March 2009
The Greenspring Investment Strategy A Greenspring Wealth Management Research Report
Introduction Greenspring has a simple, but more importantly, proven method for the management, selection and monitoring of investments within a defined contribution plan, pension plan, endowment, or foundation. We believe that most investment consultants focus on factors and criteria that have shown to have little or no predictive ability in determining future investment returns. Rather than engaging in costly speculation, our approach is based on the science of capital markets and focuses on identifying the risks that bear compensation and choosing how much of these risks to take within our client portfolios. As a fiduciary, Greenspring focuses on producing positive outcomes for participants/beneficiaries by controlling factors that have been proven to be reliable predictors of future returns. These factors are explained in more detail below. Structure Matters It is important to understand what drives investment returns over longer periods of time. The study1 cited, which reviewed various Equity Pension plans, found that traditional active management has very little impact on portfolio returns. Instead, persistent differences in average portfolio returns are explained by differences in average risk. It is certainly possible to outperform markets, but not without accepting increased risk.
Structure Determines Performance 96%- Structured Exposure to Factors -Market -Size -Value/Growth
4%- Stock Picking and Market Timing
Expected returns in the equity markets are based on exposure to the following three risk factors:
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Market
Stocks have higher expected returns than fixed income.
Size
Small company stocks have higher expected returns than large company stocks.
Price
Lower-priced "value" stocks have higher expected returns than higher-priced "growth" stocks.
Source: Dimensional study (2002) of 44 Institutional Equity Pension Plans with $452 billion of total assets
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Traditional management tends to focus on factors like stock picking (whether a company is overvalued or undervalued) and market timing (whether the market is high or low). While important, the reason these factors have such a small impact on future returns is that no one has been able to consistently exploit them. Successful investing means capturing the risks that generate expected return and minimizing the ones that do not. Avoidable risk includes holding too few securities, betting on countries or industries, following market predictions, speculating on “information” from rating agencies and paying too much for elusive “alpha” that is rarely delivered. To all these things, diversification is the answer. It takes away the randomness of individual security selection and lends structure to the investing process, positioning portfolios to take advantage of the broad economic forces that have been proven to deliver attractive rates of return over time. Size and Price Matter Groundbreaking studies by Eugene Fama and Kenneth French2 have found that the size and price characteristics of equities have dramatic impact on their expected risk and return. Size and Value Effects on US Equities from 1927-2007 11.35%
14.03% 10.35%
11.92% 9.42%
US Large Cap Value Index
S&P 500
US Large Cap Growth Index
US Large Capitalization Stocks
9.28%
US Small Cap Value Index
CRSP 6-10
US Small Cap Growth Index
US Small Capitalization Stocks
It is evident that style matters, and these risk factors will have dramatic effect on a funds long-term return. Therefore, when constructing portfolios and choosing investment products, it is important that managers adhere to their mandate in order to have constant exposure to these risk factors. Style drift occurs when managers move from one style to another (i.e. a large cap value manager buys mid cap stocks). While this strategy by a manager may help short-term performance, it alters the risk profile of the fund, since the expected risk and return of a fund is almost entirely dependent on the types of stocks are held within the fund. Investing Styles Matter Once the allocation decision has been made, the committee must determine if passive or active managers will be utilized. Greenspring Wealth Management believes that ample evidence exists to select passive managers for the 2
Fama/French data provided by Fama/French. The S&P data are provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Small company risk: Securities of small firms are often less liquid than those of large companies. As a result, small company stocks may fluctuate relatively more in price. Indexes are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio..
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majority of the asset classes being utilized. It is important to understand the distinction between the two primary styles for investment management: Active
Passive
Goal
Beat the market index
Match the market index
Success Rate Costs Premise Turnover
Hard to achieve consistently Usually high Securities are “overvalued” or “undervalued” Usually higher
Easy to achieve consistently Usually low Securities are fairly priced Usually lower
Because of the added costs of active management and the relative efficiency of markets, academic studies and real world experience support the idea that passive managers tend to outperform active managers over time. The study3 below is one of many that back up this assertion with actual data. 355 Mutual Funds vs. S&P 500 1970-2000 (31 years) 2.5%
Outperformed Underperformed
97.5%
This phenomenon of active managers underperforming passive managers is not only relevant to the equity markets. As the study4 below shows, it is also evident in the debt markets.
570 Peer Bond Funds vs. Vanguard Intermediate Bond Fund 1996-2006 (10 years) 3.3%
Outperformed Underperformed
96.7%
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Source: “Dead Funds and Return of Surviving Mutual Funds Relative to the Market, 1970-2000 (31 years)”- CRSP Source: “570 Peer Bond Funds vs. Vanguard Intermediate Bond Fund 1996-2006 (10 years), The Little Book of Common Sense Investing, page 143.
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Studies like these illustrate that it is not only difficult for an active manager to outperform their benchmark index any given year, but over longer periods of time, the case for passive management becomes even more compelling. It doesn’t necessarily mean that no one can pick winning stocks; just that it is a very rare skill that is almost impossible to identify in advance and becomes less likely over longer time horizons. The data5 below shows the top 10 mutual funds from 1994 through 2003 and their subsequent three year performance. Subsequent Performance of Top 10 Equity Mutual Funds
Ten Years January 1994-December 2003 Average Annual Rank % Rank Total Return (%) Calamos Growth A 1 1% 20.62 Vanguard Health Care 2 1% 20.16 Fidelity Select Electronics 3 1% 19.58 Fidelity New Millennium 4 1% 18.17 Alger MidCap Growth Institutional I 5 1% 17.78 FPA Capital 6 1% 17.52 Legg Mason Value Prim 7 1% 17.41 Eaton Vance Worldwide Health Sci A 8 1% 17.34 Wasatch Core Growth 9 1% 17.26 Janus Small Cap Val Instl 10 1% 17.00 Top 10 Funds Average Return 18.28 All Funds Average Return 9.41 S&P 500 Index 11.07 CRSP 1-10 Index 10.73 Number of Funds 1,121 Number of Top 10 Funds > S&P 500 Index 10 Number of Top 10 Funds > CRSP 1-10 Index 10
Subsequent Three Years January 2004-December 2006 Average Annual Rank % Rank Total Return (%) 595 60% 9.29 346 35% 11.88 974 99% 1.54 606 62% 9.23 449 46% 10.63 380 39% 11.43 756 77% 7.67 933 95% 4.78 496 50% 10.25 352 36% 11.82 8.85 10.74 10.44 11.10 985 4 3
The traditional method of using past performance as a predictor of future results has been found to be unreliable. While managers may have several years of outperformance that they tout as a reason to invest in their fund, the studies cited in this paper show that it is likely that their outperformance is attributed to luck rather than skill. Another recent study6 found that the traditional methods employed by consultants and board members of pensions, foundations and endowments actually hurt long-term returns.
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For illustrative purposes only. Mutual fund data provided by Morningstar; includes funds in “domestic stock” category with inception dates before January 1994, distinct portfolios only. Universe in subsequent period includes only surviving funds. Some fund returns and rankings may have been corrected by Morningstar since the data was first published; however, the original data is shown without alteration, in order to illustrate the information that would have been available at the time. The S&P data are provided by Standard & Poor's Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Indices are not available for direct investment; therefore their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. 6
The Selection and Termination of Investment Management Firms by Plan Sponsors, Amit Goyal & Sumit Wahal- May 2005
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Annualized Excess Returns over Benchmarks
Before and After Hiring Returns of Investment Managers 8755 Hiring Decisions over 10 Years- 1994-2003 4.00%
2.91%
3.00% 2.00% 1.00% 0.00% -1.00% 3 Years Before Hiring
-0.47% 3 Years After Hiring
On average, the pension funds surveyed in this study chose managers that generated significant excess returns over their benchmark index in the three years immediately before hiring, only to find that they could not replicate this outperformance in the corresponding future three year period. Again, the data shows that past performance has little relevance on future returns. So why do so many investors (and advisors) focus on this metric when the data points to its unreliability? We believe there are numerous factors including ignorance, the product focused sales culture of financial advisors and consultants, and our own human experiences in other areas of our lives that tell us that excellence in the past typically equates to excellence in the future. Costs Matter Mutual fund industry insiders hired Financial Research Corporation (FRC) to complete a study7 in an attempt to find a predictor of future fund performance. The study measured ten “predictors” (e.g. past performance; Morningstar ratings; expenses; net sales; asset size; risk/volatility measures) and the findings showed that most of the statistics had no predictive value. The study did, however, find one reliable predictor — expenses. Funds with lower expenses delivered “above-average future performance across nearly all time periods.” FRC concluded that a favorable expense ratio is an “exceptional predictor” for bonds, and a “good predictor” for stock funds. In keeping with these findings, Greenspring consistently reviews the internal expense ratios of the investment vehicles utilized in our client’s portfolios in order to keep costs as low as possible. Investing is not a frictionless activity. Whenever a manager buys or sells the underlying securities within a portfolio there are transaction costs that include commissions, bid-ask spread, and market impact costs. Turnover is a statistic (represented as a percentage) that identifies the frequency with which a fund or manager trades the portfolio. The higher the turnover percentage, the greater the transaction costs and the lower the net returns to the shareholders of the fund. These added trading costs serve to reduce the net returns of the portfolio and make it even more difficult for managers that trade frequently to outperform. Unfortunately, this data is not readily disclosed to fund shareholders like expense ratios (although it is factored in to any published performance numbers) and can only be estimated by using certain criteria. The chart below shows estimates of how turnover can reduce returns of a fund’s shareholders.
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Source: Predicting Mutual Fund Performance II: After The Bear, Financial Research Corporation-2002
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Average Equity and Fixed Income Turnover Costs8 Asset Class Turnover costs (% of assets) 0.55% Domestic Large Cap Equities 2.21% Domestic Small Cap Equities 1.09% Foreign Equities 1.18% Emerging Market Equities 0.43% Intermediate Term Bond 0.21% Long-Term Bond 0.19% Short-Term Bond It is evident that high turnover can have a drastic impact on future returns. In many cases a fund’s turnover costs (which are not readily disclosed) can end up being significantly higher than the fund’s stated expense ratio. Greenspring believes that many of these costs can be significantly reduced by using passive managers that do not create high turnover in their funds. Conclusion The cornerstone of our philosophy is helping our clients focus on the elements they can control rather than on those they cannot. We believe there are three aspects of the investment process that are within our control:
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Discipline - We develop an Investment Policy Statement (IPS) for each client of our firm, whether individual or institutional. The IPS sets forth asset allocation guidelines, rebalancing procedures, security selection, rate of return targets, risk tolerance and client goals. All investment decisions are made according to guidelines set forth in the IPS rather than by gut feelings or emotion.
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Diversification - We believe that a globally diversified portfolio is the only effective way to consistently deliver capital market rates of return. Each client portfolio is diversified across a minimum of ten (10) asset classes ranging from equities, debt, real assets and cash.
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Costs - Many investors are unaware of how much impact expenses can have on the growth of long-term assets. In general, lower expenses equate to higher returns. We pay careful attention to control all the costs associated with investing, both explicit costs as well as implicit costs (e.g. trading costs).
Kasten, Gregory W., “High Transaction Costs from Portfolio Turnover Negatively Affect 401(k) Participants and Increase Plan Sponsor Fiduciary Liability,” Journal of Pension Benefits (2007): 50-64.
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Disclosures: Greenspring Wealth Management, Inc. (“Greenspring�) is an SEC registered investment adviser with its principal place of business in the State of Maryland. Greenspring and its representatives are in compliance with the current registration requirements imposed upon registered investment advisers by those states in which Greenspring maintains clients. Greenspring may only transact business in those states in which it is registered or qualifies for an exemption or exclusion from registration requirements. This brochure is limited to the dissemination of general information pertaining to its investment advisory/management services. Any subsequent, direct communication by Greenspring with a prospective client shall be conducted by a representative that is either registered or qualifies for an exemption or exclusion from registration in the state where the prospective client resides. For information pertaining to the registration status of Greenspring, please contact Greenspring or refer to the Investment Adviser Public Disclosure web site (www.adviserinfo.sec.gov). For additional information about Greenspring, including fees and services, send for our disclosure statement as set forth on Form ADV from Greenspring using the contact information herein. Please read the disclosure statement carefully before you invest.