The Long Odds of Beating the Market

Odss of Beating the Market

Mutual Fund Performance, 1970 to June 20141

# of Funds % of Funds
Mutual fund universe in 1970 358 100.0%
Number of funds that survived the entire period 107 29.9%
# of funds that outperformed benchmark 45 12.6%
# of funds that outperformed benchmark by 2%+ 3 0.84%

The reality that beating the market is really hard is one that I think is starting to set in for a lot of investors. Simply put, the odds of beating the market are so low that it was almost a foregone conclusion that investors would start shifting away from actively managed strategies.

One sign of this is the data that tracks mutual fund inflows and outflows. While traditional active management shops like American Funds are shedding assets like they’re going out of style, index and passively managed fund families are growing at record pace.

I also see this phenomenon on a more anecdotal and personal level in conversations that I have with investors of all ages. It’s much less common these days for someone that I talk to not to have at least heard of index funds, for example, and at a minimum be curious about them.

The Insatiable Desire to Beat the Market

However, even in light of all of the evidence that attempting to beat the market is not a very sound strategy, I think most investors still believe it’s possible if you know what you’re doing.

More importantly, in their minds, they see beating the market as the ticket to success. In other words, their view might be best summed up as, “yeah, the odds of beating the market are low, but the rewards of doing so are too spectacular not to try.”

They might go on to reference Warren Buffett and Berkshire Hathaway before ultimately convincing themselves that beating the market can be done simply because their are living examples of such success.

Given this mindset as a starting point, I thought it would be interesting to consider the highly unlikely sequence of events that are required in order to actually beat the market. Using history as a guide and the track records of highly qualified and educated mutual fund managers, this is what would need to happen in order to achieve market-beating success:

    1. Select an actively-managed fund that performs well enough to avoid being liquidated or merged with another fund during your investment horizon.
    1. Remain invested in the fund through the inevitable storms when the manager underperforms for long periods of time (almost certainly causing you to second-guess your strategy).
  1. Benefit from gross alpha (excess returns before fund expenses) that is high enough to fully offset the fees of the fund and still pass along outperformance to you, the investor.

Let’s take a walk through each of these in a bit more detail to see just how unlikely it is for an investor to enter the active management gauntlet and come out successful on the other side.

How Long do Mutual Funds Live?

The short answer: Not very long.

If you started investing in 1970, you had 358 U.S. stock mutual funds to choose from2. Certainly a large pool, but nothing compared to the thousands of mutual funds and ETFs in the marketplace today.

Of those 358, only a shade over 100 existed as of June 2014. The rest were either closed/liquidated or merged with another fund. Simply put, that means you had a 3 in 10 chance of choosing a fund that merely managed to stay alive for 44 years. Pretty poor odds for what in reality isn’t that high of a bar for success.

It might seem surprising that so few funds were able to survive, but it really isn’t. The vast majority of actively managed mutual funds die premature deaths.

While we can’t say that the cause of death for every fund is bad performance, in most cases that is certainly the reason. Mutual fund companies don’t close winning funds very often because touting the performance of those funds is what keeps the active management asset gathering game alive.

Even the Winners Look Like Losers for Much of Their Life

Assuming we get past the first challenge by successfully choosing one of the roughly 100 funds that managed to avoid the axe, the second challenge might be even harder: Staying invested when things look really bleak.

A big misconception about winning managers is that they always outperform. In other words, investors mistakenly assume that the smartest managers not only beat the market, but they are consistent in doing so.

The folks at Research Affiliates looked into this and found that not only is outperformance rare, it is far from a steady ride along the way if you are lucky enough to experience it.

They measured this by tabulating the number of quarters during a fund’s lifetime in which it had underperformed its benchmark over the prior three-year period. Each quarter for which this was true, the fund was determined to be on the “watch list.” Presumably, an investor would be highly concerned by seeing three consecutive years of poor performance.

If you look at the same group of 358 funds that we started with, you would assume that the ourperforming funds would rarely if ever experience three straight years (12 consecutive quarters) if underperformance. That assumption would be very wrong.

In fact, the winning funds spent between 36% to 48% of their lives on the watch list!4 Think about that for a second. Even the very best funds looked absolutely pitiful for roughly 4 out of every 10 quarters. That’s 15 to 20 years out of the 44 year period where bailing out probably seemed like the right answer.

You’d need an unbelievable amount of faith in the manager and the strategy to stay invested with performance like that!

Overcoming Incredibly Long Odds for Insultingly Meager Rewards

So let’s assume that we were able to clear both the first and second hurdles. The next question is: What did we get for overcoming the long odds of beating the market?

Well, of the roughly 100 funds that stayed alive throughout the period, less than half (45) also managed to outperform their benchmark. That slices are odds of success down to a pretty grim 12.6%. Not good.

Unfortunately, that’s not the end of the bad news. Logically speaking, if we are going to bear the burden of a high risk that we will underperform, the rewards better be sweet enough to make it worth our while, right?

Unfortunately, that’s not the case when you endeavor to beat the market. Of that small group of 45 funds, just 3 managed to deliver returns of 2% or more in excess of their benchmark. Three funds!

To bring it full circle that means that of the 358 funds we started with, less than 1% (0.84% to be exact) delivered the kind of market-beating results that actually move the needle. The other 355 funds either performed so poorly that they were quietly taken to the woodshed or they roughly approximated their benchmark with almost certainly more risk.

If those odds don’t convince you to embrace passive investing, I’m not sure what will!

1. Hiring Good Managers is Hard? Ha! Try Keeping Them!, Fundamentals by Research Affiliates, November 2014
2. Ibid.
3. Ibid.
4. Flying High: RAFI at 10 Years, Fundamentals by Research Affiliates, March 2015

Are Stocks Overvalued? Or Why Global Diversification is More Important Than Ever

Global Diversification

Global Stock Market Valuations

CAPE/Shiller PE for Selected Countries and Markets

Japan (28.1)
United States (26.0)
Switzerland (23.1)
Developed Markets (21.8)
Global Stock Market (21.1)
Canada (20.4)
Germany (19.9)
Hong Kong (19.0)
France (17.5)
Developed Europe (16.5)
Emerging Markets (16.5)
BRIC* (15.2)
United Kingdom (14.0)

*BRIC = Brazil, Russia, India, and China
Source: StarCapital. Data as of 4/30/2015.

If I had to choose one word to describe how most investors view the stock market today, it would probably be frothy. We are now more than six years into the current bull market following the painful Great Recession of 2007 to 2009.

The S&P 500 index, which bottomed out around 735 in February of 2009, now stands at almost 2,100. Even more incredibly, five of the past six calendar years have produced double-digit positive returns for the index.

Of course any time the stock market is going up, so-called experts come out of the woodwork to remind us that their crystal balls are forecasting a pullback. In fact, the headline on just the other week was, “Stock market correction by October: Strategist.”

Unsurprisingly, many investors are concerned stocks are overvalued and that we are headed for an inevitable downturn. This can lead to some very poor decisions, with investors bailing out of stocks or seeking refuge in investments they don’t fully understand.

The Failure of Forecasts

The trouble with these predictions is two-fold:

  1. Extensive research has shown that forecasters are wrong more often then they are right (see Guru Grades compiled by CXO Advisory Group).
  2. Many of these experts have been calling for the bear to awake from hibernation every year since the bull market began. At some point someone will “correctly call the downturn,” but that is a pretty obvious instance of a broken clock being right twice a day.

Nonetheless, even if attempting to time the market is a fool’s errand, the valuation of the stock market is indeed important.

Although valuations aren’t of much value for predicting near-term shifts in the market, they do a pretty good job of setting proper expectations for long-term returns. Namely, when valuations are high, expected returns are lower. Conversely, when valuations are low, expected returns are high.

Understanding this is important both from a planning perspective and also as a reminder of how critical it is for investors to select the right asset allocation and embrace diversification.

What is a Valuation Ratio?

One not too surprising result of the bull market in stocks has been a surge in measurements of stock market valuation, often known as valuation ratios. Valuation ratios attempt to measure the relative “richness” or “cheapness” of a company or index.

The most common ratio is known as price-to-earnings or “P/E.” P/E is calculated by dividing a stock’s price (the numerator) by the company’s latest twelve months earnings (the denominator).

P/E tends to be quite volatile because the calculation only uses a single year of corporate earnings. Thus, although it provides some insight into the relative valuation of a company or index, it isn’t terribly helpful.

Robert Shiller to the Rescue

In order to alleviate this volatility and normalize the peaks and valleys of the business cycle and the economy, several alternative valuation ratios can be analyzed.

Probably the most well-respected by academics and industry professionals alike is a ratio known as cyclically adjusted price-to-earnings, or “CAPE.” Rather than using a single year of earnings, CAPE considers the 10-year moving average, which results in more reliable comparisons from year-to-year.

CAPE is often referred to as “Shiller PE,” as the ratio can be traced back to Nobel Prize winning economist and Yale professor, Robert Shiller. CAPE allows us to compare the current valuation of the stock market relative to history and it also provides a helpful framework for comparing stock markets in one country versus another.

U.S. Stocks are Relatively Expensive

The chart above summarizes the current CAPE ratio for some of the largest stock markets around the world, as well as a few of the more common country groupings (e.g. emerging markets).

Not surprisingly, the U.S. is near the top of the list, with a CAPE of around 26. This is roughly 60% higher than its long-term average and puts the current market firmly in the “expensive” category.

However, take a look at the rest of the chart. First, every country other than Japan and Denmark (not in the chart) is currently “cheaper” on a relative basis than the U.S.

Second, large, easily investable segments of the global stock market are priced much lower than U.S. stocks. For example, the CAPE ratio for Developed Europe (which comprises countries like Germany and France) and Emerging Markets are both hovering around 16.5. This is nearly 40% cheaper on a relative basis than U.S. markets.

Finally, note that the aggregate CAPE of the entire world stock market (including the U.S.) is around 21. Of the more than 40 investable stock markets around the globe, the majority are priced below this mark.

Global Diversification is the Right Strategy

I am an unabashed supporter of global diversification. There, I said it.

Not only are the benefits of diversifying your portfolio around the globe well-documented in the academic literature (see one of my favorite papers on the subject here), most investors are heavily overweighted in U.S. stocks.

It is critical for investors to understand that the U.S. makes up only about 50% of the world’s stock market value. The remainder lies in more than 40 other countries.

If diversification is your strategy (which I hope it is), you should take a very close look at your portfolio to figure out what your allocation is between U.S. and non-U.S. stocks. Most investors will find that their portfolios are dominated by U.S. companies, with just a small percentage allocated to international stocks. If you’re not sure how to do this, I can review your portfolio for you.

Ultimately, global diversification is a key tenet of a well-designed portfolio no matter how the market is valued. However, if you are particularly concerned about where the U.S. market is headed, there is no better time than now to reevaluate your asset allocation to ensure you are properly diversified.

Tax-Efficient Withdrawal Strategies in Retirement

Tax-Efficient Withdrawal Strategies

Comparison of Portfolio Life Under Varying Withdrawal Strategies

Smart-Tax Planning Strategy (35.51 years)
Conventional Wisdom Strategy (33.15 years)
Tax-Inefficient Strategy (30 y)

Source: Tax-Efficient Withdrawal Strategies, Financial Analysts Journal, March/April 2015.[/box]

If you’re approaching or already in retirement, you know that there are many things to consider when it comes to your personal finances and investments. Of course there are the obvious ones: Social Security, required minimum distributions (RMDs), and ensuring that you have the proper asset allocation for your risk profile.

In addition, most investors are aware of the fact that taxes are a critical issue in retirement. Aside from the taxation of Social Security, the biggest issue that most retirees face is withdrawing money from their IRAs, 401ks, and other investment accounts.

Retirement withdrawal strategies can be quite complex. However, as the chart above shows, smart tax planning can add several years to the life of your portfolio. Let’s explore this concept further to understand the implications.

The Conventional Wisdom on Retirement Withdrawals

The conventional wisdom for tax-efficient withdrawals during retirement is to tap your accounts in the following order:

  1. Taxable accounts
  2. Tax-deferred accounts (e.g. traditional IRAs and 401ks)
  3. Tax-exempt accounts (e.g. Roth IRAs and 401ks)

The idea behind this approach is to preserve the funds in Roth accounts for as long as possible in order to allow them to continue to grow tax free. This advice is widely cited by most personal finance and investment publications, as well as the largest mutual fund families and brokerage firms.

A Smarter Approach

However, as I discuss with all of my clients who can benefit from smart tax planning, the conventional wisdom is generally not the best strategy.

Instead of simply following the order outlined above, your focus as an investor should be on minimizing the actual taxes paid. This may sound obvious, but the conventional wisdom effectively ignores the details in favor of a broad brush rule of thumb.

It’s also important to note that the idea of minimizing your total taxes paid starts well before retirement. In fact, an intelligently designed tax minimization strategy applies both to the contributions you make as you build your nest egg and to the withdrawals you make during retirement.

The execution of such a strategy then becomes an ongoing process of optimizing contributions and making tax-efficient withdrawals:

  1. Optimize Contributions: Contributions should be made to tax-deferred (traditional) accounts during years in which you are in a higher tax bracket than you expect to be in during retirement. Conversely, you should make Roth contributions when you are in a lower tax bracket than you expect to be during retirement.
  2. Tax-Efficient Withdrawals: If a client has funds in a taxable account, it is generally advantageous to use this money to pay for living expenses first until the taxable account is exhausted. This is identical to the conventional wisdom. However, the next step is for investors to review their expected taxable income each year. To the extent that the investor is in the 10% or 15% tax bracket, they should strongly consider converting part or all of the funds in their tax-deferred (traditional) accounts to Roth funds. The idea, of course, is to execute conversions until the taxpayer reaches the top of the 15% tax bracket, thereby locking in low rates of taxation on the converted amounts. For some investors, it may also make sense to continue conversions into the 25% or even 28% tax bracket.

The above approach can result in significant tax savings, often to the tune of tens of thousands, or even hundreds of thousands, of dollars. Those savings can improve the investor’s lifestyle and also reduce the risk of the investor running out of money during retirement.

That said, it can be a bit challenging to illustrate the total benefit of tax-efficient withdrawal strategies because of how dynamic they can be. Thankfully, a recently released academic study helps to advance the merits and benefits of smart tax planning in retirement.

New Academic Research Sheds Light on Tax-Efficient Withdrawals

New research from professors Kirsten A. Cook and William Reichenstein, CFA, along with William Meyer, focuses on the impacts of several different retirement withdrawal strategies as it relates to the longevity of an investor’s portfolio.

Their paper, Tax-Efficient Withdrawal Strategies, appeared in the March/April 2015 edition of the Financial Analysts Journal (available for download here) and does a fabulous job illustrating the cumulative benefits of the conversion strategy I outlined above.

Here are a few key highlights from the paper:

  • Investors should think about tax-deferred accounts (such as a traditional IRA) as a limited partnership in which the investor is the general partner and the government is the limited partner. The investor owns a portion of the partnership interest (1 – t) and the government owns the remaining amount (t).
  • An investor receives 100% of the returns from a tax-exempt or a tax-deferred account. However, they typically only receive a portion of the returns from a taxable account (due to taxes on capital gains, dividends, and interest). This is a critically important point and one that I plan to explore in greater detail in a subsequent post. For the purposes of understanding the conclusions of this paper, just know that a fundamental concept of minimizing taxes on retirement account withdrawals is realizing that a Roth account is equally as tax-advantaged as a traditional account. Therefore, the conventional wisdom of simply withdrawing from traditional accounts before Roth accounts isn’t always going to be correct.
  • In order to extend the life of an investment portfolio, the investor’s objective should be to identify opportunities to withdraw funds from tax-deferred (traditional) accounts at particularly low rates. Generally, this means taking withdrawals or executing conversions during years in which the investor is in the 10% or 15% federal tax bracket.
  • The opportunities to make these withdrawals or conversions are often during the years before required minimum distributions begin and in years when the investor has large tax deductions, such as those from high medical expenses.
  • Smart withdrawal strategies can add two to three years to the life of a portfolio compared to the approach advocated by conventional wisdom. What should be even more eye opening for investors is that the worst withdrawal strategy (i.e. the most tax inefficient) can shorten the life of your portfolio by as many as five or six years.

The last bullet is obviously where the rubber meets the road. If you don’t have a clear plan around making withdrawals during retirement, it’s absolutely vital that you sit down to consider your options. Ultimately, you don’t want pay any more taxes than you need to!