Inconvenient facts

Only 17.62% of active large-cap funds outperformed the S&P 500 over the five years ending June 30, 2017. Yes, you read that right. The rest failed. In other words, if you had invested with a professional money manager who dedicated their life’s work to allocating your hard-earned money, they would have lost 82.38% of the time against a robot that essentially works for free by tracking the S&P 500. And this is nothing new. Granted, it was over five years, and during a relatively bullish time for the markets, but the numbers don’t vary much when you account for bear markets, shorter time frames, or different kinds of investments, as we will soon find out.1

Mid-cap and small-cap funds lost 87% and 94%, respectively, over the same time period. Put bluntly, if you were a CFA paid to construct investment funds for a living, it would be somewhat of a miracle if you actually beat the benchmark index you were supposed to beat. If investment companies held their portfolio managers accountable for results, nearly all them would be looking for a new career.

Surely, though, these fund managers should be able to win with longer time frames, right? Wrong. It actually gets worse as the years go by. That’s why the career lifespan of a money manager doesn’t (and shouldn’t) really last that long. The smart ones make their big money and get out while they’re ahead. Just ask Peter Lynch, who returned on average 29% per year for his 13-year career as the brains behind Fidelity’s Magellan Fund. He grew the fund from $18 million in assets to $14 billion, and then he retired soon after. Lynch once said, “in this business, if you’re good, you’re right six times out of ten. You’re never going to be right nine times out of ten.” He wasn’t that far off with that statement. Although, we suspect if you’re actively trading against the benchmark indices, you’re probably only right two to three times out of ten, tops.

How bad does it get?

The longer the time horizon, the more difficult it becomes to beat the benchmarks. So, if you’re going to begin a relationship with a professional money manager, make sure it’s only for a short period of time. For example, over the 15-year period ending in June of 2017, 93% of large-cap fund managers lost to the S&P 500. It was about the same for both mid- and small-cap funds, at 94% underperforming when compared to their targets. It’s crazy to think that there’s still a market (and a thriving one at that) for something that doesn’t deliver what it’s supposed to 80 percent (or more) of the time.

What about fixed income?

Over the last year, yes, active fixed-income money managers outperformed in both government and corporate bonds, excluding intermediate-term government bonds. So, there is some value being created from portfolio managers, you just have to look really hard to find it. This doesn’t change the fact that your actively-managed fund, led by your superstar money man (or woman), is just as likely to go bust than it is stay in business over the long haul. Long term in this particular case is 15 years, and over that period ending June 30, 2017, 47% of all fixed income funds were merged or liquidated. Those are bad odds of survivorship. It gets worse with equities, too. 55% of all international equity funds have disappeared since 2002, and 58% of domestic equity funds that started back then no longer exist as of today.

It’s difficult to pick a winning fund over the long term. It’s more difficult to pick a fund manager, and harder yet to pick a financial advisor who knows of a winning fund manager or a winning fund that will stand the test of time. Simply put, the odds are against the long-term active investor. It’s kind of a shame too, because investing in active stocks, funds, ETFs, and the like is fun. The trouble is, investing is really not supposed to provide you with a sense of entertainment; it’s designed to make you money either through income streams, capital appreciation, or both.

Surely, actively-managed REITS can beat their benchmark index, right?

Kind of. But only over a one-year period. 57% beat their benchmark, but over 3-, 5-, 10-, and 15-year periods, they all lost, and not by inconsequential amounts. The losses ranged from 72% to 85%. Those aren’t small misses. This pales in comparison, however, to Emerging Market funds that have lost 95% of the time over the past 15 years. If you’re adamant about actively investing, over the past 10 years, you would have performed better had you gone with a large-cap value fund of some sort, as nearly 36% outperformed the S&P 500 Value index. There was still a 64% percent chance you were going to lose, however. Play the odds; allocate the majority of your portfolio to index funds, and actively invest the rest if you're seeking some excitement in an attempt to beat the market.

1. Note: All statistics taken from SPIVA at file:///C:/Users/caser/Downloads/spiva-us-mid-year-2017.pdf

Capitalize on investing mistakes

Just with anything in life, mistakes will be made. It's no different when it comes to investing. The important thing to remember is that you learn from those mistakes and refrain from making them a second time around. It’s also just as important to learn from others’ mistakes. If someone you know has a terrible experience with a certain financial advisor, be sure to vet the next one you use. If someone you know invested in a very illiquid venture at a time that they needed the money, make certain that you take note of that the next time a major purchase is on the horizon. With that said, here are 5 very important investing pitfalls (in our opinion), that you should take note of, even if you haven’t experienced them yourself.

5. Being impatient

Investing takes patience. You can’t expect to make millions overnight. One of the worst things you can do is jump in and out of stocks or bonds, seeking the next big winner. All this does is increase transaction costs, trigger tax obligations, and most likely drive you crazy. There’s nothing wrong with attempting to buy the next Apple, Google, or Amazon, but when you think you have it, just give it time. There are many factors that impact a stock’s movement; don’t expect to know all the answers, all of the time. When market pundits suit up for the day and go on air touting their favorite market plays, you’d think that their version of “long-term” would be closer to a week than a year.

For tax purposes, a long-term gain or loss on a stock is considered to be one year, but in actuality, long-term is usually more than a year or two, of course depending on when the money will be needed. Being patient with your money means taking a long-term view with your investments, and the longer you’re in the market, the more probable it is that you’ll be making money.

4. Heeding the advice of market “experts”

Nowadays, it seems like every writer, TV pundit, speaker, and individual investor is an expert when it comes to putting their money to work. It’s great to take notice of what these people are saying, but don’t go changing your portfolio every time someone tells you to buy or sell. Keep this in mind: not every expert can be correct all the time. Yes, some might get it right more than others, but if they really knew what was going to happen in the future, do you think they’d be willing to share it with the world? Chances are they’d put their head down, make their prescient predictions, and live out the rest of their days as multi-billionaires. Listening day in and day out to experts won’t get you far, it will likely just confuse you on who the actual expert is. It’s incumbent on you to become the expert. Our advice is to question anything that a financial advisor or investment manager tells you. Ask questions. Take notes. Be sure to fact check anything you hear, and most importantly, know when something is too good to be true. There are no shortcuts. If it seems like a get-rich-quick-scheme, it probably is just a simple scheme to get your money.

3. Ignoring the costs of doing business

The investment industry is a business. And a big one at that. Just like any other business, it exists to generate profits. It’s not a benevolent endeavor that was created for the good of mankind. So, when you’re looking to invest your hard-earned money, pay attention to all the costs that are extracted to make the investment industry flourish. If transparency reigned supreme in the industry, our guess is that people would be very surprised at the fees, let alone other costs of doing business like taxes, commissions, and the like. Most of the time these expenses come out of your account via automatic withdrawals. Add them up and compare to other players in the industry.

We believe that if investment companies made their clients actually cut a check for each and every fee, people would think twice about who they invest with. The good news is that fees for certain investments and with certain companies have never been lower. No longer are investors subject to sales loads on mutual funds that can add up when the initial purchase is made or when redemptions occur. Pay attention to expense ratios, transaction fees, and assets under management (AUM) fees. If your advisor is charging over 1% of the money you have invested, keep in mind that you’re guaranteed to lose that exact amount year after year, compounded. The magic of compounding returns can also work against you, after all, every dollar of fees that you don’t get to keep translates into a dollar that you don’t get to invest and potentially make money on, compounded over time.

2. Holding losers and selling winners

The narrative goes something like this:

Investor: I bought ABC stock and it’s down 20%. Would you sell now or wait for it to come back?

Friend: Sometimes I sell, sometimes I hold. What are you going to do?

Investor: I think I’ll hold until it comes back, no point in realizing a loss right now, right?

Friend: You could tax-loss harvest if you have any capital gains.

Investor: I’d rather just wait until I’m even, then sell and get out at breakeven.

Friend: What if it comes back and surpasses the price that you bought it at?

Investor: I’ll probably sell if it goes over 10% of my purchase price.

Friend: Really? Why not wait until you double your money?

Investor: Maybe I will.

The point highlighted here is that a clear plan has to be put into place on both the buy and sell side. If you hold losers without a game plan, chances are you’ll never cut your losses. If you hold on to winners too long, you’ll never lock in gains and realize profits. And don’t bank on a stock coming back to breakeven (or beyond) before you choose to sell. Set a limit at a certain percentage, say 15% or so, whereby you cut your losses and allocate your money elsewhere. Do the same for taking profits.

1. Letting your emotions get the best of you

Investing is part science and part art. Computer models are now able to run highly sophisticated algorithms to execute trades by the second. That’s the science part. Fund managers also use intuition and behavioral finance techniques to execute trades based on market sentiment. Good decision-making requires both science and art. Getting attached to a particular stock will only cloud your judgement when it comes time to make a decision on whether to buy more or sell down. Never get attached to a stock, a bond, or any other investment because it’s been good to you at one point. If it’s not good to you now, consider alternatives. Letting emotions dictate the buying and selling you do is a recipe for disaster. Know when to keep your emotions in check.

Advice from notables (part 2 of 2)

"Don’t assume that a complex strategy is better than a simple strategy. The only thing extra complexity is likely to add is extra cost."

-Rick Ferri

It’s difficult to select just one piece of advice that Rick Ferri has offered over the years. He has written several books, including Asset Allocation and The Power of Passive Investing, which have both given investors a plethora of information on how best to navigate the markets. His advice couldn’t be more straightforward: keep it simple. There’s no reason to overcomplicate an investing strategy, especially when most of the time, an investor could buy and hold a basic S&P 500 index fund and enjoy returns that outpace the average investor who actively trades in and out of stocks.

Complexity does not mean you’re guaranteed large returns. It usually just means you’re paying top dollar to have someone create an unnecessarily complex plan to hopefully beat more than that simple index fund. Ferri’s advice is basic but profound; keep it simple and reap the benefits.

“The mutual-fund industry sits at the center of a massive market failure. The asymmetry between sophisticated institutional providers of investment management services and unsophisticated individual consumers results in a monumental transfer of wealth from individual to institution.” -David F. Swensen

Swensen manages a staggering $25 billion for one of the biggest endowments in the world. Yale University has entrusted Swensen for decades, so anytime he offers advice, pay attention. His most renowned work to date is entitled Unconventional Success: A Fundamental Approach to Personal Investment. In the book, Swensen discusses many failures of the investment industry, including the one vehicle that was ironically supposed to even the playing field for the average investor.

The mutual fund was a way for investors to pool funds to cut down on costs, broadly diversify, and give the everyday investor a chance to earn a return that wasn’t always available before its time. Fast forward to today and the mutual fund has become a vehicle by which institutions capitalize on individuals' lack of knowledge by extracting fees without much reservation.

In a perfect world, individuals would be the sole owners of the shares in a mutual fund, limiting the expense and thereby guaranteeing higher returns than if higher fees were incurred. As it stands, institutional fund companies market en masse, passing their advertising costs on to the investor. There’s a reason you rarely see fund companies such as Vanguard or Dimensional airing commercials during primetime slots on CNBC. The same cannot be said for Fidelity or BlackRock. To be certain, the latter are publicly traded fund companies that must increase shareholder returns at the expense of the investors in their funds. There’s no way around this. It’s a massive conflict of interest that often goes unnoticed. When possible, go direct from the fund actually offering the investment vehicle. Eliminate the middleman, and try to use fund companies that don’t rob Peter to pay Paul.

“The basic assumption that most institutional investors can outperform the market is false. Today, the institutions are the market. Institutions do over 95 percent of all exchange trades and an even higher percentage of off-board and derivatives trades. It is precisely because investing institutions are so numerous and capable and determined to do well for their clients that investment has become a loser’s game. Talented and hardworking as they are, professional investors cannot, as a group, outperform themselves. In fact, given the cost of active management—fees, commissions, market impact of big transactions, and so forth—investment managers have and will continue to underperform the overall market."

-Charles D. Ellis

Charles Ellis sums it up perfectly with this quote. Institutional investors cannot all be winners because most of the time they’re trading with themselves. If one institutional investor trades with another institutional investor, one will come ahead and the other will lose on the trade. Because the vast majority of trading is done by institutions—as opposed to individuals—the money managers, investment advisors, and marketing executives cannot claim to, as a whole, outperform the market itself. If we use the S&P as the benchmark for “the market,” institutional returns when taken in aggregate will not match the benchmark because payroll needs to be met, lights have to be kept on, and to prove their worth, institutions need to attempt to add value by spending big money on research to oust their competition. It’s better to be the market, than attempt to beat it.

"There are two kinds of investors, be they large or small: those who don't know where the market is headed and those who don't know what they don't know. Then again, there is a third type of investor: the investment professional, who indeed knows he doesn't know, but whose livelihood depends upon appearing to know."

-William J. Bernstein

This is one of our favorite quotes because it highlights how most talking heads in the media act when asked what they think is going to happen with the markets in the future. The really knowledgeable ones will admit that they have no idea what’s going to happen tomorrow, next week, or within the year. Pay attention to those people because chances are they know what they’re talking about. More often than not, though, market pundits will tell you exactly what they think you should do, right down to when and what to trade, with no limits to what they think will happen in the future.

Educated predictions are fine for extended periods of time, but when someone goes on TV and claims to know what a single stock is going to do the following day, it’s pure speculation and a disservice to anyone who heeds that advice. They pretend to know precisely because that is what puts food on the table. If they really did know, they wouldn’t need to be on TV pitching you about the next best stock to buy or the next big bust to avoid.