Actually An Active Manager is Worse than A Coin Flip

The WSJ recently ran  article about another financial professional who has seen the light and now advocates index investing.

Is Your Stockpicker Lucky or Good?

Investors pick active funds based on performance, but the long-term success of those managers is no more dependable than a coin flip

Is it luck or skill? Picking a fund manager who can beat the index is tough, but picking one who beats it through actual ability is far more difficult.
Victor Haghani, a co-founder of one of the best-known investment firms in history, says the most surprising thing is that people have great confidence that they can pick these super-talented fund managers. Currently the chief executive of Elm Partners, which espouses index investing for wealthy clients, Mr. Haghani will try to prove that to you with a simple test.
He and two colleagues told several hundred acquaintances who worked in finance that they would flip two coins, one that was normal and the other that was weighted so it came up heads 60% of the time. They asked the people how many flips it would take them to figure out, with a 95% confidence level, which one was the 60% coin. Told to give a “quick guess,” nearly a third said fewer than 10 flips, while the median response was 40. The correct answer is 143.

Mr. Haghani’s belief in indexing means he has a vested interest in the outcome. His earlier experience as an active investor gives him perspective on how hard it is to beat the market. Mr. Haghani was a co-founder of Long Term Capital Management, the hedge fund that had spectacular results from exploiting real market anomalies before its failure nearly took down the global financial system in 1998.
The research applies directly to picking fund managers. We already know that most active managers fail to beat an index fund in any given year, yet many people pay up for managers they believe have the skill to do so.

In fact most active managers perform worse than a coin flip. We are often told that the bulk of the returns from the market come from a few stocks. That fact is then is seen as implying this is an opportunity for stock pickers. They just have to overweight those stocks and they will outperform. Most actively manged funds are "closet indexers" meaning that the "active share" the part of the portfolio that differs from the rindex is small in many cases as low as 20%. That means the stock picker "just" needs to pick outperformers for the active share of their portfolios to beat the index

Of course they fail to do so and there is no persistence among those that do.

An interesting explanation of the underperformance of active managers and how they actualy do worse than a coinflip comes from the material presented in this article entitled Skewered

Consider the chart below. The returns of stocks are skewed

What is the significance of this chart ? It is pointed out that in the recent market (election day since  to the end date of the research data April 2016) in that right hand tail there were 6 stocks that returned over 50%.. But stock returns are almost always skewed the majority of stocks fall on the right side of the tail even if not as much as in the current market of FANG stocks (facebook, apple, Netflix, google) which so dominate the market gains.

The distribution of returns as seen above is  skewed to the right a "fatter tail than the standard deviation. With that fatter tail composed  above average perfoming stocks.

That means that the task of the active manager should be "simple". As we always hear "it's a stock pickers market", All that an active manager would need to do is to oild most of his portfolio in an index hugging portfolio and add to that portfolio an active share of stocks he has picked made of of stocks  among those in the right tail.

In fact looking at the chart there are more stocks to the right of median return  than below it. So the odds are actually better than 50/50.to get a stock performing above the median in a coin flip. It is like picking to get a high card from a deck where money of  the cards wth low values  have been removed from the deck.

Yet we know the statistics. Active managers consistently fail to beat the index they do worse than a coin flip.
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Is this an argument for the momentum factor

Here is the description of the methodology for MTUM from ishares:

The iShares Edge MSCI USA Momentum Factor ETF tracks an index of large- and midcap US equities, selected and weighted based on price appreciation over 6- and 12-month periods and low volatility over the past 3 years.

Not surprisingly the portfolio is quite concentrated  by sector with 32% of its assets in technology and 25.6% in financials .The portfolio is also  highly concentrated by stocks  42% of the portfolio is in its top ten holdings. In other words, at least in terms of recent performance the ETF is owning mostly stocks in the right tail. Barring shap reversals in the stocks within the period between of rebalances the portfolio should have structural potential to ourperform. And the portfolio rebalances more frequently during periods of high volatility as explained the Morningstar analysis:

In order to improve performance when volatility spikes, the fund's benchmark rebalances in between the scheduled reconstitution dates if market volatility significantly increases. When this rebalancing is triggered, the index focuses on more-recent momentum to construct the portfolio. This adjustment may help, but it isn't a panacea. There is also a risk that momentum may become less profitable as more investors attempt to take advantage of it. That said, the momentum effect hasn't gone away even though it was first published in the academic literature in 1993. Like any strategy, momentum can underperform for years. This risk may limit arbitrage and allow momentum to persist.

Intersentingly with a p/ef of 23.7 the portolio is slightly lower in valuation than the SP 500. Not surprisingly the SP 500 is less highly concentrated with 20% of ts holdings in its top ten holdings.

Also note that the portfolio only holds large and midcap stocks  This limits the likelihood of owning "shooting star" stocks which are small cap high valuation and large upside momentum--and subject to sharp downward momentum. It is also important to note that MTUM is simply a large cap growth strategy..the methodologies for stock selection are far different.

My interpretation of the potential of outperformance of momentum stocks vs the market :

• :Because of the high concentration in a few stocks the MTUM is likely to be more volatile than the overall market.
• But by concentrating its holding in stocks in the right tail...at least by recent momentum ...its likelihood of outperfromance is greater than 50/50 and greater than an active manager.
• A reversal of upside momentum does not necessarily mean underperformance by MTUM the market could reverse direction but the highest upward momentum stocks could retain their value more than the overall market
• Despite what is regarded as conventional wisdom it does not necessarily follow that the high momentum stocks will lead the market down. Furthermore as the MTUM s rebalanced the opposite will be the case the negative momentum stocks will be eliminated from the portfolio.

We don't have much data on MTUM since it only began trading in late 2013 but here is the data we do have vs the S=P 500.

Total Returns

Mtum Blue SPY (S+P 500 Green)  June 2013- present

Returns top volatility below.

Remember that volatility is a measure of both up and downside volatility. Investors care much less or not at all about upside volatility. And if you look at the total return chart you can see almost all the high volatility for MTUM was on the upside.

This is Not good For Investors

WSJ

A Tax Provision That Would Exempt Mutual-Fund Firms but Not Individuals

Mutual funds now exempted from proposal changing tax rules for some share sales

The provision would prevent investors from minimizing taxes, when they sell part of a position, by choosing the specific shares being sold. Instead, investors would have to sell their oldest shares first.

As first proposed, the change would have applied to fund companies as well as individuals.

But senators exempted fund firms after some of the largest ones, including Vanguard Group and Eaton Vance Corp. EV 0.56% , protested by saying the proposed change would tie their portfolio managers’ hands, make markets less efficient, and raise taxes on investors. 

If the change is enacted for individual investors, “it will take tax planning out of the hands of investors and advisers,

Interestingly it will take a big hole out of the marketing proposition of the robo advisors who make their tax loss harvesting a major part of their sell:

It would also affect firms like Parametric Portfolio Associates, a unit of Eaton Vance, and online financial advisers Betterment LLC, and Wealthfront Inc. These firms offer computerized tax-efficient investing strategies to individuals that typically use sales of specific groups of shares, or lots, to help boost after-tax returns.

It's rather amazing to me that the fund companies would lobby in their own interest but not in the interest of their clients. Could it be that they care more about juicing their returns and attacting assets rather than their clients after tax returns. Also this exemption will almost exclusively affect active fund managers since they do so much trading and would be keeping track of tax lots. I am not sure even this would apply to ETFs and even if it did , since they do little of such trading the impact would be minimal.

An explanation from the WSJ

Although the change would no longer affect securities sold by managers of active or passive mutual funds and exchange-traded funds, it would affect individuals who sell part of their investment in such funds.

Here’s how. Say an investor owns two lots of a sector fund bought at different prices, and they are in a taxable account rather than a tax-deferred retirement account. If the fund is trading at $90 per share now, each one acquired five years ago for $65 would have a $25 taxable gain.

But each share bought two years ago for $110 would have a $20 loss.

Under current law, investors can choose which fund shares to part with. So selling the ones that cost $110 would produce a loss to offset other gains, while selling the ones that cost $65 would produce a taxable gain.

If the provision is enacted, the first shares sold would be assumed to have a cost of $65 each, and the investor couldn’t sell the $110 shares until the $65 shares were gone.

"Shooting Stars"

I have written several times about "shooting star" stocks. Small cap stocks. usually producing a very popular consumer product.Investors assume that because "everyone is buying/wearing the product: the stock is a good investment. In a classic behavioral finance flaw, investors extrapolate the performance into the future making the valuation very high and any earnings disappointment likely to trigger a sharp decline.

Some classic examples of this have been crocs:

Deckers, the manufacturer of UGG boots (remember those), The chat is 50% below its high.

Right now the classic example is Underarmour.(UA) They had much success with some niche products in football equipment and football shoes, But those products contained no technology that could be easily copied.which it was and when Nikes marketing machine gor behind their competing product Underarmour couldn't keep up. The company ventured into other types of atheletic/leisrue shoes against the "big boys", Addidas and Nike it was left in the dust.

Another stock I would call at this point a "mini shooting star" is Lululemon (Lulu) with its premium priced yoga wear sold exclusively through its own stores. Their formula has already been copied by Athleta and its efforts in men's products have had little success.

So far it recovered from a mega selloff but is still 30% below its high. And the 50% selloff in 2014 followed by the huge runup shows how sensitive the stock is to earnings disappointments.

Will LULU experience a fate similar to UA. I certainly don't know. But I do know that the big guns of NIKE are aimed right at lulumenon's target market. (BLOOMBERG)

Nike Coming for Lululemon, Sharpens Focus on Women's Wear

By

Matthew Townsend 

Sports giant to put yoga pant studios in 5,000 stores

• Company is also refocusing on innovating in women’s gear

Nike Inc. is increasing investments in yoga pants and sports bras as part of a quest to revive growth, intensifying its battle with Lululemon Athletica Inc. for women.

Nike will open pant studios in 5,000 stores on Nov. 1 to highlight new styles for workouts and leisure, the company said in supplemental documents to an investor presentation on Wednesday. A presence in thousands of stores would dwarf the footprint of Lululemon, which helped turn yoga and fitness gear into everyday attire. It has 421 locations, mostly in the U.S. and Canada. Even after the drop LULU is at a p/e of  32. well above the p/e just below 26.

Regardless of what happens to LULU in the future the takeaway is clear. Stocks that have a high public presence because "everyone is buying it" or there is always a line probably don't make a good investment. Of all the categories of stocks across the style box (large cap growth, large value, small growth and small value). Small growth the "sexiest category" have the worst risk/return.

One more in the shooting star category in the restaurant category. Chipotle (remember the rapid expansion and lines out the door at that one ?)

And a possible shooting star: Shake Shack which went public in December of 2017 and last I saw in NY and  Los Angeles had lines out the door and is still adding locations rapidly. One thing for sure it has been a roller coaster since the ipo. I'm not sure many investors would have had the resilience to hang on as the stock fell close to 50%  Shake Shack trades at at p/e of a 65.

Bottom line: not a good idea to pick stocks based on 'there's always a line out the door' or "everyone is wearing them".

No End to Things Like This I Can Find

I

• WSJ MONEYBEAT November 9

Are High-Yield Bonds the Canary in the Coal Mine?

Junk-bond indexes have hit a rough patch, even as the U.S. stocks are at record highs

WSJ  November 14

• MARKETS 
•  TREASURYS

High-Yield Canary Isn’t Singing About Markets Doom

The selloff, mainly confined to telecoms and lower-rated bonds, should be put into perspective, investors say

CNBC November 15

Closing Bell Exchange: High-yield the canary in the coal mine?

Discussing the current state of the markets with Beth Lilly, Crocus Hill Partners; Keith Bliss, Cuttone & Co.; and CNBC’s Rick Santelli.

Hard to See Why Anyone Would Buy This Fund

Seems that only a few years after their launch the robo advisors who advocated simple long term investing with stable portfolios managed with tax harvesting and rebalancing are doing exactly what they preached that investors not do..abandon the long term strategy and move into something else.

Betterment has launched its "indexing 2.0" which uses a proprietary model (no clear data presented) making use of smart beta strategy that it claims will deliver better than market risk adjusted returns. Seems that "hope springs eternal" and Betterment perhaps looking at the short term performance of their portfolios felt the need to offer something else. As I noted even if one were to incorporate a smart beta element to portfolios there are less expensive and more transparent ways to do it.

Wealthfront has gone even further announcing a mutual fund that is anything but a simple asset class low cost allocation From  Financial Planning

The firm filed with the SEC Wednesday for what it calls the Wealthfront Risk Parity Fund. The derivatives fund would invest in global developed and emerging market equities, global developed and emerging markets fixed income, real estate investment trusts and commodities.

It is true that the fund only has a management fee of .51% vs. the more common fees of hedge funds that use such strategies which are in the area of 2% management fee and 2% of the profits....

But even taking into account those fees, hedge funds have been terrible at beating simple index portfolios. Given Wealthfront's short tenure as a firm and zero experience in managing money..it's not clear to me whether the fact that the strategy is now available to investors with not minimum is a good thing. More likely they should take advantage of the price wars in ETFs where a straightforward well allocated portfolio can be constructed for less than .10%

Financial Planning adds:

The SEC filing notes that “the fund is not suitable for all investors,” but instead only for those “who (a) understand the risks associated with the use of derivatives, (b) are willing to assume a high degree of risk, and (c) intend to actively monitor and manage their investments in the fund.”

In other words after offering plain and simple as the best path to investors Wealthfront offers a mutual fund with no minimums that is anything but simple.

An Expensive Year for Holders of Actively Managed Mutual Funds

It is a well known fact that actively managed mutual funds can be painful for individual investors since they pass on any capital gains to the fundholder..regardless of how much of that gain occurred when the investor held the fund. If the fund has a 50% gain on a stock that it has held for 5 years and sells it you owe tax on the capital gain of the fund even if you have only owned the fund for 5 months. And actively managed funds move in and out of individual stocks and need to sell stocks to raise cash for redemptions if they dont have cash on hand. An index fund does few trades and the situation for ETFs with regards to meeting shareholder inflows or outflows are totally different . As explained here :

A mutual fund manager must constantly re-balance the fund by selling securities to accommodate shareholder redemptions or to re-allocate assets. The sale of securities within the mutual fund portfolio creates capital gains for the shareholders, even for shareholders who may have an unrealized loss on the overall mutual fund investment. In contrast, an ETF manager accommodates investment inflows and outflows by creating or redeeming “creation units,” which are baskets of assets that approximate the entirety of the ETF investment exposure. As a result, the investor usually is not exposed to capital gains on any individual security in the underlying structure. 

The net effect is that the return of a fund you own (or whose performance you see listed) is significantly higher than the after tax return for someone that owns the fund,



This year has been a particularly painful one for owners of actively managed mutual funds, As the WSJ notes this has been a very good year for stocks..but it also has been a very big one for investors "getting the message" and moving from actively managed funds to ETFs and index funds. Those outflows mean the fund manager must sell stock to meet the cash needs...and those sales generate taxable gains passed on to the individual investor...and some of those may even be short term capital gains taxed at the same rate as ordinary income. And it seems active managers are no better than individuals in deciding what to sell..it seems they sell winners and hold on to losers...hoping the losers will "come back" and in the process generating a greater tax bill than if they had sold losers or at least made an attempt to match sales of winners to sales of losers to reduce the tax bill (and rebalance their portfolios at the same time.

from the WSJ

There are two forces at work here: The S&P 500 index has gained more than 17% this year, and some sectors are up even more—the type of performance that tends to lead many fund managers to cash in winning stocks to lock in gains. At the same time, as investors continue to shift out of actively managed funds and into passively managed index funds in droves, they made net withdrawals of nearly $240 billion from active U.S. equity funds in the 12 months through Sept. 30, according to Morningstar Inc., causing managers of those funds to sell winners to meet redemption requests.,,,

As of Nov. 5, more than 249 mutual funds are anticipating making capital-gains payouts to shareholders of more than 10% of their net asset values, says Mark Wilson, president of MILE Wealth Management in Irvine, Calif., who tracks mutual funds’ estimates of their capital-gains payouts and posts them on his website, CapGainsValet.com. Just 114 funds made distributions of more than 10% in all of last year, he says.

Not only are the numbers for some distributions eye popping some of the results are ironic

Some surprises

Among the surprise distributions this year are payouts anticipated by the JPMorgan Tax Aware Equity fund (JPEAX) and the PNC S&P 500 Index fund (PIIAX). The Tax Aware Equity fund estimates a payout of 8.9% this year, which is surprising since the fund is supposed to manage its portfolio to reduce capital-gains payouts, says Ms. Benz. J.P. Morgan Asset Management declined to comment.

The PNC S&P 500 Index fund is estimating a payout of more than 22%, according to PNC Funds’ website. It’s “an unusual dynamic” to see index funds make such a hefty distribution, says Mr. Wilson, because their holdings typically don’t change often. A spokeswoman for PNC Financial Services Group Inc. declined to comment

The explanation I could see for the latter fund is that some investors realized that paying a .45% management fee for an S+P 500 index instrument when it can be for basically zero elsewhere was a good reason to sell. This meant the fund needed to sell assets...and generate capital gains distributions.