by WWM | Jul 25, 2018 | Active vs Passive Management
Why does active investing not outperform a passive approach in most investment scenarios?
Glad you asked.
Efficient Markets
Most financial markets are pretty efficient. Perhaps not 100% strong form efficient (where all public and private information is reflected in the security’s price), but relatively close.
Of course, the efficiency of a particular market is a function of many factors. These include: the number of investors and analysts in the marketplace; capital market liquidity; regulatory and governmental oversight and reporting requirements; the sophistication, availability, and timeliness of relevant information; the type of asset and the quantities available for trading.
Depending on these factors, an individual market will be more or less efficient.
Do not blindly assume that all markets, even those in the same country, will have the same level of efficiency. If you want to trade equities on the New York Stock Exchange, the market should be quite efficient. If you plan to trade penny stocks over-the-counter (OTC), the OTC market will be less efficient than New York.
Markets will typically be less efficient in developing countries and in niche markets. If you wish to invest in Iraq, the markets will be less efficient than in North America. Markets for investing in emeralds or Renaissance art will not be as efficient as financial markets.
This is why I think active management is possible in small or developing markets or other areas where these factors are more difficult to achieve at a high level.
I believe that major developed country financial markets, for the most part, are close to strong form efficiency. An exception would be during extreme periods that take on a life of their own. Investment bubbles are a classic example.
If financial markets are near strong form efficiency, it is extremely difficult to use active investment techniques to outperform a benchmark. So why try? Take a passive approach that will approximate the benchmark return. It will take less time and energy, and you will have less stress in your investing life.
Active Management Costs
If financial markets are relatively efficient, then it should be hard to beat one’s benchmark with active strategies. And it is.
Adding to the problem are the incremental costs associated with active management.
A passive strategy assumes a (mostly) buy and hold approach. An active strategy will have greater trading. This creates additional research time, transaction costs, and may possibly trigger taxable capital gains for investors. These will erode one’s net returns versus a benchmark.
Further, if you pay for active management, there are fees for that service. Depending on the mutual fund company and the investment style, these can vary significantly between funds. A good rule of thumb is that the more complex a market or asset class, the higher the annual expense ratios.
In 2017, the average fund expense ratio for U.S. large cap stocks was 0.98% (per Morningstar data). That is the average across both high cost actively managed funds and low cost index funds. Still a significant percent in charges you need to recover in excess performance. Especially when you compare the average to most low cost index funds. In this market segment, many quality S&P 500 index funds (i.e., U.S. large cap stocks) cost under 0.05% annually. There had better be a lot of outperformance if you are paying 1-2% per annum in a fund’s expense ratio.
To compare fees in a less developed (less efficient) market that requires more work to analyze, consider China equities. In 2017 (again, per Morningstar), the average mutual fund investing in China region stocks had a 1.69% expense ratio.
Or, compare to a Long-Short Equity investment strategy. In 2017, this fund class average 1.91% in annual expense ratio.
The more niche or complex the fund class, expect to see higher costs.
Remember our discussions on compound returns. You want to minimize your expenses in order to maximize the capital that can be reinvested for long-term compound gains.
Paying management fees and increased costs while not normally seeing enhanced net performance is another reason you should consider passively investing.
Good Active Funds Eventually Become the Market
Over time, successful actively managed funds run the risk of becoming the market.
As a mutual fund grows in size, its ability to find unique and profitable opportunities in the market diminishes.
Say you are an excellent stock picker and decide to start a small equity fund investing in Canadian stocks. You raise $10 million in capital and begin to invest. Your initial focus is on companies with less than $50 million in market capitalization. These nano-cap companies are not heavily followed by analysts nor investors and the market is less than fully efficient.
Over time, your fund demonstrates superior performance against your chosen benchmark, the S&P/TSX Composite Index.
The superior performance is noticed by investors and subscriptions to the fund grow. One day you wake to find you are managing $1 billion. By this point, it is almost impossible not to have become the market itself. You can no longer realistically invest solely in nano-cap stocks.
At a maximum of $50 million capitalization, and at most acquiring 5% of any one entity, you would need to spread your capital amongst 400 or more companies. As we saw previously, this is a problem logistically as well as in transaction and administration expenses.
Further, by spreading your capital so thinly, the impact of any one stock is very small. If you equally own 400 different companies and one produces a 100% annual return, its effect on total portfolio performance is negligible. Unless you can find a majority of companies with superior returns, the total portfolio performance will regress to the market average.
One could also argue that if you own 400 or more nano-cap stocks, you probably reflect the nano-cap market as a whole in returns. You are now the Canadian nano-cap market.
More likely though, you would be forced to adjust your investment strategy and begin to place your capital in companies with larger capitalization. Companies where you are able to invest millions of dollars without having a material interest in the company. As a result, the large Canadian funds tend to reflect the overall market in their portfolio holdings.
For fun, just review the top 25 or 30 holdings for five extremely large, actively managed, Canadian equity funds. How much real differentiation is there in stocks between the funds?
If you think 25 to 30 holdings is too small, realize that in many very large Canadian equity funds, the top 10 holdings alone can make up 40-50% (or more) of the entire fund assets. So 25 holdings does represent a big piece of the pie.
When assessing actively managed funds that have experienced significant asset growth, always closely review recent performance. The strong performance that led to new investors and increased assets will likely regress to the market mean as the old strategies no longer work to the same extent.
Avoiding Becoming the Market
Some fund companies try to avoid these growth problems in two ways.
One, they start a new fund with limited capital so that they can invest in smaller markets without logistical concerns. Of course, if the new fund also grows, they will face the same problem in the future.
Two, some companies may close the growing fund to new subscribers. By placing a limit on the fund’s capital, the fund can maintain its strategy in the small market. Note that a fund that temporarily suspends new subscriptions is not the same thing as a closed-end fund.
Conclusion
Except in limited situations, I hope you will agree that actively managing your investment portfolio will not produce superior performance versus a passive approach.
So what investments should you look at with passive investing?
by WWM | Jul 4, 2018 | Active vs Passive Management
It is highly questionable as to whether active management is appropriate for investors.
You can find studies that indicate active management can provide superior performance in certain circumstances. But more studies conclude that, over the long-term, active management does not consistently outperform a passive approach.
What do I think?
I believe investors should generally stick with a passive approach to investing. However, I believe that there are times when it is beneficial to use active management. Today we will look at situations where I believe that active management can provide value.
Note that while I shall lay them out separately below, usually a specific investment resides in multiple boxes.
Niche Markets
I believe active management can be used in niche markets or asset classes that require specialist knowledge.
In niche markets, the number of knowledgeable analysts is less than for stocks and bonds. The less competition in researching investments, the greater the probability that a true expert can find value amongst individual assets. Also, the less competition, the easier it is to differentiate the top experts from the mediocre and poor ones.
Fine art, collectibles, gems, and wine are a few examples of niche markets.
In areas such as these, I believe experts have a definite advantage over most other investors in the segment. Therefore, being an expert, or following their recommendations, may allow for outperformance of the niche market as a whole.
I also believe that expertise in specific fields can translate into active management success even in non-niche markets.
For example, if you are a heart surgeon, you may be able to assess developments in cardiovascular tools and related public companies better than most other investors. Similarly, if you work in the high-tech industry, you may have an advantage in determining which high-tech companies and products have better likelihoods of success.
Investing in market segments where you have better technical knowledge than others may give you an edge when trying to select individual investments.
Inefficient Markets
A tenet of passive investing is a belief in markets being highly efficient.
An efficient market is one where securities’ prices reflect all relevant information. If true, then it is not possible to use active management techniques (individual security analysis and selection, market timing, etc.) to “beat the market”. A passive strategy of trying to only match the market return is the only investing option.
However, some markets may not be fully efficient. In these markets, active management may outperform passive.
Niche markets are often inefficient.
Do all investors have access to the same information concerning a new artist? Do all investors possess the same skill to assess the quality of diamonds and rubies? Probably not.
Securities markets may be less efficient in developing countries.
Some countries may not have stringent insider trading regulations. Some countries may not have comprehensive reporting requirements for companies. Some countries may be more corrupt than others. Without proper rules and governance, certain individuals may possess corporate information that other investors do not receive. This can lead to inefficient markets and allow the investors with the information to prosper.
Companies that do not trade on established markets may suffer from inefficiencies as well. Shares that trade “over-the-counter” (OTC) tend to have less consistent publicly available information for investors to assess. Compounding this is that OTC stocks often have a limited corporate history in which to examine.
Investors with preferential access to information on investments or possessing specialized knowledge concerning an inefficient market, may succeed utilizing active strategies.
Ignored Markets
Because of perceived inefficiencies in some developing markets, analysts and investors may avoid following and investing in these markets.
Even in developed nations, some market segments may not be extensively covered by analysts. Analysts and investors do an excellent job of monitoring the large-cap stocks. But often nano or micro-cap companies are ignored.
The avoidance is nothing nefarious. Rather, information availability is better with larger companies, so they are easier to monitor and assess. Also, small companies typically have a limited number of shareholders as compared to larger companies. So there is less interest in the market for small companies.
Consider China based ZZLL Information Technology, Inc. (ZZLL), an OTC stock. On July 3, 2018, it had a share price of USD 0.195, a market capitalization of USD 3.95 million, and 20.28 million shares outstanding.
Here is an example of multiple boxes being checked. Tiny company, not worth following for analysts. Too small in capitalization for active managers to invest in. ZZLL is based in an emerging market that is less efficient than the U.S. or other developed nations. ZZLL offers “syndicated media and E-Commerce platforms in the Asia Pacific region.” Possibly a niche market where local investors with expertise in these areas may have an advantage over other potential investors.
Some investors or actively managed funds may not invest in penny stocks either by choice or based on regulations or internal investment objectives. For example, in some jurisdictions funds may not be eligible to trade equities beneath certain price levels or that do not trade on authorized exchanges. As well, a fund prospectus will disclose the investment objectives and any constraints that may be imposed on investment options. As a result, some funds may not be able to invest in ZZLL, so their analysts do not cover the company.
Other investors or funds may avoid nano-cap companies on logistical grounds.
Consider the Fidelity® International Small Cap Fund (FISMX) mutual fund. It invests in foreign, small-cap stocks. Perhaps ZZLL is of potential interest. But the Fidelity fund has assets of USD 2.2 billion. ZZLL only has a market-cap of USD 3.95 million. All it would take is for Fidelity to invest 0.18% of their assets into ZZLL and they would own every available share. Given restrictions on ownership levels in companies (often 5%), Fidelity would not want to own 100% of ZZLL.
Imagine Fidelity investing in a slew of ZZLL size companies. Investing less than USD 0.5 million in company after company would be a logistics nightmare for Fidelity. That would be 3000 companies to trade, monitor, and account for. Not the easiest, wisest, or most cost-effective proposition.
Another important thing to note is the impact ZZLL would have on the Fidelity fund’s overall portfolio return. Even if you did own 100% of ZZLL, that is only USD 3.95 million in a USD 2200 million portfolio. ZZLL could return 200% per annum and its impact on fund returns is negligible. Something to keep in mind with all larger funds. Individual holdings do not significantly affect overall fund performance.
With less investors seeking opportunities in ignored markets, those that do may find active strategies successful.
Note that trading OTC shares can be a high-risk strategy. The lack of publicly available information, possible lack of corporate history, and potentially less rigorous regulatory oversight increase risk for these shares. Further, there are also liquidity issues with many of these companies which can impact one’s ability to trade the stock. I suggest extreme caution should you ever decide to trade OTC stocks.
Long-Term Market Phases
Market timing can be a costly strategy for investors. It is not an easy thing to do and if you are late to either enter or exit a market as it changes direction, you can lose a fair bit of money.
And based on many studies, it does not seem to be a successful strategy to pursue.
However, I do think that sophisticated and professional investors can take advantage of long term market phases to beat a benchmark over the short-term.
In prolonged bear markets, by moving portfolio assets into cash or defensive assets, a prudent investor may be able to protect the portfolio. When the market turns upwards again, the investor divests the safer assets and returns to the relevant asset class.
In lengthy bull markets, allocating capital into higher risk (with higher expected returns) assets or using leverage and derivatives may enhance the bull market impact on one’s portfolio.
Of course, shifting assets around in one’s portfolio requires incurring extra transaction costs.
It also may trigger premature taxable capital gains upon the sale of an investment that was sold due to market timing.
These costs, along with the cost of not timing the market swings correctly, can have a significant, and negative, impact on your performance. They are a major reason as to why active management suffers in comparison to a passive, and non-trading, approach.
Conclusion
These are the areas in which I think investors can successfully utilize active strategies to outperform a passive approach, at least in the short-term.
In each circumstance, specialized knowledge is necessary to take advantage of the situation.
If you possess expertise in certain fields, I suggest you incorporate that knowledge into your overall investment strategy.
If you do not possess the skills yourself, you can pay someone to provide the service for you. However, the greater the expertise required, the greater the management fee charged. And the greater the fees, the higher the returns needed to beat the passive benchmark. When outsourcing technical expertise, be sure that you are receiving value (in the form of superior performance) for the price you are paying. In most cases, you do not.
In each area above, investment options tend to be relatively high risk.
Before you invest, make certain you understand the risks associated with investing in niche markets, developing countries, OTC shares, and the like. Without the specialized knowledge of the market, your odds of success are rather low.
Next we will look at passive investing.
by WWM | Jun 27, 2018 | Active vs Passive Management
Given the differences between passive and active investing styles, it might appear that active management should easily beat passive results. But, based on comparative research, the reality is much less clear.
Today, we will look at a few studies and see what they recommend.
First, a quick caveat. I tend to to be a little cautious with individual studies as often data can be massaged to reflect the outcome desired by the researchers.
For example, if I looked at U.S. equity returns, as represented by the S&P 500, for a 3 year period, I might find that their performance is fantastic, mediocre, or terrible. It all depends on the 3 year blocks that I choose.
The 3 year period of 2003 (28.7%), 2004 (10.9%), and 2005 (4.9%) makes it appear that equities provide excellent returns. However, the 3 year period from 2007 (5.5%), 2008 (-37.0%), and 2009 (26.46%) is less promising. And the 3 year period from from 2000 (-9.1%), 2001 (-11.9%), and 2002 (-22.1%) suggest that U.S. equities should be avoided.
When reviewing data: consider who is preparing the study; whether there may be a hidden agenda; maintain a healthy degree of skepticism. If you see short or unusual sample sizes or time ranges, that should be a warning.
In this blog, I prefer not to review academic research. It can be quite dry and too complex for easy explanations. But in this post, I want to look at some third party studies before I give you my own views on passive versus active management.
Case For Active Management
“Can Mutual Fund “Stars” Really Pick Stocks? New Evidence from a Bootstrap Analysis”
Kosowksi, Timmerman, Wermers, and White authored, “Can Mutual Fund “Stars” Really Pick Stocks? New Evidence from a Bootstrap Analysis” in the Journal of Finance vol. 61, no. 6 (Dec 2006).
I like this study as it covers a decent sample size and a long time period. The authors examined 1788 open-end U.S. domestic equity mutual funds that operated for 5 or more years between the period of 1975 to 2002.
They found that there were more top-performing managers than would have been expected simply from the inherent variation of the fund’s returns. Further, the better results of these top managers continued in future periods.
This indicated to the authors that there were certain managers with superior skills and that their results were not simply the result of luck.
A positive in the debate as to whether active management is better than passive.
“When Active Management Shines vs. Passive”
Jane Li of Fundquest issued, “When Active Management Shines vs. Passive: Examining Real Alpha in 5 full market cycles over the past 30 years” in June 2010.
Fundquest’s sample was extremely impressive, both in number of funds reviewed and time period. They “analyzed 31,991 U.S. domiciled non-index mutual funds in 73 categories representing over $7 trillion of assets as of February 28, 2010.”
“Mutual funds were analyzed for the period of January 1, 1980 to February 28, 2010. Every fund’s behavior pattern and performance was analyzed for 5 full market cycles…”
Fundquest found that there are advantages and disadvantages to both passive and active management, depending on the particular market segment and phase of the economy.
“We found that, after adjusting for risk, active managers in general generated higher risk-adjusted returns than their passive benchmarks in bull markets, and lower risk-adjusted returns than their passive benchmarks in bear markets.”
“We also found that, on average, equity and allocation categories tended to add value in bull markets and detract value in bear markets. Conversely, fixed income categories tended to add some value in bear markets. Municipal bond and alternative categories in general were not found to add much value in either market environment.”
“Of the 73 categories in our study, we recommended a bias to active management in 23 categories, a bias to passive management in 22 categories, and deemed 28 categories to be neutral (no bias).”
A bit of a mixed bag as to when active outperforms a passive strategy. In some areas, and at some times, active management may outperform passive. At other times, and in other market segments, passive was the preferable strategy.
Also of note in their findings was four things of interest with respect to active management.
One, the longer a management team was in place, the higher the probability of outperforming the benchmark. This should make some intuitive sense. If a manager or team does not perform well, changes are made.
Two, the lower the expenses, the greater the probability of outperformance. The greater the costs, the harder it is to achieve superior performance on a net basis. Not surprisingly, this is a major argument for passive strategies.
Three, the lower the portfolio volatility as measured by standard deviation, the greater probability of outperformance.
Four, the higher the outperformance in the previous market cycle, the greater probability of outperformance in the next cycle. This meshes nicely with the Koswoski findings above. That top performance should continue in future periods.
Based on their findings, Fundquest believes that a combination of active and passive approaches should be utilized. In those categories and economic conditions that favour active management, active should be used. In the other circumstances, passive management should be followed.
Again, a positive for active management in certain situations.
Case Against Active Management
“Reflections on the Efficient Market Hypothesis: 30 Years Later”
Burton G. Malkiel authored, “Reflections on the Efficient Market Hypothesis: 30 Years Later” in the Financial Review vol. 40, no. 1 (February 2005).
The author assesses the returns of actively managed mutual funds versus benchmarks and index funds. A relatively small sample is examined, although the time frame is long.
Over short periods, the author found that some actively managed funds performed well but that there was no consistency of fund performance over the long run.
In one year results for 2003, “73% of the actively managed large-cap equity funds obtained from Lipper Analytical Services had after-expense returns lower than the S&P 500 Index. For periods longer than 10 years, more than 80 percent of the funds failed to meet this benchmark. Returns from all equity mutual funds indicated that actively managed funds underperformed index funds by more than 200 bps over 10- and 20-year periods. The weaker performance of active funds was a result of higher expenses and trading costs.”
No surprise as to his reasons for the underperformance of actively managed funds.
The author differs as well from the other studies as to whether good performance persists in future periods.
“Good performance by a fund in one period does not indicate good performance in the following period. The 20 top-performing funds during 1996–1999 beat the market by more than 50 percent. During the following four years of 2000–2003, these funds earned a return of –15.1 percent compared with –5.41 percent for the Vanguard 500 Index Fund and –5.34 percent for the S&P 500. Even the Morning- star four- and five-star funds did not perform as well as the Wilshire 500 Index over time.”
The author found “similar results for international and global markets. More than 80 percent of the European equity funds and European global equity managers performed less well than MSCI benchmarks over the 10-year period ending in 2002. Even in relatively inefficient small-cap and emerging markets, active funds did not outperform their benchmarks.”
Based on this study, it does not appear that an active management style is useful in outperforming the markets. A plus for passive management.
“False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”
In 2005, Barras, Scaillet, and Wermers authored, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimated Alphas”.
They looked at “1,456 U.S. open-end equity funds between 1975 and 2002” and assessed whether any fund outperformance versus the market (manager’s “alpha” in investing terminology) was based on skill or simply luck.
And yes, they managed to quantify luck as a component of performance. And no, I cannot explain it in a sentence or two.
“Using a large cross-section of U.S. domestic-equity funds, we find that 76.6% of them have zero alphas. 21.3% yield negative performance and are dispersed in the left tail of the alpha distribution. The remaining 2.1% with positive alphas are located at the extreme right tail.”
That is, only 2.1% of reviewed funds demonstrated that their managers outperformed the markets based on skill.
Based on this study, the ability to use active management, as opposed to pure luck, to outperform the market is quite poor. Another argument for passive investing.
Conclusion
You can look up these papers and read all the supporting evidence and conclusions. There are a multitude of other studies out there to peruse as well.
They might be of interest, but typically they bog down in very complex formulas and theory.
I think that if you do read a lot, you will come to one conclusion.
While there are many studies that claim active management can outperform passive, I would say that more find passive the better approach, on average, statistically.
What do I think is the better approach?
by WWM | Jun 20, 2018 | Active vs Passive Management
Ah, the active versus passive management debate. One of my favourite topics. Fun, because often it is extremely counter-intuitive to investors. And because many investment companies work feverishly to obfuscate their clients on the subject.
Today we shall differentiate the two strategies.
Then we shall shall see if one strategy is preferable when investing. In general, as well as in special circumstances.
Passive Investing
Passive investing is quite straightforward.
Match the Market
The underlying belief is that investors cannot beat the market. Not even the investment professionals.
A difficult statement to swallow for most investors.
Passive investors tend to believe that the markets are highly efficient. That is, the current price of a security reflects all information concerning the issuer so securities always trade at their fair value. Therefore, it is not possible to outperform the market over the long-term through fundamental or technical analysis, nor other active investment strategies.
They also believe generally that it is impossible to successfully and consistently pick the winners and losers over longer time periods. That stock selection is usually a fool’s game.
As passive investors believe they cannot beat the market, they do not try. Instead, they simply attempt to replicate the market by investing in index mutual or exchange traded funds (ETF) that mirror the benchmarks they wish to track. One can also use advanced strategies to replicate benchmarks. These normally involve the use of derivatives.
The market is normally a benchmark index or composite indices that reflect the fund’s or investor’s investment style.
For example, Standard & Poor’s (S&P) 500 may serve as a suitable proxy for a large-cap U.S. domestic fund. For investors wishing to compete against the entire U.S. equity market, the Wilshire 5000 Total Market Index may be an appropriate benchmark.
Minimal Trading
Passive investing also takes a passive approach to trading. One buys the index and holds it. There may be some activity within the investment itself as securities are added and dropped from the benchmark over time.
For example, on March 19, 2018, Nektar Therapeutics (NKTR) was added to the S&P 500. As the index only contains 500 companies, Chesapeake Energy (CHK) was dropped. If your fund fully replicated the S&P 500, it would have to sell its holdings in CHK and buy shares of NKTR.
Or, as the passive investor’s circumstances change, he may add or subtract from his holdings in the index fund.
Perhaps an investor wants to hold 50% in a global equity index fund and 50% in a global bond index fund. Over time the equity fund does very well and after two years the portfolio ratio is 70% equities and 30% bonds.
If the investor still desires a 50-50 split, he will have to rebalance the portfolio by selling some of the equity fund and purchasing additional shares of the bond fund.
Minimize Costs
In passive investing, cost control is paramount.
It is possible to invest in assets that closely match a benchmark’s gross returns. But each dollar spent on commissions, loads, management fees, and other expenses, will erode the net returns of your investment versus the no-cost benchmark.
Be very careful when planning to invest in an index fund or ETF. Always compare costs to ensure that you are getting the most return you can.
Active Investing
Active investing is the opposite of a passive strategy.
Beat the Market
Investors believe that markets are not totally efficient. As a result, by actively using different investment strategies and tactics, investors can outperform the market or relevant benchmark index. Strategies and tactics may involve the use of securities’ selection, market timing, and more complex trading techniques and investment options.
In selecting specific securities, investors may use fundamental or technical analysis. Investors are trying to find securities that are not trading at their “correct” value based on their analysis. By investing in these assets and ignoring other components on the benchmark index that are considered correctly or over-priced, investors can outperform the benchmark.
Lots of Trading
While a passive strategy is one of buying and holding, active management may trade extensively. Although this may not always be the case.
Trading may result from security analysis as the portfolio replaces expected lower performing assets with ones anticipated to have higher relative returns.
Trading may also result from market timing activities, another staple of active management.
Market timing involves identifying trends in the general market or market segments that are deemed favourable or unfavourable. Then, shifting assets into or out of the segments to take advantage of the prevailing conditions.
For example, the S&P 500 holds 500 large-cap American companies. Unless specific company conditions necessitate additions or deletions from the index, the companies remain the same.
However, what if the U.S. economy enters an economic slowdown? It may be prudent to shift one’s assets into more defensive stocks that can better weather a recession. An active investor will sell his cyclical stocks and replace them with recession-resistant investments. The passive investor does not do this; he must ride the tide.
Or perhaps the precious metals market is expected to significantly outperform the overall market while healthcare is expected to do relatively poorly. If you own a fund that reflects the S&P 500, you will be forced to hold companies such as Abbott Laboratories, Aetna Inc, Cerner, Medtronic, Zimmer., etc. Whereas, the active investor might sell most of these healthcare companies and replace them with non-S&P 500 holdings like Freeport, Newmont, etc.
Complex Tactics
Active investors often use leverage, derivatives, and short selling to try and outperform the benchmark index which does not incorporate these techniques.
These tactics are outside the scope of our discussion right now, so I simply mention them in passing.
Net Returns Not Cost Control
Active investors realize that they will incur greater costs than by using a passive strategy.
As they believe they can outperform the market, the concern is more the net returns rather than cost control.
For example, say the S&P 500 returned 10.0% over the last year. A passive strategy that replicates the S&P 500 index may have a total expense ratio of 0.10%. If the fund properly duplicates the benchmark index, the net return under the passive strategy is 9.9%.
An active fund that uses the S&P 500 as a benchmark may have a total expense ratio of 1.5%. Significantly higher than the passively managed fund. But investors believe that management performance will more than offset the extra expenses.
But does active management does provide enough extra returns to justify the higher costs?
That is the question we will consider next.
by WWM | Jun 13, 2018 | Active vs Passive Management
Do investment analysts provide positive returns for investors? That is, are you better off if you find a top analyst and follow his or her recommendations?
The evidence is not encouraging for those that wish to follow recommendations of analysts.
I think that there are some very good analysts in the business. And I think that the average analyst does a decent job of following the companies in his or her area of expertise. But does that translate into recommending that you find one or more and follow their calls? No.
I shall give you two reasons why I feel this way.
Analysts May Be Too Optimistic
One, analysts may tend to be overly optimistic in their assessments.
There are a variety of explanations as to why analysts tend towards optimism. I am not sure that I fully ascribe to any of them, but I shall point out the common ones quickly.
Existing or potential investment banking relationships between companies and their bankers may result in pressure on that bank’s analysts to provide positive assessments of the company. Usually the pressure comes in the form of employee remuneration or promotion opportunities. In some ways, I can see this occurring, especially when trying to attract new companies as clients for underwriting and other corporate finance work. But investment bankers often separate their finance groups from their research groups to try and maintain an appearance of objectivity.
Brokerage houses make money on investor commissions. Positive research reports may generate increased purchases and greater transaction revenues for the broker. There is some merit in this argument. Maybe I am a little naive, but I am not sure of the long-term benefits in brokers over-hyping stocks. Say I consistently read research reports, bought shares on the recommendations, and then saw under-performance as compared to the recommended share’s target prices. It would not take me long to a) no longer consider the research reports as having any informational value, and b) find a new brokerage house.
The analyst and/or his firm has a financial interest in the company being reported on. Again, this can be a legitimate concern for investors. In many jurisdictions though, there should be statutory disclosure requirements for any potential financial conflicts.
Most relevant professional organizations have ethical requirements concerning this and other issues relating to potential conflicts of interest. For example, the Chartered Financial Analyst “Code of Ethics & Standards of Professional Conduct” has quite detailed standards.
In a word, disclose. When you watch analysts on FOX Business, Business News Network, Bloomberg, etc., there is normally a statement as to whether the analyst, his family, or firm have a financial interest in the securities discussed.
For me, the common reasons as to why analysts are optimistic are a little tenuous.
However, that does not mean analysts are not optimistic in their estimates. In fact, there is evidence to suggest that analysts are indeed too optimistic.
In April of 2010, McKinsey Quarterly wrote that “Equity analysts: Still too bullish”.
“Analysts, we found, were typically overoptimistic, slow to revise their forecasts to reflect new economic conditions, and prone to making increasingly inaccurate forecasts when economic growth declined.
Alas, a recently completed update of our work only reinforces this view—despite a series of rules and regulations, dating to the last decade, that were intended to improve the quality of the analysts’ long-term earnings forecasts, restore investor confidence in them, and prevent conflicts of interest.”
The authors show that the over-optimism is significant as well as consistent.
“… analysts have been persistently overoptimistic for the past 25 years, with estimates ranging from 10 to 12 percent a year, compared with actual earnings growth of 6 percent.”
Even though regulatory agencies and professional organizations are working to strengthen analyst objectivity, there still appears to be a bias (intentional or otherwise) towards inflation of expected performance.
While I do not fully support the complaints outlined above, I think that there is a bit of credence to them as to the reason for bias. The weaker the regulatory environment, the greater the probability for problems.
But I believe the key factor for optimism is less sinister. It likely stems from the fact that the analysts spend much of their time listening to the companies they follow. As a result, they hear positive takes on new products, cost cutting measures, and earnings growth.
They also want to keep a good relationship with companies they track. I know of more than a few stories where analysts have been frozen out of companies that they follow because they questioned a company’s data or gave less than glowing assessments. Given that access to the company is crucial when trying to analyze it, this can have an impact on analysts.
How Can You Determine The Best Analysts?
Two, it may be difficult to identify a “top” analyst whose recommendations you can follow.
Analysts tend to specialize in specific industries. Unless you plan to invest in only one or two industries, you will have to determine top analysts in multiple categories.
Also, with many analysts to assess there are many analysts vying for recognition each year. And there may be substantial change in “top” analysts every year.
For example, on August 6, 2012, Business Insider provided readers with, “The 36 Best Analysts On Wall Street”. I am sure an excellent group.
A year later, on August 16, 2013, Business Insider offered 50 names in, “The Best Stock Analysts In America”.
Maybe I missed a name or two in my comparison, but I think only Betsy Graseck made both lists. In one short year, very little concurrence on who are the top analysts.
The shift from year to year is normal within investment categories.
That much change makes it difficult to try and follow specific analysts who you may believe are best in class.
Is Following the Pros a Waste of Time?
I do not think it wise to develop a strategy of following analyst recommendations.
But you should rely on the research reports in your own analysis. The information contained therein is usually pretty good and can help you form your own conclusions. And if you know the limitations and concerns about research reports as described above, you can factor them into your own analysis.
In the future, we will return to this topic. Specifically, how you should utilize research reports in your personal analysis. We will also consider the suitability of attempting to follow the same investment strategies of highly successful investors (e.g., Warren Buffet). But we will save that for a future date.
Next up, a we begin to look at the passive versus active management debate. Also known as, can fund managers beat their benchmarks? And, as we will see, paying a professional to manage your money is often not the wisest strategy.