For many investors, the active versus passive debate is the most contentious issue. We will present the evidence and hope you are convinced to follow our recommendation. However, the rest of the advice in this book applies regardless of which strategy you use to implement your investment plan.
There are two theories about investing. The conventional wisdom is that markets are inefficient. Smart people, through diligent efforts, can uncover which stocks the market has under or overvalued. This is called the art of stock selection. Smart people can also time the market, getting in ahead of the bull emerging into the arena and out ahead of the bear emerging from hibernation. This is called the art of market timing. Together, stock selection and market timing make up the art of active management.
The other theory is that markets are efficient, that the price of a security is the best estimate of the correct price: otherwise, the market would clear at a different price. If markets are efficient, and accounting for the expense of the effort, attempts to outperform it are highly unlikely to prove productive.
The debate about which strategy is the one most likely to produce the best results is the financial equivalent of the "Tastes great! Less filling!" debate. Like that debate, it is unlikely to end. While it rages, we can examine the evidence from academic studies, allowing you to make an informed decision on which strategy to adopt.
If the markets are inefficient, we should see evidence of the persistent ability to outperform appropriate risk-adjusted benchmarks. And that persistence should be greater than randomly expected. We can test which theory the historical evidence supports by reviewing the literature on the performance of mutual funds, pension plans, and individual investors. The evidence on hedge funds and private equity was covered in Chapter 6.
Mark Carhart's 1997 study, "On Persistence in Mutual-fund Performance," analyzed the performance of 1,892 mutual funds for the period 1961–93. The following is a summary of his findings:
The average actively managed fund underperformed its appropriate passive benchmark on a pretax basis by about 1.8 percent per annum.
There is no persistence in performance beyond that which would be randomly expected. Past performance of active managers is a very poor predictor of their future performance.[10]
Russ Wermers found even worse results in his 2000 study, "Mutual-fund performance: An Empirical Decomposition into Stock-Picking Talent, Style, Transaction Costs, and Expenses." The study covered the twenty-year period from 1975–94 and included a universe of 1,788 funds in existence during the period. He found the average underperformance on a risk-adjusted basis was 2.2 percent per annum.[11]
If anyone could beat the market, it should be the pension plans of U.S. companies. First, pension plans control large sums of money. They have access to the best and brightest portfolio managers, each clamoring to manage the billions of dollars in these plans (and earn large fees). Pension plans can also invest with managers most individuals don't have access to, having insufficient assets to meet the minimums of these superstar managers.
Second, these pension plans hire managers with track records of outperforming their benchmarks, or at least matching them. They never hire managers with records of underperformance.
Third, they hire managers who make wonderful presentations, explaining in great detail and with polished PowerPoints why they have succeeded and will continue to succeed.
Fourth, many, if not the majority, of these pension plans hire professional consultants (Frank Russell, SEI, and Goldman Sachs) to help them perform due diligence in interviewing, screening, and ultimately selecting the very best of the best. Frank Russell has boasted they have over seventy analysts performing over two thousand interviews a year. You can be sure these consultants have thought of every conceivable screen to find the best fund managers. They considered performance records, management tenure, depth of staff, consistency of performance (to ensure a long-term record is not the result of one or two lucky years), performance in bear markets, consistency of implementation of strategy, turnover, and costs. It is unlikely there is something you or your financial adviser would think of that they had not already considered.
Fifth, as individuals, it is rare that we would have the luxury of personally interviewing money managers and performing as thorough a due diligence. And we generally don't have professionals helping us avoid mistakes in the process.
With those five key points in mind, we examine the evidence.
There are two major studies on the performance of pension plans. The first is Rob Bauer, Rik Frehen, Hurber Lum, and Roger Otten's 2007 study, "The Performance of U.S. Pension Plans." The study covered 716 defined benefit plans (1992–2004) and 238 defined contribution plans (1997–2004). The authors found that returns relative to benchmarks were close to zero and that there was no persistence in pension-plan performance. Importantly, they also found that neither fund size, degree of outsourcing, nor company stock holdings were factors driving performance. This finding refutes the claim that large pension plans are handicapped by their size. Small plans did no better. The authors concluded: "The striking similarities in performance patterns over time makes skill differences highly unlikely."[12]
The second study, Amit Goyal and Sunil Wahal's 2008 "The Selection and Termination of Investment Management Firms by Plan Sponsors," appearing in the Journal of Finance,[13] examined the selection and termination of investment management firms by plan sponsors: public and corporate pension plans, unions, foundations, and endowments. The study covered the hiring and firing decisions of 3,700 plan sponsors from 1994 to 2003, finding:
Plan sponsors hire investment managers with large positive excess returns up to three years prior to hiring.
The return chasing behavior does not deliver positive excess returns thereafter.
Post-hiring excess returns are indistinguishable from zero.
If plan sponsors had stayed with the fired investment managers, their returns would have been larger than those actually delivered by the newly hired managers.
These results did not include any trading costs that would have accompanied transitioning a portfolio from one manager's holdings to the holdings preferred by the new manager. In other words, all the activity was counterproductive.
Brad Barber, professor of finance at the University of California, Davis, and Terrance Odean, associate professor of finance at the University of California, Berkeley, have done a series of studies on the performance of individual investors, concluding they aren't as bad at stock picking as many people think. They are worse. Their findings:
The stocks that individual investors buy trail the overall market, and the stocks that they sell beat the market after the sale. This result did not even consider transactions costs or tax implications of an active trading strategy.[14]
The more investors traded, the worse the results. Those trading the most underperform a market index by over 5 percent per annum. On a risk-adjusted basis the underperformance increases to 10 percent per annum.[15]
Proving more heads are not better than one, investment clubs trailed a broad market index by almost 4 percent per annum, and by more than that on a risk-adjusted basis.[16]
While it is easy to identify money managers with great performance after the fact, as we have seen, there is no evidence of the ability to do this before the fact.
The efficient markets hypothesis (EMH) tells us that lack of persistence should be expected: It is only by random good luck that a fund is able to persistently outperform after the expenses of its efforts. There is also a practical reason for the lack of persistence: Successful active management sows the seeds of its own destruction.
Jonathan Berk, a professor at the University of California, Berkeley, suggested the following thought process:
Who gets money to manage? Well, since investors know who the skilled managers are, money will flow to the best manager first. Eventually, this manager will receive so much money that it will impact his ability to generate superior returns and his expected return will be driven down to the second-best manager's expected return. At that point, investors will be indifferent to investing with either manager and so funds will flow to both managers until their expected returns are driven down to the third-best manager. This process will continue until the expected return of investing with any manager is the benchmark expected return: the return investors can expect to receive by investing in a passive strategy of similar riskiness. At that point, investors are indifferent between investing with active managers or just indexing, and an equilibrium is achieved.[17]
Berk pointed out that the manager with the most skill ends up with the most money, adding: "When capital is supplied competitively by investors but ability is scarce only participants with the skill in short supply can earn economic rents. Investors who choose to invest with active managers cannot expect to receive positive excess returns on a risk-adjusted basis. If they did, there would be an excess supply of capital to those managers."[18]
This is an important insight. Just as the EMH explains why investors cannot use publicly available information to beat the market (because all investors have access to that information, and it is, therefore, already imbedded in prices), the same is true of active managers. Investors should not expect to outperform the market by using publicly available information to select active managers. Any excess return will go to the active manager, in the form of higher expenses.
The process is simple. Investors observe benchmark-beating performance and funds flow into the top performers. The investment inflow eliminates return persistence because fund managers face diminishing returns to scale.
Edelen, Evans, and Kadlec's 2007 study "Scale Effects in Mutual Fund Performance: The Role of Trading Costs," provides evidence supporting Berk's theory. The authors examined the role of trading costs as a source of diseconomies of scale for mutual funds. They studied the annual trading costs for 1,706 U.S. equity funds during the period 1995–2005, finding:
Trading costs for mutual funds are on average greater in magnitude than the expense ratio.
The variation in returns is related to fund trade size.
Annual trading costs bear a statistically significant negative relation to performance.
Trading has an increasingly detrimental impact on performance as a fund's relative trade size increases.
Trading fails to recover its costs: $1 in trading costs reduced fund assets by $0.41. While trading does not adversely impact performance at funds with a relatively small average trade size, trading costs decrease fund assets by roughly $0.80 for relatively large trade size funds.
Flow-driven trades are shown to be significantly more costly than discretionary trades. Flow-driven trades are those created by investors' additions to and withdrawals from a fund. This nondiscretionary trade motive partially—but not fully—explains the negative impact of trading on performance.
Relative trade size subsumes fund size in regressions of fund returns. Thus, trading costs are likely to be the primary source of diseconomies of scale for funds.
The authors concluded: "Our evidence directly establishes scale effects in trading as a source of diminishing returns to scale from active management."[19]
There is another reason why successful active management sows the seeds of its own destruction. As a fund's assets increase, either trading costs will rise, or the fund will have to diversify across more securities to limit those costs. However, the more a fund diversifies, the more it looks and performs like its benchmark index. It becomes what is known as a closet index fund. If it chooses this alternative, its higher total costs have to be spread across a smaller amount of differentiated holdings, increasing the hurdle of outperformance.
For example, let's assume an active fund has an expense ratio of 1.2 percent, its benchmark index fund an expense ratio of 0.2 percent, and 90 percent of the active funds holdings are the same as those of the index fund. Those 90 percent of assets cannot outperform the index. Thus, the 10 percent of the active fund's assets that are different from the index fund must do all the heavy lifting to overcome the cost differential for 100 percent of assets. This is a very tall order, indeed.
There is another reason why it is so difficult to persistently beat the market without taking more risk: The underlying basis for most stock market forecasts is an economic forecast. Do these forecasts have any value?
In 1985 William Sherden, preparing testimony as an expert witness, analyzed the track records of inflation projections by different economic forecasting methods. He compared those forecasts to the "naive" forecast: projecting today's inflation rate into the future. To his surprise (since he was a so-called expert), he found the naive forecast to be the most accurate. That led Sherden to review economic forecasts made during the period 1970–95. One finding was that economists could not predict the important turning points in the economy. Of forty-eight predictions, forty-six missed the turning points in the economy. He also found that even economists who directly or indirectly can influence the economy—the Federal Reserve, the Council of Economic Advisers, and the Congressional Budget Office—had forecasting records worse than pure chance. He concluded there are no economic forecasters who consistently lead the pack in forecasting accuracy. Even consensus forecasts did not improve accuracy.
Sherden also studied the performance of seven forecasting professions: investment experts, meteorology, technology assessment, demography, futurology, organizational planning, and economics. While none of the experts were very expert, the folks most often joked about (meteorologists) had the best predictive powers. Sherden also made this important observation:
Despite recent innovations in information technology and decades of academic research, successful stock market prediction has remained an elusive goal. In fact, the market is getting more complex and unpredictable as global trading brings in many new investors from numerous countries, computerized exchanges speed up transactions, and investors think up clever schemes to try to beat the market. Overall, we have not made progress in predicting the stock market, but this has not stopped the investment business from continuing the quest, and making $100 billion annually doing so.
Sherden used his research to write his book The Fortune Sellers.[20]
Even professional economic forecasters have acknowledged the difficult hurdles economists face. Consider this admission from Michael Evans, the founder of Chase Econometrics: "The problem with macro [economic] forecasting is that no one can do it."[21] And this is from the head of a firm that sells economic forecasts.
There is one last example you should consider: just how difficult a task it is to outperform the collective wisdom of the market.
In May 1999, at a conference of financial economists at UCLA's Anderson School of Business, Bradford Cornell used Intel Corporation in a case study that provides insights into the value of security analysts. As you will see, because much of the value of companies with high growth rates comes from distant cash flows, the value of their stock is highly sensitive to the size of the equity risk premium (ERP): the risk premium above the rate on riskless Treasury instruments investors demand for accepting the risks of equity ownership. In 1999, Intel was certainly considered a company with expectations for a high rate of growth.
Intel had accumulated over $10 billion in cash. The Board of Directors was trying to determine if it made sense to use a substantial portion of the cash to repurchase its stock. At the time, the stock was trading at about $120 per share. Based on publicly available forecasts of future cash flows, Cornell demonstrated that if the ERP were 3 percent, Intel's stock would be worth $204. If the ERP were 5 percent, the stock would be worth $130 (about the current price). And if the ERP were 7.2 percent, the stock would be worth just $82.
With such a wide range of estimated values, what should the board do? If the stock was worth $204, they should begin an aggressive repurchase program. If it was worth $82, they should take advantage of the current "overvaluation" and raise capital by issuing more shares.
The board was faced with two problems. The first was that the valuations assumed that cash-flow projections were known. Not even the board, let alone some security analyst, can see the future with such clarity. In the real world, we can only estimate future cash flows. The second problem: Why would the board believe it could predict the ERP better than the market could?
If corporate insiders have such great difficulty in determining a "correct" valuation, even with greater access to information than any security analyst, it is easy to understand why the results of active management are so poor and inconsistent.
One of the fundamental tenets of the EMH is that in a competitive financial environment successful trading strategies self-destruct by being self-limiting. When discovered, they are eliminated by the very act of exploiting the strategy. Economics professors Dwight Lee and James Verbrugge of the University of Georgia explain the power of the efficient markets theory in the following manner:
The efficient markets theory is practically alone among theories in that it becomes more powerful when people discover serious inconsistencies between it and the real world. If a clear efficient market anomaly is discovered, the behavior (or lack of behavior) that gives rise to it will tend to be eliminated by competition among investors for higher returns.... If stock prices are found to follow predictable seasonal patterns this knowledge will elicit responses that have the effect of eliminating the very patterns that they were designed to exploit. The implication is striking. The more empirical flaws that are discovered in the efficient markets theory the more robust the theory becomes.... Those who do the most to ensure that the efficient market theory remains fundamental to our understanding of financial economics are not its intellectual defenders, but those mounting the most serious empirical assault against it.[22]
In summary, while the markets may not be perfectly efficient, the prudent investment strategy is to behave as if they were.
This evidence convinced us that the winning strategy is to adopt a passive investment strategy. It convinced the American Law Institute, as well.
In May 1992, the American Law Institute rewrote the Prudent Investor Rule. Here is some of what the institute had to say in doing so:
The restatement's objective is to liberate expert trustees to pursue challenging, rewarding, non-traditional strategies and to provide other trustees with clear guidance to safe harbors that are practical and expectedly rewarding.
Investing in index funds is a passive but practical investment alternative.
Risk may be reduced by mixing risky assets with essentially riskless assets, rather than creating an entirely low-risk portfolio.
Active strategies entail investigation and expenses that increase transaction costs, including capital gains taxation. Proceeding with such a program involves judgments by the trustee that gains from the course of action in question can reasonably be expected to compensate for additional cost and risks, and the course of action to be undertaken is reasonable in terms of its economic rationale.
The American Law Institute recognized both the significance and efficacy of modern portfolio theory (MPT) and that active management delivers inconsistent and poor results. The institute had the following to say about market efficiency:
Economic evidence shows that the major capital markets of this country are highly efficient, in the sense available information is rapidly digested and reflected in market prices.
Fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to "beat the market" ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs.
Empirical research supporting the theory of efficient markets reveals that in such markets, skilled professionals have rarely been able to identify underpriced securities with any regularity.
Evidence shows little correlation between fund managers' earlier successes and their ability to produce above-market returns in subsequent periods.
The Uniform Prudent Investor Act is currently the law in the vast majority of states. It sets forth standards that govern the investment activities of trustees. And it adopts MPT as the standard by which fiduciaries invest funds.
The goal of a passive-investment strategy is to capture the returns of markets. The use of passive investment vehicles will provide you with the following benefits:
Broad diversification within each asset class. Passively managed funds will typically own far more securities than similar (the same asset class) actively managed ones. This serves to eliminate, or at least minimize, unsystematic risk: risk for which investors are not compensated because it can be diversified away.
Low fund expense ratios. Passively managed funds typically have much lower expense ratios than actively managed ones.
Low turnover. This provides two benefits. First, the fund will experience lower trading costs, both from the bid/offer spread incurred when trading and also from what is known as market impact costs. Market impact occurs when a mutual fund or other investor wants to buy or sell a large block of stock. The fund's purchases or sales will cause the stock to move beyond its current bid (lower) or offer (higher) price, increasing the cost of trading. While you don't receive a bill for these expenses, they do lower returns. Second, for taxable accounts, there is the burden of capital gains taxes created by turnover. Lower turnover translates into greater tax efficiency.
Control over the portfolio's asset allocation. The charters of most actively managed mutual funds give their portfolio managers the discretionary freedom to shift their allocations between asset classes. This can cause investors to both lose control of their asset allocation decisions and take unintended risks by unknowingly investing in markets, or types of instruments, they wanted to avoid.
Wall Street needs and wants you to play the game of active investing. They know your odds of outperforming appropriate benchmarks are so low that it is not in your interest to play. They need you to play so that they (not you) make the most money. They make it by charging high fees for active management that persistently delivers poor performance. The financial media also want and need you to play so that you "tune in." That is how they (not you) make money.
If you are not yet convinced, consider the following admission by Steve Galbraith. Galbraith teaches security analysis at Columbia University in its M.B.A. program. He is a limited partner at Maverick Capital and the former Chief U.S. Investment Strategist at Morgan Stanley. He also co-authored Morgan Stanley's US Economic Perspectives. In March 2002, Galbraith invited John Bogle, the founder and former chairman of the Vanguard Group and a strong advocate of passive investing, to speak to his class.
In a letter to investors in the April 3, 2002, issue, Galbraith related the following about Bogle's presentation.
"He laid out the case against active management and for indexing quite powerfully. My guess is that more than a few students left the class wondering just what the heck their hard-earned tuition dollars were doing going to a class devoted to the seemingly impossible—analyzing securities to achieve better-than-market returns.... At least the students have the excuse of being early in their careers; what's mine for staying the course in my current role?" He also admitted: "We recognize that the odds are against active managers."
Galbraith pointed out that actual returns to investors in the greatest bull market ever ranged "from the subprime to the ridiculous." Galbraith closed his letter on a very revealing note: "From our perspective, perhaps in a triumph of hope over experience, we continue to believe active managers can add value." Given the role of his employer, to believe otherwise would be committing professional suicide. The winning strategy for investors is simply to accept market returns. Unfortunately, that is not the winning strategy for Morgan Stanley and its profits.
You don't have to play the game of active management. Instead, you can earn market (not average) rates of return with low expenses and high tax efficiency. You can do so by investing in passively managed investment vehicles like index funds and passive asset class funds. You are virtually guaranteed to outperform the majority of both professionals and individual investors. You win by not playing.
If you do decide to invest in actively managed funds, you will, as Galbraith noted, have the hope of outperformance. Unfortunately, the evidence demonstrates that odds of success are so low it is imprudent to try. It is the triumph of hype, hope, and marketing over wisdom and experience.