Re-posted from New Research On Performance Chasing
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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.
Re-posted from Swedroe: Value Premium Lives!
There has been much debate about the “death” of the value premium. Those making the case it has disappeared believe the publication of research on the premium has led to cash flows, which in turn have eliminated it.
They point to the last 10 calendar years of data, during which the value premium was slightly negative, at -0.8%. The value premium (HML, or high minus low) is the annual average return on high book-to-market ratio (value) stocks minus the annual average return on low book-to-market ratio (growth) stocks.
Before taking a deeper dive into the data, it’s important to note that all factor premiums, including market beta, have experienced long periods of negative returns. The following table, covering the period 1927 through 2017, shows the odds (expressed as a percentage) of a negative premium over a given time frame. Data in the table is from the Fama/French Data Library.
No matter the horizon, the value premium has been almost as persistent as the market beta premium. Even the market beta premium has been negative in 9% of 10-year periods and in 3% of 20-year periods.
Investors who know their financial history understand that what we might call “regime change,” with value underperforming for a fairly long time, is to be expected. In fact, even though the value premium has been quite large and persistent over the long term, it has been highly volatile. According to Ken French’s data, the annual standard deviation of the premium, at 12.9%, is 2.6 times the size of the 4.8% annual premium itself (for the period 1927 through 2017).
While 10 years may seem like an eternity to most investors (even institutional investors fire managers after a few years of underperformance), it can be nothing more than noise. Having to remain disciplined over such long periods is perhaps why Warren Buffett famously said that investing is simple, but not easy.
As Andrew Berkin and I point out in our book, “Your Complete Guide to Factor-Based Investing,” investors should have confidence in the value premium because it has been persistent across long periods of time and various economic regimes and has been pervasive around the globe and across asset classes. In addition to stocks, a value premium has existed in bonds, commodities and currencies (in other words, buying what is cheap has outperformed buying what is expensive).
Furthermore, the value premium has been robust to various definitions, not just the price-to-book (P/B) measure, or HML, popularized by Fama and French. Indeed, the premium is also found when using other value metrics, such as price-to-earnings (P/E), price-to-cash flow (P/CF), price-to sales (P/S), price-to-earnings before interest, taxes, depreciation and amortization (P/EBITDA), price-to-dividend (P/D) and price to almost anything—however it’s measured, cheap has outperformed expensive.
With that in mind, we can look at the size of the value premium for the 10-year period ending 2017 against some of those other metrics (all data is from Ken French’s website). While the value premium was negative by P/CF (-1.2%) and slightly negative by P/B, it was actually positive using P/E (1.2%) and P/D (0.6%)—so, on average, about zero.
Before moving on, it’s important to note many have questioned the sole use of P/B as the best value metric, especially in an age when many assets are now intellectual capital that often don’t appear on balance sheets (externally acquired intangibles do appear on balance sheets).
Reasons not to believe P/B—or for that matter, any single metric—is the superior measure of value include the fact that one metric could work better than others do for some industries, and various metrics have provided the highest premium in different economic regimes. That is why many practitioners and mutual fund families now use multiple metrics, which I believe can provide a diversification benefit.
Having covered that ground, let’s go to our trusty videotape and see how value performed outside the U.S. If value is “dead,” we should find confirming evidence in other markets.
The following table—again, using data from Ken French’s website—shows the premium for the 10 years from 2008 through 2017 in international developed markets.
|2008-2017||Average Annual Premium (%)|
No matter which metric I use, there was a value premium in developed international markets. This result actually surprised me, because research shows value stocks are more exposed to economic cycle risks—they perform best in periods of stronger economic growth because they become less risky. While the last 10 years saw the slowest economic recovery in the post-World War II era, economic growth has been even more anemic in the non-U.S. developed world.
Having shown the value premium in international markets has been fairly similar to historical levels, I can also examine live results.
Specifically, I’ll compare the returns of the passively managed, structured international value funds my firm uses with those of marketlike ETFs in three asset classes. Data is from Morningstar and covers the 10-year period ending May 4, 2018. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
|iShares MSCI EAFE ETF (EFA)||2.25%|
|DFA International Value Portfolio III (DFVIX)||2.20%|
|iShares MSCI EAFE Small-Cap ETF (SCZ)||6.05%|
|DFA International Small Value (DISVX)||5.89%|
|iShares MSCI Emerging Markets ETF (EEM)||1.29%|
|DFA Emerging Markets Value (DFEVX)||1.66%|
Note: Dimensional’s international strategies include Canada; EAFE indexes do not.
The average return of the three ETFs was 3.20%. The average return of the three Dimensional value funds was 3.25%. Thus, while there was a value premium, compound returns were no better (as the roughly 2-3% higher annual volatility of value stocks negatively affected their compound returns), but no worse, either.
One way to look at the results is that, over one of the worst 10-year periods for the performance of value stocks, value investors were not “penalized” for their strategic decisions. Another is to believe the value premium is dead.
My view is that there is a large body of evidence demonstrating logical, risk-based explanations for the value premium. While cash flows can shrink premiums, risk-based premiums cannot be arbitraged away. On the other hand, it’s possible to arbitrage away behavioral-based premiums, such as momentum (though limits to arbitrage often prevent this from occurring).
Among the risk-based explanations for the premium are that value stocks contain a distress (default) factor, have more irreversible capital, have higher volatility of earnings and dividends, are much riskier than growth stocks in bad economic times, have higher uncertainty of cash flow, and, as previously mentioned, are more sensitive to bad economic news.
Given these risk-based explanations, it is hard to believe the value premium can be arbitraged away. With that understanding, let’s consider whether cash flows have eliminated the premium.
If, as many people believe, the publication of findings on the value premium has led to cash flows that have caused it to disappear, we should have seen massive outperformance in value stocks as investors purchased those equities and sold growth stocks.
Yet the last 10 years have witnessed the reverse in terms of performance. In addition, if cash flows had eliminated the premium, the buying of “undervalued” value stocks and selling of “overvalued” growth stocks should have led to a reduction in the valuation spreads between value stocks and growth stocks.
I happen to have kept a table from a seminar Dimensional gave in 2000. It shows that, at the end of 1994, the P/B ratio of large growth stocks was 2.1 times as big as the P/B ratio of large value stocks.
Using Morningstar data, as of May 3, 2018, the iShares S&P 500 Growth ETF (IVW) had a P/B ratio of 4.7, and the iShares S&P 500 Value ETF (IVE) had a P/B ratio of just 2.0—the spread has actually widened from 2.1 to 2.4. Thus, value stocks are cheaper today, relative to growth stocks, than they were shortly after Fama and French published their famous research.
We can also look at the P/E metric. In 1994, according to the Dimensional table, the ratio of the P/E in large growth stocks relative to the P/E in large value stocks was 1.5. As of May 3, 2018, and again using Morningstar data, IVW had a P/E ratio of 20.0, and IVE had a P/E ratio 14.4. Thus, the ratio, at 1.4, was almost unchanged. There’s no evidence here that cash flows have eliminated the premium.
We see similar results when we look at small stocks. The Dimensional data shows that, at the end of 1994, the P/B of the CRSP 9-10 (microcaps) was 1.5 times as large as the P/B of small value stocks. Using Dimensional data, and the firm’s microcap fund (DFSCX) for microcaps and its small value fund (DFSVX) for small value stocks, as of April 30, 2018, the ratio of the funds’ respective P/B metrics was the same 1.5 (1.9÷1.3). When we look at P/E, again, the results are similar. At the end of 1994, the ratio of those funds’ respective P/E metrics was 1.2; it is now the same 1.2 (20.2÷16.3). Again, I see no evidence that cash flows have eliminated the premium.
Using data from Ken French’s website, we also see similar results when we look at the period starting in 2008. In 2008, the ratio of the P/B of U.S. growth stocks (4.8) to U.S. value stocks (1.1) was 4.4. By the end of 2017, the ratio had increased to 5.3 (6.3÷1.2), the opposite of what you would expect if cash flows had eliminated the premium.
Based on the logical, risk-based explanations for the value premium, and the lack of evidence pointing to shrinking valuation spreads, my conclusion is that the most recent 10 years of performance is likely just another of those occasionally occurring but fairly long periods in which the value premium is negative. If periods such as these did not occur, there would be no risk, and no risk premium. This is true of all risky investments, including stocks (and thus the market beta premium).
The bottom line is that, at least in my opinion, it’s hard to conclude the value premium is dead. Being able to stay the course during long periods of relative underperformance is what led Warren Buffett to assert that successful investing has a lot more to do with temperament (meaning discipline and patience) than intellect.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
Re-posted from www.etf.com
On the positive side, as we age, we tend to have more diversified portfolios, own more asset classes and have higher allocations to international equities. And older investors tend to trade less frequently (that’s a good thing, as the evidence shows a negative correlation between individual investors’ trading activity and their returns). They tend to be less affected by behavioral errors, such as selling winners too soon (the disposition effect) and local bias (the familiarity effect). They also tend to own mutual funds with lower expense ratios—another good thing. These choices reflect greater investment knowledge.
Older Investors Less Effective
However, George Korniotis and Alok Kumar, authors of the study, “Do Older Investors Make Better Investment Decisions?”, found that “older investors are less effective in applying their investment knowledge and exhibit worse investment skill.”
Korniotis and Kumar also found that, while older and experienced investors are more likely to follow rules of thumb that reflect greater investment knowledge, the adverse effects of cognitive aging dominate the positive effects of experience. For example, they found that stock picks tend to lag the market by ever-increasing amounts as we grow older, and they exhibit poor diversification skill.
They noted: “The age-skill relation has an inverted U-shape and, furthermore, the skill deteriorates sharply around the age of 70.” They found that “on average, investors with stronger aging effects earn about 3% lower risk-adjusted annual returns, and the performance differential is over 5% among older investors with large portfolios.”
As further evidence of this negative relationship, Michael Finke, John Howe and Sandra Huston, authors of the study “Old Age and the Decline in Financial Literacy,” found that while financial literacy scores decline by about 1 percentage point each year after age 60, confidence in financial decision-making abilities does not decline with age.
Thus, they concluded that increasing confidence and reduced abilities explain poor investment (and credit) choices by older investors—age is positively related to financial overconfidence. And overconfidence can be a deadly sin when it comes to investing. Adding to the problem is the tendency for older people to reject evidence of declining cognitive abilities.
Experienced financial advisors know that it is common for clients to experience an increase in behavioral issues when they reach an advanced age, issues that can negatively impact the odds of achieving their financial goals.
If nothing else, as we age and our investment horizon shortens, investors exhibit an increasing preference for more conservative assets—our tolerance and capacity for risk tends to fall. We want more certainty. This argues for an increasing exposure to safer bonds and other assets with low correlation to equities. Yet that can be taken to an extreme when an insufficient allocation to equities can increase the odds of running out of money.
Risks For Retirees
In his March 2017 paper, “Risks in Advanced Age,” Michael Guillemette discusses the risks that retirees face and possible solutions to help them overcome behavioral hurdles. He points out that “if financial planners make clients aware of their declining cognitive and financial literacy abilities, they may be more willing to make simplified and satisfactory financial decisions.”
Guillemette highlighted an important issue related to longevity risk: “Wealthy people are living significantly longer than their less wealthy counterparts, creating the need for retirement assets to last for an extended period. Life expectancy for the 10th percentile of household income is 76 years for men and 82 years for women. In comparison, for the 90th percentile of income (which is similar to the clientele of fee-only advisors) life expectancy is 85 years for men and 87 years for women.”
This knowledge can help in the decision to buy longevity annuities as a hedge against outliving your assets, increasing the level of certainty and reducing anxiety.
Guillemette concluded with this important insight: “It is important for financial planners to have plans in place before behavioral biases hinder older clients from reaching their goals.”
Another interesting point I’ve heard from CPAs and financial advisors who work with elderly clients is that, as people age, they tend to feel more strongly about paying less or no income tax. One example is that of an elderly person in the 15% tax bracket buying municipal bonds so he doesn’t have to pay income taxes, despite the fact that taxable bonds could provide a higher after-tax return. Older people tend not even to do the analysis because of the bias against paying taxes.
A second example involves doing Roth conversions between retirement and the start of required minimum distributions (RMDs). This necessitates paying income tax but at a low tax rate, thus avoiding paying higher income taxes once RMDs start. Educating investors about the benefits of tax-centric planning in advance of implementing them can help overcome cognitive biases and show that paying some taxes early can actually reduce taxes over the long term.
The bottom line is that it’s important for investors and advisors alike to take into account the likelihood that financial decision-making skills will eventually decline, creating the potential for poor decisions.
Thus, plans that address this issue should be put in place before that stage is reached. Plans should include granting powers of attorney for financial and health care matters to trusted family members or professionals. And these documents should be reviewed on a regular basis to make sure they are up to date.
It’s important to recognize that there are many important decisions to make as we enter the period when our cognitive skills start to decline—decisions that can have major impacts on the success of a financial plan. Among them are:
- When to begin taking social security. This is a very complicated issue, and filing at the right time can mean tens of thousands of dollars’ difference over a lifetime. Far too many people fail to consider the longevity insurance benefit of delaying social security payments as long as possible.
- The ability to take advantage of a lower tax bracket between retirement and when RMDs start to reduce the size of IRAs. Taking income at a low bracket early can lead to avoiding paying tax at a higher bracket later.
- Proper asset location, holding lower-returning assets (such as bonds) in a traditional IRA while holding higher-returning assets (such as stocks) in a Roth IRA to keep future RMDs as low as possible.
- Evaluating existing life insurance policies. Is there still a reason to keep an old life insurance policy that was necessary with a young family? That policy still has costs, even when the cash value is paying the premium. The cash value could be redeployed, for example, to fund a long-term care insurance policy.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.
by Larry Swedroe, Director of Research
There are several keys to having a successful investment experience. The first is to create a well-thought-out financial plan. This plan should begin with identifying your ability, willingness and need to take risk, as well as what it is that you want your money to do for you. Having identified all the appropriate risks and objectives, an overall financial plan can then be developed (one that integrates the investment plan into an estate, tax and risk management plan). The next step is to decide on the investment strategy most likely to allow you to achieve your goals within the risk parameters acceptable to you.
Two tools that advisors, trustees and investors can use to help identify the prudent investment strategy are the 1992 Restatement of Trust (Third), also referred to as the Prudent Investor Rule, and the 1994 Uniform Prudent Investor Act. Both of these incorporated Modern Portfolio Theory (MPT) into their writing. Among the fundamental tenets of MPT is that, done properly, diversification reduces the risk of underperformance as well as the volatility and dispersion of returns, without reducing expected returns.
Thus, a diversified portfolio is considered more efficient (and thus more prudent). The Uniform Prudent Investor Act states that “because broad diversification is fundamental to the concept of risk management, it is incorporated into the definition of prudent investing.”
Clearly, the benefits of diversification are well known. In fact, it’s been called the only free lunch in investing. It’s why I recommend that investors diversify not only across domestic equity asset classes (small- and large-cap stocks, value and growth stocks, and real estate) but also that they include a significant allocation to international equity asset classes (including emerging markets stocks).
However, investors who adopt the strategy of broad diversification must understand that they are taking on another type of risk, a psychological one known as tracking error regret. Think of tracking error as the risk that a diversified portfolio underperforms a popular benchmark, such as the S&P 500. Regret over tracking error can lead investors to make the mistake that I call confusing
ex-ante strategy with ex-post outcome.
Confusing Strategy With Outcome
“Fooled by Randomness” author Nassim Nicholas Taleb had the following to say on confusing strategy and outcome: “One cannot judge a performance in any given field by the results, but by the costs of the alternative (that is, if history played out in a different way). Such substitute courses of events are called alternative histories. Clearly the quality of a decision cannot be solely judged based on its outcome, but such a point seems to be voiced only by people who fail (those who succeed attribute their success to the quality of their decision).”
Unfortunately, in investing there are no clear crystal balls. Thus, a strategy should be judged in terms of its quality and prudence before its outcome is known, not after.
2008-2015 Provides a Test
Since 2008, investors have been faced with a major test of their ability to ignore tracking error regret. From 2008 through 2015, major U.S. asset classes provided fairly similar returns. While the S&P 500 Index returned 6.5 percent per year, the MSCI Prime (Large) Value Index returned
5.1 percent, the MSCI U.S. Small Cap 1750 Index returned 7.7 percent and the MSCI U.S. Small Cap Value Index returned 7.7 percent. The total returns of the four indices were 66 percent,
49 percent, 82 percent and 70 percent, respectively.
International stocks, however, have underperformed by wide margins. Over the same period, the MSCI EAFE Index returned 0 percent per year and the MSCI Emerging Markets Index returned
-3 percent per year (with a total return of -21 percent).
Clearly, investors who diversified globally have been disappointed. Unfortunately, that disappointment has led many to consider abandoning their strategy of global diversification. But, should we judge the strategy to have been a poor one based on the outcome? Not when we look at the question through the lens provided by Taleb.
To see the wisdom of taking the correct viewpoint (Taleb’s), let’s consider an investor at the beginning of this period (one who doesn’t have the benefit of a clear crystal ball). How did the world look to that investor? To answer that question, we’ll look at the returns for the prior five-year period.
The Good Side of Tracking Error
An investor contemplating their investment strategy looking backward at the start of 2008 would have been reviewing the following returns. For the five-year period from 2003 through 2007, the S&P 500 Index provided a total return of 83 percent. That was less than half the 171 percent total return provided by the MSCI EAFE Index and not much more than 20 percent of the 391 percent return of the MSCI Emerging Markets Index. Yes, the S&P 500 Index underperformed the MSCI Emerging Markets Index by 308 percentage points over just a five-year period.
If you think that’s bad (or impressive, depending on which side of the coin you happen to be looking at), during that same period, the DFA Emerging Markets Small Cap Fund (DEMSX) provided a total return of 430 percent, outperforming the S&P 500 Index by 347 percentage points, and the DFA Emerging Markets Value Fund (DFEVX) provided a total return of 546 percent, outperforming the S&P 500 Index by 463 percentage points. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
Looking at the domestic asset classes, the S&P 500 Index also underperformed the MSCI U.S. Small Cap 1750 Index by a total of 40 percentage points, the MSCI U.S. Small Cap Value Index by a total of 28 percentage points and the MSCI Prime (Large) Value Index by a total of 14 percentage points.
As you can see, tracking error works both ways. You have to take the positive tracking error with the negative. Importantly, I doubt that any investors looking back at the returns in the period from 2003 through 2007 would have been questioning the benefits of building a globally diversified portfolio. Regrettably, the twin problems of “relativism” (how the performance of your portfolio compares to that of your friends and to popular benchmarks) and “recency” conspire to lead investors to abandon even well-thought-out plans.
Unfortunately, too many investors have entered what Vanguard founder John Bogle calls the “Age of Investment Relativism.” Investor satisfaction or unhappiness (and, by extension, the discipline required to stick with a strategy) seems determined to a great degree by the relative performance of their portfolio to some index (an index that shouldn’t even be relevant to an investor who accepts the wisdom of diversification).
Relativism, sadly, can best be described as the triumph of emotion over wisdom and experience. The history of financial markets has demonstrated that today’s trends are merely “noise” in the context of the long term. Bogle once quoted an anonymous portfolio manager, who warned: “Relativity worked well for Einstein, but it has no place in investing.”
The recency effect — in which the most recent observations have the largest impact on an individual’s memory and, consequently, on their perception — is a well-documented cognitive bias. This bias could affect investment behavior if investors focus on the most recent returns and project them into the future. This is a very common mistake, leading investors to buy what has done well recently (at high prices, when expected returns are now lower) and sell what has done poorly recently (at low prices, when expected returns are now higher). Buying high and selling low is not exactly a prescription for investment success. Yet, the research shows that is exactly what many investors do, partly due to recency bias. And that behavior leads investors to earn lower returns than the very funds in which they invest. A superior strategy is to follow a disciplined rebalancing strategy that systematically sells what has performed relatively well recently and buy what has performed relatively poorly.
We can observe the buy-high-and-sell-low strategy at work by examining current valuations. What we should expect to see is that the dramatic outperformance of the S&P 500 has made U.S. stocks more expensive (have higher valuations) relative to international equities. Valuations are the best predictor we have of future returns. As of year-end 2015, the Shiller Cyclically Adjusted Price-to-Earnings (P/E) Ratio, referred to as the CAPE 10 ratio, was at 24.4. To estimate future expected returns using the CAPE 10 metric, you first calculate the earnings yield (E/P) — the inverse of the CAPE 10 — and get 4.1 percent. However, because the CAPE 10 is based on lagged 10-year earnings, you need to make an adjustment, since real earnings grow over the long term. I suggest using 2 percent as a real earnings growth estimate. Make that adjustment by multiplying the
4.1 percent earnings yield by 1.1 (1 + [0.02 x 5]), producing an estimated real return to stocks of about 4.5 percent. (We multiply by five because a 10-year average figure lags current earnings by five years.)
By comparison, the CAPE 10 for both the international developed and emerging markets were at much lower levels. The CAPE 10 for the MSCI EAFE Index was at 16.4. That results in an earnings yield of 6.1 percent. In making the appropriate adjustments, you get an expected real return for the MSCI EAFE Index of 6.7 percent, or 2.2 percentage points greater than that of the S&P 500 Index. The CAPE 10 for the MSCI Emerging Markets Index stood at 12.3. That results in an earnings yield of 8.1 percent. In making the appropriate adjustments, you get an expected real return for the MSCI Emerging Markets Index of 8.9 percent, almost double that of the 4.5 percent expected real return of the S&P 500 Index.
We can also measure the relative valuations of domestic versus international markets by examining the more current valuations from three of Vanguard’s index funds. The data below is from Morningstar and is as of the end of February 2016:
- S. Total Stock Market Index Fund (VTSMX): P/E of 17.0
- Developed Markets Index Fund (VTMGX): P/E of 14.3
- Emerging Markets Index Fund (VEIEX): P/E of 11.5
Investors who abandon the strategy of broad global diversification due to recency would now be selling international and emerging market equities when their valuations are much lower, and their expected returns are much higher. They likely would already have suffered the pains of the lower returns and would at this point be selling low to buy high.
We have one last problem to discuss.
I have learned that when contemplating investment returns, the typical investor considers three to five years as a long time, and 10 years as an eternity. When it comes to the returns of risky asset classes, however, periods as short as three or five years should be considered nothing more than noise. And even 10 years is a relatively brief period. No more proof is required than the negative
1 percent per year return to the S&P 500 Index over the first decade of this century. Investors in stocks shouldn’t have lost faith in their belief that stocks should outperform safe Treasury bills due to the experience of that decade.
Here’s a much more striking example. Over the 40-year period ending in 2008, U.S. large-cap and small-cap growth stocks both underperformed long-term U.S. Treasury bonds. I would hope that investors didn’t abandon the idea that these risky assets should be expected to outperform in the future just because they had experienced a long period of underperformance. Yet, when it comes to international investing, perhaps because of home country bias, investors are far too willing to abandon well-thought-out strategies involving global diversification of international equities when they experience inevitable periods of underperformance.
As I have discussed previously, investors need to understand that when they invest in risky assets (such as stocks, and more specifically small and value stocks), they should expect they will experience some very long periods in which those risky assets underperform. If that wasn’t the case, there would not be any risk.
Diversification means accepting the fact that parts of your portfolio may behave entirely differently than the portfolio itself. Knowing your level of tolerance for tracking error risk, and investing accordingly, will help keep you disciplined. The less tracking error you are willing to accept, the more the equity portion of your portfolio should look like the S&P 500 Index. On the other hand, if you choose a market-like portfolio, it will be one that’s not very diversified by asset class and will have no international diversification. At least between these two choices (avoiding or accepting tracking error), there is no free lunch.
It is almost as important to get this balance right as it is to determine the appropriate equity/fixed-income allocation. If you have the discipline to stick with a globally diversified, passive asset class strategy, you are likely to be rewarded for your discipline.
Written by Larry Swedroe, Director of Research
Much—too much—has been said and written about the relative superiority of Roth IRAs versus Traditional IRAs. The debate over which is better too often involves the technical numerical merits. In truth, the Roth wins in almost every situation because of its massive behavioral advantage: a dollar in a Roth IRA is (almost) always worth more than a dollar in a Traditional IRA. This is true regardless of one’s age, but the Roth IRA is even more advantageous for Millennials.
I must first disclaim that you can disregard any discussion of Roth or Traditional IRA if you’re not taking full advantage of a corporate match in your employer’s 401(k)—free money is still better than tax-free money. But after you’ve “maxed out” the match in your corporate retirement account, here are the top three reasons Millennials should consider putting their next dollar of savings in a Roth IRA:
1) Life is liquid, but most retirement savings isn’t.
Yes, of course, in a perfect, linear world, every dollar we put in a retirement account would forevermore remain earmarked for our financial futures. But hyperbolic discounting—and the penalties and tax punishments associated with early withdrawal from most retirement savings vehicles—can scare us away from saving today for the distant future. The further the future, the more we fear.
The Roth IRA, however, allows you to remove whatever contributions you’ve made—your principal—without any taxes or penalties at any time for any reason. Therefore, even though I’d prefer you to generally employ a set-it-and-forget-it rule with your Roth and not touch it, if the privilege of liquidity in a Roth helps you save for retirement, I’m all for it.
2) There are too many competing priorities.
Millennials are dropped into the middle of a financial should-fest. You should pay down school loans, save up for a home down-payment, drive a cheap ride, purchase the proper level of insurance, enhance your credit and save three months’ worth of cash in emergency reserves. All while having a life? No chance.
Most personal finance instruction tells you what your priorities should be, and if you’re looking for that kind of direction, I’m happy to help in that regard as well. But it’s also not a mortal money sin to employ some Solomonic wisdom and compromise between, say, two worthy savings initiatives—like short-term emergency reserves and long-term retirement savings. Therefore, while I can’t go so far as to suggest that you bag the idea of building up cash savings in lieu of a Roth, I’m comfortable with you splitting your forces and dipping into your Roth IRA in the case of a true emergency. The challenge we all face is to define “true emergency” without self-deception. (And no, splurging on concert tickets or a last minute vacation with friends don’t qualify.)
3) Roth contributions cost you less today than they will in the future.
Despite my sincerest attempt, I couldn’t avoid the more technical topic of taxes—and nor should I, in this case. That’s because it only stands to reason that you’re making less money—and therefore paying less in taxes—at the front end of your career than you will be in the future.
Therefore, in addition to beginning tax-free compounding sooner, Roth IRA contributions—which are not tax-deductible—will likely “cost you” less as a career newbie than they will as a seasoned executive. At SpaceX. On the first Mars colony. Furthermore, you can also make too much to contribute to a Roth IRA, progressively phasing out of eligibility at income of $118,000 for an individual and $186,000 for a household.
Like Coachella tickets, the opportunity to invest in a Roth IRA may not be around forever. Tax laws and retirement regulations are constantly evolving, and who knows what the future may hold. This increases their value for everyone, but especially for those who could benefit from them the most—Millennials.
This commentary originally appeared February 22 on Forbes.com
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Every year, the market provides us with some important lessons on prudent investment strategy. Many times, the market will offer investors remedial courses, covering lessons that it has already delivered in previous years. That’s why one of my favorite sayings is that there’s nothing new in investing—there’s only investment history you don’t yet know.
Last year gave us nine lessons. As you may note, many of them have appeared before. Unfortunately, many investors fail to learn from them. Rather, they keep repeating the same errors, which is what Albert Einstein called the definition of insanity. We’ll begin with my personal favorite, a lesson the market, if measured properly, teaches each and every year.
Lesson 1: Active Management Is a Loser’s Game
Despite an overwhelming amount of research that demonstrates passive investing is far more likely to allow you to achieve your financial goals, the vast majority of individual investor assets are still invested in active funds. And, unfortunately, investors in active funds continue to pay for their “triumph of hope over wisdom and experience.”
2016 was another year where the large majority of active funds underperformed, despite the great opportunity for active managers to generate alpha in the very large dispersion of returns between the best and worst performers.
For example, while the S&P 500 returned 12.0% for the year, there were 25 stocks in the index that returned at least 45.5%. Oneck Inc. (OKE) returned 132.8%, while Nvidia Corp. (NVDA) returned 223.9%. All an active manager had to do to outperform was to overweight these superperformers.
On the other side of the coin, there were 25 stocks in the index that lost at least 22.9%. Endo International (ENDP) lost 73.1% and First Solar (FSLR) lost 51.4%. To outperform, all an active manager had to do was to underweight, let alone avoid, these “dogs.”
It’s important to note that this wide dispersion of returns is not at all unusual. Yet despite the opportunity, year after year, in aggregate, active managers persistently fail to outperform. The table below shows the percentile rankings for funds from two leading providers of passively managed funds, Dimensional Fund Advisors (DFA) and Vanguard, for both 2016 and the 15-year period ending December 2016. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.)
Note that Morningstar’s data contains survivorship bias, as it only considers funds that have survived the full period. And the bias is significant, as about 7% of actively managed funds disappear every year and their returns are buried in the mutual fund graveyard. Thus, the longer the period, the worse the survivorship bias, and at 15 years, it’s quite large.
The results make clear that active management is a strategy we could call fraught with opportunity. Year after year, active managers come up with an excuse to explain why they failed that year and then assert that next year will be different. Of course, it never is.
The good news is that investors are waking up to the reality. In October, The Wall Street Journal reported that, according to Morningstar, “although 66% of mutual-fund and exchange-traded-fund assets are still actively invested … those numbers are down from 84% 10 years ago and are shrinking fast.”
Lesson 2: So Much of Returns Come in Very Short and Unpredictable Bursts
The road to investment “hell” is paved with market-timing efforts, because so much of the long-term returns provided by the market come in short, and totally unpredictable, bursts. Last year provided the following example. From January through October, the DFA Small Value Fund (DFSVX) returned 8.0%. From November through December, it returned 18.8%. For the full year, it returned 28.3%. Two-thirds of the full year’s return happened in the last two months.
These types of results are not at all unusual, For instance, the study “Black Swans and Market Timing: How Not To Generate Alpha,” which covered the 107-year period ending in 2006, found that the best 100 days (out of more than 29,000) accounted for virtually all (99.7%) of returns.
Here’s another example. There are 1,020 months in the 85-year period from 1926 through 2010. The best 85 months, an average of just one month a year (or just 8.3% of the months), provided an average return of 10.7%. The remaining 935 months (or 91.7% of the months) produced virtually no return (just 0.05%).
Peter Lynch offered the following example. He pointed out that an investor who followed a passive investment strategy and stayed fully invested in the S&P 500 over the 40-year period beginning in 1954 would have achieved an 11.4% rate of return.
If that investor missed just the best 10 months (2%), his return dropped 27%, to 8.3%. If the investor missed the best 20 months (4%), the return dropped 54%, to 6.1%. Finally, if the investor missed the best 40 months (8%), the return dropped 76%, all the way to 2.7%.
Do you really believe there is anyone who can pick the best 40 months in a 40-year period? Lynch put it this way: “Far more money has been lost by investors in preparing for corrections, or anticipating corrections, than has been lost in the corrections themselves.”
Despite this evidence, investors persist in market-timing efforts. Charles Ellis described the winning strategy in the following way: “Investors would do well to learn from deer hunters and fishermen who know the importance of ‘being there’ and using patient persistence—so they are there when opportunity knocks.”
Lesson 3: Events Occur That No One Predicted
Those who have spent their careers forecasting learn to be very humble about their predictions. The reason is that almost every year, major surprises occur. And by definition, surprises are unpredictable.
That is why, when I’m asked for a forecast, my response is that my crystal ball is always cloudy. That is also why my recommendation is to stop spending time listening to forecasts, which have no value and can cause you to stray from your well-thought-out plan. Instead, spend your time managing risk.
2016 saw at least two major unpredicted events that could have had major negative impacts on financial markets. Yet they did not. The first came in June when Great Britain voted for exiting the European Union—the so-called Brexit, which passed 52% to 48% with a referendum turnout of 72% and votes from more than 30 million people.
The other, of course, was the primary win by Donald Trump and then his election to the presidency. With both Brexit’s and Trump’s victories, the market’s immediate reaction was a dramatic self-off. And then a rapid recovery.
Lesson 4: Ignore All Forecasts; All Crystal Balls Are Cloudy
One of my favorite sayings about the market forecasts of so-called experts is from Jason Zweig, financial columnist for The Wall Street Journal: “Whenever some analyst seems to know what he’s talking about, remember that pigs will fly before he’ll ever release a full list of his past forecasts, including the bloopers.”
You’ll almost never read or hear a review of how the latest forecast from some market “guru” actually worked out. The reason is that accountability would ruin the game—you would cease to “tune in.”
But I believe forecasters should be held accountable. Thus, a favorite pastime of mine is keeping a collection of economic and market forecasts made by media-anointed gurus and then checking back periodically to see if they came to pass. This practice has taught me there are no expert economic and market forecasters.
Here’s a small sample from this year’s collection. I hope they teach you a lesson about ignoring all forecasts, including the ones that happen to agree with your own notions (that’s the deadly condition known as “confirmation bias” at work).
- In July 2015, Charles Robertson, Renaissance Capital’s global chief economist, predicted that U.S. stocks could crash 50% within the next 12 months.
- In January 2016, economists at the Royal Bank of Scotland warned that investors faced a “cataclysmic year” in which stock markets could fall by up to 20% and oil could drop to $16 a barrel. The advice was to “sell everything” except safe bonds.
- In May 2016, legendary investor Carl Icahn warned that “a day of reckoning” was coming for U.S. stock markets unless the federal government stimulated the economy with greater spending. He certainly was putting his money where his mouth was, as shortly before his prediction of a big crash, Icahn Enterprises had announced in SEC filings that it had a net short position of 149%.
- Also in May 2016, Savita Subramanian, Bank of America Merrill Lynch’s head of U.S. equity and quantitative strategy, appeared on BloombergTV to warn of a “vortex of negative headlines” (doesn’t that sound scary?) coming in the following month that could push the S&P 500 down to 1,850 (a level back near its February lows). The factors she cited to support this prediction were the then-upcoming Brexit vote, the June decision from the Federal Reserve and the U.S. election.
- Again in May 2016, John Hussman of Hussman Funds wrote: “Prevailing market conditions continue to hold the expected stock market return/risk profile in the most negative classification we identify. That profile reflects not only extreme valuations on the most reliable measures we’ve tested across history, but market internals and other features of market action that remain unfavorable. …. In any event, looking beyond the near-term horizon, I doubt that any shift in market action will meaningfully reduce the likelihood of a 40-55% loss in the S&P 500 over the completion of the current market cycle.”
- In August 2016, UBS warned of an imminent crash in the S&P 500. The bank predicted there would be a major correction within the next two months.
As poor as the preceding forecasts turned out to be, this one is my personal favorite: Just six weeks into 2016, Goldman Sachs announced that (whoops!) it had abandoned five of its six recommended “top trade” calls for the year, having gotten them wrong.
One might ask: If they got those wrong, why ever would we think they’ll get it right this time? Of course, Goldman Sachs was just as confident of its new trade calls as it was when it made its old forecasts. Overconfidence is an all-too-human trait.
To be fair, there were surely some forecasts that turned out right. The problem is that you can’t know ahead of time which ones to pay attention to and which ones to ignore. What my experience has taught me is that investors tend to pay attention to the forecasts that agree with their preconceived ideas (again, that pesky confirmation bias) while ignoring forecasts that disagree. Being aware of our biases can help us overcome them.
Lesson 5: Even With A Clear Crystal Ball …
Imagine you had a crystal ball that allowed you to foresee the economic and political events of 2016, but not stock prices. Surely that would be of great value in terms of investment decisions—or would it have been?
Would you have been a buyer of stocks if you knew that the first few weeks of 2016 would produce the worst start to a year since the Great Depression? The S&P 500 Index closed 2015 at 2,043. By Jan. 20, it had fallen to 1,859, a drop of just more than 9%.
Would you have been a buyer of stocks knowing that Great Britain would vote to exit the European Union, creating great uncertainty for the global economy and financial markets? Within three days, the S&P 500 Index fell from 2,113 at the close on June 23 to 2,001 on June 27, a drop of more than 5%.
Would you have been a buyer of stocks if you knew that, once again, the economic growth rate would disappoint, with growth failing to reach even a tepid 2%? Most of the world’s developed economies were basically stagnating, bordering on recession.
Finally, would you have been a buyer of stocks knowing that Donald Trump would win the presidential election? Be honest now, especially if you happen to lean Democrat. Within moments of his victory becoming clear, the DJIA fell more than 800 points and S&P futures had sunk more than 5%.
With the benefit of hindsight, we now know that, in each instance, the market recovered, and relatively quickly. The lesson here is that, even with a clear crystal ball (which no one has), it’s very difficult to predict stock markets. Thus, you shouldn’t try. It’s a loser’s game.
Lesson 6: Last Year’s Winners Are Just As Likely To Be This Year’s Dogs
The historical evidence demonstrates that individual investors are performance-chasers—they watch yesterday’s winners, then buy them (after the great performance), and watch yesterday’s losers, then sell them (after the loss has already been incurred).
This causes investors to buy high and sell low, which is not exactly a recipe for investment success. This behavior explains the findings from studies showing that investors actually underperform the very mutual funds in which they invest.
Unfortunately, a good (poor) return in one year doesn’t predict a good (poor) return the next year. In fact, great returns lower future expected returns, and below-average returns raise future expected returns. Thus, the prudent strategy for investors is to act like a postage stamp. The lowly postage stamp does only one thing, but it does it exceedingly well: It adheres to its letter until it reaches its destination.
Similarly, investors should adhere to their investment plan (asset allocation). Sticking with one’s plan doesn’t mean just buying and holding. It actually means buying, holding and rebalancing (the process of restoring your portfolio’s asset allocation to your investment plan’s targeted levels).
Using passive asset class funds from Dimensional Fund Advisors (DFA), the following table compares the returns of various asset classes in 2015 and 2016. (Full disclosure: My firm, Buckingham, recommends DFA funds in constructing client portfolios.) As you can see, sometimes the winners and losers of 2015 repeated their respective performances, but other times the winners became losers and the losers became winners. For example:
Lesson 7: “Sell in May and Go Away” Is the Financial Equivalent of Astrology
One of the more persistent investment myths is that the winning strategy is to sell stocks in May and wait to buy back into the market until November.
While it’s true that stocks have provided greater returns from November through April than they have from May through October, since 1926, an equity risk premium has still existed in those May-through-October months. From 1927 through 2015, the “Sell in May” strategy returned 8.3% per year, underperforming the S&P 500 by 1.7 percentage points per year. And that’s even before considering any transaction costs, let alone the impact of taxes (with the “Sell in May” strategy, you’d be converting what would otherwise be long-term capital gains into short-term capital gains, which are taxed at the same rate as ordinary income).
How did the “Sell in May and Go Away” strategy work in 2016? The S&P 500 Index’s total return for the period from May through October was 4.1%. Alternatively, during this same period safe, liquid investments would have produced virtually no return. In case you’re wondering, 2011 was the only year in the last eight when the “Sell in May” strategy would have worked.
A basic tenet of finance is that there’s a positive relationship between risk and expected return. To believe that stocks should produce lower returns than Treasury bills from May through October, you have to believe stocks are less risky during those months—a nonsensical argument. Unfortunately, as with many myths, this one seems hard to kill off. And you can bet that, next May, the financial media will be resurrecting it once again.
Lesson 8: Hedge Funds Are Not Investment Vehicles, They Are Compensation Schemes
This lesson has appeared about as regularly as our first lesson, which is that active management is a loser’s game. Hedge funds entered 2016 coming off their seventh-straight year of trailing U.S. stocks (as measured by the S&P 500 Index) by significant margins.
Unfortunately, the streak has continued into an eighth year, as the HFRX Global Hedge Fund Index returned just 2.5% in 2016, and underperformed the S&P 500 Index by 9.5 percentage points. The table below shows the returns for various equity and fixed income indexes.
As you can see, the hedge fund index underperformed the S&P 500 and eight of the 10 major equity asset classes, but managed to outperform all three of the bond indexes. An all-equity portfolio allocated 50% internationally and 50% domestically, and equally weighted in the asset classes within those broad categories, would have returned 11.0%, outperforming the HFRX index by 8.5 percentage points. A 60% equity and 40% bond portfolio with the same weights for the equity allocation would have returned 6.9% using one-year Treasurys, 7.6% using five-year Treasurys and 7.1% using long-term Treasurys.
Thus, each of these three portfolios would have outperformed the hedge fund index. Given that hedge funds tout their freedom to move across asset classes as their big advantage, one would think that it would have shown up. The problem is that the efficiency of the market, as well as the costs of the effort, turns that supposed advantage into a handicap.
The evidence is even worse over the long term. For the 10-year period from 2007 through 2016, the HFRX Global Hedge Fund Index lost 0.6% per year, underperforming every single equity and bond asset class. As you can see in the following table, hedge fund underperformance ranged from 0.4 percentage points when compared to the MSCI EAFE Value Index, to as much as 8.8 ercentage points when compared to U.S small-cap stocks.
Perhaps even more shocking is that, over this period, the only year the hedge fund index outperformed the S&P 500 was in 2008. Even worse, when compared to a balanced portfolio allocated 60% to the S&P 500 Index and 40% to the Barclays Government/Credit Bond Index, it underperformed every single year.
For the 10-year period, an all-equity portfolio allocated 50% internationally and 50% domestically, again equally weighted in the asset classes within those broad categories, would have returned 4.1% per year. A 60% equity and 40% bond portfolio with the same weights for the equity allocation would have returned 3.0% per year using one-year Treasurys, 4.1% per year using five-year Treasurys and 5.1% per year using long-term Treasurys. All three dramatically outperformed the hedge fund index.
The bottom line is that the evidence suggests investors are best served by thinking of hedge funds as compensation schemes, not investment vehicles
Lesson 9: Don’t Let Your Political Views Influence Your Investment Decisions
One of my more important roles as director of research for Buckingham Strategic Wealth is preventing investors from committing what I refer to as “portfolio suicide”—panicked selling that arises from fear, whatever the source of that fear may be. After the election of President Donald Trump, it seemed like the vast majority of times I was called in to help investors stay disciplined and adhere to their financial plans involved anxiety generated by politics.
We often make investment mistakes because we are unaware that our decisions are being influenced by our beliefs and biases. The first step to eliminating, or at least minimizing, errors is to become aware of how our choices are impacted by our views, and how those views can influence outcomes.
The 2012 study “Political Climate, Optimism, and Investment Decisions” showed that people’s optimism toward both the financial markets and the economy is dynamically influenced by their political affiliation and the existing political climate. Among the authors’ findings were:
- Individuals become more optimistic and perceive the markets to be less risky and more undervalued when their own party is in power. This leads them to take on more risk, and they overweight riskier stocks. They also trade less frequently. That’s a good thing, because the evidence demonstrates that the more individuals trade, the worse that they tend to do.
- When the opposite party is in power, individuals’ perceived uncertainty levels increase and investors exhibit stronger behavioral biases, leading to poor investment decisions.
Now, imagine the nervous investor who sold equities based on his views about, or expectations for, a Trump presidency. While those who stayed disciplined have benefited from the rally following the election, investors who panicked and sold not only missed the bull market, but now face the incredibly difficult task of figuring out when it will be once again safe to invest.
I know of many investors with Republican/conservative leanings who were underinvested after President Obama was elected. And now it’s investors with Democratic/liberal leanings who have to face their fears. The December Spectrem Affluent Investor and Millionaire Confidence Index surveys provide evidence of how political biases can impact investment decisions.
Prior to the election, respondents who identified as Democrats showed higher confidence levels than respondents who identified as Republicans or Independents. This completely flipped after the election. Democrat investors registered a confidence reading of -10, while Republican and Independent investors showed confidence readings of +9 and +15, respectively.
What’s important to understand is that if you lose confidence in your plan and sell, there’s never a green flag that will tell you when it’s safe to get back in. Thus, the strategy most likely to allow you to achieve your financial goals is to have a plan that anticipates there will be problems, and to not take more risk than you have the ability, willingness and need to assume. Furthermore, don’t pay attention to the news if doing so will cause your political beliefs to influence your investment decisions.
In conclusion, this year will surely provide investors with more lessons, many of which will be remedial courses. And the market will provide you with opportunities to make investment mistakes. You can avoid them by knowing your financial history and having a well-thought-out plan.
This commentary originally appeared January 27 on ETF.com
Larry Swedroe is the Director of Research for Buckingham Strategic Wealth. He has authored or co-authored more than a dozen books and is regularly published on ETF.com and Advisor Perspectives. He has made appearances on national television shows airing on NBC, CNBC, CNN and Bloomberg Personal Finance. Larry holds an MBA in finance and investment from New York University, and a bachelor’s degree in finance from Baruch College in New York.
If investors were asked, “Who do you think is the greatest investor of our generation?” I’d bet an overwhelming majority would answer, “Warren Buffett.” If they were then asked, “Do you think you should follow his advice?” you might think that they would say, “Yes!”
Swedroe: Active Funds Whiff Again
The year-end 2015 S&P Active Versus Passive (SPIVA) scorecard provides yet another example of why—at least when it comes to the overall results of active management relative to appropriate benchmarks—the past is in fact prologue. Following are some highlights from the recently released report:
- Last year, 66.1% of large-cap managers, 56.8% of midcap managers, 72.2% of small-cap managers and 61.9% of real estate investment trust managers underperformed the S&P 500, the S&P MidCap 400, the S&P SmallCap 600 and the S&P U.S. Real Estate Investment Trust index, respectively.
- Over the five-year period ending Dec. 31, 2015, 84.2% of large-cap managers, 76.7% of midcap managers, 90.1% of small-cap managers and 82.6% of real estate investment trust managers lagged their respective benchmarks.
- Over the 10-year investment horizon, again ending Dec. 31, 2015, 82.1% of large-cap managers, 87.6% of midcap managers, 88.4% of small-cap managers and 86.1% of real estate investment trust managers failed to outperform on a relative basis. In addition, less than 77% of active managers underperformed their benchmark in only one of the 18 asset class categories (large-cap value) that Standard & Poor’s examined.
- Over the 10-year period, on an equal-weighted basis, actively managed large-cap funds underperformed their benchmark by 0.9 percentage points, actively managed midcap funds underperformed by 1.4 percentage points, actively managed small-cap funds underperformed by 1.8 percentage points and actively managed real estate funds underperformed by 1.9 percentage points. On an asset-weighted basis, the underperformance was somewhat smaller, at 0.8 percentage points for large-cap managers, 0.8 percentage points for midcap managers, 1.3 percentage points for small-cap managers and 1.2 percentage points for real estate investment trust managers.
- For the one-, five- and 10-year periods, 59.5%, 79.0% and 80.4% of global equity fund managers underperformed their benchmarks. While the majority of international developed-market managers outperformed in 2015, over the five-year period, 55.4% underperformed, and over the 10-year period, 79.2% underperformed. Furthermore, the majority of international developed-market small-cap managers were able to outperform their benchmarks over the one- and five-year periods, but 62.5% failed to do so over the 10-year period.
- In emerging markets—a supposedly inefficient asset class where active managers purportedly have advantages—over the one-, five- and 10-year periods, 64.1%, 69.9% and 91.4% of active managers underperformed.
- Over the 10-year period, on an equal-weighted basis, active global equity fund managers underperformed by 0.8 percentage points, active international managers underperformed by 0.8 percentage points, active international small-cap managers outperformed by 0.2 percentage points and active emerging market managers underperformed by 1.6 percentage points. The figures were better for active funds on an asset-weighted basis, with global managers matching their benchmark, international funds underperforming by 0.1 percentage points, international small-cap managers outperforming by 0.6 percentage points and emerging market managers underperforming by 0.9 percentage points.
- Active bond funds didn’t perform any better. For example, over the 10-year period, 95.6% of active long-term government bond fund managers underperformed (doing so on an equal-weighted basis by 2.9 percentage points), 77.1% of active intermediate-term government bond fund managers underperformed (doing so on an equal-weighted basis by 0.3 percentage points), 77.1% of active short-term government bond fund managers underperformed (doing so on an equal-weighted basis by 0.3 percentage points) and 81.3% of active mortgage bond fund managers underperformed (doing so on an equal-weighted basis by 0.7 percentage points).
- While the high-yield bond market is often considered to be best accessed via active investing, the 10-year results show that more than 90% of actively managed high-yield bond funds underperformed their broad-based benchmark. On an equal-weighted basis, the underperformance was 1.4 percentage points (7.0% versus 5.6%).
- Funds continue to disappear at an alarming rate. For example, over the past 10-year period, 40% of domestic and global equity funds, and 37% of international developed market equity funds, were merged or liquidated—highlighting the importance of addressing survivorship bias in mutual fund analysis.
While the above data is compelling evidence on the failure of the active management industry to generate alpha, it’s important to note that all of the above figures are based on pretax returns. Given that the higher turnover of actively managed funds generally makes them less tax efficient, on an after-tax basis, the failure rates would likely be much higher (taxes are often the highest expense for actively managed funds).
The SPIVA scorecards certainly do provide us with valuable information, but there is no longer any suspense in reading them. As Yogi Berra famously said, “It’s deja vu all over again.”