Hi Guys,
Do you consider yourself an Active or a Passive investor?
I fully recognize that this is not an either/or question for most investors. Many of us would likely characterize ourselves as somewhere in the mid-spectrum that exists between the polar 100 % active advocate and the opposite 100 % passive proponent bookends.
I propose that how an investor answers two simple questions goes a long way at identifying his position on that spectrum. Here are the two basic yes/no questions.
Do you believe that market timing is a repeatable skill?
Do you believe that stock selection is a lasting skill?
The yes/no replies to these questions establish a 2 by 2 dimensional matrix.
If you answered yes/yes, you are in group 1. If you responded yes/no, you are in group 2. If you replied no/yes, you are in group 3. And if you concluded no/no, you are in group 4.
The interpretation of the matrix assignment is not rocket science. The group 1 residents are likely strong active fund true believers. The group 2 and group 3 residents are still active fund management supporters, but perhaps less adamantly so. Within the group 4 box you will find the passive Index fund proponents.
I’m sure this simplistic and linear interpretation shocks nobody. A more interesting question is: Does your investment style conform to the matrix answers that you provided?
I suspect some noteworthy exceptions exist. This little quiz might serve to crystallize your thinking on the subject; it might also help to adjust your investment style such that it is more compatible with your feelings towards the two investment dimensions that these questions probe.
I answered no/no with little hesitation. So, I am firmly in the group 4 category camp. Yet my portfolio has both active and passive mutual fund/ETF holdings. I suppose that’s because I do think that some talented professionals can enhance performance at the margins with a smidgen of superior stock selection and/or timing skills. The issue with me is that I question if they can accomplish these demanding tasks persistently, and with enough excess rewards to overcome the incremental costs. Deep down, I seriously doubt persistency, and I see the cost hurdle as almost insurmountable.
I am surely not alone in the group 4 category. My cellmates come with extraordinary credentials and authority.
From the investment community there is Warren Buffett, Charley Munger, John Bogle, Benjamin Graham, Peter Lynch, Ted Aronson, Rick Ferri, and Charles Schwab.
From the ivy covered walls of academia we have Bill Sharpe, Burton Malkiel, Paul Samuelson, Daniel Kahneman, David Swensen, Jack Meyer, and Andrew Lo.
Continuing, from the financial journalists army, there is Mark Hulbert, Jason Zweig, Jonathon Clements, Allan Roth, and Holman Jenkins. Ted’s posting of Mark Hulbert’s Butter and S&P 500 article actually prompted me to post. Hulbert is a recent convert into the group 4 rating.
It’s a mighty crowded room that is currently more heavily populated by institutional agencies. These agencies are replacing active management with a passive Index approach because of disappointing results over time..
The empirical evidence says that superior, persistent active management outcomes are sparse with miniscule odds of success. A recent Dimensional Fund Advisor study showed that only 1 % of actively managed equity funds beat their benchmarks for 5 straight years (23 out of 2,231).
I certainly could not a priori identify members of this illusive group of winners. As Winston Churchill remarked: “The greatest lesson in life is to know that even fools are right sometimes.” The debate over skill and luck within the investment community remains unresolved, but the smart money is more and more betting the luck side of that controversy.
The active fund management landscape is littered with fallen idols. Ken Heebner’s CGM Focus fund was the very best performing mutual fund from 2000 to 2009. It has hit hard times over the last 5 years. It is an extremely volatile fund that induces frequent investor turnover. Even while it was returning 18 % annually during that period, its clients were rewarded with a startling minus 10 % annual loss. That’s tragic.
Bad entry/exit timing seems to be the norm among active mutual fund supporters. They love to play the “Hot” hand. History demonstrates that Hot reverts to Cold very quickly and very unpredictably. Once again, individual active fund investors are victims to the market’s “regression-to-the-mean” law.
DALBAR annual studies consistently conclude that private investors receive less than one-half of the returns that their purchased mutual funds deliver. Individual investors have a notoriously negative timing sense that erodes their wealth.
All these studies and data are distressing and depressing, but also enlightening. Years ago, I was 100 % committed to active mutual funds. That is no longer the case. Today, two-thirds of my portfolio is consigned to passive holdings. I’m slowly learning and migrating in the passive direction.
Why not all the way? One answer is that I like the excitement, the fun, the entertainment value. Another is that I enjoy the challenge. Yet another is that I’ve been lucky all my life and hope that luck continues.
However, none of these reasons are compelling. None of these considerations override my desire for cost containment and overarching reliability. The marketplace is wild enough without accepting the additional risks of downside excursions introduced by sometimes hot, sometimes cold, often unpredictable active management. The normal market risk completely satisfies any residual boldness risks that I might still harbor.
Your thoughts on this matter will greatly enhance the value of this posting line. Please contribute to balance and extend the scope of this topic.
Best Regards.
Comments
Active. Dislike passive, although nothing against it. I like making specific investments, doing the research, etc.
"Do you believe that market timing is a repeatable skill?"
No. I just think that the level of noise, intervention and general BS in the market makes continual timing success based on technicals difficult at best. Not impossible, but increasingly difficult as the years go by.
"Do you believe that stock selection is a lasting skill?"
Over longer periods? To some degree yeah. Everyone is going to have hot/cold periods.
"Ken Heebner’s CGM Focus fund was the very best performing mutual fund from 2000 to 2009. "
When Cramer was on "Regis and Kelly" and named the fund his top mutual fund, I said that was it for the fund (and it started to fizzle around that point.)
Edit: Perhaps you should have added a third question and that is do you believe in trend persistency. For me at least, trading/investing is all trend persistency and being in synch with the rhythm of the market and the line of least resistance.
I answered no-no. And yet, only 10% of my portfolio is passive. Why the contradiction? Do I have a split-investing personality? I think you expressed it well and so I echo your thoughts here: I enjoy investing, I'm competitive, and I like the challenge.
Could I turn the other 90% over to the passive side and make more money, spend less time away from my family/friends/work, sleep better, fret less, and enjoy life more? Yes, yes, yes ... It appears to be a no-brainer.
So what's keeping me from pulling the trigger? Fear. Pure and simple. Fear of what? I'm not sure - perhaps it's my fear of admitting I'm just average at investing. So it's my pride that prevents me from being 100% passive. And yet, it's something that I know is rationally correct and best for me and my family.
Does this make sense?
Mike_E
P.S. I greatly enjoy your thought provoking comments. Keep up the good work.
So I pose the question does one believe that markets are efficient or is the entire premise flawed? Or should one overlook these flaws and adopt a passive approach, because it is still likely to beat an active approach? I think ultimately one has define who they want to be as an investor. Do you want to target relative or absolute returns. If you are happy with relative returns and style box investing, perhaps you will be better off with a passive approach. I am no longer content with relative return victories. If the market is down 40% again at some point (a real possibility) I am not going to be satisfied that I am down 30%. Passive strategies are great in up markets because they produce positive returns. When I believe the wind is at our back and stocks and bonds are cheap again I will be happy to re-adopt a passive approach.
Further, style box, or relative return investing does not account for the notion that you could be entirely removed from an asset class, or invested in another. For example. let's say a large cap growth fund was down 5% when the market was down 2%. But at the same time, high yield bonds produced a return of +6%. Were you better off becuase you only lost 2% vs. 5%, or worse off because you missed out on +6%. A passive investor would argue that this is proof you can't beat the market. I would argue that you missed an opportunity.
One more thing I would like to point out is the definition of risk. Do you define risk in terms of volitility or loss of capital? I believe most individuals define risk as a loss of capital. They should also define it as a loss of purchasing power, but that is not easily comprehended by the typical investor. Let's say you invested with a concentrated stock manager that modestly trailed the index after 10 years, but didn't lose money in any year while the market had some significant down years. Without knowing the future, would you be more comfortable knowing that your manager was managing your downside even if it cost you modest returns in the end? It's like buying a put option on your index portfolio. Is it worth the cost of insurance to know your downside is limited? I would think most investors would say that the risk protection and peace of mind is worth the cost of a modest reduction in returns. And don't ever forget what happened in Japan (market down 75% after 20 years) or the US for 20 years after 1929. It can happen again I am pretty sure Gene Fama will not be writing you a check to cover your losses if it does.
There is certainly more than one way to succeed as an investor. Your decisions become more significant each year that passes. The number gets bigger and there is one less year to accumulate assets. If you were closer to retirement I would strongly suggest you abandon the passive, static allocation approach. However, if you are young enough one could justify the approach as long as you are willing to stick with it through all market conditions. I am at a position in my life that I am far more comfortable with the active approach. I think there are going to be some excellent opportunites with great risk/reward trade-offs in the years ahead and I want to protect my capital to take advantage if and when they do arise. The current market and economic imbalances are great. In economics, imbalances must be corrected. It can be gradual or abrupt (like 2008) but they must correct. I am not predicting a market crash, but the risks are elevated due these imbalances. 60/40 portfolios will not hold up well in that environment (especially with the risk of rising interest rates)!
Now let's consider investing from a macro context...Enormous debt pile, record low interest rates, taxes that almost certainly will rise, and demographic headwinds and you start to see that the conditions we have become so accustomed the past several decades will be difficult to duplicate. Anything is possible but so many things would have to go right that beta returns has become a low probability outcome. Personally, I want the deck to be stacked in my favor before I make a 60/40 bet. That does not currently appear to be the case. This is especially true for risk sensitive investors and those with short-intermediate time horizons.
1) Because they can go anywhere, they have multiple ways to generate returns (security selection, asset class selection, and hedging/cash build up in some cases).
2) They are risk conscious. The ones used are smart managers that have their interests aligned with the investors in my opinion. If we have another market meltdown, these are the type of guys that can potentially generate 30 points of "alpha" quickly (by avoiding losses) - exactly when you need it most.
There is a reasonable chance we are going into an environment where beta-only will produce extremely low returns. Because we are in a period of global economic transformation, volatility is likely to be greater than normal (investors and gov't are reconciling the past they knew with the future they don't know). This creates additional return generating allocation oppotunities for managers who understand it and are paying attention.
Also, understand that a manager may ultimately produce negative alpha but did their job becuase they accomplished with far less risk (if you define risk as something other than volatility). Maybe a manager underperformed the market by a small % over 10 years but never left your portfolio exposed to a major meltdown. This peace of mind may be well worth the small price, and you may have even sold your beta only investment in the meantime out of fear (not fully reaping the benefits of your beta).
Just my two cents. FWIW
Regards, hank
Do you consider yourself an Active or a Passive investor?
Both !
Regards,
Ted
Maurice- Your comments made me laugh. Although not true for all "bogleheads" you are quite correct in that they are rather dogmatic in their views about passive investing.
One element that to date I do not quite understand is that even these passive investors are making active bets to their portfolios. For example:
1). Should one invest in total stock market or slice and dice?
2). How much international exposure?
3). Total bond market, intermediate treasuries, short term bond or TIPS?
4). Small cap tilt?
5). Value tilt?
6). Emerging market tilt?
7). Frontier markets?
8). Foreign bonds?
9). Timing of rebalancing bands, yearly, quarterly, % decline, etc
Every advisor cited by MJG has their own spin on passive investing. I guess the closest thing to true passive is similar to what Alan Roth proposes in total US stock index (% allocated based on global weighting), total international stock index and total bond index. One could now add total international bond index. However even Roth tilts to precious metals-energy.
Lol
Ted- see my reply to Maurice above. What exactly is a passive investor? I have never met one as someone is always making an active decision. Heck even John Bogle waffles from total bond index to advising one invests in short term bonds since treasuries were over valued.
I understand your reasons for switching to active management. You cannot deal with the emotional discomfort of beta when the market goes through those painful episodes. So a low beta and high alpha strategy is preferred.
Hope streams are eternal. You are hoping that the manager you picked and the strategy he picked will save the day next time. I really do wish you good luck there. However, often times we find out that the guy that was save us turns out to be false prophet next time. And some that managed to handle the crash through luck or skill, continued to see crashes everywhere and underperformed simple money market. The problem is that unlike cheap and reliable beta, pursuit of alpha is expensive and unreliable and often discovered after the fact. Sometimes the past alpha is really not there. The manager is not measured correctly to the correct index that its investments otherwise indicate. We think that if the manager is given more tools, more flexible mandate they will be able to use these tools timely and wisely. It is very hard to be expert in one thing and what is the confidence that they will have equal competencies in all these tools. So far, these very flexible mandate funds have been expensive and mostly not playing out as we thought they would. Therefore when I invest in active management it is pretty vanilla type, I hope that the manager can express competencies in one thing. I came to the conclusion that I do not want them to try to make macro calls but pick stocks or bonds in their domain of expertise. Even that is difficult enough...
I do know this and yet I still play the active management game. It is a paradox. Perhaps for some it is the trill and excitement... Perhaps for others some sense of being in control (however limited it might actually be) comforts our minds. I like to think for me its the latter.
Perhaps your reduced risk tolerance should have been compensated through lower beta with reduced exposure to risk assets over life time. In fact there is such a thing in the market today called target date funds. Some are better than others and while there are many critics of this approach, many investors simply under-perform these funds at about equal risk levels to their own portfolio holdings. They just don't know because they do not properly measure.
A thoughtful write(s).
A view I offer is from my personal technical (electronic/mechanical background); not as in "technical analysis" related to investing.
I hold a 6" long hex-headed threaded bolt in one hand and the appropriate hex-headed threaded nut in the other hand. I can either turn and thread the nut onto the bolt or visa-versa; or thread both onto one another, turning both at the same time. If I had proper physical access to both pieces, I would turn both at the same time as a matter of being efficient. This is my active part of the work, until both pieces are tight to perform the task.
The "binding" of a portfolio; which with this example, needs at least two pieces.
For this minimum portfolio of two pieces or the nut and bolt being two pieces; I may choose to have a helper or manage the work myself. The helpers would be the active managed funds or with managing the work myself, could be a mix of active and passive helpers.
The active side being the human side and the passive side being the more purely, mechanical side.
In either case, and I suspect would be the majority case among investors here; I will still actively manage the managed and passive. In the case of the human managed funds, I have added another layer of trust into someone or a team with whom I have no real insight. My own intuition and theirs is in play for the active side. The passive investment side only requires my own intuitions.
We are all correct in choosing our own mixes; based upon our intuitions with the humans we entrust our monies towards; as well as how we deal with the passive/mechanical funds.
You noted: "Do you define risk in terms of volitility or loss of capital? I believe most individuals define risk as a loss of capital."
Our house defines this area in the same fashion, loss of capital. One can not gain the value of forward compounding so easily, with negative numbers, eh? As to volatility . Our house views this as a form of opportunity to either leave or stay at the party; that will affect the "risk". Volatility is well expressed with two market sectors ,in particular, over the past few decades, being the metals and emerging markets. Lots of opportunities for profits and lots of chances of a portfolio receiving a good butt kicking, if the owners were not paying attention.
We're actively managing a portfolio, at this house, period.
Take care,
Catch
How anyone can split up the market in various ways with partial indexes or ETFs and still call themselves 'passive' is also beyond me. It's no great news that an active fund can do well in one time period and poorly in the next, but hasn't anyone noticed that passive index funds act the same way? For example, emerging market index funds did brilliantly for awhile and have done terribly recently. Money poured into them after they'd done brilliantly and is now pouring out of them since they've recently done poorly. Anyone see a pattern here? I think Kahneman did.
Speaking of which, how do famously active investors like Buffet, Lynch or Graham get classified as pure passive investors? With Graham I'd guess it's the usual taking of a few quotes from a late interview out of context that does it (I've read the whole interview and it's all about Graham giving suggestions on what kinds of stocks and bonds the investor should buy), but the guy who wrote One Up On Wall Street?
Indexing has simple arithmetic going for it, there's no doubt about that. Risk control, however, is an inherently active concept. I think active fund managers are in the business of risk control first and foremost. If I don't pay them to do that then I have to do it myself, and they just might be a bit better at it than I am.
Investor- appreciate the reply and somewhat agree. You will note that my portfolio does not consist of long-short funds as I do not believe one can consistently time the ups and downs. I'm primarily investing in very risk conscious value managers (Romick, Inker, First Eagle Team) that is balanced with active fixed income and momentum players (Good Harbor, managed futures). I'm adding to emerging since I like the long term risk reward but am very cautious of US equities at current valuations.
As a steward of my own capital my strong preference today is direct lending funds which I have a substantial position in lending club and a small business loan fund. Currently reviewing a first deed fund as well. IMHO, these represent a much, much better risk reward than anything else at present time. Perhaps one day I can spend the time to post my arguments.
Cheers
Heather, I support Mr. Graham's view that markets get it relentlessly right in long run, but they can be terribly wrong (aka inefficient) shorter term. I'll steal a page from Professor Greenblatt to illustrate:
Here's percent difference between high and low over past 52 weeks for some very well followed and notable stocks:
NFLX: 463%
YELP: 295%
P: 210%
CLF: 204%
HPQ: 145%
FB: 140%
That means Netflix more than quadrupled its value in less than one year's time. Yelp, tripled! Did any of these companies do something so profoundly different in the past year to double and triple their value? I'll venture to answer no, but Mr. Market thought they did.
Now, time for Saturday night cocktails!
Hope all is well. Thanks everybody.
Charles
I want to especially thank the MFO members who took precious time to craft a reply to my post. I deeply appreciation the extra effort needed. The replies demonstrate a fine diversity of viewpoints necessary to explore some of the subtleties of the topic, and our sensitivities to it. That’s good. Thank you all.
You all know that I’m a pure amateur in financial planning matters. I have never earned a dime selling investment advice or forecasts. I only participate actively on this website, and primarily focus on mathematical subjects.
I’m motivated to do so by my general observation that many US citizens, including financial counselors, are relatively numerically challenged. This observation is not only in regards to sophisticated mathematical methods, but disappointingly to simple arithmetic operations. For example, many do not exploit statistical base-rate data when making investment decisions even when that data is readily accessible.
That deficiency alone could do major damage to a portfolio. My postings and references are mostly designed and selected to address and to reduce that defect.
“Remember, O Stranger, arithmetic is the first of the sciences, and the mother of safety.” I culled that quote from John Bogle’s most recent book. He referenced Supreme Court Justice Brandeis who purportedly quoted Sophocles. I hate complexity.
The long and incomplete list of “experts” that I cited in my original post all concede that a few money managers have the skill set, the resources, and the intangible talent to beat the market. The difficulty is to identify these fortunate souls in a timely manner. Bogle’s analogy is the finding of a needle in a haystack. He concludes that that is too daunting a task. His flippant recommendation is to buy the haystack.
As I read your comments, I reviewed my original post. Even the “experts” on my Index proponent list are not always so expert; they too are not immune to mistakes, and some of these are really gross errors. I was reminded of one such error by Peter Lynch that must be close to shattering records in that category. It’s a lesson learning good story.
It’s often called “The 7 % Fiasco”. In a 1995 Worth Magazine article, Lynch claimed it is perfectly safe to withdraw 7 % annually from a retirement portfolio that is 100 % committed to equities. The absurdity of that claim was immediately challenged by Scott Burns, then of the Dallas Morning News, after completing irrefutable research. To his credit, Lynch quickly acknowledged his error and rescinded the article.
The original article could have done considerable retirement planning damage if not corrected. I was doing Monte Carlo drawdown simulations during that timeframe and was getting acceptable withdrawal rates in the 4 % annual range. By the way, add Scott Burns to my list of passive Index supporters.
I suspect we all fall victim to what the behavioral wizards call Confirmation bias. We more or less screen and sort information in a manner that reinforces our existing investment philosophy. It is very hard to resist this bias. Like one of my favorite Paul Simon songs “The Boxer” says: “A man hears what he wants to hear, and disregards the rest.” I think most of us recognize that there is no single way, no magic formula, to engage and profit from the markets.
What works to make the individual investor comfortable is right for that person. It seems that David Snowball operates this website with freedom of opinion as a guiding principle. We and our portfolios will prosper from that go-anywhere, open-minded freedom. Thank you David.
Controversy and debate is good. It generates better investment decisions. In doing so, please focus on the merits and shortcomings of the various arguments, not on any perceived personal traits of those making their cases.
Personally, I welcome opinion deviances while critically examining the substance of the supporting analysis, not its presentation style. I believe most of you guys do the same.
I suspect far too many among us invest far too much time in seeking an imaginary miracle money man. This financial miracle master will have the uncommon wisdom to correctly gauge the worldwide economic environment, be able to project the differential performance advantages between fixed income and equity market holdings, properly project critical market tipping points, assemble a portfolio that generates market-equivalent rewards while avoiding any market meltdowns, and can accomplish these Herculean tasks without incurring any major cost leakage impacts. Wow!
Such an investment superman is an unrealistic myth. A century of searching the records and scores of academic studies fail to discover more than a handful of these financial heroes, none of which were pre-identified for such extraordinary performance before the fact.
This is an overwhelming mission impossible assignment. Now, if pigs could fly ……
In closing, my number One takeaway from this exchange is that grand illusions die hard.
As a dedicated and informed group, we generally feel that both technical market timing and stock picking are almost fictional art forms, at least from a reliability and persistency perspective. We recognize that these active management techniques work sometimes, but also fail in a costly manner at other times. Yet we still pursue the golden dream of excess returns.
I suppose we all share some animal spirit genes. Hope is eternal and often conquers logic.
Good luck everybody.
Best Wishes.
There is no doubt in my mind that there is no absolute "perfect" portfolio. It's up to each of us to find one that we are comfortable with. The best advice I can give is not to constantly shift strategies and try to stick with one approach for the long term AND do not rely solely on past performance to forecast future returns.
I do believe that 90+% of investors are best off investing in globally diversified stock and bond index funds, however, like I said above I'm not one of them in today's environment. There will be a day again when the risk reward is more attractive for buy hold rebalance.
On a side note, I'm on the board of our pension plan committee at work and was successful in eliminating all active funds for our plan participants. We now offer a plan consisting of: total US stock index, total international stock index, total US bond index, total international bond index and Short Term high quality bond fund. Very, very simple and effective plan. One chooses their allocation % to stocks and bonds between US and foreign. Low costs and well diversified using 4 funds. This approach gives the average investor the best chance of a successful retirement. However, outside of work is not for this investor!
If someone forced me to select one strategy for the long term and never change it....begrudgingly I'd suggest Harry Browne's portfolio of 4 equal parts: gold, stocks, treasuries and cash
Hi Heather,
I too am a fan of the late Harry Browne on several layers. I own a couple of his books and attended a few of his sessions at the Las Vegas MoneyShow. No doubt, he was a smart investor and truly attempted to control risk as the founder of the Permanent Portfolio concept. I even voted for him once when he was a candidate for the US Presidency.
I miss this kind and gentle rail-thin man. Your mention of him allows me to tell a fond story about his presentation format. It was shockingly informal. His presentation materials were one or two dog-eared 3 X 5 index cards. They must have been used (abused) hundreds of times. They were completely covered with handwritten small sized notes, on both sides.
He rarely glanced at this reference material. He mostly spoke from the heart with a soft but engaging style. Indeed, I really do miss this departed giant.
Thank you for nudging me to recall his memory.
Best Wishes.
Anyway I agree that the posts in this thread are very thoughtful though I am skeptical that they will help me get rich.I do not epect my active managers outperform every year as most of the ones I use seem to be best in different investment climates. I do wonder/worry if having many different equity funds (even if all good mangers ) is just an expensive way to create my own index fund.
Finally , I do have a number of fund investments that are held in taxable accounts that have wonderful long term records. However, I wouldn't now invest in them but don't want to sell . Why/, because after taxes moving to a different investment was unlikely to work. I suspect many have this problem
Thanks for sharing this story. I wish I had the opportunity to meet the late Harry Browne, may he rest in peace.
Hi Heather,
Upon further reflection of your decision to favor passive Index funds for your company’s retirement program, I recalled some recent other institutional agency conversions to the passive investing discipline.
I certainly concur with your wise judgment to adopt that format, and for holding fast to any investment philosophy through an extensive fair period test. I believe we all are a little impatient and tend to abandon the ship prematurely. Simplicity and commitment work best.
Your decision to offer Index-like products is consistent with the direction being taken by many institutional agencies. There is a clear message here given that these influential institutions can trade more cheaply and more quickly than the private investor.
Also these entities have the muscle power to hire the best of the best money managers and have committees to screen for these superior managers. Yet they are taking the alternate pathway. This movement has been gaining momentum for at least a decade. The ICI 2013 Fact Book has extensive longitudinal tables that illustrate this trend for various categories of institutional investors.
Earlier this year, intrepid MFOer Ted posted a reference to an article that reported a California state pension plan (CalPERS) option to shift more of its gigantic savings into the passive Index camp. This could be a watershed event.
Apparently, before the proposed realignment, CalPERS already had an impressive fraction of its enormous holdings in passive products. That institution was unhappy with the lackluster performance of the other fraction which was assigned to numerous active fund managers, including a Hedge fund component. There is a disconnect between the extra costs and the end results which has prompted this agency to reexamine its investment advisor policies.
The evidence suggests that only about one-quarter of the active managers in the CalPERS program outperformed their benchmarks. Their excess returns did not compensate for the poor results achieved by the remaining three-quarters of active management. The CalPERS decision-makers are now asking the key question: Why bother?
Most likely, CalPERS final decision will influence other, smaller pension agencies. Their decision on this matter is expected momentarily. I am unaware of the outcome.
Best Wishes.
With my time horizon around 30 years, I'm willing to concede that in the large cap domestic arena there is probably no reason to look anywhere but a passive product. Though I prefer to avoid market-cap weighted indexes, something like VIG/VDAIX is probably going to do very well. I currently use PRBLX as a core here, but I'm weighing a switch, even if to VDIGX.
My conceptual problem comes in the areas of the market which are supposedly less efficient. Few people suggest passive bond products, and Buffet and Lowenstein have shown the success of value investing, particularly in protecting against the sorts of bubbles that plague market-cap weighted indices. I use DODWX for core exposure to domestic/int value (yes, aware of D&C's volatility, but have a long horizon. Am more concerned with AUM), but might concede VIVAX or some fundamental index would also do just fine.
My real hangup comes in areas where liquidity or market knowledge come into play. So if I buy a microcap or small value index, I run the risk of losing money to arbitrage strategies. Also, I know you've spoken against the idea that active management can reliably protect the downside, but small caps seem like an area where they might have an advantage given both arbitrage and growth risks. Fund Reveal seems to back this up with quite a few funds scoring higher on the return axis and lower on the risk axis than NAESX or VISVX. VVPSX, for instance, is marketed as primarily concerned with protection from loss of capital. Of course, there are always PVFIX and ARVIX.
The other area where I see a problem with indexing is of the international market. Many seem convinced that emerging markets are worth paying for active management, though at least part of my avoidance of an EM index is avoiding Russian and Chinese state run firms. However, Rekenthaler just wrote an article on the problem of developed international indices as well: news.morningstar.com/articlenet/article.aspx?id=608086. This makes some sense to me. The S&P 500 or Russell 3000 represents America's economy. The EAFE index represents everything else in the world considered "developed." That's a large number of countries, many of whom have little in common (Japan, Germany, Canada, for instance). Wouldn't an active manager be able to move in and out of regions to avoid valuation crises, like happened with Japan in the early 90s?
You're a particularly eloquent advocate for passive products. Was just wondering what your thoughts were on those two areas of the market in particular? Or if you had an opinion on the viability of fundamental indices?
Hi mrdarcy,
No need to apologize for a late posting. Your comments expand the discussion in yet another dimension, and that improves the usefulness of this controversial thread. In the marketplace of ideas, the time-clock is not a parameter.
You asked me to offer an Index versus active fund management opinion in three diverse investment categories: small capitalization, international, and fundamental indices.
Note that when comparing against a cap weighted Index, I placed Fundamental Indices in the actively managed category. I’m sure, the designers and sellers of these newer-age products would take issue with my assignment. But almost from a definitional perspective, a mutual fund that is constructed to beat an Index can not be an Index itself; it is part of an Index selected for out performance purposes. That’s sort of what active management strives to do.
The marketable Fundamental Indices are the successful survivors from rigorous and thorough back-testing. Loser formulations were eliminated. The proffered Fundamental Indices are likely the end product of an intensive data mining exercise.
In most cases, the excess returns over the cap-weighted Index was less than 2 % annually. Operationally, these newbie Indices will be more costly so they will be hard pressed to maintain the incremental benefits given their heavier management and portfolio turnover fee drags. Will they succeed? I have my doubts, but who knows with any certainty?
The market iron law of regression-to-the-mean is likely to rob these new Indices of any advantage that surfaced in the past. Remember, the standard investment cautionary disclaimer is that past performance is no guarantee of future rewards.
Fads come and go. In 1996, James O’Shaughnessy claimed to have discovered “What Works on Wall Street” after extensive and solid research. His carefully designed program failed him when he assembled a mutual fund using the guiding principles uncovered in his studies. His method failed the acid test of a real, evolving, adaptive market just like the ghosts of the 1960s Go-Go concept stocks did. Outsized returns are quickly competed away.
Always recall General von Clausewitz’s warning: “The greatest enemy of a good plan is the dream of a perfect plan”.
I do not invest in these enhanced Fundamentally-based Indices.
Although I am being pulled towards a more passive portfolio commitment, I still retain a healthy actively managed sleeve. If the actively managed firm controls costs and invests a significant fraction of its wealth in its own product, I am encouraged to trust them. I too believe that some of these talented guys are superior stock pickers. The issue is if the excess profits from their superior stock selections can overcome the incremental cost burden of the process itself.
I do own both passive and actively managed mutual funds/ETFs in the International and small, value equity categories. I share your viewpoint that if active management is to be successful anywhere, the likely areas for their superior performance are in small, value oriented stocks and in the wild west international arena. Unfortunately, the data do not support or encourage this assertion.
The S&P Indices versus Active Funds (SPIVA) scorecard and the S&P Persistency reports year after year destroy that dream. With an occasional exception, these reports demonstrate that the traditional Indices outdistance their actively managed competitors both annually and statistically over longer timeframes.
The number of active winners in all categories erode more quickly over time than even chance winners are expected to prevail. This gloomy trend remains intact in the international and in the small, value-oriented classes. However, there is some glimmer of hope for the small, value funds in the international marketplace.
In no way do these data compromise the Fama-French findings that small stocks and value-oriented stocks add positive incremental returns to a portfolio. The Fama-French 3-factor model is still the most reliable and comprehensive model when assembling a portfolio.
Small, value-oriented holdings add value to the portfolio’s returns. It’s just that in the US, most active managers have not consistently beaten an Index when cobbling together a portfolio of holdings with those same characteristics. These smart guys neutralize each other.
Today, to a lesser and lesser degree, I still hold onto the active fund management dream.
I hope this posting satisfies the questions you asked and is a little helpful. Be alert that I don’t consider myself an investment expert; I am a rank amateur who does read many books on this topic and advocates for statistical application to all investment decisions. Base rate statistics are fundamental inputs to good investment decision making.
Thank you for your contribution and your excellent inquiries.
Best Wishes.