My first essay (Peaceful Wealth: Where do we start the journey?) focused on the huge gap between market returns and the actual returns achieved by the average investor. Many attribute this appalling performance solely to poor investor decisions and inappropriate behavior.
My second essay (Peaceful Wealth: Beware the Broken Business Model) examined the role of traditional brokers and whether their supposed expertise helps investors solve market puzzles. We are talking about two recent academic studies that expose a harsh reality. Both studies found that commission-based insurance brokers and agents fall far short of helping investors avoid options that sabotage returns.
Now let’s look at the investment process and decide whether the traditional stock-picking, marketing-timing, and yield-hunting strategy that most investors pursue (and relentlessly promotes on Wall Street) is also part of the problem.
“It’s not easy getting rich in Las Vegas, at Churchill Downs or at your local Merrill Lynch office” – Dr. Paul Samuelson, Nobel Prize-winning economist
Most of the investment world adheres to an investment philosophy rooted in the belief that a consistent profit can be achieved by buying and selling the “right” stocks and bonds at the “best” possible time. Known as active management, this philosophy of finding success in the stock market is similar to the alchemist’s quest to create gold from base metals. Both the expert and the novice seek to transform an undervalued or mispriced asset into a personal gold mine.
Investopedia defines active management as “an investment strategy that involves continuous buying and selling actions by the investor. Active investors buy investments and continually monitor their activity to exploit profitable conditions. Active managers rely on analytical research, forecasts and their own judgment and experience in making investment decisions about which securities to buy, hold and sell”.
Buying or selling the right stocks at the right time makes intuitive sense to all of us. We are surrounded by the principles of cause and effect in our daily lives. We know that outcomes follow inputs, and therefore we can easily train ourselves to identify the reason for most life outcomes based on experience and knowledge. Sure (we tell ourselves) there are some gray areas and chance will often play a role in how things turn out. But the key to success is learning how things work and using our knowledge to maximum effect.
When it comes to investing, we know that the price of most stocks changes every day. The law of cause and effect tells us that discovering the reasons why these changes occur will allow us to forecast future events and take advantage of our knowledge. Our intuitive reasoning is bolstered by a compelling sales message delivered every day by Wall Street insiders. We accept a system that tells us that the analyst’s wisdom and experience exceed our own and are worth the price we must pay to obtain the result we seek.
Unfortunately, academic research has uncovered two major flaws in active management:
- it is expense.
- It does not work.
A broken business model, Part II
Let’s put the discussion on whether active management works for a moment and focus on the cost equation. in his book The Great Mutual Fund Trap Former Treasury Under Secretary Gary Gensler and former Financial Institutions Under Secretary Gregory Baer compare the expense of actively managing within a mutual fund to running around with heavy weights on your ankles. The fund manager may be a world class expert in his career, however the heavy burden of research, commissions, fees and other costly “ankle weights” quickly eliminate any potential advantage they may offer. The authors include the following disclosed and undisclosed costs in their analysis of mutual fund expenses that can potentially deplete more than 4% of an actively managed mutual fund investor’s wealth each year:
- Expense ratios.This is a fee that all mutual funds charge investors to cover management fees, administrative fees, distribution fees, and marketing fees. Your mutual fund company deducts these fees directly from your account. Morningstar reports that the average mutual fund expense ratio is 1.51%.
- Sales commissions. These are known as initial loads when they are paid at the time of purchase or final loads if they are paid when the fund is sold. Baer and Gensler estimate that mutual fund fees cost investors up to $20 billion per year.
- business costs. These are the undisclosed costs that active management strategies incur in the course of buying and selling stocks and bonds. They include brokerage commissions, bid-ask spreads, and the market effects on stock prices when fund managers buy and sell large blocks of shares. Baer and Gensler believe that investors sacrifice 0.5% to 1.0% of their total annual returns to trading costs.
- idle cash.Morningstar reports that the average idle cash, known as the liquidity ratio, averages 10%. High liquidity ratios are believed to cost mutual fund investors 0.2% to 0.25% of returns per year.
- Taxes. Investors holding mutual funds in taxable accounts must pay their share of any short-term and long-term capital gains the funds incur during the year. By definition, active managers buy and sell shares throughout the year, exposing investors to significant tax liability. Most investors do not realize that they are responsible for these internal taxes, even if they did not make a profit while holding the fund. The Wall Street Journal reported in an October 24, 2007 article titled Taxable payments in many funds will increase by Elenore Laise, “Over the past 10 years, the average stock fund has yielded 1.4 percentage points of return annually to taxes, according to fund researcher Lipper Inc.”
“But wait,” many investors yell, “I’ll avoid most of these costs by picking my own stocks and managing my own account. Stock picking isn’t rocket science. I know I can do just as good a job as these so-called experts.” .”
Let’s be realistic. By focusing only on the expense equation, an individual investor who selects his own stock will avoid paying mutual fund expense ratios and sales commissions. However, they will not avoid component costs of transaction fees, escrow fees, personal research costs, bid-ask spreads, short-term capital gains taxes, capital gains taxes in the long term, assuming the risks of owning a subsoil. diversified portfolio and the personal expenditure of time and effort devoted to managing investments.
“If there are 10,000 people looking at stocks and trying to pick winners, one in 10,000 will just happen to get a big hit, and that’s all that’s going on. It’s a game, it’s a chance operation, and people think they’re doing something for a purpose… but they’re not really like that.” – the late Dr. Merton Miller, Nobel laureate and professor of economics at the University of Chicago
Does active management manage to beat the markets? I can’t deny the truth. Sometimes it does, both anecdotally (there are always stories of individual investors buying Google or selling Enron on cue) and over short periods of time (this year’s No. 1 ranked mutual fund). Every year there are also lottery winners and boys who run with the Pamplona bulls unharmed. This does not mean that the lottery winner has a winning system, that the bull runner has common sense, or that active managers can consistently overcome the relentless headwinds of their high-cost strategies or an efficient market.
The academic literature that contradicts claims of active management progress in beating the market is persuasive. To quote Weston Wellington, vice president of Dimensional Fund Advisors, in a February 2007 article in Advisor Edge titled Equilibrium-Based Investing“For fans of stock picking, the evidence is not encouraging. Researchers have studied the performance of professional money managers for more than forty years in the US. The evidence is compelling: markets beat managers , not the other way around.”
Investors looking to be the exception to this rule should take note. Picking only “good” active managers or “proven” stock picking or market timing strategies are equally flawed approaches. The same article reports that actively managed mutual funds that outperform the market in any given year “are no more likely to outperform in the future than a bottom quartile performer.”
Just as the proper pursuit of weight loss must include eliminating unhealthy foods from the diet, a prudent investor must forego an investment approach that is costly and unproductive. They must reject a failed business model riddled with commission-driven self-interest, wealth-stealing fee structures, and dubious claims of market-beating expertise. The fanciful pursuits of medieval alchemists finally disappeared in the light of reason and scientific evidence. The same fate awaits the modern alchemy of active management.
There are good news. The failed investment business model doesn’t have to ruin your portfolio. Those wise enough to accept the facts and follow an investment methodology based on modern economic theory can achieve Peaceful Wealth. Investors now have powerful allies in their pursuit of retirement goals and financial dreams. We will chart our course and set sail during our next talk.