Yield of Dreams

No More Clownin' Around: It's a Zero Sum Game

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ClownActIn the spirit of fairness and objective journalism, I wanted to point you to an article that makes counter-arguments to our December 2011 cover story, “ Is Tactical Investing Wall Street’s Next Clown Act?” “ The Real Clowns,” is written by our friend Ken Solow, chief investment officer and senior partner with Pinnacle Advisory Group and author of Buy and Hold Is Dead (Again): The Case for Active Portfolio Management in Dangerous Markets. I have to give Solow credit for being so passionate about something, and it’s always a compliment when a journalist’s work creates such controversy and discussion.

That said, I’d like to respond. Keep in mind, I’m no expert; I just talk to experts for a living, so many of these thoughts will be coming from them. Also, I have nothing against clowns; it’s a perfectly respectable profession. But how can you put the likes of Princeton University Professor Burton Malkiel, Author Mel Lindauer and even Vanguard Founder John Bogle in the same category?

Just last week, Bogle was at Bloomberg’s Portfolio Manager Mash-up, being asked the question, “Is buy-and-hold dead?,” to which he responded unequivocally, “I mean, really! As a group, we investors are buy and holders.” The people trading back and forth, he added, are not going to change the market’s return; the good ones will offset the bad.

I thought I’d let Lindauer, Forbes.com columnist and co-author, The Bogleheads' Guide to Investing and The Bogleheads' Guide to Retirement Planning, respond to Solow’s piece. I believe he tells it like it is:

Here are a few hasty comments:

“It’s different this time.”

“We’re smart enough to beat the market.”

“We have the secret formula.”

IMO, these and other similar types of claims, such as those contained in the article, are nothing more than marketing hype to confuse and seduce unsophisticated investors. Otherwise, if investors knew the truth, the money managers would have to find a new line of work. Every money manager wants you to believe that they can beat the market, when we know that statistically that's simply not possible. This isn’t Lake Wobegone.

While we do know that a certain percentage of active managers will likely outperform in any given year, there is no evidence to show that the same managers will continue to outperform over long periods. When one looks at the actual data, we see that fund managers who are top performers in one or two years often end up at the very bottom of the pile in succeeding years. And the real trick is to pick that rare manager who will outperform in any given period IN ADVANCE. (It's obviously very easy to do looking in the rear view mirror.)

There’s a reason there aren’t studies showing that active management is superior to buy and hold; the data simply doesn’t exist to support claims that active managers can outperform their benchmark on a consistent basis.

Compare that to the numerous studies and actual figures showing that low-cost indexing can and does outperform the majority of active managers over time. The evidence is overwhelming, as many academic studies have shown.

And, as Professor William F. Shape has shown in “The Arithmetic of Active Management”, the underperformance of active management is a matter of mathematical certainty. http://www.stanford.edu/~wfsharpe/art/active/active.htm

One can also look at the Standard and Poors SPIVA statistics to see the number of active funds that have outperformed their various categories over various period of time. And, as I said previously, many of those outperformers will not be the same year after year.

I had a college friend who was a broker, and he told me that when someone buys or sells something, the brokerage house makes money, the broker makes money and "two out of three ain't bad." (Obviously the poor third one was the investor.) It's all about the money!

And it’s not like these guys (Bogle and the like) have ignored the rise of tactical allocation. Even Vanguard took a stab at tactical investing with its Asset Allocation Fund, which it closed in September 2011. For the one-year, three-year, five-year and 10-year periods, the fund has trailed its index.

Registered Rep. hasn’t ignored the trend either. Buy-and-hold versus tactical has been highly debated in these pages. See our July 2009 cover story, or this column by Editor-in-Chief David Geracioti. Late last year I wrote a story exploring some of the real business risks posed by not going tactical during this time of uncertainty. I get that. Clients aren’t satisfied with the status quo. They want to see a change in the way you’re managing their portfolio, because as Geracioti has said over and over, “The unprecedented happens all the time.” I believe we’ve given that argument it’s due, but that was one Solow’s main problems with our December story:

The fact is things change, and markets earn less than average returns when they are expensive. While there is yet no Nobel Prize winning theory to promote tactical and active investing, it does at least offer the comfort of common sense. The theoretical basis for buy and hold investing is a tough case to make once you dig down and understand what you are asked to believe in order for the theory to accord with reality.

But I keep coming back to: active management is hard to do. Yes, there are some that have skill and do it right, perhaps even Solow’s firm, but they are few and far between. According to Research Affiliates’ recent newsletter, last year was the third worst year for active managers. When comparing a diversified 60/40 active portfolio to a 60/40 passive portfolio, the excess manager return was -0.7 percent in 2011.

There’s no doubt advisors have become more tactical. According to Cerulli Associates research, 61 percent of advisors now cite pure tactical allocation or strategic allocation with a tactical overlay as the foundation of their portfolio construction process. But the same Cerulli report points out that this does not benefit client portfolios in the long run. In fact, the data shows that between 2008 and 2010, investor returns lag the performance of the funds themselves in each traditional asset class. For example, for U.S. equity funds, the average fund one-year total return was 18.64 percent in 2010, versus an asset weighted return of 16.65 percent for investors. “This means that advisor allocations were rarely successful in anticipating future performance when selecting investment positions,” the Cerulli report said.

In summary, I don’t have anything against active managers, and I agree with Solow when he says they are “pursuing a craft that requires a great deal of skill.” But it’s a zero sum game. The numbers cited here tell that story. I applaud advisors for wanting to be more tactical and try something different with their clients’ portfolios outside of MPT, but more often than not, you won’t be able to make a difference. Some, by the rules of probability, are going to hit the bulls eye, but there are few that can do it well. If it was easy, we’d all be billionaires.

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What's Yield of Dreams?

Casting a gimlet-eye on asset management issues.

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