WHAT'S WALL
STREET DONE
FOR MAIN STREET?

This article was prepared by Brad Simpson, LEAGUE's Chief Investment and Compliance Officer. It was published in the September issue of Business Edge News Magazine, which is delivered to decision-makers throughout Western and Central Canada. Brad and his colleagues wanted to get to the heart of how Wall Street firms have performed for individual investors over the past 100 years. So they crunched a lot of numbers and came up with some fascinating results. What follows is an updated version of the article. Click here to view the original article.

By Brad Simpson

On January 6, 1914, Charlie Merrill founded the firm we now know as Merrill Lynch. Merrill's impetus for his new enterprise was based on a simple idea: the stock market should not just be a place for Wall Street insiders, but also a place of opportunity for the general public, the broad mass of individual investors. Merrill Lynch's long-held corporate tagline says it all: "Bringing Wall Street to Main Street."

In the near-century since the founding of this iconic investment firm, individual investors around the world have made like a "thundering herd" stampeding to invest in public markets. Amidst yet another bout of market volatility, we thought it would be interesting to look back to consider what rate of return a hypothetical investor would have achieved by investing and holding in "the market" since Merrill Lynch first opened its doors for business. The question LEAGUE's research group tackled was as follows:

"What return would an individual investor have achieved, and was the return worth it, based on the risk taken and the fees paid?"

Consideration 1 -- Returns

One thousand dollars invested into the U.S. public market between January 1914 and September 2011 had a rate of return, excluding dividends, of 5.20%. If all dividends were reinvested, the return was a pretty impressive 9.72%. However, we have found that most clients like to take their dividends, so the rate of return we assumed our individual investor achieved was 5.20%.

Observation: Holding an investment for 97 years and experiencing a return of 5.20%, while not spectacular, is decent, but considerably lower than our individual investor's expectations.

Consideration 2 -- Volatility

There are a lot of ways to think about volatility. The best-known measure is the Chicago Board Options Exchange Volatility Index, or VIX. This measurement is commonly used by professional investors, but is a poor measure for two reasons. First, the data for the VIX only goes back to 1986, which clearly won't work for this study. Second, the VIX measures near-term implied volatility on S&P 500 Index Futures, which means very little to our individual investor. 

For our study, we assumed that our individual investor measured volatility based on sleepless nights!

The above chart shows the different ranges of return. For seven years, our investor had to stomach losses of 20 to 40%. For 20 years, our investor was down between 10 and 40%. Making this even more difficult are the events that had to be lived through while those losses were experienced. A few of the occurrences to cope with were two World Wars, the Vietnam war, the Cuban missile crisis, inflation in the 1970s, Asian contagion of the late 1990s, the Internet bubble in 2000, stock market crashes in 1929 and 1987, and the credit crisis of 2008.

For 30 years during this 97-year period, or 31% of the time, our individual investor would have needed a great deal of emotional maturity and rational aptitude to deal with losing money while the world around often seemed to be unravelling at the seams.

Consideration 3 -- Fees and inflation

The last consideration in our individual investor's market experience is incorporating the main impediments to performance: fees and inflation. For fees, we started with Morningstar's data on the average Management Expense Ratio (MER) for Canadian mutual funds, a sum that equaled 2.52%. We then decided, for consistency, that given the American bias of our study we needed to use the average MER of mutual funds south of the border. With this in mind, we slashed 100 basis points from the Canadian MER to give us 1.5%, which is closer to the U.S. fee. (Why the big difference you ask? That is the topic for a future study).

We then tackled inflation, using data from the National Bureau of Economic Research. We incorporated December inflation numbers at the end of each year.

The results of this analysis were, to say the least, dramatic. Adjusting for inflation, our individual investor's return went from 5.20% to 1.89%. We then subtracted the 1.50% management fee and came up with a real rate of return of 0.39%.

Observation: Clearly, a rate of return of 0.39% is shocking. In real terms, our investor's $1,000 has grown to $1,257 in just under 100 years!

Conclusion

A return of 0.39%, many years of losing money, volatility, fees, and the devastating impact of inflation characterize much of our individual investor's long-term experience.

The easy lesson from this would be to avoid investing in equity markets altogether. We think that would be a mistake. However, it does show that it is too simple to say, "Have a long-term time horizon and forget about it." A better solution is to consider an active portfolio approach to investing.

First, let's consider what would have happened had our individual investor made use of true hedges, the type of hedges inspired by the pioneering research of Alfred Jones. These provide portfolio protection during downturns, not the falsely named "hedge funds" that have so blighted the investment industry over the last decade.

If our individual investor had adopted a prudent hedging strategy, the results might have been quite different. If the worst 15 downturns were reduced by 75% due to hedging, our individual investor's return would have improved to 8.48% before inflation, 5.09% after. Second, if our individual investor had re-invested dividends, providing a further portfolio hedge, the return would have improved to 9.10%.

Both of these small measures make a significant difference to returns.

The next consideration is inflation. If a portion of the original investment was diversified into real estate and real-return bonds, the impact of inflation would have been further reduced. Real estate has inflation-hedging capacity because the owner can increase rental rates during periods of inflation. And real-return bonds pay a rate of return that is adjusted for inflation.

To deal with market volatility, our individual investor could have invested some money into private capital opportunities, which would have reduced exposure to the gyrations of public markets that are far too often driven by fear and greed. This would have positioned some of the investable funds around opportunities based more on sober, professional valuation. This would have helped greatly over those 30 years of negative returns attributable to manic behaviour in public markets.

The key is to have an active, diversified approach that is flexible and compels you to act in a certain way when uncertain things occur. This sort of discipline makes a big difference to an individual investor's returns and emotional experience. It also gives cause for paying a reasonable fee.

This is a sensible strategy that makes sense for Main Street investors, not Wall Street ones like Charlie Merrill.

DISCLAIMERS:

The information contained in this report has been compiled by LEAGUE Investment Services from sources believed to be reliable, but no representation or warranty, express or implied, is made by LEAGUE Financial Partners Corp, LEAGUE Investment Services, its affiliates or any other person as to its accuracy, completeness or correctness. Nothing in this report constitutes legal, accounting or tax advice or individually tailored investment advice. This material is prepared for general circulation to clients and has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The investments or services contained in this report may not be suitable for you and it is recommended that you consult an independent investment advisor if you are in doubt about the suitability of such investments or services. This report is not an offer to sell or a solicitation of an offer to buy any securities. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur.

This document is for information purposes only and is not an offer to sell or a solicitation of an offer to purchase securities. Any offering will be made by way of offering memorandum or, in Ontario and Quebec, will be made only to accredited investors or those investing more than $150,000.

There are risks associated with this investment, which risks are discussed in the offering memorandum and subscription agreement. You are encouraged to read the offering memorandum (available upon request) and the subscription agreement before making your investment decision.