Alex Bryan  6:35  

But in any case, there’s a lot of evidence that suggests that many active managers, in general, have a very difficult time outperforming the market. In order to understand why, it’s important to understand that active management is a zero sum game. So, in order for one investor to outperform the market, someone else has to underperform. 

So in aggregate, because active managers or active investors are defining the market, before fees, their asset weighted performance should be very similar to a representative indexes. But after fees, because active managers charge more than an index fund does, they should lag on average. And I think that’s why you see most active managers underperforming their index.

Preston Pysh  7:18  

The thing I think a lot of people don’t realize is, when you’re 1% or 2% difference from what the market’s performing, and then you compound that over a 30-year, 40-year period, you’re talking hundreds of thousands, if not millions of dollars, for people. And I really think that it’s very delusional for a lot of people because they’re like, “Oh, well, it’s just a 1% fee that I’m paying for somebody to actively manage my fund.” They don’t really realize that, (a) he’s not outperforming an index and (b) that 1% really adds up to a lot of dollars in the long run. So yeah, that’s some very interesting points.

Alex Bryan  7:52  

Absolutely. I’d like to mention that this distinction between active and passive is an important one. I think there’s a really strong case to be made for taking a passive approach to investing because of these cost savings. But that’s not the same thing as saying that mutual funds as a vehicle don’t have any future left in them. 

In fact, I was looking at the flows into mutual funds, looking at the division between active mutual funds and passive mutual funds. And actually, passive mutual funds, funds that track an index, have actually had a lot of money flowing into them, while active mutual funds have had a lot of money flowing out of them. 

So investors, it’s not really an important distinction whether you go with the ETF vehicle or the mutual fund vehicle. The more important distinction is whether you go with an active strategy or a passive strategy. Now, it’s true, most mutual funds do tend to be actively managed, but there are some good low cost passive index mutual funds that are available to investors. 

Preston Pysh  8:50  

Yeah. And I think that’s become really popular in the last… I know back in the 90s, you’d have to pay 2.5% just to get into a mutual fund, then you’d have another 2% annual fee. I mean, it was just crazy. And I think that because of the competitive nature and I think that so many people will realize that a lot of these mutual funds are not outperforming the index or the market in general. They’ve had to bring those fees down or else it was just going to be a total collapse of the whole vehicle, the mutual fund vehicle. Hey Stig, go ahead and go with the other question.

Stig Brodersen  9:24  

Okay, Alex. So while most active managers don’t outperform after fees, there are a lot of ETFs that deviate from market cap waiting in an attempt to outperform traditional indexes. Do any of these funds have any merits?

Alex Bryan  9:39  

Sure. So, there are a few strategies that have historically worked well in nearly every market studied over long time horizons. So I’ll briefly summarize some of these. So there’s value, buying assets that are cheap. Warren Buffett is known for doing that. There’s quality buying stocks with strong profitability and stable earnings. 

Low volatility bonds [and] stocks that haven’t moved around a lot, but tend to be more defensive and can weather the business cycle of grace, and that’s related to quality up to a certain extent. And then there’s momentum, which is buying assets that have recently outperformed.

Now, there’s a long and interesting literature on why these strategies work. But most explanations center around risk. A strategy of buying stocks that are cheap could be, in fact, taking on more risk. And so, you would expect to be compensated for that risk in the form of higher expected returns. So for example, a company like Series may look very cheap, but there’s a risk that it can become cheaper or go out of business. So if I buy a portfolio of stocks that are cheap, I may expect to earn higher returns for taking on that risk.

The other explanation is that there could be behavioral biases that create misprice in stocks. So investors may extrapolate past growth too far into the future and that could potentially push prices away from their feared value. If investors are really excited about what’s going on Amazon *inaudible* growth, they may be willing to overpay in order to purchase Amazon.

Let’s count the more boring, slower growing stocks like Hewlett Packard or Lexmark. Investors should look for funds that charge significantly less than actively managed alternatives and that have a simple transparent methodology. Complexity is often a sign of data mining. Remember, there’s only a handful of strategies that have been really well-vetted by the academic community. And those are the ones that I mentioned. 

So if you’re looking at a strategy that does something more complex, it’s worth being skeptical of that strategy. Also, it’s important to remember that a lot of times there are similar alternatives that offer comparable exposure for a lower fee. So we like to see transparency, we like to see low fees with these smart beta ETFs.

Stig Brodersen  11:55  

Alex, I have a follow up question to that because one thing that you spoke about regarding those ETFs was risks. So you’re saying that it might even be like lower risk, it might be higher risk, but how do you define risk when you’re talking about something like an ETF?

Alex Bryan  12:11  

That’s a great question. So there’s a lot of ways to define risk, but I think the most useful is a probability of loss and magnitude loss when it does occur. It’s difficult to get a handle on how you measure risk. One way we like to look at risk is volatility. So [it’s] looking at how much an ETF or a fund moves around. The more volatile a fund is, the wider the dispersion and possible outcomes, so the greater the probability of loss is.

Another way that a lot of investors look at risk is tracking error or the risk of underperforming the market for an extended period of time. Now, when you take any of these smart beta type bets such as buying stocks that are cheap, there’s a risk that these things, even if they work well over the very long term, they can underperform for many years. 

So if I’m an investor in the strategies, I have to be comfortable with that risk of potentially underperforming during a potentially bad time. Value, it looks really great if you go all the way back to the 1920s. But during the financial crisis of 2008-2009, value strategies underperformed because they were overweight in financials. So you have to be comfortable with these risks that you’re taking on and really have a long term horizon to profit from them. 

Preston Pysh  13:27  

Yeah, that last part  is the really important part. I think a lot of people, they think, “Oh, I’m making these decisions, and I’m going to hold it for five years.” 

They think that that’s long term. But I think that when you look at a guy like Buffett or Charlie Munger or all these other amazing financial investors that use a value approach, I mean, they’re truly buying it to own it forever. They’re buying it as an equity purchase and they don’t ever plan on selling it. So your last point’s very important.

Stig Brodersen  13:54  

Yeah. And [let’s] keep speaking about risk. This is really an interesting topic. Alex, would you say that by investing in ETS with hundreds of companies, you’re actually limiting your risk, partly because you are investing in that huge amount of companies, but also because you might be buying ETFs in larger companies that might be less risky?

Alex Bryan  14:16  

Absolutely. So the extent that stocks in a portfolio are not perfectly correlated, you can reduce your overall risk by combining them in a portfolio, right? So that’s because these stocks, their volatility can offset one another to a certain extent. So, let’s take a really simple example.

Let’s say you have two companies. One just makes sunblock, another just makes umbrellas. The umbrella company is going to have a lot of sales, at the time when the sunblock company is going to have low sales and vice versa. 

So, this idea of combining stocks into a portfolio is useful from that perspective. You intend to offset your gains and losses by having a lot of different companies that are not perfectly correlated with one another. So an ETF is useful because it reduces this risk. It spreads this risk out among the large number of companies.

Now, there’s a lot of different ways that you can make targeted bets of ETF. So there’s ETFs that target small cap stocks, there’s ETS that target the broad market. Anytime you’re deviating from a broad market ETF, you are taking on potentially more risk. 

So for example, investing in a small cap ETF will tend to be more volatile than large cap ETF and that’s because small cap companies do tend to be more sensitive to the business cycle than their large cap counterparts. But in any case, diversification is always a good plan no matter what you’re doing. 

You’re not paid to take on a company’s specific risks. So if I just hold one company in my portfolio, I’m taking a lot of risks that I could have diversified away, had I held the stock in a broader portfolio. So that’s not a necessary risk. I want to get rid of that risk to the extent that I can by using a diversified ETF or a diversified mutual fund.

Preston Pysh  16:04  

And I think for the audience, I think a lot of people need to understand that the most important thing you’ve got to do is protect your principal. For these people that go out there and think that the most important thing to do is to get a 70% return for the year, that’s fun, that’s exciting, and that’s really awesome if you can do it in one year.

But the fact of the matter is, the person who can protect their principal and minimize their losses is probably the most important thing you can do. Because if you can grow it at 10 or 20% every year and on the down years only lose maybe 1% to 3%, that’s a person who’s really going to have enormous amount of financial success because typically, the person who has that 70% year, the following year, they have a 120% loss that they don’t tell you about. 

So this discussion about risk mitigation, how do I protect my principal, is something that separates professional investors [and] insiders from people that are just really amateurs and don’t know what they’re doing. So great discussion there on the risk. Stig, is there something you want to say?

Stig Brodersen  17:15  

Yeah. Because you know, I don’t own any ETFs myself. But I think the whole idea of passive madness ETF is, for most investors it is really good idea because when you hear about these people who are making like as *inaudible* 70% a year, it is impossible if you own an ETF. 

Almost impossible, because you might only be owning 100 shares. And these guys would make like 70% or  100% a year. They might only be holding one or two, say, a tech stock, for instance. So they’re taking a huge risk which you don’t see. You only see and hear about the returns. And as Preston’s saying, next year they might go broke.

Alex Bryan  17:51  

So absolutely mitigating risk on the downside, that separates the professionals from the amateurs.It’s really difficult to overcome a large loss because a lot of investors don’t have the emotional fortitude to stick with a portfolio through those painful times. And if you stick to an index portfolio, that can help take the emotion out of the equation. You don’t have to worry about, Is this manager, someone I should fire because he underperformed in this year? You’re really sticking with this broad based index portfolio and that I think will serve investors well over the long term. 

Preston Pysh  18:34  

Hey, so I got a question for you. I actually do not like being asked these kind of questions, so I apologize. If you don’t want to answer the first part of this question, I completely understand. But I’m gonna throw it out there anyway because I’m just curious if you will answer it. If not, then we’ll just focus on the second part. 

So the question is this, what are your top two favorite ETFs and why? For example, maybe you could throw out there because they have a certain expense ratio, they have a good track record, the bid-ask ratio is good, whatever. And if you’re not comfortable naming that we completely understand. But, what would be your thought process? How would you go through assessing it at a very generic and high level? How would you go through assessing the pic of an ETF?

Alex Bryan  19:16  

So one of the funds that I like is Schwab U.S. dividend Equity ETF ticker (SCHD) and that targets dividend paying stocks with high cash flow relative to their debts, high return equity, high dividend yields, and high five-year dividend growth rate. This gives it both a quality tilt and a value tilt which may help it perform a little bit better than the market during downturns. 

So, we talked about mitigating downside risk or reducing the risk of substantial losses. I think this is a fund that can help investors weather market downturns better than most. As a result, that may help boost his long term performance. Those are some of the reasons why I like this particular fund.

But one of the best things about this fund is its expense ratio, which is only 7 basis points or $7 for every $10,000 that you invest in it. That’s comparably priced to a traditional s&p 500 index fund. So I talked about the importance of looking for smart beta funds that are not much more than traditional index alternatives. This is one which is priced right below the end of your traditional s&p 500 index funds. So for those reasons, I think that’s a pretty solid core holding for investors in the US.

In the international arena, I like Schwab Fundamental International Large Company ETF, ticker on that as FNDF. This focuses on developed market stocks outside of the U.S. I think right now, valuations in developed markets outside the U.S. are more attractive than U.S. market valuations. 

This one basically waits for holdings based on fundamental measures of size including sales, retained operating cash flows, and dividends plus share buybacks. This causes it to overweight stocks that are cheap and underweight stocks that are expensive relative to these metrics. When this one rebalances, it increases its exposure to stocks and becomes cheaper against these metrics, relative to their peers.

It trends to positions and stocks and it becomes more expensive. So essentially, it’s a value strategy. But one of the things I really like about it is it’s one of the cheapest international value funds available. It does charge a 32, I’m sorry, 32 basis expense ratio which is a little bit more than what you have to pay for a U.S. value fund but in the International Arena, it’s one of the cheaper options available.

Stig Brodersen  21:44  

Wow, Alex, those were some great tips. And I don’t know if Preston and I should check that out as well. Do you have any idea of the performance over the last 10 years or something like that?

Alex Bryan  21:56  

Actually, these two funds have not been around for 10 years. I believe they were both launched within the last… Well, I know that the Schwab Fundamental International Large Company Fun was just launched, I think, in the last year or so. The Schwab U.S. Dividend Equity ETF has been around for, I think, four years or so. So we don’t have a 10-year track record, but we have the record of their indexes and their index records have been good. But again, I like to discount back tested performance and look at the live track record to the extent possible.

In any case, I think the strategies that these funds pursue are very reasonable. They’re both taking value in buying stocks that are cheap, and historically, that strategy has worked pretty well. The U.S. Dividend Equity Fund also looks for high quality dividend paying stock, stocks that have good profitability. 

These are stocks that tend to be a little bit more mature, a little bit more stable, and can potentially weather market downturns better than most. So I think the strategy is reasonable. The expenses are attractive. Our expense ratio is low. So for those reasons, I would feel comfortable owning both of those. And in fact, I do own one of these funds. It’s full disclosure.

Preston Pysh  23:07  

Fantastic. That’s phenomenal. And so, if you don’t know what basis points are, he was saying it was seven basis points, so if you’re talking a 1% fee for this, it would be a 0.07% fee, whenever you say it’s seven basis points. Just to kind of give you an idea of how low the fees are on these funds that he’s talking about. 

Okay, Alex. I mean, you’re providing us with this fantastic information here. This is awesome. So this is a question that we like to ask all of our guests, what’s the best investing advice you’ve ever received?

Alex Bryan  23:41  

So keep costs low. If you look at the evidence behind the link between expenses that you pay and performance, there’s no clear link. Behind your fees are the less money you keep and the worst year performance it’s going to be. It’s really important to keep costs low–that you can keep more of the money that you earn, that compounds over time, and can give you a long term performance edge. That’s one of the reasons I like Vanguard so much, because they price all of their funds at cost. And I think that gives investors a long term edge. But, it’s very difficult to beat a market cap weighted benchmark after fees so I think it’s really, really important just to keep costs low. I can’t hammer that enough.

Stig Brodersen  24:28  

Great answer, Alex. Continuation of this, another question that we like to ask our guests is, if there’s any good books that they can recommend? Especially because you are an expert in indexes, perhaps you had a good book recommendation about that.

Alex Bryan  24:42  

Absolutely. So the Little Book of Common Sense Investing by John Bogle, I think is one of the best books on index investing. John Bogle is the founder of Vanguard. And again, like I mentioned, Vanguard basically prices all their funds at costs. The mutual fund owners in Vanguard actually own Vanguard itself which is why it’s able to do this. But this book, the Little Book of Common Sense Investing basically explains that active management is a zero sum game. So it’s a loser’s game if you want to try to beat the market because in order for one person to win, someone else has to lose in aggregate, there’s no benefit to that. The only way that you as an individual investor can really win consistently, is by keeping costs low through a low cost index funds. So I think this book does a really good job of walking through that intuition and helping investors understand what some of those benefits are of owning a low cost index one.

Preston Pysh  25:40  

You’re not going to find a better author than Bogle. So for everybody out there, I would definitely second  Alex’s recommendation here with this book. So great recommendation. Hey, Alex, it was really fun having you on the show. We really appreciate you taking time out of your day to talk to our audience and just kind of share all the knowledge because you’re just a wealth of information here. And we just really appreciate you sharing that with our audience.

Alex Bryan  26:06  

Absolutely. Thanks for having me.

Preston Pysh  26:08  

All right. So it’s that time where we’re going to go ahead and answer one of the questions from the people in our audience. And so this question comes from Chris Shaw. And Chris says, I’ve listened to the book on CD, Warren Buffett in the interpretation of financial statements. Then it explains the importance of finding adorable competitive advantages. In the very beginning, it states that you should really know accounting before picking stocks. How much accounting should be considered? A full degree or what? So Stig, what’s your opinion?

Stig Brodersen  26:35  

Well, Chris, it’s really a great question. I think if you want to go into individual stock picks you should be proficient in accounting and how much I’ll just return to. But if you’re more into ETFs as Alex, our guest was, then you probably don’t need to be as proficient in accounting. I think the problem about answering this question is that you cannot just put a value on that. I mean, you’re asking, do you need to have a degree in Accounting? And no, you definitely don’t need to have a degree in Accounting. 

But how much do you need to know? Well, I would say that if you know how to read the income statement, the balance sheet, and the cash flow statement, if you can go through those three statements for a company and understand at least 95% of what’s happening, I think you are probably well off. And then when we’re talking about key ratios, because there are so many investors that are big in key ratios, I’m big on in key ratios as well, but I think it’s really important that you understand how these key ratios are calculated and how they can be manipulated. 

So I think that would probably be my benchmark in terms of the accounting proficiency. So understanding at least 95% of the three big financial statements and then the most common key ratios and how they can be manipulated.

Preston Pysh  28:00  

So I agree with Stig. I’ve got the exact same opinion. I think if you’re investing in individual stock picks and you don’t have a firm grasp on accounting, you’re probably assuming a lot of risk. I guess that’s the best way I could say it. I know for me, personally, my understanding of accounting greatly increased ever since I started my own business and I owned a business.

I was actually creating an income statement, I was creating a balance sheet. I saw how money would flow from one statement to the other statement and how the cash flow statement worked. Whenever I started doing that myself, my understanding of my knowledge of it just went through the roof. And it just started really making a lot of sense for me. And I think for a lot of people, they don’t own their own business. 

And so, whenever they look at an income statement, balance sheet, or cash flow statement, it looks like an alien language to them. They just don’t really understand how it’s all correlated. But it’s like plumbing. The money flows from one statement over to the other statement. You have to understand how that’s linked and what it means as you look at statement to statement. I guess I’m of the opinion that if you don’t understand that fully, and you’re investing in individual stock picks, you’re really assuming a lot of risk by doing that.

Stig Brodersen  29:12  

Yeah. Chris, that was probably an even better answer than what I came up with because it’s really not enough that you know how to read an income statement, for instance. You need to know how that income statement interacts with the balance sheet, and how the balance sheet and checks with the cash flow statements. So yeah, Preston, that was a great answer.

Preston Pysh  29:29  

Thank you, sir. So that’s all we got for today. We’re obviously having fun here. And we really enjoy your questions. So if you guys have any questions, go to asktheinvestors.com and submit your questions there. We really like recorded questions. So record your questions, send those to us. 

We’re going to go ahead and put a free signed copy of our book, the Warren Buffett accounting book in the mail for you, Chris, and we’ll get that to you shortly. So, thanks everybody for listening to us. And we really like to thank our guests for coming on the show today, Alex Bryan. And we’ll see you guys next week. 

Outro  31:55  

Thanks for listening to The Investor’s Podcast. To listen to more shows or access to the tools discussed on the show, be sure to visit www.theinvestorpodcast.com. Submit your questions for requested guest appearance to The Investor’s Podcast by going to www.asktheinvestors.com. If your question is answered during the show, you will receive a free autographed copy of the Warren Buffett Accounting Book. 

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