Hi Guys,
Are you familiar with the Babe Ruth syndrome?
The Babe Ruth syndrome recognizes the tradeoffs between great success and abject failure; Babe Ruth setting records for his home run hitting prowess, but also notorious for his strike-out frequency.
Without too much imagination, it is easy to construct a similar analogy using Brett Favre as the focal point with his high-risk, long touchdown passes and his rally crushing interception frequency record. In most happenings there is a tension between the good and the ugly.
Investors are confronted with this tension when making mutual fund/ETF decisions. Does the investor buy into the merits of the active fund management story? Is the amateur investor satisfied with Index-like returns, or does he shoot for the stars in an attempt to secure outsized excess returns? Each of us must make our own lonely decisions.
The data suggest that investors most often seek excess returns (Alpha). The Investment Company Institute (ICI) research and records support this finding. The ICI data bases clearly demonstrate that the individual investor most frequently employs active mutual fund management. In contrast, on an average percentage basis, institutional investors hire Indexers.
The most recent ICI data releases provide the following summary statistics. The 2011 Investment Company Fact Book shows that only a small percentage of individual investors use Index products. Like 90 million folks own mutual funds, and half of these use an advisor. From the ICI Fact Book: “Of households that owned mutual funds, 31 percent owned at least one index mutual fund in 2010.” So most individual investors are still committed to active mutual fund management. That’s a commitment to purposely seeking Alpha.
This search for excess returns becomes problematic to a
retirement portfolio because it fails at several practical and statistical layers.
The semi-annual S&P mutual fund scorecards document that from a frequency purview only one-third of active managers outperform passive management on an annual average basis. Additionally, performance persistence suffers as the earlier top-managers seem to lose their skills and prescience over time at a rate that exceeds random turnover. Picking long-term successful fund managers is not an straightforward task.
Besides the frequency issue, the private investor is further challenged by the rather meager excess returns that the successful managers deliver. When these Fortunate Sons do deliver, they struggle to exceed Index levels by just a few percent over any time horizon that meaningfully impacts cumulative wealth.
So we have the likelihood of a double whammy when focusing on excess returns: low probability of successful managerial selection coupled with scanty excess returns for the assumed risk.
But there is yet more bad news. A second layer of individual underperformance is well documented. Amateur investors are not loyal to their initial investments. Mutual fund ownership turnover rates have substantially increased. Our patience levels have diminished over time. Private investors change frequently, often to follow the so-called “hot hands”. It is well documented that “hot hands” are an illusion. It seems that a regression-to-the-mean kicks-in the moment a financial commitment is made.
Decades of survey data from Dalbar clearly documents that investors recover less than one-half of what funds they employ generate. Why? Private investors are masters of bad timing. We are late to the financial party. When we do switch parties, the abandoned party outperforms the one that we recently purchased. Institutional investors suffer this same outcome, further establishing the troublesome issue of active management screening and selection. Our average record is a first-class disaster zone in this arena.
Here is a Link to a May, 2011 summary article from Alpha Investment Management (AIM) that explores some of these same problematic areas:
http://alphaim.net/newsletter_5_26_11.htmlThe Alpha reference warns amateur investors to “stay out of the kitchen.” That’s far too harsh a judgment and is somewhat arrogant. Alpha concludes that “Consistent superior performance is rare in the mutual fund world”. We have all seen those proclamations many times. AIM proposed an approach to counteract the poor timing record of individual investor.
The AIM investment strategy recommended at the end of the article was to sell in May, and transfer into a bond position until November. The AIM strategy endorses a mid-cap Index equity holdings during the fruitful November-May period.
I do not necessarily approve of the AIM investment strategy. It is one of a host of options. The AIM strategy is based solely on a statistical assessment. It does not document a causal relationship between the parameters being correlated. It could be a lucky (or unlucky) coincidence. Any correlation that does not provide a logical rationale for the correlation is highly suspect.
These findings should be a cautionary alert to all investors. We are too aggressive when constructing a portfolio. It would likely be a good policy to divide the portfolio into two separate major groups: a globally diversified, low risk, low cost, low turnover passive unit, and a more actively managed aggressive unit that is targeted to add Alpha. The actively managed Alpha-directed holdings should have well diversified, high beta, and high volatility characteristics.
The final percentage mix of passive and active components depend on the individual investors specific goals, time horizon, wealth, age, financial knowledge, and risk profile. Each investor must determine this passive/active mix for himself.
It is possible to enjoy the comforts (lower volatility) and benefits (higher rewards) provided by both investment management platforms.
Best Regards.
