(It Pays To) Keep It Simple Stupid

This principle has been around for decades, applied to situations ranging from aviation engineering to modern architecture to the animation masters at Disney. Yet, when it comes to investing our emotions tend to distract us from this guiding principle. In fact, if you take a closer look at the mutual fund industry over time you would find that straying away from this concept has proven to be very costly. Since Vanguard was founded in 1974, it has been able to save investors hundreds of billions of dollars directly and indirectly. It has done this in three different ways: lower fees, lower turnover, and the “Vangaurd Effect”. Eric Balchunas details this in his Bloomberg article:

Vanguard has saved investors $175 billion in fees since it was founded in 1974. This is based on the historical difference between the asset-weighted average expense ratio of an active mutual fund versus that of a Vanguard fund, as seen in the chart below. The difference is multiplied by the firm’s assets each year — in other words, the amount an investor would have paid if Vanguard didn’t exist.

The firm has also saved investors about $140 billion in trading costs or turnover. Every time a fund manager makes a trade, it costs a tiny amount. Generally speaking, every additional 1 percent in turnover comes with 0.01 percent in extra costs. Active mutual funds have an average turnover approximately 50 percentage points higher than a Vanguard fund.

Finally, there is the “Vanguard Effect”: The company’s influence leads other funds to lower their fees in order to better compete. For example, the average fee for active funds has dropped from .99 percent in 2000 to .77 percent today, which can also be seen in the above chart. This decline benefits the investors who make up the $10 trillion in active mutual-fund assets. In other words, Vanguard has saved non-Vanguard investors about $200 billion in active funds alone.

From this it is easy to see how one can best control costs by using a low-cost, passive mutual fund. This may feel counter intuitive by doing less, but this allows you to do more. More focus on the proper asset allocation for your risk level, more time spent on your financial planning and (most importantly) more money towards your portfolio instead of towards fees. The global market’s movement day-to-day is far too complex to try to predict. Instead we should simply focus on the things we can control: fees, diversification, taxes and discipline (rebalancing). Keeping to a more simplistic investment focus has shown to be more rewarding, as well as a much more effective use of our time.

Active Management ALWAYS Underperforms

Active asset management is the strategy of picking a small number of holdings with the goal of outperforming the broad index.  For example, an active manager may invest in small US companies and pick 40 of those companies to include in his portfolio with the hope of outperforming the actual 2,000 small US companies in existence.  Most people believe that with enough hard work and intelligence this is very possible, especially in areas where there is less competition (like small companies, emerging market stocks or high yield bonds).  But there is a simple truth that the active managers won't tell you.  The average active manager in any asset class will always underperform his/her benchmark.  It is simple math that Nobel prize winner Bill Sharpe wrote in his brilliant paper, The Arithmetic of Active Management:

Because active and passive returns are equal before cost, and because active managers bear greater costs, it follows that the after-cost return from active management must be lower than that from passive management.

Think of it this way.  The ownership of an entire asset class is made up of the combination of passive investors (those that buy and hold the entire asset class) and active investors (those that pick and choose the funds they want to own inside that asset class).  If the passive investors own the asset class (some portion of it), the remaining active investors MUST own that same asset class if you look at them in the aggregate.  Therefore, if one investor overweights Walmart in their portfolio, some other investor must be underweighting it.  It is impossible for everyone to overweight or underweight a stock since someone has to own it.  In the same vein, when an active manager buys a stock (and profits from it) someone has to have sold it to him (and therefore lost out).  Trading is a zero sum game amongst active managers.

Notice, I have not said that all active managers will underperform.  It is the average of all active managers that will always underperform because of their fees.  There will be winners and there will be losers, but the average active manager will always do worse than his/her benchmark (FYI- this plays out perfectly in the data).  This is true over any time period:  one day, one month, one year, or 100 years.  So, if you believe in this simple math equation, you need to ask yourself one more question- can I pick a manager (or be one myself) that will be in the minority camp of active managers that outperform?  We'll save that topic for a future post.

Invest Like Norway, Not Yale

David Swenson, the chief investment officer of the Yale endowment fund, has gained notoriety over the past several decades for his management of the Yale endowment fund.  In the early 1990s he decided to place a gigantic chunk of the endowment into alternative assets like real estate, hedge funds and private equity.  The results were spectacular.  From 2000 to 2012 Yale's endowment returned about 12% annually while US stocks averaged 2% during the same period.  Not only have other institutions followed suit, but so have individual investors.  Retail mutual funds investing in alternative strategies have exploded, aided in part by the success of endowment funds like Harvard and Yale.  Instead of being some fringe investment strategy, alternatives have become mainstream, with over $300 billion in these products.

While Yale has focused on alternatives, Norway has gone the opposite direction.  Here is an article from 2013 in the WSJ:

Now, let's turn to Norway. Its huge Government Pension Fund Global keeps roughly 60 percent of its assets in publicly traded stocks (half in the U.S.), 35 percent in bonds and up to 5 percent in real estate. How much does the Norwegian portfolio hold in hedge funds? Nothing. Venture capital? Nada. Commodities? Zip. Private-equity funds? Zero.

"The Yale model would not work for us," says Norwegian spokeswoman Bunny Nooryani, because "the fund is too large to implement that type of strategy." With two-thirds of $1 trillion to invest, building a meaningful portfolio of non-liquid assets would be far too cumbersome and costly. And yet the Norwegian fund has fared quite well. It has gained an annual average of 4 percent since 2000, or double the return on U.S. stocks. Since 2009, it has earned 4 percent annually, while Yale earned an average of just 1 percent a year.

The Norway portfolio is "diversified in everything," says Antti Ilmanen, an analyst at AQR Capital Management in Greenwich, Conn., who serves on the fund's advisory board. It owns shares in nearly 9,000 companies and holds approximately 1 percent of every significant stock on earth.

The Norwegian fund has another advantage, says Elroy Dimson, a finance professor at London Business School who also is on its advisory board. "Norway is willing to suffer a lot and do worse than other major investors when markets are going down," he says. The giant fund loads up on smaller stocks and on so-called value stocks, which trade at lower prices in the short term. When markets fall, these companies tend to fall even farther—but that sets them up for higher performance in the long run, according to decades of research by Dimson and other experts.

Does anything sound familiar here?  Extremely broad diversification, focus on small and value companies, low cost.  This approach is the one touted by Greenspring on behalf of its clients.  In fact, the nearly $1 trillion Norway Pension Fund is invested almost identically to Greenspring clients.  It is somewhat comforting to us to know that the largest institution in the world has adopted the same approach.  I thought it would be interesting to go back and see how things have fared for both institutions since the financial crisis and ensuing recovering.  From the period of June 30, 2007 to June 30, 2014 the Yale Endowment has averaged 5.71% per year.  During that same period, the Norway fund has averaged 5.23%.  A nearly identical return, but the Yale endowment has experienced 34% more volatility than the Norway Fund.  

Before you take this data and assume that you can't hurt yourself by investing in alternatives, please remember that Yale has $24 billion in assets and an investment office of 28 professionals working on this fund.  That gives them significant access and leverage in pricing.  Two factors that will be working against you.  In addition, there is a train of thought that Yale's outperformance will be difficult to continue.  Because so many institutions have followed their lead, the opportunities available to them will not be as favorable due to other organizations competing for the same deals.  Conversely, it is not that hard to invest like Norway.  It can be done through mutual funds or ETFs and at a very reasonable cost.  We believe Norway's approach, which is certainly less sexy than Yale's, will be the best alternative for investors in the future. 

Hedge Funds Close Up Shop

The New York Times has a story about hedge funds closing their doors over the past year or two.  When asked why, many claim that the hassle of dealing with investors or regulations is just too cumbersome.  Instead, they'd rather just manage their own money and not deal with all the red tape. Here is an excerpt:

Others are more direct. For Gideon King, of Loeb King Capital Management, running a hedge fund had just become "too cumbersome."  Mr King, who has been managing money for 21 years, informed his investors in a letter in January that he would be closing the doors.

All three have chosen instead to invest their vast personal wealth through so-called family offices, which means fewer regulatory hurdles and compliance costs. As a family office, each will not have to register with the Securities and Exchange Commission.

And if you believe that, I have a bridge to sell you.  Regulations and compliance costs are a drop in the bucket when it comes to hedge fund revenues.  Think about a fund managing $1 billion.  In a traditional 2% of assets and 20% of profits setup, in a good year, that fund might generate $20 million in asset management fees plus $20 to $40 million in performance fees.  Does anyone really believe they can't handle the "cumbersome" regulation with that kind of budget?  So why would anyone want to kill that golden goose?  The likely reason…they aren't earning those types of fees.  The dirty little truth that most won't tell you is that hedge fund managers often take extraordinary risks, and if those risks don't result in profits they will shut their fund down.  Why?  Because they can't make any money.  Investors pull their money which limits their ability to earn asset management fees.  In addition, their lack of performance negates any substantial performance fees.  When that happens, yes regulation and compliance costs do become an issue, solely because of the fact that their is so little revenue to pay for it.

So why is this an issue now?  Mainly, performance has been so abysmal that the fees I mentioned above have been decimated.  During the last 10 years (ending 4/30/2015) the HFRX Global Hedge Fund Index has returned 1.21% per year.  As you can imagine, it is hard to generate huge fees from returns as small as these.  As an investor there is no reason to take these kinds of risks and pay these kinds of fees with your money.  Put the odds back in your favor by minimizing costs and broadly diversifying.  It is a much better strategy than trying to pick a winning hedge fund.  

Shrinking The Gap

Nearly every investor experiences a gap between what the market returns and what they actually return in their portfolio.  We believe that the shrinking of that gap should be the key focus of investors and their advisors.  This post is the first in a series that is designed to determine what the factors are that lead to the gap's existence and what investors can do to shrink it.  Carl Richards, the NYT blogger, refers to this as the "Behavior Gap", and while behavior is a factor that causes underperformance, it is by no means the only factor causing investors to fall short of the returns they are entitled to.  Below is the graphic we show clients:

Shrinking the Gap

There are things we can do that are additive to portfolio performance.  Diversification, exposure to specific risk factors and how we implement rebalancing are some of the key contributors to adding value.  On the other side there are factors that drag down performance.  Taxes, fees and poor investment behavior may not be entirely avoidable but investors need to have a process on how to minimize their impact on a portfolio.

How much value can you add to your portfolio by shrinking this gap?  Everyone is different, but we believe that 2% per year is attainable for most investors.  What does that mean in dollar terms?  A lot.

For a 50 year old investor with $1 million the difference between 6% and 8% over the next 40 years is over $11 million ($10.285MM vs. $21.724MM).  This series will provide you a playbook on how to shrink the gap and earn what you are entitled to.

Information contained herein has been obtained from sources considered reliable, but its accuracy and completeness are not guaranteed. It is not intended as the primary basis for financial planning or investment decisions and should not be construed as advice meeting the particular investment needs of any investor. This material has been prepared for information purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Past performance is no guarantee of future results.