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!
Want to read more on quantifying manager fees? Check out the latest post with some groovy interactive charts from my blogging buddy Fat Tailed and Happy.
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.
16 thoughts on “The Cosmic Irony of Stock Picking Funds”
Fly to JFK and take the A train.
ok I’ll give it a go Bob. But jeez how bad do things need to get to where JFK is preferable?!
I was just debating these exact numbers with some friends over the weekend! Thanks for the write up and post… interesting stuff.
I own Dimensional Fund Advisers funds. Very low turn over, and slightly different trading rules than say Vanguard. The Vanguard total stock market for example does not own the total stock market but a weighted representation of stocks which mimics the index. Therefore it’s an index tracking fund not an index fund. Generally that works fine till the volatility hits the fan and redemptions start rolling in. The only thing the indexer has to sell are the underlying tracking stocks, not the market. This would lead to distortion in those tracking stock prices with a higher volatility than the actual index. I’ve read Bogel who write quite a bit about this and as indexing became more popular his concern became greater. Another problem is the notion of “diversity”. The idea is spread the risk across non correlated asset classes such that when one class is oscillating wildly it’s non correlated portfolio counter part is largely unaffected by those wild gyrations. Diversity is definitely NOT PhD piled higher and deeper where you choose various sectors like foreign or emerging markets to provide diversity. Foreign and emerging markets have a high to very high correlation with US stocks. In addition they are more volatile. This means if the US market drops in half, the more volatile asset drops even more. In 2008 I did a study of EM and many of those funds dropped 70%. It also seems that the little diversity they provide is on the way up, when you don’t really need it, but when it hits the fan the correlations tend toward 1.0 and so all the arrows are pointing into the dirt simultaneously and the so called diversity is actually a source of greater risk not less, for the reasons stated. Certainly cost is important but risk management is even more important IMHO.
Dimensional funds takes some of this into account and has studied what assets pay best over a long time like small value over a long time tends to beat large growth. Since you’re going to own the portfolio for decades it makes sense to own funds that pay better even though passively invested according to a given criteria. In addition Dimensional Funds do NOT have to trade the index when someone leaves or joins the index at least not immediately. When GE left the DJIA it had to be sold by tracking funds. This causes a glut of stock for sale and the price falls farther than otherwise necessary. Very often the price overshoots. The trends however favor the stock regaining it’s normal value in say 6 months, so the right time to sell is 6 months after the issue leaves the index. Same is true in reverse for stocks entering the index. The time to buy them is 6 months after entry when the price has come back down. Tweaks like this can and do generate bigger returns without the need for “active management”, the funds just take advantage of more efficient trading rules. Dimensional Funds skims a little off the top with slightly higher fees for the application of these strategies. In my opinion it’s not enough to consider just the “market average” behavior of a fund, but also how it performs under stress. I think I make a bit more than it costs me to own these funds. Not a lot maybe a % but over decades 1% extra return or 1% less volatility adds up to real money
I think this impact of being a forced seller when the name leaves the index is particularly relevant for bond funds. If you have an investment grade fund and a name gets downgraded to sub-investment grade you don’t want to be a forced seller. Since the frictional costs of bonds are much higher than stocks. So an allowance to junk bonds is usually a good thing for managers. They call it “fallen angels”.
Is that concept transferrable to the ETF space?
For example, when I look at an ETF’s prospectus and it says: “it will invest at least 90% of its net assets…in the stocks”, is that remaining 10% the “administrative latitude” bucket for things such as avoiding forced selling?
I think it could be. There are certainly investment grade bond managers that allow a 5-10% allocation to sub-investment grade for precisely this reason.
Great post! I now know how to push the buttons and poke the ego of a fund manager 😎
Between your post and Gasem’s comment I’ve learned a few things today.
Thanks for visiting!
I haven’t had the (dis)pleasure of LGA yet but say it ain’t so in terms of edging out LAX on my hate list.
Now I am totally curious about the many tricks to be played to “demonstrate” great performance….
I shall have to write a post on that one!
This post has inspired me… I simply must use a Sankey chart somewhere.
Nice work, as always.
They are awesome I agree. Thanks for visiting!
I understand that you’re mostly responding to the “gun-slinging” high-turnover managers, but aren’t there other types of low-turnover managers that don’t index (buy everything weighted by market cap/some clear formula)? The buy-and-hold value investors seem to fit in this crowd, and there’s probably a few mutual funds in this style too. For example, Mohnish Pabrai’s historical holdings from 13Fs: https://dataroma.com/m/m_activity.php?m=PI&typ=a or Guy Spier’s Aquamarine capital (https://dataroma.com/m/m_activity.php?m=aq&typ=a). Both of which seem <25% yearly. Can you put a legend with the turnover quartiles?
Also, I don't think you can make the statement that high turnover managers are more likely to be losers without looking at the number of high turnover managers in the losing groups too. If there are none in there for some strange reason, then picking high turnover managers seems like a great way to go!
Nice work though! Trying to develop an understanding myself.
Oh boy, I think the Bayesian probability police got me here. I said that conditional on picking a winner then what is the probability that it’s a high turnover manager? And the answer is low. But you make the point that’s not really the question we should ask. We should ask that conditional on the manager being high turnover then what is the probability it is a winner? And I haven’t given enough information in my post to deduce that.
You also make the point that low turnover does not equate to index hugging. And I accept that point, but I didn’t want to let it get in the way of a good post!
Thanks for visiting – and come again!
This is a really interesting post! I love how in-depth you go in each article on your site.
I didn’t really start paying attention to index fund fees until this year. It really surprised me how the management fee can swing wildly from one fund to the next. In my 401(k) it was a little disappointing to learn that the small/mid-cap funds all charge fees multiples higher than some of the more general funds.
What is the most ridiculous thing you’ve heard a portfolio manager say?
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