24 Feb 2012 Warning: Active Management is Dangerous to Your Wealth
Last week in Measuring Uncertainty I focused on the pitfalls of using performance alone to measure progress toward reaching your financial goals. It’s only natural to use returns because they are the universal language of the financial services industry. And if the language of the industry is returns, then the methodology for producing them is active management; where managers make specific investments with a primary goal of outperforming an investment benchmark index. But with return alone as your guide, you are left to wonder just how effectively your managers are improving your situation relative to your goals, how are they managing your wealth?
While they may from time to time beat their benchmarks and offer stellar returns there is no guarantee they are improving your wealth for a number of reasons. Active managers are expensive, can generate significant taxes, and will eventually under-perform their benchmarks. They concentrate your investments in less than fully diversified positions in order to best their benchmark index, thereby taking greater risk with your wealth than you may know about or need. The concentrated positions can make your investments considerably more volatile than their benchmarks, perhaps compelling you toward irrational decisions driven by fear or greed.
Actively managed portfolios are naturally more expensive than passive funds (those that match an index). Salaries and bonuses are required for the smart people who make the management investment decisions. Transactions are required to position the portfolio among companies, industries, and sectors as directed by their managers. These transactions incur commission charges by the brokers executing the trades and they also incur another significant but rarely mentioned expense known as the spread (the difference between what is paid for a stock and what it is sold for). The spread goes to the market maker of that stock. A study done by the Wharton School of Business in 1999 found that mutual fund trading costs, which are not reported in prospectuses, averaged .78%. That’s more than three quarters of a percent the managers have to clear just to beat their benchmark.
When you buy a mutual fund you pay a sales charge of as much as 5.75%. Add that to the internal expenses of the fund which can range between .25% and 2% and you have put yourself in a huge hole to climb from just to catch up to where you might have been in an index fund. For instance, if you bought a typical growth fund and paid the 5.75% up front commission, and incurred an ongoing .7% internal fund expense ratio, your fund managers would have to clear 1.83% a year for five years, just to keep you even with the benchmark index. But wait, there’s more . . . don’t forget the .78% that Wharton says is hidden among mutual funds’ expenses. Are you beginning to get the picture? In order to be of value to you in improving your wealth, the average mutual fund manager must scale a hurdle of 2.6% just to match your benchmark return, much less improve your wealth.
What we’ve been talking about so far concerns the margin or amount the fund’s returns exceed or fall short of its benchmark. Fund managers can employ all kinds of shenanigans between quarterly reports to improve returns, which usually subject the fund to more risk than is inherent in their performance benchmark. One way to check is to compare the fund’s beta to that of its benchmark index. Beta provides a measure of the volatility of a security or a portfolio relative to a benchmark. If, for example, the manager of a domestic growth fund allocates say 15% of his holdings to international stocks, he has added greater risk in the form of volatility to his portfolio than is contained in the benchmark (currency, credit, and volatility to name a few). His fund will likely carry a beta over 1.
Alpha on the other hand measures the fund’s ability to produce returns beyond those that can be captured through a combination of low-cost index funds. This measure provides a better gauge of whether the manager provides value beyond simply owning the index.
Vanguard, a champion of low cost index funds, recently did a study to determine the probability of selecting funds that offer superior alpha. In their introduction they note that “talented managers can deliver better than-benchmark returns, and it’s easy enough to identify managers who have produced alpha in the past. Unfortunately, these historical feats shed little light on a fund’s future.
The study used the Morningstar database of the returns of actively managed mutual funds from 1990 through 2010. They calculated alphas relative to the stock market’s four common risk factors, as outlined by Fama and French (1993) and Carhart (1997):
- Market risk factor (the difference between the returns of the broad stock market and risk-free U.S. Treasury bills); • SMB risk factor (a measure of the historical difference between the returns of small- and large-cap stocks; SMB refers to “small [market cap] minus big”);
- HML risk factor (a measure of the historical difference between the returns of stocks with high book-to-market and low book-to-market values;
- HML refers to “high [book-to-market ratio] minus low”); and
- Momentum risk factor (the historical difference between the returns of stocks with the highest returns over the past 3 to 12 months and those with the lowest).
For each of the rolling 36-month periods in the database, they grouped the funds in quartiles from lowest alpha to highest alpha. They then calculated the probability that a top-quartile fund would remain a top-quartile performer over the following 1-, 3-, 5-, and 10-year periods, as shown below:
“The figure presents two sets of probabilities, one calculated from a database free of survivorship bias (it includes records both of existing funds and of those no longer in existence) and a database that is survivor-biased. The results based on the two datasets were different, but both led to the same conclusion: The probability that the highest-alpha funds will remain the highest-alpha funds in subsequent periods was no better—and was sometimes worse—than chance. (In a random distribution, we would expect to see 25% of the top-quartile performers in that same quartile in future periods.)”
The study authors noted “the survivor-bias-free dataset is more reflective of an investor’s real-world experience. An investor’s long-term challenge is to identify a fund that can both outperform and stay in business long enough to deliver that outperformance to shareholders.
If you are curious about why the beige bias-free probabilities are lower, the reason is simple math, note the authors. While the numerators (top number) were similar in both datasets, the denominators differed. The denominator of the beige bias-free dataset included both surviving and non-surviving funds and was hence larger than the denominator of the blue survivor-biased funds.
The study concluded by saying “unfortunately, the quantitative evidence of this skill—alpha and other measures of historical performance—is of little help in identifying tomorrow’s superior performers. The elements that distinguish talented investment managers are difficult, if not impossible, to quantify in a simple metric. Active management is both art and science. Talent exists, it produces alpha, but its basis can’t be captured in a mechanical formula.
If your objective is to improve wealth, then it is fair to say that the odds are stacked pretty highly against you if you choose to go the way of actively managed mutual funds. They are expensive and are apt to underperform. But there’s another problem. The trading that goes on in their daily management and to accommodate those buying into or leaving the fund generates significant taxable income. If you own mutual funds in taxable accounts, you will mostly likely be hit with short and long-term gains at year’s end even if you didn’t sell a share. That’s because mutual funds are required to pass their capital gains and losses to shareholders each year and they are not insignificant. Returns on average can be reduced by a full 2% or more. These taxes represent a steady and unnecessary leak of your wealth.
A study by Blackrock reveals how much damage can be done to your wealth by the tax implications of active management. The table below represents the impact of various tax cost assumptions on a portfolio of $1 million growing at 8% for 10 years. Do not be surprised to find that the tax cost of some of your favorite growth mutual funds is easily 2%. In the figure below you will note that the impact of a 2% tax cost annually can reduce your wealth by as much as $400,000 over a ten year period. This loss CAN BE REDUCED, POSSIBLY ELIMINATED.
In my 30 years advising the most persistent wealth destroyer is that caused by emotion. Investors who make their decisions out of fear or greed are highly apt to sacrifice some of their wealth needlessly. Active management plays a significant role in contributing to these behavioral mistakes. As a performance manager for 25 years I am oh so familiar with the warning signs. “What do you think about the market ahead? “What do you think about gold?” “Should we buy some Apple shares – they’ve doubled in the last three years?” “My barber says he’s got a year’s worth of canned goods in his basement.” “Should we park some on the sidelines until things settle down a little?”
The actively managed marketplace known as the financial services industry provides a cornucopia of choices from low risk to Katie-bar-the-door. Unfortunately their marketers appeal primarily to fear or greed, and not necessarily what is best for the client’s unique wealth needs. And when investors make decisions on emotion they are apt to seriously impact their wealth.
The figure below represents another study done by Blackrock. It represents the lost opportunity of sitting on the sidelines while the stock market (S&P 500) delivers its best months of performance. It is a very real phenomenon. If I had a dollar for every time I heard “I wish I had gotten back into the market last. . . .” The S&P 500 appreciated 124% from the period 1/97 to 12/06, yet those who missed the best 10 months of that 10-year period did not even beat the returns of 3-month T-Bills, a huge sacrifice of wealth.
If a managed portfolio increases the volatility beyond a widely reported benchmark, like say the S&P 500, then shareholders may not feel comfortable sticking with it. Conversely, if a portfolio can be constructed using market-efficient fixed and equity index funds or ETFs that provides more consistent returns with lower volatility than say the S&P 500, then investors will be all the more likely to stay with it while they accumulate wealth for future needs – right?
The objective in building a market-efficient portfolio is to maximize the portfolio’s expected return for a given amount of portfolio risk, or alternatively to minimize risk for a given level of expected return, by carefully choosing the proportions of various assets, substantially fixed (bonds) and equities (stocks).
We use six standard model portfolios that are efficient relative to the capital market assumptions developed by Wealthcare Capital Management. People often ask me how we did during the Great Recession, particularly over the 2008 market period. Because we are wealth managers and not performance managers my answers are generally focused on the experiences of our clients. The short answer is that they were relatively content through the storm. Our phones did not ring any more than usual and we did not have to talk one client out of bailing.
The graph below provides a visual explanation to some extent as to why our more risk-sensitive clients remained confident. The blue line represents our most conservative portfolio (Risk Averse). The red line is the S&P 500 and the green line represents the 7-10 year Treasury index. Wealthcare’s studies have found that 7-10 year Treasuries provide the best offset to equity risk. When stocks are declining, Treasuries, historically rise in value, offsetting the wealth impact. As you can see below, the Treasuries (which represent 50% of the Risk Averse Portfolio) did exactly what they were supposed to do. They pulled the blue line up when as the red line was pulling in the other direction.
When using the capital markets to accumulate and grow wealth, active management has numerous pitfalls. As Wealth advisors we believe using market-efficient portfolios to control what is controllable; costs, taxes, and under-market performance, and continually measuring uncertainty, we can confidently work toward exceeding our clients’ important goals and aspirations.
Have a great weekend.