Book Reviews

I recently finished reading Explore TIPS: A Practical Guide to Investing in Inflation Protected Securities by fellow blogger The Finance Buff.

It was actually my second time reading it. You see, the author mistakenly thought that I might have something meaningful to add to the book, so he sent me a proof copy during the editing stage.

Instead, I found myself scribbling down several pages of notes. (The second time through the book resulted in two more pages of notes.) The honest truth is that, while I have a pretty good grasp of the basics of how TIPS work, I still had much to learn.

Random example #1: I never would have guessed that, when purchasing TIPS in the secondary market, it’s often more cost effective to place a buy order over the phone rather than online, despite the higher commission. (Reason being that the rep on the phone may be able to find you a better price on a given bond.)

Random example #2: At any given moment, every financial website may be quoting completely different yields for a given TIPS fund. The Finance Buff explains how to figure out what each of the yield figures means, and he provides advice on which figures to pay the most attention to if you’re trying to figure out what yield you’re going to get if you buy the fund. (Hint: Look for something forward-looking that’s inflation-adjusted.)

Explore TIPS covers everything that you’d need to know about investing in TIPS, things like:

• When to buy individual TIPS and when to use a mutual fund or ETF,
• How individual TIPS are taxed (and why you might want to consider a fund rather than individual TIPS if you’re investing in a taxable account),
• How to buy TIPS at auction, and
• How to buy TIPS in the secondary market (both how to understand the quote screens as well as how to minimize transaction costs).

For as much of our portfolios as bonds–and TIPS–make up, they sure get a lot less coverage than stocks and stock mutual funds. If you’re like me in that you could use a little more background on the other half of your portfolio, I’d suggest picking up a copy of the book. It’s short, it’s easy to understand, and it’s only $10 (and change) on Amazon.

April 7, 2010 0 comments

The more I’ve read about investing, the more I’ve come to see picking actively managed mutual funds as an unproductive endeavor.

In the hope of finding some evidence to the contrary, I recently read Fund Spy: Morningstar’s Inside Secrets to Selecting Mutual Funds that Outperform by Russel Kinnel, Director of Mutual Fund Research at Morningstar.

In his book, Kinnel argues that the four things to look for when choosing a fund are:

• Low expense ratio,
• Low transaction costs,
• High investment of manager’s own capital, and
• Good stewardship of investor assets.

Look for Low Costs

Kinnel’s chapter explaining the importance of low expense ratios was nothing new, though I’m always happy to see an author mention the topic.

In the chapter on transaction costs, however, Kinnel points out something I was unaware of: Portfolio turnover only reflects the lesser of purchases or sales made by the fund, divided by the fund’s assets.

In other words, in some years, a fund’s portfolio turnover figure could be quite low even though the fund incurred a great deal of transaction costs. For example, if the fund had large cash inflows from investors, it probably incurred a great deal of “buy side” costs. But if it sold very few investments over the year, its portfolio turnover would still be very low.

So Kinnel suggests that rather than looking at portfolio turnover, we should look at estimates of transaction costs. Makes sense.

Unfortunately, I don’t know where to find such estimates. Kinnel seems to suggest that they’re available somewhere on Morningstar’s site, but try as I might, I can’t seem to find them.

Investment of Manager Capital

Kinnel suggests that investors look for funds run by managers who invest a large amount of their own money in the fund. That has a certain common sense appeal.

Unfortunately, Kinnel doesn’t provide any data supporting the idea that investment of manager capital is a successful predictor of fund performance. No references to relevant studies. No footnotes. No end notes. Nothing.

He does provide a list of the 40 largest fund companies, ranked by average investment of manager capital, thereby allowing you to find a general pattern that the better-performing companies are near the top and the worse-performing companies are near the bottom. But that’s hardly the data-backed reassurance I’d look for before implementing the strategy.

Update: I recently got the chance to ask Kinnel about this in person. He explained that there simply isn’t any data yet in either direction, as Morningstar has only been collecting data on investment of manager capital for about 18 months.

Good Stewardship

Kinnel argues that one of the most important steps in selecting a mutual fund is to find a fund manager and fund company who place fund investors’ interests ahead of fund management’s interests.

Interestingly, David Swenson makes exactly the same argument in Unconventional Success. Swenson argues that, because individual investors have no access to meaningful information about the character traits of fund managers, we’d do better to stick to index funds where it’s less of a concern.

In contrast, Kinnel suggests that we rely on Morningstar to collect the information for us. You see, Morningstar provides letter grades for stewardship. “Just look for the A and B funds and avoid the Ds and Fs,” Kinnel says.

But again, there’s no data. Nothing whatsoever indicating that these letter grades have proven useful for predicting fund performance.

What am I missing here?

Toward the end of the book, Kinnel provides an analysis of the largest fund companies. For example, he has the following to say about American Funds:

“I like all of American’s funds, so I won’t say there are any you should skip.”

I don’t get it. Why, for example, would I opt to buy American’s EuroPacific Growth Fund instead of Vanguard’s Developed Markets Index Fund? Regarding Kinnel’s factors for selecting funds, it would seem that the index fund wins by a mile.

• Its expense ratio is much lower (0.29% as opposed to 0.80%), and it has no sales load.
• As an index fund, I suspect it has lower transaction costs–though again, I can’t find Morningstar’s estimates.
• Given that Vanguard is owned by the investors in its funds, I have a hard time imagining how American could possibly beat it in terms of stewardship of investor assets.

I’m at a bit off a loss. What’s the missing piece here?

February 8, 2010 4 comments

I recently read Zvi Bodie’s Worry-Free Investing. It’s a brief book that makes basically one argument.

Bodie (a Professor of Finance and Economics at Boston University) points out that the reason stocks have high expected returns is that they’re risky. And no matter how long we hold them, there’s always a chance that that risk will show up in the form of poor returns.

Bodie argues that the long-term riskiness of stocks is dramatically understated by conventional investment wisdom and that most investors have far too much allocated to stocks and far too little allocated to safer, inflation-indexed investments such as TIPS and I Bonds. In many cases, Bodie recommends a portfolio comprised exclusively of TIPS and I Bonds.

100% TIPS?

The problem, in my opinion, is that Bodie significantly understates the rate of savings that would be required for most people to reach their goals using a 100% TIPS portfolio. The reason for this underestimate is that he makes a few shoddy assumptions:

1. He assumes every investor will die at or prior to his/her life expectancy.
2. He assumes that you’ll earn a 2% real return from TIPS over any time period.
3. He assumes that the amount you pay into Social Security will also earn a 2% real return.

Life Expectancy

In Bodie’s calculations, if someone retires at 65 and has a life expectancy of 90, Bodie does the math assuming that the investor needs enough money to last for 25 years.

The catch, of course, is that approximately 50% of people will live beyond their life expectancy. Planning to only meet your life expectancy hardly seems worry-free to me.

(Real) interest rates change.

Throughout the book, Bodie assumes that you can earn a 2% real return with TIPS. This works reasonably well for an investor with a lump sum to invest, who is already some years into retirement, and who can currently buy TIPS with a 2% real return.

Of course, that overlooks a great many scenarios. For example, for the 30-year-old investor, even if TIPS are currently yielding 2% (or even more), there’s no way to know what rate of return he’ll get on the TIPS he buys at age 40, 50, or 60.

I’m not arguing that a 2% real return is unreasonably optimistic. But relying on a given return (even from a portfolio comprised entirely of TIPS) is neither risk-free nor worry-free.

Social Security is risk-free?

In most of Bodie’s examples, his math shows that the hypothetical investors need to save somewhere from 20% to 40% of their income in order to reach their goals. Bodie argues that that’s not as hard as it sounds because they’re already saving 15% of their income in the form of social security taxes.

The unspoken assumption here is that you will earn that same 2% real return on your Social Security tax payments that Bodie assumes you will earn from a TIPS portfolio.

For younger investors, I’m not even comfortable assuming a 0% nominal return on Social Security taxes. Relying on a 2% real return? Again, neither worry-free nor risk-free.

Is it worth reading?

To be clear: my point in all of this is not that TIPS are riskier than stocks. They aren’t. My point is simply that an investor following Bodie’s plan is not 100% certain of success. Not even close.

That said, Worry-Free Investing provides a thought-provoking counterpoint to the conventional wisdom of stock-heavy allocations. And for that, I’d say it’s worth reading.

February 1, 2010 10 comments

I recently finished reading David Swenson’s Unconventional Success: A Fundamental Approach to Personal Investment. (For those unfamiliar with Swenson: he’s Yale University’s Chief Investment Officer.)

The book is broken down into three sections:

1. Asset Allocation
2. Market Timing
3. Security Selection

Asset Allocation

The first section is a thorough run-down of each asset class, discussing various characteristics that make it either worthy or unworthy of investment. Swenson suggests a portfolio (one of my favorite “lazy portfolios” actually) consisting of 6 asset classes:

• 30% domestic equity,
• 15% foreign developed equity,
• 5% emerging markets equity,
• 20% REITs
• 15% U.S. Treasury Bonds
• 15% Treasury Inflation-Protected Securities

It’s good information, and I’m on board with his advice. The problem? This section of the book is boring, wordy, and repetitive. Given how engaging Swenson is as a speaker, I was disappointed.

Market Timing

The second section provides guidance on how to avoid behavioral investment mistakes. Specifically, Swenson warns against chasing performance and neglecting to rebalance your portfolio. Like the first section, it’s good advice, but not the most exciting reading.

Security Selection

Roughly halfway through the book and so far unimpressed, I was just looking forward to being done with it. Little did I know, this tamely-named section would be arguably the finest piece of investment industry muckraking I’d ever read!

In a degree of detail I’ve never seen before, Swenson highlights the various conflicts of interest between fund management companies and fund investors. I suspect that the majority of the information in this section will be eye-opening for most investors. I’m as cynical as they come with regard to the financial services industry, and there were a few moments when even I felt scandalized.

Recommended Read?

For a general introduction to investing, I’d recommend Bernstein’s The Investor’s Manifesto above this book. And in terms of avoiding behavioral investment mistakes, I’d suggest anything by Jason Zweig.

If, however, you’ve ever considered investing a portion of your wealth via actively managed mutual funds, I strongly recommend you read (the third section of) Swenson’s Unconventional Success. In all likelihood, it’ll convince you to stick with index funds and ETFs. But if it doesn’t, you’ll at least know what you’re up against (namely, the company managing your money on your behalf).

January 20, 2010 10 comments

I recently finished reading Bill Bernstein’s The Intelligent Asset Allocator.

In the introduction to Bernstein’s most recent book (The Investor’s Manifesto), he describes The Intelligent Asset Allocator as a failed attempt at writing a plain-English guide to prudent investing:

I was gratified with the response to it, both among academics and general readers. Sadly, I was less than pleased by what my friends and family told me, which usually went something like this:  ‘Jeez, Bill, it seems you know what you’re talking about, but I fell sound asleep by the second chapter.’

So I went in with the assumption that this book was going to be packed full of calculus functions and statistical jargon.

Not at all. It was really quite readable.

The Gordon Equation

As in Four Pillars and The Investor’s Manifesto, one of Bernstein’s major points is that it’s important to pay attention to valuation levels before buying an investment. For example, he argues that we can achieve a reasonable estimate of future stock market returns by using the Gordon Equation, which states that:

Expected Return = Dividend Yield + Dividend Growth Rate

It’s worthwhile to note that one of his messages in The Intelligent Asset Allocator (written in the late 90s) was that stocks were highly priced and had very low expected returns going forward, whereas in The Investor’s Manifesto (written in early 2009) the message is the opposite: stocks have taken a beating, and have pretty good expected returns going forward.

Important reminder: The Gordon Equation, while rather accurate over extended periods (20 years or more), has essentially no predictive ability for short periods–what the stock market will do next year, for instance.

Efficient Frontier

A second major lesson of The Intelligent Asset Allocator is the concept of  the “efficient frontier.” The idea is that, for any given period, there are a number of efficient portfolios, each of which provides the highest return for a given level of volatility, or the lowest volatility for a given level of return.

Of course, there’s no way to know ahead of time precisely where the efficient frontier will lie for a given period. But if we look at enough periods, we can get a sense of the types of portfolios that tend to be pretty close, thereby allowing us to draw some conclusions about intelligent portfolio design. For example:

• A portfolio comprised 10% of stocks and 90% of bonds often has higher return and lower volatility than a 100% bond portfolio.
• Over most extended periods, allocating a portion of your portfolio to international stocks will simultaneously increase return while decreasing volatility.

Would I Recommend This Book?

Absolutely–if you’re someone who finds mathematical explanations to be “meaningful and practical” rather than “abstruse and boring.”

That said, before reading The Intelligent Asset Allocator, I’d recommend reading Bernstein’s newer The Investor’s Manifesto. The message is similar, the writing is arguably better, and the data is more up-to-date (and, therefore, more relevant-feeling).

December 9, 2009 4 comments