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Efficient Market Hypothesis And Random Walk Theory: Buy ‘David Swensen’s Portfolio’

Summary The author recommends using “David Swensen’s portfolio” as a key component of the Core Portfolio. Recommendation for the Satellite Portfolio will be covered in a separate article. Recommendation is in line with the implications of Efficient Market Hypothesis (EMH) and Random Walk Hypothesis (RWH). EMH and RWH imply that it’s impossible to consistently beat the market and suggest the utilization of passive investment approach. Recommended Portfolio Allocation The main goal of this series of articles is to introduce new stock investors to academic theories and help them develop their own approach to stock investing. Knowing academic theories and their implications should help investors gain confidence in their chosen path. That confidence is key in ensuring that investors consistently execute their chosen investment strategy. As we will discuss in the next articles, consistency is one of the main friends of stock investors. I will be suggesting an approach to stock investing that will be based on findings of Nobel laureates and market practitioners. With each article, we will be moving one step closer to developing an investment approach/portfolio that individual investors will be comfortable holding on to through thick and thin. We will start with David Swensen, CIO of Yale endowment since 1985, where he manages over $20 billion (as of Q3 2014, endowment assets were $23.9 billion). Over the decade (through 2009), the endowment realized an average annual return of 11.8 percent. It is an impressive performance given that this period covers the financial crisis of 2008. David’s consistent track record sparked debates if the new college building should be named after him. He is believed to be the alumni who contributed the most to the school through his management of the Yale endowment portfolio. David is credited with inventing the Yale Model (an application of modern portfolio theory that we will discuss in the next article). David Swensen suggests that individual investors should limit their portfolio to a handful, well-selected ETFs that will provide diversification across major asset classes (e.g. stock, real estate, and bonds) and geographies (i.e. developed and emerging countries) at a low-cost and tax-efficient manner. His recommendation is very much in line with the approach suggested by John Bogle (founder of Vanguard). David lays out the proposed allocation across asset classes as following: Asset Class Allocation Domestic Equity 30% Foreign Developed Equity 15% Emerging Market Equity 5% Real Estate 20% U.S. Treasury Bonds 15% U.S. Treasury Inflation Protected Securities 15% Source: David Swensen Strategy’s Strengths and Limitations MarketWatch developed a list of funds that closely resembles exposures that David Swensen proposed. The list of funds and its historical performance is presented in the table below. As you can see from the table, the proposed allocation has underperformed the S&P 500. As of 11/14/15 Fund Allocation 1-Year Return 3-Year Return 5-Year Return 10-Year Return Total Stock Market VTSMX 30% 0.62% 15.89% 13.05% 7.45% Foreign Developed VTMGX 15% -2.85% 7.67% 3.98% 3.73% Emerging Market VEIEX 5% -16.37% -3.49% -3.85% 4.44% Real Estate VGSIX 20% 0.36% 10.45% 11.04% 7.05% Long-term Bonds VUSTX 15% 2.99% 0.92% 6.82% 6.66% TIPS VIPSX 15% -2.17% -2.64% 1.98% 3.85% S&P 500 1.29% 16.18% 13.40% 7.31% Source: David Swensen, MarketWatch Main drivers of the underperformance are allocations to foreign developed markets, long-term bonds, TIPS and emerging markets. It’s not much of a surprise to see fixed-income instruments (i.e. long-term bonds and TIPS) underperform stocks (due to equity risk premium) over the long term. Analyzing the shorter period (up to 3-5 years), one can think of many reasons for the outperformance of US stocks vs. foreign developed and EM stocks. For long-term investors, arguments of mean reversion should make them comfortable holding on to diversified portfolio over the long term. As such, investors should not discard the model portfolio proposed by Swensen just yet. As mentioned, the list of carefully selected ETFs (must be low-cost and tax-efficient) should form the base of your portfolio. We will refer to this portion of the suggested portfolio approach as “Core Portfolio”. We will discuss the second portion of the proposed portfolio “Satellite Portfolio” in the future articles and share the rational for having such a satellite portfolio that might utilize a non-passive approach. Suffice it to say that EMH and RWH should provide enough confidence to individual investors to stick with the Core Portfolio allocations as long as the investors keep in mind that over the long run stocks provide positive real return. Actual Portfolio Allocations and ETFs Given the tax efficiency of ETFs, the author finds it more appropriate to use ETFs instead of mutual funds for the Core Portfolio. The actual list of ETFs and corresponding allocations is presented below: Asset Class ETFs Allocation Domestic Equity VTI 30% Foreign Developed Equity VEA 15% Emerging Market Equity VWO 5% Real Estate VNQ 20% Long-Term Treasuries TLT 15% TIPS TIP 15% There are a number of reasons for this recommendation: 1. The actual allocation to various asset classes is in line with David Swensen’s proposed allocations. Theoretical underpinning for passive investing is presented in the last section of this article. 2. The approach utilizes low-cost and tax-efficient ETFs. Typically, Vanguard ETFs are on the low end of fees. Also, ETFs are more tax-efficient than the mutual fund structure. A word of caution before you start implementing the recommendation – I’m not a tax advisor, and therefore, I strongly suggest you consult your tax advisor for any tax-related matters. Also, I would like to mention that this article is just the first one in the series. In the next articles, we will continue exploring the stock market theories and how they impact the way I invest. Next stop will be Harry Markowitz’s Modern Portfolio Theory and the need to diversify across a broad spectrum of asset classes. This article will be followed by Noisy Market Hypothesis, which should lift the spirits of investors who would like to “beat the market”. Appendix: Theory Dr. Eugene Fama, a Nobel Laureate, is thought of as the Father of Efficient Market Hypothesis (EMH). EMH suggests that current asset prices fully reflect all currently available information. To put it simply, stock prices should react only to news; and as you know, news is random in its nature. Due to this randomness, EMH implies that consistently outperforming the market on a risk-adjusted basis is impossible. In other words, don’t put your money into an individual “hot” stock or entrust to an active asset manager. Talking about randomness, one cannot skip mentioning the Random Walk Hypothesis (RWH), which traces back to Louis Bachelier. RWH argues that stock prices are random: chances that a professional analyst identifies a winning stock is similar to a flip of the coin. In a 1965 article, “Random Walks in Stock Market Prices”, Dr. Fama draws the parallels between EMH and RWH. As already mentioned, EMH and RWH imply that stock investors would be better off investing in passive index funds or mimicking such fund investments. On average, active investing (e.g. intentionally investing a higher portion of the portfolio in a specific stock or sector) is expected to yield similar risk-adjusted returns as passive investments. Some behavioral economists (note: we will cover behavioral finance and its implications in the future articles) would even argue that active investing should result in inferior returns, as emotions of investors will make them buy hot stocks just before these stocks peak and throw the towel just before the market bottoms. Industry practitioners, such as John Bogle of Vanguard, would further argue that investing is a zero-sum game: few basis points of alpha that one active manager generates come at the expense of another active manager. Furthermore, a typical individual investor who entrusted his/her funds to an active manager would come out short after receiving an average market return, less management fees and tax bill. Typical high turnover of active asset management mandates leads to higher transactions costs (e.g. bid-ask spread) and higher tax bill (i.e. short-term gains are taxed at a higher rate than long-term capital gains and dividends). All of the above suggests that low-cost, tax-efficient ETFs are optimal investment instruments for the Core Portfolio. References/Bibliography George A. Akerlof and Robert J. Shiller, Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism , Princeton University Press, 2009 John Bogle on Investing: The First 50 Years , McGraw-Hill, 2000 Colin Read, The Efficient Market Hypothesists: Bachelier, Samuelson, Fama, Ross, Tobin and Shiller , Palgrave Macmillan, 2012 David Swensen, Unconventional Success: A Fundamental Approach to Personal Investment, Free Press, 2005 Next article: M odern Portfolio Theory: Introduce Alternatives To Your Portfolio

3 Top-Rated Prudential Investments Mutual Funds To Buy

With around $74 billion of assets under management (as of Dec 2014), Prudential Investments – a segment of Prudential Financial, Inc. (NYSE: PRU ) – offers a wide range of funds including both equity and fixed-income, and open- and closed-end funds. The company currently offers services across 41 countries and territories including the U.S., Asia and Europe. Investment professionals of the company are also involved in managing assets of major corporations and pension funds throughout the globe. Founded in 1875, Prudential Financial has $1.1 trillion in assets under management (as of Sep 2015). Below we share with you 3 top-rated Prudential Investments mutual funds. Each has earned a Zacks Mutual Fund Rank #1 (Strong Buy) and is expected to outperform its peers in the future. Prudential Jennison Growth A (MUTF: PJFAX ) invests a minimum of 65% of its assets in equity securities of companies having market capitalization of over $1 billion. PJFAX primarily focuses on acquiring securities of companies that are believed to have an impressive growth potential. PJFAX invests in securities including common stocks, nonconvertible preferred stocks and convertible securities. The Prudential Jennison Growth A fund has returned 10.5% over the past one year. PJFAX has an expense ratio of 1.05% as compared with the category average of 1.19%. Prudential Municipal Bond High-Income A (MUTF: PRHAX ) seeks to maximize income exempted from federal income taxes. PRHAX invests the lion’s share of its assets in municipal debt securities that are expected to provide return free from federal income tax. However, PRHAX may invest in securities that provide interest income, which is not exempted from the federal alternative minimum tax (NYSE: AMT ). The Prudential Municipal High-Income A fund has returned 4.3% over the past one year. As of September 2015, PRHAX held 412 issues, with 1.13% of its assets invested in Golden St Tob Securitization C Toba 4.5%. Prudential Short-Term Corporate Bond A (MUTF: PBSMX ) invests a large chunk of its assets in corporation bonds irrespective of their maturity durations. PBSMX is expected to maintain an effective duration of not more than three years. PBSMX may also invest in mortgage-related and asset-backed securities. PBSMX may allocate a maximum of 35% of its assets in dollar denominated debt securities issued by foreign entities. Not more than 20% of PBSMX is invested in securities that are rated below investment grade. The Prudential Short-Term Corporate Bond A fund has returned 1.1% over the past one year. Steven Kellner is one of the fund managers of PBSMX since 1999. Original Post

Up For Debate Yet Again: Active Vs. Passive But This Time It’s The Emerging Markets

Summary Emerging Market Indexes are not representative of the overall universe. The commodity boom caused a widespread increase in asset prices, hurting active management. Falling commodity prices should create differentials in Emerging Market countries and companies, benefiting active management. When the term “emerging markets” was coined in the early 1980s it was an exciting time for those investors attracted to this young, inefficient, and rapidly growing set of markets. Earlier on in its evolution, if an investor could stomach the added risk, actively managed emerging market investments offered a very attractive and outsized return profile. Over time though, as these markets matured in size, sophistication, and popularity the differentiation between the active and passive investment approach began to narrow and as this occurred investors began to question whether it was still possible to earn alpha, or outperformance, through active management. At Lynx, we continue to believe emerging market active management is a value added proposition. In terms of number of securities, the emerging market, or EM, universe is very large, yet the interaction most passive investors have with these markets is through the MSCI Emerging Markets Index, which is a poor representation of the overall market. The index includes roughly 800 individual securities, while the overall emerging market universe has over 10,000 public companies. Additionally, there is the issue of sell-side analyst coverage or lack thereof (chart 1); while the number of companies in the BRIC countries far exceeds those of the S&P 500, the average number of analysts covering these names is less than half. More so, of the 800 securities included in the index over 650 are State Owned Enterprises or “SOEs”. SOEs are companies either owned by, or greatly influenced by, their respective governments; well-known examples are Gazprom (GSPFY) ( OTCPK:OGZPY )(Russia), Petrobras (NYSE: PBR ) (Brazil), and China Mobile (NYSE: CHL ) (China). The inherent risks associated with such companies are typically very different from private enterprises, as their balance sheets and overall strategies are most likely driven by a country’s geopolitical goals rather than by financial motivation. When investors purchase an MSCI Emerging Market Index based ETF, roughly 30% of the holdings are SOEs, ultimately adding additional risks that may not be fully appreciated. Chart 1 Now let’s turn to active management and the opportunities it may provide. Within the developed markets, the increasing level of efficiency has made it very challenging for active managers to outperform. Originally, the lack of efficiency among the emerging markets as compared to the developed countries was a significant talking point for EM active managers, but the question today is, does this dichotomy still exist? Through the use of statistical tools such as cross-volatility, correlations, and sector, country and stock dispersions, many have attempted to answer this question. Through a joint review by Lazard, Duke University and Russell Indices, it was discovered that dispersion between EM securities has actually increased in recent years, while in past years it had been fairly static (chart 2). However, recent research also indicates that correlations between various countries in the emerging markets have been moving upwards as of the mid-2000s (chart 3). In 2006 through 2009, correlations between the countries increased, while sectors, already high, remained elevated. The overall increasing correlations in the asset class, in theory, should reduce the opportunity for active management, but let’s combine the above statistical findings with today’s environment. Until recently, China has been the major driver of growth for both emerging countries, as well as commodities. Today these dynamics are shifting as China’s growth is slowing and transitioning to a service based economy. Commodity prices have plummeted in the last year, a sign that the rising tide that lifted all ships in EM over the last 15 years has passed. As a result, the rising correlations between countries, likely a function of the general commodity price boom, should begin to subside. This should cause the country correlations to begin to fall again, opening the door for more active management opportunities. An example that exists now is that of China and India. As Chinese growth has fallen, causing commodities to plummet, India has seen its economy expand, as it is a net importer of energy and is far more diversified than China. This kind of dichotomy should replay itself across many of the index constituents in the coming years. To see a similar example of the relationship between a macro boom, indiscriminate asset price appreciation and the struggles of active management in such an environment, please refer to the Lynx white paper titled, “How Much is Too Much to Pay for Performance: Our Views on Active and Passive Investing,” which lays out our argument for how the U.S. QE caused reduced cross-volatility between domestic stocks. In such an environment the value that active management brings to an investment universe is bound to be masked. Chart 2 (click to enlarge) Chart 3 *Lazard, “Country and Sector Contagion in Emerging Markets” To recap, this paper has discussed the case for active management in EM, and has provided data which suggests a reduced opportunity set for the strategy. Now let’s review actual emerging market mutual fund performance. RBC conducted a study indicating that EM mutual funds have maintained 2% of outperformance over the MSCI Emerging Market Index over a 5 year rolling time period (chart 4). What is telling though is that in recent years the outperformance has narrowed from over 7% in 2000 to 3% in 2014. The tightening may reflect the increased correlations between countries discussed above. However, the argument for active management still holds as outperformance has been maintained. In addition to overall outperformance, outperformance by individual managers also proves to be persistent (chart 5). Top tercile EM Fund managers have maintained top 2 quartile performance in almost 70% of quarters over a 3 year period, indicating that it is possible to outperform the market over time. Chart 4 (click to enlarge) Chart 5 (click to enlarge) In conclusion, though we have shown issues associated with both the active and passive approach, all told we do not believe investing passively in emerging markets is the ideal option. Active management, which comes in various forms, not only better maneuvers through these markets’ associated risks, but it takes advantage of shifting market dynamics and individual opportunities that a quantitative, market cap weighted index approach is likely to overlook. It is also important to emphasize that the most successful emerging market allocations will be those made by investors who are comfortable and accepting of a long-term investment period.