W. Scott Simon
Anybody who has been in the investment advisory business for any length of time knows that clients are gained and clients are lost. Some departing clients might receive something like the following missive from their advisory firms:
Dear Dr. Stanislaus:
I’m distressed to see that your medical practice is leaving us as a client. I well remember years ago when I first met with you and your colleagues at your clinic in Indianapolis.
The reason why you’re leaving us is especially concerning to me: Big Bank showed you and your colleagues their portfolios that have earned high returns, and you fell for it. That makes you return-chasers.
No doubt it’s easy to succumb to such allures, especially since the 401(k) portfolios our firm has invested and managed for you and your colleagues have experienced a period of relatively low returns over the last few years. You have likely been frustrated with those returns. Still, your returns reflect those of major asset classes the world over in which your low-cost portfolios are broadly and deeply invested. Nonetheless, you turned to other sources that were all too glad to show you those portfolios of theirs that achieved higher returns over the same time period.
One of the certainties of investing is that it will always be possible for you to find portfolios that have done better than your current portfolios. You might read about them in the media or hear about them from cocktail party chatter. Or, in this case, Big Bank showed you selected portfolios of theirs that did better–in the past–than your current portfolios did.
There are a number of reasons why you should take such presentations of outperformance with a grain of salt.
First, Big Bank showed you only their portfolios that outperformed your current ones but not the ones that underperformed them, which were likely more than a few.
Second, outstanding performances over as little as a few months during, say, a decade-long period can sometimes change a losing record into a winning one. Be careful that Big Bank isn’t selectively presenting time periods in order to mask what may actually be long-term underperformances by their portfolios.
Third, it’s likely that the asset allocation of Big Bank’s portfolios differed in some way from those of your current portfolios, thereby negating from the get-go a true apples- to-apples comparison of their performances.
Fourth, make sure that the performances of Big Bank’s portfolios were cost-adjusted, including taking all costs into consideration. Many portfolios actually generate higher (invisible) implicit costs, such as market impact costs, than (visible) explicit costs, such as annual operating expenses. Implicit costs are usually nowhere to be found in disclosures of portfolio costs by providers such as Big Bank.
Fifth, make sure that the performances of Big Bank’s portfolios were risk-adjusted. It’s nice to have outperforming portfolios but was that achieved by incurring greater risk per unit than your current portfolios?
Sixth, do the composition of the Big Bank portfolios accurately reflect the composition of the benchmarks against which those portfolios are measured? All too often providers use benchmarks that are mismatched to portfolios in order to show outperformance that just isn’t there. For example, a benchmark such as the S&P 500 Index may be used to measure the performance of a portfolio composed of nothing but small-cap stocks, which are oranges in comparison to the large-stock apples of the S&P 500.
In presentations, such as those made by Big Bank, all these seemingly small, yet critical, distinctions I have just noted get lost in the shuffle of glossy color brochures and slick salesmanship.
As you can see, Dr. Stanislaus, I don’t think that being presented by Big Bank with a series of hand-picked portfolios that (purportedly) outperformed over some past time period is the optimal way for you to invest your hard-earned dollars in your 401(k) account (or in your individual retail portfolio, for that matter).
In my view, it’s far better to be invested in portfolios that implement a consistent investment philosophy that will stand you in good stead through thick and thin. Our portfolios have done that in the past and will do so in the future, but it’s unlikely that the Big Bank portfolios will.
Here’s why. First, the portfolios shown to you by Big Bank are costlier than your current portfolios and, going forward, will remain so. Investment costs have a large impact on reducing returns, and that deleterious effect only grows over time with the negative compounding of costs against return.
Second, the Big Bank portfolios are riskier than your current portfolios and, going forward, will likely remain so. The only way that those outperforming Big Bank portfolios were able to achieve higher returns was because they were invested (skillfully or luckily) in some sub-set of the market that must be–by definition–riskier than the market in which your current portfolios are fully invested.
Costs and risks can have a large impact on return. Wholly apart from these two factors, though, it’s critical to understand that–as Nobel laureate Harry Markowitz, the father of Modern Portfolio Theory, points out–the return earned by any investment is “a random variable subject to inherent uncertainty.”
Some may interpret this as meaning that “nobody knows nuthin'” about investment returns. A more comprehensive, yet largely counterintuitive, explanation follows, Dr. Stanislaus.
The investment return generated by any given individual stock (or individual bond or mutual fund or asset class, etc.) over any given period of time can be thought of as the “pricing path” of the stock. Suppose that the first step taken on the stock’s pricing path began on Jan. 1 when the stock was priced at, say, $20, and the last step on that path was taken on Dec. 31, when that stock was priced at, say, $34.
New information–otherwise known as “news”–impacts the pricing path of that stock through the year, thereby determining its return. But on Jan. 1, the content, magnitude, and sequence of information (both accurate and even wholly inaccurate) flowing through financial (and non-financial) markets that will impact the pricing path of that stock over the ensuing year (and thus determine its return) are all unknown. But when you look back in time from the vantage point of Dec. 31, the pricing path actually followed by the stock appears to have been inevitable. Based on that, many investors believe that a stock’s past pricing path will generally be the same in the future. This is known as track-record investing, which is explained more fully later.
While this thinking is entirely understandable, it’s also just plain wrong. In fact, at the end of Dec. 31, the pricing path actually taken by a stock (or any other investment) for the year was merely one path–out of an infinite number of possible pricing paths–that could have been taken starting the preceding Jan. 1. The pricing path of a stock therefore isn’t inevitable, even though it may appear to be so after the fact of its occurrence.
Rather, that path is simply a random one, subject over time to unpredictable changes in prices which, as noted, are caused by new information (i.e., news). This is why it’s a demonstrable fact (not an opinion open to debate) that the return on any investment is a random variable subject to inherent uncertainty.
Of course, many advisors, like Big Bank, that work with fiduciaries such as you in investing and managing assets act as if the pricing paths of stocks are knowable in advance. Such advisors believe that they can know which investments will be superior performers and which ones will be inferior performers through a process known as active investing.
The purpose of “active investing” (engaged in by Big Bank in spades)–to “beat the market”–takes a number of forms.
Two forms of active investing–known as “stock-picking” and “market-timing”–focus on the future. They involve attempts to profitably forecast the future price movements of stocks (or bonds or mutual funds or any investment) so that an investor can predict which investments (or investment managers) will be superior (or inferior) performers. As part of this “process,” Big Bank makes economic projections about future returns that, in my view, amount to little more than random guesses.
A third form of active investing–known as “track-record investing”–focuses on the past. This involves attempts to assess which superior performing investments from the past will continue to be superior in the future. A track-record investor, for example, pores over data from a ratings provider and picks (or avoids) highly rated (or low- rated) mutual funds because they have had a great (or terrible) track record.
All such forms of active investing–whether stock-picking, market-timing, or track record investing–lead to the widespread belief among investors that to be successful in maximizing investment performance, they must be able to see into the future or read signs from the past (or find an investment advisor who can) and extrapolate them into the future.
It’s crucial, however, to assess stock-picking and market-timing with a clear-head. Is it really possible to believe that someone can actually know (or hire someone who knows) on Jan. 1 which stock, which portfolio, which money manager, which mutual fund, which investment strategy, which asset class, which anything will end up winning the race on Dec. 31, or any point afterward?
Of course, we know that there will be winners at the end of the year (or month or week or day), but the frustrating thing is that we have absolutely no way of knowing the identity of the winners in advance of their outperformance showing up.
Big Bank–like others engaged in active investment strategies–will tell you that they can/do know in advance, and they expend millions and millions of dollars in advertising and reams and reams of reports to convince investors of such claims.
At the end of the day, though, there is no way for them (or anyone else) to actually know. We all want to believe that someone knows–it’s pretty disconcerting to think that no one knows–but the undeniable fact is that no one can know in advance what the future return will be for any investment.
Despite this, many active managers will tell you that they can consistently outperform the market and/or achieve a positive absolute return in any market environment.
Although investors may be lured by such statements, decision-makers with fiduciary responsibilities are required to soberly assess these claims. The 1992 Restatement (Third) of Trusts (which can be likened as the Bible of modern prudent fiduciary investing) spawned the Uniform Prudent Investor Act in 1994. Based on my analysis of both, it’s clear to me that passive investing is the “default standard” (my own term) of modern prudent fiduciary investing. Prudent investors may depart from a valid passive investment strategy and adopt a proposed active investment strategy, but only if the active strategy can be justified by realistically evaluated return expectations.
Such an assessment must also go beyond a backward-looking analysis (track record investing). A wide variety of sources tells us that any money manager (or investment) with a superior track record is as likely to perform poorly in the future as it is to repeat its superior performance from the past. For example:
- The 1992 Restatement (Third) of Trusts observes: “Evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above market returns in subsequent “
- Virtually every reputable study of mutual fund performance over the last half- century has found that there’s no reliable way to predict when–or which, or even if– winners from the past will win again in the future. Indeed, data show the perverse tendency for many superior track records to be followed by inferior track records. Remember that medical devices stock, Dr. Stanislaus? Just when you thought that it was going to soar in value because it had done so well over the last 18 months, it instead plunged.
- These factors are exactly why the U.S. Securities and Exchange Commission requires every advertisement for a mutual fund to carry the warning: “Past performance is no guarantee of future results.”
It is indeed a curious thing, then, that the factor of return upon which so many engage in active investing hoping to differentiate themselves from one another–namely, by achieving superior (or avoiding inferior) returns through stock picking, market-timing and/or track record investing–is, on closer examination, an activity over which they have absolutely no control, nothing more than a random occurrence, as unpredictable as a game of coin-flipping.
This letter will conclude in next month’s column.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.