April 24, 2019

The Guru and The Investor: Act 2 – The Evidence-Based Advisor Strikes Back

Act Two

The Setting

Following his interview of a hedge-fund manager to see if he should manage his retirement assets, the Investor turns his search to a different type of advisor, for a philosophy based on something called ‘evidence-based investing’.  This seemingly outlandish idea is grounded in the findings of academic research in finance to guide a logical investment approach rather than blind faith in personalities. 

Investor: Evidenced-Based Advisor (EBA), I found you on the web when I searched ‘evidence-based investing’ and I was intrigued by your approach. Evidence-based investing appears to be very different than the traditional approach espoused by most investment ‘professionals’.  I have some money to invest, but first I’d like to ask you some questions.

EBA:  Thank you for reaching out.  I’d be happy to answer your questions.  Ask away.

Investor:  How would you describe your investment philosophy?

EBA:  Our philosophy is driven by two foundational principles: 1) Follow the evidence to understand what works and what does not even if it turns out to be contrary to our existing beliefs.  2) Be humble and acknowledge that much of investing is dependent on future events, the outcomes of which cannot be known in advance.

Investor: That sounds interesting.  What is so special about you that enables you to have this philosophy?

EBA:  My curiosity about how things work and a willingness to be open with clients about what I can and cannot do.  In particular, that I am forthright about not having unique insights into future market behavior.

Investor: I see.  And so, what is the theory and the evidence that supports this evidence-based investing approach?

EBA:  I’m glad you asked.  The principle academic theory upon which evidence-based investing builds is the Efficient Market Hypothesis[1] (EMH). Stated simply, this hypothesis is that stock prices reflect all currently available information such that market prices are the best estimate of a stock’s value.

This means that investment strategies that attempt to beat the market by developing stock price estimates that differ from market prices and then trade on those estimated stock prices (i.e. find stocks that you believe should trade at a higher price than the current market price) should be exceptionally difficult to successfully execute over the long term.

Investor:  That’s a fascinating hypothesis.  Does the evidence support the EMH?

EBA:  There’s no way to directly test the hypothesis, but numerous studies have examined the performance of active fund managers—those who try to outguess the market.  One well-known study by S&P Dow Jones Indices, called SPIVA (S&P Index vs Active), reports on the performance of active fund managers versus benchmarks and adjusts for issues such as survivorship bias.  The latest SPIVA report, covering the period up to December 2018, found the following:

Over the last 15 years:

  • 92% of large-cap mutual funds underperformed the S&P 500 Index.
  • 93% of mid-cap mutual funds underperformed the S&P MidCap 400 Index.
  • 97% of small-cap funds underperformed the S&P SmallCap 600 Index.
  • 90% of international funds underperformed the S&P 700 Index.
  • 96% of emerging market funds underperformed the S&P/IFCI Composite Index.
  • 92% of intermediate government bond mutual funds underperformed the Barclays Intermediate U.S. Government Index.
  • 77% of intermediate investment grade mutual funds underperformed the Barclays U.S. Government/Credit Intermediate Index.
  • 99% of high yield corporate bond mutual funds underperformed the Barclays US Corporate High Yield Index.
  • 84% of general municipal mutual bond funds underperformed the S&P National AMT-Free Muni Bond index.

Investor:  That’s ugly.  Is that it?

EBA:  Unfortunately, for active fund managers, no.  A follow-up question is: What happens to the handful of active funds that do outperform their benchmarks?  Does their outperformance persist into future periods?  For example, among large-cap fund managers, 8% outperformed the S&P over the past 15 years.  Do they have a sustainable edge versus the market going forward?  It turns out that has been studied as well.

According to the latest SPIVA Persistence Scorecard – 2018

  • Of the top 50% of fund managers based on performance over the 12 months ending September 2014, following are the percentage of fund managers that outperformed over the following four years ending September 2018.
    • 9% of large-cap fund managers
    • 12% of mid-cap managers
    • 17% of small-cap managers

Investor: So even the few managers who actually beat the market are likely to underperform going forward. Ok, I’m convinced not to use active managers.  So what’s the alternative? What is the evidence-based investing approach?

EBA: Control what is controllable. What are the controllable parts of an investment process?  How much risk to take, how much to spend on investments, and how tax-efficient.  Create a portfolio with risk exposure consistent with your needs and comfort level and use tax-efficient, low-cost investments.

Investor:  That all makes sense, but I’ll be honest with you: It sounds kind of boring.  Don’t you have anything a little more exciting to invest in?

EBA:  No, not really.  Ultimately, investors must decide for themselves how they define investment success.  If investment success means excitement, then go with the Guru.  If investment success means a long-term disciplined approach based on academic research, then go with the Evidenced-Based Advisor.  That’s up to you…

Curtain Falls

[1] Professor Eugene Fama won the Nobel Prize in Economic Sciences in 2013 for the EMH, first proposed in the 1960s.  Following is an excerpt from  “For many of us, the rise and fall of stock prices symbolizes economic development. In the 1960s, Eugene Fama demonstrated that stock price movements are impossible to predict in the short-term and that new information affects prices almost immediately, which means that the market is efficient. The impact of Eugene Fama’s results has extended beyond the field of research. For example, his results influenced the development of index funds.”