How to Pick Managed Investments. Travis Morien Compass Financial Planners Pty Ltd firstname.lastname@example.org http://www.travismorien.com. Types of Managed Funds. There are two types of fund: Index funds seek to capture the performance of an asset class as cheaply as possible
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How to Pick Managed Investments
Compass Financial Planners Pty Ltd
There are two types of fund:
Picture by Vanguard Investments.
Picture by Vanguard Investments.
Source: Mercer/Morningstar IDPS Survey
Source: Mercer/Morningstar IDPS survey
A portrait of failure: the performance of every US large cap fund with a 15 year history vs the S&P500 and CRSP 1-10 indexes. 15 Years ending 31 December 2001 (285 Funds)
Picture credit: Dimensional Fund Advisors
It gets a whole lot worse!
DALBAR Inc wanted to work out how much of a return retail investors were actually getting from their US mutual fund investments.
The return they get isn’t necessarily the same as the average return of mutual funds because hardly anyone buys and holds, they usually chase the performance of funds that appear to be doing well, selling their funds that lag. They also have a tendency to sell (or cease contributing) during weak markets, but buy enthusiastically during strong markets, especially when those strong markets have run for several years.
Figures show that the average time retail investors hold US Mutual funds is only 29.5 months, this has been trending downward for many years.
DALBAR, Inc. have been tracking monthly inflows and outflows by retail investors since 1984, in the 1997 update of their Quantitative Analysis of Investor Behaviour Study, they concluded that:
“Mutual fund investors earn far less than reported [fund] returns due to their investing behaviour. In their attempt to cash in on the impressive stock market gains, investors jump on the bandwagon too late, and switch in and out of funds trying to time the market. By not remaining fully invested for the entire period, they do not benefit from the majority of equity market appreciation.”
Source: DALBAR, Inc. Media release of 2003 update of study.
Inflow and outflow data has been suggested to be useful as a “contrarian” timing signal. Unusually high mutual fund inflows are often a sign of an impending market top, serious outflows often auger a market bottom. Although exactly how much money one could make by doing the opposite is questionable, there is little doubt that performance chasing is historically a bad strategy.
"Investors continue to sour on stocks. So far this year, investors have made net withdrawals of $11.3 billion from their stock mutual funds according—including a hefty $3.7 billion just last week—according to AMG Data Services.” Source: Gregory Zuckerman, "Investors Rush to Buy Bonds, Fleeing Stocks," Wall Street Journal, March 11, 2003
Is index tracking more risky?
You’d think that with diligent professionals at the wheel, even if they can’t outperform indexes after costs at least they can manage risk properly by prudently avoiding risky companies. Are active funds less volatile?
Actually, active funds on average are more volatile than index funds because they are less diversified.
Source: TAM Asset Management, Inc “Investment Policy Guidelines & Strategies Within the Context of The Prudent Investor Rule, “average active fund” = average of 7125 US domestic equity mutual funds in the Morningstar Principia Pro Database July 1991 - July 2001.
Whether the market is up or down, low cost diversified investors will still outperform the majority of investors after costs, even if some investors still manage to outperform. Source: “The Inefficient Market Argument For Passive Investing”, Professor Steven Thorley, the Marriot School at BYU. Used with permission.
Source: TD Waterhouse, data by ASSIRT
Survivorship bias: amount median prices are overstated per year
Source: Russel Investment Group, periods ending 30 June 2004, “Insights” IN107.
Another bias called “creation bias” is introduced when fund managers create new funds. They give seed capital to a lot of money managers, but the ones that underperform during their trial period are never opened to the public.
In this way, all new stock funds (that the public hears about) come with a suitably high past performance, further tainting the data.
It is of course nearly impossible to get accurate figures to quantify the size of creation bias.
Source: Frank Russell Australia, data by Morningstar
Source: Frank Russell Australia, data by Morningstar
*Source: Frank Russell Australia, though Morningstar retorted with a similar finding on Frank Russell’s recommendations, which have done little better.
Your returns mostly come down to asset allocation:
Picture credit: Dimensional Fund Advisors
Source: Dimensional Fund Advisors
Value vs growth
The academic definitions of value and growth are polar opposites, they usually define value stocks as being the stocks with the lowest price to earnings ratios (PER) or price to book ratios (PBR). Growth is defined as the stocks with the highest ratios.
Value and growth are practically irrelevant in large cap funds, there are few deep value or extreme growth stocks in the top 100.
Thanks to their preoccupation with “tracking error”, many large cap “value” and “growth” managers hold virtually identical portfolios. This has lead to a myth that value and growth are just “investment styles” that perform about the same in the long term.
In fact, “deep value”, really extreme value stocks as identified by PER or PBR performs markedly better than high priced “growth” stocks.
Small cap value companies perform extremely well, but small cap growth are a disaster in both risk and return - speculators beware!
Source: Common Sense on Mutual Funds by John Bogle
Other things to look for in an actively managed fund:
The fund should be very different to an index fund. Active funds that try to minimise “tracking error” inevitably fail to add value in the long term. To outperform the index takes more than conservative tilts to 20% of your portfolio.
Top investors like Warren Buffett get beaten by the index 40% of the time. You may remember the heady days of the tech boom of the late 1990s, pundits called Buffett an obsolete dinosaur who had lost his touch, though in the end Buffett was proven right, as usual. If you want to outperform in the long term you’ll have to be prepared for periods of underperformance, and learn to ignore the pundits.
Index funds are cheap. You can buy the SSGA Streettracks ASX200 index fund for an annual fee of only 0.286%pa, so how do you value active management?
An active fund that is 80% index + 20% active will not add value. If the index hugging “active” fund is charging 1.5%pa, then they are charging a small fortune for their little tilts:80% x 0.286%pa + 20% x 6.356%pa = 1.5%pa
It would be more cost effective to combine a cheap index fund with a fire breathing active stock picking fund if you want performance, rather than buy an index hugging active fund. Don’t pay active MERs to index your money.
The marketing business vs the investment business
The priority of a fund manager keen to reduce tracking error is first and foremost to avoid upsetting people. They want to minimise the risk of relative underperformance, not maximise the probability of outperformance. If a fund manager doesn’t like an index stock, he probably shouldn’t buy it. It seems rather silly to load up on something just because it is a big company.
Many fund managers bought Newscorp at $30 not because they thought it was a good stock (in fact the majority of fund managers hated NCP at that price), but because they feared that the stock might go up further and they would temporarily lag behind. They bought NCP just in case it didn’t fall!
Nobody was fired for losing money on Newscorp becauseall the rival funds lost the same amount. Investors are less likely to pull their money out if the fund has been average than below average. Thus, managers focus on relative quarterly performance compared to peers, not long term absolute returns.
For business reasons unconnected with prudent investment strategy, fund managers keen to avoid redemptions would rather buy major index stocks they don’t like than take the risk of watching them go up while not holding them.
Tracking error is a good thing, it helps diversify your shares portfolio!
*Source: Carole Gould "The Price of Turnover”, New York Times, November 21, 1997
Turnover and tax efficiency cont’d
It is a well established fact that the bigger a fund becomes, the more difficult it is to add value. (Though of course index funds don’t find size a handicap and in fact some fund managers have used size to their advantage using methods like block trading.)
Billion dollar funds simply can’t invest in small and/or illiquid companies because they impact prices too much and would take too long to buy or sell their holdings. There is a direct conflict of interest between a fund manager’s marketing people that would like the fund to become infinitely large, and the investment people that want to keep it manageable.
There is no point researching small companies because the manager couldn’t possibly invest a meaningful amount in them, so big funds are forced to deal in the more “efficient” large cap sector of the market, where outperformance is largely a matter of luck!
Buying a very large fund with high fees & high turnover is an almost guaranteed way to underperform over the long term. Corollary: don’t buy funds that advertise on TV!
In the last few years, boutique fund managers have really come into their own, managers like Investors Mutual, Hunter Hall, MMC, Platinum and PM Capital have amazed investors with spectacular performance. There is little or no evidence that these managers are any more risky than more familiar large funds.
Staff and stability
Nothing is more annoying than buying a managed fund because you are impressed with the chief investment officer, only to have that manager poached by a rival fund manager.
Managed funds have very high staff turnover, poaching is rife! Although generally funds have succession plans in place and documented investment strategies, stock picking skill is innate to individuals and can not be branded. Staff turnover is one of the major reasons why past performance is no guarantee of future results.
Classic examples include ING’s Smaller Companies Fund, a great performer until BT poached the managers offering them seven figure salaries, also BT used to be great until the managers now known as the “BT Babies” left, and even Colonial First State have had several bad years, which just happened to coincide with Greg Perry and a few others leaving. This “musical chairs” goes on all the time in the funds industry.
Efficient market hypothesis
You’ll note that so far in this presentation I have not made the claim that the market is completely efficient and that exceptional investors are the product of pure luck, as many academics do.
I didn’t make that claim because I don’t believe it. Warren Buffett was not “lucky” to have earned nearly 30%pa from 1956 to the present day, and I don’t doubt that Colonial First State’s Greg Perry was a first rate stock picker and “his” Imputation Fund was a real winner – up until the point when he quit!
The trouble lies in identifying such individuals in advance, before their funds get too large and before the manager retires or gets poached. This isn’t much easier than outperforming the market yourself because it usually takes a superior investor to recognise a superior investment approach. Track records are fickle things in this business, by the time you have established a good one the factors that enabled you to outperform (including small portfolio size and the attendant flexibility this brings) may be gone.
Index approaches work because of low costs and tax efficiency, not because outperformance is impossible. Index funds would beat active funds regardless of how efficient the market is, in small caps, emerging markets, overseas or anywhere else.
You can believe in inefficient markets and still embrace indexing. (I do!)
If everyone indexed, would the market cease to be efficient? Would there be a bubble in index stocks?
The critics of indexing have made this claim since indexing first started gaining momentum in the 70s, but it lacks credibility.
Studies have found that index funds account for only a small percentage of monthly transactions in stocks, typically under 5%.To claim that 5% of trades by passive investors doing no analysis set the prices for the other 95% of trades by active investors defies common sense.
If sheer weight of “dumb” indexed money was what drove index stock prices then it is hard to understand how individual stocks move so differently. There are always stocks moving against the trend, indicating that those 5% of trades are not as influential in price setting as critics claim they are.
Studies have failed to find any evidence of “index bubbles”.
Web sites of interest
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