58th Mid-Year Meeting Why Would You Want to Be Average ... Fiduciary Responsibility...for different asset classes such as bonds and real estate investment trusts." _____ Percent of

Vermont Bar Association

Seminar Materials

58th

Mid-Year Meeting

Why Would You Want to Be Average?

Fiduciary Responsibility and Investment

Performance

March 20, 2014

Hilton Burlington, VT

Faculty:

Rick Hubbard, Esq.

Matt Considine, VT Treasurer’s Office

David Umstead, CFA

Created with Zephyr StyleADVISOR. Manager returns supplied by: Morningstar, Inc.

Why Would You Want to be Average?Fiduciary Responsibility and Investment Performance

David A. Umstead, PhD, CFAPresident

Cape Ann Capital, Inc.www.capeanncapital.com

VERMONT Bar AssociationMid-Year Meeting

Burlington, VT

March 20, 2015

1

Cape Ann Capital, Inc.Created with Zephyr StyleADVISOR. Manager returns supplied by: Morningstar, Inc.

Outline

Index Funds - Bogle's Folly

The Mutual Fund Marketing Machine

Reporting Without Accountability

Are there Any Managers Who Can Add Value?

2


The First Index Fund

http://en.wikipedia.org/wiki/Index_fund

"John McQuown and David G. Booth at Wells Fargo and Rex Sinquefield at American National Bank in Chicago both established the first Standard and Poor's Composite Index Funds in 1973. Both of these funds were established for institutional clients; individual investors were excluded. Wells Fargo started with $5 million from their own pension fund, while Illinois Bell put in $5 million of their pension funds at American National Bank."

"John Bogle started the First Index Investment Trust on December 31, 1975. At the time, it was heavily derided by competitors as being "un-American" and the fund itself was seen as "Bogle's folly." Fidelity Investments Chairman Edward Johnson was quoted as saying that he couldn't believe that the great mass of investors are going to be satisfied with receiving just average returns." Bogle's fund was later renamed the Vanguard 500 Index Fund, which tracks the Standard and Poor's 500 Index. It started with comparatively meager assets of $11 million but crossed the $100 billion milestone in November 1999."

3

Vanguard 500 Index Fund has underperformed the index by 27 basis points per year since its inception.Informa StyleADVISOR: Cape Ann Capital, Inc.

Performance TableSeptember 1976 - December 2014

Portfolio Performance vs. S&P 500

S&P500 Index

Vanguard 500Index FundInvestor Shares

AnnualizedReturn (%)

AnnualizedExcess

Return (%)

11.38 0.00

11.11 -0.27


4

The 27 basis point annual shortfall accumulated to 9% less wealth over 38 years.Informa StyleADVISOR: Cape Ann Capital, Inc.

Growth of $100September 1976 - December 2014

Loga

rithm

ic S

cale

100

1000

Aug 1976 Dec 1984 Dec 1989 Dec 1994 Dec 1999 Dec 2004 Dec 2014

S&P500 Index


Index grows to $6,220

Index Fund (VFINX) grows to $5,664

Expenses Matter!


5

But, as the fund has gotten larger, it has performed much better; 45 bps shortfall down to 10.Informa StyleADVISOR: Cape Ann Capital, Inc.

Performance TableSeptember 1976 - December 1995

PortfolioPerformance vs. S&P 500

S&P500 Index



AnnualizedExcess

Return (%)

14.22 0.00

13.77 -0.45

First 19 years: fund was small formuch of this period; it is difficult totrack a 500 stock index when a fund issmall; especially when computertechnology was in its infancy.

Performance TableJanuary 1996 - December 2014

PortfolioPerformance vs. S&P 500

S&P500 Index



AnnualizedExcess

Return (%)

8.56 0.00

8.46 -0.10

Second 19 years: Vanguard has cutexpenses as the fund has grown; total netassets are now $380 billion: expense ratiois now 17 bps per year; the fund hasoutperformed its expense ratio.


6


How do Traditional Managers Perform Against the S&P500?If markets are efficient at pricing securities, most of the funds outperforming the S&P will have done so by chance. There will be little consistency in the funds at the top of the rankings. Most traditionally-managed funds will flip-flop from top to bottom but, because of their higher expenses, will gradually move down the long-term rankings. Burton Malkiel, the well-known economist from Princeton, cites some interesting statistics. Malkiel published "A Random Walk Down Wall Street" 42 years ago in 1973. The book is now in its tenth edition with over one million copies sold. The quote below is from pages 267 and 268 of the ninth edition:

"A remarkably large body of evidence suggests that professional investment managers are not able to outperform index funds that simply buy and hold the broad stock-market portfolio. For the twenty years ending December 31, 2005, the average actively managed large-capitalization mutual fund underperformed the Standard & Poor's 500 large-cap index by almost 11/2 percentage points per year. While the index may not win in every single year, decade after decade, two thirds or more of professionally managed funds are beaten by index funds. The table below shows the results for the periods ending 2005. Similar results can be shown for different time periods and using different indexes for comparison. Results are also the same for international markets as well as for different asset classes such as bonds and real estate investment trusts."_________________________________________________________________________

Percent of Large-Cap Equity Funds Outperformed by S&P500 for Periods Ending December 31, 2005

1 year 3 years 5 years 10 years 20 years

48% 68% 68% 79% 82%________________________________________________________________________Source: Lipper.

7


2013 Nobel Prize In Economics: Fama, Hansen and Shillerhttp://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/2013/advanced.html

"The question of whether asset prices are predictable is as central as it is old. If it is possible to predict with a high degree of certainty that one asset will increase more in value than another one, there is money to be made. More important, such a situation would reflect a rather basic malfunctioning of the market mechanism."

"In a seminal event study from 1969, and in many other studies, Fama and his colleagues studied short-term predictability from different angles. They found that the amount of short-term predictability in stock markets is very limited."

"If prices are next to impossible to predict in the short run, would they not be even harder to predict over longer time horizons?"

"Shiller's 1981 paper on stock-price volatility and his later studies on longer-term predictability provided the key insights: stock prices are excessively volatile in the short-run, and at a horizon of a few years the overall market is quite predictable. On average the market tends to move downward following periods when prices (normalized, say, by firm earnings) are high and upward when they are low"

Most investors do the opposite of Shiller's advice; they buy when the market is high and sell when the market is low.

8


Warren Buffett's Wagerhttp://osboncapital.com/buffetts-wager-on-sp-500-vs-hedge-funds-year-7/?utm_source=email&[email protected]&utm_campaign=target

"It's now been seven years since Warren Buffett wagered one million dollars that an S&P 500 index fund would outperform the picks of a prominent hedge fund manager over a ten-year period. Another year of returns is in. Who's ahead?"

"Protege Partners a hedge fund firm in New York took the challenge, pitting a mix of five handpicked hedge funds against the index."

"The cumulative result at this point is the S&P index up 63% while the still unidentified hedge funds have managed only a 19% gain over seven years."

"We write about this every year because it reminds us of three very important investing principals."

"First, long-term returns are so much more important to the individual investor than daily, quarterly or annual performance."

"Second, having more tools does not guarantee better results. Remember that hedge funds can make frequent adjustments in holdings, can sell short, can use derivatives and can jump in and out of cash to time the latest economic and political news."

"Last and just as important, the far lower fee structure of the index investment is a big advantage versus the hedge funds which may be siphoning off two percent and more in performance each year to pay its managers."

9


Index Funds that Track the Entire Market are Special

What's Special about the Market Portfolio?

In a world where there are no trading cost or management fees, the performance of all the shares in a market must equal the performance of the all investors in that market. This is a tautology. In this environment the performance of the market portfolio is always exactly average. In the real world with trading costs, administrative costs and management fees, if one can own the market with below-average expenses, he or she will always be above average after expenses.

The Vanguard Total Stock Market Index Fund (VTSMX) began operations nearly 23 years ago on April 27, 1992

The fund currently has $421 billion in total net assets. It seeks to track the CRSP US Total Market Index. The fund holds about 3,800 stocks; each in very close proportion to market value. The fund's largest holding is Apple with a weight of 3.11%. The fund's 100th holding is Direct TV with a weight of 0.19%. Apple has a market value 16 times larger than Direct TV. The 100 largest stocks total 50% of the index. One half of the fund is invested in 100 stocks. The other half is invested in the remaining 3,700 mid and small-cap stocks. Most stock markets are dominated by a few very, very large companies.

10

The Vanguard Total Stock Market Index Fund (VTSMX) has performed brilliantly over the last 22 years!Informa StyleADVISOR: Cape Ann Capital, Inc.

vs Morningstar Domestic Equity/Balanced ManagersJanuary 1993 - December 2014

Ret

urn

-20

-10

0

10

20

30

1 year 2 years 3 years 4 years 5 years 10 years 15 years 20 years 22 years

Vanguard Total Stock Market Index FundInvestor Shares

5th to 25th Percentile

25th Percentile to Median

Median to 75th Percentile


26th %tile4.8% Rtn

14th %tile8.0% Rtn

17th %tile9.4% Rtn

9th %tile9.9% Rtn

16th %tile15.6% Rtn

23rd %tile15.2% Rtn

15th %tile20.3% Rtn

20th %tile22.4% Rtn

36th %tile12.4% Rtn

641 Funds 641 Funds 641 Funds 570 Funds 518 Funds 380 Funds 258 Funds 140 Funds 103 Funds

VTSMX returned 12.4% last year andranked in the 36th percentile amongthe 641 equity/balanced funds thatinvest exclusively in the US market. As the measurement interval getslonger, VTSMX rankings generallymove higher. VTSMX ranks in the17th percentile over the last 22 years. Many of the low-ranked funds arerunning hedge-fund like strategies. Over the last six years the market hasbeen flooded with funds that arefighting the last war; i.e. strategiesthat attempt to eliminate market risk. Unfortunately, and not surprisingly,they have eliminated market returnsas well.


11

Only a handfull of funds have outperformed VTSMX over its 22-year existence.Informa StyleADVISOR: Cape Ann Capital, Inc.

vs Morningstar Domestic Equity/Balanced ManagersJanuary 1993 - December 2014

Ret

urn

7

8

9

10

22 years

Vanguard Total Stock Market Index FundInvestor Shares


25th Percentile to Median

Median to 75th Percentile


5th %tile 9.62% Rtn

25th %tile 9.33% Rtn





103 Funds

VTSMX has outperformedthe 50th percentile managerby an average of 41 basispoints per year over the last22 years.


12

VTSMX generated 4% less wealth than the 5th percentile fund and 33% more than the 95th.Informa StyleADVISOR: Cape Ann Capital, Inc.

VTSMX vs 5th and 95th Percentile Managers over the Last 22 YearsJanuary 1993 - December 2014

Loga

rithm

ic S

cale

100

800

Dec 1992 Dec 1995 Dec 1997 Dec 1999 Dec 2001 Dec 2003 Dec 2005 Dec 2007 Dec 2009 Dec 2011 Dec 2014

GMO US Equity Allocation Fund

Vanguard Total Stock Market Index FundInvestor SharesDeutsche S&P 500 Index FundB Shares

$757 5th Percentile (GMUEX)$727 17th Percentile (VTSMX)

$546 95th Percentile (SXPBX)


13


Outline





14


What's a Fair Price to Pay for an S&P500 Index Fund?

An index fund is a commodity. The mutual fund manager simply buys and holds the stocks in the index in proportion to their market value. There is virtually no difference between one S&P500 index fund and another ... except for the way they are distributed and the fees that are extracted. There are 92 index funds in the Morningstar database that track the S&P500 index. The annual expense ratios for these funds vary enormously. Rydex's C shares top the chart at an outrageous 2.32% per year. Fidelity, in a price war with Vanguard, is the lowest at 0.02%. If there ever was proof that the market for mutual funds is broken; this is it. If you were buying a commodity ... say a bag of rice at the supermarket ... would you expect to see some offerings more than 100 times more expensive than others? Most of the high-expense S&P500 index funds are offered by insurance company affiliates that pay hefty commissions to brokers. Most clients are not aware they are paying these fees. The fee is kicked back directly from the fund to the broker. These are not one-time selling commissions. These commissions are typically paid every year. It is like all the bags of rice sell for the same price, but some bags end up being shared without the owner's knowledge.

The next three pages show the 92 S&P500 Index Funds; sorted by expense ratio. The table also shows broker's share of expenses, assets in the fund and inception date.

15

92 Series

Symbol

AnnualFee(%)

AnnualFee Paidto Broker

(%)Assets ($M)Share Class

InceptionDate

1. Rydex S&P 500 C RYSYX 2.32 1.00 20.68 2006-05-312. Rydex S&P 500 A RYSOX 1.57 0.25 32.94 2006-05-313. Rydex S&P 500 H RYSPX 1.56 0.25 324.22 2006-05-314. State Farm S&P 500 Index B SNPBX 1.44 0.95 12.10 2006-05-015. Deutsche S&P 500 Index Fund|B Shares SXPBX 1.40 0.99 1.01 2005-02-186. Invesco S&P 500 Index C SPICX 1.35 1.00 144.40 1997-09-267. Invesco S&P 500|Index Fund|B Shares| SPIBX 1.35 1.00 6.70 1997-09-268. Deutsche S&P 500 Index C SXPCX 1.34 1.00 50.42 2005-02-189. Principal Large Cap S&P 500 Index C PLICX 1.30 1.00 29.51 2007-01-1610. PNC S&P 500 Index C PPICX 1.26 0.75 8.42 2000-01-1811. Nationwide S&P 500 Index C GRMCX 1.22 1.00 15.66 2003-10-2212. BlackRock S&P 500 Stock Investor C1 BSPZX 1.19 0.90 76.70 2013-04-1913. State Farm S&P 500 Index B Legacy SLIBX 1.14 0.65 28.22 2000-12-1814. Victory Munder Index 500 R MUXRX 1.08 0.50 14.92 2004-07-2915. State Farm S&P 500 Index R1 RSPOX 1.07 0.50 6.89 2004-09-1316. Principal Large Cap S&P 500 Index R1 PLPIX 1.03 0.35 19.73 2004-11-0117. MM S&P 500® Index R3 MMINX 0.95 0.50 5.43 2002-12-3018. Nationwide S&P 500 Index R GRMRX 0.92 0.50 1.22 2007-01-3019. Principal Large Cap S&P 500 Index R2 PLFNX 0.90 0.30 37.24 2000-12-0620. Shelton S&P 500 Index K SPXKX 0.86 0.25 9.34 2003-10-1621. State Farm S&P 500 Index R2 RSPTX 0.86 0.30 19.57 2004-09-1322. Great-West S&P 500® Index L MXVJX 0.85 0.25 39.86 2011-08-0123. State Farm S&P 500 Index A SNPAX 0.75 0.25 377.66 2006-05-0124. State Farm S&P 500 Index A Legacy SLIAX 0.75 0.25 432.84 2000-12-1825. Victory Munder Index 500 A MUXAX 0.73 0.15 210.67 1992-12-0926. Principal Large Cap S&P 500 Index R3 PLFMX 0.72 0.25 221.10 2000-12-0627. MainStay S&P 500 Index Inv MYSPX 0.70 0.25 33.01 2008-02-2828. State Street Equity 500 Index R SSFRX 0.69 0.60 40.64 2005-06-0729. Deutsche S&P 500 Index A SXPAX 0.67 0.24 224.02 2005-02-1830. MM S&P 500® Index R4 MIEAX 0.65 0.25 532.28 1998-02-2731. SEI S&P 500 Index I (SIMT) SPIIX 0.65 * --- 7.86 2002-06-2832. American Beacon S&P 500 Idx Inv AAFPX 0.60 0.00 37.20 1998-03-0233. Great-West S&P 500® Index Init MXVIX 0.60 0.00 2,122.38 2003-09-0834. MainStay S&P 500 Index A MSXAX 0.60 0.25 560.67 2004-01-0235. Invesco S&P 500 Index A SPIAX 0.59 0.24 553.75 1997-09-2636. QS Batterymarch S&P 500 Index A SBSPX 0.59 0.20 234.44 1998-01-05

16

92 Series

Symbol

AnnualFee(%)



InceptionDate

37. Victory Munder Index 500 Y MUXYX 0.58 0.00 43.35 1991-11-2938. Nationwide S&P 500 Index A GRMAX 0.57 0.25 123.11 1999-12-2939. Nationwide S&P 500 Index Svc GRMSX 0.57 0.15 421.62 1998-11-0240. State Farm S&P 500 Index R3 RSPHX 0.57 0.00 2.05 2004-09-1341. Principal Large Cap S&P 500 Index R4 PLFSX 0.53 0.10 214.22 2000-12-0642. Dreyfus S&P 500 Index PEOPX 0.50 * --- 2,779.08 1990-01-0243. Principal Large Cap S&P 500 Index J PSPJX 0.50 0.25 511.61 2001-03-0144. State Farm S&P 500 Index Instl SFXIX 0.50 0.00 146.63 2002-02-2845. PNC S&P 500 Index A PIIAX 0.49 0.00 20.48 1998-10-1546. Principal Large Cap S&P 500 Index A PLSAX 0.49 0.15 250.27 2005-06-2847. BlackRock S&P 500 Stock Investor A BSPAX 0.48 0.25 1,126.64 2013-04-1048. MM S&P 500® Index Adm MIEYX 0.45 * --- 543.25 1998-02-2749. GE Instl S&P 500 Index Svc GIDSX 0.44 0.25 7.32 2005-09-3050. SEI S&P 500 Index A (SIMT) SSPIX 0.43 * --- 409.55 1996-02-2851. MM S&P 500® Index Svc MMIEX 0.42 * --- 712.03 1998-02-2752. Nationwide S&P 500 Index Instl Svc GRISX 0.42 * --- 228.98 1998-11-0253. Principal Large Cap S&P 500 Index R5 PLFPX 0.41 * --- 402.84 2000-12-0654. Vantagepoint 500 Stock Index I VPFIX 0.41 * --- 47.20 1999-03-0155. QS Batterymarch S&P 500 Index D SBSDX 0.39 * --- 8.94 1998-08-0456. Deutsche S&P 500 Index S SCPIX 0.36 * --- 629.77 1997-08-2957. Shelton S&P 500 Index Direct SPFIX 0.36 * --- 125.10 1992-04-2058. BlackRock S&P 500 Stock Service BSPSX 0.35 0.15 278.34 2013-04-1959. Invesco S&P 500 Index Y SPIDX 0.35 * --- 40.24 1997-09-2660. MainStay S&P 500 Index I MSPIX 0.35 * --- 1,392.76 1991-01-0261. State Street Equity 500 Index Svc STBIX 0.34 0.25 124.14 2003-03-1062. Deutsche Equity 500 Index Institutional BTIIX 0.31 * --- 510.90 1992-12-3163. TIAA-CREF S&P 500 Index Retire TRSPX 0.31 * --- 678.21 2002-10-0164. T. Rowe Price Equity Index 500 PREIX 0.28 0.00 24,367.34 1990-03-3065. PNC S&P 500 Index I PSXIX 0.27 * --- 160.82 1998-07-1566. Deutsche Equity 500 Index S BTIEX 0.25 * --- 430.85 1992-12-3167. SEI S&P 500 Index E (SIMT) TRQIX 0.25 * --- 347.14 1985-07-3168. USAA S&P 500 Index Member USSPX 0.25 * --- 2,693.19 1996-05-0169. State Street Equity 500 Index Adm STFAX 0.24 0.15 242.59 2001-04-1870. BlackRock S&P 500 Stock Institutional BSPIX 0.23 * --- 1,904.63 2013-04-1071. Vantagepoint 500 Stock Index II VPSKX 0.21 * --- 19.85 1999-04-0572. Dreyfus Basic S&P 500 Stock Index DSPIX 0.20 * --- 2,201.10 1993-09-30

17

92 Series

Symbol

AnnualFee(%)



InceptionDate

73. MM S&P 500® Index R5 MIEZX 0.20 * --- 984.19 2001-05-0174. GE Instl S&P 500 Index Inv GIDIX 0.19 * --- 26.15 1997-11-2575. PNC S&P 500 Index R5 PSFFX 0.19 * --- 0.01 2013-12-3076. Nationwide S&P 500 Index Instl GRMIX 0.17 * --- 1,947.36 1999-12-3077. Vanguard 500|Index Fund|Investor Shares VFINX 0.17 * --- 27,257.37 1976-08-3178. BlackRock S&P 500 Stock K WFSPX 0.16 * --- 901.69 1993-07-0279. Principal Large Cap S&P 500 Index Inst PLFIX 0.16 * --- 2,343.82 2001-03-0180. Vantagepoint 500 Stock Index T VQFIX 0.16 * --- 760.48 2013-03-0181. SSgA S&P 500 Index N SVSPX 0.15 0.06 1,535.96 1992-12-3082. USAA S&P 500 Index Reward USPRX 0.15 * --- 2,258.86 2002-05-0183. American Beacon S&P 500 Idx Instl AASPX 0.14 0.00 1,249.11 1996-12-3184. Fidelity Spartan® 500 Index Inv FUSEX 0.10 * --- 6,896.43 1988-02-1785. Schwab S&P 500 Index SWPPX 0.09 * --- 20,968.68 1997-05-2086. MM S&P 500® Index I MMIZX 0.08 * --- 613.19 2011-12-0787. TIAA-CREF S&P 500 Index Instl TISPX 0.06 * --- 1,929.29 2002-10-0188. Fidelity Spartan® 500 Index Advtg® FUSVX 0.05 * --- 46,472.60 2005-10-1489. Vanguard 500 Index Admiral VFIAX 0.05 * --- 140,189.00 2000-11-1390. Fidelity Spartan® 500 Index Instl FXSIX 0.04 * --- 24,406.67 2011-05-0491. SEI S&P 500 Index A (SIIT) SPINX 0.04 * --- 2,593.99 2013-12-1892. Fidelity Spartan® 500 Index Advtg Instl FXAIX 0.02 * --- 5,570.14 2011-05-04

18


The Toll of High ExpensesLet's compare a high-expense S&P500 index fund at the top of the table to Vanguard's Investor shares (VFINX) with a 0.17% expense ratio ranked near the bottom (#77) of the table. Invesco's B shares (SXPBX, ranked #7) have a 1.35% expense ratio and a 17-year track record. The next page compares the growth of $100 invested in the two funds.

The Vanguard fund accrues 24% more wealth in 17 years!

It gets worse.

In case the Invesco shareholders discover they are getting a bad deal, they likely face a 5% deferred sales charge (load) to get out.

19

Vanguard fund accrues 24% more wealth in 17 years.Informa StyleADVISOR: Cape Ann Capital, Inc.

Invesco shareholders with buyer's regret face a 5% maximum deferred sales charge to get out!October 1997 - December 2014

Loga

rithm

ic S

cale

70

100

$400

Sep 1997 Dec 1999 Dec 2001 Dec 2003 Dec 2005 Dec 2007 Dec 2009 Dec 2011 Dec 2014


Invesco S&P 500Index FundB Shares

$294 (VFINX)

$237 (SPIBX)


20


Is This Legal?So far!

But, there is a massive battle going on in the U.S. Congress right now. Obama has weighed in.

http://www.wsj.com/articles/obama-to-back-new-rules-for-brokers-on-retirement-accounts-1424689201?KEYWORDS=obama+fiduciary+standard

Brokers operate under what is called a suitability standard. As long as an S&P500 index fund is suitable, given the time horizon and risk tolerance of the investor, a broker is allowed to select the share class that pays him or her the most. A representative of a registered investment adviser must adhere to a fiduciary standard. Investment adviser reps are obligated, not only to confirm that an S&P500 investment is suitable, but also to find the least expensive share class.

The term adviser has no legal significance. Lots of folks have the term adviser on their business card. Someone calling himself an adviser may be operating as a broker.

The U.S. Securities & Exchange Commission provides a convenient link for investors to see if an individual is a broker or an investment adviser rep and whether there are any complaints on file. The link provides employer information as well.

www.adviserinfo.sec.gov

21


Dual Registration Adds to the Confusionhttp://www.investmentnews.com/article/20130303/REG/303039963

"In a recently released document, the commission said firms and advisers registered both as advisers and broker-dealers will be among its targets for examinations."

"While the SEC has put a premium on reviewing the approximately 2,300 dually registered firms, it also is targeting distinct broker-dealer and investment advisory businesses that share common financial professionals"

"The SEC has been beating the drum over conflicts of interest for the last 12 to 18 months, says Kelley Howes, who is of counsel at Morrison & Foerster LLP. It's sometimes hard to remember what hat you're wearing when an adviser or firm is dually registered."

22


John Bogle on Serving Two Mastershttp://johncbogle.com/wordpress/bogle-speeches

"In my opinion, the coming of public ownership of management companies played a major roll in changing the nature and structure of our industry. This baneful development began with an unfortunate decision by the U.S. Court of Appeals, Ninth Circuit (in San Francisco) that affirmed the right of a fund adviser to sell a controlling interest in its stock at a premium to its book value. The SEC argued that the transaction was a sale of fiduciary office, and hence a violation of fiduciary duty. The date of that decision April 7, 1958 was a date that will live in infamy. That seminal event, now long forgotten, changed the rules of the game. It opened the floodgates to public ownership of management companies; providing huge rewards of entrepreneurship to fund managers, inevitably at the expense of fund shareholders."

"These acquiring firms, obviously (one could even concede, appropriately), are in business to earn a high return on their capital, and they looked at the burgeoning fund industry as a goldmine for managers. (It was!) But their high return came at the expense of the returns on the capital entrusted to them by the mutual fund investors that they were duty bound to serve,"

"When a management firm is owned by a giant conglomerate, the conflict of interest is palpable"

23


Outline





26


Reporting without a Benchmark is MeaninglessA healthy relationship between advisor and client must be centered on a long-term asset allocation target. The client (not the adviser) must make this decision. Risk tolerance is a very personal attribute. Only the client can know the point at which downside volatility becomes too much to bear. Too much volatility will inevitably lead to tears and an untimely exit from the investment plan.

Clients without a benchmark, in fact, have two benchmarks; the S&P500 when stocks are going up and cash when stocks are going down. This forces the advisor to pretend he or she can successfully time markets. Sooner or later the relationship will end due to a market timing failure.

The asset allocation target provides a reference point to evaluate the success or failure of the advisor. It allows the advisor to attempt to add value without having to market time. Most statements, however, do not show performance expressed as a rate of return that can be compared to a benchmark rate of return. A typical statement shows shares held, market value, change in market value and a list of transactions. It is impossible to escape the conclusion that most advisors and brokers do not want the client to have a convenient reference point to evaluate performance relative to a benchmark.

27


Rate of ReturnIf a statement shows a rate of return it will almost certainly be what's called a time-weighted return. Time-weighted returns are relatively easy to calculate, but they ignore the impact of adding or withdrawing capital over time. A time-weighted returns are, in effect, returns per dollar invested. If an investor is trying to time markets by adding capital after a recent surge in performance, the impact of this likely destructive activity will not be reflected in a time-weighted return. A dollar-weighted return is a return that equates the ending value of the portfolio to the beginning value while taking account of all intermediate cash flows. Dollar-weighted returns are sometimes called internal rates of return. A dollar-weighted return is analogous to yield-to-maturity on a mortgage. The next page shows the calculation of the two rates of return using an example where an investor adds capital after two strong years of performance and just in time for a precipitous decline such as we had in 2008.

28


Three Ways to Calculate the Annual % Return of an Investment

Presumed Year‐EndValue Value Cumulative

Wealth Ignoring Year‐End Year‐End after Net Dollars Cumulative Flows for % Return Relative Flows Value Investment Investment Invested Profit/Loss IRR

Year 0 $100.00 $100.00 $100.00 $100.00 $0.00 ‐$100.00Year 1 30.00 1.300 $130.00 $130.00 $0.00 $130.00 $100.00 $30.00 $0.00Year 2 30.00 1.300 $169.00 $169.00 $200.00 $369.00 $300.00 $69.00 ‐$200.00Year 3 ‐50.00 0.500 $84.50 $184.50 $0.00 $184.50 $300.00 ‐$115.50 $0.00Year 4 19.00 1.190 $100.56 $219.56 $0.00 $219.56 $300.00 ‐$80.45 $219.56

7.25 0.14 ‐11.25

Simple Time DollarAverage Weighted Weighted% Return % Return % Return

Dollar‐Weighted Return is the Return that Equates All Three

Presumed Year‐EndValue Value Cumulative

Wealth Ignoring Year‐End Year‐End after Net Dollars Cumulative Flows for % Return Relative Flows Value Investment Investment Invested Profit/Loss IRR

Month 0 $100.00 $100.00 $100.00 $100.00 ‐$100.00 ‐$100.00Month 1 ‐11.25 0.888 $88.75 $88.75 $0.00 $88.75 $100.00 ‐$11.25 $0.00Month 2 ‐11.25 0.888 $78.77 $78.77 $200.00 $278.77 $300.00 ‐$221.23 ‐$200.00Month 3 ‐11.25 0.888 $69.90 $247.40 $0.00 $247.40 $300.00 ‐$52.60 $0.00Month 4 ‐11.25 0.888 $62.04 $219.57 $0.00 $219.57 $300.00 ‐$80.43 $219.57

‐11.25 ‐11.25 ‐11.25

29

2/29/20002/28/2015

from 2/29/2000 thru 2/28/2015

Portfolio Performance Since Inception

Client #3

Beg. Value 570,706.57

Net Deposits 693,447.29

Profit 1,903,565.01

End Value 3,167,632.55

Cumulative Returns

$-Wtd Portfolio Return after Fees 168.65%

Time-Wtd Portfolio Return after Fees 128.41%

Benchmark Return 82.89%

Annual Rates of Return (If > 1 Year)

$-Wtd Portfolio Return after Fees 6.81%

Time-Wtd Portfolio Return after Fees 5.66%

Benchmark Return 4.10%

Cape Ann Capital, Inc.

Captools/net30

2/29/20122/28/2015

2/28/20142/28/2015

12/31/20142/28/2015

1/31/20152/28/2015

Last 36 Months, Last 12 Months, Year-to-Date, Latest Month

Portfolio Performance for Selected Intervals

Client #3

Beg. Value 2,923,493.51 3,250,078.39 3,115,314.92 3,087,258.32

Deposits 967,429.59 967,429.59 967,113.42 962,719.80

Withdrawals (1,408,429.59) (1,109,429.59) (990,113.42) (985,719.80)

Net Deposits (441,000.00) (142,000.00) (23,000.00) (23,000.00)

Interest (1.43) (0.58) (0.49) (0.49)

Dividends 152,882.42 51,357.72 1,204.82 590.19

ST Cap Gain Distributions 32,036.15 7,383.68 0.00 0.00

LT Cap Gain Distributions 252,847.13 123,024.88 0.00 0.00

Price Appreciation 283,609.64 (110,076.08) 76,147.05 103,799.06

Management Fees 36,234.87 12,135.46 2,033.75 1,014.53

Profit 685,139.04 59,554.16 75,317.63 103,374.23

Tax Withholdings 0.00 0.00 0.00 0.00

End Value 3,167,632.55 3,167,632.55 3,167,632.55 3,167,632.55

Portfolio: $-Wtd before Fees 26.62% 2.25% 2.48% 3.38%

Portfolio: $-Wtd after Fees 25.13% 1.87% 2.42% 3.35%

Portfolio: Time-Wtd before Fees 26.44% 2.24% 2.48% 3.38%

Portfolio: Time-Wtd after Fees 24.96% 1.85% 2.42% 3.35%

Benchmark 29.32% 5.72% 2.70% 3.56%

Cape Ann Capital, Inc.

Captools/net31


Outline





32

Is this a fair coin?Ta

ils

H

eads

33

Probability of at least 16 heads in 24 trials is 8%

0.00

0.05

0.10

0.15

0.20

0 4 8 12 16 20 24Number of Successes in Twenty-Four Trials

Prob

abili

ty

34

24-Month performance for a mutual fund

180.21

144.16

80

100

120

140

160

180

200

Mar-03 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05

Gro

wth

of $

100

Fund S&P500

35

Monthly excess returns

-4

-2

0

2

4

6

Mar-03 Jul-03 Nov-03 Mar-04 Jul-04 Nov-04 Mar-05

Exce

ss R

etur

n vs

S&

P500

36

t-Statistic

Annualized Excess Return = 14.17Annualized Std Deviation = 7.36Years = 2

t = 14.17 / 7.36 * 1.4142 = 2.72

37

Probability of a t > 2.72 after 24 Months is 0.6%

6 4 2 0 2 4 6t-Statistic

Roughly equivalent to tossing 7 heads in a row.

38

Highly skillful manager?

Based on the last 24 months, if we conclude that this is a skillful manager, we do so with a very low probability of error. In other words, we can safely reject luck as the reason for this track record.Right?

39

Wrong!

This Manager has no skillThis is an index fund We are looking at the track record for the

TIAA-CREF Small-Cap Value Index Fund

40

What’s going on?

The problem is that we are comparing performance to the wrong benchmark.Look what happens if we compare performance to the Russell Small-Cap Value Index.

41

TIAA-CREF Small-Cap Value Index Fund vs

S&P500Index

Russell Small-Cap Value

Index

Excess Return 14.17 -0.14

Std Deviation 7.36 0.13

t-statistic 2.72 -1.52

42

Bill Sharpe to the rescue

William F. Sharpe, “Determining a Fund’s Effective Asset Mix”, Investment Management Review, 1988.William F. Sharpe, “Asset Allocation: Management Style and Performance Measurement”, Journal of Portfolio Management, Winter 1992.

43

First Eagle Global Fund (SGENX)

First Eagle Global Fund A (SGENX) Zephyr StyleADVISOR: Cape Ann Capital, Inc.

Current Style Exposure

20.2%

21.5%

0.8%

0.0%

25.0%

0.0%

12.9%

3.4%

0.0%

8.9%

0.0%

1.7%

5.6%

20.2%

21.5%

0.8%

0.0%

25.0%

0.0%

12.9%

3.4%

0.0%

8.9%

0.0%

1.7%

5.6%

20.2%

21.5%

0.8%

0.0%

25.0%

0.0%

12.9%

3.4%

0.0%

8.9%

0.0%

1.7%

5.6%

0% 20% 40% 60% 80% 100%

T-Bills

Bonds

Large-Cap Value

Large-Cap Growth

Small-Cap Value

Small-Cap Growth

Europe ex UK

United Kingdom

Pacific ex Japan

Japan

Small-Cap Japan

Emerging Mkts Asia

Emerging Mkts Latin Am

44



Historic Style Exposure

0%

20%

40%

60%

80%

100%

Dec 1995 Apr 1998 Aug 2000 Dec 2002 Apr 2005

T-BillsBondsLarge-Cap ValueLarge-Cap GrowthSmall-Cap ValueSmall-Cap GrowthEurope ex UKUnited KingdomPacific ex JapanJapanSmall-Cap JapanEmerging Mkts AsiaEmerging Mkts Latin Am

45



Risk Explained by Style and Market Benchmarks

Residual Explained

80.4%

19.6%

53.8%

46.2%

Style Benchmark S&P500 Benchmark

46


319.842

198.704

100

150

200

250

300

350

Dec-95 Dec-97 Dec-99 Dec-01 Dec-03

Gro

wth

of $

100 SGENX Style Benchmark

47


-3-2-10

1234

Dec-95 Dec-97 Dec-99 Dec-01 Dec-03

Exce

ss R

etur

n vs

Sty

le B

ench

mar

k

48

t-Statistic for First Eagle Global Fund (Jan 1996 – Apr 2005)

Annualized Excess Return = 5.63Annualized Std Deviation = 4.18Years = 9.33

t = 5.63 / 4.18 * 3.05 = 4.12Probability of Luck = 0.0037%

49

Best in show

The First Eagle Global Fund has been the most skillfully managed mutual fund in the country over the last 9 1/3 years.

50

First Eagle’s Record is Truly Exceptional

-6 -4 -2 0 2 4 6

t-Statistic

Roughly equivalent to tossing 15 heads in a row.

51

Sharpe’s analysis applied to all equity/balanced funds

-6 -4 -2 0 2 4 6t-Statistic

52

A lot more extreme performers than expected

With 1,173 funds tested, we should find 28 funds in each of the tails. Instead we find 115 in the left hand tail and 67 in the right.

53

Conclusions

Returns-based style analysis is a powerful first step in the search for investment management skill.About 6% of the mutual funds available to

US investors have a long-term track record that suggests a high level of skill.Of those, roughly 40% have probably just

been lucky and 60% have what it takes.

54

Documents

58th Mid-Year Meeting Why Would You Want to Be Average ... Fiduciary Responsibility...for different asset classes such as bonds and real estate investment trusts." _____ Percent of