Swedroe: Don’t Play The Loser’s Game

April 10, 2015

Recently, a blog post by Chris Marx, a senior portfolio manager for equities at New York-based AllianceBernstein (AB), came to my attention. In it, Marx commented on a March 9, 2015 article in The Wall Street Journal that highlighted the reality that today's investors should have lower expectations for future returns because valuations are now much higher than historical averages.

 

Currently, the majority of financial economists are forecasting real returns to the U.S. total stock market and/or the S&P 500 of about 4 percent, well below their historical real return of about 7 percent.

 

Marx sums up his recommended solution to the problem of lower expected returns as follows: "By choosing a[n active] portfolio manager with high conviction and a disciplined investing process, we believe investors can significantly increase the odds of meeting their financial goals—even in a market with muted return expectations."

 

Unfortunately for Marx, there's an overwhelming body of academic evidence showing that investors significantly decrease the odds of achieving their financial goals by choosing active strategies rather than passive. That's why Charles Ellis called active management the loser's game.

 

He meant that while it's possible to win the game of active management, the odds of doing so are so poor that the surest way to win is to choose not to play. That's why, whenever I come across articles like the one authored by Marx, my response is to go to my trusty videotape and review the performance of the firm, in this case, AB.

 

A Respected Firm
AB provides investment management and research services worldwide to institutional, high net worth and retail investors. As of Dec. 31, 2014, the firm had approximately $474 billion in assets under management, of which $237 billion were institutional. According to Morningstar, AB's mutual funds have about $63 billion in assets under management, excluding money market accounts.

 

AB's website boasts: "We're an asset-management and research firm with a unique combination of expertise, innovative solutions and global reach. We attract the industry's best talent—people with the relentless drive and ingenuity to spark innovative ideas. We're truly global. We've built an extensive and integrated global footprint over four decades, giving us the broadest possible perspective."

 

Sure sounds impressive. What matters, though, is whether the firm's asserted expertise and penchant for innovative solutions actually managed to generate superior performance relative to passive strategies.

 

To see if that is the case, and if Marx is right in his claim that active management gives investors the best possible chance of achieving their financial goals, we'll compare the returns of AB's actively managed domestic and international equity mutual funds to the returns of similar, but passively managed, funds from Dimensional Fund Advisors (DFA), which has comparable funds in the same asset classes.

 

In the interest of full disclosure, my firm, Buckingham, has been recommending DFA funds in constructing client portfolios for 20 years.

 

DFA Vs. AB

For our comparison, we'll only examine the funds with a 15-year track record. The table below uses data from Morningstar to show the 15-year returns through March 20, 2015, for each of the funds for which data was available.

 

15-Year Returns 

 

Fund Annualized Return (%)
15-Years Ending
March 20, 2015
Expense
Ratio
(%)
U.S. Large    
AB Core Opportunities A (ADGAX) 8.1 1.20
AB Growth B (AGBBX) 1.2 2.14
AB Concentrated Growth Advisor (WPSGX) 5.1 1.06
AB Large Cap Growth A (APGAX) 2.3 1.25
Average AB Fund  4.2 1.41
DFA U.S. Large Company (DFUSX) 4.4 0.08
     
U.S. Large Value    
AB Equity Income A (AUIAX) 7.2 1.04
AB Growth and Income A (CABDX) 6.0 0.98
Average AB Fund 6.6 1.01
DFA U.S. Large Value (DFLVX) 9.2 0.27
     
U.S. Small    
AB Small Cap Growth A (QUASX) 5.9 1.27
DFA US Small Cap I (DFSTX) 8.9 0.37
     
International Large    
Bernstein International Portfolio (SIMTX) 2.7 1.15
AB International Growth A (AWPAX) 3.1 1.37
Average AB Fund 2.9 1.26
DFA International Large Company (DFALX) 3.3 0.28
     
Emerging Markets    
Bernstein Emerging Markets (SNEMX) 9.0 1.44
DFA Emerging Markets II (DFETX) 7.8 0.34

 

 

There are five categories in which we have comparable funds. To start, we'll equal-weight each of the AB funds in the same asset class. We'll then equal-weight the five asset classes. That produces a portfolio return of 5.7 percent for AB's actively managed funds.

 

Applying the same calculation to the portfolio of DFA funds produces a return of 6.7 percent. In addition, of the 10 AB funds we examined, just three (or 30 percent) managed to outperform the comparable DFA funds.

 

Thus, despite all the supposed advantages that AB professes to possess, there's no evidence to support Marx's claim that active management improves the odds of achieving your investment goals—at least not if you're using AB's funds.

 

I would also add it's possible that the results from the comparison could have been worse, because Morningstar's data contains survivorship bias. There could have been other AB funds that performed poorly during this period and as a result where either closed or merged out of existence. I don't have the tapes to know if that is the case.

 

Expenses Matter

Applying the same methodology that we used to calculate the AB funds' average return yields an average fund expense ratio of 1.26 percent. The DFA funds' average expense ratio is 0.27 percent. The 0.99 percentage point difference in expenses fully explains the 1 percent difference in returns between the two investment firms' funds. In other words, AB failed to add value not because of poor stock selection or market-timing skills, but simply because its expenses were higher.

 

In fact, because actively managed funds typically have higher turnover rates—which in turn result in higher trading costs—the gross returns of the AB funds (before accounting for any expenses) were probably higher than the gross returns of the DFA funds. This is fully consistent with the historical evidence showing that, in aggregate, actively managed mutual funds tend to have higher gross returns but lower net returns, the only type of returns investors get to spend.

 

As noted earlier, there's an overwhelming body of evidence demonstrating that, while it's possible to win the game of active management, using actively managed funds instead of passively managed funds greatly reduces your odds of achieving your financial goals. Making matters worse is that the percentage of active managers generating alpha (outperformance appropriate to risk-adjusted benchmarks) has been persistently shrinking.

 

My co-author Andrew Berkin and I present the evidence and explain why the quest for alpha has become increasingly frustrating for active managers in our recently published book, The Incredible Shrinking Alpha.


Larry Swedroe is the director of research for the BAM Alliance, a community of more than 150 independent registered investment advisors throughout the country.

 

 

 

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