Brad DeLong's Semi-Daily Journal (2004)

Truer words have never been spoken.

I think this might be oversimplifying things a little. Normally, the only reason to invest in loaded funds is that you are doing it through some adviser, and the part of that load pays the adviser.

If the adviser has a good buy-and-hold investment philosophy, then, usually, you'll pay less in fees through sales charges than through a percent of assets or an hourly fee.

Also, return is not the only measure for mutual funds. One should also look at volatility. If one is using the return on mutual funds to provide a steady stream of income, a more volatile fund will decrease principal much faster than a less volatile fund, even if the return on the less volatile fund might be less.

Since managed mutual funds often are not just aimed at return, but also at managing volatility, or managing tax exposure, and will try this strategy at a small decrease in return, it's understandable that more mutual funds will underperform the index after taking fees into account.

Finally, people are notoriously bad at managing their own money. Individuals do a bad job of allocating their assets properly for their goals. The average mutual fund over the last 20 years has earned roughly 10% or so. The average mutual fund investor, on the other hand, has earned less than 4%. The reasons for this huge disparity is that people misunderstand the timeframe needed to get that 'average return since inception' and only hold funds for on average 18 months.

While most people are certainly smart enough to pick a mutual fund, or even spend time to develop a good asset-allocation strategy to meet their goals, they tend not to understand the time frame necessary to achieve these returns, AND, people tend to succumb to the psychological factors of the market.

As Peter Lynch says, it's not the brain, but the stomach where most investors get in trouble.

So, despite the fact the Suze Ormann and Bob Brinkler would rather you spend your money and time reading their books, buying their videos, subscribing to their newsletters, and watching their programs, unless you have the time, inclination, and intestinal fortitude to identify your investing goals, developing a good investment policy, and sticking to that policy, find a professional to help you out.

Kilroy Was Here

Once again, I don't get it - this has been well-known for, what, 30 years? Why do these underperforming active managers still have jobs?

Also, how do they manage to falsify the efficient market hypothesis by consistently underperforming? If that's the normal state of affairs, couldn't you outperform the market with an index-like fund that had less of the stocks chosen by fund managers?

Investing in low cost Index funds may not always be best. See my blog at http://ashish.hanwadikar.name/ for details.

rps -

It's because mutual fund policies are designed to achieve more goals than just return. Reduction of volatility is a big concern for some funds. (They call it disappointing with positive numbers.) A mutual fund that gains 23% when the S&P gains 25% probably won't lose any investors, but a fund that loses 25% even when the S&P lost 27% is definitely going to see some withdrawals. Furthermore, managed funds usually have to keep some money in cash to handle regular withdrawals. Mass withdrawals hurt the performance of mutual funds, since it forces managers to sell out of positions they think might be positive.

In other words, one reason managed funds may underpeform the market (or an index fund) is due more to accounting for how investor psychology can effect day-to-day operations of funds.

(This ain't necessarily a bad thing. It takes a huge set of cojones for a self-managed investor to watch your $100,000 index fund investment in March 2000 dwindle to $63,000 in March of 2003.)

As to your second question, it would be hard to have a 'index' fund of less of stocks chosen by managers. Most index funds have on the order 500 underlying investments while managed funds are closer to the 100 range.

Goldman Sachs has funds that they called CORE, (I think it stands for Computer Optimized Research Enhanced), which tries to do something like you mention. They've only been around for a few years. Not long enough to determine if the strategy is worth the higher annual fees.

Finally, for those of you in your Vanguard S&P 500 index fund, do you have any money in the Vanguard Total Bond index? Ibbotson says that this might be a good idea (see http://www.ibbotson.com/download/research/Does_Asset_Allocation_Explain_Performance.pdf)

Kilroy

Kilroy

Kilroy Was Here wrote, "If the adviser has a good buy-and-hold investment philosophy, then, usually, you'll pay less in fees through sales charges than through a percent of assets or an hourly fee."

(1) But sales charges are also a percent of assets---the only difference being they're charged once, instead of each year.

(2) Do you have any data to back up this claim?

Sure. Let's take a $100,000 investment in a suite of front-load funds in the same family. Let's say you rebalance twice yearly in the same fund family. Let's say you hold the investment for 10 years.

(A quick note here. More investable assets in the first year would have a lower investment charge. $250,000 is normally around 2.75%, $500,000 is around 2.0%, $1 M is waived.)

Standard sales charge here is normally 3.75%. That's $3750. Reallocations (if you stay in the fund family) have no sales charge. So you don't have to pay to rebalance. Standard expense ratio for good upfront funds can be 80 basis points or so. Over ten years, your upfront fees will run about ~18,000 if your investment has a 6% return.

Total fees over 10 years - $21,750, or $2175 per year.

Ok, let's look at the same scenario, no load funds, with a asset-based fee service of 1.5%. (That's going to be hard to find for $100,000, but for the point of argument.)

Even discounting the expense ratios of no-load funds (I'll give you the benefit of the doubt and say that the asset-bassed fee service invests directly in stocks rather than funds), you'd still pay fees of $23800 approximately.

As your return gets higher, the disparity between the upfront fee vs. the fee based account gets greater.

Third, let's assume that your financial advisor spends 4 hours on your first investment, and then 2 hours on each rebalance. Total number of hours over 10 years with 2 rebalances a year - 84 hours.

84 hours x $200 a hour = $16,800
Expense ratios of no load funds (30 basis points) = $6200.

Total fees = $23,000.

This doesn't count, of course, if you initiate a call to your hourly advisor. Or if you ask your advisor about tax advantages, or portfolio analysis. (services many commission based advisors provide gratis)

These are of course just back of the envelope calculations. Please take with a grain of salt.

The rational argument for attempting to hire outperforming investment management, even if you are not sure: http://ssrn.com/abstract=158708

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Abstract:
This paper proposes a Bayesian method of performance evaluation for investment managers. We begin with a flexible set of prior beliefs that can be elicited without any reference to probability distributions or their parameters. We then combine these prior beliefs with a general multi-factor model and derive an analytical solution for the posterior expectation of "alpha", the intercept term from the model. This solution can be computed using only a few extra steps beyond maximum likelihood estimation and does not require a comprehensive or bias-free database. We then apply our methodology to a sample of domestic diversified equity mutual funds and ask "what prior beliefs would imply zero investment in active managers?" To justify such a zero-investment strategy, we find that a mean-variance investor would need to believe that less than 1 out of every 100,000 managers has an expected alpha greater than 25 basis points per month. Overall, our analysis suggests that even when the average manager is expected to underperform passive benchmarks, it requires very strong prior beliefs to imply zero investment in managers with the best past performance.
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Oh, full disclosures:
- I have a CFA
- I have at times been employed on the buy side
- I am not now (nor am I looking to be)
- my retirement account's 1999-2003 monthly alpha was 30 basis points (yay!)
- that intercept came with a non-significant p-value around 0.3 (boo!)

Also, if anyone has read a good critique of the Metrick-Baks-Wachter paper, I'd love a link or citation.

Fooled by Randomness by Nassim Taleb is a good read, as is Bernstein's Four Pillars of Investing.

Stockbrokers and fund managers exist to (slowly) transfer as much of their client's money into their hands as possible. They're ticket clippers. Unless there's a dramatic increase in the financial awareness of the investor population they'll be with us for some time.

Millions and millions of investors think stockbrokers and fund managers are 'experts' at handling money. It's quite superficial (they act like experts, they're credentialled e.g. CFA, MBA), and in any case, these investors don't think it's worth their time to learn about the various efficient markets hypotheses, random walk theory etc., any more than it's worth them learning about the individual policies of political candidates. Like sheep they go with the flock. They trust stockbrokers and fund managers like they trust doctors and engineers.

They get ripped off. But there's seldom explicit deception involved. They know they're 'betting on a winner'. And as a class of victims, there are people far more deserving of sympathy.

Anyway, for every fund manager who think they're productive, there are a thousand investors who, just as delusive, think they have a special way of beating the market.

Run for your intellectual lives people, they're everywhere I tell you, they're even posting on blogs!

I wrote, "(2) Do you have any data to back up this claim?"

Kilroy Was Here wrote, "Sure. Let's take a $100,000 investment in a suite of front-load funds in the same family. Let's say you rebalance twice yearly in the same fund family. Let's say you hold the investment for 10 years."

No. By *data* I mean *empirical data*, as in data from a paper studying the issue with real humans, not with another claim. Otherwise, there's no way of looking at other aspects of your claim, like the notion that the advice you're getting from the load fund people is worth anything.

Briefly stated, stocks (and funds) are sold not bought.

Most heavily marketed goods in our economy fail to deliver...they usually significantly underperform expectations. Think of the last five movies, CDs, restaurant meals or political candidates that you bought. Did you capture alpha? I didn't think so.

Does you comment about your manager being close enough to the center of info mean that you believe there is some set of "smart" money managers with an information advantage?

In other words you do not even believe in the weak efficient market thesis?

Is it possible for a manager to consistently have better info?

The other and better case is it possible for a manager to consistently do better analysis?

Probably no for the first but possible for the second.

liberal --

I'm not sure what your asking. I thought you asked if you'd pay cheaper fees using an upfront sales charge as opposed to asset-based fees, or hourly rates. You don't need an empirical study for that, just a calculator.

As for the fact do folks do better w/ professional advisers than they do by themselves, well, the first thing that comes to mind is the recent Slate article on this subject (The 4 percent solution - http://slate.msn.com/id/2099695/).

In this article, not only does it claim that individual investors do poorly, it also claims that institutional investors (i.e. pension fund managers, trustees, etc) do better.

Is this closer to what your asking?

Kilroy

Kilroy, you seem to be almost wilfully missing the point. Individual investors do poorly because they're chasing performance, shifting money into and out of mutual funds, trying to pick the active managers who will beat the market -- when in fact the number of managers who do is minuscule. Nothing you have said, and none of the evidence you've cited, suggests that there is a better strategy for an individual investor than simply putting his or her money into a Vanguard index fund (either the one that tracks the S&P 500 (VFINX) or the one that tracks the market as a whole (VTSMX)). This funds have no up-front costs, they have tiny annual fees, and they are very tax-efficient. And they will deliver performance, over time, that is superior, literally, to almost every fund manager out there. Period. End of story.

rps,

Interesting question, If portfolio M (managed) consistently underperforms the market while portfolio I (indexed) matches it, why not construct portfolio C (clever) by subtracting M from I, and watch it outperform?

Probably because a big reason M underperforms is fees and expenses, rather than the makeup of the portfolio per se.

The mix of fees, including transaction costs, is the boon for money management and the bane for investors.

This is a bogus yardstick. If you're investing over five years and measuring investment performance over a time horizon one-fifth of that timescale, then you are always going to get the investment performance you deserve.

Kilroy, you're missing the point. I'm asking the following question: "Is it true that, *on average, in the real world*, do individual investors do better with no-load index (or related cheaply managed funds) or load funds?"

That is, the question *isn't* whether it's possible that *someone* may do better with a load fund; I'm sure someone has---at least *some fraction* of load fund advisors must be competent. But you have no way of knowing how large that fraction is unless you collect data.

The _Slate_ article you cite does present evidence that individual investors are ignorant about principles of investing (mainly the problem that they chase return and have a very short-term perspective). This is by widely accepted. But the comparison the article made was individual investors versus pension fund managers, NOT individual investors using no-load funds and no advisor or a by-the-hour financial planner versus one buying load funds.

Quick aside 401k question for those smart academics here...

Has anybody studied/figured out the impact of 401k plan rollovers on returns? For example, I work at Goldman Sachs (in IT side) where we have a 401k plan that allows us to choose certain investment options (including hedge funds for all the risk lovers out there). When I leave Goldman I will have to "rollover" my investment into a IRA or some other tax shielded vehicle. This means that I will have to liquidate my existing positions at the current market value. Potentially I could be forced to take a big loss on a highly volatile investment even though I wish to hold for long term.

Is there someway that I can continue to hold my existing positions even after I leave? Has there been a study on the effect of this liquidation effect in terms of performance of portfolios? Or am I missing something there.

If managers flip coins and overperform/underperform with 50% probabiilty, after 5 years you would expect only 3.125%, not 6%, to have outperformed in all 5 years. So this suggests that there are some skilled managers out there that it might be worth pursuing.

This 'study' used a panel of managers with five-year records. Therefore is is likely that the survivorship bias leads to a significant overestimate of the likelihood of 5-year outperformance. From the article: "Only one in three had managed funds in the same sector for more than five years. More than 350 of the 532 fund managers failed to qualify for Citywire's consistency test for this reason"

I have previously read studies of the UK mutual fund market which found that there is negligible relationship between past and future outperformance. How neatly could this be reconciled with the 3% vs. 6% issue earlier? (assuming that the 6% is fanot utterly broken by the survivorship bias?)

I'm a little disappointed nobody followed up the Metrick-Baks-Wachter paper. As I said, I am soliciting some dialectical feedback. I am jobhunting, and my current preferred employer is a big indexer. This paper undercuts my rationale for that preference. All critiques cheerfully accepted.

To reiterate, MBW's conclusion is that you need to believe fewer than 1 in 100,000 managers has an expected monthly alpha over 0.25% to justify a 100% indexing strategy.

Baks has a newish paper at http://goizueta.emory.edu/faculty/KlaasBaks/Documents/manager_000.pdf which applies to the current argument. He finds evidence for performance persistence, and further that the fund is more important than the manager.

liberal asks:

"Is it true that, *on average, in the real world*, do individual investors do better with no-load index (or related cheaply managed funds) or load funds?"

First, let me say, I have no data on this and it wasn't my claim.

My claim was, given that three financial advisors, Adam (compensated upfront by commissions), Barry (compensated by asset-based fee), and Colin (compensated hourly) each had the exact same investment policy in terms of assets, and that policy stressed a buy-and-hold strategy, over the long term you'd pay less in fees if you went with Adam.

Now on to your question. Here's what I do know. Over the last 20 years, the average mutual fund investor has earned less than 4%, when the average mutual fund has earned approximately 10%. Therefore, investment performance does not equal investor performance.

My hypothesis then is that if you can find an advisor who, rather than focusing on picking good stocks, focuses on keeping you well diversified, helps you take advantage of any tax-advantaged accounts, and keeps you from making stupid mistakes because of standard investor psychology, you're probably going to get a good deal.

Of course, not everyone needs this, but a lot of people sell their own homes and do their own taxes, that doesn't mean that CPA's and real estate agents are thiefs and pikers intent on transferring your money to their pockets and offering nothing in return. Similarly for finanicial advisers.

Kilroy

Kilroy Was Here wrote, " 'Is it true that, *on average, in the real world*, do individual investors do better with no-load index (or related cheaply managed funds) or load funds?'

"First, let me say, I have no data on this and it wasn't my claim.

"My claim was, given that three financial advisors, Adam (compensated upfront by commissions), Barry (compensated by asset-based fee), and Colin (compensated hourly) each had the exact same investment policy in terms of assets, and that policy stressed a buy-and-hold strategy, over the long term you'd pay less in fees if you went with Adam."

But your claim *assumes* that an advisor compensated by loads would advocate a buy-and-hold strategy. Furthermore, you make questionable assumptions about the fee structure of the guy paid by the hour. So, yes, it's "not your claim" if I grant you the right to stack the deck (by means of assumptions). I don't, and I don't see why I should.

Here's a counterclaim: I predict that an investor who put his money in Vanguard's well-diversified STAR fund, with a buy-and-hold strategy, will consistent do better than people playing with their own money, and most people who pay for advisors. And the cost for this? The annual operating expenses (currently 0.43%).

Sure, that fund might not be right for someone depending on an income stream. But Vanguard now has funds targeted to particular dates of retirement. I see no reason to think the implicit investment advice would be any worse than that you'd get from a load fund advisor, and it's a hell of a lot cheaper.

blipper wrote, "When I leave Goldman I will have to 'rollover' my investment into a IRA or some other tax shielded vehicle. This means that I will have to liquidate my existing positions at the current market value. Potentially I could be forced to take a big loss on a highly volatile investment even though I wish to hold for long term.

"Is there someway that I can continue to hold my existing positions even after I leave? Has there been a study on the effect of this liquidation effect in terms of performance of portfolios? Or am I missing something there."

I don't understand the question. If you rollover right away into an IRA and choose the same assets, or even just the same asset classes, your question becomes moot. It's not moot only if you can't find the same assets outside of Goldman's 401(k) plan.