Thursday, March 05, 2009

If Your Goal is Wealth Maximization, You Can't Justify Active Management Over Indexed Funds

NY Times (Feb. 21, 2009) -- There's yet more evidence that it makes sense to invest in simple, plain-vanilla index funds, whose low fees often lead to better net returns than hedge funds and actively managed mutual funds with more impressive performance numbers.

That is the finding of a new study by Mark Kritzman, president and chief executive of Windham Capital Management of Boston. The study measured the long-term impact of all expenses involved in investing in a mutual or hedge fund including transaction costs, taxes, and management and performance fees.

Mr. Kritzman calculates that just to break even with an index fund, net of all expenses, an actively managed fund would have to outperform it by an average of 4.3 percentage points a year on a pre-expense basis. For the hedge fund, that margin would have to be 10 points a year.

The chances of finding such funds are next to zero, said Russell Wermers, a finance professor at the University of Maryland. Consider the 452 domestic equity mutual funds in the Morningstar database that existed for the 20 years through January of this year. Morningstar reports that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds.

But even that sobering statistic paints too rosy a picture, the professor said. That’s because it’s one thing to learn, after the fact, that a fund has done that well, and quite another to identify it in advance. Indeed, he said, he has found from his research that only a minority of funds that beat the market in a given year can outperform it the next year as well. “By definition, therefore, such a fund could not have been identified in advance,” he added.

The investment implication is clear, according to Mr. Kritzman. “It is very hard, if not impossible,” he wrote in his study, “to justify active management for most individual, taxable investors, if their goal is to grow wealth.” And he said that those who still insist on an actively managed fund are almost certainly “deluding themselves.”


At 3/05/2009 11:57 AM, Anonymous Anonymous said...

Mr. Perry,

I would love to see some data related to housing similar to the hours worked to buy a toaster data using the old Sears catalogs. Obviously housing is different now compared to the 50's (avg. square footage) but that would be very interesting to see. I have seen your housing affordability charts, but I would like to see hours worked to buy a house.

At 3/05/2009 12:48 PM, Blogger Chico said...

It is hard to understand how this is not common sense to investors - until you realize how much Merrill Lynch, Smith Barney, etc, spend on an annual basis trying to convince the public that they can do better than "settle for market returns". Most investors have no idea how poorly they perform relative to the markets with the "help" of a Wall Street broker. Where does everyone think they get the money for the $10 million bonuses? Unfortunately it's from the little guy who buys active funds from the broker he knows from church.

At 3/05/2009 12:57 PM, Anonymous Anonymous said...

I remember seeing an article from Dalbar (?) about individual investor returns. Individuals (even with the help of a broker) had returns that averaged 8-10% below the market. At the time that seemed unbelievable to me. From what I've read since, I'm sure that between Wall Street's hidden and high fees and the market timing that they encourage, individual investors have no chance.

At 3/05/2009 1:09 PM, Anonymous Anonymous said...

One word of caution. Yes, index funds are far superior to active funds or hedge funds but the majority (90%+) of investors should still seek the help of a competent advisor. There are a few out there. Many investors realize there is no active mgt. Santa and switch to index funds through Vanguard (great start), but as soon as the market makes a bad turn, emotions take over and they sell at the wrong time, sit in cash and then jump back in when things "stabilize". A good advisor can also help guide you into which index funds to use - they are NOT all created equal. The concept of asset allocation and contrarian rebalancing is also beyond most individuals. Going it alone can often be as dangerous as using a product pusher.

At 3/05/2009 1:10 PM, Anonymous Anonymous said...

OK. How can you tell if an advisor is "competent"? They all have a good story.

At 3/05/2009 1:52 PM, Anonymous Anonymous said...

The market does better than any manager can - on average.

At 3/05/2009 1:56 PM, Anonymous Anonymous said...

I manage my own stuff through Foliotrade, where you can buy fractional shares and effectively have your own fund which you manage. And you can make unlimited trades for a subscription rate. At least if you are incompetent you have no one to blame but yourself.

Since 2000 I'm ahead of S&P by about 15%, but that isn't saying much right now.

At 3/05/2009 2:26 PM, Anonymous Anonymous said...

I would define a competent advisor is someone who is credentialed with a real designation (CFA, CFP, CPA, etc); has a fiduciary duty to their clients; and builds portfolio around the concepts of asset allocation, diversification and low cost investments. If they focus on indexing investing is an added bonus. The conversation should be focused on the investors’ needs, goals, and objectives. However, if the discussion starts with performance or their secret manager or stock selection process, then I run and not walk.

At 3/05/2009 2:40 PM, Blogger Richard Rider, Chair, San Diego Tax Fighters said...

You might want to take a look at one of the strangest mutual funds around -- it goes in and out of the market based SOLELY on whether Congress is in session or adjourned. It has high annual costs (2%), is small and quite new -- but the historical analysis is stunning.

For instance, consider the (doubtless cherry picked) time frame from 1 January 1965 through 31 December, 2008 (posted on the website).

If you had owned the S&P 500 ONLY while Congress was in session, you would have averaged 0.31% return a year. If you owned the 500 only when Congress was adjourned, you'd have earned 16.15% a year.

It's the Congressional Effect Fund, a hole in the wall operation.

At 3/05/2009 2:49 PM, Anonymous Andrew said...

seems pretty bizarre.

Index funds yes, but it is seriously true that a typical mutual fund has expenses of 4.3% annually? That would be unbelievable to me.

I'm from Canada and we are always accused of having the most expensive funds, but 4.3% here would get you fired by every investor in the country bar none.

I can't believe that this is true.

At 3/05/2009 3:07 PM, Anonymous Anonymous said...

Questions to find a competent advisor:
Do they use index funds? Yes +1
Certified Financial Planner? Yes +1
Are they a CFA? Yes +2
Do they use DFA funds? Yes +5
Do they use variable annuities? -5
Do they work for a Wall St firm (this includes your local Merrill, Smith Barney, Raymond James office)? -2
Do they use a goals-based approach (your goals not theirs)? Yes +2
Are they "Fee-ONLY" (not fee-based) +2
Do they accept payment from any of the investments they recommend? Yes -3 (THEY DON'T LIKE TELLING THE TRUTH ABOUT THIS ONE)
Do they have a degree from a real university? +1 Business school? +2
Many designations (letters behind name) are earned by selling products! Ask how they earned theirs.
Will they accept fiduciary responsibility to act in your best interst? Yes +3;
Do they recommend investments that have significantly outperformed the market? Yes -3

I have a family member who is in the investment business. He has recommended many great books to me over the years. Not "How to Beat the Market" books, but real academic books on portfolio theory. Once the light goes on, you realize most of these "advisors" have no right giving financial advice.

At 3/05/2009 3:45 PM, Blogger fboness said...

And if your goal is capital preservation first, growth second? Understanding that if you don't preserve capital then you have nothing to grow.

At 3/05/2009 3:48 PM, Blogger Billy G said...

“The deeper one delves, the worse thinks look for actively managed funds”
-Dr. William Bernstein, Author, The Intelligent Asset Allocator

“Most investors, both institutional and individual, will find that the best way to own common stocks is through an index fund that charges minimal fees”
-Warren Buffett

Need we say more?

At 3/05/2009 4:57 PM, Blogger Matt said...

Of course this is true. All one has to do is consider how fund managers get paid. They measure themselves against an index and get bonuses if they outperform it.

So, if fund manager X has a few hundred million to invest and he gets paid more for outperforming an index and will not lose his job if he is in-line or slightly below, then his motivation is to replicate the index and make a few bets that might get him a better return. He also wants to limit downside, so he doesn't go crazy with the bets. All he wants is enough to outpeform.

Of course, the outperformance doesn't justify the fees, but that's not his problem.

At 3/05/2009 9:10 PM, Blogger Thomas Shawn said...

The money I "socked away for retirement" was better left in a hole in my backyard. These nitwits cannot beat the S&P but I bet their yaghts are nice.

Screw the 401K, screw Fidelity and screw Obama.

At 3/09/2009 10:03 AM, Blogger DaveinHackensack said...

"Need we say more?"

A commenter above referred to the Hussman Funds. John Hussman has smoked the indexes since inception by hedging his downside risk. I bet most index fund investors would have been happy to pay a few basis points more for that performance now.


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