Why Active Isn’t Attractive

Recently, I decided to re-read one of my favorite books, Moneyball by Michael Lewis.  Anyone who knows me personally can attest to the fact that the only thing that can hold my attention longer than finance is sports.  If you like sports, statistics, or have seen the movie starring Brad Pitt, I would highly recommend the book.  I wanted to take a minute to share one of my favorite exchanges, which appears in both the movie, and in the book.  I believe it provides a great analogy for why a low cost, rules-based approach to investing is preferred over more costly and complex strategies.

For context, the story features Billy Beane, the general manager of the Oakland Athletics.  Billy had been a physical specimen, and top baseball prospect coming out of high school.  After an unsuccessful professional career, he developed a deep-rooted belief that the old guard of baseball had a flawed way of scouting for baseball talent.  Most of the conventional “baseball guys” felt you could interpret how good someone was by watching them.  After reading some work that was being done by Bill James, an economics major that had written several books on baseball statistics, Billy decided he wanted to use mathematical analysis to build a roster composed of the optimal lineup of players.  He hired Paul DePodesta, another economist, who studied at Harvard.  As Billy implemented his new analytics-based system, he consistently ran into conflict with his existing, old-school scouting department. 

This exchange was a classic:

One by one Billy takes the names of the players the old scouts have fallen in love with and picks apart their flaws.  The first time he does this and old scout protests. 

“The guy’s an athlete, Billy,” the old scout says.  “There’s a lot of upside there.”

“He can’t hit,” says Billy.

“He’s not that bad a hitter,” says the old scout. 

“Yeah, what happens when he doesn’t know a fastball is coming?” says Billy.

“He’s a tools guy,” says the old scout, defensively.  The old scouts aren’t built to argue; they are built to agree.  They are part of a tightly woven class of former baseball players.  The scout looks left and right for support.  It doesn’t arrive.

“But can he hit?” asks Billy.

“He can hit,” says the old scout, unconvincingly.

Paul reads the player’s college batting statistics.  They contain a conspicuous lack of extra base hits and walks.

“My only question is,” says Billy, “if he’s that good a hitter why doesn’t he hit better?”

            Excellent point, Billy.  I believe this is truly a great analogy for why actively managed investments are simply not as attractive as passively managed ones.  According to a study done by SPIVA, the overwhelming majority of actively managed funds do not outperform their index.  Here are a few highlights:

·      Over the last 15 years, 91.62% of large cap funds lagged their index.  This means you had an 8.38% chance of picking a large cap fund that would beat the index.  If I told you my strategy would have an 8.38% chance of success, you walk out of my office.

·      Over the last 15 years, 98.17% of small cap growth funds lagged their index.  A whopping 1.83% chance that you would have picked a small cap growth fund that would have outperformed.  Not as unlikely as winning the lottery, but not that far off in my view.

·      Last year (2018), 75.85% of large cap core funds lagged their index.  The long-term numbers are obvious, but even in the short term, depending on the category, it is a crap shoot. 

The numbers are staggering.  Many of the actively managed fund shops have great marketing departments that will tell you great stories about why their funds are better.  The brochures look great.  The charts and graphs look like they have to have been put together by some of the smartest minds in the business.  Pie charts, bar charts, logarithmic “mountain” charts.  It looks great. 

But what does the data tell us?  The majority of them do not perform better than a low-cost, passively managed index.  The primary reason, in my opinion, is cost.  The average actively managed fund, with all of its highly compensated portfolio managers and analysts, costs more to run than a rules-based index.  This higher cost makes it very difficult to get, net of fees, a better return than the index. 

My conclusion is that there will never be a perfect investment strategy.  But I do believe one way you can create a good one is to create a set of rules, and control what you can.  One of the things that you can control is cost.  If you don’t know how much you are currently paying, all in, for your current advice and investments, drop us a line.  We can help you break down what you are paying, and what you are receiving for that.  There is nothing wrong with paying for professional advice, just make sure you know how much you are paying, and demand that the person providing the advice shows you some data to support what they are saying, and not just a bunch of marketing materials. 

 Armahn

Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.  

All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.

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The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.  All performance referenced is historical and is no guarantee of future results.  All indices are unmanaged and may not be invested into directly.