Eugene Fama of the University of Chicago is one of three economists just awarded the Nobel Prize in Economics. Fama is best known for his formulation of the “efficient market hypothesis,” or EMH.  For investors, the main practical implication of the EMH is the superiority of “passive management” (which means matching market returns) rather than “active management” (meaning the pursuit of excess returns).  Therefore, the best way to participate in financial markets is to capture the returns of various asset classes at the lowest possible cost.  Professor Fama’s groundbreaking work on asset pricing and markets inspired the founding of Dimensional Fund Advisors (DFA).  Dimensional fund shares are not available directly to individuals but are limited to clients of a select group of fee-only financial advisory firms. The relationship between Dimensional and the independent advisor is based on shared views about how capital markets work and how best to provide clients with a successful investment experience.

We at Rockbridge would like to offer our congratulations to Professor Fama.

Market returns continued their upward trajectory again this quarter.  The US stock market (S&P 500) was up 5.2% while International stocks came roaring back with an 11.6% return for the quarter.  The steady interest rate environment caused bond returns to remain flat, up .36% for the 3-month period ending September 30, 2013.  The bond market, represented by the Barclays US Government/Credit Index, was still in negative territory for the year, down 2.3%.  Please refer to the last page of our newsletter for historical returns from various financial markets over longer time periods.

September 2013 marks the five-year anniversary of the global financial crisis.  Do you remember the fear and panic that seized the markets and the resulting doomsday predictions of the media?  Here is a partial list of what we lived through back then:

  • The US Government takes over home mortgage lenders Fannie Mae and Freddie Mac
  •  Lehman Brothers files for bankruptcy
  •  The US Congress passes a $700 Billion bailout of Wall Street
  •  Merrill Lynch sells to Bank of America
  •  The US Government bails out insurer AIG taking an 80% equity stake

SP-500-9-30-13-300x180It’s hard to believe we actually made it through that period.  The stock market imploded with the S&P 500 benchmark falling more than 50% to 752 on November 20, 2008.  We have come a long way since that fateful month.  The S&P 500 has averaged a healthy 10% annual return over the last 5 years (see chart) and the global economy continues to recover, although slowly.

What did we learn from the events of the past five years?  Fear and panic in financial markets cause us to question our decisions and despair about the future.

Key-Factors-for-Investor-Success1-300x158However, it’s important to note that a well-diversified portfolio helped investors to overcome one of the worst financial crises in American history.   We continue to believe the keys to successful investing are simple but certainly not easy.


If you did not know that rising interest rates hurt bond returns, you would be among the majority of US investors according to a recent survey by Edward Jones.  The study found that two-thirds of respondents did not understand how rising rates will affect their portfolios.

The bond math is complicated, but the result of rising rates is straightforward – bond prices go down when rates rise.  The total return for a bond, or bond mutual fund, is the combination of interest income, plus the gain when rates fall, or the loss when rates rise.

Market participants generally agree that interest rates will rise from current levels, but no one knows when, or how much:

One analysis from PIMCO suggests that 10-year rates could rise as the Federal Reserve unwinds its unprecedented monetary policy, but less than 1.5% in the near term.  Their analysis points out that the spread between the 10-year Treasury and the fed funds rate over the past 40 years has rarely been above 4%, and it rarely stays there. 

At the end of September the 10-year Treasury yield was about 2.6%, and we know the Fed intends to keep the fed funds rate near zero until we see substantial improvements in the economy, which no one expects for several quarters.  PIMCO also believes that even with a “tapering” of the Fed’s bond buying, or quantitative easing, the program will continue to effectively narrow the spread.  Hence an expectation that 10-year Treasury rates can move up from 2.6% but not all the way to 4%.

The 10-year Treasury yield rose approximately 1% over the past year from 1.6% to 2.6%, and the total return on the intermediate bond index over that time was a loss of 1.95%.  In round numbers, interest income was about 2% and the loss from price decline was about 4%, resulting in a net loss of 2%.  If rates rise another 1%, the net loss will be less because interest income is now higher, and if it takes two or three years, the cumulative total return will be positive from this point forward because you will have two or three years of interest income to offset the price decline.

So What Is an Investor To Do?

Option 1 – If you are still worried about the impact of rising interest rates, you can sell bonds and move to cash until rates go up, and then reinvest at a higher return.  This strategy requires a crystal ball.  As pointed out above, if it takes two or three years for higher rates to arrive, the interest income you miss will be greater than the price decline you avoid.

Option 2 – Sell bonds and buy stocks.  This strategy will always increase the expected return of your portfolio, but also increases risk.  A significant rise in interest rates caused the bond index to lose 2% over the past year.  You may still remember that many stock portfolios lost a third of their value during the financial crisis of 2008-09.

Option 3 – Stay the course, which is our general recommendation, along with ignoring media hype, and having reasonable expectations.


Ignore Media Hype Like:

“If anyone has been investing in bond funds for any length of time, it has been a great ride, but it’s time to hop off and…”

“Sooner or later, there is going to be a bloodletting in the bond market and…”


Such advice and warnings are no more useful than saying “sooner or later we will experience a devastating hurricane in Florida and…”

And Keep Expectations Reasonable:

Interest rates will eventually rise, and bond prices will fall.  In the meantime, bonds are paying some interest, and cash reserves are not.

Bond returns are expected to be much lower than stock returns but continue to provide valuable stability for the portfolios of long-term investors.

The active vs. passive investment management debate is one of the most highly discussed topics in the advisory industry.   The 24-hour news coverage and the constant barrage of commercials make it appear that beating the market is a very easy task.

First, let’s start with a brief definition of the two investment philosophies.

Active Investment Management – Objective is to outperform the market through superior timing and security selection.

Passive (Index-Based) Investment Management – Objective is to track market indices in order to get market returns while minimizing cost.

Recently, S&P Dow Jones Indices released their biannual scorecard measuring the performance of active funds vs. the market indices.  The study primarily compares the percentage of active funds that underperform the market index.  It also quantifies the average return of an active fund vs. their benchmark index.  The table below depicts a summary of the study by asset class.

Percentage of Active Funds Outperformed by Benchmarks

Asset Class

One Year

Three Years

Five Years

Large Cap




Small Cap








Emerging Markets




Real Estate




Long-Term Bonds




Intermediate-Term Bonds




Short-Term Bonds




– S&P Indices Versus Active Funds (SPIVA) Scorecard, Mid-Year 2013

In aggregate, most active managers underperformed their benchmarks over the past 12-month, 3-year and 5-year time periods.

What does all this data show?

  • Although it is always possible to beat the market, the overall odds are against you.
  • The odds of beating the market over a long period of time are even smaller.
  • You would have to pick winners in advance, which is nearly impossible to do.

We at Rockbridge strongly believe in passive (index-based) investment management and this study reinforces our approach.

The full results of the study can be obtained here: