Just came across this chart from Russell Investments, which corroborates much of the data from last week’s post. Thus, the conclusion remains the same: it is very, very difficult to beat the indices in domestic large-cap equities.
This post will look at US large caps through the lens of the active vs passive debate. As one the largest and best known asset classes, it is often the battleground of the debate.
There is no shortage of analysis and reporting purporting to shed light on the active vs passive debate, although most of it is noise. SPIVA publishes data quarterly, although knowing what percent of managers out/underperformed each quarter or year is meaningless, as is knowing the persistence of top ranked funds (see here). So, we’ll skip all the noise and red herrings and skip right to a good starting point: rolling returns over multiple years.
The below shows that active managers really underperformed in 1990s, then enjoyed a period of outperformance during the recession of the early 2000s, but have not added much value since.
The picture does not change much when we go from 3-year rolling returns to 5-year rolling returns. The median manager added modest value for a brief time in the mid-2000s and again around 2010.
Vanguard put out this beautiful chart of 10-year rolling returns that includes data on all percentiles of active managers (instead of just the mean or median manager). On average, most active managers underperform over most 10-year time periods. Again, this is before taxes, so the real after-tax numbers are even worse for active managers.
There is some evidence that active managers perform better in severe down markets, which you can see in the above charts as well as in the scatter plot below. It’s is debatable whether this is simply due to lower equity allocations or whether active managers are successful risk managers. Distinguishing between those two factors is really just splitting hairs, so I’ll move on and wrap up.
The data largely shows what the passive camp already knows: large cap indices are hard to beat. Over 3-, 5-, and 10-year periods, most active managers underperform most of the time.
However, the active camp will rightfully point out that there have been some time periods when more than half of managers outperform. This is true, although it is a minority of the time and does not include tax drag.
Of course, these numbers are in aggregate. Some managers may pitch themselves with a superior 10-year return and my hope is that readers will respond by saying, “Show me a history of your rolling returns.”
My final conclusion is that outperforming a US large-cap index is very, very difficult to do. It is even more difficult in taxable accounts. I don’t think its impossible and I own an actively-managed US large cap fund at the moment, but investors need a very compelling case because the odds favor passive management.
My general view (explained here) is that investors should use passive strategies in asset classes where it is difficult to beat the averages and active strategies where it is probable that the averages can be beat. Unfortunately, the active vs passive debate in many asset classes hinges on biases, dogma, and platitudes. Anecdotes and misused statistics abound, while rigorous questioning and examination are much harder to find.
Below are some questions that are commonly asked when evaluating whether active management can succeed in a particular asset class. Each is problematic in some way and also used (and the answers overplayed) by both the passive and active camps. Hopefully, the below is helpful in cutting through the BS and developing a framework for evaluating management style.
1. How many managers beat their benchmark in any given year?
The problem with the above question is that it is impossible to separate luck from skill. The number is likely to be higher in markets with higher volatility or more randomness. Therefore, we might ask:
2. How many of this year’s outperforming managers beat the market in consecutive years?
On the surface, this is a good question. However, it completely ignores the magnitude of outperformance or underperformance. Is it better for someone to gain 5% three years in a row or to get two years of 12% and one year of -2%?
3. We can look at active manager alpha over rolling 3-, 5-, 10-year periods, which should account for magnitude of gains of losses and focus on total return.
Yet, like any of the previous metrics, rolling returns vary over time. A particular manager or strategy might do well in one 10-year period and terrible in another. However, the data may show that it is consistently easy or difficult to outperform in a given asset class consistently through various regimes.
This is also a good place to pause and point out that questions #1-3 may lead to an aggregated answer, but can miss pockets of persistent outperformance. For instance, it is possible for subset of managers to consistently outperform in markets even if most underperform. That’s why #4 is important.
4. Shifting from asset classes to individual managers, it’s best to dig into the portfolio’s historical data and understand what drove performance in past years. This process is called “return attribution.”
Reviewing past performance and attribution is helpful, but certainly not prescriptive. Evaluating portfolio construction, strategy, historical returns and attribution provides a baseline understanding, but portfolios evolve over time and the future will inevitably unfold differently than the past. However, investors can understand a manager’s process and judge whether the returns were due to skill or luck and, ultimately, whether past success is repeatable or not.
The above is just a brief summary of some commonly asked questions and why they are problematic. As I mentioned, hopefully it is helpful in calling someone’s BS. We’ll dig deeper into specific asset classes over the next few weeks.
This week, we have a follow-up question from blog reader Jasmin:
How good are automated online investing services?
This is one of the most common questions I hear from millennials. Many automated investing services (also called “roboadvisors” or simply “robos”) have launched in the past several years. Robos have made investing very easy and convenient for some people, because robo clients do not have to research investments on their own or consult with an advisor. Instead of opening an account and deciding what to buy, the robo will automatically allocate and invest based on an online risk-tolerance questionnaire.
Although robos are not doing anything novel, I believe they bring a lot of value to the marketplace. Most roboadvisors offer a solid service, at a low cost, with very low account minimums. Perhaps most importantly, they provide these things to a segment of investors that did not have many good options previously.
While some investors prefer to invest themselves and others use the services of an advisor, many investors cannot meet the account minimums of a traditional advisor nor have the inclination to manage investments themselves. Robos are great for these investors.
However, there are a few important factors to consider when deciding whether or not to use a robo:
- Most of the robos only offer asset allocation advice. They cannot advise on individual investments, stock options, tax planning, real estate, and so on. It is fine to separate investment management from financial, tax, and estate planning (many investors don’t even need, much less pay for, these services). However, investors should know that roboadvisors typically provide a narrower set of services than human advisors.
- Portfolios are not customized. Clients are not able to customize their portfolio, hold positions with low cost basis that would be cost-prohibitive to sell, make tactical adjustments, or effect other personalized customizations. I tend to agree with the argument that roboadvisors should be regulated as mutual funds rather than as investment advisors, based on how the current regulations are written.
- As discussed previously, there is no best or even standard asset allocation. Designing an asset allocation is very subjective and allocations across robos vary quite a bit.
- Most of the robos only use passively-managed index funds. Sometimes passive management is better, sometimes active management is better. Passive-only is probably a better bet than active-only due to the generally lower costs, but a service that blended active and passive would be much better IMO.
- I have seen some roboadvisors market impossible and misleading claims. I won’t get into the weeds in this post, but as always: caveat emptor.
This is only tangential to the original question, but I think the outlook for robos is worth mentioning. The first wave of start-up B2C roboadvisors, priced their services very aggressively. Perhaps they priced too low. Some shifted to a B2B model of offering white-labeled versions of their services to third-parties. Others shut down or sold themselves to fund sponsors.
Fund sponsors quickly figured out that robos were a great tool for fund distribution and many sponsors bought or started their own robos. I have always thought that the fund sponsor-owned robos would be tough to beat because their product fees (from the underlying funds) can subsidize the distribution (the robo service). So far, this seems to the case, as the Vanguard and Schwab robos easily outgrew the early incumbents Wealthfront and Betterment.
This trend of sponsor-backed robos dominating should continue as many robos find it difficult to generate any net income. I doubt Wealthfront has turned a profit yet, despite being a market leader with tons of VC investment. The competition will likely get tougher too, as the sponsor-owned robos can offer their services for free (Schwab does). How can anyone compete with free? How can anyone compete with free in a commoditized industry? I don’t think it is possible.
So I think the future will be dominated by free or close-to-free robos that are mostly owned by fund sponsors. This should drive costs down, although it also brings some conflicts of interest (but those issues are common to many advisory business models, not just robos; so that’ll be another post someday). Overall, I think robos are and will continue to be a choice for a certain segment of the investor population.
This week, we have a reader question from Jasmin:
How is the stock market index of any significance for individuals?
The significance of a stock market index (or any other index for that matter) is that it is a benchmark. In other words, investors can use indices as a yardstick to measure and/or compare slices of their portfolio to.
For most investors, indices can be used to evaluate the performance of the individual asset classes in their portfolio. Investors can compare the risk and return metrics of an allocation to those of an appropriate index. When utilizing an actively managed strategy, an appropriate index or index fund can be viewed as the opportunity cost of using the active strategy.
If you own US large-cap stocks, you might compare the volatility and performance of those stocks to the S&P 500. If you own international stocks, you might compare them to the MSCI EAFE. You can compare the bond portion of your portfolio to the Barclays Agg or a number of other indices. There are multiple indices for various sectors, regions, countries, and so on. In fact, today there are more indices than stocks!
Although the above is relatively straightforward, many investors misuse indices. Below are two of the more common errors that I see:
- Comparing a multi-asset class portfolio to a single asset class index. I meet many people who compare their portfolio of global stocks and fixed-income to the S&P 500. The S&P 500 could probably be used to benchmark the US large-cap equity portion of the portfolio, but certainly not the entire portfolio.
- Viewing an index as a goal. Each individual investor has unique goals and their portfolio should reflect this. Even the largest indices have some fairly substantial risks, which investors should be aware of and may want to avoid. For instance, the “China Region” (China, Hong Kong, and Taiwan) makes up 40+% of most broad-based emerging markets equity indices or the Barclays Agg is overwhelmingly government bonds, which offer much more duration than yield today. These are just two examples of where investor goals may be inconsistent with an index’s composition. Note: Money managers may benchmark to a single index, but this is because they typically run single asset class strategies and are concerned with relative performance, neither of which is typically true of individual investors.
So, the short answer is that individuals can use indices to evaluate single asset class strategies/managers and should not be used for much more than that.
If nearly all investors engage in active management through the development or selection of a portfolio’s asset allocation, then what is the active versus passive management debate all about?
The debate is whether individual asset classes should be accessed via active managers or via passive strategies. Thus, the debate over active versus passive management is at the asset class level, rather than portfolio level (because all investors are active at the portfolio level!).
Below is a brief summary of active and passive management:
The traditional form of investing, where an investor picks individual securities that he or she expects will result in the best risk or return metrics.
At some point (I think in the 1950s) investors began to both deduce and notice that active managers (in the aggregate) could not outperform the average returns in various markets. If managers could not beat the averages, then investors would be better off accepting average returns and minimizing costs. Average returns could be nearly achieved by simply buying the entire market or a representative sampling of them.
Below is an example of where an investor must decide whether to utilize an active or passive strategy:
A hypothetical investor decides to allocate 10% of her portfolio to emerging markets bonds. The investor can do one of two things with the 10%:
- Purchase individual emerging markets bonds (or hire a manger that selects the “best” bonds, based on research, analysis, etc).
- Invest in a passive strategy that attempts to mirror the risk and return characteristics of the broad emerging market bond market.
If the investor is comfortable with the risk and returns of the broad emerging market bond market, she should consider a passive strategy. If not or she thinks that she can beat this market, active management may be a better choice.
It should be clear that neither active management nor passive management is inherently better. The decision to use one over the other should depend on both investor objectives, as well as the asset classes’ characteristics and market structure. Yet, the debate does carry on, which I believe is driven both by bias from investing product sponsors and by dogma from under-informed investors.
Looking ahead, we will examine various asset classes and how active and passive strategies fare in each.
According to All Things Liberty, the American colonists financed their revolution through printing currency (both at the state and colony-wide Congressional level). Although some debt was issued as well, the primary funding came from printing currency. If the war was won, this currency would be needed to pay taxes to the new state and federal governments.
This is similar to the recent spate of cryptocurrency Initial Coin Offerings (ICOs). A group of people issue a currency to raise money for a venture. If the venture succeeds, the currency can be used on the new platform. If the venture fails, the currency will have no use.
There are a lot of problems with the ICO model, but financing a revolution with your own currency seems preferable to taking on external debt. Taking on external debt to finance a war could easily mean trading military occupation for exploitation by creditor(s). It is a good thing that the founding fathers printed money rather than borrowing from other 18th-century powers.
Happy 4th of July!
Thus far in this series, we’ve looked at market efficiency and management styles in a general sense. Yet, investors must examine these factors and make decisions at multiple points, including when they select an asset allocation.
A completely passive asset allocation would mirror the market portfolio, which may look something like the below. Hypothetically, an investor could construct such a portfolio.
However, some investors will want a more aggressive portfolio while others will desire a less volatile portfolio. Consequently, they will adjust their allocation weights to produce different portfolios along the efficient frontier.
Yet, the efficient frontier is not a constant thing. Does it represent a 3-, 5-, 7-, 10-year, or some other time horizon? The efficient frontier will look different for each horizon, as seen below:
Once settled on a time horizon, investors face a new decision: should historical data be used or future assumptions? If historical data is assumed, which timeframe should be used? 100 years of data? Or just the most recent 10 years? Or a decade that most resembled our current situation? Each will provide a different frontier.
If one chooses to use future assumptions, what assumptions should be used? Rarely do people agree on what the future will look like and nobody can consistently predict it accurately. Below is an example of possible efficient frontiers, based on differing assumptions:
It’s not just average investors that cannot agree on what the future looks like. There is debate amongst the largest asset managers who have vast resources, huge budgets, and large teams of economists, analysts, and researchers. Below are the 2017 capital markets assumptions from three of the largest asset managers:
Regardless of whether an investor allocates to actively managed funds or passive index funds, selecting an asset allocation is an exercise in active management. In fact, allocation decisions will likely be more determinative to a portfolio’s risk and return than whether active or passive managers are used within each asset class.
A late set of weekend links for your reading enjoyment!
Stuff doesn’t make people happier. Control over their time does. So to the extent that the goal of personal finance is to make you happier, I encourage people to view it as a way to gain control over their time, rather than a way to accumulate more possessions. -Morgan Housel
Morgan Housel on What You Need to Know to Be a Successful Investor (Chris Reining)
A Kansas Investment Firm Spurring Change on Wall Street (New York Times)
Solar Power Will Kill Coal Faster Than You Think (Bloomberg)
American Chipmakers Had a Toxic Problem. Then They Outsourced It (Bloomberg Businessweek)
Before delving deeper into the topic of market efficiency and active vs passive, it may be helpful to briefly review the definitions of beta and alpha.
At it’s simplest, beta can be defined as the volatility of an asset relative to a benchmark. The benchmark is often an index of a specific sector or an entire asset class. For example, a US large-cap stock that is 20% more volatile than the S&P 500 index has a beta of 1.2. Or if the volatility is 20% less than the index , it’s beta is .8. Beta is a measure of relative volatility.
Within the Capital Asset Pricing Model (CAPM), this same beta is used to forecast returns. Under CAPM, higher beta leads to higher returns and lower beta results in lower returns. In other words, a fund with more volatility should have higher returns and a fund with lower volatility should have lower returns. Reality rarely unfolds as modeled, so an ex-post CAPM equation was created. It adds a variable called alpha to account for the difference between an asset’s actual return and it’s expected return (which CAPM predicts to be the benchmark return, adjusted for volatility). Below are a couple of examples on calculating alpha:
- An investor invests in large-cap domestic stocks and reports a 10% return, while the Russell 1000 returns 7%. The investor has produced 3% alpha.
- An investor invests in global equities and reports a 9% return, while the MSCI All Country World Index returns 13%. The investor has (negative) alpha of -4%.
The term beta is often used to refer to the risk and return characteristics of a benchmark. Some examples: US large-cap beta may refer to the Dow Jones Industrial Average or the S&P 500, investment grade bond beta is often synonymous with the Barclays Agg index, or tech beta may simply refer to a tech-sector ETF. I often refer to index ETFs as cheap, liquid beta. Some may compare large-cap beta to small-cap beta or consumer staple beta to consumer discretionary beta, when discussing risk and returns. Below are some examples of how someone might refer to beta:
- Utility sector beta is sensitive to interest rates.
- An index fund may be called beta exposure.
- An investor holds investment grade bonds and reports a -1% return while the Barclays Agg is down 3%. Some might say that the beta return was -1% (and alpha was positive 2%).
- Beta is an asset’s volatility, relative to a benchmark.
- Alpha is an asset’s return above it’s benchmark, after controlling for differences in volatility.
- Technical definitions notwithstanding, the term beta is often shorthand for a benchmark or may refer to the benchmark’s risk and return characteristics.