Evidence-based Investing, Part Two

“When you look at the results on an after-tax, after-fee basis over reasonably long periods of time, there’s almost no chance that you end up beating an index fund. The odds…are 100 to 1.” – David Swensen.

Passive investing, sometimes called index investing, is, as the name suggests, the exact opposite of active management of a portfolio.  The latter attempts to “beat the market” by various means, including selecting securities that are (hopefully) underpriced, trading holdings, and sometimes, by getting out of (and eventually back into) the market entirely.  Passive investing, on the other hand, employs a consistent strategy of buy and hold.  The $64 billion (adjusted for inflation) question is which approach is better?

The evidence proves that active fund managers actually under-perform their relevant benchmarks.  Specifically, over a 10-year period, approximately 75% to 80% of all mutual funds fail to “beat the market.” Attempting to be one of the 20% to 25% who succeed is known as “playing the loser’s game.”

And the longer the period under consideration, the worse the odds become. A study published in 2008 found that from 1975 to 2006 only one in 166 mutual funds outperformed the stock market.  That was 0.6% of the total. 99.4% failed to outperform the market.

Keep in mind that mutual funds that use active management charge more in management fees.  First of all, they have higher operating expenses, because they spend more money on research and on active trading.  And by claiming that they can outperform their peers, they can charge more, so they do.  But as an investor, you start with a handicap if the mutual fund you are using has higher expenses.

I don’t doubt that some of the active managers sincerely believe that they can deliver on their promises.  But logically, and statistics proves this out, they can’t all be above average.  So buyer beware.

Another consideration is that active management generates short-term profits, which are more highly taxed than long-term capital gains.  So, even some investment managers who think they can add value by actively managing a portfolio decline to manage a taxable account.  They believe that, after taxes, an actively managed portfolio will always underperform a passively managed portfolio.

Given the stakes in determining whether you can ever “beat the market” it’s not surprising that so much has been written on the subject.  And since we are talking about 50 years of research, it isn’t easy to summarize the evidence.  So I’ve chosen one (somewhat facetiously titled) article, How to Beat the Market in Three Easy Steps, which I think is well-written and which will give you a flavor for the logic and practical implications of passive investing.

Here are some quotes from the article by Karl N. Huish, Esq., CFP®

To be an active investor, you must say, ‘I am right, and most of you are wrong.’

One huge challenge is separating talent from luck.  Wall Street is filled (and overflowing) with bright, capable fund managers, with gold-plated MBAs and Ph.Ds in economics, mathematics, computer science and physics.  IQ tests and education resumes will not be enough to distinguish the true geniuses from the merely intelligent.  Most of these funds are advertised by top-flight marketing companies.  How do we dis­tinguish the sheep from the goats?

Can past performance help us?  This is the miscon­ception upon which many investors stumble.  It turns out that [surprise!] past performance is not indicative of future performance. A recent large study (3,700 public and corporate plans, representing $737 bil­lion invested) found that manager hiring and firing decisions made by retirement plans, endowments and foundations was a complete waste of money and time: the fund managers performed better than the market before being hired, but underperformed the market af­ter hiring.  In other words, their market-beating per­formance was luck, not skill.

David Swensen is the manager of the Yale University Endowment, which is the highest performing endowment fund over the past 20 years.  To many he is considered the greatest current institutional investor – a modern mastermind. … He stated the fol­lowing:

‘When you look at the results on an after-tax, after-fee basis over reasonably long periods of time, there’s al­most no chance that you end up beating an index fund. The odds…are 100 to 1.’

Mr. Swensen – the best in the business – isn’t very con­fident about beating the market rate of return, as re­flected in an index fund.  How confident are you that you or your advisor can identify those active funds that will – taking all costs into consideration – outperform the passive alternatives?

What Does the Research Say?

Well, what about the data?  It turns out that David Sw­ensen is just about right.  In a 2008 published study, Professors Laurent Barras, Olivier Scaillet, and Russ Wermers used the most advanced statistical testing in science (using tests from computational biology and astronomy), to drill down into the performance of active mutual funds for a 32-year period, from 1975- 2006.  The researchers found that, on a pre-expense basis, 9.6% of mutual fund managers showed genuine market-beating ability. But after expenses were de­ducted only 0.6% of fund managers outperformed the market.”

Conclusion

My Investment Philosophy is based on the belief that a passive approach is the best way to invest my clients’ money.  I follow that same strategy for my own portfolio, as well.   I am not convinced, however, that using simple index funds is the best strategy, largely because of their trading inefficiencies.

But that’s the topic of another post.