Guest contribution by Rick Ferri
There are three universal laws in the investment business: expected return is a function of risk, active management is a triumph of marketing, and alpha goes to the manager. If you are not already an index fund investor, you will likely become one with full understanding of these fundamental truths.
Risk and return follow natural economic law. We canât change this. Higher returns require taking higher risks. Treasury bills are considered a risk-free investment (not counting inflation or taxes). Youâll have to put your principal at risk at least temporarily if you wish to earn a higher return than the risk-free rate. Thereâs no getting around it.
Trying to change the risk and return equation through active management is a high-cost poker game. Thereâs no evidence that active management consistently outperforms in any asset class adjusted for risk and fees (see The Power of Passive Investing for details). If an active manager claims otherwise, theyâre either referring to a specific time period or theyâre using the wrong benchmark for comparison.
Of course, there have been and will continue to be several winning active managers each year. While these winners argue their excess return (alpha) is the result of superior skill, the problem is proving it. There is no alpha persistence to speak of. Most past winners do not stay winners ââ they fall to the middle of the pack or worse. The excess return they did earn for a while is eventually eaten away by management fees. Thus, the third universal law, alpha goes to the manager.
People will pay higher management fees if theyâre impressed with past performance or believe there is a strong probability of out-performance in the future. Thatâs where marketing comes in. Good marketing beats good management every time. The more complex the message, the greater probability a manager will be able to collect a high fee. Itâs the core reason why hedge funds are able to charge 2 & 20 (translation: Â 2.0 percent per year in management fees and 20 percent of the profits).
A friend recently asked me to check out an advisor he had an interest in. He didnât know much about the advisor, only that their investment strategy sounded impressive.
The advisorâs website was filled with complex PhD level research and baffling industry jargon that only members in the Genius Society could understand. There were also multiple links to big-name colleges and prize winning papers written by Nobel Laureates. In addition, the firm had trademarked scientific sounding acronyms that made them seem like very smart people.
Iâm not a genius and donât pretend to be one, but I was able to figure out that at the core their investment strategy was nothing more than creating a simple asset allocation for clients, and then employing mutual funds to fill those allocations. I looked at the firmâs government filing and discovered that none of the big-name research firms or PhDs had any stake or attachment to the firm. It was all a clever marketing illusion created solely to bamboozle potential clients into believing that this firm was special and their high management fee was worth the price.
I explained to my friend that slick marketing doesnât translate to higher returns especially given the 1.0 fee the advisor was charging. He could save a lot of money if he either self-managed after reading a few good books on index funds, or hired a low-fee investment advisor.
In summary, the three universal laws of Wall Street are 1) expected return is function of risk, 2) active management is a triumph of marketing, and 3) alpha goes to the manager.
If youâre not already an index fund investor, youâll likely convert after learning about these three universal laws. I converted to indexing in 1996 and have never looked back. Visit Bogleheads.org for more information on low-cost investing from unbiased, like-minded and fee-sensitive investors like you.
Copyright © Rick Ferri
