Where Smart Money Goes.®
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Where Smart Money Goes.® |
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Active
vs. Structured Investment Strategies One
of the arguments prevailing in the financial community is which form of
investing, active or structured, is the superior investment strategy.
That is, which strategy increases a client’s wealth the most?
Are investors better off paying for active management or selecting a structured
approach? First, let's define
what is meant by active and structured investment strategies. An
active investment strategy tries to find information about securities (that is
not reflected in the current security price) to obtain above average returns.
It is characterized by consistent ongoing research to formulate superior
opinions in an attempt to profit from this judgment [1].
Its two primary components are market timing and security analysis.
Security analysis is an attempt to determine if a security is correctly
valued using fundamental analysis and technical analysis.
Fundamental analysts study financial statements and profitability
outlooks for companies and industries. Technical
analysis involves reviewing charts that combine security prices, volume and short interest data
to identify market and/or stock directions. Investors
utilizing a structured strategy believe in efficient markets (see MPT
section) and
that active management is mostly a waste of time and unlikely to justify the
expenses incurred. Structured investors do not try to find overvalued
or undervalued securities and they do not try
to outsmart the market. It
is primarily a buy and hold strategy with a majority of effort placed on proper
asset allocation and diversification. The
investor’s wealth is carefully divided among risk free assets and a portfolio
of risky assets to construct an efficient portfolio (see MPT
section). The portfolio is then monitored for style drift of assets and
is rebalanced on an annual basis (if required). Let's
see how both individual and professional active money managers fared.
In 1998, a study was performed on the common stock holdings of 78,000
household accounts at a major discount brokerage firm [2].
The sample was stratified as household (60,000), affluent (12,000) and
active traders (6,000). It analyzed
investment performance of these households from 1991 to 1996. In this study the gross annualized geometric mean
return for the value-weighted index was 17.1% and 17.7% for the average
household. On
the surface the 17.7% return seems good after all it beat the index but what about trading costs?
After trading costs and bid/ask spread differences the average household
return was 15.3% and only 10% for the most actively traded accounts.
The actively traded accounts earned over 7% less in net annualized
return than was generated by an indexed approach. Table
2.1
Next,
I will review the results of professional active investment managers. A 1997 study was conducted on 1,892 diversified equity funds [3].
It encompassed monthly returns from January 1962 to December 1993. In an average year the study comprised 509 mutual funds with an average
expense ratio (without load) of 1.14% and an annual turn ratio of 77% of their
assets. For the full sample, 64.5%
of the funds charged a load fee averaging 7.3%. It was noted that fund expenses reduced performance on a one-to-one ratio
and that transactions reduced performance by 95 basis points for each buy and
sell transactions. The study
concluded that mutual fund managers do not have superior stock picking skills
and that the major difference in returns was due to the mutual fund expense
ratios, portfolio turnover and transaction costs. The
study also noted that large returns are relatively short lived. It showed that the one-year return persistence was mostly eliminated
after one year. That is, a high
number of the top-decile funds dropped to lower ranks in a relatively short
period of time. In
the response to whether technical analysis can lead to increased portfolio
returns, studies have found that future security prices cannot be predicted from
past behavior. In fact, a study by
Malkiel suggests that there is no relationship at all between a fund's past performance and
its future performance [4]. Malkiel
studied whether a mutual fund investor could put together a mutual fund
portfolio, based on past performance track records, and generate superior
returns. Several
scenarios were examined to create this elite portfolio. The two scenarios chosen were: 1) the purchase of top performing funds; and
2) purchasing the Forbes “honor roll” funds. The rate of return presented in both strategies did not include sales
charges and load fees. The
first strategy involved ranking the funds based on their prior 12-month returns
and then purchasing the top 10, top 20, top 30 and the top 40 funds. Starting with a purchase in January 1973, based on the prior 12-month
returns, the investor would then annually switch to the top
performing funds from the prior year. This
would ensure that the investor would constantly hold the top performing funds. The
second study used Forbes (the most popular investors' magazine) “honor roll”
mutual funds. To make the Forbes
honor roll, a mutual fund has to have a long history (usually 10 years or more)
of performance and must meet certain consistency goals. Honor roll mutual funds must have performed well in both up and down
markets. They must be in the top
one half of all performers in the down markets. The
results of the first scenario are presented in Table 2.2. In the first two segments, the simulated returns are higher than the
S&P. In the last two
segments, the simulated returns are approximately equal to the S&P 500.
However, none of these returns include sales charges and load
fees. Alone, the average sales load
for these funds was 8%. You may
recall that, each year, the assets are moved to the prior year's best performers to achieve
these results. Adding in these
costs would have a large negative impact on the simulated funds' returns. Thus, with fees taken into account, it is clear that buying past top
performers does not increase one's chances for better future returns. In fact, it reduces them. Table
2.2
Table
2.3
As Burton Malkiel states in a 1995 article from the Journal of Finance, “Most investors would be considerably better off purchasing a low expense index fund, than by trying to select an active fund manager who appears to possess a 'hot hand.' Since active management generally fails to provide excess returns and tends to generate greater tax burden for its investors, the advantage of passive management holds, a fortiori" (p. 571). An
equally interesting part of Malkiel's study investigated whether greater mutual fund
management expense would lead to superior returns. The study analyzed all mutual funds that were in existence from 1982 to
1991 and investigated whether returns increase with increased management expense (i.e. more stock
research). The study separated
advisory and non-advisory expense. This
was done to remove non-advisory expense from the equation since non-advisory
expenses (ex. 12b-1, advertising, administration, etc.) should not be expected
to enhance fund performance. In
either case, with or without non-advisory expense, analysis of the data did not
find any
significant relationship between performance and the level of fund expenses.
The study went one step further and removed nine funds with extremely
high expense to reduce the variability. The
findings of this analysis were the same as before. In the words of Malkiel, “The data do not give one much confidence that
investors get their money’s worth from investment advisory expenditures” (p.
570). Let's
summarize this review of empirical research on active management data. A review of 78,000 individual investor accounts found
that after sales loads and trading fees investors did not beat the S&P 500
from 1991 to 1996. In a study on
1,892 diversified equity funds (i.e. professional active managers) over 30 years
(1962-1993) it was noted that the managers did not possess superior stock picking
skills. Lastly, we have indicated that technical analysis
simply does not work over the long term. In a review of buying recent top performing mutual funds or
buying the Forbes honor roll funds, it was shown that neither strategy increased
one's chances for better returns. Works Cited 1.
Rudd, Henry and Henry Clasing, Jr. Modern
Portfolio Theory: The Principles of Investment Management. Orinda: Andrew
Rudd, 1988. 2.
Barber, Brad M. and Terrance Odean. The
Common Stock Investment Performance of Individual Investors. University of
California at Davis and University of California, Davis - Graduate School of
Management. 1998 Working Paper Series 3.
Carhart, Mark
M. "On Persistence in Mutual Fund Performance." The Journal of Finance, Vol. 52, No. 1. (Mar., 1997), pp. 57-82. 4.
Malkiel,
Burton G. "Returns From Investing in Equity Mutual Funds 1971 to1991."
The Journal of Finance, Vol. 50, No. 2. (Jun., 1995), pp.
549-572. Copyright © 2008 Karmikel Investments - ALL RIGHTS RESERVED
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