How much is reasonable for a financial advisor?

[MikeWaters]

I guy I have worked with on a number of things is probably going to take up my stock portfolio (i.e. retirement accounts).

I pretty much trust him. I knew his brother in med school. I've known him now for several years.

With my small retirement fund, he had recommended I mainly invest in index funds.

But now he says my little pot of money is large enough to manage.

He says that historically he beats the S&P 500 by 2-3%. He would charge 1% per year for him and his employees to manage my accounts.

Is 1% a reasonable charge for a relatively high-maintenance management?

[MikeWaters]

anyone have an opinion on this?

[BYU71]

[QUOTE=MikeWaters;249147]I guy I have worked with on a number of things is probably going to take up my stock portfolio (i.e. retirement accounts).

I pretty much trust him. I knew his brother in med school. I've known him now for several years.

With my small retirement fund, he had recommended I mainly invest in index funds.

But now he says my little pot of money is large enough to manage.

He says that historically he beats the S&P 500 by 2-3%. He would charge 1% per year for him and his employees to manage my accounts.:



If he historically beats the S&P by 2-3%, I assume per year, and that is net of his 1% charge, you are getting a very good deal. You could find some who are even better than 2-3% net of fees, but they will charge more than 1%.

One of the money managers I use for my clients has beaten the S&P the last 5 years, through June 30th, by 2% a year and and over the last 10 years by 5% a year. That is net of a 1 1/2% management fee.

[MikeWaters]

of course he could have been lying about the 2-3%.

[BYU71]

of course he could have been lying about the 2-3%.

I thought you said you trusted him. He should be able to provide documents that verify his claim.

He should be able to tell you how much risk he is taking to get those returns Ask him for instance what his beta is.

For instance, Growth fund of America over the last 3 years has average 8%. That is 3.64% higher than the market. However, their beta is .94. They are beating the market that badly with 94% of market risk.

[Jennerstein]

I guess there's a reason why Growth Fund of America is the biggest mutual fund in the nation, with almost 200B in assets under management. That's insane.

I actually work for CRMC's IT group as a business systems analyst, and the company seems to be doing things right. The fundamental philosophy is conservative long term investment results and we're always reminded to remember that it's shareholder's money we're managing. It's not as cheesy as remember this is Billy's college fund, or Dorothy's retirement money, but that's the culture I work in. Of course, there's no guarantee that mutual funds such as GFA or EUPAC will continue to do as well, especially with the size of the funds, but the company certainly has the right focus.

[jay santos]

I guy I have worked with on a number of things is probably going to take up my stock portfolio (i.e. retirement accounts).

I pretty much trust him. I knew his brother in med school. I've known him now for several years.

With my small retirement fund, he had recommended I mainly invest in index funds.

But now he says my little pot of money is large enough to manage.

He says that historically he beats the S&P 500 by 2-3%. He would charge 1% per year for him and his employees to manage my accounts.

Is 1% a reasonable charge for a relatively high-maintenance management?

Mike, here are my thoughts.

1. I don't think a financial advisor is EVER worth 1% of your return, unless you're into the $10M+ range of assets.
2. <$10M, don't even think about it--use Vanguard index funds and modern portfolio theory and balanced asset allocation. here are a couple places to learn. http://www.moneychimp.com/articles/risk/riskintro.htm
http://www.indexfundeducator.com/allocation.htm
3. >$10M you may think about additional diversification or the use of funds like Dimensional Fund Advisors. http://www.dfaus.com/
4. Any financial advisor who is telling you he beats S&P by 2-3% is probably dishonest or incompetent and I would run away as fast as you can.

[BYU71]

Mike, here are my thoughts.

1. I don't think a financial advisor is EVER worth 1% of your return, unless you're into the $10M+ range of assets.
2. <$10M, don't even think about it--use Vanguard index funds and modern portfolio theory and balanced asset allocation. here are a couple places to learn. http://www.moneychimp.com/articles/risk/riskintro.htm
http://www.indexfundeducator.com/allocation.htm
3. >$10M you may think about additional diversification or the use of funds like Dimensional Fund Advisors. http://www.dfaus.com/
4. Any financial advisor who is telling you he beats S&P by 2-3% is probably dishonest or incompetent and I would run away as fast as you can.

Any financial advisor who tells him that?? I think you meant to say, verify what you are told. To say any financial advisor telling you that is probably dishonest or incompetent is something an arrogant asshole or dipshit would say.

[jay santos]

Any financial advisor who tells him that?? I think you meant to say, verify what you are told. To say any financial advisor telling you that is probably dishonest or incompetent is something an arrogant asshole or dipshit would say.

Nah, I'd say someone in finance who actually would say that to a client is the true arrogant asshole and/or dipshit.

[BYU71]

Nah, I'd say someone in finance who actually would say that to a client is the true arrogant asshole and/or dipshit.

Perhaps you ought to stick to your area of expertise, which obviously isn't investment advising.

By the way, the dimension system you suggested. What is their 5 year track record on their core value equity fund.

[Flystripper]

Nah, I'd say someone in finance who actually would say that to a client is the true arrogant asshole and/or dipshit.

There have been managers that have beaten the S&P over pretty long periods. The pertinent question is always for how much risk. I know what you are saying Jay and it is true that many managers or people that try to pass themselves off as managers won't consistently give you returns above the S&P for equal risk. However, to say that beating the S&P is impossible is discounting the results of managers with documented long-term track records and is just giving too much weight to efficient markets theory. Just my opinion.

[BYU71]

There have been managers that have beaten the S&P over pretty long periods. The pertinent question is always for how much risk. I know what you are saying Jay and it is true that many managers or people that try to pass themselves off as managers won't consistently give you returns above the S&P for equal risk. However, to say that beating the S&P is impossible is discounting the results of managers with documented long-term track records and giving too much weight to efficient markets theory. Just my opinion.


My point is you can't say "any" investment advisor. If you want to say most or the majority, that is a debatable question, which I wouldn't argue with. "Any" means all. There are investment advisors who have track records that beat the S&P by 2-3%.

[jay santos]

There are investment advisors who have track records that beat the S&P by 2-3%.

How many investment advisors have track records of beating the S&P by 2-3%, including costs, which can not be attributed to pure random luck and therefore can be expected to endure into the future?

"Investment advisors" are the biggest group of con-men in America still yet to be exposed.

[BYU71]

How many investment advisors have track records of beating the S&P by 2-3%, including costs, which can not be attributed to pure random luck and therefore can be expected to endure into the future?

"Investment advisors" are the biggest group of con-men in America still yet to be exposed.


So are you standing by your claim "any" investment advisor................

By the way, the recommendation you gave, what are the 5 years returns on the core equity portfolios. I would also like the 10 year, but you seem to be having difficulty with the 5 year so lets start there.

[jay santos]

So are you standing by your claim "any" investment advisor................

By the way, the recommendation you gave, what are the 5 years returns on the core equity portfolios. I would also like the 10 year, but you seem to be having difficulty with the 5 year so lets start there.

We're not speaking the same language, so it doesn't do any good to argue.

[BYU71]

We're not speaking the same language, so it doesn't do any good to argue.


I agree why argue. Here is one investment advisors track record over the last 5 years. 10.53 vs the S&P of 7.58 net of fees, through June 30th of this year. Therefor no argument, this an investment advisor who can make the 2-3% claim.

Oh, the 10 yr is 9.4% vs 2.88% and the fifteen year is 12.5 vs 9.22%. I don't think that someone can be that dumb lucky over that long a time period.

If you have a grudge against "some" or even "most" so called investment advisors, you might be justified. However, just because you don't know any good honest ones, you shouldn't be painting them all with such a broad brush, IMHO.

[pelagius]

I'm afraid this is getting silly:

BYU71: ex post outperformance

JAY: ex ante outperformance

Jay, unfortunately didn't make that distinction clear at the beginning but the by the middle of the thread he is clearly is making an argument about ex ante performance and not ex post. A charitable reading of Jay's argument requires that you respond in terms of the ex ante probability of overpeformance.

[BYU71]

I'm afraid this is getting silly:

BYU71: ex post outperformance

JAY: ex ante outperformance

Jay, unfortunately didn't make that distinction clear at the beginning but the by the middle of the thread he is clearly is making an argument about ex ante performance and not ex post. A charitable reading of Jay's argument requires that you respond in terms of the ex ante probability of overpeformance.

Does ex post mean the advisor said what he has done and ex ante means the advisor is saying what he will do?

[jay santos]

I agree why argue. Here is one investment advisors track record over the last 5 years. 10.53 vs the S&P of 7.58 net of fees, through June 30th of this year. Therefor no argument, this an investment advisor who can make the 2-3% claim.

Oh, the 10 yr is 9.4% vs 2.88% and the fifteen year is 12.5 vs 9.22%. I don't think that someone can be that dumb lucky over that long a time period.

If you have a grudge against "some" or even "most" so called investment advisors, you might be justified. However, just because you don't know any good honest ones, you shouldn't be painting them all with such a broad brush, IMHO.

Instead of S&P I should have said a portfolio managed through modern portfolio theory--using index funds for each category--something as simple as:

50% Domestic (break out by large value, large growth, small value, small growth if you have enough to make it worth it)
30% International (ditto)
10% Real Estate/Commodities
10% Bonds

And I don't believe it's possible to beat it long term after costs. Long term = 30 - 50 years since that's the investment horizon for most on this board (should be time to death not time to retirement which is a big mistake some make).

I should say it's probably possible to beat this strategy long term after costs

BUT

the risk and probability of choosing the wrong portfolio manager is far greater than the reward you'll get above the index fund approach.

P.S. Five year returns mean ABSOLUTELY nothing to me. And ten year returns don't mean much to me at all.

[pelagius]

Does ex post mean the advisor said what he has done and ex ante means the advisor is saying what he will do?

Basically

[jay santos]

I'm afraid this is getting silly:

BYU71: ex post outperformance

JAY: ex ante outperformance

Jay, unfortunately didn't make that distinction clear at the beginning but the by the middle of the thread he is clearly is making an argument about ex ante performance and not ex post. A charitable reading of Jay's argument requires that you respond in terms of the ex ante probability of overpeformance.

My original post said that someone making that claim is dishonest or incompetent. A clarification would be that even if someone can show an ex post performance beating the market, they are dishonest or incompetent if they try to con you into thinking they can continue to do so.

[BYU71]

Instead of S&P I should have said a portfolio managed through modern portfolio theory--using index funds for each category--something as simple as:

50% Domestic (break out by large value, large growth, small value, small growth if you have enough to make it worth it)
30% International (ditto)
10% Real Estate/Commodities
10% Bonds

And I don't believe it's possible to beat it long term after costs. Long term = 30 - 50 years since that's the investment horizon for most on this board (should be time to death not time to retirement which is a big mistake some make).

I should say it's probably possible to beat this strategy long term after costs

BUT

the risk and probability of choosing the wrong portfolio manager is far greater than the reward you'll get above the index fund approach.

P.S. Five year returns mean ABSOLUTELY nothing to me. And ten year returns don't mean much to me at all.


I have discussed the modern portfolio theory with someone in the investment world I have learned to respect a great deal. He showed me all sorts of facts and figures that indicated the modern portfolio thoery is bogus and meant for intellects to mentally masterbate with. However, to each his own and if someone wants to use that method, I would say go ahead.

I have found a lot of methods will work if they are stuck too. Emotion is the one element that comes in and messes with returns.

It is a proven fact investors in mutual funds do far worse than the funds they invest in. Why, it would be my contention they get in and out at the wrong times, because of emotion. I call it the "I can't take it any longer theory". I can't take seeing my investments go down in value any longer and therefor get out. Or, I can't take seeing the market go up any longer without me in and so they get in.

One thing I will agree with you on. I suspect you are saying don't put all your eggs in one basket. I would agree with you there.

[pelagius]

I suspect you are saying don't put all your eggs in one basket. I would agree with you there.

Since this is the major implication of portfolio theory doesn't it suggest you are engaging in or buying into the importance of mental oil changes ...

P.S.

I would not got around condemming portfolio theory ... address a specific weakness but don't engage in some silly characterization based on meeting a smart guy who didn't like it.

[pelagius]

My original post said that someone making that claim is dishonest or incompetent. A clarification would be that even if someone can show an ex post performance beating the market, they are dishonest or incompetent if they try to con you into thinking they can continue to do so.

Its too strong of a statement; the advisor may just be overconfident. There is lots of empirical evidence consistent with fund managers and people in general being overconfident (i.e., they overstate the probability they are correct).

I wouldn'tnecessarily think badly of Waters friend. I am not privy to the whole conversation. Its possible he had a very nuanced discussion of risk and expected returns and Water's summary leaves something to be desired. I don't know ... more information would be required before I made the inference the Waters should avoid investing with him.

[BYU71]

Since this is the major implication of portfolio theory doesn't it suggest you are engaging in or buying into the importance of mental oil changes ...

P.S.

I would not got around condemming portfolio theory ... address a specific weakness but don't engage in some silly characterization based on meeting a smart guy who didn't like it.

Reread what I wrote, not what you want me to have meant. I mentioned someone else condemned the theory, I indicated others could use it if they choose.

I was suggesting, maybe not clearly enough diversification. Diversification could mean a portfolio of large cap value, large cap growth, small cap value, small cap growth and an international blend.

You wouldn't have to have bonds, real estate, commodities, etc. to be diversified as you probably would have to have those in order to be following the portfolio theory.

Anyway, I find diversification is enough of a mental oil change without moving onto diversification on steroids in order to get a mentally chanllenging oil change.

To each his own though. I personally would not condemn someone if the chose the "theory" as their discipline to invest by. My advice would be stick to it and don't switch with every new theory you here.

As for "genius investors". Those folks give us long term capital, over the counter bubbles and sub-prime. The first genius I encountered was Michael Milliken (sp) who gave us Junk bonds.

[pelagius]

Reread what I wrote, not what you want me to have meant. I mentioned someone else condemned the theory, I indicated others could use it if they choose.


No you took a swipe. You said a person you respect a great deal called it mental masturbation and you found it convincing ... That's a bit of swipe.


I was suggesting, maybe not clearly enough diversification. Diversification could mean a portfolio of large cap value, large cap growth, small cap value, small cap growth and an international blend.

You wouldn't have to have bonds, real estate, commodities, etc. to be diversified as you probably would have to have those in order to be following the portfolio theory.


I am fine with your first paragraph ... It may be entirely consistent with portfolio theory depending on the preferences of the investor. I think you may be arguing against a version of portfolio theory that is oversimplified and taking a stylized version too literally.






As for "genius investors". Those folks give us long term capital, over the counter bubbles and sub-prime. The first genius I encountered was Michael Milliken (sp) who gave us Junk bonds.

LTCM was clearly not following portfolio theory ... it may be an interesting example but it can hardly be used to condemn portfolio theory.

[jay santos]

Its too strong of a statement; the advisor may just be overconfident. There is lots of empirical evidence consistent with fund managers and people in general being overconfident (i.e., they overstate the probability they are correct).

I wouldn'tnecessarily think badly of Waters friend. I am not privy to the whole conversation. Its possible he had a very nuanced discussion of risk and expected returns and Water's summary leaves something to be desired. I don't know ... more information would be required before I made the inference the Waters should avoid investing with him.

overconfident = a form of incompetence. no?

I'm being overly aggressive in this thread but it's to balance what I perceive the vast majority of being way too far on the trusting side of "investment advisors".

[BYU71]

No you took a swipe. You said a person you respect a great deal called it mental masturbation and you found it convincing ... That's a bit of swipe.



I am fine with your first paragraph ... It may be entirely consistent with portfolio theory depending on the preferences of the investor. I think you may be arguing against a version of portfolio theory that is oversimplified.






LTCM was clearly not following portfolio theory ... it may be an interesting example but it can hardly be used to condemn portfolio theory.


A "swipe" is not a condemnation, let alone a "bit of a swipe".

LTCM was a swipe at supposed "smart guys" and their investing. It was meant to show "smart" and good investing do not necessarily go hand in hand. Too many let their intellect get in the way of using common sense. Of course greed takes over which is a malady of smart, dumb and average alike.

I am not arguing against "modern portfolio theory". I am saying it is one discipline that can be followed, but not necessarily "the" discipline to be followed.

Just as a closer. My favorite manager I use and showed the numbers for wouldn't be for everyone. He has some year or years in a cylce of 5 to 10 year period where he will underperform the S&P. If my client is one who gets more upset about a year of underperformance than appreciates outperformances over a longer period, I won't suggest this manager to that client. The marriage won't work.

[pelagius]

overconfident = a form of incompetence. no?

I'm being overly aggressive in this thread but it's to balance what I perceive the vast majority of being way too far on the trusting side of "investment advisors".

Yes, but itss universal incompetence ...

You have most of the ex ante implications right. It is, of course, easy to find a strategy that from an ex ante perspective that will on average outperferform the market by over 2-3%: buy a double the market ETF. Of course, its pretty risky. Controlling for risk it is very difficult to find persistence in performance particularly at that level. This is not to suggest that fund managers don't have skill but on average they charge you for that skill and after costs on average they do worse than the market. Yes, there are always some managers that outperform the market in a given period, but there is almost no persistence in the performance. Some characteristics seems to matter but only ones that are difficult to observe. For example SAT score actually matter. Managers with higher SAT scores actually outperform (relative to some risk adjustments).

[pelagius]

I am not arguing against "modern portfolio theory". I am saying it is one discipline that can be followed, but not necessarily "the" discipline to be followed.


All of your advice so far has been consistent with portfolio theory even the advice that you suggested was contrary to it. So yes you are not arguing against it. In fact as near as I can tell, broadly defined, you follow or incorporate some of its basic tenants at least occassionly.

[pelagius]

I am not arguing against "modern portfolio theory". I am saying it is one discipline that can be followed, but not necessarily "the" discipline to be followed.

Under certain conditions I might possibly agree with this but before this advice becomes credible one needs to show an actual problem with portfolio theory (and not some over-stylized version of portfolio theory). Of course, you haven't even shown a problem with the overstylized version of portfolio either (you just said you thought it was diversification on steriods which may or may not be a problem).

There are problems with portfolio theory, but nobody has brought any of them up in this discussion.

[creekster]

There are problems with portfolio theory, but nobody has brought any of them up in this discussion.

Well don't be coy, what are they?

[pelagius]

Well don't be coy, what are they?

I will highlight one.

The strongest assumption of stylized portfolio theory is that an investor knows the expected returns, variances, and covariances of the securities she is invests in. However, this is far from the truth. Estimating these things using historical data is very difficult and imprecise (expected returns more so than covarances). A non-stylized version would incorporate this source of uncertainty. One implication of this uncertainty is that you won't have precise weights as an implication and a range of weights on different securities are all potentially optimal given an investor preferences and parameter uncertainty. This is one reason why BYU71's statements are entirely consistent as opposed to inconsistent with portfolio theory (on the other hand I can write down a form of portfolio theory that was consistent with BYU71s statement and relied on parameter certainty).

The other option is to move beyond portfolio theory to equilibrium models such as the CAPM or APT type models. This is essentially what Jay has done. You get precise implications and solve the estimation issue in terms of portfolio holdings but at the expense of stronger assumptions.

[creekster]

I will highlight one.

The strongest assumption of stylized portfolio theory is that an investor knows the expected returns, variances, and covariances of the securities she is invests in. However, this is far from the truth. Estimating these things using historical data is very difficult and imprecise (expected returns more so than covarances). A non-stylized version would incorporate this source of uncertainty. One implication of this uncertainty is that you won't have precise weights as an implication and a range of weights on different securities are all potentially optimal given an investor preferences and parameter uncertainty. This is one reason why BYU71's statements are entirely consistent as opposed to inconsistent with portfolio theory (on the other hand I can write down a form of portfolio theory that was consistent with BYU71s statement and relied on parameter certainty).

The other option is to move beyond portfolio theory to equilibrium models such as the CAPM or APT type models. This is essentially what Jay has done. You get precise implications and solve the estimation issue in terms of portfolio holdings but at the expense of stronger assumptions.

Thanks for that. On further review, I guess coy works for me.

[pelagius]

Thanks for that. On further review, I guess coy works for me.

I don't won't to be too hard on people but I guess I would also emphasize that what most people call portfolio theory really isn't. Its stuff that builds on top of portfolio theory.

Really, the primary implication of portfolio theory is that optimal portfolios can be described as follows: an optimal portfolio has the highest expected return given the desired standard deviation of an investor. If someone believes that the risk of their portfolio is captured by standard deviation then portfolio theory is the right framework (yes, one can argue that standard deviation is not a good measure of risk and that is another potential shortcoming of portfolio theory). Portfolio theory provides a framework for thinking about what optimal portfolios look like. An optimal portfolio doesn't necessarily have 1000s of securities in it (although under certain assumptions it always does). An optimal portfolio can have only one stock in it.

Warren Buffet, for example, often says he doesn't follow the implications of portfolio theory. This is true in the sense that he doesn't follow the implications of portfolio theory as often presented to undergraduate students or MBAs. However, I have seen nothing from Buffet that is inconsistent with the idea that he his creating a portfolio that for a given level of standard deviation has the highest expected return possible. He just believes that the expected returns, variances, and covariances that he observes are different than and superior to other people's estimates (note, this implies that his optimal portfolio may look very different than mine even if we have the same preferences for risk and both may be consistent with portfolio theory). Portfolio theory allows for such differences (complete agreement and market efficiency are imposed in models like the CAPM that build on portfolio theory). Buffet's portfolio may be optimal or statistically indistinguishable from optimal (in the full sense of modern portfolio theory) given his estimates and taking into account parameter uncertainty, transaction costs, price impact, etc.

P.S.

These issues aside I generally think that Jay gives pretty good advice when it comes to portfolio allocation ... he may not always be diplomatic ... but his advice is pretty sensible.

[BYU71]

I don't won't to be too hard on people but I guess I would also emphasize that what most people call portfolio theory really isn't. Its stuff that builds on top of portfolio theory.

Really, the primary implication of portfolio theory is that optimal portfolios can be described as follows: an optimal portfolio has the highest expected return given the desired standard deviation of an investor. If someone believes that the risk of their portfolio is captured by standard deviation then portfolio theory is the right framework (yes, one can argue that standard deviation is not a good measure of risk and that is another potential shortcoming of portfolio theory). Portfolio theory provides a framework for thinking about what optimal portfolios look like. An optimal portfolio doesn't necessarily have 1000s of securities in it (although under certain assumptions it always does). An optimal portfolio can have only one stock in it.

Warren Buffet, for example, often says he doesn't follow the implications of portfolio theory. This is true in the sense that he doesn't follow the implications of portfolio theory as often presented to undergraduate students or MBAs. However, I have seen nothing from Buffet that is inconsistent with the idea that he his creating a portfolio that for a given level of standard deviation has the highest expected return possible. He just believes that the expected returns, variances, and covariances that he observes are different than and superior to other people's estimates (note, this implies that his optimal portfolio may look very different than mine even if we have the same preferences for risk and both may be consistent with portfolio theory). Portfolio theory allows for such differences (complete agreement and market efficiency are imposed in models like the CAPM that build on portfolio theory). Buffet's portfolio may be optimal or statistically indistinguishable from optimal (in the full sense of modern portfolio theory) given his estimates and taking into account parameter uncertainty, transaction costs, price impact, etc.

P.S.

These issues aside I generally think that Jay gives pretty good advice when it comes to portfolio allocation ... he may not always be diplomatic ... but his advice is pretty sensible.


What would be interesting would be to take Jay's breakdown, 50% domestic, 30% international, 10% RE and commodities and 10% bonds. Take randomly 3 10 year periods and 20 year periods and compare the return to a good equity manager who claims to beat the S&P by 2-3 percent. My guess would be the numbers wouldn't be that much different, especially over the 20 year period.

Either method is fine as long as the results are good. Go through the mental girations and follow the formula or find someone who is getting results and just let them manage the money for a fee.

[BYU71]

Just for kicks I took the last 10 years and applied the formula.

50% S&P 500 index (2,88%)

30% World International Index (4.65%)

10% Gov't Bond Index (5.70%)

5% Commodity Index (15.5%)

5% Reit Index (10.64%)

Yield for portfolio over last 10 years through June 30th is 4.71%, beats S&P by around 2%



During same period good ole well managed Mutual fund like Growth Fund of America did 9.18%. Take even 2% a year out for fees and net of 7.18% is pretty good.

I am in no way here giving or suggesting anyone make any type of investment in anything. My main point is that Jay's contention that "any" financial advisor who claims to beat the S&P by 2-3% is probably incompetent or dishonest is pure bull crap.

Invest your money in whatever way you feel comfortable whether it be the efficient portfolio or researching for good advisors to do it for you. There is no "only the right way" to do it.

[pelagius]

What would be interesting would be to take Jay's breakdown, 50% domestic, 30% international, 10% RE and commodities and 10% bonds. Take randomly 3 10 year periods and 20 year periods and compare the return to a good equity manager who claims to beat the S&P by 2-3 percent. My guess would be the numbers wouldn't be that much different, especially over the 20 year period.

Either method is fine as long as the results are good. Go through the mental girations and follow the formula or find someone who is getting results and just let them manage the money for a fee.

We know the answer to this empirically. Its has been looked at extensively in the finance literature. Once we adjust for risk or style, Jay's strategy does a little better on average. A funds past performance has almost no predictive power for future performance (see, for example, Carhart's 1997 Journal of Finance article that examines something very close to this question). Thus ex ante, our best estimate of how funds that performed the best in the past will perform going forward is the following: after controlling for risk they will do little better than a passive allocation before costs and slightly worse after costs.

Second Jay's breakdown, while sensible, is not necessarily an implication of portfolio theory. Its consistent with portfolio theory, but active management can be consistent with portfolio theory. Jay's view essentially adds an assumption called complete agreement and an assumption about market efficiency to get to a portfolio allocation recomendation.

[BYU71]

We know the answer to this empirically. Its has been looked at extensively in the finance literature. Once we adjust for risk or style, Jay's strategy does a little better on average. A funds past performance has almost no predictive power for future performance (see, for example, Carhart's 1997 Journal of Finance article that examines something very close to this question). Thus ex ante, our best estimate of how funds that performed the best in the past will perform going forward is the following: after controlling for risk they will do little better than a passive allocation before costs and slightly worse after costs.

Second Jay's breakdown, while sensible, is not necessarily an implication of portfolio theory. Its consistent with portfolio theory, but active management can be consistent with portfolio theory. Jay's view essentially adds an assumption called complete agreement and an assumption about market efficiency to get to portfolio allocation recomendation.


Finance literature probably written by academians (sp). Anyway, it has been a fun discussion. May everyone make a lot of money using their favorite method.

[pelagius]

Finance literature probably written by academians (sp). Anyway, it has been a fun discussion. May everyone make a lot of money using their favorite method.

Of course, its written by academics. If you think the studies are flawed then bring up problems with the studies. Just stating that they are written by academics is not a criticism. Point out flaws in the empirics.

Second, I have no problem with active management. Its fine ... its not going to make a huge difference on average. On average passive will beat active by a little not a lot and active has more chance for upside (someone may get very lucky and choose funds that happens to do fantastic). Of course, it also has a greater chance of a worse downside relative to the benchmarks since passive by definition is basically the benchmark. In fact in aggregate we can prove passive beats active under the following two assumptions:

(1) Passive in aggregate holds approximately the market portfolio

(2) Active is higher costs then passive

If passive holds the market (which seems to be true empirically in aggregate) then by definition active also must be holding the market in aggregate because by definition passive plus active adds up to the market. If active is higher costs then by definition they must do worse because in aggregate the holding are the same portfolio: the market.

Of course, in any given period some active managers do way better than passive even controlling for risk. I have always agreed with that. However, that really good performance in a given period is not usually a good predictor of future performance.

[BYU71]

Of course, its written by academics. If you think the studies are flawed then bring up problems with the studies. Just stating that they are written by academics is not a criticism. Point out flaws in the empirics.

Second, I have no problem with active management. Its fine ... its not going to make a huge difference on average. On average passive will beat active by a little not a lot and active has more chance for upside (someone may get very lucky and choose fund that happens to do fantastic). Of course, it also has a greater chance of a worse downside (relative to the benchmarks since passive by definition is basically the benchmark). In fact in aggregate we can prove passive beats active under the following two assumptions:

(1) Passive in aggregate holds approximately the market portfolio

(2) Active is higher costs then passive

If passive holds the market then by definition active also must be holding the market in aggregate because by definition passive plus active adds up to the market. If active is higher costs then by definition they must do worse because in aggregate the holding are the same: the market.

Of course, in any given period some active managers do way better than passive even controlling for risk. I have always agreed wit that. However, that really good performance in a given period is not usually a good predictor of future performance.

Basically there are some active managers who kick passive managing butt and have done so over long periods of time. Note, I said "some". Not all, not even most. Most managers actually underperform the average, which is true in about anything. I am sure you have heard about the 80-20 rule.

I will give you the high ground on theoretical arguments. I don't deal in that world and have no interest in it. That is the world of economists, who quite frankly also fall into the 80-20 rule.

If I find a manager who has consistently outperformed over the past 10 years, as for me, I will take my chances with that person over some theory. Like I have said over and over in this thread, it doesn't bother me if someone chooses to do otherwise.

[pelagius]

Basically there are some active managers who kick passive managing butt and have done so over long periods of time. Note, I said "some". Not all, not even most. Most managers actually underperform the average, which is true in about anything. I am sure you have heard about the 80-20 rule.


Yes you can find managers that have outperformed for long periods of time. I have never argued against that general idea. In fact Jay really wasn't making that argument either but I agree his original post suggested that he was in fact making that argument. 20% is too large but that hardly is an important part of your point.


I will give you the high ground on theoretical arguments. I don't deal in that world and have no interest in it. That is the world of economists, who quite frankly also fall into the 80-20 rule also.


I assume economists are in the 80% but I am not sure I know how that rule applies to economists. Or maybe you mean only 20% of economists make any sense. That might actually be true.


If I find a manager who has consistently outperformed over the past 10 years, as for me, I will take my chances with that person over some theory. Like I have said over and over in this thread, it doesn't bother me if someone chooses to do otherwise.

I don't think that's a bad strategy. Empirically on average a strategy for choosing funds with that heurisitic does fine (although not really better than other simple heuristics). Also such a heuristic can be perfectly consistent with portfolio theory. So in that sense your heuristic is probably a good one. It gives you a fund that probably in the end gives you a portfolio that is close to optimal in a portfolio theory sense but you are able to get to a near optimal portfolio without much hassle.

The implications of portfolio theory are hard to escape: once you tell me your care about the return and standard deviation of your portfolio, its really just math. Economics is flawed often enough, but math isn't.

[BYU71]

Yes you can find managers that have outperformed for long periods of time. I have never argued against that general idea. In fact Jay really wasn't making that argument either but I agree his original post suggested that he was in fact making that argument. 20% is too large but that hardly is an important part of your point.



I assume economists are in the 80% but I am not sure I know how that rule applies to economists. Or maybe you mean only 20% of economists make any sense. That might actually be true.



I don't think that's a bad strategy. Empirically on average a strategy for choosing funds with that heurisitic does fine. Also such a heuristic can be perfectly consistent with portfolio theory. So in that sense your heuristic is probably a good one. It gives you a fund that probably in the end gives you a portfolio that is close to optimal in a portfolio theory sense but you are able to get to a near optimal portfolio without much hassle.

The implications of portfolio theory are hard to escape: once you tell me your care about the return and standard deviation of your portfolio, its really just math. Economics is flawed often enough, but math isn't.

This is truly a question I will have to trust you will give me an unbias answer too. I don't know the answer. When we go back to long term capital, even though those guys were not using portfolio theory, they were using some sort of mathmatical theory to come up with all there conclusions on how to invest weren't they? I thought they were Nobel Economics winners from Stanford. Someone told me they were actually MIT.

While math isn't flawed, couldn't how you use the math and conclusions you come from in using the math be flawed?

The old joke about what is 2 plus 2 and the guy answers 4. No the answer is 22.

[pelagius]

This is truly a question I will have to trust you will give me an unbias answer too. I don't know the answer. When we go back to long term capital, even though those guys were not using portfolio theory, they were using some sort of mathmatical theory to come up with all there conclusions on how to invest weren't they? I thought they were Nobel Economics winners from Stanford. Someone told me they were actually MIT.


LTCM wasn't being run on a daily basis by academics, but it was, like most quant funds, relying on academic models and being run by academically trained people. There were a couple of famous academics involved with LTCM to some extent: Myron Scholes (Stanford) and Bob Merton (Harvard Business School). Both won the Nobel Prize for the development of the Black-Scholes option pricing formula (Black and Scholes were at Chicago when thet developed the formula).I don't know how heavy their day to day involvement was but I would certainly guess that they help developed some of the specific strategies.

Math wasn't those guys problem. It was the economics. They were using math but you can't say what they did was just math. They made some assumptions about the way the world should behave (all of which seemed pretty reasonable). In late 1998 the world didn't behave that way at all. Making assumptions about behavior and modeling how people behave is economics.



While math isn't flawed, couldn't how you use the math and conclusions you come from in using the math be flawed?

Yes, people can use portfolio theory in a very flawed way potentially. However, what is usually happening is that they are overlaying additional economic assumptions on the basic theory. Its really those additional assumptions that can go wrong. Portfolio theory is a very general framework. There is no one "right" or "efficient" portfolio in portfolio theory (there are some dumb portfolios in portfolio theory but no one optimal portfolio or even optimal risky portfolio). When people get to one "right" or one "efficient" portfolio, they are adding addition assumptions that may or may not be good.

That said base portfolio theory can go wrong as well, but not because of the math. It would go wrong because of the economics. The economics of portfolio theory is that investors care about return and standard deviation is the right measure of risk. If those are bad assumptions then, while the math of portfolio theory is right, its not very useful. You have to buy into those basic economic assumptions. Once you do buy into those assumptions is just math: specifically its quadratic programming. Finally, there are implementation issues (I highlighted one of those early) that can cause problems.

Also, note that because its "just math" portfolio theory doesn't necessarily have strong implications. You can only get so far with relatively benign economic assumptions. At some point you have to take a stand to get strong predictions like, for example, beta being a good measure of risk. Portfolio theory would never by itself give that implication (portfolio theory implies the risk of a security is the following: cov(r_i,r_p) where i is some security and p is your portfolio, which implies the risk of a security may be different for every person because everyone may be holding different portfolios overall). Portfolio theory is just a framework and because it doesn't make strong assumptions it doesn't give precise implications. That's both a strength and a weakness.