Misleading statistic: "We selected the 25 percent of funds with the best returns over those 12 months — and then asked how many of those funds actually remained in the top quarter in each of the four succeeding 12-month periods through March 2014."
The statistic that matters, as Warren Buffett and others have repeated again and again, is COMPOUND RETURN!!!
Consider these two investment options. Option 1 outperforms 60% of the time (three out of five years), but Option 2 produces a greater compound gain:
YEAR Option 1 Option 2
Year 1 8.0% 15.0%
Year 2 8.0% 7.0%
Year 3 8.0% 4.0%
Year 4 8.0% 19.0%
Year 5 8.0% 6.0%
Total gain 46.9% 61.4%
Compound/yr 8.0% 10.1%
The study I'd love to see is one that finds out (1) whether there are actively managed funds that consistently produce better compound returns than the indices over five to 10 year periods, and (2) whether there are any unusual concentrations of long-term compound outperformance that cannot be explained by chance among those funds.
For example, what if it turns out that only a small number of actively managed funds are consistent long-term outperformers but many of them claim to use the same investment methodology? That would be a very unusual concentration of long-term success. I'd love to see a study with that kind of analysis.
It depends who you are and what you're looking for.
If you're the fund manager, owner, or an individual investor, then compound return absolutely matters. You want the most amount of money at the end of the time period, and you've already committed your capital.
But if you're a retail investor trying to decide where you want to put your capital - which, presumably, is who this article is aimed at - what you're looking for is whether the fund in question will outperform your alternatives. What this article is saying is "past performance is no guarantee of future results", i.e. you do just as well putting your money in an index fund or investing via a dartboard as you would picking the top-ranked fund in last year's returns.
You don't get to travel back in time 5 years to make your investment decisions, so compound returns in the past are immaterial to you. You want the highest compound returns in the future, which on average come from passively investing in the indexes.
The problem is that the article does not make that link. Because a manager does not remain in the top quartile of his/her PEERS does not mean they necessarily under performed the index...
You don't get to travel back in time 5 years to make your investment decisions, so compound returns in the past are immaterial to you. You want the highest compound returns in the future, which on average come from passively investing in the indexes.
1. This is an article of faith.
2. "On average" doesn't matter. How much effort is required to stay away from the low end of that average is what matters.
Wouldn't you just need to look at total returns? For example here's a list of mutual funds sorted by 5 year returns http://www.barchart.com/funds/5year.php The S&P is up 77% over the last 5 years so all those funds beat the market.
The problem is we don't know which funds are going to beat the market over the next 5 years.
I'd just like to point out that the majority of those are sector funds, so it really doesn't make sense to compare it to a broadly-diversified index like the S&P 500. On top of that, many of the high-fliers in that list are leveraged ETFs, which magnify gains and losses, and would not be suitable at all for long-term portfolios.
Why not? If I have $1 to invest, I can choose either and want to know which will give me a better return after X time. Should I go broad, or sector-specific? Which has more risk? Reward?
Great point! The only quibble I have is that 'compound return' doesn't include fees. However, 'total return' includes both fees & distributions (such as dividends).
If we use fairly common fees, the table looks more like this:
Option 1: 0.25% fee, Option 2: 1.5% fee
Year 1 7.75% 13.5%
Year 2 7.75% 5.5%
Year 3 7.75% 2.5%
Year 4 7.75% 17.5%
Year 5 7.75% 4.5%
Total gain: 45.2% 50.7%
Compound/yr 7.75% 8.5%
Once you include the fees (especially if the fund has a 'load' or sales fee) actively managed funds have to do significantly better than low fee index funds just to match total performance.
Why exactly do you think calculating compound return and fees are mutually exclusive? If you want compound return net of fees then you simply calculate that. As a rule most mutual funds do in fact report their performance net of fees.
Actually, I would argue that for the purpose of what the article was trying to convey, they used the right statistic.
Let me illustrate by running with your own suggestion of trying to find out whether there are actively managed funds that consistently produce better compound returns than indices over 5 year periods. How would you actually do that?
Certainly we agree that a fund outperforming an index over one 5 year period is irrelevant to answer that question. To check whether there is a fund that consistently outperforms an index over 5 year periods, you would look at several such periods, e.g. 5 consecutive 5 year periods (for a total of 25 years of data [1]).
This is exactly analogous to the statistic used by the article, and somebody could then make the argument (like yourself) that a misleading statistic is used, and that people should instead look at the compound return over the entire period of 25 years.
There is nothing wrong in principle with the statistic used by the article.
However, it is reasonable to argue that looking at compound return over a 1 year period is too short (because typical investment time horizons are longer), and I would agree. Unfortunately, there's [1].
[1] And obviously, using such a long timespan is itself problematic for many reasons.
Right, that's absolutely a problem, but it's orthogonal to the supposed problem that OP was mentioning (e.g., it could be that those funds are so bad that even the top quartile doesn't outperform the index in a particular period).
Or perhaps OP intended to refer to this problem, and it just wasn't done very clearly.
I would be surprised when a study comes out proving the opposite, given that there are strong proofs why beating the market average is difficult: http://www.norstad.org/finance/tsmproofs.pdf. Sure none of these profs exclude the possibility of a small set of consistently winning super managers. But then again even if such superstars exist, ultimately their performance is bound to be self-limiting.
Yes we're talking about the S&P500 but I'd like to point out that this isn't a general rule of markets; past performance does not guarantee future results. The S&P500 was at around 60 in 1960 and near 2000 today. It doesn't matter when you bought or at what intervals, money invested has performed well.
nhaehnle's reply contains the fundamental error in your post, but there is another issue, which is that variance doesn't go away when you take the long run. Option 2 has more variance, and this doesn't get averaged out in the long run. Each year adds more variance to your wealth, which is a bad thing.
Sure, the variance on the yearly rate of return will shrink as the time horizon grows. But because the yearly rate is compounded, this doesn't prevent the total variance in returns from growing with time.
Long term investment doesn't cure the risk from volatile investments.
Nothing new here. Mutual funds are just a way for fund managers to charge inflated management fees for average to below average returns. Get a basic index fund and save the fees. The few years the managed funds beats the index funds will easily be offset by all the fees and other gotchas.
only problem with the index funds Is you have to buy the dogs in the index an active managed fund can get out of situations like the uk supermarkets and banks.
I number of my actively managed investments did this so now an index fund will realistically always under perform this active fund.
The entire point of decades of research, and the above article, is that next to nobody can reliably tell you in advance which stocks are "the dogs." I'm glad for you, but if you want to convince me your active funds can reliably beat the market you would need to provide me a lot more data, as you are swimming upstream against a raging torrent of empirical research.
> And Mr Buffet's investment company has beaten wall street for decades.
The difference is that he has significant inside information into many of his investments. He deeply researches the companies involved, talks to their owners, etc. He is far smarter than your average investor but he also purchases companies with far more information than your average investor.
This is a great point. Warren doesn't just hand his money over, he buys a controlling share and starts telling companies what to do. Very different from a passive investor.
It's not clear to me whether you meant to accuse Mr. Buffet of criminal behavior, here. There is certainly public information that is harder to get than other public information, but trading on inside information is a crime.
Public / Private information is only an issue when companies are publicly traded.
If you go to buy a private company you can get a lot of non public information. The same thing happens when you try and take a public company private with the caveat that you can only use that information to back out of a deal not make your first offer. AKA, you get to do an audit after the terms where agreed upon and only get to back out of you discover major issues.
I suspect jayvanguard is not talking about Berkshire Hathaway's public company investments (for which I'm sure Buffett does not use material non-public information) but Berkshire Hathaway's private company investments and acquisitions. These make up more than half the company's market cap, I believe.
not a first he didn't its only when you fund get that's big you have to start taking big positions. And fund mangers out and talk to companies - do you think that Neil Wollford does'nt have similar access
And Tesco didn't work out to well for him anyone who follows the markets could have told you that the supermarket where doing lots of dodgy stuff
The very name Berkshire Hathaway came from a failing textile company that Buffet bought control of. Incidentally, he regards it as the biggest investment mistake he ever made.
And the article misses the down side of index funds tracking errors and having to keep funds univested to account for redemptions and the fact that some types of investments hare hard to run as an index fund PE and VC
Index funds are usfull for some investors for some of their investments but they are not the holy grail.
The point is that those active funds mess it up so badly when the market is doing well that the performance of the index funds is still better over the long run.
Some do you just have to know what your doing and be prepared to invest against the market BKY LWY and TRY in the UK have done very very well for me over that last decade.
many of my long term active investments have beaten the market over 10 years by over 100% you just need to look at the ones with 50-100 years track records
Look at the average IT vs Unit trust vs bench mark
The title of this article implies that no funds beat the market over time, and that isn't true. The study it is based on (which was done by S&P, a company that profits when people invest based upon their index) doesn't look at overall returns. It looks at whether any funds were in the top 25% for the last 5 consecutive years.
The answer is no, but who cares? Profitable investing is far more about how right you are (when you are right) than how often you are right.
For those interested, Vanguard has some of the lowest cost unmanaged index funds.
Unmanaged funds typically follow indexes and lose you the least in fees, which is useful for those to subscribe to this idea that no one beats the market in the long run, and thus invest mostly in index funds.
If you want to be mildly outraged, compare your 401k program's S&P 500 tracking fund's fees with Vanguard's. Depending on your company, it can be more than 20x the cost, for a fund that requires minimal oversight.
My coworker at an old job did exactly that: found a matching Vanguard fund with nearly identical funds to our 401K. It had 1/6th the fees and that company lost a significant amount of my money. The tax benefits of the higher tax free cap for 401K's versus just having an IRA were definitely not made up for by how poorly my 401K's investments went.
I personally use Charles Schwab (just because I have my bank account with them) and Wealthfront to invest in ETFs.
Schwab is comparable with Vanguard in terms of fees and ETF availability, so I never bothered with opening up an extra account at Vanguard.
I use Wealthfront to diversify my ETFs. They take care of distributing the money I put in the account among several areas of the market (U.S. Stocks, Foreign Stocks, Emerging Markets, Dividend Stocks, Natural Resources, Municipal Bonds and Cash).
They mostly use Vanguard funds. I could probably also do this myself, but I don't really want to manually balance my portfolio every time asset classes go up and down. So far I only put the amount of money in there that they manage for free. If you intend on signing up, one word of caution:
I signed up on their homepage and had 10k under free management. If you sign up via a referral link, you get 15k. I'm still slightly annoyed that I didn't use one when opening an account. I know that it's against the usual HN policy to post them, but since it is detrimental to sign up without one, here we go: http://wlth.fr/196dDW2
(I'd check with my friends first to see if one of them is already on the platform)
I've tried both Wealthfront and Betterment and found Betterment to be much more usable. It's out-performed Wealthfront in the past 9 months or so (but over the long-term my guess is that they'll both perform similarly) Have you tried both? http://danielodio.com/betterment-vs-wealthfront-which-one-wi...
I looked at both of them initially. As far as I recall, at least back then, the fee structure for people that initially only have a small amount of money invested (10k or so), Wealthfront was slightly better.
I also like Wealthfront's UI. Not that I'd do a whole lot besides click the "add more money" button and look at the graph. Turbotax import worked nicely too.
Looking at fees I think you will be better off at Vanguard if you have at least 10K. You can also get Vanguard Target Retirement with 1k and expense ration of 0.18.
There is an entertaining public fight going on between Wealthfronts and Schwabs CEOs about their robo-investor options. Once the big boys get involved I have a feeling Wealthfront, Betterment and others are going to feel the pinch. Schwab has their offering now with zero fees (except for those from the ETFs owned).
These are the two posts I still have on my "read later" list.
I assume both of them are pretty good compared to other options (stock picking, mutual funds, ...) :)
Do you have any backtest links that show a small cash position 'is an incredibly bad idea'?
A small cash position is another diversification strategy. As your portfolio increases in value, taking some profits to cash and then having it available on the dips may be perfectly valid. Buffet himself has called cash the never expiring call option.
As far as I understood, target retirement funds will switch the allocation from stocks to bonds once you get close to retirement. With the robo advisors, you'd have to manually move your risk tolerance downwards.
I personally would hate to have that happen in an automated way. I don't want the fund to automatically move over during an economic downturn. I'd rather have it happen while the S&P is at a new high :)
If you happen to live in Sweden, i would recommend Avanza Zero[0]. Swedish index fund with no fees at all, not even courtage. (I do not work for Avanza or have any affiliation)
Swede & Avanza customer checking in. Can definitely recommend them. If you reside and Sweden, make sure to open a ISK, not an Aktie- och Fondkonto (stock & fund account).
Living in Germany and have not been able to find a bank with the same kind of service and reliability. Comdirect comes close, but not good enough for me to close my account with Avanza.
I remember that this seemed very appealing when I first looked into a place to buy ETFs. I then opened the Schwab account because I really enjoy their checking account and they are, as far as banks go, pretty solid and not prone to screwing customers over.
Actively managed funds struggle to beat the market over the long term. There's a lot of evidence that passive investing (i.e. just buying a low-fee index fund) is the way to go right now for most investors.
The presence of active management, however, is good for the rest of us. Through their struggle to beat the market, they conduct extensive research that is used to better price public equities.
Those better prices help the passive participants, since they pay roughly correct prices for the dividends they will be receiving.
There's not much emphasis on risk in this article. If some fund returns the same as the market with less risk, that's arguably beating the market. If you can get leverage from anywhere (such as a mortgage) you can invest more in such a fund than you otherwise could and make more money.
This article is extremely misleading about the statistics it presents. It claims that you could outperform the funds by investing in random stocks, but the probabilistic model presented in the "source" article (http://www.nytimes.com/2014/07/27/your-money/heads-or-tails-...) is a completely different system.
It assumes that every 12 month period, there is a 1/4 chance of being in the top quartile of funds, which is an absurd assumption and also completely unrelated to modeling success of picking random stocks. Sure, there'd be a 1/4 chance of being in the upper quartile of other funds ALSO INVESTING RANDOMLY. But to say you'd have the same chances of beating other actively managed funds makes the assumption that all the other funds are not doing any better than random investment. Big surprise that the conclusion is that funds don't do any better than random investment.
For this objection to be meaningful wouldn't the group of funds as a whole need to have outperformed the market as a whole? The average of the return of all stocks in the market is the same as the average of an infinite number of random samples from the market.
Not that I would advocate for investing in actively managed funds, but my understanding is that part of the reason it's been very difficult to beat the market these past years is because stocks as a whole have been doing very well.
At least for value investors like Warren Buffet, it seems they are more likely to be able to beat the market when it isn't so bearish, because that's when you'd be able to find stocks at good prices.
It also appears that the reason stocks are doing so well recently is because of quantitative easing, although I'll admit I don't know much about the economy; this is just what I gather from reading articles. Still, if this is true then it's rather disturbing that the markets can be so heavily influenced by decisions which are arguably outside of a business's direct control.
The reasoning goes like this: 2/2862 funds made it (or about 0.07% of funds).
The author then says: If you assume a fund has a 50% chance of beating the market, and a 50% chance of falling behind then the chances of one beating the market five years in a row would be 0.5^(5 * 2). They just state that they flip a coin twice per year per fund (hence 0.5^10), can someone explain why?
"Beat the market" is misleading. In the article "beat the market" means be in the top 25% of the market, therefore equivalent to winning two coin flips each year.
"Still, those two funds did manage to perform splendidly in that study. Their stubborn persistence at the top of the heap over that five-year period suggested that there was some hope for active fund managers. If they could do it, after all, others could, too."
If the authors expected randomly picking stocks to churn out 3 mutual funds that beat the market 5 years in a row then this explanation is nonsense. Their "stubborn persistence" is just an empty narrative slapped over a blatant case of survivorship bias. This paragraph makes it seem like whoever wrote it didn't understand any of the rest of the article.
" The truth is that very few professional investors have actually managed to outperform the rising market consistently over those years."
To be honest, the market has been performing so well I don't really care if my portfolio outperforms it. My index funds have been doing pretty well by themselves.
For an interesting perspective by a guy who runs his own hedge fund, but also appears to have a lot of insight into his own performance and the way the market works, read "Fooled by Randomness" by Nassim Taleb
Of course they have, that's the expected statistical outcome of thousands of funds. The problem is that
1) You were lucky in picking those, not prescient.
2) Their winning streak is a result of luck, not competence.
Funds are a perfect example of survivorship bias in a zero-sum game. For someone to win at beating the index, someone else must lose, and losers are routinely eliminated. So when an investor presents funds for your choosing, you only get to see the lucky ones, a biased sample. Of course it looks like a great idea to invest in them!
You do know that those funds have decades and some IT's cases century's of history behind them.
The funds I mentioned have very good track records for 3 or 4 decades or more its just that they don't pay advisors fees or pander to tracking the "index" why do you think a number of very rich families have used active funds? If its good enough for Lord Rothschild its good enough for me.
> In other words, if all of the managers of the 2,862 funds hadn’t bothered to try to pick stocks at all — if they had merely flipped coins — they would, as a group, probably have produced better numbers. Instead of two funds at the end of five years, basic probability theory tells us there should have been three.
Um. You are trying to tell me that 2 instead of 3 is enough to reject the null hypothesis? I rather doubt it.
The statistic that matters, as Warren Buffett and others have repeated again and again, is COMPOUND RETURN!!!
Consider these two investment options. Option 1 outperforms 60% of the time (three out of five years), but Option 2 produces a greater compound gain:
The study I'd love to see is one that finds out (1) whether there are actively managed funds that consistently produce better compound returns than the indices over five to 10 year periods, and (2) whether there are any unusual concentrations of long-term compound outperformance that cannot be explained by chance among those funds.For example, what if it turns out that only a small number of actively managed funds are consistent long-term outperformers but many of them claim to use the same investment methodology? That would be a very unusual concentration of long-term success. I'd love to see a study with that kind of analysis.