ITA Wealth Management

Photograph: Captain of submarine, Atlantis. Cayman Islands.

In the January/February 1991 issue of The Financial Analysts’ Journal, William F. Sharpe wrote his now famous article, “The Arithmetic of Active Management.” This is the article that proves it is impossible for the average active manager to outperform the average passively managed dollar, net of costs. Do note the word “average.” Over the next few days I want to concentrate on this article, as it is at the heart of why we are building the AA-Mosaic Portfolio as we are.

Dr. Sharpe begins his article with four quotes, the first two taken from the September 3, 1990 issue of Forbes magazine.

• “Today’s fad is index funds that track the Standard and Poor’s 500. True, the average soundly beat most funds over the past decade. But is this an eternal truth or a transitory one?”
• “In small stocks, especially, you’re probably better off with an active manager than buying the market.”
• “The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets.”
• “Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle.”

Quoting Sharpe, “Statements such as these are made with alarming frequency by investment professionals. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.”

Note: I suspect the word “arithmetic” was chosen for a reason. It implies this is so simple, mathematics is not needed.

Mull over those quotes and ask yourself, do I agree or disagree with them? Depending on your answer, you likely fall into one of two investor classes. You are an active investor in that you subscribe to the idea you can outperform an appropriate benchmark. Or you are inclined to side with the notion you can only do as well as the broad market and you are at heart, a passive investor. There may be a few readers who are Mosaic investors. These are investors who are comfortable selecting a few stocks, but round out the portfolio with index vehicles. ETFs or index funds are used to populate asset classes where the investor has no confidence they can find quality stocks. The Mosaic investor may range from someone who selects many stocks and a few index vehicles, to the investor who relies mainly on ETFs and selects only a few stocks. This latter investor more accurately describes the approach we are using to build the AA-Mosaic Portfolio. For example, we currently hold only one individual stock in the portfolio, Fastenal (FAST).

In later posts we will continue with the Sharpe article.

The small-cap growth ETF, VBK, was sold as that class tends to be a weak performing asset class. Therefore we will not hold that asset class in the AA-Mosaic Portfolio. Any small-cap growth stocks will need to come from the blend ETF, VB.

Next week the plan is to purchase some mid and large-cap core or blend ETFs. This will bring the large and mid-cap core asset classes and the cash back into balance. This would leave only the mid-cap growth asset class out of balance on the high side.

As of 2/29/2008 the AA-Mosaic Portfolio is down an annualized 18.0% while the VTSMX is struggling with a negative 39.5% annualized return. The data is available in the AA-Mosaic.xls spreadsheet. Note these are high negative values as the current market is rocky and the portfolio is only two months old.