Active Comeback?

The Wall Street Journal recently ran a story implying that actively managed funds – where stock picking strategies are employed – are on the “Comeback Trail”.  See chart:

Active comeback pic

While that may be true, relative to prior years, the unspoken message in the chart is that fewer than half of the actively managed funds produce superior returns vs. a comparable benchmark (e.g., S&P 500).

What’s also not shown here is that of the active managers who do beat the benchmark index in a given year, very few do so in the years that follow.  This suggests a randomness or luck factor at play.  However, these active managers charge high fees regardless of performance, and are often “closet indexers”, that is mostly mimicking the portfolio of their target benchmark index.

Over the past few years the flow of funds within the Mutual Fund and Exchange Traded Funds universe has been directed towards “passive” index funds which own all of the stocks in an index rather than trying to pick winners from the list.  Vanguard was the pioneer in index based investing and is the largest asset manager in the world with over $4 Trillion in assets under management.

Investors have come around to understanding that lower costs and simply buying the index is a better more consistent way to invest. Passive funds not only carry lower operating expenses, but also have much lower transaction fees due to much lower portfolio turnover, as well as being more tax efficient.

That’s why Warren Buffett famously bet $1 million that a simple index fund would outperform a collection of expertly picked Hedge funds over a 10 year period. He’s about to win that bet.

Or as Jonathan Clements, former personal finance writer for the WSJ who now manages tweeted today:

There are those who buy and hold low-cost, diversified portfolios—and then there are those who generously contribute to Wall Street bonuses.

Costs matter and chasing the latest hot performing fund is a sure way to see your portfolio under-perform.


No One Wants Simple Advice

University endowments have flocked to an investment model pioneered by David Swensen of Yale that involves heavy concentration in “alternative” investments.  Swensen’s success, like most others, is of course hard to replicate.

This interesting post  by Ben Carlson highlight how a simpler approach to investing, using index funds – called the Bogle Model after Vanguard founder John Bogle – consistently outperformed the much more complex and costly alternative model.

“the fact that the Bogle Model portfolio was in the top quartile and even top decile of endowment returns is insane when you consider the depths these universities will go try to beat the market and how sophisticated they are in the eyes of other professional investors.

These funds are invested in venture capital, private equity, infrastructure, private real estate, timber, the best hedge funds money can buy; they have access to the best stock and bond fund managers; they use leverage; they invest in complicated derivatives; they use the biggest and most connected consultants, and the vast majority of these funds still fail to beat a low-cost Vanguard index fund portfolio.”

Why would Colleges and Universities continue to spend wildly in chase of excess performance when they can access the majority of the returns of most investments via ultra cheap index funds?  Answer – no one wants simple advice.  Imagine how many endowment management jobs would be eliminated – not something any of them want to contemplate.

Push to Lower Fees Continues

The chart below highlighted by Michael Batnick further demonstrates that investors are voting with their wallets as they realize they have been paying high fees for chronically under-performing funds.  In the first half of 2016 well over 80% of actively managed funds – experts researching and hand picking the stocks in their funds – saw investment returns that lagged the market in general.

And this is particularly important as market returns are forecast to be low – in the 3% range for the near future.  Much of these funds are moving to passive index based funds that cost a fraction of the fees charged by actively managed funds.

So if you are paying a fund 1% that could eat up a third of your return, or more if the fund did not beat the market / benchmark.  What’s worse is many fund managers are “closet indexers” who get most of their return from the overall market, not from their specific stock picks.

So pay close attention to the fees you pay, both for investments and for financial advice. It’s a buyer’s market in that regard and what you don’t pay you keep.



High Fees Under Pressure

One of the biggest trends in the investing world is what some have called “Vanguarding” after the immense pressure that Vanguard is placing on its competitors in the asset management business. Similar to the effect that Google has had in my old business – online ads – or that Amazon is having on traditional retailers, Vanguard has been dominating the asset management space. And it’s been doing so largely by offering the lowest cost investment options available.

Every dollar saved via lower fees accrues and compounds to investors’ benefit over time. Investors are slowly awakening to this fact. Even typical mutual funds with operating expenses of around 1.00% are seen as expensive. Vanguard index funds typically cost 90% less. Schwab has also been offering similarly low cost ETFs.

Two stories from the past week illustrate the fee pressure on the industry. First Josh Brown covers the story of a mutual fund company being sued by its own employees because their funds used in their retirement plan are seen as outrageously high.

Since 2010, fiduciaries of the $600 million American Century Retirement Plan populated the plan’s investment menu solely with American Century funds, using a selection process “tainted by self-interest” rather than a prudent one that would have led fiduciaries to use less-expensive funds with similar or better performance, the complaint said.

As Brown says: “In other words, it’s fine for brokers across the country to sell these underperforming, overly expensive A-share vehicles to regular people – strangers – but not for us to own in our own retirement accounts.”

The second news item comes from Fidelity, the mutual fund pioneer that has long prospered by offering high cost, actively managed funds. Fidelity finally capitulated and has begun offering low cost index funds, while keeping their cash cow funds in place. Bloomberg:

“Still, it’s easy to see why Fidelity felt like it had to do something. Investors are increasingly demanding lower fees, which is somewhat problematic for a fund family like Fidelity that is widely associated with expensive, actively-managed funds. According to Fidelity, investors yanked close to $19 billion (net) last year from its actively-managed stock funds. At the same time, investors poured a record-breaking $236 billion into Vanguard, a bastion of low-cost, passively-managed funds.”

10 Principles of Investing from Jack Bogle

From Jack Bogle’s “The Clash of Cultures, Investment vs. Speculation”  below are 10 principles to follow when investing.  Cullen Roche at Pragmatic Capitalism wrote about this a while back and given the Brexit news it seems like a good time for a review.

Jack Bogle is the founder of Vanguard and the father of what is now known as “passive investing”.  Rather than paying high fees to a fund manager who tries to pick the best sub-set of stocks, Index Funds allow you to buy all stocks in any different category (e.g. small cap stocks , value stocks  etc) or in fact the entire stock market (VTI).

When Vanguard was started it managed well less than $100 million and today is managing over $3 trillion largely in the passive/indexing category.  Bogle’s words of wisdom are derived from his belief that no one can consistently outperform the market as an active stock picker, a view largely borne out in research on investing.

  1. Remember reversion to the mean.What’s hot today isn’t likely to be hot tomorrow. The stock market reverts to fundamental returns over the long run. Don’t follow the herd.
  2. Time is your friend, impulse is your enemy.Take advantage of compound interest and don’t be captivated by the siren song of the market. That only seduces you into buying after stocks have soared and selling after they plunge.
  3. Buy right and hold tight. Once you set your asset allocation, stick to it no matter how greedy or scared you become.
  4. Have realistic expectations. You are unlikely to get rich quickly. Bogle thinks a 7.5 percent annual return for stocks and a 3.5 percent annual return for bonds is reasonable in the long-run.
  5. Forget the needle, buy the haystack.Buy the whole market and you can eliminate stock risk, style risk, and manager risk. Your odds of finding the next Apple (AAPL) are low.
  6. Minimize the “croupier’s” take.Beating the stock market and the casino are both zero-sum games, before costs. You get what you don’t pay for.
  7. There’s no escaping risk. I’ve long searched for high returns without risk; despite the many claims that such investments exist, however, I haven’t found it. And a money market may be the ultimate risk because it will likely lag inflation.
  8. Beware of fighting the last war. What worked in the recent past is not likely to work going forward. Investments that worked well in the first market plunge of the century failed miserably in the second plunge.
  9. Hedgehog beats the fox.Foxes represent the financial institutions that charge far too much for their artful, complicated advice. The hedgehog, which when threatened simply curls up into an impregnable spiny ball, represents the index fund with its “price-less” concept.
  10. Stay the course. The secret to investing is there is no secret. When you own the entire stock market through a broad stock index fund with an appropriate allocation to an all bond-market index fund, you have the optimal investment strategy. Discipline is best summed up by staying the course.