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3.1 IntroductionThe most common form of active management is stock picking. On average, stock pickers will always lose by the amount of their costs and expenses. Some will do better and some will do worse than an appropriate or blended benchmark of risk factors. Since the average return of the market is the average return of all investors, the average investor gets the average return. Although you may think that you can choose or be the investor who beats the others, the probability of a money manager outperforming other managers each year is equal to getting heads on the toss of a coin: 50/50. This is because the markets are random, just like a coin toss. The chances of a manager beating a market over the long term (more than 10 years) were 1 in 36 in one study, and 1 in 39 in another 30-year study! You would be better off betting on one number on the roulette table in Vegas, where odds are 1 in 38. So far, we have collected over 200 articles measuring the performance of active managers, starting with Alfred Cowles in 1933, and the results are not good for active management. 3.2 Definitions3.2.1Stock PickersStock pickers are active investors who bet they can beat a market by picking stocks they believe will outperform an index. To be precise, the only proper comparison to their result is the portfolio they choose. All other portfolios will end up with different risk and return characteristics. Generally, stock pickers take on more risk than the index because they concentrate their bets on fewer stocks than those in the index. When they allocate their portfolio differently than the index, they are guaranteed to obtain a different return as well as a different risk level. Sometimes it is more and sometimes it is less, but we can always assume it will be different when looking at both risk and return. Since it takes at least 20 years of risk and return data to confirm skill over luck, stock pickers face a virtually impossible task in their ability to ensure continued success against the appropriate market index. However, indexes are a source of 20-year risk and return data, and consequently are the only logical choice for establishing efficient portfolios of various levels of expected risks and returns. 3.2.2Adjusted PerformanceThe performance of stock pickers must be examined on an adjusted basis. This means that all factors must be considered before we can determine if the stock picker has achieved a benefit over an appropriate index or benchmark. When comparing active management to an index, we must: 1. Make sure we are talking about the entire portfolios for the exact same period of time. 2. Confirm proper accounting of the returns, including the cash flows in and out of the account. 3. Consider the state and federal taxes paid on short and long-term capital gains and dividends. 4. Consider all fees when assessing net return. Most funds report gross performance before deduction of fees and commissions. 5. Adjust for the portfolios' exposure to market risk, size risk, and value risk factors. 6.
Consider the level of diversification of the two portfolios. 8. Consider if the over and underperformance is within the bounds of what would be expected randomly. 9. Be sure to compare results to an appropriate benchmark. Proper benchmark specification avoids inflated performance reports. 10. If looking at a group of stock pickers, be sure to include the returns of those pickers that did not survive the duration of the period, usually due to significant losses. 11. Look at all active managers in an asset class, both those who stayed in business and those who did not. 12.
Check to make sure the stock-picking manager did not drift in its designated style during
the period in question. Problems3.3.1Why Stock Pickers FailThe main reason that stock pickers fail is that stock prices are moved by news, and news is unpredictable and random in nature. Therefore, the movements of stock prices are unpredictable and random. This simple logic makes it impossible for any human being to consistently pick stocks that outperform the averages of a market. Secondly, the news that moves stock prices is incorporated into the new
price within minutes of its release. This adds a major hurdle for stock
pickers. It means they must compete with thousands of highly intelligent
and well-informed traders on a minute-by-minute basis. A Devasting Conclusion: (Click the play button on the image to the right)
3.3.2 The Stock Picker's Graveyard“Survivorship bias” is one of the many reasons that stock pickers’ returns look better than they actually are. Survivorship bias is when mutual fund managers tout their fund’s performance based on comparisons with an “average” mutual fund. This average is calculated from a list of funds that have survived during a particular period. Funds that did not survive the period are not included in the calculation. According to the Center for Research on Securities Prices (CRSP) at the University of Chicago, if only data from surviving funds is considered, the growth of a dollar for the surviving funds appears to be 19% better since 1962. If only “live growth and income funds” are considered over this period, $100 appears to grow to about $2,500. However, the only way to properly account for all active managers is to include those mutual funds that did not survive. When taking these dead funds into account, CRSP found that the average stock picker’s $100 investment grew to only about $2,100.
The Center for Research on Securities Prices (CRSP) at the University of Chicago has the only complete database of both live and dead mutual funds. Mark M. Carhart, currently Co-Head of Quantitative Research, Goldman Sachs Asset Management, New York, developed this unique database for his 1995 Ph.D. dissertation at the University of Chicago Graduate School of Business. In his dissertation, Survivor Bias and Persistence in Mutual Fund Performance, he noted that the explosion in new mutual funds has been "...accompanied by a steady disappearance of many other funds through merger, liquidation, and other means...this data is not reported by mutual fund data services or financial periodicals and in most cases is electronically purged from current databases. This imposes a selection bias on the mutual fund data available to researchers: only survivors are included.." In estimating
the performance of an equal-weight index of equity mutual funds, Dr. Carhart
found that analyzing only surviving funds biases performance upward by
about one percent per year. The financial press goes to great lengths to inform the public about active
managers with good luck, e.g., "Last Year's Top Ten Mutual Funds."
This kind of media reporting provides no data about those managers
who lose money taking chances in the market, then shutting their
doors and erasing their bad returns from the record. Well, we have bad
news for those mutual fund managers: we are exhuming their results. We
paid CRSP $1,000 (it is expensive to dig up old corpses) to prepare a list of the top
200 worst performing dead mutual funds going back to 1961. To our
surprise, this had never been done before. Here are the top twenty of
the worst performing dead mutual funds: Table 3-1 3.3.3 Incubator Funds
In addition to funds
that die, there is an indeterminable number of funds that are aborted.
These funds are referred to as incubator funds, and are basically experiments
within a fund firm that never develop into a publicly available mutual
fund. The stock picking managers of these incubator funds tried something new and ended up with a failure. This little known fact has yet to be quantified in the average returns of stock pickers. Finally, there are
the revolving doors of stockbrokers who are churning through clients and
constantly rotating from one firm to another. Their records are quickly
extinguished, never to be counted in the average of stock pickers. Two of the largest fund firms implicated in the recent scandals were among the major participants in this strategy. They started with large numbers of incubation funds in order to, in the paper's words, "upwardly bias investors' estimates of their ability, and thereby attract additional inflows," killing them off when the tough real world of investing brought their returns back down to reality. This is described as "organizing, operating, and managing" funds in the interest of their promoters to the detriment of their investors. Investors would benefit from a restriction of the promotion of the returns earned by these incubated funds during their incubation period. Table 3-2 Indeed, only two members of the original 30-stock Dow Average established in October 1928 are still included in 2011 - General Electric and Standard Oil of New Jersey, now ExxonMobil.
Figure 3-1 Polaroid shares were
a favorite among aggressive investors, soaring more than 40-fold from
their initial public offering in 1957 to an all-time high of $149.50 in
1972 ($74.75 adjusted for a subsequent two-for-one split). The SX-70 camera,
which ejected prints that developed externally, was introduced the same
year. In addition, there was talk of a forthcoming instant movie system. In the book Creative Destruction, McKinsey & Company consultants Richard Foster and Sarah Kaplan researched the original S&P 500, which was created in 1957. The survival of companies is similar to the survival of mutual fund managers. Figure 3-1 shows that in the 41 years from 1957 to 1998, only 74 of the original 500 companies were still in existence and only 12 of those outperformed the S&P 500 Index over the 1957 to 1998 period. The study found that the odds of picking a winning stock that beat the S&P 500 Index was one in 42. 3.3.3a Excellent Companies Don't Make Excellent InvestmentsMost investors
operate under the misguided assumption that great companies are excellent investments. They believe that these companies
can defy the poor odds of beating the market. In fact,
almost the entire investment industry thrives on recommending a handful of “great stocks
to buy now." The firms represented in Figure 3-1a are widely
considered to be industry leaders. They have been included at some
point among the top ten "Most Admired Companies" in Fortune's
annual survey. ![]()
In Figure
3-1b, you can see the risk and return of the 30 Dow Jones Industrial
stocks, which include several of the stocks listed above, but over a 20-year period. Please note that for the risk taken, not one company exceeded
the return that would be expected based on the diagonal line that estimates
the appropriate return for the risk taken. This line is known as the Capital
Markets Line. Figure 3-1c Further research demonstrating that good companies make bad investments is found in a 1987 study titled, “In Search of Excellence: The Investor’s Viewpoint.” In the study, investment analyst Michelle Clayman compared the returns of 29 “excellent companies” with 39 “unexcellent companies.” Clayman’s idea for this study originated from the 1982 best-seller In Search of Excellence by Tom Peters and Bob Waterman, which described 43 successful U.S. companies of which 36 were publicly traded. The book awarded companies an “excellent status” by virtue of their profitability, employee satisfaction and overall good working conditions, inspiring stock pickers nationwide to believe that they too could use winning companies to make winning investments. Clayman compared 29 of Peters' and Waterman’s “innovative and excellent” companies with 39 “unexcellent” companies she selected. Her criteria for unexcellent companies included those with terrible profitability and “Dark Ages” management. Examples of her excellent companies included powerhouses such as Johnson and Johnson, Intel, Merck, and Disney. Unexcellent companies were made up of companies like U.S. Steel, American Motors, Westinghouse Electric, and F.W. Woolworth. Figure 3-1c shows that Clayman's excellent companies were stronger by every economic measure than her unexcellent ones for the five-year period between 1981 through 1985. “The excellent companies have qualities we would all love to see in our own companies,” she observed. ![]() Clayman found, however, that the unexcellent companies showed significantly greater returns over the five years than their healthier counterparts. Figure 3-1d illustrates that between 1981 and 1985, the unexcellent companies earned investors a 298% total return while the excellent companies earned only a 182% total return. The two portfolios had almost identical standard deviations, so what made the unexcellent portfolio deliver such higher returns to its investors? The discrepancy arises because the higher cost of capital for unexcellent companies is paid to investors. Similar to individuals who approach banks for loans, borrowers with strong credit and payment histories will receive loans with lower interest rates (lower costs of capital) than that of a riskier borrower. Less stable companies end up paying higher costs of capital in exchange for their higher risk, which translates to a lower stock price relative to book value and a higher expected return for investors in those risky companies. ![]() 3.3.3b Spurned vs. AdmiredRemember Peter Lynch’s advice about buying companies whose products you like? It turns out this advice is not as good as it sounds. Great companies don’t make great investments. You may love Apple’s iPad, but this doesn’t mean Apple is a great stock to buy. In fact, the opposite is usually true. Distressed companies have earned higher returns than those of companies with lots of hype or goodwill. Unfortunately, investors generally avoid investing in distressed companies, because it seems counterintuitive to buy perceived losers.
From these ratings, Statman and Anginer constructed two portfolios, each consisting of one half of the Fortune stocks. The “admired” portfolio (often referred to as growth stocks) contained the stocks with the highest Fortune ratings, and the “spurned” portfolio (often referred to as value stocks) contained the stocks with the lowest Fortune ratings. For example, the list of admired companies included The Walt Disney Company, UPS, and Google. Spurned companies included Jet Blue, Bridgestone, and Stanley Works. Figure-Admired vs Spurned Why have value stocks delivered higher returns to their investors? The market perceives value companies to be riskier, driving down stock prices so their expected returns are high enough to attract investors. That is difficult for most investors to grasp since they prefer to believe growth stocks are better investments than value stocks. After all, investors looking for a stock tip want to hear the name of the next Apple, not the next JCPenney. As you will see in Step 8, the data indicates that investors should be interested in great investments (value stocks), not just great companies (growth stocks).
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