People Still Believe In Active Management?
Every now and then (okay, every week) I run into someone with a different investment philosophy from my own. Occasionally, the exchange is jaw-dropping. For instance, I kind of thought the passive vs actively managed investment argument had been pretty much decided for the last 10-20 years. Apparently, not everyone feels that way, despite what I consider fairly overwhelming evidence. I had lunch the other day with a well-educated, pleasant, articulate investment advisor who works for one of the big investment banks. He wanted to meet with me because he was exploring becoming a “specialist” in advising physicians. His thought was that because he had some optometrists in his family, that this would be a good idea, never mind that he had no idea how PAYE/PSLF worked, thought the costs of dealing with HIPAA were insignificant, and didn’t think it was important to spend a few weeks or months getting a CFP or CFA. He also thought the investment management was far more important than the financial planning for doctors (“we don’t even charge for financial plans in our office.”) Well, that’s fine. I suppose advisors have to start somewhere. But then he starting talking about how he actually believed in active management. At this point, 95% of the respect I had for him went out the window. His arguments were:
- I’ve looked at the data and I believe it shows active management works better.
- Studies showing active management doesn’t work include mutual fund loads, which we don’t charge.
- Although 2/3 of academics believe in passive management, 1/3 of academics believe in active management.
- Sure, doctors can retire on market returns, but an engineer making $70K needs higher returns in order to have a comfortable retirement.
- Warren Buffett can beat the market.
- The best predictor of future returns is past returns (not low costs.)
Let’s start with his first argument and take a quick look at some of the evidence, just in case any regular readers were still in doubt. Exhibit A is the SPIVA annual report card. I wish these went back for 10 or 20 years, but unfortunately they only go back five years. Still, it’s a pretty damning indictment. Here’s a chart of the end 2013 report card:
|5 Year Data- 2009-2013|
|Asset Class||% Beating Index||% Disappeared||% Changed Style|
|Multi- Cap G||31%||28%||61%|
|Mortgage Backed Bonds||60%||4%||7%|
For those looking at this type of report for the first time, the first column is the asset class. The second column is the percentage of funds in the asset class that beat their respective index. The third column is the percentage of funds that went out of business during this 5 year time period. The last column is the percentage of funds that changed their style-i.e. weren’t investing in the same asset class at the end of the period as at the beginning.
The interesting thing about data like this is that as a general rule, the further you go out, the lower the percentages get. For example, after one year, the numbers are usually pretty close to 50% of the funds beat their index. But as you go out to 5, 10, or more years, it becomes much harder for an actively managed fund to beat its benchmark. But this chart just shows the 5 year results. The results are very damning for equity funds. In only a single equity asset class (1 out of 17), did active managers beat their index on average. Typically, about 1/5th to 1/3rd of managers managed to beat the index over 5 years. However, 11-32% of them went out of business all together and another 11-68% decided they didn’t want to invest in the same asset class. Thought you were investing in a mid cap value fund? Nope. It’s now a small cap blend fund. Surprise!
Active bond fund managers did quite a bit better than the equity managers. The average manager in 7 out of 11 asset classes beat their respective index, although in only one of those categories was the victory particularly convincing. The natural conclusion would be that active fund management must really work in bonds, especially short term bonds. However, remember we’re only looking at 5 years here. If you look at the SPIVA report for 2006, you’ll see that it was only 3 out of 11 categories. In the five years ending 2012, only 30% of bond funds beat their indices.
As a long term investor, I find that data very compelling, especially for equities. I don’t worry about the fixed income side as much, since I don’t actually own a fixed income index fund! The most important factor there seems to be cost anyway, and I have very low cost bond funds. The data gets even stronger, by the way, when you compare a portfolio of index funds to a portfolio of actively managed funds. Rick Ferri’s recent award-winning white paper showed that over a 16 year period, using an index strategy was superior to an actively managed portfolio.The index fund portfolio beat the actively managed portfolios 80% of the time. Interestingly, when the actively managed funds lost, they lost by 1.6% per year. But when they won, they only won by 0.7% per year. The index funds still win when you adjust for risk and when you only use low-cost active funds.
Let’s move on to my opponent’s next argument.
Doesn’t Include Loads?
My opponent suggests this data includes those pesky loads. Well, if you actually read the methods section, it says this:
The fund returns are net of fees, excluding loads.
Well, that pretty much puts that argument to rest, no?
1/3 of Academics Believe in Active Management
His next argument was that only 2/3 of academics believe passive management is the way to go. Apparently, 1/3 of them have never seen a SPIVA report card. Perhaps there is a poll out there (I couldn’t find one) suggesting this is true, but if you were going to invest based on a poll of academics, why wouldn’t you go with the majority?
Only High Earners Can Settle for Market Returns
I found this argument pretty funny, especially considering how many engineers there are on the Bogleheads forum. Either you can beat the market reliably or you can’t. Your desire or need to do so has nothing to do with whether it is likely. Once you have accepted that trying to beat the market is either unlikely or not worth the time, effort, and money, investment management becomes a far easier and more profitable exercise. If beating the market were likely, doctors would like to do it just as much as engineers, I assure you. But it isn’t. So smart doctors and engineers don’t waste their time, energy, and money trying. They invest their time actively and their money passively. Besides, whether you make $100K or $200K, if you save the same percentage of your gross income for the same number of years (the engineers actually get a few more due to less time training), and invest the same way, that retirement portfolio will replace exactly the same percentage of your pre-retirement gross income. Simple math and truly a silly argument.
But Warren Buffett Can Do It!
Ahh..the tried and true Warren Buffett argument. The question has never been “What about Warren Buffett?” The question is why aren’t there more Warren Buffetts? On a purely statistical basis of random luck, there should be ten times as many Warren Buffetts as there seem to be. Besides, how does Warren Buffett recommend you invest?
1996- “Most investors, both institutional and individual, will find that the best way to own common stocks (shares’) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.”
2007- “The active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group – the “know-nothings” – must win….The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you’ll be buying into a wonderful industry, which in effect is all of American industry…People ought to sit back and relax and keep accumulating over time.”
2008- “The American economy is going to do fine. But it won’t do fine every year and every week and every month. I mean, if you don’t believe that, forget about buying stocks anyway… It’s a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market.”
2014- “What I advise here is essentially identical to certain instructions I’ve laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife’s benefit….My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors – whether pension funds, institutions or individuals – who employ high-fee managers.
You’re not Warren Buffett. Neither is your adviser. So do what Warren recommends and invest passively.
Best Predictor of Future Returns
In addition to the above report card, SPIVA also publishes a persistency report. It turns out that only poor past performance is predictive. If a fund was terrible in the past, it will be terrible in the future. In it was great in the past, that has no predictive value. In fact, it may even have negative predictive value. I won’t post a table, but here’s the summary:
Very few funds can consistently stay at the top. Out of the 687 funds that were in the top quartile as of March 2012, only 3.78% managed to stay there by the end of March 2014. Further, 1.90% of the large-cap funds, 3.16% of the mid-cap funds and 4.11% of the small-cap funds remain in the top quartile.
For the three years ended March 2014, 14.10% of large-cap funds, 16.32% of mid-cap funds and 25.00% of small-cap funds maintained a top-half ranking over three consecutive 12-month periods. Random expectations would suggest a rate of 25%.
An inverse relationship exists between the measurement time horizon and the ability of top-performing funds to maintain their status. It is worth noting that no large-cap or mid-cap funds managed to remain in the top quartile at the end of the five-year measurement period. The figures paint a poor picture of the lack of long-term persistence in mutual fund returns.
Similarly, only 3.09% of large-cap funds, 3.6% of mid-cap funds and 5.48% of small-cap funds maintained top-half performance over five consecutive 12-month periods. Random expectations would suggest a repeat rate of 6.25%.
So what does predict future returns? Russell Kinnel, the director of research at Morningstar, says this after studying the data extensively:
If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds….Expense ratios are strong predictors of performance. In every asset class over every time period, the cheapest quintile produced higher total returns than the most expensive quintile.
I’m not sure what they’re teaching in MBA school or at the big bank and brokerage companies, and I’m well aware that there is a momentum factor out there, but the best predictor of future mutual fund returns remains low costs, not past performance. There’s a reason the SEC requires a mutual fund prospectus has to say “Past performance does not necessarily predict future results.”
A Great Question For A Potential Adviser
Yes, there truly are people out there who still believe in active management. So when interviewing potential advisers, one of the first questions I would ask is “Can beat the market yourself or choose mutual fund managers who can?” If the answer is yes, stand up and walk out. The “value-add” you’re looking for in an advisor isn’t an unsuccessful attempt to beat the market.
What do you think? Do you consider the active vs passive debate to be settled? If not, what do you think is the best way to use active management? Comment below!