Navigating Structured Products

by Brian Harris, Senior Editor, Dimensional Fund Advisors

In recent years, structured products have gained favor among retail investors in Europe and the US. Investment banks promote these securities as sophisticated tools to help investors manage downside risk, enhance returns, or achieve other investment objectives.

Sales have grown briskly since 2006, and despite a decline after the 2008 market crisis, some industry sources expect a rebound in sales and a flurry of new products in the future.1 With this in mind, it may be useful to understand how the products work and to evaluate the costs, benefits, and tradeoffs before considering one in your investment strategy.

Basic design of structured products

A structured product is a contract that promises to pay a future amount based on the performance of an underlying asset, such as a stock, market index, or commodity. The payoff is typically linked to a preset formula. Most structured products are designed to either preserve capital or enhance returns, and are typically issued as notes.2 The notes offer a specific payout over a designated period or at maturity, and the final payout depends on the performance of the underlying asset as well as the value of the derivatives written on it. Since the product typically is issued by an investment bank, the investor is exposed to the credit risk of that entity.

One common product, a principal-protected note, generally offers a minimum return equal to the original investment, plus a potential return tied to performance of an underlying asset, such as a stock market index. If the index drops during the term, the investor gets his money back, but if the index rises, he may receive the upside gain, but usually only a part of the underlying asset’s gain. Structured products can be replicated by portfolios composed of an interest-bearing instrument, such as a certificate of deposit or zero-coupon bond, equity securities, and options or other derivative securities whose performance is linked to the underlying index.3

The following summarizes a few common characteristics of structured products:

•    Complex design: Most products have a complex design, which can make analysis of pricing, risk exposure, and potential outcomes more difficult. Some investors equate this complexity with higher potential returns, when, in fact, it may only mask high fees and risk. Worse yet, investors may not understand the range of possible outcomes. During the 2008 market crisis, some investors learned a hard lesson when the issuing firm went bankrupt or when their structured product experienced losses from poor performance of the underlying asset.

•    Substantial cost: These products tend to carry a significant markup and costs that in some cases are difficult to quantify, especially if an investor lacks the technical knowledge to analyze the underlying components of the strategy.

•    Replication: The payoff of virtually any structured product can be replicated in a portfolio by holding the underlying securities, then buying or selling derivatives written on those securities. In many cases, the costs associated with the replication portfolio are much lower than the structured product itself.

•  Tradeoffs: In return for receiving a prescribed payout, investors must accept a tradeoff in the form of a lower return and/or limited upside potential. When evaluating a structured payout, remember that there is no free lunch in the risk-return tradeoff. To pursue higher expected returns, you must accept more risk. If you do not want to bear the risk, you must transfer it to other investors and pay them for taking it.

•    Multiple Risks: First, there are the inherent risks of the underlying security (e.g., the stock or index). Investors also are exposed to credit risk of the issuing firm. The contract is an agreement with the issuer to make a pre-determined payment in the future, and thus, it is contingent on the firm being able to deliver. Liquidity risk is another issue. Although many structured products are listed and traded on exchanges, they may be difficult to sell, especially in a volatile market. To avoid a potential liquidity problem, investors should consider the time horizon of the product and attempt to match its maturity to their anticipated financial need or objective.

• Tax considerations: It is also important to check tax consequences. Some instruments may have certain appeal under the current tax rule. But, often, tax consequences differ according to the investment situation (e.g., whether one buys at the issuance or in the secondary market).

Who might benefit?
A structured product might help an investor who needs a specific payout at a designated point in the future and who is willing to pay another party to shoulder much of the uncertainty. But this benefit generally comes at the expense of lower yield or limited upside potential.

One example may be an individual who currently holds restricted company stock whose value may account for a significant portion of his total wealth. Although he might prefer to diversify this exposure, company rules may prohibit a sale until some future date. A structured product might provide protection against the downside risk of the company’s stock (even though this might mean giving up the upside potential of the stock), and at the same time, provide better-diversified exposure to an equity index, such as the S&P 500.

Perhaps most important, investors who are considering a structured product should consider why they even need a highly structured payoff in the future—and if so, whether the payoff can be structured by other means in the portfolio. In many cases, the strategy can be replicated at a lower cost, and perhaps with less risk. Many investors would prefer an alternative that is less complex and more transparent. And as the recent credit crisis taught many investors, it is wise to avoid investing in things you do not understand.

Endnotes

1 Larry Light, “Twice Shy on Structured Products?” Wall Street Journal, May 28, 2009.

2 A reverse convertible bond is one example of a yield enhancement tool. It pays investors a higher coupon rate than other comparable bonds due to its higher risk. This risk comes in the form of the issuer having the option to pay off the debt with either cash or a predetermined number of common stock shares. The method of payment at time of maturity will depend on the stock price, and the issuer will pay with common stock when it is advantageous to do so. The reverse convertible bond was popular until the last market crisis, when many investors experienced heavy losses when they were paid off with lower-value stock shares.

3 A call option provides the holder the right to buy the underlying security at a given price at a certain time in the future. A put option provides the holder with rights to sell the underlying security at a pre-specified price on maturity date. (American-style options can be exercised before the maturity date, whereas European-style options can be exercised only on the maturity date.) An option holder will exercise the put or call option only if the payoff is positive.

Dimensional Fund Advisors is an investment advisor registered with the Securities and Exchange Commission. This material on structured products is provided for informational and educational purposes only and should not be considered investment advice or an offer to buy or sell securities.

The following article from Investor’s News is an eye opener. It is so easy to think investing is easy – think again. And, enjoy reading this article and take heed.

Like so many investors in the spring of 2009, Gordon Wolf needed to dig out of a hole.

A 68-year-old psychologist in Napa, California, Wolf was a buy-and-hold sort of guy, yet the nest egg he had entrusted to his broker at Merrill Lynch was suddenly down by more than 50 percent.

The broker had invested much of it in a range of exchange- traded funds, or ETFs, a relatively new financial innovation that was replacing mutual funds in the hearts and portfolios of many investors. An ETF, which can be bought or sold like a stock, attempts to track the price of a particular basket of assets–tech stocks, for instance, or high-yield bonds, or commodities ranging from wheat to gold to oil to natural gas.

The commodity ETFs were supposed to offer a hedge against equity losses, but in the crash of 2008 everything fell in tandem. Now it was early 2009, and Wolf was watching oil fall to $34 a barrel. That had to be an opportunity, he figured, so he called his Merrill broker and asked about the U.S. Oil Fund, an ETF designed to track the price of light, sweet crude. “This seems to be something good,” Wolf told the broker, and had him buy about $10,000 of USO.

What happened next didn’t make sense. Wolf watched oil go up as predicted, yet USO kept going down. In February 2009, for example, crude rose 7.4 percent while USO fell 7.4 percent. What was going on?

For the rest of this article, go to Investors in commodity ETFs getting “eaten alive”

There are other good reasons to approach the topic carefully. Market efficiency and its offspring, passive investing, are counterintuitive for many investors. It is human nature to believe that one can beat the market (or identify someone who can) through intelligence, insight, and hard work. This belief is constantly reinforced by Wall Street and most of the mainstream media.

Even though some may characterize Dimensional’s approach as passive, it is only passive with respect to activities that don’t add value—mainly stock picking and market timing. One could argue that Dimensional is very active, however, in managing important considerations such as frictional costs and consistent exposure to targeted risks or asset classes.

Here are some examples of framing:

• We don’t speculate. We invest.Rather than relying on speculation, blind faith, or anecdotal evidence, our philosophy rests on a solid foundation of core principles from the science of investing.
• With capitalism there is always a positive expected return on capital.Capital markets are very competitive due to voluntary exchange between buyers and sellers. There is a buyer for every seller; for markets to clear, prices will adjust to new information and reach a level where there is always a positive expected return to providers of capital. Investors would not risk their capital without the expectation of a positive return. We invest in an approach that strives to capture a fair share of the capital market return based on the risk assumed.
• It is difficult to identify superior investment managers in advance.Capitalism breeds competition, and that makes markets difficult to beat. With millions of participants competing in capital markets, it is hard to identify in advance anyone who can systematically beat the market since past winners may have just been lucky and won’t necessarily win in the future. We eliminate the risk of choosing the wrong manager by following a broadly diversified approach that does not rely on stock picking or market timing.
• Diversification is the only antidote for uncertainty.Although diversification neither assures a profit nor guarantees against loss in a declining market, a properly constructed and well-diversified portfolio is a key component of a successful investment experience. We design portfolios that attempt to capture certain risks and eliminate others, depending on your preference and capacity for various types of risk.
• There is no free lunch. Risk and return are related.Higher expected returns only come from bearing more risk that cannot be diversified away. Much like a football player who chooses to play without a helmet, you should not expect to be paid more for taking risks that can easily be avoided. We focus on eliminating risks that you should not expect a reward for taking, such as concentrating your portfolio in just a few stocks.
• Control what you can.If speculation is futile, and trying to choose winners is more often a loser’s game, what can an investor do? The answer is to concentrate on what can be controlled: managing the transactional costs of investing, reducing the impact of taxes, and taking a long-term view. We implement portfolios in a way that is cost effective, tax efficient, and above all, disciplined.

Market efficiency and the active or passive decision are loaded with misconceptions that can lead to debate and confusion rather than constructive dialogue and understanding. More importantly, it can distract our attention from the most crucial element of all: discipline!

The studies comparing dollar-weighted returns to time-weighted returns are widely known, and behavioral research has documented the propensity for individual investors to skate to where the puck was (instead of where it is going). A decision to invest in an active, indexed, or Dimensional approach can often be differentiated in basis points, while percentage points often gauge the impact of an undisciplined or emotional decision unchecked by an advisor’s sound counsel.

This type of behavior is obviously hazardous to an investor’s wealth; therefore, we should attempt to determine if one of these alternative strategies has been able to mitigate some of these actions.

The charts below show the monthly cash flow into all equity funds (foreign and domestic) in the US , along with the prior twelve-month global equity market return. Cash flow bars that vary with, or more closely follow, the prior year return line could suggest more return chasing behavior among the investors within that universe of funds.

Source: ICI

Source: ICI Index is not available for direct investment; its performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is no guarantee of future results.

Source: Dimensional

A simple “eyeball” analysis of this anecdotal data suggests that investors in active mutual funds apparently were more influenced by short-term performance than those who held index funds, and advisors (and clients) who invested in Dimensional funds exhibited the most consistency.

The biggest difference between index funds and Dimensional relating to investor behavior may be the requirement for independent advice from a fee-only advisor. If part of the recipe for a successful investment experience is to stay the course, the advisor is the key ingredient to educating investors and keeping them disciplined through good times and bad.

The comments of Robert Dintzner are greatly appreciated.

Many thanks to Brad Barber for providing the ICI data.

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¹Dimensional cash flow data includes US, Canadian, UK, and Australian domiciled funds.

Dimensional Fund Advisors (“Dimensional”) is an investment adviser registered with the Securities and Exchange Commission.

This article contains the opinions of the author but not necessarily the opinions of Dimensional. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is provided for informational purposes only and should not be construed as an offer, solicitation, recommendation or endorsement of any of the products or services described in this website.

In the past five years, actively managed stock and bond funds have shown a significant rate of non-survival, and among the survivors, only a few have consistently outperformed their category benchmark.

Some people claim that strong financial markets offer opportunities for active managers to add value, while others say that active management works best in market downturns. During the past five years, the US stock market has experienced several years of moderate gains and one year of extreme underperformance (2008).

So, how have active mutual fund managers performed during this period?

As shown in this graph, of the 3,662 actively managed US equity funds operating at the beginning of 2004, 28.5% of the universe (1,043 funds) disappeared during the five-year period through 2008. Most of this non-survival occurred in years when the market delivered positive returns.

Some investors might conclude that a 71% survival rate offered strong odds of choosing a successful fund over the period, with a fund’s success defined as beating the performance benchmark for its fund category. But survival rate alone does not offer insight into future performance of a fund, as demonstrated in the next slide.

Although 2,619 actively managed US equity funds (71%) survived the five-year period, most funds did not outperform their category benchmark.

This graph shows the percentage of funds in the surviving universe that beat their benchmark in consecutive years. In the first year (2004), 33.2% of the funds were winners, but by year five (2008), only 1.4% of the funds (38 out of 2,619 survivors) had consistently outperformed their benchmark.

Additional statistics from the study reveal the inconsistency of active fund performance. On average, only 41.7% of the surviving funds beat their benchmark each year, and only 39.7% of the survivors delivered a five-year total return above their respective fund category benchmarks.

Despite the strong evidence against active strategies, some people may believe that as a group, active managers can add value. The challenge comes in identifying winning managers in advance. Some investors attempt this by choosing managers with strong past performance.

Evidence does not support their approach. In the five-year period under study, recent winners did not reliably repeat their outperformance. In fact, less than half (46%) of the funds that beat their benchmark in the preceding year did so again in the following year. Among the funds that outperformed in 2004 and 2005, only 5% beat their benchmark over the entire five years.

Like active managers in the equity universe, bond fund managers have a significant rate of non-survival and underperformance.

As shown in this graph, of the 1,670 actively managed bond funds operating at the beginning of 2004, about 27% of the universe (458 funds) disappeared during the five-year period through 2008.

Some investors might assume that a 73% survival rate offered reasonable odds for choosing a winning fund over the period, with a fund’s success defined as beating the performance benchmark for its fund category. However, survival rate alone does not offer insight into a fund’s future return.

Fund survival does not imply success. Although 1,213 actively managed funds (73%) survived the 2004-2008 period, most did not outperform their fund category benchmark.

This graph shows the percentage of bond funds in the surviving universe that beat their benchmark in consecutive years. In 2004, over 41% of the funds outperformed their respective category benchmark. By year five (2008), however, only 0.5% of the funds (7 out of the initial 1,670) had outperformed in all five years.

The study also reveals that, on average, only 30.1% of the surviving funds beat the benchmark in a given year, and over the five-year period, only 12% of surviving funds (146 out of 1,213) delivered a total return above their benchmark for the entire period.

Despite the strong evidence against actively managed bond funds, some investors believe that active managers as a group offer the best opportunity for long-term success, assuming these managers can be identified in advance. One approach is to buy recent winners in hopes that their outperformance will continue in the future.

But past winners did not typically repeat over multiple years. In this five-year period, on average, only 42% of the funds that beat their category benchmark in the preceding year outperformed in the following year, and of the funds that outperformed in 2004 and 2005, less than 2% (7 out of 399) beat their benchmark over the entire five years.

The previous column in this series focused on some theoretical aspects of market efficiency and offered points to help lead investors toward your passive corner. As they begin to march in this direction, however, other questions based on practical, if not emotional, considerations may arise. The following responses may reinforce their conclusion that a passive strategy provides the best odds of success.

Q: If there will be managers who beat the market, who cares if there are no more than would be expected by chance? We only need to pick one!

A: As explained in the previous column, equilibrium accounting presents a dilemma for active managers. We know that for every winner there must be a loser because active management is a zero sum game (before costs) relative to the market. This is due to the adding-up constraint, which infers that market returns must reflect all investors who collectively participate in the market. Therefore, the essence of the active-passive decision is to determine whether one can identify the active management winners in advance.

As I mentioned, there aren’t any more winners in this zero sum game than you would expect by chance, so the real issue is whether you can distinguish luck from skill among the past winners in an attempt to find managers who will win in the future.

There is a large volume of literature on this subject, and the conclusions generally point toward very little persistence in the superior returns of past winners. There may indeed be skillful managers, but the data is too noisy for us to pull them out of the sample that includes a large number who just got lucky. Your assumption should be that ex-ante, the expected alpha (or performance relative to the market return for a given level of risk) of any manager is negative, regardless of past performance.

Here’s another way to think about it. If you find a manager who was in the top quartile in the past, that manager has a 25% chance of being in the top quartile in the future. Unfortunately, so does every other manager, with the exception of those who charge extraordinarily high fees or have extremely high turnover, as research shows that high-cost and high-turnover managers are more likely to persistently underperform the market, net of fees and expenses.

Q: But I just read a report showing how the average manager outperformed in all the prior bear markets! Doesn’t that suggest the zero sum game did not apply in those periods?

A: These types of reports often suffer from two deficiencies. First, they usually fail to adjust for survivorship bias, which would impact the results dramatically. For example, the latest Standard & Poor’s Index versus Active (SPIVA) report indicates that survivorship in the most recent five-year period was 44.9% for Canadian equity funds.¹ If more than half the funds in Canada didn’t survive the last five years, imagine how small the sample of survivors would be today for the 1980-82 bear market. Drawing conclusions from such a small sample of survivors would be like attending a World War II fighter pilot convention and concluding that being a World War II fighter pilot results in longevity because everyone at the convention was over 80 years old. Unfortunately, that conclusion would not account for those who did not survive!

The other problem is the results in these types of reports are often equally weighted rather than asset weighted. Although it is generally instructive to show both, an equally weighted average does not reflect the actual outcome investors experienced. This is analogous to buying ten stocks but putting $91 in one stock and $1 in each of the other nine. An equally weighted return calculation would not fairly reflect the portfolio’s actual performance.

Q: Maybe in aggregate active managers won’t beat the market. But can’t they help protect me on the downside and smooth out the ride?

A: The zero sum game means it is mathematically impossible for active investors to collectively win in a down market, as the adding-up constraint holds regardless of the direction the market takes. As William F. Sharpe states in his article “The Arithmetic of Active Management,” “These assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.”²

It is no coincidence that passive strategies began to attract interest from US institutional investors in the summer of 1975. Many had suffered sharp losses in the 1973-74 bear market, despite employing active managers who claimed to offer capital preservation during difficult markets. The poor performance of actively managed strategies during the recent 2008-09 downturn provides additional evidence that, on average, active managers simply raise costs and do not provide superior performance in bear markets.

Q: An active manager incurs significantly higher costs for things like data sources, model development, research, and company visits. Don’t these added costs justify the higher fees associated with active management?

A: Higher fees cannot be justified because of the higher costs involved with active management unless you apply the logic Patrick Ewing used during the NBA work stoppage. In an interview following a collective bargaining session, he was asked to defend the escalation of player salaries to extraordinary levels, to which he responded, “People got to understand that we make a lot of money, but we spend a lot too!” The question is not are the costs of active management higher to the manager, but are the net benefits of active management higher to the investor? As we’ve discussed, the answer seems to be NO.

Q: ETFs and other passive strategies also charge fees. Wouldn’t these fees guarantee that an investor will underperform the market?

A: All investment strategies have costs, so the gross market return is not achievable for investors. Consequently, costs should be a factor when considering different passive strategies, and just because a strategy is passive doesn’t mean it is cost-effective. However, when you adjust for risk, the net return for the aggregate of all passive portfolios is higher than the net return for the aggregate of all active portfolios by roughly the difference in frictional costs. This is not a theory but a tautology, and it must hold every instant!

So, it is accurate to say that in aggregate passive strategies are guaranteed to underperform the market (even when adjusting for risk) by the amount of their frictional costs. But another way of looking at it is to say that the vast majority of active strategies will underperform by even more. Consequently, the odds are in your favour that the passive strategy beats the active one, even though it is guaranteed to underperform the market.

Q: Passive investing relies on the benefits of diversification. But does diversification even work anymore, given that everything seemed to go down in value at the same time, with passive strategies going along for the ride?

A: Although diversification neither assures a profit nor guarantees against loss in a declining market, it can help eliminate company specific (or unsystematic) risk in a portfolio. However, you cannot diversify away systematic risk, and this is what caused the market decline and drop in value of broadly diversified passive portfolios. Fortunately, systematic (or compensated) risk is the only form of risk you should expect to be rewarded for, and the only way to reduce it is to invest in a portfolio with lower expected returns.

However, contrary to what you may think, diversification has been more important than ever. Company-specific risk has increased significantly recently, and this is risk you can eliminate through diversification. It is also risk that you should not expect a reward for bearing!

When we diversify, we give up the opportunity to concentrate our portfolio in the best-performing investments in return for the assurance of avoiding overexposure to the worst-performing investments. Diversification continued to work during the most recent downturn. Although diversified equity portfolios experienced sizable declines, the losses in many widely held stocks were catastrophic—and in some cases irreversible. In addition, high-quality fixed income securities performed very well during the downturn, illustrating the important role of fixed income as a diversifier in balanced portfolios.

Q: Passive investing is a buy-and-hold approach, but does buy-and-hold really work considering investors didn’t make any money for the last decade if they just bought the whole US equity market and held it?

A: It is true that US equity investors have not been rewarded in the last ten years, but this is the risk you must accept as an equity investor in exchange for higher expected returns relative to less risky alternatives like US Treasury bills. If the risk never materialized, even over long horizons, it would be an arbitrage opportunity and the higher expected returns would not persist.

Investors shouldn’t be happy with the results over this period, but what is the alternative? If the alternative to a buy-and-hold approach is a trading strategy, the results likely would have been worse. Once again, the zero sum game’s adding-up constraint means that the only way to profit from your trading strategy is at someone else’s expense. You may get lucky, but chances are you will simply be adding more risk, higher transaction costs, and higher taxes to your portfolio while increasing uncertainty and broadening the range of possible negative outcomes in the future.

Moreover, if you’re contemplating pursuing stock picking as an alternative to buy-and-hold then you may want to consider Jim Davis’ recent analysis of all US stocks going back to 1926. He concluded that the best-performing stocks each year had a pronounced effect on the overall market return. The compound return on all US stocks from 1926-2008 was 9.4%. If you eliminate the top 10% of performers each year, the compound return drops to only 6%, and if you eliminate the top 25% of performers, your compound return goes down even further to an astonishing -1%.

Simply put, if you excluded the very best performing quartile of stocks each year, you would have lost money investing in equities over a period of more than eighty years! The implications of this finding are daunting for stock pickers, given that when you buy a stock—or continue to hold one you have already bought—there is a 75% chance each year that it will fall outside the universe of winners that accounts for all of the market’s return.

William Bernstein commented on Jim’s finding as follows.

“This may get you thinking: If a small list of securities accounts for the market’s long-term returns, why not avoid all the headaches and losses you’ve suffered recently by carefully choosing these super stocks? Simple: Because a portfolio of ‘carefully chosen’ equities could easily wind up with none of the best-performing stocks in the market—and thus produce flat or negative returns over many years . . . Remember that the point of investing isn’t to aim for the highest possible returns. It’s to make sure you don’t die poor. Yet trying to optimize your performance by seeking out the needles in the haystack is a sure way of becoming, well, poor.”³

Q: Aren’t passive strategies like ETFs best suited for do-it-yourself investors who don’t value expert advice?

A: The premise of passive investing is that no value can be added from stock picking or market timing. Passive investing doesn’t imply there is no value in expert advice. Most fee-based advisors focus on wealth management rather than stock picking or market timing. Wealth management is based on holistic advice revolving around things you can control, such as saving, spending, taxes, costs, risk management, risk budgeting, asset allocation, communication, and reinforcing discipline. The right passive investments fit very nicely in this framework, and the complexity of passive alternatives supports the need for professional advice.

Q: You make some good points, but I don’t fully grasp all of this and I’m not completely convinced. What is the bottom line?

A: Let’s say markets are in fact inefficient, that there are managers who do persist in outperforming, and that you don’t like the idea of indexing. The bottom line is that none of these points would really matter. Here’s why:

• If the market is inefficient, then the aggregate of all investors will still underperform a market rate of return by the amount of frictional costs (fees, trading costs, taxes, etc.). This is due to the adding-up constraint at work in equilibrium accounting.

• If there are superior managers, I have no way to identify them in advance and neither does anyone else.

• If you don’t like the idea of indexing, then let’s invest in passive funds that can address many of the flaws in merely tracking a conventional index.

The only question that matters is whether you, or someone you know, can reliably identify enough superior-performing investments, in advance and after costs, to outperform a market rate of return. The answer is probably NO! So let’s at least put the odds of success in your favor.

Investing is risky enough to begin with. Why add another layer of risk with no expected return?

For the first article in this series go to Active vs Passive: Man vs Market

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The comments of Sam Adams and Weston Wellington are gratefully acknowledged.

¹ Standard & Poors, Index versus Active Funds Scorecard for Canadian Funds, June 4, 2009, 5.

² William F. Sharpe, “The Arithmetic of Active Management,” Financial Analysts Journal 47, no. 1 (January/February 1991): 7-9.

³ William J. Bernstein, “Are Stocks a Loser’s Bet?” CNNMoney.com, May 9, 2009, http://money.cnn.com/2009/05/09/magazines/moneymag/stock-strategies.moneymag/index.htm (accessed July 15, 2009).

Bradley G. Steiman is Director, Head of Canadian Financial Advisor Services  and Vice President for Dimensional Fund Advisors Canada ULC. This is the first of a three part interview series on the age old debate of Active vs Passive investment strategies.

Q: If an active manager can gather information and gain insight or knowledge through research into a company, shouldn’t he be able to beat the market?

A: Not necessarily. You and I could have a different set of information or a different interpretation of the same information, while other investors may have no information at all. However, neither of us is at an advantage or disadvantage because the aggregate of all information is already contained in prices. So, rather than gaining insight or knowledge, the manager is simply gathering information the market has already digested. One way to look at it is that in order to beat the market with skill rather than luck, you don’t just need to have more information and insight than the “average” investor. You theoretically need to have more information and insight than all investors combined. An active manager has only two arrows in his quiver—market timing and stock picking. All nuanced forms of active management ultimately boil down to some combination of these two elements. Both fundamentally rely on predicting the future, and the information presented in support of the forecast is typically quite compelling. Statements are made such as “we think the price of oil will rise because . . .” or “we think the economy will recover next year because. . . .” No matter how convincing the case may seem, however, you should always ask why this information that is readily available to the market would not already be reflected in prices.

Q: It seems reasonable to conclude that the US market is fairly efficient since most of the studies in this area have relied on US data. But do these arguments break down in less developed markets where local knowledge can still play a role?

A: It is true that many studies of market efficiency focus on the US, but this is due to data availability and reliability. This does not mean that other markets cannot be as efficient, but only that tests have not been conducted to the same extent in other countries. Furthermore, the US studies originated in the ’60s, and it seems reasonable to assume that most markets are now at least as efficient as the US market was over forty years ago. It is also plausible that investors in emerging markets face greater uncertainty with regard to political developments, currency trends, and so forth. But this says nothing about market efficiency. Security prices reflect local knowledge in both developed markets and less developed markets, but the evidence from mutual fund investing in emerging markets suggests that professional managers find it just as difficult, if not more so, to outperform passive strategies in emerging markets as they do in developed markets. The active manager’s real challenge is found in the principle of “equilibrium accounting.” Since passive investors hold the market, the aggregate of all active investors must hold the market, too. Consequently, active investors cannot earn more, in aggregate, than passive investors, and both groups will earn the market return minus fees and expenses. Since active management typically generates much higher fees and expenses, the aggregate returns are lower than those of passive investors. Some active managers may outperform the market, but their success comes at the expense of other active investors. Consequently, active management is a zero sum game before expenses—and a negative sum game after costs. This adding-up constraint exists in markets around the world, whether developed or emerging.

Q: Less developed markets have fewer participants. Does the lack of competition reduce market efficiency?

A: The question of how many active investors are required for a market to be efficient is an interesting one, and the comments on this topic from Richard Posner are worth contemplating.

“No one knows just how much stock picking is necessary in order to assure an efficient market, but comparisons with other markets suggest that the required amount is small. In markets for consumer durables, homes and other products, unlike the securities markets, the amount of search is highly variable across consumers, many of whom do little or none; trading may not be frequent; products may not be homogenous (no two homes are as alike as all the shares of the same common stock); bids and offers may not be centrally pooled so as to maximize the information available to buyers and sellers. Yet these markets are reasonably efficient, albeit less so than the securities markets.”

John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law II,” American Bar Foundation Research Journal 1 (1977).

To visualize this in a simple example, let’s imagine that someone is having a garage sale after cleaning out his parents’ attic. Among the seemingly useless artifacts just happens to be an original Van Gogh painting. The seller doesn’t know it’s a masterpiece, so he sets the price at an ambitious $10. If the buyer also doesn’t know it is authentic, he will pay $10 and potentially profit from good luck if he eventually realizes what he has acquired. On the other hand, if the buyer is an art connoisseur, he will pay $10 but profit immediately from what you could call skill due to his information asymmetry over the seller (i.e., he knows it is worth a lot more but the seller does not). However, what if one more art connoisseur is attending the garage sale? At that point the price is unlikely to remain at $10 if both buyers know it is an original Van Gogh, and the eventual purchase price will rise to something much closer to fair market value. It no longer matters that the seller doesn’t have all the information because as long as both buyers have the information, neither can use this information asymmetry to gain advantage over the seller. In this story, it took only two informed market participants to strike fair value, and not all market participants needed to have all the information for prices to become much more “efficient.” As Ken French has described, markets theoretically contain an “efficient amount of inefficiency” where the marginal benefit of active investing equals the marginal cost. In reality, the incentives mentioned earlier have attracted far more active investors than necessary for market equilibrium, so the aggregate cost seems to far outweigh the benefit. This idea is relevant to less-developed markets because these markets typically impose much higher frictional costs on investors. If the costs are higher, the “efficient amount of inefficiency” would also theoretically be higher, which would limit opportunities to systematically profit from active investing, net of these costs.

Q: How could the market remain efficient if everyone were a passive investor and no one was gathering information and trading on it?

A: The Grossman-Stiglitz paradox (Sanford Grossman and Nobel laureate Joseph Stiglitz, 1980) says that if a market is informationally efficient—that is, all information is already reflected in prices—then no single agent will have sufficient incentive to acquire the information on which prices are based. If we assume markets are not perfectly efficient, the question is how much inefficiency exists and how many market participants can successfully exploit it? In equilibrium, the marginal cost of researching mispriced securities would just equal the marginal profits associated with exploiting these pricing errors. But studies of active manager performance offer compelling evidence that we have far more resources devoted to analyzing opportunities than we need to keep markets efficient. How do we know this? Because managers in aggregate not only fail to recoup their research costs, they underperform by an even greater degree. The argument that too much passive investing would hinder price discovery has been raised repeatedly since the advent of the index fund in the 1970s. The irony is that one of the most frequent criticisms of a passive approach is to ask what would happen if everybody adopted it. Unfortunately, after nearly four decades since passive investment vehicles became available, we are still nowhere near a point where the preponderance of passive investors would affect price discovery. If we were fortunate enough to reach that point, and the market became less efficient as a result (it is not clear that it would), then active investors would reenter the market until the marginal benefit of active investing would not exceed the marginal cost. Richard Posner summed it up perfectly in 1977:

“If the disinvestment of resources now employed in futile attempts to beat the market ever proceeds to the point where the market can be beaten, that will be a signal for some investors to resume the active strategy.” “The optimum amount of market information is surely not infinite. At some point, the cost of additional information must outweigh the social gain. The evidence is that this point has been reached—in fact, passed.”

John H. Langbein and Richard A. Posner, “Market Funds and Trust Investment Law II,” American Bar Foundation Research Journal 1 (1977).

Q: If market efficiency implies prices are right, then doesn’t the fact that some stocks being 80%-90% below the level they were priced at a year ago challenge this fundamental premise? Which was the right price—today’s price or the one a year ago?

A: The short answer is that both prices were probably wrong, but both prices were also your best estimate of the right price! Market efficiency is not based on the premise of prices being “right” but on them being your best estimate of fair value. All prices may be wrong; but for markets to be inefficient, the errors would have to be systematic and identifiable. You, or your active manager, must also be able to identify these errors when other investors cannot, since your profit must be at someone else’s expense. Not every investor can win in a zero sum game! However, the mistakes are mostly random rather than systematic (some prices are too high and others are too low), and there is little persistence in the ability of active investors to exploit these pricing errors. Besides, the fact that prices can change dramatically is not a sign of market inefficiency. This is a reflection of how quickly prices can adjust to a new equilibrium based on the latest information. Furthermore, there is a dilemma facing active investors who believe that pricing errors are identifiable for profit at the expense of someone else. If the price is wrong today, how can one be sure the market will eventually arrive at the “correct” price in the future? Is the market inefficient today but efficient tomorrow, or is there a chance an investor will go to his grave as the only one who knows the right price?

Q: How can you say active managers won’t beat the market when I just read about XYZ Investment Company, which has outperformed for the last twenty years?

A: We can’t say there aren’t any active managers who have beaten the market in the past, and we can’t say there won’t be any active managers who will beat the market in the future. What we can say is there haven’t been, and likely won’t be, any more than you would expect by chance. The problem isn’t that there are managers who have beaten the market; it is that there are too few of them! Let’s assume there were 5,000 funds available for investment over this twenty-year period. The 95th percentile of the distribution of outcomes from this sample (i.e., the top 5%) would represent 250 managers with a twenty-year history of generating returns that are significantly above market. At that point, you may be thinking, “what more proof do I need than 250 managers over twenty years?!” What you need to consider, however, is that if you had 5,000 proverbial monkeys managing portfolios by throwing darts at stock pages, you might observe even more than 250 who would have generated returns that put them in the top 5% of manager returns net of fees. Why? Because as David Booth likes to say, the monkeys work for bananas! The monkeys would have clearly been dismissed as just being lucky, even over a twenty-year period. However, many investors are unwilling to dismiss the superior returns of an even smaller number of managers as being largely due to luck over the same time frame. I can’t say for sure that it is all luck, but what I can say is that the outcomes don’t look much different than if there were no skill at all. For many investors, hope springs eternal, but we are going to invest your money assuming it was mostly luck, because that assumption at least puts the odds of success in your favor. As a result, your example of XYZ should only be viewed as anecdotal evidence, and we do not want to implement an investment strategy on that basis. Let’s say you had a very serious illness for which a doctor was prescribing treatment. Would you be comfortable following a treatment plan if you asked the doctor for the basis of his diagnosis and he responded, “it worked for my last patient”? Probably not, as you likely want to hear about years of scientific tests examining the whole distribution of possible outcomes, both in and out of sample, as outlined in top-tier medical journals subject to intense scrutiny, refereeing, and peer review. The basis for my prescription of a passive investment strategy rests on this type of scientific inquiry in the field of finance rather than on anecdotal evidence. The tests have been done and they are well documented. Unfortunately for many investors, the subjects of these tests are not lab rats, but real people with real money!

Brad’s future columns will address questions on the practical implementation of active and passive strategies.

The comments of Sam Adams and Weston Wellington are gratefully acknowledged.

For the next article in this series go to Active vs Passive: Real World Issues

Let’s begin with some factual data and the word of some recognized authoritative experts.

First, Standard & Poors: “Over the five year market cycle from 2004 to 2008, S&P 500 outperformed 71.9% of actively managed large cap funds, S&P MidCap 400 outperformed 79.1% of mid cap funds and S&P SmallCap 600 outperformed 85.5% of small cap funds. These results are similar to that of the previous five year cycle from 1999 to 2003.”[1]

“After taking risk into account, do more managers than you’d see by chance outperform with persistence? Virtually every economist who studied this question answers with a resounding ‘no.’ Mike Jensen in the sixties and Mark Carhart in the nineties both conducted exhaustive studies of professional investors. They each conclude that in general a manager’s fee, and not his skill, plays the biggest role in performance.”

Eugene Fama, Jr.

“There are two kinds of investors, be they large or small: those who don’t know where the market is headed, and those who don’t know that they don’t know. Then again, there is a third type of investor – the investment professional, who indeed knows that he or she doesn’t know, but whose livelihood depends upon appearing to know.”

William Bernstein, The Intelligent Asset Allocator

“It turns out for all practical purposes there is no such thing as stock picking skill. It’s human nature to find patterns where there are none and to find skill where luck is a more likely explanation [particularly if you’re the lucky mutual fund manager]. Mutual fund manager performance does not persist and the return of stock picking is zero. We are looking at the proverbial bunch of chimpanzees throwing darts at the stock page. Their ‘success’ or ‘failure’ is a purely random affair.”

William Bernstein, The Intelligent Asset Allocator

“When some individual made a fortune in the stock market, we have a tendency to assume that was because he knew something, and of course the individual is happy to reinforce that belief – yes, I was a genius or I was very clever or I always said Microsoft was going to make me rich. But what you don’t see are the thousands, hundreds of thousands, perhaps millions of people who are going, ‘I always said that ABC Company was going to make me rich, and ABC Company went bust.’”

Professor Zvi Bodie, Boston University

“…skepticism about past returns is crucial. The truth is, as much as you may wish you could know which funds will be hot, you can’t – and neither can the legions of advisers and publications that claim they can. That’s why building a portfolio around index funds isn’t really settling for average.  It’s just refusing to believe in magic.”

Bethany McLean, Fortune

“Economic evidence shows that, from a typical investment perspective, the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in the market prices of securities. As a result, fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to “beat the market” in these publicly traded securities ordinarily promises little or no payoff, or even a negative payoff after taking account of research and transaction costs. Empirical research supporting the theory of efficient markets reveals that in such markets skilled professionals have rarely been able to identify under-priced securities (that is, to outguess the market with respect to future return) with any regularity. In fact, evidence shows that there is little correlation between fund managers’ earlier successes and their ability to produce above-market returns in subsequent periods.”

Restatement of Trusts [Third] §227 General Note on Comments e through h:
Introduction to Portfolio Theory and Other Investment Concepts

From current data, from academics, from journalists and from legal scholars, it is concluded that money managers cannot, with consistency, outperform the market. In another article we will discuss what one should do about this stubborn fact.