ISMS 39: Larry Swedroe – Don’t Choose a Fund by Its Descriptive Name

Listen on

Apple | Google | Spotify | YouTube | Other

Quick take

In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake number 28: Do You Fail to Compare Your Funds to Proper Benchmarks? And mistake 29: Do You Believe Active Management Is a Winner’s Game in Inefficient Markets?

LEARNING: Don’t choose a fund by its name. Active management is highly unlikely to outperform even in inefficient emerging markets.


“Don’t choose a fund, even an index fund, by its name. Instead, you should carefully check its weighted average book-to-market and market capitalization levels.”

Larry Swedroe


In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.

Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake number 28: Do You Fail to Compare Your Funds to Proper Benchmarks? And mistake 29:

Did you miss out on previous mistakes? Check them out:

Mistake number 28: Do You Rely on a Fund’s Descriptive Name When Making Purchase Decisions?

According to Larry, most investors tend to rely on the name of a fund and its descriptive value. So they’ll look at a small-cap fund and assume it invests exclusively in small or mid-cap stocks. However, the SEC allows sufficient leeway that can cause dramatic differences in that a large-cap fund can own a large-cap value fund and even some small-cap growth stocks. In such a case, you’ll not get the asset allocation you think you should and desire. And that’s especially true, of course, of active managers who have freedom to roam.

Several academic studies have concluded that asset allocation determines the vast majority of the returns and risks of a portfolio and its long-term performance. Larry says that once investors decide on their investment policy (asset allocation), they must choose which funds to use as the building blocks of their portfolio. One choice involves implementing the strategy with active or passive managers. If investors choose passive managers, they can be highly confident that the specific investment style will be adhered to, as the fund will replicate the asset class or index it represents. There is no such assurance with active managers. With active managers, you cannot even rely on the fund’s name when making a choice.

Larry advises that you should not choose a fund, even an index fund, by its name. Instead, you should carefully check its weighted average book-to-market and market capitalization levels. That’s the simplest way to tell the true nature of a fund.

Mistake number 29: Do You Believe Active Management Is a Winner’s Game in Inefficient Markets?

The efficiency of the market for U.S. large-cap stocks is so great that attempting to add value through active management is unlikely to produce positive results. However, investors cling to the idea that active management will likely add value in less efficient markets. Unfortunately, research shows that active managers in emerging markets tend to lose over whatever period, and the longer the horizon, the worse the performance.

The asset class for which the active management argument is made most strongly is the emerging markets — an “inefficient” asset class if there ever was one. Many myths are perpetuated by the Wall Street establishment and the financial media, and that active management is the winning strategy in less efficient markets is just one of them. As the historical evidence demonstrates, active management is highly unlikely to outperform in even the allegedly inefficient emerging markets. In fact, the evidence suggests that active managers perform just as poorly in the “inefficient” markets as they do in the more efficient markets of the developed nations. Larry concludes that active managers don’t lose because they’re dumb; they lose because they’re expensive.

About Larry Swedroe

Larry Swedroe is head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.

Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.

Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.

Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.


Read full transcript

Andrew Stotz 00:00
Hey, fellow risk takers this is your worst podcast host Andrew Stotz from a Stotz Academy, and today, I'm continuing my discussions with Larry swedroe, who is head of financial and economic research at Buckingham wealth partners. You can learn more about his story at episode 645. Larry has a deep understanding of the world of academic research, about investing and particularly about risk. Today we're going to discuss two chapters from his book investment mistakes even smart investors make and how to avoid them. And we're going to be covering Mistake number 28. And 29. Number 28. Do you rely on a fund's descriptive name when making purchase decisions? And mistake 29? Do you believe active management is a winners game in any efficient markets. Larry, take it away.

Larry Swedroe 00:49
Yeah, so the problem for investors is here, they tend to rely on the name of a fund and it's the script the value. So they'll look at a small cap fund, and they assume the Fund invests exclusively in small stocks, or mid cap. So Lodge. Same thing through when we look at value versus growth stocks. But the SEC allows a sufficient amount of leeway, that you can have dramatic differences. Because a large cap fund can own a large cap value fund even can own some small cap growth stocks. And so you're not getting the asset allocation you think you're getting and you desire. And that's especially true, of course of active managers who have freedom to roam. And as we've discussed in the past, the vast, vast, vast majority of returns are explained by your asset allocation to these common risk factors we've been talking about in our series, mainly size and value, as well as then profitability, quality and momentum. So if you think you want exposure to small value stocks, and you buy a small value active fund, you may have 20% of the portfolio in large cap growth stocks. So you've lost control, because you chose to use an active manager. Now what most people don't realize is, there's even a huge dispersion among similar passive funds. So let me give you an example of this to be helpful. So Vanguard runs a small value fund and a lot of Vanguard because they tend to be the cheapest in these factor based funds. So the Vanguard small value fund I just checked before I call has an average market cap of $5.6 billion. That doesn't sound very small, to me sounds more like a mid cap fund, right? If you compare that to say DFAS small value fund, DFA uses more academic base definitions, it's about half of that, as is Avantis. This fund, which is even a bit lower DFA as a little under 3 billion Avantis is small value is 2.5 billion. And if you really want small value, I would look at Bridgeway is Fund, which has an average market cap of under 1 billion. So take a look at that you have 1 billion average mark versus, you know, 5.6 billion, they're not similar, really, at all. You can get big divergences and returns as much as maybe 10% A year based on those differences. Right. So that's a problem. And that's why I tell investors, there are two tools they can use to be helpful. One, you can go to Morningstar, and they have on their site tab called portfolio, and it will show you the growth versus value metrics. So things like price to book price to cash flow, and then they have a market cap tab, and you want the ones that have the most exposure typically, to the asset class or risk factor that you want. So that's one tool, the other as you know, Andrew, and you learn to use the tool, portfolio visualizer that shows you a more technical analysis, and it will show you what's called the loading factor, how much a fund is exposed to that factor. Now I haven't looked at this in a while, but I would guess Vanguard small value fund may have something like a point seven or point eight exposure to the size factor. Whereas DFA and Bridgeway and Avantis might be very close to one, or even higher, I think Bridgeway is over one. And in terms of value, Vanguard may have a point five or a point six. And the other three, we've been discussing Mike D, point 8.9. So you want exposure, then you want to look at not only the cost of, you know, the expense ratio, but the cost per unit of risk you're getting. So for example, just to be helpful for everybody here, let's say that one of those three funds, let's just use DFA, as an example, has 20% more exposure to the value factor. And let's assume for the moment that you think that value premium is roughly 3% a year, so your expected benefit is very simply 3% times 20% is 60 basis points a year. So the fact that the fund might cost you 20 basis points, you likely would say, I'm willing to pay 20 basis points to get 60 and expected return. Now, if you're paying 50, which is a certainty, you might say I'm not willing to pay 50 Certain to get 60 expected. So this everybody has to make the decision based upon looking at what they think the loadings are, and also the expected risk premium.

Andrew Stotz 06:36
Just can you define what you mean by loadings again? Yeah,

Larry Swedroe 06:41
so loading is the percentage exposure to that factor. So as we said, Vanguards small value fund has an average market cap of 5.6 billion, it's not going to have a very large exposure to the size premium, certainly nowhere near what bridge ways fund would be, which if you look at Morningstar, so you has about 900 million versus 5.6 billion, so I'm going to guess we could look it up. But Vanguard might have a point six, or something like that exposure to the size factor. So if you think the size premium is 2%, okay in there, then that would get you 1.2 60% of the to where Bridgeway is maybe it's 1.1. Okay, it's much smaller than that asset class. So 1.1 times two is two point to, and then you look at the difference in that tells you what they expect their return to. And if you look at the history of the funds, and I would urge everybody to look at Morningstar site and look for the years when small value outperformed, and you'll see that bridge ways fund would have significantly outperform, and vice versa, when small value did poorly, relative to say the s&p Like maybe last year, then Vanguards fund is going to outperform, it's not that one fund is better than the other, it's that the different and you have to decide which one you want. And if you want to look different, well, you should prefer the bridge weight fund for that reason. So you want to look at these risk adjusted returns. And it happens virtually every single year. Exactly the way I explained that to you. So 2013 2016 were big years for value. Small value outperform and bridge Wide Fund beat the Vanguard fund buy in some of those eight or 10%. In other years when growth outperformed the reverse was true.

Andrew Stotz 08:56
So can we take a step back and ask a question? What's the best benchmark that we should use for let's say, small cap?

Larry Swedroe 09:06
Yeah, so there really is no right benchmark. It's what exposures you want. So for example, and let's use small cap, while we know there are at least three indices that are pretty popular. There's an s&p 600, which isn't really that small, because it also screens for profitability or quality. So it's going to screen out a lot of stuff, which I think is good. And I liked that index over others, certainly over the Russell 2000, which is, I think, a poorly designed index. And then you have the MSCI 1750, which does different things. So you every investor should look to understand, read, go to the website, read how they construct their portfolio, what their rules are, and then you can go to one ETF say that benchmarks against that, which is means they're trying to replicate it. Okay, you might see an s&p 600 small value ETF and then run it on portfolio visualizer and see what the loadings are. And you can look at Morningstar and see what the metrics are. And then you can decide if that's the right fund for you. I would tell you, the s&p and the MSCI indices are far superior to the Russell indices.

Andrew Stotz 10:33
So let's talk about that. Now, just to get down to you know, what, I don't know what index I should use. You've already do? Well, yes and no, but the s&p five 600, what you've said is that it's not a pure small cap index, it's a small cap screen on quality. And did you say something else, or just quality, quality

Larry Swedroe 10:53
profitability, which is sort of kissing cousins, profitability is one of the metrics that makes up the broader category of quality, which includes things like low volatility of earnings, less financial leverage, things like that.

Andrew Stotz 11:09
And I can understand that some of you may like that index, because it gives you what you could say, are the small cap companies that you should invest in the 600 that they're talking about is out what is their universe of small caps that they're then applying their screen to? Do you know, what

Larry Swedroe 11:26
There are 600 stocks in their index that meet certain criteria, and then they choose the ones that are in that small that meet that, you know, that veteran that value index that you want to look at. So then let's move on the overall 600 Is the here's a construction rules, they lay them out for you. And then they break that up into six into three categories, their core, meaning all of it, there's a 600 value and a 600. Growth.

Andrew Stotz 12:02
Okay, so would that mean that what they're talking about is 1200 stocks

Larry Swedroe 12:07
to 600 stocks, of which a certain percentage of them will be valued when a certain percent will be

Andrew Stotz 12:15
grown? Okay. So let's talk about the Russell 2000. You mentioned that it's poorly designed, roughly, do you know I remember looking at the Russell when I was young, it was the Russell 5000 But now I see the Russell 5000 doesn't have 5000. But guess what is your thoughts about the Russell

Larry Swedroe 12:31
2000? Yeah, after another? I think you're referring to the Wilshire 5000. Yes, yes, sorry. So the Russell 2000, is actually the smallest 2000 of the lodges 3000. And at one point, there were well over 5000 stocks. So you weren't only one very small. Anyway, you certainly missed all the micro cap stocks, which happened to have the highest returns. What the research has shown us is that there are a group of stocks, which we've discussed, that are called lottery stocks. Now, a very small percentage of them would go on to do well, most do poorly, they tend to be small growth stocks, with high investment and low profitability. People think they're trying to find the next Microsoft. And that drives up their average prices. And the expected returns then turned out to be very poor. In fact, stocks with those characteristics have underperformed treasury bills. So they're a disaster. And yet, if you buy a Russell 2000 index, you're going to own some of those stocks. So academically based research firms like dimensional and AQR and Bridgeway, and Avantis. They just screen out all of those lottery like stocks and create their own indices, and s&p 500 or 600 does basically the same kinds of things. So I tell people, again, don't just go by the name, look at Morningstar, look at the metrics, look at the price to earnings, cashflow, price to sales and book value, look at the market cap, go to portfolio visualizer, run the regressions, see what the loadings are and also see how effective they are at capturing those premiums. Because portfolio visualizer will also sell you the alpha. Now you should expect in general, the alphas should be close to zero, probably slightly negative because you have expenses and trading costs. But good design and patient trading can overcome that and you end up with hopefully close to zero. You know in terms of alphas

Andrew Stotz 14:57
did I hear you correctly insane That dimensionals designing its own index is that is that the case and

Larry Swedroe 15:06
they design their own benchmarks, or let's call it, they, they take an asset class. And then based upon their academic empirical research findings, they define their construction rules. So for example, they may say, we're going to take the bottom 5% of all stocks that might be for our small cap fund, and the bottom 3% for micro caps, but we're not going to buy them all, we're gonna eliminate the funds that you know, have poor profitability characteristics, they will also will screen for negative momentum. So for stock happens to do poorly and becomes a small cap, or there was once Lodge, or it was once growth and becomes value, they won't buy it when it drops into their index. And index fund would, because it's now in their index. And their goal is to match the benchmark. But using the academic research, they found stocks with negative momentum, tend to continue to do poorly for some period of time, because the market tends to under react to news. And you'll also get momentum traders piling in tax law selling driving prices for the down till everything is all the sellers are washed out, if you will. So they wait until that negative momentum ceases, even though it's in their eligible universe, but they screen it out. Similarly, a stock may be doing very well, a small cap stock, let's just make this up, say 1 billion is the maximum they'll buy at, but they won't sell until it gets to maybe 1.2 billion. As long as the momentum is positive, they'll let it continue to grow to take advantage of that. And that actually is helpful in two other ways. Can you guess what those two other ways aren't injured?

Andrew Stotz 17:09
I don't know. It's all spinning around in my head right now.

Larry Swedroe 17:12
So that same thing works on the negative side, if you're delaying buying, right, when stocks are falling, and you're but you will eventually buy, right? Unless it goes bankrupt and keeps flying. And you delay. When stocks are going up. You delay selling until that positive momentum ceases or it becomes so big that it doesn't look like your asset class anymore. So you want to get rid of it. What are you doing to your turnover? You're increasing your turnover, now you're decreasing it because your delay will be delaying delaying the sale. So delaying turnover. Right. Or delaying trading means you're lowering your turnover, which does what to your trading costs should reduce your trading costs reduces your trading costs, you're also now capturing a bit of that momentum factor, which historically has been a premium. And what should you do watch it that also due to the funds, tax efficiency, should

Andrew Stotz 18:16
should improve it right? We've already said trading, trading costs and fees of the it's one of the most reliable indicators of long term performance as I recall. Exactly

Larry Swedroe 18:27
right. So you get natural benefits, besides getting the benefit of you know, gaining exposure to momentum, or at least reducing the exposure to negative momentum, which value tends to have because how do you get to be a value stock tends to do poorly. So there are some benefits. So they create their own constructor as well to change the subject here. But while we're on this is really important issue. So index funds are perfectly okay vehicles, they tend to be very low cost competition has driven the cost down to close to zero for a lot of indices, right. But there are some negatives, because indices are dumb. For the reasons we just described, a stock and, you know, enter an index and it's collapsing, it's doing poorly, and an index fund has to buy it because its sole goal is to match the benchmark and replicate it and everyone else knows, by the way, all the high frequency traders like Renaissance technology are out to screw the index funds, they're going to trade ahead of them and scalp some fees, you know, or spreads out of that. And so the Russell 2000 As far underperform a very similar Chris six through 10 index and its history so that's another reason don't like so you can be front run there and you are unable to Take advantage of being able to trade patiently and to take advantage of momentum. So that's why I don't own any index funds. Although I own what I would consider to be passive funds. They're passive in the sense that they define the universe in exactly the same way that the s&p 600 or MSCI, 1750. Here's how we define our universe. And they buy and hold anything that's in the universe, but applied these other screens to minimize the negatives, or eliminate them have pure indexing. And they screen out stocks where the academic research says, have poor returns. So that's why I prefer funds that are not index funds in general, but they are systematic, transparent, so I know exactly what they're doing. And they're replicable. They're not run by humans or making judgments that can override the machine, if you will, generally, because they think they're smarter than the machine.

Andrew Stotz 21:06
I like to call those exposure funds. Like they're giving me exposure to that particular element. And systematic,

Larry Swedroe 21:14
replicable, transparent, because you can buy an active fund that will give you exposure, but it won't be systematic, won't be transparent, and won't be replicable. Right. And it might depend on if the manager stays or leaves. So

Andrew Stotz 21:30
I want to go back to the index. So we've been through the s&p 600, which we've said, is not truly just pure small cap, because it's screening for quality and profitability. We've talked about the Russell 2000 to say, wait a minute, that's the smallest 2000 of 3000. And as you say, there may be some design flaws. But you know, if you wanted to say, I'm not interested in the largest companies in the market, right now, I want to look at the smallest of the 3000. Then we talked you'd mentioned about the MSCI 1750 What is that? Yeah,

Larry Swedroe 22:04
the 1750 i That's a perfectly good index, I would look at again, go to portfolio visualizer find an ETF that benchmarks that, compare that the s&p 600 ETFs. Compare it to the dimensional Avantis Bridgeway, BlackRock, they're, you know, any of these systematic vehicles, and then choose the fund that gives you the exposures you want. And far relative to the expense ratio. So in other words, I want the deepest exposure I can get. But I have to also be concerned about what the expenses are. So I'm willing to pay for risks. That expense, you know, exposure. So if Bridgeway costs 2%, more, I wouldn't own it. Because if it costs 20 or 30 years, something like that basis points. And as 60 or 70, a year or so, or 100 basis points, and I would expect the returns, I'm willing to give that up. And everyone has to make that decision about how much of the guaranteed savings you're giving up to get an expected but not guaranteed higher return. Now, the other thing is, the deeper your exposures, the less you're going to look like the market. So if you're going to be subject to this tracking error, or better stated tracking variance problem, then on the Vanguard funds, because they'll look more like the market don't own the Bridgeway fund. But if you want the highest expected returns over the long term, then I would recommend the Bridgeway fund.

Andrew Stotz 23:49
Okay. And then, and then, of course, for the listeners and viewers, we're not recommending any specific investment strategy, what we're trying to do is go through, you know, developing knowledge on this. So I went on online right now to look at the MSCI 1750 And it says the smallest 1750 companies in the US investable market 2500. So again, it's like the Russell 2000, where it's the smallest of the biggest, but then I thought okay, so let's go at this another angle. Let's go look at the VT VTi fund by Vanguard and see how many stocks are in there. What's its benchmark and in their case, the benchmark is the crisp us total market index. And I remember Vanguard switched to crisp many years ago.

Larry Swedroe 24:37
Little cheaper fees than negotiate between crisp and MSCI and s&p and

Andrew Stotz 24:44
footsie and all footsie, yes. So, but this one is interesting, because what it's saying is that the crisp us total market index is 3677 stocks. So would we say that that really is the investable universe in the US

Larry Swedroe 24:59
That's the investable public universe in the West, and the MSCI 750s. If I remember correctly, you said was the 1750 smallest of the 2500 largest. So you're entirely missing that another 1200 smaller stocks. And by the way for your listeners benefit, all the academic research shows that these factor premiums of size and value, momentum, profitability quality are much larger in the smallest stocks than they are in the largest stocks where the premiums tend to be small. So that's why my portfolio is 100% small value, because I want the deepest exposure to these factors. And you don't look anything like the market, which means that some years, I'm going to underperform. And in some years I'll outperform, but that's irrelevant to me that I'm achieving my goal of getting exposure to different factors, I want to look different from the market.

Andrew Stotz 26:06
And one of the things that I looked at when I looked at the Bridgeway small cap value fund is that well, okay, that's not really small cap, either, because it's small cap value.

Larry Swedroe 26:16
Right? They also run a small cap fund. Okay. And I, I prefer to own small value rather than small cap. Okay.

Andrew Stotz 26:25
Just combine the two. Okay. And I think that in the end, you know, what we're talking about is that, for a typical investor, who really doesn't have time or interest in all that, there's nothing wrong with owning a passive fund that owns the whole market. But if you say, you say I want to, I want to try to enhance my return and my risk adjusted return, then I may decide that rather than just holding the whole market, I'm gonna tilt towards factors that you have, you know, taught us have long lasting, you know, premiums,

Larry Swedroe 27:02
whether that's, yeah, historical guarantee on the future. Yep, that could change. Or also,

Andrew Stotz 27:07
I think the other way to say that is that there's no guarantee that the next five or 10 years is going to be outperformance. But generally they have outperformed over a long period of time. So, okay, well,

Larry Swedroe 27:20
we have 100 years of data basically, around the globe. And everywhere, basically, in the world, with a few exceptions. All of these factors have delivered performance. Now they're, depending upon the articles, you read somewhere between 406 100 factors in with John Cochran famously called the factors Zoo. But that's a gross exaggeration of people, you know, use that, you know, dampen enthusiasm about factors, their reality is that there's really only about 14, I think, and how do you get them to 400 because there might be 50 or more value factors, you have price to book price to earnings price to cash flow, price to sales, EBIT, da to enterprise value, and on and on and on. Right. And you have different momentum factors. There are dozens of them, whether use one month, three months, six months, variations of those things. Right. So the studies everyone is trying to get published. So everyone digs and tries to find it. But if not, now, we're a down which Andrew Birkin and I did, I think in our seminal book on factor investing, called your complete guide to factor Based Investing, we think there are only five or so equity factors that you really need to consider. And the whole factors though, meaning market beta size, meaning small caps, value, momentum, profitability and quality. And you could kick out profitability if you want, because it's a kind of kissing cousin, as I call it of quality, meaning profitability is one of the traits of quality. Some of the others include low financial leverage earnings stability. So if you want, you can screen just for a small value, and quality. And that gets you what you're looking for, as well. And so that's going to make it pretty simple for people but read my book. And now I'll tell you the not all of the history and the background and get you educated and allow you to make an informed decision.

Andrew Stotz 29:40
But it's also got a lot of stuff in the back where it goes through specific funds and ideas about allocations and all of that. So I think that's valuable. Well, I want to just before we move on to the next mistake, I know that Brinson study was a seminal study, you know, many years ago, talking about the importance of ads asset allocation. And I wanted to ask a question about this and because sometimes when I read Brinson work and others talking about allocations, I think to myself, compared to what I understand asset allocation is important, but what are we comparing it to? What is it better than?

Larry Swedroe 30:21
Well, for instance, study, if I remember, I mean, this goes back now, a long time I haven't looked at it could be 20 plus years, but I actually wrote a little piece about it because most people misinterpret Brinson. So Princeton study didn't say that a port 9493, or whatever the number was, a percentage of the returns are explained by their asset allocation, meaning how much exposure I have to these different factors. He said it explained, the vast majority are 93% of the variation in returns between portfolios. Okay, that's a difference. There are other studies that show that over 100% of the returns are explained by your exposure, because costs are negative. Right? So what's explaining it's not stock picking or market timing in general? So you have to understand what we're talking about. The key thing for people to get out of all of this is, the academic research shows that active management is a loser's game. What that means is, it's just like the roulette wheel. You know, in the casinos in Las Vegas, can you win? Of course you can are the odds in your favor? Of course they're not. And therefore you shouldn't play. And that act of management, I call is a triumph of hope of wisdom and experience. That evidence shows very clearly now, that's something on the order of 2% of active managers deliver statistically significant alphas. You know, once you adjust for their exposure, these fact, and that's before taxes, right? So once you include taxes, it's probably 1%. I don't know about you, I don't like playing a game where the odds of 98 or 99% against, can you win? Sure. But I wouldn't want to take my portfolio, you know, the lottery off ticket sellers. And I wouldn't want to take it to the active managers either. And so you want to invest systematically gaining exposure to the factors or asset classes that you think you want in your portfolio to give you unique, different sources of risk. Because remember, this, Jared, what most people don't know. And there's a wonderful new paper on just wrote a piece on this. Feldman MacRay wrote a book showing that Jeremy single was wrong about saying stocks for the long run. And he showed many cases, using much better database, I'd even go back into the late 1700s. Now, where stocks have underperformed bonds around the globe for many decades, and it's really regime dependent. And regimes can last for 20 3040 years. And I'll just give you one. By the way, what was it Makary is his name, ma MC qu A R r i e, and I think the name of the paper is, is really stocks for the long run. Welcome. So, if you give me a moment, I will let you know. But I know I can give you this one example because I say it all the time. Investors care about what their investment horizon might be. Right? And you could look at, for example, a 40 year period that's probably longer than many people, right? Certainly it's longer than your my investment horizon, right. And here's a 40 year period from 69 through oh eight, we're large cap growth stocks in the US and small cap growth stocks underperform long term treasuries, which is these riskless asset for a pension plan with long term lava nominal obligations. So that's a problem, you know, for invest and look at Japan. Now. The US the summit said is the triumph of the optimists. 1989 through 2023. So that's 35 years. Stocks underperformed long term, you know, the Japanese bond in Next, in both dollar and yen terms, that's 35 years, there's no guarantee that stocks are going to outperform. Right? Yep. And so you really need to think about the diversifying your portfolio. In those periods, often value stocks outperform the general market.

Andrew Stotz 35:22
Okay, so let me wrap that up. And by the

Larry Swedroe 35:25
way, yes, sorry to interrupt, but yet fellow's name is Edward Makary. And this study is stocks for the long run, sometimes,

Andrew Stotz 35:33
yes, sometimes no, it

Larry Swedroe 35:37
was published in the latest issue was a financial analyst journal.

Andrew Stotz 35:41
And in fact, it. In fact, if you want to learn more about Edward, you can listen to episode 662, where we talk about his worst investment ever, I haven't seen his latest. So I'm definitely going to go through that. And I'll have a link to that in the show notes. So thanks for here's

Larry Swedroe 35:58
one little data point for you. over the 150 years in the US from 7092 to 1941, stocks and bonds produced virtually the same wealth accumulation. And yet stocks, of course, were dramatically riskier. It was really the next 40 years that gave Siegel the evidence that stocks won in the long term. But since then, stocks have outperformed bonds, but not by much. So for MIDI two through 20 2019, when Mac or eighth finished this study that says last year, their performance with very, very simple, certainly not enough of a premium to justify the dramatic difference in risks.

Andrew Stotz 36:52
So now let's just wrap up by looking at this. Number 29. Do you believe active management is a winners game and inefficient markets. You've already talked about this. But I just was curious about the element that you're talking about emerging markets because we were like, okay, but look, emerging markets are still inefficient. I can outperform here in emerging markets. What is the conclusion that you've come to? Well,

Larry Swedroe 37:17
it's, it's not a conclusion that I come to its conclusion that the academic research shows. And you can see that every year when Standard and Poor's publishes their annual speeds and indices. And you will see that over whatever the period, active managers in emerging markets tend to lose with, the longer the horizon, the worse the performance, I just looked up at the end of the year, I write an annual piece that gets into this topic. So I happen to have the data. So what people confuse is, they think that the markets in small caps are informationally less efficient, because you don't have that many people studying these small stocks. In these far off countries, that may be true. But that's only a necessary condition for active managers to win, because active managers may be able to uncover Miss pricings. But they have to spend money to do it. The question is, is the market so inefficient, that after your costs, not only your expense ratio, but your trading costs, including market impact costs, and taxes, and in those countries often have taxes on every trade, and big bid offer spreads with us, people are afraid of being exploited by active managers who may be no more than them. So they make very wide bid offer spreads are only willing to trade a few 100 shares at a time. So when the active manager comes in, they are driving their prices up and down against themselves. So you, you have to think about is the market so efficient, that I can actually overcome costs. So you have to remember, the more inefficient, the market is informationally them, the greater the costs of exploiting that are almost certain to be. So let's just do a little test. So we have dimensional fund advisors. They are a pure, systematic, no fundamental research, they just developed as we discussed their own universe. And let's look at the least efficient of all of these things, which is emerging markets and small. So for the last 15 years, according to the Morningstar data, which is bias against the FA because all it only includes funds that have survived the full period. So that means peep, most of the funds don't survive, plus they did poorly. So they've gone So

Andrew Stotz 40:00
it's it's biased against survivors, or it's biased against deficits

Larry Swedroe 40:03
bias against the survivors, okay, because I'm just making this up. But maybe today there's only 20 emerging market small funds that have less than 15 years. But there may have been 100 that played in that space over that 50 facts 7% of all active funds, on average disappear every year. And they go to the mutual fund graveyard in the sky, but their returns investors earn live on, right. So how did if emerging market small cap stocks, which should be the poster child, right? For inefficient markets, if it was true that they were inefficient, DFA should be at least in the bottom half, and maybe in the bottom 10% Because all the active managers can beat them, right? DFA finished in the third percentile, outperforming 97%, even before taxes in the last 15 years. So how people make these statements other than to justify their existence and getting you to believe untruths, because they need you to believe that to pay their salaries. The evidence is very clear, it doesn't matter how inefficient the asset class is, in general, the cost of active management is going to be too high. Now, having said that, I am the first to admit because the research shows that as we discussed, there are some anomalies, because of dumb, naive investors, these lottery stocks, for example, that people buy, but you can screen them out, you don't have to buy an active manager to avoid that. And there aren't enough dummies in the retail world left to exploit for active managers to make enough to overcome their expenses. There are some, but in general, it's not. Because most of the time, it's Goldman Sachs trading against Templeton and Morgan Stanley, not against you and me.

Andrew Stotz 42:09
So that's great. You know, when you go back in time, many decades ago, we didn't have these exposure funds, or ETFs. To say, Well, I don't need to invest in your active fund, or I don't need to build my own portfolio of small caps, I can just buy this ETF, or fun, that's giving me exposure to that factor. But now, that's all out there. And it's been out there for many years. So

Larry Swedroe 42:35
I would add this, as we've discussed, if you go back 70 or 80 years now 90% of trading was done by individual investors, because they owned all the stock, there was only 100 mutual funds. Okay, today, you have 10s of 1000s of mutual funds, and individual investors don't tend to own individual stocks anymore, they've woken up and own mutual funds and ETFs to get the benefits of diversification and avoid all these trading costs, right? By being a passive investor, they're playing the winner's game. So what that means is 90% of the time, when active managers are trading, who are they trading against people just as smart as them, there aren't enough victims left to exploit for active managers to squeeze out more than a little bit of Alpha, but not enough in general, dogs come they're caught. So if you're going to use active managers, my advices one use people like Vanguard one, don't style drift. So if they tell you they're small value, you're gonna they're not going to be buying large growth stocks. So find the manager American funds, another family they stick to than any rule number two, low costs, active managers don't lose because they're dumb, they lose because they're expensive. And third thing is turnover matters both for taxes and expenses. So look for low turnover, guess what the Vanguard funds looked like that or active low turnover, low expense, no style drift, no style drift, and if so, if you're going to go that route, at least use funds in that category. And then you'll tend to look more like the systematic funds of dimensional Avantis. I choose to avoid them. I want to use systematic strategies that I know are dependable, and I think are more likely to produce better results. But if you're going to go active, go those routes, and you'll likely do far better than the average active investor. And you might even approach or you might get lucky and do better than the systematic funds.

Andrew Stotz 44:58
Well, that's a great wrap on a Have an wonderful discussion, you know about creating, growing and protecting your wealth. And I just found it fascinating. A lot of different things that we covered for the listeners out there who want to keep up with all that Larry's doing. I dare you to do that on Twitter. And you can find them at Larry swedroe at Twitter. And you can also find him on LinkedIn. This is your worst podcast host Andrew Stotz saying. Thank you, Larry, and I'll see you all on the upside.


Connect with Larry Swedroe

Andrew’s books

Andrew’s online programs

Connect with Andrew Stotz:

Further reading mentioned

About the show & host, Andrew Stotz

Welcome to My Worst Investment Ever podcast hosted by Your Worst Podcast Host, Andrew Stotz, where you will hear stories of loss to keep you winning. In our community, we know that to win in investing you must take the risk, but to win big, you’ve got to reduce it.

Your Worst Podcast Host, Andrew Stotz, Ph.D., CFA, is also the CEO of A. Stotz Investment Research and A. Stotz Academy, which helps people create, grow, measure, and protect their wealth.

Leave a Comment