In the March issue of Asset Class, I take a critical look at recent articles by active managers who use indexing data to support value investing but then go on to suggest that active stock picking can achieve those same or better results. In one article, Charles Lahr, a portfolio manager for bond fund giant PIMCO, points out that value stock return premium is 3% annualized over the past 85 years. He uses index data as his source and then argues for hiring PIMCO to buy and sell individual value stocks that, we assume, will generate the same or better returns than the index.
What are the chances they will succeed?
The survivorship-biased Morningstar mutual fund database gives us a very conservative clue. Before we do a screen, let’s set our bar at the Vanguard 500 index fund’s 15-year performance of 6.75% annually. So we want funds that returned 9.75% or more over that period.
Screening for all domestic (U.S.-only) stocks funds that have survived for fifteen years, we find 4,231 funds. Of those, 603 funds provided an annual return of 9.75% or better. That works out to 14.25%. So making your decision just on that screen alone, you have about a 1 in 7 chance of beating an unmanaged value stock index. Good luck, you’ll need it.
But let’s dig even deeper. First, enlightened investors know that there are three dimensions to stock returns, or, in other words, three risk factors that determine almost all of a portfolio’s return over time. They are the “market” (stocks in general are riskier than bonds and therefore should provide a higher return over time); size (small company stocks are riskier than large company stocks); and value (low-priced value stocks are riskier than higher-priced growth stocks). There are no better funds to capture these “risk premiums” than very style-specific DFA index funds. Here’s what we find looking at the past fifteen years:
S&P 500 6.8%
DFA US Large Value fund 8.4%
DFA US Small Cap fund 9.6%
DFA US Micro Cap fund 10.0%
DFA US Small Value fund 11.7%
Clearly, the small cap and value premiums were alive and well over these last fifteen years. Any advisor (indexer or stock picker) who tilted portfolios toward these risk factors should have captured at least some of the extra return.
Note that the DFA US Small Cap index fund almost met the 3% return premium target the 603 stock pickers attained. The DFA US Micro Cap and US Small Value funds exceeded it (the latter by almost 5%!).
So let’s look at the 603 “winners’ more critically. When we screen for investment style (using the Morningstar Category field), we find that all but 64 funds were either concentrated in one sector or industry (e.g., energy, health, natural resources, real estate) or had a style bias to smaller and/or more value-oriented stocks. So taking these advantageous, higher risk biases away leaves just 1.5% of the database who are true winners on a risk-adjusted basis (setting aside luck versus skill).
Now consider survivorship bias. Standard & Poor’s, in their March 2010 SPIVA report, points out that 29% of domestic equity funds left the databases over the past five years due to merger or liquidation. It’s a very reasonable assumption that funds disappear for performance reasons. And no fund company in its right mind would effectively wipe out the performance of a fund that beat the market, whether by 0.3% or 3% per year! So now those 14.75%and 1.5% numbers look high by about 30%.
In any event, what investor in their right mind would gamble their long-term, serious, retirement money on an investment philosophy (stock picking) that fails to beat a much more diversified, unmanaged index almost 100% of the time?