Being the nation’s most quoted financial planner makes Harold Evensky an easy target for those who envy his visibility and influence. But there’s a good reason why Harold gets so much more attention than the thousands of other financial planners out there. It’s the same reason why a mutual fund executive was once quoted in Fortune saying “Harold is a god” and why a guy who is so nerdy that people wonder aloud if he sleeps in his bow tie is so damn popular. It’s simply this: when it comes to financial planning, Harold Evensky is a great thinker. This guy lives and breathes planning. His wife, Deena Katz, is also one of the nation’s leading planners, and she runs their Coral Gables, Florida, business, Evensky, Brown & Katz, which frees Harold to think.
So when Harold says that advisors need to reevaluate the way they design portfolios, you’d think advisors would listen. Well, think again. Despite the fact that we have been in a bear market for three years and that many of the thought leaders in financial planning and in academia are saying that we have entered a long period of low returns in the markets, I hear almost no discussion among advisors about whether they should change their method of managing client portfolios.
Even though Harold submitted a masterly paper last year to the Journal of Financial Planning about designing portfolios differently in a low-return era, the planning profession seems to be doing business just as it did before the bear market started and before a string of academics wrote papers saying the equity premium had shrunk. While we have had a 26% recovery in the last three months from the March 11 low in the Russell 3000, what Harold is saying is important to advisors and their clients. Here is what he is saying, and what he is doing for his clients.
About a year ago, you wrote an article arguing that advisors should design portfolios differently than they have been. But I haven’t seen many advisors lining up to follow you. Why hasn’t it happened? Does a change still need to be made? To the extent I can tell, there has been little or no changing of portfolio design in the profession, and I am not sure why. One obvious answer is that people disagree with me. But I have not heard much disagreement. I think it’s a perception of, “If it ain’t broke, don’t fix it.” I have to say, however, that right now I cannot understand why advisors don’t think it is broken. Our job as planners is to look ahead, and I think it will be broken in the future. I’d say it is complacency, but I have more respect for my peers than that. I think it just hasn’t hit their radar screens. We’ve all been overwhelmed in dealing with client feelings and concerns, and our first priorities are those issues. I think advisors are dealing with fundamental planning issues and have not had the luxury to step back and think about the broader issues, about [portfolio] design and implementation strategies. My best guess is that most advisors simply have not had time to reflect. What’s frustrating is not so much that they’re not doing it, but that they’re not talking about it. We need to get this out on the table for discussion. It is extraordinarily important to look forward.
Could it be that the simplified portfolio design you are advocating poses challenges to the way an advisor runs his business? It is a more difficult story to sell if you want to get paid on the basis of assets under management. There’s not much excitement to telling someone you’ll put half their equities in a single ETF. When you think about the types of discussions we’ve traditionally had with clients, it’s focused on this and that manager, on hiring one manager and firing another. At one point, we had three large-cap growth managers, one core equity manager, one large-value manager, a small-cap growth manager, two small-cap value managers. In international we had core, value, and small-cap value managers. Whether someone adds value or not, it’s easy to create a perception that there is significant value because we’re monitoring all these styles and strategies, as opposed to saying, “I’ll take the bulk of your money and put it in a few investments.” Also, it’s a lot more exciting to say, “Pay me, and I will make you some money,” as opposed to saying, “Pay me and I will save you expenses on investing.”
The change in portfolio design that you’ve implemented is largely driven by your long-term outlook for stocks. Please explain that outlook. Over the next decade, we believe equity returns will be significantly lower than the last couple of decades and somewhat less than the long-term 70-plus year market history. No knowledgeable ob-servers disagree with that expectation. I’m actually on the optimistic end, with a 5% to 6% real return expectation. You’ve got Rob Arnott and others who say the equity risk premium is perhaps zero. Robert Shiller and Clifford Asness are not very different. I don’t know anyone who has not accepted [the notion] that returns will be lower in coming years. I am familiar with people arguing about things I say. But no one has challenged my conclusion that equity returns will be in the range I am talking about–certainly not in professional circles. If you do not accept this assumption, I think you have the burden of proof to show why returns should not be much more modest. And, if you do accept that returns will be lower, then the challenge is to ask yourself what it means in terms of the way you implement client portfolios. It is difficult, if not impossible, to defend what I call the multiasset-class, multiasset-style strategy that we have traditionally used. The numbers are so simple and compelling to me that it is not debatable.
If you accept the view that stock returns going forward will be lower, then what are the implications for advisors and their clients? For the 15 years through June 2000–prior to the big drop in stocks–the S&P 500 returned 17.6% annually. That was when most of us developed our approach to portfolio design. If you’re earning 17.6% and take off 1% for expenses for trading and the costs associated with a custodian, and if taxes are about 20% of the gross, which eats up about 3.5% of the return, and inflation is 3%, then your net after tax return is about 10.1%. That’s your real net return after taxes and after expenses.
Now let’s assume you earn a 9% gross return in the years ahead instead of the 17.6%. Take away 1% for expenses, and 1.8% of the return, or 20%, goes to taxes, and 3% is eaten by inflation. You end up with a 3.2% net return. The returns I am generating for clients are cut by over two-thirds. I end up with 3.2% annually instead of 10.1%. And if you have portfolios that are half in equities and half in bonds, the net after-tax and after-expense return will be even lower: you’ll end up with 2.5% net. In this kind of environment, if I can save 50 basis points on expenses, I just increased the return by 20%. There’s just not much left to play with. The problem is the expenses are going to be fixed and they are independent of the gross return, whatever that number is.
Does lowering your expectations mean completely rethinking the way you design portfolios and changing the way you make financial plans? Yes and no. Nothing has changed in our fundamental beliefs. We believe stocks will earn more than bonds and the world economy will be on an upward trend. We believe in diversification. We believe that there is a small-cap and value factor. What has changed is that we expect the real returns on stocks will be lower over the next decade. As a consequence, the strategy we used to implement, we now believe, will not be cost-effective in the future. We think the strategy needs to change and not the fundamentals of planning.
Explain the strategy change. The traditional institutional approach is still credible and valuable. But the problems arise from using that strategy in the retail world. So in looking at alternatives, what I have evolved our approach into is based on a “core-and- satellite strategy.” That term has been around since the early ’90s. It means you have some part of the portfolio in a core, where you are looking to capture market returns, and you are taking some risk around the perimeter, which is what is referred to as a satellite. We do the traditional work to determine the client’s proper stock-versus-bond allocation using mean variance optimization. And then we split the equity portion by putting 80% into the core holdings and 20% into satellites.
What do you do in the core? The core is the allocation in equities that captures the stock market’s return. In our case, the way we achieve equity market returns is with the Barclay Russell 3000 I Shares, which is pretty much the total market. Eugene Fama and Kenneth French [academics who have done extensive research on this issue] say you can get additional returns above the market from small-cap and value stocks. They call this the “three-factor model.” Because we believe in their work, we also have as part of the core an allocation to large, mid-, and small caps. These are not opportunistic investments. These are long-term factors that are inherent in market returns.
Specifically, how do you capture the market factor in your core stock position? We use Dodge & Cox for large- and mid-cap value, and a DFA fund for small-cap value. And we may use DFA for large value again–we have in the past. We’re using Dodge & Cox because when the government was hauling off CEOs and CFOs in handcuffs some months ago, we realized passive management is likely to own and, in fact, did own, significant allocations in many of those scandal-scarred companies. While [this approach] might be intellectually sound over extended periods, in the short term it was worrisome to our clients and to us to simply say, “Don’t worry, it will all come out in the wash.” So we made a decision to go with an active value manager at least for some period of time, and we think still there is some exposure and potential shoes to drop. We were looking for active management not so much to predict the future, but because when they hauled someone off in handcuffs we had reason to believe we’d be out of the position shortly. Our bias is toward passive management in the core positions, particularly in value, and we literally review that decision on a monthly basis to use an active manager.
Why do you have a bias toward passive management in the core? This is especially curious with value stocks, where I would think you’d want a stock picker. All the research we’ve done suggests that with core, in general, and value, in particular, active managers have not been successful in beating the indices. Value stocks are an expensive area to trade because they tend to have bigger spreads. And that’s a tough hurdle for an active manager to overcome. Also, Fama refers to a value portfolio as a kennel of dogs. An active value manager is essentially saying he will throw out the dead dogs. But the dead dogs that come back alive may be a significant part of the value factor. So active management may, in fact, be counterproductive.