While the debate over the merits of active versus passive investing is ongoing, there has been a very clear trend spanning several decades now showing that investors are slowly (but steadily) abandoning the hope of outperformance offered by active management in favor of the certainty of earning market returns (not average returns) offered by passive management.
This trend has proven inexorable as investors become increasingly aware of the low – and declining – odds that active management will outperform. For example, evidence presented in my latest book, The Incredible Shrinking Alpha, which I co-authored with Andrew Berkin, shows that while 20 years ago about 20 percent of active managers were generating statistically significant alpha, today that figure has fallen to roughly two percent. And that’s before considering the impact of taxes, which taxable investors will face.
Contributing to the trend is that, thanks to efforts like those of the research team at Standard & Poor’s, investors are becoming more cognizant of the relative performance of these two strategies. The most recent evidence comes from a September 2015 Standard & Poor’s research report. The report, which presents cross-country comparisons, provides a look at the global evidence covering the five-year period from 2010 through 2014. The following is a summary of its key findings:
While these figures present a pretty dismal picture of active managers, for taxable investors, the reality is actually far bleaker. This occurs because, for taxable investors, the greatest expense of active management (caused by its relatively high turnover) is frequently taxes. Thus, the percentage of active managers who were able to outperform after taxes would almost certainly be far lower than the S&P Indices Versus Active (SPIVA) data indicates.
We’ll now take a look at some of the academic evidence on the impact of taxes on active management results.
In their 1993 study, “Is Your Alpha Big Enough to Cover Its Taxes?”, Robert Jeffrey and Robert Arnott found that over the 10-year period they studied, 21 percent of actively managed funds beat a passive alternative on a pre-tax basis, but just seven percent did so on an after-tax basis. They conclude: “The preponderance of evidence is so convincing we conclude that the typical approach of managing taxable portfolios as if they were tax-exempt is inherently irresponsible, even though doing so is the industry standard.”
We also have evidence from a 2000 study, “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” Here’s a summary of its findings:
Again, the story is actually worse than it appears because the data above contains survivorship bias (33 funds disappeared during the timeframe covered by the study). One more point on survivorship bias: Since the study covered only funds with more than $100 million in assets, it is likely that the survivorship bias is understated. The funds that have successful track records tend to attract assets. Funds with poor records tend to lose assets or be closed, never reaching the $100 million threshold of the study.
The authors of this study – Robert Arnott and Andrew Berkin, along with Paul Bouchey – updated it in 2011. They concluded that the typical approach for managing taxable portfolios (acting as if taxes can’t be reduced or deferred) remains the industry standard. Yet they estimated that the typical active fund must generate a pre-tax alpha of greater than two percent a year to offset the tax drag from its active strategies, and most funds cannot accomplish that feat. The finding of a tax drag in excess of two percent is consistent with the findings from other studies.
It’s important to consider that because of the two bear markets we experienced in the first decade of this century, the impact of taxes on returns has been less than the long-term experience. That is why it’s important to look at data from prior periods.
The evidence is so overwhelming, that Ted Aronson of AJO partners, an active institutional fund manager with about $24 billion in assets under management, offered this advice: “Once you introduce taxes, active management probably has an insurmountable hurdle.”
This commentary originally appeared October 21 on MutualFunds.com
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The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE
While it’s a low bar, Bloomberg TV always seemed to me to be the best of the financial media. Its anchors are professional and knowledgeable. Its coverage is broad and responsible. It avoids the hype and sensationalism typical of many of its competitors.
Bloomberg recently launched a new morning program, Bloomberg Go. It features some high-powered on-air talent, including David Westin, who previously had final behind-the-scenes say at Good Morning America and is the former president of ABC News. Westin is an on-camera fixture of the new program. He works with Stephanie Ruhle, a respected Bloomberg anchor.
According to Westin, the target audience of Bloomberg Go is “busy people who want to get something they can use something they aren’t going to get somewhere else.” He continues: “If we don’t give them that, they are going to go on to somewhere else.”
The “debate”
On Oct. 12, Bloomberg Go featured a brief “debate” on the merits of active versus passive funds. On the “passive” side was my colleague, Larry Swedroe, director of research at The BAM Alliance. Taking up the active cudgel was David Barse, chief executive officer at Third Avenue Management. You can watch the clip of this “debate” here.
Swedroe explained that “while it is certainly possible to beat the market through active management…you have about a 1 in 50 chance of outperforming.” He doesn’t “like the odds.” He added that, as set forth in his recent book, The Incredible Shrinking Alpha, the odds of an active fund outperforming its appropriate risk-adjusted benchmark have been persistently declining. Twenty years ago, about 20 percent of active funds were generating statistically significant alpha. That number is down to about 2 percent today.
Barse responded that Third Avenue, since its inception, has been able to beat the benchmark it uses. He noted that the “active share” of their funds is in the “high 90s,” so the index is not a “relevant measurement” of what the firm is actually doing, which is “generating good, long-term returns.”
When confronted with data on the general underperformance of active managers against standard benchmarks (in this case the S&P 500 index) Barse acknowledged that generating alpha was “hard,” but also stated that attempting to do so was a “thrill” and an “intellectual challenge.” He said Third Avenue works “hard to do it” and it’s what the firm strives to do “every day.”
Most viewers would come away with the impression that there was merit to both sides of the argument. They might even consider investing with Third Avenue, since the import of Barse’s argument in favor of active management was that Third Avenue has a track record of successfully overcoming the odds against “beating the market.”
Not quite so fast.
The data paints a different picture
In a subsequent article, Swedroe examined the returns of three of Third Avenue’s funds. His findings were at odds with Barse’s assertions during the debate.
The Third Avenue Small Cap Value Fund (TASCX) is categorized by Morningstar as a small-value fund. Fund managers often confuse investors by using the wrong benchmark as a basis of comparison for fund performance. Swedroe clearly used the correct benchmark in his comparison, relying on Morningstar.
TASCX returned 5.20 percent per year and 8.34 percent per year for the 10- and 15-year periods ending Oct. 13. According to Morningstar, this fund underperformed all but about 10 percent of the small-value funds that survived during these periods.
Investors would have been far better off in a comparable index fund from Vanguard. The Vanguard Small Cap Value Index Fund (VSIIX) outperformed Third Avenue’s fund by a staggering 3.17 percentage points per year over the 10-year period and 1.58 percentage points over the 15-year period.
An analysis of Third Avenue’s global and international funds also demonstrated underperformance. Swedroe again used Morningstar data to ascertain the correct benchmark. He found the Third Avenue Value Fund (TAVFX) underperformed the 10- and 15-year returns of comparable passively managed funds from Dimensional Fund Advisors, no matter which mix of Dimensional’s large- and small-value funds were used, or which mix of domestic and international funds were selected.
Finally, Swedroe looked at the Third Avenue International Value Fund (TAVIX), which is categorized by Morningstar as a small-mid value fund. For the 10-year period ending Oct. 13 (the fund didn’t have 15 years of returns), TAVIX returned 1.75 percent per year. The comparable Dimensional fund, the DFA International Small Cap Value Fund (DISVX), outperformed TAVIX by a whopping 4.56 percentage points a year.
Swedroe concludes his article as follows: “Not only did Third Avenue’s funds fail to outperform in each of the cases I analyzed, but they underperformed by wide margins. Maybe, just maybe, alpha is a lot harder to deliver than many, including David Barse, think. The Third Avenue funds I looked at certainly weren’t generating alpha or beating appropriate benchmarks.”
Swedroe excluded from his analysis Third Avenue’s largest and most popular fund, the Third Avenue Real Estate Value Fund (TAREX). He later explained this omission by noting that Vanguard doesn’t have an international real estate fund and Dimensional’s comparable fund does not have a long enough track record, so he had no basis for comparison. When he looked at a 5-year time period, and took an average of the returns for Dimensional’s domestic and international REIT fund, TAREX marginally outperformed (10.48 percent to 10.2 percent).
Nevertheless, even when including this fund, Third Avenue outperformed in only one of four funds, which, as Swedroe says, isn’t “very good odds.” What’s more, the single fund that did manage to outperform just barely accomplished this feat, while the three funds that underperformed did so by greater amounts. This is consistent with the evidence showing that the margins of active management outperformance tend to be much slimmer than the margins of active management underperformance.
I asked Third Avenue for its comments on Swedroe’s analysis. It declined.
The responsibility of the media
While the interviewers on Bloomberg GO challenged Barse with general data about the underperformance of actively managed funds, they were unprepared to confront his contention that Third Avenue Management is the exception to the rule.
The data in Swedroe’s article is readily available. Think about how helpful it would have been if the moderators of this “debate” had been aware of it and asked Barse some pointed questions, like: “For the past 10 and 15 years, isn’t it a fact that investors would have earned higher returns in comparable index and passively managed funds than in your Third Avenue Small Cap Value Fund, your Third Avenue Value Fund and your Third Avenue International Value Fund?” and “How can you justify your assertion that Third Avenue Management adds ‘alpha’ for investors in these funds?”
Now that would be a real debate.
It would also be responsible journalism.
This commentary originally appeared November 3 on HuffingtonPost.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE
Behavioral economist Richard Thaler explains why financial professionals need to be familiar with psychology.
Daniel Kahneman and Amos Tversky legitimized behavioral economics—the study of how people really behave around money, as opposed to how economists say a rational person ought to behave.
Then Richard Thaler and Cass Sunstein applied the lessons of behavioral economics to everyday life with their book Nudge. The duo nudged so successfully that in recent years, their prescriptions have been put to work in corporate retirement plans—and even public policy—on a global scale.
When I spoke to Thaler to discuss his newest book, Misbehaving, a series of stories documenting the rise of behavioral economics, he told me that he has a message for those who seek to employ his methods:
“Nudge for good.”
And why does he say that?
“Not all of the applications of behavioral science in the private sector are being used to the benefit of the consumers,” explains Thaler, a professor at the University of Chicago’s Booth School of Business.
It’s a plea that Thaler extends to financial advisers. He and Sunstein didn’t invent nudging, says Thaler. “People have been trying to nudge people for a long time,” he says, “and you can do it to try and help people out or to swindle them. Bernie Madoff was an expert at nudging.”
Here are three compelling directives from Thaler to us financial advisers. They serve as guidance for how we, collectively, can do good well:
Understand the lessons of behavioral finance for your work with clients.
“If the main thing that a financial adviser does in a session with a client involves looking at spreadsheets, then they’re not doing their job,” says Thaler. “It is as much psychology as it is finance.”
“No one would think that somebody’s qualified to be a financial adviser if they don’t know the difference between a stock and a bond,” he continues, “but people think it’s perfectly fine to be a financial adviser without knowing the difference between ‘System 1’ and ‘System 2’ [Kahneman’s shorthand for two different ways that people think] or loss aversion.”
Unlike the Fed’s counsel, Thaler’s advice is refreshingly discernable. But most of us weren’t trained in the behavioral sciences. How do we learn? For starters, we’ve got to educate ourselves, and there are a number of excellent books out there.
Consider beginning with the broad perspective and historical view offered in Misbehaving. Follow that with Daniel Kahneman’s Thinking, Fast and Slow. It provides a deep but surprisingly readable dive into the science—illuminated through the device of the brain’s “System 1” and “System 2.” The Heath brothers’ Switch, as well as Thaler and Sunstein’s Nudge, then help us envision how to apply the science. Malcolm Gladwell puts his mark on the field in Blink and Daniel Pink provides a primer on the science of motivation in Drive. There are many more, but this list will undoubtedly spur some insight into how behavioral finance can be applied in your practice.
Do the work.
It is, of course, at this point—the application of wisdom directly into practice—where most advisers become stalled. We will ultimately fall into our behavioral ruts, or in Thaler’s parlance, our default systems. But in much the same way that financial planning recommendations not implemented by clients aren’t doing them any good, knowledge that isn’t actively applied in our advisory practices accomplishes nothing.
Here is where skilled practice management consultants and thought leaders like Carol Anderson of Money Quotient, Kinder Institute founder George Kinder, and Susan Bradley of the Sudden Money Institute have helped advisers shape their practices with an eye for the unseen behavioral elements of our work.
So if our client meetings aren’t spent poring over data, where should our focus be? According to Thaler, it begins with “simply recognizing that the job of understanding what your clients’ goals and fears and needs are is at least as important as crunching the numbers.” He continues: “If you understand how people think, then it’ll be easier for you to communicate with people and devise strategies that they will be able to implement.”
Embrace the fiduciary standard.
I didn’t bring it up; he did. And while Thaler didn’t want to get into the details of any proposed rules or regulations, he spoke with crystal clarity regarding the industry debate over whether or not financial professionals should be held to a legal standard that requires them to act in the best interest of their clients, as fiduciaries. “The principle should not be controversial,” he says. “Anybody who doesn’t think that a financial adviser should be acting as a fiduciary should find another line of work.”
Finally, I asked Thaler how he might sum up his advice for financial advisers.
“You can’t do your job well unless you understand how your clients think,” he said.
And once we do, let’s remember to nudge—for good.
This commentary originally appeared October 19 on Time.com
By clicking on any of the links above, you acknowledge that they are solely for your convenience, and do not necessarily imply any affiliations, sponsorships, endorsements or representations whatsoever by us regarding third-party Web sites. We are not responsible for the content, availability or privacy policies of these sites, and shall not be responsible or liable for any information, opinions, advice, products or services available on or through them.
The opinions expressed by featured authors are their own and may not accurately reflect those of the BAM ALLIANCE. This article is for general information only and is not intended to serve as specific financial, accounting or tax advice.
© 2015, The BAM ALLIANCE