by David Robertson, CFA
June 2017
For those with a predilection for self-improvement, there have never been better times. For almost any endeavor there is a useful "how-to" video on YouTube, a great book a click away on Amazon, and a wealth of knowledge available through basic Google searches or even free online courses.
Among the great resources for investors is David Swensen's book, Unconventional Success: A Fundamental Approach to Personal Investment. Although the book came out several years ago, it still provides a solid intellectual foundation for how to approach investing. At the time Swensen recommended that "investors engage not-for-profit fund management companies to create broadly diversified, passively managed portfolios." While that advice has proven quite useful for individual investors and small institutions, it was also made twelve years ago. How does it stand up today?
Before answering that question, it helps to understand Swensen's background. Importantly, as the longstanding head of Yale's endowment, he brings an unusual combination of knowledge, experience, and honesty regarding the world of investment services. This means that not only is he more than capable of understanding a wide array of investments, but he is also in a position to be brutally honest about the advantages and disadvantages of each.
Given this, Swensen highlights some of the key principles he uses to evaluate investment approaches. One is that long term investors should focus on equities over other asset classes in order to benefit from their better returns over time. Another is that the act of evaluating active managers takes a nontrivial amount of effort and resources - that can only be justified by superior results. Swensen argued that since most individual investors (or small institutions for that matter) don't have the time and resources to engage in such an effort, the best approach is to opt for easy, low cost, general exposure to the markets - for which passive funds fit the bill.
At the time, when the book was published in 2005, investing in passive funds also satisfied another important criterion for Swensen; it was an "unconventional" approach because so few were doing it. Indeed, Swensen saw fit to quote Keynes on the matter in order to emphasize its importance: "Slavishly following conventional wisdom proves unwise, as the frequently trod path often leads to disappointment."
Twelve years on, investing in passive funds can hardly be called unconventional any longer. According to John Bogle [here], "Since 2007, equity index mutual funds have enjoyed capital inflows of $1.8 trillion." That's an enormous amount of money, much of which came at the expense of active funds. The Financial Times also recently highlighted the increasing market share of passive funds [here], "Sanford Bernstein predicts that more than 50 per cent of equity assets under management in the US will be passively managed by January."
An important part of the reason for focusing on an unconventional approach is that when ideas become "conventional" they often get overdone and ultimately "lead to disappointment." This is especially important in regards to passive investing because the relative utility of the approach is based on the critical premise that markets are reasonably efficient. When most stock prices pretty fairly reflect the discounted sum of their expected cash flows, then passive investing offers an attractive low cost alternative to active management.
When market are not as efficient, however, the relative attractiveness of active management becomes much greater - and there is evidence this is happening now. For example, the FT recently noted the observations of Mustafa Sagun, chief investment officer for global equities at Principal Global Investors: "But we are seeing some short-term anomalies, some movements that aren't caused by fundamentals."
In addition, the FT also reported that researchers from Stanford, Emory University and the Interdisciplinary Center of Herzliya in Israel "found that increased ETF ownership sapped shares of their tradeability and how efficiently they respond to shifting fundamentals such as earnings, even as the correlation to the broader stock market and overall returns increased." They concluded: "our evidence suggests the growth of ETFs may have (unintended) long-run consequences for the pricing efficiency of the underlying securities."
At very least then, it appears as if much of the success of passive investing is behind us. At worst, its past success has undermined its future usefulness relative to active investing. In addition, there is also increasing evidence that the attractiveness of general exposure to stocks has declined in absolute terms because of diminishing market opportunities.
As Bogle notes, traditional index funds "ensure that investors will earn their fair share of whatever returns the market delivers, positive or negative." When valuations are high, though, expected returns can turn negative and that means the "fair" share of passive returns is likely to be negative.
This is exactly what the evidence is currently suggesting. The respected investment firm Grantham, Mayo, Van Otterloo (GMO) estimated expected returns of -3.8% for US large cap stocks in their March 31, 2017 forecast and -3.2% for US small caps. And GMO is not alone. John Hussman also writes frequently on valuation and notes [here], "From the standpoint of individual stocks, the median price/revenue ratio of S&P 500 components is now more than 50% beyond the 2000 extreme, and establishes the present moment as the single most extreme point of broad market overvaluation in U.S. history."
While these numbers are frightening enough, John Mauldin, provides a more vivid illustration [here]: "30.7% of the 2000 stocks in that small-cap [Russell] index had less than zero earnings for the previous 12 months, as of 3/22/17." Further, "A chart in the Wall Street Journal shows that the price-to-earnings ratio for the Russell 2000 was 81.46 as of May 26. That is not a typo."
The challenge here is that despite the fact that equities do tend to outperform other assets over very long periods of time, they don't always outperform. In some instances stocks are subject to significant, or even total, loss. Given the extremely elevated level of valuations and the commensurate expectation of low returns currently, it would be very hard for a fiduciary to conscientiously recommend rote exposure to stocks for investors with anything less than a ten to fifteen year time horizon. That leaves a lot of passive investors exposed.
So this raises a critical issue. If there are times when stocks are really attractive, but also times when they are really unattractive, how can one adapt to those changing conditions without devoting a lot of resources? This is the core weakness of any passive approach - whether it is related to security selection or asset allocation. It doesn't change even when conditions do.
In such instances, it is important to recognize the changes and to adapt to the new market conditions. This is exactly what Richard Bookstaber recommends in his new book, The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction. In it, he notes, "The basic message is that when there is a high degree of complexity [as there is in capital markets], you have to figure it out as you go.
Getting help in navigating a changing landscape, however, is admittedly a nontrivial task. Indeed Swensen himself noted that, "Most investors have scant access to truly unbiased, objective investment advice." While reasonably priced, objective investment advice can still be hard to find, the value of such advice rises with downside risks. Pretending such risks don't exist doesn't help.
That said, Swensen was right to highlight many of the shortcomings of active management, the costs of which must be outweighed by benefits. Since Swensen was primarily speaking to individual investors, he focused most of his attention on actively managed mutual funds which, at the time, were the dominant form of managed exposure to equities. He described, "As I gathered information for my new book, the data clearly pointed to the failure of active management by profit-seeking mutual fund managers to produce satisfactory results for individual investors."
One of the primary reasons that mutual funds "fail to produce satisfactory results" is based on a popular misconception that Swensen reveals. Many investors consider mutual fund companies to be primarily investment organizations, but they really aren't. Most for-profit mutual fund companies are really marketing organizations that are more oriented to gathering assets than anything else. The reason is clear; it is easier and more profitable to gather assets than to actually manage them well. The result is also clear; many mutual fund companies are replete with conflicts of interest that persistently erode investor returns.
Nobody understands this as well as John Bogle. Among the largest fund managers that are publicly owned or owned by financial conglomerates, he notes that conflicts of interest are actually magnified: "The principals and managers of those firms owe a fiduciary duty not only to their mutual fund shareholders but also to their public owners."
With this perspective on mutual funds, it is much easier to see why they so often fail investors. Many of the problems are simply a function of business choices - and this is probably most easily observed in mutual fund fees. Bogle, well known for his aversion to high fees, illustrates why the issue is so important: "Keep your investment expenses low, for the tyranny of compounding costs can devastate the miracle of compounding returns."
Therein lays the key. It's not so much that fees ought to always be the lowest, per se, but they must be low enough so as to not overwhelm the benefits of compounding returns. Unfortunately, since many mutual fund principles are conflicted in making this tradeoff, their mutual fund shareholders do not benefit nearly as much as they should.
Indeed, Swensen was clear to note that mutual funds are not inherently bad and, to his great credit, also cited examples of actively managed funds that serve investors well. The main question is whether the opportunity provided by such managers exceeds the effort to identify them.
In this regard, things have much improved for investors. It used to be time consuming and costly to evaluate a number of mutual funds - as it was for most things. Back in 2005, for example, the iphone had not even been invented yet.
Since then, internet speeds, computational power and mobile access have massively improved. So has the ability to research items cheaply and easily online. No longer is it the same laborious process for consumers to gather information and compare offerings. Further, offerings that emphasize transparency and inbound marketing can both facilitate consumers' efforts to learn about them and sharply constrain marketing costs at the same time. Of course there are still bad actors in the business that overspend on asset gathering activities to the detriment of their shareholders, but the difference now is that it is much faster and easier to weed them out.
In sum, improvement is an ongoing process and improvement in investing is no different. David Swensen's work, Unconventional Success, is one of the classics in providing investors a very clear and well-argued case for how to approach investing. His basic case is that investors who do not have substantial resources at their disposal should err on the side of cheap, easy, and effective exposure to markets. At the time, these criteria pointed to a passive approach.
As times have changed, so too have the tradeoffs between passive and active approaches, however. Increasingly inefficient markets now provide more opportunities for active managers to outperform. At the same time, the cost and effort of researching active managers has declined precipitously. Further, in light of substantial evidence of overvalued markets, rote exposure has become much riskier while the potential benefits of an active approach to opportunities and risk management have increased. Finally, and interestingly, for active managers seeking to improve, Swensen's work has also served as a guidebook for how to do active management right.
June 2017
For those with a predilection for self-improvement, there have never been better times. For almost any endeavor there is a useful "how-to" video on YouTube, a great book a click away on Amazon, and a wealth of knowledge available through basic Google searches or even free online courses.
Among the great resources for investors is David Swensen's book, Unconventional Success: A Fundamental Approach to Personal Investment. Although the book came out several years ago, it still provides a solid intellectual foundation for how to approach investing. At the time Swensen recommended that "investors engage not-for-profit fund management companies to create broadly diversified, passively managed portfolios." While that advice has proven quite useful for individual investors and small institutions, it was also made twelve years ago. How does it stand up today?
Before answering that question, it helps to understand Swensen's background. Importantly, as the longstanding head of Yale's endowment, he brings an unusual combination of knowledge, experience, and honesty regarding the world of investment services. This means that not only is he more than capable of understanding a wide array of investments, but he is also in a position to be brutally honest about the advantages and disadvantages of each.
Given this, Swensen highlights some of the key principles he uses to evaluate investment approaches. One is that long term investors should focus on equities over other asset classes in order to benefit from their better returns over time. Another is that the act of evaluating active managers takes a nontrivial amount of effort and resources - that can only be justified by superior results. Swensen argued that since most individual investors (or small institutions for that matter) don't have the time and resources to engage in such an effort, the best approach is to opt for easy, low cost, general exposure to the markets - for which passive funds fit the bill.
At the time, when the book was published in 2005, investing in passive funds also satisfied another important criterion for Swensen; it was an "unconventional" approach because so few were doing it. Indeed, Swensen saw fit to quote Keynes on the matter in order to emphasize its importance: "Slavishly following conventional wisdom proves unwise, as the frequently trod path often leads to disappointment."
Twelve years on, investing in passive funds can hardly be called unconventional any longer. According to John Bogle [here], "Since 2007, equity index mutual funds have enjoyed capital inflows of $1.8 trillion." That's an enormous amount of money, much of which came at the expense of active funds. The Financial Times also recently highlighted the increasing market share of passive funds [here], "Sanford Bernstein predicts that more than 50 per cent of equity assets under management in the US will be passively managed by January."
An important part of the reason for focusing on an unconventional approach is that when ideas become "conventional" they often get overdone and ultimately "lead to disappointment." This is especially important in regards to passive investing because the relative utility of the approach is based on the critical premise that markets are reasonably efficient. When most stock prices pretty fairly reflect the discounted sum of their expected cash flows, then passive investing offers an attractive low cost alternative to active management.
When market are not as efficient, however, the relative attractiveness of active management becomes much greater - and there is evidence this is happening now. For example, the FT recently noted the observations of Mustafa Sagun, chief investment officer for global equities at Principal Global Investors: "But we are seeing some short-term anomalies, some movements that aren't caused by fundamentals."
In addition, the FT also reported that researchers from Stanford, Emory University and the Interdisciplinary Center of Herzliya in Israel "found that increased ETF ownership sapped shares of their tradeability and how efficiently they respond to shifting fundamentals such as earnings, even as the correlation to the broader stock market and overall returns increased." They concluded: "our evidence suggests the growth of ETFs may have (unintended) long-run consequences for the pricing efficiency of the underlying securities."
At very least then, it appears as if much of the success of passive investing is behind us. At worst, its past success has undermined its future usefulness relative to active investing. In addition, there is also increasing evidence that the attractiveness of general exposure to stocks has declined in absolute terms because of diminishing market opportunities.
As Bogle notes, traditional index funds "ensure that investors will earn their fair share of whatever returns the market delivers, positive or negative." When valuations are high, though, expected returns can turn negative and that means the "fair" share of passive returns is likely to be negative.
This is exactly what the evidence is currently suggesting. The respected investment firm Grantham, Mayo, Van Otterloo (GMO) estimated expected returns of -3.8% for US large cap stocks in their March 31, 2017 forecast and -3.2% for US small caps. And GMO is not alone. John Hussman also writes frequently on valuation and notes [here], "From the standpoint of individual stocks, the median price/revenue ratio of S&P 500 components is now more than 50% beyond the 2000 extreme, and establishes the present moment as the single most extreme point of broad market overvaluation in U.S. history."
While these numbers are frightening enough, John Mauldin, provides a more vivid illustration [here]: "30.7% of the 2000 stocks in that small-cap [Russell] index had less than zero earnings for the previous 12 months, as of 3/22/17." Further, "A chart in the Wall Street Journal shows that the price-to-earnings ratio for the Russell 2000 was 81.46 as of May 26. That is not a typo."
The challenge here is that despite the fact that equities do tend to outperform other assets over very long periods of time, they don't always outperform. In some instances stocks are subject to significant, or even total, loss. Given the extremely elevated level of valuations and the commensurate expectation of low returns currently, it would be very hard for a fiduciary to conscientiously recommend rote exposure to stocks for investors with anything less than a ten to fifteen year time horizon. That leaves a lot of passive investors exposed.
So this raises a critical issue. If there are times when stocks are really attractive, but also times when they are really unattractive, how can one adapt to those changing conditions without devoting a lot of resources? This is the core weakness of any passive approach - whether it is related to security selection or asset allocation. It doesn't change even when conditions do.
In such instances, it is important to recognize the changes and to adapt to the new market conditions. This is exactly what Richard Bookstaber recommends in his new book, The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction. In it, he notes, "The basic message is that when there is a high degree of complexity [as there is in capital markets], you have to figure it out as you go.
Getting help in navigating a changing landscape, however, is admittedly a nontrivial task. Indeed Swensen himself noted that, "Most investors have scant access to truly unbiased, objective investment advice." While reasonably priced, objective investment advice can still be hard to find, the value of such advice rises with downside risks. Pretending such risks don't exist doesn't help.
That said, Swensen was right to highlight many of the shortcomings of active management, the costs of which must be outweighed by benefits. Since Swensen was primarily speaking to individual investors, he focused most of his attention on actively managed mutual funds which, at the time, were the dominant form of managed exposure to equities. He described, "As I gathered information for my new book, the data clearly pointed to the failure of active management by profit-seeking mutual fund managers to produce satisfactory results for individual investors."
One of the primary reasons that mutual funds "fail to produce satisfactory results" is based on a popular misconception that Swensen reveals. Many investors consider mutual fund companies to be primarily investment organizations, but they really aren't. Most for-profit mutual fund companies are really marketing organizations that are more oriented to gathering assets than anything else. The reason is clear; it is easier and more profitable to gather assets than to actually manage them well. The result is also clear; many mutual fund companies are replete with conflicts of interest that persistently erode investor returns.
Nobody understands this as well as John Bogle. Among the largest fund managers that are publicly owned or owned by financial conglomerates, he notes that conflicts of interest are actually magnified: "The principals and managers of those firms owe a fiduciary duty not only to their mutual fund shareholders but also to their public owners."
With this perspective on mutual funds, it is much easier to see why they so often fail investors. Many of the problems are simply a function of business choices - and this is probably most easily observed in mutual fund fees. Bogle, well known for his aversion to high fees, illustrates why the issue is so important: "Keep your investment expenses low, for the tyranny of compounding costs can devastate the miracle of compounding returns."
Therein lays the key. It's not so much that fees ought to always be the lowest, per se, but they must be low enough so as to not overwhelm the benefits of compounding returns. Unfortunately, since many mutual fund principles are conflicted in making this tradeoff, their mutual fund shareholders do not benefit nearly as much as they should.
Indeed, Swensen was clear to note that mutual funds are not inherently bad and, to his great credit, also cited examples of actively managed funds that serve investors well. The main question is whether the opportunity provided by such managers exceeds the effort to identify them.
In this regard, things have much improved for investors. It used to be time consuming and costly to evaluate a number of mutual funds - as it was for most things. Back in 2005, for example, the iphone had not even been invented yet.
Since then, internet speeds, computational power and mobile access have massively improved. So has the ability to research items cheaply and easily online. No longer is it the same laborious process for consumers to gather information and compare offerings. Further, offerings that emphasize transparency and inbound marketing can both facilitate consumers' efforts to learn about them and sharply constrain marketing costs at the same time. Of course there are still bad actors in the business that overspend on asset gathering activities to the detriment of their shareholders, but the difference now is that it is much faster and easier to weed them out.
In sum, improvement is an ongoing process and improvement in investing is no different. David Swensen's work, Unconventional Success, is one of the classics in providing investors a very clear and well-argued case for how to approach investing. His basic case is that investors who do not have substantial resources at their disposal should err on the side of cheap, easy, and effective exposure to markets. At the time, these criteria pointed to a passive approach.
As times have changed, so too have the tradeoffs between passive and active approaches, however. Increasingly inefficient markets now provide more opportunities for active managers to outperform. At the same time, the cost and effort of researching active managers has declined precipitously. Further, in light of substantial evidence of overvalued markets, rote exposure has become much riskier while the potential benefits of an active approach to opportunities and risk management have increased. Finally, and interestingly, for active managers seeking to improve, Swensen's work has also served as a guidebook for how to do active management right.
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