Footnotes
Footnotes
Uncertainty | Increasing Return|Track Record Investing|Total Portfolio Risk|Modern Portfolio Theory|Reducing the Size of Fluctuations in Portfolio Values|Passive Investing|Asset Class Mutual Funds|Index Mutual Funds
Because uncertainty implies risk, ordinarily the best way of managing the problem described by Markowitz – and encountered by all investors – is to diversify portfolios broadly. That is, investors should diversify because they don’t know what’s going to happen to a particular stock (or a small group of stocks, or even an asset class) in the future. Perhaps the motto of a prudent investor should be: “I can’t foretell the future – therefore I diversify.” In this way, diversification acts as a kind of antidote to uncertainty. Modern Portfolio Theory emphasizes defense (i.e., reducing risk which increases return) through diversification and low costs rather than offense (i.e., attempting to increase return) through stock picking and market timing.
Many investors focus exclusively on return. This is true despite the fact that they have no control over past returns (i.e., track records) because they’re past or future returns because they’re unknowable. Nonetheless, the “investment information system” (comprised of the media, mutual fund families, stockbrokerage firms, mutual fund ratings guides, investment advisory services such as Value Line and others) devotes considerable attention to return. Indeed, this system derives vast sums of money by encouraging investors to believe that they can predict investment return and therefore beat the market. Hopes of finding the next hot stock tip, identifying the next winning mutual fund or crowning the next guru saturate this world that many investors live in and from which they get their information about investing. This system is enormously powerful in how it affects the emotions of investors (both amateur and professional) and how it impacts their investment decision-making. The interest in reducing risk, costs and taxes pales in comparison. Yet the Uniform Prudent Investor Act places great emphasis on these simple and straightforward virtues and the critical role they play in assessing prudent fiduciary conduct.
Track record investing occurs when an investor identifies some investment such as a Morningstar 5-star mutual fund and invests in it because the investor thinks that its outstanding track record over some past time period will continue into the future. Reporter’s General Note on Restatement 3rd of Trusts (Prudent Investor Rule) Section 227 warns, however: “Evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.” The SEC reiterates this warning about track record investing by requiring all mutual funds offered for sale to feature some version of the following disclaimer: “Past performance is no indication of future results.” In addition, virtually every reputable study of mutual fund performance since the mid-1960s has confirmed that there’s no reliable way to predict when – or which – or even if – winners from the past will win again in the future. In fact, a mutual fund (or any other investment) that has performed well over a certain period in the past is just as likely to perform poorly in the future. What’s worse is that data often show the perverse tendency for superior track records to be followed by inferior track records. What does this say about many in the investment advisory industry that market their products based on track records? It says that their marketing efforts are centered on a factor – investment returns over which they have no control. It’s difficult to find an activity in the investment industry that has less value.
Total portfolio risk, according to Modern Portfolio Theory, can be separated into two kinds of risk: uncompensated risk and compensated risk. “Uncompensated risk” (which comprises about 70% of total portfolio risk) is the possibility that economic (and non-economic) news may impact uniquely the market price of a particular stock. For example, the price of Ford Motor Co. stock may go down as a result of the departure of a key Ford executive. An investor that holds only Ford stock can protect its portfolio against this risk by also owning stock in companies that are unaffected by the departure of Ford executives – a risk that is unique to Ford Corporation only. Since an investor can eliminate virtually all uncompensated risk from a portfolio with proper diversification, financial markets do not reward an investor for taking this kind of risk. “Compensated risk” (which comprises about 30% of total portfolio risk) reflects the economic and non-economic news that impacts the market price of many (or all) stocks. Since the prices of individual stocks are affected, more or less, by the risk of a general rise (or fall) in the value of the stock market itself, compensated risk is unavoidable by an investor that invests in the stock market.
The Uniform Prudent Investor Act incorporates a fundamental tenet of Modern Portfolio Theory by ordinarily mandating broad diversification of portfolios. Diversification is fundamental to proper risk management. The duty to diversify is so central to modern concepts of prudence that it is incorporated into the Prudent Investor Rule. The goal of diversification is to minimize a portfolio’s exposure to uncompensated risk so that the only risk remaining is compensated risk. A trustee’s duty to diversify uncompensated risk ordinarily applies to investing both across the asset classes that comprise a portfolio and within each such asset class. (An “asset class” is made up of investments with common characteristics.) Diversification across multiple asset classes can be thought of as a “horizontal” reduction of uncompensated risk while diversification within an asset class can be thought of as a “vertical” reduction of uncompensated risk.
Reducing the Size of Fluctuations in Portfolio Values
A mathematical concept known as “variance drain” holds that, as between two equivalently valued portfolios with the same average return, the one with the greater variance (i.e., volatility or fluctuations) will have a lower compound return. This suggests that efforts to maximize percentage return in each time period with the goal of maximizing the dollar value of a portfolio long term increases the possibility that there will be a shortfall in the portfolio’s expected dollar value. Ironically, then, an investor may fail to meet its objectives not because it didn’t seek maximum portfolio return, but because seeking maximum return (e.g., via stock picking or market timing) is often inconsistent with maximizing the probability that the portfolio will achieve sufficient dollar value.
“Passive investing” includes investing in asset class mutual funds and index mutual funds. Both types of funds are the same in the sense that their managers do not (1) pick stocks for the purpose of trying to beat the market, (2) market time, (3) engage in track record investing or (4) attempt to forecast the future. The advantages of passive investing derive from the simple mathematical fact that every financial market such as the stock market in the United States is a “zero sum game.” This is a game where some win and some lose relative to the return of a given market (or market segment).
The players who participate in the zero sum game of a financial market consist of three groups: (1) passive investors who earn the market return, (2) active investors who outperform it and (3) active investors who under-perform it. (It’s important to note that the amount of the “zero sum” is not 0, but the return of a financial market, which also happens to be the average return of all those who invest in the market. For example, the zero sum of the U.S. stock market in 2002 as measured by the Wilshire 5000 index – was a return of negative 20.85 %.) The losing active investors who underperform a financial market can be characterized as “sacrificial lambs” for the winning active investors who outperform it.
Consider four investors in a particular financial market – three active investors and one passive investor. Further consider that the market return was 30% last year and that one of the active investors outperformed that return – by 20 percentage points – thereby earning a return of 50%. The other two active investors MUST have collectively underperformed the market return by 20 percentage points. The fourth player (the passive investor) earned the market return (that is, the “zero sum”) of 30%. A passive investor is never a sacrificial lamb that loses to winning active investors. Note that the returns in this example are before costs and taxes. After they are taken into account, though, the one winning active investor actually earned less than 50% and the two losing active investors lost more than 20%. The “dead weight” of costs and taxes reduces the superiority of the winner, just as it increases the shortfall of the losers.
The same mathematical certainty demonstrated in this example holds true for yesterday, today and tomorrow and applies to any financial market (or market segment) in the world – whether “efficient” or “inefficient.” This mathematical certainty dictates three outcomes.
First, before costs and taxes, passively managed money will always outperform 50% of all actively managed money invested in any given financial market.
Second, after costs and taxes, passively managed money will always outperform more than 50% of all actively managed money.
Third, this percentage increases with time as the net performances of most (even superior) active mutual funds regress to less than the market return due to (a) the inevitable erosion of their good performances by bad performances, (b) the relatively high costs and taxes they generate and (c) the negative compounding these costs and taxes generate against accumulating wealth.
Modern prudent investment principles suggest that passive investing is the “default” standard for investing and managing trust assets. The evidence in support of this is compelling for a number of reasons.
First, the zero sum nature of financial markets means that all passively managed money invested in a particular market will earn the market return. In contrast, 50% of all actively managed money in a market (whether invested in mutual funds, separate accounts or other investment vehicles) will always earn a return less than the market return. This simple mathematical fact is sobering enough. What makes it even more sobering is that these active investment vehicles unpredictably take turns underperforming. This compounds the uncertainty facing the actively investing trustee (or its agent) when selecting investment products.
Second, the costs and taxes associated with passive funds are lower than those associated with many active investing programs. When costs and taxes are taken into account, significantly more than 50% of actively managed money underperforms in a market.
Third, passive funds are broadly diversified so they are relatively low risk. Actively managed portfolios, in contrast, aren’t as well diversified because they’re comprised of investments that differ from the market portfolio. By definition, this makes such portfolios relatively higher risk.
Fourth, passive funds don’t experience “style drift.” A passive fund ordinarily reflects the risk/return components of an asset class or index quite accurately. Style drift, in contrast, is present in many active funds. This can lead to a number of problems for the trustee holding active funds in its portfolios. For example, style drift can make monitoring difficult. Style drift can also lead an active fund to underperform its benchmark, possibly causing the trustee to replace the fund with another fund and thereby generate unnecessary costs. In addition, style drift can render imprecise the implementation of portfolio asset allocations. An important presumption on which a portfolio’s asset allocation is based is that the products used in the investment strategy to implement the asset allocation will be reflective of the asset classes comprising the allocation. Because of style drift, however, many active funds don’t reflect accurately their asset class “label.”
Fifth, passive funds aren’t subject to “manager risk” like active investment products. This is the risk incurred when a money manager is hired based on “superior past performance” (i.e., a track record) and it’s discovered later that the manager’s performance was due to luck, not skill. Even when the performance results from skill, the risk continues because it’s not known whether the skill can be repeated.
It is often asserted that passive investing is a mediocre way of investing because it earns “only” the market return. The theory of financial economics suggests, as empirical findings confirm, however, that passive investing actually results in long term performance that is in reality superior to most active investing programs. This is achieved, ironically, without even needing to beat the market.
It is important to understand that passive investing is no panacea for escaping investment risk. Even properly diversified portfolios of passive funds won’t protect investors from experiencing declines in their portfolio values during broad downturns in stock and bond markets. Although passive investing is the best way to rid a portfolio of as much uncompensated risk as possible, it can’t eliminate the risk of losing money. Portfolios of passive funds are very efficient in reducing risk, but they are not risk-free.
The manager of an “asset class mutual fund” seeks to capture the long-term performance of the underlying asset class associated with the fund by holding securities with comparable risk/return characteristics according to an identifiable factor such as market size.
The manager of an “index mutual fund” seeks to capture the long-term performance of the target index tracked by the fund. This is achieved by holding in the fund all (or a sample) of the investments that are represented in the index in the same proportional amounts. An index is representative of an asset class. Usually index funds track the performances of widely recognized indexes such as the S&P 500. Because a passive fund (i.e., an asset class fund or index fund) holds all (or a representative sample) of the investments that comprise a discrete asset class, it maximally reduces uncompensated risk within that asset class. No active fund can minimize uncompensated risk as well as a passive fund invested in the same asset class – whatever the number or combination of stocks held by the active fund. The uncompensated risk of a portfolio can therefore be virtually eliminated with passive investing.