Recent Musings

1. When building a portfolio, you basically have two choices.

With the availability of index funds, it’s not difficult to build a portfolio. The question is, what kind of portfolio do you want to build? Or, to put it another way, what are you trying to accomplish?

Do you want to trail the market when it’s going up or when it’s going down?

You can structure your portfolio to be more aggressive than the overall stock market. That will help you when the market is going up but hurt you in down markets. Alternatively, you can structure things to be more conservative than the market, in which case you’ll trail in up markets but lose less when the market is going down. The takeaway being you can’t have it both ways.

Investment returns (in the realm of normal) are within our control. Many people worry about the stock market. It doesn’t need to be that way. If you don’t want to lose sleep worrying about the market, you don’t have to. It’s all about the asset allocation choices you make.

2. When it comes to investments, there’s no such thing as perfect.

No investment is going to be perfect, and we shouldn’t expect it to be. In traditional finance textbooks, investment decisions are presented as a tradeoff between risk and return. If you want more return, you must take more risk. But if you want less risk, you must be content with lower returns.

That is a bit over-simplistic so when evaluating investments, investors should think things through much more carefully. In addition to risk and return, consider an investment’s fees, complexity, liquidity, tax treatment and the overall level of economic certainty or uncertainty.

3. When warranted, be willing to pay more.

It’s worth paying more if you’re getting extra value. Most investors are sensitive to fees and taxes—and they should be—but this comment is a good reminder not to take this too far.

Similarly, if you own an overpriced, underperforming fund, should you hang on forever just because you would have to pay some taxes if you sold?  Of course not. Do the math and don’t be afraid of costs if you think it will pay off in the long run.

4. Don’t fall in love with an investment.

Just as there’s no perfect investment, there is no investment that you should expect to remain perfect for all time. I see this as particularly applicable to thinking about index funds—an investment that appears awfully close to perfect right now.

I believe that low-cost index and factor funds are the best way to invest—and there’s plenty of supporting data. But we should never be too comfortable. Currently, indexing works exceptionally well. But it may not work forever. Markets are dynamic. Indexing might begin to work less well or other forms of investing might begin to work better. Anything can happen, so be careful. When it comes to your investments, you don’t want to be blindsided.

CBlakely, CFP®, CTFA

Why Low-Cost Investing Likely Results in Above Average Returns

Several studies found that only the top 2 to 3 percent of active-fund managers have enough skill to cover their costs. It’s hard enough to save for a house or retirement. So why pay big fees for subpar investment returns? Maybe think about low-cost investing, with an eye toward index investing.

To quote Nobel Prize winning economist Eugene Fama on active managers: “You’re charging people for stuff you can’t deliver.”

We are in the early stages of a move toward low-cost investing as huge sums of money have been flowing out of actively managed mutual funds and into index funds. According to Barry Ritholtz, “we are in the middle of the Copernican Revolution about the proper way to invest or at least the rational way to invest.”

It’s easy to think — by seeing the ads and reading newspaper articles — that if you’re just clever enough, you’re going to win. The delusion comes in the form of how the stock markets actually work.  We don’t understand the negative-sum nature of active investing. Whatever you win, I lose. Whatever I win, you lose, and we both pay to play that game. So the negative-sum nature of investing is one problem that’s often overlooked.

And then there is the second problem, which is, most people suffer from overconfidence, particularly in noisy environments where the feedback is weak. That describes the stock market. It’s incredibly noisy and it’s really easy to misinterpret what the return on your portfolio means.

Simple, perhaps, but elusive. In part because the alternative — the gamble of picking stocks — is so seductive. Which may explain why it took so long for index funds to really catch on. The index fund is more predictable, and boring — which, as Jack Bogle sees things, is its virtue. “It diversifies away the risk of individual investments. It diversifies away the risk of picking a hot manager and diversifies away the idea that you can pick market sectors like healthcare, technology, or whatever it might be.”

And then there’s the cost comparison. According to Vanguard founder Jack Bogle, “They charge a lot for this service. We estimate the average expense ratio is almost one percent for an actively managed fund. Then these active funds, all of them have sales loads. The index funds do not. The active funds further turn over their portfolios at a very high rate and that’s costly. You add that all up and the cost of owning a mutual fund on average is two percent. You can buy an index fund of, an S&P 500 Index Fund, let’s say, for as little as four basis points, four one-hundredths of one percent. In a 7 percent market, you’re going to get 6.96 percent.”

That difference — two percent versus four one-hundredths of one percent — may not sound like a lot. But over time, those numbers are compounded by what Bogle calls the “relentless rules of humble arithmetic.”

Again according to Jack Bogle, “if the market return is 7 percent and the active manager gives you 5 after that two percent cost, and the index fund gives you 6.96 after that four basis point cost — you don’t appreciate it much in a year — but over 50 years, believe it or not, a dollar invested at 7 percent grows to around $32 and a dollar invested at five percent grows to about $10. Think what an investor thinks about when he looks at that number. He says, “Wait a minute! I put up 100 percent of the capital. I took 100 percent of the risk and I got 33 percent of the return.” Well, anybody that thinks that’s a good deal, I’ve got a bridge I want to sell them.”

To paraphrase Bogle, here’s the reality of the actively-managed mutual fund business, you get precisely what you don’t pay for. So, if you pay nothingⁱ, you get everything!

Now there are those who can and some people have and have for long periods of time. Look no further than Warren Buffett. The challenge is being able to identify in advance who will outperform the market, for them to beat the market consistently year over year, and then to do it in excess of costs, fees, taxes, commissions. How can an investor tell when it is luck or skill? 

The bottom line is most people are better off with low-cost indexing for most of their invested money. Active investment management may have a role in asset allocation and portfolio construction, but only when it’s low cost, adds diversification and is not used to exacerbate behaviors detrimental to accumulating wealth.

C. Blakely CFP®, CTFA                        10/2017

ⁱ - by nothing, I mean almost nothing.

Sources: Bloomberg View - Ritholtz, Freakonomics – Bogle interview, Fama Interview 

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 – SensibleInvesting.tv Link to the video

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

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.

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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