Some fun & nostalgia

Predicting what may happen to companies, economies and the World at large  is at the core of active fund management process.

As you’ll know if you’ve read my previous posts, that I very much believe in the passive approach to investment management as I think it’s incredibly difficult to predict what might happen in any given situation.

In Fooled by Randomness, Nassim Nicholas Taleb eloquently lays out how the hidden chance in the markets has and will continue to catch out the most intelligent of our investment professionals.

Its a must read for anyone giving investment advice regardless of your current stand point.

Whilst I’m dropping names here, Donald Rumsfeld  the former Secretary of Defense in the USA, once talked about the “unknown unknowns” and it made me think of all the random events of late that have happened that fall into this category.

So to a little Friday sport that I’d like to call “who would have predicted…”

I give a few easy ones for starters and then let’s see what you can come up with…

Roland Oliver

Who would have predicted:

 

  1. The News of the World would be shut last weekend
  2. Lehman Brother would have collapsed
  3. Woolworths would no longer be on our High Streets
  4. Edinburgh Council would continue with the tram project…

Over to you.

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The long term futility of active management

A couple of weeks ago Roland mentioned a few reasons why we strongly believe in asset class investing – buying a complete representation of the market in each asset class and staying away from the two key features of active management: market timing and stock picking.
A lot of research has taken place in academic economics into the true cost of active investing and whether, on average, active managers can consistently beat the average market return after transaction and management costs are taken into account.
We believe this academic evidence, coupled with some solid figures from Standard and Poor’s Indices Versus Active (SPIVA) research, explains why even the most successful active managers of recent times, Warren Buffett and Peter Lynch, stated that passive management is best for most investors.
Using the small space a blog article allows, I will briefly go into more depth below.
This excerpt from The Cost of Active Investing by Prof Kenneth R French explains the futility of the average active manager’s task:
“Whether fund of fund investors break even or not, a passive market portfolio produces a higher return than the aggregate of all active portfolios. Why do active investors continue to play a negative sum game? Perhaps the dominant reason is a general misperception about investment opportunities. Many are unaware that the average active investor would increase his return if he switched to a passive strategy.
Financial firms certainly contribute to this confusion. Although a few occasionally promote index funds as a better alternative, the general message from Wall Street is that active investing is easy and profitable.
This message is reinforced by the financial press, which offers a steady flow of stories about undervalued stocks and successful fund managers.
Overconfidence is probably the other major reason investors are willing to incur the extra fees, expenses, and transaction costs of active strategies. There is evidence that overconfidence leads to active trading. (See, for example, Odean (1998), Barber and Odean (2001), and Statman, Thorley, and Vorkink (2006).) Investors who are overconfident about their ability to produce superior returns are unlikely to be discouraged by the knowledge that the average active trader must lose.”

According to Fama’s efficient market hypothesis, all information is already factored into a stock’s price. The very existence of active management makes this so. When we include the higher fees, expenses, and trading costs, it is clear that active investors are playing a negative sum game.
Mr French concludes thus: ‘If a representative investor switched to a passive market portfolio, he would increase his average annual return by 67 basis points over the 1980 to 2006 period.”

The figures taken from the SPIVA research show that in the US and Australia over a 5 year horizon well over half of the active managers fail to outperform indices. Not only this, the inconsistency of fund performance makes it hard to anyone to pick a winning manager. In the US, over the five years ending March 2011, only 0.96% of large cap funds, 1.14% of mid-cap funds and 2.59% of small cap funds maintained a top half ranking over five consecutive 12 month periods.

I must clarify that we do not believe that there are no active managers who can perform well. But the task of picking the few that do perform consistently better than the market over a long investment horizon is futile.
Some investors do trade actively because they really are able to produce superior returns.
The existence of superior investors, however, does not explain the behaviour of the average investor. Active investing is still a negative sum game. Every pound a superior investor earns must increase the aggregate losses of all other active investors.
We do not accept that the City or Wall Street can predict the future, and we certainly would not bet ours or your money on it.

Malcolm Stewart

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Taking the active vs passive debate a stage further

When I explain to clients and other industry professionals that our investment philosophy is passive, I usually get the response “So you just use index tracking funds and don’t bother changing things if market conditions alter?”

This usually has the initial effective of getting my blood pressure up then once I’ve calmed down, I try to give my more measured, rational explanation.

So, I’ve laid out my thinking behind the philosophy that drives our passive investment strategies and why we use Dimensional Fund Advisers to create our risk-based portfolios.

Market efficiency and its offspring, passive investing, are counterintuitive for many investors. It is human nature to believe that you can beat the market (or identify someone who can) through intelligence, insight, and hard work. This belief is constantly reinforced by the City and most of the mainstream media. Yet even when you are able to firmly plant the seeds of information to overcome those beliefs and intuition, a passive investment approach may carry the negative connotation of inactivity if not properly explained.

Although Dimensional Fund Advisors are characterised by some as passive, it is only passive with respect to activities that don’t add value—mainly stock picking and market timing. You could argue that Dimensional is very active, however, in managing important considerations such as costs and consistent exposure to targeted risks or asset classes. With this in mind, I don’t think the categorisation of “passive” or “active” investing is as black and white as some suggest.

Here are some of the philosophies we share with Dimensional that may better explain the subtle differences.

Don’t speculate. Invest.

Rather than relying on speculation, blind faith, or anecdotal evidence, our philosophy rests on a solid foundation of core principles from the science of investing.

With capitalism there is always a positive expected return on capital.

Capital markets are very competitive due to voluntary exchange between buyers and sellers. There is a buyer for every seller; for markets to clear, prices will adjust to new information and reach a level where there is always a positive expected return to providers of capital. Investors would not risk their capital without the expectation of a positive return. We believe in Dimensional’s approach because they invest in a way that strives to capture a fair share of the capital market return based on the risk assumed.

It is difficult to identify superior investment managers in advance.

Capitalism breeds competition, and that makes markets difficult to beat. With millions of participants competing in capital markets, it is hard to identify in advance anyone who can systematically beat the market since past winners may have just been lucky and won’t necessarily win in the future. We believe in Dimensional’s approach because it eliminates the risk of choosing the wrong manager by following a broadly diversified approach that does not rely on stock picking or market timing.

Diversification is the only antidote for uncertainty.

Although diversification neither assures a profit nor guarantees against loss in a declining market, a properly constructed and well-diversified portfolio is a key component of a successful investment experience. Again, we believe in the Dimensional approach as they design portfolios that attempt to capture certain risks and eliminate others, depending on your preference and capacity for various types of risk.

There is no free lunch. Risk and return are related.

Higher expected returns only come from bearing more risk that cannot be diversified away. Much like a racing driver who chooses to drive without a helmet, you should not expect to be paid more for taking risks that can easily be avoided. Our approach at Oliver Asset Management focuses on eliminating risks that you should not expect a reward for taking, such as concentrating your portfolio in just a few stocks.

Control what you can.

If speculation is futile, and trying to choose winners is more often a loser’s game, what can an investor do? The answer is to concentrate on what can be controlled: managing the transactional costs of investing, reducing the impact of taxes, and taking a long-term view. Above all we approve of Dimensional’s approach because they implement portfolios in a way that is cost effective, tax efficient, and above all, disciplined.

Market efficiency and the active or passive decisions are loaded with misconceptions that can lead to debate and confusion rather than constructive dialogue and understanding. More importantly, it can distract our attention from the most crucial element of all: discipline!

It is this discipline that is one of the key advantages to having a good Wealth Manager. If part of the recipe for a successful investment experience is to stay the course, we can provide that key ingredient of educating you in these philosophies and keeping you disciplined through good times and not so good times.

The whole approach described above is our fundament investment belief at Oliver Asset Management and it’s a subject that I will continue to bring more information to you on in the coming weeks and months.

Roland Oliver

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