- If you don't know who Dave Ramsey is,
he is an American personal finance
radio show host and author.
His radio show runs on more than 500 radio stations.
He also has a YouTube channel
with well over 1 million subscribers.
Dave is reaching a huge audience
not just in the United States, but around the world.
Dave Ramsey's advice on investing is not very good.
The things that Dave Ramsey tells you to do
with your investments are at odds
with both the current academic literature
and the empirical evidence.
I don't doubt that Dave
has helped lots of people get into debt, start saving,
and feel more confident about their money,
which are all good things.
But his advice on investing should be avoided at all costs.
I'm Ben Felix, portfolio manager at PWL Capital.
In this episode of "Common Sense Investing"
I'm going to tell you why I fundamentally disagree
with Dave Ramsey's advice on investing.
(upbeat music)
I see no better way to approach this video
than discussing the many flawed statements
that Dave Ramsey has made about investing.
I wanna be clear that this is in no way commentary
on Dave Ramsey's character.
It seems like he is genuinely dedicated
to helping his audience.
My intention here
is to educate you on the factually incorrect statements
that Dave Ramsey consistently makes about investing
and why those statements
could result in bad investment outcomes for you.
Dave Ramsey promotes the use of
actively managed mutual funds.
He does this on the basis
that strong returns are more important than fees.
According to Dave, you should worry less about fees
and more about returns.
- Here's the thing, listen to this.
If your expenses are up 1% higher average
over a 10-year period of time,
but you make 4% more rate of return, you came out.
(laughing) - [Man] I can do that,
I can do that.
- That's why return is your primary measure of which you...
Of how you pick a fund.
That's your primary measure.
The last thing I look at is expenses,
and very seldom do I find expenses being the deal breaker.
And that's the reality.
- This is true, assuming that you can find a fund
that will have strong future returns.
The problem is that contrary
to what Dave Ramsey will tell you,
a fund with strong past returns is no more likely
to have strong future returns.
Let's talk about the real reality.
In a 1991 paper titled
"The Arithmetic of Active Management,"
Nobel Laureate William Sharpe explained,
"If active and passive management styles
are defined in sensible ways, it must be the case that,
one, before costs the return on the average
actively managed dollar will equal
the return on the average possibly managed dollar.
And two, after costs,
the return on the average actively managed dollar
will be less than the return
on the average passively managed dollar."
Basically due to the higher average costs,
active funds on average must underperform
passive funds like index funds.
Morningstar, an investment research company,
has repeatedly studied the usefulness of fees
as a predictor of future performance.
They have always found the same result.
On average, funds with lower fees have better performance.
In a 2010 paper on this topic,
Russell Kinnel, Morningstar's director of research
wrote the following.
"If there's anything in the whole world of mutual funds
that you can take to the bank,
it's that expense ratios help you make a better decision.
In every single time period and a data point tested,
low cost funds beat high cost funds.
Expense ratios are strong predictors of performance.
In every asset class over every time period,
the cheapest quintile produced higher total returns
than the most expensive quintile."
In a followup to this report in 2016,
after rerunning the data on fund returns,
Kinnel wrote,
"The expense ratio is the most proven predictor
of future fund returns.
I find that it is a dependable predictor
when we run the data.
That's also what academics fund companies
and of course, Jack Bogle find when they run the data."
Vanguard has done similar analysis with similar results.
In their 2010 paper,
"Luck Versus Skill and Mutual Fund Returns,"
Eugene Fama and Ken French point out,
"The aggregate portfolio of actively managed
U.S equity mutual funds is close to the market portfolio
but the high costs of active management
show up intact as lower returns to investors."
There is no question that fees are important
despite what Dave says.
In fact, on average,
they are one of the most important factors
in choosing an investment.
But Dave Ramsey does not want you to pick average funds.
- And my mutual fund groupings have beat the market.
You just pick mutual funds that have outperformed the S&P
it's really not rocket science.
Not all of them have outperformed the S&P.
A lot of them haven't, over half haven't,
but don't pick one that didn't, you would be better.
That's all you're doing when you're picking a mutual fund,
did it beat the market?
If it didn't beat the market,
then don't pick that mutual fund.
That's not rocket science that horse hadn't won a race.
- On average, shouldn't matter
if you pick above average funds, that seems easy enough.
If you pick funds that have beaten the index,
maybe the data don't apply to you.
It's not rocket surgery, as Dave might say,
as with many of Dave's claims,
this one does not stand up to the data.
Let's start with the SPIVA Persistence Score card.
A report prepared by S&P each year,
which takes the set of funds
with the best five-year track records
and then watches them for the next five years.
If as Dave says, it is as easy as picking funds
with good past performance,
then we would expect good funds over one time period
to continue to be good funds in a future time period.
The Persistence Score card takes the top quartile funds
for the period ending March, 2015
and ranks them through March, 2019
to see how many of those top quartile funds
remain the top quartile for the full five-year period.
The results are fascinating.
0.7% of the top quartile funds remain the top quartile.
That is four of the starting 569 top quartile funds
that remained the top quartile over five years.
It would appear based on this
that picking a fund that beat its benchmark in the past,
does not help in finding a fund that will continue
to do well in the future.
The conclusion that we might start to draw here,
is that strong past fund returns
might just be due to luck as opposed to manager's skill.
In the previously mentioned paper by Fama and French,
they examined this exact issue.
Do funds that succeed do well because the manager was lucky
or because they were skilled?
They found that few funds have enough skill to cover costs.
Similarly, in a 1997 study titled,
"On Persistence in Mutual Fund Performance,"
Mark Carhart found that the results do not support
the existence of skilled
or informed mutual fund portfolio managers.
In both cases, the research was examining
the ability of managers to add value to fund returns
in excess of the returns that a passive index investor
could have gotten by passively maintaining exposure
to the same types of stocks.
For example, if an active manager
had persistent long-term out-performance
relative to the S&P 500,
because 50% of their portfolio
was in small cap value stocks,
then they weren't skilled or lucky.
They were just taking more risk.
This is highly relevant to the end investor
because instead of paying 2% for an active manager,
you could have owned a small cap value index fund
for 0.2% or less.
I don't know exactly
what is in Dave's portfolio mutual funds,
but it would be interesting to look under the hood.
- The mutual funds I'm personally invested in,
the four types I talk about over the last 40 years
have averaged 13.04%.
You can't get 12% on your money.
I know, I got 13%, okay?
The S&P during that time averaged 11.81%
which is real close to 12%, stupid people.
30 year, my investments have averaged 11.3%,
the S&P has averaged 10.89%.
So I've outperformed the S&P on the 30 and on the 40,
outperformed the S&P on the 20,
on the 10-year outperformed the S&P.
- Sorry Dave, but U.S small cap value stocks
have beaten the pants off of the S&P 500
and your funds for the past 30 and 40 year periods.
For the 40 year period ending April, 2018,
when that video was published,
U.S small cap value stocks returned 15.89% annualized.
And for the 30-year period, they returned 13.95%.
Index funds in their current easily accessible form
were not accessible 40 years ago.
But today it is very easy for any investor to seek
higher expected returns
in a way that is evidence-based
as opposed to anti-evidence.
Okay, so fees matter a lot
and flashing the market beating performance
of actively managed mutual funds
tells you very little about how those funds
will do in the future.
More than likely,
if an active fund has beaten the market
over the longterm,
it is done so by maintaining consistent exposure to stocks
with no one characteristics
that explain differences in stock returns
like smaller companies and cheaper companies,
which you can do using small cap and value index funds
at a much lower cost than a traditional active manager.
One of the things that Dave says to argue
against these realities
is that if you look at the actual data
on mutual fund performance,
about 40% to 50% of active funds beat the market
over long periods of time.
So you have a pretty good chance of picking a winning fund.
The problem with this information
and the problem with mutual fund data in general,
is that it is skewed by survivorship bias.
Funds that do well, whether by luck or skill stay alive.
Funds that do poorly close down.
When you look at the available universe of funds
at any given time,
you were only seeing the ones that have survived.
The Standard and Poor's SPIVA scorecard
looks at the survivorship bias corrected performance
of mutual funds.
For U.S mutual funds going back 15 years,
which is as far back as this report goes,
we see that 89% of actively managed funds
have failed to beat their benchmark index,
when we correct for survivorship bias.
Ouch! Survivorship bias is a big deal
and ignoring it leads to extremely misleading results.
Only 43% of US mutual funds survived
for that full 15-year period.
It should not come as a surprise
that when you look at the funds currently in existence
at any point in time, they will all look pretty good.
However, this is misleading.
Correcting for survivorship bias reveals the ugly
but expected truth
that active mutual funds rarely beat the index
over long periods of time.
I am all for financial education and empowerment.
And I think that on a lot of topics,
Dave Ramsey's advice can be very useful.
Unfortunately, Dave's advice on investing
could not be further off the mark.
There are no good arguments,
other than wishful thinking,
that investing in high fee actively managed mutual funds
regardless of their past performance,
will give you a better expected outcome.
In fact, the evidence suggests the exact opposite.
Low cost total market index funds
are the best investment for most people.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is "Common Sense Investing."
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please share it with someone
who you think could benefit from the information.
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