active vs passive?

guymo

Ryan_Futuristics wrote: »

Shouldn't make any difference - chaos doesn't discriminate


Heard a great point yesterday actually - we get so many magazine articles saying "the average investor under-performs the market" (presumably because it's one of these modern narratives that makes us feel better ... Rather than "the average investor is doing better than you")

But the statement is illogical - every sale price represents a buy price, and vice versa: the average investor *is* the market (they can't do better or worse than it), the question is whether we're using the right benchmark in every case (presumably we're using the wrong one at least as often)

This is precisely the argument in favour of broad market low cost indexing: the average investor (and this does not mean Mr Average in a grey cardigan somewhere at home, it means the mean of all the investments which are in the main done by professionals e.g. pension fund managers) gets market return less cost --- for some definition of "market". If you don't know a way to outperform the market by your investment selections, then your best option is to try to track the market at the lowest possible cost.

And on the performance of the Vanguard LS60: within the "Mixed Investment 40%-85% Shares" sector, it is up against funds with significantly higher equity components, which will be more volatile. When the US has been doing well, you would therefore expect LS60 to be a bit lower in the rankings than funds with higher equity components. Top of second quartile is perfectly reasonable.

TheTracker

Yes in a zero sum game Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

Ryan_Futuristics

Nosler wrote: »

but after fees could the average investor not be doing worse than the market?


since investors do not have the same amount to invest it is possible that richer investors make better returns and the average investor underperforms...

Fees could be a factor, but I think the overall point is: what do we really mean by 'the market'?

It's likely you'd find different 'average' investors whether you were looking at mean, mode or median averages, and then it's also: are you picking the right benchmark? ... and for this reason it's very easy to make numbers behave as you want them to

guymo wrote: »

This is precisely the argument in favour of broad market low cost indexing: the average investor (and this does not mean Mr Average in a grey cardigan somewhere at home, it means the mean of all the investments which are in the main done by professionals e.g. pension fund managers) gets market return less cost --- for some definition of "market". If you don't know a way to outperform the market by your investment selections, then your best option is to try to track the market at the lowest possible cost.

And on the performance of the Vanguard LS60: within the "Mixed Investment 40%-85% Shares" sector, it is up against funds with significantly higher equity components, which will be more volatile. When the US has been doing well, you would therefore expect LS60 to be a bit lower in the rankings than funds with higher equity components. Top of second quartile is perfectly reasonable.

Absolutely - *if* the LS60 is just the right benchmark for you

E.g. If you had a long-ish horizon, and didn't mind volatility, a smaller companies fund would probably return a lot higher (whether you used a low cost FTSE 250 tracker or a top smaller companies fund)

If your investment is to provide you with monthly income, or the potential for long-term compounding with reinvestment, you would be better off with an equity income fund (where investment trusts tend to reign supreme)

Maybe you have a slightly higher risk tolerance and would prefer to hold high-yield bonds and emerging markets (both of which have the potential to pull away from LS60 assets)

Then there's the question of whether buying US equities or bonds is sensible in today's market? (Whether the 'low risk' option is low risk just because we expect it to be)


Ultimately, what we consider 'the market' is simply how we're choosing to look at the market - and if we're looking at the market in the wrong way, then we're probably investing in it in the wrong way

Ryan_Futuristics

TheTracker wrote: »

Yes in a zero sum game Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

That's not quite the conclusion - it says the average active manager can only be assessed against an appropriate benchmark (which would inevitably imply the average would be performing at the 'average')

The bit about whether they outperform common 'passive alternatives' is a whole other paper

What you're really talking about there is: does the appropriate benchmark beat the S&P 500? Vanguard LS60 certainly wouldn't ... So why do we hold it? (rhetorical question) ... If we break the appropriate benchmark down by style, do we find other consistencies relating to performance and stability that may help us choose an appropriate benchmark for ourselves?

princeofpounds

A few points to throw into the debate:

1) The active vs. passive debate is at one level very artificial. It is impossible to avoid active decisions, unless you know, and can benchmark, the entire market portfolio.

(Which is impossible, as it includes anything from iranian islamic bonds, to stamps, to stone discs from the Isle of Yap, to be flippant about it).

And so there is always an active decision on how to allocate assets, and that decision which cannot be erased is typically by far the most active, and the most important - allocation between asset classes.

2) The post by guymo (#52) eloquently explains that the academic conclusions reached about CAPM theory, the basis of much modern finance theory including passive indexing, are actually rather incomplete and contested.

That's not to say they aren't the best approximation we have, but personally I always find it quite amusing that we try to shoehorn real-world financial developments into an almost newtonian deterministic equation. Every significant financial theory has a massive fudge factor variable sitting at the heart of it.

We'll probably figure it out about the same time as we a) discover the grand unified theory of physics and b) develop a computer as complex as the entire universe.

3) The simple basis of comparison of active and passive funds is often woefully incorrect.

Active fund performance is often negatively compared to a theoretical benchmark, whilst passive funds are often marketed on that benchmark despite only delivering that benchmark minus costs, 'minus' tracking volatility.

It would be far more realistic to benchmark active funds to their passive equivalents, for a start and as a more minor point to stop implying that a passive solution can 'give' you a theoretical index return.

4) Active management can be done for the costs as an index product. In fact, it can be done for lower costs as it does not need to rebalance as frequently to minimise tracking error. However, it wouldn't look remotely like the active management we know and love today.

Ryan_Futuristics

TheTracker wrote: »

Yes in a zero sum game Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. Empirical analyses that appear to refute this principle are guilty of improper measurement.

That's not quite the conclusion - it says the average active manager can only be assessed against an appropriate benchmark (which would inevitably imply the average would be performing at the 'average')

The bit about whether they outperform common 'passive alternatives' is a whole other paper

What you're really talking about there is: does the appropriate benchmark beat the S&P 500? Vanguard LS60 certainly wouldn't ... So why do we hold it? (rhetorical question) ... If we break the appropriate benchmark down by style, do we find other consistencies relating to performance and stability that may help us choose an appropriate benchmark for ourselves? ... If there were a black & white answer in 1991, trust me, we'd all just be holding FTSE All Share trackers

Nosler

Ryan_Futuristics wrote: »

Fees could be a factor, but I think the overall point is: what do we really mean by 'the market'?

But you were saying that it was "illogical" for the average investor to underperform the market. that has nothing to do with what we mean by the "market".


i have to admit that I'm underwhelmed by the intelligence/shrewdness shown by a lot of the posters here when they talk about investment (not aimed at you Ryan). so i can believe the average investor underperforms the market.

Ryan_Futuristics

Nosler wrote: »

But you were saying that it was "illogical" for the average investor to underperform the market. that has nothing to do with what we mean by the "market".


i have to admit that I'm underwhelmed by the intelligence/shrewdness shown by a lot of the posters here when they talk about investment (not aimed at you Ryan). so i can believe the average investor underperforms the market.

Well the S&P 500 or FTSE 350 don't necessarily reflect an entire investment universe - they're just constructs we use to quantify some (broad) aspect of a market

When we look at the Vanguard 60 fund, it wouldn't be fair to compare it to that 'market', so we create a new benchmark (which we might also call 'the market') which is the mixed investment 60% shares benchmark (which implies we place similar value on returns and on low volatility)

So there's: Do we always mean the right thing when we talk of 'the market'? And then there's: What is an average investor? Is it lining them up from 1 to 100 and picking number 50? Or is it averaging all their returns, so the guy who lost everything brings everyone's score down? ... Basically, it's saying that for everyone who sells everything on the market dip, there's a buyer picking it up super-cheap

EdGasket

Ryan_Futuristics wrote: »

On the other hand, if we're talking overvalued stocks, a 3% real return on bonds or P2P lending over 20 years would still beat a 1% real return in the markets (which is far from implausible)

How the heck are you going to get a '3% real return on bonds' with rising interest rates? A most dangerous piece of advice; you will more likely lose half your capital or more in bonds over the next few years.

P2P lending returns are also poor after tax and bearing in mind there is no FSA protection on your money; quite risky. OK for fun for a small amount but not for serious investment!

Ryan_Futuristics

EdGasket wrote: »

How the heck are you going to get a '3% real return on bonds' with rising interest rates? A most dangerous piece of advice; you will more likely lose half your capital or more in bonds over the next few years.

P2P lending returns are also poor after tax and bearing in mind there is no FSA protection on your money; quite risky. OK for fun for a small amount but not for serious investment!

That's my line! Bond funds could be risky depending on how rates rise and investors react

But there's not much risk to bond ladders (if you can afford to be properly diversified) - over the next few years your average yield should only rise, and 3% real shouldn't be unrealistic with a good proportion of corporate bonds

And there's risk with any investment, but I feel P2P lending to small business (e.g. Funding Circle) is probably one of the new asset classes we've been waiting for ... I'm currently earning 10.2% interest (estimated 7.2% after fees and bad debts - still decent after tax, and soon they'll probably be available through ISAs) ... To me it's just junk bonds 2.0