Tag Archives: Returns

Active Vs. Passive & The Simple Reasons You Can’t Beat An Index

Just recently, I was reading an article from Larry Swedroe which “discussed” the “Surprising Results From S&P’s Latest SPIVA Analysis.” To wit:

“Over the 15-year period, on an equal-weighted (asset-weighted) basis, the average actively managed U.S. equity fund underperformed by 1.4% (0.74%)per annum. The worst performances were small caps, with active small-cap growth managers underperforming on an equal-weighted (asset-weighted) basis by 1.99% (0.90%) per annum, active small-cap core managers underperforming by 2.43% (1.82%) per annum, and active small–value managers underperforming by 2.00% (1.71%) per annum. So much for the idea that the small-cap asset class is inefficient and active management is the winning strategy.”

As Larry concludes from that analysis:

“S&P’s SPIVA scorecard provides persuasive evidence of the futility of active management.”

See, according to Larry, it is clear you should just passively index in funds and everything will be just fine. 

If it were only that simple.

We Are Supposed To Be Long-Term Investors

In any given short-term period, a manager of an active portfolio may make bets which either outperform or underperform their relative benchmark. However, we are supposed to be long-term investors, which suggests that we should focus on the long-term results, and not short-term deviations. 

The following chart of Fidelity Contra Fund versus the Vanguard S&P 500 Index proves this point. Which fund would you have rather owned?

(Source: Morningstar)

Finding funds with very long-term track records is difficult because the majority of mutual funds didn’t launch until the late “go-go 90’s” and early 2000’s. However, I did a quick look up and added 4-more active mutual funds with long-term track records for comparison. The chart below compares Fidelity Contrafund, Pioneer Fund, Sequoia Fund, Dodge & Cox Stock Fund, and Growth Fund of America to the Vanguard S&P 500 Index.

(Source: Morningstar)

I don’t know about you, but an investment into any of the actively managed funds over the long-term horizon certainly seems to have been a better bet. 

Even Index Funds Can’t Beat The Index

Do you want to know what fund did NOT beat the index according to Morningstar? The Vanguard S&P 500 Index fund. 

How is it that a fund that is supposed to purely replicate an index, failed to exactly match the performance of the index. 


Fees, taxes, and expenses.

Unfortunately, in the “real world” where people actually invest their “hard earned savings,” their overall returns are constantly under siege from taxes, previously commissions, fees, and most importantly – taxes. 

An “index,” which is simply a mathematical calculation of priced securities, has no such detriments. 

The chart below is the S&P 500 Total Return Index before, and after the same expense ratio charged by the Vanguard S&P 500 Index Fund. Since most advisers don’t manage client money for free, I have also included an “adviser fee” of 0.5% annually. 

Of course, if your adviser is simply indexing for you, then maybe the real question is exactly what are you paying for? 

The Differences Between You And An Index

Which brings us to why you, nor any investment product that exactly mimics the S&P 500 index, can actually match it, must less beat it.

While Wall Street wants you to compare your portfolio to the ‘index’ so that you will continue to keep chasing an index, which keeps money in motion and creates fees for Wall Street, the reality is that you and an index are very different things. This is due to the following reasons:

1) The index contains no cash, 

If you maintain cash for expected expenses, taxes, or any other reason, your performance will lag the benchmark index. 

2) The index has no life expectancy requirements – but you do.

While it may sound great that if you just hold an index long-term you will generate 8-10% annual returns, the reality is that your investment horizon between accumulation and distribution fall within one “full-market” cycle. Start on the wrong end of a cycle (high starting valuations) and the end result will be far less than advertised.

3) The Index does not have to compensate for distributions to meet living requirements.

At the point in life when you begin withdrawing money to live on, performance is affected by the withdrawals against the value of the portfolio.  (Read more here)

4) The index requires you to take on excess risk.

Cullen Roche once penned a salient point:

“Benchmarking is a pernicious thing in financial circles. Not only because it disconnects the way the client and a fund manager understand the concept of ‘risk’, but also because the concept of benchmarking seems to be misunderstood.”

Risk is rarely understood by investors until it is generally too late.

Chasing the S&P 500 index requires you to have your portfolio fully allocated to equity risk, at all times. This vastly increases the “risk profile” of the portfolio which may not be optimal for investors approaching, or in, retirement. (Read more here)

5) It has no taxes, costs or other expenses associated with it.

As noted above, an index does not have to pay taxes on realized gains and dividends, does not have management fees, or other expenses which must be covered. All of these items will lead to underperformance from one year, to the next, versus an index.

6) It has the ability to substitute at no penalty.

In an index, if a company goes bankrupt, the index simply takes it out and substitutes another stock in its position. The index value is then adjusted for the “market capitalization” of the new entrant and the index resumes. However, in your portfolio, given you only have a “finite” amount of capital, when a company goes bankrupt, or losses the majority of its value, you have to sell that stock at a loss and buy the replacement with whatever is left or add more capital. 

It’s Your Brain, Man

Unfortunately, investors rarely do what is “logical,” but react “emotionally” to market swings.  When stock prices are rising, instead of questioning when to “sell,” they are instead lured into market peaks. The reverse happens as prices fall. First, comes “paralysis,” then “hope” that losses may be recovered, but eventually “capitulation” sets in as the emotional strain becomes too great and investors “dump” shares at any price to preserve what capital they have left. They then remain out of the market as prices rise only to “jump back in” about mid-way to the next market peak.

Wash. Rinse. Repeat.

Despite the media’s commentary that “if an investor had ‘bought’ the bottom of the market,” the reality is that few, if any, actually ever do. The biggest drag on investor performance over time is allowing “emotions” to dictate investment decisions. This is shown in the Dalbar Investor Study which showed “psychological factors” accounted for between 45-55% of underperformance. From the study:

“Analysis of investor fund flows compared to market performance further supports the argument that investors are unsuccessful at timing the market. Market upswings rarely coincide with mutual fund inflows while market downturns do not coincide with mutual fund outflows.”

In other words, investors consistently bought the “tops” and sold the “bottoms.”  You will notice the other two primary reasons for underperformance was related to a lack of capital to invest.  This is also not surprising given the current economic environment.

The Only Question That Matters

There are many reasons why you shouldn’t chase an index over time, and why you see statistics such as “80% of all fund underperform the S&P 500.” The impact of share buybacks, substitutions, lack of taxes and trading expenses all contribute to the outperformance of the index over those actually investing real dollars who do not receive the same advantages. 

More importantly, any portfolio that is allocated differently than the benchmark to provide for lower volatility, create income, or provide for long-term financial planning and capital preservation will underperform the index as well. Therefore, comparing your portfolio to the S&P 500 is inherently “apples to oranges” and will always lead to disappointing outcomes.

“But it gets worse.  Often times, these comparisons are made without even considering the right way to quantify ‘risk’. That is, we don’t even see measurements of risk-adjusted returns in these ‘performance’ reviews. Of course, that misses the whole point of implementing a strategy that is different than a long only index.

It’s fine to compare things to a benchmark. In fact, it’s helpful in a lot of cases. But we need to careful about how we go about doing it.” – Cullen Roche

For all of these reasons, and more, the act of comparing your portfolio to that of a “benchmark index” will ultimately lead you to taking on too much risk and into making emotionally based investment decisions.

But here is the only question that really matters in the active/passive debate:

“What’s more important – matching an index during a bull cycle, or protecting capital during a bear cycle?”  

You can’t have both.

If you benchmark an index during the bull cycle, you will lose equally during the bear cycle. However, while an active manager that focuses on “risk” may underperform during a bull market, the preservation of capital during a bear cycle will salvage your investment goals.

Investing is not a competition and, as history shows, there are horrid consequences for treating it as such. So, do yourself a favor and forget about what the benchmark index does from one day to the next. Focus instead on matching your portfolio to your own personal goals, objectives, and time frames. In the long run, you may not beat the index, but you are likely to achieve your own personal investment goals which is why you invested in the first place.

Impact Investing- Is It Right For You?

Over the last 30 years, the popularity of impact investing and a desire to ‘do good’ with investment portfolios has blossomed. In April 2019, The Global Impact Investing Network estimated the global impact investing market was $502 billion. While impressive, it represents less than 1% of the investing universe.

Impact investors, looking to have a positive social and environmental influence, tend to analyze factors not typically on the radar of traditional investors. In particular, ESG, an acronym for environmental, social, and corporate governance, is a framework for investors to assess investments within three broad factors.  

We all want to make the world a better place, but are investment portfolios the right tool to do that?

To answer the question it is important to step back from impact investing and explore investment goals and how wealth grows fastest to help answer the question.

As a wealth fiduciary, our mission is managing our client’s portfolios in a risk-appropriate manner to meet their financial goals. Whether a client is ultra-conservative or uber-aggressive, the principle of compounding underlies every strategy we employ.  Compounding, dubbed the “eighth wonder of the world” by Albert Einstein, is an incredibly important factor in wealth management.

Wealth compounding is achieved through consistency. Targeting steady growth while avoiding large drawdowns is the key.  To do this, we develop an aggregation of diversified investment ideas.

Investment diversification is well-touted but not well understood. Commonly it is believed that portfolio diversification is about adding exposure to many different investments within many different asset classes. True portfolio diversification is best created by owning a variety of assets with unique, uncorrelated cash flows that each individually, offer a promising risk and return trade-off.

To demonstrate the importance of drawdown avoidance, we compare two portfolios. Both average 5% annual growth. Portfolio A grows by a very dependable 5% every year. Portfolio B is a more typical portfolio with larger growth rates but occasional drawdowns. Portfolio B grows 10% a year for four years but experiences a 15% drawdown every fifth year. Despite earning 5% a year less in four of five years, portfolio A avoids losses and grows at an increasing rate to portfolio B as highlighted below.

Consistent, steady returns and no drawdowns build wealth in the most efficient manner. The more investment options we have, the better we can diversify and minimize portfolio drawdowns. When options are limited, our ability to manage risk is limited.

Is doing ‘good,’ good for you?

The cost of impact investing is two-fold. First, by limiting the purchase of certain companies and industries, you forego the potential to buy assets offering a better risk-return tradeoff than other assets in the market.  Second, due to the smaller size of your investable pool, your ability to diversify is hampered. The combination of these costs show up as more volatile returns which results in a lessened ability to compound.  

While impossible to quantify, this cost is hopefully more than offset by the feeling of having a positive impact on the world.

Inclusion or Exclusion

To invest with purpose, there are some things you may or may not have considered. Foremost on the list is the question, “Where are your investment dollars truly going?”  Most investments in stocks and bonds are in securities that were issued in the past. The company behind those stocks or bonds already raised capital and is using it to achieve their mission. We may avoid buying stocks in coal miners or tobacco companies, but the funds from a market transaction go to another investor, not the company. This holds equally true if we buy stocks or bonds of a company we deem has a positive social or environmental impact.

That does not mean our investment decisions are fruitless. Our participation affects the perceived health of a company via the liquidity we’ve provided or taken from the company’s securities. When equity prices decline and/or bond yields rise, a company will find it harder and more costly to raise new capital.

Bill Gates has some interesting views to help us understand our potential role in social impact investing. 

In a recent Financial Times article, Fossil fuel divestment has ‘zero’ climate impact, says Bill Gates, the billionaire philanthropist argues environmental change is achieved via investing in disruptive and innovative companies that tackle environmental problems, not divesting from those that do not.

Divestment, to date, probably has reduced about zero tonnes of emissions. It’s not like you’ve capital-starved [the] people making steel and gasoline,” he said. “I don’t know the mechanism of action where divestment [keeps] emissions [from] going up every year. I’m just too damn numeric.”

If you are interested in impact investing, we ask you to consider Bill Gates advice of inclusion not exclusion. Use the entire menu of investment opportunities and rigorous analysis to determine which assets are worthy. If the “disrupters” qualify under your investment protocol, include them in your portfolio and perhaps favor them. However, be cognizant of the cost of shunning companies that are doing things you don’t like.

A well-diversified portfolio with a positive risk/return structure will provide more stability and limit drawdowns. By growing your wealth as efficiently as possible, you will be able to invest more into companies that are having a positive social impact and have more wealth which you can donate in more direct, impactful ways.  

The “Nastiest, Hardest Problem in Finance”

Should retirees own any stocks? It seems ridiculous to ask that question. Of course, they should. People are living longer than ever before and need higher returns on their assets to see them through an extended retirement. And many target date funds are responding by maintaining elevated amounts of stocks through at least the early years of retirement.

How else to get those returns than from stocks?

Not so fast, says economist Allison Schrager who wrote a recent article for Quartz asking the provocative question:

“If you’re about to retire, should you pull out of the stock market?”

After all, weeks such as the last one remind investors that stocks are far from a sure thing, and can vaporize wealth quickly.

It’s true that most people haven’t saved enough to retire easily, and stocks – or the returns they’ve historically provided — may be a way to overcome savings shortfalls. But there are two problems with this argument. First, stocks may not deliver the returns we have grown accustomed to receiving from them. The best indicator of long term – say, future ten-year – returns is the Shiller PE, which is the current price of the market relative to the past decade’s worth of inflation-adjusted average earnings. That metric is over 30, despite last week’s correction. It’s two highest readings previously have been 34 in 1929 and 44 in 2000. And stocks did poorly from those two peaks over the next decade. Basically, it’s very hard for stocks to perform well for the next decade starting from this valuation.

Because of their high valuations, stocks may not outpace bonds. The 10-Year US Treasury is now yielding around 2.8%, and investors can own an index of investment grade corporate bonds that pays nearly 3.6% in the form of the iShares Investment Grade Corporate ETF (LQD). And if investors can get a highly probable return of over 3% from bonds, it’s not clear that domestic stocks will outstrip that by a lot or even at all.

Moreover, the volatility stocks often deliver can destroy retirement plans, even if stocks eke out higher average annual returns than bonds. This is because of something called “sequence of return risk.” That basically means that ,during distribution phase, when and how returns are delivered matters at least as much as the average annual return itself. I did a study of two portfolios – one all domestic stocks, and one balanced – starting in 2000 using the famous “4% retirement rule.” That means the retiree is taking 4% of the portfolio as income in the first year and boosting the first year’s dollar payment by 4% every year thereafter.

Retirement Allocation Chart 4% Retirement Rule

Source: Morningstar, Yahoo!Finance

The results are ugly for the all-stock portfolio, which reduced the account by nearly 80% after 18 years at the end of 2017. The balanced portfolio, by contrast, was reduced by only 20% of the original balance after 18 years of applying the 4% rule. The starting point for the test is admittedly random, and it includes two big stock market drawdowns. But it shows how an unfortunate starting date combined with a lot of stock exposure can hurt a retiree.

None of this is to argue that retirees should eliminate their domestic stock exposure altogether. Stocks may outpace bonds over the next decade, after all; we’re just saying the chances of that happening are low. Also, foreign stocks, especially emerging markets stocks, present better valuations, and their likely future returns are at least somewhat higher than what their domestic counterparts are offering.

Although many mutual fund families have target date funds that contain more than 50% stock exposure at the time of retirement, Schrager says the average target date fund in Morningstar’s database has 40% of its assets in stocks. That’s meaningfully lower than the classic balanced portfolio, which has 60% in stocks.

There’s a big difference between having 60% stock exposure and 40% stock exposure. In 2008, for example, a portfolio that had 60% in the S&P 500 and 40% in the BloombergBarclays U.S. Aggregate Bond Index lost around 20%, but a portfolio that had the reverse exposure – 40% stocks and 60% bonds – lost around 13%. That’s a big difference for retirees taking 4% or more from accounts in income. There are limits to how much stocks can help savings shortfalls in retirement. Don’t put a burden on them they’re not equipped to handle.

As always, your stock exposure depends on your personal risk tolerance (which is much harder to estimate than you might think), your spending needs, and how well funded you are. But Schrager is correct to note that things are different in retirement than they are when investors are saving or accumulating assets. As Bill Sharpe, whom she quotes, says, investing in retirement is the nastiest, hardest problem in finance.