Why You Need to Drop Your Mutual Funds for ETFs

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We just finished the third quarter this week and it was a tough one. The market struggled to make new highs all year before it finally ran out of steam during the week ending August 21. The S&P 500 Index traded above 2100 in July, but dropped roughly 10% to 1920 to close the quarter on September 30. Year to date, the index is down 6.75%.

While it was a disappointing quarter, we should remember that we’ve had an exceptionally long run without a correction of any size. Still, no one likes to open their quarterly statements and see that their accounts are down.

One of the myths of active fund management is that managers are able to add value during corrections through their defensive strategies. At least, that’s what we’re told when they lag during a bull market. So how did actively managed funds fare during the third quarter?

According to a report this week by JPMorgan, 67% of active funds performed worse than their benchmark in Q3. Half of those funds (34%) lagged their benchmark by at least 2.50%.

The long-term picture is even worse for active management. The Standard & Poors Index Versus Active (SPIVA) Scorecard was recently updated with data through June 30, 2015. They found that over the past 10 years, 79.59% of all Large Cap funds were outperformed by the S&P 500 Index. Over this period, the index produced an annualized return of 7.89%, versus 7.03% for the average large cap fund.

If you are still using actively managed mutual funds, chances are good that 1) your Q3 returns are even uglier than the overall market, and 2) your long-term performance has suffered significantly. That’s why we use Index Exchange Traded Funds (ETFs) as the core positions in our model portfolios. Investing in an index doesn’t mean “settling” for average returns, it has actually been the most likely and consistent way to ensure your performance is better than the average active fund.

If that isn’t enough to get you to trade in your mutual funds for an ETF portfolio, then read this article from Morningstar on mutual fund capital gains. Morningstar notes that after a 6-year rally, many mutual funds have used up their tax losses and are increasingly likely to distribute capital gains to fund shareholders at the end of this year. If this quarter’s drop causes a large outflow of capital, active fund managers will be forced to liquidate positions, creating a tax bill for the shareholders who remain in December.

It’s entirely possible for an actively managed mutual fund to be down for the year and still create capital gains for shareholders, due to trading within the portfolio. We haven’t seen this scenario in a number of years, but it looks like a distinct possibility for 2015. Index ETFs on the other hand, are extremely tax-efficient; it is quite rare for an equity index ETF to distribute capital gains, thanks to their unique structure.

If you’re a client, thank you for sticking with the plan when the market is down. We know it is frustrating. Corrections are a natural and inevitable part of the market cycle. You can take solace knowing that our Index ETF approach is demonstrating its merit both in its relative performance in Q3 and in its long-term outperformance over actively managed funds.

If you’re not currently a client, please give me a call and we can discuss how our disciplined portfolio management process can help you accomplish your financial goals. While we can’t control what the market is going to do, we can benefit greatly by focusing on what we can control, including tax efficiency, minimizing expenses, diversification, and using a time-tested index methodology.

Indexing Wins Again in 2014

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2014 was another strong year for Index funds. According to the Wall Street Journal, only 13% of actively managed large cap funds exceeded the 13.7% total return of the S&P 500 Index for the year. It seems like each year, when index funds outshine active managers, we hear different excuses why. This time, market breadth was blamed, as a high correlation of returns meant that there were few stand-out stocks for managers to make profitable trades. In previous years, we heard managers complain about a “junk rally”, or that “our style is out of favor this year”. And of course, each year, we also hear why the new year is going to finally be a stock pickers market.

We use index funds as the core of our Good Life Wealth model portfolios. Indexing works. I think the misconception about indexing is that it means settling for average returns or that it’s a lazy approach. The reality is that using index funds actually increases your chances of achieving good performance. Index funds outperform 60-80% of actively managed funds over the long-term.

Of course, some actively managed funds do beat the indices. Why not just select those funds? Unfortunately, past returns are not a reliable indicator of future performance. We know this is true – and not just my opinion – through the Standard and Poors Persistence Scorecard, which rigorously measures the persistence of fund performance. Updated in December, the Persistence Scorecard found that of 421 domestic equity funds in the top quartile (top 25%) over five years, only 20.43% remained in the top quartile for the subsequent five-year period.

Top Quartile funds based on 5-year performance (as of September 2009). Over the next 5 years, through September 2014:

  • 20.43% of the funds remained top quartile
  • 19.95% fell into the second quartile
  • 22.33% dropped into the third quartile
  • 27.09% sunk to the bottom quartile
  • 10.21% of the funds were merged or liquidated

If long-term performance was a reflection of manager skill, why are so few funds able to continue to be above average? The results above suggest that instead of high-performing funds remaining at the top, their subsequent returns are almost randomly distributed. In fact, top quartile funds are more likely to be at the bottom (27%) than to remain at the top (20%). And surprisingly, 10% of those top funds don’t even exist in five years. Unfortunately, buying that 5-star fund that has been killing the market often turns out to be a poor decision in a few years time. Then the investor switches to a new hot fund, and the cycle of hope and disappointment begins again.

Indexing avoids these pitfalls. It’s a smart way to invest. And when you look at the tax efficiency of index funds compared to active funds, indexing looks even smarter. (Don’t even ask about the tax consequences of trading mutual funds every couple of years.) But using index funds isn’t a once and done event. We carefully create our asset allocation each year in consideration of valuations, risks, and potential returns for the year ahead. Even when we don’t make any changes to the portfolio models, we still monitor client portfolios and rebalance annually to make sure your holdings stay in line with our target weightings. Perhaps most importantly, the indexing approach allows investors to focus their energy on saving and planning decisions, rather than monitoring managers or searching for the next hot fund.

Three Studies for Smart Investors

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Over the last several years, my investment approach has become more systematic and disciplined.  In place of stock picking or manager selection, I believe clients are better served by a focus on strategic asset allocation. Today, we offer investors a series of 5 portfolio models, using ETFs (Exchange Traded Funds) and mutual funds. This approach offers a number of benefits, including diversification, low cost, transparency, and tax efficiency.

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This evolution in approach occurred gradually as a result of continued research, personal experience, and pursuing the goal of a consistent client experience.  In my previous position, I managed $375 million in client portfolios, performing investment research, designing asset allocation models, rebalancing and implementing trades.  I am grateful for having this experience and want to share the reasons why I believe investors are best served by the approach we’re using today.

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My investment approach is underpinned by three academic studies.  These studies look at long-term investment performance, are updated annually, and offer great insight into what is actually working or not working for investors. As an analyst, I am very interested in what data tells us, and how this may differ from what we think will work or what should work in theory.  But even if you aren’t a numbers geek like me, these studies instruct us about investor behavior and where you should focus your efforts and energy.  I’m going to give a very brief summary of each study and include a link if you’d like to read more.

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Published semi-annually, SPIVA looks at all actively managed mutual funds and calculates how many active managers outperform their benchmarks. The long-term results are consistently disappointing.  As of December 31, 2013, 72.72% of all large cap funds lagged the S&P 500 Index over the previous five years.
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Sometimes, I hear that Small Cap or Emerging Market funds are better suited for active management because they invest in smaller, less efficient markets.  This sounds plausible, but the numbers do not confirm this.  The data from SPIVA shows that 66.77% of small cap funds lagged their benchmark and 80.00% (!) of Emerging Market funds under performed over the past five years.

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The lesson from SPIVA is that using an index fund or ETF to track a benchmark is a sensible long-term approach.  Indexing may not be exciting or produce the best performance in any given year, but it has produced good results over time and reduces the risk that we select the wrong fund or manager.  Our approach is to use Index funds as a core component to our portfolio models.

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The other conclusion I draw from SPIVA is that if large mutual fund companies, with hundreds of analysts, cannot consistently beat the benchmark, it would be foolish to think that a lone financial advisor picking individual stocks could do better.

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After looking at SPIVA, it may occur to investors that 20-35% of funds actually did beat their benchmarks over 5 years.  Why not just pick those funds?  Why settle for average when you can be in a top-performing fund?
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The S&P Persistence Scorecard looks at mutual funds over the past 10 years.  At the 5-year mark, the scorecard ranks funds in quartiles by performance and looks at how the funds’ returns were in the subsequent five years. This tells us if a top performing fund is likely to remain a leader.

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Looking at all US Equity funds, we start with the funds which were in the top quartile in September 2008. Below is breakdown of how those top quartile funds ranked in the subsequent five years, through September 30, 2013:

 

1st Quartile:  22.43%
2nd Quartile  27.92%
3rd Quartile:  20.53%
4th Quartile:  16.71%
Merged/Liquidated:  12.41%
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Of the funds in the 1st Quartile in 2008, only 22% remained in the top category in the following 5 years.  29%, however, fell to the bottom quartile or were merged or liquidated in the following 5 years.  So, if your method is to go to Morningstar and find the best performing fund, please be warned,past performance is no guarantee of future results.  In fact, the Persistence Scorecard tells us that not only is past performance not a guarantee, it isn’t even a good indicator of future results.  The results above aren’t much different than a random chance of 1 in 4 (25%).  Albeit disappointing and counter-intuitive, the reality is that past performance offers virtually no predictive information.

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Now in its 20th year, QAIB compares mutual fund returns to investor returns.  The reason why they differ is because of the timing of investors’ contributions and withdrawals from mutual funds.  For example, people may think that it is safer to invest when the market is doing well and they buy at a high.  Or, investors chase last year’s hot sector and sell out of a fund that is at a low and just about to turn around.  Investor decisions are consistently so poor that we can actually measure the gap between the average investor’s return and the benchmark.  You might want to sit down for this one – over the 20 year period through 2013, the S&P 500 Index returned 9.22% annually, but the average investor return from equity mutual funds was only 5.02%.  The behavior gap cost investors 4.20% a year over two decades.
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I draw three very important conclusions from QAIB:
– We should avoid trying to time the market (buy/sell);
– Chasing performance is more likely to hurt returns than improve returns;
– Without a disciplined approach, including a target asset allocation and monitoring/rebalancing process, what may feel like a good investment decision at the time may ultimately prove to be a poor choice in hindsight.
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These three studies are so important that I carry excerpts from the reports with me to discuss with investors. They’re fundamental to my investment approach, and hopefully, their significance can easily be grasped and appreciated by all our clients.

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While we’ve focused exclusively on investment philosophy in this post, I would be remiss to not add that the benefits of working with a CFP(R) practitioner are not limited to portfolio management.  A comprehensive financial plan includes many elements, such as savings/debt analysis, risk management, tax strategies, and estate planning.  The investment management component tends to get the greatest attention, but the other elements of a personal financial plan are equally important in creating a foundation for your financial security.

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