--- title: Elm Wealth Research | James White (9) description: Regular Elm Posts (9) --- [![Elm Partners](https://insights.elmwealth.com/hs-fs/hubfs/elm%20logo%20mini.png?width=100&height=100&name=elm%20logo%20mini.png "Elm Partners")](http://elmwealth.com/) Open main menu Close main menu # Elm Wealth Research Select Category Featured Insights How Elm Works In the News Investing 101 Risk and Return Tax Matters Uncategorized Posts by: ## James White ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/family-planning-840x420.jpg) [Uncategorized](https://insights.elmwealth.com/elm-wealth-research/tag/uncategorized) ### [What does family planning have to do with investing?](https://insights.elmwealth.com/elm-wealth-research/what-does-family-planning-have-to-do-with-investing) Nov 22, 2016, 12:00:00 AM November 22, 2016 Uncategorized ## What does family planning have to do with investing? We recently launched a new sub-section of our website, Elm Labs, as a place to experiment with interactive research and educational tools. We launched with a simple (yet tricky) family planning puzzle – and so far, we’ve had answers from over 1000 people. Assuming that there was no self-selection bias in terms of who answered it, it’s a fair estimation that the vast majority of them were finance professionals in the 45 to 65 year old age group, with about half having graduate degrees, and about two dozen being current or former professors in finance. Of these, 44% got the right answer, and of those who didn’t, 54% thought that the imbalance in the population would favor girls over boys (which is what I would have guessed too, as that seemed to be the objective of the family planning strategy to begin with). I received about two dozen emails with comments (actually, mostly were objections). The most common remark was that the (unrealistic) assumption that a couple could have as many children as needed in order to have a girl was what made the expected number of girls and boys equal. Not true: if we assume, for example, that a family stops trying after 5 boys in a row, that doesn’t change the answer that the expected number of girls and boys is still equal. I pasted a table below which shows that, just in case you’re wondering. One friend (a former stats professor) pointed me to an area of probability theory that probes questions involving stopping rules much more deeply (see [Doob’s optional sampling theorem](https://en.wikipedia.org/wiki/Optional_stopping_theorem) for a taste). As is often the case, simple problems can reveal layers and layers of more profound questions when un-ravelled by inquisitive minds. Stay tuned for more on the question of stopping rules. In particular, we’ve been working on some research that explores the question of whether a stop-loss approach to investing (more fully: *cut your losses early and let your profits run*) in and of itself has been a profitable investing and trading approach, and if so, why. | Girls | Boys | Prob | E(Girls) | E(Boys) | | --- | --- | --- | --- | --- | | 1 | 0 | 0.5 | 0.5 | 0 | | 1 | 1 | 0.25 | 0.25 | 0.25 | | 1 | 2 | 0.125 | 0.125 | 0.25 | | 1 | 3 | 0.0625 | 0.0625 | 0.1875 | | 1 | 4 | 0.03125 | 0.03125 | 0.125 | | 0 | 5 | 0.03125 | 0 | 0.15625 | | | Sum | 1 | 0.96875 | 0.96875 | [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/what-does-family-planning-have-to-do-with-investing) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/024-biased-banner.png) [Investing 101](https://insights.elmwealth.com/elm-wealth-research/tag/investing-101) ### [Lessons from Betting on a Biased Coin: Cool heads and cautionary tales](https://insights.elmwealth.com/elm-wealth-research/lessons-from-betting-on-a-biased-coin-cool-heads-and-cautionary-tales) Oct 26, 2016, 12:00:00 AM October 26, 2016 Investing 101 ## Lessons from Betting on a Biased Coin: Cool heads and cautionary tales *By Victor Haghani and Richard Dewey* [1](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-1-306) ### Introduction You’re invited to a talk by a former hedge fund manager who was a partner at a fund that famously flopped about twenty years ago. You turn up, hoping to hear some valuable insights (or at least some entertaining tales) but instead you are offered a stake of $25 to take out your laptop to bet on the flip of a coin for thirty minutes. You’re told the coin is biased to come up heads with a 60% probability, and you can bet as much as you like on heads or tails on each flip. You will be given a check for however much is in your account at the end of the half hour.[2](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-2-306) That’s it. Would you feel it was worth your time to play, or would you walk out? How would you play the game? What heuristic or mental tool-kit would you employ? These questions led us to conducting the exact experiment described above. By having participants engage in an activity as simple as flipping a coin, the betting strategy and its evolution are easily isolated for observation. This simple game also turns out to have properties that are similar to investing in the stock market as well as implications for finance and economics education. Below we’ll describe the experiment, how our subjects played the game and the conclusions we draw from the experiment. ### The Experiment Our coin-flipping experiment was played by 61 subjects, in groups of 2 to 15, in the quiet setting of office conference rooms or university classrooms. The proctor for the game outlined basic principles, such as no talking or cooperation and that subjects were not to use the internet or other resources while playing the game. The experiment began when subjects were directed to a URL that contained a purpose-built application for placing bets on the flip of a simulated coin. Participants used their personal laptops or work computers to play the game. Prior to starting the game, participants read a detailed description of the game, which included a clear statement, in bold, indicating that the simulated coin had a 60% chance of coming up heads and a 40% chance of coming up tails. Participants were given $25 of starting capital and it was explained in text and verbally that they would be paid, by check, the amount of their ending balance subject to a maximum payout. The maximum payout would be revealed if and when subjects placed a bet that, if successful, would make their balance greater than or equal to the cap. We set the cap at $250, ten times the initial stake. Participants were told that they could play the game for thirty minutes, and if they accepted the $25 stake, they had to remain in the room for that amount of time.[3](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-3-306) Participants could place a wager of any amount in their account, in increments of $0.01, and they could bet on heads or tails. Participants were asked a series of questions about their background before playing and about their experience when they finished. The sample was largely comprised of college-age students in economics and finance and young professionals at finance firms. We had 14 analyst- and associate-level employees at two leading asset management firms. The sample consisted of 49 males and 12 females. Our prior was that these participants should have been well-prepared to play a simple game with a defined positive expected value. ### Optimal Strategy Before continuing with a description of what an optimal strategy might look like, perhaps you’d like to take a few moments to consider what you would do if given the opportunity to play this game. Once you read on, you’ll be afflicted with the curse of knowledge, making it difficult for you to appreciate the perspective of our subjects encountering this game for the first time. So, if you want to take a moment to think about your strategy, this is the time to do it. If you’re a professional gambler, chances are you’ve heard of the Kelly criterion, a formula published in 1956 by John Kelly, a brilliant (if somewhat eccentric) researcher working at Bell Labs. The formula provides an optimal betting strategy for maximizing the rate of growth of wealth in games with favorable odds, a tool that would appear a good fit for this problem. Dr. Kelly’s paper built upon work first done by Daniel Bernoulli, who resolved the St. Petersburg Paradox – a lottery with an infinite expected payout – by introducing a utility function that the lottery player seeks to maximize. Bernoulli’s work catalyzed the development of utility theory and laid the groundwork for many aspects of modern finance and behavioral economics. Dr. Kelly’s paper and the eponymous formula caught the attention of gamblers and investors. It was further developed and applied to casino games and financial markets by Ed Thorp in a series of papers and popular books, most notably *Beat the Dealer* and *Beat the Market.* Following Kelly and Thorp’s initial work, many others – including Murray Gell-Mann – have further developed the theoretical foundations, while notable investors such as Warren Buffett, Bill Gross and James Simons have all reportedly made use of the Kelly formula. The basic idea of the Kelly formula is that a player who wants to maximize the rate of growth of his wealth should bet a constant fraction of his wealth on each flip of the coin, defined by the function *2 \* p – 1* , where *p* is the probability of winning. The formula implicitly assumes the gambler has log utility. It’s intuitive that there should be an optimal fraction to bet; if the player bets a very high fraction, he risks losing so much money on a bad run that he would not be able to recover, and if he bet too little, he would not be making the most of what is a finite opportunity to place bets at favorable odds. While it’s true that the expected value of the game goes up the higher the fraction the player bets, the outcomes become so skewed that a player who exhibits risk aversion will find an optimal betting fraction well below 100%. The odds themselves play a role in the optimal fraction to bet; the more favorable the odds, the higher a fraction one ought to bet. Finally, as the flips are independent random outcomes, the strategy should only depend on the player’s account balance, and not on the pattern of previous flips.[4](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-4-306) In our game, the Kelly criterion would tell the subject to bet 20% (*2 \* 0.6 – 1* ) of his account on heads on each flip. So, the first bet would be $5 (20% of $25) on heads, and if he won, then he’d bet $6 on heads (20% of $30), but if he lost, he’d bet $4 on heads (20% of $20), and so on. ### Findings: How Well Did Our Players Play?? *“How did you go bankrupt? Gradually, and then suddenly.”*   – Ernest Hemingway, *The Sun Also Rises*, 1926 Our subjects did not do very well. While we expected to observe some sub-optimal play, we were surprised by the pervasiveness of it. Sub-optimal betting came in all shapes and sizes: over-betting, under-betting, erratic betting and betting on tails were just some of the ways a majority of players squandered their chance to take home $250 for 30 minutes play. Only 21% of participants reached the maximum payout of $250,[5](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-5-306) well below the 95% that should have reached it given a simple constant percentage betting strategy of anywhere from 10% to 20%.[6](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-6-306) We were surprised that one-third of the participants wound up with less money in their account than they started with. More astounding still is the fact that 28% of participants went bust and received no payout. That a game of flipping coins with an ex-ante 60/40 winning probability produced so many subjects that lost everything is startling. The average ending bankroll of those who did not reach the maximum and who also did not go bust, which represented 51% of the sample, was $75. While this was a tripling of their initial $25 stake, it still represents a very sub-optimal outcome given the opportunity presented. The average payout across all subjects was $91, letting the authors off the hook relative to the $250 per person they’d have had to pay out had all the subjects played well. The chart below summarizes the performance of our 61 subjects, who in aggregate wagered on 7,253 coin flips, 59.6% of which were heads. Only 5 of our 61 financially-sophisticated students and young investment professionals reported that they had ever heard of the Kelly criterion. Interestingly, having heard of Kelly did not seem to help two of them: one barely managed to double his stake, and the other one only broke even after about 100 flips. In post-experiment interviews, we found that the notion of betting a constant proportion of wealth seemed to be a surprisingly non-intuitive approach to playing this game. Our results do not offer any indication that participants were converging to optimal play over time as evidenced by sub-optimal betting of similar magnitude throughout the game. How subjects played the game in the absence of employing Kelly was illuminating. Of the 61 subjects, 18 subjects bet their entire bankroll on one flip, which increased the probability of ruin from close to 0% using Kelly to 40% if their all-in flip was on heads, or 60% if they bet it all on tails, which amazingly some of them did. The average bet size across all subjects was 15% of the bankroll, so participants bet less, on average, than the Kelly criterion fraction, which would make sense in the presence of a maximum payout that would be within reach. However, this apparent conservatism was completely undone by participants generally being very erratic with their fractional betting patterns, betting too small and then too big. Betting patterns and post-experiment interviews revealed that quite a few participants felt that some sort of doubling down, or Martingale betting strategy, was optimal, wherein the gambler increases the size of his wagers after losses. Another approach followed by a number of subjects was to bet small and constant wagers, apparently trying to reduce the probability of ruin and maximize the probability of ending up a winner. We observed 41 subjects (67%) betting on tails at some point during the experiment. Betting on tails once or twice could potentially be attributed to curiosity about the game, but 29 players (48%) bet on tails more than 5 times in the game. It is possible that some of these subjects questioned whether the coin truly had a 60% bias towards heads, but that hypothesis is not supported by the fact that within the subset of 13 subjects who bet on tails more than 25% of the time, we found they were more likely to make that bet right after the arrival of a string of heads. This leads us to believe that some combination of the illusion of control, law of small numbers bias, gamblers fallacy or hot hand fallacy was at work. After the game concluded, we asked participants a series of questions, including whether they believed the coin actually had a 60% bias towards heads. Of those who answered that question, 75% believed that was the case. ### How Much Should You Be Willing to Pay to Play? Not only did most of our subjects play poorly, they also failed to appreciate the value of the opportunity to play the game. If we had offered the game with no cap, this experiment could have become very, very expensive for your authors.[7](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-7-306) Assuming a player with agile fingers can put down a bet every 6 seconds, that would allow 300 bets in the 30 minutes of play.[8](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-8-306) The expected gain of each flip, betting the Kelly fraction, is 4% and so the expected value of 300 flips is *$25 \* (1 + .04)300 = $3,220,637* \![9](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-9-306) Given the expected value of the uncapped game is about $3 million, how much should a person be willing to pay to play this game, assuming that he believes that the person offering the game has enough money to meet all possible payouts?[10](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-10-306) Just as is the case with the St. Petersburg Paradox, where players are generally unwilling to pay more than $10 to play a game with an infinite expected value, in our game too, players should only be willing to pay a fraction of the $3 million expected value of the game.[11](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-11-306) For example, if we assume our gambler has log utility (which the Kelly solution implies) and has de minimus investable wealth, then he should be willing to pay about $10,000 to play the game (the dollar equivalent of the expected utility), a small fraction of $3 million, but still a very large absolute amount of money in light of the $25 starting stake.[12](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-12-306) With a capped payout (the game we actually offered) a simple (but not strictly optimal) strategy would incorporate an estimate of the maximum payout. If the subject rightly assumed we wouldn’t be offering a cap of more than $1,000 per player, then a reasonable heuristic would be to bet a constant proportion of one’s bank using a fraction less than the Kelly criterion, and if and when the cap is discovered, reducing the betting fraction further depending on betting time remaining to glide in safely to the maximum payout. For example, betting 10% or 15% of one’s account may have been a sound starting strategy. We ran simulations on the probability of hitting the cap if the subject bet a fixed proportion of wealth of 10%, 15% and 20%, and stopping when the cap was exceeded with a successful bet. We found there to be a 95% probability that the subjects would reach the $250 cap following any of those constant proportion betting strategies, and so the expected value of the game as it was presented (with the $250 cap) would be just under $240. However, if they bet 5% or 40% of their bank on each flip, the probability of exceeding the cap goes down to about 70%. ### Similarities to Investing in the Stock Market *“If you gave an investor the next day’s news 24 hours in advance, he would go bust in less than a year.”*   – Nassim Taleb An interesting aspect of this experiment is that it has significant similarities to investing in the stock market. For example, the real return of US equities over the past 50 years was a bit over 5% and the annual standard deviation was about 15%, giving a return/risk ratio of about 0.33. Many market observers believe the prospective return/risk ratio of the stock market is well below its historical average, and closer to that of our coin flip opportunity, which has a return/risk ratio of 0.2.[13](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-13-306) Of course, there are significant differences, from the binary-versus-continuous nature of outcomes, to the question of risk versus uncertainty when investing in the stock market where no one can tell you the distribution from which you will draw outcomes. Furthermore, most investors believe the stock market is not a successive set of independent flips of a coin, but that there are elements of mean reversion and trending in stock market behavior, and of course, outlier events happen with much higher probability than would evolve from a series of coin flips.[14](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-14-306) Most people we discussed this with felt that there is a fundamental difference between flipping a coin 300 times in 30 minutes, and investing in the stock market where we have to wait 30 years to get 30 flips of the coin. In fact, to the extent that stocks follow a random walk, with both return and the risk we care about, variance, both growing proportionately with time, then horizon should not affect our betting strategy, although it does affect how highly we value the opportunity to play.[15](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-15-306) After the experiment, we discussed Kelly and optimal betting strategies with our subjects. We were left with the feeling that they would play the game more effectively if given another chance. We wonder whether any long-lasting impact could be had on investor behavior through similar discussions of sensible approaches to stock market investing. Perhaps investing in the stock market is much more nuanced and complex than betting on a biased coin, or perhaps it’s easy to stick to a sound, albeit boring, strategy for 30 minutes but impossible to maintain that discipline for 30 weeks, months or years. ### Conclusion *“This is a great experiment for many reasons. It ought to become part of the basic education of anyone interested in finance or gambling.”*   – Edward O. Thorp While we did expect to observe poorly-conceived betting strategies from our subjects, we were surprised by the fact that 28% of our subjects went bust betting on a coin that they were told was biased to come up heads 60% of the time. Before this experiment, we did not appreciate just how ill-equipped so many people are to appreciate or take advantage of a simple advantageous opportunity in the presence of uncertainty. The straightforward notion of taking a constant and moderate amount of risk and letting the odds work in one’s favor just doesn’t seem obvious to most people. Given that many of our subjects received formal training in finance, we were surprised that the Kelly Criterion was virtually unknown and that they didn’t seem to possess the analytical tool-kit to lead them to constant proportion betting as an intuitively appealing heuristic. Without a Kelly-like framework to rely upon, we found that our subjects exhibited a menu of widely documented behavioral biases such as illusion of control, anchoring, over-betting, sunk-cost bias, and gambler’s fallacy. We reviewed the syllabi of introductory finance courses and elective classes focused on trading and asset pricing at five leading business schools in the United States.[16](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-16-306) Kelly was not mentioned in any of them, either explicitly, or by way of the topic of optimal betting strategies in the presence of favorable odds. Could the absence of Kelly be the effect of Paul Samuelson’s vocal critique of Kelly in public debate with Ed Thorp and William Ziemba?[17](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-17-306) If so, it’s time to bury the hatchet and move forward. These results raise important questions. If a high fraction of quantitatively sophisticated, financially-trained individuals have so much difficulty in playing a simple game with a biased coin, what should we expect when it comes to the more complex and long-term task of investing one’s savings? Is it any surprise that people will pay for patently useless advice, as documented in studies like Powdthavee (2012)? What do the results suggest about the prospects for reducing wealth inequality, or ensuring the stability of our financial system? Our research suggests there is a significant gap in the education of young finance and economics students when it comes to the practical application of the concepts of utility and risk taking. The existence of this gap is even more surprising than the poor play of our subjects. After all, can we really blame them if they haven’t received sufficient practical training? Our research will be worth many multiples of the $5,574 winnings we paid out to our 61 subjects if it helps encourage educators to fill this void, either through direct instruction or through trial-and-error exercises like our game. --- ### Further Reading and References: - Choi, James, David Laibson, and Brigitte Madrian. *“Why does the law of one price fail? An experiment on index mutual funds,”* Review of Financial Studies 23(4): 1405-1432 (2010) - Fenton-O-Creevy, Mark, Nigel Nicholson, Emma Soane, and Paul Willman. *“Trading on Illusions: Unrealistic perceptions of control and trading performance.”* (2003) - Friedland, Keinan and Regev. *“Controlling the Uncontrollable: Effects of Stress on Illusory Perceptions of Controllability.”* (1992) - Gilovich, Thomas, A. Tversky, and R. Vallone. *“The Hot Hand in Basketball: On the Misperception of Random Sequences,”* Cognitive Psychology 3. (1985) - Green, Brett and Jeffrey Zwiebel. *“The Hot Hand Fallacy: Cognitive Mistakes or Equilibrium Adjustments? Evidence from Baseball,”* Stanford Graduate School of Business. Retrieved 2016-05-06. - Langer, Ellen J. *“The Illusion of Control,”* The Journal of Personality and Social Pyschology. (1975) - Levitt, Steven. *“Head or Tails: The Impact of a Coin Toss on Major Life Decision and Subsequent Happiness,”* NBER working paper. (2016) - Kelly, J.L. *“A new interpretation of information rate,”* Bell System Technical Journal 35, 917-926. (1956) - MacLean, Thorp and Ziemba editors. *“The Kelly Capital Growth Investment Criterion,”* World Scientific. (2010) - Miller, Joshua and Adam Sanjurjo. *“A Cold Shower for the Hot Hand Fallacy.”* (2015) - Powdthavee, Nattavudh and Yohanes E. Riyanto. *“Why Do People Pay for Useless Advice? Implications of Gamblers and Hot-Hand Fallacies in False-Expert Setting,”* Working Paper (IZA DP No. 6557) (2012) - Rotando, L.M. and E.O. Thorp. *“The Kelly criterion and the stock market,”* American Mathematical Monthly, 922-931. (1992) - Taleb, Nassim N. *“Mathematical Foundations for the Precautionary Principle,”* Working Paper. (2016) - Thorp, E.O. *“Optimal gambling systems for favorable games,”* Review of the International Statistical Institute 37, 273-293. (1969) - Thorp, E.O., 1971. *“Portfolio choice and the Kelly criterion.”* Review of the International Statistical Institute 37, 273-293. (1969) - Ziemba, W.T. *“Response to Paul A Samuelson letters and papers on the Kelly capital growth investment strategy,”* Journal of Portfolio Management, Fall, 153-167. (2015) --- 1. This not is not an offer or solicitation to invest, nor should this be construed in any way as tax advice. **Past returns are not indicative of future performance.** 2. Subject to a maximum payout that you’ll be informed of if you get close. 3. Whether they chose to not play, or did play and went bust or hit the cap. 4. We present the Kelly criterion as a useful heuristic a subject could gainfully employ. It may not be the optimal approach for playing the game we presented for several reasons. The Kelly criterion is consistent with the bettor having log-utility of wealth, which is a more tolerant level of risk aversion than most people exhibit. 5. We define “maxing out” as players who reached at least $200 by the end, and we define “going bust” as those finishing the game with less than $2 in their account at the end. 6. A result we calculated through Monte Carlo simulation. See Section 5 for more detail. 7. In fact, one reason we suspect this experiment was not performed until now is that it is quite an expensive undertaking, even with just 60 subjects. 8. We programmed the coin to be in a flipping mode for about 4 seconds, to create some suspense on each flip, and also to limit the number of flips to about 300. 9. Your opening bet, according to Kelly, would be $5 on heads. The expected gain from that flip would be $1, as there is a 60% chance of winning $5 and a 40% chance of losing *$5 = 0.6 \* 5 – 0.4 \* 5 = $1* . Your capital in the game at the moment you place that bet is $25, so the expected return on capital is 4% (*$1 / $25* ). Each successive flip of the coin will have that same 4% expected return, up until the cap is encountered, or if the subject gets down to $0.04 or less, at which point he cannot bet 20% of his account any more as we limit the subject to betting $0.01 or more on each flip. And that’s just the expected value. If a subject was very lucky, and flipped 210 heads and only 90 tails (admittedly very unlikely), then we’d have owed him about $2 billion! 10. Of course, this is not realistic, as that would be about $14 trillion trillion (*$25 \* $1.2300* ). We suspect that not even the Fed, ECB and BoJ working together could print that much money. 11. As with the St. Petersburg paradox, much of the high expected value of our game comes from unlikely but very big positive outcomes. The skew can also be seen from the fact that the median of the distribution is so much lower than the mean, which arises from the fact that if you bet 20% of your account and win, you go up to 1.2 of your wealth, and then if you bet 20% of that and lose, you now wind up at *1.2 \* 0.8 = 0.96* , or 4% less than what you had. The median outcome of 180 heads (*0.6 \* 300* ) and 120 tails would produce an outcome of only $10,504 (*$25 \* $1.2180 \* 0.8120* ), much below the $3,220,637 expected value. 12. For each flip, the expected utility is *0.6 \* ln(1.2) + 0.4 \* ln(0.8) = 0.0201* , and *exp(0.0201) = 1.02034* , which means that each flip is giving a dollar equivalent increase in utility of about 2% and so for 300 flips, we get *$25 \* $1.02034300 = $10,504* . This is also the median of the distribution, as per above footnote. If we relax the assumption regarding the player having no outside wealth, the amount he should be willing pay can be much higher than $10,000. 13. More precisely, the ratio is 0.204. 14. Perhaps more nuanced, our coin flip game generates a distribution where you make or lose a fixed amount on each flip, whereas many people believe the stock market has more of a lognormal distribution where the positive flip outcome is greater than the loss from a negative flip. That is, stocks may be characterized by outcomes of *ed* and *e-d* , whereas our coin flip has *1 + d* and *1 – d* for outcomes. 15. There are a number of assumptions in this statement, including that we display constant relative risk aversion, a common but certainly not the only representation of risk aversion among classic and modern behavioral models. 16. MIT, Columbia, Chicago, Stanford and Wharton. 17. Ziemba (2016). [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/lessons-from-betting-on-a-biased-coin-cool-heads-and-cautionary-tales) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/023-fees-main-1024x487.png) [Risk and Return](https://insights.elmwealth.com/elm-wealth-research/tag/risk-and-return) ### [Fees or Performance?](https://insights.elmwealth.com/elm-wealth-research/fees-or-performance) Oct 18, 2016, 12:00:00 AM October 18, 2016 Risk and Return ## Fees or Performance? In a recent [interview](https://elmwealth.com/passive-indexers-still-a-rare-breed-victor-haghani-on-bloomberg-tv/) on Bloomberg TV, I was asked the question: *“Should investors focus on fees or performance?”* My answer was that, while in the end it’s all about performance, it’s extremely difficult to identify reliable predictors of superior returns. So difficult that it may not warrant the effort, and at worst it can result in return-chasing behavior that harms rather than helps returns.[1](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-1-292) Fees, on the other hand, are the one component of performance we have full control over. So focusing on fees makes sense. On my ride home from Bloomberg’s studio, I continued to think about this question, and my answer. I realized that the question implies we need to make a choice between fees and performance, but we don’t. We can enjoy low fees and good performance. For years, researchers and practitioners have looked high and low for predictors that would reliably identify which mutual funds would do best in the future. They’ve looked at all the likely suspects, and some pretty unlikely ones too, for predicting future fund returns. They looked at the past one-, three-, five- and 10-year performance of a fund, the size of the fund, the Morningstar rating of the fund, the number of times the fund manager has appeared on TV, and even the fund’s proximity to Omaha.[2](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-2-292) Here’s what they found: the most powerful predictor is low fees.[3](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-3-292) The single strongest statement I’ve read on the topic comes from Russel Kinnel, director of research at Morningstar: *“The expense ratio is the most proven predictor of future fund returns…. for every category over every time period.”* [4](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-4-292) The reason I find Russel worth quoting is that Morningstar, with its famous five-star rating system, is in the business of helping investors pick the best funds, and this simple finding isn’t exactly the best thing for their business. We shouldn’t be very surprised when Vanguard’s head of research tells us that low fees are the most important predictor of future fund performance (and he has [5](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-5-292)), but for the director of research at Morningstar to say this should get our attention. It’s interesting to note that in other situations, the question of fees vs performance doesn’t have the same answer. For example, when choosing a lawyer or a restaurant, we don’t normally expect that the one who charges the least will give us the best performance. Is there something special about investing that makes it different from so many other economic activities? There is. It’s a combination of the zero sum nature of stock picking combined with the difficulty in separating luck from skill, fueled by our love of a good story.   *– Victor* --- 1. You can read more about how return chasing can be harmful to investors [here.](https://elmwealth.com/return-chasing-can-be-hazardous-to-your-wealth/) 2. I suspect proximity to Valley Forge, PA (home of Vanguard) would have given a different answer. 3. For the purposes of this note, we’re limiting our discussion to US-listed equity mutual funds and ETFs. If you factor in taxes, then the effect is even stronger, because, as you know already, the lowest fee funds are predominantly index funds and index EFTs, and they tend to distribute the least amount of short term capital gains to their holders. In fact, ETF index funds, which make up a large and growing segment of the low fee space, are particularly tax efficient, generating very low levels of realized capital gains to their holders due to the tax efficiency of their structure. 4. [“Fund Fees Predict Future Success or Failure”](https://www.morningstar.com/articles/752485/fund-fees-predict-future-success-or-failure), and “Predictive Power of Fees: Why Mutual Fund Fees Are So Important”, Russel Kinnel, Morningstar, May 2016. 5. [Vanguard’s “Mutual Fund Ratings and Future Performance”](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/www.vanguard.com/pdf/icrwmf.pdf), June 2010. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/fees-or-performance) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/021-hoopla-banner-1024x487.png) [Investing 101](https://insights.elmwealth.com/elm-wealth-research/tag/investing-101) ### [What’s all the hoopla? Passive indexers are still a rare breed](https://insights.elmwealth.com/elm-wealth-research/whats-all-the-hoopla-passive-indexers-are-still-a-rare-breed) Sep 30, 2016, 12:00:00 AM September 30, 2016 Investing 101 ## What’s all the hoopla? Passive indexers are still a rare breed We’ve just passed the 40th anniversary of the first index fund (Vanguard’s, naturally) and everyone’s talking about how passive indexing is taking over the world. That may be a good or bad thing, depending on your perspective, but a more fundamental question is whether it’s actually a fair description of what’s happening? We think not. Index funds are the offspring of Modern Portfolio Theory (MPT), which tells us that the equity portfolio that provides the most attractive return-to-risk ratio is the Market Portfolio, a market cap weighted index of all equities, everywhere. The theory says we should only invest in equities through this Market Portfolio: any other portfolio choice is simply sub-optimal. The major index fund providers offer funds that give investors direct and simple access to this Market Portfolio, such as Vanguard’s aptly named Total World Stock ETF (ticker VT). If investors were truly indexing as directed by MPT, wouldn’t we expect that these index funds, designed to deliver the Market Portfolio straight up, would attract all, or at least the lion’s share, of the assets of index investors? They don’t. The chart below shows just how tiny these Market Portfolio funds are, when compared to their component building blocks. In fact, they make up well under 1% of the roughly $4tr equity index fund and ETF market. VT, the biggest of these Market Portfolio funds, barely even scrapes into the top 100 largest ETFs in the world. Why are investors doing this? We can’t know what motivates each investor, but since at Elm we are also not investing in the straight-up version of the Market Portfolio, maybe our thinking will be representative of others. In short, while we believe that MPT is a great start for building a portfolio, there are a number of assumptions in the theory that are not realistic and lead us to go beyond a market cap weighted portfolio in constructing our Baseline portfolio, such as public equity markets being incomplete, inefficient, unrepresentative and driven by more than just the single risk factor of Beta. In addition, there are tax and cost benefits in going beyond a single holding of a Market Portfolio fund. We’ve described these in more detail in the box below.[1](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-1-251) ### Conclusion: most index investors are active index investors. While it’s undeniable that passive index products have witnessed great success, and investing has become more democratized as a result, we think it’s a stretch to say that passive indexing is taking over the world. Instead, investors are moving away from traditional, higher cost forms of active management and building more complex, granular and nuanced portfolios themselves using index products. At Elm, this is exactly our approach, which we call Active Index Investing®. If you’ve decided you want to put part of your savings into index funds, but feel you should be able to do better than putting it all into one global market cap weighted fund, then please take a closer look at what we do. You can read more about our approach [here](https://elmwealth.com/blog/our-asset-allocation-methodology/), or feel free to request a [callback](https://elmwealth.com/invest). --- ### Why index investors like us are not investing in Market Portfolio funds **Public equity market is incomplete.** Examples include the under-representation of large asset classes, such as real estate or emerging market equities, the fact that different regions have vastly different proportions of private relative to public companies, and, certain markets may not be freely accessible to international investors like mainland China. **Markets not perfectly efficient.** Market cap weights have a tendency to overweight over-valued markets and underweight under-valued markets. Remember the Nikkei in 1989? **More than just Beta driving returns.** Most investors believe there are other sources of risk premia such as small caps or value stocks. **Home bias.** Investing in one’s home market is more attractive than investing in foreign markets which carry currency risk, may be more costly to hold (e.g. withholding tax inefficiencies) and tend to be less relevant to one’s future consumption.[2](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-2-251) An extreme case is Warren Buffett’s recommendation for non-professional investors to hold only the S&P500 for their risk asset allocation.[3](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-3-251) Tellingly, Vanguard calls its most popular index fund that invests in only US equities the “Total Stock Market Index Fund,” which is probably not unrelated to why the US national baseball championship is called the “World Series.” **Tax benefits.** Having multiple holdings may allow a portfolio to be managed more tax-efficiently. For example, it provides more opportunities to realize short-term capital losses for US investors. **Cost savings.** These Market Portfolio funds aren’t the most cost effective. Vanguard’s VT is 14bp and iShares ACWI is 33bp. An investor would save 6 to 25 bps in fees by combining a US ETF, VTI @ 5bps, with an x-US developed market ETF, VEA @ 9bps, and an emerging market one, VWO @ 15bps. --- 1. Besides the reasons that we at Elm don’t invest in the cap weighted Market Portfolio as listed in the sidebar, there are other explanations for why index investors are doing likewise. For example, investors may make a sector by sector decision to go passive vs active. Also, many investors are susceptible to **line item bias**, or **naïve diversification**, which is the feeling that the more lines they see on their brokerage account, the more diversified they feel, even if those products are almost identical.   Studies by Professor Richard Thaler and others have found that investors like to spread their investments over many options on the menu, even when some investments are overlapping or even dominated. For example, investors will invest in two S&P500 index funds with different fees. Benartzi and Thaler, Naive Diversification Strategies in Defined Contribution Saving Plans, (2001) and separately, Fisch and Wilkinson-Ryan, UPenn, Why Do Retail Investors Make Costly Mistakes? An Experiment on Mutual Fund Choice (2014). Another reason may be investors may only go passive in certain geographies or sectors where they feel the market is completely efficient, and seek alpha in more niche areas. 2. [Kim Stockton](https://vanguardinstitutionalblog.com/author/kimberly-stockton/) of Vanguard, 2015: *“…the US equity market cap is about 49% of the global equity market, yet US investors have 71% of their assets invested domestically. The U.K. equity market is roughly 8% of the global equity market, yet U.K. investors have about 50% of their assets invested at home. And in Australia, resident investors have a 70% overweight to domestic equities relative to their 3.5% share of the market.”* 3. While it is true that S&P500 companies derive close to 50% of their sales from outside the US, limiting one’s investment to the biggest 500 US companies leaves one pretty far from the Market Portfolio, as it covers less than 50% of companies on a global basis and 80% of total US market cap. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/whats-all-the-hoopla-passive-indexers-are-still-a-rare-breed) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/020-daughter-main-1024x487.png) [Investing 101](https://insights.elmwealth.com/elm-wealth-research/tag/investing-101) ### [What I learned from my daughter (about investing)](https://insights.elmwealth.com/elm-wealth-research/what-i-learned-from-my-daughter-about-investing) Sep 5, 2016, 12:00:00 AM September 5, 2016 Investing 101 ## What I learned from my daughter (about investing) My daughter Jessica, a cognitive science major at university, caught me with a fun brain-teaser. It came up in a psychology class she was taking with Professor Phil Tetlock, author of *Expert Political Judgment: How Good Is It?* and leader of The Good Judgment Project. The problem goes like this: A fund of funds manager is telling a prospective client why he should engage him, by the following logic: 1) there are over 10,000 hedge funds out there, but only a small fraction, say 5%, are worth investing in, and 2) therefore you need an expert to sort the wheat from the chaff. Through years of experience and hard work, this manager is just such an expert and can discern the good from the bad with 90% accuracy. Taking his assertions at face value, how convinced should the potential client be by his logic? Of course, your antennae are up and you suspect the obvious answer, that the manager will create a portfolio wherein 90% of the funds are good ones, probably isn’t right. But it’s easy to see how if we think about this casually, we’d probably be taken in by this cognitive bias, known as Base Rate Neglect. What I liked about this problem is that I could imagine a real fund of funds manager actually making this argument, without realizing that in doing so, he’d be hoisting himself with his own petard.[1](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-1-236) As you can see with a moment’s reflection, the high incidence of false positives means we should expect just under 1/3rd of the funds in the portfolio to be good funds. In case you don’t have a moment for reflection, the calculation is in the footnote below.[2](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-2-236) True, this is better than how we’d do without expert selection, but it’s probably well under the threshold that we’d require to commit our savings to this manager. And, this is a case where we assume the expert actually is an expert! Normally we see this cognitive bias in cases of medical tests or military intelligence reports, but there are certainly many fitting examples in the realm of investing, where we’re always hoping to identify that rare, neglected gem. This little brainteaser teaches us it’s a lot more challenging than we’re apt to think. --- 1. As you know, I don’t normally draw attention to the difficulties faced by traditional active managers, preferring to focus on the positive attributes of what we’re doing at Elm Partners, but I thought this little puzzle was interesting enough that our readers would want us to violate our policy at least this one time. 2. Imagine the manager inspects 1,000 hedge funds. We’d expect 50 of them to be good ones and 950 to be not so good. Our expert would correctly select 90% of the 50 good ones, or 45, but he’d also incorrectly select 10% of the 950 not good ones, for 95. So, he’d select 140 in total, of which only 45, or 32%, are good ones. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/what-i-learned-from-my-daughter-about-investing) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/019-REITs-II-banner.png) [Investing 101](https://insights.elmwealth.com/elm-wealth-research/tag/investing-101) ### [What’s up with REITs?](https://insights.elmwealth.com/elm-wealth-research/whats-up-with-reits) Jul 27, 2016, 12:00:00 AM July 27, 2016 Investing 101 ## What’s up with REITs? *By Victor Haghani* [1](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-1-218) REITs have returned 17% in 2016, outperforming the S&P500 by 9%. There are several plausible explanations for REITs’ recent strength, such as this year’s 0.75% drop in long-term interest rates. A more intriguing explanation you may have heard about involves an upcoming change in how REITs are classified in indexes. Given Elm’s focus on index investing, I thought a brief discussion of this story might be of interest. I also provide our current view of REITs, from both a value and momentum perspective. ### Real Estate gets its own sector - REITs getting their own index industry sector will more directly confront equity managers with their underweight holding of REITs - As long as REIT index funds owned by passive investors remain large, active managers in aggregate cannot eliminate their underweight position - With a 10-year inflation-adjusted dividend yield of 3.3%, we see REITs as significantly overvalued - However, REITs’ positive momentum may be a good indicator that we are likely to see further significant price appreciation, even from this point of overvaluation. ### Real Estate gets its own sector On August 31st, S&P Dow Jones Indices and MSCI will reclassify real estate companies out of the Financials Sector to a new Real Estate Sector in the Global Industry Classification Standard (GICS®).[2](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-2-218) REITs were originally put into the Financials sector about 20 years ago when REITs were too small to warrant their own sector, and Financials seemed the nearest fit. The creation of this 11th industry sector just for REITs recognizes the tremendous growth in REITs to a roughly $1 trillion market segment[3](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-3-218) and the expectation for their continued growth, as more and more real estate moves from private to public ownership.[4](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-4-218) REITs become the 11th sector of the S&P500 on August 31st, 2016 ### Impact on Active Equity Managers So why might this index change be responsible for REITs’ recent market outperformance? The explanation starts with the observation that many active equity stock pickers manage their risk by keeping their portfolios within certain tolerances as measured against the GICS industry sectors. For example, they might want to keep their exposure to each industry within a 25% tolerance. With this new change in sector classification, their position in REITs will be explicit for the first time, and the manager might be compelled to buy or sell REITs to bring his portfolio into compliance with its risk limits. The next question is whether active managers, as a group, are under- or overweight REITs relative to their industry weight? According to [research](http://www.bloomberg.com/gadfly/articles/2016-05-09/reits-are-coming-of-age-for-investors) by Morningstar and Bloomberg, actively-managed mutual funds are more than 50% underweight REITs, as shown in the chart below.[5](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-5-218) There are a number of explanations for why these managers under-weight REITs as part of the Financial sector allocations. They may view REITs as being too sensitive to interest rates, too dissimilar to financials, overvalued (see further below for our view on REIT valuation), or just plain boring (aka low beta). In any case, once real estate becomes its own sector, these managers are likely to try to match the real estate weighting in their portfolio more closely to the index sector weight of 3%. How big an effect might this be? Let’s say these active managers decide to reduce their underweight position from 50% to 25%. They would need to buy more than $100 billion of REITs, more than enough to give the sector a very noticeable lift.[6](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-6-218) Actively-managed mutual funds are underweight more than 50% in REITs Source: Bloomberg, Morningstar. Note: Benchmarks based on Russell indices; Funds include open end; Data pulled May 6, 2016. ### Trapped, with no way out? We may not need the Morningstar research to infer that active managers are underweight REITs. Why? Because the REIT sector is one of the most indexed of all individual market segments, making REITs more indexed than other S&P sectors relative to their sizes. REIT index funds own about $100 billion in REITs, or 15% of those in the S&P500. Vanguard’s REIT index fund alone owns about $60 billion of REITs. If we view the market as made up of passive investors who own index funds and active investors who own individual equities, then unless REIT index funds shrink (and recently they’ve been growing), in aggregate, active managers are trapped in an underweight position of approximately $100 billion REITs.[7](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-7-218) A recent academic paper titled “Curse of the Benchmarks” focuses on exactly this phenomenon. It argues that when active managers are measured against market cap weighted indexes, and a sector they are underweight outperforms the rest of the market, the dollar value of their underweight position increases and they are forced to buy that sector. This in turn increases their losses and exacerbates their predicament, leading to more forced buying. We have also written on this topic in our paper on [return chasing](https://elmwealth.com/blog/return-chasing-can-be-hazardous-to-your-wealth/), and drawn a link with how this can result in short-term momentum in stock prices, followed by longer-term reversion to fair value. If anything, this problem is actually more likely to get worse in the near term. Having their own industry sector may further increase the size of REIT index funds. StateStreet, for example, recently created a new sector fund just for real estate, XLRE, which will start off at about $3 billion.[8](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-8-218) The index changes we are discussing were announced in March 2015, so it is possible that much of the price impact has already taken place. However, Morningstar used data as of only a couple of months ago, and since that date REITs have not outperformed the S&P500. This suggests that this story has not yet played out in full. Stay tuned; given the size of positions involved, in the near or medium term, we may be in for some hair-raising appreciation of REITs, and more pain for active equity managers as a whole. ### REITs from a Value and Momentum Perspective Currently, we are slightly underweight versus our Baseline allocation, because we see REITs as significantly overvalued, but with positive momentum that partly reduces our desired underweight. As REITs are required to pay out most of their free cash flow each year, our valuation of REITs focuses on dividends, rather than reported earnings, and we do not factor interest rates into the analysis.[9](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-9-218) We feel that a 4 – 5% real return for the risk of owning real estate through REITs is fair, and a little lower than what we feel is fair for the broad equity market. Our evaluation of a fair return is not based on a historical average return, but rather what we think is fair compensation for bearing the risk of holding those assets, given what we guess is the risk aversion of many high net worth investors. Translating this fair return of 4-5% into a dividend yield leads us to a round number of 6%, as we assume that about 20% of the stated dividend is a return of capital[10](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-10-218), leaving investors with a real return of 4.8% (80% of 6%), assuming that rental income grows with inflation.[11](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-11-218) So how are REITs valued today? They paid a dividend of approximately 3.9% last year. However we like to look beyond just the past year of dividends. The inflation- adjusted dividend yield over the past 10 years is 3.3%. Comparing this 3.3% dividend yield to our fair dividend yield of 6% means that we see REITs as extremely overvalued. REITs would need to fall by 45% in order to deliver a 6% dividend yield, all else equal. Based on valuation alone, we would reduce our Baseline allocation to REITs by 60%. And how do REITs look from a momentum perspective? At Elm, we compute our simple measure of momentum by comparing the current value of an asset to its average over the past 12 months, taking into account inflation and a risk premium. Currently, REITs are firmly in positive momentum territory at +15%, which, by itself, would cause us to overweight REITs by one third relative to its Baseline allocation. However, when combined with our view on their overvaluation, we currently have a roughly one quarter underweight allocation to REITs.[12](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-12-218) Our positioning in REITs is consistent with the view that in the near term, REITs are likely to continue to deliver healthy returns as active managers try to reduce their underweight exposure, while in the long term, REITs will be repriced lower to provide a fair expected long term return, as the demand from passive and active REIT investors is eventually met through the persistent growth in the sector through REITs continuing to acquire privately held real estate. --- ### Further Reading and References: - Bloomberg: [REITs Coming of Age](http://www.bloomberg.com/gadfly/articles/2016-05-09/reits-are-coming-of-age-for-investors) - MarketWatch: [New Real Estate Sector Gives REITs a Home](https://www.marketwatch.com/story/stock-markets-new-real-estate-sector-gives-reits-a-home-2016-05-11) - MarketWatch: [Onetime Event Will Give a Boost to REITs](https://www.marketwatch.com/story/this-one-time-event-will-give-a-boost-to-reits-2016-04-27) - Research Affiliates: [REIT Valuation Methodology](https://www.researchaffiliates.com/Production%20content%20library/AA-Real-Estate-Investment-Trusts-Methodology.pdf) - The Nest: [Tax Treatment of REIT Payouts](http://budgeting.thenest.com/tax-treatment-reit-payouts-22852.html) - Vayanos and Woolley, [“Curse of the Benchmarks”](http://www.lse.ac.uk/fmg/assets/documents/paul-woolley-centre/articles-of-general-interest/DP747CurseoftheBenchmarks.pdf) (March 2016) - WSJ: [When the S&P500 Breaks out REITs](http://www.wsj.com/articles/when-the-s-p-500-breaks-out-reits-you-may-get-a-tax-bill-1467990564?tesla=y) --- 1. Victor is the Founder and CIO of Elm Partners. **Past returns are not indicative of future performance.** This not is not an offer or solicitation to invest.   Thanks to my colleague Samantha McBride, who did much of the research behind this note, and to my friends Larry Hilibrand, Aneet Chachra, Arjun Krishnamachar, Rich Dewey and Bruce Lafranchi for their useful comments and suggestions. Of course, all errors are my own. 2. GICS is the leading classification system for stock exchange-listed equities worldwide and since its creation, until this change, has divided companies into 10 industry sectors. 3. REITs in the S&P500 have a market cap of about $600 billion. 4. See our [note on REITs](https://elmwealth.com/if-you-want-to-own-property-reits-provide-a-huge-head-start-vs-direct-investment/) published on our blog in April. 5. It is likely that stock pickers who run mandates for large institutions or operate inside hedge funds have been underweight too, but I have not been able to find any research on that question. 6. Assuming the market is 70% active and the total market cap of US equities is $25 trillion, we get *70% \* $25 trillion \* 25% \* 3% = $131 billion.* 7. This also assumes that REIT index funds and ETFs are held mostly by passive investors and not active stock picking managers. 8. XLRE is going to be spun out of StateStreet’s XLF Financial sector fund on September 21st in a mostly non-taxable return-of-capital transaction. 9. I’m often asked the question of why we don’t factor interest rates into this analysis. After all, with interest rates so low, doesn’t that make REITs more attractive? True, REITs may indeed look like good value versus owning 30 year US Treasury bonds, but what we’re trying to decide in our investing is what we think of REITs in and of themselves, not relative to bonds. If we overweight REITs because they are cheap relative to fixed income, but then fail to short fixed income as a hedge (and we do not take any short positions at Elm) then we stand to lose if REITs go down regardless of interest rate changes. We lose even if REITs decline less than the fixed income assets against which we viewed them as cheap. Often, the simplest approach is the best. 10. Historically, about 30% of REIT dividends have been classified for tax purposes as return of capital and capital gain. However, we believe that some of this category actually represents a pass-through of excess depreciation, and so should be thought of as income. Hence, we assume that 20%, not 30%, of the dividend is return of capital. 11. Looking at the historical record, it is difficult to conclude that REIT nominal dividends have kept up with inflation, let alone per capita income growth. Dividends have been quite volatile, making it difficult to discern a trend over the 20 year period of 1996 to 2016. It is likely that nominal dividend growth was tempered by the growth of the REIT sector through acquisitions, where new property purchases were generally at lower yields than existing holdings. 12. *Allocation relative to Baseline = 100% – 60% (value) + 33% (momentum) = 73%* , which is 27% underweight. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/whats-up-with-reits) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/018-how-to-invest-banner.png) [How Elm Works](https://insights.elmwealth.com/elm-wealth-research/tag/how-elm-works) ### [How to invest with Elm – Fidelity SMAs vs Fund](https://insights.elmwealth.com/elm-wealth-research/how-to-invest-with-elm-fidelity-smas-vs-fund) Jun 29, 2016, 12:00:00 AM June 29, 2016 How Elm Works ## How to invest with Elm – Fidelity SMAs vs Fund We offer US taxable investors a choice: a separately managed account at Fidelity, or a Delaware private Fund. (for US IRA investments, we only offer SMAs at Fidelity). The following are some of the main differences between these two ways you can invest with us. Please see the [SMA Investment Management Agreement](https://elmwealth.com/signup/IMA) for full details or [contact us](https://elmwealth.com/contact-us) to receive the fund prospectus. Please consult your tax advisor and investment advisor, as the below is not being given as advice, and each investor’s circumstances will vary. ### Some benefits of investing in the Fund over the SMA: - The fund is slightly more cost efficient, owing to its larger size compared to the average SMA account, which for example allows access to institutional share classes of some index funds in which the fund invests. If you are considering making an investment of over $2mm there would not be much difference. - If the fund continues to grow, as we hope, inflows allow us to rebalance the portfolio more cost and tax efficiently by buying what we need to increase and allowing dilution to reduce what we want to decrease, rather than having to sell and thereby pay transactions costs and realize capital gains. - The fund uses Vanguard as its custodian and broker and pays zero commissions on all trades. On the other hand, trades in an SMA at Fidelity are subject to commissions on ETF and mutual fund trades. Those commissions don’t add up to many basis points on an SMA if the SMA is $1mm or more, but for a $300k SMA the commissions add in the region of 2-3bp in a typical year of cost. Although we take commissions into account in our management of the each SMA, they can be more or less than that each year. - The Fund has a slightly more granular and diversified Baseline asset allocation, with 21 buckets as compared to 15 buckets for the SMA program. The main differences in asset buckets are that SMA program does not have separate buckets for commodities and non-US real estate companies, and Europe x-UK and the UK are combined, as are Japan and Developed Asia x-Japan. - The fund has an administrator and produces audited financials each year, while the Separately Managed Accounts do not. The fund produces a tax statement in the more summarized form of a k-1 rather than the 1099 and list of trades that come from Fidelity for the managed account. - If you are a US citizen resident in the UK for tax purposes, the Fund may be more tax efficient if you don’t redeem until after you are no longer UK tax resident. ### Some benefits of investing in one of our SMAs over our Fund: - The main attraction of the SMA, besides the reduced minimum and being available to investors who are not Qualified Purchasers, is that the account is in your name and you can take over the account at any point in time by instructing Fidelity to remove Elm Partners as manager of the account, which provides in effect daily liquidity, as compared to the monthly liquidity of our fund. - With an SMA, if you want Elm to stop managing your account, your holdings are not liquidated, and so, if you have unrealized capital gains in your investments in your SMA, removing Elm does not realize those gains. If you are an investor in our Fund and you request a redemption, that will be a taxable event, and if you have gains, they will become realized as we pay redemption proceeds to you in cash. - The SMA offers even greater transparency than the fund in that you get to see a confirm of each transaction we do in your account the day we do it (for some this could be a negative, but then you could suppress confirm reporting). - The SMA benefits from $500k of SIPC insurance. - The fund allows investors to subscribe and redeem at NAV each month, and the transactions costs, which are quite small given the type of holdings in the fund, are borne by all investors who remain in the fund, whereas in the SMA you are only subject to the transactions costs that pertain to your own subscriptions and redemptions. This is a hard effect to quantify and we think it’s a pretty small effect, especially as the Fund heavily uses index funds which themselves allow investment and redemption at NAV without a transactions cost. - If you are a US citizen resident in the UK for tax purposes, the SMA may be more tax efficient if you plan on redeeming part of your investment while you are UK tax resident and your investment has increased in value. --- ### Disclaimer: Fidelity Investments is an independent company, unaffiliated with Elm Partners. Fidelity Investments is a service provider to Elm Partners. There is no form of legal partnership, agency affiliation, or similar relationship between your financial advisor and Fidelity Investments, nor is such a relationship created or implied by the information herein. Fidelity Investments has not been involved with the preparation of the content supplied by Elm Partners and does not guarantee, or assume any responsibility for, its content. Fidelity Investments is a registered trademark of FMR LLC. Fidelity Clearing & Custody Solutions® provides clearing, custody, and other brokerage services through National Financial Services LLC or Fidelity Brokerage Services LLC, Members NYSE, SIPC. \[eReview number 830247.2.0\]. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/how-to-invest-with-elm-fidelity-smas-vs-fund) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/017-JPM-banner.png) [In the News](https://insights.elmwealth.com/elm-wealth-research/tag/in-the-news) ### [Elm’s strategy in The Journal of Portfolio Management](https://insights.elmwealth.com/elm-wealth-research/elms-strategy-in-the-journal-of-portfolio-management) May 27, 2016, 12:00:00 AM May 27, 2016 In the News ## Elm’s strategy in The Journal of Portfolio Management While past performance is not necessarily indicative of future returns, we draw comfort from knowing that the way we invest has done well over the past nearly one hundred years.[1](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-1-191) This is the main conclusion of our research paper, “[A Case Study for Using Value and Momentum at the Asset Class Level](https://elmwealth.com/wp-content/uploads/2019/06/JPM-Spring_2016-asset-class-and-momentum_Elm-paper-by-haghani-dewey-final-version-approved.pdf),” [2](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-2-191) which was just published in The Journal of Portfolio Management. We believe that our simple rules-based approach to dynamic asset allocation has the added benefit that it helps investors avoid feeling they need to make ad hoc changes to their portfolios based on current events, which tends to result in subpar long-term returns. Here are a few highlights, which you can find in the Exhibits 6, 8 and 9 in the paper: - In every decade since 1926, a dynamic asset allocation approach based on value and momentum applied to asset classes outperformed a static balanced equity/bond Baseline. - 2.5% per year was the increase in return delivered by value and momentum since 1975. It also reduced the risk of large losses. The increase in returns in the 1926-1975 period was similar. - Bear markets were the periods when value and momentum did best, resulting in significantly less negative returns than the static Baseline. - Value and momentum worked well together. In the 1975-2013 period, the biggest loss of a portfolio that relied on value combined with momentum was significantly lower than the worst loss suffered by portfolios that relied on value or momentum applied individually. --- 1. The paper describes how we apply value and momentum to our Baseline portfolio. As the paper is looking at investment periods wherein many of the asset buckets in which we invest were not available (e.g. emerging market equities prior to the 1980s), the Baseline portfolio that is analyzed differs from the Baseline portfolios we use in our various offerings currently. Also, in the paper our base case was a 50% weight on valuation and a 50% weight on momentum, whereas we currently put a 67% on value and a 33% weight on momentum. In the paper we do show the sensitivity of past returns to this assumption. 2. This paper started life as a less formal paper titled, “Investing for the Rest of Us,” which Rich Dewey and I first drafted in 2009. [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/elms-strategy-in-the-journal-of-portfolio-management) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/016-REITs-banner-1024x487.png) [Investing 101](https://insights.elmwealth.com/elm-wealth-research/tag/investing-101) ### [If You Want to Own Property, REITs Provide a Huge Head Start vs Direct Investment](https://insights.elmwealth.com/elm-wealth-research/if-you-want-to-own-property-reits-provide-a-huge-head-start-vs-direct-investment) Apr 20, 2016, 12:00:00 AM April 20, 2016 Investing 101 ## If You Want to Own Property, REITs Provide a Huge Head Start vs Direct Investment *By Victor Haghani* [1](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-1-495) If you’ve decided you want to allocate some of your savings to real estate, you may want to compare the merits of publicly listed REITs, like Vanguard’s (VNQ), versus investing in buildings directly, through private investment partnerships.[2](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-2-495) At Elm Partners, we use REIT ETFs, particularly Vanguard’s VNQ and VNQI, for US and non-US property exposure in our globally diversified portfolios. The many individual benefits of REITs add up to a surprisingly big head start over private investment vehicles. While discerning private investors should be able to identify individual properties with higher returns than the average REIT-owned property, they need to generate returns about 4% higher just to catch up with the efficiencies of REITs. As detailed in the table below, this 4% comes from four main sources: higher costs, higher taxes, less diversification and lower liquidity of private investments. This 4% hurdle translates into an 8% hurdle for return on equity when the property investment is 50% leveraged with debt.[3](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-3-495) A major worry of REIT investors is that it’s impractical to analyse all the individual holdings, resulting in the risk of buying real estate at a substantial premium to fair value (NAV). Unfortunately, US REITs are not required to give an estimate of their NAV and so we have to rely on several specialist research companies to make those estimates. As you can see in the chart below, over the past 25 years REITs have averaged a 4% premium to NAV, within a wide range of a 45% discount in 2009 to a 35% premium in 1997. Given the enormity of the task of valuing thousands of properties without specific, inside details about each property, we shouldn’t expect these third party NAV estimates to be very accurate. Indeed, it appears that the divergences may be exaggerated by the NAV estimates lagging public market price moves. Making a simple adjustment for this lag reduces the volatility of the divergence from NAV by about 40%, and brings the average to a 1% premium, as shown by the black bars. I didn’t list this as a cost or benefit of REITs vs private holdings, because, depending on timing, this could reduce or enhance returns. To flesh out a plausible negative scenario, let’s assume an investor bought REITs at a 10% premium and sold them 15 years later a 10% discount. That would cut the REIT head start of 4% a year down by only about 15%, in terms of the required return on the underlying unleveraged property investment. The return reduction could turn out to be even less than that, because when REITs trade at a premium to NAV, it is possible for them to add to their property portfolios by issuing shares to private sellers, and thus the premium to NAV can come down without harming returns. I’d be remiss if I didn’t list any benefits of holding property directly. Some argue that illiquidity can be a blessing in disguise, forcing investors to hold for the long term. Ignorance of daily price fluctuations may make the private investing experience more blissful too. Indeed, it may be that many large fortunes have arisen from people feeling “locked” in to the companies they built or the properties they bought. Property investors also derive comfort and psychic value from the tangibility of their property investments, and the ability to touch and see their investments may make their investments feel less risky than more abstract and indirect holdings through REIT ETFs. Finally, while REITs may be the dominant structure for delivering passive real estate exposure, private capital may remain the preferred structure for certain activities such as development and aggregation, even if ultimately for sale to REITs. The benefits of REITs are already well known. Investors have been enthusiastically voting for REITs with their investment dollars, bringing the value of REITs close to $1 trillion. REITs currently own about 1/8 of commercial real estate in the US, up from less than 1% in 1990.[4](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-4-495) REITs are on track to own over 50% of all US commercial real estate by 2040 even if these trends slow down by half. I hope this note has been helpful in cataloguing and attempting to quantify the relative merits of REIT vs private ownership, summing up to a 4% hurdle that privately owned properties need to exceed relative to REITs. In a future note, I’ll address the more fundamental question of the long-term expected return of real estate given today’s valuation levels. ### Table: Comparison of REIT vs private real estate investing | 0.7% | **Avoiding transactions costs**. Typically, when buying a building, an investor will incur about 5% as brokerage, legal, transfer tax and other fees, and loan arrangement fees of 2%, which together equate to about 0.6% pa over the 15 year investment horizon we assume throughout this analysis.[5](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-5-495) When investing in a REIT, these costs have already been paid. | | --- | --- | | 0.5% | REITs typically have **lower borrowing costs.** I assume REITs can borrow about 1% more cheaply from banks than private borrowers on individual properties. | | 0.9% | REITs generally benefit from **lower management costs** due to economies of scale, and lack of carried interest. This calculation assumes REITs have 0.5% lower management fees and no 15% carried interest. The cost savings can be much higher in the case of small properties managed by the investor, if the investor were to accurately bill himself for the value of his time. | | 0.6% | **Tax savings** will vary depending on the characteristics of the investor and the site of the property. One benefit of ownership through a REIT is that income that is passed out as dividends are not subject to state (or city) tax, in most states. For high tax sites, like NY or CA, this can amount to a tax saving of 10% of income, assuming that the ultimate investor is in a low or no tax state. REITs allow for longer term holding than private investments, as the manager usually has an incentive to realize gains to be paid his incentive fee. A further potential saving is that private ownership structures usually throw off miscellaneous itemized deductions which many high rate US taxpayers cannot deduct.[6](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-6-495) For non-US investors, the tax savings of REITs over direct investments might be 0.8% greater. [7](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-7-495) | | 1.0% | Substantial **diversification** is provided by REIT ETFs, such as (IYR), (VNQ), (SCHH) and (RWR), which hold over 100 individual equity REITs. These REITs in turn provide ownership in thousands of properties in different locations and of different types, many of them large properties in prime locations that would be hard for most investors to access through private ownership. I estimate this effect perhaps over-simplistically by assuming a private portfolio will be 25% riskier than a diversified REIT ETF, and so the investor would need to get 25% more return for bearing that risk. | | 0.5% | **Liquidity**: REITs are liquid. Private property takes time to transact, and the decisions to buy or sell may depend on the desires and personal circumstances of the manager of the property or other investors in the private deal. REITs are easily marginable, which allows investors to efficiently raise temporary liquidity. Listed options markets that have developed around REITs give investors even greater flexibility. An overview of the academic literature on pricing illiquidity by A Damodaran of NYU suggests a number much higher than 0.5%, but I am sympathetic to the notion that liquidity is valuable but over-priced by the market.[8](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9#easy-footnote-bottom-8-495) | | **4.2%** | **Total Head Start of REITs vs Private Ownership** | --- 1. Victor is the Founder and CIO of Elm Partners. **Past returns are not indicative of future performance.** This not is not an offer or solicitation to invest.   Thanks to Chip Parkhurst, who did much of the research for this note as a summer intern at Elm Partners, my friend Larry Hilibrand for invaluable help from start to finish, and my colleagues at Elm Partners. 2. In this note, I am using the term REIT to refer to publicly traded equity Real Estate Investment Trusts in the US. There are other types of REITs and also there is a large and growing non-US REIT market. 3. REITs are one of the most indexed of all market segments, with Vanguard, Blackrock and StateStreet owning about 30% of the large REITs, twice the ownership level in other large US equities, mostly for their index broad market and REIT index offerings. StateStreet recently created a new sector fund just for real estate, XLRE. Expense ratios for REIT ETFs range from 0.07% for Schwab’s (SCHH) to 0.43% for iShares (IYR). 4. Size of US commercial real estate market according to this [study](https://www.sandiego.edu/business/documents/sizeofthemarketdraftApril26.pdf) was $10T in 2009, which I assume has grown to $12T today. Size of REIT market cap and leverage ratio from [REIT.com](http://www.reit.com/data-research/data/industry-snapshot). REIT market ownership from 1991 based on the rate of growth of market cap of REITs being 22% and the NAREIT REIT price index growing at 4.7% pa over the period. 5. Further assumptions are 5% initial property yield, growing 2% a year, and leverage of 50% at a rate of 4%. 6. For this calculation, I assumed 5% lower tax rates and that 33% of management expenses are non-deductible for the private investor. 7. Investing through a REIT ETF such as IDUP LN can eliminate capital gains tax, reduce the income tax rate by over half to 15% and eliminate the drag of non-deductible miscellaneous itemized deductions. This should not be taken as tax advice. 8. [“The Cost of Illiquidity”](http://people.stern.nyu.edu/adamodar/pdfiles/country/illiquidity.pdf) (see page 27 in particular). [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/if-you-want-to-own-property-reits-provide-a-huge-head-start-vs-direct-investment) ![](https://insights.elmwealth.com/hubfs/Imported_Blog_Media/015-realvision-banner.png) [In the News](https://insights.elmwealth.com/elm-wealth-research/tag/in-the-news) ### [RealVisionTV: An Interview With Victor Haghani](https://insights.elmwealth.com/elm-wealth-research/realvisiontv-an-interview-with-victor-haghani-8-min-video) Apr 19, 2016, 12:00:00 AM April 19, 2016 In the News ## RealVisionTV: An Interview With Victor Haghani Victor sat down with Raoul Pal, 25-year market veteran and founder of RealVisionTV to discuss his career, his thoughts on investing, and how Elm came to be. Watch this eight minute excerpt from the full interview. *“…every once in a while a simple, static market cap approach doesn’t go the full distance in giving us a long term solution we’ll want to live with…At some point, we’ll intervene, and I didn’t want to worry about intervening in an ad hoc, subjective and undisciplined way which I figured would wind up hurting…So that was the genesis of Elm…to provide this missing building block for people’s portfolios…to provide intelligent portfolios for sophisticated investors…low cost, global diversification, transparency and a long-term, sensible exposure to risk assets.”* [James White](https://insights.elmwealth.com/elm-wealth-research/author/james-white) [Read More](https://insights.elmwealth.com/elm-wealth-research/realvisiontv-an-interview-with-victor-haghani-8-min-video) [7](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/7) [8](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/8) [9](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/9) [10](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/10) [11](https://insights.elmwealth.com/elm-wealth-research/author/james-white/page/11)