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

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