CFA Institute

There is notable disagreement among academics about how investment time horizon should affect portfolio allocations. In recent research released through CFA Institute Research Foundation, we explored this topic at length. We find that the assumption that returns are independent over time is inconsistent with historical evidence, both domestically and internationally across stocks, bonds, and alternatives. These findings suggest that investment professionals may need to re-think their portfolio optimization routines — including mean variance optimization (MVO) — which typically assume returns are random across time. This article is the first in a series of three. Here, we will provide context about how returns historically have evolved over time. In subsequent articles, we will describe what this means for equity portfolios and portfolios of real assets like commodities. Risk and Investment Horizon One commonly held belief among many investors and financial advisors is that the risk of certain asset classes, in particular equities, declines over longer investment periods, an effect commonly dubbed “time diversification.” Evidence provided to support this hypothesis is how the distribution of compounded returns tends to converge for longer investment horizons, as demonstrated in Exhibit 1, which is based on the returns of US equities from 1872 to 2023. Exhibit 1. The Distribution of Compounded Equity Returns by Investment Horizon 1872 to 2023. A key problem with this perspective is that investors should not focus on compounded returns. Rather, they should focus on compounded wealth. And compounded wealth tells a different story.  Using the same returns over the same period, Exhibit 2 includes how the distribution of wealth changes by investment horizon and there is clear evidence that it is diverging, not converging. Exhibit 2. The Distribution of Compounded Wealth by Investment Horizon for an Equity Investor 1872 to 2023. In reality, the risk of virtually all investments increases over time, when risk is defined as the increased dispersion in wealth. This perspective is consistent with options pricing models. While the risk of all investments is increasing, it is important to note that the rate of the increase could vary over time and this variance has important implications for investors with longer holding periods. If the relative risks of investments change by investment horizon, that would suggest some type of serial dependence is present, which means the returns evolve in a way that isn’t completely random. Previous research suggests that the return on an investment such as stocks is relatively random. This theory is perhaps best exemplified in Burton Malkiel’s book, A Random Walk Down Wall Street. But our research finds that autocorrelation exists.   In our paper, “Investment Horizon, Serial Correlation, and Better (Retirement) Portfolios,” we provide context around autocorrelation, or how past returns are related to future returns. We examine five US return series — bills, bonds, stocks, commodities, and inflation — using historical annual returns from 1872 to 2023, leveraging data from the Jordà-Schularick-Taylor (JST) dataset and the Bank of Canada. Exhibit 3 includes the coefficients from a series of ordinary least squares (OLS) regressions, where the dependent variable is the actual return for that calendar year, while the returns for the previous five calendar years are included as independent variables.  Historical returns for each asset class are re-centered, so they have an average return of zero and a standard deviation of one, to reduce any implications associated with historical differences in returns and risk levels. In other words, the regression is effectively based on the z-values of the historical time series returns. Negative coefficients are highlighted in blue, since this implies the risk of the asset declines over time because a positive return would be more likely to be followed by a negative return. Positive coefficients that are statistically significant, implying that the risk of the asset increases over time, are highlighted in red. Exhibit 3. Regression Coefficients for an Ordinary Least Squares (OLS) Regression, Where the Dependent Variable is the Current Calendar Year for the Asset Class 1872 to 2023. Back to Exhibit 1, there are several coefficients that are statistically significant, defined as a p value less than 0.05, which suggests the historical returns series is not truly independent across time.  Certain asset classes, such as bonds, have exhibited positive autocorrelation historically, while other asset classes, such as equities, have exhibited negative autocorrelation. This suggests that the longer-term risks of owning either asset could change due to the investment horizon. The relative risk of owning equities should decline compared to bonds, for example. Next, we look at how the risk of assets can change when considering inflation. For this analysis, we estimate the correlation between the cumulative growth in wealth and cumulative impact of inflation for different investment horizons for the same four asset classes. Exhibit 4. Historical Correlations in Wealth Growth for Various US Asset Classes by Investment Period 1872 to 2023. Inflation is often explicitly considered in certain types of optimizations (e.g., a “surplus” or liability-relative optimization). One potential issue when considering inflation, however, is that changes in the prices of goods or services do not necessarily move in sync with the changes in the financial markets. In other words, there could be lagged effects.  For example, while financial markets can experience sudden changes in value, inflation tends to take on more of a latent effect, where changes can be delayed and take years to manifest. Focusing on the correlation — or covariance — of inflation with a given asset class like equities over one-year periods may hide potential longer-term effects. The correlations of the four asset classes vary notably with inflation by different investment horizons. For example, a one-year investment horizon, which is a common time frame used for MVO assumptions, the correlations are relatively low for all asset classes, suggesting little potential hedging benefit. However, there are notable increases over a 10-year period that can at least be partially explained by positive drift for each asset. The correlation between commodities and inflation increases to 0.62, for example. The notable increase in correlations for bills and commodities is especially

What does the latest Index Industry Association (IIA) global membership survey reveal about current trends in indexes and benchmarks? Chief among the key data points is that the rapid expansion of environmental, social, and governance (ESG) indexes continues to gain momentum and diversify across asset classes. The 2022 survey found the number of ESG indexes grew by 55%, with fixed-income–focused ESG indexes and benchmarks taking the lead in driving that growth. The IIA has queried its members for the last six years to better understand how the landscape of indexes and benchmarks is evolving. Our annual global benchmark surveys gather member data about the indexes administered across identified asset classes and geographies — global, the Americas, Europe, and Asia. IIA members now administer over three million indexes, with equity indexes comprising 76% of the global total. With only about 11,000 global exchange traded products (ETPs), benchmarking is still the primary use case of indexes today. The IIA’s most recent global asset managers report revealed increased demand for ESG fixed-income indexes, and index providers have responded. The number of ESG fixed-income indexes has increased 95.8% and for the first time surpassed the number of ESG equity indexes, despite the latter growing by 24.2%. There are now more than 50,000 ESG benchmarks worldwide. Growth of Global ESG Indexes Among the various index categories, global ESG fixed income grew the fastest, expanding by 122.5%. European fixed-income ESG saw the second largest percentage increase, at 92.5%. This spike tracks with findings from our previous report: Asset managers indicated that fixed income is now the fastest-growing ESG asset class. Indeed, 76% of asset managers implemented ESG criteria within fixed income this year, up from 42% in last year’s survey. This has been an ongoing trend in recent years. As investors gain access to new and better data, there is a greater push to define ESG in fixed income. The growth rate of fixed-income indexes outpaced that of their equity counterparts for the third straight year, increasing by 4.5% compared with 4.3%. Within the non-ESG fixed-income category, municipal bond indexes grew by 10.9%, while the distribution across other categories remained stable. Growth of Global Fixed-Income and Equity Indexes Why is all this important to investors? The research and development that go into benchmarks and indexes eventually find their way back to the end investor. This year’s results highlight a chain reaction: With better ESG data, index providers create better benchmarks to track the market. This gives asset managers the tools to create better investable products. In turn, investors have more confidence that their investments are meeting their expectations. Our findings also revealed a larger misperception about equity indexes. Contrary to popular belief, the Americas does not dominate the total number of equity indexes. The region actually has the smallest percentage of equity indexes across the three geographies surveyed. But our survey does show that the Americas is leading the way in creating new fixed-income indexes. The market has the largest percentage of fixed-income indexes, with more securitized benchmarks and high-yield and municipal bond indexes than all the other regions. This development notwithstanding, the distribution of indexes across regions has remained stable and consistent over the last several years. Whether these trends gather increased momentum or start to tail off will be something we will be watching in the year ahead. 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/ champc 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. Members can record credits easily using their online PL tracker. source

Sustainability metrics and disclosures have attracted significant attention globally. Yet, assurance practices vary in the amount of work performed and investors may be lulled into a false sense of security by the word “assurance.” The voluntary nature of sustainability reporting has led to fragmented practices and concerns about greenwashing, prompting recent regulatory actions such as the European Union (EU) Corporate Sustainability Reporting Directive (CSRD) and the climate-related disclosure rule for U.S. Securities and Exchange Commission (SEC) registrants. Investors and other stakeholders increasingly rely on sustainability information for decision-making given the rise of environmental, social, and governance (ESG) considerations. Naturally, this has increased demand for external assurance, even in the absence of regulatory requirements. For instance, the Center for Audit Quality noted that in 2021, 320 of the S&P 500 companies voluntarily purchased assurance services for some of their sustainability information. However, these assurance practices vary in the level of assurance provided. The two common levels are “limited” and “reasonable.” So, what do they cover, and what sets them apart? Assurance of Sustainability Reports: What is Covered? Sustainability reports cover a wide range of topics, from environmental impacts to employee diversity, to governance oversight. They often communicate trends and key takeaways in the form of figures and tables. Notably, sustainability assurance engagements do not automatically cover all the information disclosed in a sustainability report. To understand what is assured within a sustainability report, one must refer to the accompanying assurance report. The assurance report may be included in the sustainability report, or it may be available through referenced links (e.g., on the company’s website). The assurance report should explicitly identify what is subject to assurance. For instance, the assurance report for the 2023 Sustainability Report of Siemens Healthineers states: “We have performed a limited assurance engagement on the disclosures marked with the [check mark] symbol (hereafter the “disclosures”) in the Sustainability Report of Siemens Healthineers AG.” But the assurance statements for Coca-Cola’s 2022 Business and Sustainability Report have appendices listing the indicators that were subject to assurance. The assurance report should also disclose the criteria against which the sustainability information is evaluated. For Siemens Healthineers, the criteria are the Global Reporting Initiative standards. For Coca-Cola, the criteria are also listed in the appendices and include company-specific manuals. Particularly in cases like the Coca-Cola example, investors are encouraged to go to the appendices and determine whether the chosen criteria seem reasonable given company-specific business operations. In the absence of specific regulatory requirements, companies can opt for either limited or reasonable assurance services. Limited assurance and reasonable assurance represent different levels of confidence in the accuracy of reported information. What is Reasonable Assurance? Reasonable assurance is akin to what most investors may be familiar with from financial audits. It provides the highest level of assurance. The assurance provider reduces the risk that the sustainability information is materially misstated to a predefined acceptably low level, though never to zero. Importantly, despite being the highest form of assurance service offered, reasonable assurance does not provide absolute certainty. The assurance provider does not guarantee that all possible errors or fraud indicators are detected. Because the assurance engagement provides only “reasonable” assurance, the procedures are performed on a test basis. This means that the assurance provider draws samples and uses analytics to identify specific transactions or estimates that warrant further testing. Testing may involve tracing evidence to supporting documents, confirming information with third parties or legal providers, consulting specialists to verify the reasonableness of assumptions made in estimates or calculations, and conducting on-site testing. It also includes gaining an in-depth understanding of the processes used by management to prepare the disclosures and testing the accuracy of data processed by information technology systems and manual spreadsheets. Finally, the assurance provider will evaluate whether the procedures identified any errors or misstatements. To determine whether management needs to correct these errors or misstatements before the publication of the sustainability report, the assurance provider uses a predefined materiality threshold, which may or may not be disclosed in the assurance report. If the total effect of the identified errors or misstatements is below the predefined materiality threshold, the assurance provider can sign off without additional disclosure about the identified issues because they are deemed less than material. The conclusion in a reasonable assurance engagement report is expressed in a positive form, as exemplified by the 2022/2023 ESG Report of GUESS: “Our responsibility is to express an opinion on Management’s Assertion based on our examination. […] We believe that the evidence we obtained is sufficient and appropriate to provide a reasonable basis for our opinion. […] In our opinion, Management’s Assertion related to the Key ESG Metrics and Disclosures as of and for the year ended January 29, 2022, and January 28, 2023, is fairly stated, in all material respects.” Depending on the assurance standard used, the assurance provider will likely use the term “examination” or “audit” to describe the reasonable assurance engagement. What is Limited Assurance? In a limited assurance engagement, the assurance provider still aims to perform procedures that reduce the risk that the sustainability information is materially misstated. However, the accepted level of risk of material misstatement is higher compared to reasonable assurance engagements. The procedures performed are limited in nature compared to those in reasonable assurance engagements. For instance, in the 2022 Greenhouse Gas (GHG) Emissions Assurance Statement of Coca-Cola, the assurance provider states: “The procedures we performed were based on our professional judgment. Our review consisted principally of applying analytical procedures, making inquiries of persons responsible for the subject matter, obtaining an understanding of the data management systems and processes used to generate, aggregate, and report the Subject Matter [i.e., selected GHG emission indicators] and performing such other procedures as we considered necessary in the circumstances.” The conclusion in a limited assurance engagement report is expressed in a negative form. In the case of Coca-Cola, it reads: “Our responsibility is to express a conclusion on the Subject Matter [i.e., selected GHG emission indicators] based on our review.

A CRE Investing Primer Real estate investing means different things to different people. It can be shorthand for buying a rental property — taking out a mortgage, finding a renter, and hoping to clear the monthly cost while the asset appreciates. It can also mean buying shares in a public real estate investing trust (REIT), the kind that has been around for decades and is accessible through most brokerage accounts. But real estate as an asset class is much more diverse than that. Broadly speaking, commercial real estate (CRE) may refer to many different types of property, investment theses, and risk/return profiles. Fintech-enabled investing has made private-market CRE as accessible as stocks and index funds, albeit at a higher minimum investment. Indeed, private-market CRE investing and REITs also both offer the benefit of (divisible) passive investing — no “tenants and toilets” as they say. What Is CRE Investing? CRE is any real estate investment or transaction undertaken by a professional investor. The term “commercial” can also denote multi-tenant, including multifamily. Because of CRE properties’ size and operational complexity, CRE transactions tend to involve multiple parties and offer alpha opportunities. In principle, two factors drive CRE returns: rent and appreciation. Hence, CRE is one of the few asset classes that can deliver both solid cash flow and solid total return potential. Following the JOBS Act of 2012, CRE syndication developed with various platforms providing a nexus between real estate investment firms, or sponsors, and networks of individual investors. These investors could passively invest in CRE with substantially lower, divisible barriers to entry. Access to private CRE investing has thus expanded dramatically over the past decade. This CRE series for Enterprising Investor is written for the individual investor who may be, for the first time, participating in private CRE as a passive LP investor through an online platform. So, what are the potential benefits of private-market CRE investing relative to other forms of real estate investing? Information asymmetry, geographic barriers to entry, and other private market inefficiencies give sponsors/CRE operators more opportunity to enter or exit a given investment at a favorable moment on favorable terms. Common Types of CRE Investments The four main CRE sectors, or sub-asset classes, are Multifamily, Office, Retail, and Industrial. A variety of other sub-asset classes, such as lodging, self-storage, data centers, and more exotic variants (e.g., communication towers) are CRE’s “niche” sectors. Of course, as time progresses, real estate operators innovate and expectations from tenants evolve. Macroeconomic shocks such as the COVID-19 pandemic create new demands on the built environment. As such, the lines between CRE property types may blur, and new sub-asset classes like medical office buildings (MOB) may emerge. On an institutional scale, certain properties may be mixed use, comprising any combination of residential/office, lodging, and retail. Because the investment thesis tends to be straightforward, and the underlying function is so essential, Multifamily tends to dominate online CRE investing platforms. CRE transactions involve debt — which is analogous to a mortgage for a single-family property — as well as equity, which is analogous to the owned portion of a home that grows in value as the asset appreciates. Due to the size and complexity of CRE transactions, there is often a middle layer of financing: subordinated (mezzanine debt), preferred equity, or both. The capital stack is the combination of financing instruments for any one CRE transaction. CRE investors may participate anywhere in the capital stack and tend to access such opportunities through online platforms, with common equity positions the most prevalent. In general, the more senior the position on the capital stack — debt, for example — the less risk and return potential. Debt-based CRE investments tend to mean less risk because of payment priority, contractually obligated rates of return, and shorter terms. The more junior the position in the capital stack — equity, for example — the more risk and return potential. How to Evaluate CRE Investment Opportunities The position in the capital stack and the investment style are important parameters in judging the risk/return profile of a given CRE investment. There are four main investment styles with specific risk/return profiles: Core are stabilized, cash-flowing properties that are more than 90% leased and generally operating optimally at top-of-market rates. Such properties do not require significant upgrades and tend to be located in primary markets with strong fundamentals. Most returns come from cash flow rather than value appreciation, so Core is among the least risky CRE investment styles. As such, Core investments tend to have longer hold periods and capitalize on the bond-like operational cash flow. Assets are generally conservatively levered, yielding the lowest total return potential, with a 5% to 8% internal rate of return (IRR) range netted out to passive LP investors. Core Plus are usually in primary and secondary markets and are near-stabilization in terms of leasing, at or near market rates. To increase occupancy, tenant quality, and rates, Core Plus properties may require light capital expenditure. The strategy is riskier than Core since operational cash flow is more volatile, but it is still a relatively stable and predictable strategy, yielding a total return in the 8% to 12% IRR range. Value Add are located in primary, secondary, and tertiary markets, and expanding to such niche asset classes as hotels, health care properties, etc. These properties often lease at large discounts to market rates, providing a mark-to-market opportunity to reset rents during re-leasing. Major upgrades to both interior and common areas — capital expenditures — may be needed to compete for renters/tenants, drive rents to market rates, and achieve market occupancy. Value Add relies less on generating steady operational cash flows and more on property appreciation as a key total return driver. Total returns tend to fall in the 10% to 18% IRR range. Opportunistic occupies the opposite end of the spectrum from Core. Property appreciation rather than operational cash flow drives performance. Often associated with ground-up development, substantial redevelopment, or a complete repositioning of a property, these opportunities are often highly levered

“Those who stand for nothing fall for anything.” Alexander Hamilton, first US Secretary of the Treasury In Act 1, Scene 2 of William Shakespeare’s play, Julius Caesar, a soothsayer warned Caesar to, “Beware the Ides of March.” But Caesar failed to heed this advice, and he was assassinated on March 15th in the year BCE 44. More than 400 years after Shakespeare penned this phrase, people still associate the Ides of March with impending doom. Vanguard’s former OCIO clients would be wise to follow this tradition. Trustees Are no Longer Protected by the Spirit of Jack Bogle On March 15, Mercer, a division of Marsh McLennan, completed its acquisition of Vanguard’s outsourced chief investment officer (OCIO) business. Most of the Vanguard clients who are moving over to Mercer are large institutions including endowments, foundations, and nonprofits. The transaction seemed odd to me, given that Mercer’s traditional investment consulting and OCIO services have a penchant for active managers and alternative investments. My fear is that Vanguard’s propensity for low-cost index funds over higher-fee active funds and expensive alternative investments will not survive in its OCIO practice under Mercer. In a  June 4 interview with Pensions & Investments (P&I), Mercer’s US CIO Olaolu Aganga noted that Vanguard’s OCIO clients will have access to the full spectrum of passive and active strategies on Mercer’s platform, including alternative investments. In her interview with P&I, she stressed Mercer’s breadth and depth of offerings in the form of fund of funds including real estate, private credit, infrastructure, private equity and secondaries, as well as co-investments and venture capital. The problem I have with this is that there is a preponderance of evidence – which many investors continue to reject – that very few active managers are capable of consistently outperforming inexpensive index funds. There is similar evidence that alternative investments do not add value to institutional portfolios. It especially concerned me when Aganga called out hedge funds specifically as another opportunity now opened to Vanguard OCIO clients, despite the overwhelming evidence that hedge funds are not beneficial for most institutional investors. Adding to my concern is the fact that, in my experience, when OCIOs and investment consultants present trustees with “new opportunities,” they routinely frame them in a way that overstates the benefits, understates the risks, discounts the skills required to succeed, and all but ignore incrementally higher costs. A Brief History of Vanguard Index Funds In 1976, Jack Bogle, founder of the Vanguard Group, launched the Vanguard 500 Index Fund. Unlike every other mutual fund at the time, the fund’s objective was to simply replicate the performance of the S&P 500 index. This was a highly unconventional approach, even though it conformed with well-established mathematical principles and supporting evidence that most active managers are unlikely to outperform a comparable index. In fact, only a few years earlier, Eugene Fama published a groundbreaking paper on the efficient market hypothesis (EMH). Fama presented a compelling case that securities prices incorporate all publicly available information, thus preventing investors from identifying and profiting from mispriced securities. This implied that investing in low-cost funds was the most sensible approach for nearly all investors. The Vanguard Group was the first to commercialize the index fund on a large scale. Starting with only $11 million in 1976, the fund grew rapidly. Over time, its performance validated the EMH: most actively managed funds failed to keep pace with the Vanguard 500 Index Fund. Building on its success, Vanguard soon applied the indexing philosophy in other securities markets including fixed income, international equity, and real estate investment trusts (REITs). Results were predictably similar. Something Old and Something New: The Outsourced Chief Investment Officer “Financial operations do not lend themselves to innovation. What is recurrently so described is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.” John Kenneth Galbraith, financial historian In the early 2000s, a new investment advisory model took the institutional investment plan market by storm. The model, referred to as an OCIO, was, in the words of John Kenneth Galbraith, “a small variation on an established design.” The variation was the creation of complex portfolios that relied heavily on active managers and allocations to alternative investments, such as private equity, hedge funds, and venture capital. The rationale for this approach was based largely on the exceptional performance of the Yale University Endowment. OCIOs argued that replicating Yale’s allocation would likely produce similar results. The “established design” was simply the concept of discretionary management. Prior to the emergence of OCIOs, institutional investment plan trustees relied primarily on non-discretionary advice offered by investment consulting firms. The reintroduction of discretionary management seemed like a novelty only because few trustees recalled that consulting firms persuaded them to abandon it in the 1970s and 1980s. At the time, consulting firms were hired to provide independent performance reporting, and their reports revealed that discretionary advisory services offered by bank asset management departments failed to provide sufficient value to justify the higher fees. Despite the history, many trustees bought into the OCIO concept because they believed that the higher fees were justified by the superior, Yale-like strategies that OCIOs offered. Few trustees understood that the real secret of Yale’s success was not simply a function of a blunt asset allocation strategy. Instead, it was the presence of a unique investment ecosystem that combined excellence in governance, people management, mentorship, and access. The essential replication of this ecosystem was conveniently absent from OCIO sales pitches. Over the last 24 years, assets under management (AUM) of OCIOs increased from almost nothing to nearly $2 trillion at the end of 2023. As is always the case, rapid growth attracted many new market entrants. Investment teams at large endowments left to launch new firms such as Investure, Global Endowment Management, Morgan Creek, and others. Investment consulting firms

The last 12 months have been difficult for equity income investors. The top 20% of dividend-paying stocks in the S&P 500 Index have returned 13.5% in the 12 months through March. That compares to a 29.9% return for the broader S&P 500. My message to equity income investors is: hang in there. High-yielding stocks are positioned to perform better over the next year. History, inherent biases, mean reversion, and the current market backdrop point to a comeback. Figure 1: Top Quintile of Dividend Yield As of 03/31/24; Note: 1QDY or Top Quintile of Dividend Yield. Source: S&P, Bloomberg & Wealth Enhancement Group Over the long term, buying high-yielding stocks has been a sound strategy. During the past 30 years, the highest quintile of dividend-paying stocks in the S&P 500 (20%, or 100 equities) has outperformed. From December 31, 1994, through March 31, 2024, stocks in the top quintile returned 11.9% per year. Over the same period, the S&P 500 returned 10.4% per year. That is a 1.5% premium for high-yielding stocks. While the top quintile of dividend-paying stocks is more volatile than the broader S&P 500, it has a similar Sharpe Ratio and, by design, it has a much higher dividend yield. An equity income strategy is often categorized as a value strategy because it tends to favor lower price-to-book stocks. The top dividend-paying stocks have also outperformed the Russell 1000 Value Index over the 1994 to 2024 period. Volatility in the top-yielding stocks is, not surprisingly, higher since this assumes a one-factor model. Adding a metric for dividend growth to avoid distressed companies at risk of cutting their dividend would be beneficial, but the focus of this piece is just yield. Figure 2: Top Quintile of Dividend Yield, With Equally Weighted Stocks A sector-neutral strategy has also outperformed the S&P500 and Russell 1000 Value indices over the past 20 years, but to a smaller degree. Understandably, some sectors perform better with this strategy than others, depending in part on the level of high-yielding stocks in the sector. For example, the industrial and financial sectors perform well in a sector-neutral strategy, while the consumer discretionary and technology sectors do not. Why Have High-Yielding Stocks Outperformed? There may be a few reasons for the historical outperformance of high-yielding stocks. First, behavioral economists have shown many investors who want a source of income prefer automatic dividends, rather than home-made dividends achieved by selling a holding. Second, Benjamin Graham pointed out that paying dividends disciplines company management to generate attractive returns while allocating capital wisely. In other words, management agency costs are lowered.  Third, unqualified dividends have a higher tax rate than capital gains and therefore should theoretically be associated with higher returns to compensate equity holders.  Finally, we would suggest that many investors who focus on a stock’s exciting  growth story and pay little attention to dull dividends paid through profits and cashflow are likely manifesting a narrow framing bias. To wit, price targets are routinely made by assigning a multiple to earnings. These targets cite growth with faint consideration to return on capital, which is an equally important ingredient to valuation multiples. Naturally, an all-encompassing discounted cash flow model or a dividend discount model valuation is best. The outlook for dividend-paying stocks is favorable. Just using a reversion to the mean framework points to upside. Over the last 30 calendar years, the correlation of the one-year forward return to the previous year has been -0.3 for the highest quintile of dividend-paying stocks in the S&P 500. A Mechanical Reversion to the Mean Exercise Knowing that 2023’s return was 6.9%, the 30-year average return was 11.9%, and the 30-year correlation was -0.3, we can naively forecast a 2024 return of 13.5% [-0.3 (6.9%-11.9%) + 11.9%]. A return closer to the mean. A similar calculation can be done for the S&P 500 to project a 10.0% 2024 return.  This mechanical reversion to the mean exercise points to high-yielding stocks outperforming this year. However, it is very important to consider which average to revert toward. Two key fundamental metrics are return on assets (ROA) and earnings growth. Over the last 30 years, the top quintile of dividend paying stocks in the S&P 500 averaged a 4.4% ROA and had an 8.1% one-year forward earnings-per-share (EPS) growth estimate. Currently, their ROA is 3.6%. After bottoming a year ago at 2.5%, one-year forward EPS growth is now projected to be 11.9%. With ROA just below average and expected EPS growth above average, underlying fundamentals are now close to normal, which points to the 30-year mean return of 11.9% as a reasonable bogey for reversion. Going a step further to calibrate the outlook for dividend stocks, we can model returns against several variables. Two of the better factors to forecast one-year forward returns of the top quintile dividend stocks in the S&P 500 are dividend yield and year-over-year CPI (consumer price index). The former series is a valuation yardstick and the latter is a rough proxy for rates. Both metrics are correlated to one-year forward dividend returns.  Currently, the dividend yield of the top quintile of dividend-paying stocks is at its 20-year average, while YoY CPI is above average and has been declining (see Figure 2).  If the consensus expectation that YoY CPI will continue to decline over the next year is correct, dividend-paying stocks will benefit. Figure 3: Dividend Yield, CPI, and 12-Month Returns As of 03/31/24; Note: 1QDY or Top Quintile of Dividend Yield. Source: S&P, Bloomberg & Wealth Enhancement Group While equity income investors have had a rough patch, it has been brief in the context of the historical performance of dividend-paying stocks. I will repeat my message to investors seeking equity income: hang in there. History, inherent biases, mean reversion, and the current market backdrop point to a comeback. If you liked this post, don’t forget to subscribe to 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

“The current inflation episode is just the kind of event that the fiscal theory of the price level can easily describe. It’s simple. The US government printed up about $3 trillion of money and sent people checks. It borrowed an additional $2 trillion of money and sent people more checks.” — John H. Cochrane, Senior Fellow, Hoover Institution, Stanford University “The fiscal theory, I think, is the right way to approach monetary issues and inflation. I don’t think it’s well accepted. It’s not what central bankers or a lot of academic economists adhere to . . . It’s also a heretical view. It happens to be the right one. But it’s still an uphill battle.” — Thomas S. Coleman, Senior Lecturer, Harris School of Public Policy, University of Chicago John H. Cochrane submitted his book about the fiscal theory of the price level (FTPL) to the publisher, Princeton University Press, early last year. Up to that point, despite massive fiscal and monetary stimulus in response to the global financial crisis (GFC) and more recently amid the COVID-19 pandemic, inflation had remained at or near historical lows for the better part of a generation. This all seemed to fly in the face of the conventional understanding of both inflation and monetary policy. Viewed from a classical or monetarist perspective, real interest rates stuck at zero and quantitative easing (QE) stimulus should have had some effect: Whether hyperinflation or a deflationary spiral, theory dictated extreme consequences. Yet there weren’t any — no deflation spiral or a rerun of the epic stagflation of the late 1970s and early 1980s. Modern monetary theory (MMT) was on the ascent. Inflation hawks perhaps had sounded too many false alarms to be taken seriously. Indeed, in the opening months of 2021, inflation fears had come to be seen as almost anachronistic, the relic of an earlier and increasingly irrelevant era. “Well, inflation seems stuck at 2%,” Cochrane recalled writing in the initial introduction to his book. “And for 30 years, nobody has really cared about it. Maybe someday somebody will care about this book.” Of course, several months later, inflation soared to 40-year highs and stayed there. And for those looking to understand the resurgent and unfamiliar phenomenon, the FTPL model became critical. “I’ll just say I got the opportunity to revise that introduction,” Cochrane remarked. In May 2022, Cochrane and Thomas S. Coleman, co-author of Puzzles of Inflation, Money, and Debt: Applying the Fiscal Theory of the Price Level from the CFA Institute Research Foundation, spoke with Rhodri Preece, CFA, and Olivier Fines, CFA, who are, respectively, senior head of research and head of advocacy and capital markets policy research for Europe, the Middle East, and Africa (EMEA) at CFA Institute. The lines of inquiry, informed by insights from “Covid-19, One Year Later: Capital Markets Entering Uncharted Waters” and “Money in Covid Times: A Primer on Central Bank Response Measures to COVID-19,” zeroed in on the dynamics and rationale of the FTPL theory as well as the associated implications for the inflation outlook, fiscal and monetary policy, and the markets in general. In this first excerpt in the multi-part FTPL series, the conversation centers around the nature of inflation and how the FTPL can explain both the current late-pandemic inflationary environment and its non-inflationary post-GFC predecessor as well as other historical episodes. What follows is an edited and condensed transcript from our discussion. Olivier Fines, CFA: The Bank of England has indicated that they wouldn’t be surprised if inflation reached 10% before the end of the year. So, inflation is a global phenomenon, or at least a Western one. What are the fundamental aspects of the fiscal theory of the price level and how does it explain the current rate of inflation? John H. Cochrane: It is a simple and intuitive idea. Inflation breaks out when there is more overall government debt than people think the government will repay by its future excess of taxes over spending. If people see that the debt is not going to get repaid, that means it will either be defaulted on or inflated away in the future. They try to get rid of the government debt now. And the only way to get rid of government debt is to spend it, to try to trade it for goods and services. But it’s a hot potato. There’s so much of it around; we can’t get collectively rid of it. All we can do is drive up prices. First, we try to buy assets. The asset prices go up. Then, feeling wealthier, we try to buy goods and services. The goods and services prices go up until the real value of the debt — the amount of debt divided by the price level is its real value — is back to equal what people think the government will be able to pay off. That’s the fiscal theory of the price level in a nutshell. It’s still too much money chasing too few goods. But money includes all nominal government debt, not just money itself. The current inflation episode is just the kind of event that the fiscal theory of the price level can easily describe. It’s simple. The US government printed up about $3 trillion of money and sent people checks. It borrowed an additional $2 trillion of money and sent people more checks. That’s a big increase in the amount of government debt. Now, that doesn’t have to be inflationary if everybody understands this is borrowing that will be repaid. We’re going to send people checks, but by the way, there’s going to be either higher taxes or lower spending coming soon to repay that debt. Then people are happy to hold the debt as an investment vehicle. We can talk about government borrowing crowding out investment, and other smaller issues, but borrowing by itself isn’t instantly inflationary. Sending people checks is a particularly powerful way of getting them to spend the new debt rather than hold it as savings. Milton Friedman

After a long hiatus, The Sustainability Story podcast from CFA Institute is back. In the first new episode, Paul Andrews, head of Research, Advocacy, and Standards at CFA Institute, speaks with Ceres president and CEO Mindy Lubber about the critical connection between climate risk and financial risk. Mindy Lubber believes that climate risk is financial risk and that understanding this relationship is crucial to addressing the threat. “Our job is to make the case that, whether it’s climate change or water shortages or, frankly, a number of social issues, that they have economic implications as great as any others,” she said. “They need to be part of the financial framework.” According to Lubber, companies must recognize climate’s change’s economic implications and incorporate them into their decision-making processes. Investors can help by engaging with companies to set emissions reduction goals. Lubber says the top 100 companies globally are responsible for 80% of emissions, making their actions particularly significant if climate change is to be dialed back. Uniting Stakeholders for Change  One of the obstacles to mitigating climate risk, Lubber says, is bringing together and building consensus among the various stakeholders involved. She singles out four critical cohorts in particular: investors, the investment community, corporates, and governments and authorities. Aligning all these disparate interests will not be easy, but doing so is imperative given the stakes. “If we don’t address climate, the implications are indeed frightening from an economic perspective, a societal perspective, from the future we’re building for our kids,” she said. “So we really have to do it, and we’ve got to look at where are the problems and what are the solutions.”  That where systems change comes in. Lubber describes how the Ceres Accelerator for Sustainable Capital Markets can help create lasting, positive change by ensuring equitable and consistent regulations across the entire economy. Overcoming Politicization  Lastly, Lubber acknowledges that climate issues have been politicized and that this politicization presents a significant barrier to further progress. As she sees it, the first job of corporate board members and investor trustees is to analyze risk, which is why ignoring climate risk could lead to poor decision making. But politicization is only exacerbating the problem. “It is sidetracking us and slowing things down,” she said. “The fact of the matter is the politics of hate, the politics of division, the woke capitalism charges that somehow investors ought not to be looking at all the data at their fingertips — it’s insanity.” So what can be done about this? Lubber believes fostering collaboration and consensus among stakeholders is key to driving change for a more sustainable future. “The role of analysts, financial players, is absolutely crucial,” she said. Look for new episodes of The Sustainability Story podcasts each month. You can also subscribe for free to the audio version wherever you get your podcasts. 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. 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. Members can record credits easily using their online PL tracker. source

“My basic point here is that neither the Financial Analysts as a whole nor the investment funds as a whole can expect to ‘beat the market,’ because in a significant sense they (or you) are the market . . . the greater the overall influence of Financial Analysts on investment and speculative decisions the less becomes the mathematical possibility of the overall results being better than the market’s.” — Benjamin Graham An enduring principle of financial history is that past solutions often plant the seeds of future problems. Among the least-expected examples of this phenomena were the passage of the Securities Act of 1933 and the Securities Exchange Act of 1934. These acts mandated extensive financial disclosures by publicly traded companies and outlawed market manipulation and insider trading. Prior to their passage, Wall Street stock operators routinely profited by cheating markets rather than outsmarting them. To be clear, these regulations were desperately needed to clean up US securities markets. After they were passed, skillful securities analysis, rather than market manipulation and insider trading, was largely the only way to beat the market. Of course, truly above-the-mean securities analysis was and remains exceedingly rare. But that hasn’t kept capital from flooding into actively managed mutual funds — even after the first index funds launched in the 1970s. Under pressure to differentiate their products, fund managers introduced a slew of investment strategies covering various asset classes and sub-asset classes. Increased complexity, specialization, and robust marketing budgets convinced the public that professional managers could add value to their investment portfolios beyond what they could otherwise obtain by investing in a diversified portfolio of stocks. Few paid attention when the SEC noted that the average professionally managed portfolio underperformed broad indexes before fees in an exhaustive 1940 study. For more than 80 years, the fact that few active managers add value has been validated by numerous research papers published by government agencies, including the SEC, and such Nobel laureates as William Sharpe and Eugene Fama, as well as the experience of Warren Buffett, David Swensen, Charles Ellis, and other highly regarded practitioners. Despite a preponderance of evidence, many investors continue to reject the undeniable truth that very few are capable of consistently outperforming an inexpensive index fund. Outside a small and shrinking group of extraordinarily talented investors, active management is a waste of money and time. The Extraordinary Wisdom of the Crowd So, why is the active management delusion so persistent? One theory is that it stems from a general lack of understanding as to why active strategies are doomed to failure in most cases. The primary reason — but certainly not the only one — is summed up by the “wisdom of crowds,” a mathematical concept Francis Galton first introduced in 1907. Galton described how hundreds of people at a livestock fair tried to guess the weight of an ox. The average of the 787 submissions was 1,198 pounds, which missed the ox’s actual weight by only 9 pounds, and was more accurate than 90% of the individual guesses. So, 9 out of 10 participants underperformed the market. Galton’s contest was not an anomaly. The wisdom of crowds demonstrates that creating a better-than-average estimate of an uncertain value becomes more difficult as the number of estimates increases. This applies to weight-guessing contests, GDP growth forecasts, asset class return assumptions, stock price estimates, etc. If participants have access to the same information, the total estimates above the actual amount tend to cancel out those below it, and the average comes remarkably close to the real number. The results of a contest at Riverdale High School in Portland, Oregon, illustrated below, demonstrate this principle. Participants tried to guess the number of jellybeans in a jar. Their average guess was 1,180, which wasn’t far from the actual total of 1,283. But out of 71 guesses, only 3 students (fewer than 5%) beat the average. Anders Nielsen came closest with 1,296. Average Participant Guess by Number of Participants The Seed of the Active Management Delusion Speculators prior to 1934 understood the wisdom of crowds intuitively, which is one reason why they relied so heavily on insider trading and market manipulation. Even in the late 1800s, market efficiency was a formidable obstacle to outperformance. The famed stock operator Daniel Drew captured this sentiment when he reportedly commented, “To speckilate [sic] in Wall Street when you are no longer an insider, is like buying cows by candlelight.” The Great Depression-era securities acts improved market integrity in the United States, but they also sowed the seed of the active management delusion. As companies were forced to release troves of financial information that few could interpret, markets became temporarily inefficient. Those like Benjamin Graham who understood how to sift through and apply this new data had a competitive advantage. But as more investment professionals emulated Graham’s methods and more trained financial analysts brought their skills to bear, the market became more efficient and the potential for outperformance more remote. In fact, Graham accelerated this process by publishing his techniques and strategies and thus weakened his competitive advantage. His book Security Analysis even became a bestseller. After a time, Graham concluded that beating the market was no longer a viable goal for the vast majority of financial analysts. That did not mean that he had lost faith in their value; he just knew with mathematical certainty that outperformance was too tall an order for most. Despite his indisputable logic, his warning was largely ignored. By the 1960s, too many investment firms and investment professionals had staked their businesses and livelihoods on beating the market. Letting Go of the Fear of Obsolescence The flawed belief that we can beat the market persists to this day. What’s worse, it has spread to institutional consulting and other sectors. Many firms base their entire value proposition on their manager selection skills and asset allocation strategies. Yet these are subject to the same constraints as Galton’s weight-guessing contest. For example, average estimates of asset class return

The wealth management landscape is undergoing a seismic shift as single- and multi-family offices grow in scale, sophistication, and influence. No longer just vehicles for wealth preservation, these entities are now dynamic investment powerhouses, managing diverse portfolios, integrating cutting-edge technologies, and embracing sustainable investing. For investment professionals, this evolution presents a unique opportunity: the chance to hone and leverage their expertise in a space that prioritizes long-term strategy, client-centric solutions, and innovative financial approaches. As family offices continue to expand, those who understand their complexities will be well-positioned to lead the next era of wealth management. Single-family offices are the fastest-growing segment in wealth management. According to Deloitte, the number of single-family offices worldwide surged by 31% to 8,030 in 2023, up from 6,130 in 2019, with projections that there will be 10,720 single-family offices by 2030. Alongside this expansion, assets under management are expected to grow to $5.4 trillion by 2030. For CFA charterholders in particular, this evolution represents a pivotal moment to leverage their expertise and play an instrumental role in the family office space. Transforming the Role of Family Offices Once primarily focused on wealth preservation, family offices have evolved into dynamic organizations that manage diverse portfolios, support intergenerational wealth transfer, and embrace innovative investment strategies. Single-family offices, often structured like private hedge funds, cater to ultra-high-net-worth families with bespoke financial services. Multi-family offices, meanwhile, serve multiple families, offering wealth management, tax optimization, estate planning, and more. The transformation of single- and multi-family offices to dynamic organizations aligns seamlessly with the core competencies of CFA charterholders. Long-term planning, client-centric approaches, and alternative investments are in high demand. Furthermore, as seasoned wealth managers retire, multi-family offices are acquiring their books of business, presenting leadership opportunities for those seeking to expand their client base and assume leadership roles. Strategic Planning for Intergenerational Wealth Family offices increasingly focus on managing wealth transitions between generations. To excel in this space, investment professionals must complement their technical expertise with interpersonal and strategic skills including: Understanding family dynamics: This requires navigating complex relationships and mitigating conflicts to maintain harmony during wealth planning. Environmental, social, and governance (ESG) and impact investing expertise: Younger generations prioritize investments aligned with their values, driving demand for sustainable investing strategies. Global ESG assets are projected to exceed $40 trillion by 2030, presenting an unparalleled opportunity for investment professionals to specialize and set themselves apart. Legacy and succession planning skills: This requires designing and implementing comprehensive strategies that ensure seamless wealth transitions while honoring the family’s long-term goals. Digital Assets: A Unique Niche Cryptocurrency is emerging as a significant asset class for family offices, driven by a desire to engage younger generations and diversify portfolios. Given their ability to hold illiquid assets for extended periods of time, family offices are uniquely positioned to capitalize on the long-term potential of digital assets. Investment professionals who acquire expertise in blockchain technologies, regulatory frameworks, and risk management can carve out a niche as advisors in this rapidly growing market. Understanding crypto’s broader implications — from portfolio diversification to fostering intergenerational engagement — further enhances a practitioner’s value proposition. Leveraging Wealth Tech Technology is reshaping how family offices operate, with innovations ranging from AI-driven investment platforms to advanced compliance tools. Mastering wealth tech is critical to improving operational efficiency and delivering personalized client experiences. Staying ahead in this domain requires: A deep understanding of how technology enhances client lifecycle management Insights into integrating digital tools into family office practices, from streamlining workflows to optimizing portfolio reporting Practitioners who embrace these advancements can position themselves as forward-thinking professionals who elevate both the efficiency and sophistication of family office operations. The Multifamily Office Advantage Multi-family offices offer a wealth of opportunities to refine skills and broaden impact. With a diverse client base, multi-family offices expose investment professionals to a wide array of financial scenarios, enabling them to: Develop expertise in alternative investments, tax optimization, and cross-border wealth management. These are in-demand skills in today’s global economy. Expand their roles beyond investment management into areas such as philanthropic advising, succession planning, and family governance. Lead initiatives to attract and retain high-net-worth clients, demonstrating their strategic and leadership capabilities. For those seeking dynamic and exciting careers, the multi-family office sector offers tremendous opportunities. Future-Proofing Your Career As family offices continue to evolve, investment professionals who adapt to their unique demands will find significant opportunities for growth and leadership. The future of wealth management lies in a holistic approach — one that blends technical expertise with strategic foresight, relationship management, and adaptability to emerging trends like sustainable investing, digital assets, and wealth technology. CFA charterholders are uniquely positioned to capitalize on these trends. But any investment professionals who embrace this transformation will not only enhance their careers but also play a pivotal role in shaping the next generation of family office success. source