Swedroe: Lessons Of 2017, Part 1

Every year, the markets provide us with lessons on the prudent investment strategy. Many times, markets offer investors remedial courses, covering lessons it taught in previous years. That’s why one of my favorite sayings is that there’s nothing new in investing—only investment history you don’t yet know.

Last year supplied 10 important lessons. As you may note, many of them are repeats. Unfortunately, too many investors fail to learn them—they keep making the same errors again and again. We’ll begin with my personal favorite, one that the market, if measured properly, teaches each and every year.

Lesson 1: Active management is a loser’s game.

Despite an overwhelming amount of academic research demonstrating that passive investing is far more likely to allow you to achieve your most important financial goals, the vast majority of individual investor assets are still held in active funds. Unfortunately, investors in active funds continue to pay for the triumph of hope over wisdom and experience.

Last year was another in which the large majority of active funds underperformed, despite the great opportunity active managers had to generate alpha through the large dispersion in returns between 2017’s best-performing and worst-performing stocks. For example, while the S&P 500 returned 21.8% for the year, including dividends, in terms of price-only returns, 182 of the companies in the index were up more than 25%, 49 were up at least 50%, 10 were up at least 80.9%, and three more than doubled in value. The following table shows the 10 best returners:

To outperform, all an active manager had to do was to overweight those big winners. On the other hand, there were 125 stocks within the index that, on a price-only basis, were down for the year. Fifty-nine stocks lost at least 10%, 20 were down at least 25%, and the 10 largest losers (see the following table) lost at least 44.2%. 

To outperform, all an active manager had to do was to underweight these dogs.

It’s important to note that this wide dispersion of returns is not at all unusual. Yet despite the opportunity, year after year, in aggregate, active managers persistently fail to outperform.

The following table shows the percentile rankings for funds from two leading providers of passively managed funds, Dimensional Fund Advisors and Vanguard, in 2017 and over the 15-year period ending December 2017. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends DFA funds in constructing client portfolios.)

Keep in mind that Morningstar’s data contains survivorship bias, as it only reflects funds that have survived the full period. The bias is significant, as about 7% of actively managed funds disappear every year, with their returns getting buried in the mutual fund graveyard. Thus, the longer the period, the worse the survivorship bias becomes, and at 15 years, it’s quite large.

Fraught With Opportunity

The results make it clear that active management is a strategy that can be said to be “fraught with opportunity.” Year after year, active managers come up with an excuse to explain why they failed, and then argue that next year will be different. Of course, it never is.

With that in mind, it’s interesting to note the following observation from Larry Fink, chief executive of BlackRock (which has more than $260 billion in assets under management).

The firm reportedly has been cutting back on active management and focusing instead on a more rules-based approach driven by algorithms rather than human intuition. Commenting on this change of strategy, Fink said this: “The democratisation of information has made it much harder for active management. We have to change the ecosystem—that means relying more on big data, artificial intelligence, factors and models within quant and traditional investment strategies.”

Mark Wiseman, hired in 2016 to revamp BlackRock’s equity business, added this: “The old way of people sitting in a room picking stocks, thinking they are smarter than the next guy—that does not work anymore.”

The good news is that lots of investors have figured this out. Over the three years ended Aug. 31, 2017, investors put nearly $1.3 trillion into passively managed mutual funds and ETFs while draining more than a quarter-trillion dollars from active funds, according to Morningstar. Although 66% of mutual fund and ETF assets are still actively invested, that number is down from 84% 10 years ago and shrinking fast. 2017 was the fourth-straight year that money had flowed into passive funds and out of active funds.

A good example of this trend is that, in April 2017, Pennsylvania’s elected treasurer revealed the state would move about $1 billion in funds that had been actively managed to passive strategies in an effort designed to save millions in annual fees.

Lesson 2: Valuations cannot be used to time markets.

We entered 2017 with U.S. equity valuations at very high levels. In particular, the popular metric known as the Shiller CAPE 10 was at 27.9—a level seen only twice before, in the late 1920s and the late 1990s, and both were followed by severe bear markets.

Cliff Asness’ 2012 study on the CAPE 10 found that when it was above 25.1, the real return over the following 10 years averaged just 0.5%—virtually the same as the long-term real return on the risk-free benchmark, one-month Treasury bills, and 6.3 percentage points below the U.S. market’s long-term real return. This concerned many investors, possibly leading them to reduce, or even eliminate, their equity holdings. However, it’s important to note there was still a wide dispersion of outcomes—the best 10-year forward real return was 6.3%, just half a percentage point below the historical average, while the worst was -6.1%.

In addition, what many investors may not have been aware of is that when using traditional price-to-earnings (P/E) ratios, history shows there is virtually no correlation between the market’s P/E and how the market performs over the subsequent year (or even years). The following is a good reminder of that.

In December 1996, the CAPE 10 was at virtually the same lofty level at which we began 2017 (that is, 27.7). The highly regarded—at least at the time—chairman of the board of the Federal Reserve, Alan Greenspan, gave a talk in which he famously declared the U.S. stock market to be “irrationally exuberant.” That speech, given in Tokyo, caused the Japanese market to drop about 3%, and markets around the globe followed. The next three years saw the S&P 500 Index return 33.4%, 28.6% and 21.0%, producing a compound return of 27.6%.

That higher valuations forecast lower future expected returns doesn’t mean one can use that information to time markets. And you should not try to do so, as the evidence shows such efforts are likely to fail.

This doesn’t mean, however, that the information has no value. You should use valuations to provide estimates of returns so you can determine how much equity risk you need to take in your portfolio to have a good chance of achieving your financial goals. But expected returns should only be treated as the mean of a potentially wide dispersion of outcomes. Your plan should be able to address any of these outcomes, good or bad.

Lesson 3: Even if the Fed is raising rates, it doesn’t mean you should stay in short-term bonds.

As we entered 2017, many investors were sure the Federal Reserve would continue to raise interest rates. That led many gurus to recommend investors limit their bond holdings to the shortest maturities. In late 2016, economist Jeremy Siegel even warned that bonds were “dangerous.”

On March 15, 2017, the Federal Reserve raised interest rates by 0.25 percentage points. It did so again on June 14, 2017, and once more on December 13, 2017.

However, despite the prediction that interest rates would rise having actually come to pass, the Vanguard Long-Term Treasury Index ETF (VGLT) returned 8.6%, outperforming Vanguard’s Intermediate-Term Treasury Index ETF (VGIT), which returned 1.7%, and the Vanguard Short-Term Treasury Index ETF (VGSH), which returned 0.0%.

The fact that rates are likely to rise doesn’t tell you anything about what bond maturity will produce the best return. The reason is quite simple. The markets are forward-looking—they incorporate all available information into current prices. With bonds, that means the yield curve already reflected the expectation of the Fed raising rates. Thus, unless rates rose even faster than expected, there would be no benefit to staying short as long as the yield curve was positively sloped, which it was throughout 2017.

Finally, the evidence shows there are no good forecasters when it comes to interest rates. We can see this each time S&P Dow Jones Indices produces its SPIVA scorecards. The following results are from the midyear 2017 scorecard, the latest available, and cover the 15-year period ending June 2017:

•  Just 2% of actively managed long-term government bond funds, long-term investment-grade bond funds and high-yield funds beat their respective benchmarks.
•  For domestic bond funds, the least poor performance was in intermediate- and short-term investment-grade funds, where 76% and 71% of active funds underperformed, respectively.
• Active municipal bond funds also fared poorly, with between 84% and 92% of them underperforming.
• Emerging market bond funds fared poorly as well, as 67% of them underperformed.

We’ll pick up later this week with lessons four through seven.

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.