New Research: Why Active Portfolios Don t Work

Transcription

1 New Research: Why Active Portfolios Don t Work Drew Voros, Moderator Editor-in-Chief ETF.com Richard A. Ferri, CFA, Panelist Founder Portfolio Solutions

2 Drew Voros Moderator Editor-in-Chief ETF.com Richard A. Ferri, CFA Founder Portfolio Solutions

3 A Case for Index Fund Portfolios Richard A. Ferri, CFA Founder Portfolio Solutions

4 Active Funds Losing Markets Share Source: Vanguard: Costs matter: Are fund investors voting with their feet? May 2013

5 While Low-Cost Index Funds Gain Source: Vanguard: Costs matter: Are fund investors voting with their feet? May 2013

6 Scope of the Research 1976: First S&P 500 indexed mutual fund 1992: First US total stock market index fund 1995: First US total bond market fund 1996: First total international equity fund The probability of index fund outperformance relative to active funds is widely documented. Outperformance exists in all asset classes. Surprisingly little research compares the performance of portfolios of index funds with portfolios of actively managed funds.

7 Database CRSP Survivor-Bias-Free US Mutual Fund Database through December Covers all active funds and index funds that were available for purchase over the period. Provides a real-world investor experience when building mutual fund portfolios. 32 different index portfolio scenarios; 5,000 randomly selected active fund portfolio returns compared in each scenario.

8 Scenario #1: Three Funds 40% US total stock market, 20% total int l stocks, 40% US total bond market. Vanguard index funds (Investor shares) 40% Total Stock Market Index (VTSMX) 20% Total International Stock Index (VGTSX) 40% Total Bond Market Index (VBMFX) 5,000 portfolios from a cleaned database No B shares, C shares, annuities, institutional Did not include loads, redemption fees or taxes

9 Results of Scenario #1

10 Expected Results vs. Results Individual Funds & Portfolios ( ) Indexing Win Rate VTSMX (US equity: 40%) 77.1% VGTSX (Int l equity: 20%) 62.5% VBMFX (US bonds: 40%) 91.5% Weighted 40%/20%/40% 79.9% Scenario 1 Results 82.9%

11 2 out of 3 Wins Can be a Loss Individual Fund 1.34% Median Performance Loss 0.23% Median Performance Win VTSMX (US equity: 40%) -2.01% 0.97% VGTSX (Int l equity: 20%) -1.75% 1.34% VBMFX (US bonds: 40%) -0.99% 0.23% -0.44% -2.01% US Equity International Bond Portfolio

12 Scenario #2: Time Effect Vanguard index funds from Scenario #1 40% (VTSMX); 20% (VGTSX); 40% (VBMFX) Three independent 5-year periods ; ; One 15-year period ,000 active fund portfolios per trail Does time make a difference?

13 Time is on the Side of Indexing 100% 90% 85.8% 83.4% 80% 76.5% average 77.5% 70% 66.1% 60% 50% 5-year year year year

14 Scenario #3: Multi-Asset Class 3 fund equal weight (33% each) US total stock, total int l stock, US total bond 5 fund equal weight (20% each) 3 fund plus REITs and short-term Treasury 10 fund equal weight (10% each) Large cap US equity, mid cap US, small cap US, REITs, developed market equity, emerging market equity, US total bond, short-term Treasury bonds, inflation-protected securities, tax-exempt bonds. 10-year period: ,000 active fund portfolios per trail

15 More Index Funds are Better Portfolio Index Portfolio Win Rate Median Active Portfolio Loss Median Active Portfolio Win Three-fund portfolio 87.7% -1.47% 0.54% Five-fund portfolio 87.8% -1.10% 0.44% Ten-fund portfolio 90.0% -0.93% 0.29%

16 Scenario #4: Multiple Active Funds Investors often select more than one active fund in each asset class. What effect does this have on probabilities? Three-asset-class portfolio from Scenario #1 3 trials; 16 years ( ) 1 active fund per asset class selected 2 active funds per asset class selected 3 active funds per asset class selected 5,000 active fund portfolios per trial

17 Bet the Farm on One Active Fund 87.1% 91.0% 82.9% One Active Fund Per Asset Class Two Active Funds Per Asset Class Three Active Funds Per Asset Class

18 Scenario #5: Risk-Adjusted Do active portfolios perform better on a riskadjusted basis using Sharpe ratios? Thee-fund portfolios used in Scenario #1 Time Period Number of Years Index Portfolio Win % Risk-Adjusted Index Win % % 64.9% % 91.0% % 77.7% % 74.6% % 85.3% % 85.5%

19 Scenario #6: Low-Fee Funds Do active portfolios that select funds with below-average fees perform better? Thee-fund portfolios used in Scenario #1 Lower-cost Admiral shares for index funds Active funds selected had expense ratios below average for their categories. 16 years: 1997 to 2012

20 All Funds vs. Low Fee All active funds Low-fee active funds All active funds vs. Investor shares Index portfolios win: 82.9% Winning active median: 0.52% Losing active median: -1.25% Low-fee active funds vs. Admiral shares Index portfolios win: 74.7% Winning active median: 0.54% 0% 10% 20% 30% 40% 50% 60% 70% 80% 90% 100%

21 Highlights Index fund portfolios had better performance nominally and risk-adjusted in all scenarios. Winning active portfolio alphas are meager relative to losing portfolios shortfalls. Index fund portfolio win rate increased with time, diversification, and when multiple active funds are used in asset classes. Active fund portfolios benefit from low fees, but still far below index portfolios.

22 Where to Get the Study? Download the PDF from: For inquires: For source code:

23 Disclosure This document and the performance data is provided for information purposes only and should not be used or construed as an indicator of future performance, an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Investments are subject to market risk, including the possible loss of the money you invest. Neither Portfolio Solutions, LLC nor Betterment can guarantee the suitability or potential value of any particular investment. The performance data used is actual mutual fund data. The results portrayed reflect the reinvestment of dividends and other earnings, and reflect the deduction of mutual fund expenses. Mutual fund performance can be found at CRSP Survivor-Bias-Free US Mutual Fund Database. Past performance and portfolio allocations of benchmark indexes, mutual funds, hypothetical portfolios, or actual portfolios do not guarantee similar future performance of portfolio allocations. No assurances or guarantees can be given or implied concerning future investment results for Portfolio Solutions, LLC, Betterment or any investment index. Future returns may differ significantly from the past due to materially different economic and market conditions and other factors. Investments within portfolios, and therefore, portfolios, involve risk and the possibility of loss, including a permanent loss of principal. Therefore, no current or prospective client should assume that future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended or undertaken by Portfolio Solutions, LLC or Betterment) made reference to directly or indirectly by Portfolio Solutions, LLC or Betterment in its web site, or indirectly via a link to an unaffiliated third party web site, will be profitable or equal the corresponding indicated performance level(s). Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client or prospective client s investment portfolio nor that the future performance of any specific investment orinvestment strategy will be profitable orequal any historical performance level(s). Exposure to an asset class represented by an index is available through investable instruments based on that index. Neither Portfolio Solutions, LLC nor Betterment sponsors, endorses, sells, promotes or manages any investment fund or other investment vehicle that is offered by third parties and that seeks to provide an investment return based on the performance of any index. Neither Portfolio Solutions, LLC nor Betterment makes assurances that investment products based on the index will accurately track index performance or provide positive investment returns. 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Performance data shown represents past performance, which is not a guarantee of future results. Inherent in any investment is the potential for loss as well as the potential for gain. Investment returns and principal value will fluctuate, so investors shares, when sold, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data cited. Investing involves risk, including possible loss of principal.

24 Thank you. Questions?

25 Drew Voros Moderator Editor-in-Chief ETF.com Richard A. Ferri, CFA Founder Portfolio Solutions