Wednesday, October 22, 2014

Active v. Passive Investing - What the Experts Say

Continuing on the narrative of the prior post, this post adds the thoughts of John Bogle and Charles Ellis to the active versus passive debate.

Fund managers aim to maximize investment returns. Over time, markets deliver returns on their own. They’re what we call the market return. We pay managers to deliver more than the market return. In fact, after costs, they rarely do. John Bogle who is a sceptic of active fund management described it as an industry built on witchcraft.

Of course, the fund management companies could justify high fees if they added significant value. Unfortunately, the performance of actively managed funds is consistently less than those realized by the market as a whole.

Mr. Bogle says: “We have the most prevalent rule that applies to fund managers everywhere, and that is reversion to the mean. A fund that gets way ahead in the market falls way back behind it. It’s witchcraft in the sense that it’s managers hovering over a table thinking that they have the answer. The intellectual basis for indexing is (as I’ve said), is gross return minus cost equals net return. Period. What is the intellectual basis for active management? I’ve never heard one. The closest I have come is a manager saying ‘I can do better’. They all say ‘I can do better’, 100 percent of them say I can do better than the market. But 100 percent don’t. Probably about one percent of managers can beat the market over the very long term.”

In fact, in many cases active funds were trounced by passive funds. For example, over ten years ended 2012, passive North American equity funds delivered average returns of 2.6%, as opposed to 1.7% delivered by active funds. Passive Japanese equity funds recorded average returns of 2.6%, compared to 2.0% for active. What’s more, these returns do not take into account the impact of fund fees.

Currently we have exceptionally talented portfolio managers who are trying to out-compete one another in a giant negative-sum-game. Not a zero-sum-game, but a negative-sum-game, because while they’re doing this, they are extracting charges and fees on an annual basis which erode the capital of investors. In this competition of trying to out-compete one another, there are bound to be winners and losers every year, and there are some that claim that they add value, i.e. they win more often than they lose, but if we actually examine the data, it is nearly impossible to work out who is going to outperform the rest on a consistent basis. For virtually all investors, making a decision as to which active fund to invest in is like a lottery.

This underperformance is understandable. Fees are often too high and have been rising over the past half century as skillful and diligent investment managers using technology along with near immediate dissemination of new information (think Reg. FD) have made the markets increasingly efficient. Thus, most managers will be unable to absorb the costs of trading and fees and still achieve better-than-market rates of return. Underperformance after costs is not just understandable; it is to be expected as professional investors’ trading went from a small minority 50 years ago to an overwhelming majority today.

The real valued added for investors is centered on counseling—defining the appropriate long-term objectives, risk constraints, liquidity needs, and market realities.

Gradually, however, investors have been shifting from active performance managers to indexing. The pace may appear slow, but it has been accelerating.

It is ironic that the skills of active managers have made it improbable that—other than by random chance—any specific active manager will outperform the market index for clients. Indeed, the high cost of active management combined with its less than market average track record - and the near impossibility of identifying the next star performer - should make the average investor wary.

CBlakely, CFP®       10/2014

Sources: Financial Analysts Journal July/August 2014, Volume 70 Issue 4, Rise and Fall of Performance Investing, Charles D. Ellis, CFA.   AAII Journal, June 2014, Achieving Greater Long-Term Wealth through Index Funds

Wednesday, October 15, 2014

Active v. Passive Investing - What Works and for Whom

The next several posts will attempt to add some clarity as to which strategy may work best for different types of investors.

Its fund managers whom the vast majority of us trust with our long-term stock and bond investments. They choose which stocks and other assets to invest in on our behalf - and decide when the time is right to buy and sell. But, time and again, research has shown that we over-estimate quite how talented fund managers are and how much value they add.
For all the talk of “star” performers, the empirical evidence shows that only a tiny fraction of them outperform the market with any meaningful degree of consistency. In the UK, researchers examined 516 UK equity funds between 1998 and 2008, and found that just 1 percent of managers were able to produce sufficient returns to cover their trading and operating costs.

The remaining 99 percent of fund managers failed to deliver any outperformance - either from stock selection or from market timing (always a suckers bet).

While a tiny number of “star” managers do exist, they are incredibly hard to identify. Furthermore, the research shows it takes over 20 years of performance data to be 90 percent sure that a particular manager’s outperformance is genuinely due to skill.
According to the research, for most investors, it is simply not worth paying the vast majority of fund managers to actively manage their assets. We think we’re paying for better performance and that greater skill will produce superior results. But investing almost always works the opposite way round. The less you pay, the more you keep. Counter-intuitive, but it’s true.
The investment industry and the media (think CNBC) tend to focus on historical fund performance. But Morningstar research shows that the most reliable indicator of long-term investment returns is in fact cost. Nobel Prize-winning economist Eugene Fama says: "If you're paying big management fees, the cumulative effect of that, given the way compounding works, is enormous."

So what sort of impact do fees and charges have on the value of our long-term investments? Well, over 40 years, your retirement fund, worth say $500,000 with no fees, would be reduced to just $349,100 with an annual charge of 1.5 percent. If overall charges reach 2.5% - and when trading costs are included, that’s not uncommon - this reduces the value of your retirement fund to less than $280,000.

So, even at 1.5 percent, almost a third of your retirement fund is lost in fees, rising to 44 percent when charges increase to 2.5 percentage points.
The message for investors is clear: keep costs as low as possible or find the one percent of funds that truly outperform over the long-term, this is crucial to a successful investment experience. With the stakes so high it makes sense to seek out the advice of a credentialed investment advisor who will look at the big picture with you.

CBlakely CFP®, CTFA           10/2014

Sources: Transcript of interview with Nobel Prize winning Professor Eugene Fama, Pensions Institute (Cass Business School) Discussion Paper PI-1404, Morningstar