2019, the US Social Core Equity 2 Portfolio (DFUEX) offered more than 2,300 domestic equities within its holdings. The DFA International Social Core Equity Portfolio (DSCLX) contained more than 4,500 globally diversified stocks within its portfolio. These social portfolios even extend into Emerging Markets via the DFA Emerging Markets Social Core Portfolio (DFESX). This fund contains more than 4,200 holdings as of June 2019. Lutz Financial combines these offerings to build clients’ global portfolios cost-effectively and diversified with more than 11,000 different companies.

Those investors looking for environmental impact investing are served using the DFA Sustainability portfolios. Lutz Financial’s use of the DFA sustainability strategies allows for systematic evaluation across industries on key issues, such as concerns of high greenhouse gas emissions or potential emissions from reserves of fossil fuels such as coal, oil, and natural gas.  In addition, the portfolios consider other factors important to those investors seeking to invest in sustainable companies such as:

  • Land use
  • Biodiversity
  • Involvement in Toxic Spills or Releases
  • Operational Waste
  • Water Management
  • Factory Farming
  • Cluster Munitions
  • Child Labor

Lutz Financial does not regard SRI or ESG portfolios as separate asset classes, but as an alternative framework for investing in conventional asset classes.  With this framework in mind, our approach centers on structuring portfolios to capture dimensions of higher expected returns. This is done in a cost-efficient, diversified way, all while applying a meaningful screening methodology that reflects a broad set of investors’ social and/or environmental concerns.

 

In short, bringing a positive change the organizations important to you through investments is becoming an increasingly popular way for people to support their values without having to sacrifice diversification or adequate returns. If you would like to learn more about the SRI or ESG offerings through Lutz Financial, please contact us or learn more here.

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of the Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.827.2300

jboulay@lutzfinancial.com

LINKEDIN

JIM BOULAY, CPA/PFS, CFP®, CAP® + INVESTMENT ADVISER, MANAGING MEMBER

Jim Boulay is an Investment Advisor and Managing Member at Lutz Financial. With 30+ years of experience, Jim specializes in financial planning and investment advisory services for high-net-worth individuals, families, and business owners. He lives in Omaha, NE, with his wife Regina, and four sons.

AREAS OF FOCUS
  • Comprehensive Financial Planning
  • Business Owners & Families in Transition
  • Family Office Services
AFFILIATIONS AND CREDENTIALS
  • American Institute of Certified Public Accountants, Member
  • Financial Planning Association, Member
  • National Association of Personal Financial Advisors, Member
  • Omaha Estate Planning Council, Member
  • Certified Public Accountant
  • Personal Financial Specialist
  • CERTIFIED FINANCIAL PLANNER™
  • Chartered Advisor in Philanthropy
EDUCATIONAL BACKGROUND
  • BSBA in Accounting, University of St. Thomas, St. Paul, MN
COMMUNITY SERVICE
  • Catholic Charities Endowment, Committee Chair
  • Crohn's & Colitis Foundation, Chapter President
  • Christ Child Society, Past President

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OMAHA

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P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

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Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

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Grand Island, NE 68803

P: 308.382.7850

Outsmarting the Ivy League?

Outsmarting the Ivy League?

 

LUTZ BUSINESS INSIGHTS

 

Outsmarting the Ivy League?

JUSTIN VOSSEN, INVESTMENT ADVISER & PRINCIPAL

Each year, the National Association of College and University Business Officers and Common Fund Institute produce a study on the returns of college endowments.[1]  This study tracks the results of University investment portfolios by size of their endowments.  Of the schools participating in the study in 2016, more than 93 had endowment assets exceeding $1-billion.² Schools such as Harvard, Yale, Stanford, Princeton and Notre Dame all have endowments over $1-billion and their returns were contributed to the study.

 

Obviously, the Universities with endowments over $1 billion have many resources, alumni, faculty and trustees to help them guide their investment decisions.  It is probably also safe to assume they employ the most-esteemed consultants, money managers and portfolio strategists that money can buy.

 

One would then guess that those institutions should be outperforming the market on a relative basis if they have all of the best and smartest resources at their disposal.  However, it turns out that is not the case.

 

Consider these returns for all Universities with endowments over $1 billion:

Average Annual Returns for US Higher Education Endowments For Periods Ending June 30,2016
Size of Endowment 1-Year 3-Years 5-Years 10-Years
Over $1-Billion -1.9% 6.0% 6.1% 5.7%

 

 

These returns are pretty decent, all things considered.  However, for comparison purposes, here are the indices for those periods as well.

Indices
Index 1-Year 3-Years 5-Years 10-Years
S&P 500 4.0% 11.7% 12.1% 7.4%
Russell 3000 2.1% 11.1% 11.6% 7.4%
MSCI World ex U.S. (in U.S. $) -9.8% 1.9% 1.2% 1.6%
Barclays US Aggregate Bond 6.0% 4.1% 3.8% 5.1%
CPI – U 0.7% 1.0% 1.6% 2.0%

 

While at face value it is hard to compare one asset class to a diversified portfolio, if we extrapolate a weighting to each index we can show what a blended portfolio of indices would have done against a blended portfolio of endowments.

 

To come up with a relative portfolio blend, let’s assume a 75% equity and 25% bond portfolio.  Of that, let’s assume approximately 25% of the equity component is international.  So, a blended index portfolio we could assume would consist of 55% Russell 3000 (US Broad Market), 20% MSCI World ex U.S., and 25% Barclays US Aggregate Bond.  This hypothetical allocation would not be unreasonable for funds with a very long-term time horizon looking to grow.  In contrast, the group of endowment over $1 billion carried a 13% US equity, 10% bond, 19% international equity, and 58% alternative asset allocation.  Alternative assets is a very broad space, but generally consists of hedge funds, private equity funds, private real estate and other assets such as art.  If we compare these returns we get the following:

 

Comparison Returns for Periods Ending June 30,2016
1-Year 3-Years 5-Years 10-Years
Endowments Over $1-Billion -1.9% 6.0% 6.1% 5.7%
Blended Index 0.7% 7.5% 7.6% 5.7%

 

So in three of the four time periods, the blended index won and in the longer 10 year figure, it was a dead heat.  I always say that if you show me portfolio returns for anything, I can mix and match a portfolio that will beat it with the ability of hindsight.  We did not do that, in this instance.  We carried a slightly higher weight to international equities, which had a dismal 10 years and also carried more bonds in the allocation, which carry lower degrees of risk than equities (and thus lower expected returns).

 

This is not a complex portfolio, but one we all could replicate because of the advent of index funds.  You can bet, however, if someone would have walked into Yale’s investment committee with a straight forward 55% US equities, 20% International equities, and 25% blended bond allocation proposal, they would have been laughed out of the room.  Does that mean the advice would have been wrong?  Using simple, diversified, low-cost investments and taking the time to control what you can.  Controlling behavior, allocation, goals, and taxes in the context of a financial plan isn’t bad advice, it is just not complex.

 

The truth of the matter is the market does not care how smart you are, how many initials you have behind your name, or how much money you have to invest. The capital markets deal in absolutes.  Adding complexity doesn’t necessarily increase returns as we see in this comparison.  Keep in mind, the more complex something is the higher degrees of monitoring, understanding, costs, and potential tax implications there may be.  These institutions have some of the brightest minds in finance on their committees overseeing those complexities and an organizational framework to monitor.  While they search out complexity, I think it is our goal to make the complex simpler.  We all still need to plan, monitor, and understand, but it all doesn’t have to be uber-complex to generate return.  We’ll see what the next 10 years brings, but don’t make the mistake of assuming complex is always better.

¹ http://www.nacubo.org/Documents/EndowmentFiles/2016-NCSE-Public-Tables_Average-One-Three-Five-and-Ten-Year-Returns.pdf

² http://www.nacubo.org/Documents/EndowmentFiles/2016-Endowment-Market-Values.pdf

 

 

Important Disclosure Information

Please remember that past performance may not be indicative of future results.  Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Lutz Financial), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful.  Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions.  Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Lutz Financial.  To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing.  Lutz Financial is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.  A copy of Lutz Financial’s current written disclosure statement discussing our advisory services and fees is available upon request.

ABOUT THE AUTHOR

402.827.2300

jvossen@lutzfinancial.com

LINKEDIN

JUSTIN VOSSEN, CFP®, NAPFA + INVESTMENT ADVISER, PRINCIPAL

 Justin Vossen is an Investment Adviser and Principal at Lutz Financial. With 21+ years of relevant experience, he specializes in providing wealth management and financial planning services for high net-worth families, business owners in transition, endowments and foundations. He lives in Omaha, NE, with his wife Nicole, and children Max and Kate.

AREAS OF FOCUS
  • Investment Advisory Services
  • Comprehensive Financial Planning
  • Business Owner Planning & Succession
  • High Net Worth Families
AFFILIATIONS AND CREDENTIALS
  • CERTIFIED FINANCIAL PLANNER™
  • National Association of Personal Financial Advisors, Member
  • Financial Planning Association, Member
EDUCATIONAL BACKGROUND
  • BSBA in Economics and Finance, Creighton University, Omaha, NE
COMMUNITY SERVICE
  • St. Augustine Indian Mission, Board Member
  • Nebraska Elementary and Secondary School Finance Authority, Board Member
  • St. Patrick's Church, Trustee
  • Mount Michael Booster Club Board
  • Lutz Gives Back, Committee Chair
  • March of Dimes Nebraska, Past Board Member

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All content © Lutz & Company, PC

OMAHA

13616 California Street, Suite 300

Omaha, NE 68154

P: 402.496.8800

HASTINGS

747 N Burlington Avenue, Suite 401

Hastings, NE 68901

P: 402.462.4154

LINCOLN 

115 Canopy Street, Suite 200

Lincoln, NE 68508

P: 531.500.2000

GRAND ISLAND

3320 James Road, Suite 100

Grand Island, NE 68803

P: 308.382.7850