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Merging Active and Passive Mutual Fund Platforms

MJG
edited July 2011 in Fund Discussions
Hi Guys,

Are you familiar with the Babe Ruth syndrome?

The Babe Ruth syndrome recognizes the tradeoffs between great success and abject failure; Babe Ruth setting records for his home run hitting prowess, but also notorious for his strike-out frequency.

Without too much imagination, it is easy to construct a similar analogy using Brett Favre as the focal point with his high-risk, long touchdown passes and his rally crushing interception frequency record. In most happenings there is a tension between the good and the ugly.

Investors are confronted with this tension when making mutual fund/ETF decisions. Does the investor buy into the merits of the active fund management story? Is the amateur investor satisfied with Index-like returns, or does he shoot for the stars in an attempt to secure outsized excess returns? Each of us must make our own lonely decisions.

The data suggest that investors most often seek excess returns (Alpha). The Investment Company Institute (ICI) research and records support this finding. The ICI data bases clearly demonstrate that the individual investor most frequently employs active mutual fund management. In contrast, on an average percentage basis, institutional investors hire Indexers.

The most recent ICI data releases provide the following summary statistics. The 2011 Investment Company Fact Book shows that only a small percentage of individual investors use Index products. Like 90 million folks own mutual funds, and half of these use an advisor. From the ICI Fact Book: “Of households that owned mutual funds, 31 percent owned at least one index mutual fund in 2010.” So most individual investors are still committed to active mutual fund management. That’s a commitment to purposely seeking Alpha.

This search for excess returns becomes problematic to a retirement portfolio because it fails at several practical and statistical layers.

The semi-annual S&P mutual fund scorecards document that from a frequency purview only one-third of active managers outperform passive management on an annual average basis. Additionally, performance persistence suffers as the earlier top-managers seem to lose their skills and prescience over time at a rate that exceeds random turnover. Picking long-term successful fund managers is not an straightforward task.

Besides the frequency issue, the private investor is further challenged by the rather meager excess returns that the successful managers deliver. When these Fortunate Sons do deliver, they struggle to exceed Index levels by just a few percent over any time horizon that meaningfully impacts cumulative wealth.

So we have the likelihood of a double whammy when focusing on excess returns: low probability of successful managerial selection coupled with scanty excess returns for the assumed risk.

But there is yet more bad news. A second layer of individual underperformance is well documented. Amateur investors are not loyal to their initial investments. Mutual fund ownership turnover rates have substantially increased. Our patience levels have diminished over time. Private investors change frequently, often to follow the so-called “hot hands”. It is well documented that “hot hands” are an illusion. It seems that a regression-to-the-mean kicks-in the moment a financial commitment is made.

Decades of survey data from Dalbar clearly documents that investors recover less than one-half of what funds they employ generate. Why? Private investors are masters of bad timing. We are late to the financial party. When we do switch parties, the abandoned party outperforms the one that we recently purchased. Institutional investors suffer this same outcome, further establishing the troublesome issue of active management screening and selection. Our average record is a first-class disaster zone in this arena.

Here is a Link to a May, 2011 summary article from Alpha Investment Management (AIM) that explores some of these same problematic areas:

http://alphaim.net/newsletter_5_26_11.html

The Alpha reference warns amateur investors to “stay out of the kitchen.” That’s far too harsh a judgment and is somewhat arrogant. Alpha concludes that “Consistent superior performance is rare in the mutual fund world”. We have all seen those proclamations many times. AIM proposed an approach to counteract the poor timing record of individual investor.

The AIM investment strategy recommended at the end of the article was to sell in May, and transfer into a bond position until November. The AIM strategy endorses a mid-cap Index equity holdings during the fruitful November-May period.

I do not necessarily approve of the AIM investment strategy. It is one of a host of options. The AIM strategy is based solely on a statistical assessment. It does not document a causal relationship between the parameters being correlated. It could be a lucky (or unlucky) coincidence. Any correlation that does not provide a logical rationale for the correlation is highly suspect.

These findings should be a cautionary alert to all investors. We are too aggressive when constructing a portfolio. It would likely be a good policy to divide the portfolio into two separate major groups: a globally diversified, low risk, low cost, low turnover passive unit, and a more actively managed aggressive unit that is targeted to add Alpha. The actively managed Alpha-directed holdings should have well diversified, high beta, and high volatility characteristics.

The final percentage mix of passive and active components depend on the individual investors specific goals, time horizon, wealth, age, financial knowledge, and risk profile. Each investor must determine this passive/active mix for himself.

It is possible to enjoy the comforts (lower volatility) and benefits (higher rewards) provided by both investment management platforms.

Best Regards.

Comments

  • When I began seriously investing about 20 years ago, I was a much bigger proponent of indexing. It seemed to work best in domestic (U.S.) large cap equities. My personal experience has actually moved me away from indexing, although not totally. It became apparent to me that choosing fund managers that would provide excess returns over their relevant index was not that difficult. What is more difficult is not sabotaging your own performance by engaging in market timing and performance chasing, as you mention regarding investors not realizing the returns their funds produce. Also, if you insist on pure style purity in your active managers, you will probably eliminate many good choices of managers. So if my domestic large cap manager owns some mid-cap stocks, or a few non U.S. equities, I'm not too concerned about it. The techno-purists will say it's an apples vs. oranges comparison since the active funds I may use are not style-pure, so they cannot be compared to a 100% U.S. large cap index. I don't lose any sleep over that problem. My bottom line is to realize a good risk-adjusted return on my investments. Funds with good continuity of managment and a long-term record of besting a reasonably relevant index tend to do this. The funds I use in this sector are: Sequoia Fund, Mairs & Power Growth and Vanguard Primecap. I'm fairly confident that if you hold these for ten years or more, your average annualized returns will exceed large cap index funds by more than enough to justify their higher management fees.

    Charley S.
  • edited July 2011
    Hi MJG,

    Related to your write and the individual investor; as we at MFO; with a hugh basket of choices among active managed funds and passive indexes and ETF's.

    One may consider the following mixes:

    ---passive investors using passive indexes/etf's
    ---passive investors using active managed funds
    ---active investors using passive indexes/etf's
    ---active investors using active managed funds
    ---blend investors using a mix of the above

    I'm not really saying anything different than your post, I suppose.

    Anyone may become as aggressive or otherwise, as they choose among any of the fund/index/etf styles and sectors. But, I do not feel anyone should be a passive investor on their own, even when using an advisor. This communication path should always be wide open.

    Our house fits the active investor/active managed funds category. When we favor a particular market sector, we choose to allow active fund managers pick through the choices for holdings. If and when it may appear that a particular market direction may be strong, we would consider an etf for a special use, which would then become the aggressive side of investing. One such circumstance appeared last Friday after the lackluster jobs report. Had one known or thought this would have been the outcome; a Thursday buy into IEF (7-10 year bond) would have provided a very nice return for Friday and may continue into this coming week.

    A recent post indicated 3 Vanguard indexes being used for an IRA account. I do not have a problem with such choices; as long as an investor is aware of the sector holdings/styles of such indexes; and that they should be actively managed for movement within the markets.

    The 3 indexes: Vanguard Total bond, Total Stock and Total Int'l.*** data per M*

    Total Bond = U.S. high quality bonds...gov't agency and corporate
    Total Stock = U.S. large cap blend
    Total Int'l. = Foreign large cap blend

    These are not bad choices for a mix; but one should be aware of the style(s).

    In a nutshell and example; if we at this house feel there is still value in various bond styles, we must decide whether to pursue tight bond sector etf's or rely upon a very good management team using a multi-sector bond fund to find the values and move monies as needed to follow the flows.

    At this time, we use the active managed funds. There is more than enough work in determing what sectors one's monies should be invested; let alone thinking about all of the niche sectors within a broader sector...investment grade, high yield, foreign, emerging market, U.S. gov't bonds, etc.

    Okay, enough from me and perhaps this made some sense to some of you.
    Back outside to the hot and humid air I must travel for some more physical work.

    Regards,
    Catch
  • Reply to @catch22:

    With respect to investment style, I believe Vanguard Total Stock Market Index Fund and Vanguard Total International Stock Index Funds invest in both value and stock stocks.
  • Sven, You are correct.............I grabbed the wrong wording; as they are both large cap blend.
    Thanks,
    Catch
  • Hi Guys,

    Good stuff. Thank you for your perceptive and stimulating commentary.

    From CharleyS’s posting: “My bottom line is to realize a good risk-adjusted return on my investments. Funds with good continuity of management and a long-term record of besting a reasonably relevant index tend to do this.”

    I completely agree. They may be small in number, but some financial experts have a talent for their trade that is rare. If you recognize such Superinvestors, ride their coattails whenever possible.

    I believe that CharleyS has potentially identified three such funds that could be actively managed by Superinvestors.. The pedigree of one of those funds, Sequoia (SEQUX), traces its bloodline to the legendary Benjamin Graham/Warren Buffett school. That school emphasized an investment philosophy using large safety factors because of errors buried within the imprecise assessment techniques themselves, and the uncertainties inherent in forecasting future events.

    Talent and specialized skill sets are unequally distributed within the population writ large. We have great leaders (Washington, Lincoln), inspired inventors (Edison, Tesla), military heroes (Washington again, Patton), industrial giants (Ford, Rockefeller), perceptive financers (Morgan), sports stars (too many to mention), and Superinvestors (Graham, Buffett, maybe Lynch). These sub-populations are likely very small, but a extraordinary cohort of investors do have an intuitive market feel and a companion money control discipline that most of us do not own.

    Warren Buffett made this exact argument in a well-documented address that he delivered at Columbia University in 1984. The title of his talk was “The Superinvestors of Graham and Doddsville”. I have appended a Link to that famous defense for the existence of a skilled group of investors.

    http://www.tilsonfunds.com/superinvestors.pdf

    Note that Bill Ruane, one of the individuals named by Buffett as a charter member of the Superinvestor club, managed the Sequoia Fund since its inception until his recent death. It remains to be proven that his replacements absorbed his methods and talent. I hope so; they worked with Ruane for a long time.

    It is not clear to me that Peter Lynch deserves all the accolades that are often awarded him. Certainly, early in his famed career as a mutual fund manager, Peter Lynch earned his reputation with superior returns. Most of those excess returns happened when the fund was small. It is not so well known that Ned Johnson III immediately preceded Lynch as that fund’s manager (until 1971), and actually registered a better annual record beyond that achieved by Lynch. Fidelity allowed Peter Lynch to realize his enviable record by shrewdly permitting him to invest in foreign corporations while most of his contemporaries were married and tied to the US equity marketplace.

    I also agree that the purity of investment style should not be a dominant determinant when selecting an actively managed mutual fund. The benefit to an investor is best measured by the fund manager’s absolute returns, not some adherence to a goal style or restrictive category of holdings. In the actively managed mutual fund world, let the big horse run free and unconstrained.

    Thanks everyone for your participation. I always enjoy the breath and scope of your informed opinions.

    Best wishes.
  • edited July 2011
    The user and all related content has been deleted.
  • Reply to @catch22:

    One additional note. Vanguard Total International Stock Index has gone through some changes earlier this year as it now includes both Canada and more small caps. Still Large Cap heavy but better representation of Total Intl. Market.
  • MJG
    edited July 2011
    Reply to @Maurice:

    Hi Maurice,

    Thanks for your timely and intriguing post. I particularly enjoyed your Friess/Brandywine story telling. It has a significant lesson to teach.

    As a general observation, market timing is dangerous to end wealth, especially when it is applied in a limited all IN or all OUT option set. That type of investment strategy assumes a perfect forecasting capability that simply does not exist.

    Indeed, Friess was a highly respected mutual fund manager for most of his career. Then he made a flawed rookie’s mistake on two levels. He attempted to become a market timer; he also wagered almost the entire farm on a single forecast. Perhaps his success story promoted this arrogance. Who knows for sure?

    What we do know was that it was a fatal error. Overnight he became a market timer, and, he chose poorly. How sad. He compounded the error by betting the farm on an uncertain outcome. Every professional gambler understands that a wager must be sized according to its expected likelihood of success. As probabilities approach perfect foresight, the magnitude of the wager is allowed to increase. Obviously, Friess violated this gambler’s rule.

    This betting rule is clearly explained in William Poundstone’s fun book titled “Fortune’s Formula”. The rule was developed by John Kelly in the 1950s and is therefore called Kelly’s formula. It was used by an unofficial team from MIT in successful raids on Las Vegas Blackjack tables. Here is a Link to one version of the Kelly criterion:

    http://www.turtletrader.com/data.html

    I also take issue with the rather arbitrary lines drawn by Morningstar to aid in categorizing the fund world. It does organize a huge and chaotic mutual fund assortment of products to some extent, and is useful for that purpose. But its yardsticks are not granular enough for many portfolio applications. And style drift further complicates the problem of maintaining a well diversified portfolio. It can serve as a reasonable point of departure in the portfolio construction process.

    Thank you for your meaningful contribution.

    Best Wishes.
  • Howdy All,

    MJG, per your last paragraph and M* categorization. Bloomberg has a very nice ranking system for fund types/styles/sectors. But, with the many funds that have become more difficult to place into a "breed", they too have similar problems when placing a label on a fund type. I find this often and with surprise when checking the ranking of fund "x" and discover that Bloomberg places the fund into a "flexible" fund group. When I look through the list, I do find "real" flexible funds.

    I have not attempted to determine how Bloomberg measures a given fund to find a category placement. Perhaps I should pen a question to them.

    As always, and for the best results; we must do the real digging to attempt to find the true nature of a fund.

    Take care,
    Catch
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