Hi Guys,
We have always been taught to “Don’t just Stand there, do something”. That was the way of the American Revolution, still is the style of the Marine Corp, and is effective action for most situations.
But there are exceptions to rules; Investing might just be one such exception. In the investing universe, it might be more rewarding to pervert that guiding axiom to “Don’t just do something, Stand there.” In portfolio management, passivity just might be the key that unlocks the door to treasure booty. Within the last five decades much empirical data have been collected that underpins this wisdom.
Let’s examine the evidence from both a theoretical perspective and from an empirical perspective.
The Theoretical Approach:
A hypothetical model will be formulated that serves as a comparative baseline. All data reported in that model was extracted from Morningstar
A total equity market fund will substitute as a market proxy. I’ll employ the 15-year data as a compromise between the statistical benefits that very long-term data affords and the relevance, timeliness, and freshness of shorter data sets. I’ll assume that a normal distribution applies. Needed is the average annual returns and the return volatility measure (standard deviation).
Further, assume that active mutual fund managers are more or less neutral (often their performance clusters around the norm). The historical data sets suggest that excess profits are rare and that persistent outperformance es
capes existence. Initially suppose that active management does no harm, but likewise, does no good in terms of excess rewards (again, based on past recorded performance).
Given those modeling assumptions, the only difference between a passively managed portfolio and an actively managed one will be the cost structure. The cost only impacts the annual returns, not the statistical distribution. To explore the cost dimension, postulate a realistic active cost of 1.0 %, and also 1.4 % to parametrically study the issue.
As the reference passive powerhouse, the Vanguard Total Stock Market Index (VTSMX) is more fully diversified than its domestic equivalent, the S&P 500. For our purposes, VTSMX will carry the passive investor’s flag.
From Morningstar, the VTSMX fund yielded an average annual return of 5.23 % with a standard deviation of 16.79 % (this is a constructed 15-year average since the fund has not actually existed for that extended period). Then, for this study, an actively managed portfolio would delivered after costs a 4.23 % and a 3.83 % annual return for the two cost structures. Volatility is maintained at the 16.79 % annual level.
Given these data, a simple lookup from any Normal Distribution Statistical Table shows that 52.2 and 53.3 percent of active managers fail to better their passive pacesetter. The incremental cost impose a hurdle that the active manager must overcome to defeat the passive agents.
This conceptual modeling does not bode well off the starting line for active fund management. But if they have any talent whatsoever, the cost penalty handicap should be frequently overcome. The empirical examination that follows demonstrates that even this modest challenge is not successfully navigate by the active management teams.
The Empirical Approach:
Excellent empirical performance data have been collected for decades and much examined in academic and industry studies. Experimental work often produces deep insights and actionable outcomes.
The investment heroes in the passive camp are legendary names: Bogle, Ellis, Bernstein, Buffett, Ferri, Swenson, others. The heroes in the active investment camp are more rare, a handful at best. Even these heroes have suffered bankruptcies sandwiched between euphoric temporary successes. Jesse Livermore, the famed stock operator, tragically comes to mind; he had a rollercoaster career that ended in a 1940 suicide..
The historical evidence is overwhelmingly against an active investment agenda be it institutional managers, market gurus, fund managers, and private citizens. Very few persistently outdo a simple passive approach.
Next, I’ll present several samples that document just how hazardous active investing is to long-term portfolio health.
Here is a very recent reference from the pen of Barry Ritholtz. He reports that in 2012 only 39 % of fund managers outdid the S&P 500.
http://www.ritholtz.com/blog/2013/01/fund-manager-performance-vs-the-sp/Of course you are all familiar with my semi-annual rantings that are coupled to the S&P SPIVA and Performance Persistency Scorecard releases. You can access these at:
http://www.standardandpoors.com/indices/spiva/en/euOver its 10 year history, SPIVA consistently refutes active manager’s excessive and unwarranted excess returns claims. Naturally, a minority of managers do succeed annually, but the Persistency scorecards demonstrate that percentages are below those expected from random luck alone. Skill over luck is hard to identify in any of these reviews.
The sky high fund failure rate frequency (non-survivability) is an advanced warning signal of the superior active fund management illusion.
One typical S&P finding is that “SPIVA consistently shows that indexing works as well for U.S. small-caps as it does for U.S. large-caps.” A second consistent finding is that “In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.”
Even in sectors and in market scenarios where you might anticipate that active management has an opportunity to perform brilliantly, the funds fail to do so. This is a sad, sad tale. Studies like these demonstrate that in spite of their perceived smarts, fund managers are woefully inept at even delivering benchmark Index rewards.
But woeful performance is not limited to institutional giants or fund managers; actively trading individual investors are similarly inept. Both Morningstar and DALBAR have documented this finding for decades.
As poorly as active mutual funds perform relative to a representative benchmark, private investors in these funds fail to capture the diminished returns of the funds that they invest in. Private investors are notorious hot fund seekers and herd-like followers with poor market timing skills. DALBAR will soon release its report for 2012. I anticipate it will be a carbon copy of earlier products. Past releases document that individual investors often receive only one-third to one-half of a fund’s annual returns.
Market timing is not a private investors strong suite; he gets the entry and exit times wrong. Here is a reference that allows you to download the 2012 DALBAR QAIB publication:
http://www.qaib.com/public/downloadfile.aspx?filePath=freelook&fileName=advisoreditionfreelook.pdfThe DALBAR report vividly records just how poorly private investors performed in the 2011 marketplace. Shamefully bad outcomes.
Almost an endless list of other academic and industry research projects buttress the few findings that I included here. In total, it is a comprehensive and compelling body of evidence.
The bottom-line conclusion from an empirical perspective is that active investing is truly a Loser’s Game. Active managers fail much more frequently to achieve passive benchmark returns than the theoretical formulation suggests. This finding signals that these managers are exceptionally prone to human behavioral biases that destroy wealth at a faster pace than the cost handicap implies.
Perhaps they just try too, too hard. As Charles Ellis has concluded in several of his many books, a kind of “benign neglect” might work considerably better over the long haul.
Several other factors, not discussed so far, compound the negative aspects of active fund management. One factor is the very asymmetric nature of their payoff curve. Under the few winning circumstances, the excess returns generated are marginally superior to Indices. For the many more underperforming instances, the payout matrix is much more devastating to portfolio wealth.
A second factor is that the crippling impact of active management has an accumulative effect. As the number of active funds increase within an investor’s portfolio, the likelihood of outperformnce continuously decreases. The underperformance also becomes more problematic as the time horizon expands.
Recognize that active investing produces a multi-dimensional portfolio whammy dependent upon the extensiveness and particular style of the active part. Passive Index investing just might be the smart answer to the wealth-eroding behavior of most private investors.
Your opinions are encouraged and will definitely contribute to this posting.
Best Regards.
