Security Selection - Active Investing versus Index Investing Talk to almost all academics and suggest the market is inefficient, or is inefficient enough to outperform the index, and you'll get a resounding "it can't be done..." Why? Here we'll explain why theoretically and empirically. Return Distributions of Active versus Index Mathematically, the sum of all investors with investment costs added back, must equal the sum of the market. Stated another way, the returns of all investors plus the cost of investing, must equal the total market return. If we refute this, it's like saying 2+2=5, it simply can't be. If we believe that investment managers are a good sample of investors, which we believe is a safe statement, then investment managers as a group, after fees, must underperform the market. Nobel Laureate William Sharpe has a wonderful illustration of this in his paper The Arithmetic of Active Management. Short Term Distribution of Investment Manager Returns - No Fees Before fees, we first illustrate how things might look in a Standard Normal data world. Market Average and Manager Average are the same. Assumes no Friction and perfect standard normal distribution. Short Term Distribution of Investment Manager Returns - With 2% Fee After fees, each investment manager moves lower by the amount of its fees. This leaves a small number of managers in the darker green that are now outperforming their relative index. Long-Term Distribution of Investment Manager Returns As more time passes, the distribution of managers narrow. This makes it more difficult to outperform the index. Fat Tails and Skewed Distributions In the previous three graphs, we walked you through some basics of the theoretical challenges that an active manager has in outperforming an index. Now, we'll overlay a unique statistical problem within investment markets: Negative Skew and Leptokurtic Kurtosis. Wait a minute, I don't even know what this is and now you're telling me I might have this problem? Negative Skew In a simple form, think of this as whether the distribution is heavier on one side or the other. Kurtosis In its simple form, think of this as whether the distribution is bunched up in the middle with long outstanding tails, or a shorter top, distributions closer to the middle, with smaller tails (not as many extreme outliers).Normal Kurtosis has a number of 3, Kurtosis that is greater than 3 is said to be Leptokurtic, and Kurtosis of less than 3 is said to be Platykurtic. Do not use these words at a cocktail party. Although a little difficult to see in this graph, the top of the distribution is taller. The Left Tail is skewed to the left, this means underperforming mangers underperform by a lot. The Right Tail is smaller than the Left Tail. This means that of the managers that do outperform, they outperform by a smaller amount than the amount the bad ones underperform by. Overall, this has lowered the probability that an active manager will outperform. Survivorship Bias Study 1970-2005 Study of Mutual Funds, source-Bogle Survivorship Bias is the illusory effect that investors in reality did worse than how the data says they did. This happens because bad funds die, only leaving good funds in the dataset. Once these bad funds are taken out of the dataset, one might conclude that active managers in general do pretty well. This couldn't be farther from the truth. We think it also helps explains why when investors are surveyed, the actual experience is mediocre, yet if you look at fund company offerings, most of the funds seem to be pretty good. A study of funds from 1970 to 2005 began with 355 funds and found that only 44 funds did better than a buy and hold index. Notice the far left bar is the number of funds that either died or underperformed by more than 4%. For example, 223 next to the far left column represents that during this period, 223 of 355 funds died or underperformed by a lot, more than half were in this category. The number 2 above the far right column represents that of 355 funds 2 had an average annual return of beating the benchmark by more than 4% per year. Notice that 44 of 355 funds beat the market index. Of the 355 funds that started the period, 223 funds went out of existence or underperformed by 4% or more. When funds go out of business, sell, merge, or liquidate, it's almost always related to bad performance. Of the poor performing funds, often, fund companies buy good performing funds and merge the old bad funds into the good performing funds. Remember though, this is not how the investors actually did. Once the funds are merged, studies have shown that future performance is no better than the average performance of the category, and average performance is almost always much worse than the index performance. Comparison of Style As one considers the competing strategies of active versus index investing, it's good to understand a basic comparison: How to pick specific fund managers to buy particular securities or; How you're going to specifically find the securities yourself to fill in the asset class targets. Comparison of Index vs. Active Investing Type of Analysis Active Index Note Discounted Cash Flows (DCF) Predict future revenue and expenses. Accept market expectations. Predicting Cash-Flows with accuracy has proven to be very challenging. Sum of Parts Analyze each part of the company, apply a Market Value to each part, and Sum the Parts. Accept Market Expectations. The sale of divisions, or liquidation of the company may never be realized. Momentum Find companies with accelerating earnings versus expectations and buy those companies. Understand that you will have in the Index some companies with Accelerating earnings and some with decelerating earnings. Misses in acceleration can be very harmful to a company's stock price and investors are subject to significant risks in this prediction. Relative Value Find the least expensive company compared to its peers. Buy all of the companies in the peer group. Usually there are many reasons why a company's stock is more or less expensive than its peers. Discount Rate At some point once a cash-flow is predicted, a discount rate must be applied to get to a present value, the actual rate is a significant factor in determining current target price. There is an implied invisible rate applied to the current price of all securities. This is an equilibrium of the opinions of all Investors. The discount rate has three factors, the Risk-Free Rate, the Market Risk Premium, and the Systematic Risk or Risks related to a particular security. Determining any of these is difficult, thus finding the sum of them is all the more challenging. Technical Indicators The practice of using a security's past price to formulate a future price. The current price of a security tells investors the equilibrium of all investors in the market. From one time period to the next most market researchers consider the price change to be random with a positive drift. The drift being upward in nature (this means a positive return) and over time equaling the expected return of the asset's riskiness. The above general philosophies are by no means exhaustive, however, they do give a broad framework of the most common processes employed in active management and the indexing counter-thought. Benjamin Graham Benjamin Graham is considered to be the grandfather of Investment Analysis and first quantified what is known as Value Investing in his 1934 book Security Analysis with David Dodd. In Security Analysis they analyzed the balance sheet to come up with a value and margin of safety, applied discounts to future values, and suggested buying the assets with the largest discounts to their current market prices, thus trying to get the best deal. Warren Buffet was a student of Benjamin Graham at Columbia University and has applied many of Graham's approaches to his investments. This set the stage for the work of John Burr Williams. John Burr Williams quasi-independently extended Graham's work in his 1938 publishing of The Theory of Investment Value, and is known as the creator of the Dividend Discount Model (DDM). The Argument between Active and Index based Investing The Efficient Market Hypothesis has been a central proposition in finance since the early 1970's. The core idea is that: Markets fully reflect information in securities prices. New Information is priced into Securities Prices at a fast enough rate that extra return cannot be made in competing for this new information. The equilibrium opinion of all investors create the clearing price for a security. There are several forms of the Efficient Market Hypothesis: Weak-Form Efficiency Past prices cannot help in predicating future prices. Semi-Strong Form Efficiency Prices adjust quickly to new public information and extra profits cannot be made with this information. Strong Form Efficiency - Prices reflect all information, Public and Private, and extra returns cannot be made by having this informational advantage. If researched carefully, you'll likely find that: Most market participants believe in Weak-Form Efficiency (you can't beat the market by watching prices). Semi-Strong Efficiency beliefs: Academics -It is so widely believed that the market is Semi-Strong Efficient that it's of little debate. The exception is micro-economic phenomena, which is constantly under study, and is seldom available for profit. Investment Managers - Some investment managers, like Garde Capital, believe in Semi-Strong Efficiency. The number of these believers has increased steadily and significantly over the years. Some investment managers believe markets are semi-strong efficient for all other investors, but are not semi-strong efficient for them. We believe this thought process is self-serving and illustrates the behavioral finance flaw of over-confidence. Some investment managers believe that if a manager tries hard enough extra profits can be earned. The number of investment professionals in this camp has been steadily declining over the years. All investment professionals accept that as a whole, active managers must underperform the index by the amount of fees. If for some reason they do not believe this we would argue they are mathematically delusional. Professional Investors - Most professional investors distribute in the about same fashion as academics and investment professionals. Individual Investors - Individuals are often prone to an awareness bias, recency bias, and herding mentality in their opinions of the efficiency argument. Strong-Form Efficiency - Most market participants agree that with inside information (this is illegal) that it is possible to outperform the market. What Experts Say Burton Malkiel, a strong advocate of the Efficient Market Hypothesis, published a very readable paper in the Financial Review in 2005 that summarizes the data well, we suggest reading it if given the time. When asked if private investors can learn any lesson from what Harvard does? Yes. First, get diversified, come up with a portfolio that covers a lot of asset classes. Second, you want to keep your fees low. That means avoiding the most hyped but expensive funds in favor of low-cost index funds. Jack Meyer - former President - Harvard Management Company - Business Week, 2004 Why does indexing out-maneuver the best minds on Wall Street? Because the best and brightest in the financial community have made the market very efficient.Burton Malkeil, Ph.D.Princeton Professor, Author- A Random Walk Down Wall Street Most investors, both individual and institutional, will find the best way to own common stocks is through an index fund that charges minimal fees and expenses, those following this path are sure to beat the net results (after fees and expenses) delivered by the great majority of investment professionals. Warren Buffet 1996 Annual Report The truth is that, for the most part, fund managers have offered extremely poor value for the money. Their records of outperformance have almost always been followed by stretches of underperformance. Over long periods of time, hardly any fund managers have beaten the market.The Economist "...one specific lesson, the merits of index investing. You will almost never find a fund manager who can repeatedly beat the market. A minuscule 4% of funds produce market beating after-tax results with a scant 0.6% annual margin of gain. The 96% of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8% per annum." David Swensen - Chief Investment Officer- Yale University Endowment The S&P is up 343.8% for ten years. That is a four bagger. The general equity funds are up 283%. So it's getting worse, the deterioration by professionals is getting worse. The public would be better off in an index fund. Legendary investor Peter Lynch, Barron's It's fun to play around, it's human nature to try to select the right horse. (But) for the average person, I'm more of an indexer, the predictability is so high, for 10, 15, 20 years you'll be in the 15th percentile of performance. Why would you screw it up? Charles Schwab Personally The Investor Must Decide What's Right for Themselves As an investor embarks on an actual plan, regardless of that plan being active or index based, we suggest a few things as imperatives: Have a thorough understanding of the plan and make sure you are highly confident in the plan. if you're not highly confident in the plan, it's likely that during times of market stress, the plan will change course in a way that is detrimental to your financial well-being. We're not saying blindly stick to the plan, we're saying be aware of when you're changing in a reactive way, and when you're changing in an adaptive way. Adaptive - Rebalancing when the market is down. Reactive Changing objectives because the market is down. Have good measurement systems in place. Mange to your overall goals. Make sure your strategic asset allocation model meet your needs. Ask if any tactical bets from this model added value? If you have active managers, did they add value on a risk-adjusted basis after fees and taxes and did they stick to their discipline? If you have an index-based manager, did they have a low tracking error and did they keep taxes and fees low? Our top priority is your investment success, to the degree that this is helpful to the overall education process please let us know.