Invest Like a Pro | Erik Averill, Justin Dyer | AWM Insights #55
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Episode Summary
Can hiring skilled active managers help you outperform the market?
The premise of active management is that with enough skill, one can consistently outperform the market, or the benchmark on a risk-adjusted basis.
Active managers boast their strategies can deliver. What does the evidence say?
For the 11th consecutive one-year period, the majority (60%) of Active Large Cap funds underperformed the S&P 500. The long-term stats are even worse, 70%+ underperformed over 10 years and 85%+ over 20 years. This is pervasive across all public asset classes and markets.
The verdict is clear, relatively few active managers add real value.
The evidence supports that markets seem to be very efficient, are unpredictable, and are hard to beat through individual stock picking and market timing.
But it doesn't mean you can't beat the market.
At AWM, we believe portfolios can be designed and managed that can outperform the market without having to out guess it.
Listen as Erik and Justin discuss how to avoid the traps of active managers and implement what you can do to capture the returns you deserve.
Episode Highlights
(00:54) One year since the Covid market bottom, drop in unemployment numbers, and other investment and financial news from the week
(2:08) Tax implications of cryptocurrency
(4:01) How important are professional active managers in the public markets?
(4:58) Looking at the data
(10:02) Can you figure out who will outperform in public markets ahead of time?
(11:19) Should we all just move to passive investment?
(15:23) A better option than paying for active management
(16:33) What are value drivers in the world of investing?
(17:36) The importance of portfolio management rules
(18:36) Why you need an independent advisor – not Wall Street.
Resources
What’s Happening in the Markets
Stay Connected
AWM Capital: IG | LinkedIn | Facebook | AWMCap.com
Brandon Averill: LinkedIn
Justin Dyer: LinkedIn
+ Read the Transcript
Erik Averill (00:00): Hey, everyone. Welcome back to another episode of AWM Insights. It's your power three, two CPWAs and a CFA. We are Erik, Brandon and Justin. And each week we aim to equip you with the knowledge and skills you need to invest like a pro. Here at AWM we like to point out that we are not loyal to Wall Street. We are loyal to you. So each week we aim to cut through the noise of the news and what Wall Street is selling you to help you capture the returns you deserve. Today we're going to tackle the topic of skill in the public markets. But before we do that, let's recap a little bit of what's been going on in the markets. It is crazy to think that we just celebrated, I guess, that's the right word, one-year anniversary from the COVID market bottom.
Erik Averill (00:54): So just reflecting back quickly on a year ago of just the day-to-day uncertainty of how long COVID was going to be here. Just a wild ride it's been, to think that it has been a full calendar year already. Staying on that news, on the positive side we've actually seen reporting that unemployment claims hit a pandemic low. Definitely excited to see that about unemployment numbers continuing to drop. Randomly, we've also started to see some tech CEOs being grilled at a hearing on disinformation. We've seen a cargo ship being blocked in the Suez Canal. And then a story of, maybe a cautionary one, WeWork back in the news. I mean, this was the darling of the private markets for so long. Had that iconic, just failure of trying to initially go public at a valuation around 45 billion. And now we're talking about an estimated valuation through a SPAC of around 9 billion. So we could have a whole podcast just on that topic around private markets and going public.
Erik Averill (02:08): But on the regulatory front, some positive news for banks, that they are going to be able to resume some buybacks and raise dividends this upcoming summer. The SEC is beginning to sniff around some of these SPACs. As we know, the SPAC craze has been wild over the past year. Unsurprisingly, the SEC is starting to pay a little bit more attention to that. And then one final note, we've covered cryptocurrency so often on this podcast. It's tax time. One of the questions that we've been getting from clients, from listeners and just something we want to make sure all of you are aware about, is that yes, cryptocurrency, bitcoin or anything else does have tax implications if you are a United States citizen. So make sure you're talking to your CPA about the reporting that you need to do.
Erik Averill (03:06): We're actually going to put it in the show notes. There's an incredible guide by Coinbase that can walk you through everything. So just looking out for taxes and the burden there on the cryptocurrency. Now that we're done with that, let's jump into the conversation, Justin, of how important are professional active managers in the public markets? How skilled are they?
Justin Dyer (03:33): Well, you're not going to give Brandon a hard time for not being here, man? Let's start there, man. I'm kidding.
Erik Averill (03:42): We miss you, B. So many people are going through the vaccine grind right now. Let's just say that Brandon's not as strong as he thought he was. But he's on his road to recovery. We miss you, B. We'll have you back next week.
Justin Dyer (04:01): There you go. So to your point, you made a statement of how important active investors are in the market. They actually are really important. But how skillful they actually are is a whole nother question. One of the most fascinating, in my opinion, data sets, and we'll try not to get too geeky here today, but one of the most fascinating data sets available out there is produced each year. Actually, I think they do it semi-annually. Standard & Poor's, or S&P, the same company that produces the S&P 500 Index, it's actually S&P Dow Jones, so they also produce the Dow Jones Industrial Average. It's just this big data provider within financial markets. They put together a report every six months, I believe, like I said, called the S&P Index Versus Active Report. For short, they call it SPIVA. And it's fascinating.
Justin Dyer (04:58): I mean, they look at the entire landscape. It's a very well-constructed study of public market performance. They do it in the U.S. They do it in Europe. They do it in Australia, emerging markets, et cetera. It's a great, great resource. We use it quite a bit ourselves. We use it to figure out our investing approach. It's something we're constantly looking at. Our investing approach isn't necessarily static. We're constantly challenging it. Time and time again, we're reaffirmed in our approach to not try and time the market, not get too cute with active management. Really, the data behind it is, you could look at the S&P report and say, "Okay, well, last year about 60% of all actively managed mutual funds underperformed in the market." If you were just taking the landscape on face value, you would expect at least 50% would underperform and 50% would outperform, just by random chance.
Justin Dyer (06:06): What we actually see is that because of the fees and whatnot that are involved with investing in, and on the active side those fees are generally far too high, in our opinion, my opinion, you see that they perform worse than just pure chance. That's where that 60% underperformance number comes from. There's some noise around that each year. Sometimes it's as high as 70% underperforming. It is a little bit better than chance. But one of the questions you have to take a step back and ask is, "Okay, well, maybe there's some noise in each and every year." It certainly trends to overall underperformance for the reasons I just alluded to. But then we're long-term investors. I mean, we underscore that fact time and time again. So what happens over the long term? The numbers just get even worse. You look over a 10-year period of time, everything gravitates towards around 70% of fund managers underperforming the index or the benchmark.
Justin Dyer (07:09): Over a 20-year period, it's 85 plus percent. In some cases it's even 90, 95, depending on what part of the market you're looking at, large companies versus small companies. And then additionally, hey, let's ask the question, "Well, from a risk adjusted basis, do these numbers also actually ring true or tell the same story?" What I mean by risk adjusted is, okay, for every percent of return that I get, how much volatility or how much up and down in the market do I experience over a one-year period of time? Just to really make things simple. So you can compare apples to apples from a risk exposure standpoint by doing that. The same data is true on a risk adjusted basis. So active managers, in general, are underperforming the market on an annual basis. They're doing even worse over long periods of time. And then when you take into account risk as well, the numbers are still very, very much in favor of not playing that active management game.
Justin Dyer (08:20): There are some, like I alluded to, there are some outliers in certain parts of the markets. Small cap value last year actually did okay, did better than chance if you will. Same thing can be said though when you start to look over long periods of time. Over long periods of time, 80 to 90% of those managers generally underperform. And then, let's ask the question too about persistence. I mean, that's incredibly important. Erik, I don't know if you want to unpack what persistence is.
Erik Averill (08:53): Well, what I was going to say is, and I think this is so hard emotionally for us as humans, because in so many other areas of life, there is this outperformance in whatever we do, because of the extra hard work that I've put in. Or this skill. So it's hard to emotionally believe what we're saying here is that these organizations, these huge investment funds, mutual funds, hedge funds that have all these analysts all over the world and spend all this time in this technology, what we're saying is that all of that's for nought. That they literally are spinning the wheels in charging you, the investor, these expensive expense ratios to underperform the market. And that even when we talk about persistence now of what we're saying is all right, Justin, sure, 85% don't out perform. But how about the 15%? Why don't I just go look at who those 15% are and that's who I put my money with? Because for us, that actually makes sense on the private markets.
Erik Averill (10:02): We've talked about this on previous podcasts, that the top decile of venture funds continue to win year over year, over year, over year. Isn't that true in the public markets? Well, we've actually seen the answer is, no. Yes, that 15% may outperform, but you cannot figure out who they are ahead of time. So there's this famous study done by Fama and French called luck versus skill. Ultimately, what they see is yes, 21% of the top decile of publicly traded active funds may repeat success. The problem is you don't know who they are. And that probability is equal to what you would expect to see just by chance, just by luck. So I think one of the hardest things, why we will never see everybody just adopt this and go, "Eh, that's what the evidence says," is we are hardwired in the wrong direction as investors. I think that that's what's so wild, is there's this other question of like, well, isn't there risk, Justin, if everybody goes passive? Doesn't the whole passive thing blow up if we all just say no more active management? What are your thoughts around that?
Justin Dyer (11:19): It's a super interesting question. I think a lot of people within our field have strong opinions on it. I think it's so hard to tell what truly would happen. The most compelling argument that nothing potentially, or I shouldn't say nothing would happen, there's always unintended consequences or unknown consequences. Think about the market. All the market participants, you listeners as individuals, institutions, you guys all, even just within our client base specifically, we have so many different needs within our clientele. We're buying and selling in the market on a daily basis just to meet your liquidity needs. Or your contributions, they need to be put to work. And we're going to put them to work in a certain way. So there's just table stakes. There's always money coming in and going out of the market based on all the market participants' or individual investors' unique preferences. That, in and of itself, makes a market.
Justin Dyer (12:28): Then you add a component of one or two people within that framework that are quote unquote, active managers. I can see a market still functioning in an efficient manner. Just think about real estate. A single real estate transaction has, it depends on the market, sometimes it's only a buyer to seller. Definitely not the case right now, but there could be one seller to 20 different buyers in a current market, depending on where you are in the U.S. here. That's not very much relative to the public stock market that we're talking about here. That real estate market is still arguably somewhat efficient. A buyer and a seller are coming together and making an agreement to sell. And there's not that many of them.
Erik Averill (13:22): I think you bring up such a good point, that we have to take a step back and look at what is the market. What is the structure of the market? Trillions of dollars flowing through this. Highly, highly intelligent people. And I think that that's always the case we forget. What we're not saying is, is that people aren't intelligent. We're actually saying the opposite, that there are so many intelligent individuals and incredible technology and software and trillions of dollars flowing through this. And oh, by the way, it's regulated. It's publicly traded information available at the same time. What we're not saying is that the price is necessarily right. None of us really know is the price right or wrong. It's just, you can't trade on it quick enough to trade it on either way in any predictable fashion.
Erik Averill (14:19): What we're saying here is not that you should just exit stage left and not worry about trying to make good decisions. We at AWM believe that the evidence shows you can outperform the market over the long term based off of the evidence, off of some of these factors that we've talked about in our previous podcast, on the sources of returns. I think that will always be available, because people are emotional. People do not stay disciplined. We know this, that a large part of life is when you look at high performance people that outperform, a lot of times it's just how did they behave? Were they willing to do things that were uncomfortable that nobody else was? And now you get your outperformance. That's the thing. We've seen it with value. Small value had been this thing that every article in the last 10 years is, it's dead. Fama and French, they're behind the times. It's been weeded out and boom, it shows up overnight.
Erik Averill (15:23): I think when we hear, as the listeners, what we're trying to tell you is you don't need to pay for this active management that's costing you money and costing you returns. There is a better way. There's one of these research reports that's been out by Morningstar. It's been out by Vanguard, is that the value of portfolio construction, so this investment advice that most people are paying for, it's now a commodity. The value of that's actually about 0.45%. So all these financial advisors, brokers out there that are charging you 1%, they absolutely don't justify their fees. What we're trying to, once again, equip you with the tools and the resources to say, when you think through professional, pro, expert investment management and financial structures and portfolio construction, there are so many other things that drive value. I'd love to hear, Justin, what are some of those things that drive value that investors should be looking for in an expertise when it comes to investing?
Justin Dyer (16:33): Well, you touched on some of them, these factors, if you will, sources of return that we've touched on, don't want to go down that path again today. But focusing your public market portfolio on these areas that have persistence, going back to that term, have proven over the long term to provide some outperformance relative to the market. Then the private market, we talked about that as well, where there's less efficiency. There is evidence of persistence if you can get access to these top quartile, top decile type managers and it makes sense to actually participate in that space. Then what you were alluding to, focusing on what you can control. We can control our portfolio management techniques, our trading tolerances, if you will. I mean, we're sitting here basically on the one-year anniversary of the COVID crash, let's call it that. No one predicted that.
Justin Dyer (17:36): No one knew exactly when that was going to happen. No one knew a pandemic was going to hit, what, 18 months ago. We certainly didn't. But we have portfolio management rules in place. So when the market corrected 20 plus percent and hit that amount, March 20 something last year, we have triggers in place to harvest losses that may show up in the portfolio, go into something similar, so your overall exposure to the market is consistent. We also just have tolerance bands to sell fixed income and buy into equity, even if there isn't a loss in that scenario. We're rebalancing based on what the market's doing. Fast forward a year later, those things look phenomenal right now. We look like absolute geniuses. We can pat ourselves on the back. But we didn't plan it. We had a plan in place beforehand. But we didn't say the pandemic is going to happen.
Erik Averill (18:36): And to your point, Justin, I want to talk about the value of this. To your point, this is what professionals do. They look at the evidence and say, "Intelligent rebalancing, tax loss harvesting, asset location, these things matter so much, because as an investor what I care about is not the gross return. It's the after-tax return. It's the after-tax holders that I get to choose to spend. That I get to choose to gift. That I get to choose to reinvest." So when you look at these things, these studies that are out there, this isn't what we're saying, this is what Vanguard's saying. This is what Betterment's saying. This is what these independent third-party research is showing, that tax-loss harvesting, the evidence says that it adds 0.77% of annualized return to your portfolio, intelligent rebalancing, 0.35% to your annualized returns, asset location, 75 basis points, tax efficient withdrawal.
Erik Averill (19:37): We're talking about 2 to 3% of additional annualized return by having these rule-based, tax-efficient strategies in place. If you want to outperform, stop trying to play the game of luck, of impossibility. Put the odds in your favor and say, "Man, this is where real returns come from." This is why you need a CFA. This is why you need to see CPWA. And this is why you don't need Wall Street. You need an independent advisor.
Justin Dyer (20:09): Totally. I want to underscore, we are constantly looking at the data. If at some point, hey, the adoption of passive investing actually allows active managers to outperform and the data backside up, hey, we're going to take advantage of that. But again, we're going to be very rigorous in understanding those studies as thoroughly as we possibly can. I think it's important to tie that comment back into exactly what you were just summarizing, Erik, is we are trying to outperform. We do generally outperform over the long term, because we dedicate our resources where we have a very high confidence that outperformance is there for the taking, if you will. Whereas, trying to pick the next Tesla as an example or something like that. The probability that we can do that or that anyone can do that, it's just a low return event. So why are we going to dedicate our resources on your behalf to that endeavor? The data doesn't make sense for us to do that right now.
Erik Averill (21:21): Absolutely. And we'll end with that. You hear us say this every single week. We know how hard you have worked for this money. Our job is to be here to help you capture those returns that you deserve. We just want to make sure that we're not allowing Wall Street to line their pockets by selling you and us the lie that you need their skill. Because what the evidence has shown is that the only thing they consistently do is sell us really expensive products that don't deliver. So we talk about, how do you do it the right way? How do you be a pro? It's hiring that independent expert, who's going to build your portfolios and your financial structures based on what evidence does deliver. As Justin alluded to, we believe that with the right portfolio construction and management, that you can outperform the markets without having to outguess it.
Erik Averill (22:18): Focus on the things that are going to bring you the highest probability outcomes. Focus on what you can control, taxes, rebalancing, fees and the overall structure of your portfolio. Head over to awminsights.com. I know we mentioned a bunch of resources. Once again, the crypto guide around taxes, you'll be able to download that in the notes. We'll link to some of these research reports that we've talked about, about active management. And we'd love to hear from you. Make sure you shoot us a note if there's a topic you want us to cover. But until next time, own your wealth, make an impact and always be a pro.