Night of the Living Funds

This is part two in a series on active management. For part one, click here.

A few years ago, a friend asked my advice about an IRA. Her financial advisor had chosen the investments while she was in high school.

When I looked at the statement, I was appalled. The advisor had picked two variable annuities—a long/short fund and market neutral fund—both completely inappropriate for someone with a long time horizon. My back-of-the-envelope math showed these annuities had cost her more than 100% in gains, or about $15,000, compared to a S&P 500 index fund from Vanguard or Fidelity.

How does this kind of thing happen? Simple: the advisor was paid a commission. He received a fee for putting her in products which themselves charged high fees. He had little incentive to do the right thing for his client, and every incentive to choose a product that would earn him a fee.

Unfortunately, that’s why many overpriced products still exist. Commissions-based financial advisors and cheaply designed 401(k) plans routinely put unwitting investors into products that charge outrageous fees. If we didn’t have a system that encourages these products, they simply wouldn’t exist. They would be competed out of existence by superior, cheaper alternatives.

Meb Faber has an excellent post about certain index funds that charge inexplicably high fees. One example, the Rydex S&P 500 Fund C Shares (RYSYX), has an expense ratio of 2.31% and the gall to charge a 1% exit fee on top of that. By comparison, the equivalent fund from Vanguard (VFINX) charges 0.14%. The chart below shows the performance of this fund against the S&P 500 since its inception.

Rydex fund (white line), index (orange line). Data: Bloomberg
From its inception in 2006 until April 2017, the Rydex fund has underperformed its index by a cumulative 51%, and that’s before the 1% exit fee. Imagine what that would do to your retirement fund over time.

As outrageous as these fees are, it gets worse in many active funds. First, take the Sparrow Growth Fund (SGFFX). It’s an equity fund with an expense ratio of 2.45%, a 5.75% front load (entry fee), and a 1.00% back load (exit fee). If you buy this fund, you’re signing up for over 8% in fees even if you only hold it for a year.

There’s also the Saratoga Technology & Communications Portfolio (STPAX). It has an expense ratio of 2.24%, a 5.75% front load, and a 2.00% early withdrawal fee. If an advisor bought this for you, you may not be happy about the 7.99% in fees you’ll pay in the first year. If you want to sell, no worries, just pay an additional 2.00%.

If you were a fan of the technology sector, you could have instead purchased a NASDAQ 100 index fund like QQQ, which charges 0.20% and no load. The below chart shows the performance of these two funds since QQQ’s inception date, and doesn’t even account for the 5.75% front load.

Active fund (white line), index fund (orange line). Data: Bloomberg
This underperformance is not just due to bad stock picking: the active fund would be much more competitive if not for its high expense ratio.

What about those painful front-end load fees? Consider a hypothetical fund that outperforms the S&P 500 by 0.50% every year, but charges a 5% entry fee. The chart below illustrates your dollar underperformance if you invested $100,000 in this hypothetical fund:

If you bought the fund at the end of the year 2000, it would take more than ten years for that 50 basis points per year of outperformance to “catch up” to the 5% fee you paid initially. This also assumes you picked a fund that can consistently outperform after management fees, which is a serious hurdle.

Fighting off the Zombies

Many hyper-priced funds are small, but they still survive. The way some funds stay open is by obtaining investors through unusual means. Maybe a financial advisor gets paid a sales commission or a poorly structured retirement plan offers the fund as a 401(k) option. Maybe someone buys the fund, pays the high entry fee, and feels mentally “invested.” This is the sunk cost fallacy in action.

There are still some excellent active funds with reasonable fees, but many funds remain on the market when they shouldn’t. Fund companies know that high fees are a drag on performance, and it’s easy to see how funds fail to outperform their benchmarks if they charge fees of 1%, 2%, or above. They’re like the living dead; they limp along, dragging down the healthy in the process.

Single Stock Portfolios and “My Friend is Beating Me”

Michael Batnick wrote a great post this week about a reader with a friend who invested his entire brokerage account in a single stock (Facebook). It’s hard to argue with an investment strategy when someone shows you eye-popping returns in their personal account. Although you know about the importance of diversification and the benefits of index funds, hearing this type of story can cause jealousy, a fear of missing out (FOMO), and the thought “if my friend did it, there’s no reason I can’t do it too.”

As Batnick points out, one of the major problems with holding a portfolio of volatile stocks is the emotional swing. Huge drawdowns scare investors into selling when they should be buying. Rapid gains entice people to buy more shares when they should be trimming an oversized position. So even if a stock performs well over time, the investor’s emotional mistakes eat away at their returns.

If someone asked me if they should hold individual stocks, I’d ask them a few questions. First, I would ask them how they handle volatility. Have drawdowns ever caused them to sell their stocks or go against their long-term plan? If that’s the case, I would encourage them to take a hands-off approach.
Second, I’d ask what they like about the company they want to invest in. If someone loves reading about business and can speak passionately about capital allocation, brand, long-term strategy, or return on equity, I think they’re fine investing some percentage of their portfolio in the stocks of companies they believe in. Engagement and interest will lead them to save and invest more.

My friend did it, so why can’t I?

There’s another point I’d make to someone who hears about a friend’s amazing single stock returns. Their friend may have picked a good stock, but that doesn’t mean they’re a good stock picker.

Let me explain. There is a fundamental principle in forecasting: a prediction’s apparent “success” doesn’t prove it was a good prediction. This idea is counterintuitive, and is one of the most common misconceptions in probability.

Imagine I said there is a 95% chance the New England Patriots will win the Super Bowl next year. Vegas oddsmakers would laugh in my face. There are 31 other NFL teams who follow the same rules. Even though some teams are better than others, forecasting that any individual team has a 95% chance of winning the Super Bowl would be crazy.

But what if the Patriots did end up winning the Super Bowl? Was my initial forecast of 95% proven “correct” given the outcome? No, because the ex-ante probability of an event is separate from the outcome. If you replayed the season 1,000 times, the Patriots wouldn’t have won 950 Super Bowls.

Skilled, Lucky (Photo Courtesy: United Artists)

Similarly, if I claimed “I have a 100% chance of rolling a six on this dice roll,” and then I happen to roll a six, that doesn’t prove me right. It proves me lucky.

It’s important to remember this point when judging an investor: don’t assume someone is a great stock picker based on a sample size of one. With a sample of one, the best you can do is decide if their stock pick made sense at the time, before they knew the outcome.

So Michael Batnick is right, there are plenty of pitfalls investing in a single stock, even one that performs well over time. Excessive volatility triggers emotional decisions, and emotional decisions are usually mistakes.

But you should also not assume your friend is the next Peter Lynch because they got a great return on a one stock. More information is needed.

Bad Incentives and Portfolio Managers as Salesmen

This is part one in a series about how active management could be better. This is my perspective alone. Of course, the dynamics I describe do not apply to all managers. In a prior piece, I explained how active managers could theoretically outperform their benchmarks; now we arrive at the question: why don’t they?

Part One: Bad Incentives and Portfolio Managers as Salesmen

Incentives are powerful. They unconsciously motivate everything we do. Even with the best intentions, the wrong incentives will keep pushing us to do the wrong thing. “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it,” says Charlie Munger.

Across vast swaths of the money management business, the incentives are broken, causing a vicious cycle that erodes returns. I will describe how this dynamic plays out.

There is a giant pool of portfolio managers (PMs) trying to build a track record. In such a large field of PMs, some will have periods of strong performance. Some perform well due to talent, others due to luck.

For a PM who shows good short-term performance, the incentive is to sell based on that performance. It’s hard to resist because the PM gets most of his income from a percentage fee on assets. The more the PM wants that new vacation house, the less he cares about his strategy’s fit for prospective clients. The prime directive is to grow AUM and ask questions later. He might employ a sales team whose bonus is tied to short-term inflows. Because the sales team has no long-term incentive, they will be eager to please. With these incentives, every prospective client seems like a perfect fit for the strategy.

Second prize is a set of steak knives.
Due to the laws of probability, the strategy does not outperform forever. Now that the PM has built a sizable AUM, his incentives shift to retaining assets. When performance lags, there is enormous pressure from clients to defend every quarterly return. The PM may say “some periods of underperformance should be expected in this strategy,” but that’s not how he pitched it when times were good. Clients are upset. The PM becomes myopic, short-term focused. There is pressure to hug the benchmark. It becomes harder and harder to stick to the strategy that gave him success in the first place.

It doesn’t help that many large clients want active managers to hug the benchmark. Many prefer closet indexers. Many consultants rank PMs using “optimization formulas” that heavily penalize managers for deviating from their benchmark. In my opinion, this is an area where the industry has lost its mind. If you don’t want deviation from the benchmark, don’t hire active managers—buy an index fund. If you just want less deviation from the benchmark, allocate less to active management!

Most equity managers don’t believe they can outperform every single year, much less every month. Not everyone is Renaissance Technologies. Most PMs have long-term investment strategies; they expect to have good years and bad years.

But misaligned incentives create a bad dynamic: when performance is good, the incentive is to sell fast, grow AUM, and ask questions later. This creates a poorly-fitted client base of impatient investors with unrealistic expectations. When performance lags, PMs feel pressure to become defensive or hug the benchmark, forgetting what brought them success in the first place.

What can be done about the problem of incentives?

Underlying almost every problem with active management is an uncomfortable fact: there is still more of it than we need. Too many PMs try to grow AUM without making sure clients are a good fit. Too many clients hire active managers without understanding the strategy. They develop unrealistic expectations and don’t stick with the strategy long-term. For many investors, indexing is a better approach. Encouraging more investors to use index funds will improve active management.

The other problem affecting PMs and their clients is a culture of impatience and desire to get rich. For most of us, active management shouldn’t be about getting rich quickly; it should be about getting rich eventually. Active managers should charge lower base fees (fees based on a percentage of AUM). When possible, they should use long-term performance fees and invest more of their own personal savings in their strategies. Aligning these incentives places the PM’s primary focus on long-term returns, not month-to-month AUM.

Finally, active managers need to focus on setting the right expectations and building trust. Some PMs have been model citizens in this regard. Seth Klarman’s Baupost Group has gone so far as returning money to investors when it doesn’t see enough good investment opportunities. If clients understand an investment strategy and trust it for the long term, the manager won’t need to do backflips every time quarterly performance lags a bit.

Changing these incentives would certainly benefit clients, whose fortunes are on the line. For many PMs, this could mean less money. But the system would be fair—the best active managers could thrive just by implementing their strategy. If they skillfully invest a sizable chunk of their own money, they will earn great returns for themselves. With great returns, they can attract a well-fitted client base and build a solid foundation of trust. It may take a bit longer, but everyone will be better off in the end.

Stock Picking and the Zero-Sum Game

Most stock fund managers fail to outperform their benchmarks. This is a widely discussed and repeatedly corroborated phenomenon. There are studies showing abysmal rates of outperformance among active U.S. equity managers in recent years. Warren Buffett made a famous bet against hedge funds that looks better every day. The flow of funds from active to passive (index) investing is one of the most popular discussion topics in modern investing.

All this raises the question: is it even possible for actively managed funds, as a group, to outperform passive funds?

When index funds gained popularity in the ‘80s and ‘90s, many professional investors dismissed them, believing that any decent business school graduate could outperform the market. Now, some commentators dismiss outperformance as an impossible challenge, arguing that market “efficiency” has wiped out the possibility of achieving excess returns.

Amid this discussion, a well-worn maxim is the idea that stock picking—and therefore active management—is a zero-sum game. The idea holds that market participants, as a whole, cannot outperform the market, and therefore active participants, as a whole, cannot outperform passive participants. The zero-sum game concept is often touted as an argument for passive management or for the futility of active management.

By rephrasing an assertion from William Sharpe, we can define the zero-sum game concept of markets in the following way:

The Zero-Sum Game Rule of Markets: Before costs, for any distinct set of securities, the collective return of all active participants must equal the collective return of all passive participants.

This is simple enough logic. For a distinct set of securities, any excess return achieved by one active participant comes at the expense of another.

This logic can be misused in common discourse by suggesting that actively managed funds as a group cannot, by some immutable law of finance, outperform the market. Although there is ample evidence that most actively managed stock funds have performed poorly in recent years, the zero-sum game concept does not suffice as an explanation. It is theoretically possible for active funds, as a group, to outperform passive funds, as we will see below.

Actively-Held Stocks vs. Passively-Held Stocks: a True Zero-Sum Game 

Let’s imagine the universe of equity shares split into two buckets: passive and active. The passive bucket represents all shares held by those who can only hold stocks at the market weight. The active bucket represents all shares owned by those who can hold and trade shares at any other weight. The active participants determine the market weights of all equity shares, while the passive participants must accept the market weights. Combined, the two buckets represent all publically traded equity shares. For simplicity, we will exclude fees and assume that the passive investors can invest perfectly with zero tracking error. The two buckets look like this:

Given these assumptions, the passive bucket and active bucket will always have the same return. The returns of individual active participants may differ widely, but as a group, their stocks cannot outperform the stocks held by passive participants. This is a true zero-sum game.

But, as William Sharpe also points out, there are a number of ways that active equity funds could outperform the market.

Active Funds vs. Passively-Held Stocks 

Remember that the zero-sum game rule holds true for a distinct set of securities (i.e., the set of all stocks). But active equity funds are not bound by this set; they can choose to substitute some amount of cash, bonds, or other securities outside of the set held by the passive funds, as illustrated below:

In theory, one advantage held by active equity managers is that they have a broader investable universe than index funds. And because they can reach beyond the set of securities held by the market, they could collectively outperform it. In theory, they could hold more cash in falling markets and less cash during rising markets. They could short equity futures in falling markets or sell covered calls in flat markets. This is the crucial distinction: while the returns of active stocks must equal the returns of passive stocks, the returns of active funds do not necessarily equal the returns of passive funds.

Consider the following example in a hypothetical stock market. Imagine there is one passive fund, one active fund, and other active participants who trade stocks at a variety of weights. For the first half of the year, the stock market returns -5.00%. For the second half, the market returns +10.53%. To exclude the effect of stock-picking, imagine the active fund invests all of its stocks at market weights and only adjusts the size of its cash position.

For the full year, the return of the passive fund equals the market return. But imagine that the active fund held 15% in cash for the first half of the year and 1% in cash for the second half. Assuming cash returns 0%, the results are summarized below:

The active fund outperformed the passive fund simply by modifying its cash position. Because active funds can reach outside of stocks into a broader investable universe, the zero-sum game rule does not prevent them from outperforming the market.

Active Funds vs. Other Active Participants 

Of course, there is a second (and perhaps more obvious) source of potential outperformance. Excess returns for active funds could simply come at the expense of other active investors. Anyone else who trades stocks at non-market weights including individual investors, corporations, and employee stock-plan participants (the supposed “dumb” money) could underperform, effectively transferring excess returns to professional fund managers (“smart” money).

Conclusion

This exploration is simply a reminder that actively managed equity funds could, in theory, outperform the market, and that the zero-sum game rule does not prevent them from doing so. None of this is intended as an argument for, or against, active management.

The interesting thing is that most active funds don’t outperform the market. The reasons for this deserve further exploration. Structural causes of underperformance, along with thoughts on how to tackle them, will be the subject of future pieces.