Daniel Wallick & Gregg Fisher Transcript 6/21/2013 #952

June 21, 2013

CONSUELO MACK: On this week’s WealthTrack, the active versus passive debate! Two seasoned investment pros argue the case for and against. In a surprising twist, Vanguard Principal Daniel Wallick presents the active management case while award-winning financial advisor Gregg Fisher defends the passive approach. Their arguments are next on Consuelo Mack WealthTrack!


Hello and welcome to this edition of WealthTrack, I’m Consuelo Mack. What percentage of your investments are in actively managed funds, what portion are in passive index funds or ETFs? If you are like most investors, the mix is pretty one sided. As you can see from this pie chart from Vanguard, 74% of assets under management in domestic and international stock mutual funds are actively managed and only 26% are in passive funds, although that number is growing.

But here’s the rub. The number of actively managed funds outperforming their market benchmarks has actually been declining over time. A disappointing 24% did so over the past ten and fifteen years, only 23% did over the past 20 years and a paltry 18% did over the last quarter century. Why have active managers done so poorly versus their market benchmarks? How do you find an actively managed fund that will be in that top 25% over time? Would you be better off investing in passive index funds, or ETFs? Can you combine them in your portfolios, as many of us have done, and if so how do you decide the mix? These are all questions we will discuss with this week’s WealthTrack guests.


But before I introduce them, I want to share one more piece of research from Vanguard. It is an issue we have discussed many times on WealthTrack and it shows that costs matter. As you can see from this chart of actively managed equity funds that outperformed their benchmarks, no matter which period you look at: the past 25 years, 10 years, 15 years, or 20 years, a smaller percentage of the most expensive funds on the far left of the chart outperformed their benchmarks and a much larger percentage of the least expensive funds on the far right of the chart beat the markets. Costs matter, but they are not the only consideration.


Daniel Wallick is Principal in Vanguard’s Investment Strategy Group, where he is responsible for developing portfolio strategies. He is co-author of the fascinating report I just referenced titled: “The Case For Vanguard Active Management: Solving The Low Cost/Top Talent Paradox?” We will have a link to it on our website. Surprisingly Vanguard, where index funds were created, is the 4th largest active equity manager in the U.S. with over $225 billion in actively managed stock funds.


Gregg Fisher is the Chief Investment Officer of Gerstein Fisher, an independent investment management and advisory firm that he founded in 1993. Gerstein Fisher was named to Barron’s list of Top 100 Financial Advisors in 2013 and its list of Top 100 Independent Advisors in 2011. In 2009, Fisher founded the Gerstein Fisher Research Center which partners with leading academics in finance, risk engineering, and economics to study and improve the investment process. I began the interview with this question: given the poor performance of most active stock managers why should we even bother investing with them?


DANIEL WALLICK:  Most of the assets are actually in active management, so there’s a real sort of paradox between all of this money in active, even though it has historically underperformed. And the reason, I think, is that people are interested in some slight amount of outperformance, because if you can compound just a small beating of the market, that compounding really ends up being a big deal. So people are hoping that they’re able to achieve that.

CONSUELO MACK: Tell me why you bother with active management.

GREGG FISHER: Well, I think it’s important the point Daniel just made that people in general seem to want to win, and there is something about human behavior that has them want to search for some potential out-performance. There is a strong case for investors building their portfolios using market-based or index funds. However, when you look at different asset classes, there are situations where the average outperformance for active management is better. When we look at the average across the whole universe, these numbers are true but, for example, when you look at a specific piece of the market like growth investments, what we find there is that actually active managers, on average, do seem to do a little bit better. So we might want to look at parts of the market where we, in fact, should consider active management.

CONSUELO MACK:  In your analysis at Vanguard, are there specific types of investing that tend to do better with active managers?

DANIEL WALLICK:  No. In fact, our analysis would say there’s no real space where there’s more efficiency or not. What we do see is there’s wider dispersion in some areas, and some equate dispersion with the probability of outperformance, but there’s a big difference. Dispersion just means the distance you’ll be from the benchmark. That could be positive or negative. It doesn’t actually create any better probability of outperforming the index. So no, we have not found any space where there is anything better than the index.

CONSUELO MACK: Why do so few active managers, you know, out-perform their indexes?

DANIEL WALLICK:  We would say mostly it’s because of costs. Right?

CONSUELO MACK: I would expect you to say that from Vanguard.

DANIEL WALLICK:  Well, so active managers are typically measured against the benchmark. The benchmark has no cost associated with it. Any active manager has to turn on the lights and feed the people who work for them, so there’s going to be some cost associated with that, and depending on how high those fees are, that’s a higher hurdle over which that manager needs to achieve, and that’s really why we would think that most active managers have a hard time beating the index.

CONSUELO MACK: Right. Would you agree with that that basically cost is a big factor? I know you pay a lot of attention to taxes as well.

GREGG FISHER: Sure. I do agree that cost is a major factor, but it’s not the only one. I mean, it’s very difficult to outperform the market. When you think about how much information is in the price of securities, the idea of finding mispriced securities and outperforming the market based on information that only one of us has versus the average of all of us, it’s a very difficult thing. When we then add in costs and, as you mentioned, as we’ve discussed, taxes are a critical factor as well. So when you look at, first, the challenge of outperforming the information that exists in the market; second, the costs which are critical, and then taxes, these three things are major handicaps which is why active managers have a very difficult time.

CONSUELO MACK: So how do you choose an active manager and increase the likelihood that they are going to out-perform?

DANIEL WALLICK:  So we think there are really two critical factors. One is a qualitative assessment of their people, their process of how they do their business. And again, that is a very qualitative assessment.

CONSUELO MACK: And when you’re talking about qualitative, tell me, what are the criteria?

DANIEL WALLICK:  Right, so a simple way that some people think about this is let me look at the historical three-year track record, and if somebody has done well, maybe that is an indication that they’ll do well in the future. Obviously, every disclosure document we have says that the past performance is no predictor of the future, but people are looking for something quantitative, something concrete to look at, and often they’ll look there. But what we found over the many years of doing this is that what really matters is: who are the people involved, how do they do what they do? Are they able to articulate that? Do they have a consistent philosophy? Will they stay consistent through that process no matter how challenging the current markets are? And can you acquire that at a reasonable price? Really that combination, so talent and price are really the two keys.

CONSUELO MACK: And how do you identify the talent? I mean, obviously the three years is not going to be enough, and we’re going to get behavioral aspects to this which I know are very important to you, Gregg. So how do you identify the talent?

DANIEL WALLICK:  So one, we look for people who have experience doing what they’re doing, that…

CONSUELO MACK: So 10 years, 15 years?

DANIEL WALLICK:  Again, I cannot give you a checklist, right?

CONSUELO MACK: Oh, okay. Darn it.

GREGG FISHER: There must be one somewhere.

DANIEL WALLICK:  I can’t give you a weighted average or a Greek logarithm or anything like that. It’s like Potter Stewart said. You know it when you see it, sort of thing.

CONSUELO MACK: As in pornography in his case.

DANIEL WALLICK:  Right. So what you’re looking for are people who have an intelligent process who have been doing it for a long time, who’ve been consistent in doing that, who can articulate why they’ve done what they’ve done, and if they’ve done well or poorly, they can you tell you why that is, so that you have this expectation that there’s a depth of ownership in the organization. In addition, we like to see firms that are really held by themselves. In other words, that the owners are committed to that business. They’re not working for a third party, but they’re really a part of that, and we actually look for people who care about investing, not about the business of investment management, right, people who really care about what they do and are dedicated to doing that.

CONSUELO MACK: That is something that… so you’ve really got to judge by getting to know them and understanding the organization. Right? That’s not something that you can just read on a financial statement.

DANIEL WALLICK:  No, and so certainly we’ll meet with a firm’s marketing group, but that’s really not how we’re going to make the decision, and it’s not going to be on their glossy brochure. It’s going to be much more of doing the due diligence, meeting with the folks. In our instance in terms of Vanguard, the people who are in charge of this process are actually our CEOs. So we’ve had three of those over the last 40 years, that’s the person who makes the final call on whether or not we hire somebody or not.

CONSUELO MACK: Right. Well, you’re sitting next to the CIO of his own firm and the founder of Gerstein Fisher, so how do you approach the active management issue at Gerstein Fisher?

GREGG FISHER: So at Gerstein Fisher, we take more of a quantitative approach as opposed to qualitative. I do agree that understanding people, incentives, organizational structure, these are very important things, but what we look at is if we are going to use active management in any capacity, we want to have an understanding quantitatively as what caused the manager’s outperformance, so we can use quantitative methods to analyze past performance and try to understand where the performance came from. In our experience, when active managers do outperform their benchmarks, it’s almost always because of risk, not because of good stock picking skills or some other factor. We can generally break the returns down into, was the exposure of the manager smaller than the market? Were there more value-oriented securities? Were they embracing momentum? And these really large risk factors tend to drive almost all of the excess return. In fact, what we found is that even those managers that do out-perform, when you actually do these kinds of analyses, we find that their outperformance is almost always because of risk but not because of some other stock picking or some other thing that most people tend to think it might be.

CONSUELO MACK: So is it that they’re taking less risk or more risk?

GREGG FISHER: Generally it’s more risk in some capacity, and these risks are sometimes smart risks that investors should consider taking. For example, we know that over time risk and return should be related. I mean, it’s at the core of the efficient market theory, rational risk pricing. So in fact, if risk and return are related, then investors could potentially be well served by building portfolios tilting to risk. Now, that could be done using index funds, but it could also be done using active management, and I think that’s a personal choice of investors. But there’s a lot of different ways of building portfolios to have a successful outcome.

CONSUELO MACK: Because you talk about a multifactor growth equity strategy. So you’re talking about… I read some of your literature… size, you know, whether it’s large cap or small cap and whether it’s value or growth, earned yield. You said momentum. So these are all the things that you look at in determining what your active management is going to be?

GREGG FISHER: That’s exactly right. We can either make those decisions on our own or analyze all money managers through this multifactor lens. So basically it’s looking at things quantitatively, trying to understand what risks money managers have taken and whether or not we think those risks are a process that they’re implementing that might be repeatable, because when you look at things from this point of view, it helps you to better understand what caused the outperformance, because otherwise it could be random. You do want to know that there’s some repeatable process, and this really organized things in a framework.

CONSUELO MACK: To what Daniel was talking about where people process.

GREGG FISHER: That’s right. The other point that you mentioned earlier in terms of I think it’s important to acknowledge investor behavior, and it is true that future performance isn’t necessarily indicative of past performance, but what we do know from our study of individual investors is that future performance has something to do with our past experiences, and we think that our past experiences does cause us to have a feeling about what future performance may be, and this investor behavior does influence people’s choices as to how they purchase certain investments, the timing of their investments, and this shows up in the research that we’ve done and the industry has done in terms of investor experience and investor returns versus the returns of the benchmarks themselves.

CONSUELO MACK: Right, and of course, investors always underperform the very funds that they invest in, and Vanguard’s done a lot of research on that. So talk to me about, Daniel, the fact that there is this big underperformance gap, and how much does behavior affect our returns, both ours as an investor and also the individual manager, how they behave, and that’s why it’s so important that they…

DANIEL WALLICK:  Right. Let me start with the investor. So I think it’s very challenging for all of us to stick with something, particularly if it’s had, say, a difficult run for a while, because for many of us what we want to do is fix it. We want to take action and do something to stop the hurt or the pain or the whatever. So if you have a manager that you’ve had faith in in the past, and say they had a good run for five years, but all of a sudden for three years they’ve been doing poorly, there’s a sense of urgency. Investment committees do this. Individual investors do this.  You know, we as human beings do this. We want to stop the problem, right? So what we’ll often think about is, well, we should change that manager. There was an incredible study done by some professors down at Emory University, and they looked institutional investment committees.

CONSUELO MACK: This is the smart money, right?

DANIEL WALLICK:  Exactly. They looked at 3,000 of these throughout the United States, and what they found was when they made a hire-fire decision, it typically was they were firing people who had a bad three-year track record. They were hiring people who had historically a good three-year track record and, oddly enough for the subsequent three years, the reverse proved to be true.

CONSUELO MACK: Right, reversion of the mean.

DANIEL WALLICK:  Right, so this sense of the report card of recent performance is often used as a decision factor, and you really need to stand back and not do that.

CONSUELO MACK: So tell us about how you treat the managers that you’ve chosen to manage actively managed funds, how you treat them when they have had a period of underperformance, let’s say three years.

DANIEL WALLICK:  So let me start by saying our average tenure for sub advised active managers is 13 years, and if you take out the people we’ve hired in the last five, that number actually rises to 17 years.

CONSUELO MACK: So you stick with the managers that you choose.

DANIEL WALLICK:  Yeah, we really do, and the reason for that is if we have faith in their process and their people, all those qualitative things I was mentioning before, unless those have changed, we want to stick with the manager. Now, there will be those managers who, in a moment of crisis, decide they’re going to flip the switch and go from being strategy A to strategy B. Those are the managers we would be most concerned about. You know, why are you changing? It feels like more a cash flow issue than and investment issue. So for those people who change for reasons that we don’t fully understand or value, that’s when we think of making a change, or if there’s a personnel change in the company, if the lead managers all of a sudden are no longer there, that’s another reason too. But if the people are the same, and the process if the same, and the process continues, you know, we’re going to stick with somebody through hard times.

CONSUELO MACK: Some people think that there are certain sectors of the market that call for active management. I mean, we’ve had somebody on from Morningstar recently, for instance, who said that municipal bonds, it’s so difficult. You’ve got to look at the credit worthiness of each individual issue. You can’t buy an index fund. You’re poorly served by buying index funds so therefore, you should be actively managing munis. I mean, some people say small cap stocks. Some people say local currency bond funds in international markets. Are there certain sectors that you really do need to have an active manager?

GREGG FISHER: I think there isn’t a sector where you need to have an active manager. I think investors could start with the idea that a market-based portfolio that’s globally diversified across all asset classes is a really great place to start and maybe even end. However, to the extent an investor wants to consider active management. We do think that there are places where they are more likely to have success than others. For example, both in the U.S. and internationally, there seems to be evidence that growth investing is a place where you’d have a better shot at investing with active managers than perhaps value investing. There’s a lot of evidence of this when you look at rolling 15-year periods through the test of time.

There seems to be something about the ambiguity of growth stocks and valuing them and a variety of other things that we think show up in the investor behavioral data that cause active growth strategies to have better odds than value strategies when it comes to using active management. But again, I would say that this is more about a personal choice because of the point we were making earlier about investor behavior. The research we’ve done shows that on average, investors lose about two percentage points per year just due to their behavior. This is more important than fees and, frankly, even more important than taxes.

CONSUELO MACK: These are timing their funds that Daniel was talking about.

GREGG FISHER: That’s exactly right. So I think what’s important for an investor is, well, perhaps they might consider some active management in their portfolio, and maybe it’s growth strategies or some other area where they feel they have a good shot at winning- winning meaning returns better than the benchmark, net of fees and taxes. However, I think what’s really important is that they invest in things they feel comfortable with where they can stay invested, think strategically, because if they’re invested in something where they’re not comfortable, they’ll never see the long-term results that most investors are entitled to, and this two percent investor drag is very significant, and I think it’s the most important point from our perspective.

CONSUELO MACK: Right, and very significant. Your research has shown over time it’s huge.  So any sectors that you think really that you shouldn’t invest in an index fund that you should invest with active managers in particular?

DANIEL WALLICK:  No. No, we would say what you want to do is start out with a strategic asset allocation. Use indexes to sort of build that out as a starting point much like Greg said, and then move off of that to the extent that you’d be comfortable with active. Active has certain attributes that people, we would say, people really need to be comfortable with to undertake and that’s, in particular, there’s a variability in the returns. So relative to the index or the benchmark, you’re going to be up some years and you’re going to be down some other years. You could be down for many, many years, and unless you’re comfortable with that, you shouldn’t be going into active, and the other is if you can acquire active at a reasonable cost. Right? Again, we would say those two factors. If you can live with the variability and you can acquire it at a reasonable cost, then there’s an opportunity for active to be useful.

CONSUELO MACK: And that’s the variability compared to the market, because obviously if you’re investing in the market, you’re going to get a lot of variability anyhow.


CONSUELO MACK: Yeah, and so as far as an individual is concerned then, is there an appropriate mix? Should the core… I mean, is the position at Vanguard that the core should still be index funds and the actively managed part of your portfolio is kind of around the margins, or do you have any such…?

DANIEL WALLICK:  No, I think it’s similar to what Greg was saying. It’s a personal preference, and we would say it’s an opt-out function.

CONSUELO MACK: So explain that.

DANIEL WALLICK:  So you start with a total index portfolio and then opt out to the extent that you are comfortable with the potential variability. Right? So some people have a low tolerance for that variability. If they underperform, they will always be thinking, what if, I should have, and they start kicking themselves, and it leads to bad behavior. Other people can say, “Listen. I’m going to be active. I’m going to live with that. I’m just not going to look at the portfolio for five years at a time or some long period of time, and then I’ll look at it and hopefully will capture some benefit over that period of time.” Again, to the extent that you’re comfortable with the potential variability, that would increase your potential success to using active.

CONSUELO MACK: Realistically, do any individuals actually not look at their portfolios for five years?

DANIEL WALLICK:  I would say young accumulators, right, who are in 401(k)s who might have a modest amount of their total wealth in that and know what’s going on.

GREGG FISHER:  Investors go through difficult moments- family issues, market events, the economy- and these things really do cause them to think about their strategy, and when they’re out with their friends or they’re reading the papers and they’re finding that their returns are off by just a little bit from some benchmark, I find it fascinating how distracting that could be.

CONSUELO MACK: It is time for the One Investment. So what is the One Investment that all of us should own some of in a long-term diversified portfolio? Daniel.

DANIEL WALLICK:  I would say low-cost investments, but if you’re asking me for something more specific than that…


DANIEL WALLICK:  …I would say a broad diversified equity and U.S. equity within that.

CONSUELO MACK: U.S. equity. I mean, broad diversified global?

DANIEL WALLICK:  Global, global. I would be as diversified as you are comfortable. Now, there may be liability reasons why you might want to have a home country bias, but I think thinking about sort of global equity in that form on a low-cost basis is really a great starting point for long-term investors.

CONSUELO MACK: Okay, what would yours be, Greg?

GREGG FISHER:  Well, we think global real estate. Actually what we find is most investors have a very small percentage of their portfolio in commercial real estate, particularly for U.S. investors, commercial real estate outside of the United States, and from a diversification perspective, when we look at what most traditional investors have, we see this as an asset class that has a lot of potential, some merits around the potential for inflation, and it’s generally something that investors have a small amount of exposure to that they would, I think, be well served by adding to their portfolio.

CONSUELO MACK: So how do you do that? Do you have a suggestion or… ?

GREGG FISHER:  There are a couple of index strategies, ETFs, mutual funds, index funds, and for larger investors, there would be ways to do this using individual positions, but buying a diversified basket of publicly traded real estate, REITs, where you can…

CONSUELO MACK: International, right, international REITs.

GREGG FISHER:  Right, both U.S. and also international, so a global strategy.

CONSUELO MACK: All right, interesting idea. So thank you both. I’m still going to have some active manager in my portfolio as I think most of our viewers are, too.

GREGG FISHER:  You are human.

CONSUELO MACK: Which I really appreciate. At any rate, you’re educating us on this subject. It’s a very active debate and important one. So Daniel Wallick from Vanguard, it’s great to have you here.  Thanks so much, and Gregg Fisher from Gerstein Fisher, thank you very much for being with us as well.

GREGG FISHER:  Thank you.

DANIEL WALLICK:  My pleasure.


CONSUELO MACK: At the conclusion of every WealthTrack, we give you one suggestion to help you build and protect your wealth over the long term. This week’s Action Point is: see if your funds meet the top criteria for outperformance: low costs and top talent. As we just discussed, just by simple arithmetic, the lower the cost of your investments the more you get to keep.


But as we also mentioned, costs are not the only factor. Talent matters too. Decades ago, Vanguard’s founder Jack Bogle identified what he calls the 4 P’s, which Vanguard still applies today in its search for top active managers. It analyzes people, philosophy, portfolio and performance. It is worth reading Daniel Wallick’s report, which I mentioned earlier, on how Vanguard does it. We will have it on our website, wealthtrack.com


I hope you can join us next week for our conversation with GenSpring’s Jewelle Bickford and Morgan Stanley’s Ami Forte. For the launch of WealthTrack’s ninth season, we will have a two-part series on Women, Investing, and Retirement- why women’s goals and needs require some different approaches. In the meantime, thank you so much for joining us.  Have a great week and make it a profitable and a productive one.

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