Factors In Practice: What About The Ultimate Stock Pickers?

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Includes: BBTEX, MSEGX, YACKX
by: Eric @ SERVO

Summary

A reader asks: Why should I invest in index funds when there are lists of active mutual funds that have and are expected to perform better than the market?

The reality is the vast majority (80%+) of active managers are unable to outperform their market index, and the ones who do only "win" by a few percent a year.

A more reliable way to earn higher-than-market returns is to design an index-based asset allocation that is weighted towards smaller and more value-oriented stocks.

If you'd like to read previous installments of our reader-inspired Factors In Practice, see them here. For our latest edition, a reader writes in:

"Morningstar keeps a running list of active mutual fund managers who they expect will perform much better than the market over time. Why should I use index funds when these managers are expected to produce better returns?"

I imagine the reader came across this article from Morningstar yesterday that highlights three mutual funds that have historically outperformed the market. Morningstar calls them the "ultimate stock pickers."

First, let's survey the landscape. It's important to understand that with thousands of mutual funds trying to beat the market, we're undoubtedly going to look back and find some funds have achieved this feat. In 2001, there were 2,758 domestic stock mutual funds to choose from. 15 years later, we see that only 43% of them actually survived, with the remaining 57% closed, likely due to really poor returns. And of this original set, only 17% outperformed their index benchmark. 87% either underperformed or went out of business altogether. (Source: 2016 DFA Mutual Fund Landscape)

So the first thing I'll say is that the odds that the approach you're proposing (whether aided by Morningstar's research, a professional advisor or industry consultant) will work are extremely low, less than 20%.

But 20% isn't 0%, so let's dig a little deeper. We'll look at these three funds more closely over the longest period of time each one has been in business - since November of 1998.

Name

Ticker

Annual Alpha

Market Exposure

Size Exposure

Value Exposure

AMG Yacktman Fund

YACKX

3.29%

0.78

0.02

0.45

MSIF Growth Portfolio Class A

MSEGX

1.40%

1.09

-0.07

-0.25

BBH Core Select Fund Class N

BBTEX

0.66%

0.91

-0.19

-0.07

"ULTIMATE" AVERAGE

1.78%

0.93

-0.08

0.04

Clearly, these funds are part of that small minority who, on average, have outperformed the market. But by how much? If we adjust for their exposure to the market, small cap and value factors, we find their returns are +1.8% per year higher than we'd expect. That's it, 1.8% a year. It's not the 5% a year or 10% per year that you might be thinking. The 1970s/1980s Warren Buffett isn't knocking at your door asking for seed money.

Which is my second point. Even if we isolate and can identify in advance the "ultimate" investors, those who reside in the top 17% of their profession, we find they've produced less than 2% per year more than the market. Remember there's more than 80% who have done worse, in some cases much worse.

Lastly, let's look at this 1.8% per year return in excess of the market. We know there wasn't anything more than this, because a weighted average of the three funds' exposure to the market, small cap and value factors reveals a mix that looks very much like the market, with a beta of 0.93, a negative size tilt of -0.08 and a slight tilt to value of +0.04 (the market resides at 1.0, 0.0 and 0.0 respectively). This is about what we'd expect, actively-managed funds represent a large sample of the overall market, and should look very much like the market but with higher costs. As a whole, we know active managers will underperform the market by their total costs and cash drag, even if some do a little better.

But I want to zero in on that 1.8% per year higher return. Is there an easier way to position yourself to achieve this? I think there is.

Historically, we know that the premium for holding small cap stocks over large cap stocks has been about 2% per year. The premium for holding lower-priced value stocks over higher-priced growth stocks has been even higher, about 4% per year.

This means that, even with no ability to identify in advance the 20% or so of active managers who will beat the market, you can still design a portfolio with higher-than-market expected returns by using index funds and an asset allocation that on average has increased exposure to smaller and more value-oriented stocks. And you don't have to get too extreme, an asset allocation that is about 20% smaller and 40% more value oriented than the market (2% x .2 plus 4% x .4 = +2%) should do the trick.

Let's look at such a portfolio, diversified globally, over the same period of time. We'll call it the Equity Balanced Strategy, made up of DFA's asset class funds. This isn't an exercise in hindsight (at least with regards to the Equity Balanced Strategy), by the way. This portfolio has been around for some time and can be seen on page 50 of this PDF, published in 1998.

PORTFOLIO MIX

11/1998 to 5/2016 Annualized Return

Volatility

"Ultimate" Average

+8.1%

14.5

Equity Balanced Strategy

+9.3%

17.0

Aggressive Balanced Strategy

+8.5%

13.3

Here we find that the globally-diversified, small/value-tilted Equity Balanced Strategy actually performed noticeably better than the ultimate stock pickers - its +9.3% annual return was +1.2% annually higher. So clearly, an index-based portfolio that is structured to achieve higher-than-market returns through increased exposure to small cap and value stocks has been a worthy alternative to finding the outperforming active manager needle in the haystack.

Of course, the skeptic might point out that active managers aren't so much employed to produce significant market-beating returns, but to do modestly better with less risk. And here I must concede, the ultimate mix did hold up better than the market and the Equity Balanced Strategy, its annual volatility was less and its 2008 loss was -33% compared to -41% for the Equity Mix.

But choosing safer stocks or opportunistically holding excess cash reserves is not the only approach to lowering portfolio risk (or even a very reliable one). You can simply choose to adopt an asset allocation with slightly less in stocks (say 80%), and some permanent commitment to low-risk bonds (say 20%). This is what the last row of the table above reports: the "Aggressive Balanced Strategy" is actually 80% in the Equity Mix, with 20% in high-quality, short-term bonds. This static mix produced 0.4% per year higher returns with even less volatility than the ultimate mix and had similar losses in 2008 (-32%).

My final point is this: I'm not going to fault you for wanting to "beat the market." I just think there are easier ways to do it.

Holding an index-like portfolio but employing an asset allocation that is tilted to smaller and more value-oriented stocks is a much more reliable (though not guaranteed) way to generate returns in excess of the market. Specific allocations can be designed to generate a certain level of market outperformance by observing historical small cap and value premiums, as well as a certain risk threshold by customizing the overall stock and bond mix. What's more, this approach is likely to be far more tax efficient because index funds (especially tax-managed funds) tend to significantly reduce capital gains distributions and tax inefficient bonds can be located in tax-deferred accounts.

And let's not forget that diversification, a hallmark of this structured investment approach, has its own inherent advantages. While most active managers and active portfolios will look very much like the market +/- a few percentage points a year, a more diversified allocation stands a good chance of performing much better during the inevitably long stretches when the market produces negligible returns. During the "lost decade" from 2000-2009, for example, when the S&P 500 actually lost money, the ultimate mix gained +3.9% per year while the Equity and Aggressive allocations returned +6.7% and +6.8% per year, considerably better.

Putting it all together, higher-than-market returns, superior tax efficiency and a more consistent result make it much easier to achieve your long-term financial goals.

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Past performance is not a guarantee of future results. Index and mutual fund performance shown includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or other expenses except where noted. This content is provided for informational purposes and is not to be construed as an offer, solicitation, recommendation or endorsement of any particular security, products, or services.

Disclosure: I am/we are long DFLVX, DFSVX, DFIVX, DISVX.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.