All sorts of possible cures have been suggested for the ills of active fund management. Cutting fees is surely the most obvious solution if the industry wants to stem the flow of assets out of actively managed funds. Simply trading less frequently would probably make a difference too.
One of the arguments we frequently hear is that the answer lies in higher conviction, or “real” active management.
It’s certainly true that the widespread practice of closet index tracking — charging active fees for effectively hugging the benchmark — is a big problem for the industry. As well as being fundamentally dishonest, it almost guarantees that, after costs, the investor will underperform a comparable index fund.
“Real” active managers, on the other hand, genuinely try to beat the market by investing in a smaller number of stocks which they believe will outperform.
Over the long term, only a tiny proportion of active managers outperform the market on a cost- and risk-adjusted basis — David Blake from Cass Business School puts the figure at around 1%. One thing those very few winners have in common, the evidence shows, is that they tend to be high-conviction managers with relatively concentrated portfolios. Understandably, then, the high-conviction approach is being heralded by some as the answer to the overwhelming failure of active managers to outperform.
But is it? For a start, a manager can can have high conviction and yet be completely wrong. Deviating from the index doesn’t mean you’ll see better returns than the market; it means you can expect different returns, which could either be better or worse.
New research by Tim Edwards and Craig Lazzara at S&P Dow Jones Indices suggests that far from solving active management’s problems, moving towards portfolios with fewer holdings may well exacerbate them. In a paper entitled Fooled by Conviction, Edwards and Lazzara suggest four likely consequences of active portfolios becoming substantially more concentrated, none of which makes comfortable reading for active investors.
Likely Consequence No. 1: Volatility will probably increase
Portfolios with a large number of holdings are less volatile than those with small number of holdings. So, for instance, if a manager reduces the number of stocks they hold from 100 to 20, the portfolio’s volatility will almost certainly increase.
Likely Consequence No. 2: Manager skill will be harder to identify
It’s already extremely hard to distinguish luck from skill in active management. Think of each stock pick as an opportunity for a manager to demonstrate their skill. The fewer stocks they pick, the bigger the impact that luck is likely to have on the outcome.
Likely Consequence No. 3: Trading costs will rise
There are two reasons, Edwards and Lazzara argue, why costs would probably rise with greater concentration. First, fund turnover would increase. Secondly, transaction costs per trade would also rise, because trading a higher percentage of the outstanding float in a security typically incurs a greater percentage cost.
Likely Consequence No. 4: The probability of underperformance will increase
Stock returns, in technical parlance, are naturally skewed to the right; in other words, the average stock tends to outperform the median. After all, a stock can only go down by 100%, but it can appreciate by more than that. Logically, then, portfolios containing fewer stocks will tend to underperform those with more stocks, because larger portfolios are more likely to include some of the relatively small number of stocks that elevate the average return.
So, what can we conclude from the Edwards and Lazzara paper? As the authors note, skilful managers sometimes underperform, and those who lack skill will sometimes outperform.
“The challenge for an asset owner,” they conclude, “is to distinguish genuine skill from good luck. The challenge for a manager with genuine skill is to demonstrate that skill to his clients. The challenge for a manager without genuine skill is to obscure his inadequacy. Concentrated portfolios will make the first two tasks harder and the third easier.”
Remember, S&P Dow Jones Indices is not a disinterested party in the debate about the rival merits of active and passive investing. It makes its money from licensing its indices for fund managers to use, and therefore has a vested interest in promoting passive strategies.
That said, this latest paper is a valuable contribution to the discussion and one which gives advocates of higher concentration in particular plenty to think about.
What, one wonders, would Alfred Cowles III have made of the current “debate” about active and passive investing?
Cowles was born in 1891, the son of one of the founders of the Chicago Tribune. He became a successful businessman, but his true passions were economics and statistics. One question in particular exercised his mind — can the professionals predict the stock market? — and in 1927 he set out to find the answer.
Over a period of four-and-a-half years, Cowles collected information on the equity investments made by the big financial institutions of the day as well as on the recommendations of market forecasters in the media. There were no index funds at the time, but he compared the performance of both the professionals and the forecasters with the returns delivered by the Dow Jones Industrial Average.
His findings were published in 1933 in the journal Econometrica, in a paper entitled Can Stock Market Forecasters Forecast? The financial institutions, he found, produced returns that were 1.20% a year worse than the DJIA; the media forecasters trailed the index by a massive 4% a year.
“A review of these tests,” he concluded, “indicates that the most successful records are little, if any, better than what might be expected to result from pure chance.”
11 years later, in 1944, Cowles published a larger study, based on nearly 7,000 market forecasts over a period of more than 15 years years. In it he concluded once again that there was no evidence to support the ability of professional forecasters to predict future market movements.
What is so extraordinary about Alfred Cowles’ work, and the techniques he used, is how ahead of his time he was. Cowles was the first person to measure the performance of market forecasters empirically.
Even among students of academic finance, the common perception is that it wasn’t until the mid-1970s that the value of active money management was seriously called into question, most famously by Paul Samuelson and Charles Ellis. In fact it was Cowles, more than 30 years previously, who first provided data to show that it was, to use Ellis’ phrase, a loser’s game.
So why wasn’t Cowles’ research more widely known about? Why did it take until 1975 for the first retail index fund to be launched? And why is active management still the dominant mode of investing even now, in 2018?
There are probably many reasons. The power of the industry lobby and the large advertising budgets at the disposal of the major fund houses have undoubtedly played a part, as has the growth of the financial media.
But it was Alfred Cowles himself who put his finger on arguably the biggest factor behind the enduring appeal of active management. Late in life, Cowles was interviewed about his research into market forecasters. In Peter Bernstein’s 1992 book, Capital Ideas: The Improbable Origins of Wall Street, he is quoted as saying this:
“Even if I did my negative surveys every five years, or others continued them when I’m gone, it wouldn’t matter. People are still going to subscribe to these services. They want to believe that somebody really knows. A world in which nobody really knows can be frightening.”
Cowles’ prediction has proved to be spot on. Both active management and market forecasting are far bigger industries than they were when he died in 1984. Investors, it seems, still want to believe that the market can be beaten, despite all the evidence that no more fund managers succeed in doing it than is consistent with random chance.
Think of investing, and most people think of the financial market. They think of share prices going up and down, bull runs and bear markets, spectacular successes and the occasional market crash.
The media is partly responsible. Journalists are constantly looking for stories. They have a vested interest in making investing seem exciting. That’s why they love the drama of the stock market.
Every day, newspapers publish the prices of hundreds of securities, and there are regular updates on radio and television on the latest news from the trading floor. The impression given is that investors need to keep up with the markets, and what the experts are saying about them, constantly.
The truth, however, is rather more prosaic. Successful investing is essentially very dull. It’s about filtering out the noise and focusing on a few fundamentals — ensuring you’re taking an appropriate amount of risk, keeping your costs low and diversifying broadly. Apart from rebalancing your portfolio every year or so, there really isn’t anything else to do.
In The Little Book of Common Sense Investing Jack Bogle wrote that “the stock market is a giant distraction from the business of investing”. In the long run, he explained, “investing is not about markets at all (but) about enjoying the returns earned by businesses.”
This is an altogether better way to think about investing. At a basic level, it’s about sharing in the profits of capitalism. Companies distribute those profits in the form of dividends, generally paying higher dividends when they’re doing well, and lower dividends when they’re not. The price of shares in a particular firm tends to go up when the market expects its profits to rise, and down when profits are expected to fall.
That’s why the stock market constantly fluctuates, and why, in the short term, it can be extremely volatile.
Sensible investors, however, take a long-term view. No, they’re not blind to risks such as global warming, terrorism and the threat of nuclear war. But they believe that, in general, capitalism is a system that works and that fairly rewards those who invest in in. They believe in the resilience of human enterprise and that, whatever happens in the next 30, 40 or 50 years, there will still be a demand for goods and services, and that companies will continue to make profits.
You should see investing, then, as claiming your rightful share to the proceeds of global capitalism. Remember, though, that there are all sorts of third parties — fund managers, brokers, investment platforms and so on — who would like to grab part of your share for themselves.
Warren Buffett told a story in his 2006 letter to Berkshire Hathaway shareholders, which every investor should read. It concerns the Gotrocks family, which owns all of corporate America, and receives the full value of the profits earned by those companies. Then a group of people, which Buffett calls the Helpers, offer to assist some family members to outsmart the others, "for a fee, of course". So, while the total profit earned by the Gotrocks family doesn't change, they don't get it all, having to pay some to the Helpers.
The profit of the companies owned by the Gotrocks family doesn't increase, but with more and more Helpers, charging more and more fees, the Gotrocks actually end up worse off.
Buffett’s right. There are too many Helpers in the investing industry. By removing multiple layers of “help”, which you can do by simply using low-cost index funds, you’ll end up keeping a much larger share of your investment returns for yourself.
So, go ahead. Claim your share of the proceeds of capitalism for yourself. It’s there for the taking — if only you can keep a long-term focus and resist the temptation to get caught up in all that market excitement.
One of the many reasons for indexing is that it eliminates, at a stroke, one of the biggest risks that active investors face, namely manager risk.
We’ve explained many times how the odds of beating the market through active fund selection are heavily stacked against you. Speaking in the online documentary Investing: The Evidence, Dr David Blake from the Pensions Institute says this: “The evidence shows, both for the UK and the US, that around 1% (of funds) outperform in the long term on a risk- and cost-adjusted basis. 99% of fund managers deliver negative value-added once you take into account the fees that they charge.”
All right, let’s say you’re feeling lucky, or else you don’t believe Dr Blake when he says that picking “star” managers ex ante is “impossible”. Let’s just imagine, for a moment, that you do possess a skill that has eluded every investor, professional or otherwise, to date — namely the ability to identify in advance, accurately and consistently, that tiny proportion of future outperformers. Even then you would still be relying on factors that are totally beyond your control.
Let’s take, for example, the bond fund manager Ian Spreadbury, who has just announced his retirement after more than 40 years in the City of London.
(Incidentally, the case for active management in fixed income is even flimsier than it is for equities. Because bond returns are generally modest, the costs involved in using an active manager almost always cancel out any outperformance they’re able to deliver. But we’ll leave that to one side.)
The biggest problem active investors face is distinguishing luck from skill. In a paper released in 2002, the afore-mentioned David Blake and his colleague Allan Timmermann demonstrated that it takes 22 years of performance data for a test of a fund manager’s skill to have 90% power.
Ian Spreadbury began his working life as an actuary. It wasn’t until 1985, nine years after graduating, that he moved into fund management with Legal and General. By Blake and Timmermann’s calculations, it wouldn’t have been until 2007 that you could say, with 90% confidence, that Spreadbury was genuinely skilled, as opposed to just plain lucky.
By that time, Spreadbury had spent 12 years with his next employer, Fidelity. So, how has Spreadbury’s flagship Fidelity MoneyBuilder Income fund performed since 2007? Answer: it has consistently underperformed the benchmark index. In other words, you would have been better off investing in a low-cost passive fund instead.
What’s interesting is that throughout that whole period, Fidelity MoneyBuilder Income has been highly rated by the ratings agencies. Brokers like Hargreaves Lansdown have also touted the fund in the media, predicting that Spreadbury would soon return to his winning ways. As things turned out, it didn’t happen — and nor will it happen now that Spreadbury has decided to call time on his career.
We don’t mean to single out Spreadbury for criticism. He has, in fact, performed less badly, on average, since 2007, than his peers. But we do mean to call out those who advocate switching in and out of different active funds as a sensible investment strategy.
Spreadbury is just another example of a fund manager who produced a few years of outperformance and earned considerable publicity for it and yet wasn’t able to sustain it. Once again, investors who poured into his fund on the back of all the fuss that was made have ended up disappointed.
Manager risk is a very real risk. Even if a manager is skilled, and that’s a huge assumption to make, there are so many unknowns. Here are just a few of them:
Will they be able to replicate their past success in the future?
Will they struggle, as many do, as the size of the increases?
Will they charge higher fees when they outperform?
Will you have the discipline to stick by them during inevitable periods of prolonged underperformance?
Will they move to a different fund? And in that case, should you follow them?
Will they succumb to a serious illness or critical injury?
Will they really want to carry on working into their 60s, by which time they’ll be financially very well off?
As an active investor, you leave everything to chance, and to succeed at it, you need everything to go your way. As an indexer, you pay a tiny fraction of the cost and yet you’re guaranteed to receive, near enough, the full market return, for as long as you need to.
Active management is a loser’s game, but one which the industry spends hundreds of millions of pounds every year persuading you to play.
Don’t do it! It’s a game that only they can win.
Many of the decisions that investors typically make are way beyond their circle of competence. That’s the view of GREG DAVIES, Head of Behavioural Finance at Oxford Risk.
In this interview, Gregg addresses two of the most prevalent behavioural biases investors are prone to — overoptimism and overconfidence — and argues that investors need to be much more realistic about which decisions they are sufficiently competent to make.
Greg’s specialist expertise is in improving financial decisions through behavioural science. As well as holding a PhD in Behavioural Decision Theory from the University of Cambridge, he’s an Associate Fellow at Oxford’s Saïd Business School and a lecturer at Imperial College London.
Greg Davies, in your view, how much of a problem do overoptimism and overconfidence pose to investors?
A lot of investors could be characterised as passive-aggressive. They’re passive in the sense that they leave far too much of their wealth doing nothing for far too long, and with the wealth that they do put into the market, they are aggressively trying to do something to it at any given moment. When you’re trying to do something to your investments, then overconfidence and overoptimism becomes a problem.
We all start to believe our own stories. For example, I read something in the newspaper, it resonates with me, I ascribe to it immediate and great confidence, and so I act on it. If we’re overconfident, we’re acting on stories that we shouldn’t be acting on, where we simply aren’t justified in having that level of confidence to do anything.
You mentioned newspapers there. To what extent are these behaviours encouraged by what we read in the media?
We ascribe information to things that we want to believe, so things that resonate with us we will start to believe more and more in. People will pick up and listen to all manner of things, including horoscopes at the extreme. No one ever acts, by the way, on numbers; no one buys return trade-offs. What we buy are stories, and stories come with a degree of comfort attached to them. If I have a story that is intelligible to me, if I understand it, if it just seems intuitively right, then it creeps past my guard, and the minute it is past my guard, it becomes something that I’m comfortable believing and something that I want to believe and so I become overconfident in it.
How then should investors view fund or share tips or other recommendations they read about in the money pages or on the internet?
If you were to look at all the possible decisions in front of you, some of them will be things where you genuinely have the knowledge to tell whether it’s a good or a bad decision. Warren Buffett talks about things being within your circle of competence. But some of the decisions in front of you will not fall in your circle of competence. They will be on the fringes of your competence. You might think you know something about them.
The more decisions you make, the larger the proportion of decisions that aren’t going to be in your core sphere of competence. They’re basically decisions in which you’re just going to be rolling the dice. If we’re trying to make good decisions in investing, after fees and after all the noise in the markets, we shouldn’t be rolling the dice on marginal things. We should be acting only where we really have confidence and competence.
A simple solution, surely, is for investors to make fewer decisions and just do less?
Depending on who you talk to, people will have a different answer to the question, How much should you trade to do well in the markets? There are people at one end of the spectrum who will say their favourite holding period is for ever, and here are some people who think you have to trade a lot. Wherever you are on that spectrum the right answer is less than you think it is. However much you are inclined to do, a sensible investor always does less than that.
The problem is though that it can be very tempting to try to time the market. It’s sometimes very hard to do nothing.
When markets are going up and down, it normally feels uncomfortable for us to do nothing, not to react when it seems intuitively right to do so — for example, when the market is falling and you want to get out. It’s actually very difficult for us not to act on those sorts of things. The fact is though that this is the area where overconfidence manifests itself most extremely — our tendency to think we know where things are going next. In any short or medium time frame, the simple answer is that we do not know.
The simple answer is, don’t do it. Focus on time in the market rather than timing the market. But it’s one of those things that’s simple but not easy. It’s simple to say it, but when it comes to that moment, it’s normally very emotionally uncomfortable for us not to act on what we feel to be strong information, so we jump in.
There’s an example from animal behaviour, isn’t there, that you like to use to illustrate the value of staying in the market. Talk us through that.
Yes, it’s from a study involving pigeons. You put the pigeons in a cage and they learn to peck a red light or a green light. When they peck the red light, it delivers food with a probability of 40%, and when they peck the green light, it delivers food with a probability of 60%. So these pigeons start to do things we see humans do. It's what’s called probability matching. They actually peck the green light more, because they get the food more frequently. They peck the green light 60% of the time and the red light 40% of the time.
That seems all very smart and clever until you realise you that the optimal strategy is to peck the green light all of the time. Now, interestingly, that 60:40 gap is about the same as you would expect to see major equity indices posting on a monthly basis. About 60% of months the index goes up and about 40% of months it goes down. If we could predict which months it’s going to go up or down, it would be rational to switch between being in the market and out of the market. The fact that we can’t means that we should just keep pecking the green light, because that is the most rational thing to do, unless you have a crystal ball.
We certainly live in interesting times. At the time of writing, nobody knows what’s happening with Brexit. Will a deal be reached to prevent a disorderly exit? Either way, what will be the impact on the UK and European economies? And how will markets respond?
In the circumstances, it’s understandable that many investors are considering reducing their exposure to equities until things become clearer. Investing is a hugely personal matter, and nobody should take more risk than they’re comfortable taking.
However, going to cash is not a decision that should be taken lightly, without serious thought or without seeking the opinion of a competent financial adviser. Regardless of Brexit, there’s a very strong case for keeping your portfolio exactly as it is.
So, if you’re thinking of sitting in cash while events unfold in Brussels, here are ten things need you need to bear in mind.
1. Timing the market is notoriously difficult. The evidence shows that it’s almost impossible to do it accurately with any long-term consistency, and the professionals are little better at it than the rest if us. And remember, you have to be right twice; you might get out at the “right” time and then spoilt it all by mis-timing your re-entry.
2. All known information is already incorporated into market prices. Current valuations reflect everything we know about Brexit and the likelihood of all the different outcomes. Do you honestly know something about Brexit that the rest of the market doesn’t?
3. It’s new information that causes prices to rise or fall, and that by its nature, is unknowable. True, government ministers and officials involved in the negotiations may be privy to vital information, but they’re bound by insider trading regulations so can’t act on it anyway.
4. New information is incorporated into prices within seconds, even milliseconds. If there is a significant development over the coming months, it will be absorbed so quickly by the markets that by the time you get to act on it, prices will either have risen or fallen already.
5. Correctly predicting the outcome of the Brexit negotiations won’t, in itself, be of help — unless of course you bet on it. To profit on the financial markets, what you need to do is predict how those markets will respond to the outcome you’re expecting, which is extremely hard to do.
6. Markets often react to big political events in unexpected ways. When an event is widely considered to be negative, markets often wobble initially but then recover and resume the course that they were already on. That’s exactly what happened after the Brexit referendum in 2016 and Donald Trump’s election later that year.
7. Investors typically allow their own political views to influence their investment decisions. Because most of us are prone to confirmation bias and to negativity bias to some extent, our expectations of what will happen if things either go our way or don’t go our way tend to be exaggerated.
8. The idea that there will soon be clarity over Brexit and markets will “return to normal” is unrealistic. It may well be that a deal is reached soon that takes Britain out of the European Union. But, as everyone knows by now, the divorce will be hugely complicated, and it may take many years, decades even, before the lasting effects of Brexit are clear.
9. Important though it is, Brexit isn’t the only show in town. There’s uncertainty everywhere you look, whether it’s the future of President Trump, the prospect of a global trade war or rising tensions between Russia and the West. And those are just the obvious risks. Regardless of whether the UK strikes a win-win deal with the EU that pleases everyone, or there’s a painful, disorderly exit, markets could still fall or rise sharply for a completely different reason.
10. There will always be reasons to bail out of equities. Throughout the long bull run that began in 2009, there’ve been scores of plausible arguments for getting out while the going’s good. If you had heeded any of them, you would have missed out on gains. Will it be Brexit that finally brings the bull market crashing to a halt? The bottom line is that nobody knows.
Again, you have to do what you think is right, and only time will tell what the “right” decision proves to be.
Whatever you do, though, beware of acting on emotions. Assuming that you and your adviser are comfortable with the risk you’re taking, and that your portfolio is thoroughly diversified and has relatively recently been rebalanced, the rational response is to sit tight and watch the political drama unfold.
BMO has lowered the cost of its bond ETF range by -43% from 30bp to 17bp as it passes through the economies of scale to end investors.
BMO’s bond ETFs offer access to the global corporate bond market, whilst giving investors the choice to select their preferred exposure, as defined by maturity.
iShares offers the most popular London-listed global corporate bond ETF (CRPS). This tracks the Bloomberg Barclays Global Aggregate Corporate Bond Index at 0.20% TER. Its GBP-hedged version (CRHG) understandably costs slightly more at 0.25% TER for the convenience of in-built currency hedging.
Like iShares, BMO also offers a GBP-hedged range, but has a more nuanced approach by offering investors a choice of three different ETFs each with a different maturity range: 1 to 3 years (ZC1G), 3 to 7 years (ZC3G) and 7 to 10 years (ZC7G). This compares to the average maturity of the main index of approximately 9 years.
The ability to access this exposure by maturity is particularly useful for UK institutional and pension scheme investors who are looking to construct liability-relative portfolios where both duration and currency controls are important to avoid asset-liability mismatches.
The BMO range has gathered some £117m AUM since launch in November 2015 (inflows of £3m per month on average). This compares to iShares' CRPS size of £824m since launch in September 2012 (inflows of £12m per month on average).
As the advantages of bond investing with ETFs become more apparent (secondary liquidity, transparent exposure, daily disclosure of underlying), we expect increasing price competition and greater nuance within the most popular strategies.
ZC1G BMO Barclays 1-3 Year Global Corporate Bond (GBP Hedged) 0.17% TER
ZC3G BMO Barclays 3-7 Year Global Corporate Bond (GBP Hedged) 0.17% TER
ZC7G BMO Barclays 7-10 Year Global Corporate Bond (GBP Hedged) 0.17% TER
CRPS iShares Global Corporate Bond (Unhedged) 0.20% TER
CRHG iShares Global Corporate Bond (GBP Hedged ) 0.25% TER
(All ETFs mentioned are UCITS ETFs listed on the London Stock Exchange)
Vanguard Asset Management is one of the companies that’s helping to change the face of investing. Based in the US, it came to the UK in 2009, and last year it launched a direct-to-retail operation, allowing investors with as little as £100 to invest each month to access a range of low-cost funds.
In this interview, Vanguard’s Head of UK Retail Sales NEIL COWELL explains why the company places so much emphasis on the importance of controlling costs, and discusses whether or not investors should use a financial adviser.
Neil Cowell, as a company, Vanguard is always emphasising the importance of fees and charges. Why is controlling costs such a key component of successful investing?
That’s right, we talk a lot about cost at Vanguard, and the importance of cost in investor returns. I think in the world of investing it can be said that you get what you don’t pay for. And costs do create an inevitable gap between market performance and investor return. The evidence is very clear when you look at the data. There’s data from Morningstar, for example, that clearly show that low-cost funds outperform their high-cost counterparts, and that alone gives a real indicator of why we attach such importance to it. In fact, Morningstar actually uses cost as a major predictor of a fund’s future performance, so every which way you look at it, costs are extremely important to investor outcome.
It’s not an easy message to get across to investors though, is it? In almost every other area of our retail lives, the more you pay the more you get.
That’s absolutely right. It’s counterintuitive. Clients definitely associate higher cost with higher quality and, as I said at the start, in the world of investing you get what you don’t pay for. When people see a fund priced at 1% per annum and another fund alongside it priced at 50 or 60 basis points, it doesn’t seem a lot in terms of a differential. But when that is actually compounded over time, it plays a terrific part in the overall return and takes quite a significant chunk from the final value.
How important is it, would you say, for people to have a financial adviser?
We’re very clear at Vanguard that clients are better served by working with an adviser. We spend a lot of time promoting the value of advice. We have a framework here that we call Adviser’s Alpha, which talks specifically around the value that an advised relationship will deliver over and above what a client left to their own devices may achieve. For a great investing outcome clients are well served by working with an adviser. We don’t say that clients who have the time, willingness and ability to self-serve can’t achieve a great outcome too, because that’s certainly possible. We just say it’s hard, and our message around the value of advice and what that adds is really very clear.
From your point of view, then, what are the major ways in which a good adviser adds value?
I think that there are two major parts. The first part is around the investment expertise itself, so the importance of getting the asset allocation right, the importance of rebalancing, the importance of ensuring that cost plays a part in portfolio construction. That does add value — there is no doubt about that. We rarely see portfolios that are constructed by clients themselves with a balance of equities and bonds, for example. They tend to resemble a collection of funds rather than a specific asset allocation. So there’s a real value add in the investment expertise element.
But I think, going back to the Adviser’s Alpha framework, where an adviser can really add value is in their role as a behavioural coach or an emotional circuit breaker. We see time and time again that when clients are left to their own devices they can start to make some very costly mistakes.
What are the most common mistakes you see people making when they try to manage on their own?
We see for example investors typically chasing yesterday’s winners. They invest in what appear to be yesterday’s winning funds, expecting those funds to repeat the performance and to prevail for the next three, five, seven or nine years. There is a clear pattern. People also try to time markets, which is not an advisable thing to do. Typically we see investors get there too late, by which I mean there’s a big difference between the fund return and the actual return the investor experiences. So those are two examples, chasing yesterday’s winners and getting there too late, of behaviours that really do erode value.
Another problem, of course, is that, in the words of your founder Jack Bogle, investors don’t “stay the course”. They bail out when markets tumble. And again, unadvised clients are more likely to capitulate.
That’s right. At Vanguard we have what we call our investing principles. We believe that for a great investing outcome, investors should have a clear, articulated and definable goal. They need to understand why they’re investing in the first place. Alongside that we think it’s important to have an asset allocation that’s appropriate to their individual risk profile, and also to choose the component parts of that asset allocation at the lowest cost possible. But then comes the critical element. Having constructed the plan, having put the time and effort into getting that all right, you need to tune out the noise and keep your discipline. Markets will inevitably experience degrees of volatility. There is an inherent behavioural bias in all of us which is loss aversion, and it’s inevitable that clients will at least consider bailing out. That’s when the adviser really adds value. Jack Bogle also coined the phrase, “Don’t just do something, sit there”. In other words, expect the volatility, be confident in the plan, and ride it out, for great investing outcomes.
What would you say to investors who think they can trust their ability to manage their own emotions and don’t need an adviser to do it for them?
If that is the case, then maybe they are on of those investors who has the time, willingness and ability to self-serve. I think they’re rare, because most of us are subject to some of these behavioural biases. Carl Richards, who writes for the New York Times about behavioural biases, tells the story of when he was an adviser, the CEO of a Fortune 500 company came to him and asked him to run his personal affairs. He said to him, “Why are you asking me to do this? You know far more about investing than I do.” And the CEO said, “The reason I am asking you is because you’re not me.” It was the peace around that separation, that emotional circuit breaker, that he so valued.
Where do you see the financial advice profession going in the future?
I think at Vanguard we’re very clear that the need for advice is growing. We’ve seen data from the US and UK that shows the need is now greater than it’s ever been, and it's also very interesting that people are more prepared now than ever before, according to the data, to pay for advice. I suppose we shouldn’t be surprised about that given the dynamics. People are living longer, life is typically more complex, and people are now contemplating for the first time running their own retirement pots rather than being able to rely on an employment discretionary benefit scheme or final salary scheme. There are so many reasons why people see advice as more important now, and it’s encouraging to see that coming through in the data.
Do you think some UK advice firms might feel a little threatened by Vanguard’s direct-to-retail offering?
That’s a good question. I don’t think it was a particular secret that Vanguard would at some point introduce a direct offering. The reaction from our adviser community has been very positive. A lot of them are interested in the extent to which there may be access for advisers at some point. We’re nowhere near that, and it may never happen, but nonetheless the interest is there. So I don’t think there has been a bad reaction to it.
I’ve been very encouraged over the last two or three years to see advice firms getting better and better at articulating their overall proposition. And I think that’s the key. Advisers these days are building more and more of their value proposition around their role as that financial coach, that behavioural coach, and no direct offering in the world can be a substitute for that.
A big problem for many investors is their overconfidence. They have unrealistic expectations about their own abilities at picking stocks and timing the market, and about the results they’re likely to achieve.
Bent Flyvbjerg is a professor at the Saïd Business School University of Oxford. An economic geographer, he’s an expert on behavioural economics and so-called optimism bias. His particular specialism is the planning fallacy — the tendency to underestimate the length of time and the expense involved in completing major tasks. But he also has a strong interest in how overconfidence impacts on investors.
Although Professor Flyvbjerg admits to making small, and very occasional investments in individual stocks, he mainly uses index funds, and recommends that most investors do the same. He says it’s a lesson that he’s learned from being too optimistic about his own investments in the past.
Thank you for your time, Professor Flybjerg. What exactly is optimism bias?
Optimism bias is a propensity that humans have to look at the future through rose-tinted glasses, so to look at it in a more positive light than is actually warranted by what happens when the future gets here. That’s it in a nutshell.
Why, then, are humans prone to optimism bias?
There are a lot of theories about that, but the constant is that this is probably something evolutionary, that we need optimism to do what we do in life and to get up in the morning, to get married, to have children and go to work. This is something we assume that has been with humans for a very long time, that this is something we need to survive. It’s Darwinistic in that sense.
It’s often very useful to be optimistic. You wouldn’t want a team of pessimists if you wanted to accomplish something. But optimism may also trip us up, so we might actually miscalculate risks regarding things that are very important. So you don’t want to get on a plane, for instance, when the pilot says he’s optimistic about the fuel situation. That’s not the kind of optimism that you want. But you do want to get on a plane where the flight attendant says that he’s going to give you a great trip, and they’re going to serve you great food and drinks and so on.
How rife is optimism in the financial industry, in your view?
It’s not just what I think. We know from solid research that it is very rife, it’s widespread, and it’s one of the things that you really need to guard yourself against as an investor — both your own optimism, and other people being optimistic with your money. That can lose you a lot of money.
Give me a specific example, then, of how optimism bias can trip investors up, as you put it.
Everybody hopes to have a windfall in the financial markets, and especially inexperienced beginners, who will think they’re going to be better than the average investor. People go into casinos and have this optimism where they’re going to beat the odds of the casino. The hardest thing to learn is not to be too optimistic. It’s really difficult. It takes a lot of time, and a lot of experience, and there are very few investors out there who have this cool realism that will make you successful as an investor.
But it’s very tempting, isn’t it, not to act when we keep hearing in the media plausible arguments for buying this or that?
Yes, it’s difficult not to get caught up in that, but it’s well documented that you shouldn’t listen to that kind of stuff. Day-to-day news on financial affairs is mostly noise. You need to look at much longer trends to get anything like useful information. You can always build a story around some random variation that sounds meaningful, and then you act on the basis of that and find that it’s not meaningful at all.
It’s sometimes assumed that financial professionals are above these sorts of biases. What do you say to that?
It’s not true. With professionals, there’s actually an additional bias — in addition to optimism bias — because they have a deliberate interest in making people believe they can do better. It’s what we call a strategic bias. Professional investment managers will try to make their clients believe that they’re better than the markets, and again it’s been shown that on average you’re better off without a professional investor than with one.
You said it’s very difficult to combat optimism bias. But how can you make a start?
The first thing to do is to realise that you have optimism bias. And of course, if you’re biased, you need to be de-biased. Experiments have been made on people who make decisions about things. One group is not told what the usual outcomes are, and the other group is told. So the second group will get a realistic image. They will think about that when they make their decision and will not be as biased as the first group. So just telling people what the empirical data are will make them less biased.
But the real secret to getting bias out is not to make subjective decisions. You basically want to make decisions that are more or less automatic. So instead of trying to time the market you would say like, if you are investing, that I’m going to invest every three months on a specific date; I’m going to invest whatever I have at that moment. You’ll do better than if you try to save up your funds and figure out where the market is going and try to time the market.
Optimism bias has to have an opportunity to kick in, right, and it’s only when we make subjective decisions that it kicks in. So the more you can eliminate those and go on autopilot, so to speak, the better off you will be in making investment decisions.
But again, its hard to temper your optimism when you read about professional investors who’ve made successful call, isn’t it?
There are so many things happening in the financial markets that there will always be stories like that, and that’s exactly what you have to disregard. Only if you see something that you really believe in and you were dead certain that it’s going to outperform the market would you be justified in doing something apart from just investing in something like the S&P 500.
How has your research impacted on your own investment decisions?
I actually try to use these ideas about optimism bias in my own investments. So I’m very conservative in that sense. (If you’re going to speculate) you should only put a little money on it — very small investments on things that have an enormous upside. By making a small investment you create a small downside. So you play on the large upside with a small downside, and the rest of your investments you just keep in the index.
You invest in index funds yourself. Why did you decide to go down that route?
Like many investors, I took a lot of time to learn this, and it cost me a lot of money. I did it because I saw that it was bulls**t (to suggest) that professional investment managers are performing better than the index. At the same time as I was developing my own experience as an investor this type of research became very well known in the early 2000s. Daniel Kahneman won the Nobel Prize in Economics for his research on optimism bias and the planning fallacy. That just showed me that you’re just giving money to other people instead of actually investing it and making money for yourself.
It’s no secret that active fund managers are losing business to index funds, but they aren’t going down with a fight.
The big fund houses have always had large marketing budgets, and they’re drawing especially heavily on them now.
As the US blogger Dan Solin wrote recently, the rational choice for investors is simply to “buy a globally diversified portfolio of low management fee index funds”. The problem is, “there’s a huge industry spending hundreds of millions of dollars annually to persuade you not to. They’ll say almost anything to persuade you to hand over your hard-earned money to them.”
But are the marketers getting desperate? Are they trying too hard to stem the flow of money out of active funds and into passive ones? There are signs that they might be.
A good example is a new campaign by Allianz Global Investors, the asset management branch of the German insurance company Allianz SE. Alliance GI executives have been touring the company’s 14 offices around the world, handing out brand new pairs of training shoes to its staff.
It might sound like a joke but it isn’t. Apparently it's designed to emphasise AGI’s belief in active fund management.
Bloomberg quotes Andreas Utermann, AGI’s chief executive officer, as saying: “Sneakers are just part of this brand relaunch. It’s not just the investment process that’s active, it’s the whole ethos of the firm and the way that we give advice.”
It is, of course, a huge gimmick. It plays on the conjunction fallacy — the common assumption that doing something is better than doing nothing, and that hard work and effort inevitably lead to better outcomes.
In fact, it’s the activity that’s the problem.
As the former fund house executive Lord Myners recently admitted, most funds perform better when the managers aren’t working at all (i.e. when they’re on holiday). Why? Because of the constant buying and selling that active managers feel they have be doing to justify their fees and bonuses and to keep their jobs. Every trade they make adds to the cost of using them, and as studies have repeatedly shown, cost is the single most effective predictor of future fund performance.
As well as redoubling its marketing efforts, Allianz GI is also revisiting its fee structures in an attempt to woo new customers. It recently cut the management fee on some of its funds in return for a performance fee it only charges if the fund beats its benchmark.
“You only pay if we perform,” says Utermann. “Why wouldn’t that be a good deal?”
Unfortunately, though, funds with performance fees are not the no-brainer the fund industry likes you to think they are. OK, you don’t get charged if the fund trails the index, but nor do you get reimbursed the money that you would have made if you’d invested in a low-cost index fund.
After costs, active funds underperform the index most years, often by large margins, and the performance of AGI funds over the years has been little or no better than those of its peers.
Over time, the cumulative effect of that underperformance will leave a big hole in your returns. Add to that the compounded management fee (even if it is reduced), and having to pay additional performance fees when the fund does beat the market, and it all makes a for a very bad deal for consumers.
Like the training-shoe stunt, performance fees are just a gimmick.
Compared to the US, the indexing revolution in the UK is only just beginning, and we can expect to see active managers become increasingly desperate to cling on to their market share. However tempting their offerings sound, you’re almost certainly better off steering clear.
An Englishman’s home is his castle, the saying goes. But in truth, the Scots, Welsh and Irish are just as keen on owning their own home. And for many Brits, one home is not enough; the level of buy-to-let and second home ownership is higher in the UK than almost anywhere else in the world.
Of course, people don’t just buy houses, flats and apartments to make money out of them. Homes bring enjoyment and utility to their owners that transcend financial considerations. But research has shown that most home buyers do see their purchase as a financial investment. Indeed, many now view property as a better and less risky investment than equities. What, then, does the evidence say about that?
Each year, Professors Elroy Dimson, Paul Marsh and Mike Staunton of London Business School produce a publication for Credit Suisse called the Global Investment Returns Yearbook. In it they show how the different asset classes have performed over the very long term — specifically since 1900.
There are several complications when assessing residential property as a financial investment. Most owner-occupiers, for instance, will need to take out a mortgage, and regardless of the size of the property, there are on-going maintenance costs involved in home ownership too. For landlords, those expenses are offset to some degree or other by rental outcome.
But, in real terms, how much have house prices grown since 1900? You might be surprised at how low the average price rise, after inflation, actually is.
Dimson, Marsh and Staunton analysed the data for 11 different countries and calculated the UK figure to be 1.8%. In Australia, where prices have grown fastest since the start of the twentieth century, the figure is 2.2%. The average annual price rise across all 11 counties is 1.3%, and in the United States it’s as low as 0.3%.
How then, does that compare with returns from other asset classes? Well, equities have actually produced much higher returns houses. Since 1900, the 2018 Yearbook states, UK equities have returned an average of 5.5% (and the average return since 1968 is higher still, at 6.4%). Bonds have returned 1.8% over the last 118 years — in other words, the same as the growth in UK house prices — while government bonds, or gilts, returned an average of 1% a year. Again, all of these returns have been adjusted for inflation.
Now let’s look at risk. “Housing has been less risky than equities,” the 2018 Yearbook states, “but the expression "safe as houses" is misleading.” As an example, Dimson, Marsh and Staunton cite the US, where “house prices fell by more than 36% in real terms from their late-2005 peak until their low in 2012”.
The biggest numerical fall in UK house prices in recent history was between 1989 and 1993, when they dropped 20% across the country and by more than 30% in London. After the global financial crisis of 2007-08 they fell 13%.
Of course, both equities have had a very good run. The bull market in global stocks is now more than nine years old. Despite that fall in prices immediately after the financial crash, UK houses have risen steadily in value since the mid-1990s and, according to the Office for National Statistics, houses now cost almost eight times average earnings.
Nobody knows where the price of stocks or houses are heading next. As ever, the most sensible approach is to stay diversified and not to be over-exposed to either.
If you own your own home, you are already heavily exposed to residential property. If you’re thinking of either trading up to a bigger house or investing in a second property, you need to think carefully whether the benefits outweigh the additional costs and risk involved.
Whatever you do, though, don’t invest in property expecting to make a big financial gain, even over the long term. To quote Dimson, Marsh and Staunton: “Residential property should not be purchased with an exaggerated expectation of a large risk premium. It is equity assets that provide an expected reward for risk.”
Most of us realise that worrying is irrational and counter-productive. Yet we can’t seem to stop ourselves, and research consistently shows that we worry about money and financial issues more than just about anything else.
CARL RICHARDS is a financial adviser, writer and podcaster who specialises in behavioural finance. Carl is from Utah but is currently living in New Zealand. He says there are two simple questions we should ask ourselves whenever we find ourselves fretting about something:
If the answer to either question is No, we should be tough with ourselves and stop worrying about it.
In this interview, Carl talks about our tendency to worry about the wrong things and the danger of perfectionism. He also discusses the importance of changing our attitude towards risk and volatility.
Carl, you’re renowned for your sketches for the New York Times, which illustrate simple, but important, concepts that people need to understand when thinking about money. Perhaps your best-known sketch is about the need to focus on things that matter and that we have control over — and stop worrying about everything else. How did that sketch come about?
That’s one of my favourite images and it seems to be one of the most popular. The story behind it was that my son, who was ten at the time, was playing lacrosse. My Mom came to watch. It was a beautiful, sunny fall day, with a crisp blue sky. It was a great day for a father to be watching one of their kids do something cool, and it should haver been an amazing day for my Mom.
But I could see as she walked to the game, like a hundred metres away, that something was wrong. She sat down and I said, “Mum what’s wrong?” She said, “Oh, nothing,” and I said, “No really, what’s wrong?” She said, “The dollar. I’m just so worried about the dollar. It could collapse.”
OK, my Mom, as far as I’m concerned, controls the universe, but she has no control over what happens to the dollar. So we started talking about that intersection of these two circles — things that matter and things that you can control. Because if it doesn’t matter, why are you worried about it? And if you can’t control it, why are you worried about it, other than to plan around it? If we can think about the intersection of things that both matter and that we can control, that’s really where we should focus, because that’s what will make a difference.
In your experience as an adviser, how much time and effort do people spend worrying about things that either don’t matter, or that they can’t do anything about?
I think the majority of an investor’s time, like the majority of a human’s time, is spent worrying about things that either don’t matter or that we have very little control over. The good news with investing, and with wealth management more broadly, is that if you were to make list of all the things that actually mattered, most of them are things we have control over — for example, asset allocation and our behaviour.
There is one noticeable thing that matters a lot but that we do not have control over, and that’s our return, in other words, the markets. We spend 80% of our time talking and worrying about the one thing that we can’t control. I’m just suggesting that we should maybe flip that a little bit. It doesn’t mean we should totally ignore the markets. I’m just saying, why don’t we spend a little bit more time on the things we do have control over that also matter?
It’s very difficult not to worry, though, when there’s extreme market volatility and stock prices are falling fast. That’s when having a financial adviser you can talk to really helps, isn’t it?
Yes, I think it is really important for the adviser to talk to the client about the nature of the financial markets, and to make sure the client understands the words you’re using. Often the industry, and even really good financial advisers, will use words like risk and volatility and assume that everybody will know what they mean. But most people don’t know what they mean. I know I wouldn’t if I weren’t in this industry.
As a client, the one thing I think you should feel absolutely sure you can you say to your adviser is, “Hold on. Back up and explain that.” Any good adviser will appreciate it, and if they don’t appreciate it, find a different one. It makes a lot of sense just to stop, if you don’t understand something, particularly around risk, which is incredibly important. Just pause and say, “Can you explain that to me? I want to make sure we are on the same page.”
How, then, should investors think about volatility? It’s certainly scary, but it’s not the same as risk, is it?
You should view volatility as risky in the short term, but not risky in the long term. Volatility is just, underneath, a measurement of standard deviation, which means, how much something wiggles. Stocks wiggle more than bonds, bonds wiggle more than cash. Short-term volatility is a measure of how much something wiggles in the short term. You just have to decide how to deal with that.
If you’re going to have a portfolio that is designed to meet your goals, it requires you to take a certain level of risk. The level of risk determines how much it’s going to wiggle in the short term, and you just have to decide how you’re going to handle that. There’s a whole bunch of tricks and techniques you can do to help you ignore it, but if you’re not paying attention to it in the first place you don’t have to deal with it, so that may be a hint.
Very often our attitude to risk is governed by our past experiences — particularly recent experiences. How conscious are you of that as a financial planner?
I feels to me like one of the big mistakes we make as humans is what the academics would call recency bias. We look at the recent past and we project that indefinitely into the future, particularly if the recent past has been something really negative. But even if our recent experience has been really good, we can make some major mistakes that way too. You think, for example, “I’ve had a bonus every year in January for the last three years and we’re thinking about buying a new house. Maybe we could buy a more expensive house because that bonus is around the corner.” And then you don’t get the bonus, and it wreaks havoc.
I think we’re really good at doing this. It happens all the time, and it’s something we need to check.
But what can you do actually do about it? It’s not easy, is it?
No, it’s not easy. The only solution I know to that problem is just to extend your view of recent past. Right now, in the Twitter age, the recent past is often, like, three minutes! It really helps if we can extend our view of the recent past and consider, “Oh remember, just five years ago that happened.”
Another way to deal with this problem is to record how we feel about events, particularly when we’re really scared and nervous and we want to sell, and we get walked in off that ledge by a financial adviser. At that moment it can be really useful to record how we’re feeling, to remind ourselves in the future what it’s like.
I think the ability to forget negative experiences in the recent past to discount negative experiences in the recent past has kept us alive as a species. No one would run a second marathon, and I’ve been told by my wife that nobody would have a second child if they could remember the pain of having the first one. We discount that really quickly. So just reminding ourselves of the pain, writing a note to ourselves, can be incredibly valuable.
You’ve written several times about the dangers of perfectionism, and why our desire to have everything “just so” can hold us back in our financial lives. Why do you think it’s such a problem?
There is a really unhealthy focus on the perfect — finding the perfect investment, building the perfect portfolio. Perfect really is the enemy of the good, especially as we don’t know what perfect is beforehand, and we’re guessing anyway.
I think the investment process only matters to the degree that it’s going to influence our behaviour. Your portfolio may not be the most efficient thing on the planet, but if it will helps to solve your behaviour, then it’s good enough. It’s like what Jack Bogle says about index funds — there may be investment solutions that are better than this, but the ones that are worse are infinite.
Of course, the other problem with focusing on the finer detail is that you neglect the bigger picture.
Right. I can’t tell you how many times people will send me questions like, “What is the ultimate emerging market small-cap fund?” It might represent 3% of their portfolio and they want to spend lots of time on it. In the meantime, perhaps they haven’t got their money invested, or they didn’t fund your retirement account this year.
Remember the old story of the doctor having a patient continually arguing over which medicine to take for high blood pressure. The doctor finally said, “Wait, you still smoke!” I think arguing about asset allocation and focusing on the specific investments underneath, trying to get everything perfect, really misses the point.
Investors, and indeed financial professionals and commentators, are often confused by the fact that Vanguard provides actively managed funds.
Vanguard is, of course, virtually synonymous with passive investing. It was Vanguard’s founder, Jack Bogle, who launched the first index fund for retail investors in the mid-1970s, and who has since became the most vociferous critic of active management.
Yet not only does Vanguard offer active funds, it also (at least here in the UK) enthusiastically promotes them. It’s not about active and passive, Vanguard’s marketing message goes; it’s all about cost.
To a large extent, that’s true. As research by Morningstar and others has consistently shown, cost is the single most accurate predictor of future fund returns. Certainly, Vanguard’s active fund fees are generally considerably lower than those of its rivals.
But, given the choice of an active Vanguard fund and a passive one, which should you go for? The investment author Andrew Hallam conducted research into this question in March 2015. He looked at the performance of Vanguard’s equity and bond funds, across seven different categories, over the previous ten years.
In some categories, Hallam found, the active funds produced the higher returns (particular in international equities). But, overall, Vanguard’s index funds beat the active funds by 0.71% per year.
Now, 71 basis points might not sound like a great deal, but when that figure is compounded over several decades, it can add up to a substantial amount.
Someone else who has looked at this issue closely is the financial adviser and author Mark Hebner. In June 2016 Hebner analysed the performance of all 60 of Vanguard’s US-based active funds which had a track record of at least ten years.
The fees, he confirmed, were substantially lower than the industry average. Vanguard charged an average of 0.36% for its equity funds and 0.21% for its bond funds.
Hebner then looked at turnover ratios. The average was 40% for equity funds and 90% for bond funds; in other words, a typical holding period was between one and two-and-a-half years. These figures are much more in line with the industry average and imply that Vanguard’s active managers tend to make decisions based on short-term outlooks. Although transaction costs aren’t included in the headline fee, they are borne by the investor and have a significant on net returns.
The next question Hebner addressed was whether Vanguard investors could expect superior performance in return for the premium they were paying for active management. This is what he found:
This distinction between repeatable skill and random chance is very important. By random chance alone, you would expect either one or two of the funds analysed (1 in 40 to be precise) to produce what’s called statistically significant alpha. Put another way, no more of Vanguard’s funds outperformed than you would expect just from random chance.
“In general,” Hebner concluded, “Vanguard has not demonstrated that their process of hiring the best analysts and managers and implementing their investment strategies is superior to anyone else. To say they apply a unique process to just two of their investment strategies seems very unlikely.”
So let’s go back to our original question: Are Vanguard’s low-cost active funds a good bet? They are, as with all active funds, most definitely a bet. But a good one? Well, because the fees are lower, using an active fund from Vanguard is a better bet than choosing a typical average fund.
But the bottom line is that markets are efficient. All active management, low-fee or otherwise, is a zero-sum game before costs and a negative-sum game after costs. Not even Vanguard, for all the good that it’s done for investing and for investors, is immune to those brutal facts.
Do Vanguard’s active managers possess skill and insight or have resources at their disposal that active managers that all the other big fund houses don’t? The figures don’t lie, and the figures suggest they don’t.
WHY INVESTORS SHOULD AVOID COMPLEXITY
One of the biggest attractions of having a broadly passive investment strategy is the simplicity of it. You don’t have to speculate on particular sectors or regions or constantly monitor how your portfolio is performing. The long-term market return is more than adequate to meet the need of most investors, and by simply aiming to capture that return at very low cost, you’re giving yourself every chance of a successful outcome.
Index funds themselves are beautifully simple, and so too are passively managed exchange-traded funds, or ETFs. You know exactly what you’re getting with them. But when you buy an actively managed fund you’re next quite sure. Many active equity funds, for example, include an element of bonds, cash or both, and because active managers typically turn over their entire portfolio every couple of years or so, it’s very difficult to keep tabs on everything you own at any given time.
A more worrying development in recent years is that, with active managers finding it increasingly hard to beat their benchmarks, they are resorting more and more to complex strategies. Principally, these strategies come in three different forms:
Leverage — in other words, the fund manager borrows money to increase the potential return of an investment
Short selling — that is, the manager sells a security that they don’t own, or that they have borrowed, in the hope that the the security’s price will decline, allowing them to buy it back at a lower price to make a profit
Options -- in other words, the fund manager pays for the right to buy or sell a security at an agreed price at a later date
They’re often called hedging strategies; that is, they’re ostensibly designed to protect investors from risk. In practice, though, they often have the opposite effect; all three types of strategy carry a degree of risk that the end investor may not want to take.
Worryingly, recent research from Canada has confirmed that active managers are making increasing use of these complex strategies, resulting in higher fees, lower returns and greater risk. The paper in question, entitled Use of Leverage, Short Sales and Options by Mutual Funds, was produced by three academics at the Smith School of Business at Queen’s University in Ontario.
According to the authors — Paul Calluzzo, Fabio Moneta and Selim Topaloglu — in the 15 years prior to the paper’s publication in March 2017, 42.5% of US domestic stock funds have used leverage, short sales or options at least once. Between 1999 and 2015, the percentage of funds allowed to use all three rose from 25.7% to 62.6%.
But, the researchers found, there was a price to pay for end investors for this additional complexity. Funds that used complex investments, they calculated, had a 0.59% decrease in excess return and a 0.072% increase in expenses.
So, what did the researchers find specifically on risk? To quote the paper: "Although (managers) use the instruments in a manner that decreases the fund's systematic risk, they hold portfolios of riskier stocks that offset the insurance capabilities of the complex instruments.
“We find not only that funds that use complex instruments take more risk, both systematic and idiosyncratic, in their equity positions, but also that bylaws that authorise complex instrument use are associated with greater fund risk.”
In the paper’s conclusion the authors say this: “Our results suggest that the use of complex instruments is associated with outcomes that harm shareholders: lower returns, higher unsystematic risk, more negative skewness, greater kurtosis (essentially volatility) and higher fees.
“Overall, it appears that mutual fund investors are better off choosing simplicity.”
So, why is it that active managers are using these complex strategies more and more? The bottom line is that regulators have allowed them to. But you could also argue that one reason active managers are resorting to using them is that they’re increasingly under pressure to prove that they can beat the index. Put another way, active managers are becoming increasingly desperate.
To quote the investment author Larry Swedroe: “The active world has to fight back to keep their share, and one way to do that is to add complexity. They need to say, ‘We have a story to tell, and you need to be a member of our secret club, which has all theses superior instruments.’”
Investors should not be seduced by these sorts of marketing messages. In investing, simplicity is the ultimate sophistication, and ideally that means avoiding actively managed funds altogether.
ETF Investment Strategy