A Challenge to Active Management

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Active vs. Passive Management

Scores of papers and blogs have been written about the merits of passive vs. active management.  I’ve contributed my share and here is one of my earlier posts.  Readers will find more articles by moving over to the right sidebar and looking up Passive vs. Active blogs.  There are over 25 posts on this subject.

When you read about active management outperforming the market, check on a few variables or assumptions.  1) What benchmark is used?  This morning I was reading a Seeking Alpha on this subject and the actively managed fund was using stocks outside large-cap companies, but the benchmark was the S&P 500.  That is not a fair comparison.  So look out for the comparison benchmark.  2)  What time period is used in the measurement?  Launch date of the actively or passively managed portfolio makes a big difference.  3) Is the comparison net of fees?  Actively managed mutual fund fees drag down performance by at least 100 basis points.

To be sure, there are actively managed portfolios that outperform an appropriate benchmark.  The law of averages demands this be the case.  However, if one can hold down expenses, there is a high probability the small index investor will outperform the professional by the difference related to the cost of management.  This is William Sharpe’s argument in his article, The Arithmetic of Active Management.

Here is my challenge to active investors and/or researchers who happen to be looking into the question of active or passive management.  1)  Find over 100 small investors who actively manage their own portfolios.  The larger the number the better.  2) Collect all broker statements for portfolios that have been operational for three years or longer.  Some of the portfolios should have 15 to 20 years of data.  3)  We want portfolios of different size and different launch dates.  4) Develop a customized benchmark for each portfolio much like the ITA Index used with the ITA Wealth Management portfolios.

Supplied with the appropriate data, enter all the information into a site such as bivio or a software program such as the TLH Spreadsheet.  Then determine what percentage of these investors outperformed both the VTSMX and a customized benchmarks.  Where is the evidence that active managers outperform passive or index investors?

If you are an active manager as defined by Harold Evensky, and think you are outperforming an appropriate benchmark, prove it to yourself by setting up the TLH Spreadsheet and track your performance.  Since every portfolio is different in size, makeup, or launch date, your portfolio is the one to test, not some virtual portfolio.  Test the portfolio real time and going forward.  Forget the back testing results as I never met a massaged back test I did not like.

Photograph:  Road that leads into Lhasa, Tibet

Gauss Update: 14 December 2012

A number of Platinum members are tracking the Gauss and use it as a template for setting up for their own portfolios.  The Gauss is one of the ITA Risk Reduction portfolios and I’m also experimenting with Piotroski stocks.  Within the past thirty days I sold off CRAI as it dropped below the required Piotroski High F-Score of seven (7).  Currently, there are two Piotroski stocks in the portfolio as you can see in the Performance Data screenshot.

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Rule #10: Control Retirement Portfolio Expenses

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Regardless what type of portfolio you are overseeing, holding down expenses is essential to building a strong base for the retirement years.  Take the Schrodinger Portfolio as an example.  This portfolio was launched twelve years ago.  “Reorganizing” the Schrodinger reduced expenses by 200 basis points.  As an added boost, the performance immediately improved as the portfolio initially was invested in actively managed mutual funds of dubious distinction.  If this change had not taken place, the portfolio would be somewhere between $75,000 and $100,000 behind where it is today.  That sum exceeds the retirement savings of more than 50% of American heading into retirement.  Controlling expenses is not trivial and needs to be given the full attention it deserves.

To hold expenses to a minimum, manage your own funds and by all means, use low-cost index funds or ETFs with a low expense ratio.  If you build a portfolio using index instruments, almost by default you will be holding down expenses as index instruments are less expensive than managed accounts.  Almost immediately I hear someone saying to themselves, I can’t do this on my own.  Of course you can.  Just read the Beginning Investors category on this blog and you will find all the instructions necessary to manage your own account.  If a new investor were only to invest in VTSMX or VTI they would be further ahead in a few years of the majority of actively managed accounts.

Photograph:  Panda Preserve in China