MONEY alternative investments

Wise Up About Funds that Claim to Take “Smart” Risks

A new group of funds that claim to outperform the broad market while taking less risk are worth exploring—if you're willing to look under the hood.

Ever since the dot-com crash more than a decade ago, Wall Street and the mutual fund industry have been on a relentless push to plug what they are now calling “smart” beta strategies. These funds promise reasonable returns with lower risk through a variety of techniques.

But pursuing a smart-beta strategy isn’t as simple as just buying a fund with that name and thinking it will outperform conventional index funds. There’s always a trade-off in costs, risk and return, so you need to dig much deeper to get beyond simplistic marketing pitches.

For example, let’s say you were seeking an alternative strategy to traditional S&P 500 index funds that weight the holdings in their portfolios by market valuation.

In such traditional “cap-weighted” S&P 500 funds, the top holdings would be Apple APPLE INC. AAPL 1.5778% at about 3% of the portfolio, followed by ExxonMobil EXXONMOBIL CORP. XOM 1.2026% at 2.6% and Microsoft MICROSOFT CORP. MSFT 0.8562% at just under 2%. Every other stock in the portfolio would represent a slightly lower percentage of the total holdings.

The idea behind cap-weighting is that the biggest U.S. stocks by popularity ought to represent the largest portions of a broad-market portfolio. This is what economist John Maynard Keynes called a “beauty contest,” with investors bidding up the prices of the most glamorous stocks. The downside is that these companies may be overpriced and may not have as much room to grow as other, bargain-priced stocks.

One alternative in the smart beta fund category is a so-called equal-weighted stock index fund such as the Guggenheim S&P 500 Equal-weight ETF RYDEX ETF TR GUGGENHEM S&P500 EQUAL WEIG RSP 1.2843% , which holds the same stocks as the S&P Index, only in equal proportions. This design somewhat side-steps the overpricing issue because it’s less exposed to beauty contestants, especially when they falter a bit.

To date, both the long- and short-term performance of the equal-weighted strategy has been better than cap-weighted index funds. The Guggenheim fund has beaten the S&P 500 index over the past three, five and 10 years. With an annualized return of 9.7% over the past decade through June 6, it’s topped the S&P index by more than two percentage points over that period. But it costs 0.40% in annual expenses, compared with 0.09% for the SPDR S&P 500 Index ETF.

Once you start to ignore the beauty pageant for stocks, is there an even “smarter beta” strategy?

What if you picked the best stocks based on a combination of value, sales, cash flow and dividends? You might find even more bargains in this pool of companies. They’d have strong fundamentals and might be more consistently profitable over time.

One leading “fundamentally weighted” portfolio, which also resides under the smart beta umbrella, is the PowerShares FTSE RAFI US 1000 ETF POWERSHARES EXCHAN FTSE RAFI US 1000 PORTFOLIO PRF 1.145% , which also has outperformed the S&P 500 by about two percentage points over the past five years with an annualized return of 20 percent through June 6. It costs 0.39% annually for management expenses.

The PowerShares fund owns some of the most-popular S&P Index stocks like Exxon Mobil, Chevron CHEVRON CORP. CVX 1.8772% and AT&T AT&T INC. T -2.4348% , only in much different proportions relative to the cap-weighted indexes. The RAFI approach focuses more on cash, dividends and finding undervalued companies, so it’s not necessarily looking for the most-popular stocks.

Although looking at the rear-view mirror for index-beating returns seems to make equal- and fundamental-weighted strategies appear promising long term, you also have to look at internal expenses to see which strategy might have the edge.

Turnover, or the percentage of the portfolio that’s bought and sold in a year, is worth gauging in both funds. Generally, the higher the turnover, the more costly the fund is to run. That eats into your total return. The PowerShares fund has the advantage here with an annual turnover of 13%, compared to 37% for the Guggenheim fund.

Over the long term, “fundamentally weighted smart beta strategies are likely to outperform the equal weighted approach,” note Engin Kose and Max Moroz with Research Affiliates, a financial research company based in Newport Beach, California, which largely developed the concept of fundamental weighting and is behind RAFI-named indexes.

But just considering costs doesn’t end the debate on equal- and fundamentally weighted funds. While they may be higher-performing than most U.S. stock index funds over time, they are not immune from downturns. Both lost more than the S&P 500 in 2008 and 2011.

While it may be difficult to predict how these funds will perform in a flat economy or a sell-off, they are worth considering to replace your core stock holdings, and may be the wisest choices among the smarter strategies.

MONEY Savings

Millennials Are Saving, But Men Are Saving More. Here’s Why.

Among young adults, a savings gender gap is starting early. Are you ahead or behind?

You’ve probably heard that Millennials are doing better than previous generations in saving for retirement—those who landed jobs, anyway. But here’s something you may not have heard so much about: young men are saving significantly more than young women.

That’s the finding from a new Wells Fargo survey on Millennial savings habits, which found that overall 55% of young adults are saving for retirement. But that number disguises a wide gender gap. More than 60% of men are stashing money away, compared with just 50% of women.

“We were surprised to see the gap in this generation, when they have such similar profiles,” said Karen Wimbish, director of retail retirement at Wells Fargo. She points to the relatively few number of women in high-paying positions as a key reason for the disparity. For college-educated Millennial men, the median household income is $77,000, according to the survey; for women, it’s $63,000. (Those figures are similar to 2012 data from the Bureau of Labor Statistics, which found that women ages 20 to 24 earn just 89% the median earnings of their male counterparts.)

Given that difference in pay, it’s not that surprising that 26% of young men manage to save more than 10% of their incomes, compared with just 9% of women. The majority of women surveyed (53%) put away only 1% to 5% of their pay.

For both men and women, debt loads are making it more difficult to save. Some 40% of Millennials say they feel overwhelmed by debt. Nearly half say more than 50% of their pay is going toward debt repayment, and 56% “live from paycheck to paycheck,” the survey reported. The largest payments were owed to credit cards (16% of debt), followed by mortgages (15%), student loans (12%), auto loans (9%), and medical bills (5%).

Still, paying off debt, especially high-interest credit-card balances, can be a smart move, even if it delays saving, says Dan Weeks, a financial planner at Sound Stewardship in Overland Park, Kansas. But for many Millennials, those payments are likely to slow their ability to buy a house and start a family.

One bright spot: Millennials are becoming less risk averse—nearly one-third are invested in the stock market. Among college-educated young men, median financial assets, including stocks and bonds, were $58,500; for women, $31,400. And more than two-thirds of Millennial expect their life after retirement to be better than that of their parents. They could be right about that.

MONEY Portfolios

Alex, I’ll Take “How to Invest Like a Jeopardy Champ” for $1000

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Host of Jeopardy! Alex Trebek and contestant Arthur Chu. courtesy of Jeopardy

Controversial Jeopardy champion Arthur Chu talks with MONEY about risk-taking, his long-term goals, and why he isn't in the market for a shiny convertible.

Earlier this year, Arthur Chu won a staggering 11 games on Jeopardy, nearly $300,000 in prize money, and the unofficial title of “Jeopardy Villain.”

Chu upset some gameshow purists with his counter-intuitive tactics. For instance, he relied on game theory to outmatch his opponents. Chu would often skip around from category to category and select the most valuable answers first. Fans who were used to contestants staying in one category, and starting with the least valuable answers, chafed at his approach. (Although Chu is hardly Jeopardy’s first unconventional player.)

A few months after his epic run, Chu had to figure out what to do with his winnings, and how to adjust to life with a lot more money in the bank.

The 30-year-old voice-over artist and actor lives in Broadview Heights, Ohio, and recently spoke with MONEY.

(The interview has been edited.)

Viewers seemed to view you as a risky player, but you’ve maintained that your strategy was risk-averse. How so?

For some reason, probably because Jeopardy consistently refers to its points as “dollars,” people don’t get the most fundamental rule of how Jeopardy works — the points you earn in the game are NOT dollars. They only turn into money if you win the game, if after Final Jeopardy you’re in first place. If you aren’t in first place, all your points disappear, your total is completely erased and you either get the 2nd-place $2,000 or 3rd-place $1,000 consolation prize and go home.

The expected value of winning the game versus losing is immense. Not one single dollar in your stack is worth anything if you lose. And yet people do irrational stuff all the time like make bets that ensure they’ll still “have something” if they lose the bet, even though if you lose the game “having something” and “having $0″ are completely equivalent — you get the same consolation prize either way.

So imagine if you had some bizarre contract where if your investment portfolio hit a certain value by a certain time limit, you get to keep the money. But if it’s below that value all the money is taken away. Do you see how this would be different from normal investing? How “low-risk” moves would actually be very high-risk moves — the “safer” your portfolio is, the higher the risk that you won’t hit your target and win the game, and all your money will vanish?

Speaking of risk, how do you view risk in your own portfolio?

When all I had was a small amount of savings I was invested conservatively to make sure that our total funds wouldn’t dip too low in case we needed them — specifically the Vanguard LifeStrategy Conservative Growth Fund (VSCGX).

Now that I have a much bigger stack I’m sitting on and the capacity to absorb more downside risk I have it all invested aggressively in Vanguard’s Target Date 2050 Retirement Fund (VFIFX.) I’m trying to keep everything as automated as possible so that managing money can be one less drain on my thoughts and energy among all the other stuff I have to do.

What’s your long-term investing strategy? Do you own actively managed funds?

As long as I’ve been into investing I’ve been an indexer. I’ve absorbed the gospel of A Random Walk Down Wall Street, I follow the Bogleheads forum, I’m invested in Vanguard, all of that stuff.

I’ve yet to see a compelling, rational argument that says you come out ahead with active investing — at least not without a lot more research and a lot more savvy that I really want to put into it. (You have to be able, as a non-financial professional yourself, to identify the managers you trust to give you above-market returns — and not just above-market returns but returns that are enough above market to justify the cut they take. I’ve yet to see a reliable method for doing this.)

What goals will your winnings allow you to achieve?

It’s not really buying stuff that matters most to me — the single thing I value most that’s most irreplaceable is my time. A nine-to-five job, while it comes with a lot of perks and a lot of security, takes the lion’s share of the hours in the day away from me and puts them toward something I’d rather not be doing. To be able to live a life basically like the one I have now but to have that time freed up — that’s worth more than any car or any cruise.

What does all of this money buy you?

The main thing it buys is a feeling of peace. I have no intention of quitting my job in the near future but just knowing that you don’t need a job is profoundly freeing.

Knowing that I could buy almost anything I wanted if I really wanted to is profoundly freeing — and, paradoxically, having this knowledge means I no longer think about things I want but can’t have nearly as much. When the thing that you’d be trading off for the lust-inspiring luxury is tangible — when I know that I’d be trading, say, six months of not having to work for a shiny new convertible — it puts things in perspective and helps push away the need to lust over such things.

MONEY 401(k)s

Vanguard Study Finds (Mostly) Good News: 401(k) Balances Hit Record Highs

Stock market gains boosted wealth for those putting away money regularly in the right funds. Are you one of them?

If you’ve been stashing away money in a 401(k) retirement plan, you probably feel a bit richer right now.

The average 401(k) balance climbed 18% in 2013 to $101,650, a new record, according to a report by Vanguard, which is scheduled to be released tomorrow. That’s an increase of 80% over the past five years.

The median 401(k) balance — which may better reflect the typical worker — is far lower, just $31,396. (Looking at the median, the middle value in a group of numbers, minimizes the statistical impact of a few high-income, long-term savers who can skew the averages.) Still, median balances rose 13% last year, and over five years, they’re also up by 80%. All of which suggests that rank-and-file employees are building bigger nest eggs.

Vanguard balances
Source: Vanguard Group

That’s the good news. Now for the downside. Those rising 401(k) balances are mostly the result of the impressive gains that stocks have chalked up during the bull market, now in its sixth year. (The typical saver currently holds 71% in stocks vs. 66% in 2012.) Why is that a negative? Because at some point stocks will enter negative territory again, and all those 401(k) balances will suffer a setback.

Meanwhile, the amount that workers are actually contributing to their plans remains stuck at an average of 7% of pay, which is down slightly from the peak of 7.3% in 2007. And nearly one of four workers didn’t contribute at all, which has been a persistent trend.

Ironically, the savings decline is largely a side-effect of automatic enrollment, which puts workers in 401(k)s unless they specifically opt out. More than half of all 401(k) savers were brought in through auto-enrollment in 2013. These plans usually start workers at a low savings rates, often 3% or less. Unless the plan automatically increases their contributions over time—and many don’t—workers tend to stick with that initial savings rate.

Still, when you include the employer match—typically another 3% of pay—a total of 10% of compensation is going into the average worker’s plan, says Jean Young, senior research analyst at Vanguard. That’s not bad. But most people need to save even more—as much as 15% of pay to ensure a comfortable retirement, according to many financial advisers. (To see how much you should be putting away, try the retirement savings calculator at AARP.)

Even if 401(k) providers haven’t managed to get people to step up their savings rate, they are tackling the problem of investing right. More workers are being enrolled in, or opting for, target-date retirement funds, which give you an all-in-one asset allocation and gradually shift to become more conservative as you near retirement. Some 55% of Vanguard savers hold target-date funds—and for 30%, a target fund is their only investment.

With target-date funds, as well as managed accounts (which are run by investment advisers) and online tools, more 401(k) savers are also receiving financial guidance, which may improve their returns. As a recent study by Financial Engines and AonHewitt found, 401(k) savers who used their plan’s investing advice between 2006 and 2012 earned median annual returns that were three percentage points higher than those with do-it-yourself allocations.

Vanguard’s data found smaller differences. Still, over the five years ending in 2013, target-date funds led with median annual returns of 15.3% vs just 14% for do-it-yourselfers.

The lessons for investors: You’re better off choosing your own 401(k) savings rate, and try to put away more than 10% of pay. And if you aren’t ready to manage your own fund portfolio, opting for a target-date fund can be a wise move.

 

 

 

 

 

 

 

MONEY 401(k)s

The Three Things Gen X’ers Should Be Doing In Their 401(k)s

Generation X woman in coffee shop on laptop
Make that a double-shot latte. Now's the time to focus. Tim Robberts—Getty Images

It's too early to give up and too late to delay. If ever there was a time to get your 401(k) in order, it's now.

The big things you have to get right in your 401(k) don’t vary by age: Pick a diversified mix of stock and bond funds. Keep costs as low as you can, using index funds if that’s an option. Don’t chase hot performance. But there is some advice that will matter more to you if you instantly know who’s a brain, an athlete, a basketcase, a princess, or a criminal.

1. It’s go time

Yes, you should ideally save a lot over your entire career. The truth is a lot people aren’t great about this in their 20s and early 30s. Young people have school debts to pay off and households to set up. And, let’s be honest, they have lots of free time to do fun stuff, but not such big paychecks to fund it. Maybe that sounds like you. (It certainly sounds like me.) The feeling that you are already behind can be paralyzing.

But here’s the thing: You still have time to make up lost ground. And you’ve entered your peak earning years. If you save a given percentage of your income today, that may be a bigger chunk of money than it was when your career was just getting going.

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Source: Bureau of Labor Statistics

Let this be a spur to you as well. As you can see above, at your age, you likely don’t have any lifestyle-changing raises in your future. (Sorry.) There’s not going to be a better time than now to save money.

2. Think 17%

How much you really need to save for retirement at this point depends on how much you already have. But about 17% is a good mental anchor if you want to get your savings at least roughly right now and do the math later. The amount is far more than the average 401(k) contribution of around 6% or 7%. But take a deep breath. That number includes the contributions from your employer.

Where’s the number come from? Wade Pfau of the American College of Financial Services calculated the savings rate required to safely fund a typical retirement goal. About 17% is the number he came up with for people who start from scratch with no savings at age 35, with a 60% stock/40% bond portfolio. You might do okay saving less than that if stock and bond markets go your way, but Pfau’s number is what it takes to get there even with poor returns.

Don’t delay. Wait until 45 to start, and the from-scratch required safe savings rate goes to 36%.

3. Review your risk

For young savers, market risk can be a bit of an abstraction. The amount you saved by your early 30s is probably on the low side, so even a steep market slide means losing fairly modest pile of actual dollars.

Around age 40, though, the numbers involved change. The average retirement account, according to a survey by Fidelity, crosses over the psychologically important six-figure line. Big losses feel real.

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Source: Fidelity Investments

So if you haven’t thought much about your portfolio lately, try this exercise. Figure out how much, in dollar terms, of your retirement accounts are in invested stocks. (If you have a fund, such as a target date fund, that combines stocks and bonds, be sure to include the stock portion of that fund in your total.) So imagine losing half those dollars. The S&P 500 fell by roughly 50% from top to bottom during the 2007-2009 crash, before rebounding. It could happen again. If you count up the possible losses and they feel like too much for you to stomach, meaning not just that you’d hate it but that you’d be tempted to sell, then trim back now.

That having been said, don’t be too afraid of market volatility. You have a lot of good earnings years ahead of you, and can likely bear some risk to get a better return.

MONEY Rentals

How Your Home Can Bring In Some Cash This Summer

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In addition to beach and ski destinations, homes in rugged outdoor spots do well as vacation rentals, says HomeAway. Spaces Images—Getty Images/Blend Images RM

Ever considered turning your home into a vacation rental? Here's how to make your house pay for your time away. Plus:

AAA predicts this summer will be the strongest travel season in years, and all those vacationers will need a place to stay. Should your home (or second home) be one of them?

Turning your home into a short-term vacation rental could bring in some nice extra change to pay for your own vacation, or even help you pay off that second home: Rates on rental site HomeAway.com average $217 a night.

Before you decide, ask yourself these four questions:

Do people want to come to your city?

Certainly you’ll have the best luck if your home is in, or at least near, a top travel destination. Most of the cities seeing the biggest increases in traveler inquiries, according to HomeAway, are on the beach – places like Mexico Beach, FL and Lavallette, NJ.

No sand in sight near your home? The most important thing is being near your area’s main attractions, whatever those may be, says Jan Leasure, founder of Monterey Bay Property Management. You’ll just have to charge accordingly.

So, how much CAN I make?

Your price depends on the location, of course, and your home’s size and amenities. Search comparable listings on HomeAway and similar sites to determine how much you might fetch.

Then, expenses. There’s marketing: HomeAway and VRBO charge renters 10% of each booking or a flat annual fee of $349 to $999 (the more you pay, the higher your listing will rank in search results). FlipKey and Airbnb, which offer fewer services, charge 3% per booking.

You’ll also need to hire a housekeeper to clean up after guests. HomeAway suggests ballparking each session at $20 for each bedroom and bathroom.

The biggest cost may be your time: An average nine hours a week, according to a HomeAway survey. You may prefer to pay a property manager to help with booking and maintenance. These businesses generally charge anywhere from 10% to 50% of your nightly rate depending on the level of service they provide.

And don’t forget taxes. If you rent your home for two weeks or less, you won’t owe the government a cent. Longer, and you have to pony up the taxes — but you’ll be able to deduct certain expenses. How much you can deduct will depend on how often you stay there yourself. Learn the IRS rules. You also may have to pay local tourist taxes.

Is it legal?

Your county or city may not allow short-term rentals at all (New York City largely prohibits leasing property for fewer than 30 days) or might have specific requirements such as registration and tax collection. Even if the law allows it, your individual homeowners or condo association may not.

Check the rules with your zoning department and your association board. Ideally, consult a local real estate lawyer.

HomeAway offers a helpful guide. Other good resources are at Realtor.com and the Short Term Rental Advocacy Center.

How do I protect my home?

If you’ve decided you do want to try this, guard against vacationers trashing your place with a strong rental agreement, insurance and a security deposit. The security deposit— a few hundred to a few thousand dollars depending on the value of your home and length of stay—may save you the trouble of making an insurance claim if a rowdy vacationer acts up.

HomeAway offers a sample rental agreement. Consult a lawyer to ensure it complies with local laws and to lessen the chances you’ll be on the hook for any damage your guests cause.

A good agreement should cover liability for any necessary repairs or cleaning charges following your guest’s stay, rules on smoking and pets, and a liability waiver for pools and other hazards. Miami real estate lawyer Ben Solomon also suggests adding an occupancy limit so that nice young man doesn’t bring his entire fraternity along with him.

As for insurance, call your home’s insurer to let them know you’ll be renting out your home. Most insurance are “fairly accommodating” to occasional renters, says Jeanne Salvatore of trade group Insurance Information Institute. Make sure you’ve maxed out liability coverage on your homeowner’s policy, which offers protection in case of, for example, a guest’s injury. Consider an additional umbrella liability policy of at least $1 million, says Maryland real estate lawyer Harvey S. Jacobs.

 

MONEY Investing

If You Live in Vegas, You Might Want to Buy More Bonds

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Las Vegas' more volatile home prices suggest residents should invest their portfolios more conservatively, a new report says. Glenn Pinkerton—Las Vegas News Bureau

Where you live, and how much home equity you have, should impact how you invest for retirement, argue Morningstar experts.

The collapse of housing prices five years ago made a lot of people question whether owning a home was a good investment. But you probably never connected where you live with how you invest.

That’s a mistake, says David Blanchett, head of retirement research at Morningstar. Blanchett argues in a recent paper that investors’ strategy for building retirement wealth should look beyond typical portfolio considerations — stocks versus bonds, growth versus value — and take into account the health of your real estate market.

“Real estate is the largest physical asset most households have,” Blanchett says. And it can be an important financial asset: Home equity could be tapped to help fund retirement, or a paid-off home passed along to heirs.

But, as the housing bust taught us the hard way, a downturn in home prices can wipe out equity in a flash. Especially if you own a home in a market where prices are volatile, such as Las Vegas, Miami, or Washington D.C.

In that case, you might want to adjust your investment strategy, according to Morningstar. Here are some ways your housing situation could impact your investing style:

If you live in a one-company town: Invest more conservatively. A city dominated by one industry or one company leaves you vulnerable. “If that company went out of business, or had a significant layoff, lots of people might all want to move at the same time,” Blanchett says. Even if you don’t work for the company, you’re still exposed.

If you have a lot of equity in your home: Invest more aggressively. The more equity you have in your home, the less affected you are by pricing changes. For example, if you’ve just purchased your home with 10% down, a 10% decline in home prices would completely erase the value of your investment. That same decline for someone who has paid off the mortgage would represent a much less significant loss. “You can afford to take on more risk in other parts of your portfolio,” Blanchett says.

If you rent: Increase your allocation to REITs. Stashing a 5%-10% chunk of your portfolio in real estate investment trusts is a common diversification tactic. But owning a home also exposes you to real estate. If you have a lot of home equity, or live in a riskier market, you want to stay at the low end of that allocation. If you rent, on the other hand, you could put closer to 10% of your nest egg in REITs, Blanchett says.

 

MONEY Warren Buffett

Inside Buffett’s Brain

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Warren Buffett Ben Baker—Redux

Math-minded researchers are attempting to distill the mind of the world's greatest investor. Even if they fall short of replicating Warren Buffett's craft—and they will—there are good lessons here about what it takes to beat the market.

Warren Buffett isn’t merely a great investor. He’s also the great investor you think you can learn from, and maybe even copy (at least a little).

Buffett explains his approach in a way that makes it sound so head-smackingly simple. The smart investor, he wrote back in 1984, says, “If a business is worth a dollar and I can buy it for 40¢, something good may happen to me.” This is particularly true if you add an eye for quality.

Buying good businesses at bargain prices — that sounds like something you could do. Or hire a fund manager to do for you, if you could find one with a fraction of Buffett’s ability to spot a great deal. Of course, the numbers say otherwise. The vast majority of U.S. stock funds fail to beat their benchmarks over a 15-year period.

Buffett’s long-run record makes him a wild outlier. Since 1965 the underlying value of his holding company, Berkshire Hathaway, which owns publicly traded stocks such as Coca-Cola THE COCA COLA CO. KO 1.7971% and American Express AMERICAN EXPRESS CO. AXP 1.3876% , as well as private subsidiaries like insurance giant Geico, has grown at an annualized 19.7%. During the same period the S&P 500 grew at a 9.8% rate.

Buffett is “a very unexplained guy,” says Lasse Heje Pedersen of Copenhagen Business School in Denmark. But instead of chalking up Buffett’s success to what Pedersen calls Fingerspitzengefühl—German for an intuitive touch—the professor is out to explain the man through math. His research is part of a push among both academics and money managers to quantify the ingredients of investment success. The not-so-subtle hint: It may be possible to build, in essence, a Buffett-bot portfolio. No Oracle required.

In an attention-getting paper, Pedersen and two co-­authors from the Greenwich, Conn., hedge fund manager AQR claim to have constructed a systematic method that doesn’t just match Buffett, but beats him (Pedersen also works for AQR). This is no knock on the man or his talents, they say. Just the opposite: It proves he’s not winging it. Meanwhile, other economists say they have pinned down a simpler quantitative way to at least get at the “good business” part of Buffett’s edge.

A dive into this quest to decode Buffett, 83, certainly can teach you a lot—about Buffett’s investing and your own. Yet this story isn’t just about what makes one genius tick. It’s also about how Wall Street is using modern financial research, especially the hunt for characteristics that predict higher returns, to sell you mutual and ­exchange-traded funds. If you wonder how the world’s greatest investing mind can be distilled to a simple formula, you’re right to be skeptical. That’s one message even Buffett himself (who declined to comment for this story) would most likely endorse.

The Buffett equation starts with value, but not “bargains”

The AQR authors say a big part of “the secret behind Buffett’s success is the fact that he buys safe, high-quality, value stocks.” Hardly a surprise, since Buffett has been called the “ultimate value investor.” But the truth is that Buffett is no classic bargain hunter. Can an equation replicate this fact?

In his Berkshire shareholder letters, Buffett often writes about the influence of Ben Graham, his professor at Columbia. Graham is considered the father of value investing, a discipline that focuses on buying a stock when it is cheap relative to some measure of the company’s worth. Graham especially liked to look at book value, or assets minus debt. It’s what an owner would theoretically get to keep after selling all of a company’s property.

Economists have come to back this idea up. In the 1990s, Eugene Fama and Kenneth French showed that stocks that were cheap vs. book provided higher returns than old economic models predicted. (Fama shared the Nobel Prize for economics in 2013.)

Buffett certainly buys his share of textbook value plays: Last year Berkshire snapped up the beaten-down stock of Canadian energy producer Suncor SUNCOR ENERGY SU 2.3139% at a price that was just a little above its book value per share. (The typical S&P 500 stock trades at 2.6 times book.) But since 1928, a value tilt would have brought investors only an extra percentage point or so per year. There’s more to Buffett than the bargain bin.

Buffett says so himself. He likes to cite the maxim of his longtime business partner, Charlie Munger: “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.” In his 2000 shareholder letter, Buffett wrote that measures including price/book ratios “have nothing to do with valuation except to the extent they provide clues to the amount and timing of cash flows into and from the business.” A stock being cheap relative to assets helps give you what Graham called “a margin of safety,” but what you really want a piece of isn’t a company’s property but the profits it is expected to produce over time.

Those anticipated earnings are part of what Buffett calls a company’s “intrinsic value.” Estimating that requires making a smart guess about the future of profits, which Buffett does by trying to understand what drives a company’s business. His arguments (at least his public ones) for why he likes a stock usually involve a straightforward story and are arguably a bit squishy on the numbers. Coca-Cola has a great brand, he says, and has customers who are happy to drink five cans a day.

“The best buys have been when the numbers almost tell you not to,” he said to a business school class in 1998. “Then you feel strongly about the product and not just the fact that you are getting a used cigar butt cheap.” Some economists, though, think there may be a way to get the numbers themselves to tell the story.

Predicting wonderfulness

Since the discovery of the value effect, as well as a similar edge for small companies, academics have looked for other market “anomalies” that might explain why some stocks outperform. The AQR team thinks that a trait it calls “quality” might explain another part of Buffett’s success. Their gauge of quality is a complex one that combines 21 measures, including profits, dividend payouts, and growth, but a lot of it certainly rhymes with what Buffett has said about the importance of future cash flows.

A better Buffett

There may be a far simpler way to get at this. Last year the University of Rochester’s Robert Novy-Marx published an article in the influential Journal of Financial Economics arguing that something called a company’s “gross profitability” can help explain long-run returns. He says a theoretical portfolio of big companies with a high combined score on value and profits would have beaten the market by an annualized 3.1 percentage points from 1963 through 2012.

Novy-Marx’s gross-profit measure is sales minus the cost of goods sold, divided by assets. That is different from the earnings figures most investors watch. It doesn’t count things like a company’s spending on advertising or a host of accounting adjustments, which might be important to Wall Street analysts trying to grasp the inner workings of a single company. “I view gross profits as a measure that is hard to manipulate and a better measure of the true economic profitability of a firm,” Novy-Marx says.

In a recent working paper he also suggests that gross profits may be an indicator a company has a quality prized by Buffett: a wide economic “moat.” Businesses with this trait (say, Coke’s brand) enjoy a competitive advantage that helps them defend their high profits against the competition.

Recently Fama and French confirmed that a profit measure similar to Novy-Marx’s also seemed to work. All of which adds to the case that Buffett’s value-plus-quality formula makes sense. But it doesn’t exactly describe what’s in the Berkshire portfolio.

A risky take on safety

AQR believes that there’s one more anomaly that Buffett exploits: safety. Here again, though, Buffett relies on a very particular kind of safety. Stocks that fall less in downturns—“low beta” is the ­jargon—are likely to be underpriced, says AQR. It has to do with investors’ reluctance to use borrowed money, or leverage in Wall Street parlance. When they want to increase potential returns, most investors don’t turn to leverage to amp up their market exposure. Instead, they buy riskier, “high beta” equities. That drives up the valuations on shares of high­fliers, giving cheaper, low-beta stocks an edge.

It’s unlikely Buffett ever asks what a stock’s beta is. (He often pokes fun at beta and other Greek-letter notions.) Still, he does tend to shy away from many of the glamour stocks bulls love. He famously avoided, for example, the Internet bubble of the late 1990s. “A fermenting industry is much like our attitude toward space exploration: We applaud the endeavor but prefer to skip the ride,” he wrote in 1996.

Don’t mistake Berkshire Hathaway for a safe stock, though. From the summer of 1998 through early 2000, Pedersen and company note, Berkshire shares fell 44% while the market rose 32%. What explains that? First, low beta doesn’t mean an investment won’t lose money—just that it won’t fall sharply in step with the market. (Gold, for example, is volatile but has a low beta to stocks.) Second, Berkshire concentrates on a fairly small group of stocks with big bets on certain industries, such as insurance. So if one sector stumbles, it has a large effect on the entire company.

Then there’s leverage, which Buffett isn’t afraid of. The AQR team says Buffett is a smart user of other people’s money, which increases Berkshire’s gains but can also magnify losses. This part of Buffett’s advantage also happens to be the one that would be hardest to replicate.

A big chunk of the Berkshire portfolio is in insurers it wholly owns. As Buffett has explained, this is an excellent source of cheap leverage. Insurers enjoy a “float”—they take in premiums every month but pay out only when someone crashes a car, gets flooded, or dies. For Berkshire, says AQR, this historically turned out to be like getting a loan for 2.2%, vs. the more than 5% the U.S. government had to pay on Treasuries over the same period.

Buffett was able to combine this cheap debt with another unique advantage: Even in down periods no one ever forced him to sell stock at fire-sale prices. Fund managers, on the other hand, face that risk all the time, and the ones who use borrowed juice have to worry about being hit by a cash crunch in a bad market. To simulate Buffett’s strategy in a far more diversified portfolio, the AQR model levers up 3.7 to 1, vs. Berkshire’s 1.6 to 1. As it turns out, it’s easier to build a Buffett portfolio in theory than to run a company like Berkshire in real life.

And Pedersen admits that quants can only hope to say what it looks like Buffett did. They can’t describe how his neural wetware figured it all out. “People say, ‘That’s not how Buffett does it,’ ” says Pedersen. “We agree. We don’t think that’s how he looks at it.” When Buffett bought Burlington Northern Santa Fe outright a few years ago, he was making an entrepreneurial bet on rising oil prices, reasoning that trains use less fuel than trucks. Great story. Hard to stick into a quantitative model.

1 Exp Buffett

Here come the robofunds

Finding factors that beat the market isn’t just an academic exercise. There is a huge rush to create funds exploiting one or another stock market anomaly. AQR, for instance, has launched funds using both low-volatility and high-­quality screens. Dimen­sional Funds, which runs low-cost index-like portfol­ios, has added a profitability tilt to some funds. (Novy-Marx recently began consulting for Dimensional.)

A trio of researchers at Duke has counted up to 315 new factors that have supposedly been discovered by academics, with over 200 popping up just in the past decade. They can’t all work—and the Duke team says that it is statistically likely that most of them won’t. What those factors all have in common is that they were discovered by looking backward.

Winning with Warren

As Joel Dickson, an investment strategist for the index fund giant Vanguard, says, “Predicting the future is a lot harder than predicting the past.” A cynic can easily mine past data for patterns. To dramatize that effect, Dickson put together data showing you could double the market’s return just by picking S&P 500 stocks with tickers starting with the right letters of the alphabet. If you like Buffett, try the WARREN stock portfolio above—click the image above to enlarge. (It “works” largely because holding stocks in equal proportion means a bigger bet on smaller companies, which happen to have had a good run.)

“Data mining is hugely pernicious, and the incentives to do it are high,” acknowledges Novy-Marx. He says profitability is nonetheless an unusually strong effect and simple enough that it’s not easy to game. Pedersen, likewise, says the safety factor is grounded in theory going back to the 1960s. In the end, though, you can never know whether what worked in the past will keep working in the future.

So what do you do with all this? Samuel Lee, an ETF strategist at Morningstar, says some of these new factors look promising. He has even called this a “come-to-Buffett moment” for academic finance. But he says it’s important to go in with modest expectations. Strategies that have had success are likely to look more average over time, especially once they are publicized and people trade on them. “Your main protection is just to keep fees low,” he says. “You can’t pay up for these factor tilts.” He says a factor-based fund charging as little as 0.70% of assets per year could easily see most of its performance advantage consumed by fees.

The quest to replicate Buffett’s strategies may be an attempt to improve the chances of success for active management. In the end, though, it helps illustrate how hard it is for most professional managers to truly outperform. Put simply, “Should a value manager be getting credit for having a value tilt in a value market?” asks Dickson, rhetorically. Likewise, if a combo of value, profits, and safety can explain a lot of what even the most dazzling managers do, and if it gets easier to simply add more of those elements with low-cost index funds, the fees of 1% or more that many active funds charge are hard to justify.

In short, it may not be worth it for you to try to find the next great money manager. This is a point that Buffett himself has made time and again. In a 1975 letter to Washington Post CEO Katharine Graham, he wrote, “If above-average performance is to be their yardstick, the vast majority of investment managers must fail. Will a few succeed—due to either chance or skill? Of course. For some intermediate period of years a few are bound to look better than average due to chance—just as would be the case if 1,000 ‘coin managers’ engaged in a coin-flipping contest.”

Of all the investment insights that Buffett has laid out over the years, perhaps the most widely useful one is found in his latest Berkshire shareholder letter. There, he says, his will leaves instructions for his trustees to invest in an S&P 500 index fund.

MONEY financial advisers

Why I Talk Philanthropy with Clients

A financial adviser who once kept mum about her philanthropic investments explains why she isn't shy about them now.

I never used to bring up with clients the subject of philanthropy.

Since 2005, my husband and I had been personally investing in “high social-impact investments,” but I hadn’t been talking about them with the people who came to me for my financial planning services.

Philanthropy was too personal of a topic. Whether clients donated money or not was their private matter.

And, as a financial adviser, I certainly wasn’t going to recommend any investments that earned such negligible returns–say, only 0.5% annually–no matter how much good these investments did in the world.

Then, in 2009, someone hired me to help her outline a thoughtful approach to philanthropy. That invitation tipped off a series of conversations about what she wanted. We went far beyond talking about identifying charities, how much to give, and the pros and cons of establishing a donor advised fund.

These discussions made me realize that I had been holding out on my clients. I saw that I had been making a decision for them about whether or not they wanted to invest in something with low returns but a high social impact. In doing so, I was denying them the deeply meaningful connection that I personally experienced.

I learned then, all over again and in a new light, what I already knew to be true: My obligation as an adviser is to hear what my clients want, to explore their options with them, and to help them implement the decisions they deem best. Sometimes that decision is to allocate a defined portion of an investment portfolio to high-impact investments.

A few years and many conversations later, I’ve learned to let go of the label “philanthropy.” Fundamentally, the conversation is about what people want to do with their money, and sometimes that means investing a clearly defined portion of the portfolio purely for social impact.

That may mean making a peer-to-peer loan, investing via a grassroots organization that supports local farmers, or being a seed investor in a local start-up. It might be an intentional decision to re-route a portion of the dollars clients had been donating to charities and instead choosing investments which lend those dollars to people who need access to capital.

Interesting in talking about this type of philanthropy with your clients? Here are two useful resources for finding high social-impact investments:

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Jennifer Lazarus is a certified financial planner and the founder of Lazarus Financial Planning, an independent, fee-only firm specializing in the financial planning needs of socially responsible investors in their 20s to 50s. She most enjoys helping people reach a place of empowerment and financial calm.

MONEY financial advisers

The Investing Client Who Wouldn’t Let Me Invest

What do you do when someone hires you to invest her portfolio — and then won't let you invest her portfolio? For starters, you send her 80 reports over 13 months.

My client finally spoke the words I thought I would never hear: “I would really like to get those trades in gear,” she said.

It had been 13 months since she opened her account with my investment advisory firm. In all that time, she would not agree to any major changes in her portfolio. Faced with big decisions, she wanted to discuss them. She couldn’t focus on them. She had to research them. She put us off. No trades.

Essentially, she was paying us fees for a job she wouldn’t let us do.

Was it an issue of control? I didn’t think so. A successful architect, she came to us because, she said, her portfolio was getting too big to handle. She wanted to hand it off.

She’d done pretty well investing on her own. Her portfolio was reasonably diversified. But when we asked her why she chose this or why she held that, it became clear she saw patterns that weren’t there.

If a fund performed well for five years, then fell off the charts for the next three years, she believed it would do well again, and she would wait—even if that meant years of underperformance. If her fund was a winner, no other fund should be considered—not even ones that had less risk, charged lower expenses, or performed better. Everything she held, she loved.

No amount of analytics, discussion…nothing would change that. Of course, I didn’t figure this out, and I worked hard to change her mind. I pumped out charts and sent copies of articles. We’d meet, exchange emails, and talk time and again about portfolio constructions. I’m not exaggerating: I sent her more than 80 reports as part of my effort.

I should have seen what was going on: She was uncomfortable. She was wary about making changes—about going headlong into new asset classes or new funds. She handled complex building projects every day, down to the nuts and bolts. But she kept saying she couldn’t get her mind around all these investing ideas that were so new to her. She was in a bit over her head, and she didn’t like that at all.

I eventually told her that was what investing is like. If you have a reasonably diversified portfolio, something will always be your favorite and something will always be the dog you wish would wander off. She just had to get used to being uncomfortable with the market—but comfortable with me as I steered her through it.

One day, she decided she was. And then she said we could make the trades I had wanted to make for a year.

Behavioral economists would see my client’s reluctance to trade as an extreme example of projecting the past into the future. That’s one of the ways that the intuitive human mind works. Another intuitive leap people make is to think that if they’ve been right once, they will be right again. That’s why clients so often ask why they should have to sell a winner. It’s their intuition. Intuition, though, isn’t a great tool for managing portfolios.

In all this, I gained a healthy respect for the mental gymnastics it took for this new client to become a good client. The ushering-in process can be hard. I should have paid more attention to what she was going through to reach me, rather than to what I was doing to reach her.

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Harriet J. Brackey, CFP, is the co-chief investment officer of KR Financial Services, a South Florida registered investment advisory firm that manages more than $330 million. She does financial planning and manages clients’ portfolios. Previously, she was an award-winning journalist covering Wall Street, with stints at Business Week, USA Today, The Miami Herald and Nightly Business Report.

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