Tag Archives: mutual-fund

Why We Do Not Use Active Management

Index investing or passive investing seeks to track the return of a portion of the market. The opposite is active management, which seeks to beat the return of the markets by using market timing and individual stock selection. Ironically, active managers do worse than the market on average. Active management costs more than passive management. While index investors trade infrequently, active management requires more persistent buying and selling stocks in an attempt to time the markets. These additional trades add costs to the fund. Furthermore, there are a lot of employees involved who get paid. Researchers review company financials, managers make decisions, traders implement these decisions, marketers push the products into the hands of a sales force, and the commission-based sales force takes their promised share. Every buy or sell experiences a spread between the bid and ask price. Buying a stock pushes the share price up as you buy. Selling a stock pushes the share price down as you sell shares. The larger the fund, the more the fund’s own buys and sells pushes the market in the wrong direction. To beat the index, fund managers need to pick the best time to buy and the best time to sell. If fund managers are not pushing the stock in the wrong direction, then for every active manager who is selling a particular stock there is another active manager who must be buying that stock. With active managers on each side of the trade and their higher than normal fees and expenses and they cannot as a group do better than index investing. In 1991, Nobel Prize winning economist William F. Sharpe wrote ” The Arithmetic of Active Management .” In that article, he demonstrated that after costs, the return of the average actively-managed dollar will be less than the return of the average passively-managed dollar. His reasoning is simple mathematics. Actively-managed funds need to return more on average than they cost extra in fees in order to beat the return of passive management. However, on average, there are as many actively-managed funds underperforming the index as outperforming the index. As a result, on average, actively-managed funds have a lower return than passive index funds. The idea of active management is that you should be able to anticipate movements in the market before or at least while they are moving. The idea sounds good in theory, but when put into practice, all you can say with certainty is the movements which have already happened. Our minds want to use the present tense and say “the markets are going” in a certain direction when in fact the markets have gone in a certain direction in the past and we have little or no idea of where they are heading from here. Our own studies have shown that actively trading stocks adds to the fees and expenses without actually producing a better return and that increasing the number of holdings generally increases returns probably because of the additional smaller companies known to have both higher risk and higher return. This principle, that the average active manager underperforms the average passive manager, is true for every possible index not just the S&P 500. Managers expending time and money trying to opportunistically pick the best Far East funds will underperform a lower cost Far East index fund. Managers trying to pick the best small cap stocks fare no better on average than a monkey throwing darts. Active fund managers do seek to beat their respective benchmarks and there is an enormous marketing value to having a fund which has beaten its index for 3 or 5 years even if it did so by luck. When managers are not able to beat their benchmark through stock selection and market timing, they use other techniques. Many purposefully pick an index which they can beat. Fund managers, for example, often have more small and mid-cap stocks than the index would suggest they should have. Or they will include more value stocks in order to do better in down markets. You can achieve the same effect simply by adding a small cap value index fund to your asset allocation. Active managers will often have a significant cash position in the fund. This cash position allows them to do better when markets go down giving them another edge in advertising during volatile times. With index funds, your fund is fully invested, and you could intentionally keep a separate cash position in your portfolio for the same effect and avoid the higher fees and expenses. If all else fails, fund companies simply close the funds which have underperformed the market and open new funds with a blank track record to take their place. Between 2001 and 2012, around 7 percent of mutual funds were closed each year. During that same time, the number of mutual funds grew as new funds were launched to replace them. Fund companies know that investors feel the loss from a prior high water mark much more acutely than they do the gain from a prior trough. Investors regret not being entirely in the best performing asset class more than they appreciate not being entirely in the worst performing asset class. This emphasis on short-term returns rather than long-term process is one we seek to avoid. There will always be funds which have done better than even the most brilliant asset allocation over any finite time period. Instead of active management, we recommend smart portfolio construction. Perhaps the best way to explain the difference between active management and our methodology of portfolio constructions is that our investment philosophy is not dependent on finding the lucky fund manager who can beat the S&P 500 for the next decade. We look at the characteristics of each sector of the markets over long periods of time and we invest in that track record. Only after deciding how much to invest in these categories do we search for a low cost method of purchasing the index fund. At no point are we entrusting reaching our goals to the ability of an up and coming fund manager to pick stocks and time the markets. Given a dozen stellar financial planning firms, only one will have the best returns over any five or ten-year period. Yet given the right methodology, every firm could help clients ensure that they have the best chance to meet their goals and secure a safe and prosperous retirement. Only when we look backward can we see that fund managers rarely outwit bear markets and that mutual fund investors underperform the very mutual funds they are invested in because they chase returns moving out of funds after they have gone down and moving into funds after they have gone up. It is the advisor who recommends sticking to a long-term plan who, in the end, will provide the most value. The wisdom from this analysis is to have a healthy skepticism about any claims of being able to beat the market. The Wall Street Journal had an interesting article a couple of years ago in which they asked a number of experts, ” When would you recommend using active money managers over index funds? ” My favorite answer was from Scott Adams, the creator of the ” Dilbert ” comic strip: I can think of many cases in which I would recommend active money managers over index funds. For example, I might be giving the advice to someone I hate or-and this happens a lot-someone I expect to hate later. I would also recommend active money managers if I were accepting bribes to do so, if I were an active money manager myself, or if it were April Fools’ Day. And let’s also consider the possibility that I might be drunk, stupid or forced to say things at gunpoint. I’ve also heard good things about a German emotion called schadenfreude, so that could be a factor too. No matter the marketing hype, chasing the returns of supposedly lucky active managers is not a good long-term strategy. Instead, there are many index and passive funds with very low fees and expenses which can be used to craft a diversified asset allocation with appropriate risk for your situation, especially your future withdrawal rates.

The Rational Vs. Irrational Investor

By Kevin Hansen, Director Business Development – Retirement Solutions, Principal Financial Group, Principal Funds Distributor, Inc. On occasion, we all make questionable decisions and reach incorrect assumptions. Often, this is due to cognitive biases – built-in tendencies that we all share. Many social psychologists believe cognitive biases help us process information more efficiently. But in some situations, these biases can lead us to make serious mistakes. When it comes to investing, it’s important to recognize (and hopefully avoid) the negative impact of cognitive biases on your financial decisions. I highlight four of these biases below and point out some rational responses to counteract them. Irrational Bias 1: Overconfidence Investors who see their portfolios rising for extended periods can easily forget previous down markets. This overconfidence can lead them to make risky decisions. Research shows that men are particularly vulnerable to this bias. According to Brad M. Barber, Professor of Finance at the UC Davis Graduate School of Management: “Men tend to be more overconfident than women, and overconfident investors tend to think they know more than they actually do.” Rational Response In these situations, revisiting your comfort level with risk could help you get your confidence in check. A quick call or email to your financial professional could also give you added insights. Irrational Bias 2: Anchoring The concept of anchoring revolves around people’s tendency to cling to a single piece of information during the decision-making process. This is often the first information they encounter. Once the “anchor” is set, other judgments are made based on that anchor. Consider an investor who first encounters a mutual fund that is priced at $22 a share. If the price of that fund later drops to $18.50, that person may think he or she has found a “bargain.” In reality, however, the original $22 price may have been overvalued. Rational Response Evaluate an investment based on a variety of fundamental metrics over time. Focus on the overall asset allocation plan and less on the day-by-day prices of individual investment options. Irrational Bias 3: Loss Aversion As Nobel-Prize winner Daniel Kahneman discovered, a loss generates 2.25 times more pain than the pleasure generated by an equivalent gain. A loss of $1,000, for instance, could only be offset emotionally by a gain of at least $2,250. This level of emotional “pain” could easily lead an investor to sell during periods of volatility – just to make the pain stop. Rational Response Focus on your goals for the long term to help avoid this pitfall. Irrational Bias 4: Mental Accounting Our brains have a natural tendency to organize information. When it comes to money, we tend to view some assets as being different from others based on their source or intended use. This can be helpful for investors who set aside a specific amount of money each month for retirement or another goal. That money is off the table, in a sense, because it’s in their mental “savings” box. In other situations, however, this can work against investors. A modest but unexpected inheritance is a good example. Because those inherited assets aren’t part of the investor’s current financial plan, he or she may feel like it’s “fun money,” even though investing those assets could go a long way toward helping the investor achieve an important financial goal. Rational Response Working with a financial professional on a “save some/spend some” plan to help overcome this bias. The Payoff Of Rational Thinking Emotional investing can be costly. Taking a rational approach, on the other hand, can help you focus on the essential elements of successful investing – a diversified approach and a focus on the long term. Asset allocation and diversification do not ensure a profit or protect against a loss. Principal Funds, Inc. is distributed by Principal Funds Distributor, Inc.

Cheap Funds Dupe Investors – Q1 2016

Fund holdings affect fund performance more than fees or past performance. A cheap fund is not necessarily a good fund. A fund that has done well in the past is not likely to do well in the future ( e.g. 5-star kiss of death and active management has long history of underperformance ). Yet, traditional fund research focuses only on low fees and past performance. Our research on holdings enables investors to find funds with high quality holdings – AND – low fees. Investors are good at picking cheap funds. We want them to be better at picking funds with good stocks. Both are required to maximize success. We make this easy with our predictive fund ratings. A fund’s predictive rating is based on its holdings, its total costs, and how it ranks when compared to the rest of the 7000+ ETFs and mutual funds we cover. Figure 1 shows that 70% of fund assets are in ETFs and mutual funds with low costs but only 1% of assets are in ETFs and mutual funds with Attractive holdings. This discrepancy is astounding. Figure 1: Allocation of Fund Assets By Holdings Quality and By Costs Sources: New Constructs, LLC and company filings Two key shortcomings in the ETF and mutual fund industry cause this large discrepancy: A lack of research into the quality of holdings. A lack of high-quality holdings or good stocks. With about twice as many funds as stocks in the market, there simply are not enough good stocks to fill all the funds. These shortcomings are related. If investors had more insight into the quality of funds’ holdings, we think they would allocate a lot less money to funds with poor quality holdings. Many funds would cease to exist. Investors deserve research on the quality of stocks held by ETFs and mutual funds. Quality of holdings is the single most important factor in determining an ETF or mutual fund’s future performance. No matter how low the costs, if the ETF or mutual fund holds bad stocks, performance will be poor. Costs are easier to find but research on the quality of holdings is almost non-existent. Figure 2 shows investors are not putting enough money into ETFs and mutual funds with high-quality holdings. Only 78 out of 7421 (1% of assets) ETFs and mutual funds allocate a significant amount of value to quality holdings. 99% of assets are in funds that do not justify their costs and over charge investors for poor portfolio management. Figure 2: Distribution of ETFs & Mutual Funds (Count & Assets) By Portfolio Management Rating Click to enlarge Source: New Constructs, LLC and company filings Figure 3 shows that Investors successfully find low-cost funds. 70% of assets are held in ETFs and mutual funds that have Attractive-or-better rated total annual costs , our apples-to-apples measure of the all-in cost of investing in any given fund. Out of the 7421 ETFs and mutual funds we cover, 1664 (70%) earn an Attractive-or-better total annual costs rating. Clearly, ETF and mutual funds investors are smart shoppers when it comes to finding cheap investments. But cheap is not necessarily good. The Nationwide Portfolio Completion Fund (MUTF: NAAIX ) gets an overall predictive rating of Very Dangerous because no matter how low its fees (0.62%), we expect it to underperform because it holds too many Dangerous-or-worse rated stocks. Low fees cannot boost fund performance. Only good stocks can boost performance. Figure 3: Distribution of ETFs & Mutual Funds (Count & Assets) By Total Annual Costs Ratings Click to enlarge Source: New Constructs, LLC and company filings Investors should allocate their capital to funds with both high-quality holdings and low costs because those are the funds that offer investors the best performance potential. But they do not. Not even close. Figure 4 shows that less than half (49%) of ETF and mutual fund assets are allocated to funds with low costs and high-quality holdings according to our predictive fund ratings, which are based on the quality of holdings and the all-in costs to investors. Figure 4: Distribution of ETFs & Mutual Funds (Count & Assets) By Predictive Ratings Click to enlarge Source: New Constructs, LLC and company filings Investors deserve forward-looking ETF and mutual fund research that assesses both costs and quality of holdings. For example, the Market Vectors Semiconductor ETF (NYSEARCA: SMH ) has both low costs and quality holdings. Why is the most popular fund rating system based on backward-looking past performance? We do not know, but we do know that the transparency into the quality of portfolio management provides cover for the ETF and mutual fund industry to continue to over charge investors for poor portfolio management. How else could they get away with selling so many Dangerous-or-worse ETFs and mutual funds? John Bogle is correct – investors should not pay high fees for active portfolio management. His index funds have provided investors with many low-cost alternatives to actively managed funds. However, by focusing entirely on costs, he overlooks the primary driver of fund performance: the stocks held by funds. Investors also need to beware certain Index Label Myths . Research on the quality of portfolio management of funds empowers investors to make better investment decisions. Investors should no longer pay for poor portfolio management. D isclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, sector or theme. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.