Don't Chase | AWM Insights #115
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Episode Summary
It seems natural that the most skilled and talented managers should be able to outperform on a consistent basis. In reality, the data doesn’t support this and it actually shows the opposite. In public markets, persistence, or the ability of the best to stay the best, just isn’t shown in the evidence.
If the fund managers with all their large payrolls, research, and connections can’t reliably outperform then the advisors picking stocks in their client accounts are at an even bigger disadvantage.
Index returns have been an amazing wealth creator over the last 100 years but indexes also have inefficiencies and pitfalls than can be avoided to target higher expected returns. Systematically targeting and improving the indexes allows for a more reliable way to seek returns above the index for long-term investors.
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Episode Highlights
(0:40) The data shows chasing past performance is not a good strategy.
(1:30) It is natural to seek out the best and pursue some advantage through skill or talent.
(2:00) What is missed by the industry is reporting on the best without doing the digging or investigating if the best actually have skill or happen to be lucky.
(2:45) Efficient markets make it incredibly difficult to outperform.
(3:08) If you find a manager that has outperformed, will they outperform in the future? Do they have some skill that will lead to future higher returns?
(3:30) Chasing outperformance hurts your returns and the growth of your wealth.
(3:50) Morgan Stanley, Merrill Lynch, Goldman Sachs, and the rest of the brokers built their value proposition on being able to allocate your money better than anyone else.
(4:33) The data provided by SPIVA illustrate the terrible odds of betting on US Large Cap managers to outperform their benchmark. https://www.spglobal.com/spdji/en/research-insights/spiva/
(5:24) The data shows only 15% can outperform the index so why not find that 15% who can outperform. The problem is there is no predictable way to find the outperformers ahead of time.
(6:46) Are there other criteria that can be targeted besides just indexing and taking market returns?
(7:10) There are funds and ETFs that are thoughtful about avoiding the inefficiencies of the index. Avoiding the pitfalls of indexes can be done in a systematic way.
(7:56) There are different segments of the market that can offer higher expected returns compared to indexes over long periods of time. The evidence is strong in the persistence of these factors or dimensions of returns.
(9:23) If the most elite fund managers can’t outperform with all their resources, you are at an even bigger disadvantage when a financial advisor is doing the stock picking.
(9:45) With advisors that are actively stock picking, it's equivalent to going from the NFL to high school or MLB to high school ball.
(10:20) Persistence, or the ability for the best to stay the best, is not there in the public markets. Only 21% are able to stay at the top just five years later.
(12:23) It is eye-opening for any investor that looks at the data in this area. It is not intuitive and goes against common sense in other areas of competition (especially in sports) but the evidence is clear and year in and year out continues to validate the lack of persistence.
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+ Read the Transcript
Brandon Averill (00:05): All right, Justin, we're back. We're going to dig more into our Pursuing a Better Investment Experience series. Hopefully, this is timely, given given the market environment right now, if you're listening kind of close to the recording date here, we've definitely had some volatility. We've interest rates spiking, a lot going on. So, I think it's a good-
Justin Dyer (00:25): Sure does.
Brandon Averill (00:26): ... It's a good time to dig in, and really talk about how markets work. We hit on really embracing market pricing last week. And to follow up on that, we're going to jump into the topic of resisting chasing past performance, because the evidence just doesn't support it, to be very blunt. So, I'd love for you to set the stage here a little bit, Justin. When you're looking to invest, it seems natural. I know when I got into the industry, this was definitely something that seemed natural to me. Let's go find the best manager. Somebody has to have skill out there. And in fact, a lot of people probably have to have skill out there to outperform on a consistent basis. And I'll kind of, I guess, cut to the punchline, but that's not true. It took me a little while to figure that out, but I'd love for you to just touch on it, your experience. Obviously, being a CFA, you've studied this stuff pretty in depth.
Justin Dyer (01:23): Yeah, sure, and it is really natural. I mean, when you're setting out to do anything, you want to do it the best way. You want to really seek to be the best you can possibly be in any walk of life, or any pursuit, especially with the clientele that we deal with, and those that we had just interact on a daily basis. So, I want to just start there. It's okay, I guess, giving that pat on the shoulder. It's okay. But what I think is often over missed, and unfortunately, what the industry does, is it doesn't take it a step further, because it's easy to stop and just think or present something as being the best, without truly digging underneath the hood, or going underneath the hood.
Justin Dyer (02:14): And that's what the critical step or process is that we need to take, and that we truly believe in, in the way in which we think about the world. So, getting back to kind of what we're talking about here is, "How do we apply that process," and that is to look at the data. It ties directly into what we discussed last week, around markets being efficient. And essentially, what that means when it's applied to this conversation is that it's incredibly difficult to outperform, and the data supports that. So, the analysis... The second question is, after you say, "I want to outperform. Let's go find the best fund manager," well, you can find that, and you can find somebody who outperformed the market as a whole last year. Then the next question becomes, "Well, is that manager likely to outperform this year? And what about next year? And how persistent is that outperformance? Is there skill? Is there evidence of skill being involved with that?"
Justin Dyer (03:22): You jump to the conclusion, and the answer is the data just really doesn't support that. And you, generally speaking, give up actual rates of return relative to the market by chasing this outperformance, which, like I'm saying, you're giving up performance. So, by chasing outperformance, truly, you're generally underperforming.
Brandon Averill (03:45): And I think part of the problem is our industry, and specifically you go to the big broker houses, the Merrill Lynches, Morgan Stanleys, Goldman Sachs, etcetera, they've built their entire value proposition on this notion that they're going to allocate your money better than somebody else. And so I think that's where we end up leading here. They can't give advice on, really, anything else. They're too big of institutions. The risk is far too high for the equity owners, the stockholders of those companies. And so they have to turn to, "Hey, the only value I can really add is outperformance of picking different funds," et cetera. We'll get into individual stocks later on. But when we really go back to the data, like you said, I mean, there's a study in our industry, the SPIVA, that really goes through this data.
Brandon Averill (04:38): And I thought this was fascinating, and I think you could look at this one of two ways. So, I'd love for us to unpack it. But when you look at US large cap equity, so large company managers in the US versus the S and P 500, which, again, large, but that's the index, over one year, 85% underperform, over three years, 68%, five years, 74%, 10 years, 83%. In fact, the odds are overwhelmingly against you. At least if you go to the blackjack table, you've got, what, a 49% chance of winning or something like that? But I have heard the argument on the other side, and quite frankly, the person that we came up under, I think, believes this and taught this, but, "Let's go find the 15%. Let's go find those people."
Brandon Averill (05:28): And I think the difficulty really comes, like you're talking about, is if you can't consistently figure out the criteria, or the characteristics, of that 15%, that 15% changes all the time... Year in and year out, it's changing... It just makes it really difficult. Right?
Justin Dyer (05:44): Right.
Brandon Averill (05:45): So, really looking at these different stats, I'd love for you to unpack, even a little bit more, when we're going after selecting funds, are there other criteria, besides performance, that you can maybe take a look at?
Justin Dyer (06:02): Yeah, totally. So, this isn't a, "Hey, set it and forget it. Just go buy a Vanguard fund." Those are great solutions, and it's also good to take a quick step back while I'm saying this and say the market actually gives you a good rate of return. So, if you're getting that rate of return, it's not terrible. I mean, the- Brandon Averill (06:21): It's a great wealth builder.
Justin Dyer (06:22): ... The capital markets have done an incredible job building wealth over the long term, and I think it's also important to insert here that we're talking public markets again, not private markets. We'll probably comment on comparing these two things in a second, but... I'm totally losing my train of thought on this.
Brandon Averill (06:42): There're areas of the market [inaudible 00:06:44].
Justin Dyer (06:44): Yes. So, not thinking purely as an index play, what we then do is go a little bit deeper within an index type strategy. Again, that's a great place to start. It's low cost. It's generally tax efficient, which we love. But what you can do is you can be thoughtful around tracking the market. So, indexes and benchmarks have something called a reconstitution. So, sometime throughout the year, they change the players that are within their index. Recently, a big example of that was Tesla coming into the S and P 500, replacing some other stock... I can't remember off the top of my head right now... And the market can get ahead of that, and there're some inefficiencies in that process, but if you're just purely following an index, you have to play along with that. The date that it gets added to the index, you're buying it, and there's some interesting market dynamics that come along with that.
Justin Dyer (07:43): And so being aware of that and avoiding the pitfalls makes a lot of sense. Also, just thinking about parts of the market... So, you can dissect the market. You mentioned large companies. There are also small companies in the market. There are growth companies. So, think more of the big high flyer names over the last couple of years. Those are more growth oriented companies versus value oriented companies. Those would be the opposite. If you look over long periods of time, value companies, smaller companies outperform. So, you take a broad based index approach as a starting point and then just be thoughtful around it, and not just follow it and lock step and be subject to the inefficiencies that exist there, but it's a great starting point. Introduce these other little factors and trading methodologies that actually start to add value and are a proven way. The evidence is really strong that these add value, add outperformance, over the long term.
Brandon Averill (08:41): And I think that's a fascinating point, and the one thing, even about those funds, is that they don't, year in and year out, outperform, but there is a persistence over a long period of time that they are showing up consistently if you're a long term investor without outperformance, and that's where you want to be. And unfortunately, actively managed funds just don't perform that way. They don't have that same persistence. Again, SPIVA puts out a persistence report, and the data is just overwhelming that it doesn't exist in those active funds. And I'd love to take a quick tangent, because we're talking a lot about mutual fund and the mutual fund world. A lot of people trust a single, or two or three financial advisors, which is scary, quite frankly, especially at some of these big brokerage houses.
Brandon Averill (09:28): They've got "all the research," et cetera, but if the big fund managers can't outperform, what in the world are we thinking that some of these financial advisors-
Justin Dyer (09:38): [inaudible 00:09:38].
Brandon Averill (09:38): ... Can pick stocks and outperform, because that's essentially what a fund manager is doing. For those athletes that are listening, you're going from the NFL to major league baseball to high school baseball when you've got these financial advisors picking stocks. So, it's a completely different game, and I think you just get yourself into a lot of trouble there. So, it goes both ways. These are for professional fund managers that are actively picking, or the local financial advisor that's just a broker and has the crystal ball. Neither one of them, quite frankly, have the ability or the skill to outperform. So, you kind of want to steer clear.
Justin Dyer (10:18): Well, and let's put some numbers around this "persistence" topic as well. We've mentioned it. We mentioned there is no evidence of it, but the numbers are actually really, really, really bad. It's not even like a, "Maybe you could tip this scale in favor," but just quickly, and I'm going to take this slowly, but just so it's really impactful and we make sure we get the point across, but a recent study looked at rolling five year periods. So, what that means is you have a starting month. You look 60 months backwards. That's a five year period, 60 divided by 12, so there's a five year period. You go forward one month. That's another 60 year period. So, you actually get more five year periods even though that's just a single 10 year period of time.
Justin Dyer (11:06): That's what a rolling period analysis does, and looked at the overall performance of mutual funds, took those that were in the top 25% of performance over each one of those unique five year periods of time, and then looked, "Hey, five years in the future, are those that were in that top 25%, are they still in the top 25%?" And what shows up is that only 21% of those that were in the top are still in the top five years later. So, not only is it a small, select few that is in the top 25% to begin with, but less than a quarter of those actually continue to persist from an outperformance standpoint into the future. So, it's incredibly difficult to identify who is going to outperform, what are the characteristics, and whatnot that point to it.
Brandon Averill (12:10): And to be clear, what, like seven percent of funds?
Justin Dyer (12:11): Yeah, exactly.
Brandon Averill (12:13): The math, I mean, is pretty incredible.
Justin Dyer (12:14): Yeah, 20% of 25%.
Brandon Averill (12:16): Well, I think we've beat this dead horse. Hopefully, this is pretty obvious to everybody. It certainly was eyeopening for me, at one point in my career, when you really took a look at it and you started to figure out what you actually can control for a good investment experience. And the other big thing that I think was a little bit tough, or unintuitive to wrap your head around, is this whole concept that we're going to hit on next week, and that's really trying to not out guess the market.
Brandon Averill (12:47): So, let's not try to figure out when to get in, when to get out. We all know that's really difficult to do, or at least us, within the industry, that dig into the data know it's tough to do. So, we're going to unpack that next week. We'll probably have some more good zingers there, but we appreciate your attention this week as always. Before we close out, as you guys know, you can text me. We would love to hear your questions on this. 602-704-5574. Just shoot AWM Insights in that text. Throw your question to us. We'd love to answer it next week. And until next time, own your wealth. Make an impact, and always be a pro.