Guided by the Evidence
Back when I was in grad school, I was assigned a newly published case study on Dimensional Fund Advisors (DFA)[efn_note]“Dimensional Fund Advisors,” Harvard Business School, 2002.[/efn_note]—a highly successful, yet relatively unknown, money management firm. I dug into the case, which outlined the compelling academic evidence underlying DFA’s innovative investment approach, as well as their impressive returns.
Looking back, I see this assignment as my professional “a-ha” moment: this simple, powerful and cost-effective investment strategy intuitively clicked with me. However, it also came as a shock—I worked in the investment industry prior to business school, yet remained oblivious to the overwhelming evidence flying in the face of traditional investment management. Once the light had been shed on this for me, I knew my career had to be focused on shedding light on this for others.
As graduation approached, my objective was clear: to join a financial advisory practice that served clients as a fiduciary and employed an investment approach that aligned with the evidence. That search led me to Truepoint some 16 years ago, and I’m proud to say that we’ve only deepened our commitment to this common-sense investment philosophy over time.
The philosophy I’m describing is most commonly referred to as “evidence-based investing.” At Truepoint, we embrace this label because it highlights how we use financial science to guide our everyday decision-making. Simply put, “evidence-based investing” is what helps us take an intellectually honest, consistent and rational approach to investing.
The defining attributes of an evidence-based strategy are:
- Broad diversification
- Low cost
- Tax efficiency
- Factor-informed structure
- Discipline and patience
The merits of broad diversification and low cost are clearly evident in the success of index investing. Over the past 15 years, over 92% of actively managed U.S. large cap equity funds underperformed their benchmark, the S&P 500 Index. For context, this represents over 700 professional money managers attempting to add value through stock-picking and market timing. Less than 8% of those managers succeeded. For small cap funds versus their benchmark index, 98% underperformed. Similar results can be seen across all types of actively managed funds[efn_note]The SPIVA U.S. Scorecard Mid-Year 2018 compares actively managed funds across multiple asset classes to their benchmarks. The SPIVA Scorecard is updated and published semi-annually.[/efn_note].
While the dismal track record for traditional investment management would likely surprise many investors (especially those who are clients of active managers), it is entirely consistent with the academic research. It was Eugene Fama, widely recognized as the “father of modern finance,” whose Nobel-Prize-winning work makes clear that financial markets are highly effective at pricing securities and attempts to outperform the market are likely to not just be futile, but costly.
In fact, Fama and his colleague, Ken French, concluded that a portfolio of low-cost index funds will perform about as well as a portfolio of the top three percent of active funds[efn_note]“Measuring chance,” Chicago Booth Review, May 1, 2012.[/efn_note]. This conclusion reflects the lower cost and broader diversification index funds enjoy relative to most actively managed portfolios. And it’s worth noting that employing funds can be an advantage itself, as funds allow broader and more cost-effective diversification than is practical with individual securities.
Taxes Matter Too
It’s important to note that the failure rates for active management referenced above are before considering tax costs. Another proven advantage of passive investing is the tax efficiency inherent in a low turnover approach. Studies have found that taxes have a significant negative impact on returns, averaging 1 to 3 percentage points per year for the typical active manager [efn_note]“The Value of Tax Efficient Investments,” Longmeier and Wotherspoon, Journal of Wealth Management, Fall 2006. Also, Arnott et al., 2000 and Dickson, et al. 2000.[/efn_note].
For taxable investors, the results that really matter are after tax. A low turnover portfolio is one of the key aspects of tax-sensitive investment management.
Adding Value Through Structure
The fourth defining attribute of evidence-based investing is the most complex. Decades of academic research has revealed that certain “factors”—or attributes of individual securities—have consistently produced better returns over the long term. The best known of these factors are small company size, low relative price (value), and high profitability. Incorporating portfolio allocation “tilts” to favor these factors can increase the expected return of the portfolio [efn_note]If you want to dig into the research behind factor-based investing, there is probably no better source than the original researchers, Eugene Fama and Kenneth French, who have written multiple papers on the topic. But there are easier-to-read overviews in on-line journals and even Wikipedia.[/efn_note].
The science of portfolio construction represents the primary avenue of adding value in the investment management process. This includes determining the appropriate “factor tilts” and identifying the optimal mix of funds to carry out the targeted allocation. When evaluating funds for our portfolios, we consider traditional index funds as well as funds designed to capture specific “factors.” The right combination of funds can enhance portfolio results by limiting correlation and creating ongoing rebalancing opportunities.
Behavior Eats Strategy for Breakfast
Ultimately, the fifth element of discipline and patience is the most important for all investors. Regardless of how well informed the strategy may be, realizing the benefit of evidenced-based investing is completely dependent on the investor’s ability to adhere to their investment plan throughout the inevitable ups and downs of the markets.
This includes both the short-term discipline to capitalize on rebalancing opportunities by trimming the best performing asset classes and adding to the worst, and the long-term patience to weather very extended periods of underperformance by the markets generally and the factor tilts specifically.
In addition to thoughtfully constructing our clients’ portfolios to align with the scientific principles of evidence-based investing, a major part of our role is as an ongoing external source of discipline and patience for our clients. A well-executed plan will efficiently capture the long-term returns offered by the market and, most importantly, will avoid the permanent destruction of value that often results from emotionally charged decision-making in the midst of market turbulence.
The Truth Sets Us Free
The reason we have such strong convictions about evidence-based investing at Truepoint is because the approach is borne out by academic research, empirical data and historical experience. This makes explaining its benefits very simple. It also makes us passionate about what we do – the evidence is overwhelming, but also under-communicated; our professional lives are dedicated to sharing the evidence with others so they may benefit from it just as we do in our personal portfolios.