Active versus Passive Investing

1. Active versus Passive Investing Chapter 6

2. There are two theories about how markets work. The first is that smart people, working diligently, can somehow discover pricing errors that the market makes. In other words, they can discover which stocks are undervalued (GE is trading at 30, but it is really worth 40) and buy them. And they can discover which stocks are overvalued (IBM is trading at 30, but it is really worth 20) and avoid them; or, if they are aggressive they can sell them short (borrow IBM stock, sell it at 30, then buy it back at 20 when the market corrects its error). That is called the art of stock selection.

3. In addition, these same smart people can also anticipate when the bull is going to enter the arena. They recommend increasing your allocation to stocks ahead of the anticipated rally. They can also anticipate when the bear is going to emerge from its hibernation, and recommend lowering your equity allocation ahead of that event. This is called the art of market timing. • The two strategies, stock selection and market timing, combine to form the art of active management .

4. There is a second theory on how markets work. It is based on over 50 years of academic research. This body of work is known as Modern Portfolio Theory (MPT). A major component of MPT is the efficient market hypothesis (EMH). Simply put, the premise of the EMH is that markets are too efficient to allow returns in excess of the market’s overall rate of return to be achieved consistently through trading systems. A market can be said to be efficient if investors cannot use trading strategies to increase their expected return without at the same time increasing the risks to which they are exposed.

5. If a market is efficient, active management is likely to prove counterproductive. Thus, the conventional wisdom is wrong. If this is what the evidence demonstrates, why is active management the conventional wisdom? And, why do most people follow active strategies? I believe that there are two explanations for this phenomenon. • The first is that most investors are unaware of the evidence

6. Unless you happen to obtain an MBA in finance, it is unlikely that you have even taken a single course in financial economics. The second explanation is that despite its importance, most people do not take the time to read investment books that are based on academic theory. • The bottom line is that most investors are ignorant of the academic evidence. If investors are unaware of the evidence, where do they get their investment “wisdom”? Unfortunately, they get it mostly from two sources that do not have their interests at heart: Wall Street and the financial media.

7. Despite the overwhelming body of academic evidence that demonstrates that while active management does provide you the hope of outperformance, the far greater likelihood is that you will underperform, both Wall Street and the financial media need you to believe active management is the winning strategy. The reason is that it is the winning strategy for them and not you.

8. WHOSE INTERESTS DO THEY HAVE AT HEART? • Wall Street firms are like bookies. Bookies just need you to play to win. The more you bet, the more they win. If you invest in individual stocks, the more active you are (the more you trade), the more money Wall Street makes.

9. So they need you to be active, persistently buying and selling. Or, if you use mutual funds, then they need you to pay the high fees that active managers charge.While the average actively managed mutual fund charges about 1.5 percent a year, you can buy index funds (that basically buy and hold a predetermined basket of stocks) at a small fraction of that cost. So Wall Street needs you to believe you are better off paying high fees.

10. The media also needs you to pay attention. They need you to tune in. That is how CNBC makes its profits—selling airtime. And, financial publications like Money make their profits from the sale of subscriptions and advertising. If the media told you that the prudent strategy was to develop a plan and then simply buy and hold, you would not need to either tune in or buy their recommended stocks or funds.

11. The bottom line is that there is a conflict of interest. Wall Street and the financial media, the source of most investor information, say that active management is the winning strategy for investors. Yet the academic evidence demonstrates that the conventional wisdom is wrong.

12. There is an overwhelming body of evidence demonstrating the general failure of active management strategies. This holds true whether we look at the results for individual investors, mutual funds, market-timing newsletters, hedge funds, or venture capital. On average, active strategies underperform risk-adjusted benchmarks, and there is little to no evidence of persistent performance beyond the randomly expected.

13. WHEN EVEN THE BEST ARE NOT LIKELYTO WIN THE GAME • I believe the search for top-performing stock funds is an intellectually discredited exercise that will come to be viewed as one of the great financial follies of the late 20th century. —Jonathan Clements, Wall Street Journal

14. A wizard appears, waves his magic wand, and makes you the eleventh best golfer in the world. Being the eleventh best golfer in the world earns you an invitation to the annual Super Legends of Golf Tournament. That is the good news. The bad news is that the competition is the 10 best players in the world. To even the playing field, you are given a major advantage. The rules of the game are these: Each of the other players will play one hole at a time and then return to the clubhouse and report his score. No player gets to observe the others play. Thus, you cannot gain an advantage by watching the others play. After each of the other players completes the hole, you are provided with these options.

15. Option A is to choose to play the hole and accept whatever score you obtain. Option B is to choose not to play that hole and accept par as your score. • The first hole is a par four. After each of the 10 best players in the world has completed the first hole, you learn that 8 of the 10 took five shots to put the ball in the cup—they shot a bogie. Two players shot birdies, needing only three shots to put the ball in the cup. You now must decide to either accept par or play the hole. What is your decision?

16. The prudent choice would be to choose not to play, take par, and accept a score of four. The logic is that while it was not impossible to beat par (two players did), the odds of doing so are so low (20 percent) that it would not be prudent to try. And by accepting par, you would have outperformed 80 percent of the best players in the world. In other words, when the best players in the world fail the majority of the time, you recognize that it is not prudent to try to succeed. The exception to this line of thinking would be if you could somehow identify an advantage you might have.

17. For example, if the 10 best players had played the day before you in a rainstorm, with 50-mile-an-hour winds, and you played the following day when the weather was perfect and the course was dry. Given that situation, you might decide that the advantage was great enough that the odds of your shooting a birdie (a three) were greater than the odds of your shooting a bogie (a five, or perhaps even worse). Without such an advantage, the prudent choice would be to not play if you do not have to.

18. What does this story have to do with investing? Consider this: It seems logical to believe that if anyone could beat the market, it would be the pension plans of the largest U.S. companies. Why is this a good assumption? It is for five reasons: • 1. These pension plans control large sums of money. They have access to the best and brightest portfolio managers, each clamoring to manage the billions of dollars in these plans (and earn large fees). Pension plans can also invest with managers who most individuals do not have access to because they do not have sufficient assets to meet the minimums of these superstar managers.

19. 2. It is not even remotely possible that these pension plans ever hired a manager who did not have a track record of outperforming their benchmarks or at the very least matching them. Certainly they would never hire a manager with a record of underperformance. • 3. It is also safe to say that they never hired a manager who did not make a great presentation, explaining why the manager had succeeded and why she would continue to succeed. Surely the case presented was a convincing one.

20. 4. Many, if not the majority, of these pension plans hire professional consultants, such as Frank Russell, SEI, and Goldman Sachs, to help them perform due diligence in interviewing, screening, and, ultimately, selecting the very best of the best. Frank Russell, for example, has boasted that it has over 70 analysts performing over 2,000 interviews a year. You can be sure that these consultants have thought of every conceivable screen to find the best fund managers.

21. 5. As individuals, it is rare that we would have the luxury of being able to personally interview money managers and perform as thorough a due diligence as do these consultants. And we generally do not have professionals helping us to avoid mistakes in the process. As individuals, we are generally stuck relying on Morningstar’s ratings; and despite the tremendous resources that Morningstar employs in the effort to identify future winners, its track record is poor. For example, Morningstar Fund Investor (2007) reported that all three of its recommended portfolios (Aggressive Wealth Maker, Wealth Maker, and Wealth Keeper) had underperformed since inception. Why then should individual investors with fewer resources believe they can succeed?

22. Returning to our golf story, I hope you agree that just as it would be imprudent to try to beat par when 80 percent of the best golfers in the world failed, it would be imprudent for you to try to succeed if institutional investors, with far greater resources than you (or your broker or financial adviser), had also failed about 80 percent of the time. The only exception would be if you could identify a strategic advantage that you had over these institutional players.

23. The questions you might ask yourself are: Do I have more resources than they do? Do I have more time to spend finding future winners than they do? Am I smarter than all of these institutional investors and the advisers they hire? Unless when you look in the mirror you see Warren Buffett staring back at you, it does not seem likely that the answer to any of these questions is yes. At least it will not be yes if you are honest with yourself.

24. Evidence • The consulting firm Future Metrics (2005) studied the performance of 192 major U.S. corporate pension plans for the period 1988 to 2005. Because it is estimated that the average pension plan has an allocation of 60 percent equities and 40 percent fixed income, we can compare, using Dimensional Fund Advisors (DFA) (2006) data, the realized returns of these plans to a benchmark portfolio with an asset allocation of 60 percent Standard & Poor’s (S&P) 500 Index and 40 percent Lehman Brothers Intermediate Government/Corporate Bond Index.

25. This passive portfolio could have been implemented by each of the plans as an alternative to active strategies. If the return did not match the return of the indexes (less some low expenses), it must be that the players were trying to shoot birdies while running the risk of shooting bogies—they must have been engaging in active management. Unfortunately, only 28 percent of the pension plans playing the game of attempting to outperform the market succeeded.

26. Each pension plan obviously believed that it was likely to outperform. If this were not the case, why would it have played? Unfortunately, in a colossal triumph of hope over experience (and perhaps the all-too-human trait of overconfidence), 72 percent failed in the attempt to beat par. Seventy-two percent shot bogies. • It is important to understand that by trying to be above average (beat par), 72 percent of the players produced returns that were below their benchmark. It is also important to acknowledge that it is unlikely that the failure occurred because of poor corporate governance.

27. Based on my experience, it is safe to say that the investment policy committee members considered themselves good stewards. In other words, they were smart people who performed their roles diligently—yet 72 percent of the time they failed. It is unlikely that they failed because of bad luck. If it was not bad luck, and it was not failure of process, what led to such a high failure rate? The answer is that the strategy they used—active management—was a losing strategy. This did not have to be so.

28. have to be so. Just as you prudently chose not to play the first hole of the Super Legends of Golf Tournament, they too could have chosen not to play by investing instead in index funds. By doing so, they would have earned par. • The story is actually worse than even these dismal results suggest. Consider that a large number of these pension plans invested at least some small portion of their plans in such riskier asset classes as small-cap and value stocks, junk bonds, venture capital, and emerging market equities.

29. As higher-risk asset classes, they have higher expected returns. Yet despite this advantage, for the time period surveyed, 72 percent of the funds failed to beat par. These pension plans were actually taking more risk and they earned lower, not higher, returns. • Consider also that since the average pension plan has an allocation of 60 percent equities and 40 percent bonds, some surely have a higher allocation.

30. Let us look at some further evidence on the performance of pension plans. Bauer and Frehen (2008) studied 716 defined benefit plans (1992–2004) and 238 defined contribution plans (1997–2004). The study compared their performance to appropriate risk-adjusted benchmarks, and they found that their returns relative to benchmarks were close to zero. They also found that there was no persistence in pension plan performance. Thus, despite the conventional wisdom, past performance is not a reliable predictor of future performance.

31. Bauer and Frehen, (2008) also studied the performance of mutual funds. The news, unfortunately for individual investors, is even worse. While pension plans failed to outperform market benchmarks, they underperformed pension plans by about 2 percent per annum on a risk-adjusted basis. The underperformance was attributed to the incremental costs incurred by mutual fund investors. Pension plans are able to use their size (negotiating power) to minimize costs and reduce the risks of any conflicts of interest between the fund managers and the investors.

32. Lots of Counterproductive Activity • A study by AmitGoyal and SunilWahal(2008) provides us with further evidence on the inability of plan sponsors to identify investment management firms that will outperform the market after they are hired. They examined the selection and termination of investment management firms by plan sponsors (public and corporate pension plans, unions, foundations, and endowments). They built a data set of the hiring and firing decisions by approximately 3,400 plan sponsors from 1994 to 2003.

33. The data represented the allocation of over $627 billion in mandates to hired investment managers and the withdrawal of $105 billion from fired investment managers. Here is a summary of their findings: • Plan sponsors hire investment managers with large positive excess returns for up to three years prior to hiring. • The return-chasing behavior does not deliver positive excess returns thereafter.

34. Posthiring excess returns are indistinguishable from zero. • Plan sponsors terminate investment managers for a variety of reasons, including underperformance. But the excess returns of these managers after being fired are frequently positive. • If plan sponsors had stayed with the fired investment managers, their returns would have been no different from those actually delivered by the newly hired managers.

35. It is important to note that these results did not include any of the trading costs that would have accompanied transitioning a portfolio from one manager’s holdings to the holdings preferred by the new manager. In other words, all of the activity was counterproductive. • In the face of this evidence, ask yourself what advantage you have that would allow you to have a high degree of confidence that you would be likely to succeed where the investors with the most resources failed 72 percent of the time.

36. You should also consider this fact. Within the last 15 years, Intel, Exxon Mobil, Philip Morris, and the Washington State Investment Board, with combined assets of about $60 billion, have fired all the active fund managers they had previously hired. Surely it is safe to assume that none of these plans ever hired a manager with a poor performance record. Yet each of them fired all of the managers that they had hired after a thorough due diligence process. Why were he managers all fired? Is it even remotely possible that they were fired because they outperformed? Of course it was not.

37. Thus, we can safely assume that while the active managers were hired with the expectation of outperformance, the reality did not live up to the expectation. • In 1996, Philip Halpern was the chief investment officer of the Washington State Investment Board (a large institutional investor). Halpern, Calkins, and Ruggels(1996) wrote an article in the Financial Analysts Journal on their less-than-satisfactory experience with active management.

38. And they knew from attendance at professional meetings that many of their colleagues shared, and corroborated, their own experience. “Few managers consistently outperform the S&P 500. Thus, in the eyes of the plan sponsor, its plan is paying an excessive amount of the upside to the manager while still bearing substantial risk that its investments will achieve sub-par returns.” The article concluded: “Slowly, over time, many large pension funds have shared our experience and have moved toward indexing more domestic equity assets.”

39. Returning again to our golf analogy, we determined that while it might be possible to shoot a birdie, it was not prudent for you to try. The reason is that you could not identify an advantage that would lead you to believe that you would be likely to outperform the best. The risk-to-reward ratio was poor—72 percent failed. We have seen that the same thing is true in investing—72 percent of the very best hit bogies.

40. Moral of the Tale • Wall Street needs and wants you to play the game of active investing. It needs you to try to beat par. It knows that your odds of success are so low that it is not in your interest to play. But it needs you to play so that it (not you) makes the most money. Wall Street makes it by charging high fees for active management that persistently delivers poor performance.

41. The financial media also want and need you to play so that you tune in. That is how they (not you) make money. However, just as you had the choice of not playing in the Super Legends of Golf Tournament, you have the choice of not playing the game of active management. You can simply accept par and earn market (not average) rates of return with low expenses and high tax efficiency. You can do so by investing in passively managed investment vehicles like index funds and passive asset class funds.

42. By doing so, you are virtually guaranteed to outperform the majority of both professionals and individual investors—assuming you have the discipline to stay the course. In other words, you win by not playing. This is why active investing is called the loser’s game. It is not that the people playing are losers. And it is not that you cannot win. Instead, it is that the odds of success are so low that it is imprudent to try. • The only logical reason to play the game of active investing is that you place a high entertainment value on the effort.

43. For some people there might even be another reason: They enjoy the bragging rights if they win. Of course you rarely, if ever, hear when they lose. • Yes, active investing is exciting. Investing, however, was never meant to be exciting. Wall Street and the media created that myth. Instead, it is meant to be about providing you with the greatest odds of achieving your financial goals with the least amount of risk. That is what differentiates investing from speculating (gambling).

44. You have seen the evidence on just how hard it is to beat the market on a persistent basis. The main reason is that the markets are highly efficient and the competition, in the form of the collective wisdom of crowds, is very tough. However, there are other explanations for why persistent performance is so hard to find.

45. Why Is Persistent Outperformance So Hard to Find? • The Holy Grail was the dish, plate, or cup with miraculous powers that was used by Jesus at the Last Supper. Legend has it that the Grail was sent to Great Britain, where a line of guardians keeps it safe. The search for the Holy Grail is an important part of the legends of King Arthur and his court.

46. For many investors, the equivalent of the Holy Grail is finding the mutual (or hedge) fund manager who can exploit market mispricings by buying undervalued stocks and perhaps shorting those that are overvalued. While it is very easy to identify after the fact those with great performance, there is no evidence of the ability to do this before the fact. For example, there are dozens, if not hundreds, of studies confirming that past performance is a poor predictor of the future performance of active managers.

47. These studies find that beyond a year, there is little evidence of performance persistence. The only place we find persistence of performance (beyond that which we would randomly expect) is at the very bottom—poorly performing funds tend to repeat. And the persistence of poor performance is not due to poor stock selection. Instead, it is due to high expenses.

48. This is an important insight. Just as the EMH explains why investors cannot use publicly available information to beat the market (because all investors have access to that information and it is, therefore, already embedded in prices), the same is true of active managers. Investors should not expect to outperform the market by using publicly available information to select active managers.

49. The process is simple. Investors observe benchmark-beating performance and funds flow into the top performers. The investment inflow eliminates return persistence because fund managers face diminishing returns to scale. • The study by Edelen, Evans, and Kadlec (2007) provides evidence supporting the logic of Berk’s (2005) theory. The authors examined the role of trading costs as a source of diseconomies of scale for mutual funds. They studied the annual trading costs for 1,706 U.S. equity funds during the period 1995 to 2005 and found:

50. Trading costs for mutual funds are on average even greater in magnitude than the expense ratio. • The variation in returns is related to fund trade size. • Annual trading costs bear a statistically significant negative relation to performance. • Trading has an increasingly detrimental impact on performance as a fund’s relative trade size increases. • Trading fails to recover its costs—$1 in trading costs reduced fund assets by $0.41. However, while trading does not adversely impact performance at funds with a relatively small average trade size, trading costs decrease fund assets by roughly $0.80 for large relative trade size funds.