An excerpt from The Professional Financial Advisor IV (Insomniac Press), a guide that explores the complex relationship between investors and their advisors
Daniel Patrick Moynihan gets the credit for having come up with one of my favourite quotes of all time. He said that while people are entitled to their own opinions, they are not entitled to their own facts. Although many of the perspectives shared in this book are my personal opinions, I would hasten to add that mine are at least considered opinions based on a wide variety of readings and discussions on top of working in the industry for nearly a quarter century.
Having an informed opinion basically requires taking the time to carefully consider competing options, viewpoints, and likely outcomes. Obviously, writers and commentators are only human and cannot be absolutely certain about what the future might hold.
Imagine if a doctor had the opinion that smoking cigarettes was not in any way linked to the incidence of lung cancer. The opinions of professional intermediaries are crucial in directing what people do and why they do it. In fields such as finance, it would likely be seen as a stretch to call certain things “facts.” However, I believe it is fair to say that many things are proven to be better than others at explaining likely outcomes. While not perfect, I think most people would agree that—all else being equal—professionals should recommend courses of action that generally have the best chance of being successful.
What would you think of a surgeon who recommended a patient proceed with one kind of open-heart surgery over another if you learned that the success rate for the recommended procedure was 80% and that the alternative was successful 95% of the time? Neither option is certain, but I know which one I’d want. I also don’t mind if people look at the evidence and choose the less likely option for whatever personal reasons they might have.
It has long been accepted that smoking cigarettes is linked to the increased likelihood of contracting lung cancer. For years, however, that idea was challenged, even by medical professionals. When, exactly, did it make the transition from being plausible to being probable to being verifiably true?
I ask because some people tend to get their backs up when others have the audacity to suggest that what they have believed all their lives just isn’t so. Meanwhile, the timing of the general acceptance of evidence is often vitally important. What I believe (my personal opinion) is that it is unprofessional to recommend a course of action that is less likely to yield a positive outcome without even mentioning that there are alternatives that are more likely to meet your objectives.
Essentially, every issue known to humanity is either a matter of fact or a matter of opinion. It is important to note that, while both are well-understood concepts, the expectations surrounding them are quite different. When marketing and providing financial services in a manner that is compliant with regulatory requirements, it is expected that all facts contain a reference where the validity of the concept was first established. In matters of opinion, in contrast, it is expected that the person speaking or writing clearly disclaim the position(s) as being personal opinions and nothing more.
What about matters that aren’t entirely clear? What should the standard be? There is obviously no way that regulators can monitor what is said between advisors and their clients behind closed doors. Still, I have encountered individuals in the industry who have expressed their opinions through marketing material without disclaiming them as being their personal opinions. Doing this can easily create a dangerous misconception.
Since all personal opinions are to be disclaimed, one can easily conclude that, where there is no disclaimer, the views expressed will be interpreted as a matter of fact. This, of course, further blurs the line between opinion and fact. Advisors and industry commentators are allowed to use both (or either) facts and opinions but are not always clear with their audience about the nature of what they are saying. There are many potential examples of what is considered factual, including the following:
- Research findings determined through the application of the scientific method (preferably sourced from learned journals;
- Empirical data (e.g., market share, average price) provided by reputable sources;
- Public opinion research (statistically significant poll results).
Note that certain related items might contain a great deal of professional opinion that is supported by data. This is an instance where everyone can see what is verifiable but where fair-minded individuals might come to differ on what that information really means. In these instances, we start with facts but then slide over to opinions both quickly and seamlessly—sometimes almost imperceptibly.
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Let’s take a look at the definitions in order to get a clearer understanding about the terms of this discussion. According to the Canadian Oxford Dictionary, they are as follows:
Fact: n 1. a thing that is known to have occurred, to exist, or to be true 2. a thing that is believed or claimed to be true 3. a piece of evidence, an item of verified information or events and circumstances 4. truth, reality
Opinion: n 1. a belief or assessment based on grounds short of proof 2. a view held as probable 3. what one thinks about a particular topic or question 4. a formal statement of professional advice (e.g., get a second opinion)
So is it a fact or an opinion when someone suggests that the notion that one can reasonably expect to beat the market is not supported by the weight of evidence? I suppose some would say that the answer to that question could only be gleaned by examining the evidence. Note also that there’s some wiggle room in the terminology. For instance, what, exactly, is a “reasonable expectation”?
Let’s take a few moments to examine the evidence. How accepting would you expect someone to be in examining a strategy if it had a negative impact on their bottom line? You should always consider the evidence on matters that may or may not be verifiable. You should also be careful to take into account the vested interests of constituencies that might try to persuade you to accept certain viewpoints, as they are less than impartial arbiters of truth.
Let’s take a look at a few positions that are clearly dominant in the industry today, both in terms of what that position is and what the weight of evidence suggests. The terminology used in these “position” segments is simply my paraphrasing of things that I have heard some advisors say.
Position 1: “I recommend stock picking strategies (i.e., active management) because my objective is to find active managers who will beat their benchmark.”
Evidence: For about a decade now, the people at Standard & Poor’s (S&P) have been putting out a semi-annual report called “SPIVA” (“Standard and Poor’s Index Versus Active Scorecard”). It is billed as the scorekeeper of the active/passive debate. These reports come out in all major markets, including Canada, the US, Europe, India, Japan, and Australia. “SPIVA” reports cover all one-, three-, and five-year periods, ending on June 30 and December 31. Although the results vary from report to report and region to region depending on market conditions, the index benchmark tends to beat the average performance of active funds quite consistently throughout.
Furthermore, the likelihood of benchmark index outperformance consistently increases as the time horizon expands. It is interesting that the reports only go for the most recent five years, but it would be extremely difficult for the folks at S&P to measure performance beyond five years given how many funds fold within five years after they are launched. Stated differently, although the index option generally tends to win, it would likely win resoundingly if the time horizons used were more in keeping with investors’ actual time horizons. Most people invest for several decades.
The simple reasoning behind this documented outperformance is outlined in a short paper written by William F. Sharpe in the 1990s. The logic is simple and uses nothing more than basic grade school mathematics. It essentially goes like this:
- The stock market is simply the sum of all active and all passive participants.
- The return for passive participants is the return of the stock market minus costs.
- It follows (given the first point) that the return of the average active investor must also equal the return of the market minus costs.
- Since average active costs exceed average passive costs, the average passive investor must outperform the average active investor.
Note that this is true in all markets (developed and emerging) and in all market conditions (expansion and contraction; inflation and deflation; war and peace), and there are literally no exceptions. In essence, Sharpe isn’t saying that the passive horse will win the race because it is faster; he’s saying that passive will ultimately win because it has a lighter jockey.
Also, in case you’re not familiar with the name, please feel free to plug Dr. Sharpe’s name into a search engine. He’s one of the most respected and influential financial minds alive today, having won the Nobel Prize in Economics in 1990, along with Harry Markowitz. I’d say that this simple and elegant paper is about as close to being a fact as you can get.
Position 2: “It doesn’t matter if the average actively managed product lags its benchmark and/or passive counterpart because I don’t recommend average products. I recommend only superior products.”
Evidence: To begin, such a statement would not be compliant in the first place since “superior products” is very much subjective. Remember how I noted that people can quibble over individual words? In this instance, the word in question is average. There is no evidence that anyone can reliably identify persistent outperformers in advance. There’s a reason why every mutual fund prospectus carries a disclaimer to the effect of “past performance may not be repeated and therefore should not be relied upon when making investment decisions.” They disclaim this because it’s true. Furthermore, this is not the least bit new. Harvard professor Michael C. Jensen first showed how difficult it is to pick winners in advance in an article published nearly fifty years ago.
Almost twenty years ago, Mark Carhart penned what is widely considered to be the first definitive study of the subject to date. He showed that the likelihood of a top quartile fund remaining in the top quartile for subsequent periods was more or less equally distributed. The quartile placement was about the same as throwing darts, with the distributions looking about the same as those generated by random chance. The only performance persistence seems to be on the poor side—lousy funds have a tendency to remain lousy.
Perhaps a half dozen similar studies have been published since then, and they all come to essentially the same conclusion: Consistent outperformance cannot be reliably identified in advance.
What is interesting is what was discussed in the previous chapter. In the late 1990s, there were a few annual guidebooks published to “help investors make informed decisions” about the mutual funds they were looking at purchasing. I could not find the slightest reference to either the Jensen research or the Carhart research in any of them. What is particularly disconcerting is that one of those books was authored by an advisor who was governed by regulatory rules about suitable disclosures for marketing material. No suitable disclosures about the research that contravened the fundamental premise were made, and investors were none the wiser.
Position 3: “Passive products and strategies, by definition, cannot beat their benchmarks. Only actively managed products and strategies have the potential to outperform.”
Evidence: This is true but largely beside the point. There’s a strong consensus that the primary role of a professional advisor is to get clients retired in the lifestyle they’ve grown accustomed to. As such, many people feel that beating a benchmark is an inappropriate way of keeping score because the ability to beat a benchmark is largely an unnecessary goal inserted by the active management side of the industry. When I speak with new clients, they almost all tell me that they want me to help them achieve their retirement goals on reasonable terms (i.e., without taking too much risk or sacrificing too much of their current lifestyle). In fact, when I ask my clients open-endedly what I can do for them, virtually none of them say a word about beating a market.
Furthermore, while it is true that an active approach has a greater chance of outperforming a benchmark, it is equally true that it has a greater chance of underperforming that benchmark by a wider margin than the passive alternative. How many proponents of an active approach disclose that the likelihood of significantly lagging a benchmark is greater with active strategies than it is for passive ones?
Let’s say you had $100 with two options in front of you: Option 1 gives you a 15% chance of finishing with more than $100; Option 2 gives you no chance of finishing with over $100. In fact, it guarantees that you’ll finish with only $99.50. Which do you prefer? If the story ended there, I’m pretty sure many people would choose the first option. But what if those choices were incomplete? What if, in addition to the information above, you were told that Option 1 also gave you a 15% chance of finishing with less than $90 and a 70% chance of finishing with between $90 and $100?
This is still a simplification of the choices, but you can see the problem. Risk and reward are related, and they incorporate the competing concepts of variability regarding both frequency and degree. It’s not only about whether you’ll do better or worse; it’s also about how much better or worse you’ll do. Most people are led to think only about frequency, the “odds of success” part of the equation.
In so doing, they might not give due consideration to the equally relevant “cost of failure” issue, the degree to which they will be penalized for having tried to outperform. Both are legitimate considerations, but telling only one side of the story is not offering reasonable advice; it is manipulating decision-making by using selective information.
Position 4: “Even if some active funds don’t beat their benchmarks, the costs associated with active management are well worth it. A diversified portfolio containing several actively managed funds that meet your other objectives will compensate for the losers compared to a similar basket of passive products.”
Evidence: The empirical results show the exact opposite effect. In 2009, University of Denver professor Allan S. Roth published his book How a Second Grader Beats Wall Street. Using thousands of so-called “Monte Carlo” portfolio simulations over differing time periods, he examined the odds of an all-active portfolio beating an all-passive one. In all instances, the odds were reduced as both the number of funds and the time horizon increased. In fact, in comparing competing portfolios of five active funds and five passive funds, the likelihood of the active grouping outperforming was 32% over one year, 18% over five years, 11% over ten years, and 3% over twenty-five years.
The Roth research is far from alone. A recent American study entitled “How Well Have Taxable Investors Been Served in the 1980s and 1990s?” found that the average fund underperformed its benchmark by 1.75% per annum before taxes and by 2.58% on an after-tax basis. It showed that just 22% of the funds beat their benchmark on a pre-tax basis.
Importantly, because the issue is not only one of the likelihood of outperformance but also the degree to which an active strategy would add or subtract value, the report showed that the average outperformance was 1.4% but that the average underperformance was -2.6%. However, on an after-tax basis, just 14% of the funds outperformed. The average after-tax outperformance was 1.3%, while the average after-tax underperformance was -3.2%.
All told, the risk-adjusted odds against outperformance were pegged at about 17:1. Perhaps most importantly, the odds of outperformance decrease as the time horizon gets lengthier. Note that some investors have time horizons in excess of forty years.
John De Goey is a Portfolio Manager with Industrial Alliance Securities Inc. and the author of The Professional Financial Advisor IV. Industrial Alliance Inc.is a member of the Canadian Investor Protection Fund (CIPF). The opinions expressed herein are those of Mr. De Goey alone and may not be aligned with the opinions and values of Industrial Alliance Securities Inc. or any of its affiliated companies.
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