Stock pickers manage their portfolios as if taxes do not
matter. The average active manager has approximately a 100% turnover
rate per year, while index funds range from 5% to 35%. The cost of
turnover is detrimental to the overall performance of the portfolio.
There is a substantial incentive for investors to hold their stocks
for a year or more. For stock sales with holding periods of less than
one year, the gain is treated as ordinary income and subject to the
full federal and state tax rate.
Depending on the tax bracket and state of residence, this could be
39.6% for federal taxes and 11% for state taxes, and can have a dramatic
impact on actual returns. For holding periods of one year or more,
the tax rate is reduced to the long-term capital gains rate of 15%.
3.3.13 Stock Picking Gurus and Their Real Records
The dangers of stock
picking become crystal clear when we focus on the best, brightest, and
most famous stars of the investment industry. (More Bad Bets and Big Losses)
Jack Grubman was touted as king of the telecom stock industry in the
mid-to-late 1990s. As Salomon Smith Barney’s appointed telecom
analyst, Grubman was regarded as the most influential power broker in
the industry. He was rated number one in Institutional Investor’s
annual analyst rankings and was profiled by The Wall Street Journal,
BusinessWeek, and New York Magazine. When Grubman talked, people listened.
If he said, “buy,”
people bought; if he said, “sell,” people sold. One broker
likened Grubman’s advice to a narcotic. Everybody wanted it. Salomon
Smith Barney’s 13,000 brokers passed along his stock picks to
their clients. His many monikers included, “Telecom god,” “Consigliore,”
and “Ax.” At the height of the telecom industry, he gave
advice on 40 stocks with a combined market value of more than $1 trillion.
He himself made $20 million a year.
Most everyone knows the rest of the story. The glamorous telecom sector
soared beyond imagination, and then went bust with enormous consequences.
Grubman’s top 10 picks in March, 2001, all plummeted to the lowest
of lows a year later. As of May 2002, five of the 10 were trading under
$1 a share. Three of the 10 had filed for bankruptcy including Global
Crossing, McLeodUSA, and Winstar Communications. Along with the Global
Crossing bankruptcy went $55 billion of paper wealth down the drain.
Investors lost millions relying on Grubman’s supposed wisdom. The
“King of Kings” lost his seat on the analyst throne and no
longer wears the stock picker’s crown. When asked what he learned
from this disaster, he said, “You learn that even good management
teams and macro- industry trends being favorable do not always translate
into equity returns being positive.” Spoken by the fallen stock
picking hero himself.
Here’s another example of a stock picking guru who fell from grace:
On March 30, 2000, Tiger Management LLC confirmed that it was closing
all six of its hedge funds. The legendary value investment manager, Julian
Robertson Jr., stated that he could no longer understand this irrational
market. For the first two months of the year, the funds were down 13%.
Robertson wrote, “What I do know is that there is no point in subjecting
our investors to risk in a market, which I frankly do not understand.”
This quote comes from the head of 1999s second-largest hedge fund group
in the world. If he and his numerous high priced analysts and strategists
cannot comprehend how to beat the market, how can anyone?
In another tale of misfortune from the financial industry’s elite,
the famous George Soros’ $14.2 billion investment firm lost two
top managers when the world’s largest hedge fund lost approximately
$5 billion during March and April of 2000. Here’s how the story
unfolded: Stanley Druckenmiller and Nicholas Roditi were two of the top
managers in charge of developing and implementing investment strategies
for the firm. Druckenmiller managed the $8.2 billion Quantum Fund, which
was down 22% for the first four months of 2000, while Roditi managed the
$1.2 billion Quota Fund, which plunged 33% during the same period.
Although the Soros funds survived, albeit with new managers, how much
of this poor performance can be blamed on the managers when no one can
outperform a market over a long period of time? “I think there is
going to be more fallout within the hedge fund industry,” stated
a chief executive of Tass Investment Research. This is not the first case
of a trader whose market calls have severely underperformed the markets.
For many years, Victor Niederhoffer was one of Soros’ best traders.
He later ran his own fund but was forced to close it in 1997 due to extremely
heavy losses. History is littered with discarded, former legendary investors
and strategists who eventually succumbed to the random and efficient markets,
underperforming so dramatically that they were rarely heard from again.
Table
3-4
Michael Murphy has been hailed as the number one Technology
Stock advisor. He offers his “Six Secrets to Successful Technology
Investing.” However, his record is not so successful. For the five
years ending March 1999 his Monterey Murphy Technology Fund had a mere
0.9% annualized return. An approximate index for technology stocks would
be the NASDAQ 100 Index Fund, which had an annualized return of 41.3%
over the same five-year period. The technology mutual fund average was
only 25.5% and the S&P 500 over this period was 26.2%, (Table
3-4).
The financial industry has finally begun investigating the results of
poor manager performances. In an article published in The Financial Analysts’
Journal in 1996, three top investment officers at Washington State Investment
Board analyzed some of the information discovered by financial academia.
One of the studies performed by Ronald Kahn and Andrew Rudd came to two
main conclusions: (1) no persistence of returns can be found among U.S.
equity managers, and (2) some persistence can be found among U.S. fixed-income
managers, but not enough to justify the payment of active manager fees.
According to this and other information, the Washington State Investment
Board, which had investment responsibilities in 1996 for more than $30
billion, restructured its investments. In 1993 it allocated approximately
70% of its U.S. equity portfolio to large-capitalization stocks, the bulk
of which is invested passively in an S&P 500 Index fund. Their internal
findings and newly developed and refined investment philosophy dictates
that in the case of efficient markets, the best investment style is passive.
Even quasi-active or enhanced strategies that take active bets in addition
to a passive style will not add value. The board doubted that any value
could be added to a passive investment strategy.
The Washington State Investment Board is one of the enlightened investment
organizations whose principals realize there is no value to being an active
manager. They know that active management lowers the overall value of
the portfolio and that all efforts to increase the performance of the
fund are futile. According to a study performed from 1987 to 1993, only
one out of 28 major pension funds beat a portfolio consisting of a 60/40
split between the S&P 500 Index and the Lehman Bond Index.
Financial services firms make money through trading. They take a slice
of the pie with every trade. With discount brokerages now in fierce competition,
they have reduced their profit margins per trade. In order to maintain
the same or greater profit, they must increase the number of trades individuals
make. Trading frequently is a high cost activity, not only because of
the trade commission paid to the broker, but also because of the spread
between the bid and the ask, and the fact that most individuals buy stocks
with low expected returns and sell stocks with high expected returns.
Brokerage firms are similar to casinos, in that the longer and more often
a person plays or trades in the market, the greater the chances that the
brokerage firm will make money. The investor’s odds of losing unfortunately
increase with the frequency of trading. In other words, trading can be
hazardous to your wealth.
3.3.14
Stock Pickers Don't Want You to Know the Truth
For many mutual fund managers,
analysts, traders, stockbrokers and various other individuals associated
with the financial industry, the idea of index funds strikes fear in their
hearts. This is because stock pickers and analysts charge very high fees
on mutual funds, and these fees pay for a lot of the jobs in the industry.
It is in the interest of these stock, time, manager, and style pickers
to imply that a market can be beat by listening to their strategist or
by risking money with their manager. Who will pay for their cars, houses
and yachts? Thousands of jobs in the industry are redundant and completely
useless to an investor. As one book from the 1940s asks, “Where
are the Customers’ Yachts?”
If investors consciously want to gamble, then that is a different story.
They can try to outperform the index and their fellow investors if they
wish. But, they must realize they will not be able to outperform the indexes
for any lengthy period of time. Although they may win a few times at the
roulette wheel, they will count themselves lucky, but hardly skillful.
After all, if a majority of the gamblers in Vegas actually won, who would
pay for all the fancy lights.
3.4
Solutions
Stock prices move
randomly and reflect the daily fair market value of each stock. Therefore,
the only hope of success for stock pickers is luck or chance. Time and
money are too precious to waste on stock picking. The best investment
strategy is to own a global, tax-managed, and diversified portfolio of
index funds matched to risk capacity. If investments are not on the optimal
returns line between risk capacity and risk exposure, then the appropriate
market rate of return will not be achieved.
3.5
Summary
Simply put, stock
picking is expensive speculation with negative expected returns relative
to a blended benchmark. The best advice is to just let go of it, forget
about it, stay away from it, and find something more productive to do.
3.6
Review
Questions
Questions will
appear at the end of each step to affirm your understanding of the
information presented in each particular step. When you think you
are sure of the correct answer for a question, click the "Answer"
button to check.
1.
The performance of stock pickers must be examined on an adjusted basis.
When comparing a stock picker's portfolio to an index, which factors must
be considered before determining if the stock picker has beat the index?
a.
proper accounting of returns, including cash flows in and out of the account
b. the exposure to market risk, size risk, and value
risk of both portfolios
c. level of diversification of the two portfolios
d. standard deviations or volatility measurements
e. all of the above
2.
One of the problems of stock pickers is:
a. They focus on well
diversified portfolios.
b. They are focused on the short-term rather than long-term results.
c. They adhere too closely to one style or benchmark.
d. They don't take enough risk.
3.
Stock pickers pay more taxes than indexers, because:
a) their annual returns
are higher.
b) the average actively managed portfolio has a 45% turnover rate, while
index funds range from 5% - 35%.
c) the average actively managed portfolio has a nearly 100% turnover rate,
while index funds range from 5% - 35%.
d) they don't pay fees or commissions to their brokers, thereby offsetting
the higher taxes.
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