Shownotes
In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this fourteenth series, they discuss mistake number 26: Do You Fail to Compare Your Funds to Proper Benchmarks? And mistake 27: Do You Focus On Pretax Returns?
LEARNING: Always run a regression analysis against an asset pricing model on portfoliovisualizer.com. Actively managed funds have higher tax expenses than ETFs and mutual funds.
“If you want to see if an active manager is truly outperforming and their appropriate risk-adjusted benchmark, run a regression analysis against an asset pricing model on portfoliovisualizer.com.”
Larry Swedroe
In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this fourteenth series, they discuss mistake number 26: Do You Fail to Compare Your Funds to Proper Benchmarks? And mistake 27: Do You Focus On Pretax Returns?
Did you miss out on previous mistakes? Check them out:
- ISMS 8: Larry Swedroe – Are You Overconfident in Your Skills?
- ISMS 17: Larry Swedroe – Do You Project Recent Trends Indefinitely Into the Future?
- ISMS 20: Larry Swedroe – Do You Extrapolate From Small Samples and Trust Your Intuition?
- ISMS 23: Larry Swedroe – Do You Allow Yourself to Be Influenced by Your Ego and Herd Mentality?
- ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely
- ISMS 25: Larry Swedroe – Admit Your Mistakes and Don’t Listen to Fake Experts
- ISMS 26: Larry Swedroe – Are You Subject to the Endowment Effect or the Hot Streak Fallacy?
- ISMS 27: Larry Swedroe – Familiar Doesn’t Make It Safe and You’re Not Playing With the House’s Money
- ISMS 29: Larry Swedroe – The Shiny Apple is Poisonous and Information is Not Knowledge
- ISMS 30: Larry Swedroe – Do You Believe Your Fortune Is in the Stars or Rely on Misleading Information?
- ISMS 34: Larry Swedroe – Consider All Hidden Costs Before You Invest
- ISMS 35: Larry Swedroe – Great Companies Are Not Always High-Return Investments
- ISMS 36: Larry Swedroe – Two Heads Are Not Better Than One When Investing
Mistake number 26: Do You Fail to Compare Your Funds to Proper Benchmarks?
In Larry’s opinion, mutual funds lie about their performance or bend the facts to suit their needs. The SEC requires mutual funds to define their category, but it doesn’t tell them what is the proper benchmark. So, the mutual fund can choose a benchmark that is easier to beat than a more appropriate benchmark to make it look good. A classic example is that all small-cap funds almost always benchmark themselves against the Russell 2000, a small-cap index. However, the Russell 2000 is not a small-cap stock index. The Russell 1000 is the largest 1000 of the largest 3000. The Russell 2000 is the next smallest 2000 stock of the largest 3000.
Small-cap funds should be compared to a small-cap index, and large-cap funds should be compared to a large-cap index. The same is true about value and growth funds. Mark Carhart’s classic study of the mutual fund industry determined that once you accounted for style factors (small cap versus large cap and value versus growth), the average actively managed fund underperformed its benchmark on a pretax basis by 1.8% per year. For the 5-, 10-, and 15-year periods ending in 2000, only 16%, 16%, and 17% of actively managed funds outperformed the Wilshire 5000.
To avoid making this type of mistake, Larry says you should compare the performance of an actively managed fund against its appropriate passive benchmark. If you want to see if an active manager is outperforming and their risk-adjusted benchmark is suitable, run a regression analysis against an asset pricing model on portfoliovisualizer.com.
Mistake number 27: Do You Focus On Pretax Returns?
According to Larry, active managers, on average, are smart and generate gross alpha. The problem is that their costs far exceed their ability to generate alpha. One of the oldest studies found the average stock-picking fund added value with their picks by about 0.8%. But their expense ratio was about 0.8%. The trading costs were 0.7%. Also, the cost of holding cash adds up, so they underperform by over 1% yearly. So investors, even though they may have identified a manager with stock picking skills, will underperform appropriate benchmarks anyway. But the sad part is that taxes for the average taxable investor are often the most significant expense they face.
Robert Jeffrey and Robert Arnott showed the impact of taxes on returns in their study of 71 actively managed funds for the 10 years 1982-91. They found that while 15 of the 71 funds beat a passively managed fund on a pretax basis, only five did so on an after-tax basis.
Larry says that individual investors are beginning to awaken to the critical role that fund distributions play in after-tax performance. This has been one of the driving forces behind the rapid growth of ETFs index and other passively managed funds.
About Larry Swedroe
Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.
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Connect with Larry Swedroe
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- How to Start Building Your Wealth Investing in the Stock Market
- My Worst Investment Ever
- 9 Valuation Mistakes and How to Avoid Them
- Transform Your Business with Dr.Deming’s 14 Points
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Further reading mentioned
- Larry Swedroe and RC Balaban, Investment Mistakes Even Smart Investors Make and How to Avoid Them
- Philip E. Tetlock, Expert Political Judgment: How Good Is It? How Can We Know?
- Gary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes and How to Correct Them: Lessons from the Life-Changing Science of Behavioral Economics
- Larry Swedroe, Think, Act, and Invest Like Warren Buffett: The Winning Strategy to Help You Achieve Your Financial and Life Goals