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.

Four Steps To Follow Before Choosing A Financial Advisor

When Willie Sutton was asked why he robbed banks he famously said, "because that's where the money is".  That same quote could be applied to why some financial advisors and brokers work where they do.

Some concerning new research has come to light about the existence of unscrupulous financial advisors and brokers around the country.  As many might expect, they seem to congregate around areas of wealth and individuals that can more easily be duped.  That is why you tend to see such a concentration of these advisors in retiree communities.  The Wall Street Journal exposed some of these practices in a recent article.  You can find a map here of the highest risk areas for investors.

So what are some of the things you can do as an investor to mitigate the risk of working with one of these advisors:

  1. Check them out- any advisor selling financial products has to be registered and licensed.  Go to http://brokercheck.finra.org/ to check out the advisor.  If you can't find them or they have questionable customer complaints, don't work with them.
  2. Find out how they are paid- if they don't tell you how they are compensated OR they are paid by the products they sell, your guard should go up.  You want to find an advisor who is compensated solely by you, not by what they sell you.  Unfortunately, this throws out somewhere around 90% of all financial advisors.  The best way to find one of these advisors in your area is through the National Association of Personal Financial Advisors (www.napfa.org).
  3. Get a referral- while it is not a foolproof way to determine if an advisor is good or not, it helps if you know a few clients they work with and can speak candidly about their experience with the advisor.  
  4. Look for credentials- most crooks don't want to bother getting credentials like the CFP or CFA.  Again, it doesn't guarantee that you'll work with reputable advisors, but it surely will help weed out a good number of the bad seeds.

Your guard really needs to be up when choosing a financial advisor.  If you follow the four steps above it should help mitigate some of the risk of selecting a bad one.

Do You Focus On The Dog Or The Owner?

There is a great quote that is taken from Ralph Wagner, manager of the Acorn Fund, at the blog, A Wealth of Common Sense:

He likens the market to an excitable dog on a very long leash in New York City, darting randomly in every direction. The dog’s owner is walking from Columbus Circle, through Central Park, to the Metropolitan Museum. At any one moment, there is no predicting which way the pooch will lurch. But in the long run, you know he’s heading northeast at an average speed of three miles per hour. What is astonishing is that almost all of the market players, big and small, seem to have their eye on the dog, and not the owner.

I love this quote.  We all tend to watch the market on a day-to-day basis not realizing that over our lifetimes it is moving in a fairly predictable direction.  Take a look at monthly moves in the S&P 500 since 1950:

1 mo

Now here are rolling 20 year periods in the S&P 500 over the same period:

20 yr

It is pretty obvious that over one month periods, anything is possible.  The "dog" can dart in any number of directions.  Over longer periods of time, the "owner" is fairly predictable.  He is going to get to his destination no matter how much the dog wants to fight him.  So what are you focusing on with your investments, the dog or the owner?

What The Election Results Mean For Your Portfolio

Republicans won the majority in the Senate and solidified their lead in the House of Representatives.  What does this mean for your portfolio?  

Not much.

Investors tend to put too much weight on the impact of politicians on both the economy and the stock market.  Economic trends happen over long periods of time and stock markets are driven by so many different things, of which politics and legislation are a small part.  There are numerous studies that have shown which political party is better for the stock market.  There are two major errors with those studies.  First, there aren't near enough data points for them to be statistically significant.  Second, there are literally hundreds of other variables that are impacting the stock market so it is disingenuous to attribute market returns to an elected official.  George Bush presided over one of the worst stock markets in history.  Is it fair to say that his administration caused this?  Anyone looking at it objectively would have to say no.  The stock market had two decades of growth and was at the end of one of the largest bubbles in history when he took office.  It certainly was not his fault that the bubble burst.  It was bound to happen.  

Conversely, Barack Obama has led the country during one of the best stock markets in decades.  He was lucky enough to take office at the bottom of one of the worst economic periods this country has ever seen.  It would be hard to argue that Obama's economic policies led to these fantastic returns.  As with many things in life, timing is everything.

Next time you hear a politician take credit (or assign blame) for the economy or stock market, tune it out.  They really had little to do with 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.