Wednesday, February 11, 2015

Active v. Passive - The Secret to Winning the Loser's Game

This is the final post on active v. passive investing but before moving on let me briefly summarize.

  • Academic evidence points overwhelmingly to indexing being the best way for the vast majority of people to invest. Index funds should form the biggest part of every portfolio.
  • Mathematically, after costs, the average returns of a passive investor have to exceed the average returns of an active investor.
  • The market cap-weighted index reflects the consensus view of the market and therefore is the ideal starting point for a passive investor.

But the cap-weighted index isn’t perfect and, depending on how much risk you’re prepared to take, you may want to tilt the portfolio towards other types of risk, or beta, such as small company or value stocks.

Again beta is a measure of overall market risk. But what about alpha? That’s the name given to any return provided by an investment over and above the benchmark index.
First and foremost you should be indexing. Alternatively you could tilt your portfolio towards different types of risk.

But is there ever a case for chasing alpha - either by choosing stocks yourself or by employing an active fund manager?

Professor Ken French from Tuck School of Business says: “That’s a great question. Does it make sense for the average investor to invest in an active fund? What I know is that the active investor who does invest in an active fund has to expect to lose relative to a passive strategy.”

Professor John Cochrane from the University of Chicago says: “I take a dim view of active management. For any investor to invest, you have to understand why the person you’re giving your money to is in the half that’s going to make money, and not the half that’s going to lose money. What’s special about him? What’s special about you that you know how to evaluate him?”

Much evidence is stacked against active fund management. But, say for example, in spite of everything academia has said, you still want to take a gamble with part of your portfolio, how do you choose an active fund from the thousands of funds available?

Daniel Godfrey from the Investment Management Association says: “Well certainly not just by looking at past performance. A consumer would need to do a number of things. Firstly they can just offset the decision-making altogether and go to an independent financial adviser, and many do. And they will select funds for them, and that may be a mix of active and passive funds, and that’s a perfectly sensible thing to do.”

Value investing is particularly worth investigating - as are the writings of the man usually credited with founding it - the British-born American academic and professional investor Benjamin Graham.

Like Sharpe and Fama, Graham’s aim was to take the guesswork out of picking stocks. He famously inspired one of his pupils, Warren Buffett. And Buffett’s subsequent success is testimony to the validity of Graham’s approach.

Buffett has described Graham’s book The Intelligent Investor as by far the best book about investing ever written. In it Graham wrote that investment is most intelligent when it is most businesslike.

In his preface to the fourth edition of the book, Buffett said: The sillier the market’s behavior, the greater the opportunity for the business-like investor. Follow Graham and you will profit from folly rather than participate in it.

Whichever route you go down - passive, active or somewhere in between - your behavior is absolutely critical - particularly at times when emotions are running high. Everyone knows the idea is to buy low and sell high, but time and again we do the precise opposite.

Many investors pile in just as the market reaches a top. Then, even worse, they bail out just as prices reach the bottom and are bound to rise again. That kind of behavior is sadly all too typical, and even the professionals are prone to it. The effect on the long-term value of our investments can be catastrophic.

So, how do we as investors curb that sort of self-destructive behavior? Well, one way is to have an automated approach to investing. So, once you’ve chosen a strategy and the level of risk you’re prepared to take, you leave your investments exactly as they are. Either once or no more than twice a year you should rebalance your portfolio to realign it with your risk tolerance. But again, this can be done automatically.

Merryn Somerset Webb from MoneyWeek says, “There are lots of styles that work over the long term. Value works, dividend investing works, momentum investing works if you get it right. All sorts of things work. But they only work if you stick with them."

It also helps to have a financial adviser to keep you on track. Charles Ellis says: “There are two main roles for an adviser. One is to help individuals understand themselves and what their real financial purposes are, and what their anxieties would be. And the second is to hold the client’s hand and encourage them to stay in it for the long term.”

Vanguard founder Jack Bogle says: “Why in the name of peace do we pay any attention to the stock market? It's a giant distraction to the business of investing.”

Of course it doesn’t help that we’re constantly hearing about the markets. There are specialist magazines. Almost every major newspaper has a money section. There are radio shows and, of course, entire television channels devoted to the latest on the markets and where the so-called experts think they’re heading.

And that, in a nutshell, is the secret to winning the loser’s game. First, choose a strategy that’s based on evidence - ideally one designed to capture the returns of the whole market - and then tailor it to your attitude to risk. Secondly, stick to your strategy through thick and thin. Rebalance your portfolio, yes, but most important of all, stay the course.

CBlakely CFP®, CTFA        02/2015

Sources: Winning the Loser’s Game – Charles D. Ellis;  Robin Powell: How to Win the Losers Game – Link to the video

Friday, December 12, 2014

Acive v. Passive: The Most Appropriate Investment Vehicle for the Vast Majority of Investors

In this, the third installment of active v. passive investing we attempt to do a bit of a deeper dive and find out where Nobel Prize winning economists stand on this subject.

It was Nobel Prize winner - Professor Harry Markowitz - who first emphasized the importance of studying the risks and returns of an entire portfolio. Really the cornerstone of all of what we call Modern Portfolio Theory rests on this idea of diversification. And until Harry Markowitz gave what was essentially an engineering analysis of how stock price movements interacted with each other, nobody had ever really considered it. Even though prices don’t move in a smooth fashion, prices do go up and down over time. So a stock will go up and down, sometimes many times over the course of a day, but certainly over longer periods of time. And basically what he discovered was, that’s true and every stock does that, but they don’t do it at the same time, and it’s almost like if you think of two sine waves that are in opposite phase with each other, they ultimately cancel each other out. And even though it was not the case that these stocks were in opposite phase, as long as though they weren’t in exactly the same phase with each other, you still get some dampening effect.

Then, in the 1960s came another important breakthrough, when Professor William Sharpe (also A Nobel Winner) developed what he called the Capital Asset Pricing Model The CAPM, as it’s often referred to, is a model for determining the price of a capital asset such as a stock or a bond in an efficient market. The price, depends on two things - the risk of holding that security when markets fall and the expected return. Ideally, an investor should hold all the available securities within a particular market.

In the CAPM, Sharpe also introduced the concept of market beta - the measure of the volatility of a security, or portfolio, in comparison to the market as a whole.
Sharpe referred simply to market risk. But, in the decades that followed, fellow academics identified specific types of risk, or beta, often referred to as factors. This gave rise in the 1990s to the Fama-French Three-Factor Model.

Professor Ken French from Tuck School of Business says: “What we mean by factors are things that drive common variation across stocks. So if I’m trying to say, well, airline stocks tend to move together, you could imagine an airline stock factor because it’s going to pick up common variation. Or if you say, well, some stocks tend to move a lot when the market goes up, some stocks don't move so much when the market goes up. We can have a market factor in there that just picks up the difference in the way that stocks move relative to the market. We happen to know small stocks tend to move together and big stocks tend to move together. Put together a size factor, something the way we defined it, we had lots of small stocks and we’re short lots of big stocks that would pick up that variation between how small stocks behave and how big stocks behave. So there was the overall sensitivity to the stock market. We also knew small stocks had a higher premium than big stocks and small stocks tended to move together relative to big stocks. And then we also knew value stocks, companies whose ratio of book to market, earnings to price, or cash floated price - something where it was a fundamental of the company divided by the price. Those value stocks tend to have a higher average return than growth stocks.”

To the original three factors - market risk, size and value - French and Fama have since added two more, profitability and investment. So, companies with higher future earnings will have higher stock market returns. And, perhaps surprisingly, firms that increase capital investment tend to produce poorer subsequent performance than those that don’t.

Now some of that might sound a little complicated. But these are the basic building blocks of what is often referred to as the science of the capital markets. These are very important principles with implications for every investor. 

So, how can investors apply the academic evidence - the lessons learned from more than a hundred years of rigorous research? How can we apply that to achieving financial goals?
Most of all, the evidence should make us extremely wary of anyone who claims that they have the knowledge to beat the market. Because markets are fundamentally efficient, consistent outperformance is almost impossible. So, instead of paying large sums in fees to active fund managers to deliver average returns, we should invest instead in passive funds that simply track an index at a much lower cost.

Ultimately, though, it’s not about theories or intellectual arguments at all. It all boils down to simple mathematics.

Nobel Prize-winning economist William Sharpe says: “Think about all the securities in a marketplace and think about a strategy of investing proportionally, or broad indexing. If I have one percent of the money in that market, I’ll buy one percent of the stocks of every company in the market and I’ll buy one percent of the outstanding bonds. So I’ll have a portfolio that truly reflects the marketplace. Then think about all the people engaging in other strategies, active strategies, holding different amounts of this or that. Then you ask at the end of any period - What did the passive investors earn before costs? And let’s say that’s 10 percent, just to take a number. What did the active investors make before costs? It has to be the same number. So, before costs, the total market made 10 percent, the indexers made 10 percent and the active investors made 10 percent. After costs is a different story. A well-designed index fund should have a very low cost of management. It should also have very low turnover, very low transactions costs. Actively managed funds by their very nature have higher management fees, they employ more skilled people. They also have transaction costs because they’re active. So, after costs, the average passive investor must outperform the average active investor. That’s just arithmetic.”

The cost dispute, from an investment perspective, is counter-intuitive. If you think about your purchases in other areas of your life, if you’re out buying a car, you can buy a Porsche or a Mazda – and you’re going to feel a difference in the car. Whether it’s worth that price differential to you, only you as the buyer makes that decision. But you are definitely going to feel that there is a difference in quality in terms of power, styling, finish and so forth. In investing, that equation does not hold. When you think about yourself as a consumer (not an investor), we are used to ‘the more I pay, the higher the quality, or the better the results I get’. You come to investing and it’s just the opposite, and that is a really hard behavior for us to un-learn.

So, the fund industry won’t tell you this - it has far too much to lose by doing so - but by far the most appropriate investment vehicle for the vast majority of investors is the index fund.
Although it’s a relatively simple way to invest, requiring very little maintenance, there are still some very important decisions for index fund investors to make. Which I will elaborate on in the next post.

CBlakely CFP®, CTFA           12/2014

Source: YouTube video interviews of Professors William Sharpe, Kenneth French and Eugene Fama