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One-Man Think Tank: Would your investment strategy stand up in court?

Advisors should apply due diligence not only to products and suitability, but to their overall approach, says the new ADV form.

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Ron Rhoades: It appears that relatively few investment strategies, as to the design of portfolios for individual clients, withstand academic scrutiny.

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Will Hepburn

Will Hepburn

November 8, 2010 — 2:27 AM

You have to be kidding, right? In one sentence you pooh-pooh active management, which is the ONLY type of equity investing that has worked over the past decade, and then with a straight face you say Morningstar’s star rating system is predictive of future out-performance.

Perhaps you should consider that on 6/30/00 Morningstar listed 192 growth funds with 5 Star Ratings. From July 1, 2000 through June 30, 2002 the average two-year Return of those 192 funds was -52%.

On June 30, 2000 Morningstar rated 218 Valued funds with 2 stars. From July 1, 2000 through June 30, 2002, these same 218 Funds posted an average two-year Return of +11%.

Star systems should carry disclaimer that past performance does not ensure future results.

You keep doing academic studies that say active management doesn’t work and I’ll keep adjusting my portfolios to adapt to current market conditions and I’ll be happy to compare performance with you anytime.

As Marian McClellan put it, “Everyone times the market somehow. Some buy when they have money and sell when they need money. Others use more sophisticated methods.”

Ron Rhoades

Ron Rhoades

November 8, 2010 — 2:27 PM

Will,

Thanks for the comment. Please permit me to respond.

Morningstar’s star-rating system dramatically changed in 2002, as Morningstar moved to assigning funds to large-cap, mid-cap, or small-cap; and to value, core, and growth, in adherence to a substantial body of academic research indicative that explosure of a fund to the value and small cap premia are largely indicative of a fund’s performance. In other words, exposures to these Fama-French factors, and the equity premia, form a truer basis for fund comparisions than the old “aggressive” or “conservative” assignments of funds. As a result, any research done on Morningstar star ratings pre-2002 should be disregarded, if one seeks to infer future results therefrom.

I did not, in my article, intentionally tout Morningstar star ratings. I only set forth that there exists some academic evidence, based on post-2002 analyses, that 5-star and 4-star rated funds are likely to outperform 2-star and 1-star rated funds. However, I also noted that, in my view, much more research in this area is necessary. From my own review of the academic studies conducted to date, there does not appear to be any adjustment made for a fund’s fees and costs (both “disclosed” and “hidden” – such as transaction costs within funds, and for securities lending revenue). I wonder that if the data is adjusted for such fees and costs, whether 5-star and 4-star rated funds would outperform 2-star and 1-star rated funds.

There exists substantial academic evidence that “active management” is a “loser’s game.” In my view, from a review of the academic literature, there also exists academic evidence to the contrary. In particular that “active management” does lead to higher investment strategy returns – but only before the fees of activie management are deducted.

However, my own conclusions as to the usefulness of active portfolio management strategies, derived from my own review of the academic research on academic management (which generally surveys broad data sets of active managers – mutual funds and/or pension funds), is not without several caveats:

.....First, I would also note that while individual stock selection as a form of active management continues to receive (generally) criticism from the halls of academia, various tactical asset allocation strategies receive much more mixed reviews. There are several forms of tactical asset allocation which receive some academic support. I am waiting to ascertain if such strategies will “stand the test of time” – as all conclusions from academic research should – as theories are tested over various time periods and using different data sets.

.....Second, I would also generally note that “active management” of a portfolio can never be “disproven,” as it is impossible to disprove each and every active management technique – including ones not even thought of, as of yet.

.....Third, I acknowledge that there are likely to be a few individuals who will, by virtue of their unique insights, manage portfolios in the future which outperform the appropriate benchmarks, net of fees. The daunting challenge for investment advisers who utilize outside managers (whether through mutual funds, actively managed ETFs, separate account managers, hedge funds, etc.) is to discern, through an appropriate selection technique, which managers will likely outperform in the future.

.....Fourth, the Fama-French factors, and the momentum effect, discussed briefly in my column, which do receive widespread academic support, are believed by some to disprove the Efficient Markets Hypothesis. I personally don’t believe the market is “perfectly efficient,” but I do believe that in the vast majority of markets the higher costs of active management more than offset any ability of taking advantage of anomolies. I have adopted my own version of the “semi-strong” version of the EMH.

I invite you to review the academic literature. A good place to start is the Social Science Research Network / Financial Economics Network (requires registration), where thousands of research papers are posted.

Like you, our firm achieved very positive results for our clients over the past decade. In part this is because we emphasize the small cap and value effects in the equity portion of our clients’ investment portfolios (at the same time, for most clients, we lower their overall allocation to equities). (Also, the small cap and value effects were quite strong over the past decade; I would note that this was not true with the previous decade.) We also undertake a great deal of due diligence to seek out pooled investment vehicles which possess extremely low “total fees and costs.” In addition, our disciplined methodology to portfolio rebalancing, on a targeted and/or periodic basis, led to nearly all of our clients “buying” when the market was lower (but not at its very low points, in most instances, as we don’t possess a “crystal ball”), and “taking gains off the table” as market valuations were higher. I would note that these generally positive results were obtained despite our use of a “passive” investment methodology.

I congratulate you on your past success.

The point of my article, however, was not to debate passive vs. active management. Rather, the purpose of the article was to point out that you should seek to discern what risks clients are assuming when active management strategies are employed. And, importantly, those additional risks, whether due to reliance upon the qualitative judgments and/or quantitative methodologies employed by active portfolio managers, should be disclosed in the new Form ADV, Part 2.

There are many, many active portfolio managers who enjoyed past success, including many well-respected managers of large endowments, who have seen their particular strategies suffer in future years. Like it or not, while active portfolio management can, at times, shine – it also involves the assumption of a risk of underperformance relative to various appropriate benchmarks. Depending on the strategy employed, these risks may be substantial.

In summary, the risks of underperformance of an investment strategy, relative to its benchmarks, due to errors in the quantative methodology employed, and/or errors in the qualitative judgment calls which are undertaken, can and must be disclosed in Form ADV, Part 2, when discussion occurs of your investment strategies and their attendant risks.

[FYI – I will be suggesting specific disclosures which active portfolio managers (and RIAs who employ them) can undertake, in an upcoming book on Form ADV, Part 2, which I hope to release by December 2010. And I hope to release another book on “Due Diligence” in early 2011. Look for future columns in RIABiz which summarize the recommendations I make in these publications.]

Again, thank you for your comment. Good luck to you in the future. Ron

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