Putting A Price On Investment Strategies

How much should you pay for asset management? It’s a question that comes up routinely in my travels in finance. There’s no standard answer, but most investors (and institutions) should err on the side of caution when it comes to paying hefty fees. The world is awash in claims of success for adding value over investment benchmarks, but comparing audited results with passive indices and/or simple rebalancing strategies begs to differ. Even before adjusting for taxes and trading costs, truly superior active management is a rare bird.

Unconvinced? Here’s a simple test. Take a look at a two-year chart for Vanguard Total Stock Market (VTI) and Vanguard Total Bond Market (BND) on Yahoo Finance. VTI, which tracks a broad measure of U.S. stocks, is up around 15%; its U.S. bond counterpart, BND, is higher by roughly 5% (returns as of Dec. 2, 2011). If your portfolio’s return for the last two years is inside those performance bands, it’s a sign that maybe your strategy delivers less than it appears and/or you shouldn’t be paying much for the strategy. Yes, some investors have returns north of 15%, perhaps far higher. But that begs the question: What risks did they incur to get there? It’s no great shock to find that you could have earned far higher returns for assuming greater risks. The challenge, of course, is generating strong returns while keeping a lid on risk. History reminds that that’s a much tougher trick to pull off.
Granted, the above test is hardly the last word on portfolio attribution analysis. But I’m guessing that a large number of investors, perhaps a majority, earned returns within the 5%-to-15% range since December 2009. Ditto for the vast majority of multi-asset class products available as ETFs and mutual funds. Adding value over a relevant benchmark is tough within a given asset class, and it’s no easier for multi-asset class strategies either, as I recently discussed.
Consider the record for big-cap equities. Tom Lauricella in The Wall Street Journal today reports that “over the past 15 years, 42% of large-cap stock funds have posted better annualized returns than the S&P 500, according to Morningstar Inc.” That may sound like an invitation to dive head first into active trading (or buying a fund that seeks to beat the market). But the 42% tally overstates the case. “The odds are actually much, much worse for investors,” Lauricella continues.

That’s because fund companies shut down poor performers, removing the lousy track records of their managers from the public eye—but not the damage from investors’ accounts. What results is so-called survivorship bias.

For example, as of September, fund companies had merged or liquidated 41% of the large-cap stock funds that were in the bottom 25% of the group between September 2001 and September 2006. That’s according to statistics compiled by S&P, using a database from the University of Chicago that eliminates the survivorship bias.

Going back another five years, 42% of the funds that had been in the bottom 25% for the five-year period of June 1996 through June 2001 no longer existed five years later.

Meanwhile, just because a fund survives and does well for a period of time doesn’t mean the odds are in favor of it continuing to outperform. Just 12% of the large-cap funds that landed in the top 25% in that 2001-2006 period also landed in the top 25% over the subsequent five years, according to S&P.

Here’s an even grimmer statistic: Over the five years ended September 2011, only 6% of all U.S. stock funds held onto a top-half ranking for five straight 12-month periods.

The numbers, of course, vary for each of the major asset classes, but the basic lesson is unchanged. It’s really, really tough to generate positive alpha over time. All the usual suspects conspire against the best-laid plans of active investors, including higher trading costs and taxes.
More generally, it’s hard to see around corners. To take the obvious example: How many times have you heard that the bond market was in a bubble over the last year or two? Quite a bit, by my reckoning. Yet bond prices have continued to push higher, Treasuries in particular. The market can stay irrational for longer than most of us can stay solvent, a lesson that even the bond king himself—Bill Gross of Pimco—learned the hard way this year.
The main lesson is that you shouldn’t pay a lot for beta. True for individual asset classes, true for multi-asset class strategies. Over the last three years, my proprietary, unmanaged, market-value weighted benchmark of all the major asset classes—the Global Market Index—generated an annualized total return of 11.8% through the end of November 2011. You can replicate GMI for under 50 basis points with ETFs. Clearly, no one should be paying 100 or 200 basis points for this strategy or anything that resembles it. So, how much should you pay a manager to oversee your money? Or an asset allocation fund? Probably a lot less than what most folks (and institutions) end up paying.
Don’t misunderstand: I’m not arguing that asset allocation strategies should be passive. Indeed, as I discussed in my book, Dynamic Asset Allocation, the academic literature and the empirical record make a strong case for some degree of active management of the asset mix. But we should be careful lest we go too far down this road, as some basic strategy benchmarks remind. The threat of diminishing returns rises quickly in this arena.
For instance, a simple year-end rebalancing of GMI has a history of boosting returns by 50 to 100 basis points a year with comparable (if not lower) levels of volatility. Meanwhile, equally weighting the major asset classes and returning the portfolio to equal weights every December 31 does even better. A number of products charging high fees are effectively repackaging these basic strategies and gouging investors in the process.
The idea that you can do quite well by diversifying across asset classes and applying some simple risk-management techniques like rebalancing is hardly a secret. For example, take a look at the competitive results of Paul Farrell’s Lazy Portfolios.
Yes, you can do better with more active and “sophisticated” strategies. The reality is that that most investors stumble with trying to outsmart the market through time. But the hopeless hope that everyone can be above-average persists in money management. In no other industry is so much empirical evidence ignored. No wonder that most of the finance industry’s customers have such a hard time locating their yachts.