By: Frank Armstrong
Conviction of a criminal offense requires proof beyond a reasonable doubt. That’s a very high standard indeed. But, the case against active management meets that burden of proof. Plainly put, if you want an investment strategy to reduce returns, increase risk, cost and taxes, hire a manager to try to beat the market. Ladies and gentlemen of the jury, the evidence is overwhelming.
In building my case, let’s start by examining the universe of public data on mutual fund performance. Almost everything you could want to know about mutual funds and their performance has been tabulated by Standard and Poor’s, Morningstar, The Center for Research on Security Prices (CRSP) or similar organizations. It’s all widely available. It’s not necessary to torture the databases in order to obtain reliable, actionable, timely intelligence.
The active manager claims that through either market timing or individual security selection he can add value to your investment portfolio in excess of his costs. If active management were a viable investment strategy, it should reliably outperform a purely passive index. That’s the acid test. After all, why pay a manager when you could economically purchase an entire market basket and get better performance?
Yet the record will prove that active management is a catastrophic failure to achieve that goal. Here’s the data from the annual Standard and Poor’s Index vs Active Funds Scorecard on the number of active managers that fail to match their appropriate benchmark in equities:
For active managers it doesn’t get much worse than that. The lone exception is the international small fund manager category during the period. As indicated in the graph, 26% of this group failed to beat the respective benchmark, which is the S&P Developed ex-US Small Cap index.
More detailed analysis reveals that many managers in the international small category had significant holdings in emerging market stocks, which is a different asset class that had stronger performance during the period. The large percentage of out-performance among international small managers may result from a large portion of them holding a different asset class and being compared to the wrong benchmark.
An even more devastating pattern emerges when we look at fixed income. Several show failure rates in excess of 90%.
I can hear the skeptics now. What about the “good” managers that beat the averages? Let’s stipulate that somebody always beats the averages, just like somebody always wins the lottery. But your chances of picking that manager in advance are dismally small. What would you use to distinguish skill and cunning? Past performance? Please! While it’s possible to run up quite a string, that chances of a star manager repeating are somewhat less than average.
There are two things we know for certain about past performance: First, past performance is no guarantee of future performance. That’s about the only thing Wall Street will tell you that you can take to the bank. And they are forced to tell you that. Second, past performance attracts lots of new money. The longer the string of performance lasts, the more money pours into the fund. And then the string runs out leaving the new arrivals to wonder what happened. How could this hero have lost his mojo? Perhaps he never had any in the first place. The record if full of stars that imploded costing investors billions as their funds got sucked into a black hole. I cite Bill Miller as one of the latest wonder boys banished in ignominy.
Peter Lynch is one star that bailed out at the top of his fame. He grew Fidelity’s Magellan Fund from obscurity to the largest mutual fund on the planet. After his retirement he stayed on at Fidelity to nurture and mentor Fidelity’s aspiring fund managers. If there was anybody who could pick a good fund manager it would be Peter Lynch. Yet the abysmal performance of Magellan Fund in the interim is mute testimony to the impossibility of picking winners in advance.
Across the entire universe of funds, active management costs investors from one to two percent compounded per year. We should expect under-performance. It would be bad enough if the opportunity cost was a steady one to two percent per year. But, it gets worse. Active management adds another layer of risk on top of market risk. There is a wide variation around the index return which at the tail can be devastating. Imagine if your retirement were invested in one of the funds at the far right of the distribution.
The distribution above is actually far worse than it looks. The funds listed were the survivors and Morningstar doesn’t include the several hundred funds that failed along the way. These failed funds normally get merged into other funds with better records making their performance magically disappear from the results. Survivor bias badly skews the illustration.
I grew up believing that managers added value, so it took a lot of evidence to change my view. But, literally hundreds of studies indicate it’s not so. Not one credible shred of evidence supports active managers. I believe that the case has been proved beyond a shadow of a doubt, and even higher standard than necessary in a criminal case.
The evidence is available to anyone that cares to examine it. And the data speaks for itself. I rest my case.