Synergy Investments » Buyer

Active versus passive – the debate is over

Gary Lee — Sun, 15 Mar 2015 13:53:25 +0000

At Consilium, we believe a growing body of evidence has moved us past the traditional active vs. passive debate. The best evidence comes from the US where the research has been collected and mostly aptly documented. The traditional debate contrasts an index fund, representing the passive camp, and an active equity or hedge fund, representing the active camp.

A widely publicised wager between Warren Buffett and a hedge fund manager called Protégé Partners illustrates the point. Buffett bet that that the Vanguard S&P 500 (a passive index type fund) would beat a selected group of hedge funds over a 10 year time horizon. So far the Vanguard fund is up 43.8%, compared with the hedge fund’s gain of just 12.5% since the bet was made.

Buffett’s backing of the S&P 500 was primarily an argument about the significance of cost minimisation not philosophy. In his 2013 Berkshire Hathaway letter to shareholders, Buffett said he had instructed his estate to put 90% of his funds into the Vanguard S&P 500 and 10% in cash. Here’s his rationale:

“Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal…”

This observation, from one of the greatest stock pickers in history, suggests that one does not necessarily need to agree with a passive investment philosophy to observe the weight of the evidence. The evidence shows, overwhelmingly, that investors are not rewarded by the high costs of active investment management.

When Russell Kinnel, director of research at Morningstar, attempted to identify the number one predictor of performance for investment managers, his findings also made a compelling argument in favour of low cost investing.

“If there’s anything in the whole world of mutual funds that you can take to the bank, it’s that expense ratios help you make a better decision. In every single time period and data point tested, low-cost funds beat high-cost funds… Investors should make expense ratios a primary test in fund selection. They are still the most dependable predictor of performance.” Russell Kinnel, Morningstar FundInvestor, vol. 18, no. 12 (August), p 1 – 3.

The second part of the debate focuses on persistence in performance. Every study of the persistence of active managers to deliver outperformance (and there have been plenty) shows that, once you control for risk, there is no statistically meaningful performance persistence.

To illustrate simply, Vanguard conducted a study in which they ranked all US equity funds in terms of excess return versus their stated benchmark over the five years ending 2008. They divided the funds into quintiles, separating out the top 20% of funds. They then tracked the performance of those top 20% of funds over the following five years through December 2013 to check for persistence. If the top quintile funds displayed any meaningful performance persistence, we would expect a significant majority to remain in the top 20% five years later. A random outcome would result in about 20% of the funds dispersed evenly across the five quintiles.

The results were close to random. Only 12% of funds repeated a top quintile performance, while 28% moved to the bottom quintile.

If costs really matter and performance persistence by active managers cannot be counted on, is there a reliable way outperform markets?

This is where we depart from the traditional passive vs. active discussion. Considerable research shows that low cost shares (based on a combination of fundamental ratios), small company shares and profitable company shares exhibit higher returns than the market over long periods of time. The figure below compares long term value, small cap, growth and total market indices for various markets.

Both value and small cap segments of the market outperform total market and growth. The implications of this are that not every share has the same expected return. This is probably because shares incorporate unique systematic risks, for which prices and market capitalisation are merely a proxy. And there are other proxies beyond just these two. The question is how to invest in shares with a higher expected return. Do we pay a manager to pick what he believes are the best of the bunch? Two problems arise with this approach – the manager’s fee (evidence shows this is not money well spent) and also that we lose some of the virtually costless benefits of diversification.

Passive investors can defeat both of these problems. They can use very low cost and highly diversified funds to access these sources of higher expected returns in a way that adds long term value over broad market benchmarks and peers.

In everything we do, the core of the argument is always evidence. We want to see evidence – evidence that has some statistical relevance; evidence that is persistent across time periods, pervasive across markets and has a sound economic rationale to it. We want to see evidence that ideas don’t work merely in theory or on paper, but can produce results after considering the costs of management, transactions and taxes. The problem with active management as it’s traditionally described is that the evidence simply doesn’t stack up.

As for the debate about active vs. passive… If it’s purely an argument based on conjecture and opinion, it will probably never end. However, if evidence counts for anything, we think this debate was settled a long time ago.

The post Active versus passive – the debate is over appeared first on Synergy Investments.

Market timing: a picture is worth a thousand words

Gary Lee — Sun, 15 Mar 2015 07:16:37 +0000

They say a picture is worth a thousand words.

We could easily spill a thousand words on market timing.

We could talk about how each trade involves a willing buyer and seller; each with equal interests, each with the same access to information.

We could talk about the fact that, over about 85 years, the S&P 500 has only gone up 51.02% of the days.

We could talk about the concentrated nature of returns. We could show that being out of the market, and missing the best month each year, drops returns by about 7% per year.

We could talk about a psychologist from Berkeley, named Philip Tetlock – who studied over 82,000 varied predictions, by 300 experts from different fields, over 25 years – and concluded that expert predictions barely beat random guesses. Ironically, the more famous the expert, the less accurate his or her prediction tended to be.

We could talk about Nobel Prize winner Bill Sharpe’s contention that timers need to be right 74% of the time, to overcome the frictions and costs of their moves.

We could talk about magazine covers, like the Death of Equities, that featured just before five years of 14.44% average compound returns for the S&P 500.

We could talk about how studies – ranging from the landmark paper by Brinson, Beebower and Hood, to the most recent study on New Zealand managed funds – have found that the average contribution of market timing to returns is negative.

We could talk about a study of 1,557 managed funds and 210 institutional funds, where the author concluded timing ability of managers is, on average, negative.

We could talk about how the majority of market timing newsletters underperform the market. We could talk about how, on average, market timing newsletters underperform the market by over 4.00%.

We could talk about how the market timing gurus whose calls are tracked have less than 50% accuracy.

We could talk about evidence that shows economists can’t time markets either.

We could talk about how the predictive power of last year’s return, to correctly forecast this year’s return, is 0.01%.

We could talk about the wise words of Warren Buffett, who said, “The only value of (share) forecasters is to make fortune tellers look good.”

We could talk about the simple logic that all market timing calls offset each other. If you buy, someone must sell. If you sell, someone must buy.

We could talk about a lot of things.

Or…

We could show you this picture of monthly returns and simply ask you to find the pattern.

Wishing you the very best of luck…

The post Market timing: a picture is worth a thousand words appeared first on Synergy Investments.

If I pick a winning manager, aren’t I likely to beat the market?

Gary Lee — Wed, 04 Feb 2015 07:14:44 +0000

Recently in New Zealand a few star managers have had brilliant runs, easily outperforming markets since inception.

Why on earth would an investor not want to use these funds for their New Zealand share allocation?

We have a lot of respect for what star performers have done. It’s not easy to produce exceptional performance. But for all their glory, the websites of the star performers provide us with the answer to the question above… “Past performance is no guarantee of future returns.”

When asked a question about a star investment manager we typically respond with a question of our own, “Would you believe that this is a very well studied issue?”

Many academic, peer reviewed papers have been written on the question of whether or not we can simply allocate money to a fund that has a good record, and expect to beat the market in the future. It’s a topic that has been researched across different time periods, different countries and different asset classes.

The findings of these studies are just as the disclosure statement suggests – past performance is no guarantee of future returns.

Perhaps we would put it more strongly: the evidence shows that past outperformance tells you next to nothing about future outperformance.

Below, we summarise two of the many papers on this subject, one from the United States and one from New Zealand.

In 1997, Dr Mark Carhart published “On Persistence in Mutual Fund Performance” in the Journal of Finance. This paper addresses the exact question posed above. Does the good performance of investment managers persist? Can I select a manager with good records and expect to beat the market?

To answer this question, Carhart uses a comprehensive database of 1,892 equity (share) funds from the period 1962 – 1993. Regarding the comprehensive nature of his data, he states, “the data… include all known equity funds over this period.”

The author summarises his conclusions on the persistence of investment managers’ performance this way:

“Common factors in share returns and investment expenses almost completely explain persistence in equity mutual funds’ mean and risk-adjusted returns… The only significant persistence not explained is concentrated in strong underperformance by the worst-return mutual funds. The results do not support the existence of skilled or informed mutual fund portfolio managers.”

In other words Dr Carhart is saying that, once he accounts for types of investment risk taken by the manager, investment managers beat the market in the future only by chance.

In New Zealand there is only one published study we are aware of that analyses the persistence of New Zealand investment managers. In 2006 Bauer, Otten and Tourani Rad published “New Zealand mutual funds: measuring performance and persistence in performance” in Accounting and Finance.

This study reviewed a sample of 143 mutual funds for the time period 1990 – 2003. Their results show that performance in New Zealand mutual funds does not persist more than luck alone can explain. The authors conclude:

“It has to be noted that the documented persistence in performance is mainly driven by icy hands, instead of hot hands indicating that funds that underperform (significantly negative alpha) in one period are most likely to underperform in the next period. Investors should therefore avoid these funds. However, evidence of persistently out-performing funds (significantly positive alpha) is absent.”

In summary, the paper finds no evidence that an investor can reliably outperform markets in the current period by selecting a fund that outperformed markets in the last period.

It is probably helpful to get away from the academic articles for a moment and just look at some practical examples.

There are businesses like Morningstar dedicated to rating funds. Their proprietary research goes beyond mere performance and looks to identify quality in investment management and investment approaches.

Morningstar gives their best rated funds five stars, while the worst funds get one star. If anyone is going to find a winning fund manager, it’s Morningstar.

Yet their record is in performance prediction is abysmal. A recent study looked at the 248 managed funds that Morningstar rated five stars in 1999 to see how they had performed over the ensuing decade.

The chart below shows the story. A decade later only 4 out of 248 funds were still five stars, and 87 funds had gone out of business. The average return of a Morningstar five star fund over the 10 years was worse than the average return of all other funds put together.

The data here corresponds to a study by Paul Gerrans published in the academic journal Accounting and Finance entitled “Morningstar ratings and future performance”.

Dr Gerrans found that:

“By far the strongest case to mount is that of no significant difference between relative rating and future performance…. if an investor is looking to the star for guidance, this analysis suggests that they might be better served examining information on fees, which over the period of analysis appear greater on average than ratings differentials and are far more certain.”

So we can see Morningstar is likely no guide.

Below we look at all the funds monitored by Morningstar from 2004 to 2008 in the US Large Cap Blend asset class and ranked them from the very best performing fund to the very worst performing fund. Thanks to Index Fund Advisors (www.ifa.com), we can see how this looks in graphic form using the top chart from the figure below.

The bottom chart shows the performance of those same funds from 2009 – 2013, keeping the same ordinal ranking as the top chart. There’s no real pattern, other than perhaps, on average, the badly performing funds in the first period did better in the second period.

It’s no wonder top academic researchers have told us that past performance does not persist and is no guide in selecting fund managers.

In another study, Vanguard ran a test to show the practical implications of this research, where they compared two strategies that investors may employ. The first they called “performance-chasing” and the second, “buy-and-hold”. For the performance-chasing strategy they randomly selected a fund in the top 50% of peers over the past three years. If the fund ever fell below the top 50% they would replace it randomly with another fund of the same asset class in the top 50%. In other words, this strategy was always holding a fund in the top 50% of peers based on three years of historical data. For the buy-and-hold strategy they picked a fund at random, regardless of performance history, and held it through thick and thin.

They ran this experiment over and over again, across several asset classes. Below we see the median result for all nine asset classes they tested. Buy-and-hold crushed performance-chasing.

The Vanguard study picked funds at random. In the real world, funds aren’t picked at random. Pension funds, for example, spend quite large amounts of money on consultants to help them pick the funds that are likely to be winners in the near future. Another study published in the Journal of Finance looked at pension funds in the United States. The study showed very clearly that the investment managers selected by these pension funds had very impressive track records. They produced excess returns (fancy talk for beating the pension’s existing funds) by 4% – 9% in the years before the pension funds selected them.

The study was on how the funds performed after they were selected.

The answer? The fired funds beat the hired (or selected) funds! The first year the fired beat the hired by 0.49%; the second year by 0.88% and the third year by 1.03%. Why? Because past performance is no guarantee of future performance. The results of the study are illustrated below.

What can we learn from this evidence? If persistence in performance is mostly random, then picking managers on the basis of good track records is likely to:

Increase costs and therefore reduce our expected return
Reduce the certainty we achieve that return

Neither of these results are in the best interests of investors.

None of this is to take away from the achievements of star managers with great recent performance. But it does mean that we don’t believe that their performance, impressive as it is, forms a basis on which we can conclude it is likely to persist in the future.

So what qualities and characteristics can you use to prudently select investment managers? We’ll cover that next time.

The post If I pick a winning manager, aren’t I likely to beat the market? appeared first on Synergy Investments.