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Today's Commentary: 06.16.05
The Man Behind the Curtain
by Larry Swedroe
In the film The Wizard of Oz, in order to prove that they are worthy of his help, the great and powerful Wizard gives Dorothy, the Tin Man, the Straw Man, and the Cowardly Lion the daunting task of capturing the broomstick of the Wicked Witch of the West. He, of course, never expected them to succeed. Upon successfully completing their mission they return to confront the Wizard and demand his assistance. Trying to delay the inevitable (that he cannot live up to his end of the bargain), the Wizard asks them to return at a later date.
Greatly frustrated Dorothy begins to argue with the Wizard. Unfortunately for the Wizard, Dorothy's dog, Toto, pulls open a curtain and exposes the Wizard as a fraud. In a feeble attempt at gaining control of the situation the Wizard shouts: "Pay no attention to the man behind the curtain. I am Oz, the great and powerful wizard." Unfortunately, once exposed for his true self there was no recovering. The Wizard was able to stay in power only as long as he could maintain the illusion of having magical powers.
Similarly, the Wall Street Establishment needs investors to believe that active management is the winning strategy because it is the winning strategy for investment firms.
Active investors generate the largest trading profits, the largest commissions, and the largest fees. Thus they need to "keep the Wizard behind the curtain." Unfortunately (for them), the academic community has been "pulling the curtain" on the purveyors of active management. Decades of published research have concluded that while active management is the winning strategy for the providers, it is a loser's game for investors‹while those that adopt active strategies do have the potential to outperform the market, over the long term the vast majority underperform passive benchmarks.
The following is just one example of the findings of academia on active management. Mark Carhart studied mutual-fund performance, analyzing 1,892 funds for the period 1961-93. The following is a summary of his findings; findings that "exposed the man behind the curtain."
The average actively managed fund has underperformed its appropriate passive benchmark on a pretax basis by about 1.8 percent per annum. On an after-tax basis, the performance is even worse.
There is no persistence in performance beyond that which would be randomly expected‹the past performance of an actively managed fund is a very poor predictor of its future performance.
Expenses reduce returns on a one-for-one basis and thus they explain much of the persistent long-term underperformance of mutual funds.
Turnover reduces pretax returns by almost 1 percent of the value of the trade.
Carhart's conclusion: "While the popular press will no doubt continue to glamorize the best-performing mutual-fund managers, the mundane explanations of strategy (asset-class allocation, not individual stock selection) and investment costs account for almost all of the important predictability in mutual fund returns."
It was academic studies such as Carhart's that led the American Law Institute in May 1992 to rewrite the Prudent Investor Rule. Here is some of what the Institute had to say in doing so:
Economic evidence shows that the major capital markets of this country are highly efficient, in the sense that available information is rapidly digested and reflected in market prices.
Fiduciaries and other investors are confronted with potent evidence that the application of expertise, investigation, and diligence in efforts to "beat the market" 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 with any regularity.
Evidence shows that there is little correlation between fund managers' earlier successes and their ability to produce above-market returns in subsequent periods.
Both Carhart's study and the American Law Institute's restatement of the Prudent Investor Rule were published over ten years ago. In the face of the evidence, in order to keep money pouring into such a failed strategy Wall Street needs to "keep pulling back the curtain." The following is a very common example of how both Wall Street firms and financial advisors alike try to keep the illusion alive.
An investor reads about the benefits of indexing and passive investing in general. She asks her broker (or advisor) what he thinks of indexing as a strategy. The broker typically responds with something like: "Indexing is a perfectly good strategy‹if you are willing to accept average returns. Our clients want to do better than that. We help them achieve that objective. You don't want to be average, do you?" The broker then provides a list of the funds that the firm is currently recommending. He also shows their performance history. And sure enough, the firm's list has indeed outperformed similar index funds, making a seemingly compelling case.
Unfortunately, this is typically a deception. It is very easy to identify which funds have outperformed the market in the past. Anyone with access to a database can perform that "magic." The question, however, is not whether you can identify which funds have outperformed the market. Instead, the question is: Can you identify them ahead of time?
Thus if you are ever presented with such a list ask the broker to provide you with the list of funds his firm was recommending five years ago. And then you should compare the performance of those funds to proper benchmarks. In addition, you might ask yourself the following question: If the names on both lists are not the same, why aren't they? If the older list had predictive ability would not the fund names be the same on both lists? If the names are not the same then something likely went wrong. If something went wrong last time, can you have confidence that they won't go wrong with your money? If history is any guide the odds greatly favor that the old list will have underperformed appropriate benchmarks.
Asking for prior lists of recommended funds exposes the man behind the curtain. It also exposes the illusion of active management as the strategy most likely to allow you to achieve your financial goals. The academic community continues to pull back the curtain, publishing papers on the failure of active management to deliver on its promise. And the poor and inconsistent performance of actively managed funds has led to not only a dramatic increase in the use of passive investment vehicles, but also to the pension plans of such firms such as Intel, Exxon, Phillip Morris, and Exxon Mobil to fire all of their active managers‹and surely it is safe to say that none of these firms ever hired an active manager without a track record of successfully beating their benchmarks. And it is surely even safer to say that they did not fire them because they beat their benchmarks. What these firms learned was that the Wizard had no powers.
Please Note:Opinions or commentary expressed in the above article are those of the author and not necessarily shared by the BlueMoney Report.
At Arm's Length: 06.12.05
China's problems are ones we once had in a post World War II era when production was outpacing the workforce. The surprise increases in the Chinese infrastructure beginning with a wealth seeking influx of provincial workers are creating the same problem for their industries this country once enjoyed.
Carl Sagan, the late scientist/author/guy-who-made-the-universe-axcessible had a voice that carried directly to the written page. Read Contact to see what I mean. The text sounds just like him long before the popularity of audio books transformed reading. Alan Greenspan has just such a voice. Each time I see a quote by the Federal Reserve Chairman, and I'm sure I'm not alone here, I see the him furthering to absolve himself of any credit, even if the credit due won't be as glorious as he perhaps once had hoped, in a slow calculated monotone.
You have to admire this man's fortitude and incredibly sharp poker face. He continues showing up before the Congressional committees filled with representatives of the people and they, in this instance sound a great deal like we do. It's refreshing and disquieting. Much of what the nation's top banker does is beyond the grasp of mere mortals and it seems that the questions put to the Fed Chairman were better suited to an audience at Nashville's Fan Fair.
The chairman has a limited number of visits left to Capitol HIll in his tenure before he retires in January 2006. The awe he invokes among these elected officials leaves much to be desired. The belief that firm footing is available to all could not be farther from the truth and this is where Congress has failed.
There is little likelihood that seniors, a group to which he has been a member of for two decades, understand that what he orchestrated the last several years in terms of economic direction led to forgettable years of terrible returns on their safe as cash investments. These fixed income retirees are in a protectionary stage in their investment lives and Alan slowed what little return they were getting to a trickle. This was punishment for exuberance among a few. Greenspan's rate increases have brought some of this conservative investment market back but the cost among seniors in terms of lost returns is staggering.
There is little likelihood that the average home buyer understands or cares that those boom markets of desirable housing in a growing number of neighborhoods are overpriced are because of his efforts at reining in the economy. Those neighborhoods are growing exponentially and folks have been happy to avoid the question of why instead concentrating on "how high will it go".
Each of those rapidly expanding markets are the result of a sort of overflow effect that sends people looking for less overpriced housing nearby those coveted bubble neighborhoods, the one's with the outsized real estate. Alan has done little more than "tsk, tsk" these buyers in these areas. This is a sort of symbiotic wealth suggesting that the house you buy will be located in the next hot market and in turn will mean equity riches otherwise unavailable if not unimaginable. Is this reminiscent of "the next best thing"?
That expansion has affected folks who might not normally have been able to afford such a luxury under the current economic model. And that, in many cases is forcing folks into putting everything into the purchase of a home believing that somewhere down the road, they will have built a nest egg in their house. This suggests a less than firm grip on the economic reality of the situation. It is also reflective of Greenspan's efforts to cover his tracks by leaving many Americans with little in savings, an unhealthy amount of debt, and homes they could not otherwise afford without a large amount of risk.
There is little likelihood that the members of the Joint Economic Committee of Congress asked the questions or sought the answers that you and I would have asked. You would have asked Mr. G. to respond in plain, understandable, even simple language. We shouldn't need to ask him to drop the economic doublespeak because the job he has is not supposed to be political in nature. So why speak politico. Perhaps the truth needs to be hidden behind quotable catch phrases.
There is little likelihood that the general constituency paid any attention to the remarks traded back and forth between Greenspan and the committee about "pay-go". For those of us outside the Beltway, pay-go is a tongue-in-cheek reminder that Washington should fund their programs with cuts to other programs rather than increased borrowing. Problem is these elected officials are not inclined to rein in spending anytime soon on projects that they view meritorious. What is being cut are programs considered middle class entitlements.
Because the White House and Congress have not yet realized that their responsibility to this country involves fiscal discipline, the middle class will pay the price this lack of economic direction.
The Fed Chairman has given his blessing to deficit spending with a wink and a nod and his suggestion that these same lawmakers stop running the country on a tab that can't be paid is what makes the whole pay-go suggestion laughable.
Greenspan is responsible for this behavior of deficit spending quietly condoning it since he began using phrases such as "measured". He continued to do so on Thursday of last week as he painted a picture of swirling abstractness.
In Alan's view, the economy is growing, inflation is in check, oil, while not falling below fifty dollars per barrel appears to be stabilizing, interest rates have been increased eight times and still nothing seems to suggest that the screw should not be tightened just a little further.
There is also little likelihood that the "profoundly important phenomenon" that is "really quite different that one would expect" should have the average investor more than a little worried. It means, according to those traders who set the odds on such occurrences, that the Fed will continue to raise rates because the long term bond yields are too low. Those lower than expected rates have been baffling in of themselves, as Greenspan has duly noted on more than one occasion.
Many feel as though that flat yield curve could be the result of a variety of circumstances converging all at once. Is Greenspan considering the case for international inflation when he seems puzzled at the long bonds paltry yield? Much of the rest of the world is loathe to increase prices the way the United States has been forced to do.
While this could point to the "imbalances" in the economy that might undermine the recovery and make the "soft patch" not so easy a patch to fall on, it doesn't or shouldn't come as a surprise. But the Chairman continues to be exactly that.
Labor seems to be balanced even if it is not as healthy as it should be. Most of us have forgotten the disparaged worker who no longer is looking for a replacement for their lost job. They are now fully employed in a number of part-time positions that pay less than what they were previously paid.
The housing market, resembling stock market and the loose margin rates of the nineties, also seems balanced when you consider the whole picture and not just the hot spot ATM mortgage corridors.
There is also little likelihood that investors will view his assessment of the economy as a positive for the stock market. "The soft readings in the spring were not presaging a more serious slowdown in the pace of activity" were meant to assuage our fears even as the Fed sees "unprecedented" and "froth".
In the end, we are people who tend to ignore the obvious in light of the profits available. The loss of $5 trillion in net worth only five years ago seems like a distant time and place. Runaway equity has replaced runaway stocks and the similarities are different in three respects.
We had a surplus then and now we don't. While using deficit spending to increase growth is a mostly textbook scenario, there is little history on what to do once the theory has proved correct - if it ever does. Now we are faced with the bill much the way a shopper might be faced with a choice of finding a card whose credit balance isn't maxed as the clerk stares at us warily.
We had savings or at least that is how we viewed our wealth in the stock market. Folks were planning retirements at ages only dreamed about by our forefathers a generation removed. But those savings have all but disappeared replaced by a burgeoning consumer debt that is funded by equity borrowing. That negative turn-around should worry everyone.
And even though inflation is within the Fed's window of comfort, it is not taking into account the relative inflation of everyday purchases such as food and fuel and the effects of inflation should our debt no longer be as desirable. That debt by the way is becoming increasingly hard to peddle. The dollar has not yet fallen to levels that create problems, leaving the chicken littles of the world cautious but quiet. Instead, it has climbed somewhat against the Euro giving us a false sense of worth.
The circular effect of money has become too difficult to comprehend. A sudden downturn will raise what has become a low level of concern. When taxes are cut, we borrow the money from the world's saving. When mortgages are refinanced, we tap the same source. When we demand cheaper items in greater quantities, we borrow from abroad to finance those needs. That is not resourcefulness. It's foolhardy. There is no reasonable in our economic footing.
Mr. Greenspan is hoping, as he doles out his monotoned irony to the unwitting representatives, that medicine will be easy to swallow. He wishes that the Bush administration would change their ways before he must give us the dose we have coming. Unfortunately, it will come without sugar.
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