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 

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