Alleged Local Ponzi Scheme Steals nearly $1,000,000

Lessons to be Learned

Being in the financial industry, Ponzi schemes happen more often than I like to hear, but it’s especially concerning when it hits close to home. In this case, Jeremy Lundin of Mound, allegedly stole almost $1,000,000 from local investors and never invested a penny. Jeremy, the owner of Big Island Capital (named after a popular hangout on Lake Minnetonka), promised investors “exponential returns” with very little risk.

Potential investors were sold the fund as “an investment you can be comfortable with and double your money,” and the owners would "shoot for returns of between 40 to 80%.” An excerpt of the investment strategy provided to investors is below:

“Our investment strategy is consisted of only options trading. This isn’t the buy low, sell high, keep the stock for a long time strategy that the majority of investors participate in. Options trading consists of buying or selling contracts of an underlying company’s stock instead of the stock itself. This means your money goes further and your investment grows exponentially. With this strategy, there is risk. There is a chance that the price of the stock goes the opposite way, but your investment is protected with stop losses.”

Ignoring the poor explanation of option investing compared to stock investing, the first lesson is that anyone offering sizable returns with little risk is at best ignorant of how markets work, or at worst perpetrating a fraud. In this case, it looks like the latter. Risk and return are correlated, meaning they follow the same trend, e.g., when potential return increases, so does the risk associated with that return. It’s not a perfect system, but with semi-efficient markets this holds true. Stock options, just like stocks, are traded in very large, very efficient markets.

The next lesson is not altogether obvious and many investors may not consider it unless it’s directly brought to their attention. The money invested in Big Island Capital was deposited directly into the bank account of the company. This means Big Island had custody of the assets. This also means Jeremy and Big Island could do whatever they wanted with the money. Having custody of the assets is what made it all possible. The second lesson is, your financial advisor (investment manager, wealth manager, stock broker, etc.) should never have both custody of your assets and be the one providing the advice. In this case it was easy to make fictitious account statements for each of the investors. If he did not have custody, a third-party custodian would have provided statements directly to the investors. Had a third-party custodian been involved, investors would have needed only to review their statement from the custodian and compare to what Jeremy was telling them. This Ponzi scheme, and most Ponzi schemes, are impossible to pull off if there is a third-party custodian.

There are other red flags in this case as well. Jeremy made large purchases including a Maserati, a boat, and luxury vehicles over a short time-period. While a financial advisor shouldn’t be handcuffed into living an austere lifestyle, considering the age of the company and the amount of assets Big Island was managing, it should have raised concern. Even the fact that the company was named after a known party destination should have given potential investors pause.

Key Lessons to be learned for investors: 
1.) Don't chase unrealistic returns - if it sounds too good to be true, it likely is.

2.) Avoid investment strategies you don't yourself understand - be skeptical of complex investment strategies.

3.) Always separate custody from management of the assets - when investing with anyone, the assets should always be titled in your name.

Here is the link to the article by Fox9 with an accompanying video.

Where Do I Get My Money When I Retire?

The Importance of a Withdrawal Strategy


Incomplete plans can be disastrous. A man named Carl McCunn learned this painful lesson amid the chilling landscape of Alaska. The wildlife photographer arranged for a bush pilot to fly him to an isolated region hundreds of miles north of Fairbanks. He carried enough provisions for his five-month excursion. As the end date approached, he made a startling conclusion. “I think I should have used more foresight about arranging my departure,” he wrote[i] in his journal. He was never able to follow through on his return flight plans. In the end, McCunn died. Planning is the one thing that could have saved him.

The complexity and details of building retirement savings often distract us from the ultimate end game: making withdraws. Failing to compose a complete plan can be costly. Once this problem presents itself, it's often too late to fix. In this article, we'll look at why conventional approaches to withdrawing retirement funds are inadequate and what considerations you need to make.

Why ‘Conventional Wisdom’ Lacks Wisdom

To appeal to a client's desire for simplicity many advisors overlay a basic ‘one size fits all' approach to withdraw planning. The result of this method is that money, and a lot of it is left on the table. At the end of the day, the IRS has more of your hard-earned dollars. Commonly, advisors direct clients to first withdraw from taxable accounts followed by tax-deferred, then finally, exempt sources. Why? Some experts posit that abstaining from Social Security holdings at the beginning of retirement ensures that the retiree is in a lower tax bracket upon withdrawing from tax-deferred accounts.

Solutions are as varied as the retirees themselves. That is, what works for one may not work for the other. There is no rule of thumb to withdraw planning. Moreover, the art and science of tax savvy withdraw planning is so intricate that experts in the field have turned to computer programs to customize solutions. “It can be like a Rubik’s cube,”[ii] remarks the co-founder of Social Security Solutions. “I solve the green side—and suddenly it creates problems with the yellow side.” The need for these digital solutions underscores the layers of obscurity plaguing most retirement plans. The output of such programs consists of a series of careful chess moves. Rarely is there a commonality among the outputs. This variance upends the popular notion that a simple 4% per year withdraw of one’s nest egg will suffice.

Ignore The ‘Rules’


The universal 4% rule is a fail-safe solution so long as you ignore the words ‘fail' and ‘safe.' The problem with such a rule is that it ignores inevitable market downturns. Even a portfolio of diversified asset classes is at risk of a secular market drop. This risk is real for three reasons.

First, as performance among equities becomes more correlated diversifiable risk erodes. Correlations among stocks have nearly doubled since 1980[iii]. Thus, the level of risk mitigation stemming from diversification is dropping. There are likely several causes including a more global economy and advances in trading among economies.  

Second, a retirement plan relies on continued growth throughout the span of your non-working years. Markets can become volatile during this particularly sensitive period for a retiree. As a result, the impact is considerable given that there is little or no time to recover.

Third, inflation can make significant moves over the course of your retirement years. However, more problematic is the less discussed increasing personal consumption expenditures (PCE). This number is considered by many to be more accurate than the CPI in measuring rising costs for consumers. From 1959 to 2009 the PCE “grew by an average annual rate of 3.4%” according to the Bureau of Economic Analysis[iv]. What category is most directly responsible for this rise? “A large increase in the share of PCE accounted for by services, particularly by health care,” according to the same report. This growth puts unseen pressure on the longevity of retirement savings during a time when one can expect health care needs to increase.

You'll Retire, Risk Won't

The game of managing risk is simpler in one's prime earning years. Why? You have a wide margin of error. Market downturns are recoverable over the long-term. This margin narrows as you near retirement. As discussed earlier, it becomes difficult to recover when the timeline shortens.

Simultaneously, when withdrawals occur the asset allocation balance changes. This dynamic illustrates why a retirement withdrawal strategy goes beyond choosing which account to draw from first. Retirees must also consider how asset allocations will change. If the optimal account to draw from first consists primarily of your bond holdings, then you may become over weighted in equities. This loss must have been a painful lesson for retired equity holders during the recession when the DJIA lost 54% between early October of 2007 and March of 2009. Diligent rebalancing helps with this but you must actively do it. 

Such an ugly equities picture means opting for more bonds, right? Wrong. As we noted in a previous post, 2013 was a trying year for some bondholders. The 10-Year Treasury rate increased significantly ending the year at 3.01%. This rise hammered Vanguard’s Extended Duration Treasury Bond ETF (EDV). By the end of the year, the fund lost 21.66 percent. Inflation risk can be more daunting than most expect. Today, we’re seeing plenty of signs or rising inflation which only serves to reiterate the risks.  <see: The Definitive Guide to Using Bonds in your Portfolio>

There's no perfect balance for all retirees. The important takeaway is to acknowledge this layer of complexity. Your plan must account for the intersection of risk tolerance both emotionally and concerning your solvency.

The Choice You Cannot Make

In a process fraught with choice it might be something of a relief to know that some decisions will be made for you. That is, at the age of 70 ½ you’ll face required minimum distributions (RMD) from tax-deferred retirement savings accounts. This inevitability must be included in your plan. RMDs must be calculated separately if you have numerous retirement accounts. Given the IRS penalty of 50%, you'll want to keep this parameter in mind when running the numbers.

While the required minimum is law, there are different ways to execute the provision. Some opt to use IRA funds to purchase an annuity. This strategy prevents the risk of outlasting your savings while also satisfying the RMD. However, due to the costs involved, this is rarely the best choice. Others go with an annual recalculation based on life expectancy. This choice means your RMD will be recalculated each year as you live out your retirement. Whichever way you go, remain cognizant of the fact that you’re operating in a rigid framework when it comes to RMDs.

A Dynamic Solution is Optimal

There is no way for me to give you an easy solution in the breadth of an article like this. However, if you are going to explore this alone, the biggest consideration is your tax brackets. This will guide how and when to withdraw your funds. The goal is to minimize taxes paid over the life of your plan. You can do this by picking and choosing from which accounts to draw your funds, converting and re-characterizing at opportune times, and being mindful of future key dates such as social security, pensions, and RMD’s, etc.  An example would be to withdraw from your 401(k) until, let’s say, the 25% tax bracket. From their withdrawing the rest of your funds needed from your Roth IRA tax free. This is one of the simplest examples I can give which illustrates the point that using a “rule of thumb” is never the best strategy.

When planning for retirement make sure to account for a withdrawal plan. The difference between a smart strategy and a careless one can easily be hundreds of thousands of dollars. Consult a professional who can guide you through the challenges of Roth conversions, minimum distributions and tiered withdraws.

As the months wore on the stranded McCunn ran low on provisions. Colder weather crept in and soon there was nothing left. He began to starve. Exercise careful planning to ensure there will be plenty to sustain you through the golden years.

[i] Kaniut, Larry. Danger Stalks The Land: Alaskan Tales of Death and Survival. Macmillan, 1999.

[ii] Miller, Mark. Solving The Retirement Withdraw Equation. June 14, 2016.

[iii] Increased Correlation: A Challenge to Diversification. BlackRock.

[iv] McCully, Clinton. Trends in Consumer Spending and Personal Saving, 1959-2009. Bureau of Economic Analysis. June, 2011.

The Definitive Guide to Using Bonds in your Portfolio

Understand how Bonds Work to Protect Yourself from Rising Interest Rates and the Next Bear Market.

Equities are the hero of the day. The stock market surge, sparked by the presidential election, has won the hearts of investors. In the meantime, bonds have been left in the shadows.

Though many are eager to turn their backs on fixed-income, this is a critical time to reevaluate bond holdings in your portfolio. Why? Your bonds may be at risk amid rising rates from the Federal Reserve. In this article, we will look at how impending rate hikes present a risk to bond holdings and why short-term, high-grade bonds are the solution.

Keeping Your Head Above Water in a Rising Tide   

A strengthening job market and upward trending inflation have emboldened Federal Reserve Chair Janet Yellen to deliver on her commitment to start raising interest rates. If the key factors of employment and inflation continue to rise “further adjustment of the federal funds rate would likely be appropriate,” remarked Yellen.[1] These comments should alert bondholders because rising interest rates result in falling bond prices. This kind of environment has not been seen for quite a while. 

For several decades interest rates have dropped. In 1981 “the 30-year Treasury yielded 15%; in 1991, it was 8%; in 2001, 5%; today, it is half that,”[2] remarked a journalist at Kiplinger. These falling rates caused rising bond prices. Today, the story is different amid a defrosting global financial crisis. Rates are creeping up. This movement is motivated, in part, by the Fed, and will drive bond prices down. These changes, which are outside the control of investors, underscore an often-ignored truth about bonds: they can be as risky as stocks. 

Investors only need to look back as far as 2013 to see how tumultuous the bond market can be. At the end of 2012, the 10-Year Treasury Rate stood at 1.93 percent. However, in 2013 the rate increased ending the year at 3.01%. This sharp rise took a toll on Vanguard’s Extended Duration Treasury Bond ETF (EDV). These rising rates meant the fund lost 21.66 percent for the year. A new bond investor would be shocked to learn that this traditionally “safe” investment could shed nearly a quarter of its value.

Yellen’s intention to increase inflation can accelerate the phenomenon seen with EDV’s performance. When inflation rises, we see too much money chasing too few goods. Resultantly, the purchasing power of the dollar declines. This drop motivates investors to seek greater compensation when lending. After all, they will need more income to afford the same basket of goods that was once cheaper.

In January of 2016, the CPI for all urban consumers was 238. As of January of this year, it rose to 244 marking an increase of 2.45 percent. This rising inflation will likely strengthen Yellen’s resolve thereby decreasing bond prices. While some meet Yellen's comments with skepticism, the backroom dealings speak volumes. “Behind closed doors, however, officials were laying the groundwork for raising short-term borrowing costs, the minutes showed,” remarked The Wall Street Journal.[3]

With these relationships clearly defined bond investors need to reevaluate before the rate hikes take effect. What is the best way to safeguard your holdings? Focus on short-term bonds that enjoy high-grade ratings. Let’s look at both of these characteristics.

Short and Sweet

Short-term bonds are less sensitive to increasing rates. However, investors seeking the historically stronger performance of long-term bonds have long eschewed them. Short-term bonds are primed for their moment in today’s environment of expected rate increases. Why? Their shorter duration makes them more able to weather the anticipated Federal Reserve moves. Let’s take a closer look at what duration means and why it’s important.

Duration is expressed as a number of years and indicates the sensitivity a bond has to changing rates. Imagine you hold a bond with a duration of five years. This figure means that after five years of collecting coupon payments you will have received a sum equal to the purchase price of the bond. That is, duration is linked to the coupon payments. A bond’s duration gradually decreases as the timeline to the maturity date shortens.

Rate of Return and Standard Deviation of Bonds Based on Maturity

Rate of Return and Standard Deviation of Bonds Based on Maturity

Investors holding short-term bonds are faced with a shorter duration and therefore lower risk amid increasing rates. Resultantly, those same investors can use the proceeds from their soon-to-maturing bonds to purchase new bonds that will feature higher yields.

Historically, there have been only a few, limited periods during which short-term rates increased. Specifically, since 1985 there have been five periods where the two-year Treasury yield rose. Within these spans, we see that returns on short-term bonds increases. This relationship illustrates the power of short-term bonds during times of increased rates.[4] 

Bond investors today enjoy the rare privilege of knowing what the future holds: higher rates. Yellen’s remarks have been clear and signal great advantages for opportunistic investors. “As the economy approaches our objectives, it makes sense to gradually reduce the level of monetary policy support,"[5]  stated Yellen in mid-February. Tough short-term bonds are not without risk the current direction of our policymakers creates a robust reward to offset this reasonable level of risk. Under these circumstances bonds with maturities of three to five years are wise.

While Yellen and her team broadcast clear intentions, Trump remains vague concerning policy. Equity investors appear willing to take it on faith that Trump will be friendly to businesses. Regulatory easing, infrastructure spending, and tax reductions are all believed to be on deck. However, these initiatives remain in the background as immigration headlines have dominated the media. In the meantime, many are waiting to see if he delivers jobs and wage growth to supporters still reeling from the recession.

Trepidations will continue to develop until rhetoric converts to policy. Bond investors can manage this economic risk by remaining cognizant of not only short-term maturities but also bond ratings.

Seek High-Grade When Seeking High Ground  

Bond investors must pay special attention to ratings amid uncertain times like these. Major rating agencies like Moody’s, Standard & Poor’s, and Fitch deem a bond worthy of a grade ranging from “AAA” (low risk) to “D” (in default, or serious risk of default). Low-grade bonds (“junk bonds”) must offer high yields to compensate investors for incurring high risk. Ratings help bond investors understand the future risks by assessing the credit quality of the issuing company. Ratings have significant influence over a bond’s interest rate and pricing. Is the rating the most important characteristic of a bond? Absolutely not, after all, who watches the Watchmen?

Rate of Return and Standard Deviation of bonds Based on Credit Quality

Rate of Return and Standard Deviation of bonds Based on Credit Quality

Bond rating agencies are as fallible as the people running them and as the saying goes, "to err is human." Some of these sanctimonious agencies have been on the payrolls of major firms. Conflicts of interest can arise as a result. One such case was the global financial crisis. Lauded rating agencies awarded “AAA” ratings to some collateralized debt obligations (CDOs). These instruments were most directly responsible for decimated markets in the wake of the 2008 disaster. Investors believed their “AAA” holdings to be safe when in fact they were toxic.

But I won’t get paid?

So you might be wondering if all your bonds are super-safe then you won’t be earning a good rate of return. Well it’s true that you will be earning less in yield than other bonds but with return comes risk. There is no getting around it. My suggestion to you is that if that if you want to take more risk in hopes of getting more return you should be doing so in stocks. By doing so you are getting paid a better rate of return for taking on the additional risk.

To determine how much to allocate to stocks and bonds you need to do a little planning. Start by thinking about all the cash you are going to need from your portfolio for the next 5, 10, and even 15 years. This cash should not be invested in risky assets. This is because you don’t want to be selling your investments when the markets are down to fund your spending goals. Instead invest this cash in high-grade, short-term bonds. By doing this you have whatever cash you need from the portfolio ready to be used even if we are in the middle of a bear market. Then, the rest of your portfolio can confidently invested in stocks.

Think about it. Even if we have another correction like in 2008 when stocks were down about 50%, short-term, high-grade bonds were down only slightly or in some cases even up (depending on which time period you are looking at). This means you could completely ignore the bear market, knowing that you didn’t have to sell any of your stocks when the market was down. Are you starting to get the idea? <see The Role of Bonds in Your Portfolio>

A sound bond investing strategy relies on a dimensional assessment of risk. Therefore, do a little planning and consider short-term bonds with high-grade ratings. Take a moment to understand the company issuing the bond and whether you consider the risk acceptable. Diversification is important, however, consider strategizing towards holding exclusively short-term bonds in your fixed-income portfolio. You can use funds like the SPDR Short Term Municipal Bond Index (SHM) or the Vanguard Short-Term Bond Fund (BSV), both of which holds over a 1000 individual bonds. Rates are likely to rise throughout 2016 and 2017. Today's market is a rare opportunity to capitalize on upswings explicitly cited in advance and position your portfolio for the next bear market.

[1] Cox, Jeff. Fed Chair Yellen: ‘Unwise’ to wait too long to hike interest rates. February 14, 2017. CNBC

[2] Glassman, James K. Why I’m Still bullish on Bonds. April, 2015. Kiplinger

[3] Harrison, David. Fed Eyes Aggressive Rate Increase. The Wall Street Journal. February 23, 2017.

[4] Howard, Copper J. and Williams, Rob. Short-Term Bonds: Why They Could Outperform As Interest Rates Rise. Charles Schwab. February 2, 2017.

[5] Saphir, Ann. Fed’s Yellen says ‘makes sense’ to gradually raise interest rates. Reuters. January 18, 2017.

The Tools of the Ultra Rich and Why to Avoid Them

Are Hedge Funds good tools to have in your investment toolbox?

Are Hedge Funds good tools to have in your investment toolbox?

Many think only the wealthiest Americans have access to the most effective asset managers. These Private Equity Funds, Hedge Funds, and Venture Capital firms would have you believe they are brilliant enough to call themselves financial alchemists. The truth is much simpler; these elite strategies regularly fail to match or outperform the broader stock market. Let’s take a look at the performance of these strategies and what inherent flaws are responsible for their failure to beat the simpler approach of investing in low-cost, tax-efficient index funds.

To begin, let’s look at some performance comparisons, in the short-term. Hedge Fund Research regularly publishes data on a broad assortment of hedge funds. One particular measurement, the HFRI Equity Index Hedge, reveals the faltering performance of hedge fund managers. A $1,000 investment in the holdings included in the HFRI would have grown to a little more than $1,050 for the year 2016. In comparison, the same investment in the S&P 500 would have grown to nearly $1,150. In fact, October of 2016 saw the widest gap of hedge fund underperformance relative to the S&P 500 in almost 14 years.[i]

The long-term performance is equally dismal. For the last three years, hedge fund investors have seen their passively managed brethren surpass them. As a result, “Several large institutional investors have publicly announced plans to reduce their hedge fund holdings or to liquidate them entirely as a result of under-performance,” according to Goldman Sachs.[ii]  This under-performance has become the new normal.

Equity hedge funds can certainly stand to shed some weight amid poor performance. The industry is home to $850 billion in assets globally.[iii]  For years these specialized investment techniques offered the beguiling allure of “alpha.” This term represents the degree to which a fund manager delivers growth that exceeds the performance of the broader market. The problem is that alpha has been conspicuously absent from private equity, venture capital, and hedge fund performance. The reasons for under-performance consist of costs, turnover, politics, and correlation. Let’s take a look at each to understand the fundamental flaws.

The most problematic characteristic of these funds is the cost. Commonly, hedge funds command a burdensome “2 and 20” fee structure. Managers receive 2% of the assets regardless of the performance. Additionally, managers collect 20% of the profits after exceeding a predetermined threshold. The mere existence of these fees puts alpha at a greater reach because the investors must earn enough to beat the market and make up for the fee expense. Paying 2% for the privilege to participate in a fund that falls short of the broader market is becoming a difficult proposition. The bigger problem is the 20% fee. Investors are increasingly opting for lower costs as evidenced by the fact that “Some 91% of investors’ assets were invested in funds with an expense ratio less than or equal to 1.19%,” according to a 2015 Morningstar study.[iv]  Moreover, periods of diminished returns are compounded by lock-up provisions. This restriction means an investor is unable to withdraw their funds for a period. One 2012 study determined that the average lockup period is 5.85 months for all single-manager hedge funds. [v]This standard clause ties investor's hands. Between June 30, 2007, and September 30th of 2008, the S&P 500 dropped 40%. That is, in far less than five months values for many were cut in half. Imagine how this impacts someone unable to respond to dramatic downturns. Ironically, while investors are restricted from adjusting their investments managers make many trades leading to the next problem of turnover.

Turnover occurs when managers of a fund buy and sell assets. This measurement is important because such moves generate brokerage fees and tax liability. These costs are not part of the fund’s expense ratio or the “2 and 20” fee structure. Active fund managers are always chasing opportunities thereby boosting costly turnover. Annual data between 2002 and 2015 shows that actively managed funds experience ten times more turnover than passive funds.[vi]  As a result, the average active fund turnover is 32% while the average passive turnover is just 3%. Despite its importance, turnover is not commonly measured or reported. This lack of insight leaves investors in the dark. Additionally, the problem of fund turnover is exacerbated by the poor decisions driving the regular buy/sell activity. For too long managers have looked exclusively at economic data (e.g. central bank policies) rather than the political landscape for clues.

Politics have become a greater influence of market movement than ever before. The UK Brexit referendum was an upheaval to the FTSE 250 which plummeted after the vote. Recently, renewed fears of a French exit from the EU (“Frexit”) have sent investors fleeing to the relative safety of gold, sending prices to a three-month high as of February 7th. Hedge funds have failed to consider the impact of a Trump victory on the market. The S&P 500 soared on the news of the new administration and hedge funds flopped. Managers misjudged the market in both the technology and financial sectors. As Marketwatch reporter Ryan Vlastelica explains, “Going into the election, hedge funds in aggregate had large positions in technology shares—one of the weakest-performing industries since the election—and smaller ones in financials, which have been the market’s best-performing sector over the past two weeks.”[vii]  Even Hedge Fund Research President Kenneth Heinz remarked that managers “didn’t think enough about it and were victimized by wild swings in policy and uncertainty.”[viii]  An increasingly nationalistic movement across the globe will only add to the exhaustive list of metrics hedge funds must manage. This challenge is important because active management requires insight to the dispersion of stock market prices leading to the final problem of reduced correlation.

Active managers make money betting long and short on different movements among stocks. However, a recent phenomenon has made this practice more difficult. The correlation of stock performance within like sectors has increased “leading to lower dispersion of stock performance,” according to Goldman Sachs.[ix]  This change comes amid index fund inflows thereby causing stocks to rise and fall in unison rather than based on company-specific fundamentals. As more investors awaken to the value of a passive strategy index fund holdings grow. As a result, the growth of the funds becomes more a function of mounting investments rather than company fundamentals (Read: “The Swinging Pendulum of Passive Investing”). Moreover, international and U.S. stocks have experienced increasing correlation since 1980.[x]  This global trend leaves fewer opportunities for managers to exploit discrepancies in the market. The trend is likely to continue given that “In the last year, all categories of long-term active funds lost a staggering $308 billion, while passive funds (again, largely ETFs) attracted $375 billion.”[xi]

Given the inexorable problems of cost, turnover, politics and rising correlations it’s no wonder these outflows continue. Studies repeatedly show that a low-cost, tax-efficient index strategy is the reliable way to accumulate wealth over the long-term slowly. The four problems with hedge funds discussed here represent some of the strengths in passive investing. That is, costs are low. Turnover is also small as a passive strategy just mirrors an index. The diversification across sectors helps insulate against political risk. Finally, rising correlations are less of a risk as passive funds do not seek to play one stock against another. While commitment may be difficult the strategy is easy; stay in the market, minimize costs, diversify and avoid timing. As Warren Buffet said, "Investing is simple, but it isn't easy.”



[ii] Ibid.

[iii] Fletcher, Lawrence. Hedge-Fund Managers Bombed in ’16. February 7, 2017. WSJ





[viii] Fletcher, Lawrence. Hedge-Fund Managers Bombed in ’16. February 7, 2017. WSJ




CNBC…for Entertainment Purposes Only

A similar form of entertainment...

A similar form of entertainment...

In the late 18th century Austrians were amazed at a mechanical man who could play chess. He became known as the Mechanical Turk. The automaton, consisting of gears and levers, could engage any player in a game while exhibiting stunning skill for a machine. Of course, people eventually learned it was a hoax. A man hidden under the playing table operated the arms.

People today could never be fooled by such a farce, or could they?

Much like the automaton, today’s television financial “professionals” put on a good show but lack any real ingenuity or skill. This passive engagement appeals to the public’s sense of novelty and theatrics. As media theorist, Marshall McLuhan theorized "The medium is the message." The medium is the problem.

Advertising, Not Acumen

The most popular financial shows in the world are not in the business of dispensing financial advice. They’re in the business of generating advertising revenue. They use sensationalism to keep viewers interested. This bombastic approach is not limited to those who unabashedly embrace exuberance like Jim Cramer of Mad Money. Hosts of other shows like Squawk Box and Power Lunch do the same.

The problem is the business model. The networks live and die by their ratings. This metric is critical because it drives their ability to generate advertising revenue. Therefore, the only goal is to bring viewers to the screen, not provide sound financial acumen to the masses. How do they get our attention? They use brute force. Amid an ever-increasing list of entertainment options (Netflix, Amazon, and others) hosts must resort to chest beating analysis to be heard. As one CFP summarizes, “The presentation is superb at creating confusion, yet greatly lacking in delivering worthwhile guidance.”1

The pressure for ratings comes not only from competing channels and sites but the omnipresent data of today’s world. Investors can find up to the minute research anywhere at anytime. With the sum of all human knowledge in our pocket, there is little reason to have allegiance to any particular program. Traditional television programming attempts to compete with sophisticated graphics and charting. The result of these tactics is a cacophony that never rises beyond noise.

More problematic is the authoritative stance hosts take. Jim Cramer has long abandoned any pretense of professionalism or elitism. As a result, he is the more honest of the hosts on TV. He shouts and screams and never pretends to be anyone but himself. For many viewers, this is the basis of his appeal. However, other hosts sporting a tailored suit and perfect tie offer themselves as a sage voice amid the manufactured confusion of the markets. This presentation is dangerous because it invites viewers to see them as Chartered Financial Analysts or Certified Financial Planners when they are neither. The more authoritative the presenter becomes, the more skeptical we should be.   

Reviewing Performance

The president on CNBC once remarked in his discussion of the network’s programming, “some people like politics, some like sports, some like news, but everybody is interested in money.”2 This interest in money that is, making more of it, is the only reason anyone would watch Mad Money, Squawk Box or Power Lunch. For this reason, it seems appropriate to measure the performance.

Researchers at Northeastern University reviewed the performance of Jim Cramer’s stock selections and concluded: "his aggregate or average stock recommendations are neither extraordinarily good nor unusually bad.”3 This finding is in keeping with the tenor of the show. Too often the host predicts all outcomes to hedge their reputation. The exhaustive research arrives at an unsurprising finding that “A portfolio constructed as described from Cramer’s ongoing recommendations would not produce superior performance over the entire period of analysis after adjusting for market performance, size, and book-to-market characteristics.”4

Part of the problem with executing Cramer's buy and sell recommendations is that it requires the investor to make rapid-fire trades. This activity generates burdensome fees, brokerage costs and taxable gains. It’s more than the ordinary investor can track. Following the twisted path of any host’s recommendations will cause the same problem.

However, the cost of fees and taxes are secondary to the costs associated with risk. “Systematic risk is about 20% greater than the passive S&P 500 index” warn the same researchers. While you might make a few gains, the risks incurred are dangerous and unnecessary given the middling returns. From July of 2005 through December of 2007 Cramer issued 1,387 explicit buy recommendations and 534 sell recommendations. Some of the more aggressively low-priced online brokers offer a flat fee of $4.95. However, at Cramer’s trading volume an investor would incur $6,865 in fees alone just to execute the buys. Even if an investor opted to purchase a quarter of the recommendations, their total cost would clock in at $1,716. This total is a high bar to hit just to break even.  

The Heat of the Moment

Sound investing focuses on fundamentals. The brazen hosts of network television, however, focus on the heat of the moment. Their stock selections are designed to capitalize on topical events and other short-term aberrations that have little bearing on a long-term plan.

If an investor embraces the short-term in the drive to wealth, they risk losses from unforeseen events. These television personalities live in the narrow space of intraday news. They attempt to profit from short-lived movements. The inherent problem with this approach this the broad viewership of the shows. Millions of others are watching the same program and hearing the same information. Therefore, any opportunities in the stock market are likely to be fleeting as others act to capitalize on the advice. It simply is not possible to embrace a new wealth management plan every night.

Furthermore, the frenzy of trading means missing the benefits of compounding. As share prices appreciate year over year investors, experience exponential growth as they earn interest on interest. Compounding is possible only with a consistent plan. Deviation disrupts compounding.

Supporting the importance of consistency is research from the University of Texas where academics concluded that “more style-consistent funds tend to produce higher total and relative returns than less consistent funds.”5 With so much influence on the minutia of earnings reports and nuanced company politics the TV, hosts are paying little attention to the underlying fundamentals. As a result, “unintentional style drift can lead to inferior relative performance.”6

This style drift underscores another problem with program hosts; they do not adopt a holistic approach. They choose a stock based on the news of the day without regard to how it will perform in the broader context of a cohesive portfolio. This concept forms the underpinnings of modern portfolio theory (MPT) which works to reduce idiosyncratic risk or the risk associated with the unique characteristics of a particular stock. The goal of MPT is to group various uncorrelated investments so that if one falls, the investor is not faced with a complete collapse in value. In fact, the strategy strives to see one investment rise as another falls, keeping the portfolio more or less even, while the whole of the portfolio increases in value over time.

If an investor blindly follows the recommendations of the hosts, they risk overweighting in a particular sector or succumbing to home bias which is the tendency to have a disproportionate amount of stocks from your home country. Each of the televised selections carries risks. Rarely is the risk factor of one offset by that of another.

In reality, the day to day financial news has very little impact on your overall financial situation. The best approach is to form a plan and stick to it. You are better off financially if you focus only on what you can control. Turn off the TV.




4 Ibid.


6 Ibid.

Key Takeaways from the Davos World Economic Forum

If you are a financial nerd like me you look forward to the Davos Economic Forum every year. It's an event held in Davos Switzerland where great economic minds and financial leaders get together and discuss the state of world from a financial persepctive. If you don't have time to watch hours of coverage you can take a look at our quick guide and see the key takeaways from this years meetings. Just click on the image below for a little lite reading this weekend!

Is the Stock Market Overvalued? Take a look at CAPE to find out.

Today is another article from the Fee-Only Financial Advisor Blog Sharing Group. This group is made up of other like-minded financial advisors from around the country. The purpose of the group is to share useful content and spread the word about the virtues of Fee-Only financial advice. The contributor of this article is Stephen Reh of Reh Wealth Advisors from California. His article looks at whether or not the stock market is overvalued. He uses a rarely heard of metric called the CAPE ratio. He'll explain what this is, how it works, and what it tells us about the current state of the stock market.


The Dow recently hit 20,000! This was a big psychological level for investors. While breaking this barrier is, in reality, insignificant, it symbolizes the continued growth of the stock market but also that the market may be getting too expensive. After all, the stock market has never been higher! But let’s look at the data to see how overvalued the market really is... 

CAPE – Cyclical Adjusted Price Earnings Ratio -  Shiller P/E – P/E 10 Ratio

First off, this is a valuation measure for the stock market which is based on another valuation measure, the price earnings ratio.   So, what is the CAPE? It’s the Cyclically Adjusted Price Earnings ratio!  I’ll bet your next question is “what’s that?”.  In this article, I will break it into simple terms to help you understand better and apply it to today’s stock market.

Price Earnings Ratio

In order to understand the CAPE ratio we need to explain what a Price to Earnings Ratio is and how it works. The Price to Earnings Ratio of the market, or P/E ratio, is simply the price of the stock market divided by the earnings of the market. This can also be applied to individual stocks but in this context, think of the market as a whole. The higher the P/E ratio the more expensive the market is, i.e., you are paying more in price for a relative share of profits (earnings). There is trailing P/E (based on recent historical earnings) and forward P/E (based on projected earnings estimates) but for the scope of this article, just understand it’s the price divided by the earning. <See: More Information on P/E Ratio>

Valuation Ratio

Next we have to look at something called a valuation ratio. This is simply a ratio that attempts to tell you how “expensive” (overvalued) the stock market is relative to its history.  We are going to use this by looking at the current P/E, we can compare to previous years P/E ratios.  If its higher, than we would say values are “rich” or potentially overvalued.  If its lower than average, the valuations are potentially undervalued. Are you getting curious about the current market valuation? Read on, we’re getting there.

So What Does Cyclically Adjusted Mean?

In the case of the CAPE, it’s the average of the last 10 years earnings adjusted by inflation.  The point of the CAPE is to adjust for an entire stock market / business cycle.  In most cases 10 years would capture a complete cycle. It’s really just a way to normalize the data.

What is the Intention of the CAPE Ratio?

The original intent was to forecast future long term returns and if they would be expected to be higher or lower than average. It is not intended to predict market crashes although by definition market corrections happen when markets are overvalued (otherwise they are not really overvalued are they?).

What is the Historical CAPE and Current CAPE?

The mean CAPE ratio is 16.72 since 1880. The current CAPE is 28.41 as of 02/06/2017. <Source: Shiller PE> That sounds like the market is dramatically overvalued. However, the world was drastically different in 1880. The period includes the Great Depression and two World Wars. Since 1990, however, CAPE has only spent 2% of it's time below its historical average. If it’s mean reverting, it should have reverted and returned near its mean.   What does this tell us?  It’s dangerous to use the measure to time the stock market.  Looking at CAPE over the past 25 years reveals a much different story.  According to JP Morgan’s guide to the market, the CAPE ratio has averaged 26.  The current CAPE of 28.5 then feels very normal and that the market is not overvalued.

Further, Jeremy Seigel from Wharton Business School argues that the CAPE uses a measure that is not consistently defined.  Earnings over time have been measured differently.  You cannot compare earnings in 1920 vs earnings in 2017 because the earnings are measured differently.  For example, companies used to have to write off Goodwill over time.  Since 2001, they must test for impairment and only write-off good will if it was no longer worth what the company paid. It doesn’t matter if you know what Goodwill means, the point is the definition of earnings has changed which makes the CAPE ratio flawed.

S&P500 Index: Forward P/E Ratio - Source JP Morgan Guide to the Markets

S&P500 Index: Forward P/E Ratio - Source JP Morgan Guide to the Markets

Moral of the Story?

So what is today’s “moral of the story”?  That I can use CAPE to argue the market is severely undervalued by comparing it to the late 1990's and that I can make it look severely overvalue by looking at periods of time prior to 1990.  Why is this important to you the investor?  It’s important to know that valuation ratios can give us a picture of the market but they can be manipulated by the person telling the story.  Inevitably, I get asked which ratios do I use and why?  I use the 25 year average because I think it’s more applicable to today’s world.  I also use more than one valuation ratio to create a better picture of the market.  Here is the spoiler alert, the vast majority of the time the picture painted is that the market is fairly valued.   According to JP Morgan’s Guide to the Markets, three ratios (P/E, CAPE, and P/CF) show the market is slightly overvalued and 3 ratios (Dividend yield, P/B, and EY Spread) show that market is undervalued.  How do I read into that?  The market is fairly valued or at least reasonably close.

The Swinging Pendulum of Passive Investing


Despite a growing selection of funds investors have centralized around a passive, low-cost strategy. Major names in the financial world have long touted the benefits of a passive approach. Vanguard founder John Bogle has become the face of the movement when he launched the first S&P 500 index fund available to the public in 1975.

The argument for eschewing actively managed funds is based on their well-documented underperformance relative to the broader market. The annual Morningstar active/passive barometer reinforces this truth with a review of the numbers. Their 2015 conclusion that “Actively managed funds have generally underperformed their passive counterparts, especially over longer time horizons,”[1] is in keeping with growing investor sentiment that “If you can’t beat them, join them.”

In a 12-month period through the end of November investors collectively pulled $358.8 billion from actively managed funds based in the U.S. Simultaneously investors put $479.8 billion into passive funds. Choice, it seems, has become something of a burden and the choices keep growing. In 1997 there were 6,778 mutual funds available in the U.S. Today investors can choose from over 9,000.[2]  Technology has enabled a more robust offering, but in a frenetic work environment, people have less time to tease apart the nuanced differences.

For a period niche products like livestock ETFs and other alternative investments carried a cache. However, the disciplined investor of today seeks a reasonable rate of return and therefore has resorted to the terra firma of a passive approach. Some big name players took far too long to respond to the fact that “A generation of 18- to 34-year-olds that is larger in size than the baby boomers is increasingly opting for lower-cost passive funds.”[3]  Fidelity’s sluggish answer to this movement is a collection of six new ETFs launched in 2016.

The relatively strong performance of passive funds is only part of the appeal for investors. People have become savvy on costs. Fees and expense ratios have become part of the investor’s vocabulary. Passive strategies offer inexpensive exposure to all market sectors. Investors are increasingly wary of fees eroding their gains as some analysts point to muted returns and inflationary pressure in the coming years. Studies reflect investor vigilance when it comes to costs; “Over the past decade, 95% of all flows have gone into funds in the lowest-cost quintile. Passive funds have benefited disproportionately.”[4]  The people have spoken.     

Actively managed funds have dropped the average asset-weighted fee by 4.8% in a bid to win back investors. Actively managed bond funds shed 6.0%. Despite these pleas the trend to passive funds continues because superior performance and lower costs can only portend great things to come.

Or can they?

The mounting concentration of assets within these passive funds has brought criticism to the fore. Some managers posit that shareholder-voting power has concentrated around just a few big name managers. Apple’s “top three institutional investors are prominent index fund managers Vanguard, State Street, and BlackRock. Combined, these three institutional owners control 12% of its shares and, naturally, 12% of its proxy votes. That's a lot of power to put in so few hands,”[5] warns one author. As more investors crowd this space equity purchases reach an enormous scale. Such inflows effectively increase the correlation among stock performance. The result: Diversification fails to defray risk.

Additionally, markets will become less efficient. Passive funds are tasked with matching an underlying index. Any decision to buy or sell shares is driven only by the need to maintain symmetry with the index. Therefore, large purchases from the likes of Vanguard and State Street have nothing to do with the fundamentals of the stocks. This phenomenon will ultimately create less efficient markets.

In a less efficient market share prices are slow to respond to factors, which may change the value of a stock. This is problematic because massive index funds will not respond to cogent market information. When you invest in a passive fund, you're committing to a practice of anchoring and holding firm no matter which way the wind blows.

However, sometimes we need to adjust the sails.

If a stock that is part of an index experiences a sharp price increase its market capitalization grows. That is, the share price times the total number of shares outstanding becomes a larger number. In some cases, an increased share price is the result of sound business practices, a competitive advantage or a strong product offering. However, sometimes, markets move with the same irrationality of those trading them. In such cases, an index fund would need to join the buying frenzy just to maintain the proper market capitalization proportions. Buying for this reason is less desirable than buying or selling based on the company’s fundamentals.

Throughout history, investors have seen evidence of these inefficiencies. In the late nineteen-nineties, the “dot com” bubble meant that any startup in the online sphere could enjoy massive share price run-ups regardless of fundamentals. Eventually, the bottom fell out. Following this came the credit bubble. Since that time we’ve seen commodities soar for a period without regard for their fundamental values. Markets are inefficient. The only quest is how inefficient are they?

In time, active managers will be able to capitalize on these inefficiencies brought on by monolithic, immovable index funds. We're not at this point yet. However, the exodus to indexing continues to grow unabated. In 2000 index funds held 9.5% of all stock fund assets. Today it’s nearly double that figure at 18.4%.[6]   

The Eiffel Tower would be a beautiful place if it weren’t for all the people. Perhaps this is also true of index funds. Diversification, consistency, and low costs have always formed the bedrock of a sound investment strategy. However, in the future share prices may be influenced less by their performance and more by the baseless whims of the marketplace.

Investors have long had a critical eye on active funds. Before long it will be time to turn that gaze to the underpinnings of a passive approach.  While we maintain our position that passive funds will outperform their active counterparts, rest assured we are keeping an eye on the markets so that if the pendulum ever swings too far we will be ready to make the appropriate adjustments.








What is Financial Success?

As a continuation of the Fee-Only Financial Advisor blog sharing group, this month’s post comes to us from Michael Garry, a Financial Advisor in Newtown, PA. He enlightens us to what it actually means to be financially successful.


If we look at society and societal norms, a lot of weight is given to success when it comes to defining happiness. If we see a person who is successful, it is often assumed that they are happy. On an existential level we should consider what it all means. In reality, we actually have no idea whether or not that person is either happy or successful; for a couple of reasons: First of all, we can only measure someone else’s success or happiness by what we know about them. Secondly, and more importantly, we can only measure someone else’s success or happiness by how we define success and happiness. There is really no way of knowing whether their measures are even similar to our own.

It is on this concept that we are then able to shift our focus to identifying our own unique definition of success and happiness. Once we identify those things, then we can work on building a plan and setting the goals to achieve them.

When it comes to financial success, the same case can be made as above. Identifying what financial success is, is different for everyone. The following are considerations to make when developing your own unique financial success plan.

Know What Is Important To You:

As with any plan, it is important to begin with what matters. We don’t make plans about things that don’t matter to us, right? When thinking about achieving financial success, identify areas of your money life that you feel need improvement and think about why. Looking at something and judging it might help you make a list, but creating an action plan for change requires delving deeper into why there is something missing in certain aspects of our lives.

Financial success, on a holistic level, is about more than just accumulating money and being financially stable. Success, for most of us, fosters a sense of well-being and peace-of-mind. Setting goals on the foundation of what is important to you and your family will help to accomplish this.

Plan For The Long Run:

Looking far ahead can be overwhelming for some people. It can tend to make people feel like the road is too long and they might never get there. It is important to know that we aren’t just looking from point A to point B. We are looking at the “long run” – the path is part of the process. When we set goals we design a series of steps that will help us achieve that goal. Each step is an achievement and can help us to feel better about the process.

It is important to look at how our plan is going to affect us over time, so considering what will happen over the long term when we make short term goals is an important part of creating your overall financial success plan.

Analyze possible hurdles or obstacles:

Chess is a game of strategy and one that requires us to identify possible obstacles well in advance (plan for the long run) and find solutions to get around, under, over or through them (analyze). Using the chess analogy we can begin to look at each hurdle as a challenge and an opportunity to find new and better ways to plan for and achieve our successes.

Human beings are instinctually drawn to avoiding change and taking the path of least resistance. However, it is often the case that, in order to find that path, we need to think about it far in advance of when the resistance may come. This type of “plan now, act later” strategy can feel uncomfortable for some people.

Many of our clients find this particularly challenging as some of the difficulties that they could possibly face are unknown to them. For example, making a large purchase and using retirement income to fund it can have major tax implications, or it may be in your best interest. There are many factors that go into determining the right choice for a particular situation. We help our clients understand their options and find the path of least resistance to the goal they are trying to accomplish.

Live within your means:

We are practically programmed at birth to look over the neighbor’s fence to see what’s in their yard. When we are young it is a shiny scooter (or these days iPad or Drone or Hoverboard), as we age the shiny things become larger, more expensive and more of a driving force for our day to day money choices. Keeping up with the Joneses is an extremely destructive way to look at and deal with finances. For most of us it might provide some type of short-term satisfaction but, in most cases, that is followed by longer term regret and disappointment.

Having a budget, whether you are of average means or extraordinary means, is important and critical to your financial health and success. When we create and follow a budget, we live within our means and are able to save for our goals and achieve greater success over the long term.

Invest prudently:

What does this mean? Invest prudently. You would get a thousand different answers if you asked a thousand people. But, this is what we know to be true:

·        Investing requires patience, time and commitment

·        Methods to get rich quick don’t often work

·        Diversification is important, the next big stock pick is not

·        The only way to grow your portfolio over the long term is to assume some degree of risk

·        Listening to the media will cause you anxiety and reacting to headlines will cost you money.

·        Markets work

Throughout the world, over the course of the last century, Markets worldwide have a history of rewarding investors for the capital they supply. The competition between companies vying for capital and the competition between investors vying for better returns, drives prices to fair value and so it goes. 

We believe that a prudent investment philosophy utilizes low-cost investments across a global mix of asset classes to create a diversified portfolio that is engineered to provide long-term returns and offer reasonable down-side protection. Often times this investment strategy is better left to a trusted advisor in order to stay focused on the long term goals of your financial success plan.

The desire to achieve financial success is universal, but the way to accomplish it is unique to every individual. Identifying your objectives and creating the path to achieve them takes time and patience. We hope that this helps you create an outline for your financial success. Please let us know how we can help you accomplish your goals.

Michael J. Garry, CFP(R), JD/MBA, is the owner of Yardley Wealth Management, LLC, is an independent Financial Advisor who provides Fee-Only financial planning services and investment management in Newtown, PA, and the author of Independent Financial Planning: Your Ultimate Guide to Finding and Choosing the Right Financial Planner