Building Efficient Portfolio Models - Part II: If The Market Is Efficient, Why Are You Trying To Beat It?

by: EB Investor

This series of pieces is about creating efficient portfolio models that can build and compound wealth over the long run.

In part one, I looked at the negative effects of cost and touched on the poor results of active managers in the pursuit of market-beating returns.

In part two, I will go deeper into the failure of active management to produce results for investors that are over what can be achieved with a low-cost index fund.

The ultimate question investors must answer once presented with the research is, if the market is efficient, then why are you paying exorbitant sums to try to beat it?

In part one of this series, I took a look at investment cost and how deleterious it can be to investors over the long run. I also touched on the failure of active managers to produce a return over that provided by a low cost index fund. Still, many will reason that active management is worth the cost, but the evidence tells a different story.

"But I invest in Mutual Funds That Can Beat The Index!"

Many reason that their manager will be able to provide a return over the index that will make up for all the costs of active management. 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. Even worse, then, that manager has to pick the right stocks that outperform the index. Are you starting to see how the odds of getting all those decisions correct year in and year out is stacked against you?

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.

3. Additionally, those who win in one period largely do not repeat in another. To solidify this, we turn to another report from S&P entitled "Fleeting Alpha Evidence from The SPIVA and Persistence Scorecards". They found that:

"out of 1,034 large-cap funds that existed in the universe as of Sept. 30, 2013, only 19.73%, or 204 funds, outperformed the S&P 500®. In the following year, 15.69% of those 204 funds outperformed the benchmark. By the end of the third year, none of those original 204 funds were able to outperform the S&P 500 on a consecutive basis."

A quote from "Winning the Losers Game" by Dr. Charles Ellis was of particular importance in understanding the level of fees charged by the active management business.

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)

It is clear that keeping your costs low is one of the most important keys to investment success.

Investing Is A 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.

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 outperform the low-cost market index, it is mathematically improbable that this can be repeated consistently, and instead can most accurately be explained by random chance, or simply luck.

If The Market Is Efficient, Then Why Are You Trying To Beat It?

If investing is a zero sum game as I have proven, then paying an investment manager a small fortune over time to get sub-par performance is rather nonsensical. John Bogle has been on the side of the individual investor for many years. His work in creating index funds has given the average investor a fair chance at reaping the benefits of investing in capitalism and attaining financial freedom, which can be yours for a mere 0.04%.

The index investor is not relying on the "superior" talents of an active manager to interpret the information that all other active managers already have, and somehow, find an edge that all other highly qualified active managers have missed. Instead, the index investor is putting their faith in the market, to harness the returns of capitalism, and provide the investor with all the appreciation and dividend income the market has to offer. This is because, if markets are efficient, then indexing is the most intelligent way for an individual to capture the returns from those markets.

The notion of an efficient market that incorporates available information has been assembled progressively through time through 450 years of academic research. The advancement of knowledge on the subject led Harvard financial economist Michael Jensen to state that:

"there is no other proposition in economics which has more solid empirical evidence supporting it than the Efficient Market Hypothesis (EMH)".

Reconciling EMH With Behavioral Anomalies

The question still remains what about the theories of behavioral finance? How do we explain the behavioral anomalies that exist in capital markets?

The efficient market hypothesis is a model which seeks to explain securities prices. While the market is largely efficient, small inefficiencies still exist, as supported by the research of many of the behaviorists such as Lakonishok, Shiller, and Thaler, who believe that the market is largely driven by psychological phenomena. Their work, however, does not disprove the model of efficient markets.

EMH adherents concede the existence of psychological factors but fail to see how they get incorporated into securities prices. Reviewing the research on both of these theories, I have come to believe that markets are efficient, in the sense that all available information is incorporated in securities prices, and while I concede that market prices can be bid up or down by psychological modalities of market participants, this is completely consistent with the parameters of efficient market theory.

There is simply no evidence to support the behaviorists theory to a sufficient degree, that one would discard the notion of efficient markets. Many would contend that the overreaction and under-reaction to information proves that markets are inefficient. The 1999-2000 market bubble or 2008 financial crisis are both great examples of this.

Dr. Fama clearly addressed these issues in his 1998 paper in the Journal of Financial Economics entitled, "Market efficiency, long-term returns, and behavioral finance". In this paper he states:

...many of the recent studies on long term returns suggest market inefficiency, specifically, long-term under reaction or overreaction to information. It is time, however, to ask whether this literature, viewed as a whole, suggests that efficiency should be discarded. My answer is a solid no, for two reasons.

First, an efficient market generates categories of events that individually suggest that prices over-react to information. But in an efficient market, apparent under reaction will be about as frequent as overreaction. If anomalies split randomly between under reaction and overreaction, they are consistent with market efficiency. We shall see that a roughly even split between apparent overreaction and under reaction is a good description of the menu of existing anomalies.

Second, and more important, if the long-term return anomalies are so large they cannot be attributed to chance, then an even split between over- and under reaction is a pyrrhic victory for market efficiency. We shall find, however, that the long-term return anomalies are sensitive to methodology. They tend to become marginal or disappear when exposed to different models for expected (normal) returns or when different statistical approaches are used to measure them. Thus, even viewed one-by-one, most long-term return anomalies can reasonably be attributed to chance."(Fama, 1998)

For a more thorough refutation of the behavioral theory, I recommend investors read the full paper. Dr. Fama goes into a great deal of detail proving the strength of the efficient market theory, and more than answers the challenge of many studies by behaviorists.

If you are still going to invest in active management, even after all the evidence demonstrating your poor odds, then it is important to follow a few guidelines.

First, favor mutual funds with high active share, this is the amount that the fund strays from the benchmark index. If you are going to pay for active management, you want to make sure you are actually getting active management and not a closet index fund at a higher fee.

Second, make sure that you are investing in active funds where the managers have a significant investment in their own funds.

Finally, in order to decipher between luck and skill, you can run a t-test on the funds alpha, to see whether they are able to produce statistically significant alpha, or if they are merely beating the market through random chance. As I demonstrated in part one of this series, very few funds are able to produce statistically significant alpha.

Individual investors can decide what level of their t-test they are comfortable with in terms of certainty. A t-test of 2 indicates that there is a 95% chance that the alpha that was produced was the result of skill rather than luck. Even if you find a fund that has demonstrated its manager can beat the market as a result of skill, this does not mean they are going to continue to beat the market.

In the end, active management has poor mathematical odds and it boils down to being a simple game of chance. Each individual investor has to determine whether they are willing to pay the higher fees for a small chance of beating the market. Benjamin Graham the father of value investing would advise against this, as would Warren Buffett, and scores of other highly successful investors, and financial researchers. Passive investing, coupled with a high savings rate, is the true path to wealth for most average investors.

Follow The Advice of The Experts

The best minds in financial research, as well as the best investment practitioners all agree that index investing is the best solution for most investors looking to build wealth. The two most famous examples are Benjamin Graham the father of value investing, and his most famous student Warren Buffett. Yet both of these men, advocate a low cost index investment for long term investors. With their low costs and passive ownership of stocks, it is easy to see why.

"I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook "Graham and Dodd" was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost... I'm on the side of the "efficient market" school of thought now generally accepted by the professors."
- Benjamin Graham, Financial Analysts Journal, 1976

Warren Buffett has followed a passive approach, buying the shares of large corporations and holding them indefinitely. Buffett also advocates that the individual investor use passive index funds due to their passive ownership of corporate America and low costs.

1996 Chairman's Letter - "Most investors, both institutional and individual, will find that the best way to own common stocks (shares') is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals."

2007 Chairman's Letter - "Naturally, everyone expects to be above average. And those helpers - bless their hearts - will certainly encourage their clients in this belief. But, as a class, the helper-aided group must be below average. The reason is simple: 1) Investors, overall, will necessarily earn an average return, minus costs they incur; 2) Passive and index investors, through their very inactivity, will earn that average minus costs that are very low; 3) With that group earning average returns, so must the remaining group - the active investors. But this group will incur high transaction, management, and advisory costs. Therefore, the active investors will have their returns diminished by a far greater percentage than will their inactive brethren. That means that the passive group - the "know-nothings" - must win... The best way in my view is to just buy a low-cost index fund and keep buying it regularly over time, because you'll be buying into a wonderful industry, which in effect is all of American industry…People ought to sit back and relax and keep accumulating over time."

2008 Chairman's Letter- "The American economy is going to do fine. But it won't do fine every year and every week and every month. I mean, if you don't believe that, forget about buying stocks anyway… It's a positive-sum game, long term. And the only way an investor can get killed is by high fees or by trying to outsmart the market."

2014 Chairman's Letter- "What I advise here is essentially identical to certain instructions I've laid out in my will. One bequest provides that cash will be delivered to a trustee for my wife's benefit….My advice to the trustee could not be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard's.) I believe the trust's long-term results from this policy will be superior to those attained by most investors - whether pension funds, institutions or individuals - who employ high-fee managers...If not for their fear of meaningless price volatility, these investors could have assured themselves of a good income for life by simply buying a very low-cost index fund whose dividends would trend upward over the years and whose principal would grow as well."


For investors just starting out and wondering how to invest, or those who are seasoned investors who are looking for a better, more cost efficient way to access the returns capitalism offers, this series provides investors with the evidence to support the notion that low cost index investing should be the majority of your portfolio.

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 (other than from Seeking Alpha). 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. This article does not constitute tax advice. Every investor should consult their tax advisor or CPA before acting on any information contained herein.