Intelligent Design

John McMillen | Portfolio Manager

Learn what matters - and what doesn't - when building a sound investment strategy.

Searching for the Holy Grail of Investing

February 2015

CAPE Fear: Can we use Valuation Ratios to Time the Market?

With popular market benchmarks like the S&P 500 setting record highs in 2014, many investors have become apprehensive. They’re afraid that a major market decline is imminent and are eager to find a strategy that promises to avoid the pain of an extended downturn while still capturing any up-side potential.

And yet, like the Holy Grail, that “perfect” strategy remains elusive.

But one approach that has attracted considerable attention in recent years is adjusting investments based on the CAPE ratio–the Cyclically Adjusted Price / Earnings ratio.

The CAPE ratio, developed by Robert Shiller of Yale University and John Campbell of Harvard University, seeks to provide a road map of stock market valuation by comparing current prices to average inflation-adjusted earnings over the previous 10 years.1 The idea is to smooth out the peaks and valleys of the business cycle and arrive at a more stable measure of corporate earning power. Shiller suggests that investors can improve their portfolio performance relative to a static equity allocation by overweighting stocks during periods of low valuation and underweighting stocks during periods of high valuation.

A CAPE-based strategy has the virtue of using clearly defined quantitative measures rather than vague assessments of investor exuberance or despair. From January 1926 through December 2013, the CAPE ratio has ranged from a low of 5.57 in June 1932 to 44.20 in December 1999, with an average of 17.54.

Using the CAPE ratio might appear to offer a sensible way to improve portfolio results by periodically adjusting equity exposure, and many financial writers have focused on this methodology in recent years. As an example, a timing newsletter publisher in early 2014 observed, “For the S&P 500, this ratio currently exceeds 25.6, which is higher than what prevailed at 29 of the 35 tops since 1900.”2

Many investors find such an approach very appealing. Does it work?

The challenge of profiting from CAPE measures or any other quantitative indicator is to come up with a trading rule to identify the correct time to underweight or overweight stocks. It is not enough to know that stocks are above or below their long-run average valuation. How far above average should the indicator be before investors should reduce equity exposure? And at what point will stocks be sufficiently undervalued to warrant buying again…Below average? Average?  Slightly above average?

This implementation challenge appears to be the Achilles’ heel of timing-based strategies. A study in 2013 by professors at the London Business School applied CAPE ratios to time market entry and exit points. “Sadly,” they concluded, “we learn far less from valuation ratios about how to make profits in the future than about how we might have profited in the past.”3

As an example of the potential difficulty, consider the CAPE data as of year-end 1996. The CAPE ratio stood at 27.72, 82% above its long-run average of 15.23 at that point. Federal Reserve Chairman Alan Greenspan had delivered his much-discussed “irrational exuberance” speech just three weeks earlier. The last time the CAPE ratio had flirted with this number was October 1929; the CAPE was at 28.96 as stock prices were about to head over the cliff. It seems plausible that followers of the CAPE strategy would have been easily persuaded that investing at year-end 1996 would be a painful experience.

The actual result was more cheerful. The next three years were especially rewarding, with total return of over 107% for the S&P 500 Index. For the period January 1997–June 2014, the annualized return for the S&P 500 Index was 7.67%; modestly below stocks’ long-run average, but still a strongly positive equity premium.

By comparison, a timing strategy over the same period of being fully invested in stocks only during periods when the CAPE ratio was below its long-run average produced an annualized return of 3.09%.

All timing strategies face a fundamental problem: Since markets have generally gone up more often than they have gone down in the last 90 years, avoiding losses in a down market runs the risk of avoiding even heftier gains associated with an up market.

And yet, a successful timing strategy remains the holy grail of the investment world. For decades, Wall Street firms and individual investors have spent countless hours and expended tremendous financial resources in the quest for “It”, only to realize that “It” doesn’t exist.  Using the CAPE ratio to time the buying and selling of stocks is simply another expedition that will lead to a disappointing outcome.

Searching for the key to outwitting other investors may be fun for those with a sense of adventure and lots of time on their hands. For those seeking the highest probability of a successful investment experience, maintaining a consistent allocation strategy is likely to be the sounder choice.

1. CAPE data available at; 2. Mark Hulbert, “This Bull Market is Starting to Look Long in the Tooth,” Wall Street Journal, January 18, 2014; 3. John Authers, “Clash of the CAPE Crusaders,” Financial Times, September 3, 2013. Adapted from “CAPE Fear: Valuation Ratios and Market Timing” by Weston Wellington, Down to the Wire column on Dimensional’s website, September 2014. Dimensional Fund Advisors LP ("Dimensional") is an investment advisor registered with the Securities and Exchange Commission. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. This content is provided for informational purposes, and it is not to be construed as an offer, solicitation, recommendation or endorsement
of any particular security, products, or services. 

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The Failure of Alpha

March 2012

All investors have to make a choice to embrace either a passive or active strategy when selecting investments. Passive strategies attempt to capture the market’s return, while active strategies attempt to outperform it. Gains that active managers earn above the stock market’s return are commonly referred to as alpha. Before investors pursue alpha, they should evaluate the probability of capturing it and, if captured, whether value can be added net of expenses and taxes.


Numerous studies have confirmed the vast majority of mutual funds do not deliver alpha net of expenses (e.g., Elton (1993), Carhart (1997)). More recent studies have shown up to 25% actually generated negative alpha1. In other words, the manager’s stock picks have actually destroyed value and detracted from performance. Worse yet, for those still compelled to pursue alpha, it should also be noted that negative alpha (i.e., underperformance) is on average greater than positive alpha.

The table below shows the amount of alpha generated by percentile in 2011:
Investors holding multiple actively managed funds as part of a diversified portfolio are not only likely to have more funds generating negative alpha than positive alpha, but any positive alpha achieved is likely to be offset by significant negative alpha in another. This imbalance will likely cause poor overall portfolio returns.


Attempting to generate alpha is an expensive process; it’s both data and time intensive, requiring a significant investment in both technology and manpower. To cover these higher costs, funds pursuing alpha almost always come with higher operating expenses relative to the passively managed funds. The table below lists the average net operating expense ratio of the two strategies.

In an efficient market where prices quickly react to new information, overcoming a 0.71% hurdle in additional expenses is no small task and a significant reason why actively managed portfolios often underperform their passive benchmark.


Actively managed strategies attempt to add value by continuously putting their best ideas to work in the portfolio. This inevitably increases the portfolio’s turnover ratio (i.e., amount of trading), which not only increases hard dollar costs such as commissions, but also generates realized gains in the portfolio. Capital gains incurred in this manner are frequently realized earlier and are often subject to higher ordinary income rates.

The amount of return lost due to taxes on distributions can be measured using the Tax Cost Ratio. It assumes taxes are paid at the Federal level and at the highest tax bracket. For example, the table below shows the Tax Cost Ratio for a large sample of actively managed large cap funds vs. the widely held Vanguard S&P 500 index fund over the past five years:

The table shows the Vanguard S&P 500 not only has a lower turnover, it also is considerably more tax-efficient, giving up less than half as much to taxes as its active peers did.

Considering the low success rate of capturing alpha, the higher likelihood of capturing a significant amount of underperformance, and the greater costs associated with these strategies net of fees and taxes, it is highly probable that investors would benefit from embracing a low-cost, low-turnover, passive alternative as the cornerstone for their investment philosophy. 

1Barras, Scaillet, Wermers, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas,” The Journal of Finance, February 2010.

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Just How Long Does It Take To Get Those Long-Term Returns?

November 2011

One of the most important determinants of an investor’s ability to assume risk is their stated investment time horizon. It is well documented that the longer an investor’s time horizon, the more likely a significant equity allocation may be appropriate. But what, exactly, is “long term”? While the phrase can have different meaning to different investors, it is critical to understand what the phrase means in the capital markets.

To help investors match their time-horizon with the appropriate investment, most practitioners use past history as a guide to the future. To make apt comparisons, we use data from the CRSP 1-10 Index (which is all stocks in the New York Stock Exchange divided by size into 10 deciles). The CRSP Index shows the risk and returns of the entire market, much like a well-diversified portfolio would contain. The data it shows may be surprising to many well-diversified investors, as it seems that “long term” may not be as long as people think.

The graph below highlights this. It shows that, from 1950 to 2011, the equity markets generated a positive return more than 90% of the time for holding periods of four years or longer (green area, left scale). Additionally, for time horizons of 11 years or longer, there was not a single recorded period of loss for stock investors.

The data also shows that, as the investment horizon is extended, the Maximum Annualized Loss decreases rather substantially (red line, right scale). For investors with a one- or two-year investment horizon, losses in excess of 30% have sometimes occurred (as many investors know all too well), but for those with time horizons greater than six years, annualized losses have not only been rare, with 97.9% reported positive outcomes, they have also been relatively small when they do occur. Thus, investors who at the very least want to get back any capital they invest should have a minimum time horizon of six-years – if they are in a well-diversified portfolio. (If not, all bets are off!)
In comparison, fixed-income investors will find a considerably shorter time period is needed to be reasonably assured their wealth will remain intact. As the graph below shows, two-year holding periods generated positive returns more than 98% of the time in the bond market from 1950 to 2011, and after just three years, losses all but disappeared. 

Having examined the likelihood of losses for investors in both stocks and bonds, let’s consider which asset class has the highest returns, and how long it takes to achieve those returns. Not surprisingly, stocks have historically generated higher returns than bonds, but the question is, how long does an investor have to stay invested to capture those higher returns?

The graph below examines this issue. It shows that, from 1950 to 2011, equities generated a higher return than fixed-income 68% of the time in any given one-year time frame (green area, left scale). As the investment horizon is extended, the probability of excess relative performance for stocks compared to bonds steadily increases. Once a time horizon hits approximately 15 years, less than 5% of the observed time periods have seen fixed-income securities outperform equity securities. After 21 years, there was not one occurrence where bond investors generated a higher annualized return than stock investors.

Amazingly, this data captured a 60-year time period which contained five major bear markets for stocks, with average losses in those downturns of 45%. It was also a time which, due to steadily declining interest rates, was very favorable for bonds. And yet any holding period 15 years or longer saw stocks beat bonds 95% of the time, and that percentage climbed to 100% when the holding period went out past 20 years.

The graph also shows that the average difference in performance between stocks and bonds on a year-by-year basis was significant (red line, right scale), with stocks beating bonds by an average of nearly 6%. Even as the time horizon was extended, the excess return earned by equity investors over fixed-income investors averaged almost 4% annually.
Four percent compounded annually over a lifetime will create almost unimaginable differences in terminal wealth. Despite this, even with suitably long investment horizons and the goal of wealth maximization, most investors are underexposed to equities due to their perceived risk. Though greater volatility is almost certain with higher equity exposure, history shows this risk subsides substantially – and ultimately disappears – with the passage of time.

My intention is not to discount the use of bonds; certainly an investor’s willingness and ability to remain fully invested during inevitable periods of high volatility warrants consideration of having bonds in the portfolio. However, for those looking to maximize their wealth there is strong justification to have a significant capital allocation to equities to achieve that goal.

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Fund Failures, Survivorship and Your Money

February 2011

Mutual funds have a lifecycle not too different from any living entity: They are born, they grow up, and then, eventually, they die. Unfortunately, many funds perform very poorly and are sent to an early grave, taking much of their shareholders’ original investment with them.

Since the founding of the first mutual fund in 1924, the number of funds in the industry has increased dramatically. According to the Investment Company Institute, the mutual fund industry’s trade association, today there are almost 8,000 mutual funds managing more than $11 trillion dollars:

This huge number of funds, most of which have a team of portfolio managers and analysts scouring the investment landscape for the highest return on their capital, greatly contributes to the efficiency of the market, quickly pushing securities prices to fair value.

The enormous competition also makes it extremely difficult for these funds to add value by finding securities that are mispriced. Managers who build their funds on this strategy often fail, usually after a prolonged period of painfully poor performance. This results in asset redemptions by the fund’s shareholders, ultimately making the fund unprofitable to operate.

The attrition rate for mutual funds is huge. Over the past decade, about 10% of the funds in any given year have either been closed down or merged:

The investment industry preaches about the virtues of a long-term investment view, but a 10% failure rate for mutual funds means the average fund will not last nearly as long as most of their shareholders’ investment horizons!

Though a fund closing can have an obvious negative impact on its shareholders, often it’s viewed as a blessing by the fund company, because it allows them to wipe the slate clean and move forward. You may be surprised to know that, when a fund is liquidated or merged, its substandard performance simply disappears. It’s as if the fund (and the wealth it destroyed) never existed! This allows a company to claim all of their funds have delivered great performance even if many of their funds have been closed or merged due to poor performance. By intent and design, many fund companies can legally distort investors’ perceptions about their fund family’s track record of success.

This also has a profound impact on fund-industry statistics, creating a phenomenon known as survivorship bias. Survivorship bias upwardly skews the number of funds that have beaten a given benchmark because many of the funds that performed the very worst and were closed or merged into more successful funds – historically about 10% of the fund population – are excluded from the data set.

Something to keep in mind the next time you come across those glowing mutual-fund ads in the consumer press!

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