The futility of active management

What further evidence do you need of the futility of active management than the demise of Wall Street in 2008? If the Wall Street gurus were really so smart, don’t you think they could have done better than having none of the old Wall Street firms still in existence in classic Wall Street organizations by the end of 2008?

Look at your own experience. How successful have your mutual funds or money managers been over the long term? How many times have you bought stock in a great company and lost money? I am sure that you, like me, have been disappointed by results that range from uneven to disastrous.

You bought a great mutual fund with a 10-year track record, only to have the manager tank the year you bought it. Maybe you think, as I used to, that the problem was that you had just never found the right Really Smart Guys to deliver the investment return you needed. A track record for an active manager, however, is meaningless. And yet this is used by the media and most financial magazines and rating services as the key indicator of the future success of any and every manager.

PERSONAL EXPERIENCE

Here is the answer to that conundrum of trying to find the right Really Smart Guys: Active management does not work.

I am about to use a couple of academic studies, plus some information on the cost of active management, to reinforce an argument that should be compelling based on your personal experience.

First, let me clarify what I mean by active management. Active management is an approach based on stock picking and market timing. Active managers choose to buy a stock based on judgment, opinion, research and stock analysis. Passive management is a buy-and-hold strategy that seeks to provide broad asset class or market exposure and market-consistent returns. It does not include or exclude a stock based on research, judgment or opinion.

Before I start to give you the statistical evidence, probably the first place you are going to go for information is your own experience. Have you ever been invested with any kind of money manager — whether a mutual fund or separate account or a regular brokerage account — and seen your results beat any kind of benchmark, consistently, over the years?

Consider: From 1994 through 2008, the average large-cap mutual fund that was in existence for the full 15-year period (some 400 funds) posted an annualized return of 5.61%, compared with 6.46% for the S&P 500.

And because some people claim that active managers are more valuable under the circumstances of a bear market than when the markets are trending up, Standard & Poor’s looked at the percentage of mutual funds that failed to outperform their benchmarks between 2004 and 2008 during the last bear market: 66.2% of all domestic funds, 71.9% of all large-cap funds, 79.1% of all mid-cap funds and 85.5% of all small-cap funds.

These funds that were outperformed by a benchmark pay their managers millions of dollars in fees and yet they fail to provide you, the investor, with a consistent market return. As we discuss later, you would have been far better off buying an index fund. So you might ask, why not just buy the ones that did perform well over the past 15 years? Because track record is meaningless! There is no statistical probability that the winners for the past one, five, 10, or 15 years will be the winners in the future. That’s why on the prospectus, in bold print, it states: “Past performance is no guarantee of future results.” The problem is that so many advisers and investors refuse to believe this.

We are all looking for the next Warren Buffett. (Please note that there is only one Warren Buffett, not even a half-dozen great investors.) Sure, someone always gets it right for some period of time, but everyone inevitably fails — just like Wall Street.

LEGG MASON’S MILLER

Did you read about the legendary Bill Miller’s results in 2008? Bill Miller’s Legg Mason Value Trust had outperformed the broad market (and the S&P 500) every year from 1991 to 2005, something no other manager had been able to do. But thanks to his buys of Wachovia LLC, American Insurance Group Inc., The Bear Stearns Cos. Inc. and Freddie Mac, his fund lost 58% in 2008, making his fund the worst performing in its class in the one-, three-, five- and 10-year periods, according to Morningstar Inc.

Everybody has a bad year now and then, right? And I am not trying to pick on Bill Miller. What I am saying is that it is impossible to outperform the market. The investors in Bill Miller’s fund were doing much better than the market, and now they are doing worse. Furthermore, Forbes magazine calculates that investors paid Miller and his management team $2 billion to destroy wealth.

The best any investor can hope to achieve over time is the market rate of return.

If you use active managers, the best you can hope to achieve is the market rate of return minus the fees you pay those managers. We hope these managers are out there, but we will not know who they are until they have managed money for a very long time. So we spend our time futilely looking for the next Really Smart Guy, we spend lots of money on fees and commissions, our portfolios perform poorly, and we are surprised.

Showing this comparative data on mutual funds is one of the most powerful tools I have for demonstrating the ineffectiveness of active management, but this is not the only place you can see this kind of information. I have shown it to clients for years. The fact that I have used updated data for so long demonstrates the evergreen argument. By that I mean that year after year, I update the data for the most recent year, and while the data change, the truth remains the same — that active management does not work.

What I was beginning to realize about the failure of active managers in the mid-1990s was not news to the academic world, where a large number of studies have shown that it is pretty much impossible to beat the market on a consistent basis, although I have to say that I do not need a study to confirm what I myself have learned over the years. But in addition to the present-day evidence I can offer, here is the evidence of a few of those studies going back many years.

Gene Fama, one of the key players in the development of modern portfolio theory, relied on a study done in 1969 by Michael Jensen, covering the performance of 115 mutual funds from 1955 to 1964. The results showed that the portfolios of most investors who held mutual funds for 10 years would have been worth 15% less than if they had invested in a broadly diversified portfolio of common stocks with similar risk.

In Mr. Jensen’s study, only 26 out of 115 funds performed better than the market.

In 1975, Charles Ellis published one of the seminal articles in the study of modern finance. In “The Loser’s Game,” he said, “The investment management business (it should be a profession, but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.” He then proceeded to provide an analysis of the cost structure of money management that is actually still reasonable today, saying that a manager’s fees and transaction costs are about 200 basis points annually.

From a study published in 2006 in the Journal of Financial Planning: “During the study period, most actively managed large- and mid-cap mutual funds underperformed their respective passive strategies. While every period under review had mutual funds that outperformed the passive strategy, few funds did so consistently.”

STUDY CONCLUSIONS

Mr. Fama and Mr. French have recently been working on a study about luck versus skill. This is their conclusion: “The aggregate portfolio of 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. Bootstrap simulations produce no evidence that any managers have enough skill to cover the costs they impose on investors … We cannot reject the hypothesis that no fund managers have skill that enhances expected returns.”

This is what Zero Alpha Group concludes: “Even though they are paying for brokers to assist them, investors in load-carrying mutual funds end up making significantly worse timing decisions than investors in no-load funds, underperforming their own funds’ reported returns by three times as much as no-load-fund investors.”

I could go on and on with this, but will offer a few concluding thoughts:

In 2008, stock market performance was the worst since 1931. Don’t you think that all that Wall Street talent, all the research departments and the fast computers and analysis, could have softened the blow for investors? Apparently not. Forbes says that the “average active stock fund lost 40.5%, versus a 37% loss for the market-tracking Vanguard S&P 500 Index, according to Morningstar.”

Furthermore, Forbes says, if you look at a longer time frame: “According to Standard & Poor’s, 69% of actively run large-company funds, 76% of funds buying midsize companies and 79% of funds buying small companies underperformed their indexes in the five years through last June.”

Active management does not work.

Excerpted from “Wealth Management in the New Economy” (John Wiley & Sons Inc., 2010). Norbert M. Mindel is co-founder of Forum Financial Management LLC, a wealth management firm.

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