"Investment Club" Is an Oxymoron

I understand why so many people want to be in an investment club. It's fun to discuss investing topics, especially in these volatile times. Social networking is an excellent reason to belong to an investment club. Improving your returns is not.

A blog by financial author Larry Swedroe reported an exhaustive study that showed that 60% of clubs under performed the market. The average club under performed a broad market index by 3% a year.

I was recently invited to debate active vs. passive management at an investment club. The club members, a group of wealthy retired men, refer to themselves as investment "gurus." They are absolutely convinced of the merits of active management (defined as the ability to pick stocks or mutual funds that will beat designated benchmarks).

Prior to the meeting, the club President gave me some ground rules. It is their position the past returns of the Vanguard Wellington Fund (VWELX) prove their point. They challenged me to persuade them otherwise.

They certainly picked an excellent fund to underpin their argument. This is a balanced fund, with a low expense ratio of 0.34%. Its annualized return for the 10 years ending September 30, 2000 was 14.12%. For the ensuing 10 year period, its return was 5.58%. These returns exceeded the median returns for all balanced funds by 0.71% in the first ten years and by 3.18% in the second.

According to the "gurus", this data definitively established the merit of active management. Case closed.

Not quite so fast.

I looked at the performance of all 60 balanced funds for which data was available for both 10 year periods. Here's what I found:

  • 23.33% of them out performed the median in both 10 year periods;
  • 21.67% of them under performed the median in both 10 year periods;
  • 55% of them had one period of out performance and one period of under performance.

If skill was involved in the outperforming funds, you would expect that a much higher percentage of them would outperform in both periods.

How much of the out performance in one period was related to out performance in the other? Less than 13%. This means that 87% of the out performance in one 10 year period had nothing to do with the returns in the other 10 year period. The correlation is so small, statisticians would regard it as meaningless. For details of how this calculation is performed, click here.

If skill was a meaningful factor, the correlation would be closer to 100%. The fact that the largest group had one period of out performance and one period of under performance demonstrates the lack of predictability. Investors can draw no meaningful conclusions about future performance from an impressive track record of past performance.

The focus on historical returns has more practical issues. How many investors were able to capture these returns? In order to do so, you would have to know in advance which funds would perform well in the future. However, since future performance is unrelated to past performance, how would you make such a decision with any confidence? Wouldn't you be better off in a globally diversified portfolio of low cost index funds in an appropriate asset allocation? This portfolio is certain to capture 100% of market returns, less low costs.

When confronted with this data, the "gurus" retreated to the Warren Buffet argument. They believe Buffet's past success will continue into the future. I pointed out that, if his success persists at the same rate, the market capitalization for Berkshire Hathaway will be approximately $7.3 trillion in twenty years. To put this number in perspective, Exxon Mobil's market capitalization is $342 billion. How likely is that?

The "gurus" were not persuaded. Apparently, justifying their gatherings as social events is not enough for them.

Are you?

The views set forth in this blog are the opinions of the author alone and may not represent the views of any firm or entity with whom he is affiliated. The data, information, and content on this blog are for information, education, and non-commercial purposes only. Returns from index funds do not represent the performance of any investment advisory firm. The information on this blog does not involve the rendering of personalized investment advice and is limited to the dissemination of opinions on investing. No reader should construe these opinions as an offer of advisory services. Readers who require investment advice should retain the services of a competent investment professional. The information on this blog is not an offer to buy or sell, or a solicitation of any offer to buy or sell any securities or class of securities mentioned herein. Furthermore, the information on this blog should not be construed as an offer of advisory services. Please note that the author does not recommend specific securities nor is he responsible for comments made by persons posting on this blog.

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