Systematic Relative Strength

When you came into this world, you had nothing. And when you leave this world, you’ll take nothing with you. So don’t hate your stockbroker… He’s just doing God’s work.—-attributed to Ian McAvity

Unfortunately, many consumers seem to subscribe to Mr. McAvity’s tongue-in-cheek description of advisors. It is, however, to their detriment. Financial markets can be difficult and it’s not a good idea to go it alone. At least that is the conclusion of a 2010 study by Hewitt Associates and Financial Engines. Hewitt is one of the largest 401k custodians, so they had good access to a participant database. They looked at 400,000 401k participants between 2006 and 2008, some particularly difficult years for the market, to see how they performed and how they handled their investments. Here’s what they found:

401(k) participants who use target-date funds, managed accounts, or online advice get better returns on their retirement investments than those who do not, according to a Hewitt Associates and Financial Engines study released Monday. The median annual return for 401(k) account holders using any of these forms of investing assistance was 1.86 percent higher than among investors who choose their own investments with no guidance…

According to the study, it didn’t matter what kind of help the investors received, but the type of help tended to vary to investor type. Target-date funds tended to be used most by younger and newer employees with smaller balances. Managed accounts were the choice for older employees with the largest balances. The users of online help tended to fall in between.

Here’s the bad news: only 25% of the participants availed themselves of help! 75% chose to go it alone and suffered lower returns as a result. As Hewitt pointed out in the article, a nearly 2% gap in annual returns compounded over a working lifetime means thousands and thousands of additional dollars for retirement.

I suppose people look at the advice business with a jaundiced eye, but Hewitt’s study shows it really can make a big difference. Part of the problem may also be that retail investors have been encouraged to think that financial markets are easy and that they can handle it themselves without any problem. The E-Trade baby makes it look so simple! As an advertising gimmick it’s very effective, but the reality as shown by the Hewitt study is far different. (Click here to see what happens when the E-Trade baby gets in over his head.)

Americans have a rugged independent streak and don’t like to admit there’s anything they can’t handle, but frankly, it is ridiculous not to take advantage of help if it is available. Even the Lone Ranger had Tonto.

That’s the reminder from this Morningstar article of the same name. Active share is a measurement of how different a portfolio is from its benchmark index. Portfolios with high active share have some worthwhile attributes, one of which tends to be long-term outperformance:

They’re not afraid to look different from their peers and the index even if it means short-term periods of underperformance, which they’ve all experienced or will almost certainly experience.

But funds with high active share scores stand a better chance of outperforming over longer periods of time than funds with only a modicum of active share. Funds with high active share scores outperform by so much that they even tend to overcome the bad effects of high expenses in the cases of funds that are burdened by them.

I put the good parts in bold. Good funds with high active share tend to perform well regardless of expenses. It’s so tiring to hear the indexing argument that low-expense funds are the only way to go. Low-expense index funds may be fine compared to full-fee closet index funds, but that’s not the whole truth.

However, to get that good performance, you need to deviate from the index in an intelligent way—and the investment organization needs to be tolerant of periodic underperformance.

Many investment organizations are not performance-driven, they’re AUM-driven. If you care only about assets under management, you can’t tolerate periods of underperformance for a year or two because retail investors tend to bail out. To keep the bulk of the retail investors around, some organizations try to hug the benchmark closely, figuring that they might never have big outperformance—but they won’t have big underperformance either—and they’ll make it up in marketing.

Over a number of years, the tendency of many firms to closet-index has led to a bad rap for active management: active managers can’t beat the index. The research on active share shows that to be completely false. Yet, when researchers look at a broad sample of “active” funds, they tend to have index performance less expenses. Why? Because a lot of “active” funds are not truly active. The retail investor is being charged fees for active management, yet is receiving a closet index fund. No wonder retail investors are confused!

Morningstar has some advice at the end of their article:

…investors need to be more vigilant, given the massive proliferation of index-hugging funds since 1980.

In the end, if you’re going to choose to pay up for active management, you may as well get it.

In other words, know what you own and make sure that you are actually getting active management if you are paying for it!

[If you had any doubt, relative strength is a proven long-term return factor that typically results in a portfolio with high active share. For example, our Systematic RS Core portfolio has an active share of 93.9%; the active share for the Systematic RS Aggressive style is typically even higher. Even our Technical Leaders Index (PDP) has an active share of 91.5%, proving that even an index fund of relative strength leaders may look very little like the S&P; 500! We think that bodes very well for their long-term performance prospects.]

See PowerShares for more information about PDP.