Low Cost Active Funds: Theoretical Advantages?

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TD2626
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Low Cost Active Funds: Theoretical Advantages?

Post by TD2626 » Sun May 07, 2017 7:02 pm

A piece of theory regarding indexing vs active funds has been confusing me for some time. Essentially, the existence of very low-cost active funds from Vanguard seems to substantially weaken the case for indexing. My thoughts are as follows:

It is often said that the average active fund gets the market return before expenses. This is because the average dollar in the market must get the average return. However, that statement assumes that active mutual funds are the entire market. This is not actually the case – there are other market participants as well.

Assume investors are divided into two groups. Group 1 investors are able to exploit market inefficiencies – while group 2 investors instead create market inefficiencies.

Group 1 investors are knowledgeable active investors. They are backed by teams of research analysts and carefully evaluate data contained in annual reports. Group 1 investors are the active fund managers. Assume that the value of the fraction of all dollars in the market that are controlled by group 1 can be represented by the variable “a”.

Group 2 investors are “naïve investors”. These are, for example, active individual stock investors that do not do significant due diligence. They make purchases of stocks based on, for example, “hot tips” or recommendations from their taxi driver. Or, they buy individual stock in the company they work for because they feel it’s safe. Assume that the value of the fraction of all dollars in the market that are controlled by group 2 can be represented by the variable “b”. Also assume that a+b=1 (i.e. that market dollars are divided into knowledgeable group 1’s “a” dollars and naïve group 2’s “b” dollars).

Essentially, group 2 investors – who purchase stocks for reasons other than their fundamental values – create market inefficiencies. Although the EMH suggests that such inefficiencies are limited, it is hard to argue that they do not exist. Assume that because of not doing due diligence, the active individual stock investors in group 2 have 5% returns.

If the total market returns 10%, then the average dollar in the market MUST return 10% - it’s simple math.

Thus, the theoretical return of the group 1 investor’s dollars can be calculated from the following equation, where x is the return of the group 1 investor’s dollars before fees:

(a * x ) + (b * 5% returns of group 2) = 10% returns of the average dollar

Assume that “a” equals 0.9 and “b” equals 0.1 (i.e. group 1 investors control 90% of all dollars and group 2 investors control 10% of all dollars).

Solving the equation, one finds that x is equal to 10.556% Thus, theoretically, in this situation, the group 1 investors would have returns of nearly 55.6 basis points higher than the market, before costs. It is thus predicted, by this simple model, that actively managed funds would “beat the market” before costs. However, if an active fund has an expense ratio of 155 basis points, then that fund would, in theory, loose to the market by roughly 1% per year! This is why in general, index funds beat active funds after costs.

But – the existence of very low cost active funds (primarily the ones offered at Vanguard) seems to really change things. Say you can find an active fund that charges 35 basis points per year. Thus, in this case, the fees for the active fund would eat up 35 of the 55.6 basis points of theoretical active fund advantage. However, the investor would still be ahead by over 20 basis points.

Does this calculation make sense? Would it be a good idea to put a small portion of assets in low cost active funds in case this argument turns out to be correct?

***Note: I strongly support individuals having the overwhelming majority of assets in low-cost index funds. I’m just trying to work this over theoretically in order to be even more comfortable with my recent transfers into index funds.

lack_ey
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Re: Low Cost Active Funds: Theoretical Advantages?

Post by lack_ey » Sun May 07, 2017 7:22 pm

The question is whether any advantage is greater than the additional cost.

If you look historically, the average mutual fund beat the market or the benchmark (or was it positive 3-factor alpha? I forget) before costs. Worse than the market or benchmark after costs. And sure, all the data shows that costs are predictive of performance among both active and passively managed funds.

The issue is that most recent looks at cheapest quintile of active funds (maybe decile too? it's been a while) don't show outperformance compared to the benchmarks, just better performance on average than the more expensive funds. That's before tax.

There are a lot of suggested ways to sort mutual funds to be able to select sufficiently above-average performers that you beat the market, many of which probably will not hold going forward. But I don't think sorting on costs alone gets you there, even with the data available. Could be different in the future, though.

avalpert
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Re: Low Cost Active Funds: Theoretical Advantages?

Post by avalpert » Sun May 07, 2017 7:26 pm

A simple look at mutual fund returns will show you that not all their managers are in your hypothetical group 1 - even ones that appear to be for long stretches have a tendency to follow that up with long stretches of suddenly not being those that are exploiting the inefficiency creators. One might logically conclude from this that, at least with fund managers whose records are quite public, this hypothetical grouping is a mirage and really temporary outperformance is mostly luck and persistent outperformance is rare and unpredictable in advance. The exploitees and exploiters aren't easily identified.

All that is before you start talking about fees. So sure, a lower cost active fund has an expected return that is better than a higher one - but still with more diversifiable risk then an index fund even at the same cost.

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knpstr
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Re: Low Cost Active Funds: Theoretical Advantages?

Post by knpstr » Sun May 07, 2017 7:29 pm

I skimmed your post but it appears you are thinking correctly.

The "trick" is picking the out performers beforehand.

A number of things outperform the market averages now, they just typically don't outperform consistently and forever, though some do manage a great streak.
Very little is needed to make a happy life; it is all within yourself, in your way of thinking. -Marcus Aurelius

carofe
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Re: Low Cost Active Funds: Theoretical Advantages?

Post by carofe » Sun May 07, 2017 7:59 pm

I read a report from morningstar of the best actively managed funds. Guess what, most of them where Vanguard and American Funds, which are low cost (yearly expenses).

Also, American Funds released a report stating that the most important two variables that can tell you if the actively managed funds will outperform are: manager ownership and low cost annual expenses.

So you are correct.
US Total Stock Market + Intermediate Term Bond. That's it.

GLState
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Re: Low Cost Active Funds: Theoretical Advantages?

Post by GLState » Sun May 07, 2017 8:24 pm

carofe wrote:I read a report from morningstar of the best actively managed funds. Guess what, most of them where Vanguard and American Funds, which are low cost (yearly expenses).

Also, American Funds released a report stating that the most important two variables that can tell you if the actively managed funds will outperform are: manager ownership and low cost annual expenses.

So you are correct.
If you're buying American Funds outside of a 401k plan, you'll likely encounter loads. American's EuroPacific Growth Fund class A shares has a 5.75% front end load. Front-end and back-end loads usually are not taken into account when returns are shown. A fund with a 5.75% load has a slim chance of ever outperforming an index fund when all costs are accounted for.
Last edited by GLState on Sun May 07, 2017 8:30 pm, edited 1 time in total.

carofe
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Re: Low Cost Active Funds: Theoretical Advantages?

Post by carofe » Sun May 07, 2017 8:29 pm

GLState wrote:
carofe wrote:I read a report from morningstar of the best actively managed funds. Guess what, most of them where Vanguard and American Funds, which are low cost (yearly expenses).

Also, American Funds released a report stating that the most important two variables that can tell you if the actively managed funds will outperform are: manager ownership and low cost annual expenses.

So you are correct.
If you're buying American Funds outside of a 401k plan, you'll likely encounter loads. American's EuroPacific Growth Fund class A shares has a 5.75% front end load. Front-end and back-end loads usually are not taken into account when returns are shown.
You are right, for both reports they didn't take into account front-loads. I didn't buy American Funds in the past because of that. 5% is a lot of hard working money. However, I give them the credit that 5% load + low cost annual expenses is better for the investor than no load and high annual expenses in the long term (for those that like actively managed funds). I also think they are one of the best actively managed funds out there, together with Vanguard actively managed funds.
US Total Stock Market + Intermediate Term Bond. That's it.

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BL
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Re: Low Cost Active Funds: Theoretical Advantages?

Post by BL » Sun May 07, 2017 8:54 pm

I understand you can now buy American funds at Fidelity and Schwab without loads.
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