We have more evidence that that Active Managers are unable to deliver results that are greater than the index against which they compare their performance. The Wall Street Journal weekend edition (August 22-23, 2009) referenced a study by Standard and Poor’s which indicates that index returns beat actively managed fund returns in all 13 fixed income categories over one and three years and in 11 of 13 categories over five years.
This is a bit surprising. Given the nature of bond investments, one might expect bond fund managers would be able to at least deliver the index. Frankly, they could do that if they did nothing. Instead their efforts to generate results greater than the index actually backfired.
The result is not just performance below the index. After management expenses, the results are ever worse. The average internal fund expense for a bond fund is 1.1% according to Lipper. So, the average actively managed bond underperformed the index by this additional amount.
Investors are wise to use no load passively managed funds for the fixed income portion of their portfolios. Another option would be to use individual bonds. However, for most investors, this will not provide sufficient diversification.
Sunday, August 23, 2009
Thursday, July 30, 2009
Fed Chairman Recommends Diversification
Federal Reserve Chairman Ben Bernanke recently held a town forum with local citizens in Kansas City, Mo. The event was moderated by PBS NewsHour anchor Jim Lehrer. While I have not seen the entire interview, I have read excerpts of the program in The Wall Street Journal.
When asked about investment advice, Bernanke recommended that the questioner practice diversification and avoid trying to time the stock market. Bernanke is arguably the most powerful person in the global economy. He is highly educated and well trained. His comments should serve to reassure investors that the basic principles of investment management have not gone out of style.
What are the keys to successful investing?
• Allocate across a broad range of asset classes
• Diversify within asset classes
• Use passive investment vehicles such as no load mutual funds and ETFs
• Keep your investment costs low
• Do not attempt to time the market
• Do not attempt to buy the next hot investment
• Rebalance no more often than annually
• Do not actively manage your portfolio
• Manage your emotions
We call this “Intelligent Investing.” Wall Street would prefer that you ignore these principles and instead spend your money chasing investment returns. Ignore Wall Street and listen to Chairman Bernanke.
When asked about investment advice, Bernanke recommended that the questioner practice diversification and avoid trying to time the stock market. Bernanke is arguably the most powerful person in the global economy. He is highly educated and well trained. His comments should serve to reassure investors that the basic principles of investment management have not gone out of style.
What are the keys to successful investing?
• Allocate across a broad range of asset classes
• Diversify within asset classes
• Use passive investment vehicles such as no load mutual funds and ETFs
• Keep your investment costs low
• Do not attempt to time the market
• Do not attempt to buy the next hot investment
• Rebalance no more often than annually
• Do not actively manage your portfolio
• Manage your emotions
We call this “Intelligent Investing.” Wall Street would prefer that you ignore these principles and instead spend your money chasing investment returns. Ignore Wall Street and listen to Chairman Bernanke.
Monday, July 27, 2009
Index Funds in 401(k) Plans
I recently reviewed a client’s 401(k) account. He works for local technology company. The 401(k) plan is administered by a major insurance company. It offers proprietary funds from the insurance company and a number of actively managed funds. There are no passive funds available to participants.
I encouraged my client to contact the human resources department and express an interest in adding index funds to the menu of options. I explained that passively managed index funds capture the returns of the market (minus internal expenses). Actively managed funds are more expensive and routinely fail to beat their comparable index.
The Wall Street Journal ran an article recently indicating that employers are increasingly offering index funds inside their company 401(k) plans. Currently 90% of the $1.5 trillion in 401(k) and other defined contribution assets in mutual funds are invested in actively managed offerings. The article noted that fund companies prefer actively managed funds because they produce fees that are higher than index funds.
The 401(k) industry is in need of reform. Documents provided to plan participants fail to properly disclose expenses. These expenses drag down the performance realized by plan participants. The federal government is currently considering revising the laws surrounding 401(k) plans. Let’s hope our lawmakers have the fortitude to resist pressure from the major financial institutions to preserve the status quo.
I encouraged my client to contact the human resources department and express an interest in adding index funds to the menu of options. I explained that passively managed index funds capture the returns of the market (minus internal expenses). Actively managed funds are more expensive and routinely fail to beat their comparable index.
The Wall Street Journal ran an article recently indicating that employers are increasingly offering index funds inside their company 401(k) plans. Currently 90% of the $1.5 trillion in 401(k) and other defined contribution assets in mutual funds are invested in actively managed offerings. The article noted that fund companies prefer actively managed funds because they produce fees that are higher than index funds.
The 401(k) industry is in need of reform. Documents provided to plan participants fail to properly disclose expenses. These expenses drag down the performance realized by plan participants. The federal government is currently considering revising the laws surrounding 401(k) plans. Let’s hope our lawmakers have the fortitude to resist pressure from the major financial institutions to preserve the status quo.
Sunday, July 12, 2009
Active Managers: Skill or Luck?
Ever felt lucky? Perhaps you won a game of bingo at your church one Saturday evening. Maybe you won the drawing at the local Rotary meeting. Did you ever come back from a trip to Las Vegas with more in your wallet than you when you left?
Whenever you have felt lucky, did it occur to you that the outcome was totally beyond your control? Unless you were able to rig the results, you won because of the laws of chance. These laws suggest that results of such situations are distributed in a random manner.
Those on Wall Street would have us believe that certain money managers are able through the application of knowledge, skills and experience to achieve investment performance that is better than average. They point to notable figures like Peter Lynch who ran the Magellan Fund at Fidelity from 1977 to 1990 and who reportedly beat the Standard & Poor’s 500 index benchmark in 11 of those 13 years. Bill Miller, Portfolio Manager for the Legg Mason Value Trust mutual fund, beat the same benchmark for 15 consecutive years from 1991 through 2005.
I am not particularly persuaded by the suggestion that Peter Lynch or Bill Miller or any other money manager is somehow better than all the other mangers in the investment community. I am more inclined to believe that some managers were able to outperform the market, because the laws of chance tell us that in the universe of thousands of managers a few will.
Some will disagree and believe that some fund managers are more gifted than others. They are faced with another problem. How do you identify these managers before they put together their streaks of outperformance? I liken this to entering The Rose Garden in Portland. You walk to center court. Every seat in the facility (19,980 to be precise) is filled with a money manager. We can expect that the average performance of these managers will be that of the stock market, because this population is large enough to represent the market itself. However, we know that that some of the managers sitting in the stands will turn in performance that is better than the average. The question is who? If you are an investor you have to place your money with the managers you believe will beat the market before they actually do so.
I agree with Russell Wermers, Finance Professor at the University of Maryland who said, “[It is] exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone … By definition, therefore, such a fund could not have been identified in advance.”
Given that most fund managers do not beat the market, why would anyone gamble their financial future by investing with managers who they hope will beat the market in the future?
Whenever you have felt lucky, did it occur to you that the outcome was totally beyond your control? Unless you were able to rig the results, you won because of the laws of chance. These laws suggest that results of such situations are distributed in a random manner.
Those on Wall Street would have us believe that certain money managers are able through the application of knowledge, skills and experience to achieve investment performance that is better than average. They point to notable figures like Peter Lynch who ran the Magellan Fund at Fidelity from 1977 to 1990 and who reportedly beat the Standard & Poor’s 500 index benchmark in 11 of those 13 years. Bill Miller, Portfolio Manager for the Legg Mason Value Trust mutual fund, beat the same benchmark for 15 consecutive years from 1991 through 2005.
I am not particularly persuaded by the suggestion that Peter Lynch or Bill Miller or any other money manager is somehow better than all the other mangers in the investment community. I am more inclined to believe that some managers were able to outperform the market, because the laws of chance tell us that in the universe of thousands of managers a few will.
Some will disagree and believe that some fund managers are more gifted than others. They are faced with another problem. How do you identify these managers before they put together their streaks of outperformance? I liken this to entering The Rose Garden in Portland. You walk to center court. Every seat in the facility (19,980 to be precise) is filled with a money manager. We can expect that the average performance of these managers will be that of the stock market, because this population is large enough to represent the market itself. However, we know that that some of the managers sitting in the stands will turn in performance that is better than the average. The question is who? If you are an investor you have to place your money with the managers you believe will beat the market before they actually do so.
I agree with Russell Wermers, Finance Professor at the University of Maryland who said, “[It is] exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone … By definition, therefore, such a fund could not have been identified in advance.”
Given that most fund managers do not beat the market, why would anyone gamble their financial future by investing with managers who they hope will beat the market in the future?
Saturday, June 27, 2009
Institutional Investors go Passive
A few days ago (June 22, 2009) The Wall Street Journal ran an article (“Active Managers Get the Cold Shoulder”) that indicated that large, institutional investors are moving away from active managers.
In a bear market, active managers are supposed to protect investors from losses. However, a growing body of data indicates that these managers have not been able to provide this shelter. The executive director of the Illinois State Board of Investment noted, “Active managers have not given us the added performance in a down market that we had hoped for.” The board recently moved $400 million from some large and small cap stock managers to index funds.
There is $2.3 trillion in public pension plans. A large and growing portion of these funds are passively managed. These funds are able to hire very bright investment talent. The movement towards passive management is a very strong indicator that active management simply fails to deliver consistent long term returns that are greater than the unmanaged market delivers.
You don’t have to be an institutional investor to invest passively. CWM offers low cost passive investment management to the retail investor. We call it “Intelligent Investing” and we encourage you to explore it.
In a bear market, active managers are supposed to protect investors from losses. However, a growing body of data indicates that these managers have not been able to provide this shelter. The executive director of the Illinois State Board of Investment noted, “Active managers have not given us the added performance in a down market that we had hoped for.” The board recently moved $400 million from some large and small cap stock managers to index funds.
There is $2.3 trillion in public pension plans. A large and growing portion of these funds are passively managed. These funds are able to hire very bright investment talent. The movement towards passive management is a very strong indicator that active management simply fails to deliver consistent long term returns that are greater than the unmanaged market delivers.
You don’t have to be an institutional investor to invest passively. CWM offers low cost passive investment management to the retail investor. We call it “Intelligent Investing” and we encourage you to explore it.
Thursday, June 11, 2009
Fat Tail Distributions
I received an email newsletter today from a vendor that sells financial planning software to advisory firms like Cascade Wealth. This particular company is Money Tree Software and it is located in Corvallis, Oregon. While we are not currently using their software, I have in the past.
This email caught my attention, because it mentioned Monte Carlo Analysis. You may recall from one of my prior blog postings, this is the methodology used to test the probability of outcomes. Financial Planners often use Monte Carlo simulations to determine how likely clients are to reach their financial objectives.
The recent stock market crash has caused some advisors to question the reliability of traditional Monte Carlo Analysis. The problem is that these projections rarely show major market declines. The reality, as well all know, is that dramatic market drops are not only possible, but they actually occur. We have witnessed two of these periods in the last decade alone in the tech crash in the early 2000’s and the financial sector meltdown in 2008.
Money Tree plans to enhance its software by incorporating wider distribution patterns in their Monte Carlo simulations. This means that events considered statistically very unlikely to occur will be included in their simulations. If you have ever taken a statistics class, you may remember that a normal distribution curve looks like the graph below. It displays the outcomes that occur when the pattern of distributions is symmetrical with a single, central peak at the mean (or average) of the data. Half of the outcomes fall on each side of the mean.
The spread or dispersion of the outcomes is dictated by the standard deviation. In the graph below of a normal distribution, we can expect that 68.2% of the events will fall between -1 and 1. Only 1.5% of events will fall below at -2.5 or lower.
What would this graph look like if we assumed that more outcomes occurred towards the ends of the graph and fewer near the middle or mean? The tails would become thicker. The midrange would become thinner. This is sometimes described as a “Fat Tailed” distribution.
By giving greater statistical weight to the possibility that market returns could fall outside the traditional range, Money Tree’s software will reduce the probability that a given client scenario will succeed. This should motivate the planner and the client to make more conservative assumptions.
This email caught my attention, because it mentioned Monte Carlo Analysis. You may recall from one of my prior blog postings, this is the methodology used to test the probability of outcomes. Financial Planners often use Monte Carlo simulations to determine how likely clients are to reach their financial objectives.
The recent stock market crash has caused some advisors to question the reliability of traditional Monte Carlo Analysis. The problem is that these projections rarely show major market declines. The reality, as well all know, is that dramatic market drops are not only possible, but they actually occur. We have witnessed two of these periods in the last decade alone in the tech crash in the early 2000’s and the financial sector meltdown in 2008.
Money Tree plans to enhance its software by incorporating wider distribution patterns in their Monte Carlo simulations. This means that events considered statistically very unlikely to occur will be included in their simulations. If you have ever taken a statistics class, you may remember that a normal distribution curve looks like the graph below. It displays the outcomes that occur when the pattern of distributions is symmetrical with a single, central peak at the mean (or average) of the data. Half of the outcomes fall on each side of the mean.
The spread or dispersion of the outcomes is dictated by the standard deviation. In the graph below of a normal distribution, we can expect that 68.2% of the events will fall between -1 and 1. Only 1.5% of events will fall below at -2.5 or lower.
What would this graph look like if we assumed that more outcomes occurred towards the ends of the graph and fewer near the middle or mean? The tails would become thicker. The midrange would become thinner. This is sometimes described as a “Fat Tailed” distribution.By giving greater statistical weight to the possibility that market returns could fall outside the traditional range, Money Tree’s software will reduce the probability that a given client scenario will succeed. This should motivate the planner and the client to make more conservative assumptions.
Thursday, June 4, 2009
Going Passive in Europe
If you hold a position on a subject that places you in the minority, it’s pretty nice when someone of substance enters the dialogue and supports your view. After investing hundreds of hours researching investment management, I am convinced that you, the investor, are best served by deploying your hard earned money in a low cost, passively managed portfolio. Unfortunately, the overwhelming majority of investment advisors would have you invest in an actively managed portfolio in attempt to capture returns that are greater than those of the broader markets.
This week in The Wall Street Journal, I came across an article that caught my attention, “In Europe, Are ‘Active’ Managers Worth It?” (June 3, 2009). Apparently European pension funds are questioning whether the performance they have experienced warrants the fees they pay firms to manage their assets. The Norwegian government recently dropped 16 of the 22 firms that managed its fixed income funds. Most of these firms practice active management and they all suffered substantial losses last year.
The governments of Italy, Holland, and Sweden have also shifted away from active management of their pensions. These countries are reducing fees and seeking better performance by shifting investments to passively managed funds. In the U.S., the California Public Employee Retirement System, one of the largest pensions in the world, has historically relied on passive investing in its publicly traded equity portfolio.
Those who advocate active management claim the strategy will minimize losses in a down market. However, as performance data become available, the record is showing that this did not happen during the recent stock market crash.
These massive pension funds are run by some of the smartest people in the global investment community. Their decisions to move away from active management serve to validate passive management.
If your portfolio is not currently passively managed, perhaps it’s time consider a change.
This week in The Wall Street Journal, I came across an article that caught my attention, “In Europe, Are ‘Active’ Managers Worth It?” (June 3, 2009). Apparently European pension funds are questioning whether the performance they have experienced warrants the fees they pay firms to manage their assets. The Norwegian government recently dropped 16 of the 22 firms that managed its fixed income funds. Most of these firms practice active management and they all suffered substantial losses last year.
The governments of Italy, Holland, and Sweden have also shifted away from active management of their pensions. These countries are reducing fees and seeking better performance by shifting investments to passively managed funds. In the U.S., the California Public Employee Retirement System, one of the largest pensions in the world, has historically relied on passive investing in its publicly traded equity portfolio.
Those who advocate active management claim the strategy will minimize losses in a down market. However, as performance data become available, the record is showing that this did not happen during the recent stock market crash.
These massive pension funds are run by some of the smartest people in the global investment community. Their decisions to move away from active management serve to validate passive management.
If your portfolio is not currently passively managed, perhaps it’s time consider a change.
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