ISMS 39: Larry Swedroe – Don’t Choose a Fund by Its Descriptive Name
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Quick take
In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Today, they discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake number 28: Do You Fail to Compare Your Funds to Proper Benchmarks? And mistake 29: Do You Believe Active Management Is a Winner’s Game in Inefficient Markets?
LEARNING: Don’t choose a fund by its name. Active management is highly unlikely to outperform even in inefficient emerging markets.
“Don’t choose a fund, even an index fund, by its name. Instead, you should carefully check its weighted average book-to-market and market capitalization levels.”
Larry Swedroe
In this episode of Investment Strategy Made Simple (ISMS), Andrew gets into part two of his discussion with Larry Swedroe: Ignorance is Bliss. Larry is the head of financial and economic research at Buckingham Wealth Partners. You can learn more about Larry’s Worst Investment Ever story on Ep645: Beware of Idiosyncratic Risks.
Larry deeply understands the world of academic research and investing, especially risk. Today, Andrew and Larry discuss two chapters of Larry’s book Investment Mistakes Even Smart Investors Make and How to Avoid Them. In this series, they discuss mistake number 28: Do You Fail to Compare Your Funds to Proper Benchmarks? And mistake 29:
Did you miss out on previous mistakes? Check them out:
- ISMS 8: Larry Swedroe – Are You Overconfident in Your Skills?
- ISMS 17: Larry Swedroe – Do You Project Recent Trends Indefinitely Into the Future?
- ISMS 20: Larry Swedroe – Do You Extrapolate From Small Samples and Trust Your Intuition?
- ISMS 23: Larry Swedroe – Do You Allow Yourself to Be Influenced by Your Ego and Herd Mentality?
- ISMS 24: Larry Swedroe – Confusing Skill and Luck Can Stop You From Investing Wisely
- ISMS 25: Larry Swedroe – Admit Your Mistakes and Don’t Listen to Fake Experts
- ISMS 26: Larry Swedroe – Are You Subject to the Endowment Effect or the Hot Streak Fallacy?
- ISMS 27: Larry Swedroe – Familiar Doesn’t Make It Safe and You’re Not Playing With the House’s Money
- ISMS 29: Larry Swedroe – The Shiny Apple is Poisonous and Information is Not Knowledge
- ISMS 30: Larry Swedroe – Do You Believe Your Fortune Is in the Stars or Rely on Misleading Information?
- ISMS 34: Larry Swedroe – Consider All Hidden Costs Before You Invest
- ISMS 35: Larry Swedroe – Great Companies Are Not Always High-Return Investments
- ISMS 36: Larry Swedroe – Two Heads Are Not Better Than One When Investing
- ISMS 37: Larry Swedroe – Pay Attention to a Fund’s Proper Benchmarks and Taxes
- ISMS 38: Larry Swedroe – The Self-healing Mechanism of Risk Assets
Mistake number 28: Do You Rely on a Fund’s Descriptive Name When Making Purchase Decisions?
According to Larry, most investors tend to rely on the name of a fund and its descriptive value. So they’ll look at a small-cap fund and assume it invests exclusively in small or mid-cap stocks. However, the SEC allows sufficient leeway that can cause dramatic differences in that a large-cap fund can own a large-cap value fund and even some small-cap growth stocks. In such a case, you’ll not get the asset allocation you think you should and desire. And that’s especially true, of course, of active managers who have freedom to roam.
Several academic studies have concluded that asset allocation determines the vast majority of the returns and risks of a portfolio and its long-term performance. Larry says that once investors decide on their investment policy (asset allocation), they must choose which funds to use as the building blocks of their portfolio. One choice involves implementing the strategy with active or passive managers. If investors choose passive managers, they can be highly confident that the specific investment style will be adhered to, as the fund will replicate the asset class or index it represents. There is no such assurance with active managers. With active managers, you cannot even rely on the fund’s name when making a choice.
Larry advises that you should not choose a fund, even an index fund, by its name. Instead, you should carefully check its weighted average book-to-market and market capitalization levels. That’s the simplest way to tell the true nature of a fund.
Mistake number 29: Do You Believe Active Management Is a Winner’s Game in Inefficient Markets?
The efficiency of the market for U.S. large-cap stocks is so great that attempting to add value through active management is unlikely to produce positive results. However, investors cling to the idea that active management will likely add value in less efficient markets. Unfortunately, research shows that active managers in emerging markets tend to lose over whatever period, and the longer the horizon, the worse the performance.
The asset class for which the active management argument is made most strongly is the emerging markets — an “inefficient” asset class if there ever was one. Many myths are perpetuated by the Wall Street establishment and the financial media, and that active management is the winning strategy in less efficient markets is just one of them. As the historical evidence demonstrates, active management is highly unlikely to outperform in even the allegedly inefficient emerging markets. In fact, the evidence suggests that active managers perform just as poorly in the “inefficient” markets as they do in the more efficient markets of the developed nations. Larry concludes that active managers don’t lose because they’re dumb; they lose because they’re expensive.
About Larry Swedroe
Larry Swedroe was head of financial and economic research at Buckingham Wealth Partners. Since joining the firm in 1996, Larry has spent his time, talent, and energy educating investors on the benefits of evidence-based investing with an enthusiasm few can match.
Larry was among the first authors to publish a book that explained the science of investing in layman’s terms, “The Only Guide to a Winning Investment Strategy You’ll Ever Need.” He has authored or co-authored 18 books.
Larry’s dedication to helping others has made him a sought-after national speaker. He has made appearances on national television on various outlets.
Larry is a prolific writer, regularly contributing to multiple outlets, including AlphaArchitect, Advisor Perspectives, and Wealth Management.