Posts tagged ‘passive investing’

Winning the Loser’s Game

During periods of heightened volatility like those recently experienced, it’s easy to get caught up in the emotional heat of the moment. I find time is better spent returning to essential investing fundamentals, like the ones I read in the investment classic by Charles Ellis, Winning the Loser’s Game“WTLG”.  To put my enthusiasm in perspective, WTLG has even achieved the elite and privileged distinction of making the distinguished “Recommended Reading” list of Investing Caffeine (located along the right-side of the page). Wow…now I know you are really impressed.

The Man, The Myth, the Ellis

For those not familiar with Charley Ellis, he has a long, storied investment career. Not only has he authored 12 books, including compilations on Goldman Sachs (GS) and Capital Group, but his professional career dates back prior to 1972, when he founded institutional consulting firm Greenwich Associates. Besides earning a college degree from Yale University, and an MBA from Harvard Business School, he also garnered a PhD from New York University. Ellis also is a director at the Vanguard Group and served as Investment Committee chair at Yale University along investment great David Swensen (read also Super Swensen) from 1992 – 2008.

With this tremendous investment experience come tremendous insights. The original book, which was published in 1998, is already worth its weight in gold (even at $1,384 per ounce), but the fifth edition of WTLG is even more valuable because it has been updated with Ellis’s perspectives on the 2008-2009 financial crisis.

Because the breadth of topics covered is so vast and indispensable, I will break the WTLG review into a few parts for digestibility. I will start off with the these hand-picked nuggets:

Defining the “Loser’s Game”

Here is how Charles Ellis describes the investment “loser’s game”:

“For professional investors,  “the ‘money game’ we call investment management evolved in recent decades from a winner’s game to a loser’s game because a basic change has occurred in the investment environment: The market came to be dominated in the 1970s and 1980s by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with cautious custodians or amateurs who are out of touch with the market. Now he or she competes with other hardworking investment experts in a loser’s game where the secret to winning is to lose less than others lose.”

 

Underperformance by Active Managers

Readers that have followed Investing Caffeine for a while understand how I feel about passive (low-cost do-nothing strategy) and active management (portfolio managers constantly buying and selling) – read Darts, Monkeys & Pros.  Ellis’s views are not a whole lot different than mine – here is what he has to say while not holding back any punches:

“The basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management – fees, commissions, market impact of big transactions, and so forth-85 percent of investment managers have and will continue over the long term to underperform the overall market.”

He goes on to say individuals do even worse, especially those that day trade, which he calls a “sucker’s game.”

Exceptions to the Rule

Ellis’s bias towards passive management is clear because “over the long term 85 percent of active managers fall short of the market. And it’s nearly impossible to figure out ahead of time which managers will make it into the top 15 percent.” He does, however, acknowledge there is a minority of professionals that can beat the market by making fewer mistakes or taking advantage of others’ mistakes. Ellis advocates a slow approach to investing, which bases “decisions on research with a long-term focus that will catch other investors obsessing about the short term and cavitating – producing bubbles.” This is the strategy and approach I aim to achieve.

Gaining an Unfair Competitive Advantage

According to Ellis, there are four ways to gain an unfair competitive advantage in the investment world:

1)      Physical Approach: Beat others by carrying heavier brief cases and working longer hours.

2)      Intellectual Approach: Outperform by thinking more deeply and further out in the future.

3)      Calm-Rational Approach: Ellis describes this path to success as “benign neglect” – a method that beats the others by ignoring both favorable and adverse market conditions, which may lead to suboptimal decisions.

4)      Join ‘em Approach: The easiest way to beat active managers is to invest through index funds. If you can’t beat index funds, then join ‘em.

The Case for Stocks

Investor time horizon plays a large role on asset allocation, but time is on investors’ side for long-term equity investors:

“That’s why in the long term, the risks are clearly lowest for stocks, but in the short term, the risks are just as clearly highest for stocks.”

Expanding on that point, Ellis points out the following:

“Any funds that will stay invested for 10 years or longer should be in stocks. Any funds that will be invested for less than two to three years should be in “cash” or money market instruments.”

While many people may feel stock investing is dead, but Ellis points out that equities should return more in the long-run:

“There must be a higher rate of return on stocks to persuade investors to accept risks of equity investing.”

 

The Power of Regression to the Mean

Investors do more damage to performance by chasing winners and punishing losers because they lose the powerful benefits of “regression to the mean.” Ellis describes this tendency for behavior to move toward an average as “a persistently powerful phenomenon in physics and sociology – and in investing.” He goes on to add, good investors know “that the farther current events are away from the mean at the center of the bell curve, the stronger the forces of reversion, or regression, to the mean, are pulling the current data toward the center.”

The Power of Compounding

For a 75 year period (roughly 1925 – 2000) analyzed by Ellis, he determines $1 invested in stocks would have grown to $105.96, if dividends were not reinvested. If, however, dividends are reinvested, the power of compounding kicks in significantly. For the same 75 year period, the equivalent $1 would have grown to $2,591.79 – almost 25x’s more than the other method (see also Penny Saved is Billion Earned).

Ellis throws in another compounding example:

“Remember that if investments increase by 7 percent per annum after income tax, they will double every 10 years, so $1 million can become $1 billion in 100 years (before adjusting for inflation).”

 

The Lessons of History

As philosopher George Santayana stated – “Those who cannot remember the past are condemned to repeat it.” Details of every market are different, but as Ellis notes, “The major characteristics of markets are remarkably similar over time.”

Ellis appreciates the importance of history plays in analyzing the markets:

“The more you study market history, the better; the more you know about how securities markets have behaved in the past, the more you’ll understand their true nature and how they probably will behave in the future. Such an understanding enables us to live rationally with markets that would otherwise seem wholly irrational.”

 

Home Sweet International Home

Although Ellis’s recommendation to diversify internationally is not controversial, his allocation recommendation regarding “full diversification” is a bit more provocative:

“For Americans, this would mean about half our portfolios would be invested outside the United States.”

This seems high by traditional standards, but considering our country’s shrinking share of global GDP (Gross Domestic Product), along with our relatively small share of the globe’s population (about 5% of the world’s total), the 50% percentage doesn’t seem as high at first blush.

Beware the Broker

This is not new territory for me (see Financial Sharks, Fees/Exploitation, and Credential Shell Game), and Ellis warns investors on industry sales practices:

“Those oh so caring and helpful salespeople make their money by convincing you to change funds. Friendly as they may be, they may be no friend to your long-term investment success.”

Unlike a lot of other investing books, which cover a few aspects to investing, Winning the Loser’s Game covers a gamut of crucial investment lessons in a straightforward, understandable fashion. A lot of people play the investing game, but as Charles Ellis details, many more investors and speculators lose than win. For any investor, from amateur to professional, reading Ellis’s Winning the Loser’s Game and following his philosophy will not only help increase the odds of your portfolio winning, but will also limit your losses in sleep hours.

investment-questions-border

http://www.Sidoxia.com

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in GS, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 16, 2016 at 3:15 am 1 comment

The 10 Investment Commandments

Moses ascended Mount Sinai to receive the powerful spiritual words of the Ten Commandments from God on two stone tablets and then went on to share the all-important, moral imperatives with his people. If Moses was alive today and was a professional investor, I’m sure he would have downloaded the “10 Investment Commandments” from Charles Ellis’s Winning the Loser’s Game on his e-reader, and then share the knowledge with all investors. I’m the furthest thing from Moses, but in his absence, I will be happy to share Ellis’s valuable and useful 10 Investment Commandments for individual investors:

1)      “Save. Invest your savings in your future happiness and security and education for your kids.”

2)      “Don’t speculate. If you must ‘play the market’ to satisfy an emotional itch, recognize that you are gambling on your ability to beat the pros so limit the amounts you play with to the same amounts you would gamble with the pros at Las Vegas.”

3)      “Don’t do anything in investing primarily for tax reasons.”

4)      “Don’t think of your home as an investment. Think of it as a place to live with your family-period.”

5)      “Never do commodities….Dealing in commodities is really only price speculation. It’s not investing because there’s no economic productivity or value added.”

6)      “Don’t be confused about stockbrokers and mutual fund salespeople. They are usually very nice people, but their job is not to make money for you. Their job is to make money from you.”

7)      “Don’t invest in new or ‘interesting’ investments. They are all too often designed to be sold to investors, not to be owned by investors.”

8)      “Don’t invest in bonds just because you’ve heard that bonds are conservative or for safety of either income or capital. Bond prices can fluctuate nearly as much as stock prices do, and bonds are a poor defense against the major risk of long-term investing – inflation.”

9)      “Write out your long-term goals, your long-term investing program, and your estate plan – and stay with them.”

10)   “Distrust your feelings. When you feel euphoric, you’re probably in for a bruising.”

We all commit sins, some more than others, and investors are no different. A simple periodic review of Charles Ellis’s “10 Investing Commandments” will spiritually align your portfolios and prevent the number of investment sins you make.

Read More about Charles Ellis (article #1 and article #2)

investment-questions-border

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

November 21, 2015 at 9:34 am 6 comments

Ellis on Battling Demons and Mr. Market

A lot of ground was covered in the first cut of my review on Charles Ellis’s book, Winning the Loser’s Game (“WTLG”). His book covers a broad spectrum of issues and reasons that help explain why so many amateurs and professional investors dramatically underperform broad market indexes and other forms of passive investing (such as index funds).

A major component of investor underperformance is tied to the internal or emotional aspects to investing. As I have written in the past, successful investing requires as much emotional art as it does mathematical science. Investing solely based on numbers is like a tennis player only able to compete with a backhand – you may hit a few good shots, but will end up losing in the long-run to the well-rounded players.

Ellis recognizes these core internal shortcomings and makes insightful observations throughout his book on how emotions can lead investors to lose. As George J.W. Goodman noted, “If you don’t know who you are, the stock market is an expensive place to find out.” Hopefully by examining more of Ellis’s investment nuggets, we can all become better investors, so let’s take a deeper dive.

Mischievous Mr. Market

Why is winning in the financial markets so difficult? Ellis devotes a considerable amount of time in WTLG talking about the crafty guy called “Mr. Market.” Here’s how Ellis describes the unique individual:

“Mr. Market is a mischievous but captivating fellow who persistently teases investors with gimmicks and tricks such as surprising earnings reports, startling dividend announcements, sudden surges of inflation, inspiring presidential announcements, grim reports of commodities prices, announcements of amazing new technologies, ugly bankruptcies, and even threats of war.”

           

Investors can easily get distracted by Mr. Market, and Ellis makes the point of why we are simple targets:

“Our internal demons and enemies are pride, fear, greed, exuberance, and anxiety. These are the buttons that Mr. Market most likes to push. If you have them, that rascal will find them. No wonder we are such easy prey for Mr. Market with all his attention-getting tricks.”

 

The market also has a way of lulling investors into complacency. Somehow, bull markets manage to make geniuses not only out of professionals and amateur investors, but also cab drivers and hair-dressers. Here is Ellis’s observation of how we tend to look at ourselves:

“We also think we are ‘above average’ as car drivers, as dancers, at telling jokes, at evaluating other people, as friends, as parents, and as investors. On average, we also believe our children are above average.”

 

This overconfidence and elevated self-assessment generally leads to excessive risk-taking and eventually hits arrogant investors over the head like a sledgehammer. Michael Mauboussin, Legg Mason Chief Investment Strategist and author of Think Twice, is a current thought leader in the field of behavioral finance that tackles many of these behavioral finance issues (read my earlier piece).

The Collateral Damage

As mentioned by Ellis in the previous WTLG article I wrote, “Eighty-five percent of investment managers have and will continue over the long term to underperform the overall market.” When emotions take over our actions, Mr. Market has a way of making investors make the worst decisions at the worst times. Ellis describes this phenomenon in more detail:   

“The great risk to individual investors is not that the market can plummet, but that the investor may be frightened into liquidating his or her investments at or near the bottom and miss all the recovery, making the loss permanent. This happens to all too many investors in every terrible market drop.”

 

With the market about doubling from the early 2009 equity market lows, this devastating problem has become more evident. With volatility rearing its ugly head throughout 2008 and early 2009, investors bailed into low-yielding cash and Treasuries at the nastiest time. Now the stock market has catapulted upwards and those same investors now face significant interest rate risk and still are experiencing meager yields.

The Winning Formula

Ellis acknowledges the difficulty of winning at the investing game, but experience has shown him ways to combat the emotional demons. Number one…know thyself.

“’Know thyself’ is the cardinal rule in investing. The hardest work in investing is not intellectual; it’s emotional.”

 

Knowing thyself is easier said than done, but experience and mistakes are tremendous aids in becoming a better investor – especially if you are an investor who spends time studying the missteps and learns from them.

From a practical portfolio construction standpoint, how can investors combat their pesky emotions? Probably the best idea is to follow Ellis’s sage advice, which is to “sell down to the sleeping point. Don’t go outside your zone of competence because outside that zone you may get emotional, and being emotional is never good for your investing.”

Finding good investment ideas is just half the battle – fending off the demons and Mr. Market can be just as, if not more, challenging. Fortunately, Mr. Ellis has been kind enough to share his insights, allowing investors of all types to take this valuable investment advice to help win at a losing game.

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 10, 2011 at 1:51 am Leave a comment

Winning the Loser’s Game

Besides hanging out with family and friends, and stuffing my face with endless amounts of food, the other benefit of the holidays is the quality time I’m afforded to dive into a few books. While sinking into the couch in my bloated state, I had the pleasure of reading an incredible, investment classic by Charles Ellis, Winning the Loser’s Game“WTLG”  (click here to view other remarkable book I read [non-investment related]).  To put my enthusiasm in perspective, WTLG has even achieved the elite and privileged distinction of making the distinguished “Recommended Reading” list of Investing Caffeine (located along the right-side of the page). Wow…now I know you must be really impressed.

The Man, The Myth, the Ellis

For those not familiar with Charley Ellis, he has a long, storied investment career. Not only has he authored 12 books, including compilations on Goldman Sachs (GS) and Capital Group, but his professional career dates back prior to 1972, when he founded institutional consulting firm Greenwich Associates. Besides earning a college degree from Yale University, and an MBA from Harvard Business School, he also garnered a PhD from New York University. Ellis also is a director at the Vanguard Group and served as Investment Committee chair at Yale University along investment great David Swensen (read also Super Swensen) from 1992 – 2008.

With this tremendous investment experience come tremendous insights. The original book, which was published in 1998, is already worth its weight in gold (even at $1,384 per ounce), but the fifth edition of WTLG is even more valuable because it has been updated with Ellis’s perspectives on the 2008-2009 financial crisis.

Because the breadth of topics covered is so vast and indispensable, I will break the WTLG review into a few parts for digestibility. I will start off with the these hand-picked nuggets: 

Defining the “Loser’s Game”

Here is how Charles Ellis describes the investment “loser’s game”:

“For professional investors,  “the ‘money game’ we call investment management evolved in recent decades from a winner’s game to a loser’s game because a basic change has occurred in the investment environment: The market came to be dominated in the 1970s and 1980s by the very institutions that were striving to win by outperforming the market. No longer is the active investment manager competing with cautious custodians or amateurs who are out of touch with the market. Now he or she competes with other hardworking investment experts in a loser’s game where the secret to winning is to lose less than others lose.”

 

Underperformance by Active Managers

Readers that have followed Investing Caffeine for a while understand how I feel about passive (low-cost do-nothing strategy) and active management (portfolio managers constantly buying and selling) – read Darts, Monkeys & Pros.  Ellis’s views are not a whole lot different than mine – here is what he has to say while not holding back any punches:

“The basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot, as a group, outperform themselves. In fact, given the cost of active management – fees, commissions, market impact of big transactions, and so forth-85 percent of investment managers have and will continue over the long term to underperform the overall market.”

 

He goes on to say individuals do even worse, especially those that day trade, which he calls a “sucker’s game.”

Exceptions to the Rule

Ellis’s bias towards passive management is clear because “over the long term 85 percent of active managers fall short of the market. And it’s nearly impossible to figure out ahead of time which managers will make it into the top 15 percent.” He does, however, acknowledge there is a minority of professionals that can beat the market by making fewer mistakes or taking advantage of others’ mistakes. Ellis advocates a slow approach to investing, which bases “decisions on research with a long-term focus that will catch other investors obsessing about the short term and cavitating – producing bubbles.” This is the strategy and approach I aim to achieve.

Gaining an Unfair Competitive Advantage

According to Ellis, there are four ways to gain an unfair competitive advantage in the investment world:

1)      Physical Approach: Beat others by carrying heavier brief cases and working longer hours.

2)      Intellectual Approach: Outperform by thinking more deeply and further out in the future.

3)      Calm-Rational Approach: Ellis describes this path to success as “benign neglect” – a method that beats the others by ignoring both favorable and adverse market conditions, which may lead to suboptimal decisions.

4)      Join ‘em Approach: The easiest way to beat active managers is to invest through index funds. If you can’t beat index funds, then join ‘em.

The Case for Stocks

Investor time horizon plays a large role on asset allocation, but time is on investors’ side for long-term equity investors:

“That’s why in the long term, the risks are clearly lowest for stocks, but in the short term, the risks are just as clearly highest for stocks.”

 

Expanding on that point, Ellis points out the following:

“Any funds that will stay invested for 10 years or longer should be in stocks. Any funds that will be invested for less than two to three years should be in “cash” or money market instruments.”

 

While many people may feel stock investing is dead, but Ellis points out that equities should return more in the long-run:

“There must be a higher rate of return on stocks to persuade investors to accept risks of equity investing.”

 

The Power of Regression to the Mean

Investors do more damage to performance by chasing winners and punishing losers because they lose the powerful benefits of “regression to the mean.” Ellis describes this tendency for behavior to move toward an average as “a persistently powerful phenomenon in physics and sociology – and in investing.” He goes on to add, good investors know “that the farther current events are away from the mean at the center of the bell curve, the stronger the forces of reversion, or regression, to the mean, are pulling the current data toward the center.”

The Power of Compounding

For a 75 year period (roughly 1925 – 2000) analyzed by Ellis, he determines $1 invested in stocks would have grown to $105.96, if dividends were not reinvested. If, however, dividends are reinvested, the power of compounding kicks in significantly. For the same 75 year period, the equivalent $1 would have grown to $2,591.79 – almost 25x’s more than the other method (see also Penny Saved is Billion Earned).

Ellis throws in another compounding example:

“Remember that if investments increase by 7 percent per annum after income tax, they will double every 10 years, so $1 million can become $1 billion in 100 years (before adjusting for inflation).”

 

The Lessons of History

As philosopher George Santayana stated – “Those who cannot remember the past are condemned to repeat it.” Details of every market are different, but as Ellis notes, “The major characteristics of markets are remarkably similar over time.”

Ellis appreciates the importance of history plays in analyzing the markets: 

“The more you study market history, the better; the more you know about how securities markets have behaved in the past, the more you’ll understand their true nature and how they probably will behave in the future. Such an understanding enables us to live rationally with markets that would otherwise seem wholly irrational.”

 

Home Sweet International Home

Although Ellis’s recommendation to diversify internationally is not controversial, his allocation recommendation regarding “full diversification” is a bit more provocative:

“For Americans, this would mean about half our portfolios would be invested outside the United States.”

 

This seems high by traditional standards, but considering our country’s shrinking share of global GDP (Gross Domestic Product), along with our relatively small share of the globe’s population (about 5% of the world’s total), the 50% percentage doesn’t seem as high at first blush.

Beware the Broker

This is not new territory for me (see Financial Sharks, Fees/Exploitation, and Credential Shell Game), and Ellis warns investors on industry sales practices:

“Those oh so caring and helpful salespeople make their money by convincing you to change funds. Friendly as they may be, they may be no friend to your long-term investment success.”

 

Unlike a lot of other investing books, which cover a few aspects to investing, Winning the Loser’s Game covers a gamut of crucial investment lessons in a straightforward, understandable fashion. A lot of people play the investing game, but as Charles Ellis details, many more investors and speculators lose than win. For any investor, from amateur to professional, reading Ellis’s Winning the Loser’s Game and following his philosophy will not only help increase the odds of your portfolio winning, but will also limit your losses in sleep hours.

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in GS, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

January 5, 2011 at 1:23 am 2 comments

Invisible Costs of Trading

Source: Photobucket

You can feel them, but you can’t see them. I’m talking about invisible trading costs. Although some single transaction trading costs can run as high as hundreds of dollars at the large brokerage firms, investors are generally aware of the bottom-basement commissions paid on trades executed at discount brokerage firms like Scottrade, TD Ameritrade (AMTD), E-Trade (ETFC), and Charles Schwab (SCHW) – generally less than $10 per trade. Unfortunately, these commissions are estimated to only account for 20% of total trading costs1. What most investors are unaware of are the host of invisible trading costs and expenses associated with active trading.

Here are some of the invisible costs:

Bid-Ask Spread: Besides the explicit commissions charged, traders must incur the implicit costs of the bid-ask spread. Let’s suppose you have a stock trading at $12.50 per share (ask price) and $12.25 per share (bid price). If you were to immediately buy one share for $12.50 (ask) and sell immediately for $12.25 (ask), then you would be -2% in the hole instantly – more than double the $7.95 commission paid on a $1,000 investment. Effectively, the investor would already be down about -3% the instant the small investment was made.

Impact Costs: The issue of impact costs is a bigger problem for larger institutional investors, although thinly traded stocks (those securities with relatively small trading volume) can even become expensive for retail investors. Suppose the same stock mentioned previously initially traded at $12.50 per share before you transacted, but reached $13.00 per share upon completion (with an average $12.75 price paid). The $.25 cent increase (average price minus initial price) translates into another -2% increase in the costs.

Taxes: It’s not what you make that matters, but rather what you keep that makes the difference. If you make a decent amount of money actively trading, but end up giving Uncle Sam more than potentially 40% of the gains, then your bank account may grow less than expected.

While my examples may shed some light on the costs of trading, an in-depth study using data from Morningstar and NYSE was conducted by three astute professors (Roger Edelen [University of California, Davis], Richard Evans [University of Virginia], and Gregory Kadlec [Virginia Polytechnic Institute]) showing that an average fund’s annual trading costs were estimated to be 1.44%, higher than an average fund’s overall expense ratio of 1.21%.

Unfortunately from an investor’s standpoint, as much as 30% of all trading costs can be attributed to money naturally pouring in and out of funds, due to fund share purchases and redemptions. Therefore, wildly popular or out-of-favor funds will have a detrimental impact on performance. I know firsthand the costs of managing a large fund, much like captaining a supertanker – you create a lot of waves and it can take a while to change directions. Smaller funds, however, can navigate trades more nimbly, much like a speedboat leaving behind smaller cost waves in its wake.

Style can also have an impact on trading costs. Value-based funds that sell into strength or buy into weakness can be considered liquidity providers, and therefore will experience lower trading costs. On the flip side, momentum strategies effectively pour gasoline on hot stocks purchases and pile on damaging sales to cratering losers.

Emotional Costs of Trading

More impactful, but more difficult to quantify, are the emotional trading costs of greed and fear (i.e., chasing extended winners out of greed and panicking out of losing positions due to fear). Constantly hounding winners and capitulating your losers may work in a few instances, but can lead to disastrous results in the long-run. Even if an investor is correct on the sale of a security, the investor must also be right on the subsequent buy transaction (no easy feat).

With that said, there are no hard and fast rules when buying/selling stocks. Buying a stock that has doubled or tripled in and of itself is not necessarily a bad idea, as long as you have credible assumptions and data to support adequate earnings/cash flow growth and/or multiple expansion. Consistent with that thought process, a plummeting stock is not reason enough to buy, and does not automatically mean the price will subsequently rebound. Reversion to the mean can be a powerful force in security selection, but you need a disciplined process to underpin those investment decisions.

Spiritual Savings

As I have stated in the past, investing is like a religion (read more Investing Religion). Most investors stubbornly believe their financial religion is the right way to make money. I personally believe there is more than one way to make money, just as I believe different religions can coexist to achieve their spiritual goals. Through academic research, and a lot of practical experience, my religion believes in the implementation of low-cost, tax efficient products and strategies used over longer-term time horizons. I use a blend of active and passive management that leverages my professional experience (see Sidoxia’s Fusion product), but I would fault nobody for pursuing a purely passive investment strategy. As John Bogle shows, and has proven with the financial success of his company Vanguard, passive investing by and large materially outperforms professional mutual fund managers (see Hammered Investors article).

Investing can be thrilling and exciting, but like a leaky faucet, the relatively small and apparently harmless list of trading costs have a way of collecting over the long-run before sinking long-term performance returns. Sure, there are some high-frequency traders that make a living by amassing a large sums of rebates for providing short-term liquidity, but for most investors, excessive exposure to invisible trading costs will lead to visible underperformance.

Read more about trading cost study here1

Wade W. Slome, CFA, CFP® 

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds (including Vanguard funds), but at the time of publishing SCM had no direct position in AMTD, ETFC, SCHW, Scottrade, MORN, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

December 15, 2010 at 12:05 am Leave a comment

Changing of the Guard

Over previous decades, there has been a continual battle between the merits of active versus passive management. Passive management being what I like to call the “do nothing” strategy, in which a basket of securities is purchased, and the underlying positions remain largely static. For all intents and purposes, the passive management strategy is controlled by a computer. Rather than solely using a computer, active management pays professionals six or seven figures to fly around to conferences, interview executive management teams, and apply their secret sauce tactics. Unlike passive managers, active managers do their best to determine which winning securities to buy and which losing ones to sell in their mutual funds and hedge funds.

Caught in the middle of this multi-decade war between passive and active management are Vanguard Group (founded in Valley Forge, Pennsylvania in 1975 by John Bogle) and Fidelity Investments (founded in 1946 in Boston, Massachusetts by Edward C. Johnson II).  Currently John Bogle and Vanguard’s passive philosophy is winning the war. A changing of the guard, similar to the daily ceremony witnessed in front of Buckingham Palace is happening today in the mutual fund industry. Specifically, Vanguard, the company spearheading passive investing, has passed Fidelity Investments as the largest mutual fund company according to assets under management. Before 2010, Fidelity topped the list of largest firms every year since 1988, when it passed the then previous leader, Merrill Lynch & Co (BAC).

As of July 2010, Vanguard stands at the top of the mutual fund hill, managing $1.31 trillion versus Fidelity’s $1.24 trillion. Vanguard is sufficiently diversified if one considers its largest fund, the Vanguard Total stock Market Index Fund (VITSX), sits at around $127 billion in assets. The picture looks worse for Fidelity, if you also account for the $113 billion in additional ETF assets (Exchange Traded Funds) Vanguard manages – Fidelity is relatively absent in the ETF segment (State Street). Once famous active funds, such as Fidelity Magellan (now managed by Harry Lange – FMAGX) have underperformed the market over the last ten years causing peak assets of $110 billion in 2000 to decline to around $22 billion today. The $68 billion Fidelity Contrafund (FCNTX), managed by Will Danhoff, has not grown sufficiently to offset Magellan’s (and other funds) declines.

The Proof is in the Pudding

Some in the industry defend the merits of active management, and through some clever cherry-picking and data mining come to the conclusion that passive investing is overrated. If you believe that money goes where it is treated best, then the proof in the pudding suggests active management is the discipline actually suffering the beating (see Darts, Monkeys & Pros). The differences among the active-passive war of ideals have become even more apparent during the heart of the financial crisis. Since the beginning of 2008 through August 2010, Morningstar shows $301 billion in assets hemorrhaging from actively managed U.S. equity funds, while passive equity-index funds have soaked up $113 billion of inflows.

On a firm-specific basis, InvestmentNews substantiated Vanguard’s gains with the following figures:

In the 10 years ended Dec. 31, Vanguard’s stock and bond funds attracted $440 billion, compared with $101 billion for Fidelity, Morningstar estimates. This year through August, Vanguard pulled in $49 billion while Fidelity had withdrawals of $2.8 billion, according to the research firm.

Vanguard is gaining share on the bond side of the house too:

Vanguard also benefited from the popularity of bond funds. From Jan. 1, 2008, through Aug. 31, 2010, the company’s fixed- income portfolios pulled in $134 billion while Fidelity’s attracted $33 billion (InvestmentNews).

Vanguard is not the only one taking share away from Fidelity. Fido is also getting pinched by my neighbor PIMCO (Pacific Investment Management Company), the $1.1 trillion assets under management fixed income powerhouse based in Newport Beach, California. Bond guru Bill Gross leads the $248 billion Pimco Total Return Fund (PTTAX), which has helped the firm bring in $54 billion in assets thus far in 2010.

Passive Investing Winning but Game Not Over

Even with the market share gains of Vanguard and passive investing, active management assets still dwarf the assets controlled by “do-nothing” products. According to the Vanguard Group and the Investment Company Institute, about 25% of institutional assets and about 12% of individual investors’ assets are currently indexed (2009). The analysis gets a little more muddied once you add ETFs to the mix.

Passive investing may be winning the game of share gains, but is it winning the performance game? The academic research has been very one-sided in favor of passive investing ever since Burton Malkiel came out with his book, A Random Walk Down Wall Street. More recently, a study came out in June 2010 by Standard & Poor’s Indices Versus Active Funds (SPIVA) division showing more than 75% of active fixed income managers underperforming their index on a five-year basis. From an equity standpoint, SPIVA confirmed that more than 60% domestic equity funds and more than 84% international equity funds underperformed their benchmark on a five-year basis. InvestmentNews provides some challenging data to active-management superiority, however it is unclear whether survivorship bias, asset-weighting, style drift, and other factors result in apples being compared to oranges. SPIVA notes the complexity over the last three years has increased due to 20% of domestic equity funds, 13% of international equity funds, and 12% of fixed income funds liquidating or merging.

Regardless of the data, investors are voting with their dollars and happily accepting the superior performance, while at the same time paying less in fees. The positive aspects associated with passive investment products, such as index funds and ETFs, are not only offering superior performance like a Ferrari, but that enhanced quality also comes at the low price equivalent of a Hyundai. On a dollar-adjusted basis, stock-index funds charge an average of 29 cents per $100, compared with 95 cents for active funds (almost a 70% discount), according to research firm Lipper. For example, Vanguard’s passive VITSX fund charges clients as little as 6 cents for every $100 invested (Morningstar).

There has indeed been a changing of the market share guard and Fidelity may also be losing the debate over active versus passive management, but you do not need to shed a tear for them. Fidelity is not going to the poorhouse and will not be filing for Chapter 11 anytime soon. Last year Fidelity reported $11.5 billion in revenue and $2.5 billion in operating income. Those Fidelity profits should be more than enough to cover the demoted guard’s job retraining program and retirement plan benefits.

Read the Complete InvestmentNews Article

Wade W. Slome, CFA, CFP®  

Plan. Invest. Prosper. 

www.Sidoxia.com

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds, but at the time of publishing SCM had no direct position in VITSX, PTTAX, BAC, FCNTX, FMAGX, or any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

October 3, 2010 at 11:18 pm 3 comments

Passive vs. Active Investing: Darts, Monkeys & Pros

Bob Turner is founder of Turner Investments and a manager of several funds at the investment company. In a recent article he reintroduces the all-important, longstanding debate of active management (“hands-on”) versus passive management (“hands off”) approaches to investing.

Mr. Turner makes some good arguments for the active management camp, however some feel differently – take for example Burton Malkiel. The Princeton professor theorizes in his book A Random Walk Down Wall Street that “a blindfolded monkey throwing darts at a newspaper’s stock page could select a portfolio that would do just as well as one carefully selected by experts.” In fact, The Wall Street Journal manages an Investment Dartboard contest that stacks up amateur investors’ picks against the pros’ and random stock picks selected by randomly thrown darts. In many instances, the dartboard picks outperform the professionals.

Given the controversy, who’s right…the darts, monkeys, or pros? Distinguishing between the different categorizations can be difficult, but we will take a stab nevertheless.

Arguments for Active Management

Turner contends, active management outperforms in periods of high volatility and he believes the industry will be entering such a phase:

“Active managers historically have tended to perform best in a market in which the performance of individual stocks varies widely.”

He also acknowledges that not all active managers outperform and admits there are periods where passive management will do better:

“The reason why most active investors fail to outperform is because they in fact constitute most of the market. Even in the best of times, not all active managers can hope to outperform…The business of picking stocks is to some degree a zero-sum game; the results achieved by the best managers will be offset at least somewhat by the subpar performance of other managers.”

Buttressing his argument for active management, Turner references data from Advisor Perspectives showing an inconclusive percentage (40.5%-67.8%) of the actively managed funds trailing the passively managed indexes from 2000 to 2008.

The Case for Passive Management

Turner cites one specific study to support his active management cause. However, my experience gleaned from the vast amounts of academic and industry data point to approximately 75% of active managers underperforming their passively managed indexes, over longer periods of time. Notably, a recent study conducted by Standard & Poor’s SPIVA division (S&P Indices Versus Active Funds) discovered the following conclusions over the five year market cycle from 2004 to 2008:

  • S&P 500 outperformed 71.9% of actively managed large cap funds;
  • S&P MidCap 400 outperformed 79.1% of mid cap funds;
  • S&P SmallCap 600 outperformed 85.5% of small cap funds.

Read more about  the dirty secrets shrinking your portfolio.

According to the Vanguard Group and the Investment Company Institute, about 25% of institutional assets and about 12% of individual investors’ assets are currently indexed (passive strategies).  If you doubt the popularity of passive investment strategies, then look no further than the growth of Exchange Traded Funds (ETFs – see chart), index funds, or Vanguard Groups more than $1 trillion dollars in assets under management.

Although I am a firm believer in passive investing, one of its shortcomings is mean reversion. This is the idea that upward or downward moving trends tend to revert back to an average or normal level over time. Active investing can take advantage of mean reversion, conversely passive investing cannot. Indexes can get very top-heavy in weightings of outperforming sectors or industries, meaning theoretically you could be buying larger and larger shares of an index in overpriced glamour stocks on the verge of collapse.  We experienced these lopsided index weightings through the technology bubbles in the late 1990s and financials in 2008. Some strategies may be better than other over the long run, but every strategy, even passive investing, has its own unique set of deficiencies and risks.

Professional Sports and Investing

As I discuss in my book, there are similarities that can be drawn between professional sports and investing with respect to active vs. passive management. Like the scarce number of .300 hitters in baseball, I believe there are a select few investment managers who can consistently outperform the market. In 2007, AssociatedContent.com did a study that showed there were only 22 active career .300 hitters in Major League Baseball. I recognize in the investing world there can be a larger role for “luck,” which is difficult, if not impossible, to measure (luck won’t help me much in hitting a 100 mile per hour fastball thrown by Nolan Ryan). Nonetheless, in the professional sports arena, there are some Hall of Famers (prospects) that have proved they could (can) consistently outperform their peers for extended durations of time.

Experience is another distinction I would highlight in comparing sports and investing. Unlike sports, in the investment world I believe there is a positive correlation between age and ability. The more experience an investor gains, generally the better long-term return achieved. Like many professions, the more experience you gain, the more valuable you become. Unfortunately, in many sports, ability deteriorates and muscles atrophy over time.

Size Matters

Experience alone will not make you a better investor. Some investors are born with an innate gift or intellect that propels them ahead of the pack. However, most great investors eventually get cursed by their own success thanks to accumulating assets. Warren Buffet knows the consequences of managing large amounts of dollars, “gravity always wins.”  Having managed a $20 billion fund, I fully appreciate the challenges of investing larger sums of money. Managing a smaller fund is similar to navigating a speed boat – not too difficult to maneuver and fairly easy to dodge obstacles. Managing heftier pools of money can be like captaining a supertanker, but unfortunately the same rapid u-turn expectations of the speedboat remain. Managing large amounts of capital can be crippling, and that’s why captaining a supertanker requires the proper foresight and experience.

Room for All

As I’ve stated before, I believe the market is efficient in the long run, but can be terribly inefficient in the short-run, especially when the behavioral aspects of emotion (fear and greed) take over. The “wait for me, I want to play too” greed from the late 1990s technology craze and the credit-based economic collapse of 2008-2009 are further examples of inefficient situations that can be exploited by active managers. However, due to multiple fees, transaction costs, taxes, not to mention the short-term performance/compensation pressures to perform, I believe the odds are stacked against the active managers. For those experienced managers that have played the game for a long period and have a track record of success, I feel active management can play a role.

At Sidoxia Capital Management, I choose to create investment portfolios that blend a mixture of passive and active investment strategies. Although my hedge fund has outperformed the S&P 500 in 2009, that fact does not necessarily mean it’s the appropriate sole approach for all clients. As Warren Buffet states, investors should stick to their “circle of competence” so they can confidently invest in what they know.  That’s why I generally stick to the areas of my expertise when I’m actively investing in stocks, and fill in the remainder of client portfolios with transparent, low-cost, tax-efficient equity and fixed income products (i.e., Exchange Traded Funds).

Even though the actively managed Turner Funds appear to have a mixed-bag of performance numbers relative to passively managed strategies, I appreciate Bob Turner’s article for addressing this important issue.  I’m sure the debate will never fully be resolved. In the meantime, my client portfolios will aim to mix the best of both worlds within active and passive management strategies in the eternal quest of outwitting the darts, monkeys, and other pros.

Read the full Bob Turner article on Morningstar.com

Wade W. Slome, CFA, CFP®

Plan. Invest. Prosper. 

DISCLOSURE: Sidoxia Capital Management (SCM) and some of its clients own certain exchange traded funds but had no direct position in stocks mentioned in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.

December 8, 2009 at 1:45 am 5 comments


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