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

An Interesting Summer Indeed!

I took most of this summer off. Not because I'm too busy to write or not because there was nothing of interest to write about (on the contrary). Nope, it was because I spent most of the summer rehabbing from a very complex surgery.

The condition was described to me as an aortic dissection, which occurs when a tear in the inner wall of the aorta causes blood to flow between the layers of the wall of the aorta. Aortic dissection is a medical emergency and may lead to death rather quickly even with treatment, as a result of decreased blood supply to other organs (brain), cardiac failure, and sometimes, as in my case, rupture of the aorta. My aorta tore right as I was being hooked up to life support. Lucky timing, HooWah!

Why Am I telling you this? Two reasons, first, if you have high blood pressure make sure you treat it. It's easy and inexpensive to treat hypertension. There is a reason it's called the silent killer, cause you normally feel fine right up to when you don't, and by then it may be too late. 

Next, because of technology. Without the current technology available to the Doctors in the operating room, my chance of survival was exactly zero. There was no chance. But today, with mechanical valves, Dacron™ sleeves to replace arteries, new surgical techniques, patient monitoring systems and integrated big data (yep) this second chance becomes reality for me and tens of thousands of other patients every year.

Health care accounts for one in five dollars spent in the United States. It’s 17.9 percent of the gross domestic product, up from 4 percent in 1950. And technology has been the main driver of this spending: new drugs that cost more, new tests that find more diseases to treat, new surgical implants and techniques. Much of the spending has been worth it. While the U.S. spends the most of any country by far, health care is becoming a larger part of nearly every economy. That makes sense. Better medicine is buying longer lives. 

How does this segue into investing? Well, speaking of amazing new medical devices and technology, Vanguard has low cost Health Care ETF - (ticker symbol VHT) with a solid risk reward profile. The return since inception - after taxes on distributions - is 7.08 percent. The fund was started in 2004. The passively managed fund, which has an expense ratio of 14 basis points, tracks the performance of a benchmark index that measures the investment return of stocks in the health care sector, and holds names like Johnson & Johnson and Gilead Sciences - companies involved in providing medical or health care products, services, technology, or equipment.

Now factor in the Boomers whose first wave is already hitting the retirement years and have the money to afford procedures (elective and otherwise) and Medicare that spent $562B in 2012 and that's pretty good built in demand for medical technology and devices in my opinion.

Should everyone allocate assets to a sector fund? No, not all investors should allocate assets to this sector or any other sector for that matter. What I suggest is talking to your advisor to see if your risk profile permits any allocation and how it fits into your overall strategy. There is additional risk involved when investing in a narrow band of the stock spectrum and the potential for additional reward.

CBlakely, CFP®         09/2013

Keep Taxes Low to Maximize Returns - Here's How

Portfolio research has examined the long-term impact of expenses and taxes on investment returns and concluded that, while asset allocation remains the most important factor affecting variability of returns, keeping costs and taxes low is an important factor for investors who are trying to maximize return.

Because mutual funds may distribute capital gains throughout the year, mutual fund investors are often concerned about losing investment returns to taxes. But individual stock and bond investors are vulnerable to taxes as well, depending on how they manage their investments.

Return lost to taxes sucks, but the good news is you can exercise a good deal of control here. Think about this: diversification and asset allocation are great tools for helping to reduce portfolio volatility and variability, but we're still going to be subjected to the short-term moves of the market, no matter how diligent we might be in setting up our portfolio and selecting our investments. Where we have the greatest degree of control is the area of expenses and tax-efficient implementation. Doesn't it make sense that where we can exercise the most control, we should?

Below is a table that displays where investors who want to minimize taxes may want to place their investments.

Taxable accounts	Tax-deferred accounts such as traditional IRAs, 401(k)s and deferred annuities
Here, you'd ideally place...	Here, you'd ideally place...
Individual stocks you plan to hold more than one year	Individual stocks you plan to hold one year or less
Tax-managed stock funds, index funds, exchange-traded funds (ETFs), low-turnover stock funds	Actively managed funds that may generate significant short-term capital gains
Stocks or mutual funds that pay qualified dividends	Taxable bond funds, zero-coupon bonds, inflation-protected bonds or high-yield bond funds
Municipal bonds, I Bonds (savings bonds)	Real estate investment trusts (REITs) Private equity, partnerships (IRA only)

Also to keep fees as low as possible research index funds and index ETF's and use fee only advisors!

CBlakely CFP®, CTFA                      02/2013

Source: Schwab Insights