October 15, 2015


Dear Friends,

It is normally assumed that the biggest reason actively managed funds underperform passively managed funds is their higher fees (operational expenses). But the results from a recent study make it clear that the difference is about a lot more than fees.

While not discussed in the study results, I assume the rest of the difference is likely the high cost of trading actively managed funds, a cost that is not included in the operating expense. Another factor may be that actively managed funds are often a combination of more than one asset class. Even a small position in another asset class can hurt performance compared to the index. However you look at it, actively managed funds have a difficult time beating index funds. Probably the biggest surprise from the study is the under-performance of actively managed small cap funds, an asset class where most investors believe active managers can add value. Another belief is that active managers will do better in bear markets. Turns out that’s just another myth.

recent study from S&P Capital IQ and S&P Dow Jones Indices compared active and passive funds over the past decade. The study found that only 8% to 16% of actively-managed funds beat their benchmarks after fees, but only 23% to 49% (depending on the equity asset class) outperformed excluding fees; in other words, the majority of active funds were underperforming over the past 10 years even based on gross returns before fees.

Of course, the classic caveat that “the past is not prologue” still applies, but ultimately the conclusion of the study is that there seem to be an increasing level of headwinds for actively-managed funds trying to outperform their asset class.

Q&A’s below.

To your success,

What do you think of Life Strategy Funds?
Q: In the UK, Vanguard has a family of global funds called Life Strategy funds. The funds are 100% equity, 80/20, 60/40, 40/60 and 20% equity 80% bonds. If I were working on a 60% equity 40% bond portfolio, could one of these Life Strategy funds be the core of the buy and hold global portfolio and, if so, would you supplement with any other bond or equity types?
A: Vanguard has both U.S. and U.K. groups of life strategy funds. Unlike target-date funds that change their balance of fixed income and equity over time, lifestyle funds are static, based on a predetermined level of risk. While there are some differences between the U.S. and U.K. lifestyle funds, they both suffer from the same problem. They both have virtually all of their equity holdings in very large, mostly growth-oriented companies.  Depending on how hard you want to work, I hope you will consider broadening your holdings to include both large and small value companies. Here is a link to the U.K. LifeStrategy Funds and here is a link to the U.S. LifeStrategy Funds.

If you add some large and small cap value, you will also have to add some bond funds to maintain your 60/40 balance. If you want to keep it simple I suggest adding 12% (that’s 20% of the 60% equities) in a small-cap value fund.

How do we talk about money with our mom and our kids?
Q: My husband and I have had a challenge with finding out about my mother’s investments. She is getting a little senile and I’m worried about someone taking advantage of her. Plus, we are starting to wonder how open we should be with our own children. Some are savvy but others are showing no signs of getting serious about their financial future. Do you have a good source of information that might help start a conversation with my mother and our kids?

A: My good friend Cheryl Curran has written a book entitled “The Transparent Legacy.” It is a free e-book available here. Cheryl and I worked together for over 20 years so my recommendation is very biased, but I read the book and found it helpful for a situation I was facing in my own family. Also check out “Money Talks: 100 Strategies to Master Tricky Conversations about Money.” If you explore the table of contents on Amazon I can almost guarantee you will want to spend $10 to help you through one of the many tricky conversations they cover.

What’s your opinion of Bill Gross’ long-term predictions?

Q: What is your take on the comments Bill Gross made in his August investment outlook in which he raised eyebrows by equating equity investing to a Ponzi scheme and questioning if stocks can continue to provide returns over the long-term that will be sufficient to compensate for corresponding risk? While Mr. Gross may have his own motives for making these kinds of statements, he has a formidable reputation and many people respect his opinions.

A: I am not qualified to give a meaningful projection for future returns. I do know that investors, while in the middle of a bull market, tend to expect higher returns in response to a recently rising market. Of course, the same is true after periods of market declines – investors predict lower returns. I don’t place any meaning to what amateur investors think. I also know that Wall Street experts have a product to sell and it is best sold if the story behind the product is compelling. For that reason I don’t trust the bias of a story in which the conclusion benefits the storyteller.

There is a lot of academic research (and common sense) that makes me believe we will continue to get a premium for the risk of stocks over bonds. By the way, that may be easy as the returns of bonds could very low for a period of years. There is also lots of evidence that the additional risk of small cap and value will lead to higher profits. The end of all this could be a 7% return for a diversified portfolio of equity asset classes vs. half that, or less for bonds. I would not expect the premiums of small cap and value to be as high as they have been for the last 15 years.

There is always a list of good news and bad. That is true of individual stocks or broad markets. What do you do if a brilliant person says it’s time to get out? Warren Buffet concluded it was smart to get out back in the late 1960s. He cashed out his partnership and returned the money to the investors and missed the bloodbath of the ’73-’74 bear market.

How do you figure annual distributions in retirement?

Q: I understand you set aside each year’s cost of living needs the first week of the year, but where do you keep the second and third year’s cash needs? Do they remain part of your 50/50 portfolio?
A:My wife and I take the money we need for the year during the first week of the year and normally don’t take another check until the following January. We take a 5%distribution (variable) from our 50% bond/50% equity portfolio, we have the equivalent of 10 years of short-to-intermediate term bond funds, so I don’t have any anxiety about what the market is doing day to day or month to month. It’s interesting to see my change of attitude since I retired. When I was an investment advisor, I had feelings of anxiety for my clients during market declines. Now that I’m retired that anxiety has been transferred to my readers. I don’t think I will ever shed that sense of responsibility for people doing what I recommend.
Should I sell my load funds and buy no-loads?
Q: Early in my investing career I purchased 3 load funds and paid about 5% in commissions. After I bought those funds I discovered no-load funds and haven’t paid any more commissions. I’ve held these 3 funds for over 20 years. They are all in IRAs so there’s no tax implications if I sell. I’ve done okay with the funds but not sure whether I should sell.
A: I suspect the load funds you own have higher ongoing expenses than the no-load funds your own. The damage of a load is worth eliminating but much less than the impact of higher expenses. If you pay a 5% commission on a $1,000 purchase, and make 8%, you will have $20,638 at the end of 40 years. If you didn’t pay the load and made 8% the ending value would be $21,724, or $1,086 more.
If the load fund has .5% higher expenses (which is to be expected), the ending value, without consideration for the load, is likely .5% less or 7.5%. On $1,000 an ending value at 7.5% would be $18,044.
If the expenses are higher than the no-load funds you own, or if the asset classes are not what you should have, I would liquidate and move on. I assume the load funds are actively managed and the no-load funds are passively managed, another reason to make the change.
How do I determine history of funds with short track records?
Q: You recommend investors find out what the worst periods have been for an investment so we are sure it’s within our loss limits. Some of the funds I have looked at have very short track records. How should I determine their likely losses?
A: I suggest you find a track record for a similar asset class. For example, a technology fund may look a lot like the NASDAQ Index or a large-cap blend fund like the S&P 500. Here is a link for the NASDAQ:https://en.wikipedia.org/w/index.php?title=Nasdaq_Composite&action=edit§ion=1 and to S&P 500: http://www.yardeni.com/pub/stmktreturns.pdf
Does it matter if managers have money in the mutual funds they manage?
Q: Morningstar recommends investors know how much mutual fund managers have in the fund they manage. The idea is the bigger the amount invested, the higher the likely return. I assume it doesn’t matter with index funds. Agree?
A: I agree. In fact, in many cases it may be inappropriate for an index fund manager to own any shares in the fund they manage. For example, someone could manage a S&P 500 fund but prefer a total market fund. Someone else might manage a small-cap balanced fund but have all their small cap in small-cap value.
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