Buried Treasure in Academic Journals

US News

Most Americans get their investment advice from the financial media. Unfortunately, much of this "advice" is unreliable and misleading. The most glaring example is Jim Cramer's show, "Mad Money". Allan Roth recently calculated Cramer's stock-picking skill level. He observed that Cramer made four sell recommendations on stocks that ended up being the four best performers out of 749 stocks for the six-month period ending May 13. Roth determined the odds of doing so at 1 in 13.1 billion.

An article in Barron's took a broader look at Cramer's stock picking expertise. The author concluded that "Cramer's recommendations underperform the market by most measures."

Much of what passes for financial news consists of musings by self-styled pundits giving predictions about the future. They freely dispense their views about the direction of the markets, "hot" funds managers and stocks you need to "buy now." The background for this advice is often the floor of the NYSE, injecting a sense of urgency and instilling fear and anxiety.

In stark contrast, sound financial advice based on hard, irrefutable data is often found in obscure financial journals with very limited circulation. The authors of these articles are typically academics who study the capital markets. They write for other academics and not for the general public.

A recent example is an article in the Journal of Economic Perspective authored by Burton Malkiel. Malkiel is best known for his seminal book, "A Random Walk Down Wall Street". He is an emeritus professor of economics at Princeton University.

In his well-researched article, Malkiel notes the staggering increase in total assets managed by the mutual fund industry. These assets rose from $26 billion in 1980 to $3.5 trillion in 2010. You would think economies of scale would have driven the management fees of these funds down, but that has not occurred. More than 70 percent of stock mutual funds are actively managed (meaning the fund manager attempts to beat a designated benchmark). The management fees of these funds has increased from 0.66 percent in 1980 to 0.90 percent in 2010. In contrast, management fees for index funds and exchange-traded funds can be found for 0.07 percent, and even lower.

What are investors getting for these higher fees? Malkiel found that, for the five-year period ending in 2011, the majority of actively managed funds underperformed their benchmarks. Fixed income funds fared worse. In excess of 90 percent of actively managed, government long funds, investment-grade long funds and high-yield funds underperformed their benchmarks.

The cost of chasing returns by purchasing actively managed funds is staggering. Malkiel found that over the past 20 years, investors paid 0.64 percent of the aggregate value of the total market capitalization "in the (futile) search for superior returns." He finds the willingness of sophisticated investors to pay higher fees for lower returns "puzzling" and attributes it to the misperception that branded funds are superior to generic index funds, extensive and often misleading advertising by the mutual fund industry and the overconfidence of investors.

Malkiel notes the misleading way fees are charged by actively managed funds. Few investors realize that if those fees were calculated as a percentage of the incremental returns (the amount earned by the fund over its designated benchmark), they "are likely to exceed 100 percent", not even counting the adverse tax consequences triggered by portfolio turnover.

Instead of watching CNBC, maybe you should get a subscription to the Journal of Economic Perspective.

Dan Solin is the director of investor advocacy for the BAM Alliance and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His latest book, 7 Steps to Save Your Financial Life Now, was published on Dec. 31, 2012.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information, and content on this blog is for information purposes only and should not be construed as an offer of advisory services.



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