My mum asked me if she should invest in Neil Woodford’s new fund. Like a bedazzled groupie she doesn’t stand a chance, given how he’s been marketed like a rock star who can print money.

Less sexy than Mr Woodford’s greatest hits – but compelling all the same – is research from Vanguard that states the case for avoiding active fund investing in the UK altogether.

While you can wallpaper your bedroom with this kind of evidence in the US, it’s a rare treat to get pro passive investing data that’s striped with the Union Jack.1

In The case for index fund investing for UK investors, Vanguard makes two powerful points:

• Active funds underperform index funds on average after costs.

• Some active funds can make dreams come true, but the persistence of winners is less reliable than a coin flip. So how can you hope to pick the superstars in advance?

Let’s take these one at a time to see just how strong the case for passive investing is.

Active funds underperform

Vanguard examined the 15-year track record of all the active funds available to UK investors that exist in the Morningstar universe, divided into various categories.

The broad sub-asset classes of global, UK, European, and emerging market equities were considered alongside global, pound-, dollar- and euro-denominated bonds.

The promise of active funds is that they can beat the market, because at the helm they have skilled managers who can deliver exceptional returns. That’s how they justify their high costs.

But Vanguard’s study shows that:

• More than 50% of funds failed to beat their own benchmarks in every single category over 15-years.

• In 10 out of 11 categories, more than 75% of funds failed to beat their benchmarks.

• Over 10 years, over 70% of funds lagged the market return in all 11 categories.

• Over five years, more than 50% of funds underperformed in all 11 categories.

That’s dismal.

“When you say they underperform…”

How badly are the fund managers doing?

Over 15 years the median fund manager is underperforming by anywhere between -0.18% to -0.89% on an annualised basis in every category bar UK equities.

In the UK the median fund manager has actually been outperforming by 0.32% per year, so there must have been some horrendous results booked in the bottom half the draw.

However those median figures don’t account for all the funds that were merged and liquidated over the course of 15 years.

This is known as survivorship bias. It makes the remaining funds look better than they really are because the overall figures are not dragged down by the poor returns of their eliminated fellows.

Picking winners

We’ve discussed the costs of underperformance before but, hey that’s okay. Just don’t choose a stinker, right?

Do your due diligence upfront, pick a fund manager with a stellar track record and a smart strategy, and you can forget all about average returns – or so the active fund management industry would have you believe.

Sadly, there’s a reason why all those brochures are made to carry the warning: “Past performance is not a guarantee of future results.” The fund manager league table is more brutal than trying to keep your position as top Christian versus the lions.

To test the persistence of manager’s skill, Vanguard ranked all equity funds by performance in the five years ending 2008.

It then looked at how the same funds fared over the next five years, to 2013.

As Vanguard puts it:

The results appear to be slightly worse than random.

While around 12.8% of the top funds remained in the top 20% of all funds over the subsequent five year period, an investor selecting a fund from the top 20% of all funds in 2008 stood a 65.4% chance of falling into the bottom 40% of all funds or seeing their fund disappear along the way.

• A fund’s chance of staying in the top tier over both periods = 12.8%

• A top tier fund’s chance of dropping into the bottom bracket or being closed = 48.1%

Only 2.6% out of 1,684 funds maintained their top tier status over the 10-year period.

What if you started at the bottom of the league? Well, 27.9% of those funds gained promotion to one of the top two tiers. But less happily, 51.9% were eliminated, and another 5% remained at the bottom of the heap.

These findings confirm earlier US studies that after accounting for risk there is negligible evidence that active fund managers can buck the market over prolonged periods, once you subtract their high costs.

The end of skill

One explanation for the failure of outperformance is that success itself is hardwired for self-destruction.

Larry Swedroe, in his book The Only Guide You’ll Ever Need for the Right Financial Plan, sketches the process, as described by Professor of Finance Jonathan Berk:

Who gets money to manage?

Well, since investors know who the skilled managers are, money will flow to the best manager first. Eventually, this manager will receive so much money that it will impact his ability to generate superior returns and his expected return will be driven down to the second-best manager’s expected return.

At that point, investors will be indifferent to investing with either manager and so funds will flow to both managers until their expected returns are driven down to the third-best manager.

This process will continue until the expected return of investing with any manager is the benchmark expected return: the return investors can expect to receive by investing in a passive strategy of similar riskiness.

No one doubts that some people exist who can deliver superlative returns.

The problem is you must identify them in advance to profit. You must get to them before their secret is out and the market heaps so much money upon them that they become closet trackers because their positions are so large.

Superior selection is a crapshoot for the average investor because what do you know that everybody else doesn’t? If you’re basing your decision on publicly available information then it will have already been consumed by big players who swarm over excess returns like piranhas sensing blood.

(Hint: Everyone knows about Neil Woodford.)

David Swensen, the manager of Yale’s endowment, had a chilling chapter on this problem in his book Unconventional Success.

Swensen wrote:

Precious few investors enjoy the opportunity to gather direct evidence regarding a portfolio manager’s integrity, passion, stamina, intelligence, courage, and competitiveness.

The information most necessary for selecting superior investment managers remains inaccessible to nearly every market participant.

Seeing a glowing advert for a high-profile fund manager does not constitute gathering direct evidence, needless to say.

Passive investing wins

Even if you’re sceptical about research produced by Vanguard – which is after all the biggest purveyor of index trackers in the world – there are also plenty of industry insiders, such as Swensen and Warren Buffet, who also advise ordinary investors to put their money into passive investing.

The reason is that passive investing will provide you with average returns at a low cost.

Whereas active funds will in all probability provide you with average returns minus a higher cost.

You’ll probably get to keep more of your money if you choose the low cost route.

Take it steady,

The Accumulator

1. Pedant alert: desperate to point out that the Union Jack is actually called the Union flag? Go tell these guys. [↩]

Good reads from around the Web.

The debate about ‘smart beta’ – the passive strategies that seek to give index investors some ‘alpha’ edge – has found its way into the Financial Times. [Search Result]

For those confused about the terms, FT journalist John Authers explains:

A stock with a beta of 1 moves exactly in line with the market at all times. The market itself has a beta of one.

Alpha is the variable that captures all market moves that cannot be explained by the market.

In financial parlance, you can buy beta very cheaply by buying an index fund. Meanwhile alpha is elusive and comes at a price.

This justifies the rise of passive index funds and exchange traded funds. They give you beta, cheaply.

But index funds are dumb, accepting prevailing valuations unthinkingly.

So why not offer index-like fund management that works automatically, and so keeps costs down, while exploiting anomalies in stock valuations to try to beat the index?

It sounds great in theory, and here on Monevator we’ve already looked at ways you might try to benefit – by investing in the value premium for example.

However we’re suspicious of claims that these strategies are a no-brainer route to extra returns for all. We suspect at the least you’ll pay in terms of higher risk, volatility, and trading fees.

I think there’s also a danger that the market will arbitrage away your smart beta strategy before it has actually delivered its excess gains into your portfolio.

Worse, you won’t know whether that’s what’s happening – or whether your strategy is just having an off-year or five – until it’s much too late.

Sick idea

Stamford University’s Bill Sharpe – who won a Nobel Prize for inventing the concept of beta – has a more visceral reaction.

Apparently the concept of smart beta makes Sharpe “definitionally sick”!

Sharpe says all such strategies are factor bets like the value one I just mentioned. He doubts they will last if widely followed.

In response, some smart beta advocates say their strategies will keep outperforming because the benefits come through rebalancing.

(A similar discussion flared up in last week’s comments on Monevator.)

Wouldn’t it be nice to live in their world?

I don’t know whether or not smart beta is a fad. I’m just a humble would-be George Soros in my spare bedroom, bereft of Nobel recognition.

But I do doubt you can get something for nothing. So if smart beta survives, I think it will come with downsides.

For his part, Bill Sharpe seems dismayed by how easily smart beta has captured the imagination:

“I used to worry: what if there’s too much indexing? But human nature means people keep on backing active managers.”

Yet who can blame them, when in theory it seems so easy to do better?

Look at this graph from Millennial Invest. It shows how a US large cap index fund would have done if you removed the bottom 10% of stocks per various smart beta style factors, such as worst value, worst momentum and so on:

A theoretical large cap ‘smart beta’ outperforms handily

Its creator, Patrick O’Shaughnessy, says that:

Diversification is good…to a point. But owning everything—even the junk—can be a drag on returns over the long term.

And he’s right, of course.

Similarly, while active investing is usually seen as a process of finding the winning stocks, we might as easily see it as a process of trying to eliminate the thousands of duds.

Factor in the risk of failure

Most active investors fail in their quest, and maybe most smart beta investors will meet the same fate.

For starters, as best I can tell the theoretical returns in the graph above ignore costs.

Then there’s human emotion to consider…

Any non-pure index strategy will sometimes do worse than the index: That’s a guarantee you can take to the bank. So anyone who bets on smart beta will have to endure periods of bad performance – not in hindsight on a graph, but in real-time over years and maybe decades, as their strategy lags the market and their time horizon dwindles.

They will have to faithfully hold on to make up for these poor years, with no certainty they’ll be rewarded. Many will capitulate at the worst time.

Is that a smart strategy?

For a small percentage of your money in the hope of just a glimpse at the Holy Grail, perhaps it’s worth a gamble.

But I wouldn’t bet the house on it.

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Plus good reads from around the Web.

A recent investor event I attended gave the usual insights into the average private investor’s mindset.

In 2011 I went to a monthly investing meet-up in a pub, where the talk was all of gold and oil miners. Literally nobody wanted to talk about anything else. It was one of the biggest contrarian signals I’ve ever encountered.

This time virtually everyone was debating how to prepare for the imminent stock market crash.

I’m not exaggerating – about the only people who weren’t preparing for a crash were those who believed such preparation was futile. On balance they still expected a crash, but they had a sort of passively-active mindset that steered them towards investing through the seemingly inevitable meltdown.

Is this just as big a contrarian signal as the one I saw in 2011? Does this universal pessimism mean we can be optimistic about future returns?

I’m not sure.

American splendour

While a five-year old and largely hated and ignored bull market doesn’t in itself point to an imminent plunge, higher share prices do mean inferior value and so lower returns in the future.

That’s just the way the maths works.

The US market still looks to me by far the most expensive. I’m very underweight there, and what I do own tends to be in the ‘beaten up’ category.

The always thought-provoking Meb Faber highlighted the relative expensiveness of US stocks this week in an article on home bias:

The U.S. is actually above the upper end of the range for expensive countries. […]

The U.S. was cheap relative to the rest of the world in the early 1980s, which also happened to be the start of the long bull market. [Whereas] the late 1990s saw the U.S. near the top of the range, which preceded the bear market that began in 2000.

Will the current overvaluation signal another bear or perhaps a time to shift more assets to foreign markets?

There was a similar point made by another US blog, A Wealth of Common Sense, which pointed out the average investor is greedy and fearful at exactly the wrong times:

A recent study from Harvard showed that in February of 2009 (during the crash), investors expected annual returns of only 3.9% a year going forward.

But in January of 2000 (during the tech bubble), expectations were for 14.3% annual returns.

Of course 2009 was a terrific buying opportunity while 2000 was not the time to be upping your expectations for future gains.

Perhaps those skittish investors I met are right to be cautious then – at least if they’re thinking of the US market?

Or are they set to be confounded again by this huge long melt-up that nobody has ever really celebrated?

To bail or not to bail

While I agree the US seems to be the most over-valued stock market index, that doesn’t mean it’s a reason to bail out of equities altogether.

Indeed The Wealth of Common Sense blogger seems to fall into this trap himself.

Wisely admitting how difficult market timing is – and addressing a US audience – he suggests that only the following three classes of investor should sell US stocks here:

1) Investors that have spending needs within the next few years (this has always been the case).

2) Investors that have seen their asset allocation to stocks drift much higher than their target portfolio weight (this has always been the case).

3) Investors that don’t have the willingness or ability to withstand periodic losses in exchange for longer-term gains (this has always been the case).

This is very solid advice, but I would suggest there’s also some home bias creeping in here, of the kind Meb Faber writes about.

That’s because there’s a fourth class of investor who might sell – an investor who is prepared to reduce his or her US exposure in favour of apparently cheaper overseas markets.

Cheap and expensive countries

Where might they be? The Meb Faber article has some pointers, and so did the Telegraph this week.

Its analysis looked at cyclically adjusted P/E (CAPE) ratios, price-to-book values, and dividend yields:

To be named “cheap”, markets had to be trading below their own historic valuation across all three measures.

Only a handful of stock markets managed to achieve this feat – Greece, China, Hong Kong, India, Japan, Russia and Turkey.

And the expensive? By its reckoning the US, followed rather oddly by Pakistan and Sri Lanka. (The UK is up there, too, judged by two of the measures – by CAPE we’ve still more room to run).

To conjecture wildly, I’d guess the US is so expensive because of the general fear that still persists in the financial world. Despite shares offering better value elsewhere, those with money feel more confident having it invested in America. The weight of this money may have bid up prices to excess.

In contrast, Pakistan and Sri Lanka may be the sort of expensive-looking markets that defy obvious analysis. Perhaps investors are correct to bid up these former backwaters because company profits there are going to explode?

Time will tell.

What to do if you must do something?

Valuing markets is something that looks easy to novices but is notoriously difficult, especially over the short to medium term.

Seemingly expensive markets can continue to deliver strong returns for many years, and even an eventual crash may not be enough to make up for the gains missed by those who bailed out too soon.

For passive investors, the best advice is to make sure you’re globally diversified, and then let your automatic rebalancing take the strain.

Passive investors don’t believe they’re smarter than the market, so they shouldn’t start now.

As for us active adventurers, my feeling is too many people are cautious in the UK for this to mark the top of the bull market, although of course anything can happen at any time to change that. Stock markets are inherently unpredictable!

But I do think with plenty of still-cheap countries around the world, it makes more sense for active investors to favour putting more money abroad instead of hugely dialing down their equity exposure altogether.

While I did take some money out of the market at the start of the year – someday I’ll need to buy that still-postponed property, and I was at well over 90% equity exposure by the end of 2013 – that’s mainly what I’ve been doing.

I haven’t had so much invested in emerging markets in my investing lifetime, for example, and it’s started to come good in the past few weeks. If anything I’m tempted to add more.

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