Investors Turn Toward Evidence

Seeing Is Believing The fund industry, more than most, lends itself to evidence. Some company promises that it builds the best custom houses, or gives the best haircuts, or delivers the best temporary employees. Who is to know? In contrast, thanks to the Securities Act of 1940 and to the fact that it offers off-the-shelf, easily measured products, the fund industry's assurances can readily be checked. One vendor's claims may be compared with another's. With fund sales, there shouldn't be much room for blandishments.

Historically, though, funds have been moved largely through storytelling. Yes, the tales of a fund’s superiority were typically--although not always--attached to performance figures, but the results were rarely generated over enough time, with a sufficiently large margin of success, to be anything more than suggestive. Launch a new fund, beat the competition for a few years, proclaim loudly why that success will continue, collect incoming assets. Such has been the fund industry, for almost all of its existence.

In the past 15 years, that has changed, in a big way. The turning point was the technology crash of 2000-02. When the New Millennium began, most new fund assets--counting both conventional mutual funds and the newer exchange-traded funds--went into shares that had expense ratios of greater than 1%. The recipients were actively managed U.S. growth-stock funds, which boasted the customary attributes of sales winners: strong recent total returns and a narrative about why that dominance would continue.

When that assurance fizzed, as had so many fund-industry assurances before it, shareholders had finally had enough. They changed what they were doing. By this, I do not mean that they bought S&P 500 funds, although that is certainly a major part of the change. I mean, more broadly, that fund buyers turned their backs on promises and turned forward to evidence.

1) Cost Obscured by the index-fund tsunami is the fact that investors have also scrimped with actively managed funds.

Much of this behavior owes the move by financial advisors from commission-based sales to being paid on assets under management. Under the latter structure, advisors have no reason to sell a higher-priced share, as funds no longer collect the monies that compensate advisors. Indeed, because they can demonstrate their value to clients by saving them money, advisors are motivated to use the cheapest possible shares. And that they very much are doing, as sales of institutional share classes have skyrocketed.

However, awareness of the importance of costs extends past financial advisors. Forty years' worth of lectures from Jack Bogle, fortified by such sources as Morningstar, The Wall Street Journal, and various consumer investor monthlies, has also had its effect. In their direct-fund purchases, retail investors have also gravitated toward lower-expense funds than they did in the past. The record shows that, on average, a dollar saved is a dollar gained--and shareholders are increasingly thinking that way.

2) Persistence Any strategy--or investment manager--can succeed for several years. Evidence-based buyers demand more than that. The proof should be measured in decades.

Obviously, such a long time horizon presents a problem when evaluating actively run mutual funds. The process can be shortened, on some occasions, by considering the manager’s performances on other funds, or the sponsoring fund company’s track record, or the results for rival funds that are similarly run. But there’s no way around it: Even if an actively managed fund is appropriately priced, it is difficult to justify its purchase based on the numbers. Hunches are likely to be involved.

For that reason, mechanical investment strategies are becoming more popular. Few fund managers can boast a 20-year track record. However, any number of back-tested, mechanical investment approaches can boast decades’ worth of data. Whether their results will continue into the future, or the pattern will dissipate, is another matter altogether, but the results exist. They are the basis for the ETF strategies that, increasingly, should be regarded as active rather than passive management.

3) Transparency Evidence-based investors do not take a fund company at its word.

History has shown the folly of believing otherwise. On many occasions over the past decades, fund companies have glossed over their funds’ risks, thereby exposing shareholders to losses that they could not reasonably have expected. Sometimes the confusion arises from how portfolios are reported. Fund companies are permitted to lump a certain percentage of fund holdings into the catch-all category of “Other.” In addition, their derivative positions are often difficult to model. At other times, management’s discussion deceives. (Usually, the problem lies not in what management says but rather in what it neglects to mention.)

The brave new world of index funds and ETFs eliminates the problem. While index mutual funds must officially report their possessions once each quarter, the underlying index typically reports far more often. In practice, then, the index-fund shareholder enjoys almost full transparency. The ETF owner, of course, explicitly enjoys that privilege, thanks to that investment’s basic structure.

The fund industry's transformation from selling hope to something more tangible is far from complete. Critically, many ETF strategies are missing their whys. They can show strong past performance with their back-testing. What they cannot explain satisfactorily, however, is why that lunch existed. It likely was not free. So, what price did that strategy pay? What risks did it assume that perhaps have not been punished? Why would somebody not wish to own those securities?

So, the process of evidence-based investing is not complete. However, the direction is clear. Investors--and those advisors who serve them--are increasingly paying more attention to what a fund company has done than to what it says. That trend will only intensify. As Ronald Reagan said, “Trust, but verify.” Words that fund shareholders will live by.

Closing Credits This column owes its existence to the first annual Evidence-Based Investment Conference, sponsored by Ritholtz Asset Management. When the organizers first called me (to participate in a panel about "systematic alternative investing"), the title confused me. This column represents my interpretation of their intent--which, I think, for the most part matches theirs.

In addition to putting on the occasional conference, Ritholtz publishes some pretty good blogs. At investment comedy goes (usually, not very far), this one is hard to beat.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.