Many factors inform our investment philosophy: our experience, excess investor fees, investor emotions, testing data over multiple time periods, careful reading of historical studies, the daily spasmodic CNBC charade of short-term market forecasting, as well as the academics who point to the statistical futility of trying to beat market returns. In short, an educated evolution in our thinking brought us to the conclusion that the most sensible path toward investment success lies in proper asset allocation, asset selection, and keeping total costs at a minimum. Our intent is to illuminate these factors and help you to understand why our well reasoned and factual approach to indexing offers the most likely path to investment success.
The Fear and Greed Sale
Wall Street knows how to sell. It sells fear and greed every day. Guess who profits most from these sales? The odds are heavily stacked against you and the investing public. Activity! Momentum! Adrenaline! Commissions and trading profits accrue to the brokerage as losses to the investor. Portfolio turnover averaged 10 percent in the 1960’s; today it is over 100 percent. Activity creates costs and these costs are expenses that erode your profits. Attempting to time market moves or chase returns of a hot performing stock or fund is a poorly advised pursuit. Additionally, high turnover short-term profits are not equivalent to tax efficient, long-term profits. No mention is ever made of after tax profits; also known as the money you can use! This game is not about the investor; it’s about the business of investing.
The Wind Up and the Pitch
In an index fund, a lot of business risk is eliminated through diversification. There are no concentrated bets, so you will not ride the next Google or Microsoft from IPO to riches. However, asset concentration is a double-edged sword that portends proportionate risk and drastic price declines. No pain, no gain! Hah! How about plenty of pain, no gain, with large loss! The tech heavy NASDAQ with all the dot.com IPOs and hype of a “new economy” today, more than 12 years later, is still more than 30% off its record highs, while the more diversified S&P 500 is near its all time high. The only way to beat an index is to make “active” bets. This is where the Wall Street “pitch” is spun. You are told a good story about the potential for market beating gains. In exchange, you pay fees and commissions, directly or indirectly, for a bill of goods with little, if any, enduring merit (see Exhibit 2). The Pitch is most always a one-sided story, with little discussion of the relationship between an expected return and the investor’s risk.
Passive index funds or ETFs are low margin products for Wall Street. Therefore, they do not get a lot of love in client sales presentations. In fact, the sales force (i.e. brokers/advisers) is often heavily incentivized to sell proprietary active funds or funds from an affiliate. The incentive is a cost the investor will never recover, and one that compounds over the life of the asset. Class A, B, and C shares have different ways to extract fees, and it doesn’t end there. Annual active fund management fees generally are about 1% and many brokers and advisers also collect annual 12b-1 fees of 0.25% for keeping the funds in client portfolios. Long-term studies all verify one thing: your portfolio will lag the index 85% of the time with this approach. The compounded impact of this underperformance is substantial and is a story never told on Wall Street.
Adding to the misery of active mutual funds underperformance is that individual investors in mutual funds by changing funds, often at the wrong time, obliterate most of their mutual funds’ returns1:
The data above highlights the cost that the emotions of “fear and greed” impose on the average investor. A similar study below in Exhibit 1 conducted by Dalbar likewise underscores the importance of controlling emotions and avoiding self-destructive investor behavior. From 1992–2011, the S&P 500 returned 7.8% annually while the average stock fund investor earned only 3.5%.
You Can’t Beat the Market if You Are the Market
In 1975, Charles Ellis wrote an epic and enduring article on why active mutual fund or stock investing is a “loser’s game.” One of the key reasons he cited was institutional dominance. Institutions, which include mutual fund companies, grew from 30 percent to 70 percent of the market in the ten years from 1965-1975; portfolio turnover went from 10 percent to 70 percent. His argument was clear and convincing: if you are the market, how can you beat the market? Further, how can you beat the market if you are adding fees into the mix? 85 percent of active managers in the trailing 10 year period underperformed the market. Ben Graham, Warren Buffet’s mentor, and ‘father of value investing’ was quoted in 1976, “I am no longer an advocate of elaborate techniques for securities analysis in order to find superior value opportunities. This was rewarding 40 years ago, but the situation has changed. I doubt whether the extensive effort is worth the cost….I’m on the side of the ‘efficient market’ school of thought.” Exhibit 2 provides further evidence to Ellis’ data that active management is a consistent losing proposition.
Burton Malkiel notes in a “Random Walk Down Wall Street,” that the results in Exhibit 2 are very similar over multiple time periods, over different asset classes, and different geographic regions. He further notes that “survivorship bias” serves to overstate return data. Survivorship bias means that funds that do not do well do not stay in business. Consequently, their results are excluded from the return data. This obviously will skew aggregate returns higher than if all data were included. Another tactic by fund companies is to seed incubator funds. These funds will operate for a few years and only those that do well will then be reported and marketed. The losing funds will never be seen in the data.
In 2003, Ellis also wrote “The Winner’s Game,” which offers further evidence of “losing” trends:
- Institutions total public trading on the NYSE has went from 10% to over 80% in 40 years.
- Thousands of historical databases can be called up, correlated, and examined instantly.
- The 50 largest and most active institutions execute half of the NYSE transactions; the smallest of these 50 institutional powerhouses pays Wall Street $100 million every year for services, so, naturally, they get amazingly fast first-call services of every kind every day.
- Sell-side brokerage analysts gather information to interpret—and sell swiftly to the institutions, particularly the giants, so the commission dollars can be generated. Herd thinking is the norm.
- Institutions monitor their portfolios against their index comparisons. Clients and consultants also compare at very frequent intervals, always quarterly, and often daily.
- Managers know to hug the index because clients seldom fire a manager for slight underperformance, particularly if the personal service relationship is strong. You pay extra for a “closet-indexer.”
- Turnover among investment managers has risen to where one-in-four institutional clients fire a manager each year, adding to a managers’ short-term caution.
The Evidence is The Why……
In any business endeavor, cost-control is an important factor to sustain profit. Sales and trading costs, herd thinking, and the institutionalization of the market make it highly unlikely for an investor to achieve optimal risk-adjusted returns with active fund management. A retail investor cannot compete against this – and that is good news. They are better off not participating in this costly game. The compounded impact of fees and conflicts of interest impose a very heavy cost to the investor. Whereas, the use of index funds serves to minimize cost, increase tax efficiency, and reduce risk while offering better long-term returns.
……What We Do Makes Sense for You
Investment in general is a long term endeavor subject to the investor’s time horizon. An asset mix appropriate to your life stage and financial condition is more important than individual asset class, fund, or stock selection. A diligent adviser, who is in the game to help clients achieve the best risk-adjusted returns, will get help you get the asset mix right and then be ruthless in removing or minimizing non-value related costs. A well-defined investment strategy seeks the best return at the lowest risk. Our strategies leverage historical evidence, offering you greater odds to succeed. The unbiased evidence is very clear.
1. Charles D. Ellis, “The Winner’s Game; Making your own plan is often quite rewarding,” Journal of Portfolio Management, Spring 2003, p29.