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

Is What Warren Buffett And Charlie Munger Thought In 1996 Relevant Today?

I was looking at some past Chairman’s Letters from Berkshire Hathaway (penned by Buffett and Munger) and thought you might enjoy some insightful excerpts from the 1996 letter. What was relevant for intelligent investors eighteen years ago remains so today.

On Investment Fees

   “Seriously, costs matter.  For example, equity mutual funds incur corporate expenses - largely payments to the funds' managers - that average about 100 basis points, a levy likely to cut the returns their investors earn by 10% or more over time.  Charlie and I make no promises about Berkshire's results.  We do promise you, however, that virtually all of the gains Berkshire makes will end up with shareholders.  We are here to make money with you, not off you.”

(They are talking about actively managed mutual funds and the current average expense ratio for actively managed funds is about 1.3 percent or 130 basis points. Also worth noting, only 39 percent of active managers beat their benchmarks in 2012. So for the majority of investors in actively managed funds you not only made less than the average index fund investor you paid more for the privilege.)

On Taxes

   “In 1961, President Kennedy said that we should ask not what our country can do for us, but rather ask what we can do for our country.  Last year we decided to give his suggestion a try - and who says it never hurts to ask?  We were told to mail $860 million in income taxes to the U.S. Treasury.”

     “Here's a little perspective on that figure:  If an equal amount had been paid by only 2,000 other taxpayers, the government would have had a balanced budget in 1996 without needing a dime of taxes - income or Social Security or what have you - from any other American.  Berkshire

Shareholders can truly say, ‘I gave at the office.’”

     “Charlie and I believe that large tax payments by Berkshire are entirely fitting.  The contribution we thus make to society's well-being is at most only proportional to its contribution to ours.  Berkshire prospers in America as it would nowhere else.”

(This is not relevant to this blog post but with more U.S. companies changing domicile to foreign countries to avoid paying U.S. corporate taxes – which are the highest – I found Berkshire’s perspective interesting.)

On Common Stock Investments

    

“Our portfolio shows little change:  We continue to make more money when snoring than when active.”

     “Inactivity strikes us as intelligent behavior.  Neither we nor most business managers would dream of feverishly trading highly-profitable subsidiaries because a small move in the Federal Reserve's discount rate was predicted or because some Wall Street pundit had reversed his views on the market.  Why, then, should we behave differently with our minority positions in wonderful businesses?  The art of investing in public companies successfully is little different from the art of successfully acquiring subsidiaries.  In each case you simply want to acquire, at a

sensible price, a business with excellent economics and able, honest management.  Thereafter, you need only monitor whether these qualities are being preserved.”

“Let me add a few thoughts about your own investments.  Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals.”

     “Should you choose, however, to construct your own portfolio, there are a few thoughts worth remembering.  Intelligent investing is not complex, though that is far from saying that it is easy.  What an investor needs is the ability to correctly evaluate selected businesses. Note that word "selected":  You don't have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.”

     “To invest successfully, you need not understand beta, efficient markets, modern portfolio theory, option pricing or emerging markets.  You may, in fact, be better off knowing nothing of these.  That, of course, is not the prevailing view at most business schools, whose finance curriculum tends to be dominated by such subjects.  In our view, though, investment students need only two well-taught courses - How to Value a Business, and How to Think About Market Prices.”

     “Your goal as an investor should simply be to purchase, at a rational price, a part interest in an easily-understandable business whose earnings are virtually certain to be materially higher five, ten and twenty years from now.  Over time, you will find only a few companies that meet these standards - so when you see one that qualifies, you should buy a meaningful amount of stock.  You must also resist the temptation to stray from your guidelines:  If you aren't willing to own a stock for ten years, don't even think about owning it for ten minutes.  Put together a portfolio of companies whose aggregate earnings march upward over the years, and so also will the portfolio's market value.”

(To summarize their thoughts on common stock investments: Buy and hold with a long-term time horizon and unless you really know how to value a business and understand market pricing, buy index funds. I might add that using the services of an accredited advisor to help you reach your future goals and manage expectations with regard to financial planning and portfolio construction may be the best idea of all.)

CBlakely, CFP®             06/2014

Source: BERKSHIRE HATHAWAY INC., Chairman's Letter, 1996