What is the Arithmetic of Active Management? It's just simple math.
Low fee investment advice using DFA funds
What is the Arithmetic of Active Management? It's just simple math.
Another nail in the coffin of active mutual funds as University of Chicago Professor Eugene Fama wins the Nobel Prize for economics.Read more
While constant activity pays off for some things, it works against us as investors.Read more
We all know the expression that more is better. But that might not always be the case when it comes to your investment returns.Read more
Believe it or not, there are still a large number of national lawmakers who think it's OKthat the financial advice you receive can be delivered by someone who has huge conflicts of interest. It's outrageous and costly. Fortunately, some major publications, including Time, are helping the public understand that this practice should be ended.
Investors desperately need points of reference or benchmarks to which we can compare the performance of our investments. That’s why we are constantly asking, “How did the market do today?” It’s tough to properly determine the relative performance of our investments when we compare them to the wrong benchmark. The most popular yardsticks by which investment portfolios are measured are the ever popular (and badly flawed) Dow Jones Industrials Average (the Dow) and the blue-chip stock index, Standard & Poor’s 500 (S&P 500). For far too long the Dow has been the go-to index when the media mentions stock market performance. When you hear an announcer saying that the “market” was up or down a certain amount, odds are they are referring to this archaic conglomeration of 30 almost arbitrarily selected large US companies. The only way this would be a reasonable benchmark against which to compare your portfolio would be if you owned a relatively small portfolio of blue-chip stocks in United States companies and none of them were in the transportation or utility business (those industries have their own tiny Dow indexes).
There has been a bit of improvement as some have started to compare portfolios to the S&P 500. Even we have been guilty of that, as so many investment studies use the S&P 500 for comparison. We hate doing it, but compared to the Dow Jones 30 Industrials, the S&P 500 is a far better index against which to measure your portfolio’s performance. For those with globally diversified portfolios, the S&P 500 is sorely lacking. It only tracks the 500 largest companies in the United States. It ignores the performance of many thousands of companies, both in the US and abroad.
Trying to match your portfolio against the wrong benchmark can cause emotional turmoil that often leads to bad decisions, particularly when the comparison is made over a short period of time. Let’s take a look back at 2011, for example. For the year, the Dow Jones 30 Industrials gained almost 5%. The Standard & Poor’s 500 index posted a tiny loss. Some might infer from those figures that a more focused investment, in a few blue-chip stocks, has the potential for greater returns. To a point, they would be right. Yet, those potential returns are offset by potentially greater losses.
Concluding that owning fewer stocks in a portfolio is better would be dramatically reinforced by the one-year performance of the Dow Jones Global Total Stock Market Index (DWG). This index, which includes more than 12,000 stocks from 64 different countries, lost almost 11% of its value during 2011. Had you purchased the Dow 30, at the beginning of 2011, you would’ve made almost 5%, while owning the world (or at least a pretty big part of it) would have cost you more than 10% of your investment.
So, do you put all of your eggs in a 30 stock basket for next year or should you continue to invest globally? If next year exactly mimics this year the answer is obvious. Is it likely? No! Do you know what’s going to happen to every stock market on the entire planet next year? Don’t kid yourself.
Now, let’s broaden our perspective a bit. Using the same 3 indexes, decide which would have been a better point of reference, for a well diversified portfolio over the past 10 years.
From January, 2002 through December, 2011 the Dow Jones 30 Industrials Average rose by about 22%. Standard & Poor’s 500 stock index only grew by about 9% over those same 10 years. Meanwhile, the broader DWG index rose from 1734 to 2343, increase of almost 35%. This is due to the fact that, while the US market foundered for most of the last decade, many European, Asian, and Latin American markets flourished.
In the past year, those same foreign markets have not fared as well as the US market. Given the longer-term performance international markets, it would be foolish to remove them from a portfolio based on a single bad year. Almost as foolish as it would’ve been to bail out of the US market in late 2008 or early 2009 (when the S&P 500 was worth about half of what it is today).
We continue to strongly believe in broadly diversified global portfolios. To help you maintain your long-term perspective, it is critical that you make sure you are making proper comparisons. Comparing a globally diversified portfolio of over 15,000 stocks to the Dow 30 is worse that comparing apples to oranges. It’s more like comparing apples to the entire produce department.
The financial services industry is changing. There are fewer commission based salespeople, as the advisory model switches away from trying to predict the future. This new fee based (and we prefer fee-only) approach is centered less on delivering excess return and more on helping investors avoid outsized losses. This is explained clearly in this 2010 white paper from Vanguard (click to download pdf file):
"The hardest arithmetic for human beings to master," wrote the great American working man's philosopher Eric Hoffer, "is that which enables us to count our blessings." It's a piece of wisdom worth recalling after another year that has tested the nerve of many investors and prompted questions about what current generations have done to deserve to live in such a tempestuous stage of history.
As the year winds down (if that's the word for it!), financial markets are gripped by uncertainty over developments in the Eurozone crisis. Each day brings fresh headlines that send investors scrambling from virtual despair to tentative optimism.
While not seeking to downplay the very real anxiety generated by these events, particularly in relation to their effects on investment portfolios, it's worth reflecting critically on our often second-hand memories of the "good old days."
A Brief History of the 20th Century
Nearly 100 years ago, Europe was engulfed by a war that destroyed two centuries-old empires, redrew the map of the continent, and left more than 15 million people dead and another 20 million wounded. The economic effects were significant, with widespread rationing in many countries, labor shortages, and massive government borrowing.
Just as the Great War was ending, the world was struck by a deadly pandemic—the Spanish flu, which, by conservative estimates, killed some 50 million people. About a third of the world's population was infected over a two-year period.
A little over a decade after the Great War and the pandemic, the Great Depression cut a swath through the global economy. Industrial production collapsed, international trade broke down, unemployment tripled or quadrupled in some cases, and deflation made already groaning debt burdens even larger.
In the meantime, resentment was growing in Germany over its Great War reparations to the Allied powers. Berlin resorted to printing money to pay its debts, which in turn led to hyperinflation. At one point, one US dollar converted to 4 trillion marks.
In a new militaristic and nationalist climate, fascist regimes arose in Germany, Italy, and Spain. Under Hitler, Germany defied international treaties and began annexing surrounding regions in Austria and Czechoslovakia before finally attacking Poland in 1939.
This led to the Second World War, a conflict that engulfed almost the entire globe while Japan pushed its imperial ambitions in Asia, and Germany sought to conquer Europe. More than 50 million died in the ensuing conflict, including a holocaust of six million Jews. The war ended with the invasion of Berlin by Russian and western forces, while Japan surrendered only after the US dropped nuclear bombs on two cities, killing a quarter of a million civilians.
In economic terms, the war's impact was profound. Most of Europe's infrastructure was destroyed, millions of people were left homeless, much of the UK's urban areas were devastated, labor shortages were rife, and rationing was prevalent.
While the thirty-five years after World War II were seen as a golden age in comparison, the geopolitical situation remained fraught as the nuclear armed superpowers, the Soviet Union and the US, eyed each other. The breakdown of the old European empires and growing east-west tensions led the US and its allies into wars in Korea and Vietnam.
The cost of the Vietnam and cold wars created enormous pressures concerning balance of payments and inflation for the US and led in 1971 to the end of the post-WWII Bretton Woods system of international monetary management. The US dollar came off the gold standard, and the world gradually moved to a system of floating exchange rates.
In the mid-1970s, the depreciation of the value of the US dollar and the breakdown of the monetary system combined with war in the Middle East to encourage major oil producers to quadruple oil prices. Stock markets collapsed and stagflation—a combination of rising inflation alongside rising unemployment—gripped many countries.
While the 1980s and 1990s were a relative oasis of calm—aided by the end of the cold war—there still was no shortage of bad news, including the Balkan wars, the Rwandan genocide, and recessions in the early part of both decades.
In the past decade, there have been the tragedies of 9/11; the 2004 Asian tsunami; the 2011 Japanese earthquake, tsunami, and nuclear crisis; and now, the financial crisis sparked by irresponsible lending, complex derivatives, and excessive leverage.
So from this potted history, it seems fairly clear that tragedy and uncertainty will always be with us. But the important point to take away from it is that previous generations have stared down and overcome far greater obstacles than we face today. And while it is easy to focus on the bad news, we mustn't overlook the good either.
Alongside the wars, depressions, and natural disasters of the past century, there were some notable achievements for humanity—like women's suffrage, the development of antibiotics, civil rights, economic liberalization, the spread of prosperity and democracy, space travel, advances in our understanding of the natural world, and enormous advances in telecommunication. (Oh, and the Beatles.)
Today, while the US and Europe are gripped by tough economic times, much of the developing world is thriving. Populous nations such as China and India are emerging as prosperous nations with large middle classes. And smaller, poorer economies are making advances too.
The United Nations in the year 2000 adopted a Millennium Declaration that set specific targets for ending extreme poverty, reducing child mortality, and raising education and environmental standards by 2015. In East Asia, the majority of twenty-one targets have already been met or are expected to be met by the deadline. In Africa, about half the targets are on track, including those for poverty and hunger.
Alongside these gains, new communications technology is improving our understanding of different cultures and increasing tolerance across borders while providing new avenues for the spread of ideas in education, health care, technology, and business.
Through forums such as the G20 and APEC, international cooperation is increasing in the field of trade, addressing climate change, and lifting the ability of the developing world to more fully participate in the global economy.
Rising levels of education and health, and workforce participation also mean the foundations are being built for a healthier and peaceful global economy, dependent not on debt, fancy derivatives, and fast profits but on sustainable, long-term wealth building.
Anxiety over recent market developments is completely understandable, and it is quite human to feel concerned about events in Europe. But amid all the bad news, it is also clear that the world is changing in positive ways that provide plenty of cause for hope and, at the very least, gratitude for what wealready have. These are ideas to keep in mind when we scan the news and long for the "good old days."
As a topic of conversation, investment is like sports. Everyone has an opinion. And the strongest opinions often come from those who spend more time in front of the TV than out on the field. Practitioners, meanwhile, are wary of anything labeled a sure thing. Indeed, it's one of life's ironies that the people who know the least about a subject sound the most sure of themselves. In investment, these are the ones who prop up bars telling anyone who will listen that they have found the path to certain wealth. These pub philosophers tend either to be permanent bulls or permanent bears about the market. They have their standard story, and they adapt the facts to fit. Some of them even end up writing newspaper columns and hosting television shows.
By contrast, some of the world's most respected and seasoned investors strike a humbler tone, having learned from personal experience about the unpredictability of markets and deciding to focus instead on those things within their control.
Take, for instance, the frequently heard line that smart investors should seek to time their entry points to markets and wait for the volatility to clear. We are hearing a lot of that right now as the European crisis dominates market attention.
Writing about this in 1979 before one of the biggest bull markets in history, Warren Buffett said: "Before reaching for that crutch (market timing), face up to two unpleasant facts: The future is never clear [and] you pay a very high price for a cheery consensus. Uncertainty actually is the friend of the buyer of long-term values."1
Another line from the pub philosophers is that the job of an investment expert is to spot the best market-beating returns and harvest them before someone else finds out.
Asked about this in 2007, two years before his death, legendary investment consultant and historian Peter Bernstein said it was better to focus on risk than return. "The central role of risk, if anything, has grown rather than diminished," he said. "We really can't manage returns because we don't know what they're going to be. The only way we can play the game is to decide what kinds of risk we're going to take."2
A third perennial pub conversation is the role of stock picking in investment success. The line here is that the key to wealth building lies in painstakingly analyzing individual stocks and buying them based on a forecast or even a hunch about their prospects.
Prompted by a newspaper reporter for his opinion on that piece of conventional wisdom, Charley Ellis, long-time Wall Street observer and the founder of Greenwich Associates, said the truth was actually quite the opposite.3
"The best way to achieve long-term success is not in stock picking and not in market timing and not even in changing portfolio strategy," Ellis said.
"Sure, these approaches all have their current heroes and war stores, but few hero investors last for long and not all the war stories are entirely true. The great pathway to long-term success comes via sound, sustained investment policy, setting the right asset mix and holding onto it."
While that's probably not the kind of message you are likely to hear from the instant experts who prop up your local bar, it may be a more durable and a more useful one.
Bill Miller is one of the most closely watched money managers in the industry, so it was big news when he announced his decision last week to step down as portfolio manager of Legg Mason Capital Management Value Trust (LMVTX) early next year. His departure also adds an intriguing chapter to the long-running debate regarding the value of active stock selection. Miller's most frequently cited accomplishment is the fifteen-year period from 1991 through 2005, during which Value Trust outperformed the S&P 500 each calendar year, the only US equity fund manager to have ever done so. His success attracted a wide and enthusiastic following: Morningstar named him Portfolio Manager of the Decade in 1999, Barron's included him in its All-Century Investment Team that same year, and a Fortune profile in 2006 described him as "one of the greatest investors of our time." A former US Army intelligence officer and philosophy student, his formidable intellect covered a wide range of interests, and he believed that conventional investment analysis could be enhanced with insights drawn from literature, logic, biology, neurology, physics, and other fields not obviously related to finance. His expressed desire to "think about thinking" suggested an unusual ability to assess information differently from other market participants and arrive at a more profitable conclusion.
Miller's bold and concentrated investment style would never be confused with a "closet index" approach. Big bets on Fannie Mae, Dell, and America Online, for example, were rewarded with handsome gains (as much as fifty times original cost in the case of Fannie Mae). Unfortunately, similar bets in recent years revealed the dangers of a concentrated strategy as heavy losses in stocks such as Bear Stearns and Eastman Kodak penalized results. For the five-year period ending December 31, 2010, LMVTX finished last among 1,187 US large cap equity funds tracked by Morningstar. Considering the enormous variation in outcomes among these carefully researched ideas, Miller's overall investment record presents an interesting puzzle: How can we disentangle the contribution of good luck or bad luck, of skill or lack of skill?
Over the May 1982–October 2011 period, annualized return was 11.28% for the S&P 500 Index and 11.76% for the Russell 1000 Value Index. Value Trust slightly outperformed the S&P and underperformed the Russell index by over 0.40% per year. A three-factor regression analysis over the same period shows the fund underperformed its benchmark by 0.08% per month.
Do these results offer conclusive evidence of the failure of active management? Not necessarily. The fund's expenses are above average at over 1.75% and provide a stiff headwind for any stock picker to overcome. Gross of fees, the fund's performance over and above its benchmark goes from –0.08% to 0.07% per month. This swing from negative to positive raises an interesting point that Ken French speaks to at every Dimensional conference. There are almost certainly some mistakes in market prices and almost certainly some skillful managers who can exploit them. But who is likely to get the benefit of this knowledge—the investor with his capital or the clever money manager? If stock-picking talent is the scarce resource, economic theory suggests the lion's share of benefits will accrue to the provider of the scarce resource—just what we see in this instance.
To cloud the discussion even further, both of these results, positive and negative, flunk the test for statistical significance; in neither case can they be attributed to anything more than chance. So even with twenty-nine years of data, we cannot find conclusive evidence of manager skill—or lack thereof. This is the inconvenient truth that every investor must confront: The time required to distinguish luck from skill is usually measured in decades, and often far exceeds the span of an entire investment career.
Miller is well aware of the challenge of distinguishing luck from skill and has conspicuously declined to boast about his results, even when they were unusually fruitful. He has acknowledged that topping the S&P 500 each year for fifteen years was an accident of the calendar and that using other twelve-month periods produced a less headline-worthy result.
Commentators have said that Miller has "lost his touch" or that his investment style is no longer suitable in the current market environment. These arguments strike us as the last refuge for those who find the idea of market equilibrium so unpalatable that they search for any explanation of his change in fortune other than the most plausible one—prices are fair enough that even the smartest students of the market cannot consistently identify mispriced securities.
Where does this leave investors seeking the best strategy to grow their savings?
When asked by a New York Times reporter in 1999 to sum up his legacy, Miller replied, "As William James would say, we can't really draw any final conclusions about anything." Twelve years later, this observation seems more useful than ever. And investors would be wise to treat even the most impressive claims of financial success with a healthy degree of skepticism.
Andy Serwer, "Will the Streak Be Unbroken," Fortune, November 27, 2006.
Edward Wyatt, "To Beat the Market, Hire a Philosopher," New York Times, January 10, 1999.
Tom Sullivan, "It's Miller Time," Barron's, October 12, 2009.
Diana B. Henriques, "Legg Mason Luminary Shifts Role," New York Times, November 18, 2011.
S&P data provided by Standard & Poor's Index Services Group.
Morningstar data provided by Morningstar Inc.
Russell data copyright 2011, Russell Investment Group 1995-2011, all rights reserved.