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Actively Managed Mutual Funds Fall Short Again-- And Investors Notice
I want to thank LA Times business writer Tom Petruno for the fine article that fairly assesses the pros and cons of the active/passive mutual fund controversy. I especially want to thank you for bringing the wide MFO audience’s attention to this excellent summary of current comparative performance.
Petruno offers a balanced evaluation and identifies those fund categories where an active fund proponent can increase his odds of selecting a fund manager who can add Alpha to annual returns.
Although the introductory graphic embedded some sound financial advice, the other graphs that accompanied the article were more dense with detailed comparative numbers that highlighted performance disparities. Unfortunately, these informative supportive figures were not included in your reference.
For example, one graphic showed the percentages of active fund managers who beat the various market categories. The odds were not encouraging. Another graphic displayed the accumulated profit difference between active and passive funds for the recent 10-year period for four fund classes. Again, the data demonstrated the shortfall for the average active fund when measured against an Index benchmark. These graphics would surely impress MFO participants.
Regardless, thank you for the heads-up alert. I subscribe to the LA Times, but often ignore the Sunday business section in favor of some Sunday morning tennis and a lot of Sunday afternoon football.
Reply to @MJG: Tom Petruno has been one of my favorite financial writers over the years. Its a shame he left the LA Times in 2011, and now only writes an occasional piece for the Times. Regards, Ted
If folks are interested, I'll share the SPIVA report tomorrow. It's the S&P Index Versus Active comparisons that I referred to in the October cover essay. It's likely that I need Charles to think through the implications of some of the author's decisions about, for example, style drift. I haven't highlighted it up until now because there are so many places where I sort of paused and went "really?"
It directly addresses the questions of (1) likelihood of passive outperforming by fund type and (2) magnitude of outperformance.
For now, though, I thought I'd share one smaller bit of data. This is Morningstar's Upside and Downside Capture Ratio calculation for the S&P500 and the average large cap blend fund. It's utterly predictable that the average fund trails on the upside because of the drag of cash and expenses. It's disturbing that it also trails on the downside, when some combination of a small cash buffer and ... oh, skill, should have given it some protection.
Yes, I would greatly appreciate your assessments of the SPIVA releases on a regular basis.
I would also anticipate that your assessments would be more useful to the MFO membership if you simultaneously reviewed the most current issue of the Standard and Poors’ Persistency scorecard. These two documents go hand and glove together in terms of judging the value added contributions of actively managed mutual funds. They identify the most likely investment categories that active management delivers excess returns, Alpha.
Your assessments would be particularly necessary these days given the frequent S&P researcher team turnover rates that are assigned to generate these two reports. The data is the data; I trust its accuracy. The interpretations are more challengeable given the evolving research crew. Just contrast the earlier SPIVA reports against the current versions as evidence of these changes and their impact. S&P seems to delegate the SPIVA duties to relative rookies.
On a second matter, I am not a committed fan of the way Morningstar constructs its Upside and Downside Capture Ratios. In its current form it is too crude a tool, with only limited applicability. For equities, all equities, it is singularly compared to the S&P 500 performance. That’s acceptable for the fund category that you selected for illustrative purposes, but not acceptable when judging a capture ratio for a more volatile small cap fund. Morningstar is repeating the same mistake they made when first judging and ranking funds in its earlier history. The benchmark for the Capture Ratio scoring must be more carefully chosen.
I surely do not want to increase your heavy burdens associated with the MFO website. The site is a priceless resource for the entire mutual fund community, and I am certainly including the fund managers themselves in that group. Please do not fall victim to becoming overcommitted; that could erode your zeal for the MFO project that is perfectly reflected in every monthly summary that you craft with considerable skill.
Thank you. I hope you don't object to my informal greeting.
Sorry about the delayed response. Fifty-two Propaganda exams and five senior project drafts cry out for attention and repair, so I'm running way off.
In general, the SP stuff worries me a bit because it's pretty poorly written. I know that's not a direct indictment of the quality of the analytic work, but it's not immediately reassuring either. I'll try to curl up with a good Persistency scorecard later this week and see if I can get a better sense of it.
This drum is getting old, but I will beat it again. Whether a fund beats its index is not as important as HOW it goes about getting the returns it does. I will gladly consider a fund that achieves 85% of its 'benchmark' with only 80% of the risk. I am looking for acceptable portfolio returns with risk/volatility that is reasonable. If a manager has a history of downside/volatility that is higher than the market, I would expect returns that are also higher. The issue for me is not about whether a manager beats a 'benchmark', but what the overall risk/reward is.
Nobel Laureate Bill Sharpe would be proud of your understanding of the risk/reward tradeoff. His Sharpe Ratio was one of the earliest attempts to capture and characterize both critical aspects of the investment puzzle. Later researchers, standing on his shoulders, refined his formulations.
Indeed, if your active fund manager accepts more risk in a bull market scenario, an investor would expect outsized, above average returns. Of course, the reverse would be true under bear market conditions; under those circumstances, an investor would anticipated above average downward penalties. A symmetry should exist. ( A really skilled active fund manager should operate to dampen those downward penalties. )
That is one of the essential findings that evolved from Sharpe’s early 1960s Capital Asset Pricing Model (CAPM). From that model, much to Sharpe’s annoyance, research peers and financial journalists coined the sensitivity of an investment to the overall market movement its Beta attribute. Since those early pioneering days, other factors have been identified that contribute to the investments pricing mechanism (size, value, momentum). Also various offshoots of Prospect Theory suggest that Beta is likely not symmetrical depending on either an upward or downward trending equity marketplace (like the Sortino Ratio).
I suspect, based on the CAPM concept, Professor Snowball was astonished and disappointed by the general results he reported in his chosen illustrative example between the S&P 500 Index returns and those registered by the Large Cap Blend active fund category. The Large Cap Blend Capture Ratios fell short of their benchmark targets in both directions.
Given the long-term consistency of both the SPIVA report findings and its sister Persistency Scorecard semi-annual report conclusions, the Capture Ratios did not shock me. It is yet another illustration of the daunting hurdles that active fund management continues to trip-over.
Bill Sharpe explained this compactly and convincingly in his 1960s analysis using simple arithmetic and a market-wide overall returns balance equation. Among the active manager cohort, there must be a loser for every winner. Before costs, it is a zero sum game. Given research and trading costs, and other management fees, it is a negative sum game. That’s equivalent to a racetrack that typically only returns about 85 % of the total waged in any given race to its betting public. The 15 % withheld covers operating costs, profits, and State tax largess.
So, on average, active managers do not reward their clients with above average returns. That’s impossible. On the downside, active managers again failed to protect their customers portfolios. The evidence has been accumulating for decades and has reached overwhelming proportions. Skilled managers do exist, but they are rare.
Even those who sport an excess returns average record find persistency a daunting challenge. Costs matter greatly. The near empty winners circle is populated by active managers who aggressively control costs and have low portfolio turnover ratios.
These few managers do thrive. I’m sure you hunt them out for your clients. The Vanguard Health Care fund (VGHCX) is a prime example. Over the last decade, it has outperformed its benchmark in 9 out of 10 years, including two annual downward market thrusts. Its low cost structure and low portfolio turnover rates made it a likely candidate to do so.
Even institutions are finally realizing the extreme difficulties of identifying superior active fund managers. The huge California retirement agency CALpers will likely be increasing its passively managed equity portfolios from a 30 % overall level to a 60 % commitment in the near future. The CALpers team carefully screened active managers, but these chosen Ones failed the acid market exposure over fair test periods.
The Litman/Gregory mutual fund organization, which emphasized portfolios constructed by a diligent and detailed multi-manager selection process, has not generated superior rewards. Manager changes have been made far more frequently than planned. Litman/Gregory is discovering that management selection is a tough nut.
Allow me to take exception to your assertion that folks would be satisfied with an 85 % return when accompanied by an 80 % risk statistic (undefined at this moment). I’m sure some folks would find that an acceptable tradeoff. I’m equally sure many other folks would not be so happy, especially those with a long-term investment horizon.
So I would never be sanguine over quoting any single set of target numbers for investors as a whole. It depends on a multi-dimensional set of requirements, preferences, wealth status, knowledge base, age, goals, and risk adversity attributes. I’m sure I am preaching to the choir now.
Choosing successful active mutual fund managers is a hard road. I know you try; most everyone at MFO tries; so do I. I have prospered a little but have been saddled with some poor choices as well as some successful ones. I am not sure it is worth the effort and the heartache. I hope and wish you more success than I enjoyed in this demanding and vexing arena.
Reply to @MJG: Hi MJG. Your commentary on Sharpe ratio is good. One of the most important things for investors is to determine what return they need to be able to accomplish their goals. For most investors, their long-term goal is knowing what retirement might look like: age, sources of income, no work or part-time work or volunteer work with no pay. These and other factors, including expected cash flow needs (wants), should enable the investor to determine what kind of return they need from the investment portfolio. We usually see a number in the 4-6% range. Frankly, 6% is a bit scary, but 5% is usually a pretty good number. And 5% was pretty easy the last 10 years because declining interest rates provided bond fund investors with outsized returns. Now that we are in a different climate, we believe that 'conservative' investors who need 4-5% will need to realign their thinking. Ultra-conservative might no longer be 100% bonds. While bonds will probably still be less volatile than stocks, there may be greater 'risk', at least in terms of not reaching long-term goals, than a conservative mix of stocks and bonds and alternatives.
If that is the case going forward, and I believe it will be (at least until we can once again lock in yields of 4-5% with some degree of 'safety'), then investors will be more concerned with volatility and risk factors than ever before. "Ok, I'm willing to invest in some stock funds, but I really want to concentrate on relatively low risk." This is where our efforts to find funds like I described in the previous post become prudent. Investors like the people I just described may never be able to stomach the volatility of a passive strategy, no matter that the 'average' nreturn of a passive portfolio is as good as or better than a portfolio that attempts to manage volatility. My experience over 30 years is that most 'conservative' investors will simply not stay the course when risk/volitility becomes reality. Managing risk will be key, and this is especially important when investors move from the accumulation to the distribution phase of their lives.
Since none of us knows what the future will bring, including near-gods Gross and Gundlach, I would suggest that managing risk may well be the most important part of investing. And this is where I still believe that for most people, a manager that helps them achieve their goals, that does ok but maybe not not great in bull markets, but really helps protect some on the downside, is a manager they migh retain rather than dump and run to cash when the going gets tough.
I find it easy to accept the lessons that you learned and now apply in your 30 years of real world investment advisor experience. There is no substitute for experience.
Your findings from that experience that investors of all ilk have difficulty “staying the course” for even agreed portfolios doesn’t particularly surprise me. You do not have an easy task.
That finding precisely meshes with military historical records that reveal in many direct fire fight combat engagements, only a small fraction of those soldiers participating actually fired their weapons. Regardless of any heroic pre-fight talk, many soldiers abandoned the fight immediately after the first shot was fired. For decades now, military training has focused on addressing this issue of encouraging the troopers to “stay the course”.
I respect that you speak authentically and authoritatively.
There is no doubt that you truly try to identify the proper course of action for each of your clients, and that you adjust your recommendations to better match the special needs and anxieties of each of them. Portfolio construction is a very time dependent personal matter. That’s exactly the reason I often choose not to make specific endorsements to MFO members. I trust the authenticity of your Board comments.
There is no doubt that you speak from an authoritative position. Your 30 years of field experience means that you have successfully survived both boom and bust periods. Both periods must have been a challenge given that your philosophy is to emphasize the downside protection of wealth. That usually translates to a lower Beta portfolio which makes clients unhappy during the boom cycle. Free lunches are rare. I too have a conservative investment philosophy.
Best wishes for your continued success in your professional career, and also for your personal portfolio growth. The MFO panel benefits from your keen insights.
Some thoughts... I think the flood of dollars to ETFs actually helps active managers uncover more opportunities especially during huge "Risk On / Risk Off" days.
Active management tends to own a variety of things, and their relative performance can be dictated by small/mid-cap out/underperformance relative to large caps. With how well small cap has done this year, active management's batting average should improve this year.
Management fees are always one part of the picture. It seems like Morningstar makes them the whole picture in their screens. Some of the best funds have the highest fees; for example, when Robert Gardiner was running the Wasatch Micro Cap fund, it hit its 10-year number in 2005 and had ANNUALIZED +25% per year for the last 10 years. That fund charged 2.25% in management fees. Robert Gardiner is now at Grandeur Peak and has assembled a good team there. I don't think you do yourself a service if you screen out the funds in the highest quartile of fees.
I do agree that long-term risk-adjusted returns are good to focus on and remember with a grain of salt that upside volatility can easily become downside volatility no matter what the metrics say. After all, Risk Parity funds looked great going into this year, just as Managed Futures (trend/momentum following) looked great going into 2011.
I use active management pretty heavily because I do not want to own the market. I don't invest with managers that are index huggers. I watched a webcast from DWS RREEF (REIT) fund and they had these sector deviations from the index of less than 1%, so they are definitely stock pickers, but they are hugging the index sector weights for some odd reason (probably to please institutional consultants).
I believe that active management adds a layer of long-term investing on top of the space they are investing in. I don't believe in buy and hold. I don't want to own financials or energy in all markets, for example.
What bothers me about articles like this is the lack of any mention of the importance of maintaining one's portfolio with annual rebalancing and/or dollar-cost-averaging. That way you have a better chance of beating the market over time than with a strict buy-and-hold strategy.
Comments
I want to thank LA Times business writer Tom Petruno for the fine article that fairly assesses the pros and cons of the active/passive mutual fund controversy. I especially want to thank you for bringing the wide MFO audience’s attention to this excellent summary of current comparative performance.
Petruno offers a balanced evaluation and identifies those fund categories where an active fund proponent can increase his odds of selecting a fund manager who can add Alpha to annual returns.
Although the introductory graphic embedded some sound financial advice, the other graphs that accompanied the article were more dense with detailed comparative numbers that highlighted performance disparities. Unfortunately, these informative supportive figures were not included in your reference.
For example, one graphic showed the percentages of active fund managers who beat the various market categories. The odds were not encouraging. Another graphic displayed the accumulated profit difference between active and passive funds for the recent 10-year period for four fund classes. Again, the data demonstrated the shortfall for the average active fund when measured against an Index benchmark. These graphics would surely impress MFO participants.
Regardless, thank you for the heads-up alert. I subscribe to the LA Times, but often ignore the Sunday business section in favor of some Sunday morning tennis and a lot of Sunday afternoon football.
Best Wishes.
Regards,
Ted
It directly addresses the questions of (1) likelihood of passive outperforming by fund type and (2) magnitude of outperformance.
For now, though, I thought I'd share one smaller bit of data. This is Morningstar's Upside and Downside Capture Ratio calculation for the S&P500 and the average large cap blend fund. It's utterly predictable that the average fund trails on the upside because of the drag of cash and expenses. It's disturbing that it also trails on the downside, when some combination of a small cash buffer and ... oh, skill, should have given it some protection.
David
Hi Professor David,
Yes, I would greatly appreciate your assessments of the SPIVA releases on a regular basis.
I would also anticipate that your assessments would be more useful to the MFO membership if you simultaneously reviewed the most current issue of the Standard and Poors’ Persistency scorecard. These two documents go hand and glove together in terms of judging the value added contributions of actively managed mutual funds. They identify the most likely investment categories that active management delivers excess returns, Alpha.
Your assessments would be particularly necessary these days given the frequent S&P researcher team turnover rates that are assigned to generate these two reports. The data is the data; I trust its accuracy. The interpretations are more challengeable given the evolving research crew. Just contrast the earlier SPIVA reports against the current versions as evidence of these changes and their impact. S&P seems to delegate the SPIVA duties to relative rookies.
On a second matter, I am not a committed fan of the way Morningstar constructs its Upside and Downside Capture Ratios. In its current form it is too crude a tool, with only limited applicability. For equities, all equities, it is singularly compared to the S&P 500 performance. That’s acceptable for the fund category that you selected for illustrative purposes, but not acceptable when judging a capture ratio for a more volatile small cap fund. Morningstar is repeating the same mistake they made when first judging and ranking funds in its earlier history. The benchmark for the Capture Ratio scoring must be more carefully chosen.
I surely do not want to increase your heavy burdens associated with the MFO website. The site is a priceless resource for the entire mutual fund community, and I am certainly including the fund managers themselves in that group. Please do not fall victim to becoming overcommitted; that could erode your zeal for the MFO project that is perfectly reflected in every monthly summary that you craft with considerable skill.
Thank you. I hope you don't object to my informal greeting.
Best Wishes.
Regards,
Ted
Most Current SPIVA Mid-Year 2013;
http://www.spindices.com/documents/spiva/spiva-us-mid-year-2013.pdf
Sorry about the delayed response. Fifty-two Propaganda exams and five senior project drafts cry out for attention and repair, so I'm running way off.
In general, the SP stuff worries me a bit because it's pretty poorly written. I know that's not a direct indictment of the quality of the analytic work, but it's not immediately reassuring either. I'll try to curl up with a good Persistency scorecard later this week and see if I can get a better sense of it.
David
Hi BobC,
Nobel Laureate Bill Sharpe would be proud of your understanding of the risk/reward tradeoff. His Sharpe Ratio was one of the earliest attempts to capture and characterize both critical aspects of the investment puzzle. Later researchers, standing on his shoulders, refined his formulations.
Indeed, if your active fund manager accepts more risk in a bull market scenario, an investor would expect outsized, above average returns. Of course, the reverse would be true under bear market conditions; under those circumstances, an investor would anticipated above average downward penalties. A symmetry should exist. ( A really skilled active fund manager should operate to dampen those downward penalties. )
That is one of the essential findings that evolved from Sharpe’s early 1960s Capital Asset Pricing Model (CAPM). From that model, much to Sharpe’s annoyance, research peers and financial journalists coined the sensitivity of an investment to the overall market movement its Beta attribute. Since those early pioneering days, other factors have been identified that contribute to the investments pricing mechanism (size, value, momentum). Also various offshoots of Prospect Theory suggest that Beta is likely not symmetrical depending on either an upward or downward trending equity marketplace (like the Sortino Ratio).
I suspect, based on the CAPM concept, Professor Snowball was astonished and disappointed by the general results he reported in his chosen illustrative example between the S&P 500 Index returns and those registered by the Large Cap Blend active fund category. The Large Cap Blend Capture Ratios fell short of their benchmark targets in both directions.
Given the long-term consistency of both the SPIVA report findings and its sister Persistency Scorecard semi-annual report conclusions, the Capture Ratios did not shock me. It is yet another illustration of the daunting hurdles that active fund management continues to trip-over.
Bill Sharpe explained this compactly and convincingly in his 1960s analysis using simple arithmetic and a market-wide overall returns balance equation. Among the active manager cohort, there must be a loser for every winner. Before costs, it is a zero sum game. Given research and trading costs, and other management fees, it is a negative sum game. That’s equivalent to a racetrack that typically only returns about 85 % of the total waged in any given race to its betting public. The 15 % withheld covers operating costs, profits, and State tax largess.
So, on average, active managers do not reward their clients with above average returns. That’s impossible. On the downside, active managers again failed to protect their customers portfolios. The evidence has been accumulating for decades and has reached overwhelming proportions. Skilled managers do exist, but they are rare.
Even those who sport an excess returns average record find persistency a daunting challenge. Costs matter greatly. The near empty winners circle is populated by active managers who aggressively control costs and have low portfolio turnover ratios.
These few managers do thrive. I’m sure you hunt them out for your clients. The Vanguard Health Care fund (VGHCX) is a prime example. Over the last decade, it has outperformed its benchmark in 9 out of 10 years, including two annual downward market thrusts. Its low cost structure and low portfolio turnover rates made it a likely candidate to do so.
Even institutions are finally realizing the extreme difficulties of identifying superior active fund managers. The huge California retirement agency CALpers will likely be increasing its passively managed equity portfolios from a 30 % overall level to a 60 % commitment in the near future. The CALpers team carefully screened active managers, but these chosen Ones failed the acid market exposure over fair test periods.
The Litman/Gregory mutual fund organization, which emphasized portfolios constructed by a diligent and detailed multi-manager selection process, has not generated superior rewards. Manager changes have been made far more frequently than planned. Litman/Gregory is discovering that management selection is a tough nut.
Allow me to take exception to your assertion that folks would be satisfied with an 85 % return when accompanied by an 80 % risk statistic (undefined at this moment). I’m sure some folks would find that an acceptable tradeoff. I’m equally sure many other folks would not be so happy, especially those with a long-term investment horizon.
So I would never be sanguine over quoting any single set of target numbers for investors as a whole. It depends on a multi-dimensional set of requirements, preferences, wealth status, knowledge base, age, goals, and risk adversity attributes. I’m sure I am preaching to the choir now.
Choosing successful active mutual fund managers is a hard road. I know you try; most everyone at MFO tries; so do I. I have prospered a little but have been saddled with some poor choices as well as some successful ones. I am not sure it is worth the effort and the heartache. I hope and wish you more success than I enjoyed in this demanding and vexing arena.
Best Wishes.
If that is the case going forward, and I believe it will be (at least until we can once again lock in yields of 4-5% with some degree of 'safety'), then investors will be more concerned with volatility and risk factors than ever before. "Ok, I'm willing to invest in some stock funds, but I really want to concentrate on relatively low risk." This is where our efforts to find funds like I described in the previous post become prudent. Investors like the people I just described may never be able to stomach the volatility of a passive strategy, no matter that the 'average' nreturn of a passive portfolio is as good as or better than a portfolio that attempts to manage volatility. My experience over 30 years is that most 'conservative' investors will simply not stay the course when risk/volitility becomes reality. Managing risk will be key, and this is especially important when investors move from the accumulation to the distribution phase of their lives.
Since none of us knows what the future will bring, including near-gods Gross and Gundlach, I would suggest that managing risk may well be the most important part of investing. And this is where I still believe that for most people, a manager that helps them achieve their goals, that does ok but maybe not not great in bull markets, but really helps protect some on the downside, is a manager they migh retain rather than dump and run to cash when the going gets tough.
Hi BobC,
Thank you so much for your outstanding reply.
I find it easy to accept the lessons that you learned and now apply in your 30 years of real world investment advisor experience. There is no substitute for experience.
Your findings from that experience that investors of all ilk have difficulty “staying the course” for even agreed portfolios doesn’t particularly surprise me. You do not have an easy task.
That finding precisely meshes with military historical records that reveal in many direct fire fight combat engagements, only a small fraction of those soldiers participating actually fired their weapons. Regardless of any heroic pre-fight talk, many soldiers abandoned the fight immediately after the first shot was fired. For decades now, military training has focused on addressing this issue of encouraging the troopers to “stay the course”.
I respect that you speak authentically and authoritatively.
There is no doubt that you truly try to identify the proper course of action for each of your clients, and that you adjust your recommendations to better match the special needs and anxieties of each of them. Portfolio construction is a very time dependent personal matter. That’s exactly the reason I often choose not to make specific endorsements to MFO members. I trust the authenticity of your Board comments.
There is no doubt that you speak from an authoritative position. Your 30 years of field experience means that you have successfully survived both boom and bust periods. Both periods must have been a challenge given that your philosophy is to emphasize the downside protection of wealth. That usually translates to a lower Beta portfolio which makes clients unhappy during the boom cycle. Free lunches are rare. I too have a conservative investment philosophy.
Best wishes for your continued success in your professional career, and also for your personal portfolio growth. The MFO panel benefits from your keen insights.
Active management tends to own a variety of things, and their relative performance can be dictated by small/mid-cap out/underperformance relative to large caps. With how well small cap has done this year, active management's batting average should improve this year.
Management fees are always one part of the picture. It seems like Morningstar makes them the whole picture in their screens. Some of the best funds have the highest fees; for example, when Robert Gardiner was running the Wasatch Micro Cap fund, it hit its 10-year number in 2005 and had ANNUALIZED +25% per year for the last 10 years. That fund charged 2.25% in management fees. Robert Gardiner is now at Grandeur Peak and has assembled a good team there. I don't think you do yourself a service if you screen out the funds in the highest quartile of fees.
I do agree that long-term risk-adjusted returns are good to focus on and remember with a grain of salt that upside volatility can easily become downside volatility no matter what the metrics say. After all, Risk Parity funds looked great going into this year, just as Managed Futures (trend/momentum following) looked great going into 2011.
I use active management pretty heavily because I do not want to own the market. I don't invest with managers that are index huggers. I watched a webcast from DWS RREEF (REIT) fund and they had these sector deviations from the index of less than 1%, so they are definitely stock pickers, but they are hugging the index sector weights for some odd reason (probably to please institutional consultants).
I believe that active management adds a layer of long-term investing on top of the space they are investing in. I don't believe in buy and hold. I don't want to own financials or energy in all markets, for example.