Hi Guys,
We have always been taught to “Don’t just Stand there, do something”. That was the way of the American Revolution, still is the style of the Marine Corp, and is effective action for most situations.
But there are exceptions to rules; Investing might just be one such exception. In the investing universe, it might be more rewarding to pervert that guiding axiom to “Don’t just do something, Stand there.” In portfolio management, passivity just might be the key that unlocks the door to treasure booty. Within the last five decades much empirical data have been collected that underpins this wisdom.
Let’s examine the evidence from both a theoretical perspective and from an empirical perspective.
The Theoretical Approach:
A hypothetical model will be formulated that serves as a comparative baseline. All data reported in that model was extracted from Morningstar
A total equity market fund will substitute as a market proxy. I’ll employ the 15-year data as a compromise between the statistical benefits that very long-term data affords and the relevance, timeliness, and freshness of shorter data sets. I’ll assume that a normal distribution applies. Needed is the average annual returns and the return volatility measure (standard deviation).
Further, assume that active mutual fund managers are more or less neutral (often their performance clusters around the norm). The historical data sets suggest that excess profits are rare and that persistent outperformance escapes existence. Initially suppose that active management does no harm, but likewise, does no good in terms of excess rewards (again, based on past recorded performance).
Given those modeling assumptions, the only difference between a passively managed portfolio and an actively managed one will be the cost structure. The cost only impacts the annual returns, not the statistical distribution. To explore the cost dimension, postulate a realistic active cost of 1.0 %, and also 1.4 % to parametrically study the issue.
As the reference passive powerhouse, the Vanguard Total Stock Market Index (VTSMX) is more fully diversified than its domestic equivalent, the S&P 500. For our purposes, VTSMX will carry the passive investor’s flag.
From Morningstar, the VTSMX fund yielded an average annual return of 5.23 % with a standard deviation of 16.79 % (this is a constructed 15-year average since the fund has not actually existed for that extended period). Then, for this study, an actively managed portfolio would delivered after costs a 4.23 % and a 3.83 % annual return for the two cost structures. Volatility is maintained at the 16.79 % annual level.
Given these data, a simple lookup from any Normal Distribution Statistical Table shows that 52.2 and 53.3 percent of active managers fail to better their passive pacesetter. The incremental cost impose a hurdle that the active manager must overcome to defeat the passive agents.
This conceptual modeling does not bode well off the starting line for active fund management. But if they have any talent whatsoever, the cost penalty handicap should be frequently overcome. The empirical examination that follows demonstrates that even this modest challenge is not successfully navigate by the active management teams.
The Empirical Approach:
Excellent empirical performance data have been collected for decades and much examined in academic and industry studies. Experimental work often produces deep insights and actionable outcomes.
The investment heroes in the passive camp are legendary names: Bogle, Ellis, Bernstein, Buffett, Ferri, Swenson, others. The heroes in the active investment camp are more rare, a handful at best. Even these heroes have suffered bankruptcies sandwiched between euphoric temporary successes. Jesse Livermore, the famed stock operator, tragically comes to mind; he had a rollercoaster career that ended in a 1940 suicide..
The historical evidence is overwhelmingly against an active investment agenda be it institutional managers, market gurus, fund managers, and private citizens. Very few persistently outdo a simple passive approach.
Next, I’ll present several samples that document just how hazardous active investing is to long-term portfolio health.
Here is a very recent reference from the pen of Barry Ritholtz. He reports that in 2012 only 39 % of fund managers outdid the S&P 500.
http://www.ritholtz.com/blog/2013/01/fund-manager-performance-vs-the-sp/Of course you are all familiar with my semi-annual rantings that are coupled to the S&P SPIVA and Performance Persistency Scorecard releases. You can access these at:
http://www.standardandpoors.com/indices/spiva/en/euOver its 10 year history, SPIVA consistently refutes active manager’s excessive and unwarranted excess returns claims. Naturally, a minority of managers do succeed annually, but the Persistency scorecards demonstrate that percentages are below those expected from random luck alone. Skill over luck is hard to identify in any of these reviews.
The sky high fund failure rate frequency (non-survivability) is an advanced warning signal of the superior active fund management illusion.
One typical S&P finding is that “SPIVA consistently shows that indexing works as well for U.S. small-caps as it does for U.S. large-caps.” A second consistent finding is that “In the two true bear markets the SPIVA Scorecard has tracked over the last decade, most active equity managers failed to beat their benchmarks.”
Even in sectors and in market scenarios where you might anticipate that active management has an opportunity to perform brilliantly, the funds fail to do so. This is a sad, sad tale. Studies like these demonstrate that in spite of their perceived smarts, fund managers are woefully inept at even delivering benchmark Index rewards.
But woeful performance is not limited to institutional giants or fund managers; actively trading individual investors are similarly inept. Both Morningstar and DALBAR have documented this finding for decades.
As poorly as active mutual funds perform relative to a representative benchmark, private investors in these funds fail to capture the diminished returns of the funds that they invest in. Private investors are notorious hot fund seekers and herd-like followers with poor market timing skills. DALBAR will soon release its report for 2012. I anticipate it will be a carbon copy of earlier products. Past releases document that individual investors often receive only one-third to one-half of a fund’s annual returns.
Market timing is not a private investors strong suite; he gets the entry and exit times wrong. Here is a reference that allows you to download the 2012 DALBAR QAIB publication:
http://www.qaib.com/public/downloadfile.aspx?filePath=freelook&fileName=advisoreditionfreelook.pdfThe DALBAR report vividly records just how poorly private investors performed in the 2011 marketplace. Shamefully bad outcomes.
Almost an endless list of other academic and industry research projects buttress the few findings that I included here. In total, it is a comprehensive and compelling body of evidence.
The bottom-line conclusion from an empirical perspective is that active investing is truly a Loser’s Game. Active managers fail much more frequently to achieve passive benchmark returns than the theoretical formulation suggests. This finding signals that these managers are exceptionally prone to human behavioral biases that destroy wealth at a faster pace than the cost handicap implies.
Perhaps they just try too, too hard. As Charles Ellis has concluded in several of his many books, a kind of “benign neglect” might work considerably better over the long haul.
Several other factors, not discussed so far, compound the negative aspects of active fund management. One factor is the very asymmetric nature of their payoff curve. Under the few winning circumstances, the excess returns generated are marginally superior to Indices. For the many more underperforming instances, the payout matrix is much more devastating to portfolio wealth.
A second factor is that the crippling impact of active management has an accumulative effect. As the number of active funds increase within an investor’s portfolio, the likelihood of outperformnce continuously decreases. The underperformance also becomes more problematic as the time horizon expands.
Recognize that active investing produces a multi-dimensional portfolio whammy dependent upon the extensiveness and particular style of the active part. Passive Index investing just might be the smart answer to the wealth-eroding behavior of most private investors.
Your opinions are encouraged and will definitely contribute to this posting.
Best Regards.
Comments
Thanks for the very informative report. I have some questions to ask:
1) Usually the comparisons are made on a pre-tax basis, which is OK for IRA or 401k accounts. However, on the after-tax basis, which is very important for many people, the advantage of passive investments may be even more profound. This comparison depends on the tax bracket etc., but in the future, when taxes will grow, the tax losses due to frequent trading by active managers will put many of such funds at a significant disadvantage. This supports your argument.
2) However, there are active managers who beat the market, and there are some who do it even on the after-tax basis. It is true that the fraction of such managers is very small and the chance of finding them is even smaller, but it is the goal of the groups such as ours to find them. For example, I would argue that those who invested in (almost) any fund from the Oakmark and Artisan family of funds, since their inception, had a very good chance of beating the market. Is it a statistical miracle, or an evidence that the investment culture in these families of funds can serve as a predictor of their success?
3) It seems that something like that exists in the bond land as well. Is it any surprise that PIMCO total return fund has 285 billion under management, and year after year, with rare exceptions, it beats the market? People vote by their feet. There are not so many funds like that, but its huge size shows that quite a lot of people identified this fund long ago, and benefited from it. Another super successful fund (so far), which is often discussed in this group, is PIMIX/PONDX. I learned about it from Hiyield007, and so far it served me well.
4) This suggests that instead of discussing whether an average fund can beat the market, one may ask a different question: Is it possible, after a fair amount of work, to identify those rare funds, or families of funds, which may either beat the market, or at least grow almost as fast as the market, with a smaller volatility?
5) Previous question refers not to an average fund and not to an average investor, but to a person who spends enough time to become a better than average investor. There are scientists who are better than average, doctors who are better than average, and even drivers who are better than average. So is there a chance that people in this group, or at least some of them, are (or gradually become) better than average? I do not think that I am better than average, at least not yet, but is it always a looser's game and one should not even try?
But I would totally agree that life is short, and many of us would prefer to spend our time on other things instead of investments. In that case the answer is obvious: Index funds would beat everything else, for an average investor. Of course, some work is still required to pick up decent index funds, so one cannot avoid being at least a little bit active, but I guess this is a much easier task.
The issue of using active/passive approach is very practical for me now, I am trying to understand which way to go. That is why I am so happy to learn from you and other members of this group.
With many thanks for your efforts
Andrei
I'm not an Index-er. But I'm pretty passive as an investor and am quite happy with the results. Very few changes from year to year. Some years, none. I'm itchy lately because it feels like we're experiencing one of those downturns in technical terms, almost always followed by a further leg-up, again. Sometimes, information is just information. Naked numbers, unconnected factoids, and a lot of the talking-head observations on tv or in print are extrapolating in ways that sound like guesswork. But they sure are convinced, themselves--- and you should definitely buy their BOOK!
http://www.marketwatch.com/Story/story/print?guid=8CBE259D-8138-4C3A-88A8-4ECDFD6E427F
"passivity just might be the key that unlocks the door to treasure booty. Within the last five decades much empirical data have been collected that underpins this wisdom"
I feel Passive Portfolios work, maybe and then again maybe not. I recall Sheldon Jacobs and his theory of persistency where he took last years leading fund and employed it for a second year to provide amazing results. His theory was that what worked last year does not necessarily cease to function in January of the following annum. I cannot cite reference but it remains in my head.
MJG, what about the 5 year study where Bob challenged Bill Bernstein to a Pony Express contest and trounced him by generating 13 times as much reward. His gain over five years by picking top five funds was 408 %. This will be clearly annotated by below link.
http://customer.wcta.net/roberty/
click : Introduction and click : Pony Express Report.
I agree with Disraeli, there are three classes of Lies, namely LIES, DAMNED LIES, AND STATISTICS
For my self I try to follow some persistency but realize every day is a changing parameter and that strict " buy/hold" won't work for me nor will running to hottest fund as often as frequent trade fees permit. Somewhere we must utilize a median way.
Respectfully, philpill
We can't control the direction of the wind, but we can adjust our sails
Hi Andrei,
Indeed, not all wizards in any complex field of endeavor are equal. There is always a distribution of skill, experience, resources, and luck. If you ever participated in competitive sports this becomes abundantly clear at an early age. There are always a few good men, and women too
But it is a Herculean chore to identify these talented individuals, that special market environments make into a superstar because of an amplifying convergence of market conditions and their special talents, before that transient resonance juxtaposition vanishes in a dynamic investment sea change.
That’s a mouthful to swallow. Sometimes the marketplace and the experts investment concepts just merge together to form a single entity, and profits soar. But markets precipitously change and wizards don’t easily adapt. It is not that the expert has suddenly become dumb. Just what worked so beautifully in the recent past, no longer is awarded outsized profits. Change happens.
It happened to Legg Mason’s Bill Miller. It happened to PIMCO’s Bill Gross. It has impacted mutual fund performance at the very experienced Dodge and Cox outfit. It has heaped havoc on the American family of funds performance. No person or organization is immune from such a rapid change in fortunes. Everyone is exposed to downward performance perturbations.
The industry is littered with such serious and costly mishaps. That is why the industries fund demise rate is so high. These disasters typically don’t occur in well run Index operations.
Even apparently actively managed funds with a stated divergent investment policy seem to exhibit a performance track record that is surprisingly similar. I recommend you conduct a few experiments along this line of inquiry using the Morningstar fund plotting tool, and contrasting the records of candidate funds in the same category as a function of time. These comparisons might better inform your decision making process. It makes no sense to pay extra above Index costs for nonexistent or ephemeral diversity.
Andrei, you are precisely on target with your objective to lower your overall portfolio’s risk by controlling its volatility sensitivity. However, that is probably best accomplished by investment category diversification rather than by an individual manager’s ability to do so.
In an earlier post, I quoted Julius Caesar: “Don’t be consumed by small matters”. Category diversification is the dominant player when addressing volatility control issues.
As I mentioned in previous submittals, I plan to modify my portfolio towards the more passive class. However, I do plan to retain a small percentage of actively managed mutual funds. I can not completely dismiss the excess returns challenge, and the gambling trill that accompanies it. But it will be small enough such that our retirement survival prospects are never put at risk.
Best Wishes.
Hi Philpill;
Thanks for your response.
I am familiar with the Bernstein-Pony Express challenge. Indeed the Pony Express system easily defeated Bernstein in that long ago challenge. But could that happen again if the challenge were repeated many times such that results would be statistically meaningful? I simply don’t know. My current interpretation is that it was a singular event and not likely to be repeated.
If you trust the rather vague Pony Express methodology documentation, I suggest you invest using their forecasts and selections. Let us know how it works out. I wish you luck.
I like Sheldon Jacobs very much. Earlier in his career he was a regular at the Las Vegas MoneyShow. He was always humble about his projections. Jacobs sold his forecast letter business and retired a few years ago when his formula began to breakdown. The last time I saw him, he had the sorry aura of a defeated man.
I understand that Mr. Jacobs will appear at this years Vegas MoneyShow in mid-May. I look forward to attending his lectures once again. I suspect his very simple analytical methods have changed.
Sorry that you quoted and agree with Disraeli’s statistics assertion. In some areas his observation might be applicable, but investing is not one of them. In the financial world, if you don’t trust and deploy statistical analysis, you are doomed to fail.
Without a comprehensive understanding and body of statistical data sets, how do you finally make an investment decision? I hope you don’t use a Ouija Board or animal entrails. Statistical data are the lifeblood serving mutual fund decisions, both from the fund management and the fund buyer perspectives.
Good luck. I really mean it. But since you search for persistency, you are actually using statistical methods without acknowledging it.
Best Wishes.
I am really grateful for this discussion. However, the question which I asked still remains:
It is true that an AVERAGE active managed fund is doomed to loose the competition to an AVERAGE index fund or ETF, especially after taxes.
But that is where statistical methods should be applied very accurately. We are not investing in AVERAGE funds, we are trying to pick the best. It is indeed true that Bill Gross made mistakes, just as each of us. But it is equally true that his fund PTTRX turned $10 into $78 since inception in 1987, whereas the Vanguard Total Bond Index fund at the same time turned $10 into $56. This winning of PTTRX continued, with minor deviations, during the last 25 years, which was long enough for people to take notice. That is why PIMCO Total Return fund has 285 billion under management, whereas Vanguard Total Bond Market Index has only 18 billion. People noticed and made a smart move.
The same is true for the best emerging markets fund, ODMAX. SInce inception, in 1996, it turned $10 into $94. Meanwhile Fidelity fund FEMKX during the same time turned $10 into $16. Big, astonishing difference! That is why ODMAX manages 32 billion, despite its 5.75% load, whereas AUM at FEMKX is 3 billion. People took a notice and made a smart decision.
Thus, just as philpill (and Disraeli), I wonder how should we use statistics? Should we compare index funds with average actively managed funds? Should we instead give larger weight to the fund with greater AUM? Or to better performers? This would be much more informative, but also misleading because best funds often close, trying to restrict their AUM. Any other suggestions?
This is one of the reasons why this debate still continues, despite convincing arguments in favor of passive management: The total number of funds grows exponentially, and depending on the way one slices this ever growing pie, one can prove almost anything one wants. And it is a pity, because it would be great to have a single well established rule.
But I absolutely agree that this optimization procedure is very hard to master and maintain, especially when one actively works, and then it becomes even more difficult when one gets older.
Best wishes
Andrei
S&P SPIVA Persistence Report (December 2012)
S&P SPIVA US Mid-Year 2012: Index vs Active Funds
Read the reports. Make your own judgement.
I should note that a lot of active funds that appear to beat the indices are measured against wrong inappropriate benchmarks, sometimes on purpose by the fund company.
Regards,
Ted
Good stuff Investor. Here's summary of Dec '12 report findings:
Very few funds manage to consistently stay at the top. Of the 707 funds that were in the top quartile as of September 2010, only 10% were still in the top quartile at the end of September 2012.
For the three years ending September 2012, 23.60% of large-cap funds, 15.49% of mid-cap funds and 29.37% of small-cap funds maintained a top-half ranking over three consecutive 12-month periods. Random expectations would suggest a rate of 25%.
Looking at longer-term performance, only 5.16% of large-cap funds, 3.21% of mid-cap funds and 5.10% of smallcap funds maintained a top-half performance over five consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.25%.
While top-quartile and top-half repeat rates have been at or below the levels one expects based on chance, there is consistency in the death rate of bottom-quartile funds. Across all market cap categories and all periods studied, fourth-quartile funds had a much higher rate of being merged and liquidated.
Hi Andrei,
I fully understand your frustration with an investment policy that passively seeks average performance. To most, that is unappealing because it appears like a cowardly surrender before the battle begins. The behavioral researchers would enjoy a field day with such thinking and the anxiety must be overcome on a personal level. Not easily done. Nobody wants to be labeled as just average.
I partially converted to the passive Index policy about 15 years ago after reading John Bogle’s “Common Sense on Mutual Funds” book. Since that milestone moment, I have continued my conversion incrementally; I prefer small steps, especially when investing retirement money.
The general public has matched my trickle towards index holdings, but institutional investors have increasingly flooded that trickle into a tsunami. In spite of their human and capital resources, these institutions are finally getting the message. They are so talented at what they do that they are neutralizing each other, and nobody can maintain a competitive advantage. Thus who wins and who loses (they basically distribute the market returns according to Bill Sharpe) becomes a roll of the dice. This equally matched and dedicated talent pool means that performance persistence is illusive.
Even with some giant institutions becoming major participants, Indexing is still a small fraction of daily market trades, and is likely to remain that way. That’s a good thing since the daily trading establishes the market price, keeps it fresh, and reasonably efficient.
Now let’s focus on issues surrounding the collection of merely average returns. That may seem unexciting on an annual basis, especially when contrasted against some rock-star performers. But remember, even on the short-term single year standard, Index players will outperform two-thirds of all the market participants. And if an Index strategy is consistently applied, the Indexers ranking on the rewards ladder will soar upward over time. That accumulated effect is the product of always taking an annual position that has an above average likelihood of winning over half the market participants. It is simply an exploitation of the odds strategy.
That ladder climbing is almost a certainty because year-after-year the Index policy will generate average returns while the superstars will have a few bad years slipped into their highly successful years. Make up is tough sledding; end wealth erodes quickly. It is integrated Indexing consistency that makes a champion investor destined to outperform 90 % of the market participants over the long haul. This seems to be a remake of the children’s tortoise and hare story. It is.
It is also salient to note that rock-stars all too often flash destroy, giving themselves rather than the market exaggerated credit for their success.
Ken Heebner is the poster-child for the hero turned villain turned hero again professional money manager. His annual returns volatility is breathtaking. At times his average returns are very attractive, but his clients still lose money because of poor entry-exit point tactics. To paraphrase Paul Simon, investment gurus keep slip-sliding away. Many are ephemeral players; a few do have staying power and deserve special attention.
Experience teaches that no single investment strategy works forever or under all market circumstances. Styles change.
Look, you’re a serious investor, and are totally capable of making your own investment decisions. It’s good to get other’s opinions, but in the end, you are the master of your portfolio construction, not of its performance. In the final analysis you will not “stay the course” with your portfolio unless you are comfortable with the overall choices you made and the investment policy you adopted.
The key is that you understand and fully endorse your freedom of policy design and product choice. Remember, nothing is permanent. You always retain the option to change your mind and your investments, including an overarching strategy adjustment. Also, investing is not an either/or set of decisions. You can elect to sit on the sidelines or you can move incrementally. You choose and bear full responsibility.
Best Wishes.
I do understand your general arguments, I followed previous versions of this discussion, which were extremely informative and, in general, very convincing. Nevertheless, I feel that my main question remains unanswered. So let me formulate it in a different, more concrete and focused way:
I wonder how many of you at present invest in the passive Vanguard Total Bond Market Index fund, or in Vanguard Total Bond Market ETF, BND, instead of active funds such as PIMCO total return, or its active ETF version, BOND ?
Note that if you are not investing in the funds such as Vanguard Total Bond Market Index fund, but use a combination of different bond index funds, you are in essence actively managing your bond portfolio. So I wonder whether after 25 years of outperformance of the active PIMCO total return fund you are keeping (almost) all of your bond portfolio in the passive Vanguard Total Bond Market Index fund?
Andrei
You said, "In the financial world, if you don’t trust and deploy statistical analysis, you are doomed to fail."
Can you prove this?
Or maybe your definition of statistical analysis is so broad that you assume that nobody
will dare question your statement.
Ted sums it up nicely: No matter what, at the end of the day, you have to determine the approach that works best for you.
I believe that statistical analysis is extremely helpful. The problem is that one may get different results by averaging differently. That is why there are many indexes for the same stock market: capital weighted, equal weighted, fundamentally weighted, etc. For example, should we make an average counting mutual funds, independently of their AUM, as people usually do? One may argue that most of the funds that die become small first, so most of the bad funds should be small. Thus by averaging over the number of funds ignoring their size one makes an obvious mistake. A better question is: How the money grow, in average, if they are invested in actively managed funds? These two questions require absolutely different averaging; the last one takes into account the fund size, but it should also take into account human psychology which forces them to jump from one fund to another. And here it is important to be a better than average investor, a hard task for many of us...
I do believe that the proponents of passive management are making a very solid case for their strategy. Also, MJG does not impose his view on others, he just gives the arguments, which are good and solid. But I really wonder, as a test, whether the people advocating passive management keep all of their bonds in the total bond index, or they actively manage it. This is a burning question right now, when many people believe that long term Treasuries are toxic. So if you are an index holder and honestly and consistently stay on this position, you should keep the long term Treasuries as a part of your portfolio, and keep all of your bonds in the total bond index fund. Eventually we may know whether this was a wise decision. Up to now, investing in PIMCO total return was a much better strategy.
Andrei
As is often said on this board, it's different strokes for different folks. We are all wired differently and in this game it pays to march to the beat of a different drummer.
Thanks a lot for your reply. Fantastic work with Mutual Funds That Beat The Market:)
I have the main part of my holdings in active but a significant fraction in passive. It is easier to be emotionally detached from passive. Probably with age I will totally migrate to passive - but in the meantime I enjoy being educated and getting important information at the Mutual Fund Observer. What an impressive website!
Andrei
Never was too good at math ... but, wouldn't that be an impossibility for 51% of us?
I thank you all for your participation in this exchange. The demonstrated interest in the posting far exceeded my expectations.
Although I have taken a position that simple Index investing delivers persistently superior returns when contrasted against active portfolio management, I have consistently acknowledged that the active versus passive management controversy is still an unsettled debate. Much depends on goals, timeframes, risk adversity, and current economic and political realities. There is plenty of room for a diversity of opinions.
I make no claims to any prescient forecasting skills, nor any special investing talents. You should all execute an investment policy that permits you to sleep comfortably every night. I do. But I do have preferences based on 50 years of practical investing experience and considerable financial/economic/investment/mathematics studies.
Based on this multi-discipline effort, I have mostly concluded that Index investing delivers portfolio return outcomes that generally exceed those that would be generated by an active approach. Note that I used the “mostly and generally” qualifiers to my statement. There are no 100 % guarantees in the uncertain investment universe.
I immediately concede that a passive portfolio will never top an annual ranking of all portfolio options in any given year. But it will likely be in the top one-third. Extending the time horizon beyond an annual rating, that passive portfolio will tend to climb the ranking ladder because it is consistently and persistently in the top one-third returns grouping each and every year. Active management will have better individual years, but will also generate sub-optimum results a few times that it will do harm to a long-term performance record.
Given all this, I still own a mixed active-passive portfolio. I embrace the challenge of selecting superior fund management talent. This is not an easy task.
One of my more recent fund management heroes is the former Yale endowment fund guru David Swensen. For years, his investment prowess produced double digit returns for Yale
I also liked his willingness to change his viewpoint while writing his popular book :Unconventional Success”. Initially he drafted the book to recommend his complex investment philosophy, realized that individual investors could not be reasonably expected to execute that complex strategy, and restructured the book to finally endorse a passive Index fund investment program. More power to a guy who is willing to alter a position because of practical considerations.
In my earlier submittals, I briefly mentioned that even university institutional endowment powerhouses like Yale, who employed the best-money-could-buy investment experts and wisdom, were recognizing the difficulties of persistently outperforming the overall marketplace. Many of these institutions are now committing a larger fraction of their wealth to Index products.
One reason for that defection is surely the paucity of exceptionally skilful fund managers. Another is the cost for these managers and the research needed to identify excess returns opportunities. I believe that the recent dismal performance of these university endowment projects has boosted the defection rate. There are several recent references that carefully document the disappearing excess returns for this institutional class of investors. Here is a Link to one of them:
http://www.nytimes.com/2012/10/13/business/colleges-and-universities-invest-in-unconventional-ways.html?pagewanted=all&_r=0
Click on the NY Times graphic to see that a simple Index portfolio outperformed the endowment average returns over the last three years and equaled the largest endowment group for the last five year period.
Here is a Link to an article that reports on a former university endowment manager’s attempt to replicate the endowment investment style in a mutual fund structure:
http://www.thebamalliance.com/BAMNewsMakers/BAMNewsMakersArticles/tabid/100/entryid/101/more-bad-news-for-college-en
The project is performing poorly. Some things are not easily transferable. I particularly like the closing summary in the brief referenced article, so I close with it.
“The implication is striking: If Yale, with all of its resources, cannot identify the future alpha generators, what are the odds that any individual money manager, investment advisor or other endowment can do so? This is why I believe that active management is the triumph of hype, hope and marketing over wisdom and experience."
The devastating conclusion of this closing paragraph, that was directed at the investment world’s big players, is easily extrapolated onto the investment opportunities map of individual investors.
Regardless, I wish us all successful investing as we pursue our own separate pathways.
Best Wishes.
Thanks a lot for taking your time to explain your perspective. Your arguments are indeed very convincing, and the latest argument, "do not do it at home", is an extra push which will, eventually, help me to come to peace with the inevitability to move to the passive investment camp.
And yet, my main question remains unanswered: I wonder how many members of the Mutual Fund Observer would prefer to invest in the passive Vanguard Total Bond Market Index fund, or in Vanguard Total Bond Market ETF, BND, instead of active funds such as PIMCO total return, or its active ETF version, BOND ?
It seems almost obvious to me that investing in the Vanguard Total Bond Market Index fund would be a mistake (or at least sub-optimal), as compared to investing in PIMCO total return, or in some other PIMCO funds such as PIMIX/PONDX.
But I may be totally wrong, and if so, I would be happy to understand it as soon as possible. I recall Bogle saying that those who wants to use active managements for bonds "should have their heads examined", see http://www.morningstar.com/Cover/videoCenter.aspx?id=397707
A discussion of this point, where the two attitudes clash so strongly, could give us a real possibility to check which of these two points of view is valid. Much more people invest in the PIMCO total return than in the Vanguard Total Bond Market Index fund. Do you agree with Bogle that their heads should be examined?
Sorry for pushing it so strongly; I guess I am playing the role of devil's advocate, but this simple example should be relatively easy to analyze. Many people would agree that PIMCO is better than average in managing bonds (and they are not so good with stocks). If so, the problem is solved: Use PIMCO Total return instead of the total bond index. Some other funds may do even better, but the choice of PIMCO total return would unify the principle of simplicity with beating the average. Do you agree? And if you study PIMCO funds attentively, you may find even better ways to beat the market, e.g. PIMIX. But this is less certain, and beyond the scope of the present discussion.
And if we know how to do it with bonds, perhaps we can find a way to do it with stocks as well, can we?
Andrei
Hi Andrei.
I admire your persistence in seeking a firm specific bond selection from the MFO membership.
But I note that your impassioned solicitations have not succeeded in prying a single response from our participants. That failure to make a definite endorsement is aligned with my own personal policy.
I have always abstained from making specific fund recommendations; I intend to keep that policy intact now and in the future.
Any final decision rests on how the selected fund fits into your composite bond portfolio. Just like the equity portion of your portfolio benefits from low correlation products, so does your bond portfolio.
Most starkly stated, the final choice is yours, and yours alone.
I don’t understand your reluctance to do so. You have done your homework, and have down-selected to competitive alternatives. These options will respond in like fashion to unknown and uncertain future market conditions.
In the context of overall portfolio performance over the long-term, differences are likely to be second order since one fund seems to have superior selection skills while the other offers lower costs regardless of market return conditions. These factors will tend to coalesce end performance.
So I interpret your decision quagmire as a second-tier issue. In my opinion, a more significant first-tier question that should be addressed is whether you should be increasing your bond asset allocation at this moment.
I do not pretend to know the answer to that question, but a lot of bond experts are deeply distressed over the present states of the US GDP growth rate, fearful of inflation rate prospects, the magnitude of our National debt, and the overarching uncertainty of potential interest rate increases. Buying more bonds at this juncture should be your really tough first-order decision, not the relative merits between fine PIMCO and Vanguard products.
By way of full disclosure, I have both PIMCO and Vanguard bond holdings.
I will say no more except to reiterate a Julius Caesar quote from an earlier posting: : “Don’t be consumed by small matters”.
Please have the courage to act on your extensive research and on your instincts. Don’t abdicate the decision to lesser informed members of the crew; you are the captain of your own ship.
Best Wishes.
Thanks a lot for your kind response and recommendations. I already made my own decision in this respect. This matter is interesting for me now mostly from a theoretical point of view:
If one accepts passive strategy fully, one should apply it to everything, including bonds. Then it would seem to require placing all bonds to a general index fund, like the one by Vanguard. But by observing PIMCO offerings it seems obvious that such a decision would be sub-optimal, because PIMCO total return provides similar diversification but better income, as confirmed by its 25 year long history.
If this is the case, then the bond part of the passive approach crumbles, in my view. One may discuss the stock part separately, and argue that investing with managers from Artisan, Oakmark, or Matthews, gives a real chance of outperforming the index and/or control the volatility of the portfolio.
I understand that you are using a more balanced approach and do not impose your views on others, which is great, and your arguments are really deep and practically useful. I just tried to understand the radical view expressed by Bogle, the leader of Bogleheads, who said that those who deviate from the index investing of bonds "should have their heads examined". Testing this statement for me is the first step towards testing passive approach in general.
Thanks again for taking your time to respond me in such a detailed and thoughtful way, I must think about these matters again in view of your comments.
Best wishes
Andrei
To me, the discussion about using passive funds or managed funds just seems like a small part of the whole. The effect of specific fund choice on total returns over the long term will not be "as important" as the overall portfolio construction and portfolio management (IM
Using managed or passive funds, in my opinion, is a much smaller contributor (or detractor) towards over all return over time. I've come to agree with Ted's statement, using both managed and index funds together is the way to go. A mix of market returns plus alpha.
Good discussion. Thank MJG for starting it.