Implementing TCM’s Investment Philosophy
What is Passive Investment Management?
Passive investment management makes no attempt to distinguish attractive from unattractive securities, or forecast securities prices, or time markets and market sectors. Passive managers invest in broad sectors of the market, called asset classes or indexes, and, like active investors, want to make a profit, but accept the average returns various asset classes produce. Passive investors make little or no use of the information active investors seek out. Instead, they allocate assets based upon empirical research delineating probable asset class risks and returns, diversify widely within and across asset classes, and maintain allocations long-term through periodic rebalancing of asset classes.
What is Index Investing?
Index investing is a form of passive investing in which portfolios are based upon securities indexes which sample various market sectors and are constructed by committee. Best known is the Dow Jones Industrial index, a basket of thirty very large U.S. companies. Indexes are available for most domestic and international markets, and rise and fall as individual securities within the index rise and fall.
What is Active Investment Management?
Active management might best be described as an attempt to apply human intelligence to find “good deals” in the financial markets. Active managers try to pick attractive stocks, bonds, mutual funds, time when to move into or out of markets or market sectors, and place leveraged bets on the future direction of securities and markets with options, futures, and other derivatives. Their objective is to do better than they would have done if they simply accepted average market returns. In pursuing their objectives, active managers search out information they believe to be valuable, and often develop complex or proprietary selection and trading systems. Active management encompasses hundreds of methods, and includes fundamental analysis, technical analysis, and macroeconomic analysis, all having in common an attempt to determine profitable future investment trends.
Passive Investment Management Works Best
Research supporting passive management comes from the nation’s universities and privately funded research centers. The results from this research are very clear: Active investment management is an appealing mirage which substantially boosts costs and decreases returns compared to properly designed passive portfolios. Research employed in the development of passive and index investment strategy has shown that:
Asset Class Mix Is the Most Important Determinant of Investment Returns
An asset class is a group of securities which have similar risk and return characteristics. One year Treasury bonds, or commercial real estate, or small company U.S. growth stocks, or emerging market stocks, are examples of asset classes. Research has clearly established that performance differences between different professional money managers are due predominantly (90%, or more) to the asset class they choose. Markets, not managers, produce returns.
The “Smart” Money Uses”Passive Investment Strategies
An estimated 40% to 50% of all institutional monies are in index or passive portfolios while only 3% to 4% of retail investors make use of passive strategies. Passive strategies are employed by AT&T, CALPERS, IBM, Intel, K-Mart, PacTel, Pepsi, and Stanford University, among many others.
Markets and Economies Are Unpredictable
Several statistical studies have found that the price behavior of securities, such as stocks, bonds and commodities, is indistinguishable from that of random numbers. Given that there are thousands of stock market experts, mutual fund managers, private money managers, and advisors, some will make spectacular calls and accurate predictions. Yet, extensive research has shown that, as a group, the performance of experts is what would be expected from chance guessing, there is no way of knowing in advance who will make the right call, and past success is unrelated to future performance. For example, studies have found that past earnings growth for companies is only weakly correlated with future earnings growth or stock prices. Never-the-less, active managers and investors excitedly watch earnings reports for clues to the future price of a stock. Over many decades, the prices of securities trend upward due to inflation and economic growth. Otherwise, future securities prices are unpredictable.
Economists in both the public and private sector provide a continuous series of data and forecasts in an attempt to predict future economic and investment trends. Yet, numerous studies have found that economists cannot predict major turning points in the economy, forecasting skill is, on average, about as good as chance guessing, and economic data is of poor quality and subject to frequent major revisions. For example, one study found that Federal Reserve economists did significantly worse than chance in predicting economic growth and turning points in inflation from 1980 through 1995.
Future Securities Prices Are Unpredictable
Several statistical studies have found that the price behavior of securities, such as stocks, bonds and commodities, is indistinguishable from that of random numbers. Patterns in numbers occur, technicians attribute great significance to them, but they have no demonstrated persistence or predictive power. However, selling predictions is a big and profitable business.
Risk and Return Are Absolutely Correlated
High potential returns always involve high potential risks. There are no low-risk/high-return investments. Investment risk comes in many forms but, to most investors, risk means the potential for losing investment capital and the duration or permanency of that loss. Through analyzing the best available long-term data, researchers have carefully defined the risk/return ratios of all major asset classes and identified the correlation or interdependence of different types of investments. These findings provide our best approximation of future risk and return for any given asset class or mix of asset classes, and clearly show that there are no high return, low risk asset classes.
Active Management Is Much More Expensive Than Passive Management
Active investors must overcome many costs to match the returns of the average passively managed portfolio. These include trading costs, much higher management fees, market impact costs as active managers affect the prices they pay, dilution from maintaining higher cash positions than passive managers, taxes in taxable accounts due to high turnover rates, and, commissions, if an investment “product”, like a mutual fund, is purchased through a broker or financial salesperson. These costs create a handicap for the active investor of 2.5% to 9% per year, depending upon asset class mix, and whether a salesperson is involved. The least expensive forms of active management, no-load mutual funds and “wrap fee” accounts, typically consume 2.5% per year from investor’s returns, while the average passive or index portfolio costs under 0.5% per year.
Passive Management Outperforms Active Management
Because of increased costs and risks, about 75% of active managers, as a group, underperform passive portfolios during any given year and, over time, this percentage increases until only a few outperform market averages. When matched for asset type and mix, passive managers outperform active managers by about 2% per year, on average. In addition, active management in taxable accounts creates a constant stream of capital gains taxes which must be paid each year. Studies show that after-tax returns in active accounts are 30% lower, or more, over long investment time-frames.
Exceptional Active Managers Cannot Be Identified In Advance
A tiny handful of superstar money managers with outstanding past performance are constantly promoted by the media as evidence for the benefits of active management. Yet, no one knew in advance who would outperform, the odds of selecting one are low, and the results they achieved may be due to luck. Hundreds of carefully done studies have found that past performance of money managers, mutual fund managers, investment analysts, and others is unrelated to their future performance. Track records mean nothing. The two greatest superstar active managers of our time, Warren Buffet and Peter Lynch, both recommend index funds.