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My first essay (Peaceful Wealth: Where Do We Begin the Journey?) focused on the tremendous gap between market returns and the actual returns received by the average investor. Many attribute this atrocious performance solely to poor choices and unfair practices from investors.
My second essay (Peaceful Money: Beware of Broken Business Models) examines the role of traditional brokers and whether their supposed expertise helps investors solve market riddles. We discuss two recent academic studies that highlight a harsh reality. Both studies found that commission-based brokers and insurance agents do little to help investors avoid making choices that sabotage returns.
Now let’s look at the investing process and decide that the traditional stock picking, marketing timing, and performance chasing strategy most investors follow (and Wall Street constantly preaches) is also part of the problem.
“It’s not easy getting rich in Las Vegas, at Churchill Downs or at the local Merrill Lynch office” – Dr. Paul Samuelson, Nobel Prize-winning economist
Much of the investing world follows an investment philosophy rooted in the belief that a consistent return can be made by buying and selling the “right” stocks and bonds at the “best” time. Known as active management, this philosophy of finding stock market success is akin to an alchemist’s quest to create gold from base metals. Experts and novices alike may want to turn an under-appreciated or mispriced property into a personal gold mine.
Investopedia defines active management as “an investment strategy that involves ongoing buying and selling actions by the investor. Active investors buy investments to take advantage of profitable situations and continuously monitor their activity.” Active managers rely on analytical research, forecasting and their own judgment and experience to make investment decisions on which securities to buy, hold and sell.”
Buying or selling the right stock at the right time is counter-intuitive to all of us. We are surrounded by the principles of cause and effect in our daily lives. We know that results follow inputs and so we can easily train ourselves to identify the cause of most of life’s results based on experience and insight. 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 your knowledge to maximum effect.
When it comes to investing, we know that the price of most stocks changes everyday. The law of cause and effect tells us that uncovering the causes of those changes will help us predict future events and benefit from our knowledge. Our instinctive logic is fueled by compelling sales messages delivered daily by Wall Street experts. We buy into a system that tells us that the analyst’s knowledge and experience exceed our own and are worth the price we have to pay to get the results we want.
Unfortunately, academic research has revealed two major flaws in proactive management:
- This is an expense.
- This doesn’t work.
A Broken Business Model, Part II
Let’s suspend the discussion of whether active management works for a moment and focus on the expense equation. in his book The Great Mutual Fund Trap Former Undersecretary of the Treasury Gary Gensler and former Assistant Secretary of State for Financial Institutions Gregory Beyer compared the expense of active management within a mutual fund to running with heavy ankle weights. The fund manager may be a world-class expert in his or her race, however the heavy burden of research, commissions, fees and other costly “ankle weights” quickly nullifies any potential advantage they may offer. The authors’ own analysis includes the following disclosures and unknown costs. Mutual fund expenses that can take away more than 4% of an actively managed mutual fund investor’s money each year are:
- expense ratio.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 charges directly from your account. Morningstar reports that the average mutual fund expense ratio is 1.51%.
- sales commissions. Known as front-end load if paid at the time of purchase or back-end load if paid when funds are sold. Baer and Gensler calculate that mutual fund commissions cost investors up to $20 billion a year.
- trading cost, These are the undisclosed costs that are active management strategies when buying and selling stocks and bonds. These include brokerage commissions, bid/ask spreads and market effects on share prices when fund managers buy and sell large blocks of stocks. Baer and Gensler estimate that investors sacrifice 0.5% to 1.0% of their annual total returns to trading costs.
- idle cash.Morningstar reports the average idle cash, known as the liquidity ratio, averages 10%. The high liquidity ratio is believed to cost mutual fund investors 0.2% to 0.25% of the returns per annum.
- taxes, Investors holding mutual funds in taxable accounts must pay their share of any short-term and long-term capital gains during the year. By definition, active managers buy and sell stocks throughout the year, exposing investors to significant tax liability. Most investors do not realize that they are liable for these internal taxes, even if they do not realize profits while owning the fund. The Wall Street Journal reported in an October 24, 2007 article titled Taxable payments on many funds set to rise By Elenore Laise, “Over the past 10 years, the average stock fund has surrendered an annual 1.4 percentage points of its return to taxes, according to fund researcher Lipper Inc.”
“But wait”, many investors cry, “I will avoid most of these costs by choosing my own stocks and managing my own account. Stock selection is not rocket science. I know I can make these Can do a good job like the so-called experts.” ,
Let’s be realistic. If we focus only on the expense equation, an individual investor will avoid paying mutual fund expense ratios and sales commissions by selecting their own shares. However, they will not escape transaction fees, custodial fees, individual research costs, bid/ask spreads, taxes on short-term capital gains, taxes on long-term capital gains, component costs of carrying the risks of an under-ownership. Committed personal expenditure of time and effort to manage diversified portfolios and investments.
“If 10,000 people are watching a stock and trying to pick winners, one out of 10,000 is going to score, by chance alone, a great coup, and that’s all it’s going to be. It’s a game, it One chance is the operation, and people think they’re doing something purposeful…but they’re really not.” – Late Dr. Merton Miller, Nobel laureate and University of Chicago professor of economics
Does Active Management Succeed in Beating the Markets? I can’t deny the truth. Sometimes it does, both anecdotally (there’s always the story of the individual investor who bought Google or sold Enron at the right time) and in the short run (this year’s #1 rated mutual fund). Every year there are also lottery winners and people who run with the bulls of Pamplona. It doesn’t mean that a lottery winner has a winning system, a bull runner has any common sense or that active managers can consistently overcome their high cost strategies or the incredible odds of an efficient market.
The academic literature refuting the claims of active management’s market-beating prowess is persuasive. To quote Weston Wellington, vice president of Dimensional Fund Advisors, in a February 2007 article in Advisor’s Edge titled balance based investment“For fans of stock-picking, the evidence is not encouraging. Researchers have studied the performance of professional money managers in the US for more than forty years. The evidence is compelling: Markets beat managers, not the other way around.”
Investors looking to be the exception to this rule should take note. Choosing only “good” active managers or “proven” stock-picking or market timing strategies are equally flawed approaches. The same article reports actively managed mutual funds that outperform the market in any given year have “no potential to outperform a lower-quartile performer in the future.”
Just as a reasonable effort to lose weight should involve a diet of unhealthy foods, a prudent investor should steer themselves away from investment approaches that are both costly and unproductive. They must reject a broken business model plagued by commission-driven self-interest, money-stealing fee structures and dubious claims of market-beating expertise. The fanciful pursuits of medieval alchemists eventually came to an end in the light of reason and scientific evidence. The alchemy of modern day active management is about to meet the same fate.
Good news. A broken investing business model doesn’t need to screw up your portfolio. Those who are wise enough to embrace the facts and follow an investment method based on modern economic theory can achieve peaceful wealth. Investors now have powerful allies in the pursuit of retirement goals and financial dreams. We’ll chart our course and set our sails during our next chat.
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