Reply to
@BobC:
Hi BobC,
Nobel Laureate Bill Sharpe would be proud of your understanding of the risk/reward tradeoff. His Sharpe Ratio was one of the earliest attempts to capture and characterize both critical aspects of the investment puzzle. Later researchers, standing on his shoulders, refined his formulations.
Indeed, if your active fund manager accepts more risk in a bull market scenario, an investor would expect outsized, above average returns. Of course, the reverse would be true under bear market conditions; under those circumstances, an investor would anticipated above average downward penalties. A symmetry should exist. ( A really skilled active fund manager should operate to dampen those downward penalties. )
That is one of the essential findings that evolved from Sharpe’s early 1960s Capital Asset Pricing Model (CAPM). From that model, much to Sharpe’s annoyance, research peers and financial journalists coined the sensitivity of an investment to the overall market movement its Beta attribute. Since those early pioneering days, other factors have been identified that contribute to the investments pricing mechanism (size, value, momentum). Also various offshoots of Prospect Theory suggest that Beta is likely not symmetrical depending on either an upward or downward trending equity marketplace (like the Sortino Ratio).
I suspect, based on the CAPM concept, Professor Snowball was astonished and disappointed by the general results he reported in his chosen illustrative example between the S&P 500 Index returns and those registered by the Large Cap Blend active fund category. The Large Cap Blend Capture Ratios fell short of their benchmark targets in both directions.
Given the long-term consistency of both the SPIVA report findings and its sister Persistency Scorecard semi-annual report conclusions, the Capture Ratios did not shock me. It is yet another illustration of the daunting hurdles that active fund management continues to trip-over.
Bill Sharpe explained this compactly and convincingly in his 1960s analysis using simple arithmetic and a market-wide overall returns balance equation. Among the active manager cohort, there must be a loser for every winner. Before costs, it is a zero sum game. Given research and trading costs, and other management fees, it is a negative sum game. That’s equivalent to a racetrack that typically only returns about 85 % of the total waged in any given race to its betting public. The 15 % withheld covers operating costs, profits, and State tax largess.
So, on average, active managers do not reward their clients with above average returns. That’s impossible. On the downside, active managers again failed to protect their customers portfolios. The evidence has been accumulating for decades and has reached overwhelming proportions. Skilled managers do exist, but they are rare.
Even those who sport an excess returns average record find persistency a daunting challenge. Costs matter greatly. The near empty winners circle is populated by active managers who aggressively control costs and have low portfolio turnover ratios.
These few managers do thrive. I’m sure you hunt them out for your clients. The Vanguard Health Care fund (VGHCX) is a prime example. Over the last decade, it has outperformed its benchmark in 9 out of 10 years, including two annual downward market thrusts. Its low cost structure and low portfolio turnover rates made it a likely candidate to do so.
Even institutions are finally realizing the extreme difficulties of identifying superior active fund managers. The huge California retirement agency CALpers will likely be increasing its passively managed equity portfolios from a 30 % overall level to a 60 % commitment in the near future. The CALpers team carefully screened active managers, but these chosen Ones failed the acid market exposure over fair test periods.
The Litman/Gregory mutual fund organization, which emphasized portfolios constructed by a diligent and detailed multi-manager selection process, has not generated superior rewards. Manager changes have been made far more frequently than planned. Litman/Gregory is discovering that management selection is a tough nut.
Allow me to take exception to your assertion that folks would be satisfied with an 85 % return when accompanied by an 80 % risk statistic (undefined at this moment). I’m sure some folks would find that an acceptable tradeoff. I’m equally sure many other folks would not be so happy, especially those with a long-term investment horizon.
So I would never be sanguine over quoting any single set of target numbers for investors as a whole. It depends on a multi-dimensional set of requirements, preferences, wealth status, knowledge base, age, goals, and risk adversity attributes. I’m sure I am preaching to the choir now.
Choosing successful active mutual fund managers is a hard road. I know you try; most everyone at MFO tries; so do I. I have prospered a little but have been saddled with some poor choices as well as some successful ones. I am not sure it is worth the effort and the heartache. I hope and wish you more success than I enjoyed in this demanding and vexing arena.
Best Wishes.
