2018’s Active Vs. Index Scorecard

Investment Strategy, JDH Blog, Larry Swedroe, Market Review

Since 2002, S&P Dow Jones Indices has published its S&P Indices Versus Active (SPIVA) Scorecard, which compares the performance of actively managed equity mutual funds to their appropriate index benchmarks.

Most Recent Data

The 2018 report includes 15 years of data. Following are some of its highlights:

In 2018, 69% of all domestic funds underperformed the S&P Composite 1500 (in a down year—so much for active managers outperforming in down markets). And 64% of large-cap managers, 46% of midcap managers and 68% of small-cap managers underperformed the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600, respectively. However, over longer periods, the results were dismal.
Over the five-year period ending 2018, 84% of large-cap managers, 85% of midcap managers and 91% of small-cap managers lagged their respective benchmarks. Similarly, over the 15-year investment horizon, 92% of large-cap managers, 93% of midcap managers and 91% of small-cap managers failed to outperform on a relative basis. Note the poor performance in small-caps, supposedly the most inefficient asset class, where just 9% of active funds outperformed their benchmark index. Even worse was the performance turned in by small-cap growth managers, where 98% underperformed. The least poor performance was in large value, where 79% failed to beat their benchmark.
In 2018, the majority of active managers investing in global (71%), international (77%), international small (68%) and emerging market (78%) funds underperformed their respective benchmarks. Again, the results deteriorated as the horizon lengthened.
Over the three-, five-, 10- and 15-year investment horizons, managers across all international equity categories underperformed their benchmarks, and the longer the time horizon, in general, the more funds underperformed. For example, over the 15-year horizon, 83% of global funds underperformed, 90% of international funds underperformed, 76% of international small funds underperformed and 96% of those supposedly inefficient emerging market funds underperformed.
Over the last 15 years, on an equal-weighted (asset-weighted) basis, the average actively managed U.S. equity fund underperformed by 1.43 (0.73)% per annum. Again, the worst performances were in the small-cap category, with active small-cap growth managers underperforming on an equal-weighted (asset-weighted) basis by 3.08 (1.94)% per annum, active small-cap core managers underperforming by 2.79 (1.85)% per annum and active small value managers underperforming by 2.06 (1.87)% per annum, respectively. So much for the idea that the asset class is inefficient.
Over the three-, five-, 10- and 15-year investment horizons, managers across all international equity categories underperformed their respective benchmarks. For example, over the 15-year horizon, 82% of active global funds underperformed, 92% of international funds underperformed, 78% of international small-cap funds underperformed, and in the supposedly inefficient emerging markets, 95% of active funds underperformed.
Over the 15-year horizon ending 2018, on an equal-weighted (asset-weighted) basis, active global funds underperformed by 1.36 (0.35)% per annum, active international funds underperformed by 1.78 (0.71)% per annum, active international small funds underperformed by 0.91 (0.09)% per annum, and in the supposedly inefficient asset class of emerging markets, active funds produced the worst performance, underperforming by 2.64 (1.50)% per annum, respectively.
The performance in fixed-income funds was also poor. Across the 14 categories, in just two did the majority of active funds outperform (long-term government and long-term investment grade). Over the 15-year period, in no category did the majority outperform, in only two less than 80% underperformed, in four more than 90% underperformed and in high-yield funds, the worst-performing category, 99% underperformed. On an equal-weighted basis, the underperformance ranged from 0.60% (general muni funds) to as much as 3.08% (government long funds). The news was better on an asset-weighted basis, with active funds outperforming in two categories: investment-grade intermediate (0.25%) and global income (0.89%). In the other 12 categories, the underperformance was more than 2% in two categories (long-term government and long-term investment grade), 1.5% in a third category (high-yield) and 0.8% in emerging market bonds.
Highlighting the importance of accounting for survivorship bias, over the 15-year period, 57% of domestic equity funds, 54% of international equity funds, 31% of international small funds and 32% of emerging market funds were merged or liquidated. Across the 14 bond fund categories, the merger and liquidation rate ranged from a high of 65% (government intermediate funds) to a low of 32% (global income funds).

While I believe the preceding data is compelling evidence of the active management industry’s failure to generate alpha, it’s important to note that all the report’s figures are based on pretax returns. Given that actively managed funds’ higher turnover generally makes them less tax efficient, on an after-tax basis, the failure rates would likely be much higher (taxes are often the greatest expense for active funds).

Summary

The SPIVA Scorecards continue to provide powerful evidence of the persistent failure of active management’s ability to generate alpha (risk-adjusted outperformance). In particular, they serve to highlight the canard that active management is successful in supposedly inefficient markets (like small-cap stocks and emerging markets).

The scorecards also provide compelling support for Charles Ellis’ observation that, while it’s possible to win the game of active management, the odds of doing so are so poor that it’s not prudent to try—which is why he called it “the loser’s game.” And it’s why we continue to see a persistent flow of assets away from actively managed funds.

Larry Swedroe, Director of Research, 3/18/2019

This commentary originally appeared March 13 on ETF.com

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.

March 19, 2019/by Sadie Pettit

Journey to Retirement Article in North Bay Biz

JDH Blog

We wanted to share with you that Tim Delaney’s comments have been shared as part of an article in the North Bay Biz Magazine on retirement planning!

Now, they stuck his picture way down on the last page, but if you take the time to read the article (and of course we think you should), you’ll find Tim’s sage advice sprinkled liberally throughout.

It’s a good read for a person of any age, whether you’re nearing your retirement or whether it’s still a twinkle in your eye. There are a lot of calculators you can find that will tell you one thing or another. It’s usually along the lines of, “Sock away this percentage of your income based on having this much in savings already at such-and-such an age.”

The truth is, there’s no magic formula. Planning for your retirement has to be tailored to your own goals and realities.

That said, we hope you’ll enjoy the following article for some thoughtful suggestions of the factors that you should consider as you establish the right retirement plan for you.

Journey to Retirement – North Bay Biz Magazine

(links to PDF)

November 29, 2018/by Sadie Pettit

Spooked by the market? Don’t be.

JDH Blog

October 31, 2018/by Sadie Pettit

An Awakening Bear?

JDH Blog, Larry Swedroe, The BAM Alliance

October 24, 2018/by Sadie Pettit

Re-Examining Emerging Markets Equity

JDH Blog, The BAM Alliance

By Jared Kizer, Chief Investment Officer, 9/7/2018

Emerging market equities have substantially underperformed the S&P 500 Index in 2018, with the S&P 500 up 6.5 percent and emerging markets down 4.4 percent through July. As I detailed in a recent post on international developed market equities, remaining committed to a globally diversified portfolio can be challenging during extended periods of underperformance relative to the U.S. market. In this post, we’ll look specifically at emerging markets by examining five lessons from long-run and current market data that reinforce some of the reasons investors should remain committed to emerging markets equity investing.

1. Over the long term, the evidence indicates that emerging market equities have outperformed U.S. equities.

From 1988 (the earliest data we have for emerging markets) through 2017, the S&P 500 earned average annual returns of 12.2 percent per year, while the MSCI Emerging Markets Index averaged 16.3 percent per year. In financial jargon, this difference in returns of roughly four percentage points would be referred to as a “risk premium,” indicating that markets have tended to reward long-term emerging markets investors with additional return compared to U.S. equities. This is a sensible result since emerging market equities clearly possess risks that U.S. equities do not. Emerging market investments could expose an investor to currency risk (the risk that emerging markets currencies as a group depreciate relative to the U.S. dollar), heightened geopolitical risk and lower market liquidity when compared to U.S. equities. Markets are aware of these additional risks and appear to have priced them appropriately.

2. Good news: While additional risks are associated with emerging markets investing, those risks are not perfectly correlated to U.S. equity market risk.

The three risks emerging markets investors face (outlined above) are either absent or lower for U.S. equities, but for globally diversified investors there’s a silver lining: Those risks are not perfectly correlated with the performance of U.S. equity markets. To visualize this, let’s look at a scatter plot of the annual returns of the U.S. and emerging equity markets.

Figure 1: MSCI Emerging Markets vs. S&P 500 Annual Returns (1988–2017)

Source: Thomson Reuters Lipper

Because the points are fairly scattered and not on the line, this indicates an imperfect relationship between the returns of the two markets, indicating that owning both adds diversification to your portfolio.

3. Historically, a portfolio that included emerging market equities in addition to U.S. equities has had higher risk-adjusted returns than a U.S.-only portfolio.

We can also ask the question of what allocation to emerging markets has been historically optimal for an investor with a 100 percent allocation to equities who wanted to maximize risk-adjusted returns. In the investing world, this means we want to find the portfolio that provided the most return for the volatility it experienced. This is admittedly a theoretical exercise since we can’t go back in time and experience this portfolio (and we certainly can’t expect the future to be identical to the past), but it does give us a general indication of how useful emerging markets have been historically. Over the period 1988–2017, the optimal allocation was about 80 percent to the S&P 500 and 20 percent to emerging markets. This result doesn’t necessarily mean you should allocate 20 percent of your equity to emerging markets (that’s a conversation to have with your advisor regarding your comprehensive financial plan), but it is useful in showing an allocation of zero percent likely doesn’t make sense either.

4. As with international developed market equities, emerging market equities represent a sizable fraction of the world’s equity market wealth.

As of year-end 2017, emerging markets equities were a bit more than 12 percent of the world’s equity market value with total market capitalization of almost $7.2 trillion. As with the analysis above, this doesn’t necessarily mean your allocation should be 12 percent of your equity portfolio, but this is a reasonable starting point. As a very general rule, if the market’s allocation to an asset class is meaningful, then yours likely should be, too.

5. While emerging markets can be a valuable component of a diversified portfolio, be prepared for volatility and potentially long periods of time where it underperforms U.S. equities.

The first four points lay out the case for a long-term allocation to emerging markets. That said, over the shorter term, emerging markets will inevitably have periods when it dramatically outperforms the U.S. equity market and periods when it spectacularly underperforms the U.S. equity market. For investors who are tempted to look at relative performance over shorter periods of time, it helps to understand what you should expect to see. Let’s first look at year-by-year maximum drawdowns of the S&P 500 and the MSCI Emerging Markets. The maximum drawdown is the largest peak-to-trough loss an investment earns over a particular period of time. If we say that the maximum drawdown of the S&P 500 was –20 percent in 1993, that means there was some period of time in 1993 when the S&P 500 declined 20 percent. Figure 2 plots the maximum drawdown in each year from 1988–2017 for the S&P 500 and emerging markets.

Figure 2: S&P 500 and MSCI Emerging Markets Maximum Drawdowns (1988–2017)

Source: Bloomberg

A few things stand out. First, in most years, the MSCI Emerging Markets Index has a drawdown of at least –10 percent and a significant number of years of at least –20 percent. Second, in most years, the maximum drawdown for emerging markets exceeds that of the S&P 500 (although they usually occur at different times during the year). This means investors with an allocation to emerging markets must remember it’s extremely volatile and will inevitably experience periods of substantial underperformance compared to the S&P 500. Let’s now look at rolling five-year returns for the S&P 500 and the MSCI Emerging Markets. Figure 3 presents this data.

Figure 3: Rolling 5-Year Annualized Returns (1988–2017)

Source: Thomson Reuters Lipper

The first five-year period goes through 1992 and the last goes through 2017. I’ve specifically highlighted two of the five-year periods above to give a sense of the magnitude by which U.S. equities have outperformed emerging markets over a five-year period and vice versa. For the five-year period through 1999, the S&P 500 was up 28.6 percent per year, while emerging markets were up just 2 percent per year. Conversely, for the five-year period ending 2007, the S&P 500 was up 12.8 percent per year, while emerging markets were up 37.5 percent per year. These results are even more mind-boggling when you remember that, over the entire period of 1988–2017, emerging markets outperformed the S&P 500 by an average of about 4 percent per year. This just goes to show that short-run results (though five years may feel long for some investors) can diverge from long-run results.

This commentary originally appeared September 6 on MultifactorWorld.com

October 16, 2018/by Sadie Pettit

Welcome to the New JDH!

Announcement, JDH Blog, JDH Newsletter

It’s been a whirlwind few years at JDH. Three new members joined our team. We moved in a massive way from being a paper-based firm to a digital firm. We’re even introducing online client portals this fall.

How did we choose the new logo?

We launched into a series of firm meetings to discuss: what are the firm’s goals? How do we see ourselves in the context not only of the firm but in the greater community? What makes us different than other wealth management firms?

We realized that starting conversations with the intent of improving the lives of those we encounter is a central piece of each of us here at JDH Wealth. With that in mind, we decided to find a new image that really speaks to who we are and what we want to accomplish. We dropped the word “management” from the logo, for the purposes of clarity of intent.

We took our name and built it into a symbol of growth, of goals, of aspirations – all with JDH Wealth as the support structure holding those up.

We’re pleased to share with you this rebirth of the JDH Wealth logo, and look forward to supporting you now and in the future.

July 20, 2018/by Sadie Pettit

Financial Illiteracy’s High Cost

JDH Blog, Larry Swedroe, The BAM Alliance

by Larry Swedroe, Director of Research, 6/14/2018

It’s a great tragedy that despite its obvious importance to everyone, our educational system almost totally ignores the field of finance and investments. This is true unless you go to an undergraduate business school or pursue an MBA in finance.

Eighteenth-century English poet Thomas Gray wrote, “Where ignorance is bliss, Tis folly to be wise.” When it comes to investing, ignorance certainly is not bliss—it pays to be wise. Just ask investors who lost tens of billions of dollars in the Bernard Madoff scandal. Without a basic understanding of how capital markets work, there is no way individuals can make prudent investment decisions.

The sad fact is that surveys have shown fewer than half of U.S. workers have even attempted to estimate how much money they might need in retirement, and many older adults face significant retirement shortfalls. While educational achievement is strongly positively associated with wealth accumulation, research also has found financial literacy has an even stronger and larger effect on wealth.

Households that build up more net wealth may be better able to smooth consumption in retirement, and financial literacy enhances the likelihood people will contribute to their retirement savings. Compounding the problem of lower savings is evidence that less financially literate households experience lower risk-adjusted returns.

Financial Literacy Research

Milo Bianchi contributes to the literature on financial literacy with the study “Financial Literacy and Portfolio Dynamics,” which appeared in the April 2018 issue of The Journal of Finance.

Using data obtained from a large French financial institution, Bianchi observed portfolio choices in a widespread investment product called assurance vie, in which households allocate wealth between relatively safe and relatively risky funds—predefined bundles of bonds or stocks—and are able to rebalance their portfolios over time. Assurance vie contracts are prevalent in France, being the most common way households invest in the stock market.

Bianchi then combined this data with responses to a survey he conducted with the financial institution’s clients. The survey, which ranked investor sophistication levels on a scale between one and seven, allowed him to obtain a broader picture of clients’ financial activities outside the company and of their behavioral characteristics. While investments in assurance vie may not cover a household’s entire portfolio, they often represent a substantial portion of investors’ financial wealth.

The author’s final database incorporated portfolio information at a monthly frequency for 511 of the financial institution’s clients over the period September 2002 to April 2011. On average, the assets it covered were approximately 50% of a household’s financial wealth.

Following is a summary of his findings:

Financial literacy correlated with demographic variables; in particular, education and wealth.
Financial literacy was negatively correlated with being female—a gender gap that had been observed in prior studies.
An additional unit of financial literacy was associated with a 3.5% increase in the probability of holding stocks.
More literate households experienced higher portfolio returns.
Controlling for various measures of portfolio risk, the most literate households experienced yearly returns approximately 0.5% higher than the least literate households, relative to an average return of 4.2%. These magnitudes were in line with those found in a recent study of Dutch households.
There was no evidence that, overall, households with higher financial literacy choose riskier portfolios. Instead, their risk exposure varies systematically with market conditions, allocating more to risky assets when they have higher expected returns. A 1% increase in the expected excess return of risky funds was associated with a 2% increase in the risky share for each unit of financial literacy.
Decomposing the observed changes in the risky share over time into active changes due to portfolio rebalancing and passive changes induced by differential returns to risky versus riskless funds, Bianchi found that passive changes were relatively more important for less sophisticated households. For the least sophisticated households, passive changes accounted for 64% of the total change in the risky share over 12 months. For the most sophisticated households, by contrast, passive changes accounted for 30%. This demonstrates that households with lower financial literacy display greater portfolio inertia. More educated, older and female investors display lower levels of inertia.
More literate households were more likely to act as contrarians. Rebalancing, they tended to move their wealth toward funds that had experienced relatively lower returns in the past.
The returns more sophisticated households actually experienced tended to exceed the returns they would have earned without rebalancing their portfolios. More sophisticated households were more likely to buy funds that provided higher returns than the funds they sold.

Conclusion

Findings such as these demonstrate that financial illiteracy is costly. The fact that our educational system has failed to provide much of the public with what I would consider even a basic level of financial literacy certainly is a tragedy. (The research shows this is not a U.S.-only problem.) But perhaps the bigger tragedy is that so many apparently would rather watch some reality TV show than “invest” the time and effort to become financially literate.

I have now authored or co-authored 16 books on investing, presenting the evidence from academic research. This has been my way of trying to reduce financial illiteracy and help prevent investors from being sheared by the wolves of Wall Street. Others, such as John Bogle and William Bernstein, have written outstanding books on the principles of prudent investing.

The only problem is that the sales of Harlequin romance novels (not that there is anything wrong with them) are far greater than the sales of books on modern portfolio theory and efficient markets, providing one explanation for why investors continue to use nonfiduciaries as their advisors and adopt active management strategies—strategies with a high likelihood of failure.

The bottom line is that the greatest investment you can make, and the one with the highest expected return, is an investment in your own financial literacy. Remember, if you think the price of financial education is too high, just try the price of ignorance.

This commentary originally appeared June 4 on ETF.com

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.

June 20, 2018/by Matt Delaney

The Risk and Return Implications of ESG

JDH Blog, Larry Swedroe, The BAM Alliance

by Larry Swedroe, Director of Research, 6/11/2018

Environmental, social and governance (ESG) investment strategies—along with the narrower category of socially responsible investing (SRI)—have gained quite a bit of traction in portfolio management in recent years.

In 2016, funds based on such strategies managed about $9 trillion in assets from an overall investment pool of $40 trillion in the United States, according to data from US SIF. In addition, the organization’s 2016 survey of sustainable investment assets found that in the U.S., climate change was the most significant environmental factor influencing asset allocations.

Value Play In ‘Sin’ Stocks?

While ESG investing continues to gain in popularity, economic theory suggests that if a large enough proportion of investors chooses to avoid “sin” businesses, the share prices of such companies will be depressed. They will have a higher cost of capital because they will trade at a lower price-to earnings (P/E) ratio.

Thus, they would offer higher expected returns (which some investors may view as compensation for the emotional “cost” of exposure to what they consider offensive companies).

Academic research has confirmed that the evidence supports the theory.

Higher Fees OK

Interestingly, Arno Riedl and Paul Smeets, authors of the study “Why Do Investors Hold Socially Responsible Mutual Funds?”, which appears in the December 2017 issue of The Journal of Finance, found that investors are willing to pay significantly higher management fees on SRI funds than on conventional funds, and that a majority of them expect such funds to underperform relative to conventional funds.

In other words, investors understand there is a price (in the form of lower expected returns) for expressing their social values, and are willing to pay it.

Impact On Risk?

Jeff Dunn, Shaun Fitzgibbons and Lukasz Pomorski of AQR Capital Management contribute to the literature concerning ESG investing with their February 2017 study, “Assessing Risk through Environmental, Social and Governance Exposures.”

While other studies focused on the impact of ESG/SRI investing on returns, the authors’ focus was on the risk side of the strategy. Just as it is logical to expect that investors shunning certain stocks should lead to those stocks having higher future returns, it is also logical to hypothesize that companies neglecting to manage their ESG exposures may be exposed to higher risk (a wider range of potential outcomes) than their more ESG-focused counterparts.

Risk Of ESG Neglect

The authors used the MSCI ESG database (often referred to as intangible value assessment, or IVA, data) and Barra risk models to determine whether there was any link between the two. The IVA methodology covers a large cross section of companies around the world (more than 5,000 companies as of December 2015 accounting for 97% of the market cap of the MSCI World Index) and assesses how much each company is exposed, and how well it manages its exposure, to a range of environmental, social and governance issues affecting its industry.

Dunn, Fitzgibbons and Pomorski employed the Barra GEM2L risk model to determine forward-looking (ex-ante) risk estimates. Specifically, a stock’s returns are assumed to be driven by a combination of its loadings on systematic risk factors and by firm-specific “idiosyncratic” effects, which are assumed to be uncorrelated across assets. The authors’ sample period is January 2007 to December 2015.

Following is a summary of their findings:

ESG exposures are informative about the risks of individual firms. This finding is robust to a wide variety of controls and various stock universes (U.S., developed and emerging markets).
Stocks with the worst ESG exposures have total and stock-specific volatility up to 10-15% higher, and betas up to 3% higher, than stocks with the best ESG exposures.
ESG scores may help forecast future changes to risk estimates from a traditional risk model. Controlling for contemporaneous risk model estimates, poor ESG exposures predict increased future statistical risks. The magnitude of the effect was relatively modest: A deterioration of ESG score from the 75th to the 25th percentile is associated with about a 1% increase in risk. While this increase might seem small, it may simply reflect the fact that ESG captures risks that are long-run in nature and that may not materialize in the short-to-medium term.
Across the three dimensions of ESG investing, the social and governance pillars show the strongest correlation to risk. The environmental pillar is only insignificantly related to the various risk measures.
Stocks in the first (worst) quintile of ESG scores had greater earnings volatility and were less profitable than stocks in the fifth (best) quintile. They also had more exposure to the value factor. Furthermore, they had lower Ohlson scores (a measure of default risk). Additionally, they were smaller companies. Each of these findings is related to risk and highly statistically significant. Stocks in the first quintile also had more exposure to the momentum factor than stocks in the fifth quintile. This also was statistically significant.
Consistent with theory and prior research, stocks in the first quintile of ESG scores earned 1.8% higher returns than stocks in the fifth quintile. However, while certainly economically significant, this difference was not statistically different from zero at the 5% confidence level (t-stat of 1.2). (Note that this lack of statistical significance could be due to the limitation of the short period covered by the study.) The higher returns might be a premium that investors earn for the displeasure of holding such stocks, possibly as compensation for the additional risks (such as greater earnings volatility, less profitability and greater default risk) these stocks exhibit.

What Risk Exposures Convey

Dunn, Fitzgibbons and Pomorski concluded: “ESG exposures convey information about risk that is not captured by traditional statistical risk models.”

They added: “While the effect is modest in magnitude, it is consistent with ESG exposures conveying some information about risk that is not captured by traditional statistical risk models. Overall, our findings suggest that ESG may have a role in investment portfolios that extends beyond ethical considerations, particularly for investors interested in tilting toward safer stocks. ESG exposures may inform investors about the riskiness of the securities in a way that is complementary to what is captured by traditional statistical risk models.”

The authors included this note of caution: “It would be surprising if ESG were a first-order driver of a stock’s risk beyond what is already captured in a well-constructed statistical risk model. ESG may convey information about, say, the likelihood of a governance scandal, but such a scandal may not materialize for the average company over a relatively short horizon we study here. Moreover, ESG exposures are fairly persistent and stocks with poor ESG profile tend to be poor ESG also in the future.”

The bottom line is that, while ESG investors seem likely to be sacrificing some returns to express their social preferences through their investments, it also seems likely there may be some offsetting benefit, though it may be marginal, in the form of reduced portfolio risk.

This commentary originally appeared May 29 on ETF.com

June 6, 2018/by Matt Delaney

Choosing the Right College Savings Plan

Articles, JDH Blog

by Sue Stevens, Wealth Advisor, Buckingham Strategic Wealth

The advantages of a college education are numerous: potentially higher income levels over a lifetime, learning about subjects that can help in finding a job or meeting people that may help you throughout your life. But the costs can be intimidating. The most important step is just starting to save something. Once you’ve crossed that hurdle, you need to figure out where to put your savings. There are lots of college investment vehicles, so let’s take a closer look at what some of the most popular offer.

529 College Savings Plans

Perhaps the most commonly used type of college savings vehicle is the 529 College Savings Plan. These plans are typically sponsored by individual states or financial institutions. No matter which plan you invest in, your child can use that money to attend college anywhere in the country. You gift money to these plans and as long as your child uses the money for “qualified education purposes,” the earnings are tax-free. See the chart at the end of this article for what qualifies as an expense.

You can gift up to $15,000 (2018) per person each year. This is known as the “annual exclusion” amount for gift tax purposes. There is a special exception for 529 plans that allows you to contribute up to five times the annual exclusion, or up to $75,000 (2018) per child, in any one year. Just keep in mind that you’ve then used up the annual exclusion for that five year period.

If your child doesn’t use all the money in his or her 529 plan, you can transfer it to another “qualified beneficiary’s” plan. Qualified beneficiaries would include siblings, parents (or ancestors of either), nieces or nephews, aunts or uncles, first cousins, sons-in-law, daughters-in- law, fathers-in-law, mothers-in-law, brothers-in-law, sisters-in-law and spouses of any relatives previously listed.

Note: The ability to use 529 Savings Plan money for another beneficiary is a unique feature that is not available when you use college savings vehicles like UGMA/UTMA accounts. Those accounts are strictly for the named beneficiary.

Parents (or owners) maintain control of the assets in a 529 plan until distributed and the assets are factored into the financial aid formulas at a more advantageous rate.

There are, however, some disadvantages to 529 college savings plans:

You are limited to changing investments twice a year.
Although the number and quality of investment choices within 529 plans has improved, you are limited to the options offered by your chosen plan.
Pay attention to the costs of the Sometimes costs can be higher than you would find in alternative types of investments.
Any assets not used for qualified education expenses will subject the earnings in the plan to income tax and a 10% You can avoid this by “rolling over” the plan to another qualified beneficiary.
In some cases, especially with high net worth families, the annual gift tax exclusion may be better used in another way. For example, tuition can be paid directly to the school and not count toward the gift tax. If a Family Trust has been established, you may want to use your annual gift tax exclusion to fund the Family Trust.

But if the advantages outweigh the disadvantages for you, how do you choose among all the possible 529 College Savings plans available? The most important factors to consider are:

State Tax Advantages:
Many states offer tax deductions for residents investing in their state’s 529 plan. Some states also offer generous matches for first time enrollment in their plans. This may serve as an attractive incentive, but you can’t ignore other factors, such as fees and investment choices, especially when the tax advantage is relatively small.

Note: Since the Tax Cuts and Jobs Act of 2017, states are now scrambling to rewrite their own rules about what qualifies for a tax deduction. Withdrawing money for private K-12 qualified expenses may have unintended consequences like being required to repay prior state deductions or pay tax on investment gains. Every state is different, so you’ll need to do a little research to learn more. (Read http://time.com/money/5093099/529-plans-k12-expenses-tax-bill/.)

Investment Choice:
Having the “right” investment alternatives in the plan is critical. Especially in volatile markets, you need to have investment options that give you confidence. Many plans have added fixed income choices that should help do just that.

Fees and Expenses:
Not only do you pay a fee to the managers of the 529 plan, but you also pay a fee for the individual mutual funds the plan invests in. Both of these costs need to be accounted for when comparing the total expenses of various 529 plans. You do not want to make the mistake of choosing a plan with a low management fee, only to find out the individual funds in it have very high expense ratios or vice-versa.

The Tax Cuts and Jobs Act of 2017 expands how you can use 529 College Savings Plans assets. Now you can also take up to $10,000 a year to apply to private K-12 qualified education expenses. But this brings with it some additional considerations:

How will that affect the state tax deduction you took when you made the contribution? Will you have to pay part of that back?
Should you invest the money for K-12 differently because you have less time for the money to compound?
If you take out money for K-12, will you derail the growth you were planning on to pay for college expenses?
Will having the money available for K-12 change the financial aid calculations for what parents have to contribute for private school?

Alternative College Savings Vehicles

Not everyone will choose to use a 529 College Savings Plan, so let’s take a look at other savings alternatives:

UGMA/UTMA (Uniform Gifts to Minors Act/Uniform Transfers to Minors Act):
A UGMA/UTMA account is probably the most common type of investment account for a child other than a 529 plan. The appeal is that you can invest in anything–stocks, bonds, CDs, mutual funds–at just about any brokerage or bank. The money has to be used for the benefit of the child and can’t be used for normal parental obligations. At age 18 or 21, depending on state law, the money belongs to the child and can be used for any purpose. This type of account is a disadvantage for financial aid as it is counted as the child’s asset and is subject to a higher percentage in the financial aid formula.

Note: Investment income earned above $2,100 is subject to “kiddie tax” rules. With the new tax law, instead of being subject to parents’ rates, this income is now subject to potentially higher trust rates.

Coverdell Education Savings Account (ESA):
Coverdell accounts allow you to contribute $2,000 a year from all sources that can be used for elementary and secondary school expenses as well as qualified college costs. To be eligible to contribute, your income can’t be over $110,000 (single) or $220,000 (married filing joint). Beneficiaries must be under age 18 when the account is established. Any income earned on these assets is not taxed federally. They offer the ability to invest in just about anything–like a UGMA/UTMA. They are counted as a parent’s asset in the financial aid formula.

Traditional Brokerage Account:
Some parents choose to forgo the tax advantages of other types of college savings accounts so that they maintain control of the assets. For example, some parents will fund a 529 plan to cover the cost of four years of public college. To the extent the child wants to go to a more expensive school, parents pay that portion of the cost out of savings in their own names.

U.S. Savings Bonds:
There are limited advantages for college savings with U.S. Savings Bonds. To get the tax savings in 2017, your income must be less than $93,150 (single) or $147,250 (married filing joint), you must be over age 24 and the money must be used for tuition and fees. There is a $10,000 maximum annual purchase for electronic I-Bonds and EE-Bonds ($15,000 if you purchase a $5,000 paper I-Bond with your tax refund).

IRA:
Typically an IRA holds assets earmarked for retirement. But some people choose to use the money for college costs. You can avoid the 10% penalty if you use the money for college costs from a traditional IRA. You can withdraw contributions from a Roth IRA (but not earnings) without penalty. Overall, we would tend to recommend using these plans for retirement and not for college funding.

529 Prepaid Tuition Plan:
529 Savings Plans (as described previously) are not the only kind of 529 plan. There are also Prepaid Tuition Plans, although these plans have had a number of problems. Prepaid tuition plans were designed to lock in the future cost of tuition, but as state governments have hit their own financial difficulties, these plans may not be able to deliver on those promises. In general, we would not recommend investing in this type of plan.

2503c and Crummy Trusts:
High net worth investors may have additional factors to consider when thinking about funding college for their children. There are a couple types of trusts, 2503c and Crummy, where money can be put aside for future uses including college. One of the more important considerations in these situations is where the annual gift tax exclusion amount can best be used. There are legal costs associated with setting up these trusts, so they are not for everyone.

Once you’ve decided to start putting aside money for your children’s education and formulated a strategy to do so, choose the college savings tool that makes the most sense for your family and your unique financial circumstances. The costs associated with a college (or a private K-12) education can add up quickly, so be sure that the investment vehicle you select is the right one for you.

Download this table as a PDF »

May 29, 2018/by Matt Delaney

Investing Lessons from a Poker Player

JDH Blog, Larry Swedroe

by Larry Swedroe, Director of Research

As expert poker player Annie Duke explains in her book, “Thinking in Bets,” one of the more common mistakes amateurs make is the tendency to equate the quality of a decision with the quality of its outcome. Poker players call this trait “resulting.”

In my own book, “Investment Mistakes Even Smart Investors Make and How to Avoid Them,” I describe this mistake as confusing before-the-fact strategy with after-the-fact outcome. In either case, it is often caused by hindsight bias: the tendency, after an outcome is known, to see it as virtually inevitable.

Duke explains: “When we say ‘I should have known that would happen,’ or, ‘I should have seen it coming,’ we are succumbing to hindsight bias.” She adds that we tend to link results with decisions even though it is easy to point out indisputable examples where the relationship between decisions and results isn’t so perfectly correlated.

For example, she writes, “No sober person thinks getting home safely after driving drunk reflects a good decision or good driving ability.” The lesson, as Duke explains, is that we aren’t wrong just because things didn’t work out, and we aren’t right just because they turned out well.

Don’t Judge Performance By Results

“Fooled by Randomness” author Nassim Nicholas Taleb put it this way: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (i.e., if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”

Here’s an example from poker. With one card remaining to be drawn, there are just two players left in the hand. Player X calculates that he has an 86% chance of winning. Based on those odds, he makes a large bet. Unfortunately, he loses the hand, just as he would expect to occur 14% of the times he faced the same situation. If he engaged in resulting, he would change his betting strategy because he would conclude that it was wrong to make such a bet. However, we know that if he made the same decision each time he faced those odds, over the long term, he would be expected to come out way ahead.

Let’s look at another example of resulting. John Smith, a hypothetical investor, works for Google and has nearly his entire portfolio invested in Google stock. He became a multimillionaire based on that strategy. John believes concentrating all your eggs in one basket—a basket that, as a senior executive, he could watch closely—is the right strategy. He thought diversification was only for investors who don’t have his sophistication. Of course, many other, similar situations turned out entirely differently, despite using the same strategy of concentrating risk in what you know. That’s why the saying “the surest way to create a small fortune is to start out with a large one and concentrate your risk” offers such good counsel.

Flawed Strategy

Among the once-great companies whose stock prices collapsed are Polaroid, Eastman Kodak, Digital Equipment, Burroughs and Xerox. However, despite the fact that there are far more Polaroids than Googles—showing John’s strategy is flawed—his outcome convinced him the strategy was right.

As Duke points out, once a belief becomes lodged, it becomes very difficult to dislodge. It takes on a life of its own, leading us to notice only evidence that is confirming, and causing us to experience cognitive dissonance. We then work hard to actively discredit contradicting information, a process called motivated reasoning.

Making matters worse is that research shows being “smart” actually makes certain behavioral biases worse: The smarter you are, the better you are at constructing a narrative that supports your held belief.

Duke cites the research of Richard West, Russell Meserve and Keith Stanovich, who tested the blind-spot bias. They found we are much better at recognizing biased reasoning in others but are blind to recognizing it in ourselves.

Surprisingly, at least to me, West, Meserve and Stanovich also found that the better you were with numbers, the worse the bias—the better you are with numbers, the better you are at spinning those numbers to suit your narrative. Quoting Duke: “Our capacity for self-deception knows no boundaries.” So, what does this have to do with investing?

Invest By Playing The Odds

When it comes to investing, there are no clear crystal balls. Just as in poker, the best we can do is put the odds in our favor and invest (bet) accordingly.

As I recently discussed, using factor data from Dimensional Fund Advisors from 2007 through 2017, the value premium (the annual average difference in returns between value stocks and growth stocks) was -2.3%. Unfortunately, resulting, hindsight bias and recency bias led many to conclude it was a mistake to invest in, or overweight, value stocks.

Another way to look at the situation is that, over 10-year periods since 1927, value stocks outperformed growth stocks 86% of the time—the same percentage as in the aforementioned poker hand. The value premium’s now-decade-long underperformance was not unexpected, in the sense that in 14% of the alternative universes that might have shown up, we expected value stocks to underperform.

Similarly, again using Dimensional Fund Advisors data, the market-beta premium has been negative (U.S. stocks underperformed riskless one-month Treasury bills) in 9% of the 10-year periods since 1927.

In other words, investing is risky. To be successful, you must accept that fact there will be periods, even very long ones, when the right strategy leads to poor outcomes. Even at 20-year horizons, the market beta premium has been negative 3% of the time. That is why Warren Buffett has said investing is simple, but not easy. It takes discipline to earn risk premiums.

Summary

One of the hardest things for investors to do is to stay disciplined when their strategy delivers poor results. It certainly is possible that the strategy was wrong. To determine if that is the case, look to see if the assumptions behind the strategy were correct. Seek the truth, whether it aligns with your beliefs or not. For investors, the truth lies in the data. When your theory isn’t supported by the data, throw out your theory.

While it’s certainly not an investment book, investors can learn many lessons from Duke’s “Thinking in Bets.”

This commentary originally appeared May 11 on ETF.com

May 29, 2018/by Matt Delaney