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Wednesday, February 11, 2015

Here We Go Again..."The Case for Active Management"....Not!

Hope springs eternal and the financial media and the Wall Street marketing machine always seem to come up with reasons why there are reasons to choose and actively managed mutual fund.

So the WSJ brought the latest version of this argument. Looking through the article one can see it boils down to "there are investment geniuses out there, you will be able to find them in advance and they will show great returns in the future". But I will go through parts of the article and give a more thorough critique,

 Furthermore if the author is looking to advisors as ts hose advocating active management one must ask the question "what exactly is the advisor doing ?". Ihe is simply running though past performance of active managers and choosing a portfolio made up of them ? If so he is using a methodology that has little if any chance of producing similar returns in the future. On the other hand a portfolio consisting of a mix of carefully selected ETFs can create a well diversified trasparent portfolio and in fact deal far better with some of the issues raised below than simply choosing a group of actively managed funds

Text from the article is in italics my comments in bold

There Are Still Some Scenarios Where the Hands-On Way Might Make More Sense

... many advisers still believe that at certain times, and for certain strategies, actively managed funds are superior to index funds. That is particularly true, they say, if the active fund has a good long-term track record and charges lower management fees than most of its peers.

Study after study has shown that past performance of active managers is a poor predictor of future performance. With management fees on many ETFs declining to virtually nothing…even a “low management fee” actively managed fund carries fees that are a multiple of the ETF fees. The Vanguard Total Stock Market ETF (ticker VTI) carries a management fee of .05%. Even a fund with an extremely low expense ratio of .50% (less than half the fees of the average actively managed fund) would be charging 10x the fee of the ETF.

Dividend Stocks

As yields have fallen, investors have flocked to dividend-paying stocks for income, and that has spurred rapid growth in dividend-focused ETFs. But to enhance their appeal, companies that sponsor such ETFs often design them with an easy-to-grasp mission—such as generating the highest yields or owning shares only of companies that consistently boost dividends.
Such ETFs often focus narrowly on certain sectors, such as economically sensitive or defensive stocks, ……says Todd Rosenbluth, director of ETF and mutual-fund research at S&P Capital IQ.., if market sentiment shifts away from the sector where an ETF is focused, that can hurt its overall performance. An active manager could limit the impact of such shifts by diversifying, Mr. Rosenbluth says

This is one of the “ you will find a genius active manager argument” one could easily argue that the active manager will make bad dexisions on shifting sectors. Furthermore there is much to question about the focus on dividends by investors both stock pickers, fund pickers and ETF investors. Many of these investors “searching for yield” have come to view dividend paying stocks as a substitute for bonds…they’re not.
2. If Markets Start Trading Sideways
Historically, active managers have lagged behind benchmarks during long, strong bull markets, when securities selection makes less of a difference. They tend to make up lost ground when markets level off or suffer corrections.
Could that signal better performance this year? The bull market may still have life left. But if stocks struggle and companies find earnings growth harder to come by, that is a climate that would favor active management, Mr. Reynolds says.
It seems at the beginning of every year we get the “this year will be a stockpickers market” prediction. First off I am not sure of the accuracy of the  assertion above particularly since correlation among stocks has increased. Also it is not clear how the data is constructed if the comparison is of the funds vs the S+P 500 it is not particularly valid since the S+P 500 is basically a large cap growth index so excludes value stocks large and small.
Additionally, even if the above argument were the case…how does one know in advance what the future direction of the market will be. The argument is a circular one..if you know the future direction of the market you will know when to move to an active manager…and of course you will pick the one that will outperform

3. When You Own Bonds
Bond yields move in the opposite direction of bond prices, so if rates are headed higher this year, it could be risky to own an ETF that closely tracks a broad bond index. Some types of bonds would be particularly hurt, including Treasurys and certain mortgage-backed securities.
One widely held bond ETF, iShares U.S. Core Aggregate Bond (AGG), has more than half of its portfolio in such rate-sensitive securities. …Moreover, such ETFs can’t change their portfolios to reflect concerns about rising rates, because they are obligated to replicate the performance of an index as closely as possible by owning securities in the index.

The above statement is correct but is not one of the negatives of bond ETFs but rather a positive. Since the ETFs have total transparency it is possible to build a bond allocation with ETFs and know exactly what one owns. There is no obligation to own only the total bond index (AGG) an investor could easily reduce the risk associated with rising rates by moving to short term bond ETFs. A good advisor should be able to reduce the interest rate risk in a bond portfolio through use of a mix of bond ETFs
Then we get the following argument for active bond management
 As a result, at times when rates might be headed higher, such as now, investors may be better off in an active fund with the flexibility to reduce interest-rate sensitivity….
Flexible funds also can reduce overall rate sensitivity through a range of derivatives transactions. And they can build cash positions and move to the sidelines when certain market sectors grow expensive, she adds.
“This is a time when active management can really show its value,” Ms. McDonough says.
Last year’s major event in the world of bond mutual funds with the fall of “bond king” Bill Gross and his Pimco Total Return bond fund showed exactly how such active management can produce dismal results and additional risk. Such managers take big risks based on their judgement of future bond market developments…sometimes they are right and sometimes they are wrong but the investor doesn’t even know in real time how the fund is positioned. Once again investor has taken a bet on a genius manager not a transparent bond strategy that could be easily implemented with low cost ETFs. Gross has moved on to another firm, assets have flowed massively out of  Pimco Total Return once the largest mutual fund in the world. There is a new hot “genius” fund manger whose fund has generated massive inflows and has so far had great success profiting from his bold bets on the bond market…how long that will last is of course impossible to know.

When Investing Abroad
ETFs make it easy to get non-U.S. exposure. But those based on market-cap-weighted indexes tilt toward the largest foreign markets, sometimes exposing investors to weaker economies, including, for now, Russia and Western Europe.
Actively managed international funds can fare better at diversifying away from indexes, says Jon Hale, director of manager research, North America, at Morningstar. For example, he says, they can boost returns by buying stocks in faster-growing emerging-markets nations that aren’t included in certain widely used foreign-stock benchmarks, such as the MSCI EAFE Index.

Part of the argument above makes absolutely no sense of course emerging markets aren’t include in the EAFE’s a developed international index. Those looking to add emerging markets exposure to their portfolio would make their international holding a mix of low cost developed and emerging markets ETFs,
Choosing an active manger in emerging markets means picking a manager that will make the correct decisions as to country and individual stock selection…a tough task to achieve consistently. Even the article here shows how difficult the task is. The author lumps together Europe and Russia as “weak performing economies” by which I assume he means poor performing equity markets as well. Ironically the European stock ETF VGK has outperformed the S+P 500 this year 3.1$ vs. .6%,

Furthermore an advisor can easily make use of the vast number of ETFs to allocate a portfolio not only between developed and emerging markets but to specific companies or regions...and even hedge out currency risk. I have written previously of the case for overweighing Asian Emerging markets vs other countries in the emerging market category and of hedging the risk of a weaker Euro through currency hedged ETFs. Not only is this easily done it can be done in a fully transparent manner..unlike an active manager whose holdings are not available in real time.

5. If You’re Worried About Volatility
Limiting losses can help in building a nest egg. And some ETFs aim to provide downside cushion by focusing on lower-volatility stocks. ….But active managers have more ways to play defense, …They can own higher-quality stocks and trim positions as valuations rise. “They don’t have the pedal to the metal when the markets are going up, and they put the brake on more quickly when markets are going down,” says Mr. Clift.

Another one of the “there are geniuses and you will find them argument”. While low/minimum volatility ETFs have a short tracke record they are based on a methodology which can be back tested rigorously over decades…unlike an active fund managers strategy and of course few if any fund managers have performance data going back decades.
Most importantly…if you are worried about volatility…you should own less stocks and more short term bonds.

If this article shows anything about use of actively managed funds it is how weak the case for using them is Either by choosing a small number of broad assset class funds or using a mix of ETFs to target particular sectors of the bond and global equity markets the case for using the ETFs and passing on the actively managed funds is a very strong one.


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