Active vs Passive Management

[W2R]

I noticed that most of the folks portfolios on this board declined less than market indexes. Somewhat surprising because we have so many index fans...

I have two explanations for that.

(1) Some indices are based on the movement of share prices. Lots of us in the accumulation phase bolstered our portfolios by adding our dividends/interest/LTCG to them, and didn't withdraw anything.

(2) Members whose portfolios fared worse than the indices were probably reluctant to post.

 

[clifp]

Uhhhmmm, have you heard about how well the Yale and Harvard endowments did this past 18 months? Needless to say there have been "shake-ups" in management and a "new" investment philosophy going forward http://www.nytimes.com/2009/09/11/business/11harvard.html .

DD

Did you miss this part of the article.

The Yale endowment is led by David F. Swensen, who has advocated aggressive use of alterative investments like private equity and hedge funds. At the end of fiscal 2008, Yale continued to turn in the best 10-year performance with an average annualized gain of 16.3 percent, which was followed by Harvard with 13.8 percent.
Harvard’s 10-year average annualized return has now fallen to 8.9 percent. That remains well above its policy portfolio of 4.5 percent.

Gee Harvard has only averaged 8.9% over the last 10 years.

Lets compare to index funds.
Total Stock Market average in the last 10 years is .84%
Total Bond Fund is 6.03%

So a 50/50 portfolio would be up about 3.5%/year (better than I have done) but a heck of lot behind the dumb active money managers at Harvard.

 

[clifp]

I have two explanations for that.

(1) Some indices are based on the movement of share prices. Lots of us in the accumulation phase bolstered our portfolios by adding our dividends/interest/LTCG to them, and didn't withdraw anything.

(2) Members whose portfolios fared worse than the indices were probably reluctant to post.

Actually I think a simpler explanation is that most of the forum members have relatively low equity AA 30-60% and the bond portion did pretty well. I also think (based on comments no data) that the average forum member in 2007 though early 2008 either maintained or decreased his equity AA, didn't sell in Oct or Nov of 2008. In short, avoided doing stupid things. I remembered that when I got my HEL to invest in the market in Jan 2008, there weren't many people saying that sounds a like great idea.

 

[W2R]

Actually I think a simpler explanation is that most of the forum members have relatively low equity AA 30-60% and the bond portion did pretty well.

That, too!

I also think (based on comments no data) that the average forum member in 2007 though early 2008 either maintained or decreased his equity AA, didn't sell in Oct or Nov of 2008.

My investment behavior agrees with your thoughts. In particular, I know that I did not sell in Oct or Nov of 2008 (out of sheer terror in my case). I even bought a good amount of VTSAX, VWIAX, and VFWIX in October of 2008, simply because I did not know what to do except to believe what I had been reading. I'm not sure that all of us refrained from selling in Oct or Nov of 2008, though - - I remember some saying that they were getting out at that time, though they may not say much about it now. But probably most did manage to hold on, often as part of a buy and hold strategy.

As a group, I would say that we are pretty reasonable investors. At least, we are not throwing money away in penny stocks. But I don't think that (as a group) we are investment wizards. We do have a few who seem to be in that category.

With great risk comes great rewards. I would expect that one would have to have nerves of steel to be an investment wizard (and that's not me).

 

[samclem]

I think you are being sarcastic but in fact I think you are right.

Well, I was. Actually, I'm not as hard core as my wiseacre posts imply. I do believe in value investing. And I believe there are people who pay too much for stocks. And I own a few low cost managed funds.

Why is Goldman paying Joe so much money? Is it because Goldman is filled with financial idiots who care nothing about spending the firms money? Or is it possible that Goldman's compensation executives actually know something that we don't?

Anybody who has read the newspaper in the last year and is still putting forth the financial services industry as a model of effective compensation--well, I can only surmise that such a person is making a joke.

Look, if Joe is so smart, all he'd have to do is document his picks in some way that there's no potential that he either made them up after the fact or selected the best porfolio results of many he ran simultaneously. He would realize what a goldmine this would be. And there's no way he'd keep quiet about it. These guys are not known as shrinking violets. With the magic gift, he'd be able to name his price, and he'd be shouting about his record from the mountaintops.

 

[RonBoyd]

Actually, I'm not as hard core as my wiseacre posts imply.

Ow! I am sorry to hear that. Now, I'm gonna have to go back and read em all agin.

 

[clifp]

Anybody who has read the newspaper in the last year and is still putting forth the financial services industry as a model of effective compensation--well, I can only surmise that such a person is making a joke.

Look, if Joe is so smart, all he'd have to do is document his picks in some way that there's no potential that he either made them up after the fact or selected the best porfolio results of many he ran simultaneously. He would realize what a goldmine this would be. And there's no way he'd keep quiet about it. These guys are not known as shrinking violets. With the magic gift, he'd be able to name his price, and he'd be shouting about his record from the mountaintops.

Well ya it was my turn to make a joke. Obviously, I can not defend the compensation practices in the financial industry. Still you do wonder why firms such as GS pay traders such vastly different salaries. Even if we agree that they could still attract talent if they cut the pay 80%, there must be a reason they pay Joe $10 million bonus and Sam "only" $3 million.
There are too many smart folks that come from Goldman for me to believe it is all office politics.

Obviously many of the best and brightest left the relative poverty of the investment banking and mutual fund management to start their own hedge fund and based on their past track record quite a few attracted billions. Again I can't believe that all the billions invested in hedge funds was by stupid ignorant investors, who listened to their Amerprise financial advisor or full server brokers.

I also think that a 2% fee and 20% of the profits is pretty close to naming your own prices. (Heck, I'd be willing do the work for 1/2 price.. 1% and 10% please PM me for wiring instructions ) Although some hedge fund collapsed how the average hedge fund and the top managers did over the last 1,5, and 10 years is complete mystery to me. For all I know despite the obscene fees they very well may have outperformed the market. Yet another area unexplored by academic research.

 

[DblDoc]

Did you miss this part of the article.



Gee Harvard has only averaged 8.9% over the last 10 years.

Lets compare to index funds.
Total Stock Market average in the last 10 years is .84%
Total Bond Fund is 6.03%

So a 50/50 portfolio would be up about 3.5%/year (better than I have done) but a heck of lot behind the dumb active money managers at Harvard.

Good point. Their absolute yield has been good, but now they realize 1) they have been doing so with a great deal of risk and 2) they failed to match investment risk and liquidity to their income needs.

I don't think a 50:50 TBM/TSM is an appropriate benchmark to compare endowment funds that invest in hedge funds, exotic investments and CDS's. When compared to other endowment funds the golden haired boys and girls at Harvard and Yale did not fair that well.

DD

 

[ziggy29]

Regarding trading costs, I think one of the things that use to be relevant but is increasingly irrelevant. Schwab charges me $8.95/trade pretty typical for a discount broker, the bid and ask spread is generally $.01. I generally buy 1,000 shares at time ($10 spread cost). So it cost $40 to buy AND sell a stock, on a $20 stock this is .02% and my portfolio turnover is about 30%/year putting my trading cost considerably lower than even Vanguard index funds.

Sort of an aside here, but I just got something in e-mail from Schwab about the introduction of their own ETFs which they claim have lower expenses than Vanguard ETFs and trade commission-free in a Schwab account. It should be interesting to see these funds develop a history, though the potential downside of commission-free trading on ETFs is that it could encourage hyperactive trading...

 

[FinanceDude]

Such as cheap index funds/ETF's that allow the investor to create a balanced, diversified portfolio that manages risk and incurs low fees. Shhhh! Don't let that secret out .

DD

How is that a secret??

 

[Gone4Good]

I think it does. Here is the conclusion

I read the conclusion. I also read the study. The problem with their conclusion that "some individuals can beat the market" is that is not what the study actually tested. They looked at stock trades, and in some cases only the buy side of the trade. They didn't measure how the actual account performed but rather how a theoretical account that doesn't include a lot of real world costs would perform. They not only ignore trading costs, but also the cash drag on an account used for trading. By their methodology every account was 100% invested all of the time. Is that even possible in an actively traded account? Did the investor even intend to be invested 100% of the time? What benefit / detriment did the account experience by each trader's purposeful entering and exiting the market? The study methodology doesn't address this, because they are not testing whether these individual traders actually beat the market. So we don't know if these "skillful" traders beat the market, and neither do the authors of the report. So their conclusion goes way too far in asserting something they didn't even measure.

Another real world cost not factored in to this study is the impact of taxes, which can be huge. If these great traders are paying 35% on their trading gains and I'm paying 15% on my buy and hold gains, the trader needs to beat my returns by nearly 31% to do as well as I do on an after tax basis. Add to that the compounding benefit that I get by deferring those taxes well into the future and the bar is even higher.

So if you're argument is that some people could theoretically beat the market in a zero friction trading environment with zero tax consequences then maybe the study (whose data, methodology and findings have not been peer reviewed and replicated the way Fama's and French's have) supports that theory. But if you're suggesting that people in the real world are actually doing better than the market, this study doesn't address that question.

 

[Gone4Good]

Gee Harvard has only averaged 8.9% over the last 10 years.

Lets compare to index funds.
Total Stock Market average in the last 10 years is .84%
Total Bond Fund is 6.03%

What you're missing are returns from Harvard's 65% allocation to "alternative" investments. These include things like timber lands and oil wells. They also used leverage to juice returns. I think it's probably impossible to benchmark Harvard's endowment vs. an index because there isn't an index available that includes all the kinds of stuff they invested in.

Why is Goldman paying Joe so much money?

An awful lot of the traders at places like Goldman are market makers. It's not quite as hard to make money trading when you're buying on the bid and selling on the offer.

Hedge funds are different. I don't know of any studies that benchmarked hedge fund returns to see how they've performed relative to an appropriate index, but I wouldn't be shocked to see outperformance for the class in the early days. These guys pioneered a bunch of investment techniques in a variety of asset classes. Some of this stuff involved investment vehicles that didn't exist before (like CDS, for example). But the hedge fund world has become very crowded in the last several years and all of these guys chase after the same trades now. I suspect they'll be less successful in the future.

 

[clifp]

Another real world cost not factored in to this study is the impact of taxes, which can be huge. If these great traders are paying 35% on their trading gains and I'm paying 15% on my buy and hold gains, the trader needs to beat my returns by nearly 31% to do as well as I do on an after tax basis. Add to that the compounding benefit that I get by deferring those taxes well into the future and the bar is even higher.

So if you're argument is that some people could theoretically beat the market in a zero friction trading environment with zero tax consequences then maybe the study (whose data, methodology and findings have not been peer reviewed and replicated the way Fama's and French's have) supports that theory. But if you're suggesting that people in the real world are actually doing better than the market, this study doesn't address that question.

You may have a point regarding what they are measuring is trades not account growth, I didn't read the study that closely. But I think both your arguments about trading costs and taxes are red herrings. It isn't all that hard to be 100% invested. In most years both my IRA have minimal cash balances (1%) and obviously IRA trading is tax free.

But even for taxable accounts the impact is probably much smaller than you talk about. From my reading of the study we are talking about people who made 25 trades over a 6 year period, we aren't talking day traders here. The average holding periods was 370+ days which strike me as meaning these people were aware of LT Cap gains.

I am missing how if you hold a collection of index funds (or even just Total Stock and Total Bond) and you annually re-balance and I hold individual stocks instead of an index funds, I keep my winners for a year+ and sell my loser in under a year. (This is pretty standard stuff). If we have similar performance why do I owe more tax than you. If anything individual stock traders have more control over taxes than indexers.

I'll concede that is far from the definitive study proving that individual can beat the market. I thought it was interesting.

However, you have completed ignored my main point.
EVERY STUDY THAT HAS CLAIMED THAT THE INDIVIDUAL MONEY MANAGERS CAN'T BEAT THE MARKET HAS FOCUSED ON THE PERFORMANCE OF MUTUAL FUNDS RATHER THAN ON INDIVIDUALS.

 

[clifp]

What you're missing are returns from Harvard's 65% allocation to "alternative" investments. These include things like timber lands and oil wells. They also used leverage to juice returns. I think it's probably impossible to benchmark Harvard's endowment vs. an index because there isn't an index available that includes all the kinds of stuff they invested in.

.

So what. I don't care if they made their money, buying and selling Princess Di collectibles on Ebay. I just want to find somebody who can make more than the .84%/year than the TSM has averaged over the last 10 years.
And the money managers do so while not taking more risk than a say 75/25 stock/bond allocation.

Unless I am mistaken the classic indexer says you can't beat the market so don't bother to try. I am pretty sure that faculty, students and alumni of Harvard and Yale would beg to differ at least over the last 25 years... I am guessing that French, Farma, Bogle etc. will have a tough time convincing the endowment trustees to switch to indexing.

 

[samclem]

So what. I don't care if they made their money, buying and selling Princess Di collectibles on Ebay. I just want to find somebody who can make more than the .84%/year than the TSM has averaged over the last 10 years.

I can save you big money on advisory fees. I can find you 10 investment techniques that have beat TSM over the last 10 years. If that's your measure of merit, I can help. And I'll give you all ten techniques for just $20.

Is anything gained by fixating on these particular endowments? There are a great many other endowments, pension funds, and actively managed mutual funds that underperformed TSM over the last 10 years. I'll bet you all the managers of these investments were confident that they were smarter than the herd. None of them set out to underperform an unmanaged index. But they did it, despte all the expertise and even dumb luck.

 

[Gone4Good]

Unless I am mistaken the classic indexer says you can't beat the market so don't bother to try.

Yes you are mistaken. The theory doesn't say "equities outperform all other asset classes, and always will" which is essentially what you are saying when you try to judge the performance of Harvard which includes many asset classes vs. that of the TSM which includes only equities. "The market", as properly defined, includes all asset classes. Harvard's endowment comes closer to "the market" than does the TSM. But to properly judge whether Harvard outperformed "the market" we need a proper "market" index. We don't have one, so we don't know, which was my point.

 

[Gone4Good]

The average holding periods was 370+ days which strike me as meaning these people were aware of LT Cap gains.

Nope. Go to Table 1 where you will see the median holding period for the sample they actually used in the study (Accounts with at least 25 trades) was 199 days and the average was 244.

 

[ziggy29]

I think we need to add this to the "intractable debate" list along with paying off the mortgage early or whether one should use a lump sum to pay off debts or invest.

Bottom line to me is that I *think* there may be such a thing as a market beating stock picking skill, but it can't be proven with the acceptable statistical method and we mortals can't possibly be able to tell the difference between money managers who are good and money managers who have been lucky.

 

[Nords]

I think we need to add this to the "intractable debate" list along with paying off the mortgage early or whether one should use a lump sum to pay off debts or invest.

David Snowball, a communications prof who posts on FundAlarm.com, said it best years ago: "reciprocated diatribes".

Bottom line to me is that I *think* there may be such a thing as a market beating stock picking skill, but it can't be proven with the acceptable statistical method and we mortals can't possibly be able to tell the difference between money managers who are good and money managers who have been lucky.

Bill Miller knows!

 

[clifp]

I think we need to add this to the "intractable debate" list along with paying off the mortgage early or whether one should use a lump sum to pay off debts or invest.

Bottom line to me is that I *think* there may be such a thing as a market beating stock picking skill, but it can't be proven with the acceptable statistical method and we mortals can't possibly be able to tell the difference between money managers who are good and money managers who have been lucky.

I pretty much agree with this.
I think both stock picking and asset allocations are skills and some people are significantly better at than others. By asset allocation, I mean deciding that stocks, bonds, timberland etc are relatively under or overvalued.

The problem is that (like virtually all human activities) there is a significant element of luck. More so than in most fields, I think it a takes very long time (probably a decade or more) to figure out who is lucky and who is good. And as I often say in poker "it is better to be lucky than good".

 

[DblDoc]

I pretty much agree with this.
I think both stock picking and asset allocations are skills and some people are significantly better at than others. By asset allocation, I mean deciding that stocks, bonds, timberland etc are relatively under or overvalued.

The problem is that (like virtually all human activities) there is a significant element of luck. More so than in most fields, I think it a takes very long time (probably a decade or more) to figure out who is lucky and who is good. And as I often say in poker "it is better to be lucky than good".

And if your neither then "goose" your returns with a little insider trading or outright fraud Wall Street insider trading probe widens - The Globe and Mail.

DD

 

[clifp]

And if your neither then "goose" your returns with a little insider trading or outright fraud Wall Street insider trading probe widens - The Globe and Mail.

DD

I remember my professor of Engineering Economics,had a simple defense of indexing. "If insiders do better than average, and indexers do average, what does that leave for everyone else."

It is pity that these SOBs will get to serve their sentence in minimum security prisons for non-violent offenders.