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Portfolio > Asset Managers

Fixing the Flaws

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Bill Jahnke says the system most advisors use for investing is broken. He is calling for a revolt to overthrow the regime of asset allocation used by most investment advisors. We should listen. Jahnke is a great thinker. From 1969 to 1983, Jahnke worked at Wells Fargo, eventually running the 1,100-employee investment and trust arms of the bank, Wells Fargo Investment Advisor, which was sold to Barclays Bank and is now called Barclays Global Investors. Along the way, Jahnke worked on the development of the first commercially viable index fund, helped build one of the first portfolio management software applications that allowed clients to see their daily portfolio values, and worked with many of the leading minds behind portfolio theory–including Bill Sharpe, Bill Fouse, and Barr Rosenberg. In 1983, when Wells sold its investment arm to Barclays, Jahnke bought the technology platform he had built at Wells and started Vestek Systems, which was purchased by Primark Investment Management Services, an investment technology firm that has since been bought by Thomson Financial. At 59, Jahnke doesn’t have to work. But he sees independent investment advisors as his best chance at correcting what he views as a drastically wrong turn in the road taken in the 1980s by money managers.

You attack the conventional wisdom applied by many of the nation’s leading financial planners. Why? The conventional wisdom has resulted in bad practices. Among them would be static asset allocation–the setting of asset allocation policy and sticking with it regardless of what’s going on in the world–and the overstatement of return expectations, which results in under-funding financial plans. In a world that is dynamic, static asset allocation doesn’t make sense. It’s not the way things were done for a long time. It was an idea that took root in the latter part of the 80s. Before that, the idea of sticking with investment solution through thick and thin was not part of the received wisdom. But there was a recognition that being an active asset allocator is a tough job. Then came development of performance measurement and statistics of how the stock market had done going back to 1926, and the realization that stocks had handily outperformed bonds over that period. Consultants selling databases suggested that you can take the historic numbers and put them into optimizers and use the result to make investment decisions. I believe that it is important to know how the market behaved in the past, but if you assume you can extrapolate historical returns, there is a problem. Expected returns on stocks deviate significantly from historical returns and the output of portfolio optimization programs is only as good as the input.

You say that advisors have totally misapplied the Nobel-prize-winning ideas of Harry Markowitz and Modern Portfolio Theory. So let’s focus on the hijacking of MPT for a minute. Markowitz’s name has been co-opted. Markowitz is recognized as the father of Modern Portfolio Theory. In his 1952 paper, Portfolio Selection, he cites three significant influences. One was John Burr Williams, who argued that investors should figure out what companies will earn, what they will pay in dividends and then discount dividends back to a present value. If you figure in the current price of a company’s shares, you can calculate the expected return. Markowitz said that was all fine and good, but asked, “What should we do about the risk of the stock not fulfilling your return expectations?” He figured out the mathematics of how to trade off the expected return from security selection with uncertainty, to find the sweet spot. And then he elaborated on this in his 1959 book, Portfolio Selection. I believe Markowitz would say his ideas and MPT have been co-opted. I have had several brief conversations with him about my ideas on matching investment solutions with financial planning objectives, and he recognizes that single period mean-variance optimization is not up to the task. Markowitz does not believe you can use historical returns as inputs in portfolio optimization. He thinks the assumptions underpinning the capital asset pricing model are strange. The idea that applying MPT requires that you believe in market efficiency came about because of the work by Bill Sharpe, Eugene Fama, and others. These two things got connected at the hip. But Markowitz does not believe that markets are efficient and that the process of generating returns is stable. MPT got co-opted by zealots of the efficient market school.

Another beef you have with the theory driving the advice of advisors is the widely accepted notion that the process of generating investment returns is stable. You think that is nonsense and that you cannot look at history to make returns forecasts for financial plans. A lot of the work on formulating return expectations is based on a bad assumption that the underlying population from which returns data is being sampled is stable. If the process is stable, then you can extrapolate. If it is unstable, then extrapolation can be wide off the mark, both in terms of expected return and the distribution of returns. The case against the stable return generating process is that the historical return distributions do not behave in accordance with the belief. The tails of the distribution when you plot them out on a chart are too fat, and they expand at a slower rate than predicted. Also, valuation levels of asset classes in terms of market-to-book ratios, price-earnings ratios, dividend yields and yield curves vary considerably relative to earnings and inflation expectations, which also undermines the notion of a stable return generating system. This is not something that the statisticians and econometricians were concerned about in their analysis of historical returns. For their data to be useful, however, statisticians need it to say something about the future. So they make the assumption that the population they use is stable and unchanging. To do otherwise would invalidate their assumptions about the future. Using historical data always makes that error. If you don’t believe the underlying population statistics are stable, however, then there is great uncertainty about the numbers.

So how has that mucked up the work of advisors? What it’s been boiled down to is that financial advisors were encouraged to plug historical returns into portfolio optimizers, specify the risk tolerance and come up with an investment policy. Since the historical data just creeps along glacially, once the advisor determines an asset allocation policy, he needs to stick with it. When times get tough, the advisor tells a client to stick with the asset allocation policy because market timing doesn’t work. The good news for the advisor is that he doesn’t need to really understand very much.

How does the bad assumption of a stable return generating system create flaws in portfolios? Portfolios are created with the underlying notion that the longer your holding period, the more likely it is you will get a return close to the expected return, and the less likely it is that stocks are going to under-perform bonds. According to this view, in the long run, stocks are less risky than bonds. The whole focus on managing risk is shifted to managing the short-term variability of returns. This is the central idea behind a doctrine of static asset allocation. But the whole paradigm blows up when the assumption of a stable return generating process is violated. So financial advisors and their clients have to face the prospect that in the long run they won’t get returns expected and clients won’t get their financial objectives funded. The system is broken.

You believe that the origin of these bad assumptions began when institutional investors made a wrong turn in the 1980s, and that advisors followed them down this incorrect path. Explain. The real watershed for the static asset allocation doctrine came with the Brinson studies. The 1986 Brinson study, and a subsequent one in 1991, found that an imputed static allocation of stocks, bonds, and cash explained over 90% of the variation of portfolio returns. Market timing and stock selection together explained less than 10% of the variation in returns. But the studies focused on analyzing the variation in returns and not the implications for how returns accumulate. Looking at variability of returns does not tell you anything about how returns accumulate and it is the accumulation of returns that funds financial goals. Also, expenses in the Brinson study do not show up as a determinant in the variation of returns, but they do show up over time in how portfolio returns accumulate. The Brinson studies were looking at the wrong thing and their conclusion recommending the setting of an asset allocation policy was seriously flawed. Picking up on the conclusions of the Brinsion studies, many marketing presentations throughout the 1990s claimed that asset allocation policy was by far the most important decision in investing. Compounding the problem, sales presentations trying to make the study user-friendly said asset allocation explained more than 90% of returns instead of “the variability in returns.” What the financial planning community took away from the Brinson studies was that market timing does not work, and the studies formed a basis for renouncing any form of active asset allocation. As a result, the planning community took a wrong turn and went down the wrong path.

You’re making this sound like it was some kind of conspiracy. It was no conspiracy. The authors of the Brinson studies were truly confused. They employed a methodologically flawed approach, and those who accepted the Brinson studies and marketing based on them did not understand the studies and their limitations. The practices that were promoted in the name of the Brinson studies satisfied a need in the marketplace, however. It got the active asset allocation monkey off the backs of advisors. There were a number of influential parties who provided support for the Brinson studies. Bill Sharpe, who used similar arguments in supporting his style analysis, was one. Harold Evensky, Don Trone, and others published books and articles supporting the Brinson studies and their conclusions.

Okay, you’ve criticized the conventional wisdom. But where do we go from here? Your solution is that advisors need to make return assumptions to create cash flow forecasts to help clients meet financial goals. Tell us about that. Clients should be concerned about, “What am I going to have when I am going to need it?” If advisors are using planning software, they are already on the road toward quantifying financial objectives and inputting return assumptions. They are already looking at what might happen in meeting financial objectives. The case I am making is to employ forward-looking projections of returns and not extrapolations of historical returns. I’m saying past performance–average returns, average risk premiums–are not the way to formulate expected returns that go into financial plans. To determine appropriate investment solutions, the uncertainty in expectations needs to be considered. The best way to do this in my opinion is to work with scenarios.

You believe advisors should make forecasts of earnings, dividend payout rates, price/earnings ratios, and bond yields in order to align portfolios with their clients’ needs. Explain the importance for advisors to do that kind of scenario planning. You can accurately forecast returns conditional on a set of fundamental forecasts. By forecasting growth in earnings, dividend yield, and price/earnings ratios, you can calculate future returns for stocks. It works 100% of the time. Advisors should develop a forward-looking opinion on these elements of returns. That doesn’t mean advisors have to cook it all up from scratch themselves, either in terms of making the forecasts or creating the software programs that do the market math. It’s okay to rely on others to do the heavy lifting. I have developed an expected returns forecaster. It is an Excel spreadsheet and it is not very complicated. (To download a copy, go to It calculates returns for different holding periods. So you can say to clients, “This is the return we expect for stocks the next two years, the next 10 years, and the next 30 years.” And you can also do it for bonds. You can project returns for alternative scenarios: deflation, stagflation, low growth, etc. Advisors should create at least a couple of scenarios for each client’s financial plan. The most important ones are the downside scenarios because that’s where plans are likely to fail. Blue Chip Economic Indicators provides long- term forecasts of corporate profits, interest rates and inflation in a monthly e-mail subscription service (For information, go to One approach to formulating downside scenarios is to take the most negative 20% of forecasts from the economists they survey. Making a financial plan with what you think corporate earnings will be, the current price/earnings ratio and dividend yield is a much better way to forecast stock returns than extrapolating historical returns.

What’s the difference between matching cash flows to investor goals the way you propose and the way planning is practiced now? When you go to your financial planning software, it asks for your return assumptions. Sometimes it asks what you think returns will be for an asset mix. It would be better if it would ask for individual asset class returns and let you vary the returns across time. We need more flexibility in putting in asset class returns expectations and asset mix assumptions across time. For example, you may have a scenario where you believe the stock market won’t do well for the next five years, but after that the risk premium will have been bid up and your return expectations beyond year five are much higher. You should be able to model this in a financial plan, but tools using multiperiod return assumptions and asset allocations are not currently available.

What’s your current scenario like for investors? My current mostly likely case scenario is that stocks will not do very well. Price/earnings ratios are high, dividend yields are low, the quality of earnings is low, and there is a long list of challenges for corporate America to grow earnings.

You seem very pessimistic. Why are you bearish? Read the financial press. I think I am being realistic. The current dividend yield on the S&P 500 is only 1.6%, and the current price of an S&P 500 stock, not accounting for pension under-funding and stock options, is now 32 times trailing earnings. The real growth rate for the U.S. economy and corporate profits is projected to be in the area of 3% long term. Unless you think that P/E ratios will continue to expand, there’s no way you’ll get a 10% return on stocks. It is mathematically impossible unless the P/E multiple goes to the moon. Given the consensus view that we will have 2% inflation and 3% GDP growth, the growth rate in earnings per share for U.S. publicly traded shares will likely be less than 5%. This implies that stock returns will be much lower than those historically achieved because valuations are much higher than they have been historically. The dividend yield historically was close to 5%, the P/E multiple has averaged 15 times earnings. That’s relevant because the change in P/E over time influences the returns you earn, and multiple expansion gives you a pop in returns that historically accounted for about 1.5 percentage points of return a year between 1925 and 2000. We simply do not have a sufficient growth rate in the consensus forecast to justify higher rates of return. We’ll probably get a little rebound in operating earnings because of all the stimulus–increased government spending and tax cuts and a lowering of interest rates. So we’ll probably see some economic recovery. Then, the U.S. economy will, according to the most likely scenario, grow along a 5% a year GDP trend line, and S&P 500 earnings will grow at a somewhat lower rate. Put this all together and you are looking at approximately a 6.5% rate of return before the cost associated with investing. After management fees, expense ratios, and brokerage expenses, the average investor using mutual funds is looking longer term at a 4% nominal return and a 2% real return.

Why are you targeting the independent advisor community? This is a small sandbox. That’s where the hope lies for change. You’ll need to be lean and mean and cost-effective in the coming years. Cost management is a problem for most big institutions. The turnover rate in portfolios approaches 100%, and those fees are going to somebody. Moreover, the complexity of actively managing money in a large organization is a problem administratively. It’s not as neat and clean as a buy-and-hold asset allocation solution. The business risk for the active allocator is significantly higher, because even the best allocators will be out of phase for a period of time.

Don’t advisors face the possibility of being wrong and hurting their businesses, too? Nobody gets it right all the time. But these are risks the independent advisor can better take. Independent advisors can tailor solutions without the organizational constraints. They don’t have the sales group pushing high-margin products or a research department pushing stocks. I think the small independent advisor can better get into the head of clients and do the right thing more easily than the big sandbox player can ever do.


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