Enrich Your Future 13: Past Performance Is Not a Predictor of Future Performance

Andrew Stotz 00:02
Fellow risk takers, this is your worst podcast host, Andrew Stotz from a Stotz Academy, continuing my discussion with Larry swedro, who for three decades was head of Research at Buckingham wealth partners. You can learn more about his story in episode 645, Larry's unique because he understands the academic research world as well as the practical world of investing. And today we're discussing Chapter 13 from his book, enrich your future, the keys to successful investing. And the title is between a rock and a hard place. Larry, take it away.

Larry Swedroe 00:35
Thanks for having me, Andrew. Good to be back, as you know and your listeners know, we begin each chapter with a story that we use to create an analogy to investing. And this one, I told the story of Sisyphus. Most people probably don't know who he is, but they know the story anyway, in Greek mythology, he was a prince of Thessaly in Greece, and he was really bad. He would murder people, travelers and things, and the gods eventually intervened. Hades, the King of the Underworld, sentenced him to this punishment where he was be doomed to live in hell for eternity, and the only thing he was doing is pushing this big, giant rock up a hill, and his job was to get it to the top of the hill, but whenever he could get near the top, it would roll back down, and he would have to start all over again for eternity. So of course, the question is, what does that story have to do with investing? And I came up with that analogy because of this issue. So the academic research, as we've discussed, has found that the big pension plans, the endowment so all engage top academics practitioners to help them identify which are the future managers who are going to outperform the market. You could be sure. I think we can agree that these consultants have never hired a manager who didn't have a record of outperforming right? You can be sure they thought of especially with today's technology, computer systems and databases, they've hired people with great track records. They've looked at their performance and see if it was statistically significant. Looked at their process, did it make sense, or was it just maybe a random outcome? They interviewed the people and brought them in doing things you and I in the average investor would never have access to, and yet, the research shows that the managers that these pension plans and endowments higher Go on to underperform the very managers that they replaced. Because what the process is these pension plans and endowments kind of review performance every three years or so, and if you're not beating your benchmark or matching it at least, then you get fired, typically, and they start the search again. So whenever I came across that in a presentation to a pension plan, I would ask them what their process was, and I said, Now, explain to me this your process, you know, hasn't worked. That's why I'm here, and you're interviewing new managers, right? Because the old ones that were, what if you're doing differently in the process this time, since, you know, the same process failed persistently, because you're regularly having turnover of managers. And the answer, I got to make a little joke of it, was, you know, mm, nobody has ever answered that question. I've asked it 100 times. No one has told me why they think they're going to succeed when this exact same process has failed, and they never thought to ask that question. And so that's when, of course, Einstein, although no one has found the actual quote, it's attributed to him, is the definition of insanity, is doing the same thing over and over again and expecting a different result. And yet, that is what so many pension plans, so many endowments and so many individual investors do in this search for alpha, it's certainly possible you're going to find winners, but as we discussed, that could be purely random, and maybe you're lucky enough to find the next Warren Buffett or Peter Lynch, but the odds of winning that game are so poor you. That it's simply not prudent to try. And it's gotten harder and harder over time, as the markets have become more efficient as we discussed,

Andrew Stotz 05:10
it's a little bizarre, you know? I mean, here you could say that there's actually a pattern that they could follow, which is to buy the losers

Larry Swedroe 05:22
like work either unnecessarily, but there is a somewhat of a pattern in this sense, if a manager underperforms, there's one of two reasons, it's costs and expenses and trading costs. Otherwise, it's just bad luck. Right now, it could be that your style, you're a deep value manager, and your benchmark is, say, the S, p5, 100 value index, but your exposure is to stocks that are more value, more distressed, lower price to earnings, price to book, and in that three or five year period, those stocks happen to do poorly relative to the benchmark. Nothing wrong with your strategy. All strategies like that will go through some long periods of poor performance, but in the long term, there's evidence that that works. Problem is they judge you on three years, it happens to be the wrong period. Now, those stocks are more distressed. Their PES are relatively lower than they were in the prior three years. So of course, now their expected returns are higher, and you tend to get a reversion to the mean. It's not a reversion to mean a skill. It's a reversion to mean of asset returns, because prices have moved, and we know that there tends to be short term momentum in stocks and asset classes, three months, six months up to a year or so, and then longer term, there's mean reversions, so the stocks that have done the poorest in the previous five years tend to outperform in the next five years. So you can get perversion to mean. But that's what all the research has found, that the managers that get hired go on to underperform the manager they fired. So the pension plans would have been better off doing nothing, and of course, they'd be even better off just using systematic strategies as opposed to active management strategies.

Andrew Stotz 07:35
I'm thinking about the game whack a mole, where it pops up and you've got to hit out of these holes. And it's like, that's the game that they're playing. What if we were to look at? Maybe we'll wrap it up just by asking the question, if we were look at an endowment or a pension, you know, fund, some big players out there, and they understand this. They can't go to pure passive or, you know, factor based, let's say right now, they have to choose an active manager because they're required to for whatever reason. What would you say would be the best way to deal with that, that they could defend themselves and makes them a little bit better decision, not the best, but a little bit better.

Larry Swedroe 08:25
The first answer the question is, ask yourself why they're choosing active managers in the first place. Often is because the people sitting on those boards work for active managers. I've seen many cases where charities hire, say, just to pick a name, Morgan Stanley, and it's because Morgan Stanley has made significant contributions to the charity, right? So you get, you know, that tie in, or they're taking them to the Super Bowl and the golf tournaments and those kinds of things. Another reason that I believe that they choose active managers is they have to justify their existence in the committee. You don't need a committee if you don't need to choose active managers, just say, here's our strategy. We're going to own a bunch of these index funds or other systematic strategies, and we're going to stay the cost. You get rid of your investment policy committee, and now you save a lot of money, and you don't have to pay them, and you're going to end up with better results. But they need to justify their jobs. That's what they're there for, right? So that's why, and of course, there is no reason for them to there is no one is forcing anybody to choose active managers. In fact, under the prudent investor rule, if you follow it strictly, you probably should be using systematic strategies, because. Costs. Otherwise you could be viewed, in my opinion, as being imprudent, especially if it's higher cost. Now, having said that to answer specifically your question, if I were forced to use active managers, I would, for example, choose Vanguard's actively managed funds for two reasons for two or three reasons. One is they tend to be very low cost. Maybe they're 25 basis points, something like that. So you're the average active fund is probably 75 100 basis points. So you're saving there. Number two, they tend to be lower turnover because they're not very active, they're sticking with their style. And three, they tend to be very systematic in that they don't stray. So if they say they're a small value manager, they don't go by large growth stocks, where active managers style drift all the time, and which means you're losing control of the risk of the portfolio, which is, in my mind, you know, basically, you know, violation of the prudent investor rule, you're not controlling the risk. You're not being prudent. And if you delegate that to active managers, to me, that's improved. Now, may not be imprudent under the law. But to me, that would be imprudent. So I would look for a low cost, low turnover, no style drifting, systematic strategies that look like the funds of dimensional or Bridgeway or AQR or Avantis, who do some active management? In a sense, they don't include all stocks. They say the reach of research says we're going to not own small growth stocks with high investment and low profitability because they've underperformed T bills. So an active manager could use those same kinds of screens in their choosing stocks. And the last thing I would say, I would look for broad diversification, not owning a concentrated fund. I'd rather see a fund owning hundreds of stocks than 20 or 30, because that narrows the dispersion of outcomes. Means you're taking less risk.

Andrew Stotz 12:19
And then one last question on this, then is Okay, so let's say you've now got a mix of these, you know, you basically, you're talking about Source, Source, your allocations from, you know, good companies that have good principles and low cost and the like. The second thing is, what do you do when you have a mix of those, and one of them's been out under performing for a while, you're going to get a lot of pressure, a lot of temptation, like we got to do something. How do you think about that?

Larry Swedroe 12:51
Well, first of all, I would say, over the years, I haven't done this in a long time for some compliance reasons. When I worked at Buckingham, the SEC became very restrictive about what we could do about past performance of mutual funds and reporting performance. But until that change came about, I would often analyze all of the active funds of Morgan, Stanley, Merrill, Lynch, you know, T, dot, t, w whatever, T row price, price, T Rowe Price, you know, you name it. I probably looked at 20 or 30 of them over the years, and the only one, only one of who's actively managed funds outperform their index funds, was Vanguard, and it was tiny, like a few basis, which is what you would expect. Their costs are similar, a little higher, but they can do more intelligent trading. There are negatives of indexing that can be the minima, minimized or eliminated by intelligent design, like patient trading, etc. Reconstitution of indexes is really great problems for index funds who only care about matching that index, which means, by the way, that they do almost all of the trade they know which stocks are leaving an index well ahead of time, they wait and aggregate all the trades at the last trade so they can match the closing price. Now think about that. That makes it look that they have zero trading costs, because they're traded at the closing price, right? But everyone knows they have to sell, so the high frequency traders, the rent is out trading and front running them, and they're putting downward pressure, then they sell. And exactly the reverse thing is happening. When they're adding stocks, they wait for the last second to buy and high furniture at all, buying it a little bit ahead of time. Are putting and so their price pressures are causing negative returns. But it doesn't show up. It's in the s, p5, 100 index, because that's the way they design the index. But that's phony. It's not real. They do obviously have trading costs. There is good studies on this stuff. Dimensional is going Robert or not of Research Affiliates just published a piece recently on advisor perspectives on this subject, so you can gain some small advantages, which active managers can do, just like the funds of Avantis and dimensional take advantage today. Dimensional, far as I know, like almost every trade, is only 100 shares to avoid that, and they don't wait to the last minute to trade right and have buy and hold ranges. So there are you can find active funds that design their strategies more intelligently to take advantage of the problems and at least avoid those pitfalls.

Andrew Stotz 16:09
Excellent discussion. Larry, I want to thank you again for this great discussion, and I'm looking forward to the next chapter in the next chapter is, ladies and gentlemen, hold on. The next chapter is stocks are risky, no matter how long the horizon. So for listeners out there who want to keep up with what all that Larry is doing, just follow him on Twitter, at Larry swedro, or on LinkedIn. He responds, this is your worst podcast host, Andrew Stotz, saying, I'll see you on the upside. You.