Investing Beliefs

RAM’s investment philosophy is based on a core set of beliefs that are supported by decades of academic research.

The vast majority of retail clients underperform the markets, despite the advice they receive. Just in the last 10 years, 83% of active funds in the US failed to match their benchmark [1]. Given the sheer number of firms and analysts covering stocks today, all of whom claim expertise, this should not be a surprise. 95% of security trading is done by professional investors and traders. Given these and other daunting statistics, it becomes clear that it is very unlikely that any individual mutual fund investor will be able to select active managers, such that they outperform an indexing strategy over the long-term.

Instead of focusing on trying to find the next star manager, which is a loser’s game [2], Individual investors should focus on what really matters.

Investing Beliefs RAMDiversification matters. Diversification is the only free lunch and it’s good for you. It doesn’t cost more to be diversified and it spreads your risk around. It is important to maintain diversified exposure to Canadian bonds and equity as well as the US and international markets.

Time horizon matters. If you do not expect to begin drawing down your portfolio in the next ten or so years, a growth-oriented portfolio is probably desirable. However, if you are already retired, lower risk and an income orientation are probably best. Time is your friend when investing and the more you have the more risk you can assume.

Fees matter. Mutual fund fees in Canada cannot be justified based on performance results. Do you get what you pay for? Not usually. In the asset management business fees are inversely correlated with net returns. Mutual funds with higher fees tend to have lower returns to investors.

Trading costs matter. Trading costs, which include broker commissions, bid/ask spread, and market impact (for large trades) eat into returns. All else being equal, less trading is better than more trading.

investing beliefs ramTaxes matter. In taxable accounts, trading can create taxable capital gains. Dividends and interest are subject to tax as well. All else being equal, investors should elect to defer taxes by reducing gains and income in taxable portfolios. Trading in taxable accounts is most beneficial when offsetting a loss or when rebalancing to the target asset mix.

Indexed Exchange Traded Funds (ETFs) are excellent vehicles for tax efficiency, primary because portfolio turnover in indexed ETFs is typically very low. These funds often do not incur capital gains for many consecutive years, thus deferring tax indefinitely for investors (who buy and hold). For tax-sheltered accounts (e.g. RRSP, TFSA, RESP) it is more complicated. The income in these accounts are not taxed each year, but only certain ETFs are tax-efficient and it depends on where the ETFs are traded and whether they hold securities directly or indirectly.

Performance matters. Active managers typically claim that their stock-picking skills will give them an edge to perform better than an indexing strategy. They must make this claim to justify their higher fees. The truth is that active managers can’t all be better. In fact, only a small minority of managers will beat their benchmarks over time. In a 2009 comprehensive study [3] using the performance data of 3,156 US equity mutual funds from 1984-2006, renowned professors Fama and French found that “going forward we expect that a portfolio of low-cost index funds will perform about as well as a portfolio of the top three percentiles of past active winners, and better than the rest of the active fund universe”. This conclusion reinforces the importance of fees and trading costs, as the entire benefit (and more) during this 22-year period accrued to the fund managers and their shareholders, and not to investors.

Discipline matters. Most investors perform poorly, even relative to the mutual funds in which they invest. How is that possible? Lack of discipline and poor advice from advisors. They follow the herd, buying into mutual funds after good performance and selling after poor performance. They speculate based on tips from people who know next to nothing about investing. They try to time the market, a strategy that is virtually impossible to get right on a consistent basis. They are happy to sit in cash when they really should be invested. They behave irrationally and not necessarily in their own interests.

Manager-selection risk matters. Picking stocks is a formidable task. Picking good fund managers who pick the stocks in just as difficult. Advisors typically rely on past performance when making recommendations. They look to the past to explain the future because it’s easy to rationalize. The problem is that there is no correlation between past and future performance. It’s a roll of the dice. In fact, there is evidence that managers perform worse than average following a period of outperformance. This is believed to be because manager style (e.g. value or growth) drives most performance and style shifts tend to be cyclical and unpredictable.

Luck matters – a lot. Are there skilled managers out there? Sure. It’s just that it is so difficult to figure out in advance which managers are skillful to make it profitable. You usually need many years of data to discern skill from luck and so early investors are the lucky ones and do have an advantage. By the time there is perhaps some evidence of skill, the fund is usually becoming too large, as investors pile in, chasing performance. But by then, the “easy” money has already been made by the lucky few.

[1] SPIVA U.S. Scorecard Year-end 2016
[2] Charles D. Ellis, Winning the Loser’s Game
[3] Eugene Fama and Kenneth French, Luck versus Skill in Mutual Fund Performance, 2009

“There are only two kinds of forecasters – those who don’t know and those who don’t know they don’t know”.
– John Kenneth Galbraith