There aren’t a lot of resources available for advisors who are
interested in exploring the newest investing research coming
out of academics. Of course, there are academic journals and
conferences, but most advisors need someone to pull out the
most convincing and significant studies that may be relevant
to their own practice.
Ritholtz Wealth Management and the Information Management Network sponsored the first evidence-based investing conference last November with an agenda of topics that
included the research on alternative investments, smart beta,
and portfolio allocation strategies.
The Benchmark Problem
This brings us back to the myth of the benchmark. Imagine
the famous Morningstar Style Box which fits funds into one
of nine value and size categories. On the bottom left are small
cap, value funds. On the top right are large cap, growth funds.
Historically, fund performance has been judged by comparing
their performance to a benchmark portfolio within each of the
nine fund styles. If you invest in a large-cap growth fund, you
compare its performance to the large-cap growth benchmark.
To an evidence-based investor, this makes no sense. If I want
to choose a fund that will likely outperform its benchmark, I’ll
find one that leans to the small-cap value (bottom left) corner
of the large-cap value box.
But why even choose funds in the top-right large/growth
style box when historically these stocks have underperformed?
Why not simply choose the lowest fee funds in the small cap/
value style box?
The most damning problem related to benchmarks may be
that fund managers are loathe to deviate from them. Even the
smart ones who lean to the small-cap/value edge of their style box
are at risk of an investor revolt (or being fired) if they underper-form the benchmark with the style box for a few years in a row.
This happened in the late 1990s when value stocks got
clobbered. Managers have an incentive to steer closer to the
benchmark to keep investors happy.
Of course, this leads to a phenomenon known as closet
indexing. Many active fund managers don’t really do much to
be different than a passive index benchmark.
A newly developed measure of active share quantifies the
extent to which a fund’s performance follows the performance
of an index. A 90% share means that nearly all of the fund’s
investments mimic a passive index. In other words, investors
are paying for active management but not getting any additional value for their investments.
A recent report by the European Securities and Markets
Authority identified nearly one in seven active funds in Europe
that were clearly closet indexers. But this understates the fundamental problem. Even funds that have a 60% active
share must earn their excess fees from the remaining
40% of the fund that deviates from the index.
In other words, investors are paying a lot more for
the passive portion of the portfolio than if they had
simply selected a low-cost passively managed mutual
fund or ETF for 60% of their portfolio and focused
on investing in highly active funds with their remaining 40%.
Providing Value in an Evidence-Based World
A high quality evidence-based portfolio is surprisingly cheap.
Low-cost fund families now offer small-cap value funds, as well
as funds that take advantage of additional factors such as low
volatility and profitability.
In essence, what was once alpha has now become a part of
beta that any investor can capture through passive strategies at a
low cost. That means that an evidence-based advisor will need to
look beyond simply selecting investments to demonstrate value.
The good news is that the scientific evidence points clearly
to areas in which advisors can provide significant value to
their clients. For example, investors lose at least 1% per year
because they don’t stick with their investment policy during a
recession. An advisor can help them stay the course.
Investors don’t take advantage of tax-efficient strategies
such as tax loss harvesting and locating investments in the
right sheltered account. Advisors can move investments into
the most tax-efficient areas. Avoiding behavioral allocation
mistakes and taking advantage of tax-savvy strategies alone
can help advisors more than earn their keep.
Most important, taking an evidence-based approach to advising moves the focus away from security selection and moves
it toward helping clients achieve long-term goals. Admitting
that high-performing portfolios have become a low-cost commodity can help advisors position their true value in the areas
where clients need it the most.
Michael Finke, Ph.D., is the dean and chief academic officer at The
American College of Financial Services.
The good news is that the scientific
evidence points clearly to areas in
which advisors can provide significant
value to their clients.