Active Fund Management Is A Loser's Game
CBS Money Watch: "Twice each year, Standard & Poor's puts out its active versus passive investor scorecard,
reporting on how actively managed funds have done against their
respective benchmark indexes. Every time, the results are pretty much
the same, demonstrating that active management is a loser's game -- in
aggregate those playing leave on the table tens of billions of dollars
forever seeking alpha (outperformance, adjusted for risk)."
The following is a summary of the latest scorecard's findings:
- For the five years ending March 2012, only 5.23% of large-cap funds, 5.46% of mid-cap funds and 5.14% of small-cap funds maintained a top-half ranking over five consecutive 12-month periods. Random expectations would suggest a rate of 6.25%.
- Looking at longer-term performance, 5.97% of large-cap funds with a top-quartile ranking over the five years ending March 2007 maintained a top-quartile ranking over the next five years. Only 4.35% of mid-cap funds and 15.56% of small-cap funds maintained a top-quartile performance over the same period. Random expectations would suggest a repeat rate of 25%.
For example, with a minimum $10,000 investment in the Vanguard S&P 500 Index Fund Admiral Shares, the fund's expense ratio is only 0.05% - that's just 1/20th of 1%, or $5 per $10,000 per year (that's basically free). The average annual expense ratio for an actively managed large-blend mutual fund is about 1.22%, or more than 24 times higher than the expense ratio of the Vanguard fund. And in almost all cases, those actively managed funds will underperform the benchmark indexes like the S&P500. Over long periods of time, the S&P 500 has consistently outperformed something like 94-97% of actively managed mutual funds, which as the article above points out, is a "loser's game."
When the choice is between: a) passively-managed index funds with expenses that are almost zero, and with higher returns on average than actively-managed funds over long periods of time, and b) actively managed funds with very high management fees and lower returns than passive funds over time, it is almost a mystery why active funds can survive and remain so popular?
36 Comments:
While the overall sentiment of this piece is no doubt solid, I'll point out some problems with this view. The way you're measuring outperformance, ie how many consecutive years funds outperform the market, is not very relevant. If a fund spikes up one year and makes terrific returns that greatly outperform the market, it could dip down to slightly below average for the next four years and still outperform the market over those five years. So you need to look at total return over five years, short-term rankings are irrelevant and only encourage the current short-term mentality that is prevalent. Another issue is that while active funds have been found empirically to not usually do that great, there is nothing in principle wrong with active investing. It is all about matching the risk appetite of the investor with the right fund. Some people are willing to take on more risk, while others aren't and should be in index funds. Just because current active investors are mostly incompetent doesn't damn all future active investors, as long as they get away from the current mentality.
Also, an argument can be made that even if active investors are not that great, just by the fact that they're "active," and watching the companies to make sure they have some market discipline, that is what drives the returns that passive investors benefit from. You could counter that argument by saying that since the active investors themselves usually don't beat the market, perhaps they're actually dragging overall returns down and we'd be better off if such incompetent "active" investing were removed. This is a complex question, but I think there is definitely a big role for active investing, just perhaps not of the type we have now.
In fact, what these funds do often has little relation to "investing" per se, as many are just chasing momentum and do not do near enough research. Given their limited ability to build up a big enough stake to exert pressure on most companies' boards and the crazy insider trading rules and similar regulations, most funds' activity is better likened to horse racing than "investing." These are the real fundamental problems and talk of passive vs active just glosses over the underlying issues.
It's very difficult to trade in the stock market, because of price movements and timing.
Examples:
*Price falls from 50 to 10, bought, and then falls to 1.
*Bought at 50, stayed around 50 for a week, rose to 100 a week later and sold, and then rising to 500 within two weeks after selling.
*Bought at 1, did not move for six months, sold at 1, and then rising to 50 quickly shortly thereafter.
*Bought at 10, quickly rose to 50, didn't sell, and then falls to 1.
You don't know how high or low they'll rise or fall, and when they'll move.
Also, you can outperform the market by a huge margin for years, and then there's a change in the market and all those gains are wiped out or worse within a few months.
Moreover, I've created rules. However, I don't always have the discipline to follow my own rules, particularly when I need them the most.
That should be "betting on horse racing."
" it is almost a mystery why active funds can survive and remain so popular?"
It's called effective advertising.
It works for high-priced but no better, laundry detergents also.
this is a very skewed sample set.
while i completely agree that very few active mutual funds do well, i do not think that you can extrapolate that to "active fund management is a losers game".
the guys that are the better active managers go to hedge funds, not mutual funds. they get paid a lot more that way. i know dozens of funds (myself included) that dramatically outperform the market. it is not hard to beat the market.
however, this leads to the second key issue: how hard it is to beat the market depends a great deal on how much money you are running.
beating the market with $100 million is very, very easy.
beating the market with $1 billion gets hard.
beating the market with $10 billion is really hard and with $100 billion, best of luck to you.
to succeed as an activist investor, you need to be nimble. to get in and out of positions becomes much, much harder as you get bigger and the universe of investments you can look at shrinks as a result you have to buy bigger companies/more liquid instruments and those tend to be more efficiently priced as more people look at them.
you drive them up buying in and down selling out.
the best fund managers in the mutual fund space are not idiots. give them a small pile of cash, and they will likely do quite well with it.
the problem is that their good performance when they are small attracts more and more capital until they have too much to invest well. thus, the best get swamped with an impossible task by the very nature of the game and, because they are paid a % of assets, not a % of profits, they are incentivized to do just this.
that takeaway from this is that most retail investors pick their mutual funds precisely the wrong way.
they look for big, solid looking funds run by managers with 10 year track records: precisely the guys that will be swamped with too much money to be nimble anymore.
i have seen hedge funds get crushed under this too, but the incentives are less extreme as HF's get paid a % of profits and many managers (again, myself included) keep much of our personal wealth in our funds. because we are eating our own cooking, it's worth more to us to keep returns high by limiting assets. (of course, this means lots of hedge funds wind up closed to new investment)
i guess what i am trying to say here is that while i agree that most big activist mutual funds are a mug's game, that 1. it's not because the managers are stupid but because the system is set up to flood the smart ones with capital until they can't make money and 2. that you cannot take that fact to mean that all activist investing is a loser's game. it isn't. it's just a game whose ease is inversely proportional to the size of assets you try to do it with (well, once you get over $30-50 million of so, below that, scale likely helps)
I suppose there is no such thing as pay-for-performance with respect to active fund management?
"it is almost a mystery why active funds can survive and remain so popular."
It is ironic that Vanguard's oldest fund is actively managed. The prospectus for the Wellington Fund notes the fund is subject to "manager risk".
How has this fund done since it started in 1929? It has averaged 8.19% since inception and has grown to around %60 billion.
Wellington's balanced portfolio costs .19% in fees vs. .05% for the S&P 500 fund (Admiral shares). So, it is four times more expensive.
if you want to see some fairly well-managed funds for cheap administration fees check out the Federal Thrift Savings Plan.
To correct: Wellington Fund has grown to $60 billion and has averaged 8.19% growth since inception (1929, a gutsy year but a great starting point). It is in the top 5% of balanced funds for the last ten years of performance.
"I suppose there is no such thing as pay-for-performance with respect to active fund management?"
of course there is.
it's called a hedge fund.
HF's get paid 20% (generally, it can vary a bit) of the profits they make, subject to high water marks.
if they do not perform, they do not get paid.
it's a much better alignment of interests than in the mutual fund world and far more of them beat the market.
i know dozens of HF's that have doubled and tripled market returns over the last 10 years (and some that have done much better than that)
worth considering:
brokers have an even worse incentive set.
they push you toward the mutual funds with higher payouts, not the ones that will do well. worse, they are incented to move you around a lot as they get paid on trades, not performance.
the incentive structure around a lot of retail investing is really screwed up and does not favor the little guy.
of course, the little guy has far fewer choices as well.
federal law prevents hedge funds from taking his money. you need to be an accredited investor (over $1 million in liquid assets other than your house) to invest in hedge funds and many require you to be a qualified investor (over $5 million).
thus, the little guys get shut out of the opportunities to align their incentives and left in the broker and MF space (they cannot do private placements in most companies either).
thank your local nanny state politician for that one.
"federal law prevents hedge funds from taking his money. you need to be an accredited investor (over $1 million in liquid assets other than your house) to invest in hedge funds and many require you to be a qualified investor (over $5 million)."
For those that are sub a million bucks, then possibly one could try a do-it-yourself hedge fund. Here are "83 Inverse Equity ETFs To Use As A Hedge".
Indivdual results may vary (vastly) so I would leave it to the really smart guys -- if I could afford the risk.
well.. that's essentially "self-invest".
I'm talking about hiring a fund manager to invest your money the best ways possible including hedge funds but he gets nothing if he does not perform and the better he performs, the more he also benefits.
Is this not something available to ordinary investors?
larry-
sort of.
it's called the fund of funds industry and it has largely underperformed because the fees are ruinous.
they take your money, combine it with that of others to become an accredited or qualified entity and put it into several hedge funds.
those funds charge you fees (usually 1 and 20, 1% of assets and 20% of profits). let's say a hedge fund gets you a 20% return. you'd get 15% net.
then, the fund of funds charges you 1 and 20 on top of that.
so you pay 4 more points to them.
15% becomes 11%.
that's still a good return, but it's barely half of the initial 20%.
this gets MUCH worse if returns drop.
10% is 7 back from the hedge fund and 4.6% from the f of f and, of course, you have not paid taxes yet.
35% of 10% is 3.5%, so now you are up 1.1% after tax from your original 10% if the trading strategy does not go for long term gains. (tax efficiency is VERY important to long term compounding)
so the answer is largely no, there is no good option for the little guy. you are shut of out any LP (which is how hedge funds and vc funds are structured) you cannot invest in private start ups unless you know the principals personally (and sometimes not even then) you cannot trade futures, and are no broker will even show you the interesting instruments.
the little guy has really limited options. some are just logistical. goldman sachs or de shaw is not going to write you a $5k custom derivative. there's no money in it for them.
but that fact that you cannot give $25-100k to someone they would deal with is entirely the fault of the nanny state who assumes you lack the ability to make your own investment decisions and and need them to ensure you do not hurt yourself by picking your own money manager.
I recommend
https://www.folioinvesting.com/
Here you buy a subscription, (around $29 / month) for which you can trade all you like provided you use their twice daily window trades. You can own fractional shares, so you can esily diversify into many stocks, and ETFs, effectively creating your own mutual fund.
They have easy to use tools to rebalance your account, and trading is a snap. If you need to make immediate trades, you can do that too, at competitive prices.
This is so cheap it is worth it just for the entertainment value. And, you can open "pretend money" folios to test your strategies.
As Morganovitch points out it is easier to beat the market with small positions. With out any of the "nimble trading" that peak trader thinks is required my (puny) account has beaten the S&P 500 by over 30% since 2009.
I have no broker to push trades I don't want, and the only person I have to blame for not doing better, is me. (Plus all those speculators out there manipulating the market.)
hydra-
have you tax adjusted that?
trading that much has a tendency to run up bit tax bills at full marginal tax rates.
paying 35% + state tax could easily mean you underperformed all in, not outperformed a passive portfolio.
eg:
let's say you were up 10% a year for 3 years with a high frequency trading strategy.
you could try and say that was up 33.1%, but it isn't.
you start with $100. you end year one with $110. you pay $3.50 in tax.
you have $106.5. up 10% is 117.15.
you pay 3.73 in tax. now you have 113.42.
up 10% is 124.76. taxes are 3.97.
you wind up with 120.79.
thus, returns over the period were 20.8%, not 33.1%.
tax efficiency matters A LOT and that will always favor buy and hold strategies. not only do they pay a lower tax rate, but the time when that tax will be paid is put off as well, so your full principal compounds.
to beat that 10%, you would only need 6.5% from a stock each year if you did not sell it.
re: pay for performance
they oughta make active fund managers be like personal injury lawyers!
no win. no pay.
larry-
again, they did. it's called a hedge fund. that is how they charge. it's just that only the top 10% of americans are wealthy enough to be allowed to give them money.
mutual funds are not allowed (by law) to charge that way.
thank your federal government for keeping 90% of the public from being able to find a wealth manager whose incentives align with theirs.
isn't regulation wonderful?
" it's just that only the top 10% of americans are wealthy enough to be allowed to give them money.
mutual funds are not allowed (by law) to charge that way.
thank your federal government for keeping 90% of the public from being able to find a wealth manager whose incentives align with theirs.
isn't regulation wonderful? "
gee Morg.. they let personal injury lawyers operate that way...
:-)
why not fund managers?
just ragging here...
:-)
http://www.cbsnews.com/8301-505123_162-57413912/why-hedge-funds-are-like-the-undead/?tag=mncol;lst;10
Hedge funds are not an asset class, but a compensation scheme. Those who enjoy saying they invest in a hedge fund are likely experiencing "the cocktail party fallacy."
ec-
i think you may be the one operating under a the cocktail party fallacy.
sure, hedge fund mostly refers to a structure (limited partnership) and not, actually, a compensation scheme as you claim, but the article you link is highly misleading.
such "survivor-ship bias" accrues to any kind of business.
you think if the S+P had the same stocks in it as it did in 1940, it would be where it is today?
you think mutual funds are any different?
or drycleaners?
or computer hardware companies?
as someone who has been in the hedge fund industry for 18 years, i can tell you that what really skews that data is that there are 6000 guys with $2 million in assets calling themselves "hedge funds" that are basically glorified day traders and stockbrokers with very little actual skill or knowledge.
look only at funds with, say $100 million in assets, and the out-performance becomes dramatic.
the issue is not with serious hedge funds, but with the ease of entry. any clown can get an lp and an llp and some sub docs off the rack from numerous law firms and then jump on at a little prime broker who gouges them by not letting them trade away until they get 5-10 million in assets. most have the lifespan of mayflies.
the fact that it costs 100's of k in fees to start and do ongoing compliance keeps this to a minimum in the mutual fund space.
but the bottom 6000 of 8000 have maybe 5% of the assets of the whole hedge fund space. asset adjust those numbers and you will get a VERY different picture.
calling the performance of the little guys germane to the industry is about like calling tandy a proxy for the PC industry or pop rocks a metric for candy sales.
also note:
that piece was written by an RIA, an asset class hedge funds have savaged (mostly for good reason).
i'd be very interested to see how his returns stack up against say, soros or greenlight or sac, third point, or one of dozens of other big funds.
i would be surprised to see him compare favorably.
the RIA's fight like cats to try and get the high net worth crowd and justify their fees, but they have mostly failed and lost that space to hedge funds that have outperformed them.
there's a reason why there are waiting lists at money of the top funds and that very few are even accepting new money at all.
that reason is not that rich people are stupid.
You may want to hire this guy to manage your portfolio:
'Bull's-eye investors' still lose
New study says 82% of day-traders end up in red
Aug. 17, 2004
Chimp made chump of best day-traders
Raven the chimpanzee was picking stocks by throwing darts and he was even beating the top portfolio managers with 300 percent annual returns on his Monkeydex portfolio.
This new study is a huge embarrassment for traders! These traders were not only huge losers, the 82 percent who were repeat losers were so blind and dumb they still stayed in this loser's game and just kept losing! That's the trader's DNA at work!
Worse yet, the "winners" were the dumbest of all. The so-called winning traders were not only making less than Raven the monkey, they were making less than a buy-and-hold investor.
The only people who really make money in trading are the service professionals (stock brokers, hedge-fund managers, financial advisers, etc). The pros get their commissions no matter how much investors and traders lose.
Chimpanzees are superior to human traders. The trader's DNA controls their brains; they have no choice but to chase the fantasy that they can beat the market. They are addicted to losing. The pros know this and love milking their delusional "winner's fantasy" like a cash cow."
peak-
1. i am surprise the number of losing day traders is that low. i figured it would be more like 95% with serious selection bias as the few that could actually make money would get trading jobs and no be "day traders" anymore.
2. 300% annual returns from throwing darts? that sounds awfully suspicious to me. i'd want to see actual audited financials on that. there is simply no way that is happening. i think that was in 1999 where everyhting just went nuts. i would bet she got creamed in 2000.
3. i do not understand your point about hedge funds being trading service professionals that "get their commissions no matter how much investors and traders lose". how is that true?
hedge funds make pretty much all their actual compensation on profit share. they do not get commissions.
Morganovich, typically, hedge fund managers get paid even when they lose money. Also, how big or small the portfolio is doesn't make much difference. You can still lose a huge percentage or get wiped out. Anyway, I didn't write the article.
Hydra, if you're satisfied being a passive investor losing 50% from 2007 to 2008 and gaining 30% since 2009; and losing 50% again in the next cyclical downturn, in the structural bear market, which we're likely in now, that's fine. Over 30 years, you'll roughly perform in line with the market.
Hydra, if your portfolio beat the S&P 500 by 30% instead, since 2009, then maybe you should be running a hedge fund.
peak-
"Morganovich, typically, hedge fund managers get paid even when they lose money"
you have been misinformed.
that is not so. we get paid a % of the profits we make. there is a very small asset based fee but that basically covers expenses (if that) for all but the biggest funds. on a $50-100 million fund it basically just covers your costs.
we also all have high water marks.
so if you give me 100 and i lose 50, i do not get profit share on the 50 i make getting you back to 100.
that can mean several years of not getting paid if you take a big loss.
i'm not sure where you got your info on how hedge funds work, but i do not think it's accurate, at least not for principals. sure, you still have to pay analyst salaries to keep them even when you lose money, but that comes right out of your own pocket. there is nothing "guaranteed" about it.
Nah....
Too much regulation.
Besides, like morganovich says, it is harder when you are bigger. Remember that when you beat up on government.
One of my better buys: tractor supply, up over 500%.
Like nearly everyone, I took a hit in 2008, but overall, my experience is far better than you describe.
I have been in the market over. 30 years, and what you say is mostly true for my index funds and similar investments. But my overall situation is better than that, and so is the account I manage.
The main thing I do is buy when the market falls, if it falls more, I buy more. Over thirty years, that has worked well. People who panic and get out, get killed.
I long since got back my investment, so it is almost all house money now.
I have a small fund. 5 or 7 years ago I split it between a stock market index fund and treasury notes.
it has pretty much stayed at 50-50 even though the stock side has had some pretty good gains as well as pretty good losses.
so bottom line - the stock index fund has not gained much over that time.
I'd bet that is the experience of a lot of people who have "set and forget" stock index investments.
Have the dividends from the Bond side reinvested in the Index fund.
That way you are automatically cost averaging your index fund purchases. The income from the bonds is pretty stable, so every month when the income comes in, it buys more shares when the prices are low and fewer shares when the prices are high.
Over time the index fund will gain in value over the bonds, since they are not reinvesting in themselves.
At some point, preferably when the stocks have had good gains, cut the top off and rebalance to your relative target valuations, which may change as you age, anyway.
Peak Traders point about regression to the mean is relevant. Many stocks will get beaten down over some irrelevant temporary news. If you are not afraid to buy when they go down, they will regress to the mean (or their industry mean). Within the index fund this is already happening, as they adjust their holdings to meet the index. As PT points out, this only guarantees that you will have average market performance over time, which is the whole point of an index fund.
By bringing up the point about passive investor, PT seems to imply that an agile and smart investor can beat the market, something the professional managers seem not to be able to do.
It seems as though PT's argument must eventually turn against himself, and everybody's performance would regress to the mean, including his,(and mine). If you believe that the market cannot be beaten, then there is nothing wrong with being a passive investor.
I would suggest that the market is neither rational nor efficient. for one thing, many investors are passive and invest to some index, which acts as a modulator. Therefore, while it may not be possible to beat the market by a huge amount, and do it consistently, an investor who is willing to take increased and selective risk above the market baseline, should expect to be compensated for that risk (that others have taken a pass on.)
That is my situation, the larger chunk of things is invested more conservatively, and I have a small chunk that I can afford to use with more risk, or things that I can help multiply by adding my own labor to.
Either you believe you can beat the market or you don't. Either way, there is an objective truth out there, and your returns wil be whatever they are. As with political dogma, what you beleive, doesn't necessarily affect the outcome.
have you tax adjusted that?
trading that much has a tendency to run up bit tax bills at full marginal tax rates.
Who said anything about a lot of trading?
I don't know much about rapid trading. If you sell and buy the same stock within thirty days you run into the wash sale rule, but I have not had that problem.
If I make 7% on the farm and then have to pay 30% tax on the profit, so what? Does that mean I give up making what I can? What I have to pay in taxes doesn;t affect my business decisions, unless one business decision results in less taxes than another, for the same profit.
You are correct, the return I made is before taxes, as is the market return I compared it to. Either way, the return on my (small group of individually managed stocks) substantiall exceeds the S&P 500 including dividends, over the same period.
As you point out, a different period might give different results, as my handpicked investments are more volatile than the S&P. I don't imagine the S&P returns quoted include trading costs, either. One more reason the subscription model makes sense: you don't pay for every trade.
Your trades and my trades are accumulated and executed as a block. I know, it is a socialist concept. If you are selling and I am buying the same stock, they swap the shares on the books, and split the market spread between us.
If you want an immediate trade, you can have it, at normal trading prices.
MP: After considering risk, expenses, turnover, and tax efficiency, most investors will be much better off investing in a passively-managed, indexed funds (or ETFs) than investing in actively-managed funds. In most cases, you'll be paying the managers of the actively-managed fund to lose money for you, compared to a low-cost, low turnover, tax efficient indexed fund. My advice is to avoid most actively managed funds, and instead invest your money in low-cost index funds with Vanguard or Fidelity.
The problem is not just the selection of active vs passive but the sector that one picks. It is clear that passive funds that mirrored the general economy have been huge losers since 2000 while sector funds that have avoided exposure to the general economy have done much better. I would rather pick a gold or silver fund today than your typical Vangard passive fund.
PTs comment about regressing to the mean has another side to it, one that Vange seems to ignore.
Those gold and silver funds are doing well now but they will regress to the mean, The passive funds are doing po0rly now, but they will also regress (upward) to the mean.
Suppose you own shares in fifty well known, stable companies. As a group they may very well perform much as an index does, but over time some will do better than others within the group.
By rebalancing your account periodically, you automatically sell (a little bit of) those that have gone up a little and buy those that have gone down a little. After more time has passed the situatins may reverse, at which point you rebalance again.
Unless you have a real star or a real dog in your portfolio, this will generally cause a portfolio that is rebalanced periodically to outperform a portfolio of (iitially) the same stocks in a buy and hold situation.
Foliotrade offers a tool that will do that with the push of a button, and reset your holdings to specified ratios. I assume other electronic brokers offer a similar tools.
I agree with Vange that (some) sector funds which are not dependent on the general economy have outperformed the main indexes. The problem is knowing which sector, and how long before they regress.
Hydra, if your portfolio beat the S&P 500 by 30% instead, since 2009, then maybe you should be running a hedge fund.
=================================
In response to PTs comment I ent back to look at results since pre-crisis. Since 2007 both my collection of funds and my personally managed account are beating the S&P by only 9%, or 1.9% per year.
My collection of funds includes a core of index funds, (partially following Vangels suggestion) and a portion of sector funds which I beleived would outperformn the market, but which were too risky to make a full commitment.
Still, considering the S&P, including dividends is basically flat over that period, 1.9% basically sucks. One might have done better with bonds, unless they were Icelandic or Irish.
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