How has your week gone? This week I had to go to New York and promptly got reminded of why I hate that trip since La Guardia is such a wreck. The construction work seems to have been going on for years along with all the disruption and traffic chaos that goes with it. I just hope it will all be worth it; it’s my most hated airport by a long stretch.
I won’t be changing the emphasis of my writing on this blog but I may throw in the odd curveball post soon. I’m thinking of doing something along the lines of – “How to eat ‘healthy’ at airports”. I usually fly around 75k+ miles a year so I spend a fair amount of time in airports and I’ve learned some hacks. Actually, there really isn’t a good solution to eating healthy at airports but there are some less-bad options if you know where to look and I might list them out in a post.
Since I got back on the blogging horse I feel like I’ve been tackling some quite meaty topics such as taxation, new pension legislation and fairly obscure financial instruments like STRIPS so I thought I would take the opportunity for some light relief this week. Note that I owe you a second part to the STRIPs post and that will be coming – don’t worry!
I am big user of passive investment funds but I don’t write a huge amount of ra-ra-ra about passive management, I can think of one post on the FANGS and another on fees – so this might be my first time I’ve really promoted the benefits of index investing.
However this post gives me a chance to put the boot into portfolio managers, and you can’t imagine my delight at that prospect!
As part of my job I get a steady stream of money managers wanting to sell their products to my clients. Consequently, I have to sit through many meeting and calls where they tell me how great they are. One of the things I’ve observed about investment management firms over the years is that the portfolio manager (the person who make the final decisions about trades) are the top dogs in a firm. They get elevated to a level in the firm that often makes them insufferably smug and completely lacking in humility. I have had meetings where the portfolio manager is rude to their own staff in front of me, and who then talks without pause for extended periods. Believe me, portfolio managers are often enamored with themselves.
One other thing about investment managers is that I have never met one who has provided poor investment performance. There are many tricks to be played, sleight of hand, misdirection of the reader that all play a part – but I can confirm that performance is always great.
That’s why I was so pleased to see the Dimensional report with its clarity and transparency.
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The key aspect of this report that I like is that they examine the survivorship of mutual funds over different periods. For most investors this is a massive area of neglect in their due diligence. It might surprise you that of the 2,786 equity mutual funds that were around in 2013 only around one half are left standing today. That is a big failure rate. And believe me, it’s failure. A successful fund is not shuttered by a manager!
So in looking at whether stock-picking (or ‘active’) managers add value for investors it’s important to take account of the number of funds that have fallen by the wayside over the period.
The only thing that disappointed me with with the Dimensional report were the quality of the charts. They were pretty poor, so I decided to give a few of them some pep and have re-cast them as Sankey diagrams.
Here is the first Sankey diagram that shows the attrition of the funds over the last 15 years.
You can see that of the 2,786 equity funds that were present in 2013 only 1,420 made it to 12/31/2018. Then only 501 of the funds were ‘winners’, in the sense that they beat the benchmark net of fees. In other words less than 1 in 5 of the funds accomplished what they set out to do. By any measure that’s a terrible success rate. And don’t forget that the 919 losers unashamedly still collected a fee for their failure.
Talking of fees let’s look closer at the winners. The Dimensional analysts analyzed the fees and divided the funds into quartiles, from high cost to low cost. Each fund was placed in one quartile; low, med/low, med/high and high cost.
In the Sankey chart above I’ve show the winners divided into their quartiles.
What do you immediately see? The winners are more likely to be the lower cost funds. This perhaps is not surprising since it’s easier to have a positive net performance if your fees are low. Or said another way; if your fees are high then to add value to your investors you need to beat the benchmark plus the high hurdle of your fees.
Let’s now examine the impact that manager decisions have on the success.
Portfolio turnover measures frequency with which a manager trades the stocks in the portfolio. A high turnover indicates frequent trading in an attempt to add value, whereas a buy-and-hold investor will have very low turnover. Passive funds typically have low turnover since over time they only need to slightly adjust their relative weights of the stocks or add or eliminate a stock if it gets added/removed from the index.
The funds were divided into quartiles based on the frequency of stock turnover in the portfolio. You can see from the above chart that of the winners most were low or med/low turnover funds.
Take a moment to digest this. The most successful funds (and success is relative as you’ve seen!) were the ones where the portfolio manager did the least!
In the money management industry there are few insults more demeaning than to call a portfolio manager a “closet indexer”. This implies they are simply pretending to trade stocks but actually just following the index (and charging active management fees…). Any red-blooded portfolio manager would want to distance themselves from this accusation by staking their ‘skill’ on their stock bets and showing how they are trading to add value.
However, (with my barely contained schadenfreude) if you insist on choosing an active fund then how can you maximize your chance of winning?
You choose a manager with low fees, and low stock turnover.
Ummm… so you in fact need to choose a fund that is as close to a passive fund as you possibly can! The most likely winner will be a low cost fund where the portfolio manager touches it as little as possible!
Author Bio: I started actuary on FIRE as I did not see any actuaries taking a prominent role in the personal finance area and wanted to remedy a shortage of actuary jokes and write for those that appreciate rigor with fancy charts. In my regular day job I advise corporate US on investment and retirement strategies. I’m a qualified actuary, investment adviser and have a PhD in mathematics and reserve the right to have the occasional math post.