By: Investor Solutions
Whether you’ve been with us for a long time or a short time, you know that our ideology is steeped in the belief, and research confirms this, that passive management yields greater returns over time. You know that active management generally doesn’t outperform the benchmark index; most times it underperforms, especially after fees and taxes. You also know that past performance is no indication of future performance and the worst investment strategy would be to select a fund based on its past performance. It’s a guaranteed losing strategy.
If active managers are so knowledgeable and talented, then why don’t they consistently outperform the market and their peers? With everything that’s gone on in the past five to 10 years, we think it’s a great opportunity to see if anything has changed.
In order to make this a fair comparison, we had to come up with a search criterion, a “filter”, to ensure our comparison was “apples to apples”. We know that certain asset classes outperform others because of the risk associated with them. We needed to make sure all our funds were similar in their asset class purchases so no outperformance could be based on the differential in asset returns, but rather purely on the manager. We also needed the funds to be similar in nature to a specific benchmark (i.e., the S&P 500). We first started with all the mutual funds available within the public universe. We then filtered out everything, but large cap. This allows us to track returns vs. a popular index like the S&P 500. To make our search even more reflective of the index, we further filtered our results by eliminating those funds that invested 10% or more in foreign equities. We also wanted to focus on funds that didn’t stray too far outside their large cap target, so we eliminated any funds that had a meaningful concentration in small or value. We took the five year performance of the funds that fit our criteria as of the end of December 2003.
What we found were 290 funds that fit our search. Out of the 290 we selected the top 20, based on their annualized return, to analyze. Jumping to the present, we found the five year returns as of December 2008 for the same 290 funds, if they were still available, and compared the results to determine consistency in manager performance. Here are the results:
Previous Period Return (Jan. 1999 – Dec. 2003)
Subsequent Period Return (Jan. 2004 – Dec. 2008)
Of the 290 funds in 2003, only 89 managed to beat the S&P 500 before fees and taxes were considered. Only 36 were able to do that as of 2008. Active managers often flip the account quite often without regard to the tax consequences. The capital gains taxes can be devastating. All of these funds had expense ratios much larger than a passive index fund tracking the S&P 500. Some also consisted of hidden fees and large front end loads. Half of the twenty funds contained loads that were up to 5.75%. This means those funds’ returns were negative or barely positive for the period. It also reduces the amount of funds that beat the S&P to a fraction. (Wells Fargo closed their fund because of underperformance and later reopened a new one using the same ticker symbol.)
Looking at these funds’ 2008 rank, most of them dropped off the radar. Calamos went to the bottom half of the list. Legg Mason ranked second to last and five more followed close behind at the bottom of the rankings. Only two funds were able to improve their positions, not by having great performances, but by limiting losses. Chase was able to attain a 1% gain over 2004 to 2008. Although year to date they haven’t done too well. Touchstone was able to climb two spots by only losing .68% between ’04 and ’08, as long as you don’t count their 5.75% front load and 1.25% expense ratio.
Looking at the standard deviation column you see just how risky these funds actually are. In comparison, the standard deviation of the S&P 500 over this period is approximately 17%. The average of these twenty funds is 21.7% with some ranging in the 30s.
This shows you just how unpredictable the performance of active managers really is. A few important lessons can be learned:
- It is impossible to pick which fund is going to be a top performer
- Active management increases rather than reduces investment risk
- Most funds tend to outperform based on mixing asset classes and are not pure large growth or whatever benchmark they compare themselves to. This just means they are taking on more risk to try and boost profits. You’re better off with a diversified portfolio consisting of the right mix of assets. It can reduce your overall risk and increase returns.
- Taxes and fees are a big disadvantage in an active portfolio and are too often not considered. When taken into account, they can drastically alter the performance landscape.