The Loser's Game
By Ken Kivenko | Wednesday, September 20, 2006
Why Mutual funds lag the broad indexes.
“Unhappily, the basic assumption that most institutional investors can outperform the market is false. The institutions are the market. They cannot as a group outperform themselves. Today, 90 percent of all NYSE trades are made by investment professionals. The reason that investing has become a loser’s game-especially for the professionals who manage mutual funds-is that each manager’s efforts have become the dominant variables.”
—Charles D. Ellis, “Winning the Loser’s Game”
Introduction
We often hear from the mutual fund industry about the benefits of “professional portfolio management.” These smart, well-educated dedicated mavens employ sophisticated analysis tools, exceptionable databases, and meet with companies. They also employ competent technical support staff coupled with modern / telecommunications /computer networks and thus in theory, are well equipped to routinely beat the applicable market benchmark(s).
The role of the portfolio manager is to manage the fund in accordance with the fund mandate defined in the Prospectus with the goal of providing unitholders superior positive returns relative to a pre-defined benchmark, other similar funds and what a reasonably informed investor could do on his/her own. This is active professional management. Sounds good eh?
The reality
There is no statistically valid evidence that “professional management” results in consistently superior unitholder returns (even considering the positive effects of survivorship bias that can add 1-2 % to returns over longer measurement periods). A 1997 study at Wilfred Laurier University by G. Athanassakos et al concluded: “Our results demonstrate the absence of any consistent stock-picking or market timing abilities by the managers of the majority of Canadian mutual funds, with the possible exception of resource funds. Moreover, past performance is not found to have any predictive ability for a fund’s future performance.”
Yes, the professional analyst team pour through financial reports, analyze the charts and numbers, meet with management and work hard to understand the industry sector and dynamics. Despite this, the job is an almost impossible one today. Let’s review some of the key factors adversely impacting today’s stock analyst /portfolio manager.
Key factors
Fund fees and expenses : Professional managers always have to contend with the management expense ratio (MER) “tax” on invested assets. The average actively- managed Canadian equity fund has a MER of about 2.3 % [F-class funds have much lower MERs but they are not directly available to retail investors]. This is quite a hurdle to overcome, year in, year out. The miracle of de-compounding ensures that the longer these fees eat away at the asset base, the greater the damage will be. A recent study by a team of academics found Canadian MERs to be among the highest in the world.
The impact of fund size : Another issue is fund size. Mutual funds have grown enormously over the last decade due to GIC refugees and the shift from Defined benefit pension plans to Defined contribution plans. With 100 holdings, many positions will be less than 1 % of the fund. Simple statistics suggests then that no matter how good stock selection is, a 1 %t holding even with a spectacular price appreciation won’t have much of an impact on the overall fund value.
Cash is a drain on returns : By its nature; cash does not earn the benchmark return. When investment money pours in it must be invested quickly to capture the benefits of a Bull market. Since the MER % stays constant independent of fund size, there are no economies of scale benefits. Some cash also needs to be kept to handle redemptions and available for developing investment opportunities. Distribution reinvestment and new purchases also brings in a constant flow of new cash. The problem- in a low interest rate environment or rising market, cash may have difficulty earning the benchmark rate of return. Typically, cash in a Canadian mutual fund runs between three and ten percent with some as high as 25%.
Transaction costs sap gains: Brokerage commissions eat away at returns. On average, mutual funds have portfolio turnovers approximating 100 %. True, large funds may pay a lower unit transaction rate but it’s still a drag on returns. The added costs of the portfolio turnover ultimately take their toll on relative fund performance because it is higher than that experienced by the passive benchmark indices. (After-tax, the situation would be even worse for unitholders since the portfolio turnover of a “churn” fund is far greater than an index). Note that trading commissions are not part of the MER and are measured by the Transaction Expense Ratio which is additive to the MER.
Market Dynamics getting harder to read : Even with the best analytical tools in the world, how the stock price will behave is becoming more unpredictable than ever due to program trading, day trading, online chat groups, after-hours trading, complex derivative products, globalization of markets, currency/ interest rate fluctuations, option programs hedge funds, etc. New Event Risks like terrorism don’t make the job any easier.
Meetings with Management not reliable indicators : Meetings with management can be useful but more as negative signals than positive. Attitude, experience, signs of opulence and the ability to answer tough questions are powerful indicators. Contemporary CEO’s are trained, skilled and convincing communicators. Two portfolio managers independently interviewing the same company executives can and have come to diametrically opposed conclusions about the future direction of a company.
Managers themselves can get caught up in fads : Many analysts were caught up in the “new economy” firms built on a foundation of Jello or sand. New valuation methodologies were proposed such as web-site hits /day and new e-business funds, now defunct, were created. Outrageous stock option plans were ignored as was the method of accounting for them. Nortel stands out as a prime example of all that can go wrong with “on –site” visits and financial analysis when a mania hits.
The indexing principle is not the manager’s friend: Perhaps the simplest argument against active management and for passive management (indexing) is Dr. William F. Sharpe’s famous indexing argument The Arithmetic of Active Management from logical first principles. He argues that the average actively-managed dollar will equal the return on the average passively managed dollar, but after costs, the return on the average actively managed dollar will be less than that of the average passively managed dollar. He begins with the self-evident observation that the market return will be a weighted average of the returns on all the securities within the market.
Since each passive manager will obtain the market return (before costs) than it follows that the return on the average actively-managed dollar must equal the market return. The market is a closed system, therefore the average passive return must equal the average actively- managed return (before costs). If the average active dollar outstripped that passive dollar, then the total market return would be increased, and this isn’t the case because it is a closed system. The market return is unchanged whether active or passive managers are plying their trade. Therefore, collectively active managers cannot consistently beat out passive managers. Sharpe acknowledges that some active managers do beat the market sometimes , even after costs, but the trick of course is to find them just before they do it.
Manager turnover a negative: The Fund Company wants more Profit and the more fees the more Profit. Fund managers understand this, but typically don’t control the Fund Company, which places them in a potential conflict situation. Managers know that funds tend to underperform as they become larger. This gives managers an incentive to leave a fund after it becomes too large, but before the size has eroded its performance. Investors are best served by investing for the long run, but it is quite possible that the manager will not be there as long as the unitholder. An individual investor’s long- run of 35 or more years to retirement is likely to be much longer than the tenure of a hot fund manager at any given Fund Company. The best money managers are like free- agent professional athletes, here today- gone tomorrow.
Disruptive change hurts performance : Not only do managers job-hop, with surprising regularity, but the mandates of the funds themselves also change. Mutual fund companies routinely merge funds with each other, change fund objectives and change fund style. A new manager may go through a portfolio cleansing process adding to fund expenses. All of this change can be disruptive to the main goal-beating the benchmark.
The funds ARE the market: A basic change has occurred in the investment environment; the markets have come to be dominated by the very institutions that were striving to win, by outperforming it. In fact, by the 1990s, the institutions became the market. No longer is the active fund manager competing with amateurs; now he’s competing with other experts in a loser’s game where the secret to winning is to lose less than the other. Study after study has confirmed that only a small number of managers have consistent and superior long-term performance records. A main reason managers’ results are so disappointing is that the competitive environment has changed in just 30 years from quite favorable to very adverse .
No Continuous Process improvement process : Industrial and service companies have embraced Total Quality (sometimes referred to as Six-Sigma or Excellence initiative) as a standard approach to process improvement and problem solving. Malcolm Baldrige Award winners have significantly beaten the S&P 500 index because of the emphasis on continuous improvement. Even if all the critiques of portfolio management prove to be wrong, mutual fund companies have not embraced Total Quality (TQ) i.e. there is no well-organized process to continuously improve results.
Valuation Analysis getting more difficult : Determining the market success of the company’s offerings and hence the earnings growth rate requires making assumptions under uncertainty. In the technology sector especially, the task of timing product introductions, in evaluating product success and determining profit margins is daunting not just for analysts but for companies themselves. Disruptive technologies such as the internet can lead to tremendous, unpredictable market volatility and irrationality. Again, more assumptions are needed to make earnings projections. As assumptions pile on assumptions, the valuation model has a good chance of error.
Governance breakdowns Trading abuses : Conflicts-of –interest can punish the long-term investor and fund performance. For example, Eric Zitzewitz, a business Professor at Stanford has written 2 key papers relevant to the recent mutual fund frequent trading/ market timing scandals, RESEARCH PAPER NO. 1749 “ Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds” Oct. 2002 and RESEARCH PAPER NO. 1817 “How Widespread is Late Trading in Mutual Funds?” Sept. 2003. Both papers are available in pdf format at http://gobi.stanford.edu/facultybios/bio.asp?ID=306.
According to his studies, market timing costs U.S. long-term shareholders $5 billion a year and late trading costs them $0.4 billion. The U.S. fund industry is about $7 trillion, so the loss factor is 5.4/7000=0.00077. Canada ’s $600 billion mutual fund industry could be expected to have similar proportionate damage. According to Prof. Zitzewitz, these losses may add up to 1% or less in lost returns in a given year or about $10 for each $1000 invested in a fund. In Canada , the OSC required 5 major fund companies to return $205.6 million to unitholders. Soft-dollar trading is another potential abuse that can hurt fund performance. Some estimates put Canadian fund soft- dollar trading at about 25% of all trading transactions.
Compensation Practices drives behaviour : There’s an old expression in the HR field-“What gets rewarded, gets repeated.” If portfolio managers are rewarded on the growth of the fund, i.e. Fees rather than performance, than portfolio managers will tailor their initiatives towards growth. They’ll be quoted by the media, appear on ROB TV, maybe even publish a book. This activity, coupled with a marketing blitz, while distracting the manager from obtaining return performance goals, does earn the Fund Company increased profits and the portfolio manager a fat compensation package. If more compensation was truly performance-based and unitholder focused, we might see better results.
Benchmarks have inherent advantages : Benchmarks are costless and frictionless, so they are in a way idealized constructs making them very hard to beat. And they aren’t entirely passive either; dogs are driven from indexes from time to time.
Government related constraints/cost-drivers : The 6% Goods and Services Tax (GST) of course must be applied to segments of the fund’s expenses. And the government limits fund investments to 10 % of any publicly traded company’s market capitalization. Self-dealing regulatory constraints may limit investment scope, particularly bank-owned fund operations. Additionally, increased regulation- related costs in the future may drive fund expenses higher (or fund Company profits lower). Thanks to Norbourg , Crocus, Portus and others and the horrific mutual fund scandals, new regulations are being imposed and developed that may require fund Governance boards and tighter reporting and disclosure i.e. more expenses.
Conclusion
Given the many factors outlined, it should not be surprising that contemporary portfolio managers face a major uphill battle in their war against the benchmark indexes. Professional management (the heart of the mutual fund industry) has lost much of its effectiveness and credibility. For those few managers who focus globally, move quickly, consider small caps/special situations where market efficiency is weaker, have advanced forecasting tools, use sophisticated financial instruments and practice continuous improvement (Total Quality), there’s still a fair chance to outperform. (Note: Beating the benchmark is only one factor for investors-consistency, downside risk, tax-efficiency, service, governance and even ethical investment considerations play a role in investor decision making.) .
Finding these few exceptional money managers and funds will be a tough challenge for mutual fund investors in the decade ahead. Otherwise, an indexing strategy may be well worth looking at.
Ken Kivenko P.Eng.
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