Passive, Index investing - Modern Portfolio Theory, The Power of Asset Classes

1. The Basics of
Asset Class Investing
Copyright 2008, Abacus Portfolios, LLC. Used with Permission.
Stakeholders Capital is a registed investment advisor.
Abacus Portfolios, LLC is a registered investment advisor.
1

2. A Revolutionary Idea
Markets work. Risk and return are related.
Capital markets do an excellent job of factoring all The compensation for taking on increased levels of
available information and investor expectations into risk is the expectation of earning greater returns.
the prices of publicly traded securities.
(There’s no such thing as a sure bet. The more risk
(In plain talk - Everything that anyone knows has you take, the bigger the potential payoff.)
already affected the stock price. There’s no point in
trying to outwit millions of other people.)
Portfolio structure explains
performance.
Diversification is key.
The asset classes that comprise a portfolio are
Comprehensive, global asset allocation can neutralize
responsible for 94%* of the variability of portfolio
the risks specific to individual companies, industries,
returns.
investment styles, and countries.
(We’ve identified that risk causes long term returns,
(Said another way, seed your garden with plants that
everything else is random noise and luck.)
will bear fruit in each of the four seasons.)
* Source - Brinson, Hood, Beebower (1991)
That’s the theory, but what do you do about it?
2

3. Three Ways to Invest in Stocks
Asset Allocation Stock Selection Market Timing
Deciding which CLASSES OF Predicting which INDIVIDUAL Predicting WHEN to get in or
THE STOCK MARKET (large STOCKS within each asset class out of the stock market or
stocks, small stocks, value stocks) are going to perform better than certain asset classes based on
your money should be invested in others based on research, research reports, economic
for the long run. company visits, recent forecasts, or world events.
performance, or a hunch.
This chart shows which Stock Selection Asset Allocation is
philosophy various investors is more important more important
and advisors follow.
Market
(Based on internal research)
Financial press
Timing is Almost nobody
Most retail investors
Which do you believe in? possible
Most academic research
Market 94% of mutual funds*
ACTIVE MANAGEMENT
Timing is Reputable stockbrokers 35% of institutions
futile Most money managers Abacus
PASSIVE MANAGEMENT
* Sources: Ibbotson Associates and Morningstar, Inc. - Morningstar data as of 12/31/2007
Now, let’s look at Active vs. Passive Management
3

4. Who Can Beat the Market?
There are about 25,000 mutual funds currently trading in the U.S., and 94% of them are actively-managed.
Thi s means that they employ stock selection and/or market timing in an attempt to “beat the market”.
These mutual funds hire the best and brightest of the nation’s business school graduates, spend enormously
on sophisticated computer systems, and employ just about every technique imaginable to add to their
returns. How have they done at achieving their goal of beating the market?
Percent of U.S. Large Stock Funds that Underperformed the S&P 500 Index
100% Sources: Ibbotson Associates and Morningstar, Inc. - Morningstar data as of 12/31/2007
93% 95% 90% 93% 91%
88% 86% 86%
83%
75% 78% 78%
67% 69% 68% 66%
64% 61%
58%
50% 54%
52%
25%
0%
88
89
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
19
19
19
19
19
19
19
19
19
19
19
19
20
20
20
20
20
20
20
20
In the past twenty years, never has a majority of active U.S. large growth funds beat the S&P 500.
It doesn’t work in general, but some people can do it, right?
4

5. How To Pick a Winner
Ten Years Subsequent Three Years
Here’s one strategy. Divide up your money and give it
1994-2003 2004-2006
to the highest performing mutual fund managers who
Average Average
Rank % Rank Rank % Rank
Return Return have the highest overall returns for the past ten years.
1 1% 20.62 595 60% 9.29
As this chart shows, even if you employed a strategy of
2 1% 20.16 346 35% 11.88 buying the decade’s top ten funds, the likelihood is that
none of them would be among the best performers
3 1% 19.58 974 99% 1.54
going forward. In this case, only four of them could
4 1% 18.17 606 62% 9.23 beat the S&P 500. One of them was ranked 974 out of
5 1% 17.78 449 46% 10.63 985. And on average, they earn 1.6% less than the
index, a huge amount of underperformance.
6 1% 17.52 380 39% 11.43
So, you can’t rely on skill...
7 1% 17.41 756 77% 7.67
8 1% 17.34 933 95% 4.78
What’s an investor
Fund names in initial rank order
9 1% 17.26 496 50% 10.25 1 Calamos Growth A
2 Vanguard Health Care
supposed to do?
10 1% 17.00 352 36% 11.82 3 Fidelity Select Electronics
4 Fidelity New Millennium
5 Alger MidCap Growth Institutional I
Average 18.28 589 60% 8.85 6 FPA Capital
7 Legg Mason Value Prim
8 Eaton Vance Worldwide Health Sci A
S&P 500 11.07 10.44 9 Wasatch Core Growth
10 Janus Small Cap Val Instl
# of funds in study 1121 985
For illustrative purposes only. Mutual fund data provided by Morningstar; includes funds in “domestic stock” category with inception dates before January 1994, distinct portfolios only. Universe in subsequent period includes
only surviving funds. Some fund returns and rankings may have been corrected by Morningstar since the data was first published; however, the original data is shown without alteration, in order to illustrate the information
that would have been available at the time. The S&P data are provided by Standard & Poor's Index Services Group.
Indices are not available for direct investment; therefore their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
5

6. Don’t Trust Your Emotions
The Gallup Index of Investor Optimism is a measure of how confident the typical investor is at a given
point in time. Can’t we use overall investor confidence as a guide? What that means is that typically,
investors feel most confident and
Score Date What Happened Next?
buy when the market is at its peak,
Highest Score
178 January 2000 Dot Com Bubble Burst.
and feel most scared and sell when
(most optimistic)
the market is at its lowest point.
Lowest Score
5 March 2003 Best 9 month return in decades
(least optimistic) That’s buying high, and selling low.
A study, done by the research firm DALBAR, Inc., compared $100,000
actual returns earned by individual investors over 20 years
$75,000
with a few popular market indexes over that same time frame.
ANNUALIZED $50,000
INVESTMENT
RETURN
S & P 500 Index 11.9%
$25,000
Average Equity Mutual Fund Investor 3.9% S&P 500
Inflation
Inflation 3.0%
Avg Investor 20 Years
1/1/1986-12/31/2005, Dalbar, Inc.
OK, Passive Investing
Starting with $10,000, after twenty years the average
sounds great...
equity mutual fund investor ended up with $21,493.
The same amount invested in the S&P 500 ended with $94,754!
Are you sure it works?
6

7. Results of Basic Indexing
How does a index strategy stack up against the pros? The following graph compares a very basic asset
allocation (60% S&P 500 index & 40% bonds) to 192 large corporate pension plans from 1988-2005.
1616 Selection of included
Corporate Pension Plans
Basic
1414
As the graph for this 60/40
Anheuser-Busch Cos., Inc.
Strategy
performance period 1212 Avista Corp.
Cooper Industries, Inc.
Annual Average Returns (%)
demonstrates, a basic
Delta Air Lines, Inc.
1010
index strategy does Edison International
FirstEnergy Corp.
better than 70% of 88 Goodyear Tire & Rubber Co.
professionally managed Ingersoll-Rand Co. Ltd.
66 IBM Corporation
pension plans. Jefferson-Pilot Corp.
44 Lincoln National Corp.
Sherwin-Williams Co.
22 Sunoco, Inc.
SunTrust Banks, Inc.
00 UAL Corp.
Union Pacific Corp.
Company 130
Company 160
Company 170
Company 120
Company 140
Company 150
Company 180
Company 190
Company 100
Company 192
Company 110
Company 30
Company 60
Company 70
Company 80
Company 90
Company 10
Company 20
Company 40
Company 50
Verizon Communications, Inc.
Basic 60/40
Company 1
VF Corp.
West Pharmaceutical Svcs., Inc.
Williams Cos., Inc.
Wolverine World Wide, Inc.
Basic 60/40 is 60% S&P 500 Index, 40%
Lehman Brothers US Government/Credit
I’m sold, but why would I pay an Bond Index Intermediate, rebalanced monthly.
Source: FutureMetrics (December 2006); all
companies with fiscal year ending December,
with complete return data from 1988-2005.
The S&P data are provided by Standard &
advisor for such a simple strategy? Poor’s Index Services Group. Lehman
Brothers data provided by Lehman Brothers,
Inc.
7

8. Beyond Basic Indexing
So we see that even a bare bones basic passive strategy beats the majority of the most advanced institutional
active investment portfolios run by the best and brightest investment advisors.
What happens when you go beyond a basic strategy to a more diversified passive strategy?
Asset Class Diversified Portfolio
Quarterly: 1973-2006
Annualized Annualized
Compound Standard
Merrill Lynch One-Year US Treasury Note Index
Return Deviation
Fama/French International Value Index
(Reward) (Risk)
Dimensional International Small Cap Index
S&P 500 Index
Basic 60/40 Portfolio 10.31% 10.94%
CRSP 6-10 Small Cap Index
Fama/French US Small Value Index
Diversified Passive 12.22% 10.76%
Fama/French US Large Value Index
60/40 Portfolio
Your risk (standard deviation) decreases, and your annual return increases.
Lehman Brothers data provided by Lehman Brothers, Inc. The S&P data are provided by Standard & Poor’s Index Services Group. The Merrill Lynch Indices are used with permission; copyright 2007 Merrill Lynch, Pierce, Fenner & Smith
Incorporated; all rights reserved. CRSP 6-10 Index data provided by the Center for Research in Security Prices, University of Chicago. US Small Value Index and US Large Value Index provided by Fama/French. International Value Index provided
by Fama/French (January 1975-December 2004) and MSCI EAFE Index (net dividends, January 1973-December 1974). MSCI data copyright MSCI 2007, all rights reserved; see MSCI disclosure page for additional information. International Small
Cap Index: 1970-June 1981: 50% UK small cap stocks provided by Hoare Govett and 50% Japan small cap stocks provided by Nomura Securities; July 1981-present: compiled by Dimensional from StyleResearch securities data; includes securities
of MSCI EAFE countries, market-capitalization weighted, each country capped at 50%; rebalanced semiannually.
Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio.
Past performance is not a guarantee of future results. Not to be construed as investment advice. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not represent actual
investment performance.
8

9. Words of Wisdom
“Most investors, both institutional and individual,
will find that the best way to own common stocks is
through an index fund that charges minimal fees.”
- Warren E. Buffett
Chairman, Berkshire Hathaway Corporation “The greater the trustee’s departure from one of the valid
passive strategies, the greater is likely to be the burden of
justification and also of continuous monitoring.”
Third Restatement of Trusts: Prudent Investor Act
“All the time and effort that people devote to
picking the right fund, the hot hand, the great
manager, have in most cases led to no advantage.”
- Peter Lynch
“The reality is you don’t need to understand
Portfolio manager for the Fidelity
any of the complex aspects of the stock market.
Magellan fund from 1977-1990
You don’t need to own stocks. You need to own
the stock market.”
—John Bogle, founder of Vanguard Funds
9