The Case for Active Investing

[CM]

JavaGuy started a thread named "American Funds pushes back against indexing." It links to the company website and data purporting to show that American Funds equity products have beaten their indexes over many decades. I find this credible, but more importantly, active managers in aggregate do beat their indexes before expenses.

I think it's important to point this out because it seems to be an article of faith on personal finance blogs that individual investors cannot improve on the returns of index funds by researching stocks and investing actively. Yet fund managers (including the good, the bad, and the awful) do it despite many disadvantages relative to individual investors.

The biggest disadvantage is size. They may have to manage $10 billion, but you may not have $10 million. They also hold cash to fund withdrawals they can't control. They risk losing clients (who typically chase short-term performance) if they make substantial investments in out-of-favor companies that may take several years to pay off.

Individual investors can also manage their portfolios to optimize their personal tax burden, thus improving after-tax returns, the ultimate bottom line.

There is no reason to believe that a busy physician (lawyer, engineer, etc.) with no financial training can beat indexes. On the other hand, if you have the time and the interest, why shouldn't you be able to use the advantages above to improve upon the pre-expense, market-beating returns of active managers?

For example, WCI must have invested enormous time and effort in this blog and related speaking engagements over a number of years. Many other physicians invest time and money and suffer a significant hassle factor to build a real estate portfolio. Blogs and rental properties may provide attractive returns or losses (measured in time or money), depending on the ability and work ethic of the blogger/landlord.

I contend that effort invested in equity management is the same, but apparently this is a minority opinion.

[Zaphod]

People also forget that hedge funds absolutely used to crush it for a long time even with their fees. What has happened is simple market forces. These margins brought in so much competition there is very little alpha left to fight for. At the same time factors and knowledge is no longer hidden in black boxes but on the web for all to see, further decreasing any hidden values and pockets to be exploited. Yes its possible, and in fact used to be easy, but there are simply way too many very smart people all clamoring for a fixed amount of outperformance, its a self limiting thing.

At the same time people have become even more fickle and dont want any draw downs which has taken hedge fund to be closet indexers for the great majority and certainly for mutual funds/etfs. Those with active share can and do outperform, albeit with volatility and no predictability. You have to choose funds that are not representative of the overall market/index and are concentrated, but there is also increased risk that when combined with the above make little sense.

Its actually far easier for us little guys to do better with such small amounts of capital, but again is risky personally and the possible upside is not great compared to the downside. We are already lucky that we have an income that allows us to win by contributions only, why take on extra risk?

For the record I myself do some types of investing that would be seen as heretical and excessively risky, but I do know the risks and see the points of those that do not.

[CM]

Zaphod wrote:

People also forget that hedge funds absolutely used to crush it for a long time even with their fees. What has happened is simple market forces. These margins brought in so much competition there is very little alpha left to fight for. At the same time factors and knowledge is no longer hidden in black boxes but on the web for all to see, further decreasing any hidden values and pockets to be exploited. Yes its possible, and in fact used to be easy, but there are simply way too many very smart people all clamoring for a fixed amount of outperformance, its a self limiting thing.

At the same time people have become even more fickle and dont want any draw downs which has taken hedge fund to be closet indexers for the great majority and certainly for mutual funds/etfs. Those with active share can and do outperform, albeit with volatility and no predictability. You have to choose funds that are not representative of the overall market/index and are concentrated, but there is also increased risk that when combined with the above make little sense.

Its actually far easier for us little guys to do better with such small amounts of capital, but again is risky personally and the possible upside is not great compared to the downside. We are already lucky that we have an income that allows us to win by contributions only, why take on extra risk?

For the record I myself do some types of investing that would be seen as heretical and excessively risky, but I do know the risks and see the points of those that do not.

Click to expand...

If you mean that the upside is not great compared to the downside because the index (the default option) provides an adequate return (given the amounts we can save), so that the benefit of outperformance is outweighed by the consequences of underperformance, I think that is a reasonable position on average.*

If you mean that the degree of outperformance or underperformance has a negative skew, I'm not sure why that should be true. A monkey with darts should have a 50:50 chance of either outcome with a Gaussian distribution, correct? If you can add any value relative to a monkey, the distribution should have a positive skew.

 

*Today's circumstances are not average. With the Shiller PE above 28 (http://www.multpl.com/shiller-pe/), expected returns are well below average. If the PE10 was in the single digits, I'd be more inclined to rely on an index fund and call it a day.

[Complete_newbie]

I am with you CM and Zaphod is on point.

1. We are all very lucky (? not a good word) that we can generate the income that we do. Not many can. It'll take a good homerun hit in a business for a business owner to generate MD income. Not saying we make a lot, but enough so that one can invest in index funds and be FINE.

2. I personally believe that income allows us to TAKE more risk. What happens in real life is dump in index fund 3 portfolio or whatever and call it a day. Because thinking is "Do not lose money!" Playing it safe.

3. As a "newbie" I am struggling to understand if index investing is really investing at all. I mean I set up a 3 fund portfolio in 401 K recently (yes long story, I didn't have 401K before) and it is on auto set. Is that investing? really? I have NO idea what a company's balance sheet is or revenue growth etc. On the other hand I have been screening RE investments and am finally close to pulling the trigger with 2 other partners on a deal after like 6 months of modeling, due diligence etc. I understand my risks, market, and what I can do to achieve the returns. I think that is investing.

4. Totally agreed. 10% S&P 500 returns last year. Legit because economy kick rear or BS? with PE of 28 yea...the later.

5. Your thoughts are going on deaf ears on this forum. Also passive investment is so simple, it sells on personal finance blog. Can they really talk about unique investments as a replicable process for readers to then be able to generate ad income? Yea. Not so much.

[The White Coat Investor]

CM wrote:

JavaGuy started a thread named “American Funds pushes back against indexing.” It links to the company website and data purporting to show that American Funds equity products have beaten their indexes over many decades. I find this credible, but more importantly, active managers in aggregate do beat their indexes before expenses.

I think it’s important to point this out because it seems to be an article of faith on personal finance blogs that individual investors cannot improve on the returns of index funds by researching stocks and investing actively. Yet fund managers (including the good, the bad, and the awful) do it despite many disadvantages relative to individual investors.

The biggest disadvantage is size. They may have to manage $10 billion, but you may not have $10 million. They also hold cash to fund withdrawals they can’t control. They risk losing clients (who typically chase short-term performance) if they make substantial investments in out-of-favor companies that may take several years to pay off.

Individual investors can also manage their portfolios to optimize their personal tax burden, thus improving after-tax returns, the ultimate bottom line.

There is no reason to believe that a busy physician (lawyer, engineer, etc.) with no financial training can beat indexes. On the other hand, if you have the time and the interest, why shouldn’t you be able to use the advantages above to improve upon the pre-expense, market-beating returns of active managers?

For example, WCI must have invested enormous time and effort in this blog and related speaking engagements over a number of years. Many other physicians invest time and money and suffer a significant hassle factor to build a real estate portfolio. Blogs and rental properties may provide attractive returns or losses (measured in time or money), depending on the ability and work ethic of the blogger/landlord.

I contend that effort invested in equity management is the same, but apparently this is a minority opinion.

Click to expand...

Many investors think this. Then they try it. Then they realize why investing in index funds is so smart. It's a lot harder than it looks and unlike most things in life, additional effort doesn't necessarily pay off.

[Zaphod]

I do mean your first point. As to Shiller CAPE its not that great to use for forward returns as its been predicting terrible returns every year and it has not materialized. One day it will and people will say it was predicted, but down periods occur no matter what. We have spent the last two decades 98% higher than average cape and it has been until just this year a flat market, we just may possibly be breaking into a new bull market finally. We'll see if Trump throws any kinks in that, but I lean to that before thinking we'll crash (outside of 20-30%, which is absolutely normal and you have to expect).

The economy is doing great and has been. Until this changes, over valuation, etc..etc...insert favorite scary theme will only have temporary flux in the market and be meaningless in long term. Heres a comment I made during last years scare, and you'll note it was the day before the official bottom. WCI was selling bonds and buying stocks, I was going all in stocks as well at the time.

Zaphod | February 10, 2016 at 1:54 pm

"Agree with using the recent market high, makes it dead simple. If youre dead set on timing (and I wouldnt be if you’re long term) your upside from waiting is much smaller than that for getting in now. You’re already 10-15% off the highs depending on your fav broad index.

Thats as good a time as any unless you are for certain we are about to have a recession. Bear markets without a recession (4 of last 10) seem to end near the 20% range, and only those during recessions go much further (obv 6/10). There was a good paper on this a day or two ago. So while more downside may be in the cards…the risk/reward is firmly in favor of being in even so."

The other thing to realize and I tried to touch on in first post is in any given year the amount of out performance you can gain is at the expense of someone else losing, it is a zero sum market from this standpoint. There are so many people now chasing this that it is has been spread so thin as to almost be non existent. This is the problem active management has been coming up against. Also as returns are lower due to lower growth overall fees start to represent a consequential amount of your return. Information asymmetry was where it used to be made and that is almost a nonexistent phenomenon now.

Unless you have an understanding of where your out performance is going to come from, the amount of risk youre willing to take to get it, and when to call it quits you are much more likely to harm yourself than do well long term. That is, you have a process that makes fundamental sense either by structure (my fave), psychological (2nd fave), regime, info asym (pretty much impossible now), or some mechanical system. Most people including learned famed investors/managers of the past in most cases were simply the statistical anomalies that did well. In fact if you find all the 80s gurus and then totally disregard that they came up in the period of the largest fat pitch ever (1982), which accounts for likely 90% of their greatness, you see the number that did great for 20 years is consistent with the number that would have by chance. Not very reassuring.

[WallStreetPhysician]

I've written several posts about this topic on my blog:

8 Reasons Why You Should Not Trade

If You Must Trade, Follow These Five Rules

In short, if you are going to trade, you need an edge. Physicians working hard caring for patients do not have the time, knowledge, energy, or resources to gain that edge.

I'm writing a series of posts about Wall Street traders / investors who have successfully beaten the market. The common theme among them is that they have some advantage over the rest of us that enables them to beat the market. That advantage is different for each trader, but none of these advantages is something that can be replicated by your typical retail physician investor.

Many physicians will beat the market, and they will brag about it to their friends or on message boards, but it will be purely because of luck.

[The White Coat Investor]

Just a reminder that the reason active management no longer works isn't because nobody is smart enough to outsmart the market. The reason is that there are too many very smart people trying to outsmart the market. The more people try to beat it, the harder it becomes to beat. So what might have been easy for Benjamin Graham was harder for Warren Buffett is nearly impossible for you and I.

[CM]

It is difficult. It requires education (formal or informal) and research. It might not pay off, and most people don't want to invest the effort. Who can blame them?

Most blogs don't make money. Rental properties and franchises can lose money. All of these things require effort and risk.

However, just about everyone acknowledges that it's possible to earn a return on effort with blogs, real estate, or franchise operations. Yet there seems to be a consensus that equity investing is an impossible black box.

Based only on my acquaintances, most people fail at active investing because they don't make sufficient effort. They dive in without knowing what they are doing, or they treat the endeavor like a night at the casino. They are the bloggers that give up after a year, and the franchisees who don't understand their UFOC.

But I should stop writing. The fewer intelligent, motivated investors the better (for the rest of us).

 

[WallStreetPhysician]

Duplicate post.

[WallStreetPhysician]

CM wrote:

It is difficult. It requires education (formal or informal) and research. It might not pay off, and most people don’t want to invest the effort. Who can blame them?

Most blogs don’t make money. Rental properties and franchises can lose money. All of these things require effort and risk.

However, just about everyone acknowledges that it’s possible to earn a return on effort with blogs, real estate, or franchise operations. Yet there seems to be a consensus that equity investing is an impossible black box.

Based only on my acquaintances, most people fail at active investing because they don’t make sufficient effort. They dive in without knowing what they are doing, or they treat the endeavor like a night at the casino. They are the bloggers that give up after a year, and the franchisees who don’t understand their UFOC.

But I should stop writing. The fewer intelligent, motivated investors the better (for the rest of us).

 

Click to expand...

Trust me, there are plenty of smart people working on Wall Street. Some people lament the brain drain from academia into finance; imagine all the advances we could achieve in science and medicine if the best and brightest worked in medical research instead of coding algorithms to make money off Donald Trump's tweets.

[Zaphod]

CM wrote:

It is difficult. It requires education (formal or informal) and research. It might not pay off, and most people don’t want to invest the effort. Who can blame them?

Most blogs don’t make money. Rental properties and franchises can lose money. All of these things require effort and risk.

However, just about everyone acknowledges that it’s possible to earn a return on effort with blogs, real estate, or franchise operations. Yet there seems to be a consensus that equity investing is an impossible black box.

Based only on my acquaintances, most people fail at active investing because they don’t make sufficient effort. They dive in without knowing what they are doing, or they treat the endeavor like a night at the casino. They are the bloggers that give up after a year, and the franchisees who don’t understand their UFOC.

But I should stop writing. The fewer intelligent, motivated investors the better (for the rest of us).

 

Click to expand...

I dont think thats the case. With all those other things you have to put in effort to do well, and unless you're cracking the nut it wont happen at all. No one believes investing is a black box, its just that literally the richest and brightest people in the world are all gunning for it as well, competition is fierce and that makes the return lower.

In contrast to those things investing gives you a return for no effort whatsoever, and its pretty dang good. Then given tax, commisions, and other drag the more effort you put into investing often times the more likely you harm your returns. So it just has to make dang good sense. I think we all go through periods feeling like we can and should beat it, I have been trying for the last several years to do less and less and be more focused in what I do if anything. I still cant seem to totally stop myself, but I wish I could, though I like my strategies and they are not dependent on any fancy extra work (besides all the learning I guess).

[ginmqi]

OP wrote:

"most people fail at active investing because they don’t make sufficient effort.

...

But I should stop writing. The fewer intelligent, motivated investors the better (for the rest of us)."

 

Seemingly two cognitively competing views. On the one hand you tout that the reason for non-success is people not making enough effort...but then again in the last sentence you imply that the fewer people the better it is for the rest of us (implying there is a zero sum phenomenon).

 

A few thoughts:

-What indexes are the active guys using to measure? Seems like a biased selection if they can select funds that make their own look good.

-You mention they do beat indexes...before fees. Can consumers easily buy into active funds, beat indexes AND come out ahead after fees?

-If you know of or have a way to beat indexes...why not share it? If this is not a zero sum game, as you mentioned, there should be no problem in sharing the wealth so that your colleague, friends, family, and everyone else can benefit from increased investment returns.

 

"The primary takeaway is that actively managed funds have a very high bar standing in the way of market-beating performance. Since 1871, the S&P 500 Index has returned about 9% annually. Thus, with an average fee of 0.84%, an actively managed mutual fund would need to generate a 9.84% annual return just to match the returns of an unmanaged stock market index." source: http://www.fool.com/investing/2016/08/27/index-funds-vs-mutual-funds.aspx

Of course there are managers who can beat the index consistently year after year for 10, 20, 30 years. See legends like Peter Lynch and et al. But where are you going to find someone who can do that for you for 30 years?

As a high earning professional, I contend that we are LESS in need to take risk. We're already VERY fortunate to be in our position as MDs in the USA worrying about retirement and returns and not about our next meal or if our family will live through a bombing/attack/famine/etc in a neighborhood/nation that's MUCH worse. So this is why I stick with indexes and I don't try to chase the highest return possible.

 

 

[CM]

WallStr.

[WallStreetPhysician]

CM wrote:

WallStreetPhysician wrote:

CM wrote:

It is difficult. It requires education (formal or informal) and research. It might not pay off, and most people don’t want to invest the effort. Who can blame them?

Most blogs don’t make money. Rental properties and franchises can lose money. All of these things require effort and risk.

However, just about everyone acknowledges that it’s possible to earn a return on effort with blogs, real estate, or franchise operations. Yet there seems to be a consensus that equity investing is an impossible black box.

Based only on my acquaintances, most people fail at active investing because they don’t make sufficient effort. They dive in without knowing what they are doing, or they treat the endeavor like a night at the casino. They are the bloggers that give up after a year, and the franchisees who don’t understand their UFOC.

But I should stop writing. The fewer intelligent, motivated investors the better (for the rest of us).

 

Click to expand…

Trust me, there are plenty of smart people working in Wall Street. Some people lament the brain drain from academia into finance; imagine all the advances we could achieve in science and medicine if the best and brightest worked in medical research instead of coding algorithms to make money off Donald Trump’s tweets.

Click to expand…

I know who works on Wall Street. I earned an MBA from Booth (a prominent Wall Street feeder) and the CFA designation while working as a healthcare equity analyst. My former colleagues are scattered throughout the sell side and (mainly) the buy side.

Click to expand...

What chance does a full-time physician have to out-analyze the mutual funds / hedge funds who employ your former colleagues?