CFA Institute

The Ownership Dividend: The Coming Paradigm Shift in the U.S. Stock Market. 2024. Daniel Peris. Routledge — Taylor & Francis Group. Could the next opportunity in the stock market be with dividend stocks? According to Daniel Peris, the answer is “yes,” and after reading his insightful book, The Ownership Dividend: The Coming Paradigm Shift in the U.S. Stock Market, readers may find it hard to disagree with him. Peris is a senior portfolio manager at Federated Hermes, having joined the firm in 2002. His focus has been dividend-paying stocks, and he is considered one of the leading authorities on the subject. Previously, Peris authored several books on investing, including two about dividends: The Strategic Dividend Investor (McGraw Hill, 2011) and The Dividend Imperative (McGraw Hill, 2013). Both books remain valuable for any investment professional because they challenge one’s assumptions about how well companies use their cash. In The Ownership Dividend, Peris writes that there is soon to be a realignment in the stock market that could create “profitable opportunities for those who are prepared.” The shift will be from investors preferring a price-based relationship with their investments over a cash-based one. After four decades of an “anything goes” environment, where investors were dependent on the ever-changing price of a stock, Peris believes the tide has begun to turn. Investors will demand that more companies share their profits via dividends. Predicting a realignment in the stock market is bold and could easily be dismissed; however, Peris makes a great case for why dividends should be given a lot more attention than they currently receive. Peris carefully explains how the past four decades of declining interest rates have led investors to focus on the price growth of shares, rather than the income they provide. His argument is well crafted, and he challenges the generally accepted notion that large, successful companies do not need to share their earnings with shareholders by paying dividends. By recounting the role that dividends historically played in the stock market, Peris takes readers through an account of how dividends encouraged investment and how they have been diminished by the misapplication of the work of Franco Modigliani and Merton Miller, whose Dividend Irrelevance Theory has been misused as an argument for companies not to pay a dividend at all. The Dividend Irrelevance Theory states that the dividend policy of a company has no effect on its stock price or capital structure. The value of a company is determined by its earnings and investment decisions, not the dividend it pays. Thus, investors are indifferent as to whether they receive a dividend or a capital gain. As Peris points out, however, this theory is often misunderstood. Created in 1961, the theory assumes that most companies would be free cash flow negative, because they operated in capital-intensive industries and would need external capital to fund their growth plans and to pay dividends. While that may have been the case in the 1960s, Peris estimates that this situation applies to only 10% of the stocks in today’s S&P 500 Index. The current S&P 500 is made up primarily of service companies that are free cash flow positive and have sufficient cash flow to fund their growth and also pay a dividend. Peris provides countless reasons for the role that dividends play as an investment tool, but his review of stock buyback programs should be read by every investor. He is ahead of his time and unafraid to point out that perhaps the emperor has no clothes. While many on Wall Street applaud stock buyback programs as a tool to boost earnings per share, Peris exposes the reality that too often a significant portion of what is “bought back” is used for employee stock option plans. Investors would be well served to understand how stock buyback programs are often diluted by stock compensation plans. In fiscal year 2023, Microsoft repurchased $17.6 billion of its common stock and issued $9.6 billion in stock-based compensation. Microsoft is hardly an outlier; the past 40 years have seen dramatic growth not only in stock buyback programs but also in employee stock option plans. Over the course of 10 chapters, Peris makes a compelling case for the importance of dividends. His book is written for practitioners, not academics, which makes the book approachable and absent of any pretense. While his target audience may not be professors, it would be a useful book for anyone teaching a course on investing, which should include the idea that on Wall Street, there is never just one way to value an investment. The fact that investing in dividend-paying stocks is out of fashion on Wall Street is well accepted; even Peris acknowledges that fact. But what if Wall Street is getting it wrong? What if Peris is right that dividends will soon become much more important? As Peris sees it, the fall in popularity of dividend investing can be attributed to three factors: the decline in interest rates over the past four decades, the change in the securities tax code in 1982 that enabled share buybacks, and the rise of Silicon Valley. These three factors caused the stock market to shift from a cash-based return system (where dividends mattered) to one that is driven by near-term price movements. However, these factors have potentially run their course. According to Peris, “The 40-year decline in interest rates has come to an end.” Over time, he maintains, the market will revert to where investors will expect a cash return on their investments. Each factor is thoroughly explored by Peris, but his review of the relationship between interest rates and the cost of capital is especially timely. As interest rates fell from their highs in the early 1980s, companies had little difficulty raising capital. The recent rise in interest rates could make it more difficult. It was not long ago that investors were faced with money market funds and CDs having negative real rates of return, leaving them few options in which to invest for current

Finding suitable peers for financial analysis is a vexing task that requires careful consideration of firms’ underlying economics, accounting choices, and financial statement presentation. But without comparable financial statement information, peer benchmarking may yield less meaningful and even misleading insights that negatively impact earnings forecasts. In a recent study published in The Accounting Review, we developed a methodology to identify comparable firms for benchmarking and analyzed its implications for analyst outcomes and valuation with multiples. In this post, we will highlight the salient details, some of which may surprise you. There are different ways to define peer firms, such as industry membership, stock index membership, closeness in market capitalization, and similarity in value drivers (e.g., P/E ratio, return-on-invested capital, and growth). As an alternative to traditional classifications, researchers have tested new ways to identify peer firms, such as investors’ co-search, intensity of firms’ filings with the SEC’s EDGAR, and stock information on Yahoo! Finance. These widely utilized methods fail to directly address a crucial aspect of firm benchmarking: the availability of key financial statement information for peer firms. When several financial statement line items are missing for a peer firm, analysts struggle to derive meaningful inferences from the comparative to the focal firm’s financial statements. Our financial statement benchmarking (FSB) measure aims to fill this gap. The data and code are freely available on our website. Capturing the Degree of Overlap Between Financial Statement Items Built on the Jaccard similarity coefficient, pairwise FSB captures the degree of overlap in financial statement items reported by two firms, with scores ranging from 0 (no overlap) to 1 (full overlap). The higher the FSB score, the greater the benchmarking information available to external users. For instance, if the focal firm has reported 270 items, 200 of which overlap with 220 items reported by the peer firm, the FSB score is 0.69 (200 / (270 + 220 – 200). To put this into context, the average score for analyst-chosen peers in our sample is 0.68. Assuming that FSB is a helpful metric in capturing the similarity of two firms’ underlying economics and accounting choices, we expect it to be positively correlated with analysts’ choices of peer firms. Our sample of analyst-chosen peers comes from a Review of Accounting Studies article, “Analysts’ choice of peer companies.” By manually screening more than 2,500 sell-side equity analysts’ reports, the authors extracted data on comparable peer firms selected for the focal firm in each report. In our study, for each analyst-chosen peer firm, we selected a matching firm in the same industry that was not chosen but which had a similar size and valuation multiple. The results show that analysts tend to choose peer firms that are more comparable to a focal firm from a financial statement benchmarking perspective. When FSB is higher by one-standard-deviation, the likelihood of being selected as a peer firm by an analyst increases by 13%. Higher FSBs Increase Accuracy of Earnings Forecasts Does choosing peers with higher FSBs have positive implications for analyst performance? We find that when the average FSB of the set of analyst-chosen peer firms is one-standard-deviation higher, the accuracy of analysts’ earnings forecasts increases by about 23%. When selecting peer firms, look for firms that have more similar financial statements to the focal firm, even if that means searching outside the focal firm’s main industry. In fact, only 40% of the analyst-chosen peer firms operate in the same product market as the focal firm. Which companies do you think would be good peer firms to choose when analyzing Colgate-Palmolive? Morningstar lists Procter & Gamble and Unilever as top peers for the company. Despite being listed on a US stock exchange, Unilever has a modest 0.69 FSB score with Colgate-Palmolive. This is likely because the company uses International Financial Reporting Standards to prepare its financial statements. Using different accounting standards reduces comparability due to differences in the recognition and presentation rules. In contrast, P&G and Colgate-Palmolive have a higher FSB score of 0.77, suggesting a greater comparability than Unilever and Colgate-Palmolive. In contrast to Morningstar’s approach, Google Finance creates a list of peer firms based on investors’ co-search activity. Notably, among the peer firms Google Finance lists for Colgate-Palmolive is Coca-Cola. Although this observation may seem unintuitive at first blush, our methodology suggests that, from a financial statement benchmarking perspective, Coca-Cola would be an excellent fit in this case because its FSB score with Colgate-Palmolive is well above the average at 0.82. This may explain why investors extensively co-search the financial information of the two companies. Validation and Testing After validating and testing the pairwise FSB metric, we aggregated data across all industry peers of the focal firm to understand how easy it is to benchmark a firm’s financial statements overall. This process yielded a large panel of firm-level FSB data. Also, to enrich our methodology, we decomposed FSB at the financial statement level, generating separate FSB scores for the income statement, balance sheet, and statement of cash flows. While analysts’ consensus earnings and net debt forecasts are more accurate when firm-level FSB is high (i.e., it is easy to benchmark and understand a firm’s financial statements), income statement and balance sheet benchmarking play different roles in those outcomes. We find that the Income statement FSB score predicts the accuracy of earnings forecasts but not net debt forecasts. In contrast, balance sheet FSB score predicts the accuracy of net debt forecasts, but not earnings forecasts. In economic terms, a one-standard-deviation increase in income statement (balance sheet) FSB is associated with a 17.3% (12.1%) more accurate consensus earnings (net debt) forecasts. These findings highlight that benchmarking benefits depend on the context of the analysis.  For the Investor: Industry, Industry-Size, or FSB Peers Beyond positive analyst outcomes, a key question for investors is whether choosing peer firms based on FSB improves valuation with comparables. To this end, we compared the predictive ability of the valuation multiples formed using FSB-based peers to those of the models employing traditional methods for peer firm

In the realm of finance, cognitive biases profoundly influence investor decision-making. Among these biases, confirmation bias remains particularly pervasive. Confirmation bias is the inclination to favor information that aligns with pre-existing beliefs while discounting contradictory evidence. Confirmation bias is exacerbated by echo chambers on social media platforms, where algorithm-driven content personalization creates an environment that reinforces investors’ views. Platforms such as X (formerly Twitter) and Reddit are especially prone to these dynamics, particularly among younger, retail investors, significantly shaping market perceptions. This blog post explores the mechanisms through which confirmation bias and echo chambers influence investor behavior on these platforms and proposes strategies for mitigating their impact. The Role of Social Media: X and Reddit X and Reddit have emerged as crucial sources of financial information for retail investors. While these platforms provide real-time updates and foster community insights, they also serve as fertile ground for reinforcing confirmation bias. X: The platform’s algorithm curates user feeds based on interaction history. For investors, this means that following specific finfluencers often results in an information bubble dominated by like-minded content. This is a key point made in the Research and Policy Center’s report, “The Finfluencer Appeal: Investing in the Age of Social Media.” An investor with a bullish outlook on tech stocks, for instance, is likely to receive a feed saturated with optimistic analyses, discouraging exposure to more skeptical viewpoints. This reinforcement of one-sided perspectives amplifies confirmation bias, leading to unbalanced decision-making. Reddit: Finance-oriented subreddits like r/WallStreetBets exemplify how echo chambers operate. These communities are prone to groupthink, where popular sentiments are upvoted while dissenting views are suppressed. This effect was particularly evident during the GameStop and AMC short squeezes in 2021, where the echo chamber dynamics led investors to disregard financial fundamentals and make emotional investment decisions. Many retail investors who bought GameStop or AMC at peak prices faced severe financial losses as the stocks subsequently collapsed. Impact on Financial Decision-Making The interplay between confirmation bias and echo chambers has driven significant financial phenomena in recent years. A recent example also revolves around GameStop — the flash rally of 2024. This recent event was sparked by the re-emergence of Keith Gill (Roaring Kitty) on Reddit and X after a three-year hiatus. Gill’s return prompted a sudden surge in GameStop’s stock price, which rose by more than 70% in a single day, reaching a peak of nearly $31 before plummeting by over 50% within just a few days. This led to significant losses for many retail investors who bought in at elevated levels, reminiscent of the speculative mania of 2021. Similarly, in the cryptocurrency market, platforms like X and Reddit have fueled speculative hype, particularly during bull runs. Many investors bought into projects like Cardano (ADA) without fully understanding the associated risks. Cardano experienced a sharp decline, dropping more than 40% from its 2024 peak, highlighting the volatility and uncertainty surrounding even well-known projects. Despite its ambitious promises of creating a scalable and sustainable blockchain ecosystem, Cardano’s progress has often been ambiguous, leading to skepticism about its real-world utility. The hype-driven environment, coupled with confirmation bias, led many investors to disregard warning signs, resulting in substantial losses during market corrections. Mitigation Strategies Although confirmation bias and echo chambers are pervasive, platforms like X and Reddit still provide substantial value for staying informed. X offers rapid access to breaking news and expert opinions, while Reddit allows for in-depth discussions and diverse community insights. To fully benefit from these resources without falling victim to biases, investors must adopt strategies to mitigate the risks of engaging with these platforms. Here are some strategies that can assist: Follow Diverse Perspectives: On X, consciously follow accounts that present differing opinions. If your perspective is typically bullish, include skeptics and contrarian voices in your feed to broaden the scope of content and challenge your views. Diversify Reddit Communities: Rather than relying on a single subreddit, explore a range of finance-oriented communities with varying viewpoints. Engaging with diverse perspectives helps prevent the pitfalls of group thinking and encourages a more nuanced understanding of market dynamics. Seek Non-Social Media Sources: To mitigate the effects of social media echo chambers, supplement your information sources with trusted financial news outlets, peer-reviewed academic papers, and market research reports. These sources provide more rigorously vetted information that is not influenced by the algorithms that curate social media content. Challenge Personal Beliefs: Regularly adopt a devil’s advocate approach toward your own investment ideas. For every positive argument, deliberately seek out and evaluate counterarguments, weighing evidence on both sides before deciding. It may even be worth engaging in discussion and actively asking trusted experts in your network or in online communities to challenge your investment thesis. Key Takeaway In an era where information is abundant yet algorithmically filtered to align with individual preferences, it is imperative for investors to recognize and actively counteract confirmation bias. Platforms like X and Reddit can offer valuable insights, yet they also distort an investor’s perception of financial realities, creating significant risk to their financial well-being. By deliberately seeking diverse viewpoints and critically assessing their own beliefs, investors can foster a more balanced and informed decision-making process. Maintaining intellectual flexibility in finance is not merely beneficial; it is essential for navigating complex and rapidly evolving markets. Let us commit to stepping outside the confines of the echo chamber and cultivating a broader, more informed perspective. source

Despite a brief return to normalcy in 2022, equity factor strategies have experienced performance challenges relative to cap-weighted indexes since the COVID-19-induced market crash of 2020. While there are many explanations for these challenges, our focus here is on another question: Is it possible to retain the benefits and economically sound basis of a factor approach to equity investing while more closely aligning a factor portfolio’s performance with a cap-weighted benchmark? Before we answer that, let us briefly review the drawbacks of cap-weighted indexes. In cap-weighted indexes, companies with higher market caps receive a higher weighting in the index. Smaller companies, on the other hand, which presumably have the most room to grow, receive a lower weighting. The risk inherent in investing in cap-weighted index strategies is threefold. One, they may experience losses as companies with the largest weights “mean revert” to lower price levels. Second, by underweighting smaller companies, cap-weighted strategies may prevent investors from meaningfully benefiting from companies with the most growth potential. Finally, cap-weighted index strategies are relatively concentrated in a small subset of the largest stocks. This lack of diversification runs against a cornerstone of modern investing and leaves investors vulnerable to significant downside risk if one or more of the largest companies in the index experience large drawdowns. In contrast, a properly constructed equity factor strategy will be driven by risk factors that have been shown to reward investors over the longer term. These factors — Value, Momentum, Size, Profitability, Investment, and Low Volatility — have been empirically validated over several decades by various researchers and possess a clear and intuitive economic rationale. Multi-factor portfolios that have exposure to all six factors are typically more diversified and lower volatility investment vehicles compared with cap-weighted indexes and the products that emulate their behavior. While the latter characteristics have served factor portfolios well, as we have seen, in some market environments, equity factor portfolios may underperform cap-weighted strategies. The question is: Is there a way to retain the benefits of factor investing while staying more aligned with the performance of cap-weighted indexes? What Is to Be Done? As we show below, a binary choice between factor investing and cap-weighted-like performance is not necessary. While tilting towards cap-weighted benchmarks in a wholesale manner will likely not benefit investors in the long run, there is a middle way: continue investing in a factor strategy but apply tracking error constraints to reduce the performance gap between cap-weighted and “unconstrained” factor portfolios over a given period. As our analysis demonstrates, applying the latter adjustments to a factor portfolio has both pros and cons, both in the short and long term. How Do Tracking Error Constrained Factor Portfolios Behave? The chart below shows the recent performance differences between a standard six factor portfolio –where each factor has equal weight — and tracking error (TE) constrained variants of it. When we apply TE constraints, the table indicates the performance gap between the factor portfolios and the cap-weighted index shrinks considerably. The cost that these portfolios pay, however, is around 100 basis points (bps) of additional volatility and a deterioration of downside protection, as measured by maximum drawdown. Factor Portfolios with Tracking Error Constraints,31 December 2022 to 30 June 2023 CapWeighted Six FactorEqual Weight Six FactorEqual Weight1% TE Target Six FactorEqual Weight2% TE Target Return 17.13% 6.04% 14.70% 12.38% Volatility 14.44% 13.10% 14.05% 13.72% SharpeRatio 1.01 0.27 0.87 0.72 Max. Drawdown 7.43% 7.90% 7.51% 7.61% RelativeReturn – -11.09% -2.43% -4.75% TrackingError – 4.65% 0.98% 1.95% InformationRatio – n/r n/r n/r Max. Relative Drawdown – 10.04% 2.19% 4.29% The sector composition of the TE-controlled portfolios in the following table shows that the strong underexposure to the Technology sector falls significantly relative to the standard multi-factor portfolio. This may not come as much of a surprise. After all, larger technology companies have been one of the primary drivers of the outperformance of cap-weighted vehicles relative to equity factor strategies. Sector Allocations as of 30 June 2023 Cap Weight-ed Six FactorEqual Weight Six FactorEqual Weight1% TE Target Six FactorEqual Weight2% TE Target AbsoluteWeight Relative Weight Absolute Weight Relative Weight Absolute Weight Relative Weight Energy 4.7% 6.3% 2.0% 5.3% 0.6% 5.9% 1.2% BasicMaterials 2.3% 2.6% 0.3% 2.4% 0.0% 2.4% 0.1% Industrials 8.8% 7.4% -1.4% 8.3% -0.4% 7.9% -0.9% Cyclical Consumer 12.4% 11.7% -1.0% 12.0% -0.3% 11.7% -0.7% Non-Cyclical Consumer 6.5% 11.2% 5.1% 7.4% 0.9% 8.3% 1.8% Financials 12.7% 13.1% 1.5% 12.9% 0.2% 13.1% 0.4% HealthCare 14.2% 17.7% 4.2% 14.8% 0.6% 15.4% 1.2% Tech 34.5% 21.5% -15.7% 31.7% -2.8% 28.9% -5.7% Telecoms 1.1% 2.0% 0.9% 1.3% 0.2% 1.6% 0.4% Utilities 2.7% 6.6% 4.1% 3.8% 1.0% 4.8% 2.1% Over a longer measurement horizon, the following chart demonstrates that controlling for TE detracts from long-term risk-adjusted performance by increasing volatility and reducing returns. The information ratios and the probability of outperforming the cap-weighted index over various horizons also deteriorate slightly. Long-Term Risk Adjusted Performance,30 June 1971 to 31 December 2022 Cap Weighted Six FactorEqual Weight StandardPortfolio Standard PortfolioTE 1% Standard PortfolioTE 2% AnnualReturns 10.22% 13.10% 10.95% 11.63% AnnualVolatility 17.33% 15.53% 16.82% 16.38% Sharpe Ratio 0.33 0.55 0.38 0.43 Max.Drawdown 55.5% 50.9% 54.0% 53.5% AnnualRelativeReturns – 2.88% 0.72% 1.41% AnnualTrackingError – 4.20% 1.14% 2.21% InformationRatio – 0.69 0.63 0.64 Max. RelativeDrawdown – 20.1% 5.8% 10.7% OutperformanceProbability(One Year) – 66.89% 67.71% 67.38% OutperformanceProbability(Three Years) – 79.42% 75.81% 75.30% OutperformanceProbability(Five Years) – 86.94% 84.62% 84.44% Conclusion Tracking error risk control is an effective way to manage the out-of-sample tracking error of multi-factor indices, and it can also help reduce sector deviations of multi-factor indices. We don’t have to throw out the baby with the bathwater. However, over the long term, aligning a factor portfolio’s performance with a cap-weighted index may be detrimental to both absolute and risk-adjusted returns. Moreover, simple cap-weighted approaches to equity investing lack the economic and conceptual foundations to justify their use. While they may outperform in certain market environments, they do not possess the formula for superior long-term risk-adjusted performance. If you liked this post, don’t forget to subscribe

The following is based on “Redefining the Optimal Retirement Income Strategy,” from the Financial Analysts Journal. Financial planning tools largely assume retirement spending is relatively predictable, that it increases annually with inflation regardless of an investment portfolio’s performance. In reality, retirees typically have some ability to adapt spending and adjust portfolio withdrawals to prolong the life of their portfolios, especially if those portfolios are on a declining trajectory. Our latest research on perceptions around retirement spending flexibility provides evidence that households can adjust their spending and that adjustments are likely to be less cataclysmic than success rates and other common financial-planning-outcomes metrics imply. This suggests that spending flexibility needs to be better incorporated into the tools and outcomes metrics that financial advisers use to advise clients. Flexible and Essential Expenses Investors are often flexible on their financial goals. For example, a household’s retirement liability differs from a defined benefit (DB) plan’s liability. While DB plans have legally mandated, or “hard,” liabilities, retirees typically have significant control over their expenses, which could be perceived as “soft” to some extent. This is important when applying different institutional constructs, such as liability-driven investing (LDI), to households. Most financial planning tools today still rely on the static modeling assumptions outlined in William P. Bengen’s original research. This results in the commonly cited “4% Rule,” where spending is assumed to change only due to inflation throughout retirement and does not vary based on portfolio performance or other factors. While the continued use of these static models may primarily be a function of their computational convenience, it could also be due to a lack of understanding around the nature of retirement liability, or the extent to which a retiree is actually comfortable adjusting spending as conditions dictate. In a recent survey of 1,500 defined contribution (DC) retirement plan participants between the ages of 50 and 70, we explored investor perceptions of spending flexibility and found that respondents were much more capable of cutting back on different expenditures in retirement than the conventional models suggest. The sample was balanced by age and ethnicity to be representative of the target audience in the general population. Ability to Cut Back on Various Spending Groups in Retirement Spending Group 0% — Not Willing to Cut Back Reduce by 1% to 24% Reduce by 25% to 50% Reduce by 50% or More Food (At Home) 29% 42% 21% 7% Food (Away from Home) 12% 41% 25% 20% Housing 31% 29% 22% 12% Vehicles/Transportation 13% 46% 26% 13% Vacations/Entertainment 14% 36% 25% 20% Utilities 31% 45% 16% 8% Health Care 43% 30% 17% 8% Clothing 6% 44% 25% 22% Insurance 32% 40% 19% 8% Charity 18% 31% 12% 19% Source: PGIM DC Solutions as of 5 October 2021 According to traditional static spending models, 100% of retirees would be unwilling to cut back on any of the listed expenditures. In reality, though, respondents demonstrate a relatively significant ability to adjust spending, with notable variations across both expenditure type and households. For example, while 43% of respondents wouldn’t be willing to cut back on health care at all, only 6% would say the same about clothing. In contrast, certain households are more willing to cut back on health care expenditures than vacations. A spending cut’s potential cost may not be as severe as traditional models imply. For example, models generally treat the entire retirement spending goal as essential: Even small shortfalls are considered “failures” when the probability of success is the outcomes metric. But when we asked respondents how a 20% drop in spending would affect their lifestyle, most said they could tolerate it without having to make severe adjustments. Impact of a 20% Spending Drop on Retirement Lifestyle Little or No Effect 9% Few Changes, Nothing Dramatic 31% Some Changes, But Can Be Accommodated 45% Substantial Changes and Considerable Sacrifices 13% Devastating, Would Fundamentally Change Lifestyle 2% Source: PGIM DC Solutions as of 5 October 2021 For example, only 15% said a 20% spending drop would create “substantial changes” or be “devastating” to their retirement lifestyle, while 40% said it would have “little or no effect” or necessitate “few changes.” Retirees appear to be far more sanguine on a potential reduction in spending than traditional models would suggest. The clear ability to cut spending as demonstrated in the first chart, and the relatively small implied potential impact on retiree satisfaction, or utility, in the second, at least for a relatively small change in spending, has important implications when projecting retirement income goals. While understanding each retiree’s spending goal at the more granular expenditure level is important, so too is having a sense of what amount of spending is “essential” (i.e., “needs”) and “flexible (i.e., “wants”) when mapping out assets to fund retirement liabilities. The following chart provides some context on what percentage of the total retirement income goal constitutes “needs.” Distribution of Responses: The Composition of a Retirement Goal That Is a “Need” (Essential) Source: PGIM DC Solutions as of 5 October 2021 While the average respondent says that approximately 65% of retiree spending is essential, there is notable variation: The standard deviation is 15%. Spending flexibility is critical when considering the investment portfolio’s role in funding retirement spending. Virtually all Americans receive some form of private or public pension benefit that provides a minimum level of guaranteed lifetime income and can fund essential expenses. In contrast, the portfolio could be used to fund more flexible expenses, which are a very different liability than is implied by static spending models that suggest the entire liability is essential. Conclusions Overall, our research demonstrates that retirement spending is far more flexible than implied by most financial planning tools. Retirees have both the ability and the willingness to adjust spending over time. That’s why incorporating spending flexibility can have significant implications on a variety of retirement-related decisions, such as required savings level (generally lower) and asset allocations (generally more aggressive portfolios may be acceptable, and certain asset classes become more attractive). For more from David Blanchett,

With its riveting victory over France in the World Cup finals and the heroics of its all-time great team captain Lionel Messi, Argentina has good reason to celebrate. But as the post-World Cup glow subsides, the country faces significant and deep-seated economic and financial challenges. Inflation reached an annualized rate of 92.4% for the period ending 30 November 2022, placing added pressure on a population already hard hit by years of stagflation and anemic economic growth. Moreover, after three decades of deficit spending, concerns about the solvency of Argentina’s public debt remain ever present. Indeed, the current prices of credit default swaps (CDS) indicate a 60% chance of default by 2024, according to Cbonds data. Argentina has not always endured such dire economic conditions. In fact, it was the 10th richest country in the world per capita in the early 20th century. To be “as rich as an Argentine” was a common aspiration. So what explains Argentina’s fall from the economic heights, how can it recover, and what lessons does it offer other emerging market economies? Argentina’ economic golden age from 1860 to 1930 owed much to its agricultural breadbasket, the Pampas, and the bounty of wheat, corn, wine, and beef it produced. Foreign investment from Germany, France, and the United Kingdom flowed in, and high wages attracted immigrants from Italy, Spain, and elsewhere. From 1860 to 1899, Argentina’s real GDP advanced at an astonishing clip of 7.7%. per year. During the first two decades of the 1900s, Argentina’s economy outperformed both Canada’s and Australia’s. Making a bet on Argentina’s future, Harrods even opened its first overseas location in the capital of Buenos Aires. With the Great Depression, however, Argentina’s decades of economic expansion came to a halt. Though the pain was global and other nations suffered similar economic declines, Argentina has yet to return to a trajectory of sustained economic growth. Inflationary Shock and the Maradona Era Where did Argentina stray from its development path? As the Great Depression led to a collapse in Argentina’s exports, widespread populist discontent destabilized the government. Over the next 50 years, populist regimes alternated with military dictatorships. Scarred by the export shocks of the Great Depression, Argentina’s economy turned inward. Rather than grow international trade, the country’s leaders embraced a misguided economic philosophy of self-sufficiency. Formulated by the economist Raul Prebisch, this approach sought to protect the development of domestic industries through import tariffs, subsidies, and even the nationalization of certain sectors of the economy. Following a coup d’etat in 1976, the new military junta began to reverse some of these protectionist policies and open up the economy to more international trade. But economic liberalization and the junta’s interests did not always coincide, and amid the country’s deteriorating finances, the initial results were mixed, so these efforts were soon dialed back. In 1978 meanwhile, Argentina hosted the World Cup, and the national team captured it first championship. Though the tournament had its share of controversy — state intervention was not limited to the Argentine economy — the victory constituted a bright moment in an otherwise dark era for the country. An ongoing challenge in this era stemmed from tax revenue, or the lack of it. Shortfalls grew especially severe in the midst of the Falklands War in the early 1980s and like many governments before it, Argentina’s rulers printed more and more money to finance the conflict, setting off rampant inflation and debasing the currency. By the end of the war, the annualized inflation rate was running at 82% per year. Argentina Inflation Rate (%), 1978 to 1984Annual Change on Consumer Price Index High inflation was a worldwide phenomenon in the 1980s, and Argentina was hardly alone in its struggles. As economists explored heterodox shocks to control rising prices and following a return to democratic government in 1983, Argentina’s leaders implemented the Austral Plan two years later. This replaced the traditional Argentinian peso with a new currency, the austral. (Though critics described the austral as effectively a peso with three zeros chopped off.) The Austral Plan also included wage freezes and tariff reductions. Initially, the program reduced inflation to a more modest yearly rate of 50% or so. In 1986, the country’s GDP grew at a respectable annualized 6.1%, and, behind the legendary Diego Maradona, Argentina captured its second World Cup. But the hoped-for recovery proved illusory as what became known as Argentina’s lost decade dragged on and economic growth continued to sputter. Massive fiscal deficits led the government to increase its money printing and inflation ramped up to unprecedented levels. In July 1989, it was running at 200% per month and ended the year at an annual hyperinflationary rate of nearly 5,000%. Argentina Inflation Rate (%), 1984 to 1990Annual Change on Consumer Price Index The Reform Era When Carlos Menem took office in December 1989, public expenses and the fiscal deficit added up to about 36% and 7.6% of GDP for the year, respectively. Menem lifted price controls, removed barriers to cross-border capital flows and international trade, simplified the tax code, and privatized several state companies. But his most fateful decision was converting the austral back to the peso and pegging it to the US dollar. This marked the beginning of what became known as the “convertibility regime,” which lasted into the early 2000s. The fixed-exchange rate regime, or currency board, was not a new concept, and many other countries have pursued similar arrangements. But when nations peg their currency to a foreign one, they effectively forfeit their ability to conduct independent monetary policy. If the US economy grew more rapidly than its Argentinian counterpart, Argentina’s central bank had to print more money to keep up with the fixed rate of exchange. This drove domestic inflation higher as the peso supply outpaced domestic production. In effect, the currency board was in thrall to US monetary policy. Still, the fixed-exchange rate regime initially showed promise. Inflation ran over 2,000% in 1990 but declined to only 1.6% in 1995. The Argentine government also

Earlier this year, the head of the US Department of Justice’s anti-trust unit vowed to crack down on the buyout sector’s aggressive deal-making practices. What that implied wasn’t entirely clear. As long as it remained a cottage industry, private equity (PE) was always lightly regulated. Even after the late 1980s junk bond mania demonstrated PE’s potential to wreak economic havoc, rudimentary reporting guidelines, weak accounting standards, and lax legislation all but endorsed PE’s capacity for incomparable value creation. The Gilded Age of Private Markets The SEC attributes the private markets’ phenomenal expansion to a comparatively casual regulatory framework relative to that of the public markets. Perhaps the industry’s small size and lack of systemic risk justified such leniency. At the peak of the 2007 credit bubble, the top traditional asset managers handled about $70 trillion in global assets while private capital firms only managed $3 trillion. But the landscape is changing fast. Every year from 2010 to 2020, in the United States private markets raised more capital than the public markets did. Last year, private capital firms had almost $10 trillion in assets under management (AUM). The growth rate is impressive, and so is the sector’s influence on the economy and equity markets through buyouts, take-privates, IPOs, and other corporate activity. Last year, private capital firms sponsored 38% of global M&A deals. In any given year, PE- and venture capital (VC)-backed IPOs may represent between 20% and over 50% of all public listings on national stock exchanges. But as the industry expands further, the risks will accumulate. Efficient markets require an unfettered flow of timely and accurate information as well as complete transaction transparency. These characteristics typically apply to the public equity and bond markets, but not to private capital. Tepid Attempt at Regulation The only real government effort to impose detailed disclosure requirements on PE firms occurred in the United Kingdom as the global financial crisis (GFC) unfolded. Amid sweeping job cuts at PE-owned businesses, trade union pressure combined with public outcry led to Treasury Select Committee hearings. In response, the British Private Equity & Venture Capital Association (BVCA) organized a commission to develop a code of practice to encourage more transparency. The commission recommended a set of voluntary disclosures, not serious regulation that would hold fund managers accountable. In the end, many of the PE practitioners expected to follow the so-called Walker Guidelines never reported on the performance and economic impact of their investee companies. Fifteen years later, all that remains of the initiative is a rather toothless reporting group run by the BVCA. This lack of detailed reporting requirements helped persuade BlackRock, Fidelity, and other traditional asset managers to launch alternative investment activities in private markets. The Reformation of Private Markets Yet, given recent developments, stricter supervision is warranted. In the first two years of the COVID-19 pandemic, for instance, almost half of LP investors, including those responsible for running retirement plans, allocated capital to PE fund managers whom they had never met in person. Even sophisticated institutions were cutting corners to secure their share of annual allocation. Such practices raise an obvious question: Who protects the clients and ensures that conflicts of interest are adequately dealt with? Of all the sector’s shortcomings, political capture may be the most perverse. This is hardly a new issue. The emergence of “access capitalism” was flagged almost 30 years ago. But the general trend towards influence-peddling has intensified. With so much firepower, alternative asset managers have secured the services of former presidents and prime ministers, among other policymakers. For all the criticism of the accountancy profession, a supervisory body does provide oversight and can sanction firms and practitioners alike. Audit regulation was strengthened in the wake of the telecom and dotcom crash of the early 2000s. In the UK, since the GFC, the Financial Reporting Council has fined accountancy firms for botched audits. And the UK government plans to strengthen the supervisory framework by granting new powers to a soon-to-be-created Audit, Reporting and Governance Authority. By contrast, thanks to their access and influence, private capital investors face very little scrutiny despite managing the population’s savings and retirement funds. So what should the regulatory priorities be? A Possible Regulatory Agenda Five areas in particular warrant comprehensive reform: 1. Information Accuracy and Disclosure Valuations can be subject to extensive finessing and manipulation. Academic research shows that PE operators inflate fund values, particularly when trying to raise money. Loose mark-to-market rules have turned the valuation exercise into a form of legerdemain that enables PE portfolio companies to demonstrate less performance volatility than their listed peers. But by failing to reflect fair market value, alternative asset managers simply adopt a mark-to-myth approach. Today, the most tempting ground for potential accounts manipulation is in private markets. Naturally, this has repercussions on the equity markets when inflated asset valuations are used as proxies ahead of anticipated IPOs, as the WeWork saga and last year’s SPAC-sponsored listings demonstrate. The integrity of performance reporting is another concern. Private capital firms can restrict the dissemination of data related to their activities and underlying portfolios. Indeed, one of the advantages of being controlling shareholders is the ability to withhold information. Warren Buffett raised the issue of performance disclosure at Berkshire Hathaway’s Annual General Meeting (AGM) on 4 May 2019: “We have seen a number of proposals from private equity funds, where the returns are really not calculated in a manner [that] I would regard as honest . . . If I were running a pension fund, I would be very careful about what was being offered to me.” Even if LP investors might be partly responsible for such shenanigans, proper reporting is paramount if they are to make informed decisions. One way to bridge the data gap and move towards an industry-wide governance framework would be for PE practitioners to adopt the Global Investment Performance Standards (GIPS) already used by many asset managers. 2. Fees. Efforts to end excessive rent extraction may provide the acid test for the sector.

Economists and market participants have introduced increasingly sophisticated models over the past half-century to explain the ups and downs of the equity markets. With some adjustments to corporate earnings measures and risk-free rates, these methods describe market movements quite well. But there is a simpler way to account for how equities behave. What if we de-emphasize their financial nature and think of them as high-end consumer goods — luxury watches, for example — whose prices are determined by the forces of supply and demand? Equities occupy an elevated position in Abraham Maslow’s hierarchy of human needs. Simply put, we buy stocks only after we have seen to our shelter, food, transportation, education, and other more immediate concerns. The higher our income, the freer we are to invest in equities, and vice versa. Based on this perspective, income inequality becomes a hidden driver of equity prices. In a very equal society, equities are less in demand. Why? Because the need for shelter and consumer goods trumps the need to own stocks. Imagine 20 households each have annual incomes of $50,000 while a single household has $1,000,000. According to our research, the latter household’s demand for equities is nearly 20 times that of the other 20 households combined. While traditional finance’s equity performance models still work, there is an alternative explanation for the 40-year secular bull market based on 19th century laws of supply and demand. On the demand side, rising income inequality mechanically drives equity demand up and with it, returns. On the supply side, net share issuance has been anemic ever since the Securities and Exchange Commission (SEC) legalized share buybacks in 1982. Classical economics explains what happens when demand for a good rises faster than its supply: The real price of the good must increase. Thus, the secular bull market that started in 1982 has been the direct consequence of strong demand growth fueled by ballooning income inequality, among other factors, combined with supply that has not kept up. The S&P 500’s real price return during the 1982 to 2021 bull run was 6.9% per year, according to our analysis. That’s 6.2 percentage points better than the 0.7% generated annually between 1913 and 1982. What explains that difference? Of the excess return, we find that 2.4 percentage points stems from a sea change of sorts. Income equality was on the rise in the late 1970s and early 1980s, but then the tide turned and increasing income inequality has since become the norm. Another 1.4 percentage points of the excess price return results from the supply squeeze caused by the 1982 SEC’s decision on share buybacks. The rest is due to growing equity allocations, lower inflation, and lower interest rates, among various other factors. So what if the world had been different? Had income inequality trends not reversed or the SEC not permitted buybacks, the S&P 500’s real price in 2021 would have been starkly different. We express these dynamics by focusing on the real price evolution of a $10,000 investment made throughout 1982 in the S&P 500 and realized throughout 2021. Outcome of a $10k Investment Made in 1982 and Realized in 2021 (Average Real S&P 500 Price Index in 1982: 317) Buybacks as Is Assumption Inequality as Is Negative InequalityTrend Stoppedin 1982 Negative InequalityTrend Continuedsince 1982 Dividends Fully Reinvested $315k $193k $133k Dividends Not Reinvested $134k $81k $56k Average Real S&P 500 Price (in 2021 Dollars) 4,261 2,581 1,764 Sources: Cowles Commission, S&P, Oliver Wyman Buybacks as Before 1982 Assumption Inequality as Is Negative InequalityTrend Stoppedin 1982 Negative InequalityTrend Continuedsince 1982 Dividends FullyReinvested $315k $193k $133k Dividends NotReinvested $81k $49k $33k Average RealS&P 500 Price(in 2021 Dollars) 2559 1540 1047 Sources: Cowles Commission, S&P, Oliver Wyman The market would have risen in all scenarios. But there is a major difference between the S&P 500’s 230% increase in the most bearish scenario and its 1240% actual increase. So, while income inequality is not the be-all and end-all of stock market performance, it is a critical factor that was previously hidden from view. What does this mean for the secular bull market’s future viability? To be sure, cyclical headwinds will play a role at times, as they have over the past year or so. But rising income inequality will continue to propel equity markets unless and until the ballot box decides otherwise. If you liked this post, don’t forget to subscribe to the Enterprising Investor. All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer. Image credit: ©Getty Images / Zorica Nastasic Professional Learning for CFA Institute Members CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. 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The debate over the inclusion of private investments in 401(k) plans is a hot topic in the investment community. With more than $8 trillion in assets and a growing asset base the US defined contribution (DC) market is a significant, largely untapped market for privates. The research paper “Why Defined Contribution Plans Need Private Investments[i]” — a 2019 collaboration between the Defined Contribution Alternatives Association (DCALTA) and the Institute for Private Capital (IPC) — provides an analysis of the potential benefits of including private equity and venture capital in DC plans, with the clear conclusion reflected in the paper’s title. A balanced view should consider the objectives of the study’s sponsors.  Specifically: DCALTA’s mission statement calls for “advocacy on the benefits of including hedge funds, private equity, and other alternative investments within a defined contribution framework.”   Consistent with the organization’s mission, the 2019 study’s bold conclusions include: Investing in private funds “always increases average portfolio returns” when publicly traded stocks are replaced with private equity (referred to as “buyout” in the study) and venture capital investments.  The study states that “…despite the wide dispersion of returns in private funds, the ability to diversify by investing in multiple funds is sufficient to have nearly guaranteed superior returns historically.” The message: If you play the game right, private investments always win. A careful reading of the research should ring alarm bells for the prudent investor or fiduciary: 1. It implies that any outperformance of private investments vs. public markets justifies investment. 2. The study uses mean returns, which improves scenario results, when median results are more appropriate. 3. It assumes that the tiny VC market in the 1990s could have accommodated impossibly large investments in the simulation’s early years. 4.  Assumes that the overall size of the venture capital market was equal to the buyout market, when in fact it is much smaller. 5. The cost assumptions for indexing traditional stocks and bonds are relatively high. There are lower-cost options available in the market.   6. The paper’s findings are based on hypothetical returns, while a recent real-world study indicated that the median fund of funds’ return has trailed the S&P 500. The Devil’s in the Details The paper compares the historical returns (from 1987 to 2017) of a traditional 60/40 stock/bond portfolio to simulated portfolios in which a chunk of the publicly traded stock allocation is replaced with randomly selected venture capital and/or buyout funds. To compare results with public markets, the paper uses public market equivalents (PME) — a methodology for assessing the performance of private equity relative to a public equity benchmark — as a key measure. For example, the median PME of 1.06 for private equity means the typical buyout fund return was 6% better (over its entire life, not annualized) than returns from a similar investment pattern in the S&P 500. Is that good?  I think the late David Swensen, esteemed head of the Yale endowment, would have said no.  He wrote: “The high leverage inherent in buyout transaction and the corporate immaturity intrinsic to venture investments cause investors to experience greater fundamental risk and expect materially higher investment returns.”[ii] The authors’ conclusions seem to suggest that even a 1.01x PME is worth the trouble. The prudent investor would disagree.   Mean Public Market Equivalent (PME) Return Median Public Market Equivalent (PME) Return Private Equity (aka Buyout) 1.12 1.06 Venture Capital (VC) 1.18 0.86 Source: “Why Defined Contribution Plans Need Private Investments.” In Fact, You Aren’t Invited to the Party Despite median VC performance that trailed public markets[iii], mean returns were juiced by a small number of killer VC funds that Acme 401(k) Plan can’t (and couldn’t) access.  For simulation purposes, everyone was invited. In practice, there was a velvet rope — even for large, institutional investors. This is no secret. The research acknowledges it: “Top VC funds are also difficult for most investors to access because of excess demand for these funds and the tendency for VC general partners to limit the size of their funds.” Temporal Anomalies and Retroactive Re-Weightings In 1987, the DC market in the US was worth $525 billion.[iv]  A 10% target allocation in venture capital, which the simulation assumes, would therefore require a $52.5 billion investment.  Unhelpfully, total venture capital raised for the five years from 1987 to 1991 was $31 billion.[v]  Marty McFly’s 401(k) plan could have reaped the spoils of the halcyon years. Not all of us have a time-traveling DeLorean. The simulation also relies on equal allocationsbeing made to both VC and buyout funds, despite the capitalization of the (higher returning) VC funds being much smaller than the buyout market. The simulation massively over-weights the smaller, better performing (based on the mean result) VC funds. Is this what they mean when they say VC investment leads to great innovation? Finally, the 60/40 Vanguard index funds used for most of the period of the paper, (VTSMX and VBMFX) have annual expense ratios of 14 and 15 basis points, respectively, when much lower-cost options have been available from Vanguard and others for years.  It’s Cheap if You Ignore the Costs The study’s key scenario calls for plans to invest in 10 funds per year. Most institutional investors in private markets invest in less than three per year. To get to the desired 10+ funds, the plans would likely need to invest in funds of funds. In the unsimulated world, that costs more money. The paper’s assumed added costs of up to 0.5% per annum for privates compares with real world fund of funds costs of ~2%.[vi]  In addition, the paper’s claim that returns were virtually guaranteed to perform better than a 60/40 portfolio appears to not reflect any additional costs associated with private investments A more constructive approach would be to analyze the actual performance of funds-of-funds. Helpfully, academics already have. One study[vii] shows that more than half of the funds of funds underperformed the S&P based on PME. The paper’s authors note: “Our results also have policy implications regarding

After working with private clients for 27 years, I’ve done many non-traditional things beyond offering them investment advice. I’ve gone for runs; attended funerals, bar mitzvahs, and concerts; and even referred one client to a top-flight pro-sports surgeon when he dislocated his shoulder. This year, I mailed holiday cards to every client. It featured a photo of my husband and me with our gigantic Bernese Mountain dog, Grace, all wearing our Santa hats — well, Grace refused to wear hers. A few days later I received this note from one of my long-time clients: Barbara, Thank you for the wonderful card. I feel I need to meet the one “member of the family” that I have never had the privilege of looking in the eye. May 2023 be a super year for you & Duncan. All best, (His name) This was the first time I’ve had a client request a meeting with my dog! And of course, I set it up immediately. Grace and I had a great visit with this lovely couple, and we talked about topics that had absolutely nothing to do with their investment portfolio. Grace was thrilled that they offered her some rippled potato chips and lots of belly rubs. What a fun way to start the New Year! Here are seven more surprising ways to bond with clients: Maria Pia Leon, Director Client Services, Forbes Family Trust, Miami “A couple of years ago, a long-time client asked me to help him with a very different task: putting up and restoring a 1960 Rolls Royce. It was the car he had used in his wedding, and over time, it had deteriorated. I have always loved classic cars, and I always had the crazy idea of working on a 1978 Porsche 911, so this request was not so much out of my realm. “The project took us three years; then while he was visiting last summer, we finally went for a ride in the car. Just the look on his face showed me that those three years of reviewing catalogs, auctions, and color palettes were so worthwhile. This entrepreneur embraced his passion and helped a family tradition continue. As a trusted adviser, I see my role as helping to sustain the wealth for generations, and for me, this includes a car with meaning if it is part of a family story. I am pleased this car will be used for weddings and special occasions of future generations.” Blair duQuesnay, CFA, Lead Advisor, Preserve, Ritholtz Wealth Management, New Orleans “Last fall I was planning on travelling to Southern California for an event, so I decided to reach out to several clients in the area to arrange meetings. I had never met one of my newer clients in person: We started working together at the beginning of the pandemic, so we had only met virtually. She is a single retired woman who lives alone in Northern San Diego County, which is quite a long drive — 30 minutes or so — from where I was staying. I told her I would look for a local hotel and we could have dinner together. She said, ‘Why don’t you just stay with me?’ “Now maybe this might seem a bit weird, but I said ‘Sure,’ and we ended up having a very relaxed time getting to know each other. She gave me a tour of her beautiful property and garden, we went to a not-fancy local place for dinner, and later we watched Netflix on her couch together . . . just like friends. The next morning, I drove back to LA with pomegranates and passion fruit from her garden. My daughter really loved the passion fruit!” Kathrine Madsen, Senior Investment Advisor HNWI/UHNWI, Private Banking Elite, Danske Bank, Copenhagen “When I started out in this business 15 years ago at age 28, fresh out of Copenhagen Business School, I was very self-conscious and always wondering if I was good enough to do this job. Over the years, I have realized that you can memorize P/E ratios but that won’t make you trustworthy. Either you have a trusting relationship with your clients or you don’t. Trust has to come naturally. I like to give my clients a sense of who I am in real life, not just the corporate Kathrine. “During the pandemic, one of my wealthiest clients and I deepened our bond: We both had a lot of time on our hands. On occasion she would send me LinkedIn profiles of men she deemed to be good potential for me to date. Then I shared with her that I had taken on a hugely challenging project of renovating my kitchen all by myself. She said ‘Oh how cool are you? Send me some pictures!’ “I have an integrated dishwasher, and it was a tough job getting it to fit properly. The plate had to perfectly match to the top drawer of my kitchen table. I was so excited that I aced it on the first attempt! I filmed a video of this successful situation and texted it to my client. At age 28, I would never ever have expected that I would do something this odd, texting a video of my dishwasher to a major client. It is interesting how these types of relationships start and how they evolve.” Guillaume Drouin Garneau, CIM, Portfolio Manager, RBC Dominion Securities, Montreal “In addition to being an investment adviser, I’m a passionate cyclist, in pursuit of adventure, pushing my physical and mental boundaries to new levels. I’m also the co-owner of Le Club Espresso Bar, an online retailer of premium cycling brands and a unique space offering an espresso bar and a boutique under the same roof. Our mission is simple: To gather and grow the cycling community, provide a selection of high-quality cycling brands, and to expand the third wave of coffee, a movement to produce high-quality coffee. “A few of my clients are very interested in coffee, and one asked me