What Does Active Investing Cost? What Does It Pay?

by: Peter F. Way, CFA

Summary

The con argument: Being an active investor means making lots of choices, taking lots of risks, working hard to keep informed, trying to stay out of trouble, worries.

Con again: Portfolio managers at multi-million-dollar mutual funds can’t beat simple market average benchmarks; how do you expect to do better? Who’s going to pay you for your hard work?

Yet another con: Show us some evidence that active investing beats low-risk buy and hold passive investing in market-tracking ETFs.

Pro response: Here are several portfolios of major stocks, systematically chosen daily, growing at double the market averages day after day, despite the market rising at a 66% annual rate.

The same accessible information source has been regularly besting buy and hold over years of history by applying a Time-Efficient, Risk Management Discipline.

In August the S&P 500 rose at a +66% annual rate

Passive Pete: Why bother to try to beat that 66% rate? All the passive investor has to do is commit capital and sit and watch it grow.

Active Al: Well, how do you decide when to commit capital? If it was committed in SPDR S&P 500 Trust shares (NYSEARCA:SPY) at year end 2013 and kept there, like a true buy-and-holder, the +66% annual rate of August was needed to bring that capital's lazy year-to-date gain back up to a +13% annual rate. From $184 to $201. Is that what floats your boat, sends Junior and his sis to college, and builds a retirement for you?

Passive Pete: Well it was growing all the time, sometimes faster, like August, but we had no big-time worries of taking market-timing risks. Besides, lots of studies have shown that trying to time the market never works. Even most of the smart portfolio managers running millions of dollars of mutual fund money, 80% of them, can't keep up with the index ETFs. SPIDERS track the index perfectly, so why mess with a known outcome?

Active Al: You mean like the outcome known in 2008-2009, when the market lost 60% of its value?

PP: Yeah, because now it's back at a new high over 2000. The strongest economy of the strongest country in the world brought it back. It always will.

AA: And it only took 5 years to do it. So you're back to where you were then, except the kids are 5 years closer to college and you're 5 years closer to retirement - or 5 years further from it. Pete, you need to recognize that when you invest capital, you also invest time.

That's why active investing is so important, it forces us to be efficient with time in the ways we invest our capital. Let me show you a series of stock portfolios set up each day this past month from choices by market professionals. The pros who are each paid a million or more a year to put their employers' millions at risk hundreds of times a day. Told by the way they choose to protect that capital by hedging.

What the pros spend on risk protection tells exactly what they think the risks are. Records of their actions that have been kept over years tell how good their guesses have been about how far the stocks' prices may get pushed. There's a service that makes all that available, and I have their lists for the past month.

When each day's top ten ranked stocks are checked against the sell targets for each stock we can see if or when the targets were reached, or where the prices are now at the end of the month.

A day-by-day scorecard

There have been 19 days that we can measure this way. Since August 1 was a Friday, its list can't be committed to until Monday, the 4th. We use the day's closing prices to mark buys and sells because there is little question of being able to get an action taken at that point. At the end of the month, the 29th is the last day to get a closing price, but deciding on stocks from a list of the 28th puts their buys at a 29th price with no value change. So the 27th is our last day to decide which buys on the 28th will be measured on the 29th.

With 19 active days to August, there are 190 buys to fill the 10-stock portfolios. Each buy carries its own cost and sell target, the latter being determined by the top of the hedging price range forecast. If pros won't spend to protect against being short up there, we shouldn't hang around waiting for higher prices. That's time to take the profits and put them to work in another winner.

You're worried about losers? So am I, so our selection process focuses on just those stocks and ETFs where these pros' past forecast records have produced wins 9 times out of ten, or better, on hundreds of prior bets in the past 5 years.

Accomplishments are verified by all 190 of them. Then we can compare their results with parallel buys in, say, SPY, to see if the pros' implied preferences give us any better active investment selection results than a passive market-index approach.

The real-time results

How is that working now? They beat the parallel buy results for SPY in 17 out of the 19 days' portfolios. By an aggregate of +60%. Here are the details of the first two days.

In each table, the first 4 columns show the date of the data producing forecasts of the top ten ranked stock buy candidates from a large population of possible equity investments, some 2,500 stocks and ETFs. Shown for each of those candidates is their symbol, Range Index, and top of the price range forecast, which is used as a sell target. The Range Index tells what percent of the whole forecast price range lies below the then current market quote.

The buy price for each stock is the closing price on the next market day, a known cost base sure to be achievable. The sold price is the first end of day price at or above the sell target in the following 3 months, or the closing price on that 63rd market day after the forecast day if the sell target has not been met.

The days held are calendar days between the buy date and the sale date, and the annual rate of return is the average daily percent gain per day, plus 1, raised to its 365th power, minus 1.

To get a parallel measure for the market average, the same approach is taken for price change in the same time period for SPY, but with a focus on the difference between its percent change and that of the subject stock.

For example, Keurig Green Mountain's (NASDAQ:GMCR) sold price of $136.55 divided by its cost of $118.81 equals 1.1493. The same-time SPY price change at 1.0332 subtracted from GMCR's result = 0.1161 or +11.6%. These differences, when cumulated for each day's "portfolio" of ten stocks will give a direct measure of performance between selected stocks and the market.

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Collecting those differences for the month of August for this portfolio of ten actively selected stocks totals +51.5%, or an average per stock of over +5%.

Measured a different way, the geometric average of price gains for all ten stocks is shown in the bottom row of the table as 1.0814. The parallel measure for the SPY positions is 1.0322. Their difference is just under +5%.

The typical holding periods for these positions averages just over 22 calendar days, so the active stock selections gained at an annual rate of +264%, while the SPY positions gained at +68.8% (not shown).

Here are the results for the active investment stock selections on the second measurable day of August.

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That day's selections were a bit less dramatic, but continued to beat their SPY twins during the rest of the month by +14.6%.

Here is how the aggregate results compare between active stocks and SPY parallels in each day by day portfolio, through the month. With fewer days available to perform, of course the achievements get progressively smaller. But you can see how the portfolios persistently outperform the index.

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And here are the day-by-day aggregate results of the portfolios, repeating that summary data in the above tables from the first two:

This set of "portfolios" of top-ten ranked stocks results from our behavioral analysis of the self-protective hedging actions of arguably the best informed and most experienced equity price range forecasters in the business.

Their actions reflect conditions specific to the individual securities, ones that they have seen before and reacted in ways very much like the present. We select out the issues where their prior judgments have been most productive with the least price drawdown risks encountered in achieving expected price objectives.

When their ten top selections in each day of August 2014 are tracked through to the end of that month, either the forecast sell targets have been reached, or they were marked to market at the close on Friday August 29th. Duplicate purchase and sell dates in SPY and geometric mean averages of both the ranked Buys and the SPYs for each day are compared side by side in the table above.

The point to be made here is that active investing decisions involving intelligent, experienced, price-sensitive selections of a wide variety of securities can be made day after day that significantly outperform identically-timed actions in the S&P 500 index tracked by SPY.

Note that in only two days out of 19 did the selected securities underperform their market parallels, and then by fairly trivial differences, in time periods limited to 3 days or less. Where the active selections had holding periods over a week, out-performances of significant double-digit percentages often resulted.

The average per-day gains of the active selections are more than double those of the same-time holdings of the market average. These are not the kinds of trivial few percent differences often crowed about in professional journal articles. Annual rate differences here are between multi-hundred percent gains and less-than 100% rates.

When comparisons of buy-and-hold approaches with the market average are pursued instead of the time-efficient holding periods, the differences in favor of active investing are strengthened. The price gain of the S&P 500 from July 31st's close of 193.09 to the 200.71 at the end of August, calculated as a +3.95% gain, falls to an annual rate of +57.7%, compared the +79% time-efficient use of capital by SPY in parallels to the 190 portfolio buys.

The cumulative daily average advantage of active investment selections over the market average similarly timed, makes a "no contest" out of the comparison, at a +243% annual rate, rather than SPY's +79%.

But, is a one-month test sufficient?

Have we attempted to measure the depth of the ocean with, by chance, in the dark, a sounding between a couple of the Hawaiian islands? And have obtained a misleading set of readings?

A sample of 190 individual selections, spaced regularly across a month, is more than a one-shot-dunk claiming a championship. It even favors the (passive) opposition by using a far-above-average market-gaining period as a competitive arena.

Still, similar tests over many more months would be more convincing. Our experience gives us confidence that similar outcomes have preceded this limited exercise, but remain only to be documented, which we will do. In the meantime, our record of over 200 SA published recommendations gaining at +58% rates across the length of 2013 while the S&P 500 rose only 29% offers further reassurance.

Conclusion

Passive Pete is in big trouble if committed to an investment philosophy that buy and hold of a market-average ETF will provide anything more than high cost (in foregone price gains) results in exchange for more sleepy investment afternoons than disturbing ones.

Active Al has found the expert help to make possible a continuing series of intelligent selections as to specific securities and to sector and asset emphasis that is likely to bring him very satisfying investment accomplishments. Ample evidence exists and is being strengthened that far better than average can be produced by active investing, and the related discipline of time-efficiency.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.