How the investment industry sees advice

A few weeks ago I had the opportunity to speak with John Wilson, CEO of Sprott asset management. We were both attending an alumni dinner, I was there as an alum and he was there as the headline speaker. We bumped into each other during the pre-dinner mingle and took immediate mutual interest due to each other’s name tags. I would have never guessed who he was, so his title of “CEO Sprott Asset management” piqued my interest; John noticed my title of “Investment Advisor” and enthusiastically asked if my firm uses Sprott funds. I almost felt bad telling him that we would never consider using Sprott funds. I explained the idea of a market based investment philosophy and mentioned Dimensional funds and he proceeded to laugh that I had drank the kool-aid. He asked me why I would would want to buy index funds when there are managers that outperform the market? I rebutted that it is next to impossible to consistently determine which fund manager is going to outperform. The conversation went on and finished with John’s final point that it is the job of the investment advisor to find the fund managers that are going to outperform the market. If a client is with a good investment advisor, they will consistently be in the funds that perform well. If their advisor doesn’t pick winning funds, they are not good advisors.

It is not uncommon for advisors to pitch their value as their ability to pick the winning manager ahead of time. Is that investment advice? As a client, do you want the person that you are paying to manage your money to spend their time picking which mutual fund manager is going to be able to beat the market in the future? In reality, investment advice is not about picking the next hot stock or the winning fund manager. Investment advice is about applying an evidence based approach to markets to help people achieve their financial goals while managing their concerns. An advisor that is focused on researching fund managers or picking stocks is only fuelling the emotions that lead to poor investment decisions.

How does your financial advisor decide what to invest your money in?

Financial professionals are obligated to offer their clients a suitable investment, but there are many things that can affect which suitable investment your advisor will recommend.

Licensing is one constraint that has the potential to affect a recommendation; some advisors are only licensed to deal with specific types of products such as segregated funds or mutual funds.  In some situations an advisor may be mandated or strongly encouraged to deal exclusively with proprietary products produced by their firm - this can be seen with bank advisors or firms that operate with a captive sales force.  Once an advisor has established the pool of investment choices that they are able to offer you, how do they narrow it down?  Many financial products will pay the advisor for recommending them to a client, and some products pay more than others.  If there are two similar products to choose from, it is possible for an advisor to be swayed by higher compensation.

If we eliminated all of those outside influences, then what would they invest your money in? It's still not an easy question to answer.  Some advisors might pay for research to find the fastest growing companies, or the most undervalued companies.  Maybe they would recommend a dividend strategy, or a portfolio of bank stocks.  They might cite the latest economic data with the intention of directing you towards the most profitable country to invest in.  There are countless ideas and methods of investing that an advisor might pitch, and they will likely be based on some level of prediction.

When you are building your investment portfolio, you don't need to be able to predict the future.  It is important to be very wary of making investment decisions based on the financial news or Jim Cramer's latest tip.  There is a wealth of data and peer reviewed academic research that can serve as a guide in building a robust portfolio that does not rely on prediction.  It is possible to use the whole market as a tool rather than trying to guess which company or geography you should invest in, and by building a globally diversified and rebalanced portfolio the emotion is removed from making investment decisions.

So next time your advisor makes a recommendation, make sure you know what they are licensed to offer you, how they are being paid, and the logic behind their final decision.  If there seems to be a conflict of interest, or they start talking about how China's economic growth is going to affect their favourite stocks, run far, and run fast.

Is Picking Mutual Funds any Different from Picking Stocks?

Today I received an email from an advisor that continues to work with actively managed mutual fund providers to serve his clients.  He sent me a document that a fund company had produced for him showing that actively managed mutual funds have consistently beaten their benchmark ETFs, and asked me what I thought.  My response follows:

Thank you for thinking to send this over.

I think it’s very interesting that the active management vs. ETF/passive debate is important enough for this fund company to have made this document.  I think it is even more interesting that they are pushing their advisors to sell their active funds while they are also making ETFs on the side.

But look, the thing you have to understand is that there will be funds that outperform just like there will be stocks that will outperform. I could go and find a bunch of stocks that have beaten a benchmark over the last ten years and say that it’s possible to beat the market.  It's important to understand that with a mutual fund, any time you are not holding the whole benchmark there can be periods when you outperform and periods when you underperform.  I could go and find a bunch of funds that have not beaten their benchmark over the last ten years just as easily as they found ones that did.

The key though, is that you or I, or even the fund managers don’t know when they will be winners or when they will be losers.  You can go and say "ok, the XX was up 11% over the S&P/TSX last year, I’m going to put my client in that one". But you know as well as I do that past performance does not indicate future performance.  You are betting on that fund doing well on your client’s behalf based on how well it did last year; you have no idea if it will be up or down in the future.  If you don’t know what the fund will do in the future, why not just accept the market’s returns and get rid of the high MER instead of hoping that the fund happens to be up during the period that your client is invested?

Picking funds is on the same level as picking stocks in my opinion.  You can say "well this manager has tons of experience and the fund has done well in the past" and so on, but that’s no better than looking at the financials of a company and saying "oh they have strong earnings, good management, and a stable dividend I will pick that one".  There is simply too much information in both cases to make an accurate prediction AND your clients are paying high fees for you to place these bets... it just doesn’t sit well with me.

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How Hard is it to Beat the Market?

How hard can it really be to beat the market?  If I say that all available information is included in the price of a security, it follows that someone had to act on the available information in order for it to be included in the price.  Someone had to get the information, make a decision to buy or sell the security, and then execute a trade for that information to be included in the price.  So every time someone can be the first to act on new information they must make a profit, right?

In 1945, F.A. Hayek pointed out that there are two types of information:

  1. general information that is widely available to all market participants, and

  2. specific information about particular circumstances of time and place, including the preferences and needs of each unique investor. 

As a pricing mechanism, the market is able to aggregate all information into a single metric.  That metric is the price, and it is constantly influenced by participants competing with each other to be the first to bring information to the market in order to make a profit.  As hard as they try, no single market participant can have the full set of information because new information is being randomly generated constantly.  If someone overhears a conversation between two Apple employees, they are in possession of information that nobody else has; if someone sees an oil tanker sink in the middle of the ocean, they have unique information; if a pension fund manager goes on a site visit to a mine and hears something before everyone else, they have specific information particular to their circumstances – there is an infinite amount of information like this being constantly generated, and due to the nature of the market, people want to use their information to profit.  What does this mean for investors?  It means that all available information can be included in the price of a security without any single provider of information being able to profit from the information that they contributed.

So in short, it’s really really hard to beat the market.

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Risks Worth Taking

Wealth creation takes place when cash flow is steady, there is time to recover losses, and risk is tolerable. 

It's not uncommon for the ability to take risk in the market to be confused with the desire to gamble.  There are some risks worth taking, and some risks that can turn an investment account into a sophisticated platform for placing bets.

Of course, it's a lot of fun to do research and be immersed in the latest information about a company or an industry with the hopes of taking action before the market does.  Consider, though, the amount of other individuals, and more importantly institutions and mutual funds, that are trying to do the same thing.

By the time you read a Bloomberg News headline, the market has already reacted.  By the time the company you're following discovers a new reserve, institutions have already started trading.  The ability of the collective players in the market to price a security as soon as new information develops is intimidating.

It's easy to think that with enough research, it should be possible to outsmart the market by predicting new information before it happens, but new information develops randomly.  If we could predict all new information accurately we wouldn't need the market to create wealth.

So what's a risk worth taking?   It has been proven through years of research that small cap and value stocks produce superior returns over the long term.  Constructing a portfolio tilted toward these asset classes can increase expected returns without relying on speculation.  With these tilts in place, diversifying globally, and across asset classes can almost eliminate non-systematic risk.  You may never make 200% on a speculative bet, but major losses will likewise be reduced.

In creating wealth, the sequence of returns is just as important as the returns themselves.  It's very difficult to beat the long term compounded returns of a robust portfolio with a series of speculative bets.

This may not sound exciting, and it shouldn't.  Well documented research stands behind these remarks - I'm talking about using science to invest, and science is not nearly as exciting as gambling. 

Market Based Investing

In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management.  The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market.  Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time.  It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.

I am happy to disagree with the idea of predictive investment management, but don’t condone the idea of passive investing either. I stand behind a strategy called market based investing.  It is the idea of harnessing what the market has to offer, while taking advantage of asset classes within the market that have been shown over the long term to produce higher returns than the market itself. The idea is to hold the entire market, and then increase the proportion of certain asset classes relative to the market to take advantage of their higher expected returns. Trying to determine which markets would be the best to apply this strategy at any given time would be betraying a scientific approach in favor of prediction. The solution is to build globally diversified portfolios in order to capture the returns of markets around the world while reducing the impact of any single market.

These globally diversified portfolios tilted towards specific asset classes are then rebalanced systematically to eliminate predictive and emotional tendencies as markets move. Implementing this rules-based system ensures that emotions and predictions are removed from investment decisions, and sets a market based portfolio apart from the active vs. passive debate.

The Grossman-Stiglitz Paradox

I have mentioned this paradox before, so I thought it deserved some discussion.  The Grossman-Stiglitz paradox states:

  1. If markets are efficient and securities' prices reflect all available information and,
  2. obtaining information about securities requires resources (time, money)


  1. Why do people commit resources to researching securities at all, and
  2. if people don't need to commit resources to researching securities, then how did the prices get right to begin with?

To me it is a very simple relationship. If there are people that do believe that there are mispricings to be exploited, they will spend their resources to exploit them. It only takes a few mispricings to make people believe that it is possible to find more mispricings. When mispricings do exist, as soon as enough people exploit them, the prices will tend toward their true value. So, markets are efficient because there are a bunch of people out there that don't think that markets are efficient. It becomes an equilibrium situation.

I remember a discussion with a Carleton University finance professor where I asked what would happen if everyone started to buy the index and stopped trying to beat the market. Following our discussion, if everyone started to buy the index, mispricings would start to develop regularly, and arbitrageurs would be able to profit. The profits that these people made would attract other people, and eventually everyone would return to chasing the dream of beating the market. It really all comes back to psychology; nobody wants to accept being average and moving with the market when there are hot shot managers out there that promise to produce double digit returns. There is a lot more emotional attraction to investing with the guy, or to being the guy that can beat the market.

At the end of the day some people will beat the market, sometimes. Statistically, it is very unlikely that anyone will consistently beat the market over a long period of time, and whenever one manager beats the market, another manager must underperform. I love the idea of active management. It is flashy, glamorous, and exciting. Nobody wants to accept being average, but it is far better to be consistently average than to outperform the market one year and underperform the next. Remember how important the effects of compound returns are in building up wealth.

I say let the stock pickers, the gurus, and the hotshot managers try to beat the market. They get to have fun spending their clients' money to make bets and predictions, and they keep the markets efficient for the rest of us.  To look at it another way, it is all of the dollars paid to active fund managers that keep markets efficient - nothing's free, I'm just glad I'm not the one paying for it.

The paradox of actively managed funds

A recent paper by two Wharton professors and a colleague at the University of Chicago discusses the effects that the size of a mutual fund, the size of the fund industry, and fund manager skill have on the performance of actively managed mutual funds.  Historical data trends in these areas were studied to gain information on two hypotheses: as the size of an active fund increases, its ability to beat its benchmark decreases; and as the size of the active fund industry increases, the ability of any given fund to outperform the market decreases.  This study finds that fund size does not have a significant correlation with performance, but the size of the active fund industry does have a significant and negative correlation with performance.  A 1% increase in the size of the active fund industry was associated with an almost 40 bp decrease in the annual performance of the sample of funds examined.  This goes along with what we know from the Grossman-Stiglitz paradox; the more people that are trying to beat the market, the harder it is to get an information edge to beat the market.

Interestingly, the study found that the returns attributable to fund manager skill have increased over the period 1979-2011.  This increase in skill can be attributed to experience, education, or better use of technology. Increasing skill has not been evident in returns because returns have been hampered by growth of the active fund industry.  The study also found that the performance of a fund suffers as it gets older due to constant industry growth and the consistent introduction of more skilled competition.

This paper confirms what we already know about how competition drives the efficiency of markets.  As more entrants compete for alpha, it becomes more difficult to generate it.  It also tells us that although new funds may have increasingly skilled management, the positive effect of this skill decreases quickly in the first few years of the fund's existence.

If growth in the actively managed fund industry decreases the performance of actively managed funds, why would any investor continue to contribute their assets to actively managed funds?

"I want to invest in actively managed funds so that I can beat the market, but by investing in actively managed funds I am decreasing the chances that my actively managed fund will beat the market." It's a new paradox.

(Link to the paper)

How To Construct a Portfolio:

The first step in constructing your investment portfolio is determining a goal for the investment.  Setting an objective allows you to create parameters that make it possible to determine the rate of return that you will require.  The return will be the number that is required to bridge the gap between the amount of capital that you will invest, and your ultimate goal.  Once this model has been created, the parameters and the required rate of return can be adjusted in order to arrive at a required rate of return that is plausible, and that fits with your investment style.  As an example, if you begin with a principal investment of $5000, make a $100 monthly investment, have a 20 year time horizon, and a goal of saving $100,000, you will require a compound annual growth rate of 8.7%.  If it is determined that 8.7% is not feasible, or if it does not fit with your preferred investment style, the parameters can be adjusted.  Following the same parameters, if we increase the principal to $10,000 and the monthly investment to $200, we only require a 3.8% annual return to achieve the goal.  In the charts below, the green bars are the invested principal and the blue bars are investment returns.  Take note of how heavily the person on the left is relying on investment returns to achieve their goal, if the market does not perform as expected they will have a much greater shortfall than the investor on the right.

$5000 principal, $100/month, 20 year horizon, $100K Goal

$5000 principal, $100/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

$10,000 principal, $200/month, 20 year horizon, $100K Goal

Armed with an idea of the rate of return that you will need to achieve your goal with your given parameters, the next step is to determine your tolerance for risk.  Risk and return are very closely related in that an intelligent investor will not assume more risk than is necessary to achieve a given return, and when more risk is assumed the investor expects to be compensated for assuming it.  If we look at the performance of the S&P 500 since 1950, the general volatility of the equity market can be observed.

S&P 500 Performance  - 1950 - 2013

S&P 500 Performance - 1950 - 2013

This chart shows the potential for gains, but it also shows the that capital can be lost in large amounts.  If an investor is able to stay invested when the market is in a dip, history tells us that the market will rise again with time.  This idea gets much more complicated when we factor in psychology and the time horizon of the investor.  If you panic when the market is low and liquidate your investments, you will miss the gains when the market recovers and be stuck holding your losses; similarly, if you have a set date where the capital will be needed and the market is low when you need it you will either be stuck with the losses or not be able to access the capital until the market recovers.  The above chart shows the S&P 500 index which is only an example of a group of stocks.  An investor can build a different portfolio of stocks that is subject to less risk, they can invest in bonds, they can invest in real estate - there is no shortage of investment opportunities, the challenge is building a portfolio that fits your individual needs and investment style.  The following chart from Vanguard illustrates the average returns, and the variability of returns for various portfolios consisting of stocks and bonds from 1926 through December 2012.  Selecting a mix of equities and fixed income securities is called asset allocation - asset allocation is how a portfolio is constructed to fit a risk profile.


With the ideas of setting a goal, determining an acceptable level of risk to achieve that goal, and the right asset allocation to meet that risk level, we are ready to begin selecting the securities.  Picking individual securities is like going to the casino, or like flipping a coin.  The prices of securities reflect all publicly available information, and trying to guess at the new information that may affect the price is not a particularly effective practice.  I once had a pension fund manager tell me that even the best analysts are only right 70% of the time.  It is, however, possible to reduce the risk and increase the expected return of a portfolio through diversification.  Historically, returns of any asset class vary considerable from year to year, and combining assets classes in a portfolio can mitigate this volatility.  To further reduce volatility, global diversification reduces the effect of any single asset class or market.  The figure below shows the variability of returns across asset classes and geographies, common sense tells us that by combining securities across these asset classes and geographies in a meaningful we can reduce the overall volatility of that portfolio.

Variability of Returns.png

At this point we have taken the following steps to construct a suitable portfolio:

  1. Determined an objective for the investment
  2. Determined a time horizon and required rate of return to achieve the objective
  3. Determined a tolerance for risk
  4. Established an optimal asset allocation based on, time horizon, required return, and risk tolerance
  5. Diversify away the risks of investing in any single asset class, market, or geography
  6. The final step is determining a management strategy.  There are two ways that a portfolio can be managed; read after the jump.

What the Automotive Industry Can Teach Us About Mutual Funds

Up until General Motors (GM) went bankrupt in 2009, their business practices created a beautiful juxtaposition for the business practices of Toyota.  GM had been able to rely on their size, market share, and Japan's non-existence to remain profitable for many years.  This fostered an environment of complacency in their ability to perform their core activity...creating vehicles.  In 2006, GM's profitability was mostly derived from financing the sale of their vehicles while they lost an average of $2,300 on each sale; their core activity had become financing while they were still stuck with making cars.  They were using inefficient manufacturing techniques to create a wide array of uncompetitive vehicles.

In contrast, it's no secret that Japanese automotive manufacturers have absorbed the market share that GM was slowly giving up; in 1960 GM held 50% of the North American market, while they only held 19% in 2009.  There were some very clear factors that contributed to this shift in the market, and, strangely enough, I believe that the same principles can be applied to the current state of the mutual fund industry.  The principles are very basic; efficient manufacturing practices, and competitive products.

Efficient manufacturing practices were revolutionized by the Japanese with Just-in-Time manufacturing (JIT).  American manufacturing methods employed economies of scale to keep the cost of machine hours down; they would have a large production run of a single part and then change the machinery to produce the next part.  The problem with this was that the time and cost associated with changing the machinery was cumbersome.  In the event that a manager suddenly needed a small run of rear doors when the machines were set up for front doors, they would be paying a premium for those machine hours.  JIT made the manufacturing process flexible by implementing production machinery and a labour force that was interchangeable; managers no longer had to pay a premium for unexpected production runs because multiple machines could be quickly set up for a small production run of any part.  These interchangeable parts in the manufacturing process eliminated the high fixed costs of any single production run.  Parallels can be drawn between JIT in auto manufacturing and the trading done within a mutual fund.  

Active fund managers will conclude through research that it is the right time to purchase a certain amount of a given security.  When they fill this order, they will be paying a premium to obtain the specific amount of securities at a specific time due to the nature of bid-ask spreads; at a given time spreads will vary, and filling the kind of large market order that an active mutual fund would place will result in paying varying prices for different available lots.  In contrast, a portfolio designed with holding diversified across asset classes and geographies would not need to accept an undesirable bid-ask on any individual security because they would not be looking to purchase any particular security at any exact time.  A mandate may require a certain weighting of domestic small cap stocks, but the individual securities could be anything fitting that description.  This approach lowers overall trading costs; trading costs are not something to be overlooked either.  It would not be unusual to see an actively managed small cap fund with a trading expense ratio as high as 1%.

Lowering the costs associated with producing either a car or a mutual fund is beneficial to both the customer and the manufacturer, but if the product is not competitive, the cost savings do not drive any value.  In 2006, consumer surveys about vehicle value showed that people perceived Toyota vehicles as being better designed and built, costing less to own, and lasting longer than GM vehicles.  This higher perceived value combined with lower manufacturing costs allowed Toyota to grow its margins while GM’s margins became negative.  GM boasted a massive portfolio of brands and vehicles, each one with a wide array of available features.  This lack of focus and internal competition made it very difficult for GM to produce any single excellent product; in contrast, Toyota has only two brands (Toyota and Lexus), and the vehicles that each brand produces have fewer options.  Toyota’s focused approach to the continuous development of excellent products combined with their low costs allowed them to surpass GM as the number 1 auto manufacturer in the world.  As GM’s margins were squeezed by high manufacturing costs and competition with Toyota’s low prices, the quality of their products continued to suffer.  Near the end, and since their re-birth, GM has eliminated or sold many of the brands in their portfolio.

In the context of mutual funds, the industry is in a similar state as GM was before they went bankrupt.  Current funds in general are not of a high quality, they are costly to produce and costly to own.  Much like GM, fund companies are managing massive amounts of mutual funds.  On average, mutual fund companies manage 117 funds, a huge contrast to the average of 1.7 funds managed in 1951.  Just as GM had to eliminate many of their brands to pursue a more focused effort, mutual fund companies have been going through the same kind of consolidation.  Between 2001 and 2012 there was a 7% per year failure rate for mutual funds; failing funds would be absorbed into funds with strong records to mitigate the evidence of their poor performance.  If a mutual fund company were to take the same approach to their product portfolio that Toyota has taken in manufacturing vehicles, it would produce a few high quality, engineered, and focused products.

So, I have drawn a comparison between the automotive industry and the mutual fund industry.  Why do we care?  We care because those who cannot learn from history are doomed to repeat it.  If I went back in time and had a choice between investing in GM and investing in Toyota, I think it’s obvious where my money is going.  If I wanted to use this analogy to decide where to put my money today? Dimensional Fund Advisors would be my Toyota.

Investment Evolution

I have spent the last two weeks doing a lot of reading.  I will soon be entering a new professional environment with new philosophies on investing, and I made it a priority to educate myself on the broad governing concepts that form the investment style of this new firm.  In the readings that I have done I have come across information that I already knew, information that I did not know, and new implications of concepts that I already understood.  Below is a summary of my thought process as I gained an understanding of three-factor asset class investing:

The Efficient Markets Hypothesis (Fama, 1966) asserts that current securities prices reflect all available information and expectations.   Based on this theory, stock mispricing should be considered a rare condition that appears with randomness, and active management strategies cannot consistently achieve alpha

The Efficient Markets Hypothesis states that investors may be best served through passive, structured portfolios using asset class diversification to manage uncertainty and position for long term growth

Diversification helps reduce uncertainty and control risk

Diversification across asset classes allows for efficient portfolio management and flexible trading

Global diversification of overall investment strategies (conservative, moderate, aggressive etc.) created by combining asset classes can minimize the volatility caused by the inherent randomness of returns

A globally diversified portfolio should include asset classes that are exposed to different macro risk factors, with different dimensions of risk and return across the globe

Using the size of a country’s stock market relative to the world’s total market value rather than economic data (population, GDP, consumption etc.) to assign asset classification removes emotional distortions caused by economic statistics

Severe negative volatility (7% or greater decline in monthly value) has, historically, been experienced simultaneously by domestic large cap, domestic small cap, international developed markets, and emerging markets equities only 3.4% of the time between 1988 and 2009.  This negative correlation shows the importance of global diversification

In any given year, a small subset of stocks may contribute a large portion to the market’s overall return; with the CRSP 1-10 Index from 1926 to 2012 as a sample, removing the top performing decile of stocks reduces the total return from 9.6% to 6.3%.  Because it is impossible to consistently pick winners before the fact, it is logical that the optimal portfolio will maintain broad diversification

The three dimensions of stock returns are the equity market (complete value weighted universe of stocks), the company size (market cap.), and company price (BtM)

Returns of the CRSP 1-10 Index show that the smallest capitalization stocks produce both superior returns, and also the highest standard deviation in returns

The size effect of superior returns has been established over the longest available time period (1926-2012), but over shorter periods returns of small caps have been significantly above, and below the S&P 500