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Why diworsification is bunkum

Index tracking funds and ETFs
hiriskpaul
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Why diworsification is bunkum

#425541

Postby hiriskpaul » July 7th, 2021, 12:53 pm

A couple of years old now, but here is a fascinating paper from Vanguard which helps to explain why the vast majority of fund managers underperform over the long term. It is not just charges, it is lack of diversification.

https://www.vanguardinvestments.se/docu ... eturns.pdf

Lots of interesting stuff in this paper, but one point I liked in particular is that if managers are able to pick winners with a better than 50% success rate, the chances of long term outperformance increases as the number of picks increases. In other words, someone with an edge should churn their portfolio! No mention of trading costs though, which would obviously be to the detriment of such a strategy.

EthicsGradient
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Re: Why diworsification is bunkum

#425574

Postby EthicsGradient » July 7th, 2021, 3:13 pm

hiriskpaul wrote:the vast majority of fund managers underperform over the long term.

That's only true in certain markets, notably North America.

An American study (so 'foreign' means non-US) showed the average active fund outperformed the average index fund in:
Foreign large-cap blend
World large-cap
Diversified emerging markets
Europe stock
Corporate bond

https://www.cnbc.com/2020/11/24/heres-w ... funds.html

Certainly "vast majority" is a myth.

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Re: Why diworsification is bunkum

#425581

Postby Lootman » July 7th, 2021, 3:24 pm

EthicsGradient wrote:
hiriskpaul wrote:the vast majority of fund managers underperform over the long term.

"vast majority" is a myth.

How can a majority out-perform? That is like saying most drivers are better than average.

I suppose if there were a few enormous losers then more than 50% could out-perform. But otherwise?

Hariseldon58
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Re: Why diworsification is bunkum

#425592

Postby Hariseldon58 » July 7th, 2021, 3:57 pm

Lootman wrote:
EthicsGradient wrote:
hiriskpaul wrote:the vast majority of fund managers underperform over the long term.

"vast majority" is a myth.

How can a majority out-perform? That is like saying most drivers are better than average.

I suppose if there were a few enormous losers then more than 50% could out-perform. But otherwise?


I can envisage a situation where the majority of active fund managers could outperform, consider a market where a large proportion of the index is concentrated in a few poorly performing large companies, by not holding those large ‘dogs’, active managers could outperform an index.

The Irish index has 80% of so concentrated in the top 5 stocks, room for a different outcome… the UK property index is fairly concentrated and presently SEGRO dominates, previously British Land and Land Securities were the big boys, an active manager who was shy of these two holdings would have outperformed.

hiriskpaul
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Re: Why diworsification is bunkum

#425605

Postby hiriskpaul » July 7th, 2021, 4:27 pm

EthicsGradient wrote:
hiriskpaul wrote:the vast majority of fund managers underperform over the long term.

That's only true in certain markets, notably North America.

An American study (so 'foreign' means non-US) showed the average active fund outperformed the average index fund in:
Foreign large-cap blend
World large-cap
Diversified emerging markets
Europe stock
Corporate bond

https://www.cnbc.com/2020/11/24/heres-w ... funds.html

Certainly "vast majority" is a myth.

That article flies in the face of just about every other piece of research ever done on actively managed funds. The primary reason I suspect is that it is based on Morningstar data that contains survivorship bias. One other factor is the small print "Asset weighted returns". What that means is they have weighted bigger funds higher than smaller funds. Sounds reasonable, but is another source of bias as investors chase performance. Bigger funds tend to show better performance than average after 10 years due to money rushing into the fund following a period of good performance.

Take a look at the SPIVA scorecard data for comparisons free of selection biases. The data busts a lot of myths, such as active fund managers doing better in emerging markets or with small caps.

Sometimes a majority of active funds do outperform for a year or 2 and this can generally be explained by managers investing outside their remit. For example by UK managers investing a proportion of their money in non-UK stocks. If UK stocks do badly on average during the period compared with non-UK, then holding non-UK stocks can flatter returns.

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Re: Why diworsification is bunkum

#426699

Postby AWOL » July 11th, 2021, 2:32 pm

Actually in some cases it comes from closet tracking (too little active share) and high fees although in other cases it's poor stock selection that results in the majority of active funds underperforming the market. Sadly most humans cannot see past survivor bias, and the other biases at play here.

The reality is that some active funds outperform as they have a winning strategy that works for a period of time. Ultimately their winning streaks all end but they can have long winning streaks. When there are so many funds there are bound to be winners. If only we knew when it would last!

It's harder to see with ITs sometimes due to mergers, renaming, etc. but it happens there too the data is just harder to source.

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Re: Why diworsification is bunkum

#426714

Postby 1nvest » July 11th, 2021, 3:26 pm

Dow and Jones devised three indexes, that later transformed into the Dow-Jones Industrial Average, the better case. Accordingly anyone who invested equally across all three former choices would have relatively under-performed the 'average' - where that historic 'average' is sourced from the better case outcome. Vanguard, a predominately seller of Index funds use such as a suggestion as to why you should buy into their products. Historically cigarette manufactures used to sell how smoking was good for you.

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Re: Why diworsification is bunkum

#426876

Postby gryffron » July 11th, 2021, 11:39 pm

Lootman wrote:How can a majority out-perform? That is like saying most drivers are better than average.

We’re talking about total return AFTER CHARGES. Since the charges on managed funds are higher than trackers, and often much higher, (and charges on the index are zero), it is entirely plausible that the majority can UNDER perform. Which is what the OP said.

EthicsGradient wrote:
hiriskpaul wrote:the vast majority of fund managers underperform over the long term.

That's only true in certain markets, notably North America.
Certainly "vast majority" is a myth.

An FT study over 5 years found that 75% of surviving UK managed funds underperformed the FTSE100 (after charges) over just 5 years. And that’s ignoring the ones that were so bad they were wound up or merged during the study period. Sounds like a pretty substantial majority to me.

Gryff

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Re: Why diworsification is bunkum

#428527

Postby 1nvest » July 18th, 2021, 4:28 pm

gryffron wrote:
Lootman wrote:How can a majority out-perform? That is like saying most drivers are better than average.

We’re talking about total return AFTER CHARGES. Since the charges on managed funds are higher than trackers, and often much higher, (and charges on the index are zero), it is entirely plausible that the majority can UNDER perform.

As private investors one thing we can 'control' is the degree of costs/charges. Buy a US stock tracker and the fund will levy a fee/costs and benchmark to the net total return index, that deducts 30% from dividends. Good funds outperform that by 0.15% as that's the reduced UK/US tax treaty rate (and same for Ireland, where many ETF's are domiciled). Deduct perhaps 0.1% in fund fees and investors lag the mathematical based Index by those costs, along with any brokerage costs such as regular fees/currency conversion fees ...etc.

Consider a £100,000 investment with a broker that levies a £10/month fee and a free trade (£120/year). Conversion to US$ might cost 1% FX (£1000). A US stock tracker fund might cost 0.1% (£100), 2% dividend (around £2000 value) has 15% deduced in US withholding tax (£300) and a 1% FX conversion cost (£20). In total £1520. If sold after a year then again another £1000 approximately in FX conversion fees. Up at around 2.5% for a round trip year investment into a US stock index tracker. And that's assuming no UK taxation on dividends/capital gains.

Broadly its noted that the average investor lags the market average by around 2%/year. I guess many investors churn their portfolios relatively frequently, or perhaps buy into the likes of Investment Trust that might levy 1% type fees or maybe more.

Consider another case, a investor whose asset allocation comprises a third each in US stock, gold, short term Gilts. They open a Freetrade account opting for the Plus option that for near £10/month also includes a free ISA account and reduces the SIPP account price from £10 down to £7 (I've rounded the x.99/month type figures here i.e. £10 instead of £9.99), so for £17/month (£204/year) they have General/ISA/SIPP accounts.

They opt for SGLN, VUSA, IGLS fund holdings, combined 0.1% expense (£100). Assuming no other income they can only invest £2880 into a SIPP to which £720 is added by HMRC. Denominated in £'s there's no FX fees except on the VUSA dividends, which with £33,333 invested and 2% dividend yield = £666 dividend, £3 FX cost at Freetrades 0.45% FX charge rate. When the US stock is held within SIPP being a pension fund the US applies no US dividend withholding tax.

£204/year brokerage costs, £100 fund fees, £3 FX costs, along with a £720 SIPP credit = positive £413 (which relative to £100K = +0.4% relative OUTPERFORMANCE).

A swing of around 3% compared to other investors. In some cases that might be the entire total real return.

Some investors might look just at 0.1% or perhaps even lower 'fund fees', and that the fund appears to outpace its benchmark, maybe not realising that they might be giving up a large chunk of the overall real rewards. The financial sector is the worlds largest/richest sector and is proficient at hiding such costs from investors, as a means to pay for their high wages and expensive buildings.

The government don't help much either, MP's only call upon citizens to get voted, once voted in they serve others - with money. Instead of promoting simplicity and transparency they permit opacity that serves those with money rather than the citizens they supposedly represent. A transition from previous generations where the state would provide means for simplicity and reasonable real rewards to its citizens. Such benefits can still be achieved, but its a case of being aware and managing/navigating a rather complicated system. Many individuals could OUTPERFORM, but it takes effort and awareness that many simply do not apply/understand.

Based on the above a all US stock investor might look back at history and see that stock-heavy yielded the higher reward, perhaps that seemingly supported a 4% SWR, If in practice they lag by 2.5% before taxes, then after taxes they might have been better off in a cash deposit account. I used the above US stock, gold, bonds as the second example as that diversifies equally across £, $ and global currencies (gold is a form of global currency as well as being a commodity), with stock, bond, commodity asset diversity. Whist historically that supported a lower SWR it wasn't much lower and where if in practice its more cost efficiently applied could in practice better all-stock investors rewards, after costs. Yes contrived examples and all very subjective.

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Re: Why diworsification is bunkum

#428532

Postby 1nvest » July 18th, 2021, 4:44 pm

Note that in my previous post I opted for the Freetrade Plus account option, which is more expensive than its general account that is free, but where adding in a ISA adds £3/month (and to add a SIPP costs another £10/month).

With their Plus account you earn 3% on any cash in the account up to £4000. You also can select from a broader range of stocks/funds such as RMAP (gold fund by the Royal Mint that's backed by physical gold and where you can redeem shares for physical gold (expense 0.22%)) i.e. if you wanted to redeem fund gold to physical gold sell (lower expense ratio) SGLN, buy RMAP and then redeem RMAP into physical gold. XUKS is also a Plus account only fund (short FT100) that if paired with VUKE (long FT100) tends to flatline in total combined return, but where capital tends to migrate from XUKS over to VUKE, which if held in SIPP and ISA respectively !!! (A useful alternative to 'cash' (IGLS) also earning near zero). For a US comparable example click the Annual Returns tag in this link


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