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How To Select A Financial Advisor: The Least You Should Know (Part 11 In eBook Series)



How To Select A Financial Advisor: The Least You Should Know (Part 11 In eBook Series)

Chapter 10: Active Management vs. Passive Management

If a financial advisor’s value proposition is founded on their (or their firm’s) ability to consistently pick winning stocks, mutual funds or investment managers, or to time the market swings, it is highly unlikely that they will agree with what you will learn in this chapter. However, facts are facts.

Active management: Attempting to beat the risk-based returns of the broad market or a particular asset class, either through individual security selection or market timing. Any mutual fund, annuity, or separate account manager attempting to beat the market subscribes to active management. The term “active” does not necessarily mean that the manager is executing frequent buys and sells, although this is often the case.

Passive management: Attempting to match the risk-based returns of the broad market or a particular asset class by broad ownership of many or all stocks in the broad market or asset class. An example of a security relying upon passive management would be a no-load S&P 500 index fund.


The term “risk-based” return speaks to how much risk was assumed in pursuit of the returns achieved. A common measure of risk in financial instruments is the standard deviation—a statistical measurement depicting the degree to which numbers in a series vary from the series average. Think of standard deviation as a measure of volatility. Although not a measure of risk per se, it is often referred to as such.

Assume that a mutual fund benchmarks to the S&P 500 index, which has a standard deviation of 10 and an annual return of 10 percent for the last 10 years. A fund with a 10 percent, 10-year return, and a standard deviation of 11, exposed shareholders to 10 percent more risk to achieve the same return as the index. Therefore, the fund experienced a lower risk-based return.

Focusing on volatility as the standard measure of risk when comparing the performance of various investments may seem a bit odd. Most people are more concerned with losing money than they are with how much the price of their investment fluctuates, especially if they are long-term investors; however, volatility is the standard metric, and “standard deviation” is the term you need to remember when identifying risk-based returns. By the way, just because a stock or asset class is considered to be more risky does not necessarily mean that it may ultimately provide a higher return.

If someone says that the ABC fund had a 10 percent return over the past five years, several questions should come to mind immediately:
• Which index does the ABC fund use as a performance benchmark?
• What was the return for the benchmark index over the same period?
• What was the standard deviation of the ABC fund over the five-year period?
• What was the standard deviation of the index over the five-year period?

You should be able to find this information on the mutual fund’s website. Be sure the comparison is made after all fees and taxes are considered.

A great and long-running debate among money managers is whether active management is superior to passive management. Active managers have much higher expenses than passive managers, higher trading costs, higher overhead and higher taxes to contend with. It is nearly impossible for the majority of managers to overcome those costs—sort of like a racehorse overcoming the burden of a significantly overweight jockey.

For equities, I rely upon investment vehicles that employ passive management, such as no-load index funds, exchange-traded funds (ETFs), and true no-load mutual funds offered by Dimensional Fund Advisors (DFA). The DFA funds are only available to individual investors through a Fee-Only investment advisor, and the DFA managers rely on a passive approach.

Certain few talented investment managers managing securities in a particular asset class may be able to beat the market for a while. If they possess an edge—superior knowledge or some other advantage, or are dealing with very inefficient securities as opposed to mainstream securities—maybe a few of them will consistently beat the market for a significant period of time.

For instance, the distressed-debt markets (that is, bank loans or bonds issued by companies or countries that are now in financial duress) require tremendous skill to navigate. It can be hard to get good information, and it’s harder still to predict which of those distressed debt issuers will actually be able to make good on their obligations. The more readily that information is available about a security, the lower the odds of your gaining an edge over other investors. What everybody knows is not worth knowing. For example, think of how difficult it is to get any edge when investing in blue chips stocks.

We call markets like distressed debt “less efficient.” These markets provide greater opportunity for a manager to outperform. But this does not mean that a specific manager will actually outperform, just that the conditions are more favorable.

The questions you should ask yourself are:
• Can you or your financial advisor select which manager will outperform
in the future?
• Will you be able to get onboard before the period of out performance has run its course?
• What criteria will you use to select that investment manager?
• What if you are wrong? What is your exit strategy?
• What is the added expense of employing active managers?

In my opinion, for most investors, the high probability of potentially significant under performance is not worth the low probability of finding the proverbial needle in the haystack. Many allegedly active fund managers are simply “index-huggers.” They buy substantially the same stocks as their chosen benchmark index—the index by which they grade their performance. They slightly overweight or underweight a particular sector, such as healthcare stocks, but think about it—this approach is very close to simply buying an S&P 500 index fund, yet the investor is paying annual expenses of perhaps 2.0 percent for “active” management, rather than a fee of 0.20 percent for an index fund or exchange-traded fund.

It has been said that mutual funds (and annuities) are sold, not purchased. I submit that most investors would avoid actively-managed funds if they understood that their odds of success are so low.

The Random Walk Guide to Investing by Burton G. Malkiel, published by W.W. Norton & Sons, Inc., explains that whenever large numbers of individuals are participating in an activity, there will always be a small number of individuals with exceptional performance. He offers an example of 1,000 individuals in a coin-flipping contest tasked with flipping heads as many times in a row as possible. Since coin-flipping is a 50/50 proposition, one-half of the flippers are eliminated with each toss, i.e., after the first toss, only 500 are left to toss again. After the second toss, only 250 remain and so on until—on the seventh toss—only eight contestants will have flipped heads each time. These are the “experts”—the ones that will be heralded by the media as the best in their field.

Now instead of coin-flippers, let’s imagine that we are discussing the field of active money managers. No large number of individuals—regardless of the endeavor—can escape the laws of probability, including investment managers. There will always be a few exceptional individuals. Unfortunately, nobody knows in advance who they will be. This is the trouble with stock-picking and manager selection…the odds are against you.

Should You Ever Try to Beat the Market?

If you want to be more aggressive, you could deploy a small portion of your investments in active management in an attempt to enhance performance. Maybe you will be able to pick the next outperforming mutual fund or investment manager. Or maybe you can successfully pick individual stocks that outperform, just be aware that becoming a passive investor in low-cost index funds or ETFs is a steadier path to success.

What about Bill Miller of Legg Mason? A November 19, 2011 Wall Street Journal article by Jason Zweig, Value Lesson: The Long Climb and Steep Descent of a Stock Picker, describes the rise and fall of Bill Miller. His hot streak of beating the S&P 500 for 15 consecutive years abruptly ended in 2006. The article also states that “According to Morningstar, only 26 actively-managed mutual funds have beaten the market index each year over any given 10-year period since 1990.”

What about the FairHolme Fund’s Bruce Berkowitz, named domestic stock manager of the decade in 2010 by Morningstar? According to InvestmentNews, he under performed approximately 99% of his peers in 2011.

What about Warren Buffett? Mr. Buffett is exceptional—a statistical outlier. Mr. Buffett is also an exceptional businessman, and it might be that his guidance to company management as well as his representation on company boards correlates to the phenomenal success of many of his stock picks.

Active managers are less diversified than their chosen benchmark index. This stands to reason. They could not beat the index without differing from the index, or outguessing the market’s broad swings.

Also, when investors seek active managers, they tend to hurt their odds of success even further by chasing performance. Egged on by the financial media and eager salespersons, investors purchase yesterday’s winners. They typically invest after the great performance is over in hope that it will continue, but it seldom does.

Market-timing is not a reliable investment strategy, either. The following illustration shows that if you stayed fully invested for the entire 5,043 days, your return would be 9.10 percent. However, if you missed the 10 best days by attempting to time the market, your return would fall to just 5.40 percent (see illustration on the next page).

Vanguard founder, Jack Bogle said it best: “Don’t look for the needle in the haystack, just buy the haystack.”

(Download eBook For Chart)

Again, mutual fund companies are required by law to include a statement in their marketing material to the effect that “past performance is not indicative of future performance.” This fact does nothing to hinder the Wall Street marketing machine. As a marketing tactic, hyping past performance works, no matter what disclaimer is required.

So what should an investor do? Matching the market’s performance is much easier than beating it. Utilizing investment vehicles such as cost-effective, tax-efficient index funds makes sense. Costs are one of the few things investors can control.

Conversely, many mutual funds fail to beat their own chosen benchmark index. The chance of any investor—professional or novice—consistently beating the market is very low. Which funds will outperform next year, or the year after? Nobody knows, not even the fund managers. So how is your financial advisor supposed to know? And if he does not know, what is his stock-picking or fund-picking or manager-picking advice really worth?

It’s All About Cost Control

When it comes to investments, you cannot control:
• Picking winning stocks consistently
• Picking winning managers consistently
• Timing the markets

Actively-managed funds leave you stuck with factors you can’t control.

Less-costly index funds at least leave you in control of costs and not
vulnerable to poor stock-picking.

Neither performance-chasing nor hope is much of an investment strategy. The illustration on the following page depicts the difference between the fund total return between 2001-2010, which amounted to 6.94 percent, and the average investor’s return over the same period—minus 20.24 percent! Chasing after hot sectors or hot funds left investors holding the bag when these funds ran out of steam. Passive management through index funds (or “indexing”) is the preferred strategy of the successful Thrift Savings Plan for federal employees, as well as the retirement plans of many states. See www.tsp.gov.

Hot-Hand Fallacy

Definition

-Perceiving trends where none exist and consequently taking action on this faulty observation.

Implications

-Investors desire to invest in last year’s winners

–   Favoring a “hot” money manager or asset class

-Skill is inferred from a random pattern of chance

-Can lead to erroneous assumptions and predictions

Using passive, low-cost investments is crucial, but there’s more to the equation. You need to determine your asset allocation. That’s the subject of the next chapter.

(How To Select A Financial Advisor Series – Ed Mahaffy)

Request Copy of eBook In Its Entirety With Charts

Ed Mahaffy

Our first priority is helping you take care of yourself and your family. We want to learn more about your personal situation, identify your dreams and goals, and understand your tolerance for risk. Long-term relationships that encourage open and honest communication have been the cornerstone of my foundation of success.

Our approach is cost-effective and tax-efficient. As an independent investment advisor, we can offer you a personalized financial strategy, not a generic investment program. Your individual portfolio will be based on your unique situation, your values, your preferences and your goals. It will be designed to account for change, in the markets and in your circumstances.

As your professional partner, we’ll work hard to earn your trust and confidence, and provide the advice and service you deserve. Send me a note regarding any questions you may have about any particular investment concepts or products. We’ll get back to you quickly with a thoughtful answer.

Request A Copy of “How To Select A Financial Advisor” at

https://www.clientfirstwm.com/download-my-book

You can reach me directly at ed@clientfirstwm.com or call 501.603.0406

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