The longer the time horizon, the less the variability in average annual returns.
The key to fund selection is to focus not on future return—which the investor cannot control—but on risk, cost, and time—all of which the investor can control.
These three variables determine stock market returns over the long term:
- The dividend yield at the time of initial investment.
- The subsequent rate of growth in earnings.
- The change in the price-earnings ratio during the period of investment.
The initial dividend yield is a known quantity. The rate of earnings growth has usually been relatively predictable within fairly narrow parameters. And the change in the price-earnings ratio has proven highly speculative.
However, changes in interest rates tend to have a countervailing effect on bond prices and bond reinvestment rates: a higher yield lowers interim values before maturity, but raises the rate at which the interest is reinvested. (A lower yield does the reverse.)
The source of return on bonds has but one powerful determinant, and one that is known in advance: the current interest rate.
Short-term bonds are a superior alternative to money market funds. Short-term bonds are relatively insensitive to interest rate fluctuations; long-term bonds are hugely sensitive.
On Risks and Asset Allocation
Risk, in turn, is defined in terms of short-term fluctuations in expected value.
As a crude starting point, two-thirds in stocks, one-third in bonds.
Bonds are best used as a source of regular income and as a moderating influence on a stock portfolio, not as an alternative to stocks. Remember, the goal of the long-term investor is not to preserve capital in the short run, but to earn real, inflation-adjusted, long-term returns.
Stocks have delivered more than twice as much growth in purchasing power as bonds.
The volatility of stock returns quickly falls as the holding period lengthens.
The model assumes that, over long time periods, stocks will outperform bonds, as they have since 1802. It also assumes that stock returns will be less predictable, as demonstrated by a higher standard deviation of returns.
The advantage of a fixed-ratio strategy is that you automatically lock in your gains and reduce your equity exposure as equity prices increase.
Cautious tactical allocation may have a lure for the bold. Full-blown tactical allocation lures only the fool.
But when risk (measured by standard deviation) was taken into account, only the lowest-quartile expense groups distinguished themselves with outstanding risk-adjusted returns.
“Although investment strategy can result in significant returns, these are dwarfed by the return contribution from investment policy, and the total return is severely impacted by costs.”
All of the costs in investing—advisory fees, other fund expenses, and transaction costs—bite into the risk premium.
The equity risk premium is, simply stated, the extra return required by investors to compensate them for taking the extra risk of owning common stocks rather than risk-free U.S. Treasury bonds.
Minimizing investment costs is part and parcel with minimizing portfolio risk.
The central task of investing is to realize the highest possible portion of the return earned in the financial asset class in which you invest—recognizing, and accepting, that that portion will be less than 100 percent.
To earn the highest of returns that are realistically possible, you should invest with simplicity.
If you own any funds outside of a tax-deferred retirement plan, don’t forget that taxes are costs, too.
Two highly probable, if not certain, forecasts can be made:
- Funds with unusually high expenses are likely to underperform appropriate market indexes.
- Funds with past relative returns that have been substantially superior to the returns of an appropriate market index will regress toward, and usually below, the market mean over time.
In highly efficient market segments comprising commodity-like securities, it is extremely difficult for even the most brilliant money managers to garner a significant margin of advantage—before the deduction of costs.
You can use past performance to determine consistency and risk. For a fund to earn a top performance evaluation, it should have, in my opinion, at least six to nine years in the top two quartiles and no more than one or two years in the bottom quartile.
In using the word performance, I am not limiting my interest solely to return. Risk is a crucial element in investing.
With risk astonishingly constant, high returns are directly associated with low costs.
Cost is a key determinant of the relative returns earned by funds.
Whatever style they seek, investors who don’t seriously consider limiting selections to funds in the low-expense group and eschewing funds in the high-expense group should take off their blinders.
Typical total trading costs for an investment manager are estimated to be about 0.8 percent of the amount of transaction value.
I truly believe that it is generally unnecessary to go much beyond four or five equity funds. Too large a number can easily result in overdiversification.
Owning more than four randomly chosen equity funds didn’t reduce risk appreciably.
The alleged virtues of multifund diversification and risk control hardly appear compelling.
My best judgment is that international holdings should comprise 20 percent of equities at a maximum, and that a zero weight is fully acceptable in most portfolios.
The principal reason that the returns of actively managed mutual funds fall short of the returns of the stock market is their costs.
The success of indexing is based not necessarily on some notion of market efficiency, but simply on the inability of all investors in any discrete market or market segment to outpace the universe of investments in which they operate.
There is substantial evidence of persistence in the relative risks assumed by individual funds, largely because of the investment style they follow.
On Measure of Returns
We use the Sharpe ratio, based on the number of percentage points of a fund’s excess return (over the risk-free rate) for each percentage point of volatility.
An extra percentage point of standard deviation is meaningless, but an extra percentage point of return is priceless.
Modigliani formula is a measure of the risk-adjusted returns of some investment portfolio. It measures the returns of the portfolio, adjusted for the risk of the portfolio relative to that of some benchmark (e.g., the market). We can interpret the measure as the difference between the scaled excess return of our portfolio P and that of the market, where the scaled portfolio has the same volatility as the market. It is derived from the widely used Sharpe ratio, but it has the significant advantage of being in units of percent return (as opposed to the Sharpe ratio – an abstract, dimensionless ratio of limited utility to most investors), which makes it dramatically more intuitive to interpret.
In down markets, Sharpe ratios don’t convey accurate information.
The top risk-adjusted ratings were consistently earned by the funds with the highest total returns.
In fact, the funds in the group with the lowest expense ratios had the highest net returns. At the same time, they assumed a nearly identical level of risk (volatility), and therefore provided distinctly higher risk-adjusted returns.
In each case, the measurement of risk was based on three factors:
- Duration, a better measure than average maturity when evaluating a fund’s sensitivity to interest rate risk.
- Volatility, a measure of the variations in a bond fund’s monthly returns relative to the average taxable or tax-exempt bond fund.
- Portfolio quality, using ratings by Standard & Poor’s Ratings Services. Investment-grade bonds are rated from AAA (highest) to BBB (lowest).
With risk almost a constant, the winning return in long-term municipal bond funds is achieved by the group with the lowest costs.
On Foreign Holdings
The calculation of an efficient frontier, which is designed to determine the precise allocation of assets between U.S. and foreign holdings. The goal is a combination that promises the highest return at the lowest level of risk.
For the long-term investor interested in spreading investments around the globe via mutual funds, international index funds offer a sensible approach.
“If you invest in the Standard & Poor’s 500 Index as a whole, you own a diversified global portfolio.”
On Fund Selection
Relevance between past records and future performance
Relying on past records to select funds that will provide superior performance in the future is a challenging task.
The researchers have found no way to evaluate fund past returns and predict future winners with confidence.
The odds of selecting mutual funds that are top performers in the future have proved extremely poor.
Funds of Funds
The funds of funds not only lag the market—we now know that five of every six funds have done that—but they seriously lag even the style categories of the funds in which they invest, in part because of the extra layer of costs they almost universally add.
It goes almost without saying that investors who consider owning funds of funds should look first at those that (1) do not add this extra layer of costs, (2) themselves focus on low-cost funds, and (3) carry no sales loads.
Largely because of the creation of so-called target-date funds, in which fund managers select (and manage) a collection of funds under their supervision and—as a broad generalization—offer them to investors as an asset allocation package designed for retirement in a specific year, reducing equities and increasing fixed income securities as the target retirement date approaches.
Fund size has an impact on the performance. Checking the fund’s quartile rankings over time (mentioned in Rule 4) will reveal whether growing size has had an impact on relative return.
There are three major reasons why large size of mutual funds inhibits the achievement of superior returns: the universe of stocks available for a fund’s portfolio declines; transaction costs increase; and portfolio management becomes increasingly structured and group-oriented.
Large asset size reduces drastically the number of important portfolio positions that can be included in the investable universe available to a portfolio manager of a large fund.
Reverse to Mean
In the long run, a well-diversified equity portfolio is a commodity, providing rates of return that are highly likely to resemble closely and finally fall short of those of the stock market as a whole.
RTM (reverse to mean) is sending a powerful message about the futility of evaluating funds based on their past returns. But RTM, even though it may take decades to appear, is a principle borne out by history.
Stock market irrationality can be measured by the ephemeral—but critical—factor represented by the stock market’s price-earnings ratio.
Given the power of mean reversion in the returns of individual mutual funds, an index fund provides the most reliable participation in the future returns of equities as a group.
Provided that quantitative funds become available at costs competitive with those of index funds—and succeed in providing extra returns—enhanced indexing may also represent an important challenge to the status quo.
Blame the fund investor if he or she selects a fund with a small-cap strategy that fails to outpace the return of the total market over the long term, even though it outperforms the small-cap universe. But blame the fund manager if its small-cap fund fails to outpace the small-cap universe, even if its long-term return surpasses the return of the total market.
It is next to impossible to market-time a changing cash reserve position.
Low expenses, low turnover, and a fully invested participation in equities are the hallmarks of index fund excellence.
Here, tax-inefficient is the operative term for mutual funds.
Authoritative studies suggest that turnover rates would have to be reduced to 20 percent or less to engender a material lessening of the tax burden.
As taxes are deferred, returns rise significantly with each additional year that an investor elects to hold fund shares.
“Taxable investing is a loser’s game. Those who lose the least—to taxes and fees—stand to win the most when the game’s all over.”
The surprising, if simple, fact is that broad diversification makes it just as difficult to achieve significant underperformance relative to the market as to achieve significant over performance.
He found that, over a 30-year period, most investors would accumulate the greatest level of terminal wealth by keeping stock funds in a tax-deferred account, and holding tax-exempt municipal bond funds in a taxable account.
Investors must realize the importance of not merely minimizing taxes, but also maximizing after-tax returns.
Mutual fund managers [must] awaken to the critical issue of taxes.
The tyrannical impact of fund expenses combined with taxes paid on fund dividends and capital gains distributions, if almost completely ignored by the mutual fund industry, can no longer be ignored by fund investors.
On Time Horizon
The four dimensions of investing: (1) return, (2) risk, (3) cost, and (4) time. Three are the spatial dimensions: length (which I’ll describe as reward), breadth (risk), and depth (cost). But there is also a temporal dimension: time. This temporal dimension interacts with each of the three spatial dimensions of investing, enhancing return, reducing risk, and magnifying the impact of cost.
Among all strategies, market index strategies have the longest time horizons.
As your time horizon increases, the variability of stock market returns declines. As the years roll on, compounding moderates market risk. Furthermore, the risk of earning the stock market’s long-term return declines quite steeply during surprisingly short spans.
In the risky business of investing in stocks, most of the risk reduction is accomplished in a decade.
Descending the slope of risk is far easier than ascending the slope of reward.
Given that we have no control over the market’s future returns, the intelligent investor will seek to minimize costs, thereby maximizing their share of whatever long-term returns the market bestows on us.
Reward and risk go hand in hand. The conventional wisdom of finance teaches that if one is to increase (or decrease), so must the other. Cost has a significant impact on both reward and risk. Lower costs make it possible to earn a higher return without assuming extra risk, or to hold reward constant and reduce risk. And because the passage of years multiplies the aggregate reward, moderates the volatility risk, and magnifies the burden of cost, time interacts with each of the three spatial dimensions of investing.
On Fund Management and Fees
What are the mutual fund industry’s founding principles? Management, diversification, and service (including daily valuation of fund shares, liquidity, full disclosure, and convenience).
Fund management, in my view, should be defined by a spirit of trusteeship, professional competence and discipline, and focus on the long term.
“The principal function of investment companies is the management of their investment portfolios. Everything else is incidental to the performance of this function.”
Let me point out six areas of information in which you, as an investor, can better educate yourself: (1) cost, (2) fee waivers, (3) performance, (4) proxy voting, (5) alternative investment strategies, and (6) investment guidance.
A high-cost portfolio must have a significantly higher stock position and a lower bond position to generate a return equal to that of a low-cost portfolio.
Investors should seek realistic information that shows a fund’s true yield after the deduction of all expected costs, and should generally ignore the teaser rate created by the fee waiver.
The conventional rates of return to measure a fund’s performance (time-weighted, on a per-share basis), with few exceptions, reflect performance that is significantly higher, and in many cases radically higher, than the returns actually earned by its shareholders (dollar-weighted, on the basis of total net assets).
Shareholders owe it to themselves to pay at least as much attention to the prices they pay for their funds as to the prices they pay for their cars.
Rather than being perceived as an owner of the fund, the shareholder is perceived as a mere customer of the adviser. At that point, the mutual fund is no longer primarily an investment account under the stewardship of a profession manager, but an investment product under the control of a professional marketer.
Indeed, nothing precludes a fund from raising its advisory fee by, say, 0.25 percent and spending the entire windfall on marketing, and many funds seem to do exactly that.
“There is no evidence that 12b-1 fees generate benefits which are passed along to fund shareholders who pay these fees.” The analysis showed that equity funds without 12b-1 fees had outperformed their peer equity funds with such fees by a margin of 1.5 percentage points per year, an astonishing and highly significant gap.
The fundamental role of corporate directors is to serve only one master—the shareholders of the corporation.
I’ll call the equation Gross Return - Expenses = Net Return the constitutional principle, and the tenet “In efficient markets, mediocrity is the norm” the statutory law.
The easiest and surest way for a fund to achieve the top quartile in investment performance among peer funds is to achieve the bottom quartile in expenses.
A group of related investment companies (mutual funds), owned by their shareholders (or, less commonly, trusts effectively owned by their beneficiaries) and governed by their directors. Each fund in the group contracts with an external management company to manage its affairs in return for a fee. The management company undertakes to provide substantially all of the activities necessary for the fund’s existence: investment advisory services; distribution and marketing services; and operational, legal, and financial services.
For when investment returns are divided, the more the manager earns, the less the shareholder earns. A dollar in profits for the management company is a dollar less for the mutual fund shareholders. It’s as simple as that.
There is a contrast between the mutual organization’s sole orientation (to enhance the returns of fund shareholders) and the industry’s dual orientation (to enhance the returns of fund shareholders and management company stockholders alike).
The ideal investment management industry should have three key attributes: (1) A high proportion of publicly traded financial assets is managed passively at very low fees by a small number of large, global providers, with the large economies of scale inherent in passive management passed on to the customers; (2) A low proportion of publicly traded financial assets is managed actively for performance-based fees by a larger number of smaller providers, because true value-adding active management is a scarce resource in both capability and capacity; and (3) Industry investment performance information is expressed as risk-adjusted net performance relative to pre-defined investment benchmark portfolios which reflect the managed portfolios’ stated investment policy.
What distinguishes a superior company from its competitors is not the dimensions that usually separate companies, such as superior technology, more astute market analysis, better financial base, etc.; it is unconventional thinking (Continued) about its dream—what this business wants to be, how its priorities are set, and how it organizes to serve.
After reading Common Sense on Mutual Funds, move on to Malkiel’s A Random Walk Down Wall Street, Ellis’s Winning the Loser’s Game, and my own Unconventional Success.