I am a bit behind on this thread but I’m refering to your first post where you make an argument about active funds beating indexes based on Morningstar data. The problem with this is that Morningstar does not track failed funds.

http://www.morningstaradvisor.com/articles/article.asp?docId=4397

MarketWatch did a story on this March 29, 2006 and found:

“When the “survivor bias” factor is removed, actively managed mutual funds in all nine of the Morningstar Principia “style boxes” lagged their related indexes for the 10-year period.

In all but one of the 42 narrower Morningstar fund categories, the survivor bias effect worked to inflate fund returns, the study said.”

http://www.marketwatch.com/story/survivor-bias-in-morningstar-data-eyed

On MorningstarAdvisor, Russel Kinnel says:

“Indexing Is Tough to Beat

Going back to the beginning of our index return calculations in July 1997 through January 2006, I found that the Morningstar Index won in two thirds of the cases.”

http://advisor.morningstar.com/articles/article.asp?docId=4388

You wrote:

“So, we only use fund managers that are truly independent.”

Some of the rules that you suggest are pretty arbitrary and yet you still don’t give a concrete method or list. With stocks and mutual funds, we atleast have past data to play with. You just ask us to trust that you can choose “all-star fund managers” without any evidence.

It feels like when I went to a MLM event and they asked me to think about what dream house I wanted before they told me anything about their product. Your sales pitch is to convince people they need to do better than average so that they will spend money chasing it.

“A good advisor should be able to recommend funds that are at least better than the average mutual fund.”

Why isn’t average good enough? Why chase higher returns and risk having lower than average returns as a result? Especially when the chasing costs more.

“We would need to charge 1-1.5% on top of the index MER (since a comprehensive financial plan takes us 15-20 hours of work in total), which would put the return 1.5-2.0% below the index.”

This is the whole answer and remarkably candid. You are confusing two different things, your business model and the client’s best interest. It may be that the client’s best interest is an index fund, even if it is not profitable for you. You could just charge for the 15-20 hours of work at an hourly rate. Instead you are weighing your business plan over the best interests of the client.

At the very least, you should be honest with every client you have and inform them that you do not recommend index funds because the pricing scheme is not profitable to you.

DAvid: “I worry that too many of us want something for nothing, and look for the easy way to riches”.

I wouldn’t call any investing “an easy way to riches”. Passive investing is simple, for sure, but definitely not easy. It is hard to resist the temptation to tinker and improve chasing the dream of a perfect plan, when you already have a good plan.

“But should one expect the same fund to meet that goal for that period?”

We’re talking about leveraged investments held in taxable accounts. Every time, you switch, you incur a tax penalty that handicaps long-term returns.

“If value investors such as Buffett can get great returns by purchasing temporarily out-of-favour giants, can others?”

I don’t deny that you can beat the market. Only that it’s hard and a very high hurdle. And the active managers are starting out with a 2% handicap they have to overcome just to break even. That’s why the odds are against picking a winning manager prior to the fact.

Once again you have made some excellent points. Probably better than most. The last paragraph said it the best.

I was trying to raise a point not discussed in this blog, that is Risk Management…see my comments on #37. My guess is many people who like the SM or don’t like the SM have not reviewed their situation or just don’t understand Risk Management and are only looking at the markets and not looking at their best asset …their health! Is it covered?

regards,

Brian

But should one expect the same fund to meet that goal for that period? Even the Sleepy Portfolio has a regular rebalancing. Should not the investor review their portfolio at some interval to see if it or the manager is meeting the stated goals? We re-evaluate our vehicle needs as time progresses, we may change homes a number of times in the same span of years, why should we expect the same fund to continue to be satisfactory all the time? Just as there are times to exit individual stock holdings, there must be times to exit various funds, even certain ETFs — i.e. you might have wanted to be out of NASDAQ based funds in late 1999 or so……

If value investors such as Buffett can get great returns by purchasing temporarily out-of-favour giants, can others? While the returns may not be stellar every year, they don’t necessarily have to be. Comparison shopping Stock market returns can be as disheartening as learning your co-worker paid less for his car than your identical one. Set your goals, and work toward them, and adjust as necessary. Racing for the last penny may not get you the goal you truly seek.

I worry that too many of us want something for nothing, and look for the easy way to riches! Spending the time and effort should have rewards, whether it is our profession, family, hobby or financial health.

DAvid

Not “difficult”. Impossible!
When I choose a “winning fund” for a client – regardless of what I based the selection on – I know that it was pure luck.

The only truism that seems to hold up over long periods of time is that disciplined value managers tend to do ok. There are of course many exceptions, but if you start with a pool of disciplined value managers who have shown the ability to choose undervalued stocks over a period of MANY YEARS, then your odds of selecting “a winner” are better than they would be otherwise. Chasing winners is probably the worst strategy, yet the easiest to sell the public on. In fact, when I get calls from clients asking me to put them in a particular sector or whatever, then I know the top is in. heheh. Great contrarian indicator.

And while I don’t have the data to support the following belief, I think buying into a fund managed by someone who meets the criteria I outlined above, at a time when the manager has performed POORLY, is a good strategy. Buy the WEBs when they look bad. If you buy value at the ugly point of the cycle, and you are patient, the wheel will come around again and you could do very well.

p.s. Great comment thread. So rare.

The difficult part comes in finding out who will out perform in the future. Here, past performance has been shown to be a poor predictor. The history of mutual funds is littered with hot managers who became stone cold.

The problem with active management is that the odds are not in the investors favour of outperforming the index with the same fund over the long term of 20 years or more.

I disagree with how you define risk, but I’m glad you recognize how imperfect your attempt at predicting moves to the downside is. What did all the historical data predict about C, BAC, BSC et al?

Yes, it’s better than nothing. What else are we to do – right? We have to at least TRY to give the client the ride they want. But every now and then something blows up. I’ve seen it every few years. Something that was rated low or medium volatility experiences an outsized loss. It’s Russian roulette.

“My suggestion, Slick, is to define what you really believe. Then find a way to adapt your practice. Your belief may be very different from ours, but if you do what you honestly believe is best, our career can be very fulfilling.”

Thanks, Ed. I’m giving it a lot of thought right now because I’m at a crossroad in my life (business and personal). I’m really not well-suited for this occupation because I don’t like selling and I don’t like calling people, etc. I’m an introvert. More of a thinker/philosphical/independent type of person. I have the nature of a fund manager or hedgie – not advisor. Outgoing people are very well-suited for our profession. I’m not ambitious either – not driven for more, more, more. (I know, I know – that’s BLASPHEMY in our society! lol). I have enough. I’m happy with what I have. Although I’ve been doing this a long time, I really don’t have much of a client base. I have well-off clients only, but just not that many of them. I could’ve made a lot of money (I’m very good at selling when I want to – good at closing/presentations – and am well-connected to wealthy people) – but I chose not to. Odd, eh? I spent my time raising my kids instead. No regrets. If I do stay in this field, it’ll have to be done differently. Otherwise, I’m going to go into something else.

I agree.

Optimally, *if* one is going to pick a mutual fund over an etf or index fund, then make sure it’s one that does NOT mimic an index. What’s the point of paying 2.5% without going for alpha? That to me is what makes no sense. If you have a typical widely diversified fund that has everything in it, and they charge you 2.x%, you’re guaranteed to underperform. Over decades, it’s a HUGE amount of money being taken. People dont’ think long-term, so they don’t appreciate how much of a difference of 1.5% over 20 years can make.

Or you can spend some time looking for individual stocks that beat the index. A few that come to mind include Shaw Communications, Sask Potash, and a number of utilities. If you are going to be in it for the long run, it might be wiser to choose from the market of stocks, rather than buy the whole market.

DAvid