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Bogleheads momentum investing mutual funds

bogleheads momentum investing mutual funds

Find helpful customer reviews and review ratings for Dual Momentum Investing: An Innovative Strategy for Higher Returns with Lower Risk at You just want to get back to your target weights. So I think the key idea with rebalancing is that you've got some idea what's a good long run. The Bogleheads are a group of like-minded individual investors who follow the general investment and business beliefs of John C. Bogle. BETTING IN NON HANDICAP RACES2RUN

And you can think of dividend yield and a little bit from net buybacks. Those other components. Antti Ilmanen: Equity market returns. There's that nice intuition there but that doesn't mean that there's a tight correlation between economic GDP growth and equity returns. It turns out that there's almost zero correlation. So this is one of these things I highlighted in the book. That when you look at these numbers in the US over time, or you compare across countries, you find very modest relations between GDP growth and equity returns, even though we intuitively think that equities are sort of participating in the real economy.

Rick Ferri: And I read that, and I understand on a country by country basis you can't say GDP growth is this, therefore earnings per share growth is that. Therefore you take some multiple, and therefore this is what the price of the stock market should be. On a country by country basis, I understand that. But globally, looking at global GDP growth, isn't it more highly correlated? The global equity market to global GDP growth?

Antti Ilmanen: Contemporaneously there's almost nothing. But equity markets tend to predict next year's growth, so that way you do get something, and I think there it is true, and so certainly when equity markets are predicting next year recession then you have got low return. So yeah, I think that correlation becomes when you take, not looking at monthly returns, but you'll look at let's say annual returns, and in a forward-looking sense you do find some decent relation.

And so the intuition, I think, is right that equity returns are both somehow participation in global growth and they are vulnerable to any hiccups or something more serious to that global growth. And that's the big risk then in equity markets. This is a reasonable number to plan for? Antti Ilmanen: Good numbers.

Yeah, yeah I think so. It's a good point estimate. And so fair, sort of humility, or sense of uncertainty around them. But as point estimates that's what I would use. Rick Ferri: So that's one side of the equation, right. Now we've got to go to the fixed income side. Now we go to the fixed income side and we've got choices there between Treasury bonds and corporate bonds.

So let's start out with Treasury bonds, intermediate term Treasury bonds. There has been a premium paid for going out on the yield curve to the year mark, where you've picked up more than just the inflation rate. So now inflation plus something for Treasury bonds, for longer term, say year Treasuries.

Antti Ilmanen: Yeah so it's, well it's the realized return has been quite benign because again we got these windfall gains when bond yields were falling, and that is probably not fair to think in a forward looking sense what we should expect to get. Our cash has become in some sense stingier, and the intuition is that government bonds used to have an extra term premium partly because of the high inflation uncertainties of inflation risk premium, and that probably was bid down to near zero in the stable inflation decades after And then government bonds further turned into a safe haven asset when stock bond correlation turned negative.

So simple capital asset pricing model intuition says that if you have got a negative beta investment which basically really smooths equity returns, then that could even justify your negative premium. And I think that has helped government bonds become more expensive and in a forward-looking sense then, we really may have even justified a negative premium. And again, realized returns turned out to be very good because of the surprisingly benign picture on both falling inflation expectations and falling real yields.

So I would expect something half to one percent maybe, extra over cash. And so roughly that amount of real return on intermediate and 10 year bonds. Rick Ferri: That's very interesting, that it's come down. What about the Fed's balance sheet? In the Fed letting these bonds roll off, and so there's going to be more supply out there. I mean wouldn't that have an effect of pushing up the yield, the real yield? Antti Ilmanen: Yeah so besides the inflation risk premium, safe haven premium, we said supply-demand factors are the next thing and and that clearly was helpful during the time of quantitative easing.

And now it's going to give you some headwinds during quantitative tightening. That's why I chose to talk about 10 years, where I sort of hope these things don't play out anymore. The quantitative tightening story is hopefully there for the next couple of years and then that issue is over.

Rick Ferri: So we're looking at somewhere between a half a percent to one percent perhaps over the risk-free rate over T-bills. Realistically, I mean you're going to get paid something for taking term risk. Antti Ilmanen: Exactly. Rick Ferri: Not as much as it was. Antti Ilmanen: Yes, and very short term there is this question what happens with inflation. And we--if the Fed has to be more aggressive because of that-- and that that may tell a more bearish story for the next couple of years.

Rick Ferri: So let's move on then to another premium in the fixed income market, and this is credit risk. Instead of being in Treasuries we're going to be in intermediate term corporate bonds or mortgages or high yield versus investment grade corporate bonds. We're going to take credit risk.

And here I found interesting in your book, because you changed your mind on this. You were kind of negative on investment grade corporate bonds, but you seem to have changed your mind here in this book. So talk about credit risk, and then talk about what caused you to change your mind.

Antti Ilmanen: Sure, sure. Well first, so I would say empirical evidence that says that you do earn some of the credit spread but you don't you don't tend to earn all of it. It's roughly speaking historically you've earned about half of the spread, and we may return to that a little later. But then there's a question, like are credits worth including when they have an odd blend between government bonds and equities. And it might be that they are sort of a superfluous asset there.

And I was leaning towards this idea in my first book that maybe you really don't need them. And in the second book, I was leaning the other way. Well I'm sort of notoriously a two-handed economist, that I don't have very black and white views. But so certainly I did lean more positive.

And the argument's volatility-more positive on credits--where partly just from having a strong decade, like after we had just in a relatively bad decade for credits. And now is our strong decade so that more importantly I looked at some historical research from many decades back, which was telling a more positive story on credit performance, and it's sort of extra benefit you get beyond government points and equities. However, actually I've been called on this topic many times and people are saying you really shouldn't trust too much the data from the s to s in credit markets.

The data just sucks so badly that evidence is relatively weak. And then arguably the last decade evidence, again, should be discounted because the Fed obviously had a big role in also pushing credit asset prices higher during that period. So I would still lean mildly more positively. But you hear very weak views. Rick Ferri: But you--do you, are or you were positive--in your view of double B rated bonds, so-called fallen angels. And I'd like to hear if you're still positive on that.

And the reason I say that is because individual investors sometimes take a position in a Vanguard high-yield corporate bond fund. Now I don't own this fund, so I'm not touting it. I do talk about it in some of my books for the exact reason that you've talked about it in your books. But this double-B rated area, where the fallen angels are, does tend to seem to have an extra kick to it.

So you talk about that, and you think if that does have any benefit potentially to a portfolio. Antti Ilmanen: Yes I think so. I mean it is a micro story. But it is in credit markets, it is the best pocket, and the intuition. So fallen angels now refers to bonds that are downgraded from investment grade to speculative grade, so typically triple-B to double-B. And many institutions have got rules that they have to sell bonds during the next month to stick with their mandates and there is effectively a fire sale.

And I already wrote about it in my first book and I basically checked the evidence for the second book. Is the effect still there? And it is still there through the s and so on. It has been very costly for investors to sell those fallen angels in these fire sales. Indeed if you look at the long run performance, how much of the overall credit spread investment grade investors earned in excess return over treasury it's ballpark is about half, and there's not much default loss that happens there.

So there are some technical effects. And this is the most important technical effect. Even broadly speaking we are eating up a meaningful part of this extra credit spread. Investors lose a meaningful part of the average credit spread by participating in that fire sale. So by selling those fallen angels, within the first month. Rick Ferri: You're talking about investment grade credit spread--by selling the fallen angels, they lose a lot of total credit spread.

Anti Ilmanen: Yes those bonds that are downgraded, they lose a lot of value in that next month. If you even would wait six months that would help meaningfully, but ideally just try to stick with those because they have got as good performance historically as any other credit investments. Rick Ferri: Under liquid asset class premia you do list commodities and there you talk not only about individual commodities but about commodity strategies.

So could you go into commodities. Many investors think that there is no reward for commodity investing, and it turns out that that's true in the long run, if you think of a single, especially single spot commodity. And a little bit of that comes from the futures part, the roll effect in the long run, historically. But the bigger part is so-called diversification return. It takes down the compound return, geometric mean, but those individual commodities are also very lowly correlated with each other.

So you can diversify across them in very simple ways and you can reduce portfolio volatility and reduce that volatility drag. Rick Ferri: I'm going to push back a little bit here. Antti Ilmanen: Please. Rick Ferri: That is a trading strategy. That's not a premium on an asset class, correct. I mean, as you said, if you just bought the asset class and held it buy and hold, and basically you get maybe the inflation rate. But what you're talking about is a trill… Antti Ilmanen: No.

Rick Ferri: Okay, go ahead. It's true that you have to buy--I mean in theory you might do it with spot commodities, by the way, but nobody could do that because you don't want to buy your pork bellies. Rick Ferri: No. I understand you're doing one month futures or something.

So, but it is really, the only thing you are doing here, you are rolling every month to a quarter, something. So it is none of the things that you-- it is not a momentum strategy--roll strategy, this part that will be extra. This is saying that just by reducing portfolio volatility and the volatility drag you are generating positive return.

It's a complicated thing. Rick Ferri: I understand. But it's not a market weighted or capitalization weighted strategy at all. It is basically an equal weighted strategy. So you have to come up with your equal weighted index that you're going to target and then every month you have to trade the portfolio to get it back to the equal weight.

So I mean it's an active strategy. Antti Ilmanen: It is but it can be a very simple strategy. I mean somebody, some active managers. Antti Ilmanen: So yeah. It's a futures trading strategy. Somebody will have to do that. It can be at a very low cost or you can try to add some of those extras, carry and momentum type of strategies on top of that. But if you want to keep it simple, it is very modest cost.

But it's true that it's not total buy and hold when you use futures. Rick Ferri: Let's talk about gold for a second. You did talk about gold and your view on that was? Antti Ilmanen: Zero real return in the long run. It is low compared to many other assets but it makes sense mechanically because you are not earning any coupons or dividends.

And logically it sort of makes sense because gold has been a sort of safe haven or hedge. An admittedly imperfect one, but against a variety of yields it has tended to do relatively well both in rising inflation scenarios or in equity market drawdowns. Not very reliably. For example this year we had both of those and gold hasn't shown. Rick Ferri: Interesting. Okay so those are the asset classes: cash, equities, Treasury bonds, corporate bonds including fallen angel high-yield bonds, and commodities.

So those are the asset classes and the risk premia. Now let's get into the second part of your book, style premia. Things like value investing, momentum investing, quality investing. And then you have carry. So there are some styles where I think the consensus of researchers has converged to saying that there is a long run premium which looks pretty much empirically as good as equity premium.

Rick Ferri: This is a long-short or just long only? Antti Ilmanen: And this can be both. Any of these strategies can be applied as long only portfolios where you tilt a little more. While you already favor last year's winners in momentum; favor more boring good quality or low beta stocks in defensive or high dividend yield stocks in carry.

Or you can do a long-short strategy in all of these cases, and you could also apply them outside stock selection, do this, use this in country allocation. And if you do this, so both of these are useful — the latter approach long-short is more aggressive.

It will give wonderful diversification benefits because then you have got many different return sources. But it has got problems because they are unconventional and they will challenge investor patience much more than equities, if you have a bad window for these strategies. Rick Ferri: I think that most individual investors, if they're going to do style premia factor investing it's going to be long only, and it's going to be in one fund.

So it's a multi-factor fund. How do you feel about multi-factor? Antti Ilmanen: Oh thank you. I clearly like it because again, I like diversification and many of these styles relative to each other are very lowly correlated. Even value and momentum as activities are negatively correlated. And sometimes some others. But you get really nice benefits when you combine these strategies.

So I think anybody who chooses to use only single, one style, has to have a really strong conviction that this is the one thing I believe in, as opposed to the other ones. Because again, there are these three, four, five things which all seem like quite good complements to each other, as well. Rick Ferri: You find that there's a higher value premium in small cap rather than large cap. Antti Ilmanen: I think for many of these premiums we find that on paper thel small segment is a better fishing pond, which is also higher premium there, and again that's on paper and it could be that after trading costs much of that goes away.

So in general I think we tend to find as good opportunities after costs in large cap and small cap segments. So I don't have a strong view on this, as I know many other people do. Rick Ferri: The last item that you put in style premia is called carry, where carry is a long-short strategy.

And the simplest way of describing it is what looks expensive you sell and what looks cheap you buy. So you're selling very low yielding country bonds and you're buying very high yielding country bonds. Is that a fair assessment of carry? Antti Ilmanen: Well I think when you say cheap and expensive, I would call that the value strategy, whereas for carry I would just call it high yielding and low yielding.

And in some cases carry and value sort of go hand in hand, and I like dividend yield strategies and book to price strategies are highly correlated, but they can be--so I would say in equities the carry strategy would be using dividend yield, or a broader payout yield metric, to favor certain stocks over others. But then if you think of some other asset contexts, the most famous carry strategy perhaps is currency carry.

And then basically currency carry strategy of favoring high yielding currencies is very different from a currency value strategy, where you look for currencies that look cheap based on purchasing power parity. Rick Ferri: It's strictly a yield concept. Buy the high yields, sell the low yield. Rick Ferri: And it could be across any asset class. Rick Ferri: So this is what carry means. Okay, but it is long-short.

I mean it's not just long only? It can be both. Again, you can do long only favoring high dividend yielders. It's not a great strategy but it's a mildly positive Sharpe Ratio strategy. Rick Ferri: The next area is what's called illiquidity premia. And here can be divided up into the three major categories, which are real estate, private equity, and then private loans or private credit.

Let's start out with real estate. A lot of people just own a home or they have rental property or they buy a REIT fund. Well first, people may extrapolate too much when you look at real estate prices in recent decades. I think with this illiquid asset it's also helpful to take this dividend discount model idea. That you ask what's the expected return through expected yield, expected real growth, and maybe expected change in valuation.

Empirical evidence suggests that with real estate you pretty much get the yield, but you shouldn't expect changing valuations, and the real growth you can debate whether it's been positive or negative in the long run. That I think zero is a very reasonable number. So I will say basically I think that you are going to earn your yield and the relevant yield for real estate is basically something, free cash flow yield. So if you are thinking of a bigger number like rent to price ratio, rental yield, that's all too high because you have to subtract expenses which are often one third of that.

More than bonds but less than equities. And the intuition is that you don't get any real growth. Lots of thinking about illiquidity premia, because like I sometimes say illiquidity premia are overrated, and one intuition just is that people really like the smoothing feature. That it's sort of painful to lock your money for a long time, but it's really nice to get the lack of mark to market. And those two features could offset each other. And so one place where you can measure illiquidity premium arguably pretty well is in real estate where you compare listed REITs to direct real estate, which is much less liquid.

And it turns out that when you look at this pretty long history--we've got 45 years of data in the US--we find that actually there's been an inverse illiquidity premium. REITs have outperformed. And then the counter argument will be that they are not really comparable.

That REITs have got lots of beta and leverage. And it's true that when researchers have adjusted for those beta and leveraged differences you get some of that negative illiquidity premium away, but you never get a positive illiquidity premium in any analysis that I've seen. So again the evidence is very modest on the idea that there is a great illiquidity premium in private assets. Rick Ferri: That's very interesting. And the other two which I don't really want to spend that much time on are private equity and private credit.

Most individual investors really don't have access to good private equity. Antti Ilmanen: They are recently sort of institutional favorites, but I think that institutions tend to be over optimistic on them. And partly they really like the smoothing feature, but also I think they have got higher expectations, I think, because of this growing investor interest in that space.

I think even if there was an extra return, I think much of that has been beat down. And again, another logic is that the smoothing has taken it down. So I think it's a pretty reasonable thing to think that you get pretty similar returns from private equity as public equity after all fees, which are much higher in private equity. And likewise private credit versus public credit. Net returns could be very similar on both sides.

So I don't think investors are missing much by not having access to this, but there are lots of dream sellers out there who tell a different story. Rick Ferri: Well let's talk about the active managers and alpha, which is the fourth category that you have. And there we've got managers that are trying to pick stocks, not systematic, but trying to pick stocks. And talk about alpha decay, should investors be seeking alpha? I mean that is the holy grail which is so lovely but so elusive.

And I think it's good to be realistic about it and expect very little on that. Obviously there's a lot of marketing for it, and there is to be--to be clear--there is some evidence, you know, mutual fund evidence is not good on managers generally providing net positive alpha.

But institutional managers, hedge funds, private equity may have collectively outperformed. But that's again, it has come down. You mentioned this concept of alpha decay, that evidence from more recent data is questioning even whether there is, there has been net outperformance. Obviously some managers will outperform and then you can question whether it's been luck or skill and so on. And this is one of these eternal debates.

And yet it is interesting that so many investors still like to do either their own active investing, or traditional active managers and pay decent fees. And that is somehow telling of the both marketing success and over confidence that we have. Rick Ferri: So that's the technical side of your book. But then you have a whole different side of the book. It had to do with behavior and being patient and sustaining a conviction.

And so could you talk about why you wrote this side of the book and the main points on what you were trying to get across. I think if I have to pick one sort of bad habit from investors it tends to be related to impatience. So the other way to do it is what we call asset weighting, where you weight each fund's return by the amount of money or the amount of assets that the fund has, and then divide by the total value of all the assets across all the funds.

So that gives you an asset weighted rate of return. And the difference between those numbers will tell you whether the larger funds are doing better or doing worse than the smaller funds. And the reverse, if the numbers are reversed. And over the long enough time horizon what you quite often see is that both the simple average and the asset weighted average return of these funds is less than that of the index to which is being compared. Rick Ferri: But how much of a difference is it?

I mean is it better to get in bigger active funds than smaller active funds. Craig Lazzara: Depends on the period. I don't think I could make a blanket judgment about it. This last six months, for example — I mentioned we just published SPIVA for the first six months of — the last six months the asset weighted average did less well than the equal weighted average, meaning the smaller funds did better.

But there have been years when the reverse has been true. Rick Ferri: So it's probably pretty equal then over time? Craig Lazzara: I would think so, yeah. Rick Ferri: And you've also done--you've added this over the last few years--you tried to do some risk-adjusted numbers. So you're looking at Sharpe Ratios which is a function of adjusting for call it the volatility of the funds. And what that has shown is that, in other words, are the active funds even though they're underperforming, they're less volatile.

Is that a factor? Craig Lazzara: No, that is in fact just the opposite. The average actively managed fund in the SPIVA database is more volatile than the index to which it's being compared. It's very clear that most active managers do not produce less risk than the benchmarks that you're comparing them to. The one thing that is particularly interesting about that paper, as I'm recalling it, is that unlike returns, where a manager might have good returns one year year and bad returns the next and that fluctuates, the volatility profile of funds is fairly stable.

So there's some stability in volatility of active funds. But there's no--I mean some funds, yes, are less volatile--but the majority are not. Rick Ferri: So you've also done this for International equities and for U. S bonds. So let's start with the international equities first, which is a completely different database. I mean you're in a completely different market, has nothing to do with the US, nothing to do with the original U.

Is the data the same? Craig Lazzara: The conclusion is the same. I mean we can--I can answer the question really in two ways. One is that as part of U. So same database, and that gets you the same answer. But then … our business has expanded internationally. Other clients in other regions have said, well what about Canada, what about Europe, what about Australia.

Europe, Australia, Latin America, Canada. I'm sure I'm leaving things out-- India. And the conclusion is remarkably consistent. I mean there are exceptional years, yes, in all these places. But if you look at long periods of time, even an interval as short as five years, the majority of active managers underperform a benchmark that is appropriate to their investment style.

It's very, very consistent. Rick Ferri: So let's go back, circle back to investors here in the U. S are investing in International, in foreign stocks through foreign mutual funds that are managed here in the U. Craig Lazzara: The conclusion is the same, yeah. There's no evidence that the managers of international funds do any better than the managers of a domestically focused fund.

Rick Ferri: Okay. I have to ask you this because a lot of people say, well yes, but not in Emerging Markets. I mean Emerging Markets, you can go out and you can find active managers that are going to outperform. I mean do you find that to be true? Craig Lazzara: Well some, sure. But there's no consistency there either. I mean I think the thing that makes SPIVA results what they are is that in most markets, including Emerging Markets, including all the international markets I mentioned, in most markets the investment business is very largely institutionalized--most of the money is controlled and managed by institutional, by which I mean mutual and pension funds, endowments--you know, professional asset managers.

Which means that the managers of Emerging Market funds or the managers of Canadian funds, or the managers of U. S funds, are competing against other professionals who have the same skill set, information access, computational ability, and knowledge of the markets there.

It's a fair game. It's not like one set of investors, the professionals have access to information and trading data that is superior to that of the others and so the ones with superior knowledge can take advantage of the ones with less knowledge. Here it's professionalized pretty much across the board.

Rick Ferri: Well here in the U. S anyway. Craig Lazzara: Certainly in the U. S, and increasingly globally too. Rick Ferri: Yeah. Well let's get into fixed income. So you also do this with fixed income. You look at treasury indices versus managed treasury funds and corporate bond funds versus corporate bond indices. And does the data hold there? Craig Lazzara: Yes. Although I would say it's more volatile there because in the following sense if you're in an environment where interest rates are increasing, as we have been now, if most fixed income managers have a duration in their portfolio that is less than that of the index to which they're being compared, then the majority can outperform in periods when rates are increasing.

And they will then underperform in periods when rates are decreasing. The importance of duration in fixed income analysis is just overwhelming. If you get that decision right you can get a lot wrong and still be a really good bond manager. And because it's so important, I think you see more fluctuation, you'll see in some categories a larger majority outperform one measurement period and then underperform the next measurement period, simply because the direction of interest rates is changing.

The other thing to keep in mind about fixed income markets, certainly government treasury markets in particular, is unlike the equity markets where basically all of the players are what an economist might call rational profit maximizing--I'm trying to make a lot of money you're fund you're trying to make a lot of moneyin the fixed income market there is one very large player who is not a profit maximizer, or that being the Federal Reserve.

So you have another presence in fixed income that sometimes, depending on his interest rate decision, sometimes helps the manager, sometimes hurts the managers. But there is this other factor which you don't see in the equity world. Rick Ferri: I guess it would also be a little different because the dispersion of returns among bond managers is going to be much narrower… Craig Lazzara: Much, much lower. Rick Ferri: Than the dispersion of returns of equity managers. Craig Lazzara: Yeah, very much so.

In fact there's a David Swenson--the late head of the Yale endowment- I think at one point was quoted as saying the difference in performance between a top decile bond manager and a bottom decile bond manager was so small that it wasn't worth your time to try to figure out who was who. Rick Ferri: Very good.

No they might use different indices, but it's the same result. And Vanguard does an annual study too and it's the same result. And they're using different indices, but again, it doesn't really matter that much. The results all come out to about the same and the results are this: Can active funds beat the benchmark?

The answer is yes, but not many, not by much, not for long, and the winners are not predictable. And with that let's get into the second study that you do which is called a persistence study. So tell us about persistence? Craig Lazzara: Okay. And the question that we asked in the persistence scorecard is really very simple. It says, for example, let me identify all of the funds who were above average two years ago and say of those that were above average two years ago how many were above average last year?

You go back five years and say of those who are above average five years ago how many were above average four years ago, three years, two years ago and so forth. Rick Ferri: So what you're trying to measure here then is does the outperformance carry forward? Recognizing that only a minority of active managers outperform in a given year.

If I focus on the more successful active managers from this in the historical data will I be more successful going forward. The simple way to say the question that the persistence scorecard tries to answer is do winners continue, do losers continue, is there persistence in skill? Rick Ferri: Or does it ask is there actually skill or is it randomness? Craig Lazzara: The way to think of it is this.

When you identify a manager who has outperformed how can you tell whether his outperformance is a result of genuine skill or simply of good luck. And the answer to that question is genuine skill should persist. Good luck is ephemeral, comes and goes, you're lucky this year, not last year, or not next year.

And so what the persistence scorecard does is to — at various time horizons and various break points — look at funds which have outperformed historically and asked did their outperformance continue. For example, there are many many cuts in the persistence scorecard. One thing we do is to say let's go back with 10 years of data, take all the managers who were above average in the first five years and say how do they do in the second five years.

And obviously if you were in the top half of the universe five years ago, in the first five years, and skill persists, the likelihood is you should have a lot higher probability of being in the top half of the distribution in the second five years than the managers who were in the bottom of the distribution in the first five years.

And what the persistence scorecard tells us is that there's relatively little persistence. In other words the example I just posed, the last time we ran persistence, if you take again all large cap managers, go back 10 years, take the first five years and say of the managers who were above average in the first five years how many of them were above average in the second five years. Rick Ferri: So less than half.

So this is like a random event. I mean if you think about it it's like well, it seems like half should be at least half of it. No, exactly right. That's the default, is half. In other words, if the results are completely random, half of the managers are going to be in the top half and it turns out that somewhat less than half of the top half managers from 10 years ago are still in the top half in the second five year period.

Rick Ferri: Now what about the bottom half? Did any of the managers in the bottom half end up in the top half. Craig Lazzara: Oh sure, sure. So I guess what you could say about the top half is that the lower probability they will merge or go out of business. They have that momentum probably because they have a lot of assets in the fund if you're in the top half. Craig Lazzara: Yeah and there's some persistence, I think not in performance, but of a stickiness of funds.

If you're in a fund you may not want to get out for a variety of reasons. So if historical success, if you look, let's say at the large cap funds and do this five-year exercise. If you're in the top half in the first five year period you're less likely to go out of business or to liquidate. You're not particularly likely necessarily to repeat in the top half, but you're likely to live, to persist in terms of still being around.

Rick Ferri: Now you also divided these down into quartiles. So you can look at the top quarter and then the second quarter, and then the bottom three quarters and then the bottom quarter. And it doesn't appear overall that it's much different than random, what happens to a fund.

Craig Lazzara: So that's a very fair summary, again coming back to the way the exercise works if skill is randomly distributed, or results are randomly distributed. So if you look at large cap US managers again and say look in the first five years what percentage of large cap U.

S managers who were in the first quartile in the first five years repeated in the first quartile the second five years. Rick Ferri: Random? Craig Lazzara: Yeah, and if you go to look at Mid cap and Small cap it's even worse. Rick Ferri: A manager who has skill like a bowling team or a top tennis player should continue, I mean you know they should continue to win. The fact that the persistence score says what it says, in other words, that there is no predictive value in historical performance.

I mean I think it says two things, Rick. One is it reminds us that what active managers are trying to do is very difficult. It's so difficult that most of them don't do it particularly well. And secondly it reminds us as investors who are potentially identifying funds to buy, that historical performance is not a good gauge of what will happen in the future.

Rick Ferri: Some have said that fees are a good indication. In other words if you have low fees you have a higher probability of outperforming. Do you work any of that into your studies? One we haven't done the study directly.

I know Morningstar has and the summary is exactly what you say. If you were instead of picking a fund based on past performance, if you pick the fund based on I want something in the lowest quartile of fees, that's a more sensible strategy than picking a fund that has outperformed by a lot recently. Rick Ferri: Oh, you do a gross, you do a gross of fees. Craig Lazzara: Now not surprisingly, somewhat fewer managers underperform when you don't count their fees. But it's still a majority. I remember doing a meeting with a client and so well I'll make it as simple as I can.

Institutional SPIVA tells us that most institutional managers and most mutual fund managers gross of fees underperform most of the time. The conclusion doesn't change. I mean the numbers change a little bit but the conclusion doesn't change really at all. Rick Ferri: That's interesting. I wonder how much of that is related to just the amount of cash that they have, and have to have in a portfolio.

And you know bull markets occurring at times when there's cash in a portfolio, which is hurting performance, and you know kind of an asset allocation decision as opposed to his stock selection decision. Craig Lazzara: Part of it could be that. But we've done some work on this topic because we hear this objection all the time.

Well, you know that index funds will outperform because they're fully invested in a rising market, but not in a falling market. And if you look back at the falling markets and our historical database, look for example at - The majority of managers underperform. So the data don't really support. Rick Ferri: Can't make that argument about cash then? I mean I think there's a slight advantage, sure.

The other thing to keep in mind, of course, is that that we are at a point in in the investment business now where sophisticated mutual fund managers, which I would think would include most if mostly not all of them, there are ways to equitize your cash if you have you to have a lot of cash on hand because you might get redemptions. Well you can buy index futures to so-called equitize the cash, giving you the return of the equity market.

So I think that that wasn't possible 50 years ago certainly, but certainly it is today. And I also think that also rebuts that argument. Rick Ferri: Past performance is not an indication of future results, is really what the persistence studies are. Craig Lazzara: That is a very good summary, yes.

Rick Ferri: A lot of it is random. Skill is very difficult to discern. Very hard to go out and pick a manager that actually has skill, and I get — one of the problems with trying to pick a manager that has skill is that everyone is looking for these managers. And if you actually identify somebody that has skill, that money is going to just pile in and that in itself could harm the performance of the fund.

We see that quite frequently. Craig Lazzara: One thing I think we know for sure about fund flows is that the vast majority of fund flows come into funds that have recently done very well. So especially if you think back to what you just said Rick, that past performance is not a good indicator of future performance, to allocate money based on past performance is just saying you're almost asking to underperform and of course that's what happens.

It's understandable. People want to buy something that has done well. Except that the fact that it did well last year does not tell you much about how it's going to do this year. Rick Ferri: So let's talk about a report that I did that you've read. So as an advisor for 35 years, if I just took client money and allocated it between stocks and fixed income, and then within the stock side the U.

S stocks, International stocks. And on the fixed income side treasury bonds, corporate bonds or Total Bond Market Fund. And all I did was buy the cheapest index fund I could get on the U. On the international side a Total International Fund. On the bond side a Total Bond Market or if I wanted to have a municipal bond fund a Municipal Bond Index Fund or something similar to it because Vanguard actually has actively managed Municipal bond funds that should basically be index funds because there's so many bonds in there.

If all you did was buy a portfolio of index funds and nothing else. Forget about trying to pick active managers. Forget about trying to pick managers who are going to outperform the international market or the small cap market or whatever. Just forget it. Just buy all index funds, the cheapest you can, and maintain your asset allocation. When you put it all together in a portfolio the probability of the portfolio outperforming a portfolio with active funds in it is actually higher than the individual silos because there might be a couple of active funds that you own that outperform but the underperforming funds drag everything down.

So I've been pounding the table on this, and of course, Jack Bogle did for years, and the Bogleheads pound the table on this. Just put together a few good index funds in a portfolio and hold it for the long term and you'll be far better off. Do you agree with that? Craig Lazzara: Absolutely, absolutely. I mean I think the mistake people make and then you what you addressed in your in your study, Rick, with the mistake people make is to say that diversification will help me so I'll pick an active U.

S fund, for example, or maybe two active U. S funds, and then I'll diversify by picking an active International fund, an active bond fund and so forth. And the difficulty is that that works if the expected return or the expected benefit of buying those active funds is positive. But if the expected benefit of buying the active funds is negative — which SPIVA and other research demonstrate very clearly that it is — you're basically compounding the mistake.

I mean another way to say that is let's suppose I go into a casino. I go up to the roulette wheel and I put ten dollars on red and I spend, lose my money. And the next roll I'm going to put ten dollars on black, now because I'm going to diversify.

I mean it's you're not diversifying anything except randomness. I am a lousy basketball player. So let's suppose that I was to get into a free throw shooting contest with Michael Jordan.

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