Archives For Active Investing

How would you like to choose mutual funds that will outperform benchmarks of the stock market? This is an ongoing pursuit of millions of people. Up until recent decades, people intuitively believed that if you pay professionals to spend hours every day researching stocks, they would outperform a brainless benchmark. It was only a matter of how big the outperformance would be – at least that was what people believed. Since then, multiple studies compared the performance of actively-managed mutual funds with benchmarks, and found out that it is not as trivial as intuitively seemed.

The task: This article reviews an academic study that tried to find out what portion of actively-managed mutual funds outperformed benchmarks due to skill, as opposed to random luck. This can help you decide whether you want to pay someone to try to outperform the benchmarks by picking the right stocks or by timing the market.

The study is by Russ Wermers, a professor of finance at the University of Maryland, Laurent Barras of the Swiss Finance Institute, and Oliver Scaillet of the University of Geneva. It observes returns of actively-managed mutual funds over the 32-year period of 1975 to 2006. It avoids short-term biases by including only funds with at least 60 months of returns, and is free of survivorship bias, by including funds that existed at any time in the period observed.

How do you decide? Given the alternative of passively managed funds that track diversified benchmarks, combined with the fact that globally diversified stock investments recovered from all declines in hundreds of years to achieve handsome long-term averages, you have to make a good case for trying to beat benchmarks, while risking doing worse.

You may choose to use an actively managed mutual fund if the odds of outperforming the benchmark are substantially higher than the odds of underperforming it. A smart speculator would do so given any chance of success over 50%, while a more risk-averse individual may want much higher odds.

The results: Can you guess what the chance for success was based on this study?

During the 32 year period studied, from 1975 to 2006, only 0.6% of funds delivered higher returns than their benchmark through skill (not even counting sales loads).

Feel free to reread the number above – the number is indeed less than 1%.

The decision: Based on these results, choosing actively managed funds seems unlikely to make you excess money while adding the risk of one person making wrong predictions. Neither the conservative investor nor the smart speculator should see any benefit in taking this chance.

Accepting the results of passively managed funds may sound boring, without the excitement of trying to “beat the market”, and plain “average”, but when compared to the dismal results of actively managed funds, it seems like the more sensible approach. It may be average compared to the benchmarks, but outstanding compared to most investors that still use actively managed funds.

What can you control? By narrowing it down to passively managed funds, you can avoid the risks of stock picking and market timing. Instead you can focus on things you can control such as minimizing costs, minimizing taxes and maximizing diversification. By using such criteria for selecting mutual funds you can peel off the speculative layer, turning yourself from a speculator to an investor, with a more direct link to the productive capacity of the world.

Disclosures Including Backtested Performance Data

This article reviews an article published by the Journal of Financial Planning: The Difficulty of Selecting Superior Mutual Fund Performance * [February 2006]. This is one of many research projects that compare actively managed mutual funds with passively managed funds and past performance with future performance.

First, let’s explain the two types of mutual funds:

Actively managed mutual funds tend to select stocks individually and time the market with the hope of outperforming the average market.

Passively managed mutual funds try to replicate the returns of the market, or a certain asset class, and are usually called index funds.

Several important results are presented:

  1. 90% of Large Cap Active Managers underperformed Indexes, over a 20-year period .
  2. 97% of Mid Cap Active Managers underperformed Indexes, over a 20-year period .
  3. Past Winners became Losers . Actively managed funds that outperformed indexes over the first 10 years, underperformed the indexes in the following 10 years. Past winners became losers, hampering the chance of predicting outstanding fund managers.
  4. Higher Taxes . The results were magnified when considering taxes: active managers lost 0.89% more of the returns to taxes, when compared to index funds (1.51% loss compared to 0.62%).

What can we conclude from these results? If you are looking to get the highest returns on your investment, you would not want to settle for average. You would like to find a superior fund manager that can beat the market.

Unfortunately, most fund managers underperform the market. When going to smaller companies, it is nearly impossible to find a fund manager that is better than the average market (3% chance!)

Even if you managed to find the rare fund manager who beat the market for many years, s/he is likely to do worse than the market in the future.

You are at a dead-end. Ads focus on recent returns of mutual funds. Returns of indexes that have a consistent investment allocation and that are measured over periods of 25+ years may be more reliable. The ads tend to focus on periods no longer than 10 years. Even Morningstar gives significant weight to returns over the past 3, 5 and 10 years. The whole mutual fund industry focuses on ratings that do not provide you with helpful information.

The good news! It turns out that if you settle for “average”, you end up outperforming most investors. Once you are settled on average, you can focus on things you can control and measure very well: diversification, minimization of taxes and all other investment costs. You might think that you settled for average, but at this point, very few people, including most sophisticated money managers are doing better than you.

* Referenced with permission.

Disclosures Including Backtested Performance Data

[Updated Data February, 2011]

Are your investments having the right impact on your life? This is a critical question that any investor should ask, because investments can make you rich or poor, peaceful or stressed, work hard or get effortless gains.

If you answer any of the following questions with a “yes”, this article is for you:

  1. Is the long-term performance of your investments less than 15% per year?
  2. Are you spending more than a couple of hours per year dealing with your investments?
  3. Do you ever get nervous about your investments?

This article provides ideas for achieving the goals implied by these questions.

Is the long-term performance of your investments less than 15% per year?

Most investors don’t even match the returns of the S&P 500, which averaged less than 11% since 1970. If this is true about you, you are like most investors, including most professionals.

By putting all of your money into one mutual fund in 1970, you could have achieved more than 11%, outperforming most investors in the US! All you had to do is a single transaction, buying a US Large Value Index mutual fund.

If you had diversified your investments into large and small stocks all around the world and held them from 1970 until 2007, you could have crossed the 15% annual returns. This is using a naïve split of the money equally between the following Indexes: US Large Value, US Small Value, International Value and Emerging Markets Value1, and rebalancing annually.

Are you spending more than an hour or two per year dealing with your investments?

Our intuition says that if we study the market well enough, we can perform better than the average. History showed us repeatedly that people cannot consistently get larger gains by choosing certain stocks or timing the transactions. There are many reasons for this, including:

  1. Higher costs in many forms:
    1. Mutual fund fees. Hedge funds are at the extreme end of the spectrum by charging both a percentage of the money managed and a significant percentage of your gains!
    2. Broker and investment advisor fees.
    3. Increased trading costs compared to a buy-and-hold strategy in terms of transaction costs, broker fees (bid-ask spread), taxes that are less deferred and short-term gains.

    In order to beat the performance of buying and holding index funds, you have to make up for all the extra costs.

  2. We are emotional about investments in many ways.
    1. We believe in and invest in what we know, even when it’s not the best investment. The most heartbreaking cases I’ve seen were related to investing large amounts in an employer’s stock.
    2. We buy after large increases when stocks are expensive and sell after large declines, when stocks are cheap. This happens because we expect the recent past to continue, instead of studying the long-term behavior of the portfolio.
    3. The most prevalent mistake I have seen is going after promising investments, not considering the current price. Today’s best example is real estate.
  3. When concentrating on fewer stocks or countries, you cannot afford to include risky companies, since they are more likely to go bankrupt. This is a big loss since, as a group, they grow faster than average.

By sticking to the simple portfolio of index funds mentioned above, you limit your work to rebalancing.

Do you ever get nervous about your investments?

Investments can cause stress in many different ways, usually during long and steep declines. You start by asking yourself, “When is my portfolio going to recover?” As time passes, you ask, “Is it going to recover? Can it make up for all the declines, and continue its long-term growth?”

What mistakes can lead to this?

  1. Concentration. By buying only a few stocks, or stocks that are concentrated in one sector, country or region, you can see your portfolio crash hard and long. A couple of examples are:
    1. Investment in the Nasdaq in early 2000, led to declines of over 80%. More than 5 years later, we still saw 60% declines!
    2. Individual stocks got completely wiped out, resulting in 100% irreversible losses of investments.
  2. Individual stock selection and market timing. As mentioned above, our intuition leads us to believe we can do better by selecting our stocks and timing our transactions. Since it doesn’t always work, we get nervous about the negative outcomes.
  3. Lack of history. If you don’t know how your investments reacted to world events in the past, you can’t know what they would do in the future. Even if you do know what they did, but you change the composition of your portfolio over time, you change the potential future.

How can you avoid stress, and even increase your peace of mind over the years?

  1. Diversify! By buying more companies of some group (e.g., International Large Value), the average expected growth does not change, but the magnitude and length of declines decreases. In fact, when you hold thousands of stocks, you can afford to put a portion in various emerging markets and less mature companies. Your long-term returns increase, and the decline periods shorten, because some of the stocks go up while others go down.
  2. Invest in Index Funds. There are numerous advantages to this choice:
    1. Index Funds can help you diversify your money into thousands of companies all around the world.
    2. With careful selection, you can pay about 0.5% in total mutual fund fees, increasing your returns by 1% or more when compared to actively managed mutual funds.
  3. Learn the history of your portfolio. We have a long history of the behavior of various indexes, going back as far as 1927. With this amount of history, you can learn how your portfolio behaves in different cases, and see extreme disasters that your portfolio was able to recover. Even long-term history does not guarantee the success in the future, but it can give you a sense of the robustness of your portfolio in the face of major disasters.
  4. Buy and hold. Other than rebalancing, do not change the construction of your portfolio. After you learned what worked for many decades, stick to it and don’t let emotions get in your way.

These actions will keep you calm whether your portfolio goes up or down. When up, you enjoy the growth; when down, you take the opportunity to buy low, and make even more money. As the portfolio grows, your peace of mind increases.

To summarize

You may achieve returns of 10%-20%, with minimal work. You do that while sleeping really well at night, by knowing that you didn’t gamble on specific companies, industries, countries or time of buying and selling.

A few notes about the approach described above:

  1. If you can access the Dimensional Funds mutual funds (requires an investment advisor that is certified to use them), you might be able to cross the 15% annual returns in the long run if history is any indication of the future. They might provide the best vehicle for the investing approach described above.
  2. The equal allocation described above is a naïve example that shows the ease of achieving high returns. Quality Asset Management constructed a portfolio that would historically achieve returns of over 17%, as simulated since 1970.
  3. There are many other considerations, including taxes. There are many ways to invest in ways that minimize taxable gains along the way. This is outside the scope of this article.

If you are getting rewarded with these long-term returns for doing virtually nothing while having peace of mind, you are doing things right.

You can work harder, or with higher risks and still be doing things right. But you should be rewarded with much higher long-term returns, well over 20%, in order to justify the extra work or stress. If the risks are higher, you should consider carefully if you can afford them and want to take them.

1 Returns include simulated data before fund inception.

Disclosures Including Backtested Performance Data