 Welcome everyone to the 33rd edition of Bogleheads on investing today our special guest is Jeff attack Jeff has been an analyst and manager at Morningstar for nearly 20 years and today we're going to talk about active management versus passive index investing Hi, everyone, my name is Rick ferry and I'm the host of Bogleheads on investing this podcast as with all podcasts Is sponsored by the John C. Bogle Center for Financial Literacy a 501 C3 non-profit organization that you can find at Bogle Center net where your tax-deductible contributions are greatly appreciated today our special guest is Jeff Patak Jeff has been an analyst at Morningstar for almost 20 years He has in-depth knowledge of active management strategies index versus active management and Jeff knows the score now some of the terms Are you going to hear today might be a little geekish like five-factor model three-factor model regression analysis and so forth we kind of throw them around a little bit But try to bear with us when we're talking about all of that We're trying to decipher whether or not the active managers actually have skill and outperforming their benchmark And if so, how many by how much and for how long? So with no further ado, let me introduce Jeff Patak. Welcome to the Bogleheads on investing podcast Jeff Well, it's my pleasure. Thank you so much for having me Jeff you've been in the portfolio management analysis business for well, just about 20 years and You've been on all aspects of it. You've actually been a Advisor for Morningstar. You're an analyst for Morningstar. You're an equity analyst for Morningstar You have a tremendous background in the active versus passive debate But before we dig into that debate, I'd like to get a little background on you Tell us a little bit about your history and some interesting facts Sure, sure. I'm happy to and thanks again for having me. Yeah, I'm a Chicago area product They can't get rid of me I was born and raised here went away for four years to school up at the University of Wisconsin in Madison where I Earned my bachelor's degree in accounting and and promptly returned to Chicago and Entered the public accounting profession, which is where I spent the first eight years of my career First two of which were kind of banging the balance sheet so to speak as a commercial line auditor and the last six of which were Where I was part of a national technical accounting and auditing think tank I suppose you would say which was it so happened based in the Chicago area and then when Anderson met its Untimely demise that was actually the catalyst for me to move over to Morningstar, which is what I did in 2002 So the silver lining for me Was finding Morningstar, which is where I've made my career ever since and as you mentioned I've Done stints originally I started out is is a is a fund analyst and and then I've done stints and equity research ETF research I spent some time in the investment management part of our business and then more recently I returned to research heading up our global manager research team and in the way to put that into context is we've got a team of over a hundred analysts globally whose job it is to assess Active and indexed mutual funds and ETFs and their equivalents on a qualitative basis That culminates in a rating called the analyst rating that they assign and so so I work arm and arm I suppose you would say with them and in helping them to assign those ratings and push thought leadership into the market So that's been the tour to this point and then more recently They asked me if I could help out as chief ratings officer So now I spend a little bit more time focused on our rating systems and making sure that they're as usable and effective as possible Well, thanks, so I want to frame today's conversation because this is my area meaning I've written a number of books on index funds my first one that I wrote was back in the 1990s and then Books on indexes asset allocation using index funds ETFs a history of index investing and so forth This is my my thing so to speak so I'd like to just get into the a conversation, but I want to frame it for you This is the way I framed it in a book. I wrote called the power of passive investing that starting out with the history of mutual funds and why they were created to begin with with the first mutual fund being created in 1924 and It was for a very different purpose everything was actively managed back then and The mutual funds were created basically to offer people The ability to have a diversified portfolio of securities that the otherwise maybe could not have afforded But it wasn't according to John Bogle's 1951 thesis from Princeton. It wasn't for the purpose of outperforming the market. It was a convenience thing Is that how you see it? That's right I think that traces the beginning of the arc of the industry and and basically giving investors the ability to Pull their capital so to speak and in maybe in ways where they don't court Owners trade offs that they would have courted if they've been trying to invest in individual securities transaction costs Being an example not that it was a free ride in the early mutual funds But I'm sure that there were some efficiencies that investors in addition to convenience is the big game There were efficiencies that they also read Let's spring forward to again some of the early research on Active mutual fund performance was done well before the first index funds were created the work that I did and looking at data and studies that were done and back far back as the 1930s by Alfred Cowell's but by Going forward over the years by Bogle and various academics in the 1960s all seem to point to the fact that These actively managed funds were in fact not outperforming the markets. Then in fact some did but most by and large did not but again, it wasn't a concern at the time because the purpose For having mutual funds was to just get diversification in a relatively easy way by pulling capital together as you said but it was these studies on active management that Led to a lot of questions about well, why isn't there an index fund that tracks say the S&P 500 Why do you suppose that was why did it take so long to create an S&P 500 index fund which by the way Didn't get created until 1975 and actually went public in 1976 So I think that that may be not to widen out too much But I think that maybe it's something that's innate to the American spirit were strivers and I think that that perhaps You know, it just comes naturally to us to not just try to attain a goal But to exceed it and you know say what you will about active management But the name of the game there is to try to clear the bar and so I think that that's that's probably one reason I think that incentives are probably Another reason there's probably a whole sort of litany of reasons that we can cite why it took a while I would suppose another barrier was It just it seems counterintuitive and we still You know find ourselves having to dispel this notion But there's sort of that whole idea why would you settle for average in an index fund? Which is literally what it strives to deliver you in so far as it does a good job of tracking whatever market segment It's seeking to track Where where it's above average is once you take fees and a consideration and other frictions You would otherwise encounter an active strategy you end up doing Better than average and and those that those excess returns compound over time And that's one of the reasons why index funds are as formidable As they are in many market segments You know, but that could be a tough sell it doesn't intuit I think for a lot of people and so I I think that when you take the three of those things together were Strivers there's incentives that maybe conspire against indexing and it's also something that doesn't immediately intuit That's probably three reasons why why indexing took took a little while to to really take root I'll add a fourth reason and that is cost Meaning that prior to I think it was 1975 there were fixed commissions in the Exchanges where it cost a lot of money to Buy 500 stocks in a fund And if you had money coming in and out of a mutual fund like an index fund would have They would have to go to the market in order to keep it somewhat balanced or Tracking the index they'd have to buy and sell A lot of individual securities and with fixed commissions I think it probably made it prohibitively expensive until I believe it was 1975 When congress did away with fixed commission costs and that spawned companies like char swab and discount brokerage firms That's right. And then I think if we were to focus on, you know, maybe the last decade or so and we've seen this torrential shifts from Commission based to fee based advice. I mean changes in advice practices Are probably something else that have ushered in indexing no indexing it arrived by then And I think that some of the factors that we focused on Explain why it had arrived But I think if we're looking for one of the factors that explains why The demand for indexing has accelerated to the extent that it has in recent years I think that that's probably a pretty pivotal shift to talk about You know the fact that for many advice givers It was more about planning or what they might call behavioral modification or tax management Rather than going out and trying to capture alpha And so the name of the game became to try to lower the internal cost investment cost or whatever that it is They were delivering, you know, that's that's a pretty pivotal development I think and in the overall adoption of of indexing which is a bit unique to I think the last 10 or 15 years Now I have a thesis and I know you may not agree with it that I wrote about in the power of passive investing and I've said several times is that The evolution of mutual funds into indexing Caused actively managed funds to become obsolete at least for the purpose in which they were created Which was simply to offer people a diversified portfolio of individual securities Not trying to outperform the market But just to have a portfolio that's diversified by pulling your assets together in a fairly Low-cost way rather than going out and trying to Buy a portfolio of multiple stocks with high commissions and so forth That when indexing came along it was a better mousetrap. I mean it did that better Then actively managed funds at least that portion of it And which is probably why ed johnson from Fidelity Said this When john bogel launched The first Index mutual fund at vanguard now the s and p 500 fund he said I can't believe that the great mass of investors are going to be satisfied with just receiving Average returns the name of the game is to be the best and this gets to your Concept of well people are have animal spirits and are trying to outperform But to me this was a big shift in active management up until the time indexing came along in the 1970s It was more about being able to get a diverse wide portfolio of stocks At a relatively reasonable cost and not about beating the market But the introduction of index funds in the 1970s Caused this pivot in active management now the name of the game Was to beat the market Would you agree with that? I would agree with that. Yeah, one of the predicates like you point out Of active funds was to deliver that market exposure. So it was beta and alpha And as you say as some of these barriers and frictions Were sanded away As maybe some of the intellectual resistance to indexing Fell away then beta also fell away as a predicate for active and it became all about alpha And so like you say the value proposition Has changed and and as those expectations have shifted I think that you can argue that That it's become an even more stiflingly competitive environment for active funds than before Which somewhat turns on its head the early orthodoxy Which held that as more people embrace passive it would create Greater inefficiency in the market And it would be a turkey shoot for active funds because they would have all these opportunities that they could easily pick off And I think that what research has found work that we've done and and a copious amount That's been done by academics and others is that if anything It's becoming more difficult. So again, it sort of upends that that early orth that active funds would have a better go of it Once indexing made inroads I have to give a shout out to larry swedrow who Co-wrote a book the incredible shrinking alpha would highlights exactly what you're talking about you would think That with all of this indexing going on that active managers would have an easier time About performing when in fact it's become more competitive and more difficult to outperform And there's no evidence whatsoever that an increase in indexing has caused Better performance in the active management space. In fact, you can make an argument that the opposite Has actually occurred Let me jump into some research that I did and that is portfolios of index funds versus portfolios of actively managed funds And here's a little bit different dynamic since it's so difficult for active managers to outperform the markets It doesn't matter what the category is could be bonds could be stocks and we're going to get into the data in a little bit here But if all you had was a portfolio of a few index funds the probability of that portfolio outperforming a portfolio Of actively managed funds is higher than the probability of any of the individual index funds outperforming active funds in their particular category So as we look at each individual category, we can see that us stock large cap Is a x percent chance index funds will outperform and then International same way and bonds same way and so you have all these individual silos individual categories But when you're looking at portfolios If all you did was put together a portfolio of all index funds The probability that that portfolio will outperform a portfolio of all active funds actually goes up even higher than the individual silos It would make sense. I know we're not talking about taxable versus Versus pre tax if it's taxable then it's fairly academic that's not something we talked about to this point And maybe we will later in the conversation But I know that you and we have done work looking at the performance of active funds after tax and It's grim You basically as far as I'm concerned if you're looking to invest actively Do it in a qualified account because if you do it in a taxable account You're likely to be eaten alive by taxes over time to say nothing of just The challenges that you face and succeeding with fact if it's possible It's very very difficult within a taxable account As far as a qualified account and kind of doing the kind of acid tests you describe That that makes sense to me the cost advantages compound I wonder if and maybe your research found this There was also some benefits to Style purity and unadulterated market exposure that you would get through Index products that perhaps you wouldn't get through A basket of comparatively messier active funds that have exposures to different styles I know that our research has found that Generally speaking you will find that active funds do a little bit better in markets that are selling off And we can talk again about why that is But in rising markets generally speaking index products will do better Just because they tend to be a bit more style pure And so I wonder if you're picking up a little bit of that as well But generally speaking if you keep the cost down you keep it simple And you keep your market exposures on and the market cooperates with you I would expect that kind of outcome Yeah, let's get into the style purity and also something called survivorship bias in a lot of the data There is a concept called duns law. Have you ever heard of duns law? I have yes Yeah, basically it just says exactly what you said that when markets are going up In that portion of the market that is outperforming Index funds tend to outperform because the managers are messy and they're not style pure But in that segment of the market that's not doing well Is underperforming the rest of the market The active managers tend to do better because the active managers are messy and they're not Holding to their style style purity and the consistency of active managers to maintain their style is a big factor And creates a big difficulty. Does it not and determining Whether an active manager has skill or not? It does it does and that's one of the reasons why it can become valuable important To look at performance through a number of different lenses, you know, maybe not just raw returns But risk adjusted and maybe not just sort of a single factor regression but a multi factor regression And so I think that things like Fama French three or car art four or now we've got five six seven I mean picked your multi factor regression But those are ways to To separate alpha from beta and as you rightly point out because active funds artists style pure They tend to be messiered other styles You want to control for those sorts of things and and that can be especially important over shorter periods of time Markets are noisy managers are messy and so the nexus of those two things is You know, manager success rates can cycle up and down You and I know from reading the the press that this is the storyline that that always keeps giving is that managers are one category Active managers, I should say are prospering others in another category Aren't a deep flump and in in many cases the reason why you see those sorts of variations Is done flaw because you have managers that perhaps are in one area of one specialty Where they've had a tailwind and and that's propelled them past their index over some period of time Whereas conversely you've got managers that maybe you do a different style or invest in a different way That have encountered a headwind and that explains their slump and so Done's law is a pretty handy concept to keep in mind. Just as you're trying to make sense of it all What's the report that Morningstar has that does some of this analysis? My colleague ben johnson and others on our passes team Publish this it's called the active passive barometer. We go category by category And we see how many active funds we're able to outperform a composite of Passive funds that make up that category and those categories are constructed based on holdings based analysis That's how we determine which funds to lump together Into peer groups is by looking at the attributes of their holdings And then per our Morningstar category classification methodology assigning them to a category So like in the case of let's say a large value fund These are funds that are exhibiting the traits through their holdings of funds that favor the stocks of larger companies that are inexpensive by a number of measures We do try to point out some of these puts and takes that you get For the reasons that you mentioned again, that's that's done's law so to speak the fact that You know, if you have a manager like if we focus on maybe the most recent decade It's a large cap manager and they really skew towards mega and maybe lean towards growth That's probably been a good fact over the past decade or so just because that Part of the style box is done quite quite well Conversely, if you had another manager that maybe it was in that large growth box But they own quite a bit of mid and and maybe they mixed in some core and even some sort of busted growth stories That are sitting in the value side Of a ledger a manager like that probably wouldn't have done as well And so a simple success ratio isn't necessarily going to do that attribution for you But through our research we try to make sure that we point those things out so that people understand What might be driving some of the trends that they're seeing So indexes have certainly changed Well, I shouldn't say they've changed indexes have certainly been expanded what the definition of an index is Has expanded significantly in the past. I'll call it 15 years or 20 years where Well prior to say 2003 or 2004 an index was The s and p 500 or the total stock market Or the total bond market or the total international market of some sort, but they were very big large gorilla type composites of securities from US and international and fixed income But that has changed dramatically and the definition of an index I don't think it's a definition based on what john bogel standard would be of what an index is but There have been in my view a lot of actively managed products that have now calling themselves Indexing and I believe that morning star calls them Strategic indexes. Is that the name that you use? Strategic beta. That's right. The industry refers to it as smart beta. We think that did itself serving So we call it strategic beta. It's exactly what you've described rick, which is that there are indexes quote unquote but What it really is is it's it's a rules based implementation of active management It's those rules Which dictate which types of securities? You will select it's really not about faithfully tracking a given market segment Let alone a sort of a wide swath of the market typically what it's about is Sort of narrowing in on a specific set of securities that possess certain attributes per the rules that have been specified And we call that strategic beta And and my work I did on the etf book that I wrote I broke down these strategic indexes and Tongue-in-cheek I called them special purpose indexes sp indexes or spin indexes for short Now because there was a lot of spin going on in the marketplace here about what these things actually were But how my opinion? So these strategic indexes have really expanded but there's two things going on here. It's not only The investment selection and so what goes in the index that's different. Let's say You're going to do some quantitative work to determine Which individual securities go into the strategic index, but it's also The weighting of those strategic indexes that have changed where They're selecting securities based on some quantitative or qualitative factor like esg or such But how they weight those Stocks or bonds in the index Is also changed to using the same factors in many ways. So you might have a a factor weighted Into how how small cap is it or how value? We is it or how esg prone is it? So it's not only individual security selection It's individual weighting and this to me. I mean this is active management, but the sec allows These products to be called index funds because they track as you said a Model of some sort or at least a methodology to me It's a little kind of unfair and it's a little was a little bit of a way of which active management companies to get back at The indexers. How do you feel about that? You know, I do agree that there has Maybe been a certain lack of discipline when it's come to Devising some of these strategies. I mean, I think that we can look at something that's fairly plain vanilla like a value index I mean, technically one could argue given the fact that it's literally factor tilting That it's aiming to do something apart from the broad cap weighted market And I don't think that probably, you know, you or I would look at that and be like, okay This is improve it at all or there's not a body of research that undergirds this So I think that you know, what you're referring to is this proliferation of products that we've seen that have targeted You know be very narrow market segments or you know, maybe data mine their way to a particular index methodology And then they put that out there and it kind of promptly rolls over It's just a bit of gimmickry We have seen a lack of discipline in some of the products that we've seen come out there And so that's why, you know, we've tried to take some steps through some of the methodologies that we've developed again This is ben johnson and his team were but at the forefront of coming up with strategic beta tags and different classification metrics that You know, we can try to make available to investors so that they can make more informed decisions about what are You know, they are active strategies I'll be at those that are Implemented through a set of rules that you know are delivered in the form of an index If you take the smp 500 and you divide it between value and growth to me The purpose isn't to recommend either value or growth It's just simply to take an industry like the smp 500 and create a value and a growth segment of it or take the total market and Divide it into large cap mid cap small cap when you put these things all back together again It's still the total market similar with Industries in other words you could take the 11 industry classifications And you could make and they have made in indexes or indices out of each of the 11 But when you put them all back together again, it's still the total market So that that's one type of slicing and dicing And I don't have any problem with that. It's the other stuff It's the stuff that is selecting securities And then weighting them differently The active management stuff that's being called indexes that I have a problem with because it really has confused people You know with this idea that Fundamental indexing for example is better than traditional indexing. Well You know fundamental indexing is a selection process and then a weighting process It's an active management process. It's not the same as You know buying the whole market No, I think you're right. I think buyer beware is the right mentality to take into that You know the one thing that I could say in defense of a thoughtful smart beta or strategic beta approach One that files a prudently constructed index that's maybe founded On you know robust research that's been conducted in a careful way The index isn't going to lose its nerve Which is sounds a bit glib, but you know one of the things that that investors Do have to confront when they invest with an active manager is Agency risk or career risk. It's this notion that if things go against the active manager He or she might be likely to buckle under the pressure. And so maybe they are tilting sort of towards a set of securities that have been underperforming And the phones are ringing off the hook. Clients are upset They want a piece of the action and the action is not where that manager is investing at the moment And so what do they do? They sell the underperformance and and maybe they glom on to the index or Buying to the part of the market that's been doing better. And and what happens You know performance suffers because they tend to buy into the the market segment that's about to roll over And we see this repeat again and again and again and Contrast that with this strategic beta product I'm not suggesting for a moment that they're all well constructed or thoughtful, but the index shouldn't lose its nerve It's going to keep doing what it's designed to do, you know, maybe again take our sort of quintessential value index It's going to probably keep buying, you know, rebalancing towards stocks that look cheap by price to book or what have you Whereas maybe another manager who is tilting towards that style Maybe because of the agency risk, maybe because of that career risk They might not be as committed to doing that when push comes to shove So I think that's one thing that you could say and then in so far as they're wrapped In the ETF structure There are certain tax advantages, but that's more of a wrapper thing ETFs versus open and mutual funds that it is an indexing thing I think that probably something I would just focus on if you're evaluating a strategic beta product Let's get into the Percentages the these are the tables that you do and vanguard has done Stands it and pours does them through their SPIVA studies. There has been several academics who have put together performance tables to show the percentage of time that active management in each category Outperforms these are usually done either annually or semi-annually I look at all of these studies and have been looking at them for years standing in pores I've been doing them for 20 years and I know you've been doing them for a long time and vanguard, of course Has been looking at this data a long time and there have been a lot of other Academic studies and they all come out to From what I see just about the same Numbers and to me that numbers are Or over any five year period of time if you start out with 100 funds That are trying to outperform say the market That 25 percent Of those funds will go out of business or merge And usually that's because of very very poor performance the other another 50 percent Will underperform of which half or 25 percent will underperform by more than 1 percent and then the other 25 percent will underperform by maybe less than 1 percent And then last you have the 25 percent that outperforms And this generally will outperform by call it a half a percent There are 25 percent of the active managers who have in the past outperformed over a five year period of time Problem is figuring out who they're going to be Before it happens. So our my number is fairly accurate at least on the equity side They are and maybe I'll sort of back up a little bit I did a little bit of sifting around in our database going back in time and in overtime There have been around 58 000 funds and ETFs in existence and this includes all the different share classes These are us funds and ETFs Of that roughly 58 000 around 31 000 or 53 percent have died So that just gives you a sense. I mean you go back through time at some point There has been a sum total of nearly 60 000 funds and ETFs And around 31 000 of those have perished. They've been merged or liquidated, obsuited in some way And so that is one obstacle that you are facing right off of that is just perishability Many funds it's basically it's a coin flip whether your fund is going to live or not As far as the rest of your number So, you know, you've got a certain percentage of funds that are going to perish They're going to fall away Yes, it breaks down around the way you describe for instance in our most recent active passive barometer report Which is a report I referenced before that my colleague ben johnson and and others on his passive research team Conduct, you know, we found in the large Category so this is us equity It was around 15 20 percent of the funds in those categories Beat the passive proxy And so those are very sobering numbers And as you can imagine is you extend that time horizon further out to 10 to 15 to 20 years It tends to telescope even lower And so I think that it's not contradictory to say that it's not hopeless to succeed with active investing While at the same time acknowledging that it's a very sobering picture when you look at the data The odds are not stacked in your favor Different categories of active funds do Outperform for a while and it might have to do with duns law But that they don't you tend to persist They tend to fall back We've noticed this even in fixed income and fixed income Right now when you look at it You would say gee I should do active management fixed income But that would only be if you were looking at say the last 10 years Of fixed income because 10 years ago You wouldn't have been saying that you would have been saying I should just do index funds. So these things do streak and It's hard to pick the category where you're going to have More active funds outperform, but it does happen I could look at any data from any five year or 10 year period And there will be a category Or two where the active funds have been Outperforming but it doesn't persist So can you talk with us about persistence? No, you're right. Yes, because when over these shorter periods of time Where maybe you see a bunch of active funds in a category or a style outperform Usually There's some sort of stylistic tailwind that they're enjoying and I'm that's not to denigrate active investors You know, they're a very sort of accomplished educated well-trained lot You know, but it's it's very competitive and and it can be difficult to unearth You know truly undiscovered ideas and so what you tend to find is that You know, maybe they skew towards one style or another and so when that style has the wind at its back That's when you'd see them outperform Maybe I'll give you an example of kind of how the numbers this will just sort of further I suppose underscore what you said before Using an actual category as an example This is from our most recent active passive braum to report which was as of december 31st 2020 And if you looked as of that date Within the europe stock category So these are funds that invest primarily In stocks that are domiciled somewhere on the broader european continent 74 of the funds In that category outperformed over the year ended december 31st 2020 But then as you extend the time period to three to five to 10 to 15 years, what you find is that The numbers shrink way down. So for instance over the trailing 10 10 years through december 31st 2020 Around a third of active european stock funds Beat their benchmark and so that's inclusive of the great Year that they had in 2020 that probably boosted the 10 year number a little bit than it otherwise would have been But it's still quite low and that's kind of a constant when you look across the different categories That that we study. I mean the category for instance over the trailing 10 years ended december 31st 2020 That had the highest success ratio was global real estate And that was 48 percent meaning that 48 percent Of the active global real estate funds that existed 10 years before we began that december 31st 2020 measurement period Beat their benchmark and so it's very very difficult as you extend this over longer periods of time And and you experience mean reversion as a fund that stylistic tailwind becomes a headwind And then other sort of realities intrude Such as the economic viability Of the product if it doesn't reform the manager Probably is going to be tempted to mothball it to to merge it with something else or just to liquidate it So that it's got a better offering of funds to show and so that's how those numbers end up falling And you end up with those low success rates that you see Let's look at fees how fees factor into this and there's been a lot of Academic work and you've done a lot of work on fees. You do your annual fee study every year And pretty much there is a very high Persistent correlation among all asset classes Between the fee that the active managers charge and their performance There's a lot of closet indexing going on Where a lot of managers are just buying Basically what's in the index and charging a higher fee for it But can you talk about the correlation? between fees And active returns versus the index of funds We've done quite a bit of work here I would highlight some work that my colleague ross kennel did some years ago where he looked at A multitude of different factors to determine which seemed to be the most predictive and You know the factor that really stood out was fees So the lower they were the the likelier it was that fund would succeed by by different measures To give you a more recent example that I might return that active passive barometer report that I referred to before And this is available to any of your listeners if they google for it They should be able to pull it up and and download it free of charge It's it's available publicly so you can see for yourself But not only do we tally up the number of active funds that have beaten their Composite benchmark over time But we also break those categories into cost quintiles. And so What we take a look at is, you know, how the funds that were grouped not only by style but also by cost Do relatively speaking and what you find is that Almost uniformly the lowest cost quintile Outperforms the index at a higher clip than the highest cost quintile And usually you're talking about multiples of difference now granted it doesn't necessarily Upend one's thinking about whether it's better to be active versus indexed in these categories But I think it does give you an appreciation for how much cost can tilt the odds In your favor just to give sort of a quick example Using a category that I think is familiar to a lot of investors us large blend The lowest cost quintile over the trailing 10 years ended december 31st 2017 percent of the active funds in that lowest cost quintile managed to beat their benchmark Contrast that with the highest cost quintile just four percent of those high-cost large blend funds Beat their benchmark over that trailing 10-year period. I mentioned the odds go from vanishingly small To slightly better if you focus on cost But when you look across these 20 categories that we track as part of this report With the exception of just a few you find that cost us tilt odds in your favor And so certainly if I were making my pecking list that would be way up there on the list of criteria that I'd be focused on in the study that I did with alex bankie of betterment at the time on active mutual fund Portfolios versus index fund portfolios. We did go in and carve out just the lower cost active funds and re-ran the numbers and these were the active funds that were Uh in the 50 percentile or lower as far as fees So they were the least expensive or lowest half of the funds and we did find that it made did make a difference Say over a 10-year period of time if you included all active funds in a portfolio Call it a a five fund portfolio of different u.s. Stock international stock A couple of bond funds and maybe a small cap fund of some sort If you included all active funds in there Versus an all index fund portfolio of the same mix that the index fund portfolio outperformed over 90 of the time however, when you just use the Lower cost active funds in the study The index fund portfolios outperform the active funds about 80 percent of the time so there was an incremental benefit to just Using lower cost active funds so that didn't really move the needle that much, but it did move the needle But back to my other point that I made earlier is that what I found that a different research was that when looking at the Funds that actually did have out for the manager that did outperform And you could literally say they Using information ratios and other statistics that they had skill Was that their funds were not the cheapest nor the most expensive that the They tended to run between 0.7 and a little less than 1 percent I imagine that would be almost required if you really do have skill you have to put some research dollars into Finding those opportunities No, no, that makes sense Maybe when you consider the fact that you have some fairly accomplished successful boutiques out there Who are not going to be the cheapest game in town? I would imagine that was probably part of your cohort where you were seeing some high performers that weren't The lowest cost perhaps you had some in there that You know, maybe we're investing in styles that are a little bit more costly to implement You know, maybe you would think of small company stocks or non-us stocks, especially em Typically those charge a little bit more So that does that does make sense to me that that you would find that I think that overall though, you know, when you're trying to think about sort of those odds of success Focusing on cost is something that'll well serve investors I want to get into a couple of other areas where you have measured The gap between the performance of markets and the performance Of investors in those markets and you call it mine the gap and these studies I found to be very interesting because they're performance gap studies and I've Seen an interesting trend here where it appears as though Investors are getting better at managing their portfolios. Is that what these studies are telling me? Yeah, so you're right that the report is called mine the gap It was pioneered by someone I mentioned before Russ Kinnell some years ago And then we've had other analysts that have been conducting the study since then Amy are not my colleague most recently We we conducted our most recent mine the gap study For the period end of December 31st 2019 We're in the process of updating the version that will be as of 12 31 2020 So stay tuned be able to look out for that but when we did the most recent one, which again was as of 12 31 19 When we looked at that 10 year period ended then we found that there was virtually no gap between The dollar weighted return that investors earned in their funds and the returns of those funds and For sake of clarification when we talk about the dollar weighted return You liken that to an internal rate of return. So essentially what you're doing is you're taking into account The assets that were invested in funds the cash flows over some period of time And you're trying to solve for the return that would explain how you ended up with the sum of Assets at the end that you ended up with taking into account the beginning balance And the cash flows in the interim and and I would say that it's it's an encouraging story that we've seen the gap Close because I think that when we've conducted this study in the past We found that there could be a fairly sizable gap a percentage point even two percentage points That separated investors returns from their funds returns meaning that They had in opportunity timed their purchases and their sales You know in the most vivid example of this would be investors who Are chasing performance and and they end up buying high and selling low in situations like those You find that the dollar weighted returns the investor return Far trails the the total return that is the the return of the funds And so it's encouraging to see that these two numbers have have converged over time And it does suggest that we're seeing better habits or at least we're seeing some of the the less self-harmful behaviors from investors that we had seen before again, though That this was just through end of 2019 what we haven't quite tallied up what what we saw in 2020 And and there was some evidence of misbehavior then so we'll see what uh what what this next installment shows I'm curious if your data is able to separate out advised portfolios from self-managed portfolios And if you're seeing different trends and advised portfolios then self-managed portfolios I wish we could but we can't uh it used to be as you know that share class would tell you To a certain extent which of the funds Are advised where there's a financial advisor that's involved Versus say a no load share class or an institutional share class where we can safely say that it's an individual investing on their own Or doing so in a self-directed way say within a retirement plan But those boundaries have basically been blown to smithereens Especially institutional share classes. Those are no longer the sole province of institutions We've got many individuals that are self-directing and investing in those share classes Which they're able to access through a retirement plan. So it's a long-winded way of saying We can't separate it out quite that cleanly. What we can do is look at other dimensions Asset class morning star category. We've done some work looking at it by volatility level or costs of the funds concerned You know and there are some interesting findings there I would say that probably the the one that really jumps out is allocation funds Allocation funds would include things like target date funds, which have become a mainstay In defined contribution plans and over the 10-year period ended december 31st 2019 What we found is that the average dollar that investors in allocation funds put to work Out earned the funds. So they actually By regularly contributing into these funds is is the practice with the defined contributions plans as you know They ended up reading a slightly higher return than their funds did To the tune of about a 40 basis point positive gap annualized And so that's a really really encouraging outcome to see just knowing the central role the defined contribution plans will play In the retirement future of of so many folks who are in the workforce So so that was something that certainly did jump out from our most recent report I think that most of those funds are not advised meaning that there's no Extra fee being paid to any advisor On top of that. I think pretty much most of the money is in those funds is going to be just quote-unquote self-directed By the investor would you agree with that? I would agree with that and in a number of cases as you know We've got investors who are being defaulted in to a target date fund Now generally speaking, you know the the lion's share I would guess of the assets that are in target date funds probably Were not defaulted in just because it predated predated that practice And that's where the lion's share of the assets are but you're right that I would expect the bulk of that is not advised So this investor gap that is shrinking or in some cases have gone away At the same time Huge flows have left active management and gone to indexing Is there a link? Well, I don't know that I would necessarily say that indexing On its own would promote better behavior I think that what we have to consider as context in a number of these situations What we have seen is that you know, we had investors who had you know Maybe a small basket of active funds that were targeting particular styles And they're switching into programs or strategies where they're better Diversified and really the name of the game isn't to beat a benchmark It's basically to construct an asset allocation that helps to advance the objectives that are called for by a more encompassing financial plan And I think that context is important because I think that if you have investors that You know are maybe less jumpy because they're not as focused on beating a benchmark over time But rather seeing that they're making progress with their plan as implemented through a broader asset allocation framework That's implemented with passes They're just going to be less prone to to buy and sell in opportune times They'll stick with the plan and then there are certain mechanisms that enforce this right? I mean we talked about the fine contribution plans That's kind of the name of the game is you're just putting your money in in a regular fashion It goes into the target date fund and it takes care of everything for you and in some of those cases those target date funds Are investing in index funds? And so I think that some of that context is important I think that there probably is evidence You know anecdotal or otherwise that that index investors You know, they approach investing in a slightly different way They maybe are a bit more focused on the long term and managing what they can like cost and tax efficiencies And therefore they don't have the same propensity to trade around their portfolio Is maybe another type of investor is a different set of motivations including beating the market Or maybe they're a little bit more fixated on performance and perhaps they're more tempted to chase Well, it makes me circle back to my original comment at the beginning of this podcast that the original purpose back in 2004 for starting mutual funds was to give people a diversified portfolio and it wasn't necessarily to outperform the market And now index funds have Been come a better mousetrap And made active funds obsolete And to me the performance gap data is Showing that people are figuring this out Okay, one last question. We hear a lot of stories in the media. I think these come up all the time Negative stories about indexing indexing Is it's going to blow up the market because so much of the market Is in index funds now it's causing The market to be way overvalued Is there any relevance to any of these stories that we hear in the news media? I think that's mostly bunk and self-serving I think that you know the the strongest proponents of arguments like those tend to be those that You know stand to gain from active investing Finding followers and there's many thoughtful defenders of active investing. I don't want to denigrate them to but It tends to be a self-serving argument I think the most important thing to keep in mind and it's a point I know that that you and and other vocal heads have made repeatedly and I think It's a point well taken is that a cap weighted index that does a good job of capturing a beta of Delivering a market exposure By definition, it should be mirroring the other the sum total of other participants that are investing in that same area including active managers and so Sort of this notion that indexing is going to get so big that it's going to be destabilizing or somehow a fund house mirror distort markets I mean to me that's self-contradicting in so far as an index is like holding up a mirror what you see is The sum total of what other participants are engaged in in that market including active investors and so So I I don't buy that argument I continue to think that that indexing is is a proven way for investors to get Low-cost exposure to market segments is part of a more encompassing plan. I think that There can be a place for active investing But I think that investors should be judicious about it and one of the best ways To sort of really understand what your limits might be there is just to look at some of the data that that we try to make available And that others have made available That would give you a sense of what the odds of success are And know what sort of barriers stand in your way so that you know when you do put on an active exposure You know what you're getting into and and you've calibrated your expectations accordingly Well, jeff it's been wonderful to have you on vocal heads on investing and you're just a wealth of knowledge Coming from an unbiased source. I would say that you know morning star is not trying to Manage money not trying to outperform anything just trying to put out there The data as they see it and thank you so much for being on vocal heads on investing today Oh, it's been my pleasure. Thank you so much for having me. I really enjoyed it This concludes vocal heads on investing episode number 33 I'm your host rick ferry Join us each month as we have a new guest in the meantime Visit bogelheads.org bogelcenter.net the bogelheads wiki view our new bogelheads live speaker series Get involved in your local bogelheads chapter or a virtual community and tell others about it. Thanks for listening