Larry Swedroe: Persistent Returns Remain Elusive

Discuss all general (i.e. non-personal) investing questions and issues, investing news, and theory.
Post Reply
Random Walker
Posts: 2109
Joined: Fri Feb 23, 2007 8:21 pm

Larry Swedroe: Persistent Returns Remain Elusive

Post by Random Walker » Fri Jun 16, 2017 9:03 am

http://www.etf.com/sections/index-inves ... in-elusive

Larry reviews recent SPIVA scorecard showing that passive is the winning strategy

Dave

User avatar
nedsaid
Posts: 8821
Joined: Fri Nov 23, 2012 12:33 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by nedsaid » Sun Jun 18, 2017 1:49 pm

Looking pretty darned discouraging for active managers, isn't it?
A fool and his money are good for business.

User avatar
TD2626
Posts: 586
Joined: Thu Mar 16, 2017 3:40 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by TD2626 » Sun Jun 18, 2017 2:18 pm

I feel that active managers can on average get a small amount (mabye 50 basis points) of alpha a year before fees by exploiting market inefficiencies caused by individual stock traders following "hot tips" or investing blindly in ESOPs. There is unfortunately a large risk/standard deviation to this alpha. The risk, though, doesn't have a high correlation to the rest of the market. If you have a fund that has an expense ration of 30-40 basis points, a very small allocation to active may be able to be justified.

... Lots of calculations later ...

I ran some MPT based calculations that showed that, given reasonable assumptions about alpha, expense ratios, correlations, returns, and many other parameters, the portfolio that maximizes Sharpe ratio is roughly 90% index funds and 10% active funds. Adding more than about 10% active funds reduced the Sharpe ratio substantially, according to my model. Note that this model assumed Vanguard active fund level expense ratios. Higher expense ratios (especially those above 50 basis points) are very, very hard to justify.

The calculations Sharpe ratio increase from going from 100% index funds to 90% index funds was only about 0.0001. When you get out to the fourth decimal place in the Sharpe ratio, the difference is negligible.

Almost all alpha, if it even exists, is kept by the managers in high fees. I guess those concerned about black swan "what if everyone indexed" events could put a small portion of their portfolio in low-cost, broadly diversified active funds... but is the complexity worth it?

Indeed, investors who go for things like Vanguard Wellington instead of a 60/40 three-fund indexed portfolio probably won't come out far behind over the very long term due to Wellington's very low expense ratio.

This exercise, though, opened my eyes to how much expense ratio matters and why the "cost matters hypothesis" is so strong. It also showed how hard it is to beat index funds. That's why I feel index funds are the best option for the overwhelming majority of most investors and most portfolios.

User avatar
nisiprius
Advisory Board
Posts: 34311
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by nisiprius » Sun Jun 18, 2017 2:28 pm

TD2626 wrote:...Almost all alpha, if it even exists, is kept by the managers in high fees...
Indeed.
...I guess those concerned about black swan "what if everyone indexed" events could put a small portion of their portfolio in low-cost, broadly diversified active funds... but is the complexity worth it?...
Please elucidate further. "Black swans" are sudden, low-probability, unexpected events. If the threshold for problems with too much indexing is 75%, what would be the scenario in which we would go from about 30% passive (current) to over 75% indexed so suddenly and completely that it would be a dangerous event? What is the advantage in using active funds now? Why can't we cross that bridge "when" we come to it?

John C. Bogle has said "Successful investing involves doing just a few things right and avoiding serious mistakes." What is the scenario in which keeping entirely in index funds until the actual moment when problems start to become evident would be a serious mistake? What is the scenario in which having a portion in active funds would be more than incrementally better?
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

User avatar
TD2626
Posts: 586
Joined: Thu Mar 16, 2017 3:40 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by TD2626 » Sun Jun 18, 2017 3:33 pm

nisiprius wrote:
TD2626 wrote:...Almost all alpha, if it even exists, is kept by the managers in high fees...
Indeed.
...I guess those concerned about black swan "what if everyone indexed" events could put a small portion of their portfolio in low-cost, broadly diversified active funds... but is the complexity worth it?...
Please elucidate further. "Black swans" are sudden, low-probability, unexpected events. If the threshold for problems with too much indexing is 75%, what would be the scenario in which we would go from about 30% passive (current) to over 75% indexed so suddenly and completely that it would be a dangerous event? What is the advantage in using active funds now? Why can't we cross that bridge "when" we come to it?

John C. Bogle has said "Successful investing involves doing just a few things right and avoiding serious mistakes." What is the scenario in which keeping entirely in index funds until the actual moment when problems start to become evident would be a serious mistake? What is the scenario in which having a portion in active funds would be more than incrementally better?
A black swan is an unexpected event. By nature, no one can predict it. If it was predictable, it would not be a black swan. We've never had a scenario where there was >50% indexing so we can't predict what would happen.

Although no one can predict what may happen, here are some very, very, very low probability ideas:
-Major malfeasance by index providers (Russell, MSCI, etc)
-A drastic increase in fees charged by index providers (Russel, MSCI, etc) to index funds
-A sudden and large increase levels of front running that affects indexers
-An enormous speculative bubble, driven almost solely by individual investors in individual stocks, that index funds are forced to ride up and down but active funds stay away from
-Regulations or policies that adversely impact operations of index funds
-Index fund providers deciding that they feel like charging higher and higher fees (or not offering index funds anymore at all).
-Large problems with ETF speculators trading very rapidly in and out of the whole market without regard to the valuations of individual companies
-The equity risk premium going down because investors can now so easily and cheaply eliminate non-diversifiable risk.
-Funds being adversely affected by investors leaving to a different "next hot thing" (since index funds seem to be very popular now).

There is the possibility that a hypothetical indexopacolypse happens so suddenly that investors can't change funds fast enough. Also, in taxable any changes in strategy generate taxable gains that produce a tax drag, so one needs to adopt a strategy that will work well in any circumstances - buy and hold forever, and stay the course.

It very likely will be fine to have high levels of indexing in the market. I can't really see any issues with the theory behind indexing. I strongly support the vast majority of investors having the vast majority of their funds be indexed.

Also, my post was mostly intended to be not about black swan risk but about the observation that if active funds have the potential to generate 0.5% alpha, a 1% ER fund never makes sense but a 0.3% ER fund (like Vanguard offers) might be reasonable in an AA plan since 0.5% - 0.3% = 0.2%.

User avatar
TD2626
Posts: 586
Joined: Thu Mar 16, 2017 3:40 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by TD2626 » Sun Jun 18, 2017 3:37 pm

Also, just to clarify, I really, really like index funds. I'm just getting a bit nervous over "should I ditch my last active fund or keep a small allocation in active" so I've been poking around and trying hard to find any issues with theory of indexing.

That I haven't found any huge issues with indexing after lots of effort is a good sign that indexing is the best thing to do long term.

User avatar
nisiprius
Advisory Board
Posts: 34311
Joined: Thu Jul 26, 2007 9:33 am
Location: The terrestrial, globular, planetary hunk of matter, flattened at the poles, is my abode.--O. Henry

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by nisiprius » Sun Jun 18, 2017 3:51 pm

TD2626 wrote:Although no one can predict what may happen, here are some very, very, very low probability ideas:
These are not rhetorical questions, you may have some interesting answers, but none of the ones you mention seem to be an argument for making an active allocation now.
Major malfeasance by index providers (Russell, MSCI, etc)
How does that affect me? The index provider is bribed by some company to allocate 30% of the index to that company, and the company's stock then tanks?
-A drastic increase in fees charged by index providers (Russel, MSCI, etc) to index funds
Doesn't affect me until the instant it happens. Total Stock's expense ratio rises from, say, 0.05% to 5%. At that point, everybody redeems in order to reinvest somewhere else. The rules say they are required to redeem at NAV, so there's no concern about the shares of the fund becoming depressed due to the mass outflow. In a fund like Total Stock, there's shouldn't be any drastic problem meeting a mass redemption because everything in it is liquid and has an actual market price. (Nothing drastic happened to PIMCO Total Return even though it lost 2/3rds of its asset, hundreds of billions of dollars, when Bill Gross exited... although that was spread out over a couple of years).[/quote]
A sudden and large increase levels of front running that affects indexers
Supposedly the modern indexes are very difficult to front-run effectively.
An enormous speculative bubble, driven almost solely by individual investors in individual stocks, that index funds are forced to ride up and down but active funds stay away from.
Not a problem. It is the active funds, not the index funds, that are required to execute in such a situation. If some stock multiplies in market value by a hundredfold, the index fund does nothing. It just goes on holding the same number of shares, and their value automatically multiples by a hundredfold. It is the active funds that have a problem because they must sell in order not to participate in the bubble.
Index fund providers deciding that they feel like charging higher and higher fees (or not offering index funds anymore at all).
Fine, so I cuss, shrug, redeem and buy something else. If they quit offering index funds they probably merge them into active funds and I don't need to do anything at all.
Regulations or policies that adversely impact operations of index funds.
Again, why do I need to anticipate this? Why not wait until it happens?
Large problems with ETF speculators trading very rapidly in and out of the whole market without regard to the valuations of individual companies.
Affects the whole market, and thus the stocks held by the active funds. So it may be a problem structurally for the stock market as a whole, but you don't avoid it by going active.
The equity risk premium going down because investors can now so easily and cheaply eliminate non-diversifiable risk.
Again, it's not a problem that can be avoided by switching to active funds (or holding an active fund allocation).
Funds being adversely affected by investors leaving to a different "next hot thing" (since index funds seem to be very popular now).
How are they adversely affected? This is the seemingly fundamental misunderstanding I keep hearing all the time. How, exactly, would the Vanguard Total Stock Market Index Fund be adversely affected by a large-scale defection? Walk me through it. And, again, this would affect active funds the same way unless they were overweighted in the next hot thing, which some of course would be (and thus outperform the market and the index fund) and some would not (and thus underperform).

The thing that people seem to miss is you redeem your mutual fund shares at the NAV of the individual stocks the fund is holding. The market doesn't judge the fund itself. 100 shares of AAPL held by a good mutual fund are worth exactly the same amount as 100 shares of AAPL held by a bad mutual fund.

If I carefully stir a pot of soup and then ladle out a well-mixed sample for myself, I don't make the soup left in the pot any better or worse than it was before.

I guess you can think of some "black swan" scenarios, such as this: index funds are declared illegal, the reduced expenses of index funds versus index funds is declared to be ill-gotten gains, and a "clawback" provision requires that all index fund investors not only to switch to active funds, pay a fine representing the total amount saved by lower expense ratios in index funds over the time they've held the funds.
Last edited by nisiprius on Sun Jun 18, 2017 4:02 pm, edited 3 times in total.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

MIpreRetirey
Posts: 640
Joined: Fri Sep 06, 2013 12:35 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by MIpreRetirey » Sun Jun 18, 2017 3:56 pm

TD2626 wrote,
A black swan is an unexpected event. By nature, no one can predict it. If it was predictable, it would not be a black swan. We've never had a scenario where there was >50% indexing so we can't predict what would happen.
Wouldn't index funds just sell(buy) all securities they hold equally by market cap? Like all their holdings are sold(bought) at a correlation of +1? It's still just left to the actives to change valuations to anything different. And at high indexing markets...it could take only small volumes of active trading to change prices. But with much smaller actives, there would be less competition, and less consensus among them?

User avatar
TD2626
Posts: 586
Joined: Thu Mar 16, 2017 3:40 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by TD2626 » Mon Jun 19, 2017 11:54 pm

nisiprius wrote:These are not rhetorical questions, you may have some interesting answers, but none of the ones you mention seem to be an argument for making an active allocation now.
Thank you for your very rigorous reply - you made good points (far better than I ever could). Apologies for my long winded response, and for taking a day or so to compose a reply.

I wrote some code and updated some of my models and spreadsheets. I also spent a good bit of time on Portfolio Visualizer.
The math is suggesting that, baring unusual or extenuating circumstances (such as a large unrealized capital gain in taxable):
1. Any fund with an expense ratio of greater than about 0.5% is virtually impossible to justify holding, ever.
2. Expense ratio matters. A lot.
3. Depending on expectations regarding alpha (and the standard deviation of alpha), an allocation to very-low-expense-ratio active funds may be justified. Plugging in the most reasonable inputs to my model I could come up with, it suggested a 5-10% allocation to active funds.
4. Thus, it may be possible to justify a 5-10% allocation to active funds with an expense ratio lower than about 0.5%.

Theoretically, one would not want to take significant active management risks (i.e. risks that any one individual fund manager screws up). One would do this by getting many funds from many different fund shops. For example, the Vanguard STAR fund has exposure to 11 Vanguard active funds and a 0.32% expense ratio. Wellington Admiral has a 0.16% expense ratio. It's hard to find active funds at less than 0.5% ER outside of Vanguard but Dodge and Cox could be an option.

Thus, by buying many funds (and/or funds of funds) to reduce active management risk and by and keeping expense ratios in the 0.3% range, it may be possible to get some expected alpha, on the order of 20 basis points per year. The expected alpha would come from the "average low cost active fund" outperforming the market because the market includes individual stock investors (including ESOP participants) who would on average underperform. The high standard deviation of the, say, 20 basis points of alpha that one could in theory keep after fees makes this a very risky investment - though fortunately the risk likely does not have a high correlation to the rest of the market.


A few specific responses to questions raised:
nisiprius wrote:If I carefully stir a pot of soup and then ladle out a well-mixed sample for myself, I don't make the soup left in the pot any better or worse than it was before.
This is a great way to think about index funds. A nice picture in the mind like this helps one see things more clearly.

TD2626 wrote:An enormous speculative bubble, driven almost solely by individual investors in individual stocks, that index funds are forced to ride up and down but active funds stay away from.
nisiprius wrote:Not a problem. It is the active funds, not the index funds, that are required to execute in such a situation. If some stock multiplies in market value by a hundredfold, the index fund does nothing. It just goes on holding the same number of shares, and their value automatically multiples by a hundredfold. It is the active funds that have a problem because they must sell in order not to participate in the bubble.
I think this is a very good point. A huge index fund like Vanguard Total Stock has a ~2 stake in nearly every large US company. If one company suddenly becomes 10% of the economy, the has the same 2% stake in the company. That's different from having a more or less constant number of dollars in each company (which can be achieved more effectively with a small value tilt than through the implicit factor loads of many active funds).

TD2626 wrote:Major malfeasance by index providers (Russell, MSCI, etc)
nisiprius wrote:How does that affect me? The index provider is bribed by some company to allocate 30% of the index to that company, and the company's stock then tanks?
This sort of thing (or front running becoming an enormous, 5% a year drag kind of problem) would be the kind of scenario in which active funds do better than index funds - though such scenarios are so very unlikely as to best be considered impossible.


I think you've shown that virtually every "black swan" issue that could arise is not an issue that can be avoided by holding active funds.
For example,
TD2626 wrote:The equity risk premium going down because investors can now so easily and cheaply eliminate non-diversifiable risk.
nisiprius wrote:Again, it's not a problem that can be avoided by switching to active funds (or holding an active fund allocation).
I agree.

nisiprius wrote: I guess you can think of some "black swan" scenarios, such as this: index funds are declared illegal, the reduced expenses of index funds versus index funds is declared to be ill-gotten gains, and a "clawback" provision requires that all index fund investors not only to switch to active funds, pay a fine representing the total amount saved by lower expense ratios in index funds over the time they've held the funds.
Amazingly, even in this event, index fund investors would not underperform active investors.


There's a whole group of scenarios in which active investors get only mild risk-adjusted outperformance - so small as to make almost no difference. I think things like front running or regulations affecting index funds generally belong here.

Indeed, after thinking about it some more, it seems like active funds have more black swan risk. Investors in the Sequoia Fund (which bet heavily on a single company, Valeant Pharmaceuticals and tanked) have found this out. A fund manager can mess up very badly.

If speculating and market timing is very, very bad for an individual investor, how would it make sense to pay a fund manager to speculate and market time? Does the fact that a fund manager has access to quantitative research analyst teams change the fact that market timing and speculation is bad? Does it merely "lessen" the fact that these activities are bad?


In response to suggestions (made several places) along the lines of "why not wait and change allocations if something bad happens to indexing?":
In taxable, it is very hard to change because it may require paying large capital gains taxes when selling highly appreciated fund shares. It's better to have a forever allocation that can weather all scenarios so no changes are ever needed.


In response to this:
TD2626 wrote:Funds being adversely affected by investors leaving to a different "next hot thing" (since index funds seem to be very popular now).
nisiprius wrote:How are they adversely affected? This is the seemingly fundamental misunderstanding I keep hearing all the time. How, exactly, would the Vanguard Total Stock Market Index Fund be adversely affected by a large-scale defection? Walk me through it. And, again, this would affect active funds the same way unless they were overweighted in the next hot thing, which some of course would be (and thus outperform the market and the index fund) and some would not (and thus underperform).
I actually do have a reasonable reply here of a scenario in which index funds underperform active funds:
1. Index funds become the "next hot thing" - but then people grow tired of them and switch to other types of investments.
2. Index funds thus are faced with massive outflows/defections.
3. The fund's AUM drops by a large margin (~70%).
4. The fund is forced to distribute its unrealized capital gains whoever's left in the fund (when they would otherwise have to go partly to those who sold).
5. Buy-and-hold taxable investors in the fund get hit with an enormous capital gains tax bill.

Of course, this is a small issue because index funds are fairly tax efficient, many investors are in tax-advantaged accounts, funds would attempt redemption in kind for large defectors, and Vanguard would funnel gains into its ETF shares. But it could be an issue at some point. It likely didn't happen in PIMCO because bonds don't generate the kinds of capital gains that stocks do.


One issue is that alpha may not exist. It is not clear whether or not it does. There are individuals who (stupidly) are willing to put all their money in their employer's stock regardless of the stock's price. This may introduce inefficiencies into the market. However, these inefficiencies likely are small because the individual retail investors don't pay $10000 a share - they actually end up paying fairly close to the market price. Also, who really profits from any inefficiencies - active mutual funds? Probably not - instead it would be prop traders or HFT traders.

All considered, I'm still faced with a nagging feeling that I should have 5-10% of the portfolio in low-cost active. But I realize from this exercise that there's little to theoretical or mathematical justification for this belief. It's all based on thin air and the inertia of active being the more "traditional" route.

heyyou
Posts: 2770
Joined: Tue Feb 20, 2007 4:58 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by heyyou » Tue Jun 20, 2017 10:42 am

The percentage differences that are being discussed are not centered on zero. The passive investor would still get an average return, just not as much as the better(luckier) active funds, same as now. Our world does not end if the active average exceeds the passive average.

User avatar
k66
Posts: 413
Joined: Sat Oct 27, 2012 1:36 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by k66 » Tue Jun 20, 2017 1:31 pm

It would appear though that persistence does exist... persistence of inconsistence (within a group).
LOSER of the Boglehead Contest 2015 | lang may yer lum reek

User avatar
TD2626
Posts: 586
Joined: Thu Mar 16, 2017 3:40 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by TD2626 » Tue Jun 20, 2017 10:09 pm

heyyou wrote:The percentage differences that are being discussed are not centered on zero. The passive investor would still get an average return, just not as much as the better(luckier) active funds, same as now. Our world does not end if the active average exceeds the passive average.
Yes, very good point you alluded to. People (including, I admit, myself) focus too much on overperformance vs underperformance. What matters more is performance and whether that meets your goals. Having an extra basis point in overperformance to gloat over doesn't matter your performance is -32% and the market was down -32.01% - if you took too much risk and can't afford those losses, you're in trouble either way.

There are two kinds of underperformance - slight and massive.

Slight underperformance is underperforming (on average over the long run) by tens of basis points per year.
Substantial underperformance is underperforming by 1% or more per year over long periods.

Slight underperformance usually isn't worth loosing sleep over.
Substantial underperformance (which can occur from paying 1% a year to expensive funds) can be very bad to someone's goals and plans.

Whether someone invests in S&P index funds vs TSM funds, invests in Fidelity vs Vanguard vs Schwab index funds, invests in Target Risk funds vs the underlying funds, or invests in all index funds vs mostly index funds and a small allocation to low cost active funds like Wellington or STAR shouldn't matter. These choices almost certaintly only involve risks of slight underperformance over the long run. (I am suggesting that the last option may be a reasonable strategy for those who are worried about risks from excessive indexing levels).

I think Swedroe's article shows that most active fund investments (with their high expense ratios - money that's paid out and lost forever), represent unacceptable risk of substantial underperformance - the kind that can really affect one's goals.

The risk of substantial underperformance means having large or concentrated allocations to active funds (particularly those with high expense ratios) is unacceptable in my opinion.

User avatar
David Jay
Posts: 4053
Joined: Mon Mar 30, 2015 5:54 am
Location: Michigan

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by David Jay » Wed Jun 21, 2017 8:37 am

TD2626 wrote:investing blindly in ESOPs"
How does one "invest" in an ESOP?

I understood that by definition an ESOP is an ERISA governed retirement plan that requires a proportional share distribution across all participants (typically based on W-2 wages)? I know our plan does not allow for any voluntary contributions.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

deltaneutral83
Posts: 433
Joined: Tue Mar 07, 2017 4:25 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by deltaneutral83 » Wed Jun 21, 2017 8:49 am

I probably don't understand a lot of the jargon in this thread but even if an active manager beats his benchmark by 120 basis points every year (which would be above average I assume for a manager) and let's say he has low active expense ratios like 60-80 basis points he still is keeping whatever added alpha in the form of AUM fee, is this not more or less correct? And this doesn't even take into account front or back end loads?

User avatar
TD2626
Posts: 586
Joined: Thu Mar 16, 2017 3:40 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by TD2626 » Wed Jun 21, 2017 8:50 pm

David Jay wrote:
TD2626 wrote:investing blindly in ESOPs"
How does one "invest" in an ESOP?

I understood that by definition an ESOP is an ERISA governed retirement plan that requires a proportional share distribution across all participants (typically based on W-2 wages)? I know our plan does not allow for any voluntary contributions.
Good catch.

I was intending to reference situations where individual investors have money in stocks without regards to valuations whatsoever; these situations often happen when individuals buy stock based on "hot tips" or own their employer's stock. Owning employer stock can come about in many ways - including buying it intentionally in 401Ks. I think that ESOPS likely have a more marginal effect because of them being involuntary, and due to index float adjustments that sometimes remove ESOP owners from the market for the purposes of cap weighting. Also, I don't think employer stock ownership is "investing" - it is either involuntary, for control purposes, or pure speculation.

User avatar
TD2626
Posts: 586
Joined: Thu Mar 16, 2017 3:40 pm

Re: Larry Swedroe: Persistent Returns Remain Elusive

Post by TD2626 » Wed Jun 21, 2017 9:08 pm

deltaneutral83 wrote:I probably don't understand a lot of the jargon in this thread but even if an active manager beats his benchmark by 120 basis points every year (which would be above average I assume for a manager) and let's say he has low active expense ratios like 60-80 basis points he still is keeping whatever added alpha in the form of AUM fee, is this not more or less correct? And this doesn't even take into account front or back end loads?
Hypothetically, if you have outperformance of 120 basis points every year, and an 80 basis point expense ratio, you would get 120 - 80 = 40 basis points of outperformance.

There is enormous risk to this 40 basis points - it probably has a standard deviation of 3-6%. Is a 40 basis points enough return to be fairly compensated for a 3-6% standard deviation? Well, if this risk has a low correlation to the rest of the market, possibly.


Although I used your numbers in this example, I don't consider them possible. I would be looking at alpha of around 50 basis points per year over the long run and fees of 30 basis points or so (on par for Vanguard's active funds). So you'd get to keep (after fees) 50 - 30 = 20 basis points.

By having a small, buy and hold allocation to a wide variety of active funds (or funds of funds) such that all funds have an expense ratio less than 50 basis points and the active funds total have an average 30 basis point expense ratio, one would diversify away much of the manager risk. Things like the Vanguard STAR fund would go a long way to doing that sort of thing. Thus, the standard deviation of the 20 basis points would be closer to 3% than 5% over the long run. (Note that this risk is on top of the already large risk due to the market itself). Due to the low correlation between the 20 basis points and stock returns modern portfolio theory would suggest a small allocation to low cost active might be worth it.

This all assumes that the 20 basis points exists. If it doesn't at least one probably won't loose more than 20 basis points or so, which isn't a serious impact - especially with a portfolio of 95% index and only 5% active.

Post Reply