Evidence Based Finance

01/05/2023

Stick with value.
Wait for mean reversion.

This post updates our value spread with data through the end of 2022. The fourth quarter of 2022 saw value recover from the bout of temporary insanity that gripped some portion of the market over the summer, but the spread ends 2022 very much still in rarified territory – at the 94th percentile, t...

01/02/2023

Initial thoughts for 2023:
The US market ended the year about -20%, pretty bad.
Looking historically though, how many negative back to back years has it had since 1928? Only 4.
Great news for us right? Maybe not:

The conditions in those years except for 1939-1941 were all pretty similar. In 1928, 1973, and 2000 the Fed hiked rates into a recession.
While not guaranteed, a recession is widely expected for 2023.

What to do? Stay the course, don’t change what you’re doing. Don’t try to predict the market. Don’t listen to experts because they don’t know either.

09/13/2022

The Evidence Based Investor details 20 years of active management failure:

    By LARRY SWEDROE   Nobel Prize winner Eugene Fama is considered the father of the efficient market hypothesis (EMH), which asserts that financial markets are “informationally efficient” — the result of financial markets processing millions of trades, reflecting the viewpoint of investor...

08/17/2022

The spread between growth and value is back at an all time high and Cliff Asness asks if everyone out there is "Cray Cray".
Any mean reversion between growth and value will continue to be favourable for the evidence based value investor.

This adds another three months of data to the May entry in our series of value spread updates. Over the past two months, some portion of the market went temporarily (I hope) insane, punishing value, as we measure it, to the point where the value spread has retraced most of its modest gains since the...

08/17/2022

Had an opportunity to discuss my philosophy on financial advice, fees, and evidence based investing with Dr Yatin Chadha on his BeyondMD podcast:

‎Show beyond MD with Dr. Yatin Chadha, Ep Evidence Based Investing - Jan 27, 2022

08/16/2022

Part 5: Diversification

Indexes do not always make for optimal portfolios, as they can have heavy weightings in certain sectors. More than half of the market capitalization of the S&P/TSX Composite Index, for example, is in just two sectors, energy and financial services. An actively managed portfolio can diversify away from such concentrations, and can include attractive sectors and securities that are not well represented in the index.

The first point is true, Canada’s market has large weightings in Energy and Financial Services. But do actively managed funds create increased value by diversifying into “attractive sectors and securities that are not well represented in the index”?

This assertion would be easy enough to prove, just provide long term fund returns in Canada.

Unfortunately, Canadian managers have underperformed their benchmarks 84-91% after fees, over the last 10 years. It seems they aren’t finding more attractive sectors and securities than the benchmark.

However, for the first time in their argument for active investing: Recent studies have shown that truly actively managed portfolios tend to outperform. A 2009 paper by Yale finance professors Martijn Cremers and Antti Petajisto concluded that the best-performing funds focus heavily on stock selection, and have high “active share,” a measure that identifies the portion of a portfolio that is different from the benchmark index.

The implication here is that most active managers are trying to just look like the benchmark, when you isolate for “active share” you find that they do tend be a predictor of outperformance.

Although the paper and its methods have been widely panned, Cliff Asness of AQR Capital effectively recreated the study in his own paper “Deactivating Active Share” and found that “for a given benchmark, we did not find reliable evidence that high-active-share funds earn higher returns than low-active-share fund”. While funds with more active share looked and behaved less like the benchmark, there was no ability to predict whether that performance was good or bad. He went on to conclude “that active share does not reliably predict performance and that investors who rely on it to identify skilled managers may reach erroneous conclusions.”

The authors investigate Active Share, a measure meant to determine the level of active management in investment portfolios, and find it wanting.

08/16/2022

Part 4: Asset Allocation market timing

CI claims that “Active managers will respond to changes in the markets and the economic cycle by adjusting the allocation of their portfolios to reduce volatility and improve results. Investors with passive investments are more likely to be missing out on this crucial aspect of investing.“

We know from SPIVA reports that most active funds do not have “improved results” – particularly relative to their benchmark. However, do active funds have reduced volatility? While active management underperformance of returns becomes common knowledge, this claim that active funds provide a smoother, less volatile return has taken hold.

On its face, the claim seems absurd. They are claiming to own fewer stocks, taking on more risk to try to achieve outsized gains, but that, even with more risk, investors should expect less volatility/smoother returns.

S&P researched this claim in their research paper “The Volatility of Active Management” and found that “Over the full sample period, an average of 80% of U.S. funds and 65% of European funds demonstrated greater volatility than their category benchmarks” Their sample period was from 2007-2015, so it included the 2007 &2008 market correction.

08/16/2022

Part 3: Positioned for Opportunity

“Active portfolios can be structured to invest in securities and sectors that offer greater potential growth than the market as a whole. Active managers can add value by identifying and buying companies that are undervalued or out of favour, or those that offer above-average growth prospects.“ - CI asset management

This implies that active managers have sufficient skill to consistently outperform their counterparts and the benchmark. Although the idea makes sense, smart people should be able to find good deals consistently in the stock market… does this work in reality?

In 2010, Eugene Fama (2013 Nobel prize winner for economic sciences) and his colleague Ken French published “Luck vs Skill in the Cross Section of Mutual Fund Returns” which concluded that on average US equity fund managers do not demonstrate evidence of skill. If there were uncommon skill involved in stock picking, you would expect that skill to be demonstrated over a period of time, or it could be perceived as just luck.

S&P do a Persistence Scorecard, that reviews how fund managers perform relative to their peers over time and their ability to stay in the top quartile consistently. Were they able to consistently outperform, it would be a clear sign of skill.

In their 2020 scorecard, S&P research “reinforce the notion that choosing between active funds on the basis of previous outperformance is a misguided strategy. After all, there remains a 98.5% chance that a top-quartile fund will not stay in the top quartile for the next four years.”

S&P Indices

08/16/2022

Part 3: Downside protection

CI states that “during periods of market weakness, active managers can take steps to protect assets within a portfolio by switching to safer more stable investments. Meanwhile, a passive mandate offers no flexibility and is designed to be always fully invested.”

Again this is true, passive funds are designed to be fully invested and you will take the brunt of market downturns. However, active managers CAN take steps to protect and switch to more stable investments. But can they do this reliably and get back in to capture the upside?

Ben Felix of PWL capital summarized the downside protection question like this “while active fund performance is generally very poor on average, it appears to be slightly less poor during bear markets”. He found that in the 11 down markets in the US and Europe from 1973 – 2003, there were only 5 instances where more than 50% of active managers outperformed.

Do they capture the upside after a market downturn though? This must be viewed in a long-term lens and we will review in the next post.

When you watch a magic act, it’s fun to be fooled. Even though we know it’s just a sleight of hand, it’s still entertaining when that torn-up card reappears out of nowhere.

08/16/2022

Part 2: The potential to outperform

CI notes although both have fees “that active management offers the potential to outperform the market benchmark, while a passive portfolio will under-perform the index due to fees and expenses.”

This is true, active management has the potential to outperform. But how often do they outperform a benchmark and can they do it consistently? No.

There are mountains of evidence across all markets that show roughly 20% of funds tend to outperform the benchmark over 10 years, the evidence can be reviewed in my article “The case for passive low cost investing”. Importantly though, this idea is made moot with William Sharpe’s rationale that because fees are so much higher for actively managed funds “the average actively managed dollar must underperform the average passively managed dollar, net of costs.”

Simple math proves the value of low cost index investing over expensive mutual funds.