Charles Ellis hammered the latest nail in the coffin of professional money management. His article, “The Rise and Fall of Performance Investing” appeared in the summer issue of Financial Analysts Journal*. It declares the era of performance money management over. Done. Finished.
The most important observation in his article is this: The armies of analysts and professionals are now so large and their expertise is so great that markets are truly efficient. So professionals don’t have a lasting edge on the market prices for stocks. They have no advantage in the market. And if they have an edge, they pay it to themselves as the cost of management.
This isn’t news for regular readers of this column; you’ve been hearing it from me for over 20 years. But consider this an official notice. It’s not just another missive from a cranky journalist. Financial Analysts Journal *serves the 123,000 individuals around the world who are Chartered Financial Analysts (CFAs). They are the elite of the financial world. Many owe their jobs to the idea that professional analysis will buy superior performance.
So this is a real sea-change article. It’s a declaration, by an informed observer, that the emperor is out walking, stark naked.
Another thing Ellis comments on is the deceptive nature of money management pricing. Usually priced as a percent of assets, it can seem quite modest. (Who could quibble about a mere 1 percent of assets?) But measure the same fee as a percent of the return on assets and it will balloon to 12 to 15 percent of the return on your money. Often more.
In fact, he observes, the true cost is even higher. “Because indexing consistently delivers the market return at no more than the market level of risk,” he writes, “the informed realist’s definition of the fee for active management is the incremental fee as a percentage of incremental returns after adjusting for risk.”
To explain that in words a non-CFA can understand, here’s an example. Suppose a fund produces a net annual return that is 0.5 percent higher than the return of its benchmark index. If the fund has annual expenses of 1.5 percent this means its gross return was 2.00 percent ahead of the index. But the manager took 75 percent of the added return (1.5/2.0).
Meanwhile, the investors get 100 percent of the risk. And, by the way, they get to pay full fees in all the losing years, too.
The reality here is that when we poor sheep buy a managed fund, we’re buying an investment lottery ticket. You can understand with a comparison. If you buy a lottery ticket for $1 you are taking a chance that your choice will be one of the tickets that wins some of the money.
State lotteries keep about 50 cents of every $1 collected. They pay out 50 cents in prizes. So your lottery ticket has what statistical types call an “intrinsic value” of 50 cents. The ticket will mean more, or less, to you— but its average value will be 50 cents.
Now lets compare.
Recently, the Morningstar database had 683 managed large-blend funds with a 10-year performance record. These funds invest in large capitalization domestic stocks. Only 201 of those funds— about a third— beat the S&P 500 Index over 10 years.
The average return of the 201 winning funds was an annualized 0.95 percent higher than the index. With a 33 percent chance of adding 0.95 percent to what your money would earn in an index fund, the intrinsic value of your “ticket” is 0.32 percent, annualized (.33x.95). But your management lottery ticket will cost about 1.03 percent more than a low-cost exchange traded index fund. (The expense ratio average for this group of managed funds is 1.07 percent, and a low-cost exchanged traded index fund costs 0.04 percent.)
You can see where this is going.
When you buy a managed fund you are paying an extra 1.03 percent for the privilege of getting that 0.32 percent annualized added return.
This makes lottery tickets look pretty good.
In casinos they would call that 1.03 percent the “vig.” They make billions on vig like this. The investing game isn’t exactly the same as casino games, but the guys who run the mutual funds do pretty well, too.
*earlier this was mis-identified as The Journal of Portfolio Management.