By: Frank Armstrong, CFP®, AIFA®
When I was a child, every county fair, and every carnival had a snake oil salesman. These remarkable fellows persuaded otherwise sensible citizens to suspend disbelief long enough to sell a product of zero value that claimed an exhausting list of miraculous cures and benefits without any evidence whatsoever that the product was either safe or effective. The lack of any evidence was no deterrent. Testimonials, anecdotes, and plain old BS kept the rubes coming. And, of course, when the product failed to deliver the salesmen was long gone.
A faint imitation of the snake oil salesman persists in health food stores where labeling a vegetable or substance natural or organic greatly increases profits. But, true snake oil salesmen have all migrated to Wall Street where they merrily sell active management to a new generation of rubes.
The recent market unpleasantness has provided active mangers with opportunities to question each of the tenants of modern financial theory. Few of us enjoyed the eighteen months of hell during the recent market disruption. To say the least it was disconcerting. Many investors are feeling burned, bruised and battered. It’s natural to reconsider your assumptions after a traumatic experience. But, you could certainly learn just the wrong lessons. There are plenty of folks out there that will help lead you astray.
Active management claims to deliver additional benefits (the ever allusive alpha) through either individual security selection or market timing. While conclusive truth in the securities markets is impossible to find, the overwhelming evidence suggests that active management reliably generates increased cost, tax, and risk while reducing returns. It is, however, highly profitable, and as long as rubes will buy, the snake oil salesman is always happy to oblige.
Modern financial theory is the enemy of the active manager. Passive strategies capturing the benefits of efficient markets, long term buy and hold, and Modern Portfolio Theory with global diversification are safe, economical and effective ways to profit from the long term growth of the world’s markets. As investors adopt these methods the active manager’s market share and profits are threatened. It should come as no surprise that they will fight back to preserve their empires.
We may divide them into thieves, fools and charlatans.
The Madoffs of the world simply stole money. Fools actually believe that they have some special insight that a few billion of their closest friends have missed. And charlatans see no reason to give up a good gig.
Whichever they are, their siren song has variations of the Wall Street’s Three Big Lies:
Modern Portfolio Theory is Dead
Oh, really? Or, do you just not understand it? The guts of MPT are that investors are risk averse, and that appropriate diversification reduces risk to its lowest possible amount at any desired return target. NaÃ¯ve diversification simply buys a collection of assets, reducing the possibility that an adverse event in a single holding will decimate the entire portfolio. It’s better than no diversification at all, but, diversification is best accomplished by using asset classes with low correlations to one another.
But, when you take diversification as far as it can go, market risk remains. That’s the risk that cannot be diversified away. In other words, MPT is a tool to manage risk toward an optimum result. It never claimed to eliminate risk. In fact, MPT software predicts that events of this magnitude will happen with some frequency. Unfortunately, they can’t predict when they will happen.
Of course, eliminating risk eliminates the possibility of increasing returns. Market risk is the engine that generates returns above the zero risk level. If you want higher returns than Treasury Bills or CDs, you simply have to accept risk.
Market risk appeared with a vengeance during late 2007, all of 2008 and part of 2009. While this was the single worst market decline since the Depression, the fact that risk manifested itself does not negate the benefits of MPT. Investors that utilize MPT can expect to substantially lower risk over the market cycle, leading to higher terminal values and/or a higher probability of success whatever their objectives.
The corollary to the MPT is Dead claim is that correlations are moving together. Of course, correlations are variable just as expected return and risk vary over time. There was never an assumption that correlations were fixed. We expect them to increase and decrease over time in a random pattern. There is little data to support the idea that markets are systematically and irrevocably moving toward complete linkage. As long as there is any correlation less than perfect, investors will receive a diversification benefit.
No one disputes that during times of financial panic, correlations will increase. During the recent market unpleasantness, there was almost no place to hide in the world’s equity markets. However, after the panic abated, markets began to diverge again.
Diversification is Dead
We will happily stipulate that during 2007 to 2009, diversification did little to improve results in the short term. However, longer term results show a distinct benefit. As I pointed out in a previous article, global diversification eliminates the possibility of having all your funds in the worst performing asset class. For the decade, you would have had to look pretty far to find an asset class worse than the S&P 500 (domestic large companies). Every other asset class had positive returns and a diversified portfolio held up surprisingly well.
Buy and Hold is Dead
This is the steady refrain of the active manager whether he advocates individual security selection or market timing. I agree that buy and hold is the absolute worst way to manage a portfolio ¦ unless you consider all the rest. The evidence that active management will systematically increase cost, increase risk, increase tax exposure and reduce returns is clear beyond a reasonable doubt. Never-the-less, active managers will continue to peddle their snake oil as long as rube investors will buy.
Someone always wins the lottery, and there is always someone that predicts a market event. They get lots of attention from the media after the fact. But, winning the lottery or being right once is not a sign of genius. And media attention certainly attracts lots of new assets to the lucky few that got it right.
You can follow the snake oil salesman if you wish. After all, just because it’s never worked before doesn’t mean it can’t ever work. Or, you can follow the research. It’s always worked before and offers you the best chance of a successful investment experience.