High ER and Index fund results

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bilperk
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High ER and Index fund results

Post by bilperk » Sun Apr 07, 2013 9:36 am

Someone posted this comment:

"The relative [better] performance of index funds compared to the total set of all funds is not that disputable. And yes, if one simply discards the top 20% of the HIGHEST EXPENSE RATIO ACTIVE FUNDS from the population, index funds get into the bottom half."

Is this true? Are there studies that show the relative active -passive performance if the funds with the highest 20% of ERs are removed? 50%?
Bill

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Random Musings
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Re: High ER and Index fund results

Post by Random Musings » Sun Apr 07, 2013 10:33 am

Some thought that have passes through my mind on this one...

With very low active ER funds, I thought the studies concluded that you have a better chance, but no guarantees to still outperform. This would not account for the [edit: remaining portion of the] other 80%.

Over very long periods of time (20 to 30 years), I though passive wins 80 to 85 % of the time.

Rick F just mentioned something about a strategy of using funds before they get to large, works on paper but not easy to implement in real world.

Also have to consider adjusting actives for risk.....

RM
Last edited by Random Musings on Sun Apr 07, 2013 12:32 pm, edited 1 time in total.
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bilperk
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Re: High ER and Index fund results

Post by bilperk » Sun Apr 07, 2013 10:51 am

Well, it seems to me that if just eliminating the 20-30% of the Highesr ER active funds from the selection pool would change the odds of indexing outperforming to less than 50%, that would be pretty easy to do. This is why I am questioning if the 20% number or even a 50% number has been shown to be true.
Bill

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Re: High ER and Index fund results

Post by pauliec84 » Sun Apr 07, 2013 11:18 am

Well, it seems to me that if just eliminating the 20-30% of the Highesr ER active funds from the selection pool would change the odds of indexing outperforming to less than 50%, that would be pretty easy to do. This is why I am questioning if the 20% number or even a 50% number has been shown to be true.
This would be a very significant result even with the selection bias. It means there is a strategy out there that we can take, i.e., selecting low E.R. active funds, and beat the market.

Th evidence I know about would say this is not true. With that said, I think there is space for "passive management" shops such as DFA which simply produce alpha not buy picking winners but buy being liquidity providers rather than takers.

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Re: High ER and Index fund results

Post by winterescape » Sun Apr 07, 2013 11:48 am

A personal conversation I had with Jack about Index VS active funds and the apparent dichotomy within Vanguard (Wellington, STAR, etc…) he indicated that given the same asset allocation (stock, bond) and holdings (value, growth, small cap, large cap, etc) that the ER was the driving factor in predicting performance. The comment I do recall him making was that with an index fund you have no risk of underperforming the market.

Now I am leaving out other points which may or may not be significant to your situation, largely taxes. If you are restricting your holdings to a tax sheltered account this point is moot.

A Study from Morningstar evaluating the predictive ability of the Morningstar rating system concluded much the same thing.
http://www.morningstar.com/advisor/t/42 ... uccess.htm?

The point that is frequently made here on the forums is that the ER of index funds is typically significantly lower than the ER of a actively managed fund and so any active management strategy needs first to overcome that delta before contributing to the funds performance.

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Re: High ER and Index fund results

Post by Rick Ferri » Sun Apr 07, 2013 12:03 pm

On average any single year, index funds outperform 60% of all actively managed funds. If 20% of lesser performing active funds were eliminated, then the percentage of active fund beaten by index funds would fall from 60% to 50%. Thus, if all high fee funds underperformed index funds, then it's feasible that index funds might fall in the bottom half.

The problem with this theory is that not all high cost active funds underperform index funds. So, you would have to know which high cost active funds were going to underperform to get this strategy to work.

Rick Ferri

PS. I've done a lot of work on screening actively managed fund in an attempt to narrow the probability of underperforming. Lower fees do help the odds a little, but with low fee active funds comes a lot of "closet indexing." Many low fee active funds don't deviate much from an index fund return. So when there is true alpha, it's not very large.

Rick Ferri
The Education of an Index Investor: born in darkness, finds indexing enlightenment, overcomplicates everything, embraces simplicity.

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Re: High ER and Index fund results

Post by bilperk » Sun Apr 07, 2013 1:05 pm

Thanks Rick. The person who said that claimed there were studies to show it but couldn't find them. I was pretty sure this made little sense because it is so easy to screen for ER. I think this person is just taking the costs matter hypo too far.
Bill

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Re: High ER and Index fund results

Post by stratton » Sun Apr 07, 2013 1:28 pm

Rick Ferri wrote:PS. I've done a lot of work on screening actively managed fund in an attempt to narrow the probability of underperforming. Lower fees do help the odds a little, but with low fee active funds comes a lot of "closet indexing." Many low fee active funds don't deviate much from an index fund return. So when there is true alpha, it's not very large.

Rick Ferri
What about actively managed sector funds?

The Financial Times John Authors in his week end column

High cost leave managed fund without a defence
Another option is to abandon diversification and really try to beat the market. This is risky. But according to Morningstar, most sector fund managers, investing only in a small universe of stocks, do beat their benchmarks. When combined with index funds inside pension funds, such funds make great sense.
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Rick Ferri
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Re: High ER and Index fund results

Post by Rick Ferri » Sun Apr 07, 2013 3:56 pm

Is that before or after survivorship bias? Something like 70 percent of tech funds have closed since 2001.

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Re: High ER and Index fund results

Post by grabiner » Sun Apr 07, 2013 4:05 pm

bilperk wrote:"The relative [better] performance of index funds compared to the total set of all funds is not that disputable. And yes, if one simply discards the top 20% of the HIGHEST EXPENSE RATIO ACTIVE FUNDS from the population, index funds get into the bottom half."
I'm surprised that this is true with just 20%, but it's a comparison of apples and orange slices. I would not be at all surprised if the average low-expense active fund beats the average index fund; there are plenty of S&P index funds with loads and 12b(1) fees, and an active fund with lower cost should beat those funds more often than not.

I would expect that if you throw out the highest-expence 20% of both index and active funds in each peer group, index funds retain whatever advantage or disadvantage they had.
Wiki David Grabiner

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Re: High ER and Index fund results

Post by ThePrune » Sun Apr 07, 2013 7:01 pm

bilperk wrote:Well, it seems to me that if just eliminating the 20-30% of the Highesr ER active funds from the selection pool would change the odds of indexing outperforming to less than 50%, that would be pretty easy to do. This is why I am questioning if the 20% number or even a 50% number has been shown to be true.
Another key queston to ask of actively managed funds is what percentage of outperforming funds achieve this result by skill versus mere luck. After all, if the actively managed funds that outperform the index averages do so by by luck, there's no sense in purchasing them (i.e. no sense in paying higher fees for luck)! Chapter 4 in Rick Ferri's book The Power of Passive Investing got me started along this line of thinking.

The 2 recent academic articles I like to share with people that deal quantitatively with the Passive versus Active management debate are:

Eugene Fama and Kenneth French, Luck versus Skill in the Cross Section of Mutual Fund Returns, Journal of Finance Vol. 65, No. 5 (2010) pp1915-1947.

L. Barras, O. Scaillet and R. Wermers, False Discoveries in Mutual Fund performance: Measuring Luck in Estimated Alphas, Journal of Finance Vol. 65, No. 1 (2010) pp 179-216.

Both research reports, covering a long-range (multi decade) time period, produced very similar results: after accounting for mutual fund fees, only a very tiny fraction of activiely managed mutual funds appear to have outperformed based on skill rather than luck. The Fama-French study estimated only about 3% outperformance based on skill. The Barras-Scaillet-Wermers study estimated only about 0.6% outperformance based on skill.

So based on these extensive studies, I see little to entice me to investigate approaches to find the thin slice of the "best of the best" of the actively managed, skillful funds. The odds appear to be too poor.
Investment skill is often just luck in sheep's clothing.

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Rick Ferri
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Re: High ER and Index fund results

Post by Rick Ferri » Sun Apr 07, 2013 7:08 pm

Go to page 15 of this Vanguard report: The Case for Index Funds.

The charts are a little small and hard to read, but you can see in each asset class how fees affect return. The highest cost active funds do not have the worse returns, nor do the lowest cost active funds have the best return. The general trend slopes that way, but it's very noisy. The best performing funds tend to have average fees for the category.

Rick Ferri
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Re: High ER and Index fund results

Post by leonard » Mon Apr 08, 2013 7:42 pm

bilperk wrote:Someone posted this comment:

"The relative [better] performance of index funds compared to the total set of all funds is not that disputable. And yes, if one simply discards the top 20% of the HIGHEST EXPENSE RATIO ACTIVE FUNDS from the population, index funds get into the bottom half."

Is this true? Are there studies that show the relative active -passive performance if the funds with the highest 20% of ERs are removed? 50%?
Even if it is true, there is no action you can take based on the information that would improve the anticipated return you would get, over and above index funds.
Leonard | | Market Timing: Do you seriously think you can predict the future? What else do the voices tell you? | | If employees weren't taking jobs with bad 401k's, bad 401k's wouldn't exist.

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Re: High ER and Index fund results

Post by pkcrafter » Mon Apr 08, 2013 11:31 pm

bilperk wrote:Someone posted this comment:

"The relative [better] performance of index funds compared to the total set of all funds is not that disputable. And yes, if one simply discards the top 20% of the HIGHEST EXPENSE RATIO ACTIVE FUNDS from the population, index funds get into the bottom half."

Is this true? Are there studies that show the relative active -passive performance if the funds with the highest 20% of ERs are removed? 50%?
Bill, you are asking the Bogleheads if it's true, but did you also ask the "someone" who posted it if it's true? In other words, does he have some article, study, or documentation that it's true? I've never seen such a study, and Rick is correct, there are some high cost funds that seem to have pretty good records, but as a whole the highest cost funds are at a significant disadvantage.

I think there are problems in assuming that index funds would underperform 50% of active funds if the top 20% of active funds with highest costs are eliminated. Index funds win for two main reasons--one is low cost, and the second is problems that active funds can and do run into. Some of these problems are due to manager miscalculations and some are due to internal and external factors managers can't control. And you might even add a third reason, plan ol' bad luck. In addition to these reasons, the math doesn't add up. If index funds beat 80% of all funds after 20 years, why would they drop to under 50% if the top 20% of high cost active funds were eliminated from the bottom of the list?

Maybe another way to look at this is 20% of active funds beat index funds over a 20 year period, and if you eliminate the highest cost funds the number of active funds winning will not go up because you eliminated the dogs. You don't increase the number of winning funds, you only reduce the average amount of loss.

1000 funds, 200 beat the index returns. 20%
800 funds, 200 beat the index returns. 25%, not >50%

Paul
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Re: High ER and Index fund results

Post by KyleAAA » Tue Apr 09, 2013 12:16 pm

I think a more useful way to phrase the question is like this: given an ultra low cost active option (like, say, Wellesley of Wellington), would you STILL pick an index fund if the cost difference were under .15%? 0.10%? At what point would you roll the dice on active? I don't care what percentage of active funds actually end up being able to beat the index. All I care about is whether or not I can determine which ones might in advance. Maybe if the cost advantage is small enough, it would be worth taking a chance on active.

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Re: High ER and Index fund results

Post by grabiner » Tue Apr 09, 2013 7:38 pm

KyleAAA wrote:I think a more useful way to phrase the question is like this: given an ultra low cost active option (like, say, Wellesley of Wellington), would you STILL pick an index fund if the cost difference were under .15%? 0.10%? At what point would you roll the dice on active? I don't care what percentage of active funds actually end up being able to beat the index. All I care about is whether or not I can determine which ones might in advance. Maybe if the cost advantage is small enough, it would be worth taking a chance on active.
And a lot of Bogleheads agree with this principle; if an active fund better meets your investing needs, and the cost difference is trivial (normally, this requires an IRA or 401(k)), it's a fine choice. I am all-index now, but I have held Growth&Income, Windsor, and International Explorer in the past, and don't consider any of those to be a mistake. I have also held International Growth in my taxable account in the past, which was a mistake and cost me capital-gains tax to fix by switching to Tax-managed International.

Normally, I recommend index funds (if available) when giving advice, because they are a natural default portfolio. But I won't recommend that a poster who already has something like Wellington in an IRA sell it.
Wiki David Grabiner

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The other benefits of indexing.

Post by Taylor Larimore » Tue Apr 09, 2013 8:29 pm

Bogleheads:

Sometimes we forget that higher average returns are not the only benefit of indexing. Other benefits that can be even more important:.

Lower risk: The increased diversification of index funds results in lower risk. Baer & Ginsler did a study of Standard Deviaton for actively managed funds vs. the total stock market over both 5 and 10-year periods. Their conclusion: "The returns of actively managed funds were 20 to 25% more volatile than the broad market."

Consistency: Only once in the past 15-years did Vanguard's Total Stock Market Index Fund fall below its large-blend category average. As a result, at the end of last year it was in the top 29% of all large-blend funds before tax, and the top 20% after tax.

Continuation: Of 355 actively managed equity mutual funds around in 1974, less than half survive today. Indexers do not have to worry that their fund will disappear.

No style drift: We know that asset allocation determines about 90% of portfolio performance. Managed fund allocations often change.

No overlap: It is almost inevitable that a portfolio of managed funds will have overlap. This is not a problem with index funds.

No manager changes: History tells us that the average manager leaves within five years. Index fund investors do not worry about manager changes.

No asset bloat: which often causes large successful funds to underperform (Magellan, Leg Mason Value Trust).

Less cash dilution. Index funds hold less cash than active funds.

Under-performance: No worry that a manager has "lost his touch."

Tax-Efficiency: Index funds are significantly more tax-efficient than most managed funds. It is after-tax return that counts.

Low maintenance: Index funds are simple, predictible, and easy to understand, explain, and maintain.

Peace of mind: Indexers know the averages are always working for them. The index investor has much less worry and more free time to spend with family and other more enjoyable endeavors.

Best wishes.
Taylor
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Re: High ER and Index fund results

Post by wshang » Tue Apr 09, 2013 10:29 pm

This might be an opportunity to bring up another aspect other than ER - turnover. High turnover results in costs which are not reflected in ER. I have a large position in the Mairs and Power Growth Fund. I think one of the major reasons why it has managed to beat the S&P500 over the 10 and 20 year timeframes despite the ER of 0.72 is the extremely low turnover rate of 1.58%.

That said, are there other factors which are not reflected in Expense Ratio which one should look at?

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Re: High ER and Index fund results

Post by ftobin » Wed Apr 10, 2013 10:35 am

wshang wrote:I have a large position in the Mairs and Power Growth Fund. I think one of the major reasons why it has managed to beat the S&P500 over the 10 and 20 year timeframes despite the ER of 0.72 is the extremely low turnover rate of 1.58%.
It's average market cap holding is $15b, compared to $55b for the S&P 500, or $30b for Total Market. I'd suggest that the S&P 500 is not the appropriate benchmark.

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Re: High ER and Index fund results

Post by tsturbo » Wed Apr 10, 2013 7:50 pm

^^^^^^
What he said

Thank you Taylor for the great reminders index funds have over active management

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