Bogleheads® on Investing Podcast 033 – Jeff Ptak, host Rick Ferri (audio only)

00:00:00.000 | [MUSIC PLAYING]

00:00:09.860 | Welcome, everyone, to the 33rd edition

00:00:12.360 | of Vogelheads on Investing.

00:00:15.060 | Today, our special guest is Jeff Patak.

00:00:18.480 | Jeff has been an analyst and manager at Morningstar

00:00:21.720 | for nearly 20 years.

00:00:23.540 | And today, we're going to talk about active management

00:00:26.440 | versus passive index investing.

00:00:28.720 | [MUSIC PLAYING]

00:00:38.000 | Hi, everyone.

00:00:38.720 | My name is Rick Ferry, and I'm the host

00:00:40.600 | of Vogelheads on Investing.

00:00:42.880 | This podcast, as with all podcasts,

00:00:45.800 | is sponsored by the John C. Vogel Center

00:00:48.040 | for Financial Literacy, a 501(c)(3) nonprofit organization

00:00:53.840 | that you can find at vogelcenter.net,

00:00:57.840 | where your tax-deductible contributions are

00:00:59.920 | greatly appreciated.

00:01:01.680 | Today, our special guest is Jeff Patak.

00:01:05.200 | Jeff has been an analyst at Morningstar

00:01:08.200 | for almost 20 years.

00:01:10.000 | He has in-depth knowledge of active management strategies,

00:01:14.480 | index versus active management, and Jeff knows the score.

00:01:19.600 | Now, some of the terms that you're going to hear today

00:01:21.800 | might be a little geekish, like five-factor model,

00:01:25.200 | three-factor model, regression analysis, and so forth.

00:01:28.840 | We kind of throw them around a little bit,

00:01:30.840 | but try to bear with us.

00:01:32.920 | When we're talking about all of that,

00:01:34.440 | we're trying to decipher whether or not

00:01:36.640 | the active managers actually have skill

00:01:40.440 | in outperforming their benchmark.

00:01:42.640 | And if so, how many, by how much, and for how long?

00:01:48.020 | So with no further ado, let me introduce Jeff Patak.

00:01:52.000 | Welcome to the Vogelheads on Investing podcast, Jeff.

00:01:55.120 | - Well, it's my pleasure.

00:01:55.960 | Thank you so much for having me.

00:01:58.080 | - Jeff, you've been in the portfolio management analysis

00:02:03.080 | business for just about 20 years,

00:02:07.200 | and you've been on all aspects of it.

00:02:10.180 | You've actually been a advisor for Morningstar.

00:02:14.160 | You're an analyst for Morningstar.

00:02:15.640 | You're an equity analyst for Morningstar.

00:02:17.880 | You have a tremendous background

00:02:19.660 | in the active versus passive debate.

00:02:23.120 | But before we dig into that debate,

00:02:25.760 | I'd like to get a little background on you.

00:02:28.000 | Tell us a little bit about your history

00:02:30.160 | and some interesting facts.

00:02:32.200 | - Sure, sure.

00:02:33.020 | I'm happy to, and thanks again for having me.

00:02:35.120 | Yeah, I'm a Chicago area product.

00:02:37.680 | They can't get rid of me.

00:02:38.840 | I was born and raised here, went away for four years

00:02:41.920 | to school up at the University of Wisconsin in Madison,

00:02:44.460 | where I earned my bachelor's degree in accounting

00:02:47.800 | and promptly returned to Chicago

00:02:50.360 | and entered the public accounting profession,

00:02:52.560 | which is where I spent the first eight years of my career,

00:02:55.480 | first two of which were kind of banging the balance sheet,

00:02:58.520 | so to speak, as a commercial line auditor.

00:03:01.400 | The last six of which were where I was part

00:03:04.480 | of a national technical accounting and auditing think tank,

00:03:08.120 | I suppose you would say, which was,

00:03:09.680 | it so happened based in the Chicago area.

00:03:12.760 | And then when Anderson met its untimely demise,

00:03:16.720 | that was actually the catalyst for me to move over

00:03:19.280 | to Morningstar, which is what I did in 2002.

00:03:22.080 | So the silver lining for me was finding Morningstar,

00:03:25.840 | which is where I've made my career ever since.

00:03:29.080 | And as you mentioned, I've done stints.

00:03:31.480 | Originally, I started out as a fund analyst

00:03:34.840 | and then I've done stints in equity research, ETF research.

00:03:39.760 | I spent some time in the investment management part

00:03:42.500 | of our business.

00:03:43.840 | And then more recently, I returned to research,

00:03:45.680 | heading up our global manager research team.

00:03:47.740 | And the way to put that into context is we've got a team

00:03:51.800 | of over a hundred analysts globally,

00:03:54.640 | whose job it is to assess active and indexed mutual funds

00:03:59.600 | and ETFs and their equivalents on a qualitative basis

00:04:02.960 | that culminates in a rating called the analyst rating

00:04:05.420 | that they assign.

00:04:06.260 | And so I work arm in arm, I suppose you would say,

00:04:09.660 | with them in helping them to assign those ratings

00:04:12.440 | and push thought leadership into the market.

00:04:14.920 | So that's been the tour to this point.

00:04:16.520 | And then more recently, they asked me if I could help out

00:04:19.120 | as chief ratings officer.

00:04:20.360 | So now I spend a little bit more time focused

00:04:22.920 | on our rating systems and making sure

00:04:24.640 | that they're as usable and effective as possible.

00:04:27.040 | - Well, thanks.

00:04:29.360 | I want to frame today's conversation

00:04:31.240 | because this is my area.

00:04:34.040 | Meaning I've written a number of books on index funds.

00:04:37.680 | My first one that I wrote was back in the 1990s

00:04:40.720 | and then books on indexes,

00:04:43.360 | asset allocation using index funds, ETFs,

00:04:46.760 | a history of index investing and so forth.

00:04:49.000 | This is my thing, so to speak.

00:04:51.800 | So I'd like to just get into the conversation,

00:04:54.160 | but I want to frame it for you.

00:04:58.400 | This is the way I framed it in a book I wrote

00:05:01.320 | called "The Power of Passive Investing."

00:05:04.000 | That starting out with the history of mutual funds

00:05:09.000 | and why they were created to begin with,

00:05:13.800 | with the first mutual fund being created in 1924.

00:05:17.520 | And it was for a very different purpose.

00:05:22.040 | Everything was actively managed back then.

00:05:24.480 | And mutual funds were created basically to offer people

00:05:29.480 | the ability to have a diversified portfolio of securities

00:05:34.520 | that the otherwise maybe could not have afforded.

00:05:37.760 | But it wasn't, according to John Bogle's 1951 thesis

00:05:42.640 | from Princeton, it wasn't for the purpose

00:05:44.960 | of outperforming the market.

00:05:47.080 | It was a convenience thing.

00:05:48.800 | Is that how you see it?

00:05:50.000 | - That's right.

00:05:52.080 | I think that traces the beginning of the arc of the industry

00:05:55.520 | and basically giving investors the ability

00:05:58.400 | to pool their capital, so to speak.

00:06:00.840 | And it may be in ways where they don't court

00:06:03.840 | onerous trade-offs that they would have courted

00:06:06.560 | if they'd been trying to invest in individual securities,

00:06:10.200 | transaction costs, being an example.

00:06:12.800 | Not that it was a free ride in the early mutual funds,

00:06:15.480 | but I'm sure that there were some efficiencies

00:06:17.720 | that investors, in addition to the conveniences

00:06:20.320 | that they gained, there were efficiencies

00:06:21.680 | that they also reached.

00:06:23.520 | - Let's spring forward to, again,

00:06:26.120 | some of the early research on active mutual fund performance

00:06:29.720 | was done well before the first index funds were created.

00:06:33.400 | The work that I did in looking at data

00:06:37.760 | and studies that were done far back as the 1930s

00:06:42.720 | by Alfred Cowles, but by going forward over the years

00:06:47.720 | by Bogle and various academics in the 1960s,

00:06:53.240 | all seemed to point to the fact

00:06:54.920 | that these actively managed funds

00:06:58.600 | were, in fact, not outperforming the markets.

00:07:01.440 | In fact, some did, but most, by and large, did not.

00:07:06.440 | But again, it wasn't a concern at the time

00:07:09.400 | because the purpose for having mutual funds

00:07:13.560 | was to just get diversification in a relatively easy way

00:07:17.240 | by pooling capital together, as you said.

00:07:20.600 | But it was these studies on active management

00:07:24.560 | that led to a lot of questions about,

00:07:27.920 | well, why isn't there an index fund

00:07:31.120 | that tracks, say, the S&P 500?

00:07:33.800 | Why do you suppose that was?

00:07:34.880 | Why did it take so long to create an S&P 500 index fund?

00:07:38.720 | Which, by the way, didn't get created until 1975

00:07:42.160 | and actually went public in 1976.

00:07:44.800 | - So, I think that maybe, not to widen out too much,

00:07:49.960 | but I think that maybe it's something

00:07:52.680 | that's innate to the American spirit.

00:07:55.520 | We're strivers, and I think that perhaps

00:07:59.480 | it just comes naturally to us

00:08:02.320 | to not just try to attain a goal, but to exceed it.

00:08:05.960 | And say what you will about active management,

00:08:08.680 | but the name of the game there is to try to clear the bar.

00:08:12.360 | And so, I think that that's probably one reason.

00:08:15.840 | I think that incentives are probably another reason.

00:08:20.760 | There's probably a whole sort of litany of reasons

00:08:23.520 | that we can cite why it took a while.

00:08:25.880 | I would suppose another barrier

00:08:27.880 | was it just, it seems counterintuitive.

00:08:31.160 | And we still find ourselves having to dispel this notion,

00:08:35.440 | but there's sort of that whole idea,

00:08:37.680 | why would you settle for average in an index fund,

00:08:42.680 | which is literally what it strives to deliver you in

00:08:45.480 | so far as it does a good job of tracking

00:08:47.840 | whatever market segment it's seeking to track.

00:08:50.880 | Where it's above average is once you take fees

00:08:54.000 | into consideration and other frictions

00:08:55.920 | you would otherwise encounter in an active strategy,

00:08:58.680 | you end up doing better than average.

00:09:01.240 | And those excess returns compound over time,

00:09:05.360 | and that's one of the reasons why index funds

00:09:07.920 | are as formidable as they are in many market segments.

00:09:12.440 | But that could be a tough sell.

00:09:13.800 | It doesn't intuit, I think, for a lot of people.

00:09:16.120 | And so, I think that when you take

00:09:17.760 | the three of those things together, we're strivers.

00:09:20.120 | There's incentives that maybe conspire against indexing,

00:09:23.760 | and it's also something that doesn't immediately intuit.

00:09:26.640 | That's probably three reasons why indexing took a little

00:09:30.240 | while to really take root.

00:09:33.160 | I'll add a fourth reason, and that is cost.

00:09:36.280 | Meaning that prior to, I think it was 1975,

00:09:40.960 | there were fixed commissions in the exchanges

00:09:44.960 | where it cost a lot of money to buy 500 stocks in a fund.

00:09:49.960 | And if you had money coming in and out

00:09:53.440 | of a mutual fund like an index fund would have,

00:09:56.320 | they would have to go to the market,

00:09:57.720 | and in order to keep it somewhat balanced

00:10:01.280 | or tracking the index, they'd have to buy and sell

00:10:06.280 | a lot of individual securities, and with fixed commissions,

00:10:09.400 | I think it probably made it prohibitively expensive

00:10:12.240 | until, I believe it was 1975, when Congress did away

00:10:16.640 | with fixed commission costs, and that spawned companies

00:10:20.080 | like Charles Schwab and discount brokerage firms.

00:10:22.760 | That's right, and then I think if we were to focus on,

00:10:27.000 | you know, maybe the last decade or so

00:10:28.760 | when we've seen this torrential shift

00:10:32.800 | from commission-based to fee-based advice,

00:10:36.280 | I mean, changes in advice practices

00:10:38.840 | are probably something else that have ushered in indexing.

00:10:42.120 | Now, indexing had arrived by then,

00:10:44.080 | and I think that some of the factors that we focused on

00:10:47.440 | explain why it had arrived, but I think if we're looking

00:10:50.600 | for one of the factors that explains why the demand

00:10:54.640 | for indexing has accelerated to the extent that it has

00:10:57.920 | in recent years, I think that that's probably

00:10:59.840 | a pretty pivotal shift to talk about.

00:11:02.440 | You know, the fact that for many advice givers,

00:11:04.960 | it was more about planning or what they might call

00:11:07.720 | behavioral modification or tax management,

00:11:10.840 | rather than going out and trying to capture alpha,

00:11:13.320 | and so then the name of the game became

00:11:14.960 | to try to lower the internal cost, investment cost,

00:11:17.760 | or whatever it is they were delivering.

00:11:19.840 | You know, that's a pretty pivotal development, I think,

00:11:23.520 | in the overall adoption of indexing,

00:11:26.880 | which is a bit unique to, I think, the last 10 or 15 years.

00:11:30.040 | - Now, I have a thesis, and I know you may not agree with it,

00:11:34.040 | that I wrote about in "The Power of Passive Investing,"

00:11:37.120 | and I've said several times, is that the evolution

00:11:41.040 | of mutual funds into indexing caused actively managed funds

00:11:46.040 | to become obsolete, at least for the purpose

00:11:49.640 | in which they were created, which was simply

00:11:51.800 | to offer people a diversified portfolio

00:11:54.680 | of individual securities, not trying

00:11:57.120 | to outperform the market, but just to have a portfolio

00:12:00.360 | that's diversified by pulling your assets together

00:12:03.160 | in a fairly low-cost way, rather than going out

00:12:06.320 | and trying to buy a portfolio of multiple stocks

00:12:09.360 | with high commissions and so forth,

00:12:11.560 | that when indexing came along, it was a better mousetrap.

00:12:15.000 | I mean, it did that better than actively managed funds,

00:12:18.320 | at least that portion of it, which is probably

00:12:21.520 | why Ed Johnson from Fidelity said this

00:12:26.520 | when John Bogle launched the first index mutual fund

00:12:32.200 | at Vanguard, now the S&P 500 fund.

00:12:34.520 | He said, "I can't believe that the great mass

00:12:37.480 | "of investors are going to be satisfied

00:12:40.080 | "with just receiving average returns.

00:12:43.640 | "The name of the game is to be the best."

00:12:46.720 | And this gets to your concept of, well,

00:12:49.440 | people have animal spirits and are trying to outperform.

00:12:53.680 | But to me, this was a big shift in active management.

00:12:57.040 | Up until the time indexing came along in the 1970s,

00:13:02.000 | it was more about being able to get

00:13:04.600 | a diversified portfolio of stocks

00:13:07.240 | at a relatively reasonable cost

00:13:09.400 | and not about beating the market.

00:13:11.480 | But the introduction of index funds in the 1970s

00:13:16.080 | caused this pivot in active management.

00:13:18.880 | Now the name of the game was to beat the market.

00:13:22.840 | Would you agree with that?

00:13:24.200 | - I would agree with that.

00:13:26.440 | Yeah, one of the predicates, like you point out,

00:13:29.360 | of active funds was to deliver that market exposure.

00:13:33.600 | So it was beta and alpha.

00:13:36.600 | And as you say, as some of these barriers

00:13:38.960 | and frictions were sanded away,

00:13:43.160 | as maybe some of the intellectual resistance

00:13:45.400 | to indexing fell away, then beta also fell away

00:13:50.400 | as a predicate for active.

00:13:52.000 | And it became all about alpha.

00:13:53.440 | And so, like you say, the value proposition has changed.

00:13:57.280 | And as those expectations have shifted,

00:14:00.160 | I think that you can argue that it's become

00:14:03.240 | an even more stiflingly competitive environment

00:14:05.320 | for active funds than before,

00:14:07.400 | which somewhat turns on its head the early orthodoxy,

00:14:10.840 | which held that as more people embraced passive,

00:14:13.920 | it would create greater inefficiency in the market.

00:14:18.440 | And it would be a turkey shoot for active funds

00:14:21.440 | because they would have all these opportunities

00:14:23.360 | that they could easily pick off.

00:14:25.000 | And I think that what research has found,

00:14:27.880 | work that we've done and a copious amount

00:14:30.600 | that's been done by academics and others,

00:14:32.600 | is that if anything, it's becoming more difficult.

00:14:35.760 | So again, it sort of upends that early orthodox funds

00:14:39.320 | would have a better go of it once indexing made inroads.

00:14:43.520 | - I have to give a shout out to Larry Suedro,

00:14:46.280 | who co-wrote a book, "The Incredible Shrinking Alpha,"

00:14:50.160 | which highlights exactly what you're talking about.

00:14:52.000 | You would think that with all of this indexing going on,

00:14:55.120 | that active managers would have an easier time

00:14:57.400 | of outperforming when in fact, it's become more competitive

00:15:00.400 | and more difficult to outperform.

00:15:02.360 | And there's no evidence whatsoever that an increase

00:15:05.800 | in indexing has caused better performance

00:15:09.320 | in the active management space.

00:15:10.600 | In fact, you can make an argument that the opposite

00:15:13.120 | has actually occurred.

00:15:14.840 | Let me jump into some research that I did,

00:15:17.400 | and that is portfolios of index funds

00:15:21.240 | versus portfolios of actively managed funds.

00:15:25.280 | And here's a little bit different dynamic.

00:15:27.320 | Since it's so difficult for active managers

00:15:29.920 | to outperform the markets,

00:15:32.000 | it doesn't matter what the category is,

00:15:33.720 | could be bonds, could be stocks,

00:15:35.040 | and we're gonna get into the data in a little bit here.

00:15:37.720 | But if all you had was a portfolio of a few index funds,

00:15:43.320 | the probability of that portfolio

00:15:45.800 | outperforming a portfolio of actively managed funds

00:15:50.480 | is higher than the probability

00:15:53.120 | of any of the individual index funds

00:15:55.520 | outperforming active funds in their particular category.

00:15:59.880 | So as we look at each individual category,

00:16:01.880 | we can see that U.S. stock, large cap,

00:16:04.520 | there's a X percent chance index funds will outperform,

00:16:08.040 | and then international, same way, and bonds, same way.

00:16:12.000 | And so you have all these individual silos,

00:16:13.800 | individual categories,

00:16:15.440 | but when you're looking at portfolios,

00:16:18.000 | if all you did was put together a portfolio

00:16:20.800 | of all index funds,

00:16:22.240 | the probability that that portfolio

00:16:24.720 | will outperform a portfolio of all active funds

00:16:27.360 | actually goes up even higher than the individual silos.

00:16:30.840 | - It would make sense.

00:16:32.920 | I know we're not talking about taxable versus pre-tax.

00:16:36.200 | If it's taxable, then it's fairly academic.

00:16:38.280 | That's not something we talked about to this point,

00:16:40.160 | and maybe we will later in the conversation,

00:16:41.960 | but I know that you and we have done work

00:16:44.520 | looking at the performance of active funds after tax,

00:16:48.800 | and it's grim.

00:16:50.520 | You basically, as far as I'm concerned,

00:16:53.760 | if you're looking to invest actively,

00:16:56.600 | do it in a qualified account,

00:16:58.680 | because if you do it in a taxable account,

00:17:00.800 | you're likely to be eaten alive by taxes over time

00:17:04.520 | to say nothing of just the challenges that you face

00:17:07.360 | in succeeding with active.

00:17:08.720 | It's possible it's very, very difficult

00:17:11.320 | within a taxable account.

00:17:13.640 | As far as a qualified account

00:17:15.080 | and kind of doing the kind of acid tests you described,

00:17:18.200 | that makes sense to me.

00:17:19.680 | The cost advantages compound.

00:17:22.280 | I wonder if, and maybe your research found this,

00:17:25.560 | there was also some benefits to style purity

00:17:29.680 | and unadulterated market exposure

00:17:32.040 | that you would get through index products

00:17:34.520 | that perhaps you wouldn't get through

00:17:36.680 | a basket of comparatively messier active funds

00:17:40.320 | that have exposures to different styles.

00:17:42.200 | I know that our research has found that,

00:17:44.200 | generally speaking, you will find that active funds

00:17:46.280 | do a little bit better in markets that are selling off,

00:17:50.040 | and we can talk again about why that is.

00:17:52.360 | But in rising markets, generally speaking,

00:17:54.600 | index products will do better

00:17:56.480 | just because they tend to be a bit more style pure,

00:17:58.480 | and so I wonder if you're picking up

00:17:59.680 | a little bit of that as well.

00:18:01.040 | But generally speaking, if you keep the cost down,

00:18:03.280 | you keep it simple, and you keep your market exposures on,

00:18:06.080 | and the market cooperates with you,

00:18:08.000 | I would expect that kind of outcome.

00:18:10.360 | - Yeah, let's get into the style purity

00:18:12.280 | and also something called survivorship bias

00:18:14.840 | in a lot of the data.

00:18:16.480 | There is a concept called Dunn's Law.

00:18:20.320 | Have you ever heard of Dunn's Law?

00:18:22.160 | - I have, yes.

00:18:23.000 | - Yeah, basically it just says exactly what you said,

00:18:25.200 | that when markets are going up,

00:18:27.040 | in that portion of the market that is outperforming,

00:18:30.600 | index funds tend to outperform

00:18:33.480 | because the managers are messy,

00:18:35.600 | and they're not style pure.

00:18:37.720 | But in that segment of the market that's not doing well

00:18:41.240 | is underperforming the rest of the market,

00:18:44.600 | the active managers tend to do better

00:18:46.760 | because the active managers are messy,

00:18:49.560 | and they're not holding to their style.

00:18:51.960 | Style purity and the consistency of active managers

00:18:55.440 | to maintain their style is a big factor

00:18:58.480 | and creates a big difficulty, does it not,

00:19:00.720 | in determining whether an active manager has skill or not?

00:19:05.720 | - It does.

00:19:06.640 | It does, and that's one of the reasons

00:19:08.520 | why it can become valuable and important

00:19:12.440 | to look at performance through a number of different lenses,

00:19:15.960 | maybe not just raw returns, but risk adjusted,

00:19:18.920 | and maybe not just sort of a single factor regression,

00:19:21.960 | but a multi-factor regression.

00:19:23.520 | And so I think that things like Fava French 3

00:19:27.200 | or Carhartt 4, now we've got 5, 6, 7,

00:19:30.400 | I mean, pick your multi-factor regression,

00:19:32.800 | but those are ways to separate alpha from beta.

00:19:36.640 | And as you rightly point out,

00:19:38.120 | because active funds aren't a style pure,

00:19:40.640 | they tend to be messier to other styles.

00:19:43.120 | You wanna control for those sorts of things.

00:19:45.400 | And that can be especially important

00:19:47.560 | over shorter periods of time.

00:19:49.800 | Markets are noisy, managers are messy.

00:19:53.040 | And so the nexus of those two things is,

00:19:56.760 | manager success rates can cycle up and down.

00:19:59.760 | You and I know from reading the press

00:20:02.640 | that this is the storyline that always keeps giving,

00:20:06.560 | is that managers in one category,

00:20:09.560 | active managers, I should say,

00:20:10.920 | are prospering, others in another category

00:20:14.200 | are in a deep slump.

00:20:15.520 | And in many cases,

00:20:17.280 | the reason why you see those sorts of variations

00:20:20.280 | is done flaw, because you have managers

00:20:23.000 | that perhaps are in one area or one specialty

00:20:26.560 | where they've had a tailwind

00:20:28.320 | and that's propelled them past their index

00:20:30.680 | over some period of time.

00:20:32.600 | Whereas conversely, you've got managers

00:20:34.360 | that maybe do a different style

00:20:36.160 | or invest in a different way

00:20:37.880 | that have encountered a headwind

00:20:39.560 | and that explains their slump.

00:20:41.080 | And so Dunn's law is a pretty handy concept

00:20:45.080 | to keep in mind,

00:20:46.240 | just as you're trying to make sense of it all.

00:20:48.880 | - What's the report that Morningstar has

00:20:50.920 | that does some of this analysis?

00:20:53.640 | - My colleague, Ben Johnson and others

00:20:56.240 | on our passes team published this.

00:21:00.200 | It's called the Active Passive Barometer.

00:21:02.360 | We go category by category

00:21:04.760 | and we see how many active funds

00:21:07.920 | were able to outperform a composite of passive funds

00:21:12.920 | that make up that category.

00:21:15.040 | And those categories are constructed

00:21:17.760 | based on holdings-based analysis.

00:21:19.720 | That's how we determine which funds to lump together

00:21:22.800 | into peer groups is by looking at the attributes

00:21:25.680 | of their holdings

00:21:27.000 | and then per our Morningstar category

00:21:29.160 | classification methodology,

00:21:30.640 | assigning them to a category.

00:21:32.840 | So like in the case of, let's say a large value fund,

00:21:36.640 | these are funds that are exhibiting the trades

00:21:38.600 | through their holdings of funds

00:21:40.040 | that favor the stocks of larger companies

00:21:42.400 | that are inexpensive by a number of measures.

00:21:46.160 | We do try to point out some of these puts and takes

00:21:48.640 | that you get for the reasons that you mentioned.

00:21:51.480 | Again, that's Dunn's Law, so to speak,

00:21:54.000 | the fact that if you have a manager,

00:21:56.760 | like if we focus on maybe the most recent decade,

00:22:00.480 | it's a large cap manager

00:22:01.880 | and they really skew towards mega

00:22:04.160 | and maybe lean towards growth.

00:22:06.280 | That's probably been a good fact over the past decade or so,

00:22:10.040 | just because that part of the style box

00:22:12.840 | has done quite, quite well.

00:22:14.840 | Conversely, if you had another manager

00:22:17.440 | that maybe it was in that large growth box,

00:22:20.520 | but they own quite a bit of mid

00:22:22.280 | and maybe they mixed in some core

00:22:24.280 | and even some sort of busted growth stories

00:22:27.240 | that are sitting in the value side of a ledger,

00:22:30.480 | a manager like that probably wouldn't have done as well.

00:22:33.120 | And so a simple success ratio,

00:22:34.760 | is it necessarily gonna do that attribution for you?

00:22:37.560 | But through our research,

00:22:38.880 | we've tried to make sure that we point those things out

00:22:40.920 | so that people understand what might be driving

00:22:42.840 | some of the trends that they're seeing.

00:22:45.200 | - So indexes have certainly changed.

00:22:48.000 | Well, I shouldn't say they've changed.

00:22:49.320 | Indexes have certainly been expanded.

00:22:52.840 | What the definition of an index is,

00:22:56.240 | has expanded significantly in the past,

00:22:59.440 | I'll call it 15 years or 20 years,

00:23:02.280 | where prior to say 2003 or 2004,

00:23:07.280 | an index was the S&P 500 or the total stock market

00:23:13.560 | or the total bond market

00:23:15.560 | or the total international market of some sort,

00:23:17.560 | they were very big, large gorilla type composites

00:23:22.040 | of securities from US and international and fixed income.

00:23:27.040 | But that has changed dramatically.

00:23:30.880 | And the definition of an index,

00:23:33.720 | I don't think it's a definition

00:23:34.880 | based on what John Vogel's standard would be

00:23:37.320 | of what an index is.

00:23:38.360 | But there have been, in my view,

00:23:41.200 | a lot of actively managed products

00:23:43.200 | that have now calling themselves indexing.

00:23:46.920 | And I believe that Morningstar calls them strategic indexes.

00:23:51.040 | Is that the name that you use?

00:23:53.240 | - Strategic beta, that's right.

00:23:54.720 | The industry refers to it as smart beta.

00:23:57.400 | We think that's a bit self-serving,

00:23:58.680 | so we call it strategic beta.

00:24:00.280 | It's exactly what you've described, Rick,

00:24:01.960 | which is that they're indexes, quote unquote,

00:24:05.360 | but what it really is is it's a rules-based implementation

00:24:10.360 | of active management.

00:24:13.000 | It's those rules which dictate

00:24:16.000 | which types of securities you will select.

00:24:20.800 | It's really not about faithfully tracking

00:24:23.360 | a given market segment,

00:24:25.080 | let alone sort of a wide swath of the market.

00:24:27.960 | Typically what it's about is sort of narrowing in

00:24:30.800 | on a specific set of securities

00:24:33.200 | that possess certain attributes

00:24:34.960 | per the rules that have been specified,

00:24:36.680 | and we call that strategic beta.

00:24:38.400 | - And my work I did on the ETF book that I wrote,

00:24:42.800 | I broke down these strategic indexes,

00:24:46.560 | and tongue-in-cheek, I called them special purpose indexes,

00:24:51.480 | SP indexes, or spindexes for short,

00:24:56.360 | because there was a lot of spin going on

00:24:58.240 | in the marketplace here

00:24:59.200 | about what these things actually were,

00:25:01.280 | but that was my opinion.

00:25:03.520 | So these strategic indexes have really expanded,

00:25:05.960 | but there's two things going on here.

00:25:08.440 | It's not only the investment selection,

00:25:12.000 | and so what goes in the index that's different.

00:25:14.960 | Let's say you're gonna do some quantitative work

00:25:18.800 | to determine which individual securities

00:25:22.760 | go into the strategic index,

00:25:25.840 | but it's also the weighting of those strategic indexes

00:25:30.560 | that have changed,

00:25:31.920 | where they're selecting securities

00:25:34.320 | based on some quantitative or qualitative factor

00:25:37.880 | like ESG or such,

00:25:40.000 | but how they weight those stocks or bonds in the index

00:25:44.440 | is also changed to using the same factors in many ways.

00:25:48.440 | So you might have a factor weighted

00:25:51.320 | into how small-cap is it,

00:25:53.680 | or how value-y is it,

00:25:55.320 | or how ESG-prone is it.

00:25:58.960 | So it's not only individual security selection,

00:26:02.080 | it's individual weighting,

00:26:03.280 | and to me, I mean, this is active management,

00:26:05.520 | but the SEC allows these products to be called index funds

00:26:10.520 | because they track, as you said,

00:26:14.080 | a model of some sort, or at least a methodology.

00:26:18.520 | To me, it's a little kind of unfair,

00:26:20.360 | and it's a little, it was a little bit of a way

00:26:22.760 | of which active management companies

00:26:24.200 | to get back at the indexers.

00:26:26.240 | How do you feel about that?

00:26:27.600 | - You know, I do agree that

00:26:30.440 | there has maybe been a certain lack of discipline

00:26:34.920 | when it's come to devising some of these strategies.

00:26:39.200 | I mean, I think that we can look at something

00:26:40.840 | that's fairly plain vanilla, like a value index.

00:26:44.480 | I mean, technically, one could argue,

00:26:46.080 | given the fact that it's literally factor tilting,

00:26:49.280 | that it's aiming to do something

00:26:51.680 | apart from the broad cap-weighted market.

00:26:55.280 | And I don't think that probably, you know,

00:26:56.840 | you or I would look at that and be like,

00:26:58.560 | okay, this isn't prudent at all,

00:27:00.600 | or there's not a body of research that undergirds this.

00:27:03.760 | So I think that, you know, what you're referring to

00:27:06.240 | is this proliferation of products that we've seen

00:27:08.920 | that have targeted, you know,

00:27:10.720 | be very narrow market segments,

00:27:13.360 | or, you know, maybe data mine their way

00:27:16.080 | to a particular index methodology.

00:27:19.040 | And then they put that out there,

00:27:20.320 | and it kind of promptly rolls over.

00:27:22.560 | It's just a bit of gimmickry.

00:27:24.520 | We have seen a lack of discipline

00:27:26.280 | in some of the products that we've seen come out there.

00:27:28.520 | And so that's why, you know,

00:27:29.880 | we've tried to take some steps

00:27:31.560 | through some of the methodologies

00:27:33.040 | that we've developed.

00:27:33.880 | Again, this is Ben Johnson and his team

00:27:35.520 | who have been at the forefront of coming up

00:27:37.520 | with strategic beta tags

00:27:40.080 | and different classification metrics that, you know,

00:27:42.880 | we can try to make available to investors

00:27:45.040 | so that they can make more informed decisions

00:27:47.640 | about what are, you know, they are active strategies,

00:27:50.520 | albeit those that are implemented through a set of rules

00:27:53.760 | that, you know, are delivered in the form of an index.

00:27:56.720 | If you take the S&P 500

00:27:58.800 | and you divide it between value and growth,

00:28:01.200 | to me, the purpose isn't to recommend

00:28:04.160 | either value or growth.

00:28:05.200 | It's just simply to take an indice like the S&P 500

00:28:08.680 | and create a value and a growth segment of it,

00:28:11.280 | or take the total market

00:28:12.520 | and divide it into large cap, mid cap, small cap.

00:28:15.640 | When you put these things all back together again,

00:28:17.480 | it's still the total market.

00:28:19.240 | Similar with industries.

00:28:21.520 | In other words,

00:28:22.360 | you could take the 11 industry classifications

00:28:24.560 | and you could make,

00:28:25.400 | and they have made indexes or indices

00:28:27.640 | out of each of the 11.

00:28:29.080 | But when you put them all back together again,

00:28:30.560 | it's still the total market.

00:28:32.080 | So that's one type of slicing and dicing.

00:28:36.080 | And I don't have any problem with that.

00:28:37.840 | It's the other stuff.

00:28:39.200 | It's the stuff that is selecting securities

00:28:43.240 | and then weighting them differently.

00:28:45.440 | The active management stuff that's being called indexes

00:28:48.120 | that I have a problem with

00:28:49.840 | because it really has confused people.

00:28:52.000 | You know, this idea that fundamental indexing, for example,

00:28:56.040 | is better than traditional indexing.

00:28:58.560 | Well, fundamental indexing is a selection process

00:29:02.000 | and then a weighting process.

00:29:03.720 | It's an active management process.

00:29:05.320 | It's not the same as buying the whole market.

00:29:08.960 | No, I think you're right.

00:29:10.640 | I think buyer beware is the right mentality

00:29:12.880 | to take into that.

00:29:14.360 | You know, the one thing that I could say

00:29:16.280 | in defense of a thoughtful smart beta

00:29:20.120 | or strategic beta approach,

00:29:22.560 | one that files a prudently constructed index

00:29:25.800 | that's maybe founded on robust research

00:29:30.120 | that's been conducted in a careful way.

00:29:33.240 | The index isn't gonna lose its nerve,

00:29:35.440 | which sounds a bit glib.

00:29:37.120 | But one of the things that investors do have to confront

00:29:41.360 | when they invest with an active manager

00:29:43.200 | is agency risk or career risk.

00:29:46.040 | It's this notion that if things go

00:29:47.520 | against the active manager,

00:29:49.200 | he or she might be likely to buckle under the pressure.

00:29:53.280 | And so maybe they are tilting sort of

00:29:56.240 | towards a set of securities that have been underperforming

00:29:59.760 | and the phones are ringing off the hook,

00:30:02.480 | clients are upset, they want a piece of the action

00:30:05.520 | and the action is not where that manager

00:30:07.760 | is investing at the moment.

00:30:09.480 | And so what do they do?

00:30:10.480 | They sell the underperformance

00:30:11.960 | and maybe they climb onto the index

00:30:14.800 | or buy into the part of the market

00:30:16.720 | that's been doing better.

00:30:17.880 | And what happens, you know, performance suffers

00:30:21.280 | because they tend to buy into the market segment

00:30:24.160 | that's about to roll over.

00:30:25.600 | And we see this repeat again and again and again.

00:30:28.640 | And contrast that with a strategic beta product,

00:30:31.680 | I'm not suggesting for a moment

00:30:33.320 | that they're all well-constructed or thoughtful,

00:30:35.720 | but the index shouldn't lose its nerve.

00:30:38.200 | It's gonna keep doing what it's designed to do.

00:30:41.000 | You know, maybe again,

00:30:41.840 | take our sort of quintessential value index.

00:30:45.360 | It's gonna probably keep buying, you know,

00:30:47.880 | or rebalancing towards stocks that look cheap

00:30:50.760 | by price to book or what have you.

00:30:52.920 | Whereas maybe another manager

00:30:54.720 | who was tilting towards that style,

00:30:56.880 | maybe because of the agency risk,

00:30:58.600 | maybe because of that career risk,

00:31:00.040 | they might not be as committed to doing that

00:31:02.600 | when push comes to shove.

00:31:03.880 | So I think that's one thing that you could say.

00:31:05.440 | And then insofar as they're wrapped in the ETF structure,

00:31:09.600 | there are certain tax advantages,

00:31:11.520 | but that's more of a wrapper thing,

00:31:14.080 | ETFs versus open-end mutual funds

00:31:16.440 | that it is an indexing thing.

00:31:18.560 | I think they're probably something I would just focus on

00:31:20.560 | if you're evaluating a strategic beta product.

00:31:22.880 | - Let's get into the percentages.

00:31:26.120 | These are the tables that you do and Vanguard has done.

00:31:30.480 | Standard & Poor's does them through their SPIVA studies.

00:31:33.480 | There has been several academics

00:31:35.080 | who have put together performance tables

00:31:38.400 | to show the percentage of time

00:31:41.400 | that active management in each category outperforms.

00:31:45.720 | These are usually done either annually or semi-annually.

00:31:50.040 | I look at all of these studies

00:31:51.280 | and I've been looking at them for years.

00:31:52.720 | Standard & Poor's have been doing them for 20 years

00:31:55.360 | and I know you've been doing them for a long time.

00:31:56.960 | And Vanguard, of course,

00:31:58.280 | has been looking at this data a long time.

00:32:00.120 | And there have been a lot of other academic studies

00:32:03.120 | and they all come out to, from what I see,

00:32:05.720 | just about the same numbers.

00:32:08.440 | And to me, that numbers are,

00:32:10.800 | or over any five-year period of time,

00:32:13.920 | if you start out with 100 funds

00:32:17.680 | that are trying to outperform, say, the market,

00:32:21.240 | that 25% of those funds will go out of business or merge.

00:32:26.240 | And usually that's because of very, very poor performance.

00:32:31.800 | The other, another 50% will underperform,

00:32:37.000 | of which half, or 25%, will underperform by more than 1%.

00:32:41.680 | And then the other 25% will underperform

00:32:44.640 | by maybe less than 1%.

00:32:48.240 | And then last you have the 25% that outperforms.

00:32:52.520 | And this generally will outperform by,

00:32:55.440 | call it a half a percent.

00:32:58.160 | There are 25% of the active managers

00:33:01.360 | who have in the past outperformed

00:33:03.840 | over a five-year period of time.

00:33:05.040 | And Bellman's figuring out who they're going to be

00:33:08.120 | before it happens.

00:33:09.280 | So are my numbers fairly accurate,

00:33:11.680 | at least on the equity side?

00:33:13.960 | - They are.

00:33:14.880 | And maybe I'll sort of back up a little bit.

00:33:16.840 | I did a little bit of sifting around in our database,

00:33:19.680 | going back in time.

00:33:20.920 | And over time, there have been around 58,000 funds

00:33:25.440 | and ETFs in existence.

00:33:26.960 | And this includes all the different share classes.

00:33:29.360 | These are U.S. funds and ETFs.

00:33:31.840 | Of that roughly 58,000, around 31,000, or 53%, have died.

00:33:36.840 | So that just gives you a sense.

00:33:40.760 | I mean, if you go back through time,

00:33:42.200 | at some point, there has been a sum total

00:33:45.160 | of nearly 60,000 funds and ETFs.

00:33:48.760 | And around 31,000 of those have perished.

00:33:51.480 | They've been merged or liquidated, obsoleted in some way.

00:33:56.480 | And so that is one obstacle that you are facing

00:34:01.640 | right off the bat, is just perishability.

00:34:05.280 | Many funds, it's basically, it's a coin flip,

00:34:08.640 | whether your fund is going to deliver or not.

00:34:11.920 | As far as the rest of your numbers,

00:34:13.400 | so you've got a certain percentage of funds

00:34:16.200 | that are going to perish, they're going to fall away.

00:34:18.920 | Yes, it breaks down around the way you described.

00:34:21.440 | For instance, in our most recent

00:34:22.720 | Active Passive Barometer Report,

00:34:24.440 | which is a report I referenced before

00:34:26.040 | that my colleague Ben Johnson and others

00:34:28.920 | on his passive research team conduct,

00:34:32.720 | we found in the large cap category,

00:34:35.640 | so this is U.S. equity, it was around 15, 20% of the funds

00:34:41.640 | in those categories beat the passive proxy.

00:34:46.040 | And so those are very sobering numbers.

00:34:49.880 | And as you can imagine, as you extend

00:34:52.320 | that time horizon further out to 10 to 15 to 20 years,

00:34:57.240 | it tends to telescope even lower.

00:35:00.400 | And so I think that it's not contradictory

00:35:03.160 | to say that it's not hopeless to succeed

00:35:05.840 | with active investing, while at the same time

00:35:08.480 | acknowledging that it's a very sobering picture

00:35:11.520 | when you look at the data,

00:35:13.160 | the odds are not stacked in your favor.

00:35:16.440 | Different categories of active funds

00:35:19.040 | do outperform for a while,

00:35:21.600 | and it might have to do with Dunn's Law,

00:35:23.920 | but that they don't tend to persist.

00:35:27.000 | They tend to fall back.

00:35:29.040 | We've noticed this even in fixed income,

00:35:30.840 | and fixed income right now, when you look at it,

00:35:35.680 | you would say, "Gee, I should do

00:35:38.640 | "active management fixed income."

00:35:41.400 | But that would only be if you were looking at,

00:35:44.080 | say, the last 10 years of fixed income,

00:35:47.560 | because 10 years ago, you wouldn't have been saying that.

00:35:51.120 | You would have been saying, "I should just do index funds."

00:35:53.520 | So these things do streak, and it's hard to pick

00:35:58.520 | the category where you're going to have

00:36:01.200 | more active funds outperform, but it does happen.

00:36:05.040 | I could look at any data from any five-year

00:36:07.280 | or 10-year period, and there will be a category or two

00:36:11.920 | where the active funds have been outperforming,

00:36:15.560 | but it doesn't persist.

00:36:17.560 | So can you talk with us about persistence?

00:36:19.720 | - No, you're right.

00:36:21.640 | Yes, because when, over these shorter periods of time

00:36:25.560 | where maybe you see a bunch of active funds

00:36:28.920 | in a category or a style outperform,

00:36:32.080 | usually there's some sort of stylistic tailwind

00:36:35.800 | that they're enjoying.

00:36:36.640 | And that's not to denigrate active investors.

00:36:39.960 | They're a very sort of accomplished, educated,

00:36:43.120 | well-trained lot, but it's very competitive,

00:36:47.000 | and it can be difficult to unearth

00:36:49.560 | truly undiscovered ideas.

00:36:51.000 | And so what you tend to find is that

00:36:53.560 | maybe they skew towards one style or another,

00:36:56.880 | and so when that style has the wind at its back,

00:36:59.400 | that's when you'd see them outperform.

00:37:01.200 | Maybe I'll give you an example of kind of how the numbers,

00:37:03.880 | this will just sort of further, I suppose,

00:37:06.120 | underscore what you said before,

00:37:08.400 | using an actual category as an example.

00:37:10.800 | This is from our most recent Active Pass Abroad Report,

00:37:14.200 | which was as of December 31st, 2020.

00:37:17.600 | And if you looked as of that date

00:37:19.880 | within the Europe stock category,

00:37:22.320 | so these are funds that invest primarily in stocks

00:37:26.240 | that are domiciled somewhere

00:37:27.560 | on the broader European continent,

00:37:29.880 | 74% of the funds in that category outperformed

00:37:34.880 | over the year ended December 31st, 2020.

00:37:38.480 | But then as you extend the time period

00:37:40.640 | to three to five to 10 to 15 years,

00:37:42.880 | what you find is that the numbers shrink way down.

00:37:46.560 | So for instance, over the trailing 10 years

00:37:49.320 | through December 31st, 2020,

00:37:52.000 | around a third of active European stock funds

00:37:56.640 | beat their benchmark.

00:37:58.280 | And so that's inclusive of the great year

00:38:01.600 | that they had in 2020,

00:38:03.520 | that probably boosted the 10 year number a little bit

00:38:06.440 | than it otherwise would have been,

00:38:08.480 | but it's still quite low.

00:38:10.200 | And that's kind of a constant

00:38:11.840 | when you look across the different categories

00:38:14.480 | that we study.

00:38:15.760 | I mean, the category, for instance,

00:38:17.600 | over the trailing 10 years ended December 31st, 2020,

00:38:21.600 | that had the highest success ratio was global real estate.

00:38:25.080 | And that was 48%, meaning that 48%

00:38:28.880 | of the active global real estate funds

00:38:31.960 | that existed 10 years before we began

00:38:35.760 | that December 31st, 2020 measurement period

00:38:38.920 | beat their benchmark.

00:38:40.320 | And so it's very, very difficult

00:38:42.280 | as you extend this over longer periods of time

00:38:45.120 | and you experience mean reversion

00:38:47.400 | as a fund that stylistic tailwind becomes a headwind.

00:38:51.520 | And then other sort of realities intrude

00:38:54.280 | such as the economic viability of the product.

00:38:57.360 | If it doesn't reform,

00:38:58.800 | the manager probably is going to be tempted

00:39:01.720 | to mothball it, to merge it with something else

00:39:04.480 | or just to liquidate it

00:39:05.960 | so that it's got a better offering of funds to show.

00:39:08.400 | And so that's how those numbers end up falling

00:39:10.240 | and you end up with those low success rates that you see.

00:39:13.120 | Let's look at fees, how fees factor into this.

00:39:17.000 | And there's been a lot of academic work

00:39:19.400 | and you've done a lot of work on fees.

00:39:20.720 | You do your annual fee study every year

00:39:23.200 | and pretty much there is a very high

00:39:26.880 | persistent correlation among all asset classes

00:39:32.120 | between the fee that the active managers charge

00:39:37.000 | and their performance.

00:39:39.400 | There's a lot of closet indexing going on

00:39:42.000 | where a lot of managers are just buying

00:39:44.280 | basically what's in the index

00:39:45.440 | and charging a higher fee for it.

00:39:46.960 | But can you talk about the correlation

00:39:50.160 | between fees and active returns versus the index funds?

00:39:55.160 | We've done quite a bit of work here.

00:39:57.400 | I would highlight some work

00:39:58.680 | that my colleague Russ Kinnell did some years ago

00:40:01.440 | where he looked at a multitude of different factors

00:40:05.080 | to determine which seemed to be the most predictive.

00:40:07.680 | And the factor that really stood out was fees.

00:40:11.280 | So the lower they were,

00:40:12.480 | the likelier it was that fund would succeed

00:40:16.240 | by different measures.

00:40:17.920 | To give you a more recent example,

00:40:19.360 | I might return to that Active Passive Barometer Report

00:40:22.000 | that I referred to before.

00:40:24.320 | And this is available to any of your listeners.

00:40:26.720 | If they Google for it,

00:40:27.840 | they should be able to pull it up

00:40:29.200 | and download it free of charge.

00:40:31.560 | It's available publicly so you can see for yourself.

00:40:34.680 | But not only do we tally up the number of active funds

00:40:38.160 | that have beaten their composite benchmark over time,

00:40:43.160 | but we also break those categories into cost quintiles.

00:40:47.360 | And so what we take a look at is how did funds

00:40:52.000 | that were grouped not only by style,

00:40:53.400 | but also by cost do relatively speaking.

00:40:56.320 | And what you find is that almost uniformly

00:40:59.320 | the lowest cost quintile outperforms the index

00:41:03.520 | at a higher clip than the highest cost quintile.

00:41:07.600 | And usually you're talking about multiples of difference.

00:41:09.640 | Now, granted, it doesn't necessarily upend one's thinking

00:41:13.840 | about whether it's better to be active

00:41:16.200 | versus indexed in these categories.

00:41:18.560 | But I think it does give you an appreciation

00:41:20.240 | for how much cost can tilt the odds in your favor.

00:41:24.000 | Just to give sort of a quick example,

00:41:26.760 | using a category that I think is familiar

00:41:28.920 | to a lot of investors, US Large Blend.

00:41:32.160 | The lowest cost quintile over the trailing 10 years

00:41:35.840 | ended December 31st, 2020.

00:41:38.800 | 17% of the active funds in that lowest cost quintile

00:41:44.120 | managed to beat their benchmark.

00:41:46.120 | Contrast that with the highest cost quintile,

00:41:49.040 | just 4% of those high cost Large Blend funds

00:41:53.600 | beat their benchmark over that trailing 10 year period

00:41:56.960 | I mentioned.

00:41:57.800 | The odds go from vanishingly small to slightly better

00:42:02.200 | if you focus on cost.

00:42:03.760 | But when you look across these 20 categories

00:42:06.640 | that we track as part of this report,

00:42:08.920 | with the exception of just a few,

00:42:11.280 | you find that cost does tilt odds in your favor.

00:42:13.760 | And so certainly, if I were making my pecking list,

00:42:16.720 | that would be way up there on the list of criteria

00:42:20.080 | that I'd be focused on.

00:42:21.440 | - In the study that I did with Alex Bankey of Betterment

00:42:26.880 | at the time, on active mutual fund portfolios

00:42:31.880 | versus index fund portfolios,

00:42:34.880 | we did go in and carve out just the lower cost active funds

00:42:39.880 | and reran the numbers.

00:42:43.360 | These were the active funds that were in the 50 percentile

00:42:48.360 | or lower as far as fees.

00:42:50.400 | So they were the least expensive

00:42:52.000 | or lowest half of the funds.

00:42:54.280 | And we did find that it did make a difference.

00:42:57.040 | Say over a 10 year period of time,

00:42:59.920 | if you included all active funds in a portfolio,

00:43:03.200 | call it a five fund portfolio of different US stock,

00:43:07.000 | international stock, a couple of bond funds,

00:43:09.760 | and maybe a small cap fund of some sort.

00:43:12.080 | If you included all active funds in there

00:43:15.880 | versus an all index fund portfolio of the same mix,

00:43:19.040 | that the index fund portfolio outperformed

00:43:21.120 | over 90 percent of the time.

00:43:22.600 | However, when you just use the lower cost active funds

00:43:26.640 | in the study, the index fund portfolios outperformed

00:43:30.960 | the active funds about 80 percent of the time.

00:43:33.800 | So there was an incremental benefit

00:43:35.840 | to just using lower cost active funds.

00:43:39.880 | So that didn't really move the needle that much,

00:43:41.680 | but it did move the needle.

00:43:43.880 | But back to my other point that I made earlier

00:43:46.160 | is that what I found in a different research

00:43:48.280 | was that when looking at the funds

00:43:50.400 | that actually did have alpha,

00:43:51.520 | the managers that did outperform,

00:43:53.240 | and you could literally say they,

00:43:55.360 | using information ratios and other statistics,

00:43:57.840 | that they had skill,

00:43:59.440 | was that their funds were not the cheapest

00:44:03.600 | nor the most expensive,

00:44:04.800 | that they tended to run between 0.7

00:44:09.160 | and a little less than 1 percent.

00:44:11.720 | I imagine that would be almost required.

00:44:13.840 | If you really do have skill,

00:44:14.960 | you have to put some research dollars

00:44:16.720 | into finding those opportunities.

00:44:19.600 | - No, no, that makes sense to me.

00:44:22.160 | I mean, when you consider the fact

00:44:23.560 | that you have some fairly accomplished,

00:44:25.760 | successful boutiques out there

00:44:27.440 | who are not gonna be the cheapest game in town,

00:44:29.720 | I would imagine that was probably part of your cohort

00:44:32.280 | where you were seeing some high performers

00:44:34.280 | that weren't the lowest cost.

00:44:36.600 | Perhaps you had some in there

00:44:38.680 | that maybe were investing in styles

00:44:41.840 | that are a little bit more costly to implement.

00:44:45.080 | Maybe you would think of small company stocks

00:44:47.200 | or non-US stocks, especially EM.

00:44:50.200 | Typically, those charge a little bit more.

00:44:54.320 | So that does make sense to me that you would find that.

00:44:58.200 | I think that overall, though,

00:45:00.280 | when you're trying to think about

00:45:01.360 | sort of those odds of success,

00:45:03.680 | focusing on cost is something that a well-served investor.

00:45:07.720 | I wanna get into a couple of other areas

00:45:09.520 | where you have measured the gap

00:45:13.240 | between the performance of markets

00:45:16.440 | and the performance of investors in those markets.

00:45:19.760 | And you call it mind the gap.

00:45:21.480 | And these studies I found to be very interesting

00:45:23.440 | because they're performance gap studies.

00:45:26.080 | And I've seen an interesting trend here

00:45:30.280 | where it appears as though investors are getting better

00:45:34.120 | at managing their portfolios.

00:45:36.680 | Is that what these studies are telling me?

00:45:39.320 | - Yeah, so you're right.

00:45:40.480 | The report is called "Mind the Gap."

00:45:42.120 | It was pioneered by someone I mentioned before,

00:45:44.800 | Russ Kinnell, some years ago.

00:45:47.000 | And then we've had other analysts

00:45:48.880 | that have been conducting the study since then.

00:45:52.240 | Amy Arnott, my colleague, most recently.

00:45:54.600 | We conducted our most recent "Mind the Gap" study

00:45:58.040 | for the period end of December 31st, 2019.

00:46:01.160 | We're in the process of updating the version.

00:46:03.200 | That'll be as of 12/31/2020.

00:46:05.520 | So stay tuned, be on the lookout for that.

00:46:07.440 | But when we did the most recent one,

00:46:09.400 | which again was as of 12/31/19,

00:46:12.760 | when we looked at that 10-year period ended then,

00:46:15.640 | we found that there was virtually no gap

00:46:18.160 | between the dollar-weighted return

00:46:20.960 | that investors earned in their funds

00:46:23.880 | and the returns of those funds.

00:46:25.600 | And for sake of clarification,

00:46:28.000 | when we talk about the dollar-weighted return,

00:46:30.600 | you'd liken that to an internal rate of return.

00:46:33.520 | So essentially what you're doing

00:46:34.760 | is you're taking into account

00:46:36.800 | the assets that were invested in funds,

00:46:39.040 | the cash flows over some period of time,

00:46:41.960 | and you're trying to solve for the return

00:46:44.520 | that would explain how you ended up

00:46:46.360 | with the sum of assets at the end

00:46:48.320 | that you ended up with,

00:46:49.280 | taking into account the beginning balance

00:46:51.800 | and the cash flows in the interim.

00:46:53.520 | And I would say that it's an encouraging story

00:46:56.720 | that we've seen the gap close,

00:46:58.720 | because I think that when we've conducted this study

00:47:00.960 | in the past,

00:47:02.400 | we found that there could be a fairly sizable gap,

00:47:04.920 | a percentage point, even two percentage points

00:47:08.720 | that separated investors' returns

00:47:11.400 | from their funds' returns,

00:47:12.720 | meaning that they had inopportunely timed

00:47:16.480 | their purchases and their sales.

00:47:19.680 | You know, and the most vivid example of this

00:47:21.320 | would be investors who are chasing performance

00:47:25.000 | and they end up buying high and selling low.

00:47:27.320 | In situations like those,

00:47:29.360 | you find that the dollar-weighted returns,

00:47:32.000 | the investor return, far trails the total return,

00:47:36.200 | that is the return of the funds.

00:47:37.960 | And so it's encouraging to see

00:47:40.000 | that these two numbers have converged over time.

00:47:43.480 | And it does suggest that we're seeing better habits,

00:47:46.680 | or at least we're seeing some of the less

00:47:49.920 | self-harmful behaviors from investors

00:47:52.200 | that we had seen before.

00:47:53.880 | Again, though, this was just through end of 2019.

00:47:57.200 | We haven't quite tallied up what we saw in 2020,

00:48:00.520 | and there was some evidence of misbehavior then.

00:48:02.680 | So we'll see what this next installment shows.

00:48:07.120 | - I'm curious if your data is able to separate out

00:48:11.680 | advised portfolios from self-managed portfolios,

00:48:16.680 | and if you're seeing different trends

00:48:20.920 | in advised portfolios than self-managed portfolios.

00:48:24.040 | - I wish we could, but we can't.

00:48:28.160 | It used to be, as you know, that share class

00:48:31.920 | would tell you, to a certain extent,

00:48:34.720 | which of the funds are advised,

00:48:38.720 | where there's a financial advisor that's involved,

00:48:42.200 | versus, say, a no-load share class

00:48:43.840 | or an institutional share class where we can safely say

00:48:46.520 | that it's an individual investing on their own,

00:48:49.280 | or doing so in a self-directed way,

00:48:51.640 | say, within a retirement plan.

00:48:53.920 | But those boundaries have basically been blown

00:48:56.120 | to smithereens, especially institutional share classes.

00:48:59.360 | Those are no longer the sole province of institutions.

00:49:02.960 | We've got many individuals that are self-directing

00:49:06.280 | and investing in those share classes,

00:49:07.840 | which they're able to access in their retirement plan.

00:49:09.680 | So it's a long-winded way of saying

00:49:11.840 | we can't separate it out quite that cleanly.

00:49:14.960 | What we can do is look at other dimensions,

00:49:18.200 | asset class, Morningstar category.

00:49:21.200 | We've done some work looking at it.

00:49:23.360 | High volatility level or cost of the funds concerned.

00:49:27.720 | You know, and there are some interesting findings there.

00:49:29.720 | I would say that probably the one that really jumps out

00:49:33.400 | is allocation funds.

00:49:34.960 | Allocation funds would include things

00:49:36.840 | like target date funds, which have become a mainstay

00:49:39.960 | in defined contribution plans.

00:49:41.720 | And over the 10-year period, end of December 31st, 2019,

00:49:45.720 | what we found is that the average dollar

00:49:48.040 | that investors in allocation funds put to work

00:49:51.240 | out-earned the funds.

00:49:53.280 | So they actually, by regularly contributing

00:49:56.480 | into these funds, as is the practice

00:49:58.320 | with the defined contributions plans, as you know,

00:50:01.640 | they ended up reaping a slightly higher return

00:50:04.240 | than their funds did to the tune

00:50:06.440 | of about a 40 basis point positive gap annualized.

00:50:09.920 | And so that's a really, really encouraging outcome

00:50:13.080 | to see just knowing the central role

00:50:14.840 | that defined contribution plans will play

00:50:17.320 | in the retirement future of so many folks

00:50:19.920 | who are in the workforce.

00:50:20.920 | So that was something that certainly did jump out

00:50:23.400 | from our most recent report.

00:50:25.280 | - I think that most of those funds are not advised,

00:50:27.800 | meaning that there's no extra fee being paid

00:50:31.680 | to any advisor on top of that.

00:50:34.480 | I think pretty much most of the money in those funds

00:50:37.920 | is going to be just quote unquote self-directed

00:50:40.960 | by the investor.

00:50:42.200 | Would you agree with that?

00:50:43.480 | - I would agree with that.

00:50:45.640 | And in a number of cases, as you know,

00:50:47.480 | we've got investors who are being defaulted

00:50:49.360 | in to a target date fund.

00:50:52.000 | Now, generally speaking, the lion's share,

00:50:55.280 | I would guess of the assets that are in target date funds

00:50:57.720 | probably were not defaulted in

00:50:59.840 | just because it predated that practice

00:51:02.520 | and that's where the lion's share of the assets are.

00:51:04.640 | But you're right that I would expect

00:51:06.480 | the bulk of that is not advised.

00:51:09.040 | - So this investor gap that is shrinking

00:51:13.120 | or in some cases have gone away,

00:51:15.960 | at the same time, huge flows have left active management

00:51:20.960 | and gone to indexing.

00:51:24.040 | Is there a link?

00:51:24.920 | - Well, I don't know that I would necessarily say

00:51:28.760 | that indexing on its own would promote better behavior.

00:51:33.760 | I think that what we have to consider is context.

00:51:37.360 | In a number of these situations,

00:51:39.800 | what we have seen is that we had investors

00:51:43.240 | who had maybe a small basket of active funds

00:51:46.800 | that were targeting particular styles

00:51:49.520 | and they're switching into programs or strategies

00:51:52.160 | where they're better diversified

00:51:54.120 | and really the name of the game isn't to beat a benchmark.

00:51:58.320 | It's basically to construct an asset allocation

00:52:01.200 | that helps to advance the objectives

00:52:02.880 | that are called for by a more encompassing financial plan.

00:52:06.680 | And I think that context is important

00:52:08.560 | because I think that if you have investors

00:52:10.800 | that are maybe less jumpy

00:52:13.280 | because they're not as focused

00:52:14.680 | on beating a benchmark over time,

00:52:16.600 | but rather seeing that they're making progress

00:52:19.480 | with their plan as implemented

00:52:21.200 | through a broader asset allocation framework

00:52:23.440 | that's implemented with passes,

00:52:25.280 | they're just gonna be less prone to buy and sell

00:52:29.000 | at inopportune times, they'll stick with the plan.

00:52:32.280 | And then there are certain mechanisms

00:52:34.680 | that enforce this, right?

00:52:36.120 | I mean, we talked about defined contribution plans.

00:52:39.200 | That's kind of the name of the game

00:52:40.840 | is you're just putting your money in, in a regular fashion.

00:52:44.000 | It goes into the target date fund

00:52:46.160 | and it takes care of everything for you.

00:52:48.240 | And in some of those cases,

00:52:49.400 | those target date funds are investing in index funds.

00:52:53.440 | And so I think that some of that context is important.

00:52:57.640 | I think that there probably is evidence,

00:53:00.760 | anecdotal or otherwise that index investors,

00:53:05.480 | they approach investing in a slightly different way

00:53:08.680 | they maybe are a bit more focused on the long-term

00:53:11.120 | and managing what they can like cost and tax efficiencies.

00:53:15.160 | And therefore they don't have the same propensity

00:53:17.320 | to trade around their portfolio

00:53:19.560 | as maybe another type of investor

00:53:21.240 | is a different set of motivations,

00:53:22.720 | including beating the market,

00:53:24.480 | or maybe they're a little bit more fixated on performance

00:53:27.200 | and perhaps they're more tempted to chase.

00:53:29.520 | - Well, it makes me circle back to my original comment

00:53:33.320 | at the beginning of this podcast

00:53:35.440 | that the original purpose back in 1924

00:53:38.800 | for starting mutual funds

00:53:40.480 | was to give people a diversified portfolio

00:53:42.960 | and it wasn't necessarily to outperform the market.

00:53:45.880 | And now index funds have become a better mousetrap

00:53:50.880 | and made active funds obsolete.

00:53:54.440 | And to me, the performance gap data

00:53:56.920 | is showing that people are figuring this out.

00:53:59.880 | - Okay, one last question.

00:54:02.120 | We hear a lot of stories in the media.

00:54:03.640 | I think these come up all the time,

00:54:05.880 | negative stories about indexing.

00:54:08.400 | Indexing is, it's gonna blow up the market

00:54:12.480 | because so much of the market is in index funds now,

00:54:16.000 | it's causing the market to be way overvalued.

00:54:20.000 | Is there any relevance to any of these stories

00:54:21.840 | that we hear in the news media?

00:54:23.400 | - I think that's mostly bunk and self-serving.

00:54:27.200 | I think that the strongest proponents of arguments

00:54:30.440 | like those tend to be those that stand to gain

00:54:33.920 | from active investing, finding followers.

00:54:37.400 | And there's many thoughtful defenders of active investing.

00:54:40.160 | I don't wanna denigrate them too,

00:54:42.080 | but it tends to be a self-serving argument.

00:54:44.520 | I think the most important thing to keep in mind,

00:54:46.480 | and it's a point I know that you

00:54:48.160 | and other Bogle heads have made repeatedly.

00:54:50.640 | And I think it's a point well taken

00:54:52.640 | is that a cap-weighted index

00:54:55.640 | that does a good job of capturing a beta,

00:54:59.760 | of delivering a market exposure,

00:55:03.320 | by definition, it should be mirroring the other,

00:55:06.760 | the sum total of other participants

00:55:08.480 | that are investing in that same area,

00:55:10.840 | including active managers.

00:55:12.720 | And so sort of this notion that indexing

00:55:16.240 | is going to get so big that it's gonna be destabilizing

00:55:19.080 | or somehow fund house mirror distort markets.

00:55:23.760 | I mean, to me, that's self-contradicting

00:55:26.480 | insofar as an index is like holding up a mirror.

00:55:29.280 | And what you see is the sum total

00:55:32.000 | of what other participants are engaged in in that market,

00:55:34.960 | including active investors.

00:55:36.520 | And so I don't buy that argument.

00:55:39.880 | I continue to think that indexing is a prudent way

00:55:44.320 | for investors to get low-cost exposure to market segments

00:55:48.120 | as part of a more encompassing plan.

00:55:50.440 | I think that there can be a place for active investing,

00:55:54.840 | but I think that investors should be judicious about it.

00:55:57.560 | And one of the best ways to sort of really understand

00:56:00.600 | what your limits might be there

00:56:02.160 | is just to look at some of the data

00:56:04.480 | that we try to make available

00:56:06.120 | and that others have made available.

00:56:07.840 | That would give you a sense of what the odds of success are

00:56:10.680 | and know what sort of barriers stand in your way

00:56:13.160 | so that when you do put on an active exposure,

00:56:17.080 | you know what you're getting into

00:56:18.400 | and you've calibrated your expectations accordingly.

00:56:22.120 | Well, Jeff, it's been wonderful to have you

00:56:23.480 | on Bogle Heads on Investing.

00:56:24.640 | You're just a wealth of knowledge

00:56:27.000 | coming from an unbiased source, I would say,

00:56:28.800 | that Morningstar is not trying to manage money,

00:56:32.600 | not trying to outperform anything,

00:56:35.000 | just trying to put out there the data as they see it.

00:56:38.600 | And thank you so much

00:56:39.720 | for being on Bogle Heads on Investing today.

00:56:42.360 | Oh, it's been my pleasure.

00:56:43.280 | Thank you so much for having me.

00:56:44.320 | I really enjoyed it.

00:56:45.600 | This concludes Bogle Heads on Investing, episode number 33.

00:56:49.720 | I'm your host, Rick Ferry.

00:56:51.680 | Join us each month as we have a new guest.

00:56:54.360 | In the meantime, visit bogleheads.org,

00:56:57.760 | boglecenter.net, the Bogle Heads Wiki,

00:57:01.160 | view our new Bogle Heads Live Speaker Series,

00:57:04.960 | get involved in your local Bogle Heads chapter

00:57:07.400 | or a virtual community, and tell others about it.

00:57:10.880 | Thanks for listening.

00:57:11.920 | (upbeat music)

00:57:14.520 | (upbeat music fades)

00:57:17.600 | (upbeat music)

Bogleheads® on Investing Podcast 033 – Jeff Ptak, host Rick Ferri (audio only)

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