Guest Article

Flingin' It - 8/19/16

Flingin' It is an occasional version of the Accountable Update where I throw out a variety of topics that may potentially impact ATX Portolio Advisors' clients and friends. I will also share articles from other sources that I enjoyed or found interesting. I hope some of it sticks!

In this edition, I have a quick update on a proposal from the Treasury Department that could significantly impact estate plans for some readers. I also share a piece from DFA where the relationship between GDP growth and stock market returns is explored. Finally, I included an always entertaining article by Jim Parker from his Outside the Flag series. Enjoy!


Popular Estate Planning Technique Curtailed By Proposed Treasury Regulation

Family Limited Partnerships (FLPs) have been a popular estate planning tool for high net worth families' over the past 15 years or so as a series of Tax Court rulings favored their use. On August 2, the Treasury Department proposed new regulations that will remove or severely restrict the primary tax benefit of FLPs, discounted valuations for lack of control and marketability of family controlled entities.

Currently, FLPs allow for the value of property placed into the partnership to be discounted, which can reduce the size of an estate, and ultimately estate taxes. General Partners, usually the older generation, can further reduce their holdings (and estate taxes) by gifting partnership interest to limited partners, typically the heirs, while retaining control of the property. 

Unable to get anything done in Congress, an increasingly assertive Obama administration is essentially taking authority through Executive action from the vacuum created by gridlock to further their agenda, in this case, estate tax reform. Since multi-millionaires are the only impacted group, don't expect much outcry from either side of the aisle as what essentially is a "1%" loophole, is closed. 

What should you do? The regulations must go through a 90 day comment period and wouldn't be enacted until 30 days after that. If you have an estate valued greater than $5.45 million as an individual or $10.9 million as a married couple, there is still time to call up your estate planning attorney to see if there is any need or opportunity to review or update your estate plan. 

If you would like to be introduced to a qualified estate planning attorney, feel free to get in touch to discuss your situation.


Economic Growth and Equity Returns

A relevant question for many investors is whether their view of economic growth should impact how they invest.

Opinions about future economic growth often differ across market participants. For example, in a survey of more than 60 economists conducted by the Wall Street Journal in June 2016, estimates of US GDP growth in 2017 ranged from 0.2% to 3.7%.[1] A relevant question for many investors is whether their view of economic growth should impact how they invest. In this regard, they may be surprised to find that the historical link between annual GDP growth and equity returns has been quite weak.

Exhibit 1 shows annual GDP growth vs. annual returns for developed and emerging markets. These plots indicate that there has not been a strong relation between GDP growth and equity returns in the same year. For example, in developed markets country/year combinations[2] when GDP growth was positive, the spread in returns was substantial: 323 country/year combinations had returns above 10% while 192 country/year combinations had returns below −10%. We see a similar pattern in realized returns for developed markets country/year combinations when GDP growth was negative. Emerging markets show a similar pattern.

 

Exhibit 1.       Annual GDP Growth and Equity Market Excess Returns

Sources: World Bank, MSCI, Morningstar. Shorter time periods shown for some countries due to data availability. Past performance is no guarantee of future results. See Data Appendix for details.

Sources: World Bank, MSCI, Morningstar. Shorter time periods shown for some countries due to data availability. Past performance is no guarantee of future results. See Data Appendix for details.

Despite this weak relation between GDP growth and stock returns in the historical data, investors often ask whether shorter-term fluctuations in economic cycles impact stock returns in the near term. Stated differently, while on the surface Exhibit 1 presents a weak picture of GDP growth and stock returns in the same year, is there a relationship between the two that is not obvious from this exhibit? 

To address this question, we examine 23 developed markets from 1975 to 2014 and 19 emerging markets from 1995 to 2014.[3]  Each year, countries are classified as either high or low growth depending on whether their GDP growth was above or below that year’s median GDP growth, defined separately for developed and emerging markets. We then look at stock market returns of high and low growth countries over the following year. The return for each group of countries is the average stock market return of all countries in the group weighted by countries’ market capitalization weights.


Exhibit 2 shows that, historically, differences in GDP growth over the past year contained little information about differences in equity returns this year. In both developed and emerging markets, average annual returns were similar for high and low growth countries. In fact, low growth countries had slightly higher average returns than high growth countries, although this return difference was not reliably different from zero. In other words, there is no evidence that this return difference occurred by anything other than random chance.

 

Exhibit 2.       Equity Returns and Economic Growth in High and Low Growth Countries [4]

Sources: World Bank, MSCI, International Finance Corporation (World Bank). Past performance is no guarantee of future results. Filters were applied to data retroactively and with the benefit of hindsight. Returns are not representative of indices or…

Sources: World Bank, MSCI, International Finance Corporation (World Bank). Past performance is no guarantee of future results. Filters were applied to data retroactively and with the benefit of hindsight. Returns are not representative of indices or actual strategies and do not reflect costs and fees associated with an actual investment. Actual returns may be lower. Please see Data Appendix for more information.

Can superior forecasts of short-term future economic growth help improve investment decisions? To address this question, we extend the analysis and assume perfect foresight about GDP growth over the next year. We now study the returns of high and low growth countries over the same year we measure GDP growth. This is not an implementable strategy because investors do not have the advantage of knowing economic growth in advance. They must rely on GDP forecasts, adding additional uncertainty. Exhibit 2 shows that even under the assumption of perfect foresight, using GDP data would not have generated reliable excess returns for investors. In developed markets, low growth countries had higher average annual returns than high growth countries, whereas in emerging markets, high growth countries had higher average annual returns than low growth countries. Neither difference in returns was reliably different from zero. This suggests that markets quickly incorporate expectations about future economic growth, making it difficult for investors to benefit from growth forecasts even with the advantage of perfect foresight. Differences in equity returns across countries seem to be driven more by differences in discount rates than by differences in GDP growth, even under a perfect forecasting scenario.

conclusion

Many investors look to economic growth as an indicator of future equity returns. However, the relation between economic growth and returns in the historical data has been shown to be weak. This should not come as a surprise given that returns are determined by discount rates and investors’ aggregate expectations of future growth. Surprises relative to those expectations, whether positive or negative, may cause realized returns to differ from expectations. The evidence presented here suggests that differences in GDP growth contain little information about differences in stock returns in the same year and over the subsequent year. This means that it is difficult for investors to earn excess returns by relying on estimates of current or future GDP growth—even estimates that perfectly forecast GDP growth over the next 12 months.

[1].   “Economic Forecasting Survey,” Wall Street Journal, http://projects.wsj.com/econforecast.
[2].   Each observation in Exhibit 1 represents, for one country in one calendar year, the equity market excess return over one-month US Treasury bills as well as the rate of GDP growth. For example, one of the observations shows that in the US in 2014, the equity market excess return was 12.7% and GDP growth was 2.4%.
[3].   See Data Appendix for details. 2015 GDP growth data was not available for most countries at the time of writing.
[4].   A t-statistic is a measure for the reliability of an average return difference. Normally, a t-statistic of at least 2 in absolute value is necessary to reliably say that the result is different from zero.

Data Appendix

Developed markets since 1975 (unless stated differently):
MSCI Australia Index (net div.), MSCI Austria Index (net div.) (from 1980), MSCI Belgium Index (net div.), MSCI Canada Index (net div.), MSCI Denmark Index (net div.) (1980), MSCI Finland Index (net div.) (1988), MSCI France Index (net div.), MSCI Germany Index (net div.), MSCI Hong Kong Index (net div.), MSCI Ireland Index (net div.) (1988), MSCI Israel Index (net div.) (1999), MSCI Italy Index (net div.), MSCI Japan Index (net div.), MSCI Netherlands Index (net div.), MSCI New Zealand Index (net div.) (1988), MSCI Norway Index (net div.), MSCI Portugal Index (net div.) (1990), MSCI Singapore Index (net div.), MSCI Spain Index (net div.), MSCI Sweden Index (net div.), MSCI Switzerland Index (net div.) (1981), MSCI United Kingdom Index (net div.), and the MSCI USA Index (net div.).

All of the following emerging markets are included since 1995 for Exhibit 1.

For Exhibit 2, since 1995 (unless stated differently):
MSCI Brazil Index (gross div.), MSCI Chile Index (gross div.), MSCI China Index (gross div.) (from 1996), MSCI Colombia Index (gross div.), MSCI Egypt Index (gross div.) (1998), MSCI Greece Index (gross div.), MSCI Hungary Index (gross div.), MSCI India Index (gross div.), MSCI Indonesia Index (gross div.), MSCI Korea Index (gross div.), MSCI Malaysia Index (gross div.), MSCI Mexico Index (gross div.), MSCI Peru Index (gross div.), MSCI Philippines Index (gross div.), MSCI Poland Index (gross div.), MSCI Russia Index (gross div.) (1998), MSCI South Africa Index (gross div.) (1996), MSCI Thailand Index (gross div.), MSCI Turkey Index (gross div.).

A country is included in the analysis for Exhibit 1 in a given year if MSCI index return and GDP growth data are available and in the analysis for Exhibit 2 if MSCI index return, country weight, and GDP growth data are available. Returns are in USD. GDP growth is real GDP growth in local currency, converted to USD using constant 2005 USD as provided by the World Bank.

Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

Past performance is no guarantee of future results. There is no guarantee an investing strategy will be successful.


Outside the Flags

History on the Run

When news breaks and markets move, content-starved media often invite talking heads to muse on the repercussions. Knowing the difference between this speculative opinion and actual facts can help investors stay disciplined during purported “crises.”

At the end of June this year, UK citizens voted in a referendum for the nation to withdraw from the European Union. The result, which defied the expectations of many, led to market volatility as participants weighed possible consequences.

Journalists responded by using the results to craft dramatic headlines and stories. The Washington Post said the vote had “escalated the risk of global recession, plunged financial markets into free fall, and tested the strength of safeguards since the last downturn seven years ago.”[1]

The Financial Times said “Brexit” had the makings of a global crisis. “[This] represents a wider threat to the global economy and the broader international political system,” the paper said. “The consequences will be felt across the world.”[2]

It is true there have been political repercussions from the Brexit vote. Theresa May replaced David Cameron as Britain’s prime minister and overhauled the cabinet. There are debates in Europe about how the withdrawal will be managed and the possible consequences for other EU members.

But within a few weeks of the UK vote, Britain’s top share index, the FTSE 100, hit 11-month highs. By mid-July, the US S&P 500 and Dow Jones Industrial Average had risen to record highs. Shares in Europe and Asia also strengthened after dipping initially following the vote.

Yes, the Brexit vote did lead to initial volatility in markets, but this has not been exceptional or out of the ordinary. One widely viewed barometer is the Chicago Board Options Exchange Volatility Index (VIX). Using S&P 500 stock index options, this index measures market expectations of near-term volatility.

You can see by the chart above that while there was a slight rise in volatility around the Brexit result, it was insignificant relative to other major events of recent years, including the collapse of Lehman Brothers, the eurozone crisis of 2011, and the severe volatility in the Chinese domestic equity market in 2015.

None of this is intended to downplay the political and economic difficulties of Britain leaving the European Union, but it does illustrate the dangers of trying to second-guess markets and base an investment strategy on speculation.

Now the focus of speculation has turned to how markets might respond to the US presidential election. CNBC recently reported that surveys from Wall Street investment firms showed “growing concern” over how the race might play out.[3]

Given the examples above, would you be willing to make investment decisions based on this sort of speculation, particularly when it comes from the same people who pronounced on Brexit? And remember, not only must you correctly forecast the outcome of the vote, you have to correctly guess how the market will react.

What we do know is that markets incorporate news instantaneously and that your best protection against volatility is to diversify both across and within asset classes, while remaining focused on your long-term investment goals.

The danger of investing based on recent events is that the situation can change by the time you act. A “crisis” can morph into something far less dramatic, and you end up responding to news that is already in the price.

Journalism is often described as writing history on the run. Don’t get caught investing the same way.

[1]. “Brexit Raises Risk of Global Recession as Financial Markets Plunge,” Washington Post, June 24, 2016. 
[2]. “Brexit and the Making of a Global Crisis,” Financial Times, June 25, 2016. 
[3]. “Investors are Finally Getting Nervous about the Election,” CNBC, July 13, 2016.

 

About Jim Parker
Jim Parker is a Vice President for DFA Australia Limited, a subsidiary of Dimensional Fund Advisors. As head of the communications and marketing team in Australia, Jim helps create strategies to communicate Dimensional's philosophy and process in ways that engage clients, prospects, regulators, and the media. He does so through presentations, books, papers, and articles, including his "Outside the Flags" column and, more recently, his weekly "Coffee Break" links to interesting articles. 

Jim joined Dimensional in 2006 after 25 years working as a journalist in newspapers, television, radio, and online media. His specialty was financial journalism, particularly in relation to economics and financial markets. Jim holds a bachelor of arts in social and economic history from Deakin University and a journalism certificate from Auckland Technical Institute.

Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. 

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services. 

 

Issue Brief - What Is Fiduciary Advice?

Photo by Simon Cunningham 

Photo by Simon Cunningham 

Last fall, I wrote about the Department of Labor's proposed Fiduciary Rule for retirement advice in the October 30 edition of the Accountable Update. Since then, they have released new rules governing the $7 trillion that individual investors have invested in IRAs. The rules go into effect next year, but if you are an ATX Portfolio Advisors' client, not much changes. We already put your interests first and even make a Fiduciary Pledge to our customers. However, if you would like to have a better understanding of what fiduciary advice is, the following "Issue Brief" from Dimensional Funds does a nice job of summarizing the differences between two different standards that currently apply to investment professionals.

Once you understand the difference, you may be asking two questions:

  1. Why would I ever want anything BUT fiduciary advice?
  2. Would I rather work with someone that voluntarily chose a fiduciary standard, or someone forced to by the government?

What Is Fiduciary Advice?

Dimensional Fund Advisors
May 2016

Anyone searching for investment advice is undoubtedly confronted with many choices of service providers operating under titles such as certified financial planner, financial consultant, registered investment advisor, stockbroker, and insurance agent.

These titles can be confusing because on the surface it is not clear whether these professionals are legally required to have a client’s best interest in mind when making investment recommendations.

Many investors may have read that the Department of Labor (DOL) announced a substantial overhaul in the regulation of financial advice given on retirement savings. Central to this discussion are two terms: fiduciary and suitability. What does it mean for an advisor to operate on a fiduciary standard, and how does this differ from a suitability standard?

THE FIDUCIARY STANDARD

The DOL has described a “fiduciary” as someone who is required to put their clients’ best interest before their own profits. Fiduciaries include registered investment advisors, advisors to mutual funds (like Dimensional), and others who hold themselves out to be fiduciaries (like trustees and certain retirement plan consultants).

Fiduciaries are required to act impartially and provide advice that is in their clients’ best interest, and in doing so, must act with the care, skill, prudence, and diligence that a prudent person would exercise based on the current circumstances. A fiduciary must avoid misleading statements about fees and must avoid conflicts of interest.

Fiduciaries are typically compensated by payment of a fee rather than a commission. Fiduciaries to retirement plans, plan participants, and IRAs are also prohibited from receiving payments that create conflicts of interest unless they comply with the terms of certain exemptions issued by the DOL.

Probably most importantly, clients can expect that a fiduciary will act with transparency and avoid prohibited conflicts of interest. For example, given two comparable investment choices for a client, a fiduciary should typically recommend an option with lower management fees.

Fiduciaries are personally liable for breaches of their fiduciary duties. For example, if there is a loss caused by a breach of fiduciary duty, the fiduciary must make the plan or IRA whole by restoring any losses caused by the breach and restoring to the plan or IRA any profits made through the use of plan or IRA assets. Civil actions to obtain appropriate relief for a breach of fiduciary duty may be brought by a participant, beneficiary, fiduciary, or the US Secretary of Labor, and the fiduciary may be subject to excise tax penalties.

THE SUITABILITY STANDARD

Historically, representatives of a broker-dealer are required under the securities laws to judge the suitability of a product for a prospective investor, based primarily on that person’s financial goals, income, and age. Unless agreed otherwise, under this standard the rules do not legally require a recommendation of the most cost-effective product, a disclosure regarding conflicts associated with the investment, or disclosure of the compensation received when making that recommendation. Under the new DOL rule, it may mean that common forms of broker compensation, such as commissions and revenue sharing, will be restricted.

A SINGLE STANDARD OF ADVICE

As many financial advisors are dual registered as both brokers and investment advisors, it can be difficult to determine under which standard investment advice is given. A primary goal of the recent regulatory changes was to create a single standard for retirement financial advice based on a fiduciary model. Many clients already receive fiduciary advice, and for those clients the change in rules will not have much impact. Following the new DOL rule, it may be the case that professional financial advice for retirement assets (whatever the source) is subject to a level fiduciary standard.1 However, as with any investment advice, clients should conduct their own research, ask questions, and learn more about the reputation and philosophy of an advisor.2

 

1.     Note that in certain circumstances, information provided by advisors or brokers may not be treated as fiduciary advice. Some examples of these exceptions from the new DOL rule are providing general investment education, simple “order-taking” (executing an order to buy or sell without providing a recommendation), or certain “robo-advice.”

2.     For informational purposes only and not for the purpose of providing tax or legal advice. You should contact your tax advisor or attorney to obtain advice with respect to any particular issue or problem.

Source: Dimensional Fund Advisors LP.

All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.

This information should not be misconstrued or otherwise interpreted as legal advice. Please consult with qualified legal or tax professionals regarding your individual circumstances.

"Issue Briefs" on Diversification and Yields

"Is diversification still worthwhile?"

"Why buy bonds when rates are going up?"

These are two of the most common questions that I'm asked by investors. The latter one for over 20 years!

After several years of the largest domestic stocks outperforming, well, just about everything, it can be easy to forget why investing in small/mid sized companies and internationally in both developed and emerging markets makes sense.

It is also understandable to be concerned about the impact of rising rates, especially since the Federal Reserve increased them in December. However, it may be surprising to many that market driven rates have actually fallen since the hike. In this week's Accountable Update, I share perspective on both of these questions with "Issue Briefs" from my friends at Dimensional Fund Advisors.

The first, titled Why Should You Diversify?, reviews why spreading your eggs to more than one basket still matters. If you read this blog often, much of this piece will be information that is probably already familiar, but an occasional refresher never hurts.

In the second, Revisiting Yields, DFA discusses their strategy of designing bond portfolios that may increase expected returns by using information in the yield curve and applying it globally and with varying maturities. 

If you would like to review your diversification, yields, or overall portfolio and goals, get in touch.