Larry Swedroe

How You Interpret the Data Makes All the Difference

Business Week is a highly regarded publication. Unfortunately, while its reporting of the business news is excellent, the value of its investment advice is often wrongheaded. The reason is that their objective is to sell magazines and gain advertising revenue.

Their interests are simply not aligned with those of their readers. What sells magazines and ads is the hype of active management. Passive management is not only boring, but once you have told your readers to buy and hold a globally diversified portfolio of passive asset class or index funds, what is left to say? You can't keep repeating the same story every week.

The preceding explains why despite the superior returns generated by passively managed funds, financial publications are dominated by forecasts and stock selections from so-called gurus and the latest hot fund managers. The following two quotations are good examples. The first is from the August 1995 edition of Money magazine. "Bogle (of the Vanguard group of funds, the largest provider of retail index funds) wins: index funds should be the core of most portfolios today." The headline for the cover story read: "The New Way to Make Money in Funds." The second is from the February 1996 edition of Worth magazine. "The index fund is a truly awesome invention. A cheap S & P 500 or a Wilshire 5000 Index fund ought to constitute at least half of your portfolio."

Despite these comments, for the reasons mentioned previously, the publications will not give passive management their wholehearted endorsements. Instead they print stories with such headlines as "Sell Stocks Now," or "Ten Stocks to Buy Now."

Returning to Business Week, one of its regular columns is called "Inside Wall Street," and consists of the stock selections of columnist Gene Marcial. The July 24, 2000 issue contained an analysis of his 1999 stock picks. The article concluded that Marcial's stock-picking results were "sensational." They came to this conclusion by showing that Marcial's picks trounced both the DJIA and the S & P 500 indices, while they only slightly trailed the Nasdaq.

Business Week measured the price performance of each stock recommended in Marcial's column during 1999 and compared their price performance against the S&P 500, DJIA, Russell 2000 and Nasdaq benchmarks. Price performance was measured against these indexes one day after the column was printed as well as 1 month, 3 months and 6 months after publication of the stock tips.

It is worth noting that Marcial's picks were up an average 8.8% the day after they appeared in print, compared to an average daily increase of 0 .3% in the S&P 500 Index. Unfortunately investors couldn't buy at the previous days close. Also, unfortunately for investors, studies have shown that when new information is known about a stock, virtually the entire price move occurs in the very first trade. Thus investors likely paid about 9% more for Marcial's picks than the previous close, clearly reducing the value of his picks for those investors that attempted to capitalize on Marcial's skills.

Larry Putnam, a contributing writer for the Web site indexfunds.com, took a closer look at Business Week's claim that stock-picker Marcial "trounced" most indexes and slightly trailed the Nasdaq index in 1999. When analyzing mutual funds or stock picks it is important to make sure you are making apples-to-apples comparisons, something Business Week failed to do (thus providing misleading information). Putnam compared the price performance of Marcial's 155 stock picks to their appropriate benchmarks. Here is a summary of what he found:

85 (or 55%) of Marcial's 155 picks traded on the Nasdaq and AMEX. These are typically smaller-cap and technology-related stocks.

70 picks (45%) traded on the NYSE. These are more typically large-cap growth stocks.

When you compare Marcial's picks with a portfolio that is weighted 55% NASDQ Index and 45% S & P 500 Index, his 155 picks should have increased in price an average of 25.5% for the six month period.

Marcial's picks were up 25.9%. When compared to the predicted 25.5% increase, the 25.9% reported increase for Marcial's stock selections no longer look so "sensational."

In addition, Marcial's returns do not take into consideration the fact that investors were highly unlikely to have been able to take advantage of the 9% first day price rise. They also ignore trading costs (bid/offer spreads) and commissions. This is particularly important when you consider that nearly half of Marcial's picks were priced under $15, and about one third were priced below $10. Stocks with such low prices are typically very small-cap stocks. These small-cap stocks carry much greater trading costs than do large-caps. For example, the bid/offer spread (an estimate of trading costs) for the largest 10% of stocks is just 0.65%. However, for the smallest 10% of stocks it is almost seven times as great at 4.3%. And, then you have to add in commissions (buy and sell) as well.

Once you subtract all estimated trading costs, Marcial's supposedly impressive returns no longer look so hot. In fact, using any reasonable estimate of the costs of implementing a "Marcial" strategy would have produced returns that were substantially below an appropriate benchmark. One other thing to consider is that this analysis ignored the potential large tax implications of such an active stock picking strategy. Putnam's work points out how easily investors can be misled by misleading information.

Investors need to carefully examine all claims of superior performance to ensure that they are both comparing apples-to-apples and that trading costs (or estimated trading costs) are included in comparisons of returns. Remember that a strategy must be implementable to be of any value.

Larry Swedroe is the author of "The Only Guide To A Winning Investment Strategy You Will Ever Need." He is also the Director of Research for and a Principal of Buckingham Asset Management, Inc. in St. Louis, Missouri. However, his opinions and comments expressed within this column are his own, and may not accurately reflect those of Buckingham Asset Management.