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Does Ethical Based Investing Impact Returns?

Socially responsible investing (SRI) has been referred to as “double-bottom-line” investing. The implication is that you’re seeking not only profitable investments, but also investments that meet your personal standards. Some investors don’t want their money to support companies that sell tobacco products, alcoholic beverages or weapons, or firms that rely on animal testing as part of their research and development efforts. Other investors may be concerned about social, environmental, governance, labor or religious issues.

It is important to note, however, that SRI encompasses many personal beliefs and doesn’t reflect just one set of values. Therefore, it’s no surprise that each socially responsible fund relies on its own carefully developed “screening” system.

Analyzing the Numbers

According to the Social Investment Forum (SIF), U.S. SRI assets under management registered an increase from $639 billion in 1995 to $3.7 trillion in 2012, and an increase in their relative market share from 9 percent to 11 percent over the same period. Given their growth, an important question is whether “ethics-based” investing can impact returns. Sadok El Ghoul and Aymen Karoui — the authors of the

December 2015 study, How Ethical Compliance Affects Portfolio Performance and Flows: Evidence from Mutual Funds — sought the answer to that question.

The authors applied value-weighted scores using firm-level holdings to assess the level of corporate social responsibility (CSR) of a fund. This allowed them to compare fund performance based on the CSR criterion. To rate individual companies, they employed a KLD database. KLD Research & Analytics is a leading authority on social research for institutional investors, offering research, benchmarks, compliance and consulting services analogous to those provided by financial research service firms.

The authors considered two competing hypotheses. On the one hand, investing in firms that comply with social responsibility practices is likely to reduce the set of investment opportunities available and increase their monitoring costs. Ethical compliance would then negatively impact financial performance. On the other hand, fund managers that target socially responsible firms might in fact target firms with solid financial fundamentals, which in turn would translate into higher performance. In other words, the multiple screening steps taken by fund managers may eliminate poorly managed companies with underperforming stocks. In this case, investing in socially responsible stocks would be a value-generating strategy.

Their study covered the period from 2003 through 2011 and 2,168 U.S. equity mutual funds. To measure risk-adjusted returns, the authors used the four factors of market beta, size, value and momentum. The following is a summary of their findings:

  • High-CSR funds attract larger flows.
  • High-CSR funds tend to hold fewer stocks; they are less diversified.
  • There is strong evidence that an increase in the level of CSR comes at the expense of a reduction in performance. Said another way, the CSR level of the portfolio is negatively related to its risk-adjusted performance. This result stands controlled for common fund characteristics such as volatility, flows, the size of the assets under management, the number of stocks, the expense ratio and turnover.
  • The alpha, or the annualized risk-adjusted return (net of fees), of low-CSR funds was -0.8 percent, while the alpha of high-CSR funds was -1.5 percent. The difference, 0.7 percent, was highly statistically significant (t-stat of 5.8). The difference could not be explained by the expense ratios because they were virtually identical (1.24 percent for low-CSR funds and 1.21 percent for high-CSR funds).
  • The CSR level negatively predicts the next year’s fund performance.
  • There is no evidence of persistence in performance beyond a horizon of one year. Funds with a highCSR score exhibit weaker persistence or higher reversal in their performance.
  • Evidence in the literature on mutual funds has shown that investor flows respond positively and significantly to past performance. However, this relationship weakens as the level of CSR increases. Investors in funds with higher ethical standards become less responsive to past performance and derive their utility from non-financial attributes. As the level of ethical compliance increases, it becomes more difficult for investors to find similar investment alternatives and therefore they may be more reluctant to switch to other funds, even when these funds register poor performance.

The authors noted that their findings were consistent with those of a study appearing in the November 2015 issue of the Journal of Banking and Finance, Do Social Factors Influence Investment Behavior and Performance? Evidence from Mutual Fund Holdings. Funds that are more invested in “sin” stocks display higher risk-adjusted performance.

The findings mentioned above are also consistent with those from Harrison Hong and Marcin Kacperczyk, authors of the study, The Price of Sin: The Effects of Social Norms on Markets, which appeared in the July 2009 issue of the Journal of Financial Economics.

They found that for the period from 1965 through 2006, a portfolio long sin stocks and short their comparables had a return of 0.29 percent per month after adjusting for a four-factor model comprised of the three Fama-French factors (beta, size and value) and the momentum factor. The statistics were economically significant. In addition, as out-of-sample support, they found that sin stocks in seven large European markets and Canada outperformed similar stocks by about 2.5 percent a year.

The Bottom Line

The conclusion that we can draw from these studies is that social norms have important consequences for the cost of capital of “sin” companies. They also have consequences for SRI investors, who pay a price in the form of lower expected returns and less effective diversification.

While many investors will vote “conscience” over “pocketbook,” there is an alternative to socially responsible investing at least worth considering: avoid socially responsible funds and donate the higher expected returns to the charities that you are most passionate about. In that way you can directly impact the causes you care deeply about and get a tax deduction at the same time.

By, Larry Swedroe

Director of Research for the BAM ALLIANCE

This commentary originally appeared February 9 on MutualFunds.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 Hoffman & Associates. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

Jason No Comments

Accepting the Uncertainty of Our Financial Lives

I have a friend who is an emergency room physician in Salt Lake City. The other day, he described to me an interaction he had with a distressed, uncomfortable patient. After doing all the tests he could and finding nothing wrong, all he could do was give the patient that age-old, wonderful doctor advice: “Go home, rest up, drink fluids and call me in the morning.”

“The funny thing about this patient,” my friend told me, “was that after I told him nothing was wrong and he should just go home, he actually seemed disappointed.”

This happens all the time, according to my friend. It often seems like the patient would rather have a bad diagnosis than face an uncertainty that could well be labeled “good.” It’s fascinating: We yearn so badly for clarity that we often prefer a negative outcome we’re certain about to one that leaves us in suspense.

There is a lot of research about the relationship between uncertainty and worry. In 2001, a study by Michel J. Dugas, Patrick Gosselin, and Robert Ladouceur said of the connections: “Considering that daily life is fraught with uncertain situations, individuals who are intolerant of uncertainty may perceive several ‘unacceptable and disturbing’ events in the course of a single day.”

Clearly, that intolerance of uncertainty can wreak all sorts of havoc at home, at work, at school or in relationships. It should come as no surprise that it can create major problems for us in our financial lives as well.

One way this fear manifests itself in our investments is when we make hasty or rash decisions based upon cataclysmic market forecasts, like the one this year from RBS suggesting that people sell everything in their portfolios except high quality bonds.

In spite of the abundance of evidence that proves that market forecasts are often wrong and lead individuals to make decisions that hurt them over the long run, we still embrace and act on them. We do something that we know is a bad idea just to eliminate that feeling of uncertainty. Selling when your portfolio is down 20 percent — we know that’s a bad idea. But we prefer the negative outcome of locking in those losses because it’s certain.

We all know that life is uncertain. You can’t predict the future. You can’t time the stock market. You can’t forecast which years are going to be good and which years will be bad.

So how can we get better at accepting it? We can build a portfolio that matches our goals. We can own lots of different kinds of investments, with the knowledge that most of the time, they won’t all fall sharply at once. We can keep the costs of those investments down.

But after we’ve nailed down all those things, there’s still going to be uncertainty in the air. The sooner we can accept that the better. That’s life. That’s reality.

This commentary originally appeared February 8 on NYTimes.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 Hoffman & Associates. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

Jason No Comments

Keep Calm and Step Forward

A good friend, Sherman Doll, related the following story. Sherman has been a two-line sport kite flier for years. While not a pro, he has learned a few tricks from observing the flying behavior of these kites. He told me that one of the most difficult skills for beginners to master is what to do when their kite starts to plunge earthward.

The natural, panicky impulse is to yank backward on the lines. However, this action only accelerates the kite’s death spiral. The effective, kite-saving technique is to calmly step forward and thrust out your arms. This causes the kite’s downward acceleration to stop, allowing you to regain control and end its plunge. What does this have to do with investing?

2016’s Grim Beginning

As you may already have observed, 2016 got off to a bad start for equity markets around the globe. In fact, for the S&P 500 Index, the first five trading days were the worst-ever start to a year, with a loss of 6%.

Combined with the weak performance of global equities in 2015, and all the geopolitical turmoil in the world, the stomachs of many investors started to rumble, especially upon hearing pronouncements from market “gurus” forecasting doom and gloom.

For example, George Soros is predicting a crisis similar to the one we had in 2008, with problems in China being the trigger. And it certainly doesn’t help when respected investors such as Jeremy Grantham and Carl Icahn are proclaiming that the market is vastly overvalued.

Over the 20 years that I’ve been providing investment advice, I’ve learned that when we have situations like the one we’re in now, many investors begin to “catastrophize.” They begin to focus solely on the negative news—such as ignoring the 292,000 increase in employment, along with an upward revision of 50,000 to the prior month’s gains, reported on the fifth day of trading in 2016. These investors begin to anticipate everything that could possibly go wrong, and end up in a loop of worry and anxiety that leads at best to indecisiveness and at worst to panicked selling.

Now, returning to my friend’s story about flying kites …

Just as when a kite starts to plunge earthward and the natural, panicky reaction is to yank backward on the lines, the natural, panicky reaction to a dive in your portfolio’s value is to pull back (sell). In both cases, pulling back is the wrong strategy. The right strategy is the less intuitive one. It involves the choice to remain calm and step forward (actually buying stocks to rebalance your portfolio back to your desired asset allocation).

Buffett’s Advice

Warren Buffett is probably the most highly regarded investor of our era. Read his statements carefully regarding efforts to time the market:

  • “Inactivity strikes us as intelligent behavior.”
  • “The only value of stock forecasters is to make fortune-tellers look good.”
  • “We continue to make more money when snoring than when active.”
  • “Our stay-put behavior reflects our view that the stock market serves as a relocation center at which money is moved from the active to the patient.”

And finally, Buffett recommends that if you simply cannot resist the temptation to time the market, then you “should try to be fearful when others are greedy and greedy only when others are fearful.”

While it is tempting to believe that there are those who can predict bear markets and, therefore, sell before they arrive, there is no evidence of the persistent ability to do so. On the other hand, there is a large body of evidence suggesting that trying to time the markets is highly likely to lead to poor results.

For example, a study on the performance of 100 pension plans that engaged in tactical asset allocation (a fancy term for “market timing,” allowing the purveyors of such strategies to charge high fees) found that not one single plan benefited from their efforts. That is an amazing result, as even random chance would lead us to expect at least some to benefit.

Avoiding Investment Depression

If you’re prone to investment depression, one way to help avoid the downward spiral that many investors experience (which can lead to panicked selling) is to envision good outcomes.

To help you do just that, I have gone to my trusty videotape and come up with some data that should not only be of interest, but should also enable you to envision positive outcomes. My thanks to my colleague, Dan Campbell, for producing the data, which covers the 89-year period from 1926 through 2014.

  • There were 33 years (or 37% of them) in which the S&P 500 Index produced a loss during the first quarter. By the end of 18 of those years (or 55%), the S&P 500 had produced a gain. Of those 18 years, the highest return occurred in 1933, when the S&P 500 returned 54%. The best performance during the last three quarters in each of those years was also in 1933, when the S&P 500 returned 79.2%. The last time the first quarter ended in negative territory but full-year returns turned positive was just recently, when in 2009, the first quarter finished with a return of -11% and went on to recover for full-year gains of 26%.
  • There were 31 years (or 35% of them) in which the S&P 500 Index produced a loss during the first six months. By the end of 11 of those years (or 35%), the S&P 500 had produced a gain. Of those 11 years, the highest return occurred in 1982, when the S&P 500 returned 21.4%. The best performance over the last half in each of those years was also in 1982, when the S&P 500 returned 31.7%.
  • There were 24 years (or 27% of them) in which the S&P 500 Index produced a loss during the first nine months. By the end of four of those years (or 17%), the S&P 500 had produced a gain. Of those four years, the highest return occurred in 1982, when the S&P 500 returned 4.0%. The best performance over the last quarter in each of those years occurred just recently, when in 2011, the S&P 500 returned 11.8% over the last three months.

Summary

Warren Buffett has accurately stated that “investing is simple, but not easy.” The simple part is that the winning strategy is to act like the lowly postage stamp, which adheres to its letter until it reaches its destination. Similarly, investors should stick to their asset allocation until they reach their financial goals.

The reason investing is hard is that it can be difficult for many individuals to control their emotions (greed and envy in bull markets, and fear and panic in bear markets). In fact, I’ve come to believe that bear markets are the mechanism by which assets are transferred from those with weak stomachs and without an investment plan to those with well-thought-out plans—meaning they anticipate bear markets—and the discipline to follow those plans.

A necessary condition for staying disciplined is to have a plan to which you can adhere. But that’s not sufficient. The sufficient condition is that you must be sure your plan avoids taking more risk than you have the ability, willingness and need to take. If you exceed any of those, you just might find your stomach taking over. The bottom line: If you don’t have a plan, develop one. If you do have one, and it’s well-thought-out, stick to it.


This commentary originally appeared January 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.

© 2016, The BAM ALLIANCE

Jason No Comments

The Secret Wall Street Doesn’t Want You to Know

I am not endorsing any political views, but I did note an observation made by Bernie Sanders in the recent Democratic presidential primary debate. He stated that Wall Street’s “business model is greed and fraud.” There’s a lot of data supporting that view.

A history of unethical conduct

The Securities and Exchange Commission (SEC) compiled a list of enforcement actions that led to or arose from the financial crisis. Here’s a small sampling:

Citigroup – The SEC charged Citigroup’s principal U.S. broker-dealer subsidiary with misleading investors about a $1 billion collateralized debt obligation (CDO) tied to the housing market in which Citigroup bet against investors as the housing market showed signs of distress. The court approved a settlement of $285 million, which will be returned to harmed investors.

Deutsche Bank AG – The SEC charged the firm with filing misstated financial reports during the financial crisis. Deutsche Bank agreed to pay a $55 million penalty.

Goldman Sachs – The SEC charged the firm with defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter. Goldman agreed to pay a record penalty in a $550 million settlement and reform its business practices.

J.P. Morgan Securities – The SEC charged the firm with misleading investors in a complex mortgage securities transaction just as the housing market was starting to plummet. J.P. Morgan agreed to pay $153.6 million in a settlement that enables harmed investors to receive all of their money back.

Merrill Lynch – The SEC charged the firm with making faulty disclosures about collateral selection for two CDOs that it structured and marketed to investors, and maintaining inaccurate books and records for a third CDO. Merrill Lynch agreed to pay $131.8 million to settle the charges.

Even though penalties ordered or agreed to as a result of misconduct surrounding the financial crisis exceed $1.9 billion, the fines paid by these firms and others amounted to little more than a slap on the wrist.Many believe it’s back to “business as usual” for them.

Perpetuating a belief in an expertise that doesn’t exist

That “business” means persuading you to give them your money to “manage.” This is no mean feat. The data is overwhelming that the securities industry does not have the expertise to “beat the market” reliably and consistently. A recent Standard & Poor’s Indices Versus Active (SPIVA) scorecard found that over the one-, five- and 10-year periods ended Dec. 31, 2014, more than 80 percent of large-cap actively managed funds failed to deliver incremental returns over the benchmark.

Think about that information. The S&P 500 index consists of the 500 largest and best-known publicly traded companies in the United States. To “beat the benchmark,” all active managers have to do is overweight the winners and underweight the losers. As my colleague, Larry Swedroe, recently noted, 2014 gave them plenty of opportunity to do so. There were vast differences in the returns of the 10 best-performing and the 10 worst-performing stocks in the index that year.

If active managers had skill, surely more than a small minority would have been able to identify the “winners.”

Better alternatives

As I previously discussed, investors familiar with this hustle have a far better alternative. They can simply refuse to entrust their money to those with no demonstrated expertise. Instead, they can choose to become evidence-based investors and capture global returns using low management fee index funds.

This prospect is Wall Street’s worst nightmare. It has marshaled its vast resources and is fighting back witharticles extolling the purported benefits of active management.

Meritless advice

Jim Cramer leads Wall Street’s charge. Here’s the “advice” he gave in a September 2015 article to those just starting out on their investment journey. It’s so irresponsible that I want to quote it.

Cramer is credited as saying that he believes a diversified portfolio of five to 10 individual stocks is the best way to maintain a portfolio.

The article then goes on to quote him directly: “Now, before you start picking stocks, you need to forget everything you’ve ever heard about that classic piece of so-called investing wisdom, buy and hold. We don’t buy and hold here on ‘Mad Money’ — it’s a great way to lose your shirt.”

As usual, Cramer referenced no data to support these views. In reality, the latest research indicates that, for investors in U.S. equities, to be confident of reducing 90 percent of diversifiable risk 90 percent of the time, the number of stocks required is, on average, about 55. In times of distress, it can increase to more than 110 stocks.

Investors can easily reduce risk through appropriate diversification by purchasing low management fee index funds.

Cramer’s observation that a “buy and hold” strategy is “a great way to lose your shirt” is also belied by the evidence. For the period from Dec. 31, 1993 through Dec. 31, 2013, the average investor had an annualized return of about 2.2 percent. Investors who “bought and held” an index fund tracking the S&P 500 earned 8.5 percent, less the low management fees charged by the fund.

Ironically, the best way to “lose your shirt” might be to follow Cramer’s stock picking advice. In a well-reported debacle, on April 6, 2015, Cramer gave his hapless viewers a list of 49 stocks to “buy right now.” Six months later, only 28 percent of them closed higher than their April trading price. In just six months, investors who followed Cramer’s advice lost 7.09 percent of their money.

Once you recognize that Cramer and many others in the financial media are just shills for an industry that wants you to chase returns, buy and sell stocks and bounce in and out of the market, you will have made a giant step toward investing in an intelligent, responsible — and evidence-based — manner.

This commentary originally appeared December 8 on HuffingtonPost.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.


 

Dan Solin is director of investor advocacy for the BAM ALLIANCE.

Dan is a New York Times bestselling author. His latest book, The Smartest Sales Book You’ll Ever Read, was just released.

The author of several books on investing, his Smartest series includes:

• The Smartest Sales Book You’ll Ever Read
• The Smartest Investment Book You’ll Ever Read
• The Smartest 401(k) Book You’ll Ever Read
• The Smartest Retirement Book You’ll Ever Read
• The Smartest Portfolio You’ll Ever Own
• The Smartest Money Book You’ll Ever Read

In addition, he writes financial blogs for The Huffington Post, Daily Finance, Advisor Perspectives and USNews.com.

Dan is a graduate of Johns Hopkins University and the University of Pennsylvania Law School.


 

Jason No Comments

12 Books Every Investor Should Own

Larry Swedroe, Director of Research for the BAM ALLIANCE 1/7/2016

Does reading more books appear on your list of New Year’s resolutions? If so, check out this excellent guide to 12 great books that every investor should own and pick up Larry Swedroe’s “The Incredible Shrinking Alpha” in 2016.

Find it on USNewsandWorldReport.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 Hoffman & Associates, Inc. or the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.

Jason No Comments

The Most Valuable Asset is Yourself

Carl RichardsYears ago, my colleagues and I conducted a fairly large-scale research project. We interviewed a bunch of high-income professionals who provided professional services. This group included doctors, dentists and lawyers, and like most of us, they earned money only when they were working. In essence, they traded their time for dollars.

Our finding was this: Homes and retirements accounts aside, the most valuable asset they owned was the person staring back at them in the mirror each morning. Chances are, the most valuable investment you own is the investment called you.

A more technical way to think about it is that the most valuable asset you own is the present value of your future earnings. But here’s the problem: Despite what your spouse may tell you, the investment called you is getting less valuable with every year that passes.

It’s nothing personal. I’m sure you’re great. But this is simple math. Every year that goes by means you have one fewer year to earn money. If I were to sketch this for you, it would look like this.

Traditional financial planning spends almost no time on this issue. Instead, the traditional financial services industry focuses on getting you to take as much money as you can and put it into other investments, like mutual funds, stocks and hedge funds. That’s all fine and, to be clear, a very important part of your overall plan. But far more needs to be said about the investment called you.

One person doing some fascinating work on this topic is Joshua Sheats at his site, Radical Personal Finance. If you’re interested in this subject (hint: you should be), you might want to check out his more technical treatment.

But for this column, I want to focus three ways you can think about this.

The Beginning

Make your starting salary as high as possible. Remember that friend from high school who had a great summer job? At the time, he made what seemed like a lot of money. Everyone was jealous. Then when you headed to college in the fall, your friend’s summer job turned into a full-time job. Why would he quit making money to go to college? But you put in the time and graduated a few years later.

Now your friend is a supervisor, but you’re a doctor. By investing in education and training, you increased your starting point and initial value. Obviously, not all us of really want to become doctors, but you get the idea. In the beginning, don’t let short-term rewards get in the way of increasing your long-term value.

The Middle

Make more money each year. Yes, I know this advice is obvious. But rather than being satisfied with just the annual cost-of-living adjustment, look for ways to increase your value where you work. Pick up new skills. Take extra classes and projects that no one wants. Don’t settle for doing just enough. To borrow a phrase from the author Cal Newport, make yourself so valuable they can’t ignore you.

Outside of your 9-to-5 job, find a side gig if you can make time. What could you do to earn an extra $1,000 each month? What happens if you start earning enough to cover your mortgage? What happens if you build a business that earns more than your regular job? This phase reminds me of Aesop’s fable about the ant and the grasshopper. Do a little more today and avoid being the grasshopper.

The End

Make your working window longer. Look, I know most of us really like the idea of retiring, but it’s a myth. Most people don’t simply work their guts out until 60, then suddenly pull that plug and put on the golf shoes. People are living longer, and you might be facing a very boring 20 or 25 years without work.

You can only golf so much.

Instead, most people find they still want to be doing something. Contributing value to the world. Working. So plan on it (and invest in your health too, so you’ll still be physically capable of working).

But think of this side hustle as an opportunity to do something you love to do. Maybe it looks a bit more like this: You work at your day job until 55 and then slow down a bit. You do more of the work you love. Maybe you’ve always wanted to be a teacher, or perhaps you’d really love to become a guide at your local botanical garden. Whatever the work, it lengthens your overall line.

You may love the job you’re doing now, but your employer might have a set retirement age. Could your value be so great that they might consider working with you as a consultant for a few more years? Adding a little time at the end will give your line another upward bump.

These are just a few of the ways we can invest in ourselves. And by now, you’ve probably thought of a dozen things you can do that are unique to your own life. If you’re willing to share, I’d love to hear your ideas. You can find me on Twitter @behaviorgap or send me an email, carl@behaviorgap.com. Just don’t ever forget that more we invest in ourselves today, the more valuable we become over time and the less we need to worry about that line on the chart.

This commentary originally appeared December 14 on NYTimes.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.

© 2015, The BAM ALLIANCE

Jason No Comments

Rising Rates Don’t Doom REITs

Swedroe-headshotAs we have discussed many times, much of the “conventional wisdom” on investing is simply wrong. For our purposes, we can define conventional wisdom as those ideas that become so commonly accepted that they go unquestioned. Today we’ll look at the idea that rising interest rates would doom returns to real estate investments, specifically the returns to real estate investment trusts (REITs).

This assumption, that returns from REITs will indeed tank if interest rates rise, is one I have been hearing a lot about lately as people speculate on the future actions of the Federal Reserve and projections for short- and long-term rates. This speculation seems to have reached even higher pitch (it that’s possible) ahead of the Dec. 16 meeting in which the Fed is expected to decide to raise interest rates.

As regular readers of my books and blog posts know, my writing isn’t based on my personal opinions, or anyone else’s for that matter. Instead, it is built upon findings from academic research, data and the historical evidence. However, before we dive into the data on interest rates and REIT returns, there’s an important point we have to cover, and that’s the difference between information and value-relevant information.

Information Vs. Value-Relevant Information

If you have information you think should impact the market—unless it happens to be inside information, on which it’s illegal to trade—that information is already embedded in the market’s prices. Thus, if the market expects interest rates to climb, the impact from rising interest rates is already reflected not only in the current yield curve, but also in the prices of REITs. It’s already too late to act on such information, because while it may be important information to have, it’s not “value-relevant” information.

To see evidence of the market’s expectation regarding rising interest rates, just examine the current yield curve. It’s about as steep as the historical average, with the difference between one-month bill rates and 10-year Treasurys now at about 2.3%.

With this understanding about the difference between information and value-relevant information, we can now turn to the evidence on the relationship between interest rates and REIT returns.

The Relationship Between REIT Returns And Interest Rates

To determine whether the conventional wisdom on the relationship between REIT returns and interest rates is correct, we can check the historical correlation of the returns between the Dow Jones U.S. Select REIT Index and five-year Treasury bonds.

For the period January 1978 to October 2015, the monthly correlation of returns was actually a positive 0.076. If we look at quarterly correlations, for the period January 1978 through September 2015, the correlation was 0.089. The semiannual correlation for the period January 1978 through June 2015 was even lower, at 0.023. And the annual correlation from January 1978 through December 2014 was lower still, at just 0.019. With correlations of close to zero, there’s really no basis for the belief in the conventional wisdom that rising rates are bad for REITs.

For another example of how the conventional wisdom associating rising interest rates with poor returns from REITs can be wrong, let’s look at some additional historical data. Specifically, let’s examine returns to the Dow Jones U.S. Select REIT Index during the last period of rising interest rates. The Federal Funds (FF) rate bottomed out on June 25, 2003, at 1%. Over the next several years, the Fed kept raising the FF rate until it peaked at 5.25% on June 29, 2006. On June 25, 2003, the five-year Treasury note was yielding 2.3%. On June 29, 2006, the yield had risen 2.9 percentage points to 5.2%.

How did REITs perform during this period of sharply rising rates? From July 2003 through June 2006, the Dow Jones U.S. Select REIT Index returned 27.68% per annum, providing a total return of 108.15%. During the same period, the S&P 500 Index returned 11.22% per annum, providing a total return of 37.57%.

Consider The Source

If rising rates are supposed to be bad for REITs (and for stocks in general), why did they produce such great returns? The reason is that the impact of rising rates on REIT returns depends on the sources of those rising rates. If rising rates reflect strong economic growth, then the expected returns to REIT investments might also be good.

This could be a reflection of stronger demand, as well as the likelihood of a falling risk premium, which causes valuations—for example, price-to-earnings ratios—to rise.

On the other hand, if interest rates are rising because inflation is growing faster than expected, the markets could become concerned that, in order to combat inflation, the Fed could begin tightening monetary policy. That would likely put a damper on economic growth, and probably cause a rise in the risk premium, which causes valuations to fall.

So we see that there are some periods where rising interest rates are more likely to be good for REITs, and some periods where rising rates are more likely to have a negative impact. That explains why the correlations have been close to zero over the long term.

The takeaway here is that, once again, we see that just because something falls under the conventional wisdom doesn’t make it correct. Hopefully, the lesson learned is to not simply accept the conventional wisdom as fact, but to question it and ask for the evidence supporting it.


This commentary originally appeared December 9 on ETF.com

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