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KESSLER: TREASURY BOND CONTRARIAN TRANSCRIPT

July 10, 2015

On this week’s WEALTHTRACK, our guest is taking on the Wall Street consensus. The overwhelming sentiment from economists, analysts and strategists is that the great bond bull market, particularly in U.S. Treasuries, is over. Treasuy bonds have been described as extremely overvalued, risky and undesirable. Not so says global bond manager Robert Kessler. He is sticking with his decade long, bullish view on Treasuries and says the Federal Reserve is in “no position to raise interest rates.”

CONSUELO MACK: This week on WEALTHTRACK, rock climbing bond manager Robert Kessler continues to chart his own course and reach for U.S. Treasury bonds, while other investors say they are too risky to own. Why Kessler says Treasuries are the safest route in a treacherous climate, next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. Ever since WEALTHTRACK was launched ten years ago Wall Street has consistently gotten one prediction wrong. How many times have you heard economists, analysts, strategists, columnists and yes even Federal Reserve officials warn us to prepare for rising interest rates?

The overwhelming sentiment has been that the great bond bull market, particularly in U.S. Treasuries was over. Treasury bonds have been described as extremely overvalued, risky and undesirable.

And on occasion they appeared to be right. There have been several periods, some recent when yields have gone higher, or “backed up”, as they say in the bond world.

The one lone and dependably contrarian voice against this anti- Treasury chorus has been a WEALTHTRACK guest since the beginning. He was correct back in 2005. He has been through the years since, and he might prove to be right still.

He is Robert Kessler, Founder and CEO of Kessler Investment Advisors, a manager of fixed- income portfolios with a specialty in U.S. Treasuries, for institutions and high net worth individuals globally. Now for years Kessler and his team have been tracking several indicators that continue to convince them that rates will remain low. One is not widely followed by the public, but it is by Federal Reserve officials. It’s called the “Output Gap” and it measures the difference between the economy’s actual growth and its potential. In this case between real GDP, that’s ex-inflation and the congressional budget office’s measure of potential GDP growth. The gap is currently about 2.5%.

For an economy growing around 2.2% throughout the recovery that slack in the economy is sizable. As the New York Fed wrote recently: “Resource slack by this measure seems larger than that implied by most estimates of the unemployment gap. Historically, inflation tends to be restrained if the economy is operating below potential.”

Restrained it is! Another key piece of evidence cited by Kessler for continued low rates is inflation. As you can see from this chart of a measure of Consumer Price Inflation – in this case the core PCE, or Personal Consumption Expenditure Price Index, excluding food and energy prices, inflation has been running well below the Federal Reserve’s target of 2%.

I began my conversation with Kessler by asking him why, in his opinion, the Fed is in no position to raise interest rates.

ROBERT KESSLER: The Fed would raise interest rates if in fact their mandates were at the levels they should be at, and their mandates are inflation or the stability of rates.

CONSUELO MACK: Prices.

ROBERT KESSLER: Of prices and employment.

CONSUELO MACK: Full employment.

ROBERT KESSLER: Full employment, and employment has gotten a very sticky kind of a basis to it right now because we don’t quite know what full employment looks like when a lot of people are not involved or they’re temporary in the economy. So we kind of leave employment out for a moment and go back to inflation, and since inflation hasn’t reached the target since 2009 almost, it’s very difficult to perceive that the Fed is going to raise rates when, in fact, they’re not even at the mandated area that they want to be at. So when we look at the Fed as to when the Fed will raise, I don’t know, but we do know that until those things actually happen, the Fed probably won’t be raising rates.

CONSUELO MACK: So why is the Fed saying that they are going to raise rates?

ROBERT KESSLER: I don’t think the Fed is exactly saying that they are going to raise rates. What the Fed is really saying is they’re dependent on data.

CONSUELO MACK: It’s data dependent.

ROBERT KESSLER: And the data that we’re talking about would be as Mr. Bernanke used to use and other chairmen of the Federal Reserve have commented that they use the PCE deflator, personal consumption expenditures. And whether you look at the headline number which includes energy and food or you look at the numbers that would be historically what we’re looking at, they’re not even close to the two percent the Fed would like to see. So when you look at inflation and you say, “Wait a second. Those numbers aren’t there,” and the Fed is data dependent, it’s kind of natural that the Fed would say, “Well, we’re really looking at these numbers, and we believe we’ll get there,” and they have a magic term for this. It really is magical. It’s transient. The number is transient. We really aren’t at that two percent level, but we will be there, and when we get there we’re going to be raising rates. So the marketplace immediately assumes what that will be and …

CONSUELO MACK: And they read the minutes of the FOMC meetings, and they’re seeing that there’s this debate going on, and they’re seeing that there are a sizable number of Fed officials who are saying that we need to raise rates; that we don’t need them to be this low for this long.

ROBERT KESSLER: But we hear this every year.

CONSUELO MACK: Yes, we have heard it every year.

ROBERT KESSLER: And one of the things you and I have discussed is the question of what is normal, because the Fed likes to say, “We’d like to get back to normal.”

CONSUELO MACK: Right, normal levels of interest rates.

ROBERT KESSLER: I’d like to see everything back at normal too. That means normal wages which right now are running at around two percent, 2.2 percent, and that 2.2 percent has been down there for the last five, six, seven years.

CONSUELO MACK: Right. In this recovery.

ROBERT KESSLER: In this recovery. It’s not at three, and it’s not at four which would be normal. It’s at two, so we’re not there with that, and so what’s normal about QE1, QE2, QE3 or stimulus programs we’ve never seen before, and European stimulus programs we’ve never seen before and Chinese stimulus programs we’ve never seen before?

CONSUELO MACK: To this extent, right.

ROBERT KESSLER: If none of this is normal, then we can’t really talk about, well, I think it’ll be normal in September or October or November or December. So I think what happens is the Federal Reserve and its governors walk around and they say, “This is what we’d like to see. We’d like to see something normal,” but that’s entirely different than the reality of what the numbers really are, and it’s our job at least when we talk to public or when we at least have the ability to talk about investments that we talk about reality, not what we’d like to see.

CONSUELO MACK: And so what’s the reality that you’re seeing? I mean, so aren’t we close enough that it could be reasonable to assume that the data is getting close enough for the Fed to raise rates?

ROBERT KESSLER: I don’t mean to disagree with Wall Street which I tend to do a lot.

CONSUELO MACK: A lot.

ROBERT KESSLER: A lot, but we are now at the absurd level of saying we really are looking at a deflationary environment around the world, and we have proof. China just came out and they said our number one that we look at in terms of wholesale inflation is negative four and a half percent, and the kind of retail side of it is negative more than one percent. Well, China is exporting that number to us, meaning they want to sell goods to us cheaper because that’s what their prices are, and they’re competing with Japan who would like to sell them even cheaper, which is not inflationary. It’s cheaper meaning deflationary, and then you have Europe, Mr. Draghi running their central bank saying, “We need to really stimulate and get our currency down so we can export cheaper than them.” So you have a whole global marketplace trying to export to everyone else lower and lower prices. That hardly sounds like inflation. So we have kind of this vested interest in the United States. We love to talk about inflation, but there really isn’t any.

CONSUELO MACK: Right. And the vested interest, tell me, because as you said you do disagree with Wall Street a lot, and one of the things, a faulty assumption that you’ve mentioned to me is that the Fed needs to raise interest rates to a normal level. So we don’t really know what normal is, or do we? I mean is there a normal level that you see that the Fed or at least Wall Street doesn’t see?

ROBERT KESSLER: I think you look to see why someone’s saying something. You have bankers all over Wall Street telling you we need to raise those rates. Well, why do they say that? They make a lot of money if rates go higher. And if you own those financial stocks, you’re going to do better. Well, I don’t happen to own those financial stocks, and I’m not a believer in JPMorgan and Citicorp and the rest of them. So you have to look and say, well, that’s what they really want. They want you to raise rates.

CONSUELO MACK: But looking at the data, Robert, at Kessler Investment Advisors, where should Fed funds be, and where should the 10-year Treasuy rate be looking at the data that you look at?

ROBERT KESSLER: Now you get into the complicated question of should we be looking at the Taylor Rule which is a methodology that John Taylor came out with that has validity, but all of these numbers really require that you put the proper input into them, and most people decide to put the input that they want.

CONSUELO MACK: So when you put the input in, though, what numbers are you getting?

ROBERT KESSLER: Then we would come out with minus one and a half to a half of one percent.

CONSUELO MACK: In the Fed funds rate.

ROBERT KESSLER: In the Fed funds rate. How could you possibly think in a world that everyone is trying to stimulate enough to move things along that we want to raise rates? We have so many countries now for the first time. We talk about normal. So many countries with negative interest rates.

CONSUELO MACK: Negative rates. Right. Exactly, and the sovereign debt of France and Germany.

ROBERT KESSLER: And a lot of people make fun of it. I mean we have bond gurus that argue this is the craziest thing. Of course it’s the craziest thing. On the other hand, it’s there. Rates don’t go negative unless there’s a reason for that, and the answer is which is the problem right now in the whole global economy. There’s too much supply and very little demand, and everyone wants to sell something to someone who really doesn’t need it, and that’s that excess supply. It’s excess factories. It’s excess real estate in China. It’s excess everything in Europe, and I’ll skip the Greek situation because whatever way it gets resolved, Greece will still have the same problems.

CONSUELO MACK: Too much debt.

ROBERT KESSLER: Too much debt.

CONSUELO MACK: Too many obligations.

ROBERT KESSLER: It’s interesting to people who should be watching. The best thing to own when there’s too much debt and deflation is cash because cash takes on greater and greater value, and debt gets worse and worse and worse. That’s why people want inflation. Wow. If I can get the price of my house up, who cares about the debt? And if I can get the value of anything up, commodities, interest …

CONSUELO MACK: You inflate your way out of debt.

ROBERT KESSLER: An interesting thing about commodities which we noticed the other day, the industrial commodities …those are the five, I’ll use industrial commodities in terms of metals.

CONSUELO MACK: So copper.

ROBERT KESSLER: Copper, aluminum, all those things that we need to use. They’re making five-year lows. If things were getting better, why are they making lows? And they’re not the only ones. The CRB index which uses agricultural products as well, they’re making lows too, or they’re bouncing around on their lows. So the argument that, in fact, things are really getting better, we need to raise rates because of inflation, where? And this whole complicated process revolves back then to Wall Street, and Wall Street says, “We need to raise rates, because if I tell you we’re going to raise rates because things are getting better, you’ll buy more stocks.”

CONSUELO MACK: The end of the bull market in Treasuries which many in Wall Street, most in Wall Street have been saying now for as long as I can remember, certainly the last six years at least. You have been saying the opposite. So why isn’t it the end of the bull market in Treasuries?

ROBERT KESSLER: This end of the bull market is almost on the absurdity now because every two years Bill Gross, Jeffrey Gundlach, someone comes out and says it’s the end of the bull market, and then of course we make another new low in the Treasury market. There’s no such thing as a bull market or a bear market in Treasuries. Treasuries are simply something that are guaranteed by the United States government. You don’t need to buy a 10-year or a 30- year Treasury. Treasuries represent cash, and there’s absolutely no logical reason why you don’t own some Treasuries, and the best way to own them depends on really what your horizon is in owning them. That’s all.

CONSUELO MACK: So since 2000, S&P 500 4.4 percent annualized returns, 30-year U.S. Treasury 7.6 percent annualized returns. The last six years, the S&P 500 was 22.3 percent annualized returns. Over the last 40 years I remember looking at the statistic, and Treasuries have outperformed stocks by a very wide margin. We never should have invested in stocks. We should have been in Treasuries. It was a bull market.

ROBERT KESSLER: This is an argument that shouldn’t be made. You shouldn’t be comparing Treasuries to the S&P index. It becomes a little bit …

CONSUELO MACK: Except if you’re looking at appreciation, it sure has worked.

ROBERT KESSLER: Treasuries represent a part of a portfolio that is absolutely 100 percent secure. It also represents a part of a portfolio that’s a hedge against terrible things that always happen. Believe me. They will keep happening, and Treasuries represent that, and at the same time as you point out, there are periods of time that Treasuries really outperform as an investment. Those are three good reasons, all of which…

CONSUELO MACK: Especially if interest rates start at whatever, 18 percent and go down to …

ROBERT KESSLER: So Treasuries shouldn’t be either/or. Treasuries are a part of the approach to investing that virtually every major institution really has. It’s just that it’s not convenient for Wall Street to want to sell something that really appears to be … well, what the heck. I give you a very good example. Usually people who buy long-term Treasuries or Zero Coupon Treasuries which we’ve talked about on this show, once they put it into their portfolio, they tend not to do anything with it.

CONSUELO MACK: They just forget about them and wait until maturity.

ROBERT KESSLER: They just forget about it. Now that is not a good idea if you’re selling someone stocks. You don’t want someone to put it over there and not turn it over. We like to think we keep things long term.

CONSUELO MACK: Longer term.

ROBERT KESSLER: We are long-term players when we advise on portfolios, so surely some place in your portfolio you want a riskless entity. Riskless because you’re not saying it’s an investment. It comes under the savings, and the traditional way to look at savings is you want the money back. You’re not interested in how much you make, and so there is a part of your portfolio for that purpose.

CONSUELO MACK: But shouldn’t we distinguish between let’s say a one or a two-year Treasury note as savings that you’re going to get your money back in one and two years between a 30-year Treasury bond which has tremendous … they call it duration … long duration, tremendous interest rate risk.

ROBERT KESSLER: Sure, and if you ..

CONSUELO MACK: Because many people don’t hold something for 30 years and just waited for it to mature. I mean that is considered to be a fixed-income investment.

ROBERT KESSLER: But you have no hesitancy or someone has no hesitancy to recommend a stock which is not 30 years. It’s 1,000 years. You don’t buy a stock and say, “Oh my god. It’s going to pay off in two years.” You own it indefinitely until you sell it.

CONSUELO MACK: But realistically an investment time horizon for a bond is … most people don’t hold anything for 30 years, at least eight.

ROBERT KESSLER: Most people don’t own stocks for an indefinite period of time.

CONSUELO MACK: No, they don’t.

ROBERT KESSLER: And so I think when you look at the 30-year Treasury, it’s simply because it has more opportunity if you believe rates are going to either stay where they are, or they’re going to drop.

CONSUELO MACK: Right, and you do believe that. And for instance I was looking at a prediction that you made, and I think it was that the 30-year Treasury, you think the yield’s going to drop to two percent or below, and the 10-year at one percent or below. I mean that’s just completely contrary to what everyone else on Wall Street is saying.

ROBERT KESSLER: You know you have Switzerland with negative rates, a reputable country. You have Germany, 0.85 their 10-year Treasury. You have rates all around the world that are dropping because of the deflationary events we’re looking at. Why would one assume that at two and a half or three and a half percent or three and a quarter percent for the 30-year Treasury that it’s not dropping to two? And the only reason you’re, “Oh, no. It can’t drop to two,” is because everyone’s telling you it can’t.

CONSUELO MACK: And the premise is that the U.S. economy, it recovered sooner. It is a stronger recovery than the one that’s happened in Europe. Not true?

ROBERT KESSLER: The U.S. economy, which we all agree, is by all measures recovering at the slowest pace it has ever done since any period of time.

CONSUELO MACK: But it’s still faster than what’s happened in Europe for instance, and Japan.

ROBERT KESSLER: And by that same definition it sells at a much higher rate. The assumption that most people are making is we know the rates are going up. So why would you own that? Now I’m not making that assumption obviously, but why not just make the assumption that if the rates aren’t going up and there’s absolutely nothing but a deflationary environment that we’re looking at all over the world, since when does the United States decouple, get away from every other country in the world? Are we so much of an island that we …? And the answer is, we were the first to put this big stimulus plan into effect. So we recovered a little bit better.

The trouble is when you take away the stimulus, we suddenly find out we’re not recovering much at all, and we call it the Output Gap, and the Output Gap right now in the United States is about two and a half percent, and what’s interesting about that is if we continue to grow at two percent where we are right now, it will take us into about 2022 or 2023 before we catch up and then you can raise some rates. If we grow at three percent, that would be better. About 2018. Oh, but we’re not growing at three percent.

The world has a serious problem. It’s our job it seems to me, without being disingenuous, and I think it is disingenuous to sit here and tell people things are better than they really are. It’s nice that they appear to be getting a little bit better, but even wage growth which you and I briefly mentioned …

CONSUELO MACK: That anecdotally we’re seeing the minimum wage raised in certain states. We’re seeing Wal-Mart raising it’s minimum wage.

ROBERT KESSLER: We are growing on a wage growth, any way you look at it, at about 2.2, 2.3 percent.

CONSUELO MACK: Annualized.

ROBERT KESSLER: Annualized, and we should be looking at close to four. So we’re not at four. We’re at 2.2. That’s not any kind of wage growth. Yeah, it’s better than one, but it’s really nothing, and so when we hear that Wal-Mart may be raising the minimum wage or Seattle is … on a meaningful basis to the United States, to the country, you’re looking at 30 years of wages going down. We’re finally getting a number maybe that’s hardly acceptable but slightly going up. Is that good? Yes, of course it’s good. Am I optimistic about the future of China and about the future of the United States? Of course I am.

CONSUELO MACK: Eventually.

ROBERT KESSLER: It’s a timing question. CONSUELO MACK: So here we are almost at the end of our conversation on

WEALTHTRACK, but we are at a position where you don’t think the Fed is in a position because of the slow growth and the disinflation we’re seeing to raise interest rates any time soon despite all the expectations. That the economy is going to be slower than most people think, and the recovery is going to continue to be very tepid. And what about the stock market which we’ve had a six-year bull market?

ROBERT KESSLER: Look.

CONSUELO MACK: How vulnerable is that?

ROBERT KESSLER: The object of me sitting here is not telling you how to play risky assets. The object is to sit here and say there is a lot of risk in the world at the moment.

CONSUELO MACK: And therefore, for a one …

ROBERT KESSLER: Therefore, get cash. Cash is a big deal right now because cash may be worth 30 or 40 percent. How do you get 30 or 40 percent out of cash? The market is going to drop. When it does, and it will, 30 or 40 percent, then you can use some of that cash to buy things. We as investors never are prepared for that.

CONSUELO MACK: And so the One Investment for a long-term diversified portfolio would be to hold some cash. Is that right?

ROBERT KESSLER: I like cash, and every year I always tell you buy long-term U.S. government Treasuries. I would continue to say that, but I think cash is more important, and I think that’s the one thing you’re hearing not to do. Everything Wall Street tells you right now is you don’t want any cash because the alternatives are you don’t get paid anything on cash. You don’t need to get paid anything.

CONSUELO MACK: They don’t get paid anything on cash.

ROBERT KESSLER: You as an investor sit with the cash and you get no money. You have no interest on it, and the answer is, yeah, but you’ll be able to buy everything at some point cheaper, and that’s really important. Last but not least, in a deflationary environment as I just described from China, Europe and the rest of the world, in a deflationary environment cash is more and more and more valuable, and especially now. So I think it’s worthwhile certainly to look at that and say, “Do I have enough cash if the market does what it always will do?”

CONSUELO MACK: Robert Kessler, always a treat to have you on WEALTHTRACK.

ROBERT KESSLER: Thank you.

CONSUELO MACK: And always thought-provoking as well. Thanks.

WINTERS: MARKET MANIA? TRANSCRIPT

July 3, 2015

CONSUELO MACK: This week on WEALTHTRACK, are index funds raging out of control? Are these passive, low-cost funds actually a threat to retirement savings? Wintergreen Fund’s noted value investor David Winters sounds the alarm next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. As we celebrate our tenth anniversary year on WEALTHTRACK we have been taking an in depth look at one of the biggest investment trends for the past decade, the huge migration of both institutional and individual investors from actively managed funds to passive, index- based ones, especially ETFs. As we have reported before, index funds now account for a third of fund assets up from 14% ten years ago.

And recently, Exchange Traded Funds, or ETFs, have seen the lion’s share of the fund flows. As Morningstar has reported, U.S. ETFs have more than two trillion dollars in assets compared to nearly 13 trillion for mutual funds. That means 14% of funds assets are now in ETFs up from a mere 4% ten years ago.

During the current six year bull market index funds have outperformed the vast majority of actively managed funds. In addition the cost benefits of index funds are considered to be overwhelmingly in investors favor, especially when compounded over time.

The asset-weighted expense ratio for passive funds was just 2/10 of a percent in 2014, compared with 8/10 of a percent for active funds. Even investors in active funds are opting for lower cost ones. During the past decade the lowest cost quintile of active funds received $1.07 trillion of the total $1.13 trillion of the net new flows into all actively managed funds. With better performance and lower costs it’s hard to find anyone critical of these developments, but we have one with us today. Not surprisingly he is an active fund manager.

He is David Winters, Chief Executive Officer of Wintergreen Advisers and Portfolio Manager of the Wintergreen Fund which he launched in 2005. Winters was nominated for Morningstar’s International-Stock Fund Manager of the year award in 2010 and 2011. He has been a WEALTHTRACK regular since the beginning because his traditional value –oriented, global approach worked for years. But the last five years have been rough with the fund underperforming its benchmark and Morningstar World Stock category.

I began the interview by asking Winters why he thinks the move to index funds is a dangerous market mania.

DAVID WINTERS: Well, the idea of index funds, Consuelo, is fine, but what’s happened is it’s become this universal truth, and people have poured more and more and more money into index funds and because the way it works is they’re capitalization weighted.

CONSUELO MACK: Why is market capitalization a problem?

DAVID WINTERS: Well, because the more that something goes up, the more you have to buy, and so the stocks that do the best or that are most favored by the market, the index funds buy more and more of, and the companies that are not in favor, for example the companies that are not what we call the bubble tech, biotech stocks, get sold. It’s just the mechanics of it. It’s a computer program.

CONSUELO MACK: So from a value investor perspective as you are at Wintergreen, what are you seeing then? That the most expensive stocks are the ones that are getting the most owned in let’s say an S&P 500 index fund.

DAVID WINTERS: Well, what’s happened in the study that we’ve done, it shows that unless you own the most popular, most expensive securities, you can’t outperform, and so what that does is it feeds into this idea that the index funds are promoting in their marketing that they are inherently superior, but what they’re doing is they’re getting the public, in our opinion, to buy ever more expensive securities and neglect what’s undervalued. Investing is the only business, Consuelo, where people want to buy what’s going up as opposed to get a good deal. Value investing is getting a good deal.

CONSUELO MACK: So another problem that’s less obvious about indexation that you have highlighted, and we have a report that we will link to on our website, WealthTrack.com, is that the concentration of shareholder power in the big index firms, the Vanguards, the BlackRocks and the State Street, I think you said that they hold 16 percent of the shares outstanding of the top 25 companies in the S&P 500. Why is that a problem?

DAVID WINTERS: Well, what it’s done is it’s ended up giving enormous power to a very few number of firms, and so they get to determine, and the voting record is they basically had been voting 90 percent give or take in favor of every pay package. The great managers should get paid, but most of them shouldn’t get paid astronomical fees, and so what you end up losing is this dynamic of the shift of power that it’s in too few people’s hands and, in our opinion, they aren’t using that power to rein in the excesses of what’s going on in these big companies.

CONSUELO MACK: But hasn’t that always been the case? I mean haven’t big institutional investors traditionally voted overwhelmingly for management anyhow? Right? And I don’t know what Wintergreen’s record is of all of the stocks that you hold. I mean you have a focused portfolio, but I don’t know what percentage that you have in voting for management either.

DAVID WINTERS: Well, we’ve tried to find companies that are not excessive in their behavior and …

CONSUELO MACK: So you’ve been choosing them.

DAVID WINTERS: Occasionally we’ve gotten unfortunately surprised like by Coca-Cola last year where they wanted to vote themselves this massive pay package when they weren’t doing well, and so we brought it to people’s attention, and ultimately there were many shareholders who agreed, and the package was withdrawn.

CONSUELO MACK: And why is executive compensation and excessive executive compensation … and that depends on whose point of view you have … why is that a huge problem for you at Wintergreen? Why do you think it’s something that we really need to pay attention to?

DAVID WINTERS: Well, there’s two elements. It’s not only the fee that people are paying for investment managers, and you could say that index funds are low fee, but we argue that they’re actually very high cost because they’ve been rubber-stampers for these massive pay packages, and if you give somewhere between two and four percent of the value of a company away every year as a gift to your buddies or your cronies as the way it looks, what you’re really doing is in 10 years or so the ultimate shareholder has much less and, from a societal perspective, a group of few people have a lot of money, and the American public basically gets left holding the bag.

CONSUELO MACK: Let me go back to the concept of the popularity of index funds being a market mania, and you say it’s akin to something like the nifty fifty, to the tech bubble. Why do you view it that way? Why do you think it’s so dangerous?

DAVID WINTERS: Well, what’s happened, Consuelo, is that the money flows have increasingly gone into the index, and people have been told that the index is it, and again it’s a self-fulfilling prophecy, and it’s a very narrow group of securities that are going up, and increasingly we can tell from the numbers that are reported from the New York Stock Exchange that people are borrowing money, and considering you can tell what people are doing with the money, they’re either borrowing on their mutual funds or on ETFs, and so you’ve got this small group of companies that are very, very richly valued, and if history is a guide sooner or later they pop.

CONSUELO MACK: And so that’s what you think we’re seeing. We’re seeing this funneling into a narrower and narrower group of stocks, and I’m just looking because you call it an illusion of safety and lack of diversification that really worries you, and that Apple, Microsoft, Facebook and Intel for instance comprise 20 percent of the total return of the S&P 500 in 2014, and you think that is a big problem.

DAVID WINTERS: Well, because these are companies that everybody loves and everybody owns, and they believe that they’re going to grow at rapid rates forever. That’s not possible. First of all, they’re big. Secondly, they’re very short-cycle companies. We think a company like Apple, you know, has great products, but it’s an undifferentiated commodity with a six- month life, and everybody’s in love. Anytime, anybody. It’s a crowded trade. Everybody’s in on this. Everybody’s buying it. Everybody believes it. There’s nobody on the other side. There are very few people left doing fundamental value analysis, and so we can find fabulous bargains, and when I’ve seen this before in 2000 and when I’ve read the history of the nifty fifty when I was a kid, it ends in tears.

CONSUELO MACK: But you know, there are great companies, and that’s what you look for as well. Apple has been a great investment, and it’s kind of revolutionized the way that we use technology and revolutionized social media. And is it just that you think now it’s really overvalued?

DAVID WINTERS: Look. I don’t know whether it’s going to double or triple from here, but everybody owns the stock. Everybody believes it’s going to grow at 30 percent every quarter. It’s not possible.

CONSUELO MACK: And this is one of the reasons that you think that for retirees in particular, for retirement portfolios that this index mania, as you call it, is so dangerous. Right?

DAVID WINTERS: Absolutely because you have people who can’t really afford to lose their money are all talking about this and doing it, and it becomes a self-fulfilling prophecy as all the cash goes in. It’s market weighted, and we think again index funds are fine in moderation, but this has become extreme, and you have the other side where you have securities that trade at big discounts that are neglected now because the public and institutions are all doing the same thing at one time. I think it’s a bubble. It’s to the point we think of being irresponsible.

CONSUELO MACK: So of course this creates opportunities for you as a value investor; the fact that the crowd is going in this small group of stocks, and there you’ve got the rest of the world to invest in. So tell us about some of the opportunities that you’re finding that are counter to this kind of a trend that we’re seeing in indexation.

DAVID WINTERS: Well, here in the U.S. we like CSX. It’s a railroad in the southeast. The company is doing better. The management’s doing better. They’ve been tapped on the shoulder at least once, maybe twice by Canadian Pacific. So it’s a special situation. They run the company better. The stock goes up, or they get taken over, and we hope they just run the company better and they do a good job, and it’s a good company. People aren’t interested in CSX. It’s boring. You know? It’s a railroad. So you know we think that by being one of the only ones left who reads annual reports, visits companies, studies assets, that it’s an advantage because when this whole thing begins to unwind, we believe people should be putting at least some of their money in under valuations, not just chasing tomorrow’s dreams.

CONSUELO MACK: If you look at how index funds have done and specifically the S&P 500 index funds, again, which are the largest ones, that over the last six years they have vastly outperformed most active managers, and they certainly have outperformed … I think the S&P 500’s annualized returns over the last five years were something like 14 percent, and Wintergreen’s were like six and a half percent, so a huge outperformance. Why has the gap been so large between Wintergreen and the S&P 500 for instance, David?

DAVID WINTERS: Well, we don’t Apple Computer. We don’t own Intel. We don’t own any of the bubble stocks. We would never even in retrospect have bought them because they always looked expensive to us, and then also people have focused only on U.S. companies, and there’s a whole world out there, and so this has been we think mostly just sentiment driven. You’ve had index funds that have become massive marketers, and they’ve convinced people that these are low fee, which they are, but they’re high cost, and there’s huge concentration in a few number of what we think are very expensive, very dangerous securities, and so it’s our money and our friends’ money, and we’re going to do what we believe is responsible. In 2000 this sort of bubble went on, and everybody was doing it.

CONSUELO MACK: So this feels like that. Right?

DAVID WINTERS: Well, this feels worse because then you didn’t have index funds who were taking all the money and basically buying a small group of securities on a daily basis and pumping the whole thing up and selling off everything else. Then it was just euphoria. This is an institutional bubble that’s become almost a societal bubble that we think is very dangerous, and at some point, for us at Wintergreen the bigger the bubble has gotten, the more hard it is for us to keep up because we own stocks that trade at you know, six times, seven times, eight times earnings that are boring. People want excitement. It’s part of the whole phenomenon.

CONSUELO MACK: Oh, psychology of the markets, and when you’re talking about this, the mania aspects, this is exactly the kind of conversation that we would have had in the late 1990s when basically people capitulated and just said, “You know what? I don’t understand it. I just got to go this way because that’s where everybody’s making money.” So you think it’s going to end badly.

DAVID WINTERS: Well I think, well, except for us, Wintergreen and a few others, everybody’s capitulated. They all believe that indexation and buying the most expensive securities is the only thing to do, and we believe that at some point the whole thing will reverse.

CONSUELO MACK: We’ve been talking about ETFs and indexed funds on WEALTHTRACK over the last 10 years as a matter of fact, and one of the arguments that’s made is that it’s very difficult to pick an active manager that’s going to consistently over long periods of time beat the market because investment styles go in and out. You might have a decade where value is in. You might have a decade where growth is in. What about that argument, that in fact for the average person they’re better off investing in the stock market which does go up over time?

DAVID WINTERS: The problem for most investors is they buy when it’s high and then they panic, and it never works. There are good investors out there. There have been many good investors on your show over the years that if people had been willing to say, “I understand what they do. I believe them,” and they ride it out … nobody always outperforms, and this idea that you can jump from value to hyper-growth to doing LBOs doesn’t work. What does work and all the people I know who are really wealthy in the world did it by investing in a business or in a series of securities and sticking with it.

CONSUELO MACK: And the kinds of companies that you look for, if I looked at a snapshot of the Wintergreen Fund for instance … and let me just find them in my notes … is that I know that you’ve got 16 percent in cash right now, 37 percent in U.S. stocks, 47 percent in non U.S. stocks. How defensive is the Wintergreen Fund right now with that 16 or 17 percent in cash?

DAVID WINTERS: We’re a buyer and the cash is probably a little lower today. We find that there’s a lot to do because there’s a lot of undervalued securities. We’re bargain shoppers, and today what’s so different is you can buy A quality companies cheaply. It used to be you had to be what my business partner, Liz Coenaur, calls the dented soup can approach where you had to kind of …

CONSUELO MACK: Kind of damaged goods.

DAVID WINTERS: Yeah, it was C quality stuff cheap. Now we can buy A quality because everybody’s in the index fund mania.

CONSUELO MACK: Because that’s so interesting. So many other people are talking about how over valued the entire market is. So the indexes are over-valued, but underneath as you were saying there are many, many companies that are under-valued, and also 47 percent non U.S.. You’re finding more opportunities overseas?

DAVID WINTERS: People have forgotten that there’s a world sort of beyond the Atlantic and Pacific, and a lot of the growth even despite things may be slowing down, a lot of the opportunities are beyond the U.S., and so we’ve stuck to our knitting. Going back to that question of finding a mutual fund manager who will do a good job which we do the best we can, and we think there’s a lot to do overseas. The other thing about it, I would say, is sometimes underperforming is a good thing.

CONSUELO MACK: Why?

DAVID WINTERS: Because you’re not participating in the silliness that everybody else is doing. You’ve left the party. You’ve decided you’re not going to participate in that, and so it’s about discipline. It’s about hard work.

CONSUELO MACK: Let me ask you about the cost equation. We had Burton Malkiel on recently who was the author of “A Random Walk Down Wall Street”, very well-known financial thought leader in the industry, and one of the things that he told us is there’s one certainty in investing, and the certainly is that the more the money manager takes, the less the investor has. So the cost advantage of index funds is profound. In the Wintergreen Fund … I’ve asked you about this before … it’s 1.89 percent annual fee, and out of six and a half percent that’s a third of my return investing in the Wintergreen Fund goes to you. How do you answer that cost issue, and why are your fees so expensive? According to Morningstar, your fees are high.

DAVID WINTERS: Well, we also have an institutional class where the fees are lower, so you can do that.

CONSUELO MACK: Right, but they’re still 1.6 percent or something, but it’s still high by Morningstar standards.

DAVID WINTERS: Well, basically everybody’s gone to indexation. We’re one of the only ones in the world who’s doing any fundamental research anymore, and there have been periods of time where we have outperformed.

CONSUELO MACK: Oh, absolutely.

DAVID WINTERS: And there are periods of time where people are doing things that we think are ridiculous like now where we’re doing the right thing in our opinion, and I think if you look at what’s happened, and you made the point before about institutional investors, Wintergreen stood up in Coca-Cola. We read the proxy. We saw that there was a problem. We didn’t see any index funds get up and say, “Don’t do this.”

CONSUELO MACK: Right, except State Street did end up voting with you against the compensation package.

DAVID WINTERS: Yes, and we appreciated and acknowledge State Street for doing that, and we respect them, but we brought the issue up. State Street didn’t, and we’re willing to do things. We’ve helped reorganize Consolidated-Tomoka, and today it’s a much better company than it was. So we do things that others don’t, and I think most mutual funds, most investors fundamentally have become closet indexers.

CONSUELO MACK: And what should individual investors do? I mean should they be more proactive do you think in the … for instance, what do we do if we hold index funds?

DAVID WINTERS: Well, again it’s my personal opinion and I’m biased, but I think you shouldn’t have all your money in an index fund. Some of it is fine, but you’ve had this boom. No boom lasts forever. Everybody seems to have forgotten the mortgage crisis. It wasn’t that long ago. It’s the same sort of thing.

CONSUELO MACK: Housing prices will never go down. Right.

DAVID WINTERS: Never go down. Put more leverage on houses. You’ll just do phenomenal. It didn’t work. People got crushed, and so if it were me I’d be taking money out of index funds, and I’d be putting it in the people who … and there are a number of really wonderful people on Wall Street. I mean I think it’s a great business. I think there are a lot of ethical, high-quality people, and you many of them. They’ve been on the show, and you can choose a handful of people and you leave the money. Don’t look at it every five minutes. Great wealth is created over time.

CONSUELO MACK: One investment for a long-term diversified portfolio. What should we all own some of?

DAVID WINTERS: Oh, you know, that’s so hard because the one that I have on my mind I don’t think that it would be so easy for people to own, but I’ll mention it anyway. We own shares in a company called Sun Hung Kai Properties which is in Hong Kong.

CONSUELO MACK: Hong Kong.

DAVID WINTERS: And why they’re so interesting is it’s some of the best property in Hong Kong, but they also have diversified into Shanghai. They’re a huge land bank, and everything they’ve built is on the mass transit railroad system. So they can get people in and out, and they’re very humble. The disclosure is excellent, and their long-term record is great, and you can buy it at 35 or 40 percent discount.

CONSUELO MACK: To what you think their intrinsic value is.

DAVID WINTERS: Yeah, and so intrinsic value is growing. You get a big discount. You have quality management. It’s the Wintergreen trifecta, and this is why we just went and saw all their properties. People aren’t doing this work anymore, Consuelo. So we think we earn the fee to go do the work, protect the shareholders and figure out interesting companies that have the ability to outperform over time.

CONSUELO MACK: And this is the time as well to have what’s called an active share. If were to look at you at Wintergreen, your portfolio, an active share portfolio, is one that deviates widely from the index, and you active share is probably off the charts in that you’re going to look at the Wintergreen portfolio, and there’s no index that matches the Wintergreen portfolio.

DAVID WINTERS: You know, we’re investors. It’s our own money, and there was a study recently done about patient capital, and if you basically are a long-term investor and you have a long-term timeframe, you can do great, but this whole idea that you can trade in and out, and that you’re going to follow this bubble and jump off that bubble and get on the next doesn’t work. What works is doing the work. Understanding what you’re owning. Buying good businesses run by honest people, and buy them cheaply.

CONSUELO MACK: And you just have to understand that there are going to be periods of underperformance from indexes, especially in a big bull run like we’ve had for the last six years.

DAVID WINTERS: Which is a warning sign, and unfortunately what happens is people get sucked in that this is going to go on forever. The trees are going to grow to the sky. Sooner or later somebody comes along with a chain saw!

CONSUELO MACK: We’ll leave it there. David Winters from the Wintergreen Fund, thank you so much for joining us on WEALTHTRACK.

At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point picks up on research we discussed with David Winters. It is: Look for independent minded managers who think like owners.

Some recent academic studies show that what’s called “patient capital” outperforms the market and the competition over time. Managers who have high active share portfolios, that means their holdings are very different from their benchmark, and who trade infrequently, in other words stay in companies for several years, outperform their benchmark on average by more than 2% a year net of costs.

The patient capital approach is a characteristic of most great investors.

Next week we are going to talk to an outspoken contrarian who has successfully bucked conventional wisdom for the last decade at least. Treasury bond manager Robert Kessler will speak his mind and take on Wall Street. He is always worth listening to.

To see this program again and other WEALTHTRACK interviews please go to our website on WealthTrack.com. Also feel free to reach out to us on Facebook and Twitter.

Thank you for watching. Have a great Fourth of July weekend and make the week ahead a profitable and a productive one.

HOUGAN & PERON: LOW-COST ALTERNATIVE TRANSCRIPT

June 26, 2015

 

Investors are abandoning traditional, actively managed mutual funds in favor of “passive” index funds, particularly exchanged traded funds, or ETFs. Wall Street has taken note and is offering a wide variety of ETFs to attract investment money. How do you tell the difference between a good ETF and a bad one? When is it better to invest in an ETF? When is a traditional mutual fund the wiser choice? ETF experts Matt Hougan, CEO of ETF.com, a leading ETF research firm and Matthew Peron, head of Global Equity at giant wealth management firm, Northern Trust provide the answers you need to make the best investment decisions on this tenth season premiere.

CONSUELO MACK: This week on WEALTHTRACK, investors are flocking to passive index funds, especially exchange traded funds or ETFs. Should you join the migration? How to tell a good ETF from a bad one with index fund experts, ETF.com’s Matt Hougan and Northern Trust’s Matt Peron is next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this special 10th anniversary edition of WEALTHTRACK, I’m Consuelo Mack. Yes, we launched this program at this time, in the summer of 2005. Our mission then and now is to help you, our viewers, and ourselves, build financial security for a lifetime. So this week we are delving into the two biggest trends in investing that are really coming into their own in the past decade. Money is pouring into passive, index funds and specifically into exchange traded funds or ETFs. Global assets in ETFs just broke through the 3 trillion dollar mark. There are nearly six thousand ETFs and Exchange Traded Products to choose from, listed on 62 exchanges in 51 countries, although more than two thirds are in the U.S.. Unlike index based mutual funds, started in 1974 by Jack Bogle at Vanguard, ETFs which were created in 1993 by State Street with its S&P 500 SPDR ETF, can be bought and sold like ordinary stock shares on a stock exchange. They are also extremely tax efficient, for reasons we will explain in a moment. However similar to traditional index mutual funds, ETFs are low cost. That feature has become a huge draw for investors.

According to a recent report by Morningstar analyst, Michael Rawson, 95% of flows into funds of all types over the last ten years have gone into funds in the lowest cost quintile. And the biggest winners by far have been passive funds, especially ETFs.

Passive funds now account for 31% of total fund assets covered by Morningstar, up from 14% a decade ago. ETFs are gaining market share fast. They now account for 14% of mutual fund assets up from only 4% ten years ago.

The largest ETF and the most heavily traded security on any stock exchange is State Street’s pioneering SPDR 500. However the variety of ETFs offered is exploding. They come in all shapes and sizes. They are based on broad market indexes as well as tiny niches. For instance one of the most popular slices recently has been baskets of Japanese and European export companies hedged against the yen and the euro.

ETFs are available in stocks, bonds and commodities with different flavors being created every day. That means it is becoming more of a buyer beware product. How to tell the difference between a good ETF and a bad one? When should you use them, when not?

This week’s guests are ETF veterans, as both analysts and users. Matt Hougan is the CEO of ETF.com, a leading authority on Exchange-Traded Funds. Prior to becoming CEO he was President of North America for the firm where he oversaw its core online and print media properties, ETF.com and ETF report. Hougan writes for The Wall Street Journal, has been a 3 time member of Barron’s ETF roundtable and is an ETF columnist for The Journal of Financial Planning.

Matthew Peron is Senior Vice President and Managing Director of Global Equity at Northern Trust, a leading investment management firm with nearly a trillion dollars in assets under management. Among his responsibilities is overseeing what the firm calls its “Engineered Equity Strategy” which it describes as a middle way between active and passive management. Northern Trust was one of the early users of index mutual funds and ETFs. 80% of its global equity assets, nearly $400 billion dollars worth are in indexed strategies.

I began the interview by asking both of them why ETFs have become so popular.

MATT HOUGAN: They are so popular. They’re rapidly taking market share from traditional mutual funds, and the reason is simple. They are on average lower cost. They’re more tax- efficient, and they provide the kind of targeted exposure that makes sense in this sort of macro-driven market. So if you want to target China or you want to target Brazil, there’s a way to do that. If you’re worried about rates rising, there are tools to do that. So you have low cost, tax efficiency, targeted exposure. They’re the right tool for today’s market. That’s why they’re growing.

CONSUELO MACK: And Matt Peron, at Northern Trust you’ve been using passive index funds for years, and Northern Trust is one of the top five global indexers as a matter of fact?

MATT PERON: Correct.

CONSUELO MACK: You’re also using ETFs now and have been for a while. What is the attraction to ETFs?

MATT PERON: Well, we launched our FlexShares ETF platform about four years ago for a lot of the reasons that Matt mentioned which is that it has tax efficiency and other advantages that we want to make sure we offer to our clients, and so we see it as a strategically important place to be for our firm and for our clients.

CONSUELO MACK: So what’s the big advantage that ETFs have over mutual funds, Matt?

MATT HOUGAN: For traditional index funds.

CONSUELO MACK: Yes.

MATT HOUGAN: Well, they tend to be a little more tax-efficient and, of course, you can trade them intraday which you can’t do with a mutual fund. You can only buy that at the end of the day, and you can also get certain exposures in ETFs that aren’t available in mutual funds. You can buy gold. You can buy those individual countries or sectors. Those are just more liquid, easier to trade. You can trade them intraday. There’s still a place for mutual funds as well. It just depends on what kind of portfolio you’re building, whether it’s a retirement account or a taxable account. Different structures can make sense in different portfolios.

CONSUELO MACK: Okay, and we’ll talk about that a little bit later, but Matt Hougan, let me follow up with you. On ETF.com you analyze ETFs. You rank them. What makes a good ETF versus a bad ETF?

MATT HOUGAN: Great. There are three questions you have to answer when you look at an ETF. First you have to ask, is it low cost and does it track its index well? Remember these are supposed to track exactly on an index. So you want to make sure that the fund company is doing their job. You can find that data at ETF.com or places like Morningstar. You want to make sure they’re liquid, because unlike a mutual fund you have to trade it, and when I say, are they liquid, what I mean is, is the spread relatively small? Because you have to pay the spread between the bid and the ask every time you trade. You want to see that certainly be inside 10 cents. Five cents is better. One cent is obviously fantastic.

CONSUELO MACK: And you look at that when you’re evaluating ETFs, what the spread is and liquidity.

MATT HOUGAN: Absolutely yes. We look at the expenses, the tracking, the spread, and then the last thing which is probably the most important thing is the actual portfolio. So the biggest mistake people make with ETFs is they say they get exposure to one particular thing. They say they give exposure to technology stocks or China, and they assume that they’re all the same. But if you take 2014 for instance, the difference between the best performing China ETF and the worst performing one was over 40 percent. That’s a big number. So you have to take the time to look inside. Make sure the fund is giving the exact exposure you want, and then make sure it’s a good ETF. It tracks well. It trades well and it’s low fee. Then once you do that, you have a fund that’s ready to buy.

CONSUELO MACK: Okay. And at Northern Trust, Matt Peron, you use not only your own ETFs as you just mentioned, but you also use outside ETFs. So how do you evaluate them?

MATT PERON: That’s right, a lot of the same ways that Matt was speaking about. For our wealth clients we’re going to evaluate the ETF. Make sure all the structural issues that Matt mentioned with emphasis on the portfolio construction, making sure it’s constructed intelligently and it’s going to deliver the exposure we want for the clients, and that goes for our own funds as well as the external funds that we use.

CONSUELO MACK: So what kind of ETFs, Matt Hougan, are the most popular right now?

MATT HOUGAN: Well, the most popular ETFs are the biggest, broadest ETFs generally, so ones that give full exposure to the U.S. market, ones that give full exposure to the bond market. Those get the giant amount of assets, and that’s great because most people’s portfolio should be anchored with those broad, low-cost exposures. ETFs are great at that.

CONSUELO MACK: So that would be the same with, again, the indexed mutual funds as well. It’s the S&P 500.

 

MATT HOUGAN: That’s exactly right.

CONSUELO MACK: And is it the same big players? Is it the Vanguards, the BlackRocks?

MATT HOUGAN: It’s Vanguard. It’s BlackRock. It’s State Street, but there are two other areas that are really growing fast right now. One is currency-hedged exposure. So maybe you want to buy exposure to Europe but you don’t want exposure to the euro. There are ETFs that let you do that. Five years ago you had to be a big institution to do it. Now my father can do it in his Schwab account. Right? And the other one is Smart Beta. These are ETFs that take traditional index exposures and tweak them. They try to find a way to outperform the market a little bit, and there’s a wide variety of strategies, some great, some not so great, but they’re attracting real assets because they give people a low-cost tool that might provide risk-adjusted outperformance against the market.

CONSUELO MACK: So the Smart Beta funds, they are not really completely passive. They’re not based on a known index. These are being created by fund companies, and so the index itself is actively managed how it’s put together. They are picking and choosing what securities go into it, and then it’s passive once the index has been created. Is that right?

MATT HOUGAN: That’s right. So they’ll look at the market, and they’ll identify some way or reason they think they’ll get outperformance. Maybe they think stocks that aren’t very volatile will outperform over the long haul, so they’ll design an index that picks only the stocks that are the least volatile in the market, and they’ll buy those in the fund and then they’ll run on up. The great thing about this is in times of yore you would have an active manager who effectively did the same thing, but they would charge a percent or more. Now you can get this same exposure because it’s quantitatively designed. It’s in an index. You set it and it’s easy to manage for maybe 40 basis points or 30 basis points, less than half the cost. So you get the same kind of result for a third or half the fee. It’s a great outcome.

CONSUELO MACK: And Matt Peron, let’s talk about what Northern Trust has been doing for years in fact. It’s called Smart Beta now, but you called your strategy “Engineered Equity”. So tell us about what that is and why you think that’s actually a middle way between passive and active management.

CONSUELO MACK: Right. So we’ve been offering this strategy that’s called “Engineered Equities” which, much as Matt described, it’s part of that smart beta category if you will, although our take on it is they’re much more targeted towards what we call compensated risks. So what these are, are factors or groups of stocks in the market that will move together, have certain characteristics and a risk return profile that you understand its pattern, and you can understand how to implement it and how to capture those advantages for your clients.

CONSUELO MACK: Matt Hougan mentioned one which is low volatility. So what you call the like factor or style, their factor tilts or styles, so low volatility is one. Quality, value, dividend yield, small size. Why have you chosen those types of styles in particular, and why are they so important for us to understand as investors?

MATT PERON: Well, those factors that you mentioned we believe are compensated factors. That means you can earn typically above average risk-adjusted returns or above the market risk-adjusted returns. You can also deploy them in your portfolio strategically. So for people with longer horizons who can take volatility, they can have a value-tilted strategy. For someone who has a shorter time horizon, a low volatility strategy might be appropriate for them, and so you can really tailor it to the risk profile of the individual.

CONSUELO MACK: But we’re finding more products coming out that are really slicing these very narrowly. Right?

MATT HOUGAN: Oh, there’s an incredible boom in products because people are seeing them attract assets, so everyone has their own particular flavor. So you can get down to micro factors or niche areas of the market. I like what Matt said about finding those that focus on compensated risks. The best Smart Beta ETFs are drawing on work that’s been going on in academics and quantitative finance for years and years and years. There are a number of well studied factors that have proven themselves out over decades, and the best Smart Beta ETFs are capitalizing on those. What you have to worry about are some of the Smart Beta ETFs or “Smart Beta” ETFs, that are maybe focusing on more fad-like things, narrow niche areas of the market that sound good and are in the papers but maybe haven’t proven themselves over five, ten, fifteen, twenty years.

CONSUELO MACK: So Matt Peron, speaking of academic research, that’s very important in the kind of factors and styles that you use as well, right, in your ETFs?

MATT PERON: That’s right. So we want to make sure that the factors that we use are well researched and supported in the academic literature, that we can bear them out in our own empirical testing from data sets that we’ve built going back 50 years and therefore they are well supported and we are confident that we can deliver them and they’ll give you the risk and return profile that we expect.

CONSUELO MACK: Okay, so what kind of a premium do these kind of factor tilts give you? What should we expect from the kind of indexes that focus on those kind of styles?

MATT HOUGAN: Oone thing about investing we all know is there’s no free lunch. So these factors that we’re talking about are targeting things in the market that maybe add a little bit of risk to your portfolio, but the idea is the pay off or more than pay off if you hold them for long periods of time. So we mentioned earlier value. Value stocks have possibly more risk than growth stocks. Maybe they’re a little bit challenged, but as you hold them over long periods of time you get paid off. One important thing about Smart beta ETFs which I like to emphasize is you have to hold them for long periods of time. It’s too easy to get caught up in a Smart Beta ETF that beat the market for the past three years, buy it, see it underperform for a year and sell it. That’s the worst possible outcome. People do naturally chase returns, and they want to see those returns repeated, but these are designed to deliver over three years, five years, ten years. If you’re not going to hold it for a substantial period of time, you’re better off just buying a plain index fund, because there will be periods when you underperform, and you have to have the stomach to see that through.

CONSUELO MACK: So why is “Engineered Equity” as you call it at Northern Trust or Smart Beta, why is that the middle way? Why are you getting the best of both worlds?

MATT PERON: Well, if you combine the active which is really about delivering excess returns, but if you get them through these systematic factors that I was talking about, then you can still get excess returns provided that, as Matt says, you hold it over the cycle. Hold it for a long time, but you get also the efficiency of indexation which is nice, very cost efficient.

CONSUELO MACK: And explain, Matt Hougan, the tax efficiency aspect. Why are they so tax efficient?

MATT HOUGAN: Sure. Well, think about a mutual fund. If you and I own a mutual fund and we bought it 10 years ago, and the price has gone up and you sell your shares, the mutual fund has to sell stock to give you cash. When it does that, if it bought stock that’s gone up in price, it creates a capital gain. At the end of the year it has to pay it out to all the other shareholders including me. So because you sold that mutual fund, I have to pay tax at the end of the year. The way ETFs work are different in two ways. One, when you want to sell your ETF, you just sell it on the open market to another investor. So the ETF doesn’t have to sell shares to raise cash to pay you. You get them from Matt who bought it on the open market. And then, if a large institutional investor redeems shares, because that happens in ETFs, what happens is the ETF company doesn’t sell shares to give them cash. Instead it kicks out the underlying stock that it has, and not only that but it will look at the underlying stocks that it holds and says, “These ones have big embedded capital gains. If we ever had to sell them, we’d be in trouble. I’m going to give that to you, Mr. Institutional Trader, and you worry about it.” So what you see in ETFs is they’re continually cleansing out capital gains. You have ETFs that have been around for 20 years which have negative embedded capital gains. They’ve never paid out a capital gains. It’s just a beautiful structure. It’s inherently more tax efficient.

CONSUELO MACK: So when do you make the distinction and the recommendation to a client whether they should own an actively managed mutual fund or a more passive ETF?

MATT PERON: Right. So the first and most important question is to back up and zoom out and see what is the right strategy for the client first and foremost. What are the right strategies that you need to implement, and then it’s to determine the best to fulfill or implement that strategy, whether it’s a mutual fund, active, passive, ETF, and those can be different for different regions and markets. They can be different for different client goals. So they get down to client-specific issues, but the most important thing is to back up and see where is the client in the lifecycle. What are the goals that they’re trying to achieve, and design the right strategies. That’s the dominant factor. You get that right and then you worry about how to fulfill.

CONSUELO MACK: So are there any general rules of thumb, Matt, as far as use of mutual funds are concerned versus ETFs in clients’ portfolios?

MATT PERON: I would say there’s not really. It’s really more about what strategy. Where do we have the most confidence in delivering the strategy? So it really is strategy by strategy, and it’s all about ensuring we get the outcome we want for the client.

CONSUELO MACK: But are there strategies that are missing in the ETF universe, for instance, where you’ve got to go to the mutual fund world, or you’ve got to go to individual accounts that you’re managing?

MATT PERON: Certainly I would say that there are situations where an active manager makes the most sense, and you’d really want to use an active mutual fund in that case. That’s one example.

CONSUELO MACK: Okay. And you feel that way, too, Matt Hougan. Right?

MATT HOUGAN: That’s the big difference, the place where there are mutual funds that there aren’t ETFs is in the active particularly equity markets because ETFs have to be fully transparent on the active side. They have to say what they own every day. Equity managers who are on the active side don’t like to do that. So you don’t see a lot of active equity ETFs with significant exposure. If you find an active equity manager that you love and you trust them and you believe they’ll continue to deliver returns, you’ll probably have to buy that in a mutual fund, and that’s just fine. There’s nothing wrong with mutual funds. It’s just in many situations ETFs are better.

CONSUELO MACK: And yet we’re seeing some star managers managing ETFs. Right? So is that going to be a big trend?

MATT HOUGAN: I think it’s going to be a huge trend.

CONSUELO MACK: You do.

MATT HOUGAN: I mean you’ve seen particularly on the bond side …

CONSUELO MACK: So Bill Gross, for instance, is one.

MATT HOUGAN: Bill Gross and Jeffrey Gundlach.

CONSUELO MACK: Jeffrey Gundlach.

MATT HOUGAN: And Jeffrey Gundlach had the most successful mutual funds in the world. He felt compelled to enter the ETF market. And why? Because ETFs are stealing one or two percent of market share from mutual funds each and every year because clients are demanding them in particular areas, and if you’re a manager, you want to be where the clients want to be. So offer it in a mutual fund for people who want it that way. Offer it in an ETF for people who want it that way, and let your investors decide.

CONSUELO MACK: And yet with these star managers, are you seeing their funds come down to a competitive ETF level or … ?

MATT HOUGAN: What we’ve generally seen is them price the ETF shares the same way they price their institutional mutual fund classes. So if you’re a big investor with $5 million, you can buy a mutual fund at very low fees. If you’re a regular investor with a thousand bucks, you can now get the same fee on that ETF, so that what we’re seeing. They’re competing. They’re different access vehicles, but that’s about where the price point is sorting out.

CONSUELO MACK: And Matt Peron, what is missing in the ETF universe? I mean where would you like to see products created? What areas?

MATT PERON: Well, one of the things that we’re working on are fixed income ETFs because the indexes in the fixed income world are very flawed. They’re not perfect, and there’s a real opportunity. So we’ve launched a number of fixed income ETFs to address these gaps if you will in the market and looking at applying some of the engineering work we did on the equity side to the fixed income side. So that’s something we’ve launched off our FlexShares platform recently, and we’re excited about that.

MATT HOUGAN: If I can jump in there, I would agree. Fixed income indexes are silly. The way they work is you invest more in the things that issue more debt. So why would you invest the most in the most indebted companies or countries? One thing Northern Trust has done, they have an ETF. I think it’s SKOR.

MATT PERON: That’s right.

MATT HOUGAN: Which they take corporate bonds, and instead of just investing in the most heavily indebted companies, they look at the credit of those companies and actually invest the way any sort of intelligent person would do.

CONSUELO MACK: That’s a novel idea. Not.

MATT HOUGAN: And it’s shocking. It didn’t exist until these guys came to market with it. So of course that’s smart. You wouldn’t loan money to the heavy debtor. You would loan money to the guy who’s never borrowed money but needs a little bit today.

CONSUELO MACK: So that’s the same argument, though, that’s being used against capitalization-weighted indexes is that you’re paying up for the most expensive stocks. So in this case you’re saying the same applies in fixed income, and the same applies in the ETF world. Right?

MATT HOUGAN: That’s.. Well, yeah. So there’s a Smart Beta gold rush. So everyone’s coming to market with Smart Beta strategies. And guess what? All of the back tests look unbelievable. No one launches a fund with a bad back test. That just doesn’t happen. The question is, what happens going forward? So my advice to people is to look at the methodology. See if it makes sense intuitively. Is it founded in academic research? Is it clear and simple, or is it a black box with 27 different calculations? Because if it’s the latter, they probably fine tuned that so the back test looked pretty good. If it’s a simple factor drawn from academic finance that you’ve seen over and over again, chances are it’s going to persist.

CONSUELO MACK: It is time for the one investment for a long-term diversified portfolio. So Matt Peron, what would yours be?

MATT PERON: I would say for a younger investor, a value strategy, and for someone older or closer to retirement, a low volatility strategy.

CONSUELO MACK: All right, and why is that? Why value for someone younger and a low volatility for someone who’s older?

MATT PERON: Because as we spoke about earlier, value tends to be more volatile but will provide longer excess return over longer time horizons, and the data’s very clear on this. We spoke about it earlier that over rolling five-year periods or longer, the chances of outperforming the index is quite high.

CONSUELO MACK: In a value strategy.

MATT PERON: In a value strategy.

CONSUELO MACK: And the low volatility …

MATT PERON: Low volatility strategy. Obviously when you’re near retirement you want to have less opportunity for risk, for permanent loss of capital. So a strategy that varies less, that doesn’t vary so much would be more appropriate in that case.

CONSUELO MACK: Okay. And Matt Hougan, what would your choice be for a long-term diversified portfolio? MATT HOUGAN: It would be deeply boring, Consuelo. On my website I have the world’s lowest cost ETF portfolio. It’s six ETFs. It provides exposure to 4,000 stocks and all the bonds in 40 different countries for an expense of eight basis points. That’s 0.08 percent. If you have a portfolio that you’re still paying active fees on the core for a percent or more, getting into something … it doesn’t have to be that portfolio, but something like that that’s below 10

MALKIEL & TUCHMAN: RETIREMENT AUTOPILOT TRANSCRIPT

May 22, 2015

CONSUELO MACK: This week on WEALTHTRACK, putting your retirement portfolio on auto pilot. Financial thought leader Burton Malkiel has joined forces with online investment advisory pioneer Mitch Tuchman to offer retirement portfolios of low cost index funds that automatically rebalance with a human touch. Why they believe the combination will lead to safe retirement landings is next on Consuelo Mack WEALTHTRACK.

Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack. One recurring theme on WEALTHTRACK over the years has been how individual and institutional investors sabotage themselves over time. One way they do it is by chasing hot performance, and buy high, and abandoning investments during market declines and sell low.

The other major way investors hurt themselves over time is by not paying sufficient attention to investment costs. Expenses matter. As one of this week’s guests, famed financial thought leader Burton Malkiel tells us: “One thing I am absolutely sure about is the lower the fee… the more there’s going to be for me as the investor.”

Luckily there are products available to help us avoid both mistakes and more are being created every day. One of them, index funds are already a huge hit with investors and their popularity is growing by leaps and bounds.

According to Morningstar low cost, index based mutual funds and ETFs now have 31% of all fund assets up from just 14% a decade ago.

The other development, to counteract destructive investor behavior is in its early stages. Its automatic investing. It’s being used in target date funds. Some advisors use software that does it in portfolios. And we are now seeing the next generation, with so called robo-advisors. Barron’s recently did a cover story on it called “The New Face of Financial Advice” and highlighted four robo portfolio services: Betterment launched in 2010, Wealthfront launched in 2011, and two recent entries, Charles Schwab Intelligent Portfolios and a hybrid, Vanguard Personal Advisor Services, which requires the involvement of a human financial advisor to provide what Vanguard calls “behavioral coaching” to prevent clients from making those bad market timing decisions.

This week on WEALTHTRACK we are highlighting another service that also combines low cost investing, automatic rebalancing and the human touch.

It’s called Rebalance IRA and there are two personal reasons I am focusing on it. It has two legendary financial thought leaders on its investment committee, with impeccable credentials whom I have had the privilege of interviewing on WEALTHTRACK over the years. They both help develop, oversee and set policies for the portfolios offered to Rebalance IRA clients.

One of them, Charles Ellis has been a highly respected investment consultant to pensions, endowments and governments for decades. He is the author of numerous investment books including the classic “Winning the Losers Game” and “The Elements of Investing”, co-authored with his good friend and fellow financial legend, Burton Malkiel.

Professor Malkiel is also on the Investment Committee and is one of today’s guests. Malkiel is an emeritus Princeton University Economics Professor and author of the classic, “A Random Walk Down Wall Street,” now in its 11th edition.

Our other guest is no slouch himself. He is Mitch Tuchman, Managing Director and Co-Founder of Rebalance IRA which he launched in 2013. Rebalance IRA is a low cost, investment advisory service for accounts of $100,000 on up. As its name indicates it is specifically for retirement accounts and it automatically rebalances their portfolios. It currently has nearly $300 million under management. Before that Tuchman founded MarketRiders, the first online investment advisory service for do- it-yourselfers. It now oversees about $4 billion in accounts. For many years, Tuchman has also been a technology entrepreneur and consultant to numerous Silicon Valley companies.

I began the interview by asking him why he created Rebalance IRA.

MITCH TUCHMAN: I didn’t start off in this business. I moved to Silicon Valley to work at Atari many, many years ago, and after a successful career as a software entrepreneur, I sold a company and I had money to invest, but also a year earlier I had a very interesting experience in life. We had a child who was severely disabled, and I realized I needed to invest this money for 100 years, not just my own retirement, and the gravity of that task was weighing heavy on me as I went to look for options in the financial services industry, and I looked at all the fees and the structures, and I just never found anything that was satisfying to me. So it led to a seven-year career in the investment business, and what I discovered was a completely different method of investing, a whole different language, whole different approach to investing and it was startling to me. As I got more into it, I’m sure this has happened to you, Consuelo, and definitely I know it’s happened to you, Burt, people began to ask you, “What do I do?” because they know you’re someone in the business, and as I was asked I would start saying, “Well, let me see what you’ve got. Show me your portfolio,” and I was again shocked. I would see terribly overpriced mutual funds, horrible allocations, loads, lots of trading, and it began to get very upsetting to me. So I was also experiencing new financial instruments like exchange-traded funds which are innovations, low cost, almost zero trading commissions, and I started to see over time. You know what? The methods of the large endowments and foundations and successful retirement pools, the institutions that Burt has spent his life consulting with, those can now be brought down to everyday investors, and that’s why I got the entrepreneurial bug again and got back into the game of running a company that this time was a convergence of software and financial technology.

CONSUELO MACK: So explain what is Rebalance IRA?

MITCH TUCHMAN: So Rebalance IRA is an investment management firm, and we focus on everyday investors who have between 100,000 and a million dollars. Generally they’re over 45, and we manage their retirement assets for them. Our mission is to help people retire with more. They’re not do-it-yourself investors, and we manage their money in a very low-cost way under a fiduciary standard, and we offer them a credentialed, highly-trained advisor and a support person as their team to work with and we execute an investment methodology that I’m sure we’ll talk a lot about because this man sitting next to me is responsible for having invented quite a bit of it.

CONSUELO MACK: Right. So Burton Malkiel, here you are. Sorry. You’re an investment icon, and I’m sure that you get approached many times a day, a week, whatever to get your name on a committee and to get involved in a company because anyone would love to have your reputation behind them. So why did you get involved in Rebalance IRA?

BURTON MALKIEL: Well, because I wanted to put my name behind something I really believed in and I think, as Mitch just said, that most people just get terrible investment advice. They get it from people who are conflicted, who are not necessarily interested in the investor’s best interest but are interested in their own, and therefore, they’re very high-priced and they put investors into the kind of funds where they get an extra commission. So the funds themselves are very high-priced, and so I would only put my name behind something that I absolutely believe in. We use nothing but index funds, low-cost index funds at Rebalance IRA. I believed in indexing from before the time that index funds even existed.

CONSUELO MACK: Existed, right.

BURTON MALKIEL: I believe that there are extra returns available from rebalancing the portfolio periodically, and so my answer is very simple. This was something that operates on principles that I’ve believed in all of my life, and I’m delighted to do that particularly if it’s likely to help individual investors saving for retirement, because if we’ve got a crisis in this country, the crisis is that so many Americans have inadequately saved and inadequately invested for their retirement and are likely to have a much less good retirement than they should have.

CONSUELO MACK: There are other services out there. I mean you are on a board of Vanguard for many years, so there are index companies that offer retirement services. So what’s different about Rebalance IRA?

BURTON MALKIEL: Well, one of the things that Rebalance can do that a Vanguard and a Schwab, which are two other companies that are in the game, can’t do, is that we can be completely unconflicted in terms of the ETFs that we put into the portfolio.

CONSUELO MACK: So open architecture. You can do whatever.

BURTON MALKIEL: So it’s an open architecture. When you go to Schwab who is one of the competitors doing this, you’ll notice that in the Schwab Composite portfolio, there’s nothing but Schwab funds. Vanguard’s a wonderful company, but in the Vanguard portfolio there’s nothing but Vanguard funds. So I think what is really important about Rebalance IRA is that we are simply looking for the best kind of fund at the lowest cost.

CONSUELO MACK: How many portfolios are you offering? How do you make the decisions? I know, Burt, that’s part of your job is to make the decisions of what goes into the portfolios but, Mitch, do you want to tell me about kind of what the model is?

MITCH TUCHMAN: Sure, well, there’s basically six model portfolios.

CONSUELO MACK: Six model portfolios.

MITCH TUCHMAN: They’re book-ended by an income portfolio and a growth portfolio and then the four in the middle, and basically what we’ve done is we have created a growth portfolio of index funds that includes U.S., foreign developed, emerging market. We believe in a small cap tilt as they say in the business and some REITs.

CONSUELO MACK: You’ve got stocks. You’ve got bonds. You’ve got dividends, whatever.

MITCH TUCHMAN: Sure, and then on the income side we have … now this is where Burt and Charlie Ellis who’s also on our Investment Committee, have actually said certain markets are not efficient.

BURTON MALKIEL: Look. I’m an index investor. I believe in indexing. I would start off saying buy a total bond market fund, but if you look at what’s in a total bond market fund, it’s about two thirds either direct Treasury securities or government agency securities.

CONSUELO MACK: Right. This is the Barclays Aggregate.

BURTON MALKIEL: Which are in effect government securities and the yield is, in my judgment, quite inadequate, and so what we have done is, we’ve tried to look at parts of the bond market that are not too risky but give the investor at least some chance of a decent return, and we’ve also used an income, dividend-paying stock substitution for at least a part of the bond portfolio. So there is some interesting things that we’ve done. We generally have a little more of a portfolio composition in foreign and emerging markets than other investors because we start off from the view that a lot of these markets are basically cheaper than the U.S. market. We don’t take big bets on things, but there are people behind this who are putting the numbers into portfolio theory, and we have a little different investment mix than I think many other people would have.

CONSUELO MACK: So Burt, take me through the investment committee meeting. For instance, I’m looking at some of the things and what Mitch just mentioned. So you’re dealing with a portfolio of high-yield corporate bonds, U.S. dollar emerging market bonds, intermediate corporate, small cap as you said, an all-world ex small cap, developed market stocks, emerging market stocks, high dividend yield stocks, REITs. Vanguard Total Stock Market Index is in there as well. So you’ve tried to keep it relatively simple. Right?

© 2015 MackTrack. All Rights Reserved Page 5 of 10

CONSUELO MACK: | WEALTHTRACK Transcript 5/22/2015 – Program #1148

BURTON MALKIEL: We’ve tried to keep it relatively simple, but these are exactly the kinds of things that the investment committee decided upon. In other words, when we first put the portfolio together the first thought was, okay, bonds are going to be a total bond market fund, and for the reasons we’ve just discussed we’re uncomfortable as an Investment Committee with that, and so what the Investment Committee then talked about was, okay, what can we do? And far should we deviate from what’s a total bond market fund? So that would be one of them. The other would be how much should we have in emerging markets. Are emerging markets really very much more risky than developed markets? Are emerging markets really very much more risky than Europe? And in bond defaults we have some emerging market bonds. Well, where are the defaults likely? They’re going to be in places like Greece that are in development markets. So when you ask what the Investment Committee talks about, these are precisely the kinds of things the Investment Committee talks about. You can call it active if you want, but all of the individual instruments are passive, are indexed and are low cost because let me tell you. All of us need to be very modest about what we know and don’t know about financial markets, but the one thing I am absolutely sure about is the lower the fee that I pay to the purveyor of the investment service, the more there’s going to be for me as the investor.

MITCH TUCHMAN: Yeah, let me make one final point about what Burt said. We’ve only made one modestly significant change to the portfolios in several years. So it’s not like we sit around and change percentages. We made a decision to boot out the aggregate bond index for an intermediate, high-grade corporate bond index. We’re not making changes, but we do rebalance so that’s to your question.

CONSUELO MACK: And how often does that happen for events in the markets?

MITCH TUCHMAN: Well, it’s both actually. So we do a calendar rebalancing every year for all the clients.

CONSUELO MACK: At the end of the year or … ?

MITCH TUCHMAN: Well, if you’re not taking distributions … we have clients that are over 70 who are taking distributions. That happens in November like clockwork, and if you’re not taking distributions that happens about right now like clockwork because people are contributing to their IRAs. So we do a calendar rebalancing for everybody depending upon whether you’re distributing, and then second there’s usually a volatility rebalancing, and that happens because the markets begin to ebb and flow and things get dicey, and sometimes the allocations move past a threshold, and when they do that alarm bells are triggered and it’s time to do a rebalancing for most all the clients, and that’s what we do. The important thing about rebalancing is that it always answers the question for the client, “Well, what are you guys going to do when you think the markets are going down? What are you going to do when you think the markets are going up? What are you going to do? What are you going to do?” and that helps clients understand that we’re not sitting around with a crystal ball predicting the future, going, “Which way is the wind blowing?” and trying to make a guess. That we have a process and the process is the process and it’s why large endowments and foundations get great returns. They run under a process. And knowing there’s a process helps our clients feel that these guys are not going to make wild guesses. There’s no cowboys, and it really gets down to peace of mind for the clients, and that’s really our business.

BURTON MALKIEL: So let me just if I could …

CONSUELO MACK: Please.

BURTON MALKIEL: I think it is less well understood than it should be what kind of advantages you get from rebalancing. Let me give you a little simulation that I did with simply two investments, a bond market index fund and a stock fund, starting in 1996 just when Alan Greenspan made his famous irrational exuberance speech. So what we do in this simulation is once a year … we did it at the beginning of January. You could do it anytime. You simply said let’s say you have a 60/40 portfolio, 60 percent stocks, 40 percent bonds, and every year what rebalancing means is you just bring the proportions back down, and that rebalancing once a year added between one and one and a half percentage points to the return. Now you…

CONSUELO MACK: A year. Right? A year.

BURTON MALKIEL: A year. Per year.

CONSUELO MACK: What’s a realistic expectation now for a diversified portfolio as far as annualized returns? It’s come down a lot. Right?

BURTON MALKIEL: My sense is that a diversified portfolio of common stocks, one ought to think of certainly no more than a six percent rate of return. I don’t think it will be the nine to ten percent that we’ve enjoyed over the last 100 years. I think that by getting into some of these other markets like emerging markets we can do a little better than that. I think real estate is still a relatively good investment outlet for people which we access through REIT index funds.

CONSUELO MACK: Through REITs.

BURTON MALKIEL: So I think we might be able to do a bit better than that, but we are clearly in a single-digit world today, and we don’t want to give anybody the impression that it’s 10 percent from now until kingdom come. It just isn’t, and what’s important for people to realize is if they are saving on the basis of thinking that they’re going to get 10 percent rates of return, I don’t think it’s going to happen.

CONSUELO MACK: One of the things that I’ve talked to Charlie Ellis about, who is also on your advisory committee, is the fact that we’ve kind of got to really change our attitudes towards retirement. We’ve got to work longer. We’ve got to save more. Spend less. I mean all of the things that none of us really want to hear as well, but obviously at Rebalance IRA you’re cognizant of those realities too, and so it sounds to me as if a goal is to, number one, avoid the permanent impairment of capital which is to avoid losses. So it’s almost more of a value tilt. Right? If something goes up too much, you’re going to pare it down. So there is a value tilt to the entire portfolio.

BURTON MALKIEL: Right. Absolutely. Absolutely. That’s what rebalancing does.

CONSUELO MACK: Right, and so that’s where you can get the edge over the index, over the typical benchmark indexes, and it’s to prevent us from making stupid mistakes.

MITCH TUCHMAN: If you ask any investor, name the top five investment mistakes you’ve made, and then they will sheepishly name them, and then you say, “If you had all that money back in your account, how much would your net worth be?” and they just shake their head. Way higher. Charlie wrote a book called Winning the Loser’s Game.

CONSUELO MACK: The loser’s game.

MITCH TUCHMAN: Winning the Loser’s Game. The loser’s game is playing to win, and investing is about playing not to lose. If you work really hard not to lose money, you end up ahead of 90 percent of the people.

CONSUELO MACK: How much attention do you pay to income? Because if you look historically, over 40 percent of returns in stocks have come from dividends. How important is that in the Rebalance IRA portfolios?

BURTON MALKIEL: It’s extremely important, and again probably one of the things where we will differ from some other portfolios is that we even have almost as a separate asset class dividend-paying stocks, dividend growth stocks because we think that that is extremely important, and I think it’s probably the way today that people ought to concentrate in order to get income, because they won’t get it from a total bond market portfolio.

MITCH TUCHMAN: And one of the silver linings of having a global portfolio is that coming into this year after the U.S. had run so much and dividends were down below two percent, it was the international funds that were over three percent. So the dividends have been paying off very well in a foreign developed country ETF.

BURTON MALKIEL: And the other thing the dividends will do is give you the advantage of dollar cost averaging because what we will do is reinvest those dividends, and that is a wonderful way of making your assets grow.

CONSUELO MACK: Great. Last question I ask everyone on WEALTHTRACK is if you had one investment to make in a long-term diversified portfolio. This is assuming we all have long-term diversified portfolios. What’s the one investment we should all have in it? Mitch, do you want to take it first?

MITCH TUCHMAN: Well, actually why don’t you start, Burt, because I liked your answer to that, and I had a way to hitchhike that.

BURTON MALKIEL: Well, if I had only one thing that I could buy, I would buy a world equity stock fund. That is a stock fund that had U.S., that had Europe, that had Japan, that had emerging markets, that had the entire world.

MITCH TUCHMAN: Okay, so I’m going to hitchhike off of that. I’m going to agree, and that is VT, Victor Tom. It’s a global index fund put out by Vanguard.

CONSUELO MACK: Vanguard.

MITCH TUCHMAN: But one of the things we do for our clients is we say let’s open up a Roth IRA for your child, and let’s put 500 bucks, $1,000 in it and just buy VT, and for a child that’s one of the greatest gifts you can give them. Not so much an iPhone and not the next crazy outfit. You put it in a Roth IRA, and that kid will watch the power of compounding and start to understand how this works.

CONSUELO MACK: Excellent. Thank you both so much, Mitch Tuchman for joining us and Burton Malkiel. It’s great to have you back on WEALTHTRACK.

BURTON MALKIEL: Thank you very much. My pleasure.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point picks up on the one investment recommendations of both Malkiel and Tuchman. It is contribute to a young person’s Roth IRA.

As we have discussed numerous times on WEALTHTRACK there is no greater investment strategy than the power of compounding and the more time it has to work the higher the returns. What better way to make a long term difference in a child or young adult’s life than to put shares of a low-cost global mutual fund or ETF in a Roth IRA. It will be a gift that keeps on giving.

Next week, as WEALTHTRACK celebrates its official tenth anniversary…it’s a big one…we are delving into two big investment trends: the move to passive investing, which this week’s guests are passionate proponents of, and specifically the hugely popular exchange traded funds, or ETFs. ETF.com’s CEO, Matt Hougan and Northern Trust’s Head of Global Equity, Matthew Peron will explain why not all ETFs are created equal..and how to tell the difference.

To see this program again and ten years worth of our other Financial Thought Leader and Great Investor guests, go to our website WEALTHTRACK.com. 

Also please share your thoughts with us on Facebook and Twitter. Thank you for watching.

Have a great weekend and make the week ahead a profitable and a productive one.

RUSSO: LONG-TERM VALUE TRANSCRIPT

May 22, 2015

CONSUELO MACK: This week on WEALTHTRACK, great global value investor Tom Russo looks for leading consumer brand companies with the capacity to reinvest and what he calls the capacity to suffer. Why both qualities matter are next on Consuelo Mack WEALTHTRACK Hello and welcome to this edition of WEALTHTRACK, I’m Consuelo Mack.

In preparation for this week’s interview with global value investor Tom Russo, I read some articles about Russo’s investment hero warren Buffett. One of them was by, Roger Lowenstein, author of a wonderful Buffett biography, “Buffett: The Making of an American Capitalist”. We’ll have more on the book later.

In his 2011 article, “A Harsh Look at the Real Warren Buffett”, Lowenstein was uncharacteristically critical of Buffett for a management decision he made about a key employee. We will have a link to the article on our website. What caught my eye was Lowenstein’s observation about Buffett’s quote “searing independence.”

Here’s what Lowenstein wrote: “In 1969, after a fabulous run as a hedge-fund manager, he decided that Wall Street was barren of opportunities and returned his investors’ money. This was unselfish as well as prescient. The market crashed. Then, in the mid 1970’s, when the market was mired in a virtual depression, Buffett leapt back into the game, now using Berkshire as his vehicle. America had abandoned stocks, but to Buffett, popular sentiment was irrelevant. Traders looked at trends, volume charts, and moving averages. Buffett peered beneath the stock certificate to the underlying business. By focusing on the long-term business prospects, he reclaimed the economic values that were obscured by Wall Street sophistry.”

Well, fifty years after taking control of Berkshire Hathaway, Buffett continues to focus on long- term business prospects. He owns a portfolio of roughly 80 companies, for “forever” as he puts it. He has never sold a share of Berkshire personally, and has only recently started giving shares to charity through to the Gates Foundation.

But what are American investors doing? They have largely abandoned buying individual stocks… they are switching from actively managed mutual funds that do, to passive index funds. And they are certainly not holding for the long term. Trading is in, investing is out. This week’s great investor guest, Tom Russo is from the old Buffett school of investing in businesses, not pieces of paper.

Russo is managing member of the investment advisory firm Gardner Russo & Gardner which he joined in 1989. He oversees more than $9 billion dollars of separately managed accounts and Semper Vic Partners, a Limited Partnership. The global value, long-term oriented portfolio has beaten both the Dow and the S&P handily over the last quarter of a century.

I began the interview by asking Russo about his view that so much of investing has to do with storytelling.

TOM RUSSO: I think it defines the parameters in which successful investors operate. It helps describe the questions that are best asked. I remember the firm I trained with, the Sequoia Fund. Bill Ruane used to have a question that he would ask of managements when we’d visit for example, and he’d say, “What are the chances that your business will lose money next year?” and all of the conversation of Wall Street was about whether the firm would earn $2.10 or $2.11, and Bill would say, “What are the odds that you’ll lose money?” And of course the management team is first perplexed. Finally they’re a bit disturbed. At the end of it they’ll say something like, “Well, look. For that to happen, the following three things would have to happen.” Well, those are the only three things you should care about, and so the device, the technique of investing. You have to learn how to ask the right questions, and I always remembered the one that Bill Ruane used so well.

CONSUELO MACK: So what kind of stories make the best investments as far as you’re concerned?

TOM RUSSO: Well, I would say the best stories for me or the best investments for me are those businesses that have the ability to reinvest since we manage money for taxable investors, and our goal is not to have a large amount of turnover which triggers taxes and forces you to learn deeply about businesses on a regular basis which I find to be elusive at best. So by staying with the businesses that we know and understand, if they have the capacity to reinvest, we’re much better off than if they don’t.

CONSUELO MACK: And explain what the capacity to reinvest means, because if you talk to most Wall Street analysts for instance or portfolio managers, they’re saying, “No, no. We want free cash flow. We want generated returns that are going to go to stockholders. So we want to see you, Mr. CEO or Ms. CEO, return cash to me in the forms of stock buybacks, in the returns of dividends,” but the capacity to reinvest means what to you?

TOM RUSSO: Well, it means just the opposite of what Wall Street is asking, so then I find that we’re on a very divided play field at that point. When I meet with management, my advice to them is to make sure they invest every penny possible. The jargon …

CONSUELO MACK: The opposite of what the rest of Wall Street is telling you.

TOM RUSSO: The jargon today is cash flow conversion, and that means how much of your reported net income per share can you pay out to investors. Well, Wall Street likes that number to be over 100 percent. I just as soon have it be zero. I just as soon have the business have prospective uses for capital that are sufficient to consume all of the net income let’s say, and it’s an example that’s been kind of pushed to my awareness through watching Berkshire develop all these years. They never once paid out the money that they generated, and they had ample internal uses for it, and watching that compound take place over decades based on retaining and the reinvesting well and reinvesting in a way that wasn’t orthodox in the first place. It’s unorthodox for a firm like Berkshire to hold $55 billion in cash at any given time just waiting for the next best opportunity, but it’s given them an enormous amount of competitive advantage over the years.

CONSUELO MACK: Berkshire Hathaway of course is one of your largest holdings, but a criticism of Berkshire Hathaway and any other company that holds a large horde of cash is that I’m not paying you guys basically to hold cash. I’m paying you to invest the capital to my benefit as a shareholder.

TOM RUSSO: And I think the answer is simply over what period of time. The need to have it happen immediately will prevent the better long-term returns that Berkshire can generate by having the flexibility of having capital available. The lamenting of how difficult it was to invest that money in 2007 and 2006 allowed for enormous returns when 2008 came along, and that $55 billion worth of cash had a very high calling to help bail out General Electric or Goldman Sachs or Harley Davidson at rates above 10, 12 and 14 percent, respectively. He may have not earned much along the way, but when the time came that the money was worth a lot, he knew how to charge and he had it available.

CONSUELO MACK: And he did know how to charge and, of course, everyone says, “All right, well, Berkshire Hathaway. Of course it’s Warren Buffett and Charlie Munger. Well, yeah, they’re going to do the right thing,” but the other companies that you invest in. So what kind of reinvestment do you look for? What’s the best kind of reinvestment? Because sometimes they can make terrible choices.

TOM RUSSO: It’s true. I think in our experience at least, the best reinvestment has for me been companies that have fairly knowable, certain and appealing brands, brands in effect being a measure of how something’s perceived not to have an adequate substitute, and that in the consumer’s mind develops, delivers to the manufacturer inelastic demand, all of which are terribly valuable, so you have a loyal consumer with loyal brands. The manufacturer is able to raise prices on them when they need to, to make a decent return. All that’s available in traditional markets for those businesses who happen to have an awareness in the consumer’s mind in developing markets. It’s the reinvestment from the markets that can no longer absorb capital into those markets that can fully absorb it and then generate a very high return on the incremental money that’s spent in markets that have an awareness of the brands that we own but don’t yet have necessarily the capacity to consume, but they will, and that’s population growth dependent. It’s consumers with disposable income dependent which is underway in the markets around the world. So think about Nestlé. It has products of 150 countries. They’ve been there forever, but the products have been expensive and a bit out of reach forever, and today they’re becoming less expensive and more in reach because Nestlé is developing the route to market, the advertising, the investment in the retail channel to make them available, and with that availability comes rising affordability as GDP per capita grows around the world. It’s an ideal investment.

CONSUELO MACK: You said the revenues of your portfolio of companies, and I think your top 10 companies are 70 percent of your portfolio, and 36 percent of the revenues of that portfolio, that very focused portfolio, come from the emerging markets.

TOM RUSSO: That’s about right.

CONSUELO MACK: And 15 percent from Europe. So the international piece is really important to you. Why?

TOM RUSSO: Well, because that’s where the growth is going to come from, and the companies that we’ve really struggled with over the years have been those businesses who lacked an outlet, a logical sense of outlet where capital have a high rate of return by expanding the business because they were geographically constrained. When the business has a very natural place to deploy the capital, it’s just much easier. Warren and Charlie, in terms of the world of storytelling …

CONSUELO MACK: Well, they’re domestic.

TOM RUSSO: They’re domestic, and they’ve attempted to go overseas, but the storytelling that I think about in that context is they like to step over one-foot fences. That’s what they say their goal in life is…

CONSUELO MACK: Meaning?

TOM RUSSO: It’s a limit to complexity of stepping over a one-foot fence, not a ten-foot fence, and for us I’ll give an example of Brown-Forman which …

CONSUELO MACK: My favorite manufacturer of my favorite bourbon which is Jack Daniel’s.

TOM RUSSO: Yes, Jack Daniel’s, and 28 years ago their shares collapsed because there’s a problem with poorly situated reinvestment. They bought a California cooler business that was quite poor. They owned Lenox. They owned Hartmann, a bunch of businesses non-core to Jack Daniel’s, and by the time I came around in 1987 they had so exhausted anything that they could do outside of Jack that they resolved as a family to take their free cash flow and develop the global business. Now at the time they only had five markets around the world where Jack Daniel’s sold more than 50,000 cases, but they’re willing to invest against current income because it’s expensive to open up markets. They’re willing to invest for their future based on the one thing they knew they could trust which is the strength of Jack Daniel’s. They had to pioneer it in markets around the world, and if you fast forward to today after having spent 27 years sort of carefully cultivating this business in international markets, they now have 50,000 cases in over 50 markets. So from five markets to 50, they’ve been able to get that brand established, and that’s been very expensive. So along that period of time they were deploying their capital to fund it, and the burden on income meant that they were probably understating their natural profit, but in so doing they built an enormous opportunity for the future.

CONSUELO MACK: And that’s another key concept that you look for in a company. We talked about the capacity to reinvest, what you call the capacity to suffer. What do you mean by that?

TOM RUSSO: Well, they had to come through years of underreporting profits because of the investment burden placed upon their upfront spending, and that is something that very few companies possess because of the concerns over the requirements by Wall Street analysts to have very predictable and excessive amounts of near-term profits and on the part of activists who are currently shaking up the tree and saying, “If you don’t do something right now, we have enough people to come in and do something better with the company.”

CONSUELO MACK: What gives a company the ability to withstand that pressure to have the capacity to suffer? Is it the family holding that you mentioned?

TOM RUSSO: For us it’s been, in the Brown-Forman’s case it was the family control. It’s the same with Heineken. It’s the same with Berkshire. It’s the same with Richemont. It’s the same with a host of the businesses that we own. It’s family control because the family can say as Heineken recently did when they received a full takeover offer, “No thank you. We’ll wait. We have our sight on our own future, and we’re independent. We can stay so.” In Brown- Forman’s case, nothing will happen with that company without the family’s consent, and so the management team that’s been driving the penetration globally has the security of knowing that what they’re doing is what they’re hired to do, and they won’t lose the mandate simply because of a fickle institutional shareholder comes in and out of large blocks of their shares. These are family businesses. I think that ironically gives me more comfort that the future will look brighter later than if they were purely public companies even though the equity markets generally don’t charge a premium for family-controlled companies because they’re so frightened about the malevolent family, the family that actually takes from the public rather than invest for the future, and so fearing that, the family-controlled shares often are available at lower prices. The measure of how you value that business, however, is quite interesting because one thing that you would recognize is that if in the case of Brown-Forman as they develop those 50 markets you have upfront burden on reported profits, your P/E is going to actually seem higher than it would be were they not willing to invest so deeply today for future business tomorrow. And so the valuation metrics so often used by investors which is P/E, may lead to a different outcome when you’re dealing with a business like Brown-Forman which for so many years has dedicated itself to investing against current income to build the future.

CONSUELO MACK: Is there a better metric than P/E? What would you … ?

TOM RUSSO: Market share.

CONSUELO MACK: Market share.

TOM RUSSO: Through market share and the developing…

CONSUELO MACK: So that’s what you look at, these global brands.

TOM RUSSO: The growth in market share. I mean here we’ve gone from five markets with 50,000 cases to now 50 markets. We’ve gone from half a million cases of Jack Daniel’s to over 10 million cases of Jack Daniel’s. Now that’s a very important development because the next 10 million that we sell will generate to the operating income a far higher share than the last 10 million. The development that they’ve been able to accomplish, however, is something that’s terribly important, and you can measure that and keep abreast of that.

CONSUELO MACK: The capacity to suffer now as we just mentioned, you run a portfolio that’s very international. You’ve had a tailwind prior to this because the dollar as you described in a letter was kind of gently declining. Well, now the dollar is not so gently. It has been strongly accelerating, and that’s hurt your portfolio. What do you do in a situation like this?

TOM RUSSO: The companies. First we visit the companies and say, “What can you do in this situation?”

CONSUELO MACK: Right, when the dollar’s this strong.

TOM RUSSO: And there’s very little you can do. I mean Nestlé reports in 100 different countries, 100 different currencies. Maybe not that many currencies but they pull it all together in Swiss francs at the end of the day. Philip Morris does business in every country outside the United States, and they pull it all back in dollars at some point. The burden on Philip Morris is that they’ve earned four dollars plus or minus a share for the past four years. That’s what they’ve reported, but in fact with constant currency it would be something close to the $6.50. So that amount of earnings that they aren’t reporting because of translation gets translated at P/E multiples to a lower price stock than what would have happened had they not had that currency headwind, but that reverses over time, and it’s happening as we speak. Actually the real goal isn’t to have a currency-neutral or currency-exposed portfolio. It’s to have our clients’ money in the parts of the world where consumption will grow and where investments will enjoy better returns, and I think with that exposure over time we’ll probably see stronger currency relative to those markets. It’s not unlike America relative to England in 1914 when England was the reserve currency. America was sort of an upstart new market, and we just out-produced and outperformed, and over time the dollar became a much stronger currency than the British pound.

CONSUELO MACK: Your top 10 holdings, as I mentioned, 70 percent of your portfolio. You’ve held many of them for well over a decade, and I’m looking Berkshire, Nestlé, Wells Fargo. Even through the financial crisis you held Wells Fargo. Philip Morris International through Altria, Richemont, Heineken, Pernod Ricard, Unilever, Brown-Forman. Truly buy and hold even through tough times. Why? TOM RUSSO: Well, the fact is those are great businesses. I was actually quite pleased to hear you say the names. They sounded very fine to me, the names. They resonate well.

CONSUELO MACK: They’re all well known.

TOM RUSSO: But they’re great brands. Typically they’re great brands. It’s very hard to find the combination of businesses behind which you can invest with managements who care about investing for the long term with owners that are willing to share it with you on equal terms within the world of family-controlled companies. I just read an article on Perry Ellis which is being sued by a couple of outside investors, and they said that the family, there are sort of insider transfers and all the rest of sort of $50 million over the past that many years. Well, you just don’t hear that about the Heineken family or the Brown family or Johann Rupert’s family in Richemont. Warren Buffett is a perfect example. They earn their money the same way we do by and large, and that’s really valuable to find that alignment of interest and that lack of agency cost. I can’t find it broadly, and when I do I want to make sure we stay with it.

CONSUELO MACK: We mentioned activist investors earlier. What’s your view of activist investors?

TOM RUSSO: Well, I think they’re painted with one brush, and I think that always as the case is a risk. I would think back over the years of some of the early work done by Carl Icahn or others, Boone Pickens for example. Very early in times they were up against an intransigent kind of corporate America muscle.

CONSUELO MACK: They were called corporate raiders back then.

TOM RUSSO: They were called raiders back then, but the fact of the matter is they were really unseating the seats of power. Now fast forward to today. I found myself once recently at a hotel going to a meeting. I arrived and there was a placard that says, “Corporate activist presentation upstairs,” and so I went upstairs. I looked at the handout. The first thing was, “Find a target.” Well, that’s not what I would think is sort of noble calling. You might end up with an activist position if a business that you otherwise wanted to participate in stumbled on issues of governance. I think it’s something that begrudgingly you get drawn into, but I wouldn’t want to spend my days doing that. I’d much rather…

CONSUELO MACK: You call yourself a corporate cheerleader as a matter of fact. So you find a target to cheer, not to shake up.

TOM RUSSO: Yes, yes. And also just to support and to make sure that there’s an opposite voice. When you’re a CFO of a company or a CEO of a company and the only thing that you hear from investors across the land is, “Give us all that money back and then some, quickly,” at some point you lose the sense that are other types of investors who might say, “Wait a minute. If you defer and you invest for the future, we may actually have a much better future than if we deplete the corporate right now with distributions and stop investing.” And the beauty about the businesses that have that capacity to suffer through long-term investing is that up against a field now diminished in their competitor vigor because they’re being asked to deliver everything today, our companies with a longer-term horizon have better prospects for results because the investments that they put on the ground face less competition, whereas the other people could easily be there alongside if they’re being asked to return money and not burden the income today with future spending. Our businesses that can absorb those risks or those not risks, but those realities of reinvestment are much better off.

CONSUELO MACK: Tom, I have to ask you about Berkshire Hathaway. So obviously Warren and Charlie are both senior citizens. Do you envision holding Berkshire Hathaway beyond Warren and Charlie?

TOM RUSSO: Yeah, I’m perfectly comfortable with that as an investment. It’s such a rare combination of operating companies that all have their own forward momentum. It’s a fabulous place for the seller of a business that has the kind of virtues and values that Berkshire seeks.

CONSUELO MACK: Because …

TOM RUSSO: Because of what they offer. They offer the seller the chance to have a liquidity event to de-risk their family in some ways while still having the privilege of running a business that they’ve carefully created over decades in many cases, with the same people without the pressure of dressing themselves up for a very quick sale to another private equity firm. It’s permanent capital. Now that’s really valuable to just some people because other people don’t care. They’ll take the highest bid.

CONSUELO MACK: Quick question for you. One investment for a long-term diversified portfolio. What should we all hold some of?

TOM RUSSO: Well, I’d say at this particular moment … now it hasn’t been so for a while, but right now I think Philip Morris is an interesting position. I’ve owned it for almost 30 years through various forms. This is the international only business, and the dollar has, as I said, burdened the report of profits by as much as $2.50 over four years in a row. They’ve invested heavily in defending against competitive assaults across a variety of different markets. They fought back contraband and unlisted cigarettes in all sorts of markets, and they’re in the midst of launching a new product that costs them a lot of money, over $2 billion invested in the new technology.

CONSUELO MACK: Which is …

TOM RUSSO: For reduced-risk cigarettes, that Philip Morris has spent over the past 10 or 15 years something like $2 billion. They have one today that they’re rolling out. It launched in Italy and in Japan. I think it will be quite promising. The senior management of Philip Morris who have always been dedicated users of the traditional Marlboro product line have switched, and they’ve switched to a product that satisfies their needs. Now we all hear about e- cigarettes. We see them. There’s a lot of discussion about whether they’ll be disruptive. The trouble is that they haven’t typically satisfied what the consumer wants. They want flavor and they want nicotine delivered in a fashion much like cigarettes, and what Philip Morris has created is a product that does that.

CONSUELO MACK: And we will leave it there.

TOM RUSSO: Thank you.

CONSUELO MACK: Tom Russo, such a treat to have you on WEALTHTRACK. Thanks so much.

TOM RUSSO: Thank you very much.

CONSUELO MACK: At the close of every WEALTHTRACK we try to give you one suggestion to help you build and protect your wealth over the long term. This week’s action point comes from this week’s great investor guest, Tom Russo about his investment hero, Warren Buffett. Russo chose two of his favorite books about the “Oracle of Omaha” to share with us. So this week’s Action Point is: Add two Buffett books to your summer reading list.

The first is “Buffett: The Making of an American Capitalist”. It is also one of our favorites, written several years ago by top financial journalist, Roger Lowenstein, a past WEALTHTRACK guest and former Wall Street Journal colleague of mine, it provides remarkable insights into Buffett’s personality, thinking and investing approach.

The second Russo recommendation is “Berkshire Beyond Buffett: The Enduring Value of Values” by Lawrence Cunningham. Published in 2014 it tackles the question everyone asks about Berkshire Hathaway. What happens when Buffett is no longer on the scene? Cunningham makes the case that Berkshire’s hands-off, own forever culture is the glue that holds the company together and predicts that it will endure.

To see reviews of these two books and other WEALTHTRACK recommendations visit the WEALTHTRACK BOOKSHELF section on our website. You can also see more of our rare interview with Tom Russo in our EXTRA feature.

Thank you for watching. Have a great Memorial Day weekend and make the week ahead a profitable and a productive one.

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