Alphabeticity Bias in 401(k) Investing

It's interesting how little biases creep into how people make investing choices.  For example, the alphabetical order of the 401K choices listed in a plan brochure (or website) can influence the choices that investors make.

This is discussed in a recent paper published in the Financial Review (an academic journal that I c0-edit). 

Here's the paper
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3295400&mod=article_inline

And here's a link to a discussion in the WSJ. https://www.wsj.com/articles/for-some-401-k-holders-picking-funds-is-as-simple-as-abc-unfortunately-11575861000?shareToken=st5b42cefaa561463394d1c01677966180

There are several solutions to this problem.

1. Don't have so many options on the plan in the first place.   If there are just 5 choices, people are more likely to work down the full list.
2. Group choices in more logical groups.   For example, group by "equity" "bonds" "international".  And again, don't provide too many choices.
3. Allow re-sorting of the list.

Mutual Fund trading costs.

An interesting post from Josh Brown.  What really caught my eye was this:

Trading costs are too high, too. What comes along with lots of trading is lots of trading costs. Scherrer puts the annual cost at around 1.4% (average) to 2.59% for small cap managers, which really takes a chunk out returns.

Remember that when you buy an actively managed fund you are already paying the fund expense ratio which can run 0.5% - 2% depending on the fund.  Add to that 2% trading costs and it is amazing that any of these funds ever beat the market.

Mutual Fund Fees - You get what you don't pay for...

Simple, clear, video on the evils of mutual fund fees.

http://www.guardian.co.uk/money/video/2013/mar/19/mutual-fund-animated-guide-video

The illusion of superior fund performance

It is well documented that past mutual fund performance is a poor predictor of future performance.

And despite the fact that active mutual funds are all but guaranteed to underperform the average index fund in the long run, people still chase winners.   A nice article in the NYT presents some recent data showing the folly in this strategy.

A simple analogy explains the main point - if I flip a coin 4 times and each time it lands on heads, does this mean that it will land on heads the 5th time because I am a skilled coin flipper?

More on target date funds..

Freakonomics blog talks about why not all target date funds are alike.

Why target date funds are like hotdogs.

Target date mutual funds are portfolios of funds that adjust the allocation to stocks and bonds based on how close the fund is to its specific target date.  These funds are, in theory, great for people saving for retirement, as they gradually reduce the risk exposure of the fund as the retirement date gets closer.  By buying a target date fund, the retiree doesn't have to worry about rebalancing his/her portfolio each year.

This article explains the idea pretty nicely and contains a graphic showing how the allocations might change over time.

So what's not to love about target date funds?  A lot actually.   Ron Elmer has done a nice investigation of exactly what goes into one of these funds.  You can read it here.  The analogy I'd like to make is one of making hotdogs.  The good cuts of meat (the good funds) are generally sold directly to the public, but the nasty stuff is mushed up and put into hotdogs (target date funds).   To understand why this is so, you need to know a little bit about how mutual funds come and go.  

Most mutual fund companies are constantly starting new funds.  But no one wants to put money in these new funds because they don't have a track record.  In addition, because they are small, their expense ratios are often pretty high.  But the mutual fund company can stick these start up funds in a target date fund.   Because people buy the target date fund without paying attention to the funds within the fund, they will put money into these start up funds.  The start ups that do well will most likely be sold directly to investors (these turn out the be the good cuts), but the ones that do badly will be closed or folded into other funds and replaced with a new startup.

As a result, at least for the target date fund that Ron looked at, the fund is heavily weighted towards new, high fee funds that have poor track records.  Case in point, the Fidelity Freedom 2035 fund has an expense ratio of 0.77% which is basically the average of the funds it contains.   This is much higher than the expense ratio of an equivalent portfolio of index funds.

As a side note,  the Fidelity Freedom 2035 fund is one of the options offered to employees at my institution.

Luck or a brilliant value strategy?

Was Bill Miller's 15 year streak at the helm of the Legg Mason Value Trust luck or a skilled implementation of the value strategy (picking cheap stocks)?  

An article in the FT claims that there must have been something to his ability because even though the fund completely tanked in 2007 and hasn't recovered, it did post 15 years of outstanding returns.  

The probability of beating the market 15 years in a row is 0.5 raised to the power of 15 which is about 0.003%.  This is equivalent to about 1 in 33,000.   Obviously he was very very lucky if it wasn't skill.  But I think the FT makes a simple flaw in the analysis.  The fact that we are talking about this guy is because he beat the market for 15 years.  If it wasn't Bill Miller it would have been someone else.  

The point is that we only know he was a 15 year winner after the event.  This is the fundamental problem with active portfolio management - it is easy to pick the winners after the race is over, but impossible beforehand.

Given that Miller's case is so rare, I am inclined to think that he was just a lucky outlier rather than a skilled stock picker.  I have nothing against Mr Miller, I just don't believe that skilled stock pickers exist.  

Without sounding like a broken record, indexing is the only way to go.

Note: with the FT if you want to see the article, you need to register for a free account.  Sorry.

Mutual funds without morals.

A must read for anyone who buys actively managed mutual funds.  Ron Elmer explains how mutual funds game the system by merging, closing or changing style to make their bad returns look good.

Yet another reason to index.   You do index don't you????

Recent active fund manager's performance.

The InvestorCookBooks blog posts some interesting statistics on recent fund manager performance - conclusion:   you're probably better off indexing.  But you knew that already, right?

Does Wall Street "hate" solar stocks?

I came across this article by the manager of the Green Alpha Fund - an environmentally focused mutual fund that is run out of the Sierra Club.   In full disclosure, I am a member of the Sierra Club and very supportive of much of their work, but this article seemed a little over the top.

The basic premise is that several solar power related stocks, such as LDK Solar, are being shorted irrationally by Wall Street firms that somehow "hate" solar power.  Without getting into a debate on whether or not LDK is fairly valued or not, it is worth noting a few things.

1. Short selling is a risky strategy - you are exposed to losses that can be potentially far greater than your gains.  You also have to pay to borrow the stock (in order to short), and thus you are constantly incurring losses if the stock just does nothing.  As a result, it is not that surprising to find that most of the evidence on short selling supports the idea that short sellers tend to be pretty informed.  These traders have a lot to loose and their positions are expensive to put on and as a result they tend to have done their homework.

2. To say someone has an "irrational hatred" of a stock because they short it, is quite frankly, stupid.  I am sure that short sellers as a group don't have any pathological desire to see solar power fail as an alternative energy source, they are just interested in making money on overpriced stocks.

3. The price level of solar stocks is not really a barometer of the viability of solar power.   In fact, it seems reasonable to think that specialty solar stocks may do poorly in the long run as the technology becomes more of a commodity and their competitive advantage gets eroded.  We've seen this happen in the LED lighting market.

4. If the Green Alpha Fund really thinks these shorts are irrational, then they should keep quiet and buy more solar stocks - they'll be proven right in the end (if they are correct).

Short sellers are frequently vilified in the press, by politicians, and by the management of shorted firms.  They are cast as some sort of unpatriotic group that is only interested in ruining everyone's fun.   In reality the evidence shows that markets that have active short sellers are priced much more efficiently and show less tendency to develop speculative bubbles.  In the end, short sellers are good for markets and that includes the market for solar stocks.

Fees punish hedge fund investors

Investors who buy in to a mutual fund that then invests in hedge funds have seen their wealth eaten up by fees.

Let's be clear here.  You cannot consistently beat the market, so don't waste money trying and don't waste money paying someone else to try for you.  There are really only two things you have control over: 1) how much you save and 2) what fees you pay.   You should maximize 1, minimize 2 and stop kidding yourself that you know which way the market is going.

Performance of Fund Managers

Reposted from my colleague, Craig Newmark, a study that shows that Fund Managers in the past 3 years have failed to deliver consistent performance.

The study shows that only a tiny fraction of all funds have been able to consistently perform in the top 25% of all funds.  As Craig notes, "this is no surprise for academics",  i.e. markets are very efficient.   But the authors of the study don't quite see it that way.

However, while these findings suggest that investors might be better off settling for the consistently average returns of index-tracker funds, Potter of TRMC says that would be a mistake. “This is not about changes in the quality of fund management,” he emphasises. “It’s a reflection of the fact there hasn’t been any consistency in the market itself.”Fund managers generally find it easier to outperform when the equity markets have followed a steady trend for some time. Potter notes that there were relatively high consistency ratios around 2003, after a downward market slide, and in 2007, towards the end of a long bull market.

Actually, I'd argue that Mr. Potter is completely wrong here.  It is entirely about the quality of fund management - and this is not to say fund managers are good or bad.  The key issue is that investment markets are so efficient that if a manager does post three years of superior performance, it is more likely that this is due to luck rather than skill.   The probability of being in the top 25% 3 years in a row is just (1/4)(1/4)(1/4)=1.5%.   The fact that the study finds only 1.3% achieve this feat over the past 3 years seems entirely consistent with an efficiently operating market.   Sure there are some time frames when a few more outperform, but again this is luck.  For a summary of luck vs skill check out my earlier post.

So what is the average investor to do?  One word:  Index.

Beta chasing

Via my colleague, Craig Newmark.  Apparently 80% of quants use beta as a key factor in stock screens.

The idea behind "chasing beta" is that high beta stocks have higher expected returns than low beta stocks.  Therefore, if you are chasing absolute returns, then high beta is the way to go.  

The idea does have a few flaws.  First it assumes that there is a direct relation between historic beta and future returns.  While academic studies have shown this to be true, the magnitude of the relation is below what theory predicts.  Second, assuming that you can juice up your portfolio returns with higher beta, also assumes that your benchmark is not risk adjusted.   A risk adjusted performance measure (such as alpha etc) would strip away this higher beta effect.  Finally, why not just buy the low beta stocks (which by implication are being ignored) and then lever up?

Is there really a mutual fund outflow?

Felix Salmon gets to the bottom of the Mutual Fund outflow statistics which caused quite an uproar today. There was even a story on Public Radio's marketplace tonight about the $33 bn that apparently has been pulled from equity funds.

The truth, as Felix nicely points out is that while there has been an outflow from domestic equities, the overall flow into world wide equities as a whole is still positive.

Overall, mutual fund flows are pretty much flat this year.

Finally - what those mutual funds titles really mean

Ever wondered what the difference was between "Aggressive Growth" and "Ultra" funds? Well click here for the full explanation.

Excellent stuff - and quite funny unless you actually own one these things.


HT: Felix Salmon

Luck vs Skill in mutual fund management

Gene Fama and Ken French show that after you take account of fees, actively managed mutual funds underperform index funds. This is not new news really, but Fama and French present the evidence in an exhaustively robust way. The evidence against active management is very strong.

Felix Salmon summarizes the article nicely here.

Still, most investors will ignore the results of this and other similar studies and chase returns by trying to pick actively managed funds. In the long run they will fail.

Dilbert on Mutual Funds

This might be more funny if it actually wasn't true.


HT: the unknown professor.

Why active managers underperform..

A nice post on Portfolio.com on why active managers underperform. Click through to the underlying article also.

The basic idea: Only about 1/5 of stocks are actually significant winners. Most don't do too much. A completely passive approach to picking stocks uses an equal weighted method and will put at least some money in the unknown "winners". But most active managers don't equally weight, and weight more heavily in their "expected" winners. As they (the active managers) don't actually have any stock picking skill, there is a good chance that there overweighting is in stocks that will underperform (i.e. they overweight in the 4/5 that don't do too much).

This relates to my recent post on the re-jiggering of the Dow and S&P 500. More I think about it, it seems that rather than index funds, folks should invest in randomly generated "buy and hold" funds. Which of course, are not available in most retirement plans.

Active vs Passive Management...Mutual Funds

Gene Fama and Ken French have a new paper out. "Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates"

On their blog they summarize their findings....

Our new paper, Luck versus Skill in the Cross Section of Mutual Fund Alpha Estimates, takes another look at the performance of mutual funds. Bootstrap simulations produce no evidence that any managers have enough skill to cover the costs they impose on investors. If there are managers with sufficient skill to cover costs, they are hidden among the mass of managers with insufficient skill.

Yet more evidence against buying funds with active management fees. If you are investing for the long run you can basically control two things. Diversification and fees. So buy well diversified index funds.

R-squared and return predictability.

The R-squared of a regression of mutual fund returns on various measures in the so-called 4 factor model is a measure of how much of the fund's returns can be explained by the model. The 4 factor model is pretty close to the "state of the art" for return measurement. A lower R-squared implies that the fund's returns are less well explained by the 4 factor model.

A recent working paper argues that this R-squared has useful forecasting ability. Specifically that lagged R-squared is negatively correlated with future fund alphas. Even more surprising is that the negative relation also extends to information ratios which is commonly defined as alpha divided by the funds idiosyncratic risk. This is important because you could boost alpha by just sacrificing diversification. The information ratio result suggests that this is not the case.

The authors interpret their findings as evidence of "selectivity or active management".

Interesting stuff. Especially after I just finished teaching my MBAs that idiosyncratic risk is not priced. Hmmm the tangled web we weave...

The paper in question is...

"Mutual Fund's R2 as Predictor of Performance"

YAKOV AMIHUD, New York University - Stern School of Business

RUSLAN GOYENKO, McGill University - Faculty of Management


and appears on SSRN here