What does the data say on how the retail investor should invest their hard earned money?
“The data showed that the top 2 to 3 percent had enough skill to cover their costs and that the other 97 or 98 percent didn’t even have that.”
First off some basics we are all aware that investors should be diversified.
A diversified investment is a portfolio of various assets that earns the highest return for the least risk. That’s because assets, such as stocks, fixed income, and commodities, react differently to the same economic event.
In a diversified portfolio, the assets don’t correlate with each other. When one rises, the other falls. It lowers overall risk because, no matter what the economy does, some asset classes will benefit.
They offset losses of the others. There’s also little chance that the entire portfolio will be wiped out by any single event. That’s why a diversified portfolio is your best defense against a financial crisis.
For most investors this mean investing in a fund so that their £x per month or other sum can be pooled with other investors and diversified efficiently. This will be with an asset manager and from the point of view of this article there are two types of fund that is actively managed and one that is passively managed.
Active management is the use of a human element, such as a single manager, co-managers or a team of managers, to actively manage a fund’s portfolio. Active managers rely on analytical research, forecasts, and their own judgment and experience in making investment decisions on what securities to buy, hold and sell. The opposite of active management is passive management, better known as “indexing.”
Passive management is a style of management associated with mutual and exchange-traded funds (ETF) where a fund’s portfolio mirrors a market index. Passive management is the opposite of active management in which a fund’s manager(s) attempt to beat the market with various investing strategies and buying/selling decisions of a portfolio’s securities. Passive management is also referred to as “passive strategy,” “passive investing” or “ index investing.”
In the UK firms such as Jupiter Asset Management make a big deal about the human (or active) element of their approach.
Information from here on is largely from the Freakonomics podcast on this topic so has a more American slant.
Many investors pay firms to manage their money — sometimes a percentage of assets, sometimes a flat fee. In return, you may get a variety of services — including advice about insurance or taxes. And, of course, investment advice: how best to save for a house, or your kids’ tuition, or retirement, whatever. Why pay someone for that advice? Because, let’s face it, investing can be confusing, and intimidating. All that terminology; all those options. So you hire someone to navigate that for you — and they, in turn, use their expertise to pick the very best investments for your needs. This is called active management. They actively select, let’s say, the best mutual funds for your needs. And you pay them for their expertise. You also pay those mutual funds, by the way — sometimes there’s what called a sales load when you buy it; and an expense ratio, a recurring fee the fund deducts from your account. So, between the mutual fund fees and the investment fees, that’s usually at least a couple percent off the top — and that’s whether your funds go up or down, by the way. So hopefully they go up. Hopefully the active management you’re paying for is at least covering the costs?
The data showed that the top 2 to 3 percent had enough skill to cover their costs and that the other 97 or 98 percent didn’t even have that.
It’s enough to make you think that maybe it’s not worth paying those investment experts for their expertise. If only there were some simple, cheap way to avoid all that active investing that often doesn’t pay off and just passively own, say, a small piece of the entire stock market. Well, as you may know, there is. They’re called index funds and E.T.F.s, for exchange-traded funds. They can be bought very cheap. And in recent years, a lot of people have been buying them.
The data shows that around a trillion and a half flowing into index funds and a half a trillion flowing out of active funds, which is a $2 trillion shift in investor preferences. It is definitely a revolution.
More and more people are starting to get the idea that rather than spending, let’s say, $10,000 to buy five different mutual funds, each made up of a basket of hand-selected stocks, you spend all $10,000 on one fund that simply tracks an entire stock index — the S&P 500, maybe. It’s going to be a lot cheaper than buying those separate, actively-managed funds — and, as the data have shown again and again — it will likely perform better as well. Over the past decade, according to The Wall Street Journal, “between 71 and 93 percent of U.S. stock mutual funds either closed or failed to beat their closest index funds.”
After all the data shows that if we go back to 1970, we find that there were approximately 400 funds in business and basically 330 or 340 have gone out of business. It turns out, in that period, there were two mutual funds who beat the market by more than 2 percent per year. Two! That’s half of 1 percent of all the funds that started in the business. Those are your odds.
DUBNER (from Freakonomics): “Harvard’s annualized net returns for the past 10 years were less than 6 percent. In fact, when you look at the top-performing Ivy endowments, they were all around 8 percent for those 10 years. Again, sophisticated, expensive management with access to all kinds of information and investments. Just out of curiosity I went and looked at my boring own kids’ college savings fund, which is stashed in a pretty dull and very cheap 529 plan. There’s just a handful of choices, index funds. There’s one growth fund, one value fund, a couple of bond funds, and it costs pretty much nothing. And lo and behold, my ten-year annualized net return beat every single Ivy endowment. Those are the best and the brightest. Why on earth would anyone want to pay those fees for active management, whether you’re an individual investor like me or a huge endowment like Harvard?”
However for all the news about the passive revolution, it’s worth remembering that only about 30 percent of all mutual and exchange-traded funds are being passively managed.
It should be noted that the financial markets go through this regular creative destruction every few years. Back in the early 70’s, commission prices were fixed. You couldn’t discount a commission if you wanted to. It was actually a legal regulation. Once that changed suddenly everybody predicted the end of the world of finance. “Oh my God, what’s going to happen? They’re going to start cutting prices!” That is what happened. You cut prices. More people were able to access the capital markets. It worked out really well.
Every few years we go through one of these major innovations. Not too long ago, E.T.F.’s didn’t exist. We take for granted that for five bucks I could go out and buy an E.T.F. of every major index I want.
So what did we learn?
“The data showed that the top 2 to 3 percent of actively managed funds had enough skill to cover their costs and that the other 97 or 98 percent didn’t even have that.”
“That passively invested funds over the long term have beaten even the top performing Ivy league endowment funds.”
Alastair Majury resides locally in the historic Scottish city of Dunblane, and is a Senior Regulatory Business Analyst working across the country. He is also a volunteer officer at the local Boys’ Brigade company, a charity which focuses on enriching the lives of children and young people, and building a stronger community. Alastair also serves on the local council (Stirling Council) as Councillor Alastair where he represents the ward of Dunblane and Bridge of Allan, topping the poll.
Alastair also has a post graduate diploma in Banking and Finance from the University of Stirling and also contributes to Data Driven Investor.