An article in The Wall Street Journal contrasts passive and active stock investment strategies of the two members of the Bogle family. The father, John ‘Jack’ Bogle, practices the former approach
Jack Bogle is the founder of Vanguard Group and considered by many investors as the father of passive investing, or using funds that try to capture the return on an entire broad basket of securities, such as the S&P 500.
while the son, John Bogle Jr., prefers the latter one
The junior Mr. Bogle then started Bogle Investment Management LP, his current firm, in 1999. Like many active managers, he uses computer models to analyze earnings surprises, relative stock valuations, corporate accounting and the like.
Results have apparently been in favor of active management:
The flagship Bogle Small Cap Growth Fund was launched 14 years ago and has delivered an annualized return since then of 12.4%, compared with 8.6% for its benchmark index, the Russell 2000, according to Morningstar.
However, this statistic is misleading. As of the end of November 2013, the 10-year annualized return of the Bogle Small Cap Growth Fund (BOGLX) was 8.89%. The annualized return of the iShares Russell 2000 ETF (IWM), which follows the fund’s stated benchmark, was 9.01% in the same period. Moreover, the iShares Russell 2000 Growth ETF (IWO), implementing a benchmark more relevant to the fund, returned an annualized 9.19%.
The fund’s lifetime outperformance cited by the article is mostly due to the 1999-2000 period when small-cap growth stocks enjoyed a strong run-up during the technology market bubble. In its first year since inception on October 1, 1999, BOGLX returned about 69.9% compared to about 21% of the Russell 2000® index in the same period.
Let’s also take a look at the fund’s performance from the Alpholio™’s perspective. Here is a cumulative RealAlpha™ chart since early 2005:
The fund started to significantly underperform its reference portfolio of exchange-traded funds (ETFs) in mid-2007, well before the onset of the financial crisis. From mid-2008 to mid-2012, the fund’s cumulative RealAlpha™ was relatively flat. The fund began to outperform only about a year ago:
This year, John Bogle’s fund has generated total returns of 40%, through Tuesday, according to Morningstar, compared with 35% for the Russell 2000 and 34% for the similar Vanguard fund.
The following chart shows the percentage ETF weights in the fund’s reference portfolio over the same analysis period:
Just three ETFs, iShares Russell 2000 Growth (IWO), Vanguard Small-Cap Growth (VBK), and iShares Morningstar Small-Cap (JKJ), collectively accounted for about 85% of the reference portfolio on average. This indicates that a substitution of the fund with a better-performing collection of alternative investments was relatively straightforward.
It looks like the elder Mr. Bogle was right after all — it is difficult for a stock picker to outperform on a truly risk-adjusted basis. To access more information on BOGLX, please register on our site.
An article in Forbes laments a recent change of focus in ETF industry conferences from traditional “market-tracking” products to active investment strategies. By “market-tracking,” the author clearly means the classic market-cap weighted indexing that is prevalent in ETFs.
This brings up two questions. The first one: What really qualifies as active management? A one-time decision to invest in the entire stock market, such as through the Vanguard Total Stock Market ETF (VTI), is arguably an act of active management. So is a decision to split the investment portfolio between 60% VTI and 40% iShares Core Total U.S. Bond Market ETF (AGG). Likewise, a decision to adopt
“a fixed asset allocation to various asset classes based on an investor’s long-term needs.”
Periodic portfolio rebalancing to such a fixed allocation is also a form of active management, if not market timing, even if conducted on a fixed schedule. That is because one of its attributes is to “buy low, sell high,” i.e. lock in the gains in appreciated assets to cheaply purchase other assets in anticipation of a reversal to the mean.
Similarly, any modification of a “fixed” asset allocation in response to a change in the investor’s age or life circumstances also qualifies as active management.
Finally, it is worth noting that indices tracked by passive ETFs are also actively managed. Over time, the membership of securities in the index will change, and frequently so due to an arbitrary decision from a management committee rather than as a result of an explicit formula. A recent recomposition of the Dow Jones Industrial Average is one case in point. Another example is a recent switch of the Vanguard Emerging Markets ETF’s (VWO) underlying index from MSCI to FTSE, which caused all South Korean stocks to be removed from the fund.
Active management inevitably takes place at all stages of the investment process, even one based on passive instruments.
The second question that arises: Where is the ETF industry heading? The first wave of ETFs was about attaining economies of scale while implementing traditional market indices. It created a few dominant providers but resulted in a race to the bottom in management fees.
The second wave was about spreading horizontally to all niches of the market. Many of such exotic strategies failed to garner minimum assets of $50-100M that are typically required for an ETF to survive.
The third wave is about non-market-cap indexing, whether equal-weighted or fundamentally-weighted (“smart beta“). Such funds are a blasphemy to market-cap indexing purists who spend a lot of time poking holes in these strategies.
The next wave, pending regulatory approval of infrequent reporting of fund holdings, will be about active management. The ETF structure is attractive to actively-managed mutual fund vendors because it allows them to lower fees and survive the onslaught of cheap market-cap indexed ETFs.
All this makes traditional fee-based advisers nervous:
In the end, most advisers continue to do what’s in their clients’ best interest; they create a long-term asset allocation, buy low-cost index fund, and then stay the course!
The problem is that in many cases investors pay a recurring annual fee of anywhere from 0.2% to 1.5% of assets for a one-time setup of a portfolio pie-chart (frequently with small variations from the adviser’s “moderate” allocation template), followed by periodic rebalancing and reports. That enables a typical adviser to spend only about 11% of time on investment research, while devoting about 18% to client acquisition and prospecting, and 48% to client management.
In the end, the market will rightly decide what type of financial products survive and flourish. Marketing gimmicks aside, innovation in the ETF industry is a good thing because it gives investors more financial instruments to choose from at an ever-decreasing cost. Alpholio™ can use these new products to form reference ETF portfolios that better explain the performance of actively-managed mutual funds and arbitrary portfolios.
An article in The Financial Times shows the following statistics of mutual fund industry professionals who invest their own assets in low-cost passive vehicles, such as index funds and exchange-traded products (ETPs):
|Portion of Assets in Passive Products
||Percentage of Responders*
* Numbers do not add up to 100 due to rounding
The main reason why about two-thirds of these professionals have a sizable part of their assets in passive instruments is said to be the compliance with fund industry regulations that prohibit trading in individual stocks or bonds. However, investment in actively-managed mutual funds is not prohibited, which is evidenced by one-fifth of professionals having only non-passive products in their private portfolios. It really looks like most fund professionals tout “alpha-generating” products to others by day, but personally shun them by night. How revealing.