Better Odds- Blackjack Or Active Management?

When we review prospective client portfolios, it is almost guaranteed some portion of their money is invested in some sort of active management strategy.  As you may know, active management is the strategy of attempting to beat a benchmark.  This could be done through market timing (buying and selling at opportune times) or stock picking (buying winning stocks and selling ones that will underperform).  The alternative strategy is often called passive management, though we like to call it "evidenced based" management.  Essentially, you own the entire market and don't try to time when to buy or sell securities or pick one stock over another.  The "evidence" suggests that this method of investing has a much higher probability of success.

As I was thinking about the idea of probabilities, I thought it might be fun to compare active management to another game that is all about probabilities…blackjack.  First, let's look at the statistics on active management.  Actual results* show us that 17% of stock mutual funds have beaten their benchmark over the last 15 years.  Bond funds fared much worse, with only 7% beating their benchmark during the same period.  If the goal of active management is to beat a benchmark, they are not doing a very good job.

So what about blackjack?  The odds you will win one hand of blackjack (factoring out ties) is 46.36%.  But we are measuring 15 years of whether an active manager can beat the benchmark.  What is the chance you will win money at blackjack if you play 15 hands in a row?  The answer:  17.5%.

Long story short- you have almost identical odds to walk away with more money after 15 hands of blackjack than you do trying to pick an active manager that will beat the market over 15 years.  The odds are much worse trying to pick a bond fund that will beat the market.  We all have heard that as long as you play for a long enough time, the house always wins.  Maybe you should think about who the "House" is when you are investing and shift the odds more in your favor.

 

*The US Mutual Fund Landscape, 2016 Report

Actively Managed Mutual Funds vs. Powerball

Are you invested in mutual funds?  If so, are any of them active managers?  Whether you know it or not, the odds are stacked against you compared to investors that have chosen passive investment options.  First, it is important to know the difference between the two:

  • Active mutual funds- managers attempt to "beat" the market by buying securities they believe will outperform while selling securities they believe will underperform.  In addition to more frequent trading, these funds typically employ higher fees as well
  • Passive mutual funds- passive mutual funds can be considered "buy and hold" investments since there is very little turnover in these funds.  They attempt to replicate an index or section of the market.  There is no forecasting or predictions on the future, and therefore costs tend to be much lower.

So which strategy does better?  Passive funds as a whole will always have better returns than active funds.  It is a mathematical fact.  If the market comprises ALL the active and passive funds, then as a whole these funds will replicate the market, BEFORE FEES.  It turns out to be a zero sum game.  For every high performing manager, there is a corresponding manager who is trailing (not everyone can outperform the market).  When you take into account the fees associated with active funds, this group as a whole, underperforms.

But that doesn't mean there are no active funds that outperform.  In fact, there are some, but it is almost imposssible to identify them in advance.  In addition, for longer-term investors, the probability that you'll find a great active manager appears to be neglible.  In fact, a recent article on Think Advisor, they had the following quote, taken from a study by Research Affiliates:

The odds of selecting the sort of benchmark-beating mutual funds investors dream of are a slim 1 out of 119, yet investors would not likely stick with them even if they did pick these superstars.

Research Affiliates’ managing director John West and researcher Amie Ko take readers of their November newsletter deep into the institutional manager selection process to show how even the most disciplined professionals, let alone inexperienced consumers, find it difficult to consistently beat the market through active management.

“With these odds, you actually have a slightly better chance of collecting a cash prize on the multi-state Powerball lottery,” West and Ko write.

So there you have it- choosing an actively managed mutual fund that they define as a "superstar" (outperform S&P 500 by 2% per year) has a lower probability of success than winning the powerball.  While slightly amuzing it is an imporant analogy to understand.  Even with the lastest technology on manager attribution, performance measurement and fund statistics, professionals are unable to select funds that consistently outperform.  Take this to heart the next time you need to make an investment decision.

The Risk Of Star Managers

For those of you not following the investment industry closely, one of the highest profile mutual fund managers recently left the firm he co-founded (you could say he was forced out) to start at a new company. Bill Gross, dubbed the "Bond King" ran the PIMCO Total Return Fund, the largest bond fund in the world after disagreements with the Board of Directors at his parent company, a supposed autocratic leadership style, and trailing performance at his fund for the past several years. This is a classic example why we try to avoid "Star Managers". Let me explain our reasoning:

  1. Funds run by star managers are dependent on those managers- if you invest in a fund that has a high profile manager running it, you are really putting all your hopes in that manager being able to continue.  What if he retires?  What if he becomes disabled or dies?  What if he gets caught in some sort of scandalous behavior?  We don't like investment strategies that are dependent on one person or a small group of people.
  2. There is still no evidence star managers are skillful- studies and evidence confirm that past performance (the key metric of a star manager) has no predictive ability on future results.  The data suggests that it is much more likely that star manager performance is attributable to luck.
  3. Star managers typically cost more- because star managers have great track records they tend to charge higher expenses than funds that have no star performer.  For example, Bill Gross's flagship fund, the PIMCO Total Return fund has an expense ratio of 0.46% which is very competitive, but is still nearly 6 times more expensive than the Vanguard Total Bond Market Index Fund, a fund that has no star manager and just attempts to replicate an index.
  4. Star managers will underperform- every star manager will have some period of underperformance.  Bill Gross experienced this the last few years.  As an investor you have to determine whether or not that underperformance warrants a change or not.  There are plenty of managers that have bad performance and stay bad until their fund merges or shuts down.  Conversely, some star managers have small periods of underperformance before reversing course and outperforming again.  As an investor you need to figure out which direction your fund is going and position accordingly.  Unfortunately, there is no data that can help you determine what the right decision is.

Rather than focusing on funds run by "star managers" we prefer to focus on things under our control.  We call it evidenced-based investing:  investment strategies must be rooted in evidence that has been tested and found to be true.  If you take this approach it is very difficult to choose funds that have star managers.

Trying To Beat The Market? Not Much Has Changed

If you’ve been invested in the stock market the last five years, congratulations.  You’ve made the most important investment decision…how to allocate your assets (hopefully you’ve had a healthy percentage in stocks).  That decision is by far the most influential decision on portfolio performance, so getting the allocation mix right is paramount.  One of the next decisions you need to make is how to invest in each portfolio asset class (stocks, bonds, etc).  It can be done by purchasing individual securities or through mutual funds.  If you are like millions of other Americans, mutual funds tend to be the product of choice.  It allows you instant diversification without much capital or labor of buying hundreds of securities.  

One of the key questions for purchasing funds is whether you should buy a fund that tries to beat the market or one that matches the market.  The majority of investors today are still trying to beat the market.  We think this is foolish since the evidence is so overwhelming.  Standard and Poors came out with their semi annual research piece on this topic.  The results seemed pretty conclusive to us:

SPIVA Mid-Year 2014 Scorecard

Over the last 5 years, we see that in almost every category, 80-90% of all funds fail to outperform their benchmark.  The costs associated with trying to outperform an index eventually catch up with these managers, making it difficult to experience sustained outperformance.  We have been beating this drum for 10 years (since the inception of our firm) and will continue to do so, as we believe it is a story investors need to hear.

 

A Stock Pickers Market?

I am not sure how many times I’ve heard that this is a stock pickers market, but it seems like it is a pretty common comment among pundits.  In a bull market their argument is that a good stock picker will be able to search out the cream of the crop and avoid those laggard stocks that can drag down performance.  In a bear market, a stockpicker can practice risk management, focusing on defensive stocks that will reduce volatility.  It all makes sense in theory.  Unfortunately, the data disputes the execution of that theory.  A recent Merrill Lynch report gives us the facts:

Screen Shot 2014-07-15 at 9.57.17 AM 

So far this year only 19% of all active large cap managers have outperformed their index.  This is pretty horrific for investors in active funds and continues to validate our strategy of focusing on low cost, passive strategies.  You may not ever own the best performing mutual fund, but you are virtually certain to never own a fund in the bottom half of their peers.  We think that trade-off is well worth it.

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.