The following are in response to Joe Tomlinson’s article, Can Advisors Add Value Through Fund Selection?, which appeared on February 26:
Dear Editor,
I appreciate the inherent advantages of low-cost indices, but I do wonder about all those studies that say "active" can never reliably add value. Specifically, you are likely aware that most managers are constrained to a benchmark and cannot exercise much discretion. To use a wonky term, they have "low active share." On the other hand, there are managers who eschew conventional benchmarks and manage money in a more flexible style (i.e. they have a high active share).
Has anyone pitted the high active-share managers (eliminating the index-huggers) versus the indices?
I would be curious to see (especially from the beginning of the secular bear market in 1999) how these two style matched up.
My personal bet is that in secular bull markets indexing wins, but in secular bear markets, you will want some high active-share managers in the portfolio.
Jeff Harring
Raymond James
St. Petersburg, FL
Joe Tomlinson replies:
You make a good point about "high active-share" managers. I'll see if I can find any studies. The challenge for anyone doing such studies will be to find a big enough data set of managers to produce statistically significant results.
Dear Editor,
Tomlinson cited two studies as showing that on average, actively managed funds picked by informed professionals [401k sponsors] probably cannot outperform their index-fund counterparts. He suggested the same statement might be applied to other informed professionals such as investment advisors. I am relying on Tomlinson’s summary of the two studies and did not review them independently.
As for the first study, what struck me was that the time period covered (1994-1999) represented the market inflation during the tech bubble. It’s never been a secret that actively-managed funds are at a disadvantage in raging bull markets, such as one finds in the formation of a bubble, if for no other reason than that mutual funds have “cash drag.” Indeed the Wall Street Journal reported a few years ago that Vanguard, king of the index funds, found in the past few decades “…fewer active funds beating the broad market in bull periods than in the downturns.”
The other study cited covered a more balanced January 2000 through June 2007, representing both a market downturn and upturn, and reportedly also supported the author’s thesis.
This notion that I might be wasting my client’s money by selecting funds does raise a concern, so I reviewed the performance of actively-managed funds in the account I’ve managed the longest. The largest actively-managed equity fund position I’ve held in that account was Vanguard Primecap. Since it was bought in July of 1996, it has returned (according to FastTrack data) 10.7% versus the index fund’s (SPY or Schwab 1000) return of 7.4%. The second-largest actively managed fund position held was Longleaf Partners Fund. Since it was bought in March of 1996 it has returned 9% versus 7.3% for the index. This is of course only anecdotal and I’ll accept luck as a partial explanation.
And I would not disagree that finding actively-managed funds that can outperform the market, represented by an index fund, over the long term is difficult. But the idea that advisors shouldn’t try mischievously reminds me of the response one bond-fund manager once gave to the idea that he and his colleagues shouldn’t attempt to assess where interest rates were headed because the task was so difficult. His response was something to the effect that bond fund managers who didn’t think they should try to figure out where rates were going ought to perhaps consider becoming cab drivers instead.
Obviously advisors should do whatever it is that they think adds value for their clients. For some of us, finding fund managers who we believe generate additional risk-adjusted returns may be a valuable part of a multi-strategy approach to investment management.
Geoffrey Foisie
Investments Manager
Shawbrook
Alexandria, VA
Joe Tomlinson replies:
Based on the two studies I reviewed, I actually have come around to the belief that it's likely that there are indeed advisors who possess both the skill and discipline (and not just luck) to select funds that will outperform index funds after expenses. However, it is also likely that these talented advisors are in a minority among all advisors who claim to possess such talent. So, as I stated in the article, this "creates a dilemma for clients in terms of how much to pay for advisors that claim superior fund-selection capabilities." Despite the arguments that Geoff makes, I still find myself favoring "core only" or "core and satellite" approaches and not comfortable betting entire portfolios on active management.
Advisors need to decide for themselves where they can best add value for clients, and there are many opportunities other than selecting the best actively-managed funds. I expect there will be more studies coming out like those mentioned by Wade Pfau that I cited in the article that examine the different ways advisors can add value. I urge advisors to objectively examine the evidence that such studies produce.
The following is in response to Wade Pfau’s article, Breaking Free from the Safe Withdrawal Rate Paradigm: Extending the Efficient Frontier for Retirement Income, which appeared last week.
Dear Editor,
Thank you for your insight and research on this very important topic. Maybe I missed the explanation in the article, but how is it that a 0%/100% allocation to stocks and fixed SPIAs, respectively, ends up with approximately 30% in real value of financial assets at death (Y-axis) as depicted in Figure 1? Since all financial assets are initially used to purchase SPIAs, wouldn’t the remaining financial assets at death be zero? Or does the SPIA income exceed expenses in the early years, which results in accumulating the excess in an account and growing over time to reach 30% of the initial pool of assets? If there is an accumulation of excess SPIA income, at what rate does this accumulation grow? If there is no accumulation of SPIA income, wouldn’t this shift the red efficient frontier curve closer to the X-axis with the 0%/100% point lying on the X-axis (0% financial assets)?
Jim
Jim Schwartz, CFP®, CDFA™
Strategic Wealth Advisors, LLC
Scottsdale, AZ
Wade Pfau responds:
Your explanation is right. The initial payout is 5.84%, but the couple only needs 4%, so the excess SPIA income is invested into stocks. The couple doesn't spend more than 4%.
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