Readers have challenged 1stMill's preference for actively managed funds
Several readers posted comments to my recent: Why I no longer own an S&P 500 index fund.
Most comments pointed to the benefits of index funds and asset allocation. And a number of comments challenged the thinking behind my preference for actively managed funds.
At risk of sounding like Tom Cruise with his public professions of love for Katie, I am going to take another shot at presenting my case for why I like managed accounts.
First, some perspective
1. I enjoy the dialogue. So your constructive comments are encouraged.
2. My goal with this blog is not to tell you what you should do. Rather, I share my opinions and experiences, in hope that readers may benefit by hearing of my successes as well as my failures. In turn, I learn from your posts and comments.
3. I have just enough knowledge to be dangerous, so my opinions should not be considered investment advice.
Buy an Index Fund!
Many well respected sources including Motley Fool are emphatic: Index funds are the only way to go. Motley Fool points out that almost all actively managed equity mutual funds over time lose money to the market averages. And those funds that do beat the markets return typically do so for only a short period of time, and then quickly reverse course.
Notice they said ALMOST ALL. There are a few actively managed equity mutual funds that have consistently managed to beat the odds (examples below).
My response to readers comments (similar comments have been aggregated)
C: The average actively managed fund underperforms relevant asset class indexes.
1stMill: This is true.
C: Comparing the S&P 500 to a balanced fund is an apples to oranges comparison.
1stMill: I dont feel that a comparison between two choices for where I invest my money is inappropriate. At this point in time I choose managed accounts over index funds. Disclosure: As noted in earlier posts, mutual funds represent only a portion of my portfolio.
C: Passive investors construct a portfolio of different asset classes with low correlations (U.S. stocks, foreign stocks, bonds, etc.) and rebalance their portfolio perhaps annually. S&P500 index fund would be just one part of your portfolio.
1stMill: This comment reflects what I believe to be prudent mainstream advice. I will however comment on some of the pros and cons of this approach...
Pro: According to what I have read, this approach has proven to top 90% of actively managed accounts. Quoting Warren Buffet:
...The best way to own common stocks is through an index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals.
Con: At least with index funds, the best you can do is match the average for the index.
C: Nobody can reliably pick actively managed funds that can beat the S&P 500.
1stMill: While it is true that finding exceptional actively managed funds may not be easy, it doesnt mean they dont exist. Case in point...
Sunday afternoon, while going through closets looking for items to donate to hurricane victims, I came across an article I forgot I had, titled The Investors Dilemma Mutual Funds or Stocks? Written by Mohnish Pabrai, the article was published in September 2001.
In the article, Mr. Pabria built a case for why most actively managed funds lag index funds, and why index funds lag what Pabria calls ... Buffetts (actively managed) style of focused value investing.
Also in the article, Mr. Pabria noted 5 actively managed value-oriented funds worth consideration. Now after four years have passed, I am posting the current results below. Remember, what follows represents his entire list (i.e. I have not culled out losers) -- and this was published in 2001, without the benefit of hindsight.
Sequoia Fund
Third Avenue Value Fund
Longleaf Partners
Oakmark Fund
Baupost Fund
A Google search turns up multiple references to this fund. Although I could not find a homepage.
Note: I have done zero due diligence on these funds, so this is not a recommendation. Further, most are likely now closed to new investors (actively managed value funds tend to do that). You may also find that some of these funds are only open to qualified investors -- with high minimums.
Closing thoughts
My favorite holding, Dodge & Cox Balanced, is larger and better known than the funds listed here. D&C Balanced also includes fixed income, while these funds do not. The point is that I believe a well run, actively managed value fund has more latitude to do what is required to beat the index.
Is it worth the time and risk (of under performing the index) to find and place a bet on a good actively managed account? For me, the answer is yes. As I said earlier, this is not investment advice and I am not telling you what you should do. But isn't it nice to at least know your options?
Disclosure: As noted in earlier posts, mutual funds represent only a portion of my portfolio.
[09/08/2005 - Read more posts on this topic: A new category has been added for the index fund debate.]
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Today the index fund debate continues with two posts: One posing new questions for pro-indexers -- and this -- featuring the writings of John C. Bogle of Vanguard fame. If, like me, you invest in actively managed funds and have not yet studied Mr. Bogle's ... Read
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In the latter half of the '90s I had an S&P 500 index fund, which I exited as the market went south. This post lists the rationale behind my decision to -- at least for now -- avoid S&P 500 index funds. Note: The S&P ... Read
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I'm dumbfounded by this logic. Have you even read Bogle? Or Malkiel? Or any of the others? These arguments have been so thoroughly refuted further comment seems pointless...
John C. Bogle, "Three Challenges of Investing: Active Management, Market Efficiency, and Selecting Managers," a speech given in Boston on October 21 2001. http://www.vanguard.com/bogle_site/sp20011021.html
"The Case for Indexing," Vanguard, September 2003.
https://institutional3.vanguard.com/iip/pdf/Case_Indexing.pdf
John C. Bogle, "Equity Fund Selection: The Needle or the Haystack?," a speech presented before the Philadelphia Chapter of the American Association of Individual Investors, November 23 1999. http://www.vanguard.com/bogle_site/bogle_speechesequity.html
Ronald N. Kahn and Andrew Rudd, "Does Historical Performance Predict Future Performance?," BARRA Newsletter, Spring 1995 (735kb). This paper also appeared in Financial Analysts Journal, November/December 1995, pp. 43-52. This paper finds no persistence in stock funds, but some persistence in bond funds. However, the persistence in bond funds still points to a passive strategy because the small benefit of being able to pick winning (active) bond funds is more than cancelled out by the disadvantage of higher expense ratios associated therewith. http://www.barra.com/research/barrapub/hpp-n.aspx
William J. Bernstein, "Sucker's Bet: Overwhelming empirical evidence shows that attempting to select successful active managers is virtually impossible, so why try?," Financial Planning, April 1 2001. http://www.financial-planning.com/pubs/fp/20010401034.html
Bill Schultheis, "Reversion in Action," 1999. A great explanation of this concept for lay people. Here Schultheis explains why picking strong performing mutual funds is a losers game. http://www.coffeehouseinvestor.com/reversion.htm
That's probably enough for today... Some just won't let the active management myth die to the detriment of their portfolios.
You can't say I didn't try,
Cheers,
JC
Thanks for doing a little more work on your case for actively managed funds. Still, your using one "data point" and while the results seem positive, they pale in comparison to the larger body of evidence supporting efficient markets.
Besides, the author of the article you refer to concludes with:
"To close on a somewhat positive note, Id like to add that a few professional investors have consistently beaten the market following Buffett style of focused value investing closely. Id recommend that the reader stick to index funds or investigate investing with managers like..." [the ones you mention, 20% of which are no longer operating].
Seriously, thanks for your effort!
GP
Regarding the apples to oranges comparison, I think our disagreement is on our approach to constructing a portfolio. I agree that one should consider the return of the fund when choosing. However, I do not believe that one should choose funds solely based on their past returns (hey--lets load up on oil and real estate stocks :). Instead, one should decide how they are going to allocate their portfolio over different asset classes or sectors. Once you have done that, you can compare funds that can be interchangeable in the particular slice of your portfolio you are considering. IMO, comparing funds from different asset classes is not productive.
The active-vs-passive debate is a whole debacle that for most people is a matter of faith. I personally am persuaded by the academic studies that were linked above, but so long as you are considering the expense and taxes, it probably won't make that much of a difference. For me, picking a fund manager is sort of like picking individual stocks: risky and not a whole lot of potential upside. To each his own.
I have a tough time believing anyone who put money into an index fund in the year before the bubble burst in march 2000 -- and held onto it -- is happy with their decision. They may not see a return for years, or decades.
That being said, a few commenters have remarked that there are few fund managers that have beaten the market over time. But let me throw out the following question -- will new tools, technologies, and strategies -- not to mention Sarbox and other regulatory changes in the past few years -- make fund managers better at making picks, and thus have a better chance of beating indux funds?
Short answer Fidelity is "NO". New technologies will not give active managers an edge, because the competitive advantage the new technology gives them is quickly distributed amongst all active managers. Now you're working twice as hard just to stay even. Nobody has a longterm sustainable competitive advantage. That's why indexing is the only rational solution.
I would dare say someone who purchased a widely diversified portfolio of index funds the year before the crash is doing quite nicely compared to someone who threw their money at active managers.
JC
Fidelity Observer, the S&P500 is not the only kind of index fund. Other asset classes did okay during the 2000 downturn.
Yes! I'm happy with my (mostly) index funds!
Since the mid 90s (when I started working) my portfolio has included the following index funds: S&P500, Mid-Cap Index Fund Investor Shares, Small-Cap Value Index Fund, Emerging Markets Stock Index Fund, representing about 80% of my invests. The remaining 20% is in actively managed funds.
My 5 year CAGR is 13.6%. (see note)
My average total cost: 0.27%!!!
I use Sharpe's Monte Carlo Simulation to pick my optimal asset allocation (free with Vanguard).
Given my asset allocation, I might have done better picking a favorite active manager. Odds are I would have done worse. Either way, it would have cost a lot more in fees.
I'm staying the course and evidence suggests that not many people will outperform me.
Note: Maxed out 401k and IRAs since 97, so return bears substantial weight of the 2000 decline. Asset allocation has changed. Was not invested in concentrated funds prior to 2000 crash. Always invested with Vanguard.
GP
There's a lot to be said for indexing. But it's proponents have greatly overstated their case, in my view. Indexing has pros and cons, just like most other investing strategies.
The benefit of indexing is that it locks in for the individual investor the return earned by the market as a whole. That's usually a good thing. It's not such a good thing when stocks are at the valuation levels they are at today, however. What the indexer is doing today is locking in a not-so-great long-term return.
I follow an approach to investing that I call "Valuation-Informed Indexing." With this approach, I lower my allocation to an index fund at times of high valuation and increase it at times of low valuation. The historical stock-return data indicates that this approach is likely to do well in the long term (but not necessarily in the short term).
An alternate means of avoiding the not-so-hot long-term returns likely to be obtained by indexers for investments purchased at today's valuation levels is to engage in individual stock-picking. That approach takes more work, but it provides the investor who is not satisfied with the long-term returns likely to be earned from today's valuations with a chance to do better than the indexers.
Rob Bennett
The Financial Freedom Blog
www.PassionSaving.com
Rob,
You're a market timer! Ha!
Did you say Jack Bogle and Professor Malkiel overstated their case for indexing? Something tells me you haven't read them.
Stockpicking as a prudent alternative?? Please stop it... my sides are splitting! That's a real knee-slapper!
JC
JC:
I am a market timer. There's an important distinction that needs to be made in saying that, though. I am a long-term market timer. There is a lot of evidence showing that short-term timing does not work. There is also a lot of evidence that long-term timing does work.
I view Bogle as one of the smartest investment writers out there. His book on mutual funds is outstanding. If you read Bogle's work carefully, you'll see that he understands the effect that changes in valuation have on long-term stock returns.
I personally tend to favor indexing over picking individual securities. But that's primarily because I don't have the time today to do the research required to make picking individual securities pay off. If I had more time, I would follow a combined approach.
There are some indexers who at times express hostility to those who follow different approaches. I think that's unfortunate. I also think it reveals defensiveness on the part of the indexers who do this. I don't think it reflects well on the indexing strategy, which I view as a good strategy (but not one without its flaws).
Rob
Rob,
You have the last word, my friend...
JC
Index management is good for most people who don't have much time to do fund research. But if you have more time and energy in research and picking good mutual funds, as those folks on morningstar's forum, with discipline, knowledge and experience, you surely can beat the market over time by picking good money managers.
Theorectical evidence:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=414441
Empirical evidence
http://socialize.morningstar.com/NewSocialize/asp/FullConv.asp?forumId=F100000015&convId=155115#1006751
If you don't believe about active management, I can let you see from your own eyes.
Follow the performance of these no-load funds from today for any period you like,
RSPFX SGIIX DODFX FINSX BJBIX RHIIX
Benchmark: their relative percentile rank among their peers within the same category. Or give me your mix of indices that can beat these funds based on minmium variance optimization.
By the way, good funds tend to close early but I am only showing you a live example that active management can beat index and you can see yourself by how much. (I could give you a list of funds that are all open but I strongly suggest you do your own research).
