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Bogleheads on Investing with Dr. Derek Horstmeyer: Episode 57

Post on: April 27, 2023 by Rick Ferri

For our 57th Episode of Bogleheads on Investing Podcast, host Rick Ferri interviews Dr. Derek Horstmeyer, a Professor of Finance at George Mason University's School of Business where he publishes regularly on investment topics, ETF & mutual fund performance, and corporate finance. He writes a monthly column for the Wall Street Journal along with his students and writes frequently for the CFA Institute. he has also been published in the Quarterly Journal of Finance, Managerial Finance, and several other mainstream business publications.

Dr. Horstmeyer is very active at GMU outside the classroom. He co-founded and currently leads the first student-managed investment fund and currently serves as director of the new Financial Planning & Wealth Management degree at Mason. 

Dr. Derek Horstmeyer

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Rick Ferri: Welcome to the 57th edition of Bogleheads on Investing. Today our special guest is Dr Derek Horstmeyer, professor of Finance at George Mason University School of Business, who publishes a monthly Wall Street Journal column on interesting investment topics and also publishes for the CFA Institute and other major publications.

Hi everyone. My name is Rick Ferri and I'm the host of Bogleheads on Investing. This episode, as with all episodes, is brought to you by the John C. Bogle Center For Financial Literacy, a non-profit organization that is building a world of well-informed, capable and empowered investors. Visit the Bogle Center at boglecenter.net where you will find a treasure trove of information, including transcripts of these podcasts.

Before we begin today I have two special announcements. The first announcement is the opening of registration for the 2023 Bogleheads investment conference to be held in Bethesda Maryland just north of Washington D.C. from Friday October 13th through Sunday October 15th. We've pulled together an action-packed agenda full of Bogleheads favorites as well as well-known investment and personal finance experts who will be appearing at the event this year. We have Charles Ellis, Paul Merriman, Clark Howard, Jonathan Clements, Michelle Singletary, J.L. Collins, Barry Ritholtz and Wade Pfau, to name just a few of our special speakers, along with Bogleheads’ favorites such as Mike Piper, Alan Roth, Christine Benz, Bill Bernstein, and I'll be there too. Go to boglecenter.net to see a full lineup and to register for this unique event.

The second announcement is that there will be a guest host for this podcast for the next five episodes. Within the next week my wife and I will be loading up the truck and the dog and hooking up the travel trailer and heading out for a five-month travel adventure. We'll head northwest to the Rocky Mountains, up into Canada into the Yukon, over to Alaska then turn north up to the Arctic Circle and keep on going until we can't go any further and then put our toes in the Arctic Ocean. We'll then tour around in Alaska for about a month before heading back. And during that period of time your guest host on this show will be Jon Luskin. Jon has a fantastic lineup of guests including Nobel Laureate William Sharpe. I'll be back as the host in October right after attending the Bogleheads conference.

Our special guest this month is Dr. Derek Horstmeyer a professor of Finance at George Mason University School of Business where he specialises in corporate finance. He writes a monthly column for the Wall Street Journal and the CFA Institute on cutting edge research in finance. His work has also been cited in Forbes, Bloomberg, CNBC, Fortune and other outlets. He's a dedicated teacher. He helped create and lead the first student managed investment fund at George Mason University, developed numerous programs at the college such as the MS in finance and CFA tracks, and currently serves as the Director of the new Financial Planning and Wealth Management major at the University.

One interesting aspect of the way Dr. Horstmeyer teaches is he encourages his students to do unique research and helps them get published. So with no further ado let me introduce Dr. Derek Horstmeyer. Welcome to Bogleheads on Investing

Derek Horstmeyer: Thank you sir. It's great to be here and please call me Derek. 

Rick Ferri: Thank you. Well you've written down a lot of topics. And what intrigued me about your writing, which I find all over the place in the Wall Street Journal and CFA Publications--I mean your name is out there--is the depth and the range of different topics that you talk about. And a lot of them have to do with individual investors and things that we should be aware of--whether we take action or not--we should be aware of it .

But the other thing that I'm very impressed with is that you bring your students into the conversation. You co-author a lot of these articles. So could you tell me first of all a little bit about yourself, your bio, and then how you bring your own students into this.

Derek Horstmeyer: Sure, yeah. To start off obviously I'm a professor at George Mason University. I've been there for about 10 years now. Before that I was at PhD student at USC and Stanford University, and yeah, it's been great. It really is just a great feature that you get to reach out to students. And they are enthusiastic to do help and to do this data work.

And not only that, I get employers reaching out all the time saying did John Smith actually co-author this Wall Street Journal piece with you. And it really opens doors for the students. It really is a win-win to have these students kind of help with this work and do the data work and have a phenomenal thing to have on their resume. 

Rick Ferri: Outside of being a professor you're also an avid swimmer and a squash player and a devoted fan to everything that is Reno, Nevada.

Derek Horstmeyer: Very true. Yeah I am a squash player first. Obviously your prime age for being a squash player is probably 25 to 30, so I'm a little bit over my prime there but I still try and play as much as possible. But oh man, is that a hard sport.

Rick Ferri: I have a piece of advice: try pickleball. All of us over the age of 50 are getting into pickleball, so maybe you're getting there.

Derek Horstmeyer: I’ll probably be there soon.

Rick Ferri: Okay very good. Well the way we're going to do this today is I've broken down all of these articles that you've written in the Wall Street Journal with your students and the articles that you wrote for the CFA Institute and their publications. And there were literally dozens of them on your website derekhorstmeyer.com. There's just a laundry list of all these articles. You publish one a month in the Wall Street Journal, one a month for the CFA Institute, plus others.

And I categorize them by individual Investments, portfolio management, taxes, and then the last one I call investor behavior. So four different categories I put them into for this interview. And so I'm going to start with investments.

So under investments they are individual investment categories. For example--and I'm going to throw this out there because this is something that I have been big on for a long time--high yield bonds, do they belong in a portfolio or do they not belong in a portfolio? On the Boglehead site you will find the camp is divided. I am on the side of yes they can add value. What did your research say about high yield bonds?

Derek Horstmeyer: The title of the article was Do Junk Bonds Pay Off In The Long Run and we found in general  they're basically in line with the Sharpe Ratio that you would expect. The funds that we were looking at were mutual funds and ETFs that had the word ‘High Yield’ or ‘Junk Bond’ or other names like that in the title of the fund. So we didn't look at the underlying D-rated or C-rated or BBB minus rated debt itself, but the fund that was carrying it. 

And in general what we found was comparable returns to the S&P 500 with a little bit lower correlation. So there are some diversification benefits here and a little bit lower volatility. So yes, it did seem on the whole that this could add some value to your portfolio. But again, don't expect that this is going to be a groundbreaking investment that's going to outperform the S&P by a significant amount.

For instance, to quantify what I'm saying, what we found was that over this 30-year period when we could study these things, the S&P delivered 7.8% and the high yield bond fund delivered 7.1% with a little bit lower volatility. 

Rick Ferri: Some people will say don't buy credit risk just buy treasuries and take your credit risk with equity. How do you feel about that strategy?

Derek Horstmeyer: Yeah, that's an interesting point. So I think this research would highlight that taking some credit risk in the bond market is appropriate just because, again, you're getting near S&P 500 returns over the long run. But it doesn't have a perfect correlation with the S&P, so again, what it's doing is slightly diversifying your positions.

We also noticed it had less crash risk. So we defined that as did the S&P 500 drop 4% in a month or more, and we found that high yield bonds had a lot less of these big drops on a monthly basis.

Rick Ferri: Interesting. Well let's go into another area of mostly non-investment grade fixed income, and this is preferred stock. This is another thing that I personally own in a fund, an ETF, an index fund--a small amount I've owned for many years. I also used to manage preferred stock portfolios. It's kind of unusual because it's such a small market, but I always felt that there was something there, and there's not a lot of research on this. But you did do an article and you did do some research on this. So can you talk about it? 

Derek Horstmeyer: Sure, yes indeed. So again, you're right. There's not a lot of funds out there that are concentrating on this. And so we were able to look back at 10 years of data from basically 2010 to 2020 on preferred shares. And we found that in general these came in around the returns and volatility of long-term bonds. So to put numbers to that, over the past 10-year period long-term bonds delivered about 7%. Preferred stocks delivered about 7.2% and with a little bit less volatility than long-term bonds. So again, an appropriate thing to add to a portfolio, and definitely to an equity portfolio.

But again, we didn't see some strange out of equilibrium behavior where preferred stocks absolutely knocked it out of the park. But again I will say this caveat. All of this data that we were looking at was a 10-year period, because again, we couldn't find any major funds that went back before the mid 2000’s.

Rick Ferri: And one other thing about preferred stock is there is a tax benefit to it for taxable investors. Was that part of your--first explain what that is--and then was it part of this calculation.

Derek Horstmeyer: So yeah, very good point. We looked at pre-tax returns and we compared everything on a pre-tax return basis not with the post-tax benefit of preferred stock.

I do want to say one thing before we move on is that all the things we're talking about today are not investment recommendations, we're just discussing these things. I don't want people who are listening here to get confused that we're actually making investment recommendations because we're not.

Rick Ferri: So the other thing about preferred stock that I personally like is I own it in my taxable account and a lot of the dividend yield that comes in is treated as a long-term capital gain because it's a stock dividend. It may be more tax efficient than owning a corporate bond, and again, it's a complicated asset class. It's not widely followed. 

Derek Horstmeyer: Of course.

Rick Ferri: All right. Well and then there was this one other area which I found very interesting. It affects a lot of people across a lot of different states and that is municipal bond performance by state. And I didn't realize how much of a difference there was.

Derek Horstmeyer: Very true. We were surprised by these results as well. We went out there and collected data on muni bond offerings. Obviously we're focusing here on the big states that have muni bond mutual funds or ETFs. So we were able to get about 15 different state offerings and calculate returns based on these different state funds.

And in some cases buying a muni offering for a particular state makes sense over the past 10- 15 years of data that we have--even if you don't get obviously the tax benefit of living in that state. So, for instance, to put numbers to this, Colorado and Missouri over the past 10-15 years have averaged about a 4% rate of return over that time period, and Maryland on the opposite end returned about 3%.  So there's about a 1% spread there. And again this is pre-tax.

Interesting to see that you get this big spread and it's not totally explained by risk just because we didn't see any significant differences between Colorado and Maryland in the volatility of these things.

Rick Ferri: Obviously it's not due to Colorado funds having lower fees than Maryland funds. I mean you factored that, correct?

Derek Horstmeyer: Yep, we factored that in. One idea that we had, and again it didn't fully pan out, maybe it could be the age of the population. So you can imagine maybe there's a bit more wealth in places like Maryland, and a bit older individuals, and so they all rush into the muni bond offerings and push rates of return down. So that was one theory. But that didn't line up with all the other states that we had in this data set.

Rick Ferri: And taxes--obviously if you're in California and you're paying 13% tax versus Texas and you're paying no taxes-- that doesn't explain it either?

Derek Horstmeyer: That doesn't explain it either. From what I can tell, w looked at Florida--was really high up on the return list--and so I think Florida had something like a 3.9%, something like that, rate of return over the past 10-15 years and to the best of my knowledge Florida's a pretty darn low tax state. That's why a lot of people move there.

Rick Ferri: Yeah and I'll ask one more question about this and that is, is it a factor of the makeup of the portfolio, were there a lot of hospital bonds in Maryland versus general obligation bonds in Colorado. I have that backwards

Derek Horstmeyer: No, that's a great thing. We didn't dive into the actual holdings, but again, we did look at the volatility. The volatility was pretty close across the whole spectrum of 15 different states that we looked at.

Rick Ferri: So the volatility was the same. It was only the performance that was different.

Derek Horstmeyer: It was only the performance, and we're not talking again about huge spreads but a one percentage point spread per year is pretty big. And again that's the top performer against the bottom performer.

Rick Ferri: Well let's go into another topic and this has to do with inflation. So we've had a bout of inflation here and everyone is wondering where should I be putting my money if I want to hedge against inflation. And you've written a couple of articles about this.

Derek Horstmeyer: Yes, it's always a fascinating topic. How do you preserve your money or how do you just have something that just correlates positively with inflation. Obviously a lot of people piled into TIPS, Treasury Inflation Protected Securities, and then they had a horrible 2022 because the ramp up in price happened at the very beginning of 2022 or even end of 2021.

And so you think the things that are going to protect you don't do as well. And so we looked at this. Not surprisingly, S&P does really poorly during inflationary periods. Again we looked from

1970. So I should be very clear. This data came from 1970 to 2021. So before the most recent big bout of inflation.

Something else we saw, not surprisingly, real estate actually hedges very well, and did very well during high inflationary periods.  This is tangible real estate. It should be very clear, not REITs but tangible real estate. And not surprisingly, oil, gold, and silver were the best performers over the high inflationary periods and the two worst performers, the S&P 500 and intermediate bonds.

Rick Ferri: Well that wasn't good for last year.

Derek Horstmeyer: Exactly. Yeah So this data was up to 2020 - 2021. And then obviously we saw it play out exactly like that, or close to like that last year.

Rick Ferri: It was funny about--last year people who may have bought gold at the beginning of last year when inflation was coming back-- were disappointed that it didn't do well. And I think he had to look back and see what the price of gold did as soon as the pandemic hit. Everybody started hoarding gold so the price of gold shot up four or five hundred dollars an ounce as soon as the pandemic hit and there wasn't any inflation. It was probably deflation during that period of time. And then when inflation came rolling around and gold didn't do anything, it actually went down and I was telling people, well you already had the gain. The gain occurred before there was even inflation- not that people were anticipating inflation--they were just hoarding gold at that time too because of what was going on in the world.

Real estate does a good job of hedging inflation but not if interest rates are also going up and you have a pandemic and occupancy rates start going down and you start seeing foreclosures in a banking crisis all at the same time. So it's period specific but in general -

Derek Horstmeyer: In general you're exactly right. There’s a lot going on in the past three years and so we can't just isolate it to inflation.

Rick Ferri: Let's go on to the next part of this, which we started to work on a little bit, which is portfolio management. And you've written a lot of articles about portfolio management, both active and passive. And I first want to talk about an article that you wrote which I thought was very interesting. Is it better to roll your own--pardon my French--roll your own portfolio by buying a few broad market index funds than it is to use a one and done target date fund?  There's a lot of people who will happily create their own index fund portfolio, or if it's easier, use a target date fund. And what did you find there?

Derek Horstmeyer: Yeah. This obviously takes some effort but we looked back and said are you getting fleeced on your target date fund, for lack of a better word. And so we said could you construct your own and do better here. And what we found was, in general, you could construct your own for about 10 basis points less per year. So you're saving 10 basis points by constructing your own. And obviously that takes a bit of effort. So again to put numbers to this we were looking at the average target date fund charging you about 30 basis points a year and using the same fund family bond and equity holdings you could create that same portfolio for 20 basis points. So they're charging you 30 basis points. You could go in there and using the same thing that they're using you could do it for 20 basis points. So they're kind of taking 10 basis points from you for the management and for shifting it over time. That's what we found, and we found that the longer you went out on the target date spectrum, say the 2060 target date funds, those are the ones where they were charging the most. 

Rick Ferri: Really?

Derek Horstmeyer: Interesting enough, they're charging the young kids.

Rick Ferri: More money.

Derek Horstmeyer: Yeah, more money to manage these things. And so this adds up over time. We calculated if you did it yourself over a 10-year period you would have an extra 3% return if you just did it yourself.

Rick Ferri: Oh wow! That's fairly significant.

Interesting offshoot of what you just said, that the fund companies are charging you 10 basis points. Some may be a little bit more to do the portfolio management. So you could go to a mutual fund company, Vanguard or whomever, and for 10 basis points you can get a pretty darn good portfolio managed for you, and I tongue-in-cheek look at that and say, well why are investment advisors charging a hundred basis points to do the same thing.

Derek Horstmeyer: Yeah, very good point. You wonder how they stay in business.

Rick Ferri: Well they stay in business because people think they're getting what's called value added. But anyway we'll go, that's a different topic. All right now we're going to get into the active versus passive debate a little here, and you've written quite a bit about active management. And we have a three-fund portfolio--Boglehead portfolios-- you refer to them as lazy portfolios in your article, versus what's called a valuation based, which if you could explain what that is, but it's active management. So how do they compare?

Derek Horstmeyer: Very good. So this was one that just came out a month ago for the Wall Street Journal, and it won't surprise anyone in this group, that time in the market doesn't work. Well we looked at this one--was the age-old Fama versus Schiller debate--they both won Nobel prizes 10 years ago for their work in market efficiency. Eugene Fama comes down on the efficient side and Schiller would always say you could time the market based on the P/E ratios or his CAPE Ratio. And so what we did was we said well does that still hold true. We looked at how the P/E ratio changes in our market and we kind of followed his advice from back in the ‘70s which said if the P/E ratio is very high at 20 or above you should shift over to a bond portfolio-- we used  70% bonds, 30% equity. And if the P/E ratio for the market goes down below 12 then you should shift over to equities, and again, 70% equities, 30% bonds. And we tested the strategy. Does this work, does this help you on a risk-adjusted basis.

Rick Ferri: Relative to what portfolio, what was the passive portfolio?

Derek Horstmeyer: The passive portfolio was just 50/50. 

Rick Ferri: Ah good. Okay thank you.

Derek Horstmeyer: Which is 50/50. So if you formed a 50/50 portfolio, how would you compare against this. And not surprisingly, it hasn't done well. Interestingly enough, before 1950 this actually juiced returns a little bit, but since then nope, you'd be underperforming, and again, I think to most people this wouldn't surprise anyone just because basically using the strategy you would have been out of equities since 1995 for the most part. It would have been really out of equities, and obviously we've seen crazy strong growth in equity since 1985. So it was interesting.  We also updated this and tried to move the valuation points so that it made sense in a post-2000 world, and still we saw no results. 

Rick Ferri: Interesting.

Derek Horstmeyer: Yeah we kind of biased it and moved things up--still no risk-adjusted returns. I followed this strategy that Schiller lined out and partially won a Nobel Prize for.

Rick Ferri: It's interesting that you said something, prior to 1950 it worked because it seems like market structures do evolve. When Fama/French came out with their three-factor model showing that the determinants of portfolio return were both the market beta, the size of the stocks in the portfolio, and whether they had high price to book or low price to book basically, and since that time, at least the size portion hasn't really materialized.

Derek Horstmeyer: Oh yeah.

Rick Ferri: Again, they looked at data going back prior to 1994 and it worked really well. But then from ‘94 coming forward it just hasn't seen--at least the size premium hasn't worked--the value versus growth has been very difficult lately, but we think it should work, I think in the long term because it's a sort of a fundamental reason why it should work. But what is interesting is that the dynamics of the market do seem to change over the long term as taxation on buybacks change, and dividend structure-- I mean all these things change--causing companies to react. And it causes changes in the marketplace.

Derek Horstmeyer: Nope, very true. It's been a bad 15 years for small caps. Everyone swore that you could juice returns by going with small caps and small caps haven't done well, and obviously up until a year ago value stocks obviously didn't do well. Growth had this great decade obviously due to low interest rates and a few other things.

Rick Ferri: Yeah, well talking about large and small. Let's talk about another paper you wrote which is, Look If I'm Going To Invest In An Actively Managed Fund Should I Invest In a Large Actively Managed Fund Or A Small Actively Managed Fund. Intuitively I'd say well I want a small fund where the manager has maneuverability. But you did some work on this.

Derek Horstmeyer: Yeah it was interesting to find that your biggest actively managed funds actually did better than the small funds, on average, after taxes. This was a little interesting to us because we thought you're right, you would go with a small fund just because it had more maneuverability like you said, or ability to fly below the radar and maybe not have their strategies mimicked.  A big fund would just be kind of lumbering and bloated. But we didn't really find that. We found that small funds had more turnover and therefore were less tax efficient. And while the big guys didn't trade as much, that actually worked to your advantage. 

Rick Ferri: Let's go on to another way of picking actively managed funds, and this is do we go with the fund manager who's been around for 35 years. What, do we hire the fund manager who is right out of one of the Ivy League colleges, 30 years old.  How does age and experience work in this marketplace?

Derek Horstmeyer: Yeah, again this is for active mutual funds. We looked at 20 years of data and looked at how did the short-tenured managers compare against the long-tenured individuals? And I don't think it would surprise anyone the long-tenured fund managers were on average, on a post-tax basis, a little bit better than your rookies. But they didn't have that right tail to their distribution. So in other words they didn't hit a lot of home runs. They were just kind of steady Eddies, they just delivered you a very close return to the benchmark. Some would call that almost closet indexing--that's a term that people have thrown out at some active fund managers that are just trying to follow the index when they should be doing more active management. 

And then the rookies on average underperformed. But every once in a while you had a rookie that just did very well-- knocked it out of the park, took on a lot of risk--but it worked out. So if you want big and boring you go with the individual that's long-tenured.  If you want to take on some risk and maybe have a winner then you go with the rookie. But on average they underperformed.

Rick Ferri: We talked about a lot of investments, strategies of the active managers versus the passive, and how you might try to choose an active fund that might outperform. Experience of the manager, the size of the fund, valuation models. But how important--I guess the elephant in the room is fees. Fees, there's been studies out there. What did you find about fees?

Derek Horstmeyer: Sure. It's not going to surprise anyone. I should say that all of these past results-- doesn’t matter if you're a rookie or a long-tenured manager--you are still underperforming the benchmark over a 10-year period. Obviously to this group that's not going to surprise anyone. Now when we looked at fees, fees were the single determinant of long-run return. It's your turnover and then your fees. It's how tax efficient you are. And then what you're charging. And we looked at the most egregious mutual funds out there in terms of fees. They are charging more than 1.5% per year. And these were just the worst performers. It's amazing these funds still exist out there, but there's quite a few of them that are still charging 1.5% or more to manage a fund.

And not only did they underperform by 1.5%, they underperformed by about 2% on average. So not only do they charge you a lot, they did worse than their fee structure would suggest. Again obviously I'm preaching to the choir here, but if somebody's charging you 1.5% to manage something, you just don't touch it with a 10-foot pole.

Derek Horstmeyer: True. Or these are being crammed in really bad 401-k offerings.

Rick Ferri: Oh is that right?

Derek Horstmeyer: Well yeah. I haven't written on this but I've done some consulting work and looked at very small companies--just get the dregs of the 401-k offerings--and a lot of times these awful offerings are crammed in there.

Rick Ferri: Oh all right, now we're going to get into a couple of controversial active management strategies and those will be the last two questions on this. ESG, environmental social and governance. A lot of information out there on this. Big fight in Washington D.C. now over this. Is it alpha enhancing? Are they really helping the world? Is it just a fad? What did you find out? 

Derek Horstmeyer: Yep. The evidence goes back and forth and in general ESG funds are just going to probably match the benchmark over the long run. I know energy has had a good past  year. So ESG underperformed during that period. But we kind of looked at a different tack and said what are you really getting with ESG in terms of your correlation coefficients? What is it moving with? What risks are you exposed to? 

And what we found was because when an ESG portfolio is formed they need to cut something, they are obviously cutting energy. They need to add something to make up for that, and so not surprisingly a lot of tech companies out there have good ESG ratings. So what we found was if you invest in an ESG fund you have a higher correlation with tech, and you have a higher correlation with the Russell 2000. You're taking on more small cap risk and more tech risk. 

Rick Ferri: I see.

Derek Horstmeyer: And because of that you actually had close to the same level of correlation with the change in oil prices, which was kind of another thing. ESG funds were about the same level of correlation with the underlying price of oil.

Rick Ferri: Correlated with the price of oil. So if the price of oil goes up everybody's looking at alternative energies. So maybe some of these funds that specialize in that do better.

Derek Horstmeyer: Yeah. So we found the S&P had a correlation of 0.22 with change in oil prices and ESG funds on average 0.23, a little bit higher correlation to oil.

Rick Ferri: Interesting. All right we're going to get into the last one about active management and it's the one on everybody's mind, or I should say on everybody's computer, and that is AI, artificial intelligence. Is this the new active management? Is there hope for buying a fund that employs AI and this will outperform? Is this it?

Derek Horstmeyer: We did a deep dive. We got access to one particular AI fund--even the person that was running it couldn't explain, kind of just said that it's a black box and it's trained on this past data and I don't know what it's doing. And it would try and predict and move in and out of the market. And this particular one actually did an okay job. It had much higher risk, Sharpe Ratio was pretty comparable, but it was moving in and out on a daily basis. We're trying to figure out what is going on inside this black box that's making it sell out on these days and we got some insight but we couldn't tell.

Rick Ferri: Well you're not supposed to or you're supposed to be smarter than humans.

Derek Horstmeyer: Exactly. And so this one was taking on excessive risk and it did pretty well, but again on a Sharpe Ratio basis, kind of matched the S& P 500, but you're right, if AI is going to work then all the AIs will just be trading and then…

Rick Ferri: Then it won't work.

Derek Horstmeyer: Then it won’t work, exactly.

Rick Ferri: It works until it doesn't.

Derek Horstmeyer: It works until it doesn't. There's an equilibrium, it has to be.

Rick Ferri: All right, let's get off of this topic of portfolio management and get into something that we all love and that's taxes. We've all just recently paid our taxes, or did our taxes, so we've realized that funds--some of them–distribute capital gains at the end of the year even in years where the markets are down. We all realize that some funds are distributing dividends, and maybe some of the dividends are not too tax efficient. And we learn a lot about what we own if we really start to study our tax returns. Because it can really affect our after-tax returns. So you did a lot of work on taxes and mutual funds and ETFs. Let's talk first about turnover within a fund and how does that affect taxes?

Derek Horstmeyer: Sure I've always told my students this, and I've always been told this--well you should just look to the turnover of a fund and that'll tell you how tax efficient it is. So we took a step back and said well how true is that? Can you just look at the turnover of an actively managed fund or even an index fund and does that predict how tax efficient it is? And it was pretty much a muddled picture. Some funds were better and some funds weren't, but on average it was kind of just a wash. And so what I mean by that was we separated within asset classes. We looked at high turnover funds and low turnover funds. On average they kind of just had the same tax efficiency. And so we started thinking there's a lot that's captured by a turnover measure. It doesn't separate out are you trading short-term capital gains? Are you incurring long-term capital gains? Are you maybe trying to tax loss harvest? All these things that are going into the underlying turnover measure. And so that is kind of lost in one simple measure. And so that was our ending conclusion. You can't really see that with a turnover measure.

Rick Ferri: Interesting. You did do work on the ETF structure versus the open-end mutual fund structure, the traditional open-end mutual fund structure, and you did come through a different conclusion about ETFs versus traditional open-end mutual funds.

Derek Horstmeyer: Yes indeed. Again, another thing that I've always been told is that ETFs are more tax efficient but I've never heard a quantifier, literally how much more tax efficient they are.  And so we designed this pretty simple study where we looked at within a fund family, so it had to be the same fund family. It had to be the same benchmark, the same expense ratio--within two basis points--and the same underlying holdings. For instance, we looked at Charles Schwab, Charles Schwab S&P 500 ETF compared to the Charles Schwab S&P 500 Index Fund. I'm not sure if those two were in our study, but I'm just giving an example. So it's the same holding, same everything

Rick Ferri: Almost identical.

Derek Horstmeyer: Almost identical, same expense ratio, same everything except one is a mutual fund and another is an ETF. And then we looked at how much has their performance differed. And what we found was it differs by about 20 basis points to 25 basis points per year.

Rick Ferri: That's what the benefit to the taxable investor was.

Derek Horstmeyer: Yes, on a post-tax basis the ETF outperformed by about 20 basis points.

Rick Ferri: Wow that's a lot.

Derek Horstmeyer: Yeah it's significant and again obviously this is due to the redeeming in kind feature of ETFs. But that adds up over time, that 20 basis points. That's if you're holding that in a taxable account. That's a percentage point every four years or so.

Rick Ferri: Sure. Now Vanguard is a little different .Their structure is different. Can you explain that, and then why it really wouldn't fit into this study?

Derek Horstmeyer: Sure .Yeah Vanguard was omitted from our study just because their ETFs and mutual funds have the same post-tax returns, net of the difference in the expense ratios. And that is again because of this patented system that Vanguard has which basically gives the same benefits that an ETF has to the mutual funds. I believe that the patent is--I've read it is expiring soon.

Rick Ferri: it is expiring but it doesn't mean they're going to stop doing it. It just means others don't have to pay Vanguard to do it .

Derek Horstmeyer: Yes exactly. Which will be good because then other groups will have this same benefit and it'll be more tax efficient for all, hopefully. 

Rick Ferri: You would think though, over the years, that since it was a really good idea back 20 years ago when they did this at Vanguard, you would have thought that if it was, other fund companies would have just paid Vanguard some fee to use the patent. But I've heard all kinds of different stories about why that never happened. Some of it had to do with the fund companies not wanting to pay Vanguard anything. And then other times I've heard that Vanguard wasn't interested in leasing the patent to anyone. But it is coming off patent I understand and maybe--in fact I have seen and heard of companies that are preparing to launch products where the open end fund and the ETF are a share class of the same underlying portfolio, so they'd be treated the same for taxes.

Derek Horstmeyer: Interesting.

Rick Ferri: Another section of taxes, tax loss harvesting. You did a lot of work on this. Now you did it with individual stocks, but if you've also done some work on just tax loss harvesting of ETFs within a taxable portfolio, that would be helpful. So tell me what is tax loss harvesting and what's the benefit.

Derek Horstmeyer: Sure. Again I should give the caveat here that tax loss harvesting is very unique to a particular situation, but we try to capture how much could one individual juice returns by tax loss harvesting. So again the idea here with tax loss harvesting is you sell loser stocks to offset some capital gains tax liability. And we did a lot of simulations. Here we looked at past 50 years of data and not surprisingly during high volatility periods or strong down years, that's when tax loss harvesting could juice your returns the most. And on average, on down years or high volatility years, we saw you could add about 2% on that year by tax loss harvesting. But over the long run, on average, you're looking about I would say a percent or so return that could be added to your portfolio by tax loss harvesting.

Rick Ferri: To make it clear you add it to your return because eventually you have capital gains.

Derek Horstmeyer: Yes.

Rick Ferri: Because you're only allowed to write off three thousand dollars a year of losses against your income. So if you don't have any gains. But if you have gains then you could write off these losses against those gains. So when you're talking about in the long term adding one percent, you're assuming you're going to have gains from, I don't know, the sale of a piece of property, the sale of a business, even the sale of your primary home if it goes over the $250,000 or $500,000 limit if you're single or if you're married. And therefore this is how you make up that one percent.

Derek Horstmeyer: Yes, yeah. So again we're generalizing here to something that's incredibly individual-specific. Tax loss harvesting obviously is most beneficial when you're going to incur a very large taxable event. I don't know, a sale of a business or something.

Rick Ferri: So well that breaks things into another question I have, and I don't know if you've written on this or not. I didn't see anything. It has called direct indexing, and this is where instead of just buying the S&P 500 or the total stock market index fund, you go out and you hire a company--and even Vanguard does this now--so it's widely sold out there, and I will say sold---so that you end up with a portfolio of 500 different stocks or a thousand stocks in your portfolio, literally an 85 page account statement every month of individual securities. But the program sells the losers, generates tax losses, and then rebuys or fills in or substitutes, or the different programs do it in different ways. Wait 30 days, rebuy it back.. And you generate quite a bit of tax loss in a year or two, when you might need it. In other words you're going to sell a business or you've got a big single security that you're going to be selling and there's a big capital gain. You want to maximize the losses. So that's how direct indexing is sold. On the downside you have to pay fees on that pretty much for the rest of your life because what are you going to do with a thousand stocks. My views of direct indexing might not be as rosy as the people who are selling this product but what are your views on direct indexing?

Derek Horstmeyer: I was hearing so much about this about a year ago and then it kind of dissipated. I wish I could say more about this. I just haven't dug into the data. I don't know if there is data availability yet because again, to the best of my knowledge, it's individually created for a person. Correct me if I'm wrong, but it was--I remember hearing O'Shaughnessy, hopefully I'm pronouncing that name right-- they were on TV a year ago really propping this thing up and saying how great it was. But I haven't heard much since then.

Rick Ferri: Direct indexing firms, if you had created the software to do it became extremely valuable, the companies themselves. Wealthfront was almost sold to UBS at extremely high valuation because of the direct indexing products. I mean these direct indexing companies were going for crazy multiples and then it disappeared. You're right. I mean last year, 2022, when the market went down it all stopped. In fact UBS backed out of the deal with Wealthfront. I will admit there are individuals who could use this as long as there's some sort of an exit strategy to get out of it so you don't for the rest of your life have an 85-page statement and have to pay fees.

Let's go on to the last phase, the last part of this, and that is investor behavior and particularly I think I want to get to a little bit of performance chasing. We hit on this with the Fama-French three factor model a little bit. Where when it first came out Dimensional Fund Advisors adopted it and they started promoting three-factor investing. And then Rob Arnott and Research Affiliates came out with fundamental indexing. And all of a sudden smart beta was the big thing. It didn't really pan out as far as the performance, since it got to be really popular. Even though these things are academic based, sometimes they don't actually work. And my question to you as an academic is how much weight should investors put on these new academic discoveries about investing, or should they wait to partake in them for at least 20 or 25 years to see if it actually works in reality?

Derek Horstmeyer: Yeah, it's an interesting phenomenon. At Boston College, who've been writing a lot on this and their names just slipped my mind. But they published a number of works that go back and look at anomalies. Anytime an anomaly is announced it disappears pretty quickly. So there's a lot of writing in finance that goes and looks at an anomaly. This could be the, I don't know, January effect anomaly. It could be any of this, and as soon as it's published it disappears. 

And that's kind of what we've seen with this five factor model. For those who don't know about it, it isolates how small companies do against big companies, how high book to market do against low book to market. Three factors plus what we call a quality factor. All the factors really haven't done well since the year 2000 except for the quality factor.

Rick Ferri: By quality you mean quality of earnings. 

Derek Horstmeyer: Yep. People have different definitions for this, but you know Vanguard has a quality ETF. A lot of others do, and it's companies that have positive Return on Assets (ROA) and growing ROA.

Rick Ferri: Yeah that has done well. But that's a later factor, right. I mean that came out later on.

Derek Horstmeyer: Yes that came out really recently. That has come out in the past 10 to 15 years if I'm not mistaken. 

Rick Ferri: I think the fourth factor that came out was momentum, and Cliff Asness did a lot of work on that at the University of Chicago. It is a dissertation on that. I had him on the show and then this quality--I believe was the fifth factor that came even later than momentum. Correct me if I'm wrong, but I think that's the lineage.

Derek Horstmeyer: Definitely correct. That came out with a group of researchers at the University of Rochester

Rick Ferri: So it hasn't had time yet to go awry. 

Derek Horstmeyer: Yes.

Rick Ferri: I don't know. I'm just saying it seems to me that even in the academic world, or taking what's called evidence-based investing-- this is a term that I never liked but it's out there-- and saying look, here's the evidence from the past, therefore it's going to--I don't say it's going to be the future--but there's evidence that it'll be there in the future. And I just never bought into that. But it sold a lot out there, evidence-based investing. It's sold as being scientific, a scientific way to invest. And I don't know, to me that's just marketing. What do you think? 

Derek Horstmeyer: Yeah I think it's… we always need a new marketing gimmick, like you said

Rick Ferri: Smart beta.

Derek Horstmeyer: Yeah, and then there were dynamically adjusted multi-factor ETFs. I haven't heard from those in a while. But you always need to come up with something that seems to fit the bill even better. But it disappears quickly and again, if people are curious to read this research that really does go through the 200 anomalies that we've identified, it's a gentleman named Jeff Pontiff at Boston College who's done a lot of work and chronicles and shows you just how much once something's talked about, it disappears quickly. So Jeff Pontiff.

Rick Ferri: All right. So you know Bogleheads philosophy is buy a few low-cost index funds, broad market index funds, rebalance if you can-- I mean and you'll probably use your tax-advantaged accounts to do rebalancing, or new money to rebalance, and so that you can be tax efficient and stay the course. How does this sound to you as an academic who has studied all this other stuff?  It's a loaded question by the way. 

Derek Horstmeyer: I've been part of this group for 20 plus years. It still seems to hold true in the data. You know there's no magical solution here, just being low cost and tax efficient is 98 - 99 percent of what you can do over the long run. Doesn't matter if you're an active manager and you think you can beat the market over the long run. You're going to underperform, it's just a matter of time. The way I explain it to my students, because they're always so gung-ho and because they read about, I don't know, Renaissance Technology or some hedge fund out there that we think is beating the market and I say well even if there are a few that can beat the market they don't want your money. They're not taking your money.

Rick Ferri: Right.

Derek Horstmeyer: If a hedge fund is asking for your money, you're probably going to lose money with that hedge fund.

Rick Ferri: So true.

Derek Horstmeyer: Yeah. So being tax efficient, low cost is the best you can do.

Rick Ferri: And stay the course.

Derek Horstmeyer: Stay the course.

Rick Ferri: Well Derek, thank you so much for being on Bogleheads on Investing.  I really enjoyed having you here today.  It's always great to get these different perspectives, and I've got to give you a lot of credit for what you're doing at your school, getting these young people involved, not just having them do projects but you being a real advocate for them, getting them published.  I mean that is so huge for them in their careers. Continue the great work.

Derek Horstmeyer: Well thank you for having me on this podcast.  It's been great.

Rick Ferri: This concludes this episode of Bogleheads on Investing.  Join us each month as we interview a new guest on a new topic.  In the meantime visit Boglecenter.net, Bogleheads.org, the Bogleheads Wiki, Bogleheads Twitter.  Listen live each week to Bogleheads Live on Twitter Spaces, the Bogleheads Youtube channel, Bogleheads Facebook, Bogleheads Reddit. Join one of your local Bogleheads chapters and get others to join. Thanks for listening.

About the author 

Rick Ferri

Investment adviser, analyst, author and industry consultant


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