Someone once said that the difference between unethical and ethical advertising is that unethical advertising uses falsehoods to deceive the public, while ethical advertising uses truth to deceive the public. Looking through all the mutual fund ads that run in the consumer press, it appears the investment industry has become expert in the latter.

With 45% of Americans investing in mutual funds, accounting for more than $9.6 trillion dollars, competition is fierce in the industry. Just about any newspaper or magazine will have advertisements like the one pictured below by Putnam Investments:

Covering two full pages in Investment News magazine, it was impossible for the reader to miss this ad and its clear message: Our managers are talented and experienced, and our funds have delivered exceptional performance.

While the ad is truthful, there is a larger truth that isn’t being communicated: For most of these funds, all this talent and experience has not translated into added value for the funds’ shareholders when measured against a passive benchmark.

The ad leans heavily on the managers’ outperformance against Lipper Categories, but these are not the same as a passive benchmark. Lipper Categories are simply group comparisons, comprising data gathered from other actively managed funds; given that over any measured period it is common to see 50% to 80% of actively managed funds fail to beat their passive benchmark, using Lipper tells me the Putnam funds beat a bunch of other actively managed funds which on average fail to beat their passive benchmark. Essentially, by using a Lipper average, Putnam has lowered the bar.

Second, the advertisement touts a single year’s performance (2009). Measuring performance over a single year tells investors absolutely nothing other than it would have been nice to have held those funds for that year. Past performance, especially only a single year’s performance, cannot be extrapolated into the future, and leading investors to believe it can is disingenuous.

So what happens when Putnam’s Large Cap funds are properly benchmarked against passive indices over an extended time? The table below shows how the funds in the ad stacked up over the past 10 years to an appropriate market benchmark.
 

^{Morningstar Direct April 30, 2000-April 30, 2010}

On both a nominal-return basis and risk-adjusted basis as measured by the Sharpe Ratio (return per unit of risk assumed), only two of the six funds (33%) added any value at all. And the two funds that did add value barely did so once the amount of risk they assumed was factored in. So while it is certainly true that 100% of the Putnam U.S. large-cap funds beat their Lipper Average in 2009, considerably less have beaten their passive benchmark on a nominal or risk adjusted basis over a meaningful period of time.

This is very similar to what the broad-based data confirms and what we see on a daily basis: the majority of actively managed funds can’t beat their passive benchmark. Delivering market-beating returns is a difficult thing to accomplish for mutual funds, so most fund ads seek to change the yardstick by which they are being measured to avoid this unpleasant truth.

Trying to guess what the politicians in Washington are going to do in the coming year is a nearly impossible task; however, one thing most observers agree on is that taxes are likely to be increased for affluent investors in the years ahead.

While we can’t yet know to what extent tax rates are going up, we do know investors will always be well served by structuring portfolios in the most tax-efficient manner possible. There are three essential ways this can be accomplished:

1. Minimizing Trading
2. Embracing Passive Investment Management
3. Practicing Asset Location 

1. Minimizing Trading: Trading causes not only tax recognition, but may also cause the tax burden to increase if a short-term capital gain is realized. Many investors are under the misguided belief that activity is good because they, or their investment manager, are moving from investment to investment, seizing “opportunity” in the process. And many active managers secretly believe activity is good because it helps them look busy, which helps justify their high fees.

The reality however, is that frequent trading doesn’t add value – it actually drags on performance. This is attributable to the fact that the new position purchased must not only generate at least the same return as the old position, but must also earn a premium to compensate for the incurred trading cost (commissions and bid/ask spreads) and the newly created tax liability. When this burden is multiplied among hundreds or even thousands of trades in a portfolio over a number of years, it is unlikely any investor or manager will be able to recoup these additional costs on a consistent enough basis to justify active trading as a strategy. This is why most active managers fail to beat their passively managed benchmark.

2. Embracing Passive Investment Management: The second rule, which is a close cousin to the first, is to hold only passively managed investments. Passively managed funds experience very little turnover as they are rebalanced only when the index is reconstituted (changed). Actively managed funds, by contrast, typically experience much higher portfolio turnover as active managers trade constantly in an attempt to replace “overvalued” securities with “undervalued” securities. One way to track the cost of a portfolio’s turnover is to observe the Tax Cost Ratio.

The Tax Cost Ratio measure how much of a fund’s annualized return is reduced by the taxes investors pay on distributions. For example, if a fund had a Tax Cost Ratio of 2% for a three-year period, and the fund’s pre-tax annualized return was 10%, an investor in the fund actually earned only 8%.

The table below shows the summary statistics of all Large Cap Value funds’ 10-Year Tax Cost Ratio and Turnover Ratio in Morningstar’s database:
 

The table clearly shows a higher tax burden is created by higher levels of turnover. It also shows the average Large Cap Value fund lost 1.08% annually over the past 10 years due to taxes – a significant number since the Large Value asset class only returned 3.07% over the same time period. Comparatively, the Large Cap Value position used in portfolios managed by Capital Directions has a 10-year Tax Cost Ratio of 0.49, placing it well within the top percentile of the most tax-efficient funds.

3. Practicing Asset Location: Asset location refers to the intentional placement of assets into specific types of accounts based on their predominant source of return. Due to differing tax treatment of capital gains and income, it is prudent to invest securities whose gain will be subject to ordinary income rates (typically much higher than capital gain rates) in tax-deferred accounts to the greatest extent possible.

Prudently placing investments in the correct account allows for a higher after-tax return without assuming any additional risk. It’s the closest thing to risk-free return an investor will ever get.

Unfortunately most investors – and their advisors – still populate tax-deferred and taxable accounts with similar securities. This is a shame, because a study by Carnegie Mellon University showed that investors can lose up to 20% of their after-tax returns by mislocating investments.

By following these three rules, investors can take significant strides to keep the returns they have earned for the risk they assumed. Remember, it’s not what you earn that matters: It’s what you keep.

Volatile markets are especially dangerous for investors as they often lead to dramatic changes in an individual’s willingness to assume risk, causing those who would normally embrace a buy-and-hold strategy to engage in market timing. When stressed investors are contemplating bailing out of the market, most willingly admit that they won’t be able to make a perfect call on the market’s bottom or top, but believe they can get “close enough” and view any lost return due to a timing mistake as negligible.

This cost, however, is usually massively underestimated, especially for those individuals who consider themselves to be long-term investors.

The real cost can be shown with simple math. For example, below is a chart showing the weekly percentage gain or loss in the S&P 500 index from January 1, 2009 through November 3, 2009:
 
The chart shows the S&P 500’s best weekly return over the measured time period was March 9-13, when it gained 10.79%. Not coincidentally, this was the first week following the market bottom on March 9. From that point through November 3, the S&P gained 55.14%.

Now consider an investor who was out of the market and missed only the first week of the recovery before jumping back in.  Though most investors would be impressed and quite satisfied with the 40.03% subsequent gain from March 14 through November 3, this is actually 15.11% less compared with someone who was fully invested in the S&P 500 for the period.

So how does missing out on the first week’s return of 10.79% end up costing the investor 15.11%? Where did the additional 4.32% come from? The answer lies in the simple beauty of compounding.

Consider two hypothetical investors, one who was fully invested the week of March 9 with a $100,000 investment, and another who waited a week and then put the same $100,000 into the market the week of March 16.

As you can see, the first investor, who enjoyed the 10.79% gain the week of March 9, began the following week with $110,790, while the second investor who waited a week to get back in the market began with the original $100,000.

From that point through November 3, though both investors’ portfolios compounded at the same rate, the fully invested individual was compounding an initial larger amount. The extra $10,790, compounded at the portfolio’s rate of return from March 14 through Nov 3, 2009, grew to $15,109 at the end of the period. This explains the additional 4.32% the buy-and-hold investor enjoyed and is a very real part of the opportunity cost the market timer incurred.

Opportunity costs will only increase over time as missed returns will never have the chance to compound. At the end of 10 years, assuming an 8% return, the original $10,790 mistake grows to $23,297; at the end of 20 years it grows to $50,291, and after 30 years the cost to the investor is $108,576 and we haven’t even factored in the costs of more frequent transactions or the earlier recognition of capital gains the market timer will also incur.

As you can see, timing mistakes are not simple rounding errors. They result in very real dollars lost that investors will never get back, and the opportunity cost of missing those gains will only grow to ever greater amounts over time.

Investors have two choices: They can either choose to stay invested and be 100% assured of capturing the market’s return, or they can engage in market timing, which not only has a lower probability of capturing the market’s return but will also continually compound errors over time.

Ask economist and layman alike about the recent activities of the Fed and you’ll likely hear the foregone conclusion that inflation is right around the corner. As a result, many investors are questioning whether their current portfolio is properly structured for such an environment, and, if not, what changes should they make?

A common theme among investors who fear a rise in inflation is to invest heavily in “real” or tangible assets such as gold, commodities, or real estate. Looking at the historical relationship between inflation and the above-mentioned assets, however, there is little evidence that these asset classes reliably help buffer a period of high inflation.

The table below shows the correlation between the above mentioned assets’ yearly returns and inflation over the past thirty years. Correlation is measured between -1.0 and +1.0, and captures the strength and direction of a relationship. Investors who expect inflation to go up would prefer to hold assets that have a high positive correlation (> 0.70) and avoid assets with a high negative correlation (< -0.70). Correlations that are close to zero have little to no relationship; sometimes they move together, sometimes they don’t. As such, they don’t provide a reliable hedge – and that is what we find with commodities, gold and real estate: 

Clearly these asset classes don’t live up to their reputation as inflation hedgers. In fact, gold (the asset class everyone seem intent on piling into right now) has often done the opposite of what investors expect, going down during high inflationary periods and going up during low inflationary periods, as seen in the graph below:

Using the correlation data from the table above, investors should not be surprised to see the following returns in 1980 and 1981 when inflation was running in double digits:
 

Nor should they be surprised to see the following returns 2002-2003 when inflation was running in low single digits:

Just as we would expect from the lack of correlation, there is no clear behavior pattern with commodities and gold in relation to inflation. And while real estate would appear from these examples to be the best hedge, there are many examples (such as the early 1990s) when real estate suffered big losses during a period of high inflation.

In addition to the uncertain relationship with inflation, all of the above assets have historically yielded higher levels of volatility than the broad market:

As the table above shows, investors selling equities to fund purchases of real assets are likely to actually increase their risk. Combine this with the lack of a strong relationship between inflation and these asset classes and it becomes clear that making a major shift in one’s portfolio to offset this risk is likely to be a fruitless exercise.