Active Investments: Hope Springs Eternal
Hope. It is the only thing stronger than fear. A little hope is effective. A lot of hope is dangerous. A spark is fine, as long as it’s contained.
A Lot of Hope Is Dangerous
Hope springs eternal; especially among the proactive-management crowd. But hope isn’t a good plan. The data simply does not support the idea that active investments can outperform the market over longer periods of time. Passive management, as many studies have demonstrated, almost always wins out in the long term — both because it’s inherently more tax effective and because it’s less costly.
This Time It’s Different
The proponents of active management argue that the more expensive endeavor of trying to better the markets is poised to take over the leaderboard after more than a decade of being trounced. Armed with little more than hope and theory, the active manager suggests that markets cycle (we agree) and similarly, so does the opportunity to outperform the broad markets (we disagree). However, the fallacy of the cyclicality of active versus passive investment management is that outperforming managers persist. Unfortunately, the data does not support those who have convinced themselves of active’s inevitable positive outcome. Most supporters utilize the techniques promulgated by Tony Robbins; that is, if you say it enough then you’ll start to believe it. And, heck, it may even come true.
According to the 2016 Mid-Year S&P Dow Jones SPIVA report:
- During the one-year period, 84.62% of large-cap managers, 87.89% of mid-cap managers, and 88.77% of small-cap managers underperformed the S&P 500, the S&P MidCap 400®, and the S&P SmallCap 600®, respectively.
- The figures are equally unfavorable when viewed over longer-term investment horizons. Over the five-year period, 91.91% of large-cap managers, 87.87% of mid-cap managers, and 97.58% of small-cap managers lagged their respective benchmarks.
- Similarly, over the 10-year investment horizon, 85.36% of large-cap managers, 91.27% of mid-cap managers, and 90.75% of small-cap managers failed to outperform on a relative basis.
With respect to the common mis-belief that inefficient markets provide a predictable opportunity for active management out-performance:
- From the 2015 SPIVA mid-year report: It is commonly believed that active management works best in inefficient markets, such as small-cap or emerging markets. This argument is disputed by the findings of this SPIVA report. The majority of small-cap active managers consistently underperformed the benchmark in both the 10-year period and each rolling five-year period since 2002.
- Meanwhile, managers across all international equity categories were outperformed by their benchmarks over the 10-year investment horizon.
According to the December 2016 S&P Dow Jones SPIVA Persistency Scorecard:
- Relatively few funds can stay at the top. Out of 631 domestic equity funds that were in the top quartile as of September 2014, only 2.85% managed to stay in the top quartile at the end of September 2016. Furthermore, 2.46% of the large-cap funds, 2.20% of the mid-cap funds, and 3.36% of the small-cap funds remained in the top quartile.
- For the three-year period that ended in September 2016, persistence figures for funds in the top half were equally unfavorable.
- It is worth noting that less than 1% of large-cap funds and no mid-cap or small-cap funds managed to remain in the top quartile at the end of the five-year measurement period.
I’ve often heard the argument that the post-2008 environment has been artificially manipulated through global monetary policy and, therefore, the statistics supporting lower-cost, passive investing are irrelevant — even fleeting. In fact, it is promoted by many an active manager that as a “more normal environment” develops, it’ll be active’s time to shine. This claim, however, conjures up memories of Sir John Templeton who, in his 2002 book The Four Pillars of Investing stated “The four most expensive words in the English language are this time it’s different.” Templeton died in July 2008 before the so-called “unique” post-crash environment was initiated.
Spoiler Alert: None of the data in this paper or the referenced studies factor in taxes; a force that erodes value at an alarming rate. Without adding to the technical parts of this piece, suffice it to say that the data generally supports the notion that active investing is far less tax efficient when compared to passive strategies.
Vanguard, often thought of as the biggest proponent of passive management actually actively manages almost half of their $4 trillion in assets (much of it in fixed income, however, which yields better, albeit not exciting, prospects for active outperformance). Perhaps it is because Jack Bogle, synonymous with Vanguard, is a constant champion for passive investing that many consumers think that’s all Vanguard does.
In 2009 Vanguard issued a study addressing the active-passive debate. Again, the data in this initial study is essentially free from the argument regarding the artificially manipulated environment we’ve found ourselves in since early 2009.
In an update to their original study, Vanguard questions if ten years is an appropriate time horizon to study performance. The authors state:
- In the ten years ended December 31, 1999, 71% of active managers underperformed the U.S. stock market, But during the decade ended December 31, 2008, 37% lagged, a change of 34 percentage points over nine years. We see a further shift when looking at the ten years ended 2013, when 55% of active managers underperformed.
- Although 63% of of active managers beat the broad market over the ten years ended December 31, 2008, most of that success can be attributed directly to the performance of value and small-cap stocks combined with the outsized growth in the number of small-cap funds. Likewise, the significant underperformance of active managers over the decade ended December 31, 1999, was largely due to the performance of large-cap growth stocks and the large portion of funds in the large-cap blend and large-cap value style boxes.
- The takeaway, then, is that during periods of notable deviation in performance between opposing market segments (such as large and small or growth and value), the distribution of active managers will be much more pronounced.
The essence of the Vanguard study is the investors’ trade of the uncertainty of outperforming a passive alternative in exchange for benchmark deviation, higher costs, and generally higher taxes. The challenge, however, is identifying the start and finish to each run of a particular style or segment. Said differently, we’ve yet to see anyone be able to accurately and consistently predict the start and finish of a cycle when small caps will do better than large caps or value will outperform growth, etc. These assets cycle: Of that we are sure. But nailing the timing and duration is all but impossible.
Warren Picks Stocks
Contrasting the arguments made by the active class of investors emerges arguably the world’s greatest investor, now one of the world’s richest men, Warren Buffett. However, unlike Buffett’s peers on the Forbes’ list who have created their wealth in financial services, Buffett accomplished this feat by selecting investments and patiently letting them compound; and not by the fees generated from offering to do so. He may be, in fact, the world’s least expensive asset manager. He is free.
On one hand it is odd that the the man billed as the world’s greatest investor has advocated passive investing for decades and continues to do so. But, Buffett recognizes that he is a statistical outlier. Buffett outlines in his 2017 letter:
In Berkshire’s 2005 annual report, I argued that active investment management by professionals — in aggregate — would over a period of years underperform the returns achieved by rank amateurs who simply sat still. I explained that the massive fees levied by a variety of “helpers” would leave their clients — again in aggregate — worse off than if the amateurs simply invested in an unmanaged low-cost index fund. (See pages 114–115 for a reprint of the argument as I originally stated it in the 2005 report.)
Subsequently, I publicly offered to wager $500,000 that no investment pro could select a set of at least five hedge funds — wildly-popular and high-fee investing vehicles — that would over an extended period match the performance of an unmanaged S&P-500 index fund charging only token fees. I suggested a ten-year bet and named a low-cost Vanguard S&P fund as my contender. I then sat back and waited expectantly for a parade of fund managers — who could include their own fund as one of the five — to come forth and defend their occupation. After all, these managers urged others to bet billions on their abilities. Why should they fear putting a little of their own money on the line?
What followed was the sound of silence.
Though there are thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess, only one man — Ted Seides — stepped up to my challenge.
Buffett goes on to explain the simplicity of his theory:
If Group A (active investors) and Group B (do-nothing investors) comprise the total investing universe, and B is destined to achieve average results before costs, so, too, must A. Whichever group has the lower costs will win. (The academic in me requires me to mention that there is a very minor point — not worth detailing — that slightly modifies this formulation.)
And if Group A has exorbitant costs, its shortfall will be substantial. There are, of course, some skilled individuals who are highly likely to outperform the S&P over long stretches.
In my lifetime, though, I’ve identified — early on — only ten or so professionals that I expected would accomplish this feat. There are no doubt many hundreds of people — perhaps thousands — whom I have never met and whose abilities would equal those of the people I’ve identified. The job, after all, is not impossible. The problem simply is that the great majority of managers who attempt to over-perform will fail.
The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane — a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul — said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”
Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference: The lucky monkey would not find people standing in line to invest with him.
Therein lies the fragrance of hope. It takes but just one win at the tables to lure the addicted gambler back into play.
In October 2011 (updated May 2013) Brad Barber, Gallagher Professor of Finance at U.C. Davis, and his student, Guojun Wang, posed the question: Do (Some) Universities Earn Alpha?
In their study they analyzed the returns of US educational endowments using style attribution modeling.
In their abstract they state:
For the average endowment, models with only public stock and bond benchmarks explain virtually all of the time-series variation in returns, yield no alpha, and generate sensible factor loadings. Elite institutions perform well relative to public stock and bond benchmarks because of large allocations to alternative investments. We find no evidence that manager selection, market timing, and tactical allocation generate alpha.
Alpha is defined as the additional return an investor receives above and beyond the return they would expect for the risk taken. In other words, alpha would be achieved when a manager outperformed their benchmark through superior security selection.
The study analyzed endowment returns over a twenty-one year time period ending in June 2011. Their thorough and mathematically derived analysis led Barber and Wang to the following conclusions:
- We find no evidence that the average endowment is able to deliver alpha relative to public stock/bond benchmarks.
- In measuring the returns earned by elite institutions (defined as those with students with the highest SAT scores), Ivy League schools delivered consistent positive alpha when compared to a blend of passive indices. However, this outperformance was directly attributed to the Ivy’s allocation to hedge funds and private equity.
- Once benchmarks for private equity and hedge funds were added to the passive control group, the alpha evaporated.
- The authors state: Our results suggest that endowments fail to earn alpha from manager selection or dynamic asset allocation.
- The vast majority of endowments choose to play the loser’s game, with mixed results. The average endowment allocates 73% of its domestic public equity and 66% of fixed income assets to active management…..Clearly, endowments make these allocation to expensive active strategies hoping for benchmark beating returns.
In summary, the widely regarded study suggests that on average consultants add limited value since most endowments are similarly allocated and that active managers add no value whatsoever. Given that this time frame principally predates the crash of 2008, this author questions the cyclicality of active versus passive investing.
Evangelists Make the Best Disciples
Even Barber and Wang end their paper with the notion that “hope” is a primary driver in investment committee decisions — hope of beating the passive representations of the markets.
Buffet adds in his letter that he is often asked for advice and consistently suggests low-cost, passive investing, stating;
I believe, however, that none of the mega-rich individuals, institutions or pension funds has followed that same advice when I’ve given it to them. Instead, these investors politely thank me for my thoughts and depart to listen to the siren song of a high-fee manager or, in the case of many institutions, to seek out another breed of hyper-helper called a consultant. That professional, however, faces a problem. Can you imagine an investment consultant telling clients, year after year, to keep adding to an index fund replicating the S&P 500? That would be career suicide. Large fees flow to these hyper-helpers, however, if they recommend small managerial shifts every year or so. That advice is often delivered in esoteric gibberish that explains why fashionable investment “styles” or current economic trends make the shift appropriate.
Enter the evangelist pedaling the story of salvation through an active manager’s prowess (note that every document issued by our industry states that past performance does not guarantee future performance; a lesson we’ve learned time and time again). Whether they truly believe — much like a religious fundamentalist might believe — their interpretation of a version of “the gospel,” or perhaps they cannot fathom the career suicide Buffett suggests above and simply sell that which can be sold, and/or they are simply willing to ignore data in search of confirmation for that which fuels their paychecks.
The financial services industry is riddled with unnecessary complexity and products often manufactured to address the fear or elation du jour. The truth is that 99% of the population is likely well served by a simple globally diversified mutual fund replicating the typical endowment mix of 60% stocks and 40% bonds. Mind you, there are countless articles hyping the death of the 60/40 portfolio, yet the data persists that this mix is generally the right balance of return and volatility for most investors. Simply compare your portfolio to Vanguard’s VSMGX for any reasonable time frame and we can all celebrate the few outliers who performed as well in a diversified portfolio.
Vegas Odds and Baseball
We often posit that investing is the opposite of a persistent Vegas gambling binge. If one were to play any Vegas game, placing the same bet every time, they would ultimately run out of money. This is because of the simple and clear fact that the odds are decidedly against the gambler. It’s just a matter of time.
In contrast, investing yields the opposite results if one places a continuous bet by simply rebalancing their portfolio and staying invested for the duration. The longer that investor stays at the table, the greater their probability of success.
To be clear, we do not appreciate fundamentalism of any kind — that includes a fundamentalist statement that passive is always better than active. We know that not to be true. However, there is a plethora of data supporting the persistence of passive over active and a dearth of data supporting the persistency of active management. To add weight to the headwinds that active management faces, consider that all of the studies and articles ignore the drag of taxes on a portfolio and presuppose that investors can both identify managers that can persist in bettering the passive alternatives. It isn’t so.
Instead, we appreciate Warren’s approach to investing, which he likens to baseball, citing Ted William’s strategy of discipline in waiting for the right pitch, suggesting that if Williams waited effectively, that he would hit .400. Investing, fortunately, gives you the opportunity to watch unlimited pitches; allowing you to swing at only the fattest pitches and only when you are ready; perhaps allowing you to hit .800.
And, that in a nutshell is our approach at AdvicePeriod. We believe in keeping fees and taxes to a minimum and passively investing until there is a compelling reason to do something different. We occasionally see fat pitches in private equity and other strategies where there truly is an information advantage and we occasionally see a fat pitch from a hedge fund manager that can impact their portfolio through activist behavior (like Paul Singer) or strategies that capitalize on the smallest pricing inconsistencies (like D.E. Shaw). After taking taxes, liquidity, and fees into consideration, we may include these strategies in our portfolios. But, for most, these are nice-to-have as opposed to need-to-have investments; particularly when caught in a downdraft like hedge funds have been as of late.
At AdvicePeriod, we do not believe that hope is a strategy. After thirty years in the business and decades of performance analysis as a service to other advisors, we’ve seen plenty of poor performance, typically at the hands of the professional advisor. In fact, it was the rarest of clients that outperformed their benchmarks over time. Today we advise clients by occasionally sitting on top of the best teams at the biggest Wall Street firms and see nothing different. We audit numbers for accountants serving the wealthiest people in the entertainment industry and see nothing different. All of their advisors deliver poor performance in exchange for high fees and often illiquidity. It can be maddening when presented with such clear facts to understand the power of hope.
For years when our old firm believed in hope and refused to adapt (ultimately contributing greatly to our departure to create AdvicePeriod), each quarter was a fingers-crossed, let’s see what we get moment for client portfolios. We had no control, but we believed we did. Not until we firmly accepted that we cannot predict the results of the markets and neither can the significant majority of professionals (in fact, the only thing that is predictable is how inaccurate most of the prognosticators are), did we start to focus on the areas where we could add value. This, we feel, is the future of the industry.
Today our firm is on the forefront of planning and tax management. We deploy technology to create efficiency — so we can do more for less. We focus on tangible results from structural changes to move the big levers like estate tax minimization and income tax strategies, including the most contemporary tax loss harvesting technology. The days of hope are in the rear view mirror. Today — and for the foreseeable future — we choose to focus on the facts and maneuver from a place of confidence.
In closing, another quote from Mr. Buffett worth remembering,
“When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”