In a recent “Your Money” column in the New York Times, John Wasik did a great job of delivering the status quo message about portfolio expenses. He reminds us that John C. Bogle, Founder of the Vanguard Group, and many others, have performed studies that demonstrated that active managers cannot beat a passive index because of the fees charged in actively managed funds. He reminds us that these consist not only of the well-known and often discussed fees in a fund’s expense ratio, but also include ‘hidden’ fees like the cost of managers who leave too much money in cash (which does not earn market returns), and fund transaction costs. The article goes on to mention a recent paper by William Sharpe, the Nobel Prize winner this year in Economics, who compared the expense ratio of Vanguard’s Total Stock Market Index Fund to a more expensive actively managed fund, and found that the costs of active management were $2,000 for a $10,000 investment over ten years.
When investors rely on markets, rather than managers, to earn investment returns, it is obvious that fees and expenses for active management cost a lot of money and present a drag on market returns. The problem for investors is that relying on markets to deliver returns, assumes that:
- Markets will earn the historical average, or expected return.
- That investors are willing to accept 100% of the risk (or volatility) that markets throw their way while earning those expected returns.
The evidence is overwhelming that markets are capable of rioting for long periods of time with a level of volatility well beyond what most investors are comfortable with. Unfortunately, the evidence is also overwhelming that markets riot because they are not always efficiently priced, meaning that investors are capable of bidding prices much higher (or much lower) than the underlying fundamental value of the securities.
The problem with proponents of indexing is that they continue to focus their efforts on a performance comparison that is irrelevant for most investors. It is true that the average mutual fund manager who invests money in a style-constrained manner, typically within a specific Morningstar Style Box, cannot outperform a style-constrained benchmark or index for that same style box. And it is also true that fees and expenses are one of the main reasons this is true (on average). The studies that prove this outcome are called “tracking error” studies, where groups of active managers are compared to a single benchmark to see how the active managers track the benchmark performance. Unfortunately, the methodology used in these studies is flawed because it doesn’t measure how active active managers actually are. In my book, Buy and Hold is Dead (AGAIN), I devoted a chapter to two Yale researchers, Martijn Cremmers and Antti Petajisto, who studied active share and discovered that most “active managers” are actually closet indexers who gravitate towards owning large percentages of stocks that make up their underlying index. Notably, once the managers who are more active in their strategy (versus just owning the index) are identified, their investment performance is significantly better than the index. The lesson here is that index investing guarantees underperformance while active management at least gives you an opportunity to beat the market. (And the best active managers do beat the market.)
The use of tracking error studies to compare active managers with indexes misses the point entirely. The real question for investors is, “Do you want to fully embrace market risk in order to earn market returns all of the time? Or, if markets are obviously overvalued and prone to riot, do you really care about fees and expenses, and would you rather sell the market at that point and live to invest another day?” Bogle, Sharpe, and the rest of the academic crowd still desperately clinging to the notion of efficient markets don’t believe there is any good time to sell the market. That’s too bad. Investors who ride the market through every decline run into the difficult problem of negative compounding. If you lose 50% of your investment in a bear market, you need to gain 100% back in a bull market just to break even. Presented with that reality, the fees for active management start to look very attractive, assuming that the active manager can systematically manage risk and earn returns.
Investors looking for a study to prove that unconstrained managers — or managers who have the ability to invest outside of any single style box — can outperform will be disappointed. First, there is no academically acceptable universe of managers who are allowed to invest in such a manner. You have to look to the distorted performance data of hedge funds in order to find managers with a charter to go anywhere in their pursuit of value. Unfortunately, that data is so polluted with performance biases that most academics reject it outright. Second, unlike style-constrained tracking error studies where the benchmark is easy to determine, in a non-style-constrained world that is not the case. What benchmark is suitable for an unconstrained manager like Pinnacle? The answer is unclear, and different benchmarks will result in different conclusions about the efficacy of active management.
It’s interesting that Sharpe’s study uses a ten-year time horizon, which is the same period of time that Pinnacle presents in our GIPS compliant track record. Instead of being obsessed by fees and expenses under the false assumption that your only choice is to accept market risk, I invite investors to do what professional investors do, which is to carefully analyze our returns, our process, our people, our philosophy, and the risk that we’ve exposed our clients to over the past decade. After careful consideration of our track record, investors can decide if our returns should be attributed to skill or to luck.
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