The line between active and passive managers is not always clear. An article from the Journal of Indexes looks at the passive overlap of actively managed funds and the expenses charged. Passive overlap is the holdings in an actively managed fund that are exactly the same as the benchmark index. In effect, a fund that is marketed as active may be significantly passive.

One immediate benefit of indexing part of an active fund is that it reduces the tracking error of the fund to the benchmark. Lower tracking error is good if the index is well constructed. The problem arises when higher active manager fees are paid for what amounts to a significantly passive fund. To be fair, fund expenses have a wide range within both passive and active funds. Typically, however, active funds tend to have higher fees. Ideally, if passive overlap is very high, we would hope that the fund manager would charge a lower rate because the actively managed component is less.

In the regression analysis shown in the article, “there is little relationship between expense ratios and passive overlap.” So, whether there is 0% passive overlap or 60% passive overlap, this variable has little impact on the fund expense ratio. This doesn’t seem right.

One must ask, is this really an active fund, or is this an active fund with passive characteristics and typically active-style fees? It’s not Halloween all-year long, maybe the mask should be removed.

In sales, I’ve always believed that if one doesn’t believe in the product, then success will be limited. A similar study is being done for portfolio managers that do not invest in the funds that they manage. An Investment News article reports that out of 4,383 funds, 51% of portfolio managers do not own any shares of the funds that they manage.

There may be different reasons, such as the portfolio manager doesn’t have any money, or perhaps it’s a fixed income fund and the manager is invested in all equity. But do these reasons explain why 51% of portfolio managers do not have a stake in the funds they manage?

Of the 49% of portfolio managers that do invest in their own funds, only 413 of them have $1 million or more of personal assets tied into funds that their clients own. It is not yet empirically proven, but it appears that there is a strong positive correlation between managers that own their own funds and better performance.

Aligning fund manager interests with fund shareholders is important, if only because it speaks to the manager’s conviction in his own beliefs. The same is true for investment advisors. What does it say for investment advisors with a fiduciary responsibility to clients who also invest in the strategies and funds that they use for their clients? If you’d like, you can ask us.

Jason Zweig from the Wall Street Journal usually provides a good perspective on investing. His article, “Staying Calm in a World of Dark Pools, Dark Doings,” gives an excellent high-level view of the world of high frequency trading, and what investors can do to avoid being slaughtered.

In a market where some traders can “buy or sell in 400 microseconds, or nearly a thousand times faster than you can blink your eye,” do you really want to try to play against them? And if one can’t play against them, is it advisable to join them? The first observation is that “if you try to play Wall Street’s new game on Wall Street’s terms, you will probably come off the field in a gurney.” So the answer is simple, don’t play their game by their rules.

Flash orders “constitute less than 3% of trading,” yet the high-strung franticness is appealing because it seems so exciting and profitable. In the stock market, recall that one person’s gain is another’s loss. Add insider information and this cloaks & dagger mystique, and then it becomes exhilarating to the public. Turn off the TV, count to ten and breath. Welcome back to reality. There is no need for illegal information, a trading super-computer, or rabbit’s feet to reach your investment objectives.

Successful investors are disciplined enough to know that they choose their time horizon, and that all of this high-frequency hype is nothing but noise. Get rid of the noise, invest well and smartly, and enjoy your life.

A George Mason University professor says that a fund with lower expenses can actually increase the overall costs - which eats away at total returns. He argues that this is because the fund can increase its internal turnover (i.e., internal trading) as it gets larger. This could be true for actively managed funds, but unlikely for passive funds. In any case, we’re fairly certain that a blanket statement like that should not be made - even if we wanted to bash the follies of actively managed funds.

In a recent WSJ article, we see that the anxiety of investors to get into capital markets overwhelms their sense of frugality. That is to say, investors will pay exorbitant fees, particularly as markets are going up.

There are many more studies on the effect of fees. Fees are probably the most controllable aspect of investing - so why let them get out of control by not paying attention? Picking funds based on fees would be a mistake, but then, not considering fees at all would also be a mistake. If one’s investment philosophy is met by a fund or several funds then the question must become - how do I reduce my overall costs and is it worth the expense? No investor wants to come to the late realization that he’s been paying dearly for his investments. It’s better to manage your expectations right from the start, and manage what is more easily controlled - like one’s investments.

Looking at individual fund expenses is not enough.  One must look at the weighted average cost of the entire portfolio.  Expenses, like returns, have to be aggregated.  Better to own an investment account, rather to blindly fund your fund manager’s expense account.

Michael Edesess from Advisor Perspectives provided a nice write up of an in depth study by Eugene Fama and Ken French. The study looks to add statistical evidence to support the notion that professionally-managed portfolio returns resemble a random walk around the market average. The conclusion is that beating the market cannot be done consistently. The question becomes, can active managers add alpha to a portfolio if the expectation is a random walk around the market’s mean return?The ever-elusive alpha is the excess return over market returns, adjusted for risk. There are practical expenses that need to also be factored into the equation, such as management fees and transaction costs. On average, the active manager alpha is basically zero (negative once fees are incorporated).

Fama and French compare the distributions of actual returns data versus simulated data that is similar to the actual data. The difference is that the simulated data is constructed to not have any alpha - positive or negative. They achieved this data simulation by randomizing 273-month periods, 10,000 times. Thus, a single period may include, July 1997, February 1985, and so on.

The two distributions were very similar. The conclusion is that “there is a statistically insignificant tendency for poor performance to persist and an even less significant tendency for good performance to persist” (Edesess, 3). From this conclusion one may observe that active managers, on average, do not outperform the market; and one that does beat the market will do so randomly and inconsistently.

In terms of managing one’s investments, this study suggests that a market portfolio that captures the natural return premiums that exist may do better, net-of-fees and excess transaction costs, than an actively managed portfolio.

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Best Regards,
Bryan & Alex
McLean Asset Management Corporation

In Sunday’s New York Times, on the front page of the Mutual Funds Report, in the left column, there is a small graph entitled “Growth vs. Value - Returns in the third quarter.” What it shows is that for 3Q 2009, small-caps and value oriented mutual funds led domestic mutual funds.

Here’s a re-creation of their graph, using data from the Center for Research in Security Prices (CRSP).

Our investment philosophy utilizes mutual funds that are purposefully titled towards small-caps and value-style stocks. The reason is that we believe that small and value risk factors have superior long-term return premiums. Here’s a look at the total returns of the popular U.S. Russell indexes, over 1-, 5-, 10-, 15-, and 30-year time periods.

1-year, ending 9/30/2009

5-years, ending 9/30/09

In the short-term (i.e., 1-, and 5-year periods), we see that Value funds underperformed the rest of the market.  Who knew which classes would perform as they did?  What we do know is that historically, over the long-term, small and value funds have outperformed the rest of the domestic market.  As we just showed in the 1- and 5-year graphs, there is inherent volatility in markets, and that is part of the risks that must be accepted.

10-years, ending 9/30/2009

15-years, ending 9/30/2009

Extending the time period out to 10- and 15-years, begins to show us significant outperformance of value over growth.  In the shorter-time periods, the total loss was somewhat negligible, and at least manageable.  If an investor lost the total return upside of small-caps and value-based funds in the long-run, then the missed returns become incredibly significant.  Nowhere is it more apparent then in the 30-year graph below.

30-years, ending 9/30/2009

Small-caps and value-style mutual funds don’t always outperform large-cap growth and blend, but over the long-term, there has been significant outperformance on a total, and annualized-return basis. The data in the last graph is no mistake. If you ask yourself, what would it take to earn these kinds of returns? The answer is to hold a market portfolio that is biased to small-caps and value-style funds.

Investing always has risks involved, but certain risks (i.e., Small and Value) may add greater long-term value to a portfolio than others.  Even though we don’t show international indexes in the preceding graphs, the small- and value- premiums exist in international markets as well.  We are students of the past, and empirical studies suggest that adding small- and value-risks will add significant return premiums.  Doing this on a global scale, and correctly managing one’s risk tolerance by adding in diversified and global fixed income, are perhaps the first steps towards developing a sustainable portfolio.

Past performance is not indicative of future returns. One cannot invest directly in an index, and no one actually earned the exact returns shown in the graphs above.

All returns data is from the Center for Research in Security Prices.  Indexes are used in the above graphs are the following:

US Large Cap Blend - Russell 1000 Index
US Large Cap Growth - Russell 1000 Growth
US Large Cap Value - Russell 1000 Value
US Small Cap Blend - Russell 2000 Index
US Small Cap Growth - Russell 2000 Growth
US Small Cap Value - Russell 2000 Value

Active managers swing and miss, again and again.  Third time’s a charm - so we wish them luck.

Back on September 16th, we posted the “Cost of Volatility,” which discussed a Morningstar study that showed that investors that held specific sector funds tended to do worse than the fund itself - the reason being that investors could not comfortably bear the volatility of the fund. Morningstar has provided some more data, and Sam Mamudi covers the results in his article, “Active Management Loses in Risk Study.”

Mamudi reports that, “The study by Morningstar Inc. found that, over the past three years, while about half of actively managed funds outperformed their respective Morningstar indexes - which cover the nine different Morningstar investment styles -only 37% [outperformed] on a risk-, size- and style-adjusted basis. The numbers are similar for five and 10-year returns.”

In our Inflation Risk and Portfolio Decisions blog, we touch on the danger of managing a portfolio based on a specific risk factor. But what about taking on more risk with the notion of earning greater returns? In theory, increasing risk should mean increasing potential returns (and potential losses). As the “Cost of Volatility” study showed us, investors have a hard time dealing with high volatility. This recent Morningstar study illustrates that not only do actively managed funds deliver more risk, but 63% of them underperform on a risk-, size-, and style-adjusted basis.

Studies continue to show that index funds generally outperform actively managed funds on a significant scale. Also, that index funds tend to take on less risk, and so are easier to digest through a full time-horizon (preferably long-term).  Taking controlled risk is good for a portfolio, and in our view, tilting a portfolio towards small-cap and value funds helps to increase expected returns.

Inflation was a big topic of discussion at the DFA Investment Symposium. It brought up questions about commodities, asset class correlations, and how to view and manage inflation within a portfolio. Inmoo Lee presented on “Inflation and Investment Decisions.” In this blog, we touch on assets’ correlations to inflation and the common decisions that investors face when managing inflation risk. In that context, we look at the typical inflation hedge investments and how investors should really decide how to hedge inflation.

The correlation of specific assets to inflation is not enough when weighing investment decisions. Basing portfolio management decisions solely on such correlation statistics fails to meet the primary mandates of successful investing.

A common argument is that commodities, like gold or oil, are good inflation hedges. The table below looks at correlations between inflation and different assets, as well as the average returns and average standard deviation of each asset. The CRSP 1-10 is representative of the entire US equity market, and all data goes back as far as possible to embrace historical accuracy. In terms of finding an inflation hedge, one would want an investment with a higher correlation to inflation. If the correlation were +1.0, then that suggests that the returns of the asset increase perfectly with an increase in inflation. Would an investment decision based on inflation correlation serve the greater purpose of reducing risk and adding to returns?

From the table above, a portfolio of equity (CRSP 1-10) mixed with TIPS might help to achieve those two goals of risk reduction and return maximization. The CRSP 1-10 shows higher average returns, while TIPS shows the lowest standard deviation. By using commodities like gold or oil, one would most likely increase the standard deviation without an equally rewarding increase in returns.

In a portfolio where equity is the major component, then equity will drive the risk of the portfolio. If commodities are added, then investors face potentially higher volatility with lower expected returns, and no long-term income generation from the commodities. At the end of the day there are two takeaways: 1) TIPS has theoretically and empirically shown to probably be a better inflation hedge than any commodity; and 2) A high-level, total time-horizon, complete portfolio perspective must be kept when making good investment decisions.

*All items CPI-U data from the U.S. Bureau of Labor Statistics.  LT Gov’t Bonds data from Ibbotson Associates.  The S&P data are provided by Standard & Poor’s Index Services Group.  TIPS data are from Barclay Capital (Barclays Capital US TIPS index). Commodities data are from Standard & Poor’s (S&P GSCI index).  Gold data are obtained from the World Gold Council website (http://www.research.gold.org/prices/), London PM Fix gold price. Oil Prices (West Texas Intermediate Crude oil prices) are from http://www.economagic.com/em-cgi/data.ede/var/west-texas-crude-long#Data. CRSP 1-10 data are from the Center for Research of Security Prices.  Index is not available for direct investment; its performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

To be more accurate: “That very night in Max’s room a forest grew….” -Where the Wild Things Are. 

I’ve been waiting a while to use this title and after the markets’ run during this quarter it seems appropriate. Over the last seven months the S&P 500 stock index has gained over 45%.

For the quarter the S&P 500 has gained 15.5% and Small Company and International stocks have each gained 19%.

Although this is great relief for many investors, like Max’s forest, these trees will not grow to the clouds.