Evaluating Managed Funds

[Ed Miller]

Thanks buffett. I'm actually learning something about investing, I think. [img]/images/graemlins/smile.gif[/img]

Trying to pick individual stocks has been frustrating for me so far (granted, I haven't put much time into it), because every time I think I've found a good one, I catch some big red flag or fatal flaw or something in the 10-K. Who knew building a Marketocracy portfolio could be so stresful. [img]/images/graemlins/tongue.gif[/img]

I'm sure I'll get the hang of it.

Right now my Microsoft 401k is 100% in Vanguard Value Index Fund Investor Shares (VIVAX). I just let it sit there since I left the company in 2003 because I didn't know anything better to do with it.

I want to roll it over to a Vanguard IRA. I think I might move a significant percentage to Fairholme and spread the rest between some other Vanguard Index funds. Something like:

Fairholme - 40%
Vanguard 500 Index Fund Investor Shares (VFINX) - 20%
Vanguard Small-Cap Index Fund Investor Shares (NAESX) - 20%
Vanguard Total International Stock Index Fund (VGTSX) - 20%

I don't know if this portfolio is too aggressive.. FWIW, I'm 26 and optimistic about my future earning power.

Just kinda throwing this out there for a sanity check before I rollover.

[jively]

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Trying to pick individual stocks has been frustrating for me so far [...]

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I am in investment advisor, and as I mentioned in another thread, I feel strongly about passive, non-forecasting investments strategies.

This board may be a bad place to state my opinions, as most of you seem to trade, but I'll try anyway.

Take any stock - Altria was mentioned in this thread. 11 million shares of Altria traded today. So, pensions, mutual funds, and individuals bought 11 million shares of it today - and all of those buyers think the stock is going up. But other pensions, mutual funds and individuals sold it today - the same 11 million shares worth! - and all those sellers think it is going down, or there is someplace better for their money. So, who is right?

And, what do I or you or any individual know that is better information than the millions of people that trade that stock every day? Inside information, is of course, illegal. And all other information is basically made available to everyone at the same time. All "news" that is basically unpredictable.

I believe that, because millions of people are researching and buying and selling all of the stocks every day, there is no one that can pick stocks and beat the benchmark over a long period of time.

Hey, actually 2+2 is a great place for this tidbit. People looking at mutual funds and their past performance - how many months or years of past performance do you need to know that a funds' outperformance is statistically significant? With variance, a losing poker player can win 100 BB or 300 BB over some short periods of time, right? Well, if Morningstar says some mutual fund is outperforming their benchmark over the last 1, 3, and 5 years, does that mean that the fund company or fund manager actually has skill in picking which stocks are going to go up and which down?

Ken French of Dartmouth College said that if a fund outperforms it's benchmark by 3% a year on average, it takes 140 years of perfomance history to tell if it's statistically significant!

Think of it another way. Take 1000 fund managers and put them in a room. Ask them to flip a coin and try to get heads. After one flip, roughly 500 will flip tails, and they will be asked to leave the room. Roughly 500 flip heads and stay, and flip a second time. Do this for 10 flips. It would not be unusual for 1 of these fund managers to flip heads 10 times in a row. (Odds of that are 1 in 1024.) (If you had 2000 fund managers, you'd probably have at least one of the flop 10 heads in a row.)

So, was that fund manager skilled at flipping heads? No, they just happened to be the lucky one who happened to do it. So, if you take 1,000 US Large Cap Blend mutual funds, you can probably find 1 that outperformed their benchmark for 10 years in a row. Skill? Could just be luck like the coin flipper.

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I want to roll it over to a Vanguard IRA. I think I might move a significant percentage to Fairholme and spread the rest between some other Vanguard Index funds. [...]

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Vanguard is a great company with index funds and low expenses. In fact it is a mutual company owned by the shareholders, so they are not trying to rip off their investors and earn a profit. I have used Vanguard in the past and highly recommend them. (I don't use them now, and have never worked for them.)

I'd skip that Fairholme and stick with index funds. There's a lot of good web sites and books about asset allocation with index funds. If you want to be aggressive (100% stocks) and diversified, how about something like:

20% Total Stock Market Index
20% Value Index
10% Small Cap Index
10% Small-Cap Value Index
10% REIT Index
10% European Stock Index
10% Pacific Stock Index
10% Emerging Markets Stock Index

For Vanguard IRAs I think it's a $2,000 minimum per fund, so you could do this allocation with $20,000. With a smaller amount, I could come up with a simpler allocation.

If you want to be a little less aggressive, add Short-Term Corporate Bond Fund and keep the stock funds in the same proportion.

A great book I recommend is The Four Pillars of Investing by William Bernstein:

http://www.amazon.com/gp/product/0071385...ks&v=glance

Good luck!

-Tom

[buffett]

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there is no one that can pick stocks and beat the benchmark over a long period of time

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Oh, please.*

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Take 1000 fund managers and put them in a room. Ask them to flip a coin and try to get heads....

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Have you read The Superinvestors speech?




* I'm not saying it's easy, I'm just saying that all tautologies are false [img]/images/graemlins/wink.gif[/img] and there's a lot of data that contradict you/Fama/French/Malkiel/Samuelson/.....

[Ed Miller]

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* I'm not saying it's easy, I'm just saying that all tautologies are false [img]/images/graemlins/wink.gif[/img] and there's a lot of data that contradict you/Fama/French/Malkiel/Samuelson/.....

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Honestly, I don't understand how people who lived through 1998-2001 could claim that the stock market is too efficient to beat.

BTW, I definitely appreciate your advice, jively. And I agree 100% that index funds are an excellent investment vehicle. But I don't believe that the market is always priced too efficiently to exploit.

Though, I certainly agree with you that you can't look at a managed fund's return for the past X years and draw a conclusion about its ability to pick stocks well.

[rockrock]

Ed,

I think that one or more of Fama/French/Maliel have stated that while the markets may not be completely effecient all the time, it's best to allocate assests as if EMT were true.

Jeff Vinik subsequently got fired/resigned from Fidelity and now runs a hedge fund. The point is (I think), it's impossible to predict what managers will outperform in the future.

As to your book list, there is one that from all my reading, makes the most sense out of all this debate. It cites the relevant academic papers, recent research and makes a compelling case.

The name of the book and it's description at Amazon is misleading. The Only Guide to a Winning Investment Strategy You'll Ever Need : The Way Smart Money Invests Today - link

If you are at all curious about all of this it would be unfortunate not to read it.

[Ed Miller]

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If you are at all curious about all of this it would be unfortunate not to read it.

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I'll be happy to read it. I'll order it today.

[jively]

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there is no one that can pick stocks and beat the benchmark over a long period of time

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Oh, please.*

* I'm not saying it's easy, I'm just saying that all tautologies are false [img]/images/graemlins/wink.gif[/img] and there's a lot of data that contradict you/Fama/French/Malkiel/Samuelson/.....

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Ok, maybe the stock market is less than 100% efficient, and it is possible for a few active managers to outperform their benchmark over a long period of time. However, by the time you have enough years of data to see they are truly skilled and not just lucky, they'll be retired. And if you are trying to find those managers before they have all of the necessary data, you could be wrong and underperorm the benchmark.

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Take 1000 fund managers and put them in a room. Ask them to flip a coin and try to get heads....

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Have you read The Superinvestors speech?


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I just looked it up. I'll look at it in more detail later. However, it looks like Graham and Dodd are into deep value, right? Great. I like deep value as well. The Fama/French research from 1992- shows that deep value outperforms the market over long periods of time, and I recommend a deep value tilt. When looking at the past performance W. Buffett mentions, is there still positive alpha after evaluating on the 3-factor model?

The average compound annual return from 1927 to 2004 is:

10.4% S&P 500 Index
11.4% US Large Cap Value Stocks

-Tom

P.S. Didn't W. Buffett say that most investors would be better off in index funds during a shareholder letter in the 90s?

[adios]

I'll interject something here, evaluating the risk to acheive the expected albeit uncertain returns must be evaluated as well. Sounds like a trite statement but I assure you it is not. For example if I take the "equivalent" risk of leveraging SPY by 2-1 in my portfolio but only "expect" investment returns 1.5x what I would expect with SPY by investing in my portfolio, I've taken on more risk than I need to. Hope I explained what I'm driving at. Anyway in evaluating any money managers record IMO one has to evaluate the risk that was undertaken to achieve the returns.

[derosnec]

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I'll interject something here, evaluating the risk to acheive the expected albeit uncertain returns must be evaluated as well. Sounds like a trite statement but I assure you it is not. For example if I take the "equivalent" risk of leveraging SPY by 2-1 in my portfolio but only "expect" investment returns 1.5x what I would expect with SPY by investing in my portfolio, I've taken on more risk than I need to. Hope I explained what I'm driving at. Anyway in evaluating any money managers record IMO one has to evaluate the risk that was undertaken to achieve the returns.

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Exactly. This is a complex decision (efficient frontier stuff, etc) for which he is not going to be able to make a profitable decision without the requisite background in finance (unless he gets lucky). He might consider lottery tickets instead, which are going for a buck a pop.

[DesertCat]

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P.S. Didn't W. Buffett say that most investors would be better off in index funds during a shareholder letter in the 90s?

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Yes, Warren Buffett is well aware of the poor performance of most fund managers, and that is why he's advised the average investor to choose index funds. But the point of his "Superinvestors of Graham & Doddsville" is that while the market is frequently efficient, it's consistantly beatable by a smart investor. His example investors didn't squeak by the indexes either, most of them crushed the indexes and did so taking substantially less (real) risk.

Of course I'm not sure how Buffett beat the market since he believes the CAPM is pure BS, and that Beta has nothing to do with risk. He's just an old fuddy duddy so out of touch with these smart academic types that he's content with a 50 year record averaging north of 25% a year....