The Case For Evidence Based Investing:Part II - Theoretical Foundations

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  • I continue my exploration into evidence based investing by exploring the impact of cost on your investment portfolio.
  • I will explore the notion of reducing volatility as a reason to select active funds.
  • I will further discuss the zero sum game and explore the theoretical foundations of Evidence Based Investing.

Today, many investors, and even professional practitioners give little thought to the academic breakthroughs that constitute the theoretical frameworks that support optimal investment strategies. Most investors have questions about how to invest. How should an investor position their investment portfolio to attain the maximum total return at the lowest possible cost? How can an investor minimize risk and maximize return, especially when taxes are a consideration? In this piece, I want to walk investors through the theory and practice of evidence based investing, and some of the impediments to winning the loser's game.

The Tyranny of Compounding Costs

Most investors have very little knowledge about the costs of investing and what effect they have on their long-term ability to create wealth. Likewise, they also fail to understand the mathematical improbability of finding a manager who can reliably produce alpha, year in and year out, that overcomes the cost of speculating in stocks. It's not just your IRA, or brokerage account. Keeping track of the fees on your 401(K) or other employer sponsored retirement plan is also important. If investors calculated the total fees, commissions, and charges to speculate in stocks, they would be shocked at what it is costing them.

"Calling costs "death by a thousand cuts" is a little too dramatic, but the slow bleed can do a surprising amount of harm. A typical saver spends something like $ 170,000 in fees by the time they retire and gives up a fifth of their potential return. Can you imagine how people would react if, instead of paying that amount little by little and having to read about it in tiny letters buried in a quarterly statement most of us glance at briefly, we got presented with a bill for $ 170,000 at age sixty-five?" Spencer Jakab, Heads I Win, Tails I Win

Most investors see the cost of investment management as a fact of investing. Whatever it is, the vast majority of investors would see this as insignificant when their exclusive investment managers have them believing they can produce high levels of alpha in return. However, the compounding effect of costs on your wealth could be dramatic over time.

Investing is the one discipline where the old adage "you get what you pay for" does not apply. To put it simply, in investing, the less you pay, the more you get. The challenge is that most investors simply do not understand just how much that active manager is costing them. The expense ratio is just the beginning. Many funds also carry 12b-1 fees, loads, transaction costs, and, if it's in a taxable account, one must also account for the tax cost. All of these fees add up, reducing any "advantage" an active manager can provide to 0%, or in many cases, taking it negative.

Funds may also charge redemption fees, soft dollar costs, opportunity costs, and other costs, many of which are difficult to quantify. Hopefully, you are beginning to see that active management costs much more than you thought, and the odds are simply not in your favor.

Still many reason that their manager will be able to provide a return over the index that will make up for all these costs and then some. Unfortunately, this does not happen in the real world of investing in a predictable way for two reasons:

1. Predicting which asset class will win in any given year is already an impossible task, but then to predict which manager will be able to beat the index is even more difficult and virtually impossible.

2. Research continues to prove, that those who win, even over long periods of time, have more to do with luck than skill, and the alpha generated still largely does not cover the compounding effect of yearly costs.

A quote from "Winning the Losers Game" was of particular importance in understanding the level of fees charged by the active management business. If you are like me, it will open your eyes to the reality that active management is largely a losers game.

Though some critics grouse about them, most investors have long thought investment management fees are best described with one three-letter word: low. In particular, fees are seen as so low that they are almost inconsequential when choosing an investment manager. This view of fees is a delusion of investors—and a not-so-innocent deception by investment managers. Framing, the way we describe and see something, can make a major difference. And so it has been with investment management fees. Seen correctly for what they really are, fees for active management are very high—and much higher than even most critics of fees have recognized. When stated as a percentage of assets, average fees do look low: a little over 1 percent of assets for individuals and a little less than one-half of 1 percent for institutional investors. But is this the right way to measure or describe fees? No! Not even close! Here’s why.

The investors already have their assets, so investment management fees should really be based on what investors are getting and what managers are expected to produce: returns.

Calculated correctly as a percentage of returns, fees no longer look low. Do the math. If future stock returns average, as most observers seem to expect, 7 percent a year, then those same fees are not 1 percent or 0.5 percent. They are much higher: more than 14 percent for individuals and over 7 percent for institutions. But even this recalculation substantially understates the real cost of active investment management. That’s because index funds produce a “commodity product” that reliably delivers the market rate of return with no more than market risk. Index funds are now available at fees that are very small: 0.10 percent or less for individuals and 0.03 percent or even less for institutions. Because the commodity product is available to all investors, we should apply the lesson learned in Economics 101: When a reliable commodity product is widely available, the real cost of any alternative is the incremental cost as a percentage of the incremental value. So rational investors should consider the true cost of fees charged by active managers not as a percentage of total returns but as the incremental fee as a percentage of risk-adjusted incremental returns above the market index. Thus, correctly stated, management fees for active management are remarkably high.

If you think that the level of fees should be in proportion to the actual benefit the fund shareholder gets, you’ll be impressed to learn that the fees most mutual funds charge, relative to incremental risk-adjusted returns, are over 100 percent. That’s right: All the value added over the index commodity product—plus some—goes to the fund manager. And there’s nothing left over for the investors who put up all the money and took all the risk.

It is a funny business—and worth thinking about. Are any other services of any kind priced at such a high proportion of client-delivered value? How long can active investment managers continue to thrive on the assumption that clients won’t figure out the reality that, compared with the readily available index fund alternative, fees for active management are astonishingly high?"(Ellis, p. 177-179, emphasis mine)

The Zero Sum Game

The notion of a zero sum game is difficult for many investors to understand, yet it is essential to understanding the case for index investing. Dr. William Sharpe’s 1991 paper describes the zero sum game very well, and I urge readers who want a more thorough analysis of the subject to give it a read. In essence, the notion is that returns for every dollar invested are equal before fees. This is because for any investor who increases their holdings of a particular stock, they are doing so because another investor has decreased their holdings of that stock. So all else being equal, returns of actively managed funds should be lower than passively managed funds due to the excessive cost of active management. Therefore, for an active manager to beat an index consistently they must achieve a return greater than the index consistently. Seeing as the evidence proves that most active managers fail to beat the index consistently, investors are at a distinct disadvantage by investing in active funds. Furthermore, if an investor thinks they can find the managers that do outperform consistently, the evidence is not in their favor. The data clearly shows that investors who outperformed in the past are not statistically likely to outperform in the future, a concept with which I had to come to grips.

The following graph will make this principle even more clear.

One of the largest criticisms of this ideology is the notion that active managers can pick a select group of stocks that outperforms the low-cost index investment. While it is certainly possible for active managers to out perform the low-cost market index, it is mathematically improbable and can most accurately be explained by random chance.

What about Volatility?

One of the arguments I hear a great deal, about why active management is more than worth the fee is that they can achieve the market return at less volatility. I know this argument well because as a recovering active investor, I used to make it myself, but there are a few important points to be made.

First, there is no guarantee that the performance of the past will materialize in the future. Charles Ellis explains the notion of random chance and the unpredictability of future performance by describing a series of coin flips. We would not expect the future outcome of a coin flip to be determined by previous coin flips, so is it with investing. Just because a manager has succeeded in the past, there is no guarantee that they will succeed in the future; what is guaranteed is the fee you will pay. This is where the t-stat can come in handy to decipher whether a manager has true skill that we expect to persist or not. In more than 90% of cases, you will find no skill exists.

Second, when we examine the performance of those funds, it is largely the allocation to cash or other assets which allows them to outperform. Let's look at First Eagle US Value (FEVAX) which is often cited by active investors as proof of a superior investment approach due to its metrics during drawdowns. I would argue that First Eagle simply holds more cash and has a standing allocation to precious metals, giving investors less exposure to market beta, which is what creates the reduction in volatility. Yet investors can recreate the portfolio with passive funds at a much lower cost.

I want to look at the 10 year period from 2007-2016 to demonstrate the fact that active investing does not pay off using an often cited "successful" active fund.

Name Cumulative Return 2007-2016 Allocation
First Eagle US Value 74.07%
DFA Large Company (S&P 500 Index) (DFUSX) 87.44%
Composite Index 75.63%
DFA US Value III (DFVIX) 93.10% 67.07%
Vanguard Developed Markets Index (VDVIX) 30.06% 5.12%
DFA Short Term Government (DFFGX) 26.98% 18.14%
Vanguard Intermediate Investment Grade (DFICX) 54.60% 1.07%
SPDR Gold Index (GLD) 71.79% 8.60%

There are a few interesting points to consider. FEVAX has a load of 5.0%, though many brokers allow you to buy the fund with the load waived. The fund also has an expense ratio of 1.09% and a 12b-1 fee of 0.25%. The fund has failed to beat its benchmark index, the S&P 500 by 13.37%. It also failed to beat its value factor equivalent DFA US Value III by 19.03%. Even when I recreate the portfolio allocation to get as close to FEVAX as possible the index composite benchmark still beats the active fund by 1.56% and for a much lower total expense ratio than the active fund. When we recreate the composition, it still fails to outperform. This is a great example of how the marketing of active funds, can largely be greater than the substance of their performance.


In Part I of this series I have aimed to demonstrate the problem with speculating in stocks, how you mathematically probably can't beat the market even if you think you can, and neither can that high priced manager you are paying. In Part II, I have shown how much you are really paying to try to beat the market and how the compounding of those costs can eat your wealth alive, leaving you less prepared to retire, send your kids to college, or whatever other goals you may have. In Part III of this series, I will explore the virtues of evidence based investing, explore the research on which it stands, and why it is a better investment strategy for the long run than speculative active management. In Part IV I will review portfolio optimization and the merits of working with a qualified wealth manager. In Part V I will explore quantitative tools to analyze active managers, and how investors who wish to use active managers can put the odds in their favor, through manager due diligence and data driven analysis.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is for informational purposes only and is not an offer to buy or sell any security. It is not intended to be financial advice, and it is not financial advice. Before acting on any information contained herein, be sure to consult your own financial advisor.

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