Hi Guys,
Here are a few further thoughts and interpretations that expand on Part 1 of my earlier post.
There is little doubt that funds flourish that do generate positive Alpha. However, they are few in number and their excess rewards over time are modest and unreliable at best. In a portfolio that has many active fund holdings, it is highly likely that any such positive contributions will be neutralized by those actively managed funds that are underperformers.
The mutual fund landscape is heavily populated by these underperformers. The positive Alpha funds do not adequately compensate for the many more losers. It is an asymmetric playing field. Kahneman’s Prospect Theory addresses this issue.
Additionally, a regression-to-the-mean is forever operational in the investment universe. For any extended time horizon, this regression law erodes any annual superior results. It is a challenging task to identify any fund (especially a-priori) that will consistently deliver plus Alpha outcomes. Good luck in this unpredictable domain.
It is an amusing oxymoron that actively managed mutual funds always tell us that “Past performance is not indicative of future performance”, yet they also, almost instantaneously, ask that you favorably evaluate their superior past performance. This obvious disconnect doesn’t seem to trouble them. It does trouble me.
The mutual fund industry is populated by very smart professionals. These well-trained, organized, and competitive participants tend to neutralize one another. The more I explore these issues, the more I am convinced that the search for superior mutual fund managers is all a grand waste of time. I’m venturing more and more into the Index world arena.
Whenever questioned, active fund managers always appear to have a reasonable story, a respectable approach, and an attractive strategy for promised success. Subsequent performance data uncovers the weaknesses of their methodology; failures are abundant and returns are often disappointingly dismal. Annually, a large percentage of actively managed products exit the battle field. By itself, that’s a telling and a tilting lesson.
I am sure David Snowball is very careful and fully alert when conducting his fund manager interviews. His probing must be an uneasy assignment. He deals with smart, talented, and focused fund managers, These guys may or may not be superstar money managers, but they are all superstar salesmen. Their presentations reflect their agenda and their incentives. Professor Snowball is well trained to separate the wheat from the chaff using learned skills, a cautionary examination, and a healthy dose of skepticism. I don’t envy him his task since fund managers are adroit at decoying the chaff to resemble real wheat.
I have arrived at my own decisions on this matter. I am shifting my portfolio much more dominantly towards the Index direction. I conclude that the accumulative evidence is overpowering. Chart 1 in this submittal is devastating evidence against active management from both a time and a numbers perspective. The shocking finding is that diversification among active managers doesn’t improve the situation; it likely amplifies the negative impacts of cost drag and the poor trading habits of these managers. Surely there are a few atypical exceptions.
As usual, you are the boss of your own portfolio; you own it. You are free to take charge, to develop your own plan, and to execute that plan. My hope is that the data I collected for this posting will allow you to make a more informed decision that adds strength to your portfolio and provides you more comfort in your decision making. I wish you luck.
In his classic book “Thinking, Fast and Slow”, Daniel Kahneman repeatedly reverts to the tension between clinicians and statisticians. That same tension exists among all investors, and even within the MFO clan. At least part of that tension is driven by an individuals lack of a statistical education. That hole in his education will eventually cause a hole in his financial decision making, and finally a shortfall in his portfolio’s performance. By downsizing or ignoring statistical analysis an individual investor enhances his risk without a compensating reward. He is truly flirting with a disaster of his own design.
Years ago, I initiated my participation in Fund Alarm, and later in the MFO site, to encourage a broader understanding and a fuller utilization of statistical methods. I remain dedicated to that goal regardless of wordsmith harassments (never direct attacks against the statistical procedures themselves) against that purpose. I am not dissuaded from that objective; I will continue the march.
I’ll be talking to you guys occasionally further down this bumpy, twisting, and sometimes discontinuous investing road. Black Swans do make the road discontinuous.
It’s fitting to close with an ancient Chinese saying credited to Lao Tzu: “If you don’t change direction, you’ll end up where you are heading.” You folks get to decide if a revised compass heading is needed.
Best Regards.
Comments
As usual, you've chewed on a lot here.
I am interested in how you implement the change reflected in your statement "I’m venturing more and more into the Index world arena."
Over the comparatively modest number of years I have been investing, I have tried a couple of different ways of combining active and passive strategies. It can be a bit of a challenge, because (as the Morningstar portfolio Xray tool well shows) what is inside the active funds can do strange things to what you are trying to do with the asset allocation that one uses to guide how you handle your index funds.
Most recently, when I have had a choice, I have settled on an "investment sleeves" approach. I choose a few strategies that make the most sense to me. Then allocate a percentage of the portfolio to each strategy according to my degree of conviction. Then choose allocations/funds/managers within those strategies. So, for example, I will allocate a large percentage of the total portfolio to an overall strategy such as passive indexing, and then treat that "passive indexing sleeve" as a distinct portfolio.
How are you handling the evolution of your portfolio(s) to conform to the evolution in your thinking?
gfb
Hi Greg,
Thanks for your readership and reply.
I agree that it can be a challenge to maintain a precise portfolio asset allocation given the flexibility that active fund management often assumes.
Some mutual fund houses do try to enforce a rigorous asset class discipline while others allow their managers more freedom to “go anywhere”. Fidelity fired Jeff Vinik specifically because he abandoned stocks for bonds while managing their flagship Magellan fund.
I suspect you are much more organized and more disciplined than I am in maintaining a specific asset allocation. I follow very loose guidelines, check infrequently, and consequently permit rather large perturbations for at least moderate timeframes (like one year). I simply do not believe that investing is a very precise science.
I X-ray my portfolio quarterly and usually modify it once a year, rarely twice a year. I really do not sweat the details.
Initially, about 25 years ago, my portfolio was 100% actively managed mutual funds. Today, it is roughly 50 % Index and 50 % active mutual fund and ETF holdings. I rate these holdings annually. The Index holdings are just about never at the bottom of the pile; frequently an active fund occupies that anchor position. That active fund is now a candidate for replacement by a passive component.
So, by attrition, my portfolio is gravitating in the passive Index direction. I am seriously thinking about escalating that process, perhaps even dramatically.
I really do not segregate our families portfolios into distinctive sleeves. When making decisions, our individual portfolios, both active and passive, are merged into a single whole for planning purposes. Of course these plans incorporate both tax liability and longevity considerations.
Greg, I do believe that you are doing things correctly; that you are on the right track.
Best Wishes.
Hi Charles,
Many thanks for reading both parts of my overly long submittal. I appreciate your patience, your kind words, and your question.
I am a much more committed buy-and-hold investor now than I was when I purchased my first stock position in the mid-1950s. I was never a rapid fire trader, but I definitely was more active in the past than I currently am. Mine has been an emerging investment philosophy, guided both by practical experience and extensive book readings. I even took a few formal courses.
I have tried both technical and fundamental techniques, have abandoned many of them, and have loosely and selectively adopted a few elements from both disciplines. So my approach is a mixed bag given the uncertain persistency of any of these market tools.
Probably the most significant lesson that I extracted from this long, and sometimes sorrowful , investment history is the wisdom that markets are mean reverting. The marketplace has a strong, compelling pull towards a regression-to-the-mean. All good things end abruptly, so constant vigilance and adaptability are cornerstones for investment survival. But too much activity also hurts performance, so a balance, that is likely different for each market participant, must be identified.
Predating the Peter Lynch method of choosing a stock by personally testing its acceptance and its products, my first stock encounter was Chock Full o’Nuts company after I observed its hugely successful outlets in New York city.
Initially I traded using the Magee and Edwards tome “Technical Analysis of Stock Trades” as a guiding template. Later, I discovered Benjamin Graham’s “Intelligent Investor” book and mutated into a fundamentals-based investor. I discarded many of the principles advocated by both texts, but did retain those that fit my own investment style. At this moment, I invest using a loose and limited mix from both these tool kits
For example, from a technical perspective, several times each month, I still examine the 200-day Indices moving averages to gauge market momentum. Things evolve. In the past, I used the charts constructed from daily price changes; today, I use charts made from monthly reporting frequency. There is statistically a discernable difference. The daily formulation gave far too many false signals.
For example, from a fundamental perspective, I examine Price-to-Earnings ratios to gauge overpriced or underpriced scenarios. I review market-wide profit projections.
From a macroeconomic perspective, I review absolute GDP levels and their growth rates. Demographic shifts, inflation forecasts, and interest rates also influence market returns. I examine the AAII Investor Sentiment Survey to assess the individual investor’s overall emotional feelings from a contrarian’s viewpoint.
I only explore these numbers several times per month. Excessive trading is hazardous to our wealth; excessive market examination is hazardous to our wealth and health.
I do not evaluate these data in any formulaic manner. I suspect that my approach is much fuzzier and less disciplined than many who contribute to the MFO Board. Precise quantification of financial terms can be very misleading and give a false sense of security if the inputs are not accurate, if the data changes in unpredictable whip-like fashion, or if the models are incomplete or entirely wrong-headed. Investment data and analyses suffer from all these deficiencies.
I did not venture into the mutual fund mire until the mid-1980s. My bible for that entry decision was Burton Malkiel’s classic “A Random Walk Down Wall Street”. Until that fateful tipping point my smallish portfolio was 100 % in stock holdings. That book dramatically altered my investment perceptions and style.
Since my Malkiel enlightenment, I have more or less consistently shifted my portfolio away from individual stocks and into mutual funds and ETFs. I sold my last stock position about 5 years ago.
Today, I would classify my investment philosophy as buy-and-hold, but not forever. I typically trade only once or twice a year with a goal to incrementally improve my portfolio by pruning some unwise earlier investments.
I never have personally participated in the sector rotation tactic; I allow my active mutual fund managers to perform that delicate task. I’m simply not well informed enough to play that sensitive game. Again and again those annual Periodic Tables of sector returns demonstrate the volatility and the unpredictability of sector rewards. I am surely not a qualified soothsayer in that arena; I’m not sure anyone else is either.
I do have a few long term market preferences, and my portfolio reflects those biases. I do practice broad portfolio holdings diversification, but I have also overweighed my positions in the health care and the real estate sectors. That’s just me and my special brand of prejudices; I do not necessarily recommend those extra positions for someone else’s portfolio with its specific time horizon, risk aversion, target allocations, and special set of preferences.
In summary, I deploy my small array of market signals to incrementally adjust my top-tier asset allocation mix of equity and fixed income holdings. I do not use these indicators to modify my next level of allocation classes. My modest list of indicators is not sufficiently precise enough to perform that more subtle, sorting task.
I hope this clarifies, but I’m somewhat dubious given the rather disorganized manner by which I make and enforce my investment decisions. In every military battle, plans are modified after the first shot is fired.
Best Wishes.