The High Cost of Stock Market Alchemy

| February 02, 2015
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Retirement Strategies

The alchemist of the Middle Ages sought to create gold out of inexpensive iron.  Today’s alchemists are alive and well on Wall Street and Main Street as mutual fund managers and individual investors seek to create their own gold by successfully picking stocks and timing markets.  Does active management add value or is it part of a broken business model investors must reject in the pursuit of wealth?

 

“It is not easy to get rich in Las Vegas, at Churchill Downs or at the local Merrill Lynch office” –  Dr. Paul Samuelson, Nobel Laureate economist

Most of the investment world adheres to an investment philosophy rooted in the belief a consistent profit can be achieved by buying and selling the “right” stocks and bonds at the “best” time possible.  Known as active management, this philosophy of finding stock market success is akin to the alchemist’s pursuit of creating gold from common metals.  The expert and novice alike seek to transform an under-appreciated or incorrectly priced asset into a personal goldmine.

Investopedia (www.investopedia.com) defines active management as “an investment strategy involving ongoing buying and selling actions by the investor. Active investors purchase investments and continuously monitor their activity in order to exploit profitable conditions. Active managers rely on analytical research, forecasts and their own judgment and experience in making investment decisions on what securities to buy, hold and sell.”

Buying or selling the right stocks at the right time makes intuitive sense to us all. We are surrounded by the principles of cause and effect in our daily lives.  We know that outcomes follow inputs and therefore we can easily train ourselves to identify the reason for most of life’s outcomes based on experience and insight.  Sure (we tell ourselves) there are a few gray areas and chance will often play a role in how things turn out.   But the key to success is learning how things work and putting our knowledge to use for maximum effect.

When it comes to investing, we know the price of most stocks changes everyday.  The law of cause and effect tells us that uncovering the reasons why those changes occur will allow us to forecast future events and profit from our knowledge.  Our intuitive reasoning is reinforced by a compelling sales message offered everyday by Wall Street experts.  We buy into a system that tells us the analyst’s wisdom and experience exceeds our own and is worth the price we must pay to obtain the outcome we seek.

Unfortunately, academic research has uncovered two major flaws in active management; it is expensive and it does not work.

 

A Broken Business Model, Part II

Let’s suspend discussion on whether active management works for a moment and focus on the expense equation.  In their book The Great Mutual Fund Trap, former Undersecretary of the Treasury Gary Gensler and former Assistant Secretary for Financial Institutions Gregory Baer liken the expense of active management within a mutual fund to running with heavy ankle weights. The fund manager might be a world class expert in his or her race, however the heavy burden of research, commissions, fees and other expensive “ankle weights” quickly eliminates any potential advantage they may offer. The authors include the following disclosed and undisclosed costs in their analysis of mutual fund expenses that can potentially drain over 4% of an actively managed mutual fund investor’s wealth per year:

  1. Expense Ratios – this is a fee all mutual funds charge investors to cover management fees, administrative fees, distribution fees and marketing fees.  Your mutual fund company deducts these fees directly from your account.  Morningstar reports the average mutual fund expense ratio is 1.51%.
  2.  Sales Commissions – known as front-end loads when paid at the time of purchase or back-end loads if paid when the fund is sold.  Baer and Gensler calculate mutual fund commissions cost investors up to $20 billion per year.
  3.  Trading Costs – these are the undisclosed costs active management strategies incur in the course of buying and selling stocks and bonds.  They include brokerage commissions, bid/ask spreads and the market effects on share prices when fund managers buy and sell large blocks of stock.  Baer and Gensler believe investors sacrifice 0.5% to 1.0% of their annual total returns to trading costs.
  4.  Idle Cash – Morningstar reports the average idle cash, known as the liquidity ratio, averages 10%.  High liquidity ratios are believed to cost mutual fund investors 0.2% to 0.25% of return per year.
  5.  Taxes – investors holding mutual funds in taxable accounts must pay their share of any short-term and long-term capital gains the funds incur during the year.  By definition, active managers buy and sell stocks throughout the year, exposing investors to significant tax liability.  Most investors do not realize they are liable for these internal taxes even if they did not realize a profit while owning the fund.  The Wall Street Journal reported in an October 24, 2007 article titled Taxable Payouts on Many Funds are Set To Surge by Elenore Laise, “Over the past 10 years, the average stock fund has surrendered an annual 1.4 percentage points of returns to taxes, according to fund researcher Lipper Inc.

“But wait”, many investors shout, “I’ll avoid the majority of these costs by selecting my own stocks and managing my own account.  Stock selection is not rocket science.  I know I can do as good a job as these so called experts.”  Let’s be realistic.  If we focus only on the expense equation, an individual investor selecting his or her own stocks will avoid paying mutual fund expense ratios and sales commissions.  They will not, however, avoid the component costs of transaction fees, custodian fees, personal research costs, bid/ask spreads, taxes on short-term capital gains, taxes on long-term capital gains, bearing the risks of owning an under-diversified portfolio and the personal expense of time and effort committed to managing the investments.

 

“If there’s 10,000 people looking at stocks and trying to pick winners, one in 10,000 is going to score, by chance alone, a great coup, and that’s all that’s going on.  It’s a game, it’s a chance operation, and people think they are doing something purposeful…but they’re really not.” – the late Dr. Merton Miller, Nobel Laureate and University of Chicago Professor of Economics

Does active management succeed in beating markets?  I cannot deny the truth. Sometimes it does, both anecdotally (there are always stories of the individual investor who bought Google or sold Enron at just the right time) and over short periods of time (this year’s #1 rated mutual fund).  Each year there are also lottery winners and guys who run with the bulls of Pamplona unscathed.  This does not mean the lottery winner has a winning system, the bull runner has any common sense or active managers can consistently overcome the unrelenting headwinds of their high cost strategies or an efficient market.

The academic literature contradicting the claims of active management’s market-beating prowess is persuasive.  To quote Weston Wellington, vice-president of Dimensional Fund Advisors, in a February 2007 article in Advisor Edge titledEquilibrium-based Investing, “For fans of stock-picking, the evidence is not encouraging.  Researchers have studied the performance of professional money managers for over forty years in the U.S.  The evidence is compelling: Markets beat managers, not the other way around.”  Investors seeking to be the exception to this rule should take note.  Picking only “good” active managers or “proven” stock-picking or market timing strategies are equally flawed approaches.  The same article reports actively managed mutual funds that outperform the market in any given year are “no more likely to outperform in the future than a bottom-quartile performer.”

Just as the proper pursuit of weight loss must include ridding one’s diet of unhealthy foods, a prudent investor must wean themselves from an investment approach that is both expensive and unproductive.  They must reject a broken business model plagued by commission driven self-interest, wealth-stealing fee structures and suspect claims of market-beating expertise.   The fanciful pursuits of medieval alchemists ultimately died away under the light of reason and scientific evidence.  The same fate awaits the modern day alchemy of active management.

There is good news. The broken business model of investing need not doom your portfolio.  Those wise enough to embrace the facts and pursue an investment methodology grounded in modern economic theory can achieve Peaceful Wealth.  Investors now have powerful allies in their pursuit of retirement goals and financial dreams.  We will chart our course and set our sails during our next chat.

This material is intended for educational purposes only and is not intended to serve as the basis for any investment or purchasing decisions.

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