Again Low Fee Index Funds Beat Active Managed

[OldShooter]

@all4j, I'll address a couple of your points:

... I get a statement showing these results. It shows 4% more than the index fund -- it does not show adjusted returns stripping out risk from volatility. ...

Unfortunately, the word "risk" is almost useless as a quantitative measure when applied to investing. In Markowitz' 1952 paper that was the foundation of Modern Portfolio Theory he very casually said the he was considering standard deviation (aka volatility) to be his measure of risk. With that approach, you can't strip risk from volatility because they are the same. Personally, as a long-term investor I am not concerned by volatility unless SORR raises its ugly head. Risk to me is GE, Enron, JDS Uniphase, Sears Holdings, etc. -- investments that permanently lose value. Further, volatility includes both "up" and "down" variations equally. I'm not sure many of us would consider an upward deviation of our investment to represent risk. For me overall, the concept just doesn't work.

So, the short version, IMO is that your questions can't be answered. The good news, though, is that I can't remember variance risk to have been a consideration in any of the research or literature concerned with the random walk that makes index investing the winner.

... Arguments devolve into rationalizing a point of view, logic & impartiality to the side. ..I

I'm not sure who you were painting with that brush, but I was trained as a scientist and engineer and have approached investment from a science mindset. All the technical papers, data, books, and studies I have found point to the random walk explanation that in turns leads one to indexing. I am as greedy as the next guy, however, so if scientifically credible results pointing to a better strtegy appear, I will be happy to jump towards it.

If you're interested in logic and impartiality I'd be happy to PM you a list of references authored by experts whose bios you can check out in Wikipedia. You will also find many in the Nobel listings as well. Just let me know.

 

[all4j]

If you're interested in logic and impartiality I'd be happy to PM you a list of references authored by experts whose bios you can check out in Wikipedia. You will also find many in the Nobel listings as well. Just let me know.

Ignoramus et ignorabimus

So, put your kind offer on one side of the scale & your signature line on the other.... I'll pass, but glad you found something that you feel works for you

 

[Qs Laptop]

@all4j, I'll address a couple of your points:

In Markowitz' 1952 paper that was the foundation of Modern Portfolio Theory he very casually said...blah blah blah...

"1952" and "Modern Portfolio Theory". Really?

Do I really have to go into how the economy and availability and variety of goods and services have changed in SEVENTY YEARS??!!

 

[ERD50]

Good explanation & I appreciate the time you took; unfortunately I don't think I communicated very well. In retrospect, not sure the point was worth making, but I'll try a bit different approach. I readily admit I may be assuming things about this specific study based on other studies I've seen in the past.

Assume a fund manager develops a better mouse trap -- claims to add 5% on top of what the market might give. For his/her expertise/trouble, he/she will charge me 1% more than the index fund going rate. He/she blatantly says they'll be taking on more risk (after all, shouldn't expect higher return without higher risk) than the market, but they have an approach to mitigate that risk.

I make the decision to buy in & lo/behold they deliver as hoped. I/we took on added risk & got higher returns, net 4% over the index fund.

I get a statement showing these results. It shows 4% more than the index fund -- it does not show adjusted returns stripping out risk from volatility. Now, I may make the decision to cash in my chips & walk away OR I may let it ride.

What I personally would do is say -- well if I strip out the non-market return but still apply the higher fee, how would i have done. No better than index? then why bother...all it did was leave with with more $s & higher taxes....

Hey, I'm not against index funds or active managed -- to me, both are tools in a tool box to be used as appropriate. But to strip out the pros & still apply the cons shouldn't take a study to guess the result....I saw something similar recently with another site where they stripped out inflation to review tips. Seriously.

That's fine. I think I can answer this simply, and separately from Old Shooter's reply.

It's fine if you say you are willing to take on more risk/volatility in order to 'beat the market'. Your decision. And in this hypothetical case, it worked out for you. Good.

All I'm saying, is that it is no longer apples-apples to compare to the benchmark, as you did decide to take on more risk/volatility.

Rather than "water down" the results by adjusting your AA as I gave in my example, let's look at it the other way - what if I leveraged my holding in the index fund, such that the volatility was equivalent? Would the active manager beat that (including any costs on the index to leverage)? If not, I'm not sure I want to expose myself to the risk that their performance might not be sustainable (but that's me, you might be OK with it).

Now, you might say that investing in the active fund is easier than leveraging, OK maybe. But unless you are already 100/0 AA, adjusting the bond or cash allocation is effectively doing the same thing, and that is why I took that approach in my example. But maybe the leveraging view better fits what you were looking for?

Does that make sense?

-ERD50

 

[ncbill]

I have accepted that not only are future macro trends subject to a lot of random chance (pandemic, war, legislation, etc.), but that investing is another step into the abyss of the unknowable in that the investor also has to guess how their own analysis and knowledge compares to all the other market players. So it seems unsurprising to me that study results show that you cannot know ahead of time which active strategy or manager will beat the market.

But as a passive investor, I am a free rider and the system cannot work if everyone thought that beating the "system" was pretty hopeless. Somebody has to believe they know enough more than everyone else in order to make the trades that create the price discovery process. So I thank you for your service, trading and incurring costs so I don't have to.

Yep, don't forget William J. Bernstein says only a 4 in 5 chance your retirement plans will work anyway because of major factors beyond your control:

The Retirement Calculator from Hell, Part III

 

[all4j]

That's fine. I think I can answer this simply, and separately from Old Shooter's reply.

It's fine if you say you are willing to take on more risk/volatility in order to 'beat the market'. Your decision. And in this hypothetical case, it worked out for you. Good.

All I'm saying, is that it is no longer apples-apples to compare to the benchmark, as you did decide to take on more risk/volatility.

Rather than "water down" the results by adjusting your AA as I gave in my example, let's look at it the other way - what if I leveraged my holding in the index fund, such that the volatility was equivalent? Would the active manager beat that (including any costs on the index to leverage)? If not, I'm not sure I want to expose myself to the risk that their performance might not be sustainable (but that's me, you might be OK with it).

Now, you might say that investing in the active fund is easier than leveraging, OK maybe. But unless you are already 100/0 AA, adjusting the bond or cash allocation is effectively doing the same thing, and that is why I took that approach in my example. But maybe the leveraging view better fits what you were looking for?

Does that make sense?

-ERD50

It does make sense. But I sense my main point is still being lost. I bolded one of your sentences not because I agree or disagree. Rather to try & use that to shed light. Again, I'm not advocating for/against either active managed or index. Mainly trying to say the "study" -- or at least most of that type -- has a methodology that to me is suspect.

Again, I think the only way to get higher returns is to take more risk. But I don't think it prudent to take on more risk than you are rewarded for.

So 1st, these adjusted returns are adjusted only for one dimension: volatility (or at least that is my understanding -- I haven't dug into it). Yet many risks exist, some of which aren't quantifiable anyway. So, adjusting, to me, doesn't get both sides to apples. 2nd, not all actively managed funds have an objective of matching "the market" (whatever the index is). Say we are looking at stocks & the index is "total stock" market. Is that market weight? equal weight? Idk. But consider some funds are geared to high dividend, small cap value, tax efficient, etc. Did adjusting for volatility address that? Hardly. If the time period is a time when large cap growth dominates & market weight index is largely concentrated (oops, that might be concentration risk in the index but not actively managed....), would you expect small cap value to beat the index? Last, I'll mention the selection of a benchmark....Anyway, I struggle to see how the study could find any other result. If, using above example, large cap growth dominated heavily, could just count those active funds & see if "most" have a chance.

I see the usefulness of using risk adjusted returns to evaluate past performance & see if an investor was compensated for taking risk. It could be useful in several ways. One might show that nominal results of actively managed were higher, but risk adjusted (& expense adjusted) were lower; this might be a red flag.

I've personally used both & I generally evaluate based on entire portfolio. I've had many cases in which a combination increased overall return & lowered overall volatility from an overall portfolio view. In my case, it isn't an either/or decision. But others will have different needs.

Hey I'm not trying to convince anyone to change their investing approach, take on more risk than comfortable, etc.

 

[ERD50]

.... Hey I'm not trying to convince anyone to change their investing approach, take on more risk than comfortable, etc.

It's all good - this is just a friendly, and IMO, somewhat interesting discussion.

Originally Posted by ERD50 View Post .... All I'm saying, is that it is no longer apples-apples to compare to the benchmark, as you did decide to take on more risk/volatility.

It does make sense. But I sense my main point is still being lost. I bolded one of your sentences not because I agree or disagree. Rather to try & use that to shed light. .....

Again, I think the only way to get higher returns is to take more risk. But I don't think it prudent to take on more risk than you are rewarded for. ...

... 2nd, not all actively managed funds have an objective of matching "the market" (whatever the index is). Say we are looking at stocks & the index is "total stock" market. Is that market weight? equal weight? Idk. ...

I personally try to keep this simple. I do believe that a personal investor is best served with a simple portfolio, VTI/BND at whatever AA they feel comfortable with and understand the ramifications.

So that's my benchmark. I don't care if the active fund manager considers their benchmark to be small cap, dividend aristocrats, or the blue cheese sector - that's up to them, their performance against my benchmark is all that matters to me. After all, that is my alternative to their active fund. And that's how I'm going to measure them.

... I see the usefulness of using risk adjusted returns to evaluate past performance & see if an investor was compensated for taking risk. It could be useful in several ways. One might show that nominal results of actively managed were higher, but risk adjusted (& expense adjusted) were lower; this might be a red flag.
... .

But isn't this exactly what I'm saying? All we have is past performance (relative to the benchmark, not as an indicator of future gains/loss) to make this judgement, and you seem to be agreeing that it needs to be risk adjusted for the comparison. So we agree?

Getting back to a practical example, since I prefer an ~ 70/30 AA, if I was shown an active fund that appeared to have a very good track record, good enough to tempt me to take a decent sized stake in it, I would be evaluating that volatility, and adjusting my AA to get back in line. Otherwise, I could just adjust my AA to get there, so why bother?

Now, if that active fund did better in good times and less bad in bad times, I think that a volatility adjustment based only on std dev may be misleading. So I'll bite - show me one with a long track record.

-ERD50

 

[all4j]

It's all good - this is just a friendly, and IMO, somewhat interesting discussion.



I personally try to keep this simple. I do believe that a personal investor is best served with a simple portfolio, VTI/BND at whatever AA they feel comfortable with and understand the ramifications.

So that's my benchmark. I don't care if the active fund manager considers their benchmark to be small cap, dividend aristocrats, or the blue cheese sector - that's up to them, their performance against my benchmark is all that matters to me. After all, that is my alternative to their active fund. And that's how I'm going to measure them.




But isn't this exactly what I'm saying? All we have is past performance (relative to the benchmark, not as an indicator of future gains/loss) to make this judgement, and you seem to be agreeing that it needs to be risk adjusted for the comparison. So we agree?

Getting back to a practical example, since I prefer an ~ 70/30 AA, if I was shown an active fund that appeared to have a very good track record, good enough to tempt me to take a decent sized stake in it, I would be evaluating that volatility, and adjusting my AA to get back in line. Otherwise, I could just adjust my AA to get there, so why bother?

Now, if that active fund did better in good times and less bad in bad times, I think that a volatility adjustment based only on std dev may be misleading. So I'll bite - show me one with a long track record.

-ERD50

I'm in agreement with you on most of your points; although I'm not sure that is what the study said. I agree with keeping it simple & am on a path for that myself. In the past, I've indulged (not always with success) in tweaking & making portfolio too complex. Overall, it served me well. Now, I tend to think how easy it will be for someone to follow in my footsteps once I'm not running things. Puts me at a disadvantage in regard to a recommendation. But before that, I'll say that backtesting is just a data point to me. I tend to look at overall portfolio -- not just 'a' fund. And so I can rile the market timing crowd, I will consider overall upcoming factors. For example, I do NOT expect the next x years to look like the last x years as far as bonds. So, I'll look more broadly, taking data points with grains of salt.

As far as recommending a fund? Don't really feel comfortable with that, but...I'm not particularly versed with portfolio visualizer, but am guessing you are. 70/30 is probably not as common as 60/40 & that may be a catch. I'd suggest looking at Vanguard Wellington (vwelx -- share class goes back a long time), Dodge & Cox Balanced (DODBX), and Oakmark Equity & Income (OAKBX). Play around with those in terms of time frames. When I do similar exercises, I find it useful to determine 1st what success is -- cagr? sharpe? etc. Tax implications may also be a deal breaker.

If you don't mind the re-balancing of diy, probably a waste of your time though. Again, I'm not advocating for these (or any other)...mainly commenting on the method of the study & conclusions drawn from such

 

[Montecfo]

I will say that i think the idea that the indexer shrugs off higher active returns because the active investor took "greater risk" is a little bit silly.
It is as if the indexer wants the active manager to win by holding exactly the same.stocks as the index. Otherwise the risk difference invalidates the comparison somehow.

There are many portfolios that are both lower risk and likely lower return than a broad equity index. Should those investors also turn up their nose at a higher return from a more risky index?

As long as both portfolios are reasonably diversified and not attacking the market differently (such as using options or futures) I see very little difference.

 

[ERD50]

I will say that i think the idea that the indexer shrugs off higher active returns because the active investor took "greater risk" is a little bit silly.
....

That would be silly. But I don't think that's what most indexers are saying, it certainly isn't mine.

... It is as if the indexer wants the active manager to win by holding exactly the same.stocks as the index. Otherwise the risk difference invalidates the comparison somehow. ...

I don't know where you come away with such ideas. Of course the active investor must be doing something different.

... As long as both portfolios are reasonably diversified and not attacking the market differently (such as using options or futures) I see very little difference.

I don't care if they use futures or options, options can certainly be used by active investors (look at the covered call thread).

Nothing wrong with taking added risk/volatility - but that should be accounted for in any comparison. As I explained to all4j, the easy way is (assuming each investor is not 100/0 AA) is to adjust the AA of the two until standard dev is equal (easy to do with that portfoliobacktest site), then compare performance.

-ERD50

 

[OldShooter]

... Nothing wrong with taking added risk/volatility - but that should be accounted for in any comparison. As I explained to all4j, the easy way is (assuming each investor is not 100/0 AA) is to adjust the AA of the two until standard dev is equal (easy to do with that portfoliobacktest site), then compare performance. ...

I am curious: Barring SORR concerns, why do you think that standard deviation is a useful measure of risk?

 

[ERD50]

I am curious: Barring SORR concerns, why do you think that standard deviation is a useful measure of risk?

I don't really. It's a measure of volatility, but that's what is usually meant when people speak of 'risk'. It's hard to know what the real 'risk' is of an investment. This is all rear-view mirror stuff anyway, so I guess risk is "it went down".

-ERD50

 

[ERD50]

So here's an example for Montecfo.

https://tinyurl.com/2aegh7r3 << link to portfoliovisualizer

UPRO is a 3x leveraged SPY fund. It outperformed SPY. Is it 'better'? Do we ignore the much larger dips?

-ERD50

 

[Montecfo]

So here's an example for Montecfo.



https://tinyurl.com/2aegh7r3 << link to portfoliovisualizer



UPRO is a 3x leveraged SPY fund. It outperformed SPY. Is it 'better'? Do we ignore the much larger dips?



-ERD50

You are making my point for me. Higher return portfolios should not be dismissed because they may be "riskier" if the risk is small (this was not an example of that).

And this happened earlier in this thread (higher active return dismissed due to higher "risk"). It would be a mistake to think every comment is aimed at you.

Mostly not.

 

[ERD50]

You are making my point for me. Higher return portfolios should not be dismissed because they may be "riskier" if the risk is small (this was not an example of that).

And this happened earlier in this thread (higher active return dismissed due to higher "risk"). It would be a mistake to think every comment is aimed at you.

Mostly not.

Well, it's hard to tell which comments are for what when it isn't quoted.

Anyhow, I don't think we are communicating. I'm not "dismissing" higher return portfolios (remember, I said I like money!), I'm saying that higher risk/volatility needs to be accounted for. Which would generally mean that to maintain an overall 'risk' profile, you would need to offset that added risk/volatility somewhere else in your portfolio. So after you do that, do you really come out ahead? It's a question, not a statement.

I think this has run it's course. Looking for higher returns is great, but there are considerations (or else everyone would be there!).

-ERD50

 

[Montecfo]

Well, it's hard to tell which comments are for what when it isn't quoted.

Anyhow, I don't think we are communicating. I'm not "dismissing" higher return portfolios (remember, I said I like money!), I'm saying that higher risk/volatility needs to be accounted for. Which would generally mean that to maintain an overall 'risk' profile, you would need to offset that added risk/volatility somewhere else in your portfolio. So after you do that, do you really come out ahead? It's a question, not a statement.

I think this has run it's course. Looking for higher returns is great, but there are considerations (or else everyone would be there!).

-ERD50

I used your comment as example, but it was not aimed at you, as I thought my response made clear.

 

[all4j]

Mainly to satisfy my own curiosity, I dabbled with portfoliovisualizer just to see. I got to think that a 70/30 might outperform the balanced funds I mentioned since stocks have had some good runs. Not knowing best parameters, I went with rebalance quarterly & reinvest dividends (realizing a diy might not do that). The portfolios were: 1) 100% Wellington (VWELX), 2) 100% Dodge & Cox Balanced (DODBX) & 3) 70% VTSMX (Vanguard total stock index) + 30% VBMFX (Vanguard total bond index). Vanguard total stock was the new kid, so analysis went from Jan 1993 - July 2022, just shy of 30 years.

Results for $10k initial investment -- Dodge & Cox ended with $146980 or cagr of 9.51%; 2nd place was Wellington $136922, cagr 9.25%; 3rd place was 70/30 with $115676 or cagr 8.63%. Not surprising to me that D&C had highest std dev, but Wellington had lowest. Wellington also had best sharpe/sortino ratios, followed by D&C....

So, I'm sure it would be fairly easy to change the index funds, time period, look at max drawdowns, etc & have different result. I didn't see where risk and/or volatility adjusted returns were shown in order to compare.

I do know that after almost 30 years, D&C would have >$30k in my pocket as compared to 70/30 & I wouldn't have regretted not knowing an adjusted return amount. I wouldn't have had to rebalance myself & being only 1 fund (vs 2), it would have been simpler. Including if someone else had to pick things up due to my unavailability.

But as said, bottom line isn't the only consideration & something to be said for SWAT factor...Happy investing!

& in case I haven't been clear...this is not an endorsement of any und mentioned nor a crusade to avoid index funds for those who prefer

 

[Phroig]

I haven’t used Portfolio Visualizer recently, but there was a Factor Regression tab where you could compare alphas for your funds.

 

[Koolau]

I think this has run it's course. Looking for higher returns is great, but there are considerations (or else everyone would be there!).

-ERD50

And, some of us believe we have "enough" without w*rking at it. I love the term "couch potato" portfolio. It's not for everyone but for those of us who want to just live life and believe we are more or less "set", we tend to find this discussion a spectator sport. YMMV

 

[Montecfo]

And, some of us believe we have "enough" without w*rking at it. I love the term "couch potato" portfolio. It's not for everyone but for those of us who want to just live life and believe we are more or less "set", we tend to find this discussion a spectator sport. YMMV

It's a good point.