“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.”
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.
“Individual investors tend to invest in a small number [of stocks] and they don’t know how to construct a portfolio. Professional portfolio managers control risk.” – says Jim Peterson, vice president at the Schwab Center for Financial Research.
In the June 10th post, I wrote about the dangers of buying stocks in companies you think you know well, and I extolled the virtues of diversification. One reader posted a comment saying that he believed that owning 30 to 35 individual stocks was “sufficient” diversification. I’m not so sure.
Today’s Hot Tip: Don’t Buy Stocks! an article by Howard Gold, written in 2008, reinforces my arguments. He interviewed several professionals to make his point. Here is a summary of his article.
William Bernstein, a money manager and the author “estimates that because of close correlations between markets, even 100 carefully chosen stocks can’t match the diversification of holding just a couple of index funds and ETFs that cover the global market.”
If you’re still not convinced, just how much work are you willing to put into picking stocks?
According to Gold, “even individuals who have good stock-picking skills rarely can do the necessary research to post consistently good results over time.”
He quotes a study by the Schwab Center that “tracked the portfolios of Schwab clients who had $5,000 in household equity and whose accounts were either at least 95% individual stocks (including foreign shares and ETFs) or 95% open-end equity mutual funds.
The survey, taken over 2005-2006, produced stunning results:
The fund investors substantially outperformed the stock pickers, with less than half the risk and after all expenses.
Though it covered only two years—and the investors may have held other assets at other financial institutions—it did take in a huge number of the 3.5 million clients of Charles Schwab, about as good a sample of the US investing public as you can find.”
Doing Your Homework
“You have to have tremendous energy to devote to the stock-picking process,” says David Swensen, chief investment officer of Yale University. “Individuals don’t have the time or the resources.”
In his book “Unconventional Success: A Fundamental Approach to Personal Investment,” Swensen advises individuals to stick to a set of broadly diversified index funds.
“If you try to manage your own money and invest in your own stocks, and you don’t…do every single piece of homework necessary, you won’t beat the market, and you’ll probably lose money,” says one well-known investing guru. “If you don’t have the time or the inclination to do this work, then I’m begging you, please don’t try to invest in individual stocks.” (Emphais added.)
Who said that? Vanguard founder John Bogle? No, it’s Jim Cramer, who pounds the table for individual stocks amid the booyahs and silly hats on his weekday Mad Money show on CNBC.
“Investing is fun for a lot of people, and if they want to try their hands [at stock picking], they should go for it,” says Peterson. “Just make sure that the majority of your portfolio is diversified.”
Gold’s observation is that the rest of us should “get our thrills and chills elsewhere.”
You can only achieve real diversification by investing in both stocks and bonds. Moreover, within each category, you need to have many individual securities to be truly diversified.
Suppose you believe that your portfolio should include the following asset classes: large-cap U.S. stocks, small-cap U.S. stocks, large-cap international stocks, small-cap international stocks, stocks from emerging markets, and Real Estate Investment Trusts. How can you possibly achieve this diversification without hundreds of individual securities? In my opinion, you can’t, which is why you need mutual funds.
The portfolios I construct for my clients typically have mutual funds with thousands of securities. That is diversification.
“The deeper one delves, the worse things look for actively managed funds.” – William Bernstein.
Despite the title, this post is not about nostalgia, about the simpler times of pillow fights, water balloons, and The Lone Ranger.
It is about the education of an investor: me.
My last post discussed the risks of investing using individual stocks. My point was that you simply cannot get enough diversification that way; therefore, you have unnecessarily increased your risk.
If you’ve been reading my posts, for example here and here, you have probably noticed that an underlying theme of this blog is my conviction that the right way to invest is to use mutual funds, specifically those that follow a “passive” approach. I have believed this for 40 years.
How did I come to this belief? Forgive my stroll down “memory lane,” but I actually went through something of a conversion process. You see, back when I was in school I decided that I wanted to become a securities analyst.
Being a securities analyst meant that I would become a specialist within a particular industry and, through rigorous and comprehensive analysis, I would choose the “good” companies to invest in within that industry. By the way, when I said “school” I meant high school; even at the tender age of 17, I had already set my path to fame and fortune (at least, in my own mind).
My plan, all those years ago, was to attend a liberal arts school and study Economics, because I thought that was the discipline that would be most useful to me. I figured that I would major in Economics and then go on and get my MBA in Finance. Was I a precocious, or merely delusional, 17 year old?
Well, I graduated with an undergraduate degree in Economics from Lafayette College, and in an exit interview with a career counselor, I was asked what my future plans were. I was steadfast in my conviction that I was going to get an MBA in Finance and then work on Wall Street. Even four years of studying Economics and Accounting had not changed my plan.
But a funny thing happened on the way to Wall Street. What I learned in graduate school changed my mind and also my career path.
Perhaps my professors were that convincing or the theory and evidence were just too persuasive. For I learned that, because of competitive markets, it was nearly impossible to identify undervalued stocks and therefore “beat the market.” I recall one professor, George Benston, remarked that you could beat it (the market) with a stick but not as an investor.
Who believed such things in the 1960s? Followers of the Chicago School of Economics; in my case, at the University of Rochester. This is not the time to discuss the relative merits of the Chicago School, but suffice it to say that such economists as George Stigler and Milton Friedman were held in very high esteem at the U of R. In particular, Friedman was considered a “minor” deity (and I’m not so sure about the “minor” part). To diminish the hero worship I remember that Benston irreverently but still affectionately referred to Friedman as “Uncle Miltie.”
The Finance I studied in the 1960s was so new that it was not covered in any textbook. Instead, we read primary documents (journal articles) by such pioneers as Harry Markowitz, William Sharpe, and the team of Modigliani and Miller, known as M&M. These were the people who would later win Nobel prizes in economics.
One professor, Michael Jensen, had just written his groundbreaking Ph.D. dissertation on the performance of mutual funds. Eugene Fama was his thesis adviser. Jensen actually coined the term “Alpha,” which is a measure of excess returns achieved by investment managers. More formally it is a statistical estimate of “how much a manager’s forecasting ability contributes to the fund’s returns.” When you hear someone on TV talking about “creating Alpha” you now know where that term came from. I’d bet that 90% of investors don’t know that.
But the punch line is that Jensen learned that mutual fund managers could NOT create Alpha, i.e. they could not “beat the market.”
His research was published in the Journal of Finance in 1967 and here are his conclusions:
The evidence on mutual fund performance indicates not only that these 115 mutual funds were on average not able to predict security prices well enough to outperform a buy-the-market-and-hold policy, but also that there is very little evidence that any individual fund was able to do significantly better than that which we expected from mere random chance. It is also important to note that these conclusions hold even when we measure the fund returns gross of management expenses (that is assume their bookkeeping, research, and other expenses except brokerage commissions were obtained free). Thus on average the funds apparently were not quite successful enough in their trading activities to recoup even their brokerage expenses. (Emphasis added.)
Since 1967, there have been many, many follow-up studies and, they have confirmed his basic finding that active investment managers cannot “beat the market.” Neither can stockbrokers or “experts” on TV. And reading articles about hot mutual funds or “10 Stocks to Buy Now” is a waste of time.
If mutual fund managers and pension fund managers– some of the so-called experts – cannot use securities analysis or trading strategies to “beat the market” why would you, an individual investor, even want to try?
Now there’s the real lesson that 90% of investors do not know.
Did the title get your attention? You’re probably wondering, am I changing my approach and now making a stock market prediction? Have I turned bearish (pessimistic) as so many people are? No. Plain and simple.
What I want to do is save you from the potential losses caused by buying individual stocks. Sadly, this is not merely an academic discussion, since I have known many people who have been crushed by losses in individual stocks. It upsets me to know that the devastation could have been avoided.
Buying individual stocks certainly gives you something to talk about over drinks with your friends. But I don’t believe that the cocktail chatter advantage means you should actually buy individual stocks. I don’t invest in individual stocks for myself, and I don’t recommend it for my clients.
People always have their reasons as to why their favorite stock is just “great.” Some have done their research and have created a model that predicts that the stock that they are going to buy will double in the next four years. Others have been following the same company for decades and are convinced that now is the time to buy.
Usually they’re talking about well known companies, such as General Electric, Johnson & Johnson or General Motors. Did I get you? I made that last one up. In actuality, no one has ever told me that he was planning to buy General Motors. That’s good, because looking back, we now know that GM, even though it was once considered a solid “blue chip” stock, was not in fact such a smart investment .
And there’s the rub. Looking back, it is crystal clear that we should’ve bought Microsoft when it first went public. We should’ve bought Google. Anyone with the time and inclination can do the research and figure out which stocks they should’ve bought. But it’s not so easy going forward.
For one thing, there’s an excellent chance that whatever you have learned that convinced you that a particular stock is a good buy is already known by everyone else. Therefore, the current price already reflects the brilliant insights you so cherish. But another reason is that stocks are inherently risky. If you are not using mutual funds to achieve diversification, but only buying a few stocks, you’re adding to your risk, unnecessarily.
Chances are you’re buying the stock of a company that you know quite well. If you live in Seattle there’s a good chance that Microsoft and Starbucks are in your portfolio. Great. And if you live in Rochester, New York there’s an excellent chance that you had Eastman Kodak and Xerox in your portfolio. Not so great, we now know.
In Atlanta, many people have invested in Coca-Cola. By the same token, people in Houston had invested in Enron. Where you live, and what you are familiar with, are not good reasons for investing.
Neither is loyalty. Maybe your grandfather gave you some stock before he died and told you never to sell it. I’m sorry, and I mean no disrespect, but don’t listen. That stock with a family pedigree could be the next General Motors.
Or maybe you used to work for a great company and you have accumulated a lot of stock in your former employer. But were you lucky enough to have worked for Exxon or unlucky enough to have worked for Citigroup or Bear Stearns? Why let luck play such an important factor in your investment success?
By now you get the idea. I’ve probably been way too repetitive. But this is a really important concept.
As Nick Murray, author of Simple Wealth, Inevitable Wealth, says “Diversification is the conscious decision never to be able to make a killing, in return for the priceless blessing of never getting killed.”
“There are plenty of legitimate reasons to be concerned about our economy and the markets right now. But worrying that your retirement security might be jeopardized should your fund company fail isn’t one of them.” – Walter Updegrave.
Imagine the worst (which is currently not that difficult) and your mutual fund firm declares bankruptcy. Walter Updegrave, Money Magazine senior editor, discusses this scenario in an article published October 15th online: When investment Firms Go Bust. If you are feeling nervous about your mutual fund firm, this article will give you comfort.
Question: If an investment firm like Fidelity or T. Rowe Price goes bust would I lose the money I have in mutual funds in IRAs and other accounts? —Gerry Cheok, Gaithersburg, Maryland.
Answer: Already in this financial crisis, we’ve seen investment banks, commercial banks and mortgage firms fail or require some sort of government bailout to keep them afloat.
To date, however, no mutual fund companies have bitten the dust or required a government loan or investment to prevent them from going under. I hope that will continue to be the case, although in this wild and wooly market, I suppose anything is possible.
But the good news is that even if a fund family were to get in trouble or go belly up, the money you have invested in mutual funds – whether in an IRA, 401(k) or any other type of account for that matter – would still be safe.
Indeed, the value of your mutual fund accounts is pretty much unrelated to the health of the fund company itself.
Why? Several reasons.
Separation of assets
First, the money you invest in a mutual fund doesn’t actually become part of the assets of the mutual fund firm, as is the case when you buy a CD at a bank. Instead, your money goes to whichever mutual fund you’re buying. You receive shares in the fund for your investment, and the fund manager then invests your money in securities that become part of that fund’s portfolio of assets.
And although most people think that the mutual fund firm – be it Fidelity, T. Rowe Price or any other fund sponsor – owns the mutual funds with the firm’s name on them, that’s not the case.
The fund firm – or sponsor as it’s known in fund industry lingo – merely has an agreement with the fund to manage its assets and sell the fund’s shares. The fund itself is a separate entity from the sponsor and has its own board of directors. And the owners of the fund are the fund’s shareholders, the people like you who have invested money in the fund own its shares.
That goes for all the securities in the fund as well – stocks, bonds, Treasury bills, whatever. The mutual fund firm doesn’t own them either. The fund’s shareholders own them. So if a mutual fund company were to get into financial trouble or go into bankruptcy, the assets of the individual funds would not be available to the mutual fund company or its creditors to meet the firm’s obligations.
No funny stuff
But, ah, you may ask, in dire circumstances wouldn’t the mutual fund company somehow manage to dip into the till even if only temporarily to get them out of a financial bind? Couldn’t fund shareholders’ money be at risk that way?
Actually, the odds of a struggling fund company getting its hands on fund assets are remote at best. To avoid such malfeasance, federal law requires that the securities owned by a mutual fund be held separate from the fund’s sponsor in a custodial account, usually at a bank or trust company. The fund’s assets are also segregated from the custodian bank’s or trust company’s assets as well.
Finally, to protect shareholders from the possibility that a dishonest employee of the mutual fund company, custodian bank or some other person could get at a fund’s assets, federal law requires funds have fidelity bond insurance which covers instances of fraud, embezzlement and the like.
I’ve sketched the main outlines of how mutual funds operate. But if it would make you feel better, you can get more detail by checking out this investment company fact book.
Should you be worried?
If your mutual fund company were to fail, the assets of your fund would be secure, totally insulated from the fund sponsor’s financial problems. The failing mutual fund company would arrange for another mutual fund company to assume management of your fund, or your fund’s board of directors would do so. Either way, you and other fund shareholders – who are still the fund’s owners – would have to approve the new arrangement.
Of course, these protections have nothing to do with the market value of the funds you own in IRAs or other accounts. That will be determined by the market price of the securities owned by your fund. If your IRA is invested in shares of a mutual fund that tracks the overall stock market and the stock market drops, so will the value of your IRA. But that has nothing to do with the financial health of your fund company.
To sum up, there are plenty of legitimate reasons to be concerned about our economy and the markets right now. But worrying that your retirement security might be jeopardized should your fund company fail isn’t one of them.