Archive | Research

More Power in Passive Portfolios

Rick Ferri and Alex Benke recently collaborated on an interesting white paper called A Case for Index Fund Portfolios, which I introduced in my previous post. They compared index portfolios to thousands of randomly generated active portfolios to estimate the probability of outperformance. Passive came out ahead in about 80% to 90% of the trials, which is compelling enough. But there were some surprises, too. Let’s look at a few of them.

Indexing gets better with age

Ferri and Benke’s paper was novel in that it looked at portfolios rather than individual funds. They found that combining index funds led to greater outperformance than you would expect from examining the funds in isolation. In other words, the portfolios were greater than the sum of their parts. The authors called these factors Passive Portfolio Multipliers, or PPMs

One of these PPMs highlights the importance of taking a long-term view. Ferri and Benke looked at the five-year periods ending in 2002, 2007 and 2012. The first of those periods includes the dot-com bubble, while the last includes the worst market crash since the Great Depression. Not surprisingly,

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Putting the Portfolio Odds in Your Favour

It’s well known that the majority of actively managed mutual funds underperform comparable index funds over any period longer than a few years. In fact, that statement has become so uncontroversial that even mutual fund salespeople freely acknowledge it. But a recent white paper co-authored by Rick Ferri, A Case for Index Fund Portfolios, takes this idea a step further.

Academic studies of mutual funds go back to the 1960s, and the well-known SPIVA scorecards are updated twice a year. So there’s no shortage of data on individual funds. But investors don’t use mutual funds in isolation: they build portfolios of funds in several asset classes. And there has been surprisingly little research on the performance of actively managed portfolios compared with passive alternatives.

Ferri introduced this idea in The Power of Passive Investing in 2011, and I wrote about his findings when that book came out. Now Ferri and his co-author Alex C. Benke have improved the analysis using more robust data. “The probability of outperformance using the simplest index fund portfolio started in the 80th percentile and increased over time,” the authors write in their summary.

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Seeing Diversification in Action

Why should you add multiple asset classes to your portfolio? That seems like a simple question, but it’s one many investors would answer with only a vague comment about “more diversification.” It’s more precise to say you do so to increase expected returns or to decrease volatility. Sometimes these are mutually exclusive, but Harry Markowitz won a Nobel Prize for explaining that you can sometimes accomplish both at the same time. That insight is the basis for Modern Portfolio Theory.

One of the clearest illustrations of this idea can be found in Larry Swedroe’s book Think, Act, and Invest Like Warren Buffett, which I reviewed late last year. Swedroe shows how the return and risk characteristics of a 60/40 portfolio change as you slice and dice the equity allocations.

A portfolio made up of just the S&P 500 and five-year Treasuries returned 10.6% annually from 1975 through 2011, with a standard deviation of 10.8%. By gradually splitting that equity allocation into multiple asset classes (international stocks, value stocks, small caps, and commodities) the portfolio’s annual return increased 150 basis points to 12.1%,

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Why Your Problem Is Not Your Funds

In Monday’s post I looked at “smart beta,” which promises to outperform cap-weighted indexing strategies. I’m frequently asked if I think Couch Potato investors should dump their traditional index funds in favour of these tempting alternatives. Here’s why my answer is no.

I could rhyme off technical reasons for being skeptical about the outperformance of alternative indexes: the research ignores costs and taxes, the strategies may not work in the future, and so on. But I won’t go down that road, because the most important reason is not technical, but behavioral.

Everything beats the market—except investors

To recap, two recent papers from Cass Business School in London looked at US stocks from 1968 through 2011, a period when a cap-weighted portfolio would have returned 9.4% annually. (Canadian stocks had an almost identical return over those 43 years.) The researchers examined 13 alternative strategies—which favoured value stocks, small-cap stocks or low-volatility stocks—and found all of them outperformed, with returns between 9.8% and 11.5%.

For many people, the takeaway from these findings is, “I should use alternative indexes, because I can beat the market by a point or two.” My reaction is different: I want to know how many investors earned even 9.4%.

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Does “Smart Beta” Really Beat Cap-Weighting?

“Smart beta” has become a buzzword in investing circles, especially among pension funds and other institutional investors. The term may be new, but the idea isn’t: it’s about looking for ways to capture the returns of an asset class with a strategy other than traditional cap-weighting. These alternatives include fundamental indexing, equal-weighted indexes, low-volatility strategies and a few more exotic techniques.

A growing body of evidence has highlighted the inherent flaws in cap-weighted indexes, which are undeniable. By their nature, cap-weighted indexes give the most influence to the largest companies, as well as any that happen to be overvalued. That’s a potential problem because these are companies that are most likely to underperform the broad market over long periods.

A second potential problem with cap-weighted indexes is concentration. This isn’t an issue in huge markets like the US, or in a multi-country index like the MSCI EAFE. But it’s a concern in small countries like Canada (where Nortel once represented about a third of our entire stock market) and in individual sector funds. That’s why I favour the BMO Equal Weight REITs (ZRE) in the Complete Couch Potato portfolio: unlike its competitors,

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Does Dollar-Cost Averaging Work?

Many readers were surprised when I answered a recent Ask the Spud question by suggesting you’re usually better off investing a lump sum rather than using dollar-cost averaging (DCA).

DCA is popular technique that crops up all the time in personal finance books—David Chilton’s The Wealthy Barber was one of the first to popularize it back in the late 1980s. If you need a refresher, DCA is a strategy for investing a large sum gradually. For example, if you have $100,000 you might invest $25,000 today and the same amount in each of the next three quarters, or perhaps $5,000 at a time over 20 months.

The idea sounds appealing: if the markets plummet after you invest a lump sum, you’ll suffer a major loss and be filled with regret. However, by investing a little at a time you avoid putting all your money at risk immediately, and if markets decline you’ll benefit by making some of your purchases when prices are low.

Roy, the eponymous hero of The Wealthy Barber, made DCA seem like magic: “Dollar cost averaging is as close to infallible investing as you can get.

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Are Investors Really This Clueless?

Franklin Templeton recently released its 2013 Global Investor Sentiment Survey, which polled 9,518 people from 19 countries. The survey found that 81% of Canadian investors “expressed optimism about reaching their financial goals.” However, many of the other results suggest this optimism may be misplaced.

I want to stress this wasn’t a random survey conducted on street corners, where you would expect some respondents to be oblivious teenagers or people without money to invest. All of them were at least 25 years old and owned a significant amount of stocks, bonds or mutual funds, ensuring they had “a knowledge base from which to answer the survey questions.”

Here’s the first head-slapper: 52% of Canadians in the survey believed the stock market declined or was flat in 2012. In fact, the S&P/TSX Composite was up 7.2% last year. That’s a remarkable lack of awareness that shows how many investors still refuse to believe we’ve been enjoying a bull market for more than four years. Even more amazing, almost a third of US investors also said the market was flat or down in 2012, despite a rip-roaring 16% return for the S&P 500.

Given these misperceptions,

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Estimating Future Stock Returns

What are the long-term expected returns for stocks? That’s a fundamental question every investor needs to consider when deciding on an appropriate asset allocation. Unfortunately, it’s not a question anyone can answer with certainty—though there’s no shortage of gurus with opinions.

In a paper published last October, researchers at Vanguard examined 15 commonly used methods for forecasting stock returns to see how much predictive power they would have had in the past. These included price-to-earnings (P/E) ratios, dividend yield, earnings growth, economic fundamentals, and recent stock returns. And just for fun, they threw in a red herring: the trailing 10-year average rainfall in the US.

For each variable, the researchers set out to find whether it would have helped predict US stock returns during the 10 years that followed. Suppose, for example, you measured the trailing one-year dividend yield on stocks in 1950. How useful would that variable have been in explaining inflation-adjusted returns from 1951 through 1960? They repeated this for all the factors, in all rolling 10-year periods starting in 1926.

Turns out about half the variables were entirely useless: “Many popular signals have had a lower correlation with the future real return than rainfall,” the researchers wrote.

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Planning to Drive a Monte Carlo

One of the lessons I’ve tried to stress is that investing is not about choosing the right products. ETFs changed the game by giving the little guy sophisticated and low-cost investment tools—no doubt about that. But the fact is, whether you choose this fund from iShares or that one from Vanguard will likely have zero impact on your overall success.

That’s why I was pleased to read Chapter 4 of Larry Swedroe’s new book, Think, Act, and Invest Like Warren Buffett. The chapter is called “The Need to Plan: It’s Not Only About Investments,” and it explains why we need to look at the bigger picture.

“There is evidence showing the biggest drivers are your spending rate, your savings rate, and how long you work,” Swedroe told me in a recent interview. “They influence the outcome far more than an extra 1% return you might get if you are a brilliant investor—and we know active investors would kill for 1% or 2% of alpha. When you run a Monte Carlo you can see how much more important these factors are.”

What’s a Monte Carlo?

Running a Monte Carlo doesn’t mean driving a classic Chevy coupe.

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