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Tuning Out the Noise

Dimensional Fund Advisors believe that the right financial advisor plays a vital role in keeping investors focused on what really matters.  Click on the link below to watch the short 2 minute video.

Tuning Out the Noise

New Medicare Cards | What You Need To Know

New Cards Increase Identity Protection, But Also Fraud AttemptsMedicare logo

Beginning in May, the Centers for Medicare & Medicaid Services (CMS) will begin mailing new identification cards to beneficiaries. The Medicare cards have been redesigned to help reduce the potential for identity theft — Social Security numbers and other personal information have been removed and now feature a randomly assigned 11-digit Medicare Beneficiary Identifier (MBI) that is unique to each person and not tied to someone’s personal information.

The aim of this initiative is to offer protection. Fraudsters, ironically, are using the newness of the program as an opportunity to get recipients to give up their MBI and personal and financial information.

Amy Nofziger, a fraud expert with AARP, says: “Anyone who is calling you for personal or financial information, hang up the phone.” She recommends that anyone who is contacted should report the scam by calling 1-800-MEDICARE.

It’s important to note that while the cards are new, Medicare benefits are remaining the same. We encourage you to visit the official Medicare website for more information about the new cards, tips to avoid scam attempts and a state-by-state timetable for when the cards will be delivered.

Behavioral Biases – The Demon of Investing

An advisor’s job is just as much about helping clients control their investing bias and emotions as it is about building and managing an appropriate portfolio.  Here are five traits we see:

Which way to go road sign Anchoring Bias – It occurs when you fix on or “anchor” your decisions to a reference point, whether or not it’s a valid one.

Confirmation Bias – We humans love to be right and hate to be wrong.  It tricks us into being extra sympathetic to information that supports our beliefs and especially suspicious of – or even entirely blind to – conflicting evidence.

Familiarity Bias – It’s a mental shortcut investors use to more quickly trust an object that is familiar to us.  Investors are quicker to invest in familiar US holdings versus unfamiliar foreign investments.

Framing Bias – Nobel laureate Daniel Kahneman defines the effects of framing as follows:  “Different ways of presenting the same information often evoke different emotions.” For example, he explains how consumers tend to prefer cold cuts labeled “90% fat-free” over those labeled “10% fat.”  By narrowly framing the information (fat-free = good, fat = bad; never mind the rest), we fail to consider all the facts as a whole.

Herd Mentality – Mooove over, cows.  You’ve got nothing on us humans, who instinctively recoil or rush headlong into excitement when we see others doing the same. “The idea that people conform to the behavior of others is among the most accepted principles of psychology,” write Gary Belsky and Thomas Gilovich in “Why Smart People Make Big Money Mistakes.”

Wrapping Up One Year and Beginning Another

Happy-New-Year-Images-2018-HD-1-1Financial check-ups much like medical check-ups serve an important purpose. To ignore either may place a person in peril.  So let’s get started:

  • Are the provisions of your will current?  Do they accurately reflect your current intentions for disposing of your assets?
  • Are your beneficiary designations for retirement plans, IRAs, life insurance, etc coordinated with your will provisions?  Remember beneficiary designations override will provisions.  Check all beneficiary designations to make certain they actually are as you remember them to be.
  • Do you have a long-term financial plan for you and those who are financially dependent on you?
  • Are you saving enough?
  • Have you selected the tax appropriate investment vehicles for your savings – IRA, Roth IRA, 401(k), taxable investment accounts?
  • Is the asset allocation of your investment portfolio appropriate considering your risk profile – your need, ability and willingness to take stock market risk?
  • Should you make a current contribution to a 529 College Savings plan for your children or grandchildren?  Alabama offers an excellent plan.  We will be glad to help you open new 529 accounts.
  • Do you have your investment emotions in check?

Resolutions For A New Year:

  • I will not forget that owning a share of stock is actually owning a piece of a company organized and managed to provide goods and services to its customers and make profits for its owners – me.
  • I will watch and read financial news for entertainment purposes and not for investment advice.
  • I don’t know more than the market.
  • I accept that what is happening in the market now will change.  I just don’t know when, in what direction, and for how long.
  • I trust the financial science upon which my investment portfolio is based.
  • I won’t let emotions control my investment behavior.  I will remain emotionally neutral and stick to my investment plan.
  • I plan to enjoy life.

Food For Thought…

“You only get one mind and one body. And it’s got to last a lifetime.  Now, it’s very easy to let them ride for many years. But if you don’t take care of that mind and that body, they’ll be a wreck forty years later, just like the car would be.”   — Warren  Buffett

Healthy foodThe food choices you make daily might lower your odds of getting Alzheimer’s disease, some scientists say.

Researchers have found that people who stuck to  a  diet  that  included  foods  like  berries, leafy greens, and fish had a major drop in their risk for the memory-sapping disorder, which affects more than 5 million Americans over age 65.

The eating plan is called the MIND diet.  Here’s how it works.

Brain-Friendly Foods

MIND stands for Mediterranean-DASH Intervention for Neurodegenerative Delay.

But the MIND approach “specifically includes foods and nutrients that medical literature and data show to be good for the brain, such as berries,” says Martha Clare Morris, ScD, Director of Nutrition and Nutritional Epidemiology at Rush University Medical Center.

You eat things from these 10 food groups:

  • Green leafy vegetables (like spinach and salad greens): at least six servings a week
  • Other vegetables: At least one a day
  • Nuts: Five servings a week
  • Berries: Two or more servings a week
  • Beans: At least three servings a week
  • Whole grains: Three or more servings a day
  • Fish: Once a week
  • Poultry (like chicken or turkey): Two times a week
  • Olive oil: Use it as your main cooking
  • Wine: One glass a day

You avoid:

  • Red meat: Less than four servings a week
  • Butter and margarine: Less than a tablespoon daily
  • Cheese: Less than one serving a week
  • Pastries and sweets: Less than five servings a week
  • Fried or fast food: Less than one serving a week

The Benefits

One study showed that people who stuck to the MIND diet lowered their risk of Alzheimer’s disease by 54%. That’s big. But maybe even more importantly, researchers found that adults who followed the diet only part of the time still cut their risk of the disease by about 35%.

Even if you don’t have a family history of Alzheimer’s disease or other risk factors, you may still want to try this eating plan because it focuses on nutritious whole foods and good for your heart and overall health. Last, understand that even though diet plays a big role, it’s only one aspect of Alzheimer’s disease, so get regular exercise and manage your stress to lower your risk even more.



Understanding Different Types of Risks

Larry Swedroe on the importance of integrating all risks (not only the investment kind) into an overall financial plan.


Larry Swedroe, Director of Research, The BAM ALLIANCE

Harry Markowitz received the Nobel Prize in Economic Sciences in 1990 for his contributions to the body of work known as “modern portfolio theory.” Probably his greatest contribution was to turn the focus away from analyzing the risk and expected return of individual investments to considering how its addition impacts the risk and expected return of the overall portfolio.

Markowitz showed it was possible to add risky assets (with low or negative correlation) to a portfolio, increasing the expected return without increasing overall risk. He also demonstrated the importance of diversification of risk.

Today most investment advice focuses on the development of portfolios that are on the “efficient frontier.” A portfolio that is on the efficient frontier is one in which no added diversification can lower the portfolio’s risk for a given return expectation (alternately, no additional expected return can be gained without increasing the risk of the portfolio).

Working with the efficient frontier, investment advisors tailor portfolios to the individual investor’s unique situation. Unfortunately, far too many investors and/or their advisors only focus on the risks of the investments themselves.

Managing Financial, Not Just Investment, Risks

When developing an overall financial plan, there are risks—other than investment risks—that are important to consider. Not integrating the management of these risks into an overall financial plan can cause even the most carefully considered and well-thought-out investment plans to fail. Among the other risks that should be considered are human capital (wage-earning) risk, mortality risk and longevity risk. Let’s consider how these risks should be integrated into an overall financial plan.

Human Capital Risk

We can define human capital as the present value of future income derived from labor. It’s an asset that doesn’t appear on any balance sheet. It’s also an asset that is not tradable like a stock or a bond. Thus, it’s often ignored, at potentially great risk to the individual’s financial goals. How should human capital impact investment decisions?

The first point to consider is that, when we are young, human capital is at its highest point. It’s also often the largest asset young individuals have. As we age and accumulate financial assets, and our time remaining in the labor force decreases, the amount of human capital relative to financial assets shrinks. This shift over time should be considered in terms of the asset allocation decision.

The second point is that we need to not only consider the magnitude of our human capital but also its volatility. Some people (such as tenured professors, doctors and government employees) have stable jobs, and thus their labor income is almost like an inflation-indexed annuity. In other words, it acts very much like a bond. Other people (such as commissioned salespeople and construction workers) have labor income that is more volatile, and thus acts more like equities. Financial advice should incorporate these differences.

For example, for people with safer labor income, it might be appropriate to invest more aggressively—with a higher allocation to equities overall and perhaps higher allocations to riskier small and value stocks. Those with riskier labor income should consider holding less aggressive portfolios (those with higher bond allocations).

This gets to the heart of Markowitz’s work on portfolio theory: An asset shouldn’t be considered in isolation. Note there may be times when the riskiness of one’s human capital changes (after a career change, for example). If the riskiness of the human capital increases, one should consider reducing the riskiness of the other assets in the portfolio, and vice versa.

A related issue is the significance of human capital as a percentage of total assets. If human capital is a small percentage of the total portfolio (because there are large financial assets), the volatility of the human capital and its correlation to financial assets becomes less of an issue.

Correlation, Health And Mortality

The third point we need to consider involves one of the most basic principles of investing—don’t put too many eggs in one basket. Individuals should avoid investing in assets that have a high correlation with their human capital. Unfortunately, far too many people follow Peter Lynch’s advice to “buy what you know.” The result is that they invest heavily in the stocks of their employers.

This is a mistake on two fronts. The first is that it’s a highly undiversified investment. The second is that the investment is likely to have a high correlation with the person’s human capital. Employees of such companies as Enron and WorldCom found out how costly a mistake that can be.

The fourth point to consider is that human capital can be lost due to two risks that need to be addressed by means other than through investments. The first is the risk of disability. This risk can be addressed by the purchase of disability insurance. Thus, the risk of disability and how to address it should be part of the overall financial plan. The other risk is that of mortality. That issue can be addressed by the purchase of life insurance (we will discuss that in more detail).

There are still other points to consider. All else being equal, people with a high earning capability have a greater ability to take more financial risk because they can more easily recover from losses. However, they also have a lower need to take risk. All else being equal, the higher their earnings, the lower the rate of return they need from their investment portfolio to achieve their financial goals—they can choose less risky investments and still achieve them.

Risk Tolerance And Adaptability

Another factor is investors’ willingness to take risk—their risk tolerance. It’s important that investors don’t take more financial risk than their stomachs can handle. The reason is that, when the inevitable bear markets arrive, they might be more inclined to panic-sell, and the best laid plans would end up in the trash heap of emotions.

Even if they were not driven to panic, life is just too short not to enjoy it. One should be able to “sleep well” with his or her investments. Thus, a high earnings capability, or even a high need to take risk, shouldn’t necessarily result in an aggressive investment portfolio.

Yet another factor to consider is the ability to adjust your “supply” of human capital. Consider the following: You develop a financial plan that allows you to retire at age 65. However, the market’s rate of return falls below the expected return you built into your plan, or you weren’t able to save as much as you had expected. Now you will need to work longer.

Can you continue in the labor force? What level of income can you generate? Will the market allow you to sell your skills, and at what price? Younger workers typically have more ability to adjust their supply of human capital. In addition, those with a variety of skill sets also have a greater ability to adjust their supply to economic conditions.

We’ll revisit this discussion later in the week to consider additional risk factors, including mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.

This commentary originally appeared April 12 on

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

An Integrated Investment Plan Is Key

A sound investment plan isn’t the only way to find financial security.


Earlier this week, we looked at the importance of incorporating different types of risk—specifically, human capital risk—into an overall financial plan. Today I will focus on mortality and longevity risk, and using “tax alpha” strategies to improve the odds of achieving your financial goals.

Mortality Risk

For those families whose human capital makes up a substantial portion of their total assets, protecting that capital via the purchase of life insurance should be part of the overall financial plan. Life insurance is the perfect hedge for mortality risk because its return is 100% negatively correlated with the human capital asset.

The younger the investor (the higher the human capital), the greater the need for life insurance. The amount of insurance required can be determined through what’s called a “needs analysis.” It can also be related to bequeathal motivations.

It’s important to note that life insurance can be used for purposes other than to hedge mortality risk. For example, it may be the most effective way to pay estate taxes. It can also be useful in terms of business continuity risks. Thus, while the individual’s need for insurance to hedge the risks of human capital falls as he or she ages, the need for life insurance might actually increase.

Longevity Risk

Longevity risk is the risk that you will outlive the ability of your portfolio to support your desired lifestyle. This risk has increased for much of the population with the decline of defined benefit plans (which, like social security, pay out for a lifetime) in favor of defined contribution plans. Also, advances in medical science continue to expand life expectancy. Longevity risk can be addressed by the purchase of lifetime payout annuities.

While the academic literature demonstrates that many investors would benefit greatly from the purchase of immediate annuities or deferred income annuities (because of “mortality credits” built into the product—in effect, people who die earlier than expected subsidize those who live longer than expected), very few are purchased.

The main reason seems to be that people are risk averse, in the sense that they don’t want to risk giving up their assets and then dying soon. The fear is that the assets would no longer be available for their heirs. But this is only true if they live a shorter-than-average life span. By definition, half will live longer. And for them, buying a payout annuity preserves any remaining assets for the estate.

The academic literature suggests that deferred income annuities are superior to immediate annuities for the purpose of protecting against longevity risk. Deferred income annuities can be purchased in an investor’s mid-60’s, with income beginning at age 85. Investors should begin to consider purchasing immediate annuities during their mid-70’s and buy them before they reach age 85.

Since the payouts from annuities are dependent on the level of interest rates (among other things), a recommended strategy is to diversify the interest rate risk by purchasing various annuity contracts over time instead of all at once. This strategy also preserves liquidity for some period. Monte Carlo simulations help analyze the benefits of annuitization. It’s also important to understand that delaying social security benefits as long as possible provides longevity insurance.

Another risk is also related to longevity. As we age, the risk of needing some form of long-term health care increases. It’s estimated that at least 60% of people over age 65 will require some long-term care services at some point in their lives. And contrary to what many people believe, Medicare and private health insurance programs do not pay for the majority of long-term care services most people need—help with activities of daily living, such as dressing or using the bathroom.

Thus, when investors develop an overall financial plan, they should consider the purchase of long-term care insurance. Again, the use of Monte Carlo simulations can help analyze how the purchase of long-term health insurance impacts the odds of achieving one’s goals.

These examples demonstrate why having a well-developed investment plan isn’t sufficient for financial planning purposes. Other important risks also exist. We need to consider another broad category called wealth protection.

Wealth Protection Insurance

Financial plans can fail in several ways because we don’t have sufficient insurance. A well-developed plan covers not only longevity and mortality risks, but disability.

Sufficient coverage should also be in place for all types of property and casualty risks, as well as the all-too-often overlooked personal liability risks covered by umbrella policies that protect against claims from lawsuits. Because needs change over time, incorporating a regular, thorough review of your overall insurance needs is an important part of the financial planning process.

In addition to integrating into an overall financial plan the management of the risks we have discussed, integration of strategies that add “tax alpha” can significantly improve the odds of achieving your financial goals.

Tax Alpha

Tax Alpha refers to the additional performance benefit gained from your investments through tax savings. Following are just two ways tax alpha can improve results:

1. You can take advantage of a lower tax bracket between retirement and the time that required minimum distributions (RMD) start to reduce the size of IRAs. Taking income at a low bracket early can lead to avoiding paying tax at a higher bracket later.

2. You can achieve proper asset location, holding lower returning assets (such as bonds) in a traditional IRA while holding higher returning assets (such as stocks) in a Roth IRA to keep future RMDs as low as possible.


Having a well-thought-out investment plan is a critical part of the financial planning process. However, it’s only the necessary condition for likely success. The sufficient condition is to integrate the investment plan into an overall financial plan that also addresses the risk management issues discussed above. Even then, other issues may need to be considered.

For example, for those with charitable intent, there are more, and less, efficient ways to make donations. The same is true for the transfer of wealth, whether through lifetime gifts, leaving a legacy or both. A well-thought-out financial plan helps to ensure that transfers to loved ones or to charity are made in the most tax-efficient manner, in a way that maintains the donors’ financial independence during their lifetime and meets their nonmonetary objectives.

If your planning doesn’t address each of these issues, I hope this serves as a wakeup call. It’s not too late to act—until it is.

This commentary originally appeared April 14 on

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

How to Help Aging Parents With Their Finances

Helping aging parents with their finances.

Role reversal: If you have aging parents, they may need help sorting out their finances. Stuart Vick Smith lays out some steps you can take to help them feel in control of their financial life.

Find it on

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

A More Complex View On Value

Larry Swedroe shows that book-to-market isn’t the only criteria for defining the value factor.

Eugene Fama and Kenneth French’s 1992 paper, “The Cross-Section of Expected Stock Returns,” resulted in the development of the Fama–French three-factor model. This model added the size and value factors to the market beta factor.

As my co-author, Andrew Berkin, and I demonstrate in “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” the value premium has been persistent across long periods of time and different economic regions, and pervasive across the globe and even asset classes (cheap assets have outperformed expensive assets).

And while the most common metric used to define value has been the book-to-market (BtM) ratio (as in Fama and French), it has been robust in other definitions. For example, in the United States for the period 1952 through 2015, the annualized value premium was 4.1% (t-stat = 2.4) as measured by BtM, 4.7% (t-stat = 2.9) as measured by the cash flow-to-price ratio, and 6.3% (t-stat = 3.4) as measured by the earnings-to-price ratio.

Measuring Value

Ray Ball, Joseph Gerakos, Juhani T. Linnainmaa and Valeri Nikolaev contribute to the literature on the value premium in their February 2017 paper, “Earnings, Retained Earnings, and Book-to-Market in the Cross Section of Expected Returns.” Their study, using Center for Research in Security Prices and Compustat data, covers the period July 1963 through December 2015. The sample excluded the bottom 20% of stocks (microcap stocks) as ranked by NYSE market capitalizations, as well as financials.

Note that excluding these financials is typical in academic papers. Omitting the smallest stocks is done so that these stocks don’t dominate results—they make up more than half the number of stocks but have much less market-cap weight. It’s also important to note that, typically, one sees stronger results for factors in these smaller-cap stocks. For example, using BtM, the value premium is much larger in small stocks than in large stocks.

Ball, Gerakos, Linnainmaa and Nikolaev begin by noting that book value of equity consists of two main parts: retained earnings (earnings less dividends) and contributed capital (the value of subsequent net share issuance). Following is a summary of their findings:

  • Retained earnings-to-market subsumes book-to-market’s predictive power in the cross section of stock returns despite comprising, on average, only 42% of the book value of equity (book-to-market predicts the cross section of returns only because it contains retained earnings).
  • The accumulated dividends component of retained earnings is uninformative of the cross section of average returns (another example of dividend policy not being relevant to expected returns). The authors state: “This result is consistent with book-to-market’s explanatory power arising only because it provides a good proxy for expected earnings yield.”
  • Retained earnings-to-market is a significant predictor of future earnings yield, and thus returns, while contributed capital has no predictive power.
  • The value premium (the return on the high minus low portfolio) is greater using retained earnings-to-market than using book-to-market (43 versus 35 basis points per month) and has stronger statistical significance. Using only contributed capital, the value premium falls to 7 basis points per month and is no longer statistically significant (t-stat = 0.54).
  • Retained earnings predicts the cross section of stock returns out to seven years, while book-to-market predicts returns only as far out as three years.


Relative to the value premium, this last finding provides an argument against the mispricing (behavioral-based) theory, and for the risk-based theory. As the authors point out: “Why would the correction of mispricing occur gradually over a horizon that extends at least as far as seven years, especially bearing in mind that all this accounting information is made publicly accessible at essentially zero cost for all firms and all years?”

Finally, the fact that book-to-market’s explanatory power comes from the earnings component highlights the potential importance of including price-to-earnings and cash flow metrics instead of just BtM (as some investment firms do, such as Bridgeway Capital Management and AQR).

Another alternative is to include the new profitability factor in construction of value portfolios (as Dimensional Fund Advisors does), as retained earnings contain information about future expected earnings/profitability. It will be interesting to see if these findings will be incorporated into portfolio construction rules of funds that seek to capture the value premium.

This commentary originally appeared March 29 on

By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.

The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

© 2017, The BAM ALLIANCE

Private Equity Adds Risk, Little Return

Larry Swedroe on how the risk of private equity doesn’t always equal higher returns.

The term “private equity” is used to describe various types (e.g., buyout funds and venture capital funds) of privately placed (nonpublicly traded) investments. Even though buyout (BO) funds and venture capital (VC) funds have similar organizational and compensation structures, they are distinguished by the types of investments they make and the way those investments are financed.

BO funds generally acquire 100% of the target firm (which can be public or private) and use leverage. VC funds take minority positions in private businesses and do not use debt financing. Today BO funds account for about three-fourths of private equity deals.

Private equity (PE) excites many investors, offering the opportunity for spectacular returns (although, as with most investments, we generally hear only the stories with happy endings). Even the term conveys an exclusive nature, especially for investors who yearn to be “players.”

Capital committed to PE funds worldwide has risen substantially in the past two decades, thanks largely to U.S. pension funds searching for alternatives to public equity markets that might help them meet their return objectives. Endowments seeking to replicate the successes of the Yale Endowment have also contributed to the growth of PE funds. And it is reasonable to assume that high-risk, illiquid investments are priced by investors to deliver higher expected returns than publicly traded securities to compensate for the greater risk.

The Historical Evidence

Steven Kaplan and Berk Sensoy contributed to the literature on the performance of PE funds through an extensive survey of current research on the performance of private equity. Following is a summary of the findings from their October 2014 paper, “Private Equity Performance: A Survey”:

  • BO funds have outperformed the S&P 500 net of fees by about 20%, on average, over the life of the fund.
  • VC funds raised in the 1990s outperformed the S&P 500, while those raised in the 2000s have not.
  • Before the 2000s, buyout and VC fund performance showed strong evidence of persistence.
  • Since 2000, there is little evidence of BO fund persistence (with the exception of persistence among those in the bottom quartile, the worst performers), while VC fund persistence has remained strong.

Unfortunately, the returns data presented by Kaplan and Sensoy isn’t risk-adjusted. Private equity is really much riskier than an investment in a publicly traded S&P 500 Index fund, making it a wholly inappropriate benchmark. For example …

  • Companies in the S&P 500 are typically among the largest and strongest companies, while VC typically invests in smaller and early-stage companies with far less financial strength. Studies have estimated betas for BO funds at about 1.3 and for VC funds at 1.6 to 2.5. Adjusting for the higher betas alone would have erased any evidence of outperformance. Similarly risky but also publicly available small value stocks have also outperformed the S&P 500 by a wide margin—from 1927 through 2016, the S&P 500 returned 10.0%, while the Fama-French Small Value Index (ex utilities) returned 13.6%.
  • Investors in private equity forgo the benefits of daily liquidity. It’s well-documented in the literature that investors will demand a premium for investing in illiquid assets, especially those that perform poorly in bad times (like PE). There’s no adjustment in the returns data for the risk of illiquidity. In addition to the lack of liquidity relative to investments in mutual funds, private equity investors also forgo the benefits of transparency and broad diversification (and for individuals, the ability to harvest losses for tax purposes).
  • The median return of PE is much lower than the mean (the arithmetic average) return. PE’s relatively high average return reflects the small possibility of a truly outstanding return, combined with the much larger probability of a more modest or negative return. In effect, PE investments are like options (or lottery tickets). They tend to provide a small chance of a huge payout but a much larger chance of a below-average return. And it’s difficult, especially for individual investors, to diversify this risk.
  • The standard deviation of private equity exceeds 100%, in comparison to standard deviations of about 20% for the S&P 500 and about 35% for small value stocks.

In their survey, Kaplan and Sensoy observed that the authors of the 2013 study, “Limited Partner Performance and the Maturing of the Private Equity Industry,” found that, in the more recent sample of PE funds raised between 1999 and 2006, there was no evidence that endowments outperform other limited partner types or display any superior skill at selecting general partners.

According to Kaplan and Sensoy, this study (which Sensoy also co-authored) concluded that “the disappearing endowment advantage is consistent with other secular trends in the industry, particularly the decline in VC performance since the late 1990s and the decline in performance persistence in BO firms.”

Latest Evidence

Reiner Braun, Tim Jenkinson and Ingo Stoff contribute to the literature on private equity performance and its persistence with their study, “How Persistent is Private Equity Performance? Evidence from Deal-Level Data,” which was published in the February 2017 issue of the Journal of Financial Economics.

Their findings were consistent with those of Kaplan and Sensoy. Their study covered timed cash-flow data at the deal level for 13,523 investments made by 865 buyout funds (not VC funds) run by 269 general partners (GPs). The investments were split roughly equally between the U.S. and Europe, with a few in other regions, and span the period 1974 to 2012. This is important, as most other studies examined only U.S. data.

The authors noted: “As well as being extensive and detailed, for the vast majority of the GPs in our sample we have their complete investment history. This is clearly critical when analysing performance persistence, and lack of completeness is a problem that has plagued earlier analyses. We source the data from three fund-of-fund managers who required all GPs who sought capital to provide this detailed deal-level information in a standardized format. Importantly, the sample includes all the GPs upon which the fund-of-fund managers performed due diligence, whether or not they actually chose to invest.” They also partitioned the data sample into an early period up to the end of 2000 and a later period from 2001 onward.

Following is a summary of their findings …

  • While there was evidence of performance persistence in the early period, it was weaker than performance persistence found in previous studies and has largely disappeared in recent years. The authors stated: “This is consistent with the PE sector maturing, with financial engineering and valuation techniques becoming commoditized, professionals moving between or forming new GPs, and the ways to create operational improvements to portfolio companies becoming assimilated across firms.”
  • Competition has clearly increased in recent years, but not evenly over time or by region. When a large amount of capital chases deals, persistence tends to be lower.
  • There is significant evidence of top-quartile performance persistence but only in low competition states. On the other hand, GPs who make bad deals tend to repeat, irrespective of the state of competition.

Braun, Jenkinson and Stoff concluded: “Overall, the evidence we present suggests that performance persistence has largely disappeared as the PE market has matured and become more competitive.”

They add: “Those Limited Partners (LPs) who were early investors in PE—such as endowments—established relationships with successful GPs which were valuable when the market was developing. However, those relationships, and access to funds—at least on the buyout side—are now much less valuable and are no longer a source of LP out-performance.”

For investors, the research has an important implication: If past performance provides little guidance on the choice of GPs, how can one identify the future top performers

Swensen On Private Equity

If you’re considering investing in PE or sit on the board of a committee that is doing so, be sure to consider these sage words of advice from David Swensen, chief investment officer of the Yale Endowment: “Understanding the difficulty of identifying superior hedge fund, venture capital, and leverage buyout investments leads to the conclusion that hurdles for casual investors stand insurmountably high. Even many well-equipped investors fail to clear the hurdles necessary to achieve consistent success in producing market-beating active management results.”

In his book, “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen offered the following observation on BO funds: “Investors in buyout partnerships received miserable risk-adjusted returns over the past two decades. Since the only material differences between privately owned buyouts and publicly traded companies lie in the nature of the ownership (private vs. public) and character of capital structure (highly leveraged vs. less highly leveraged), comparing buyout returns to public market returns makes sense as a starting point. But because the riskier, more leveraged buyout positions ought to generate higher returns, sensible investors recoil at the buyout industry’s deficit relative to public market alternatives. On a risk-adjusted basis, market equities win in a landslide.”

Swensen also cited a Yale Investments Office study that provides some insight into the additional return required to compensate for the risk in leveraged buyout transactions. He writes: “Examination of 542 buyout deals initiated and concluded between 1987 and 1998 showed gross returns of 48% per annum, significantly above the 17% return that would have resulted from comparably timed and comparably sized investments in the S&P 500. On the surface, buyouts beat stocks by a wide margin. Adjustment for management fees and general partners’ profit participation bring the estimated buyout result to 36% per year, still comfortably ahead of the marketable security alternative…. Because buyout transactions by their very nature involve higher-than-market levels of leverage, the basic buyout-fund-to marketable-security comparison fails the apples-to-apples standard. To produce a risk-neutral comparison, consider the impact of applying leverage to public market investments. Comparably timed, comparably sized, and comparably leveraged investments in the S&P 500 produced an astonishing 86% annual return. The risk-adjusted marketable security result exceeded the buyout result of 36% per year by an astounding 50%age points per year.”


The bottom line is that if you’re willing, able and have the need to take more risk in search of higher returns, the most likely to place to find that is not in PE, but rather in publicly available small value stocks. And you can access these higher expected returns through low-cost, passively managed and tax-efficient funds. You can globally diversify their risks as well. In addition, you’ll have all the benefits of daily liquidity and transparency.

This commentary originally appeared March 27 on

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