made a $9,000 bet on the story of managerial skill and you’re hoping for a good
return on that bet.
The science says that this is a sucker’s
bet. A manager may have had a few lucky
years where they’ve been able to justify
their extra costs, but there is no evidence
that even the star fund managers are able
to consistently earn their keep.
Evidence (or research) does say that
fund managers should follow the research
and identify factors that provide return
above beta. This was the philosophy of
David Booth, also a student of Eugene
Fama, who created an investment management company that hoped to exploit
some of the newly identified factors, or
dimensions, of stocks that provide a higher-than-average return. His fund company,
Dimensional Fund Advisors, ended 2016
with $460 billion in assets by following
the evidence-based investing philosophy.
How then do evidence-based investment portfolio managers earn their keep?
First, they need to be aware of the evidence. Dimensional recently added a
new factor — profitability — to capture
a firm characteristic that has historically
predicted higher returns.
Research is constantly unearthing
potential new factors. Being skeptics,
scientists test (and often reject) these factors using data from various time periods
and countries outside the United States.
Evidence-based investing requires that
advisors pay attention to the current state
of knowledge in financial economics. Recent studies have unearthed the potential
value of investing in funds that invest in
low volatility securities, low-beta stocks,
or even leveraged bonds.
In many cases, once a factor has been
identified, its ability to predict higher performance appears to go away. The small stock
effect has largely disappeared since it was
identified by scientists as more traders overweighted small cap within their portfolios.
Source: Savant Capital Management, a fee-only wealth management firm with some $5 billion in assets
and a financial advisory team of about 40 individuals, based in Rockford, Illinois.
EBI’s SCIENTIFIC FRAMEWORK
Science has produced many tremendous advances, from lifesaving medical
treatments to instantaneous communication. Historically, though, science has had
little influence on investing. Instead of keeping pace with advancements in modern portfolio theory along with historical and statistical evidence, investors and
money managers often rely on conventional wisdom and flawed assumptions.
According to Savant Capital Management, the goal of EBI (evidence-based investing) is to maximize after-tax returns for the individual investor while minimizing
risk and protecting portfolios from market downturns. Approaching a problem or a
set of questions from an evidence-based point of view has profoundly affected the
field of medicine, and now investing. EBI offers a way to answer investment questions
in a systematic, analytical, and scientific manner as described in the four steps below.
Eliminate Meaningless Questions
• What is the best way to capture market returns?
• Do professional money managers perform better than market indexes?
• Can you beat the market by identifying great money managers?
• Can market timing improve returns?
• Can investors overcome the fees charged and taxes generated by money
Ask Meaningful Questions
• What is the role of bonds and what types of bonds are most appropriate?
• Is it advantageous to diversify overseas?
• Can small stocks be safely included in diversified portfolios?
• Are value stocks preferable to growth stocks?
• Should diversified portfolios invest in assets other than stocks and bonds?
Apply the Evidence
• For investment selection, both passive (indexed) and broad-based market
funds have the essential characteristics of being low cost, tax-efficient,
• Rebalancing ensures a commitment to long-term risk control and can
enhance return. Simply put, rebalancing allows you to systematically purchase investments that have declined in price and sell investments that
have increased in price.
• As legendary investor Sir John Templeton said, “For all long-term investors, there is only one objective: maximum total return after taxes.”
Monitor for Effectiveness
• The last step, monitoring for effectiveness, is a very important part of the
process. We refer to it as “robust investment oversight” which we believe
significantly enhances investment results by eliminating needless risk.