Active Mutual Fund Managers Not Getting Any Better

Below is a copy of a post from a blogger I follow - The White Coat Investor: A doctor who tries to help his peers through the noise of all things financial.

This is a great summary of recent performance of actively managed mutual funds relative to their respective index:

Active Mutual Fund Managers Not Getting Any Better

Posted on January 28, 2013 by White Coat Investor

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Every year Standard and Poors publishes a “scorecard” comparing active mutual fund managers to the indexes.  Every year it’s pretty much the same story- active fund managers can’t persistently beat a passive investment.  This year’s version recently came out.  Here are the highlights:

1) From September 2009 to September 2012, 23.6% of large-cap funds, 15.5% of mid-cap funds, and 29.4% of small-cap funds remained in the top half with regards to fund performance (AKA beat a low-cost index fund.)  Random chance would lead to 25% of remaining in the top half for all 3 years.

2) From September 2007 to September 2012, 5.2% of large-cap funds, 3.2% of mid-cap funds, and 5.1% of small-cap funds remained in the top half for all 5 years.  Random chance would lead one to expect at least 6.25% would remain in that category.

In essence there is no persistence of performance.  You CANNOT choose an actively managed mutual fund based on past performance and expect that to persist in any way, shape, or form.  Actually, that’s not entirely true.  There is some persistence of performance….among the bottom quartile funds.  They’re much more likely to be merged or liquidated than better performing funds.

As one part of the study they took mutual funds that performed in the bottom half over a 5 year period and took a look at how they performed over the next 5 years.  For all US Domestic funds, those in the bottom half over the first 5 years had a 36.8% chance of being in the top half over the next 5 years, a 34.5% chance of being in the bottom half, and a 28.7% of disappearing completely. Now, I think it’s safe to say that those that disappeared weren’t doing well, so in reality 63.2% of bottom half funds stayed in the bottom half.

Moral of the story?  Good funds go bad and bad funds stay bad.  If the chances of you choosing a 5 year winner are only 1 out of 20, and you have to do this for 5 or 10 different asset classes, the odds of you designing an actively managed portfolio that will outperform a passively managed portfolio seem astronomically small.  Save yourself the trouble and buy low-cost index funds.

A Concise Explanation of Efficient Markets and The Difficulty of Truly Beating The Market

Nate Silver uses the efficient market hypothesis (EMH) to demonstrate how our brains will use simplified models.

The simplified EMH - the simple statement in #1 below,  is often attacked by those who say that the EMH is invalid. But, by the time you read to #7 - which is a concise definition of the EMH, it becomes much harder to argue against the EMH.

The next time someone claims to outperform the market you should ask: Do they outperform relative to risk and transaction costs?

Nate Silver:

"Consider the following seven statements, which are related to the idea of the efficient-market hypothesis and whether an individual investor can beat the stock market. Each statement is an approximation, but each builds on the last one to become slightly more accurate.

1. No investor can beat the stock market.
2. No investor can beat the stock market over the long run.
3. No investor can beat the stock market over the long run relative to his level of risk.
4. No investor can beat the stock market over the long run relative to his level of risk and accounting for  his transaction costs.
5. No investor can beat the stock market over the long run relative to his level of risk and accounting for his transaction costs, unless he has inside information.
6. Few investors beat the stock market over the long run relative to their level of risk and accounting for their transaction costs, unless they have inside information.
7. It is hard to tell how many investors beat the stock market over the long run, because the data is very noisy, but we know that most cannot relative to their level of risk, since trading produces no net excess return but entails transaction costs, so unless you have inside information, you are probably better off investing in an index fund.

The first approximation—the unqualified statement that no investor can beat the stock market—seems to be extremely powerful. By the time we get to the last one, which is full of expressions of uncertainty, we have nothing that would fit on a bumper sticker But it is also a more complete description of the objective world."

Nate Silver (2012-09-27T00:00:00+00:00). The Signal and the Noise: Why Most Predictions Fail-But Some Don't (Kindle Locations 7462-7475). Penguin Press HC, The. Kindle Edition.

Beating the Stock Market: From Nate Silver's "The Signal and the Noise: Why Most Prediction Fail-But Some Don't"

" As the legendary investor Benjamin Graham advises, a little bit of knowledge can be a dangerous thing in the stock market. After all, any investor can do as well as the average investor with almost no effort. All he needs to do is buy an index fund that tracks the average of the S&P 500. In so doing he will come extremely close to replicating the average portfolio of every other trader, from Harvard MBAs to noise traders to George Soros’s hedge fund manager. You have to be really good—or foolhardy—to turn that proposition down. In the stock market, the competition is fierce. The average trader, particularly in today’s market, in which trading is dominated by institutional investors, is someone who will have ample credentials, a high IQ, and a fair amount of experience. “Everybody thinks they have this supersmart mutual fund manager,” Henry Blodget told me. “He went to Harvard and has been doing it for twenty-five years. How can he not be smart enough to beat the market? The answer is: Because there are nine million of him and they all have a fifty-million-dollar budget and computers that are collocated in the New York Stock Exchange. How could you possibly beat that?”

 "In practice, most everyday investors do not do even that well. Gallup and other polling organizations periodically survey Americans on whether they think it is a good time to buy stocks. Historically, there has been a strong relationship between these numbers and stock market performance—but the relationship runs in the exact opposite direction of what sound investment strategy would dictate. Americans tend to think it’s a good time to buy when P/E ratios are inflated and stocks are overpriced. The highest figure that Gallup ever recorded in their survey was in January 2000, when a record high of 67 percent of Americans thought it was a good time to invest. Just two months later, the NASDAQ and other stock indices began to crash. Conversely, only 26 percent of Americans thought it was a good time to buy stocks in February 1990—but the S&P 500 almost quadrupled in value over the next ten years"

Nate Silver (2012-09-27T00:00:00+00:00). The Signal and the Noise: Why Most Predictions Fail-But Some Don't (Kindle Locations 6096-6103). Penguin Press HC, The. Kindle Edition.

Is Dogbert your Financial Advisor?

Have you really reviewed what your investment fees are?

Many dont even know what they are paying due to hidden fees in mutual funds and the way many advisers bill their clients.

A fee-only advisor will openly disclose all the fees you are paying and how you are paying them.

To find a Fee-Only advisor in your area go to: http://www.napfa.org/

For more from Dilbert's creator Scott Adams read this great piece from the WSJ:

http://online.wsj.com/article/SB10001424052748704913304575370913870866820.html?mod=ITP_thejournalreport_0 

VERY SIMPLE YET VERY POWERFUL

The following quote is from Mike Pipers book "Investing Made Simple"
It is a simple expansion on Nobel prize winner William Sharpe's explanation of why index funds beat most other investors.

Why Index Funds Win: If the entire stock market earns, say, a 9% annual return over a given decade, and the average dollar invested in the stock market incurs investment costs (such as brokerage commissions and mutual fund fees) of 1.5%,  …then the average dollar invested in the stock market must have earned a net return of 7.5%.

Now, what if you had invested in an index fund that simply sought to match the market’s return, while incurring only minimal expenses of, say, 0.2%? You would have earned a return of 8.8%, and you would have come out ahead of most other investors. It’s counterintuitive to think that by not attempting to outperform the market, an investor can actually come out above average. But it’s completely true. The math is indisputable. John Bogle (the founder of Vanguard and the creator of the first index fund) refers to this phenomenon as “The Relentless Rules of Humble Arithmetic.”

Piper, Mike (2009-10-01). Investing Made Simple: Index Fund Investing and ETF Investing Explained in 100 Pages or Less (Kindle Locations 453-458). Simple Subjects, LLC. Kindle Edition.

The Truth is "I Dont Know"

Above is from the brillant Ally Bank commercial.

Below is a quote from the 1940 investment book "Where are the Customers Yachts"

For one thing, customers have an unfortunate habit of asking about the financial future. Now if you do someone the signal honor of asking him a difficult question, you may be assured that you will get a detailed answer. Rarely will it be the most difficult of all answers - "I Dont Know"

The lesson is that as much as we crave AND PAY for financial prognostications. In the long run, we really dont know. In fact, what we do know is embedded in the price of the security. In other words the expected is built into the price. The problem comes when the expected fails to happen. Then we have volatility in our investments.

I am often confronted by investors that think that if they pay high expenses to large firms they will get some insight into the future. Unfortunately, after all their charts and graphs and analysis they do not prove to know more than the market as a whole. And, after the fees for the crystal ball gazing, the big firms underperform the market over time.

This reminds me of the Malcom Gladwell piece in The New Yorker. He tells the story of the brilliant investor: Victor Niederhoffer, who in 2001 was predicting that the markets would be quite. He had his fortune invested that way. Then planes flew into the world Trade Centers.

http://www.gladwell.com/2002/2002_04_29_a_blowingup.htm

In the end: we just cant predict what tomorrow will bring.


What I do know is this: The best thing one can do is build a stock portfolio that looks like the market, then balance it with short term bonds based on the amount of risk you need to mitigate.
This can be done with low cost index funds and ETFs and the help of a fee-only advisor who can help you determine how much risk you are comfortable with and who can then gude you to an appropriate portfolio - all at a reasonable cost.

Where Are The Customers Yachts?

Once in the dear dead days beyond recall, an out-of-town visitor was being shown the wonders of the New York financial district. When the party arrived at the Battery, one of his guides indicated some handsome ships riding at anchor. He said "look, those are the bankers' and brokers' yachts."
"Where are the customers' yachts?" asked the naive visitor.

-Ancient Story

The above is the epilogue to the classic investment book: "Where are The Customers Yachts."

 Many feel that they have to pay large sums to large firms to help them with the elusive idea that their investments will consistently beat the market. Unfortunately, nobody has found the formula to beat the market. The only ones getting rich are the banks and brokers. So why not just be the market?
The best thing one can do is build a stock portfolio that looks like the market, then balance it with short term bonds based on the amount of risk you need to mitigate.
This can be done with low cost index funds and ETFs and the help of a fee-only advisor (if needed).