Financial & Estate Planning

Practical Finance: Rules of Thumb to Forget. Number Three….

PRACTICAL FINANCE

RULES of THUMB to FORGET. NUMBER THREE….

If you read or follow personal finance publications and blogs, you’ve undoubtedly seen some headlines to articles or posts that read like these from the past year or two:

  • “More evidence that it’s very hard to ‘beat the market’ over time, 95% of finance professionals can’t do it”
  • “Why Active Managers Still Underperform”
  • “Active Managers are Losers”

A conclusion or rule of thumb follows: “You’d be a fool to invest in any fund other than the lowest cost index fund.”

These headlines would not appear with such frequency without some statistical support for the proposition they espouse. Indeed, Standard & Poor’s updates and publishes a regular scorecard[i] of their S&P Indices versus Active Fund Managers. These scorecards typically indicate that between 80-85% of Active Managers underperform an index, such as the S&P 500, over meaningful periods of time, like 5 years. Standard & Poor’s includes more than 10,000 funds in the comparison. So, on the surface, the conclusion that there is simply no merit in using an active manager might not seem ridiculous. In our 48 years of working with clients, however, our experience tells us that this is one of those areas where the biggest challenge to solid reasoning is what we “know” to be true that is not.

Given the data, what is wrong with the reasoning that one should eschew any and all active management? We’ve learned from our experience in actually investing money for families that there are two key elements to reaching a sound conclusion about this question.

First, it is important to put raw statistics into perspective and understand the almost inevitability of the numerical result in a scorecard like that prepared by Standard & Poor’s. When you stir 10,000+ fund portfolios into the stew, it is to be expected that their aggregate holdings will look pretty much like the market itself, which is also what the S&P 500 Index approximates. The resulting average return of the 10,000 funds (before considering fees) of a large group of funds ends up being about the same as the S&P 500. It really could not be any different mathematically. Since all of the funds charge a fee, the average fund would thus have to deliver a return that underperforms the S&P 500 Index, which has no fees. So, there is really nothing at all surprising in the numerical outcome that the majority would underperform, once fees are subtracted.

Second, but perhaps most important, many of the so-called “active managers” might better be labeled “closet indexers”. Finance professionals use a term, “Active Share”, to calculate the proportion of stock holdings in a manager’s portfolio that differs from the benchmark index. Without going into all of the detail here, suffice it to say that over the past 4 decades, the number of fund managers who build portfolios that do not differ materially from the index has increased (low Active Share measure). A study by professors at Yale University[ii] noted that the percentage of fund assets with Active Share greater than 80% went down from 58% in 1980 to 28% by the year 2003. It may be even lower today. Why does this matter to you as an investor? Here’s why: the most credible academic research suggests that the minority of funds which DO out-perform the market are the ones with very high Active Share scores. (By the way, that does not mean that a high Active Share measurement ensures out-performance, because the worst performers also typically have high Active Share calculations.) Active Share is very valuable in identifying and excluding closet indexers, which is extremely important because their active management fees virtually guarantee they will underperform the index. Stated well by our Chief Investment Officer, Ryan Patterson, CFA, CFP®, “If there is any “Rule of Thumb” here, it might more properly be stated: You’d be wise to avoid a closet-index fund.”

So, what is the sound conclusion? We believe that the key is to avoid “mantras” that take on the level of a religious fervor. Rather, recognize that two things can be true, side-by-side:

  1. Passive indexing strategies have a proper and worthwhile place in that they provide a very high likelihood of obtaining the return for the market segment you might desire at an extremely low cost, and typically with high tax efficiency.
  1. Active investing strategies can indeed enhance portfolio construction and produce excess returns. It becomes a bit easier to identify those fund managers who have demonstrated consistency in such superior results if you use techniques like Active Share measurement (it is not the only tool, of course) to exclude the closet indexers from consideration.

[i] https://us.spindices.com/spiva/#/

[ii] https://som.yale.edu/news/news/nearly-one-third-actively-managed-us-mutual-funds-are-closet-indexers-finds-new-study-yale