9 Secrets of the Empowered Investor, Part 2

This post is the second of three that outline nine critical factors in investment success, as identified by Keith Matthews, a portfolio manager with Tulett, Matthews & Associates in Montreal.

4. Value and small stocks outperform over time.

Many investors look for opportunities in growth companies. But long-term data show that investments in value companies (which have low price-to-book ratios, and are often out of favor) have produced higher returns than growth companies. Small companies have also produced higher returns than larger, more well-known companies.  These premiums appear to exist in all parts of the world.

These observations were reported by finance professors Eugene Fama and Kenneth French in the early 1990s. They explained that investors perceive higher risk in value and small companies and, accordingly, their stocks should provide higher expected returns. This is consistent with the notion that markets are efficient.

Portfolios that are “tilted” toward value and small-cap stocks add more risk, and therefore should have higher expected returns than the broad-market indices over the long term.

5. Markets move randomly and unpredictably.

The chart below ranks the best and worst performing asset classes each year from 2000 through 2008. Can you spot the pattern and use this information to predict which asset class will lead the pack in the years to come?

Of course, that was a trick question: there is no pattern. Markets and asset classes move randomly and unpredictably, and investors often regret bold portfolio moves based on forecasts and predictions. There is no evidence that tactical asset allocation — that is, moving in and out of asset classes in an attempt to enhance returns — is an effective strategy over the long term.

Index investors use a “set and rebalance” approach to asset allocation that is not based on crystal balls. Rather than trying to predict the next hot asset class, they get exposure to all of them at all times.

6. Passive outperforms active over the long term.

Few actively managed strategies have matched index or asset-class returns over any period longer than a few years. Only a very small percentage of actively managed Canadian, US and international equity funds beat their benchmarks over the last five years, according to Standard & Poor’s. There is nothing new here: similar results have been seen since the first studies of manager performance in the 1960s.

What’s more, there is no way to identify the winning funds in advance with any real confidence.

Index funds and ETFs will never rank number one in any given year, but they are the best choice for long-term investors. By doing nothing more than tracking the major indices, the iShares S&P/TSX Composite (XIC), the iShares DEX Universe Bond Index (XBB) and the Vanguard Total Stock Market (VTI) have all ranked in the top quartile over the last five years, according to Morningstar. (In other words, they beat at least three out of every four funds in the same asset class.) The longer the time period under review, the wider the gap between index funds and their active counterparts.

In addition to superior performance, index funds and ETFs also offer excellent transparency, pure asset allocation, low fees and greater tax efficiency.

See also:

9 Secrets of the Empowered Investor, Part 1

9 Secrets of the Empowered Investor, Part 3

7 Responses to 9 Secrets of the Empowered Investor, Part 2

  1. Sam June 11, 2010 at 12:01 am #

    This is good. I like the chart in No. 5, which looks like a replication of a scatter diagram. Monte Carlo anyone?

  2. Michel June 11, 2010 at 6:10 am #

    Great stuff! Can’t wait for the next three. Some active managers of funds might beat the index, but not for long. Check the 10 or 15 year results!

  3. Financial Cents June 11, 2010 at 7:59 am #

    Great work on Part 2 Dan! I really like the figure you used in #5 – excellent visual.

    I think anyone who has been at passive, index investing over the last few years (or hopefully longer) would agree you wholeheartedly, markets are generally efficient. While index funds and ETFs will never be #1, they won’t be far behind even with tracking errors considered. Seems you’re a big fan of iShares too (XIC and XBB), nothing wrong with that.

  4. Sebastien June 11, 2010 at 8:34 am #

    Good post, during the last 6 months I have put in place an asset allocation and rebalancing scheme in accordance with this after reading Bernstein, Gibson, Rick Ferri and Bogle.
    For the value outperformance, I know it is a long time trend but I am scared that this trend has been on for long enough and that it reverses, making growth stocks outperform…Who knows? I was burned in 2007 when ‘dividend achievers’ etfs were launched: DVY, XDV, PID. Those underperformed the last years from the minute they were launched. In the prospectus they were showing incredible backwards calculated returns which with hindsight now looks like data mining to optimize the past returns.
    Then again, maybe I should just rebalance, pour new money in those and they will lead the next cycle.

    What are the thoughts of this community on the future of the ‘value tilt’? Should we stick to the XIUs and VTIs of this world or should we allocate a portion of the portfolio to the value tilt?

  5. gpsguy55 June 11, 2010 at 1:06 pm #

    The chart in number 5 shows luck is a factor in investing. Being lucky or unlucky certainly affects returns, reference Jim Otar’s book “The Retirement Myth” for spreadsheet proof.

  6. Canadian Couch Potato June 13, 2010 at 7:54 pm #

    Sophie: You make an important point that I tried to address in
    this post.

    It’s true that an actively managed fund that trails its index by, say, 0.25% would be preferable to most ETFs, which trail their index by more than that. Rather than comparing active funds to the index benchmark, it’s more illuminating to compare active funds to passive funds (ETFs). The funds mention in item 6 all trounced the vast majority of active funds, and many others can make that claim, too. But not all of them, you’re right. That’s why it’s not enough to choose just any ETF when building a portfolio.

  7. SophieW June 13, 2010 at 7:24 pm #

    I’m not so sure that showing the abysmal percentage of mutual funds that outperform the index is all that relative to passive investing. I’m not coming to MF’s defence here – I am a true convert – but isn’t the objective of ETFs to follow the index? So they will never beat the index either… Aren’t we comparing apples to oranges?

    Maybe we should be looking at how far behind the index most MFs fall due to their MERs and then compare them to ETFs.

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