The Investment Scientist

A New Year Resolution for Investors

Posted on: December 28, 2010

New year resolution

Tom making his new year resolution

[Guest Post by Tom Warburton] How’s this for a New Year’s Resolution – repeat after me – I Resolve That I Will Abandon Personal Stock Picking And I Will Not Permit That Foolishness To Be Foisted Upon Me By Stock Brokers, Money Managers Or Financial Advisors.

New evidence shows up every day suggesting that it makes more sense to invest in index funds than to personally pick stocks, invest in hedge funds, invest in actively managed mutual funds or let a money manager pick stocks for you.

Of course index funds don’t look very appealing after a wretched year for stocks; however, the data in numerous studies indicates that – after fees and taxes the vast majority of hedge funds and actively managed funds fail to do better.

In the February 1, 2009, issue of Economics & Portfolio Strategy (a newsletter for institutional investors) Mark Kritzman pounded another stake in the hearts of stock pickers (i.e. Active Managers).  Mr. Kritzman, who teaches a financial engineering course for graduate students at M.I.T.’s Sloan School of Management, analyzed the long-term impact of the expenses incurred – taxes, management fees, performance fees and transaction costs – on hedge funds and actively managed fund performance.

This study sounds simple but measuring these costs accurately is tedious.  Performance is highly dependent on the sequence of taxes incurred and performance fees levied, all of which is triggered by the random sequence of positive and losing years

Mr. Kritzman devised a method to take contingencies into account. He calculated the average return over a hypothetical 20-year period, net of all expenses, of three hypothetical investments: a stock index fund with an annualized return of 10 percent, an actively managed mutual fund with an annualized return of 13.5 percent and a hedge fund with an annualized return of 19 percent. The volatility of the three funds’ returns – along with turnover rates, transaction fees, management fees and performance fees – was based on what he determined to be industry averages.

As is consistent with a vast number of other studies, Mr. Kritzman concluded that when performance was accurately measured net of fees and taxes the winner was the index fund.  After fees and taxes the index fund’s average return was 8.5 percent a year, versus 8 percent for the actively managed fund and 7.7 percent for the hedge fund.

The hedge fund performance and actively managed fund performance were significantly impaired by taxes and expenses.  Taxes and expenses ate up huge amounts of return – 9 and 3.5 percentage points a year, respectively.

So, how much out-performance would a hedge fund or actively managed mutual have to produce to overcome the incremental taxes and expenses?  Mr. Kritzman concluded that to break even with the index fund the hedge fund would have to outperform the index fund by 10 points a year.  The actively managed fund would have to outperform by an average of 4.3 percentage points a year.

Can that be done?  How many actively managed mutual funds are able to out-perform the S&P 500 Index by at least four percentage points a year over a statistically significant period of time?  Well, there were 452 domestic equity mutual funds in the Morningstar database that existed continually for the 20 years through the time period Mr. Kritzman studied.  Morningstar reported that just 13 of those funds beat the Standard & Poor’s 500-stock index by at least four percentage points a year, on average, over that period. That’s less than 3 out of every 100 funds – a virtual needle in a haystack.

Of course, figuring out ‘who did well’ in the past is pretty easy.  Figuring out ‘who will do well in the future’ is darn near impossible.  Let’s not forget – Past Performance Is Not Predictive Of Future Performance.  It’s a well-known fact that very few funds that out-perform one year do well the next year.

Finance Professor Russell Wermers at the University of Maryland believes that “it is exceedingly probable that any fund that has beaten the market by an average of more than one percentage point per year over the last decade achieved that return almost entirely due to luck alone.”

So now we have the issue of ‘luck’ versus ‘skill’.  Hey, if 1,000 people went over Niagara Falls in a barrel, we expect one or two to survive.  Will that be due to luck or skill?  If 1,000,000 people buy lottery tickets, we expect that one or two will win.  Will that be due to luck or skill?  Stock picking is the same way – investors are encouraged by unscrupulous, or perhaps uninformed, advisors to confuse luck with skill.

Mr. Kritzman believes the investment implications are clear, “It is very hard, if not impossible, to justify active management for investors if their goal is to grow wealth.” He went on to state that “those who insist on an actively managed fund are almost certainly deluding themselves.”

In tax-sheltered accounts Mr. Kritzman conceded, the odds are relatively more favorable for active management, because, in his simulations, taxes accounted for about two-thirds of the expenses of the actively managed mutual fund and nearly half of the hedge funds. But he emphasized the word “relatively.”  “Even in a tax-sheltered account,” he said, “the odds of beating the index fund are still poor.”

Before I close I’ll include a quote from Professor Meir Statman, the Glenn Klimek Professor of Finance in the Leavey School of Business at Santa Clara University:

The house (casino) takes a cut on each spin of the wheel, paying out less in winnings than it collect in bets. So roulette is a negative-sum game, and so is your non-index mutual fund (actively managed fund).

The New Year is only a few days away.  We all know our well-intentioned diet and exercise resolutions are likely to fade as 2011 moves along.  So, let’s resolve to do something that overwhelming evidence suggests will be terrific for our long-term financial health – repeat after me – I Will Abandon Personal Stock Picking And I Will Not Permit That Foolishness To Be Foisted Upon Me By Stock Brokers, Money Managers Or Financial Advisors.

Get The Investment Fiduciary monthly newsletter in your mailbox. Check out my High-Net-Worth Wealth Management services.

1 Response to "A New Year Resolution for Investors"

Good post but a couple of points. There is a huge difference between picking stocks and buying an actively managed mutual fund. Buying a stock incurs very little in fees. If you want to gamble and take a shot at hitting the jackpot it is probably the best casino in the world. Buying an actively managed fund on the other hand is expensive. Taking it one step further and hiring an investment advisor to buy you funds is ultra expensive.
Along these lines I have my clients index at least 80% of their retirement assets. With the remainder they can buy individual stocks. Many, who limit investment in a single name to 5% of total assets, don’t trade actively, and do their research tend to do ok.

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



You may also get his monthly newsletter, or join his Facebook page for regular wealth management insights. Michael's email is info[at]mzcap.com.

Twitter: @mzhuang

Error: Twitter did not respond. Please wait a few minutes and refresh this page.

%d bloggers like this: