BY CHARLES MCGRATH ·
Re-posted from New Research On Performance Chasing
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
This article originally appeared on ETF.COM here.
There is a considerable body of evidence demonstrating that the post-hire performance of active managers tends to be disappointing relative to their pre-hire performance. Specifically, managers’ performance tends to regress toward zero after adjusting for expenses, risk, exposure to common factors and survivorship bias. For example, the research has found that:
- Mutual fund net inflows associated with retail investors are positively related to past performance. Mutual fund gross inflows follow positive performance, and gross outflows follow negative performance.
- Pension clients (institutional investors) withdraw assets from managers with poor past performance and increase flows to recent winners. Yet the managers fired go on to outperform the managers hired.
- While 20 years ago, about 20% of actively managed funds were generating statistically significant alpha, that figure is now about 2% as the market has become more efficient, the competition has gotten tougher and, as described in my book, “The Incredible Shrinking Alpha,” academics have been converting what was once alpha (a source of outperformance) into beta (a common factor that can easily be replicated).
- There is little evidence of performance persistence among hedge funds and actively managed mutual funds.
Problems with performance chasing
Despite the evidence, strong past performance is the prerequisite for manager selection by individuals as well as institutional investors. Robert Ferguson, Anna Agapova, Dean Leistikow and Joel Rentzler contribute to the literature on the persistence of performance among active managers with the paper, “Chasing Performance and Identifying Talented Investment Managers,” which appears in the Spring 2018 issue of The Journal of Investing. Their focus is on explaining why investors are likely to get poor results from performance-chasing.
The authors begin by noting that while choosing managers on the basis of historical performance might make intuitive sense, “it takes an impractically long time to differentiate talented from untalented managers – far longer than the five years or so that many investors believe is sufficient.”
They provide a mathematical example involving a world that contains 20 untalented managers (who have a normal distribution of returns with a mean alpha of 0 and a standard deviation of 2.68%) and one talented manager (who generates 3% alpha, which is very large, with a 3% tracking error).
Ferguson, Agapova, Leistikow and Rentzler demonstrate that we should expect, randomly (purely by luck), one of the 20 untalented managers will generate an alpha about 50% greater than 3% over the next 20 years. In fact, they write, “the probability that the talented manager beats all 20 untalented managers over the five-year period is only about 14.8%.”
Thus, performance-chasers end up with the untalented manager 85.2% of the time. And that is using a five-year horizon. Many institutions use three-year horizons, in which case the odds of hiring the talented manager would be even worse. Even at 10 years, the odds are just 36% that the talented manager will outperform all the untalented ones.
Making matters worse is that the probability the talented manager will beat all 20 untalented managers is surprisingly small for all lengths of measurement period. Even after 15 years, it only rises to about 55%. To achieve a 95% (99%) probability that the talented manager will outperform, you need a 38-year (54-year) historical performance record.
Such lengthy records are rare. Even if they existed, the likelihood is that the manager would have received so much cash flow that the hurdles to generating alpha would have become virtually insurmountable. That’s the curse of success – it sows the seeds of its own destruction.
The authors illustrated how the probability that a talented manager’s performance will exceed the best in a pool of untalented managers can be surprisingly small, even over long periods. It helps explain why performance-chasing has produced such poor results for individual and institutional investors alike. A better use of historical performance relegates it to a secondary role, the primary focus being an a priori analysis of a manager’s investment process (security selection and trading strategy).
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
Reposted from www.seekingalpha.com
There is an enduring debate about active versus passive management.
There are advantages and disadvantages to each strategy that investors should consider.
In this series, I will provide investors with an overview of the various strategies, and provide information that will help them select what is best for them.
I will explore Passive Investing in this piece, followed by various forms of active management in Part II.
The enduring debate among financial practitioners is whether active or passive management of portfolios is best. In this series, I want to go over four main strategies, and explore in detail the pluses and minuses of each, and who benefits most with each strategy. With this information in hand, you can be better able to select the strategy that works best for your specific situation, or, if applicable, that of your client.
Strategy 1: Passive Management
Objective: The passive investor would argue that markets are efficient and thus there is no use in trying to beat them. Thus, the objective of passively managed funds, is to buy all the stocks in a particular market, such as the S&P 500, and track the performance of that index. Because we have no way of knowing which stocks will beat the market and which will not, the passive investor would reason, you are better off buying the entire market at a very low cost, and taking the return provided by ‘the market’.
Best For: Passive investing is best for investors who want to track the market at a very low cost, and are not concerned with beating the market. Passive investors simply own the whole market, and receive the return of the index, minus any expenses.
Advantages: The advantages of passive investing are many.
- The strategy is supported by many Nobel Prize winners, and highly successful investors. Research continues to support this strategy because of the poor results of active management, and because of the research demonstrating that markets are efficient. (1) More information supporting this conclusion is included in the ‘Further Research’ section.
- Research by S&P, included in the ‘Further Research’ section below, demonstrates that over long measurement periods, active managers have a difficult time beating the passive index, which means that instead of obtaining average returns from passive investing, the index fund is actually obtaining very high returns relative to their active fund peers. (2)
- Additional research by the S&P, included in the ‘Further Research’ section below, demonstrated that for those funds that do beat the index, it was very difficult for them to continue to do so from one year to the next. (3)
- By buying the whole market, your returns tend to correlate to the market averages, with little or no tracking error.
- In addition, index funds, can be purchased at rock bottom fees as low as 0.04%. The less you pay in fees, the more you have available to take advantage of compounding over time. Every dollar paid out in expenses, loses the ability to compound and add to your wealth over time.
Disadvantages: The disadvantages of index funds are:
- You are buying the whole market, which means you own some really great companies and some not so great companies.
- Additionally, because you are tracking an index, you are guaranteed to underperform the market every year after costs and expenses.
- Index funds also do not give any consideration to the prices they pay for securities. Because traditional index funds are weighted, by market capitalization, as stocks get larger and more expensive they make up more and more of the index. This seems counter-intuitive to the very principles of investing, which tell investors to buy low and sell high.
- There are many structural issues with index funds, such as their inability to act like owners and represent the interests of shareholders. Research continues to prove that index funds vote with management the majority of the time as you can see in the ‘Further Research” section below. (4)
1. A Sampling of Research Supporting Market Efficiency
– George Gibson (1889) wrote the book, “The Stock Markets of London, Paris, and New York,” mentioning the concept of efficient markets. Gibson wrote, “when shares become publicly known in an open market, the value which they acquire may be regarded as the judgment of the best intelligence concerning them.”
– Fama (1965) defined an efficient market for the first time in his empirical analysis of stock market prices in which they conclude that they follow a random walk.
– Samuelson (1965) provided the first real arguments for efficient markets in his paper, “Proof,” that properly anticipated prices fluctuate randomly.
– Fama et al. (1969) undertook the first ever event study (although they were not the first to publish), and their results lend considerable support to the conclusion that the stock market is efficient.
– Published in 1970, the definitive paper on the efficient markets hypothesis is Eugene F. Fama’s first of three review papers: ‘Efficient Capital Markets: A Review of Theory and Empirical Work’ (Fama, 1970). He was also the first to consider the ‘joint hypothesis problem’. Granger and Morgenstern (1970) published the book, “Predictability of Stock Market Prices.”
Ellis (1975) published the article, “The Losers Game,” in the Financial Analysts Journal. The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.
Malkiel (2003) examined the attacks on the EMH and concludes that stock markets are far more efficient and far less predictable than some recent academic papers would have us believe.
Malkiel (2005) showed that professional investment managers do not outperform their index benchmarks and provides evidence that by and large market prices do seem to reflect all available information.
2. Research on The Failure of Active Management
The 2017 SPIVA Scorecard demonstrated a consistent long term trend that active managers, in the aggregate, have trouble beating the index.
“over the 15-year investment horizon, 92.33% of large-cap managers, 94.81% of mid-cap managers, and 95.73% of small-cap managers failed to outperform on a relative basis.”
The 2016 SPIVA Scorecard has put together an excellent analysis showing that active funds do not beat the index. It states:
“Given that active managers’ performance can vary based on market cycles, the newly available 15-year data tells a more stable narrative. Over the 15-year period ending Dec. 2016, 92.15% of large-cap, 95.4% of mid-cap, and 93.21% of small-cap managers trailed their respective benchmarks.”
2015 SPIVA Scorecard Results:
3. S&P Research on Persistence
“out of 1,034 large-cap funds that existed in the universe as of Sept. 30, 2013, only 19.73%, or 204 funds, outperformed the S&P 500®. In the following year, 15.69% of those 204 funds outperformed the benchmark. By the end of the third year, none of those original 204 funds were able to outperform the S&P 500 on a consecutive basis.”
4. Research on the Structural Challenges of index funds
It may be said, with some approximation to the truth, that investment is grounded on the past whereas speculation looks primarily to the future, but this statement is far from complete. Both investment and speculation must meet the test of the future; they are subject to its vicissitudes and are judged by its verdict. But what we have said about the analyst and the future applies equally well to the concept of investment. For investment, the future is essentially something to be guarded against rather than be profited from. If the future brings improvement, so much the better; but investment as such cannot be founded in any important degree upon the expectation of improvement. Speculation, on the other hand, may always properly-and often soundly derive its basis and its justification from prospective developments that differ from past performance…The individual investor should act consistently as an investor and not as a speculator.” – Benjamin Graham, Security Analysis
When you look across the index universe. The top three index providers are owning more and more of corporate America, giving index funds more power over shareholder proposals. This has real consequences for capitalism that more investors should be concerned about.
“Every new indexed dollar goes to the same places as previous dollars did. This “guarantees that the most valuable company stays the most valuable, and gets more valuable and keeps going up. There’s no valuation or other parameters around that decision,”… the result will be a “bubble machine”-a winner-take-all system that inflates already large companies, blind to whether they’re actually selling more widgets or generating bigger profits. Such effects already exist today, of course, but the market is able to rely on active investors to counteract them. The fewer active investors there are, however, the harder counteraction will be.” – New Yorker Is Passive Investment Actively Hurting The Economy?
A 2017 paper looked at the effect the big three – Vanguard, BlackRock (NYSE:BLK), and State Street (NYSE:STT) – have on corporate ownership and the creation of new financial risks for capitalism. The authors from the University of Amsterdam explore the challenges with passive investing being concentrated in a few firms, versus the advantages of competition and the fragmentation of active investing. Because active investing is more fragmented, it results in corporate ownership being spread around to dozens upon dozens of firms. This prevents any one firm from having potential undue influence over corporate management.
The authors state:
“When we talk about the power of large asset managers, we are concerned with their influence over corporate control and as such their capacity to influence the outcomes of corporate decision-making. Shareholders can exert power through three mechanisms. First, they can participate directly in the decision making process through the (proxy) votes attached to their investments. In a situation of dispersed and fragmented ownership, the voting power of each individual shareholder is rather limited. But blockholders with at least five percent of the shares are generally considered highly influential, and shareholders that hold more than 10 percent are already considered “insiders” to the firm under U.S. law. The growing equity positions that passive asset managers hold thus increase this potential power.”
“The size of a node in the visualization can be interpreted as the potential shareholder power of the particular owner within the network of control over listed companies in the United States. Thus, when seen together, the Big Three occupy a position of unrivaled potential power over corporate America.
When Vanguard pioneered its index fund concept in the mid-1970s it was attacked as “un-American,” exactly because they held shares in all the firms of an index and did not try to find the companies that would perform best. Therefore, the new tripartite governing board of BlackRock, Vanguard, and State Street is potentially conflicting with the image of America as a very liberal market economy, in which corporations compete vigorously, ownership is generally fragmented, and capital is generally seen as “impatient.” Benjamin Braun has argued that passive investors may, in principle, act as “patient” capital and thus facilitate long-term strategies. Hence, the Big Three have the potential to cause significant change to the political economy of the United States, including through influencing important topics for corporations, such as short-termism versus long-termism, the (in)adequacy of management remuneration, and mergers and acquisitions. We reflected on a number of anti-competitive effects that come with the rise of passive asset management, which could have negative consequences for economic growth and even for economic equality. As well, we signaled how the continuing growth of ETFs and other passive index funds can create new financial risk, including increased investor herding and greater volatility in times of severe financial instabilities.”
Strategy 2: Active Management-Factor Funds
Objective: The objective of factor funds, or multi factor funds, is to capture specific factors that academic research has shown to beat the overall market over long measurement periods.
Factor investors, like index investors, are simply trying to own the market, while capturing the factor premiums that research shows come from some variation of the Five Factor Model, for example. This model was introduced by Eugene Fama, and Kenneth French. Their research demonstrated that stocks beat bonds (market factor), value stocks beat growth stocks (value factor), small cap stocks beat large cap stocks (Size factor), profitable companies beat non profitable companies (profitability factor), and positive investment characteristics beat those with negative investment characteristics (investment factor).
Therefore, they argued, that by tilting towards these factors of outperformance, we would stand a better chance at beating the market in a more efficient systematic manner. Dimensional Fund Advisors (DFA), is the largest provider of dedicated, research based, factor strategies.
They have been able to beat the market at a higher rate than traditional active management, not through security selection but rather factor tilting. Using these funds, however, requires a DFA financial advisor, which will mean an increase in cost to the investor. However, factor funds are now offered by many different providers, both in single factor and multi factor strategies.
Best For: Investors who are seeking a low cost, academically-based strategy to beat the market through the capture of factor premia. These funds are quite passive in nature but are categorized as active because of the factor tilting strategy, which does create tracking error, which at times can be significant depending on the specific factor targeting strategy utilized. This strategy is not advised for investors who are not comfortable with tracking error.
- While these funds are actively targeting specific factors, they are highly passive in nature.
- They can be purchased at a relatively low cost in mutual fund and ETF form.
- They provide exposure to specific factors which research demonstrates, may allow investors to outperform the market over the long run.
- If factors go out of favor for extended periods, investors could underperform the broad index.
- There is no telling that the future will look like the past, and thus targeting specific factors may become more challenging, or unreliable as markets, and economies change.
- Some of these strategies require a financial advisor, which may increase the overall cost to the investor, and meaningfully drag down net investment results.
In this first piece, I took a look at passive investment strategies both through the broad index fund as well as the factor fund lens. In Part II, I will explore various forms of active management, and what investors would benefit most from each. Taken together, these two pieces should be read together, and can serve as a guide to choosing the right investment strategy for you.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.
Reposted from http://www.investmentnews.com
With its data-driven models the company attracted third-most money in 2014 behind Vanguard and JPMorgan
Jan 19, 2015 @ 9:14 am
By Bloomberg News
When Molly Bernet Balunek expressed interest in putting money into mutual funds run by Dimensional Fund Advisors, she didn’t know she was in for a rigorous courtship ritual.
Before getting the go-ahead to invest in Dimensional’s products last year, Ms. Balunek, a financial adviser from Cleveland, had to submit to an interview, fill out a questionnaire and pay out of her own pocket for a two-day trip to Austin, Texas, where she listened to the company’s executives explain how they do business. The process, which Ms. Balunek described as “intense,” took about five months.
“It is a two-way evaluation process — Dimensional wanted to understand my business structure and investment philosophy as much as I wanted to understand theirs,” said Ms. Balunek.
The ritual is part of a sales process that has helped Dimensional attract the third-most money last year after Vanguard Group Inc., known for its low-cost index funds, and JPMorgan Chase & Co. Like Vanguard,
Dimensional is capitalizing on a growing belief that stock pickers can’t consistently beat markets. Dimensional’s approach, though, comes with a twist: unlike traditional index strategies, the funds use data-driven models to beat traditional benchmarks.
Dimensional is among a small group of managers toppling the dominance of firms such as Fidelity Investments and Capital Group, which have built their reputations on picking individual stocks. Among the fastest-growing U.S. mutual fund firms after assets surged almost six-fold in the past decade, Dimensional attracted almost $28 billion in new money in 2014.
Dimensional believes beating the markets is an exercise in futility and most managers cannot justify the fees they charge. What sets Dimensional apart is its investment philosophy, using research pioneered by Nobel laureate Eugene Fama and Kenneth French, of focusing on specific factors or dimensions that have helped certain indexes beat benchmarks such as the S&P 500 Index.
Dimensional, which sells its funds only through approved advisers and never directly to the public, spends considerable effort educating investors on how its approach works. Its system of picking advisers breeds a high degree of loyalty. The firm received the highest grades in customer loyalty among mutual fund companies in a July 2014 survey of U.S. financial advisers conducted by Cogent Reports of Cambridge, Mass.
“They’ve developed a brilliant way of locking in money and the advisers who use them seem to love it,” said Lawrence Glazer, a managing partner at Mayflower Advisors, a Boston-based adviser that oversees $2 billion.
David Butler, who runs Dimensional’s financial adviser business, said he could “count on one hand,” the advisers who have stopped using the company’s funds in his nearly 20 years at the company.
Advisers who use Dimensional, “tend to buy into the firm’s unique philosophy and investment approach and direct a higher proportion of their mutual fund dollars to the firm,” Linda York, a Cogent vice president, wrote in an e-mail.
Dimensional’s assets have more than doubled since 2009 to $381 billion in a mix of mutual funds and institutional accounts. Part of the growth is the result of shifting client sentiment, as investors disillusioned with the ability of stock pickers to insulate them from losses during the 2008 crisis have increasingly turned to cheaper alternatives such as index mutual funds and exchange-traded funds.
Mutual funds that pick U.S. stocks experienced $98 billion in redemptions in 2014. During the same period, investors added $167 billion to domestic stock index funds and ETFs, according to data from Chicago-based Morningstar Inc.
Vanguard attracted $219 billion in mutual fund and ETF deposits last year. Fidelity had redemptions of $5.3 billion while American Funds, the mutual fund arm of Capital Group, won $345 million.
Mayflower’s Mr. Glazer said while low-cost indexing is popular at the moment, there is no guarantee it will remain so.
“If the history of asset management is any guide, the companies and styles that were the leaders in one decade, won’t be the leaders in the next decade.”
“Conventional active managers promised a lot that they weren’t able to deliver,” David Booth, 68, chairman and co-founder of Dimensional, said in an interview at his company’s headquarters in Austin.
Mr. Booth built his firm around the ideas of his University of Chicago mentor Mr. Fama, who won the 2013 Nobel Prize in economics for his work on efficient markets. In 2008, crediting the school for his success, Mr. Booth donated $300 million to his alma mater, which renamed its business school the University of Chicago Booth School of Business.
Mr. Fama and his research partner, Dartmouth College’s Mr. French, have argued that stock-price movements are unpredictable and that trying to pick securities that will beat the market is pointless.
“Most people are fooling themselves when they think they have the ability to hire a superior manager,” said Mr. French, in a video posted on Dimensional’s website.
The pair’s research also shows that certain factors can produce higher returns. Using historical market data, they found that over the long term, small stocks have outperformed large ones, value-oriented equities have beaten growth and more profitable companies have done better than less profitable peers. Dimensional’s funds reflect those tilts, with portfolios composed of small-cap companies, value shares and stocks of companies with above-average profits.
Over the past five, 10 and 15 years, Dimensional’s stock funds have outperformed about 70% of peers, according to Denver-based Lipper. Bond funds, a smaller piece of the business, trailed about 60%. Over the past 15 years, almost 90% of the company’s stock and bond strategies with a track record that long have topped their benchmarks, Dimensional data show.
Dimensional executives say that they can’t quantify or guarantee the amount of outperformance they can generate.
“If we can beat the benchmarks by 50 basis points a year — and in many strategies by 100 basis points — I will do handstands,” said Mr. Booth.
For the last 15 years, Dimensional’s funds have benefited from a rally in small-capitalization and value shares. Since the end of 1999, small stocks, as measured by the Russell 2000, have returned more than twice as much as large stocks, represented by the S&P 500 Index. Value stocks gained about four times as much as growth stocks.
The opposite pattern prevailed during the technology boom of the late 1990s, as big stocks and growth stocks outperformed, data compiled by Bloomberg show. In 2014, small cap stocks lagged behind large ones by a wide margin. They trailed again in 2015 through Jan. 13.
William Smead, a stock picker who runs the $952 million Smead Value Fund and invests in big companies, said if historical patterns hold, small cap stocks could lag behind large ones for the next six to nine years.
Setting realistic expectations for performance is just one piece of Dimensional’s close relationship with advisers, a relationship that began as an accident, according to Mr. Booth.
In the 1980s, the firm managed money exclusively for institutional investors. In 1988, an adviser approached Mr. Booth about investing in Dimensional funds.
The idea was intriguing and also somewhat disturbing, said Mr. Booth, who was concerned that advisers would move in and out of the funds too often, burdening other investors with higher costs. Minimizing trading costs is part of Dimensional’s plan for adding value. The solution was to create a system in which the company could pick advisers who bought into Dimensional’s approach and played by its rules.
“They don’t want advisers who are traders, they don’t want hot money and they don’t want people who are chasing performance,” said Ms. Balunek, who described the process of becoming a Dimensional adviser as more “invasive” than she anticipated.
Mr. Booth said the extended process — including having advisers pay their own way to the introductory seminar — has paid dividends.
“We have made it kind of a pain in the neck to buy the funds, but that has created a mutual affinity.”
Bob Rall, an adviser from Merritt Island, Fla., can speak to that affinity. He started out with a firm that tried to pick individual securities and said he got tired of client losses because of bad stock picks.
He found out about Dimensional 12 years ago and attended one of their conferences. Mr. Rall now has about 90% of the $35 million he oversees invested in Dimensional funds.
“They poured us big glasses of Kool-Aid, we drank it and haven’t looked back,” he said.
Advisers are also attracted to the credentials of the academics behind Dimensional’s investing and trading strategies. In addition to Mr. Fama and Mr. French, Nobel Prize winner Robert Merton of Massachusetts Institute of Technology is involved in designing products for the company.
Having advisers that believe in the firm creates another benefit for Dimensional and its customers, according to Michael Rosen, chief investment officer at Angeles Investment Advisors in Santa Monica, Calif., who oversees $45 billion for endowments and pensions.
“Educated advisers are more likely to prevent their clients from making radical changes when markets drop,” said Mr. Rosen. “The fact that those assets are sticky will add value for the investors.”
Dimensional’s approach to markets, with its tilts toward small and value stocks, at one time made it distinct in the money-management business, said Alex Bryan, an analyst with Morningstar. Many firms are now competing in the same arena including AQR Capital Management, he said, and products such as low-cost ETFs are also vying for investor capital.
“Investors have a lot of options now,” said Mr. Bryan. “They don’t have to go to Dimensional to get exposure to those strategies.”
Mr. Booth isn’t worried by the competition. He has invested in systems that will allow the firm to grow, although he refrains from projecting how big it might get. When the company passed $50 billion in assets in 2004, he said, “It was already bigger than we thought it could possibly be.”
Mr. Booth, who owns Dimensional along with other past and current employees and directors, doesn’t see that changing anytime soon. He said he has turned down repeated requests to sell Dimensional or take it public.
“The next generation of leadership is in place and they will worry about firm ownership,” said Mr. Booth. “For the time being we are ignoring the fact that we are getting older. This is what we want to be doing.”
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